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Ratings On Saudi Arabia Affirmed At 'A-/A-2'; Outlook Stable

Tuesday, November 21, 2017/ Editor -  

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Overview

  • In our view, recent shifts in Saudi Arabia's political power • structures and societal norms, alongside various regional stresses, could increase the risk of policy mistakes that could result in increased domestic and geopolitical tensions.
  • However, we also consider that these structural reforms could empower Saudi citizens and make Saudi Arabia more attractive to investors over the medium term, as the authorities intend.
  • We are therefore affirming our 'A-/A-2' foreign and local currency sovereign ratings on Saudi Arabia.
  • The stable outlook is based on our expectation that the Saudi authorities will take steps to consolidate public finances and maintain government liquid assets close to 100% of GDP over the next two years.

Rating Action
On Nov. 19, 2017, S&P Global Ratings affirmed its 'A-/A-2' unsolicited long- and short-term foreign and local currency sovereign credit ratings on the Kingdom of Saudi Arabia. The outlook is stable.

As a 'sovereign rating' (as defined in EU CRA Regulation 1060/2009 'EU CRA Regulation'), the ratings on the Kingdom of Saudi Arabia are subject to certain
publication restrictions set out in Art 8a of the EU CRA Regulation, including publication in accordance with a pre-established calendar (see 'Calendar Of 2017 EMEA Sovereign, Regional, And Local Government Rating Publication Dates: Midyear Update,' published July 10, 2017, on RatingsDirect). Under the EU CRA Regulation, deviations from the announced calendar are allowed only in limited circumstances and must be accompanied by a detailed explanation of the reasons for the deviation. In this case, the reason for the deviation is the significant changes to the authorities' governing arrangements. The next scheduled rating publication on the sovereign rating of the Kingdom of Saudi Arabia will be on or before April 6, 2018.

Outlook
The stable outlook is based on our expectation that the Saudi authorities will continue to take steps to consolidate public finances and maintain government liquid assets close to 100% of GDP over the next two years. We think the risks emanating from recent shifts in Saudi Arabia's political power structures and societal norms, alongside various regional stresses, are balanced by the possibility that these structural reforms could empower Saudi citizens and make Saudi Arabia more attractive to investors over the medium term.

We could lower our ratings if we observed further deterioration in Saudi Arabia's public finances. Fiscal weakening could entail prolonged double-digit central government deficits as a percentage of GDP, a quicker drawdown of fiscal assets, or an unexpected materialization of contingent liabilities. The ratings could also come under pressure if we observed a significant increase in domestic or regional
political instability as a result of the increasing centralization of power.

We could raise the ratings if Saudi Arabia's economic growth prospects improved markedly beyond our current assumptions.

Rationale
The ratings on Saudi Arabia are supported by its strong external and fiscal stock positions, which we expect it will maintain despite large central government deficits. The ratings are constrained by weak economic growth, limited public sector transparency, and limited monetary policy flexibility.

In our view, recent shifts in Saudi Arabia's power structures and societal norms, alongside various regional stresses, could increase the risk of policy mistakes that could result in increased domestic and geopolitical tensions, deterring investors, or delaying the consolidation of the kingdom's public finances. However, we also consider that these structural reforms could empower Saudi citizens and make Saudi Arabia more attractive to investors over the medium term, as the authorities intend.

Institutional and Economic Profile: Domestic and external political volatility could further dampen economic growth

  • Centralization of decision-making in the political system has • increased, in our view, with limited checks and balances. The succession process is a source of domestic political volatility.
  • We expect real economic growth to be broadly flat in 2017 and to pick up only slowly thereafter as oil production cuts and fiscal consolidation dampen domestic demand.
  • We estimate trend growth in real per capita GDP of about 0.7% during 2011-2020, at the lower end of the range for peers (1%-4%) that display similar levels of development.

In November 2017, security forces arrested around 200 people, including members of the kingdom's political and business elite, at the behest of an anti-corruption commission headed by crown prince Mohammed Bin Salman Al Saud. This marks a significant shift in the traditional power-sharing and consensus-building arrangements of the kingdom. We view these arrests as an attempt to communicate that all levels of the social strata must adhere to the crown prince's vision of a fairer and more productive society, as well as an attempt to sideline potential rivals. The arrests include princes, high-profile businessmen, and sitting and former cabinet officials such as the the head of the National Guard, the Economy and Planning Minister, and the ex-Minister of Finance. The authorities have taken decisive action, but the lack of an independent body to implement such a purge also highlights weaknesses in Saudi Arabia's institutional framework, in our view, and introduces a new level of uncertainty to the investor environment. The authority's actions may result in short-term capital outflows, but could improve medium-term prospects if implemented objectively, and noticeably reduce the level of corruption.

