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Saudi Arabia – High fiscal deficit unsustainable in the medium term Saudi Arabia (KSA) is one of the largest oil exporters globally, and accounts for more than 10% of the world’s crude oil production. The Kingdom’s fortunes are dependent on oil realization, which contributes c.55% of its GDP and 80% of its revenue. Consequently, a 50% correction in Brent prices (from c.USD100 / BBL level in 2010–14 to c.USD50 / BBL since October 2014) has led to a sharp deterioration in the country’s finances. The KSA has recorded large fiscal deficit – 16% of GDP in 2015 and 17% of GDP in 2016. Successive deficits have pushed the country into a corner, resulting in strict austerity measures, including lowered public spending on wages / subsides and infrastructure. Moreover, the government is also levying new taxes / fees, and planning strategic asset sales (Aramco IPO planned in 2018) to improve its finances.Notwithstanding these austerity measures, the IMF estimates that the KSA will record fiscal deficit (% of GDP) of 10% in 2017, 6% in 2018, 5% in 2019, and 1% in 2020. We estimate that in funding the fiscal shortfall, the KSA’s FX reserve will shrink to USD450bn by 2020 (down 20% from USD567bn in end-2016), while its gross debt / GDP ratio will worsen to 24% in 2020 from 12% in 2016.Fiscal tightening has slowed the KSA economy and hurt corporate earnings and retail spendingThe KSA government is embarking on the path of fiscal consolidation through lower infrastructure spending / public wage bill and imposition of new taxes, which is adversely impacting corporate earnings and retail spending. The IMF has lowered the KSA’s GDP growth forecast for 2017 to 0.4% from 2.0%, and expects weak GDP growth (2% or below) until 2020, compared with an average GDP growth rate of 5% in 2010–15. Tadawul earnings will continue to shrink in the next two years (2017-18), underlining weak corporate performance. Corporate credit growth declined to 1% in 2016 (due to lower capital outlay), while borrowing rates hardened as the government sucked liquidity from the banking system to fund deficits. Altogether, we envision structural weakness in the KSA until the government revives investment.<figure class="editor-figure mceNonEditable"><img class="editor-image img-responsive" src="https://static-prod.smartkarma.com/images/media/000/031/175/original/Exhibit%201...JPG?1502107208" data-smartkarma-image-id="31175"></figure>Expansionary monetary policy needed to help revive KSA’s economy; SAR devaluation is an effective tool for bridging fiscal deficit and boosting government spending The KSA government should engineer its monetary policy to reinvigorate its stalled economy, given limited headroom for boosting investments with large fiscal deficits. Developed economies such as the US, Eurozone, and Japan, have adopted easy monetary policies (QEs) to lift their ailing economies. Given the unique nature of the KSA’s economy (high reliance on oil income driving government spending), SAR devaluation could be an effective monetary policy tool for boosting demand without compromising fiscal balance. To the KSA’s credit, the government earns in hard currency (USD), while most of its expenditure is incurred in local currency (SAR). Ceteris paribus, SAR devaluation would lead to higher revenue realization from the sale of crude oil in SAR terms, thereby minimizing revenue shortfall. With improving fiscal balance, the government can restart investments (i.e., increase money flow) to reignite the economy. Low current account deficits and stable inflation are not impediments for SAR devaluation in the KSA.Our analysis shows that 25-30% SAR devaluation would effectively bridge KSA’s fiscal deficit We sourced Brent price estimates from FactSet for our analysis. We see a gradual increase in Brent price from USD55 / BBL in 2017 to USD65 / BBL by 2020 which looks probable in an oversupplied crude oil market with stable US stockpiles. Under a base case (i.e., 0% SAR devaluation), we estimate the KSA’s fiscal deficit at 10% of GDP in 2017, 9% in 2018, 8% in 2019, and 6% in 2020 (or) fiscal shortfall of USD70bn in 2017, USD66bn in 2018, USD58bn in 2019, and USD48bn in 2020. With higher SAR devaluation, the KSA’s fiscal balance should improve incrementally, as the government books higher oil revenue in SAR terms.