Can the Saudi Arabian FX peg persist in a world of diminished OPEC relevance?

In the 6-months since we first undertook a detailed analysis of the Saudi Arabian economy, little has happened to change our conviction that the 30-year old USD/SAR peg is inconsistent with a world where the price of oil is increasingly inelastic to the policies of OPEC. Despite the recent pick-up in oil prices, Saudi Arabia is still faced with the challenge of a widening current account deficit and declining FX reserves, while the need to limit the hit to GDP of lower oil revenues has resulted in a 21.6% of GDP budget deficit. Some optimism has been generated by the government’s plan to fund a Sovereign Wealth Fund by selling part of Saudi Aramco. However, establishing a SWF aimed at generating non-oil income may in part be inconsistent with the SAR-peg in the current climate: the much mooted sale of a 5% stake in Aramco over the next 18 months would likely generate funds that are equivalent to the decline in Saudi FX reserves over the past 12 months. Long-USD/SAR positions in the FX forwards continue to be attractive, as a larger risk premium needs to be attached to the SAR-peg, while the carry cost of such a position continues to represent a small price for adding convexity to an investor’s portfolio

The reduced importance of OPEC lessens the relevance of the SAR-peg

Recent developments have done little to shake our concern that the 30-year-old Saudi Riyal peg to the USD is vulnerable in a global economy where oil prices have moved structurally lower and where OPEC has diminished pricing power. The on-going development of fresh extraction technologies is creating a supply shock, which has sharply increased the actual and potential output from non-OPEC oil producers. Moreover, the breakeven cost of these new technologies, most notably the US fracking industry, continues to decline, which is adding to the persistence of the supply shock. While Saudi Arabia’s decision some years ago to switch policy from supporting the price of oil to maintaining it’s market share was a core driver of the decline in crude prices from above USD100 p.b., in many respects the government was accepting a changed reality in the market. With the price of oil being less elastic to OPEC supply – and with OPEC hardly a homogenous adherent to supply quotas at the best of times – the scale of Saudi output reduction that would be required to drive prices substantially higher and to hold them there would be ruinous to the domestic economy. Hence, as we transition to world of disruptive technology in the oil industry and where OPEC has reduced relevance, the macro-economic backdrop for the Saudi economy is one of a substantially lower oil price than was envisioned only a few years ago, even with Brent Crude having recovered back towards USD50 p.b. in recent months.

 

Lower oil prices have had a deleterious effect of Saudi’s external accounts

The impact of lower oil prices on the Saudi economy continues on the path we outlined in our earlier note. (The Saudi Arabian currency peg and the price of convexity.) Weak oil prices continue to have a deleterious effect on Saudi Arabia’s external liquidity position. The current account balance has swing from a surplus of 25.5% of GDP in the heady days (for oil exporters) of 2008, to an 18.2% of GDP surplus in 2013 to a deficit of -3.5% last year. In USD terms, last year’s USD41.5bn current deficit compares to an USD135bn surplus in 2013. The IMF expects the current account deficit to widen to -10.2% of GDP in 2016.

Chart 1. Saudi Arabia’s current account balance

S1

Source: FRED

 

FX reserves continue to slide

Such a large swing in the current account balance continues to create a balance of payments deficit which the Saudi central bank (SAMA) is required to offset by depleting it’s FX reserves in order to maintain the SAR-peg, In June, SAMA’s FX reserves dropped to USD570bn, a 51 month low and which represents a USD101bn Y/Y decline.

 

Domestic liquidity conditions are tightening

While SAMA has been increasing the sophistication of it’s monetary policy framework in recent years, it is clearly unable to sterilise the impact of such a notable withdrawal of liquidity from the economy. Money supply growth has started to contact while domestic interest rates are rising, with the 13-week SAMA bill yield (1.43%) up from 0.81% and end-2015 and from 0.39% a year ago.

Chart 2. Liquidity growth has started to contact

S2

Source: FRED

Fiscal policy is smoothing the hit to GDP growth – at a vary large price

The tightening of monetary conditions allied to lower oil revenues are acting to slow economic growth, with the IMF expecting real GDP growth to drop to 1.2% in 2016 from 3.4% last year. However, considering the scale of the deterioration in Saudi Arabia’s external accounts, this drop in economic growth may appear milder than many would have assumed. This reflects the critical role that fiscal policy plays in stabilising the Saudi economy in the face if wild swings in oil prices. During periods of high oil prices, the government runs a large fiscal surplus to try and withdraw demand from the economy and limit over-heating risks, while weak oil prices sees the government tolerate offsetting budget deficits. Hence, the government’s fiscal accounts are feeling the brunt of lower oil prices. In 2008 the government ran a budget surplus of 29.8% of GDP and as recently at 2012 the surplus remained double-digit, at 12% of GDP. However, last year the deficit ballooned to 21.6% of GDP. As a consequence of the budget deficit, government debt is set to rise sharply higher. Domestic debt measured just 5.8% of GDP last year, but within 5-years this could top 100%.

Chart 3. A dramatic fiscal deterioration is helping to smooth the hit to GDP

S3

Source: FRED

Saudi Arabia’s demographic and unemployment situation limits the capacity for fiscal austerity

This does not appear to be a stable equilibrium. Absent the positive external shock of a surge in oil prices, the outlook is for a continued loss of FX reserves, tighter domestic liquidity conditions and a ballooning budget deficit as the government tries to limit the hit to GDP growth. The government also has a challenge in trying to rein-in the budget deficit via austerity measures since a tighter fiscal policy would increase the sensitivity of real GDP to the decline in oil prices. This is particularly problematic in Saudi Arabia given the country’s demographic and unemployment imperative to generate economic and income growth: around 50% of the Saudi population is aged under 25 and youth unemployment stands at a third.

