Domestic macro costs of Saudi Arabia’s unchanged oil policy are likely to become more acute  and apparent, a report said, highlighting that safeguarding forex reserves will require deep budgetary cuts at current oil prices, rather than the gradual cuts being contemplated.

As these are likely instead to keep imbalances elevated, a sharper adjustment down the line may be necessary, stated the report from Bank of America (BofA) Merrill Lynch Global Research, titled, “GEMs Daily: Saudi Arabia FX reserves; Andean oil exporters; India event risks”.

Sama reaffirms commitment to USD peg

Saudi Arabian Monetary Agency’s Sama’s recent comments reaffirming its commitment to USD peg are in line with our view that verbal intervention is likely to be the first line of defence. Sama could also intervene directly in the forex forward market to lower the points but this type of intervention is likely to remain infrequent and only contemplated if forward points move much higher towards the 1998 speculative highs, in our view.

Recall that Sama carried out unsterilized small-scale interventions in 1993 and 1998 in the forex forward market to reduce speculation, at a time it only held forex reserves of 4-9 per cent of GDP over the period. In our view, fiscal policy is a superior tool to deflate the economy and one that has historically been used in the past.

The root cause of the rapid drawdown in forex reserves in the first half (H1) of 2015 has been an unsustainable fiscal deficit approaching 20 per cent of GDP, partly driven by one-off items.

“A devaluation would need to be very large to make a dent to the twin deficits, in our view. This provides in turn an incentive for policy-makers to hold out, in our view. Although the current account deficit is relatively small, its elasticity to the USD is small,” said Jean-Michel Saliba, Mena economist.

“It would require a large devaluation to bring the current account to balance as non-oil exports are small and oil exports are priced in USD. Furthermore, imports are largely directly or indirectly government-related. The fiscal gains of devaluation also appear overstated.”

How long can Sama forex reserves last?

Safeguarding forex reserves will require deep budgetary cuts at current oil prices, in our view. Our dynamic analysis suggested that current low oil prices could rapidly erode the sovereign creditworthiness, even as the sovereign balance sheet is at its strongest on an historical basis. Despite the rapid drawdown over 1H15, Sama’s forex reserves still stood at c100 per cent of GDP in June, and government deposits at Sama represented $294 billion or 42 per cent of GDP.

Another way to look at sustainability is a static analysis to calculate the number of years required to exhaust government deposits under various oil, spending and financing scenarios.

“Note that these deposits are at the direct disposition of the government to finance spending. IIP data suggests $340 billion in foreign assets were held by entities other than Sama at end-2014 (of which portfolio assets, and currency and deposits represented $200 billion and $88 billion respectively). We interpret the $31 billion increase to $151 billion in other miscellaneous liabilities of Sama in 1H15 as a sign of capital flow repatriation. This may keep them at the indirect disposition of the government in separate arrangements, in our view,” said Saliba.

“Based on the narrow definition of resources available to the government, we think that there is no realistic mix of debt financing and spending cuts at S$30/bbl that can decrease pressure on forex reserves, and pressure on the USD peg would be acute if oil prices were to be sustained at this level. However, at $40/bbl and $50/bbl, debt financing and deep capex cuts (to bring spending 25 per cent lower) can keep government deposits at Sama covering 7 years and 11 years of government spending, respectively.

“Government spending has historically adjusted to oil prices with a variable lag. It is worth recalling that spending was 50 per cent lower in 1988 compared to its 1981 peak as oil prices tumbled, and government spending in 2000 was at the same levels as that of 1980 in nominal terms,” Saliba added.

Official pronouncements suggest nevertheless cuts are likely to be gradual, partly given domestic imperatives and savings. Local press suggests that the government is conducting a review of capital spending plans, and is contemplating budget capex cuts of 10 per cent or more. Wages would not be affected. The impact of capex cuts on the national economy is mitigated by the employment of foreign labour in related sectors, in our view. There appears to be no consideration to lifting fuel subsidies before construction of the public transport system ends.

“As such, we think large budget deficits are still likely to persist over the medium-term, in our view. This is likely to erode buffers and leave questions on the sustainability of the fiscal stance to linger, in our view,” said Saliba.

Privatization comes back to the government’s agenda

The government consideration of a privatization program as per local press is not surprising at the current juncture, in our view. Recall that the privatization program was initially started in 1999 with the creation of the now-dissolved Supreme Economic Council, following the drop in oil prices in 1998. Small-scale privatizations took place in the early 2000s, and 2002 saw large privatization in telecom and postal services.

Selling public sector stakes is one of the non-debt creating financing options for the government that would conserve forex reserves, encourage private sector development and improve services delivery. That being said, given the lack of non-oil taxation, this would only contribute to one-off financing flows alongside savings from a drop in budgetary allocations to the privatized entities, in our view. The 2014 budgetary appropriations for public institutions totalled SR161 billion ($42.9 billion or 14.5 per cent of total budget spending). – TradeArabia News Service