<figure class="editor-figure mceNonEditable"><img class="editor-image img-responsive" src="https://static-prod.smartkarma.com/images/media/000/031/176/original/Exhibit%202...JPG?1502107282" data-smartkarma-image-id="31176"></figure>On the contrary, the IMF estimates that the KSA’s fiscal deficit will come down sharply from 10% of GDP in 2017 to only 1% in 2020; however, we take the IMF’s projections with a pinch of salt, given that the agency is factoring in strong rebound in Brent prices to USD70 / BBL in 2019 and USD80 / BBL in 2020, which seems unrealistic in the current market environment.Factors in favor of SAR devaluation<ul><ul><li>Wide gap between the KSA’s 2017 budget breakeven oil price of USD82/BBL and spot Brent (below USD50 / BBL) gives way to fiscal imbalance. The KSA government has budgeted 2017 fiscal deficit of 8% of GDP using average oil price of USD55 / BBL. However, lowering the breakeven oil price implies lower spending, which is equally bad for the economy. <figure class="editor-figure mceNonEditable"><img class="editor-image img-responsive" src="https://static-prod.smartkarma.com/images/media/000/031/171/original/Exhibit%203.JPG?1502105895" data-smartkarma-image-id="31171"></figure></li></ul></ul><ul><li>The KSA’s fiscal imbalance is unlikely to disappear any time soon, as Brent continues to trade below USD50 / BBL and is showing no sign of hardening, despite extension of a crude oil production deal (1.7m bpd) to March 2018. In our opinion, Brent recovering to USD80 / BBL by 2020 is a far-fetched expectation.</li><li>The SAR-USD exchange rate looks overvalued, with widening gap between Brent (proxy for SAR) and dollar index.</li><li>The forward currency market has started to factor in SAR devaluation (albeit, in modest terms) as the SAR is trading above the official peg rate of 3.75 / USD.</li><li>Pressure is building on the KSA to devalue SAR, against a backdrop of 20-100% depreciation in the local currencies of leading crude oil exporters (Russia, Brazil, Nigeria, and Mexico) since January 2015. Separately, Australia (a global metal and mining hub) has seen 40% depreciation in the AUD since January 2013, following a decline in industrial commodity prices.</li></ul>

Saudi Arabia – High fiscal deficit unsustainable in the medium term Saudi Arabia (KSA) is one of the largest oil exporters globally, and accounts for more than 10% of the world’s crude oil production. The Kingdom’s fortunes are dependent on oil realization, which contributes c.55% of its GDP and 80% of its revenue. Consequently, a 50% correction in Brent prices (from c.USD100 / BBL level in 2010–14 to c.USD50 / BBL since October 2014) has led to a sharp deterioration in the country’s finances. The KSA has recorded large fiscal deficit – 16% of GDP in 2015 and 17% of GDP in 2016. Successive deficits have pushed the country into a corner, resulting in strict austerity measures, including lowered public spending on wages / subsides and infrastructure. Moreover, the government is also levying new taxes / fees, and planning strategic asset sales (Aramco IPO planned in 2018) to improve its finances.Notwithstanding these austerity measures, the IMF estimates that the KSA will record fiscal deficit (% of GDP) of 10% in 2017, 6% in 2018, 5% in 2019, and 1% in 2020. We estimate that in funding the fiscal shortfall, the KSA’s FX reserve will shrink to USD450bn by 2020 (down 20% from USD567bn in end-2016), while its gross debt / GDP ratio will worsen to 24% in 2020 from 12% in 2016.Fiscal tightening has slowed the KSA economy and hurt corporate earnings and retail spendingThe KSA government is embarking on the path of fiscal consolidation through lower infrastructure spending / public wage bill and imposition of new taxes, which is adversely impacting corporate earnings and retail spending. The IMF has lowered the KSA’s GDP growth forecast for 2017 to 0.4% from 2.0%, and expects weak GDP