Unwelcome shock

Published in The Gulf, 1 December 2015

Riyadh reacted to a recent downgrade by S&P with heavy criticism of the ratings agency, but S&P is far from being alone in its analysis of the Saudi economy.

It has been impossible to ignore the financial challenges facing the Saudi government this year. Oil has been at or around $50 per barrel since August while the cost of running the generous welfare state requires something closer to $100 per barrel. Analysts have consistently said cutbacks will be needed, and that message has been echoed by senior officials. In late October, oil minister Ali al Naimi said the government was looking at the idea of cutting fuel subsidies.

Even so, the decision by Standard & Poor’s (S&P) to downgrade the kingdom’s credit rating on 30 October from AA- to A+ appears to have come as an unwelcome shock to the government. The ratings agency said it made the change because of the rapid deterioration in the government’s financial position. Lower oil prices has meant the fiscal deficit is likely to jump from 1.5 per cent of GDP last year to 16 per cent this year. S&P warned further downgrades could be made if the government did not make sizeable and sustained cuts in its deficit.

It did not go down well in Riyadh. “We consider S&P’s credit assessment reactionary, driven by fluid market factors rather than changes in the fundamentals of the sovereign,” said the ministry of finance in a statement. “We believe that S&P’s decision was not only rushed, but analytically inconsistent with the idea of ratings being a medium-term tool.”

Saudi Arabia is often sensitive to criticism, but the facts seem straightforward enough. And while the ministry pointed to “the vast difference in approach and credit view demonstrated by the other agencies”, some of those other ratings agencies have also changed their assessment this year. Fitch Ratings, for example, put Saudi Arabia’s rating on negative outlook in August, citing the worsening fiscal position.

“The decision by Standard & Poor’s is hardly surprising in light of the deterioration in the fiscal position this year and lack of a clear agenda to rein in the budget deficit,” says William Jackson, senior economist at London-based Capital Economics.

In the usual run of things, a downgrade would not make much difference to the Saudi government. It has limited debt and sells its bonds to local banks rather than international investors. This year it is issuing around SR100 billion ($26.7 billion) and next year it is expected to issue a further SR190 billion. “There is plenty of scope for local banks to absorb that,” says an economist at one Saudi bank.

However, the government appears to be looking further afield. Media reports in November indicated that officials in Riyadh are planning to tap the international bond market next year. In those circumstances, any downgrades mean the cost of issuing debt will rise for the government.

Saudi bonds will still look a safe bet for most investors, notwithstanding the recent downgrade and the risk of more to come. Public finances are in a relatively healthy position. The government ended last year with gross debts equivalent to just 1.6 of GDP, according to the International Monetary Fund (IMF). And as well as issuing debt it can also cover its budget shortfall by using the vast savings it accumulated during the recent oil boom.

Nonetheless, the downgrade throws into sharp relief the longer-term issues facing the economy and highlights the need to pursue fiscal reforms and economic diversification. Until it manages to do so, the government’s financial position will be at the mercy of international oil prices, which have stayed stubbornly low in the second half of this year.

Usually, low oil prices provide a spur to global growth, prompting more demand and a reason for oil prices to then rise again. However, that normal pattern is not happening at the moment. “We thought the fall in commodity prices - particularly oil - would create stronger demand and, as we approach 2016, that we would see more growth, but that doesn’t seem to be coming through,” says Keith Wade, chief economist at Schoders, a UK asset manager. “The world economy seems to be stuck with growth around about 2.5 per cent.”

For as long as these factors persist, the pressures on the Saudi economy are not going away. Even if the Saudi government does take the axe to some spending programmes in the forthcoming budget, as many anticipate, it will take time for that to have an effect. The emphasis is expected to be on capital spending cuts but these take time to feed through as commitments made to existing projects cannot always be easily cancelled.

In the longer-term, cuts to subsidies will probably have to be made, as Al Naimi has warned. However, the government is likely to move ahead with such measures with extreme caution, lest it provoke public dissatisfaction and disquiet. “We don’t get the sense that there is an immediate rush to address subsidies in Saudi Arabia,” says Paul Gamble, director of the sovereign group at Fitch Ratings.

And despite the apparent willingness to consider spending cuts in some areas, particularly capital projects, in other areas the reverse is happening. The costs of the ongoing war in Yemen are unknown but likely to be high and even when it ends Riyadh is likely to be pressured to help pay for the reconstruction of the country, given that its bombs have caused so much destruction.

At some point oil prices are likely to recover, but no-one expects them to leap back to the three-figure level any time soon. S&P is predicting an average oil price of $63 per barrel from 2015 to 2018, well below the price needed to balance the government’s books based on its current spending patterns. That means the structure of Saudi Arabia’s economy will continue to pose a challenge unless some fundamental changes are made.

A few days after the S&P downgrade Christine Lagarde, managing director of the IMF, paid a visit to Riyadh where she held talks with King Salman, the finance minister Ibrahim al Assaf and others. Her advice echoed many of the points made by S&P.

“Prudent fiscal management has helped build-up substantial policy buffers over the past decade, but reforms that would put the large fiscal deficit on a firm downward path are needed,” she said, in a statement issued at the end of the trip. “The decline in oil prices has increased the importance of reforms.”

Riyadh can expect the outside world to keep delivering the same message for some time yet, whether it likes it or not.