Banks are believed to have frozen hundreds of domestic accounts as part of the crackdown, part of which may eventually be appropriated by the government, supporting the public finances. We expect the authorities to be sensitive to the potential for these actions to weaken the domestic banks.

Power has been further centralized in the person of the crown prince, who now controls all three branches of the security forces (military, internal security
services, and the national guard). In our view, this increases the risk of policy mistakes at a time when Saudi Arabia faces significant regional challenges. These
include: heightened tensions with Iran following Saudi Arabia's interception of a ballistic missile close to the city of Jeddah, believed to have been fired by Iranian-aligned Yemeni rebels; and Saudi Arabia's push to curtail the powers of an Iranian-backed party to Lebanon's governing coalition, Hezbollah. Saudi Arabia's war in Yemen--apart from the related loss of life--also contributes to military and security services being the single largest spending item, at about 30% of total government expenditures. However, we do not expect any of these challenges to significantly impact the domestic economy. Rather, we believe that they add to the government's already heavy policy program, which could weaken its commitment to the fiscal adjustment plans.

Saudi Arabia is also a member of the coalition of Arab states, which has imposed a boycott on Qatar, cutting diplomatic ties as well as trade and transport links with the country on June 5, 2017. In our view, the impact of the boycott may not be confined to within Qatar's borders and is likely worsening Saudi Arabia's trade balance. We expect political tensions within the Gulf Cooperation Council (GCC) countries to persist over the next few years.

In our view, efforts to modernize the economy through an incipient cultural revolution could also risk increasing domestic tensions with more conservative
sections of the population. In October 2017 the crown prince made a speech vowing to return the religiously conservative country to 'moderate Islam,' while the activities of the religious police have been curbed over the past year. In September 2017, King Salman issued a decree, expected to be implemented in June 2018, allowing women to drive for the first time. These measures currently appear to be broadly popular, but represent a challenge to more conservative sections of the population, who lack the channels to express their views.

The authorities are also expected to revise the highly ambitious National Transformation Program (NTP) announced in June 2016. The program provides substance to the Vision 2030 announcement in April 2016, which encompasses the government's strategy to rebalance the economy away from its historical reliance on fossil fuels and expatriate labor. We understand the broad thrust of the NTP will remain, but that key tenets may be delayed or scrapped, with the original plan being viewed as too aggressive. Among other things, the NTP aimed to:

  • Create more than 450,000 jobs in the nongovernmental • sectors by 2020;
  • Privatize state assets, increasing the private sector's share of GDP to 60%, from 40% in 2014;
  • Increase the female workplace participation rate to 30% from 22%;
  • Achieve a balanced budget by 2020, partly by reducing government spending on public sector wages to 40% of total spending by 2020 from about 45% at present;
  • Reform the education system; and
  • Raise the Saudi home ownership rate to 52% by 2020 from 47%, thus easing the housing shortage.

In our view, the program could result in accelerated economic growth and an overall rebalancing of the economy. However, the timing and completeness of any such structural improvements will depend on the achievement of challenging targets over a number of years. At this time, we have not factored in any specific effects from the NTP into our forecasts.

We expect the oil sector's contribution to real economic growth in 2017 and 2018 to be largely flat. Non-oil sector growth will likely remain the economic driver, but at a subdued 1% in 2017 and 2018. Our estimate for GDP per capita for 2017 is $21,200, supported by the slowdown in population growth from close to 3% on average in 2011-2015, to about 1% in 2016-2017. In our view, the weak population growth highlights the economic downturn in the kingdom, along with reduced job prospects for foreign workers. We view the government's aim of achieving a balanced budget by 2020 as challenging at a time when the government is striving to take measures to support the private sector and provide jobs for the 40% of 15-24 year olds who are unemployed. To some extent, these could be conflicting aims, in our view.

