• We expect the Saudi government's expansionary budget will help boost economic growth.
• We forecast wider fiscal deficits, but expect Saudi Arabia will retain strong government and external balance sheets.
• We are affirming our 'A-/A-2' long- and short-term sovereign ratings on Saudi Arabia.
• The outlook remains stable.
• Rating Action

Saudi Arabia, March 30, 2019:  On March 29, 2019, S&P Global Ratings affirmed its 'A-/A-2' unsolicited longand short-term foreign and local currency sovereign credit ratings on Saudi Arabia. The outlook is stable.

The stable outlook reflects our expectation that Saudi Arabia will maintain a pace of moderate economic growth and retain strong government and external balance sheets over the next two years, despite wider fiscal deficits.

We could raise the ratings if Saudi Arabia's economic growth prospects improve beyond our current expectations, for example, as a result of a more diversified economy.

We could lower our ratings if we observed fiscal weakening beyond our expectations, or a sharp deterioration in the sovereign's external position. An unexpected materialization of contingent liabilities or a buildup of arrears could also place additional pressure on expenditure. Additionally, the ratings could come under pressure if we observed a significant increase in domestic or regional political instability.

Rationale

The ratings on Saudi Arabia are supported by its strong external and fiscal stock positions, but constrained by its limited monetary policy flexibility, sizable fiscal deficits, and the limited transparency of its government assets and institutional framework.

We expect that the government will try to reduce its budgeted expenditure to achieve its goal of a balanced budget by 2023, especially in light of oil production cuts following the December 2018 OPEC agreement. However, our fiscal expectations have weakened since our last review, due to our revised oil price assumptions, lower expected oil production volumes, and higher budgeted fiscal expenditure.

While decision-making structures are centralized and, in our view, relatively opaque, we do not expect any major deviation from the stated domestic policy course of planned economic diversification and gradual socioeconomic liberalization.

Institutional and Economic Profile: An era of change brings both risks and opportunities

• The Saudi government has articulated an ambitious strategy to reduce the economy's dependency on oil and imported labor, to transform the domestic education and job market, and balance the budget by 2023.
• Policy decision-making is centralized, with limited institutional checks and balances.
• We expect that the pace of reform implementation will slow slightly, allowing time for the numerous introduced measures to show results.

We expect that the key parameters of Saudi Arabia's institutional framework will remain broadly steady through 2022. Decision-making around future policy reform is likely to remain centralized. We anticipate that the government will strive to rebalance its public finances away from hydrocarbons and attract foreign investment, while reducing its reliance on expatriate labor. Fiscal reforms are yielding results, with 2018 non-oil revenues increasing by approximately 35% over 2017. That said, we expect that any material economic benefit from the overall reform package will likely only materialize beyond our ratings horizon.

The country will partly fund its ambitious economic reform program using the large fiscal and external buffers that it amassed during the pre-2015 era of twin balance of payments and budgetary surpluses. The government is implementing a series of reforms that include social measures aimed at increasing labor participation (particularly of women), improving levels of educational attainment, and raising the private sector's role in the economy, while achieving a balanced budget by 2023.

However, following the announcement of an expansionary fiscal budget for 2019, we do not expect the government to meet this budgetary target. We estimate the central government deficit will average close to 7.5% of GDP over 2019 to 2022. We also take into consideration our updated oil price assumptions, which we have revised downward since our last review (see 'Brent Crude Price Assumption For 2019 And 2020 Raised To $60 Per Barrel,' published March 18, 2019, on RatingsDirect), and our expectation of lower oil production volumes

Research Update: Saudi Arabia 'A-/A-2' Ratings Affirmed; Outlook Stable

(10.2 million barrels of oil per day [mbpd] in 2019). We note the government's over-compliance with OPEC production cuts, which aim to boost oil prices. If oil prices increase, this could quickly improve Saudi's fiscal position, as it did in 2018.

We continue to anticipate that public investment will increase under a four-year stimulus plan whose goal is to stabilize private-sector demand. In addition, the announced increase in 2019 expenditure underpins our real growth expectations, which average about 2% per year over the forecast horizon. Despite some positive signs in high-frequency private-sector data, we expect only moderate credit growth. Given that oil production makes up a significant portion of Saudi Arabia's GDP, our growth forecast for the country continues to be highly sensitive to assumptions of OPEC production targets--not least because Saudi Arabia maintains the world's largest installed crude oil production capacity at around 12 mbpd, and is the key marginal producer. In November 2018, Saudi produced just over 11 mbpd. Our GDP per capita estimate is just under $23,000 in 2019, and we expect that, on a trend basis, growth will remain well below that of peers.