 

The National Transformation Plan for a post-oil economy

In response to the growing economic challenge facing Saudi Arabia, the government has unveiled a National Transformation Plan aimed at stabilising the country’s macro-economic framework and diversifying the economy away from oil. The scale of the challenge can be seen from the statistic that the government’s non-oil budget deficit stood at 64% of GDP in 2015. The plan contains some fiscal austerity measures (reduced price subsidies, tax increases and imitating a sales tax) but for the political reasons noted above, there are limits to how far the government may be willing to move down this path. Moreover, while the budget deficit is eye-wateringly large, the Saudi economy has and can cope with debt/GDP at over 100%. (Chart 4.) While the budget deficit is an alarming medium-term trend, it is not the immediate spur to a broader SAR peg change that declining FX reserves might be, as we discuss in more detail below.

Chart 4. Saudi Arabian government debt/ GDP is set to return to 100+%

S4

Source: FRED

Aramco sale to fund a SWF – a path out of the current policy dilemma?

More critical components of the plan are to try and diversify Saudi Arabia’s external income stream away from oil. One path to this is to expand the size and scope of the Saudi Public Investment Fund and turn it into one of the world’s largest Sovereign Wealth Funds. It’s assets would be expanded by the sale of state assets, most notably part of Saudi Aramco, the state oil company which has an estimated market worth of around USD2trn. Selling part of Aramco and transferring these funds into a SWF that can invest in a diversified manner could reduce the cyclicality of Saudi revenues. In theory, the Aramco sale could substantially ease the problem of Saudi’s weakened balance of payments position in the face of lower oil prices.

Chart 5. Saudi FX reserves have declined by over USD100bn year-on-year

S5

Source: FRED

 

No. A SWF may be inconsistent with the SAR-peg in the current climate

However, establishing a SWF funding with a partial Aramco sale is not a solution to Saudi Arabia’s current problem. Quite simply, establishing a SWF might be incompatible with the SAR peg. This is because defending the SAR peg requires a plentiful availability of liquidity foreign assets, which might mean funds being transferred from a SWF to the pool of FX reserves in a manner that negates the government’s ability to build a notable non-oil income stream. As an example, there is an expectation that 5% of Aramco will be sole over the next 12-18 months. That might provide around USD100bn for a SWF. However, that is less than the fall in Saudi FX reserves over the past 12 months. Hence, state asset sales would risk defending the SAR more than building the foundation for a post-oil economy. (There is also the issue that the Saudi government might face political and social issues were it to expand foreign ownership beyond a certain point, since Aramco is inter-twined with the Saudi economy and government, which adopts a system of patronage for the extended royal family.)

 

FX reserves not the budget deficit are Saudi Arabia’s key immediate challenge, and ensure that a peg-break is a non-negligible risk

The most immediate challenge to Saudi Arabia is therefore not the budget deficit but the level of FX reserves. At USD570bn these remain sizable, but continue decline at a rapid pace, and are USD175bn or 23.5% lower than their August 2014 peak. One of the lessons of economic history over the past two decades is that when a fixed exchange rate is inconsistent with a changed domestic and/ or external economic structure, it can result in rapid FX reserve losses and ultimately a disruptive currency break (the Asian financial crisis) or increased domestic economic weakness (the impact of the Euro on non-core Eurozone economies). By contrast, were the SAR to be floating it would address some of the current policy weaknesses in the economy. During periods of weak oil prices, a lower exchange rate would smooth the flow of revenue to the government in local currency terms. A floating currency or at least a dirty float would prevent the current rapid decline in FX reserves, domestic interest rates could fall and liquidity growth improve, while a SWF could be established with less concern about funds needing to be transferred to stabilise the SAR-peg. A weaker SAR would also act as a back-door austerity policy that would improve the external accounts by increasing the SAR cost of imports.

 

The downsides of a peg break would need to be addressed

Of course, a weaker SAR has some notable drawbacks, most clearly the increased cost to imported non-discretionary consumption items, most notable food. Hence, and float would need to be associated with a potential transfer of subsidies towards food prices, which – when combined with broader import compression – could make the economic impact of a SAR float, to use fiscal parlance, progressive relative to current fiscal tightening plans.

 

A long-USD/SAR position has an embedded long convexity component

Economic and policy developments since we first analysed the Saudi Arabian economy have therefore not altered our core conclusion – the need to retain a long USD/SAR position in the FX forwards. This position will benefit from a higher risk premium needing to be attached to the SAR-peg given the growing incompatibility of this FX regime with the changed circumstances of the oil market, while the FX forwards will also be biased to the right by tight domestic liquidity conditions. In addition a long-USD/SAR position has a key convexity element to the position whereby there is the non-negligible risk of an SAR peg break. As we stated in our earlier note, a cost benefit analysis argues strongly against a small FX policy shift: this would fail to improve Saudi Arabia’s current economic challenge while – by breaking a 30-year monetary anchor – individuals and companies might be inclined to increase foreign asset holdings for fear of future FX shifts which could exacerbate the balance of payment position. Either the SAR-peg would need a sizable devaluation or, far more optimally, could see a transition to a floating exchange rate regime.

Chart 6. USD/SAR, 1-year forward and the implied USD appreciation

S6

Source: Bloomberg

 

Pay 1-yr USD/SAR FX forwards on an implied yield of 1% or below

The 1y USD/SAR FX forward has an outright level of 3.787 vs. a spot of 3.75. The implied 1-year USD appreciation of 0.98% appears an extremely cheap price to pay for adding convexity to an investment portfolio. We would recommend paying the 1yr FX forward when the implied yield drops below 1.0%. A partial take-profit can be when the premium rises towards 2.5%, but clearly we would recommend a core strategic long-USD position to be maintained while an investor trades the current range with a part of their position.