Flexibility and Performance Profile: Strong external and fiscal position from a stock perspective

  • The central government balance improved significantly over the first half of 2017. However, given uncertainties surrounding pent-up capital spending and outstanding government arrears to private sector contractors, our forecast is broadly unchanged. The government remains a strong net creditor.
  • We expect the current account to post small deficits over the forecast horizon, supported by rising oil production and a modest increase in oil prices after 2018.
  • Monetary policy effectiveness is limited given the fixed exchange rate, which requires Saudi Arabia to closely follow movements in the Fed Funds rate even when they may not be appropriate for Saudi Arabian economic conditions.

The government's targeted deficit for 2017 is about 8% of GDP, alongside a goal of achieving a balanced budget by the end of the decade under the Fiscal Balance Program 2020. We expect a central government deficit of about 9% of GDP in 2017, narrowing to 4% by 2020. Our 2017 government deficit estimate remains largely unchanged, partly due to uncertainties around the outstanding level of goverment arrears to private sector companies, and despite the deficit having halved to about 6% of GDP during the first half of the year.

In the medium term, we partly base our more conservative view of the government's fiscal consolidation prospects on our oil price assumptions, which are broadly flat over our forecast period through year-end 2020 (see 'S&P Global Ratings Raises Its Oil And Natural Gas Prices Assumptions For 2017,' published Dec. 14, 2016, on RatingsDirect). We also factor in our expectation that Saudi Arabia's oil production will remain at around current levels of 10 million barrels per day (bpd) in order to shore up prices at these levels, in line with OPEC's decision in late 2016. We factor in an additional 2% of GDP in government revenues starting in 2019, due to the expected introduction of a 5% value-added tax in 2018. We note that the non-oil deficit remains at about 23% of GDP over the first half of 2017, the same as in 2016, highlighting that the improvement in the budget so far this year has come through oil revenues rather than any diversification of revenue sources or expenditure cuts.

Our forecast for the annual change in general government debt (which is our preferred fiscal metric because in most cases it is more comprehensive than the
reported headline deficit) is for an average increase of about 4% of GDP. In Saudi Arabia's case, the change in general government debt is lower than the central government deficit because we have assumed that the deficit is financed 30% by asset draw-downs and 70% by debt issuance. Such a split implies that Saudi Arabia would report gross liquid financial assets of 101% of GDP by 2020. These fiscal assets include the central government's deposits and reserves on the liabilities side of the balance sheet of the Saudi Arabia Monetary Authority (SAMA), government institutions' deposits, and an estimate of investment income. We also include in our calculation an estimate of government pension funds' liquid assets.

We acknowledge both upside potential and downside risk to these forecasts. Upside potential stems principally from oil prices. The downside rests with the scale of the required fiscal consolidation and the broader impact it will likely have on theeconomy.

Our general government balance consolidates the central government and the social security system. It also includes our estimate of investment income from sovereign wealth fund assets, which largely accounts for the difference between our central government and general government deficit projections.

Although Saudi Arabia's fiscal profile has weakened on a flow basis, we believe it has remained strong on a stock basis. Net general government assets (the excess of liquid fiscal financial assets over government debt) peaked at 121% of GDP in 2015 (partly due to the estimated 14% decline in nominal GDP). Government liquid assets fell by about 10% of GDP in 2016 according to our estimates, largely related to a transfer of assets to the Public Investment Fund. However, absent disclosure on whether or not these assets remain liquid, we have excluded them from our estimates. We forecast that the government's net asset position could decrease to 74% of GDP in 2020. We believe Saudi Arabia is facing a period of adverse terms of trade, from a previously strong position.

Under its Fiscal Balance Program, the government is looking to privatize some of its holdings to stimulate economic growth, improve the fiscal position, and contain the cost of public sector salaries, while at the same time cushioning the socioeconomic impact of fiscal consolidation on low-income households via the introduction of a 'Citizens Account.' In March 2017, the government significantly reduced income tax rates for producers of hydrocarbons in the kingdom. The rate for the largest companies, including Saudi Aramco, the world's largest oil producer, fell to 50% from 85%. The tax rate is in addition to a 20% royalty payment the company makes to the government. The government will now be incentivized to encourage Saudi Aramco to follow a generous dividend policy to compensate for the reduction in tax revenues. In this way, the interests of investors and the government will be more aligned, increasing the company's attractiveness ahead of the listing in the capital markets of part of its shares or a bundle of its downstream subsidiaries. Various reports suggest that about 5% of Saudi Aramco could be sold before 2019. The valuation of Saudi Aramco remains highly uncertain, but a sale of 5% of its shares could be the world's largest equity sale. Commentators suggest that the company could be valued at $1 trillion-$2 trillion (150%-300% of GDP), making a 5% stake worth about 7%-15% of GDP. As these plans are still being formed, and the ultimate use of the funds to be generated is unclear, we have not factored proceeds from a potential IPO into our projections.

