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Economic outlook bright on promising oil demand and prices
Oil above $70 enables Kingdom to keep spending high while generating generous fiscal surpluses, says analyst.
May 21, 2010 12:17 by Rasha Reslan
The economic environment is clearly much better than it was six months ago, especially after oil prices held above $80 a barrel in March and April. With May’s commodity selloff due to global contagion worries, crude prices promise to be volatile, but not necessarily fiscally concerning. Oil above $60 a barrel buttresses Saudi Arabia’s strong revenue position and encourages a healthy recuperation in foreign trade and personal consumption. Anything above $70 a barrel, moreover, enables the Kingdom to keep spending high while generating generous fiscal surpluses.
Saudi Arabia’s medium-term prospects are cautiously optimistic given the outlook for oil demand and prices. OPEC member states have been incrementally raising output to meet growing demand despite the group keeping its output target unchanged since December 2008. Saudi crude oil production rose in March to 8.26 million barrels per day from 8.13 million barrels per day in February – 2.7 percent higher than the first quarter of last year. Still, a sustainable recovery in the United States and Asia is important for oil demand more broadly.
Saudi Arabia has acted to balance global oil supply because it maintains 1.5 to 2 million barrels per day of spare capacity, developed following investments of $63 billion in the last five years. The Kingdom plans to invest a further $107 billion in the next four years in energy projects. The cost of drawing each barrel from onshore and offshore wells has risen substantially, the oil minister said last month. In 1998, extracting oil from the onshore Shaybah field cost $5,000 per barrel of daily capacity. Eleven years later, it cost double that for the onshore Khurais field and triple that for the offshore Manifa field.
Higher output and oil prices have enabled the Saudi Arabian Monetary Agency, SAMA, to replenish its foreign asset holdings. SAMA’s net foreign assets in March amounted to SR1.56 trillion, bringing them back to the levels of a year ago. The central bank had drawn down foreign assets by 7.5 percent, or SR122.3 billion, in 2009, to help fund budgetary requirements during a period of depressed oil prices. At the height of the drawdown in September 2009, SAMA’s net foreign assets were 14 percent off peak levels hit in November of 2008 – a year that saw oil prices swing as high as $147 a barrel before plunging below $40 a barrel in a matter of months.
Far less dependent on exports to Europe than countries in North Africa, Saudi Arabia could see its trade flows improve as the euro weakens further versus the dollar, although exports to the euro zone (accounting for 10.6 percent of the total) could get hit. European banks will continue to approach the Gulf with risk aversion, compounding the hesitancy to free up bank credit. On a micro level, as European bank valuations drop, this will create a negative wealth effect on Gulf sovereign wealth funds and investors at large. Saudi Arabia relies very little on European leverage for financing various expansion projects and its banks have limited exposure to Europe. But deleveraging among global peers could prompt local hold on abandoning risk aversion policies. Most Saudi banks, meanwhile, hold more US paper than European paper. Bank for International Settlements data for the fourth quarter of 2009 show European banks have around $174 billion of Gulf exposure, US banks $34 billion and UK banks $83 billion. Of this total cross-border banking exposure in the Gulf, half is with the UAE, 16 percent with Saudi Arabia and 17 percent Qatar.
Keeping volatile global conditions in mind, public investments remain strong albeit signs of gradual recuperation in private investment. The country awarded SR20.9 billion in development contracts in the first quarter – down almost 50 percent from the year earlier, although we expect this level to ramp up later this year.
Current account data also look more robust than previously expected. In revised numbers released by SAMA, the current account surplus was SR99.4 billion in 2009, up from a prior state estimate of SR76.7 billion. The gain resulted from stronger export revenues of SR711 billion, 3 percent more than earlier expected, including oil export revenues of SR609.7 billion – 6 percent higher than the prior estimate. In view of rising imports and higher oil output and prices, we are raising our 2010 current account surplus forecast to SR173 billion, or 10.9 percent of GDP.
Inflation picks up
Against this propitious fiscal backdrop, we have decided to revise our inflation forecast for 2010 upward to 4.7 percent from a previous expectation of 4.3 percent in view of the recent acceleration in global commodity prices, particularly of food, as well as domestic factors including housing and a general rise in the cost of goods and services. Inflation in April rose to 4.9 percent, the highest since June 2009, and while we expect a deceleration in commodity and energy prices in the months to come, the price momentum is high enough to justify raising our headline forecast.
The Food and Agriculture Organization’s (FAO) food price index, which fell sharply in the first 10 months of 2009, has picked up pace this year, gaining more than 20 percent year on year in January and February. While food price inflation slowed to 16.1 percent in March, momentum in prices is still comparatively high versus 2009. The FAO index measures price changes in a food basket comprising cereals, oilseeds, dairy, meat and sugar.
