Riyadh-Mubasher: When oil prices started dropping in 2014, Saudi Arabia (Aa3 stable) began tapping reserves to sustain government spending amid its oil revenue shortfall. Consequently, total foreign reserve assets dropped from a high of about $746 billion in August 2014 to under $620 billion by the end of 2015, Moody’s said in a recent report.
The authorities began issuing debt in mid-2015 to slow this drain, but defending the currency peg amid speculative threats—which have been on the rise— also requires use of the kingdom’s reserves.
Absent a sustained recovery in oil prices or fiscal consolidation measures that reverse the current trend, the pace asset depletion and the accumulation of debt will place downward pressure on the sovereign’s credit metrics.
Similar low oil price episodes in the past suggest Saudi Arabia is well positioned to fend off pressures on its currency peg. Fiscal surpluses averaging 11% of GDP in the 10 years preceding the current oil price decline enabled the kingdom to pay down its debt to a very low level and build up large buffers in the form of foreign reserves.
“We believe this provides the government with ample space to support its peg in the short term. But the reform effort to diversify the economy and reduce the government’s reliance on oil poses a greater challenge,” the agency said.
Recurrent deficits will erode buffers and lead to a build-up of debt. Absent a sustained recovery in oil prices, the medium term trajectory will depend on the government’s fiscal consolidation efforts.
Fiscal consolidation will hurt growth, though this will be partly offset by higher oil production. One key difference between past episodes of low oil prices and this time around is that the kingdom has opted to increase its oil output to maintain its market share, rather than reach a production cut agreement with its fellow OPEC members. As a result, real GDP growth emerged relatively unscathed at around 3.4% in 2015.
“We expect it to remain positive at around 1.5% this year, whereas during a similar oil price shock in the late 1990’s, the country underwent an economic contraction following oil production cuts,” Moody’s said.
Geopolitical developments are further undermining the kingdom’s fiscal profile and macroeconomic prospects. The state’s escalating proxy wars with Iran are diverting funds away from addressing domestic economic challenges. As it stands, Saudi Arabia's 2016 budget allocates 25% of its spending on military and security spending alone.
The extent to which the kingdom decides to keep these policies up and at what cost to its fiscal and macroeconomic profile will be an important credit consideration.
Pressures on the currency are rising, but history suggests Saudi Arabia will continue to defend its peg Saudi Arabia’s fixed exchange rate, which has been in place since 1986, aims to smooth the effect of oil price swings on the non-oil economy. However, the peg limits the Saudi Arabian Monetary Authority's (SAMA) ability to use monetary policy to respond to shocks.
During times of economic stability, fixed exchange rates are generally associated with lower transaction costs, higher trade openness, lower inflation, and disciplined macroeconomic policies.
However, pegs can be costly to maintain when significant domestic and external imbalances develop, which is happening now in Saudi Arabia. We project fiscal deficits of around 12%-15% of GDP over the next two years compared to a 10% surplus on average in the two years preceding the oil price decline; and a current account deficit of 8%-12% of GDP over the same period compared to a 20% surplus on average in 2012 and 2013.