We understand the government's arrears have largely been to building and construction companies, a sector that accounts for about 8% of total bank loans,
equivalent to about one-third of the banking sector's capital base. The banking system nonperforming loan ratio was 1.4% at end-2016, which we expect will rise to 2%-3% over the next two years due largely to continued vulnerability in the contracting sector. We classify the banking sector of Saudi Arabia in group '4' under our Banking Industry Country Risk Assessment methodology, with '1' indicating the lowest risk and '10' the highest.

Given the Saudi riyal's peg to the U.S. dollar, we view monetary policy flexibility as limited. The long-standing currency peg helps to anchor the population's inflation expectations, but binds Saudi Arabia's monetary policy to that of the U.S. Federal Reserve. We expect that the peg will be maintained. At a time of already significant change and regional geopolitical instability, GCC countries are unlikely to increase economic uncertainty by amending this fundamental macroeconomic policy. Consequently, the riyal's real effective exchange rate has appreciated by 16% since December 2014 and is approximately 37% over the December 2007 level, according to Bruegel data. The riyal's long-term real effective appreciation since 2007 has been the most pronounced among all GCC sovereigns. In our view, this indicates an ongoing deterioration of international competitiveness of the country's modest tradables sector, which is likely to dampen non-oil GDP growth, absent any offsetting factors, such as improved efficiency or technological capacity.

We continue to view Saudi Arabia's external position as a strength. We expect that Saudi Arabia's liquid external assets, net of external debt, will average about 185% of current account receipts (CARs) over 2017-2020. Gross external financing needs are about 45% of the sum of usable reserves and CARs over 2017-2020, suggesting ample external liquidity. That said, usable reserves continue to decline, largely due to fiscal deficit financing. We expect them to reach about $400 billion at end- 2017, compared with $536 billion at end-2015. Our calculation of usable reserves subtracts the monetary base from gross foreign currency reserves for sovereigns that have a long-standing fixed peg with another currency (because the reserve coverage of the base is critical to maintaining confidence in the exchange-rate link). We estimate reserve coverage (including government external liquid assets) at about 20 months of current account payments in 2017, falling to 15 months by 2020.

Kingdom of Saudi Arabia Indicators

Savings is defined as investment plus the current account surplus (deficit). Investment is defined as expenditure on capital goods, including plant, equipment, and housing, plus the change in inventories. Banks are other depository corporations other than the central bank, whose liabilities are included in the national definition of broad money. Gross external financing needs are defined as current account payments plus short-term external debt at the end of the prior year plus nonresident deposits at the end of the prior year plus long-term external debt maturing within the year. Narrow net external debt is defined as the stock of foreign and local currency public- and private- sector borrowings from nonresidents minus official reserves minus public-sector liquid assets held by nonresidents minus financial-sector loans to, deposits with, or investments in nonresident entities. A negative number indicates net external lending. LC--Local currency. CARs--Current account receipts. FDI--Foreign direct investment. CAPs--Current account payments. The data and ratios above result from S&P Global Ratings' own calculations, drawing on national as well as international sources, reflecting S&P Global Ratings' independent view on the timeliness, coverage, accuracy, credibility, and usability of available information.

Kingdom of Saudi Arabia Rating Score Snapshot

S&P Global Ratings' analysis of sovereign creditworthiness rests on its assessment and scoring of five key rating factors: (i) institutional assessment; (ii) economic assessment; (iii) external assessment; (iv) the average of fiscal flexibility and performance, and debt burden; and (v) monetary assessment. Each of the factors is assessed on a continuum spanning from 1 (strongest) to 6 (weakest). Section V.B of S&P Global Ratings' 'Sovereign Rating Methodology,' published on Dec. 23, 2014, summarizes how the various factors are combined to derive the sovereign foreign currency rating, while section V.C details how the scores are derived. The ratings score snapshot summarizes whether we consider that the individual rating factors listed in our methodology constitute a strength or a weakness to the sovereign credit profile, or whether we consider them to be neutral. The concepts of 'strength', 'neutral', or 'weakness' are absolute, rather than in relation to sovereigns in a given rating category. Therefore, highly rated sovereigns will typically display more strengths, and lower rated sovereigns more weaknesses. In accordance with S&P Global Ratings' sovereign ratings methodology, a change in assessment of the aforementioned factors does not in all cases lead to a change in the rating, nor is a change in the rating necessarily predicated on changes in one or more of the assessments.