The implications of firm global food prices for Saudi Arabia will be upward pressure on the consumer price index. Food and beverage costs constitute the biggest weighting in the consumer basket at 26 percent, followed closely by the rent, fuel and water component at 18 percent. Saudi Arabia is heavily dependent on food imports. In 2008, imports of animal, vegetable, prepared food, beverages and tobacco amounted to SR62.2 billion, 14 percent of total imports, according to official data. Construction costs are also getting squeezed due to parallel construction progress on a series of mega projects.
Other factors likely to contribute to Saudi inflation are home furnishings and other goods and services, a category including more than 400 items. These two categories comprise 24 percent of the index. Each of these components witnessed year-on-year price acceleration of 4 percent in March. However, import costs are moderated by the stronger dollar and largely benign inflation rates experienced by key trading partners. We expect the dollar to strengthen this year and that the euro will continue to weaken, although markets will eventually react to the reality that the US deficit situation is not auspicious. US inflation should average 2.2 percent in 2010 and 2.1 percent in 2011. Euro zone inflation is forecast to average below 1 percent this year and 1.4 percent in 2011, while price rises in China average below 3 percent in 2010 and 3.1 percent in 2011 and overall Asia inflation is seen at 3.3 percent and below 4 percent during the same period.
Slowing rental inflation is another factor likely to stabilize the headline rate this year. Rising rents were the biggest driver for high inflation in 2008, when the headline rate peaked above 11 percent in July. A continuation of firm rents has sustained inflation at a historically high 4 percent, even as other countries in the Gulf experienced deflation. Rental inflation, which peaked at 23.7 percent in July of 2008, stood at 12 percent in March, down for the third straight month.
According to a BSF real estate survey in April, rents in Riyadh and Jeddah are falling. Such trends are likely to bear on inflation of the rental index, which also includes fuel and water. We predict housing index inflation could fall to 7-8 percent levels later this year from March levels of 10 percent. The persistence of slowing but high rental inflation and rising food costs are forecast to keep Saudi inflation at elevated levels, averaging 4.7 percent this year compared with 5.1 percent in 2009, the drop owing mainly to softening rents.
We also do not expect wage inflation to be a factor this year or next due to ample labor supply in the region and Asia at lower price equilibrium. State fiscal expansion should not at this point stoke inflation and certainly not hyperinflation, but the concentration of spending among few private participants may stifle price competition in certain sectors.
Why is credit languishing?
Taking robust economic fundamentals into consideration, stagnancy in bank credit is not commensurate to the size of local banks, their liquidity and the macroeconomic well being of the country. Unlike other Gulf states where banks continue to suffer the consequences of sharp property market corrections and corporate defaults, Saudi Arabia has fared very well. Its property market is undersupplied, prices are resilient and home finance accounted for only 2.6 percent of total bank loans as of March. Private companies have de-leveraged and, unless there is a drastic shift in global circumstances, there should be no new large skeletons of bad debt hiding in the closet.
The state, through specialized credit agencies like the Public Investment Fund (PIF) and the Saudi Industrial Development Fund (SIDF), has offered generous financial support to keep key infrastructure projects on track. By the end of March, the value of these independent organizations stood at SR585.29 billion, down 7.3 percent from 2008, according to SAMA data. Expansionary spending should, in theory, boost confidence of private sector investors in the economy and catalyze bank credit. But despite all of the ingredients for a perfect recipe of bank credit revival appearing to be in place, lending continues to be listless. Typical reasons given for languishing bank credit growth are 1) banks are implementing tighter conditions on relationship lending; and 2) private-sector companies are not seeking loans as they focus instead on reducing their debt positions. These two reasons tell part of the story, but they omit two additional crucial components outside of banks’ control.
Firstly, state intervention with interest-free financing, while advancing official development ambitions, fails to persuade banks to jumpstart lending; the state is leaving little room for banks to partake in strategic projects in sectors such as utilities and transport. It may be prudent to reassess the state’s business model to strike better balances between government involvement and private sector participation on the one hand, and interest free lending and more costly bank credit on the other. In the medium term, the economic costs of failing to involve banks will outweigh any savings in financing. The government should avoid creating a scenario where it is forced to carry the burden for economic development by crowding out most private participants in favor of a select few. Participation of mid-segment companies, including contracting firms, should be emphasized, while efforts made to achieve local content sourcing. Mid-level contractors could be granted contracts directly from the government rather than only through sub-contractors, as often happens now. Mega projects may need to be recalibrated to allow a wider pool of private participants.
Secondly, the state is re-thinking large-scale, low-risk expansion projects (particularly in energy), forcing delays in project rollouts that also impedes efforts to widen the project financing pool for banks until 2011. Project delays witnessed in 2009 hit private-sector appetite for investments and, in turn, their participation suffered.