Official labor force statistics show the number of non-Saudi employees has declined by about 1.3 million since 2017. However, this change is not visible in official population statistics. Without employment contracts, we understand that non-Saudis have to leave the kingdom, and note that if net emigration of skilled labor were significant it could lead to weaker growth prospects.

We expect the long-standing tension with Iran to remain high. Saudi Arabia's war in Yemen contributes to military and security services being the single-largest spending item, at about 30% of total government expenditure. We do not expect any of these foreign policy 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 its fiscal adjustment plans.

Flexibility and Performance Profile: Strong external and fiscal positions from a stock perspective, despite ongoing fiscal pressures • We expect wider fiscal deficits over the next two years than in our last review, due to lower oil price assumptions and higher fiscal expenditure, despite improved non-oil revenue collection.

• While we forecast an accumulation of foreign currency reserves, we note a continued increase in external debt that somewhat moderates Saudi Arabia's strong external stock position.
• Monetary policy effectiveness is limited by the fixed exchange rate, which largely requires Saudi Arabia to follow movements in the U.S. federal funds rate, even when they may not be appropriate for Saudi Arabian economic conditions.

We now expect the government's net debt position will weaken by over 4% of GDP per year on average over 2019 to 2022. Lower oil price assumptions, as well as the government's expansionary stance, have heavily weighed on these expectations. We expect oil prices to drop to $55 per barrel in 2021 and beyond, and that production will remain at around 10.2 mbpd on average over 2019, before gradually increasing to 10.5 mbpd by 2022. We note that Saudi Arabia's daily production increased by 500,000 barrels in November 2018 from September, and this ability to ramp up production at times provides significant upside to revenue. Still, we expect that the government will reduce expenditure in response to lower oil revenue and to try achieve a balanced budget by 2023.

In addition to the budget, we understand that the government has a separate plan focusing on domestic capital expenditure that is being implemented by the Public Investment Fund and the National Development Fund, with related expenditure totaling an estimated 5% of GDP in 2018. Compared with many rated sovereigns, the Saudi authorities spend far more on investment, and this could raise growth potential toward the end of our ratings horizon.

We assume that the central government deficit is financed 30% by asset drawdowns and 70% by debt issuance. This split implies that Saudi Arabia would report gross liquid financial assets of about 82% of GDP by 2022. These fiscal assets include the central government's deposits and reserves (accounted for on the liabilities side of the balance sheet of the Saudi Arabia Monetary Authority), government institutions' deposits, and an estimate of investment income. We also include in our calculation an estimate of government pension funds' liquid assets.

Our general government balance consolidates the central government and the social security system, and it also includes our estimate of investment income from sovereign wealth fund assets. The latter largely accounts for the difference between our central government and general government deficit projections.
Although Saudi Arabia's fiscal profile has been weak on a flow basis in recent years, we believe it has remained strong on a stock basis. We expect net general government assets (the excess of liquid fiscal financial assets over government debt) will average just over 50% of GDP between 2019 and 2022; this compares with about 65% in our last review. We have revised the figure downward, due to the potential impact of continued wide fiscal deficits.

We do not expect that the recently announced purchase of Saudi Basic Industries Corp. (A-/Stable/A-2) by Saudi Aramco will directly affect the government's fiscal position. However, given the large size of the acquisition (reportedly $69 billion), potential debt raised by Saudi Aramco to facilitate the transaction could, under certain conditions, affect our assessment of the contingent liabilities the government is exposed to through its government-related entities (see Credit FAQ: When GREs Raise Debt, What Are The Implications For Sovereign Ratings?, Nov. 19, 2018). We note, however, that none of the ratings on Gulf Cooperation Council sovereigns have been negatively affected by our assessment of their potential contingent liabilities so far.

We continue to view Saudi Arabia's external position as a strength and estimate that current account surpluses will average 5% of GDP through 2022 versus an average deficit between 2015 and 2018. We expect that Saudi Arabia's liquid external assets, net of external debt, will average about 160% of current account payments over 2019-2022. This figure has weakened somewhat, because we expect an increase in public-sector external debt (we expect entities, such as the Public Investment Fund, and potentially some GREs, like Saudi Aramco, to raise debt externally). Gross external financing needs will likely remain at about 40% of the sum of usable reserves and current account receipts over the same period, suggesting ample external liquidity. We expect usable reserves will increase over the forecast period, in line with current account surpluses. In our calculation of usable reserves, we subtract 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).

Given the Saudi riyal's peg to the U.S. dollar, we view monetary policy flexibility as limited. The longstanding 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.