growth (2% or below) until 2020, compared with an average GDP growth rate of 5% in 2010–15. Tadawul earnings will continue to shrink in the next two years (2017-18), underlining weak corporate performance. Corporate credit growth declined to 1% in 2016 (due to lower capital outlay), while borrowing rates hardened as the government sucked liquidity from the banking system to fund deficits. Altogether, we envision structural weakness in the KSA until the government revives investment.Expansionary monetary policy needed to help revive KSA’s economy; SAR devaluation is an effective tool for bridging fiscal deficit and boosting government spending The KSA government should engineer its monetary policy to reinvigorate its stalled economy, given limited headroom for boosting investments with large fiscal deficits. Developed economies such as the US, Eurozone, and Japan, have adopted easy monetary policies (QEs) to lift their ailing economies. Given the unique nature of the KSA’s economy (high reliance on oil income driving government spending), SAR devaluation could be an effective monetary policy tool for boosting demand without compromising fiscal balance. To the KSA’s credit, the government earns in hard currency (USD), while most of its expenditure is incurred in local currency (SAR). Ceteris paribus, SAR devaluation would lead to higher revenue realization from the sale of crude oil in SAR terms, thereby minimizing revenue shortfall. With improving fiscal balance, the government can restart investments (i.e., increase money flow) to reignite the economy. Low current account deficits and stable inflation are not impediments for SAR devaluation in the KSA.Our analysis shows that 25-30% SAR devaluation would effectively bridge KSA’s fiscal deficit We sourced Brent price estimates from FactSet for our analysis. We see a gradual increase in Brent price from USD55 / BBL in 2017 to USD65 / BBL by 2020 which looks probable in an oversupplied crude oil market with stable US stockpiles. Under a base case (i.e., 0% SAR devaluation), we estimate the KSA’s fiscal deficit at 10% of GDP in 2017, 9% in 2018, 8% in 2019, and 6% in 2020 (or) fiscal shortfall of USD70bn in 2017, USD66bn in 2018, USD58bn in 2019, and USD48bn in 2020. With higher SAR devaluation, the KSA’s fiscal balance should improve incrementally, as the government books higher oil revenue in SAR terms.On the contrary, the IMF estimates that the KSA’s fiscal deficit will come down sharply from 10% of GDP in 2017 to only 1% in 2020; however, we take the IMF’s projections with a pinch of salt, given that the agency is factoring in strong rebound in Brent prices to USD70 / BBL in 2019 and USD80 / BBL in 2020, which seems unrealistic in the current market environment.Factors in favor of SAR devaluationWide gap between the KSA’s 2017 budget breakeven oil price of USD82/BBL and spot Brent (below USD50 / BBL) gives way to fiscal imbalance. The KSA government has budgeted 2017 fiscal deficit of 8% of GDP using average oil price of USD55 / BBL. However, lowering the breakeven oil price implies lower spending, which is equally bad for the economy. The KSA’s fiscal imbalance is unlikely to disappear any time soon, as Brent continues to trade below USD50 / BBL and is showing no sign of hardening, despite extension of a crude oil production deal (1.7m bpd) to March 2018. In our opinion, Brent recovering to USD80 / BBL by 2020 is a far-fetched expectation.The SAR-USD exchange rate looks overvalued, with widening gap between Brent (proxy for SAR) and dollar index.The forward currency market has started to factor in SAR devaluation (albeit, in modest terms) as the SAR is trading above the official peg rate of 3.75 / USD.Pressure is building on the KSA to devalue SAR, against a backdrop of 20-100% depreciation in the local currencies of leading crude oil exporters (Russia, Brazil, Nigeria, and Mexico) since January 2015. Separately, Australia (a global metal and mining hub) has seen 40% depreciation in the AUD since January 2013, following a decline in industrial commodity prices.

SAR Devaluation – Effective Tool for Reinvigorating KSA's Stalled Economy