The kingdom may have to make some unpalatable choices if the fiscal squeeze continues.
The budget that is due to be published by the government of Saudi Arabia in December will be examined more closely than most. The kingdom’s published fiscal plans are often unrealistic, in terms of both projected oil receipts and how much will be spent, but they do at least give an indication of Riyadh’s policy direction.
This year, with the collapse in oil revenues, the pressure is on for the government to find some big savings. The Washington-based IMF has forecast that Saudi Arabia will run a deficit of about 20 per cent of GDP this year. The December budget, which will outline the spending priorities for the coming year, could provide a useful indication of how the government will deal with the shortfall next year, and what it might do to try and bring it under greater control.
“There has to be a shift in the fiscal stance,” says Simon Williams, chief economist for the Middle East at UK bank HSBC. “The drop in revenue is too deep and looks set to be too long-lasting to ignore.”
There are only a few policy options to deal with the mismatch between revenues and expenditure, and not all of them are available. On the revenue side, oil production is already running close to full capacity and cannot be increased to any great extent. Increasing non-oil revenues through taxation is also unpalatable (see boxout).
That leaves spending cuts as the main option, which is what the government is doing. However, it is being cautious about where the axe falls.
“The adjustment in Saudi Arabia is primarily focused on capital spending,” says Paul Gamble, director of the sovereign group at UK/US-headquartered Fitch Ratings. “Capital spending is very large. It’s more than 10 per cent of GDP. It’s going to take time for capex [capita expenditure] to come down because there are a lot of big multi-year projects going on, but that’s the key area of adjustment.”
Some changes to current expenditure could also be in the pipeline. Spending on public sector wages is being protected and subsidies have, for now at least, not been touched. However, Riyadh has floated the idea of cutting fuel subsidies and there may be a slowdown in the rate of hiring in the public sector. Any such moves will be welcomed by the IMF, which has said that reducing the cost of public sector employment is one of several steps the kingdom needs to consider.
“The drop in oil prices means the government needs to adjust its fiscal policy,” said Tim Callen, head of the IMF’s mission to Saudi Arabia, in a conference call with the media in September, following the fund’s latest annual review of the kingdom’s economy.
“The needed fiscal adjustment, in our view, should include an expansion of non-oil revenues, improved efficiency of public investment, energy price reform and firm control of the public sector’s wage bills.”
Another area of spending that is opaque but almost certain to be growing at an unsustainable rate is military expenditure. This is not included in the published budget and it is not clear how much is being spent.
The International Institute for Strategic Studies (IISS), a London-based think-tank, estimates the Saudi government runs the third-largest military budget in the world, with an outlay of some $81bn in 2014. It is likely to be substantially higher this year as a result of the conflict in Yemen.
“Saudi defence spending has been in the region of 12 per cent of GDP, which is very high by international standards and that was before the Yemen war,” says James Reeve, deputy chief economist of local bank Samba. “There’s no doubt there’s scope for that to be reduced.”
Alongside the spending cuts, the government has been drawing down its savings and raising new debt. The foreign currency reserves held by the Saudi Arabian Monetary Agency (Sama), the kingdom’s central bank, dropped from $746bn in August last year to about $665bn in August this year.
The pace of drawdowns has, however, been slowing in recent months. Jadwa Investment, a Riyadh-based investment bank, says average net withdrawals from government accounts in the first half of the year were running at $13.7bn a month, but by August they had fallen to $1.9bn.
The reason for that slowdown is the bond programme the government launched in June. That month Riyadh issued a SR15bn ($4bn) bond, its first such issue since 2007. Overall, the government is expected to sell SR100bn of bonds to the local market this year, and a further SR190bn next year, according to Samba.
With debt of just 1.6 per cent of GDP, according to the IMF, there is plenty of scope for this to continue. However, US ratings agency Moody’s Investors Service warned in a report issued in October that while Riyadh has room to issue more debt, widening deficits are weighing on the kingdom’s credit profile. Other agencies have made similar warnings.
“We put Saudi Arabia’s AA rating on negative outlook on 24 August, reflecting a pretty significant fiscal deterioration,” says Fitch Ratings’ Gamble. “The buffers are still very large in Saudi Arabia, but they are being eroded.”
Any ratings downgrade would be a symbolic blow to the kingdom, but it would not have any great consequences given Riyadh’s relatively low debt level and the fact that sovereign debts are being sold into the domestic market rather than to international investors. Given that, and the large savings Saudi Arabia has, the overall fiscal picture looks to be manageable for now.
“If you look at the top-line numbers, it’s not such a bad picture, particularly now that they’ve started to issue public debt,” says Reeve. “It pushes out the day of reckoning by quite some way. “In our forecasts, domestic debt is to likely to reach about 30 per cent of GDP by 2020, assuming that roughly half of the fiscal requirement is financed by domestic debt and the rest by draw-downs of net foreign assets. If you think of comparable emerging markets, then 30 per cent of GDP is pretty comfortable.”
The situation the government is facing may be a difficult one, but it is not unprecedented. Saudi Arabia had to deal with large deficits in the 1980s and made swingeing cuts to its spending then.
“During the 1980s, capital spending was cut by 98 per cent from peak to trough and it didn’t return to its previous peak until 2009,” says Jason Tuvey, Middle East economist at UK-based Capital Economics.
The difference this time is that the population is far larger and the cost of the welfare state far greater. Cutting capital expenditure may be relatively straightforward, but if low oil prices persist into the future then the current expenditure bill will also have to be adjusted downwards. That will prove a far greater challenge for the Finance Ministry as it tries to draw up other budgets in the future.
“If weak oil prices persist, Saudi Arabia is facing the worst terms of trade shock in a generation,” says Williams. “Debt is low and the kingdom’s savings are high, and I expect these balance sheet strengths to protect them for now. But the economic problems feel even more engrained than they did in the 1980s, when oil last fell so sharply. Public spending is much higher, the deficits are larger and the population is much bigger and still growing fast.”