Related Criteria And Research
Related Criteria

  • General Criteria: Methodology For Linking Long-Term And Short-• Term Ratings - April 07, 2017
  • Criteria - Governments - Sovereigns: Sovereign Rating Methodology - December 23, 2014
  • General Criteria: Use Of CreditWatch And Outlooks - September 14, 2009
  • General Criteria: Methodology: Criteria For Determining Transfer And Convertibility Assessments - May 18, 2009

Related Research

  • Sovereign Risk Indicators – Oct. 13, 2017. 
  • Credit FAQ: Potential Implications Of Qatar Boycott For Gulf Cooperation Council Sovereigns, Aug. 9, 2017
  • Gulf Sovereigns Will Find It Hard To Diversify Away From Hydrocarbons, July 25, 2017
  • Middle East And North Africa Sovereign Rating Trends Midyear 2017, July 12, 2017
  • Calendar Of 2017 EMEA Sovereign, Regional, And Local Government Rating Publication Dates: Midyear Update, July 10, 2017
  • Banking Industry Country Risk Assessment: Saudi Arabia, June 7, 2017
  • Default, Transition, and Recovery: 2016 Annual Sovereign Default Study And Rating Transitions, April 3, 2017
  • Sovereign Debt 2017: MENA Borrowing Is Expected To Decline By 20% To $136 Billion, Feb. 23, 2017
  • S&P Global Ratings Raises Its Oil And Natural Gas Prices Assumptions For 2017, Dec. 14, 2016
  • Why Standard & Poor's Has Taken Mainly Negative Rating Actions • On Saudi Banks, April 1, 2016
  • Assessing The Effects Of The Saudi Government's Debt Issuance Program On The Domestic Banking System, Sept. 2, 2015
  • 2014 Annual Sovereign Default Study And Rating Transitions, May 18, 2015
  • Jobs And Skills, Not Infrastructure, Are A Key To Overcoming Gulf Sovereigns' Oil Dependency, Nov. 17, 2014
  • Lack Of Monetary Flexibility In The Middle East And North Africa Constrains The Sovereign Ratings, Nov. 7, 2014
  • Hooked On Hydrocarbons: How Susceptible Are Gulf Sovereigns To Concentration Risk?, June 30, 2014

In accordance with our relevant policies and procedures, the Rating Committee was composed of analysts that are qualified to vote in the committee, with sufficient experience to convey the appropriate level of knowledge and understanding of the methodology applicable (see 'Related Criteria And Research'). At the onset of the committee, the chair confirmed that the information provided to the Rating Committee by the primary analyst had been distributed in a timely manner and was sufficient for Committee members to make an informed decision.

After the primary analyst gave opening remarks and explained the recommendation, the Committee discussed key rating factors and critical issues in accordance with the relevant criteria. Qualitative and quantitative risk factors were considered and discussed, looking at track-record and forecasts.

The committee agreed that the key rating factors were unchanged.

The chair ensured every voting member was given the opportunity to articulate his/her opinion. The chair or designee reviewed the draft report to ensure consistency with the Committee decision. The views and the decision of the rating committee are summarized in the above rationale and outlook. The weighting of all rating factors is described in the methodology used in this rating action (see 'Related Criteria And Research').

Ratings List
This unsolicited rating(s) was initiated by a party other than the Issuer (as defined in S&P Global Ratings' policies). It may be based solely on publicly available information and may or may not involve the participation of the Issuer and/or access to the Issuer's internal documents. S&P Global Ratings has used information from sources believed to be reliable based on standards established in our policies and procedures, but does not guarantee the accuracy, adequacy, or completeness of any information used.

Certain terms used in this report, particularly certain adjectives used to express our view on rating relevant factors, have specific meanings ascribed to them in our criteria, and should therefore be read in conjunction with such criteria. Please see Ratings Criteria at www.standardandpoors.com for further information. Complete ratings information is available to subscribers of RatingsDirect at box located in the left column.


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