"They are working for their market share, not for the price," Kazakh Prime Minister Karim Massimov told Bloomberg on Saturday, during the same interview in which he predicted that sooner or later, dollar pegs in Saudi Arabia and the UAE would have to be abandoned.
The Saudis are essentially betting that their FX reserves all large enough to allow the Kingdom to ride out the self inflicted pain from persistently low crude prices on the way to bankrupting the US shale space. But the battle for market share comes at a cost, especially when ultra easy monetary policy in the US has served to kept capital markets open to heavily indebted drillers, allowing otherwise insolvent producers to remain in business longer than they otherwise would. It is, as we’ve noted before, a fight between the Saudis and the Fed [26].
In the midst of it all, the petrodollar has died a rather swift if quiet death and as we documented on Saturday [27], the demise of the system that has served to underwrite decades of dollar dominance has left emerging markets in no position to defend themselves in the face of China’s move to devalue the yuan. With Kazakhstan’s decision to float the tenge, we are beginning to see the post-petrodollar world (or, the "new era" as Karim Massimov calls it) take shape.
Over the weeks, months, and years ahead we’ll begin to understand more about the fallout and nowhere is it likely to be more apparent than in Saudi Arabia where widening fiscal and current account deficits have forced the Saudis to tap the bond market to mitigate the FX drawdown that's fueling speculation about the viability of the dollar peg. Here’s Bloomberg on why [28] the current situation mirrors a "very scary moment" in Saudi Arabia’s history.
The oil price was near its lowest in more than a decade, cash reserves were being depleted, emerging markets were in turmoil and Saudi Arabia was beginning to panic.
“It was a very scary moment,” said Khalid Alsweilem, former head of investment at the Saudi Arabian Monetary Agency, the country’s central bank. “And luckily at that point, oil prices started going up. Not by design, by good luck.”
That was 1998, and now Saudi Arabia’s fortunes threaten to turn again. This time, luck might not be enough as the government tries to protect the wealth of a nation whose economy has swelled by five times since then. The bastion of conservative Sunni Islam also is paying for an expanding role in regional conflicts in the face of a resurgent Iranand Islamic State extremists who have bombed Saudi mosques.
Economists are predicting a budget deficit of as much as 20 percent of gross domestic product and the International Monetary Fund forecasts a first Saudi current-account deficit in more than a decade. Reserves at the central bank tumbled 10 percent from a year ago, or by more than $70 billion.
As a result, bets on the devaluation of the riyal are surging. The Tadawul All Share Index lost 18 percent in the past three months and dragged stocks down across the Gulf region. The benchmark’s moving averages made a so-called death cross on Aug. 18, a sign to some investors that more losses are ahead.
The Saudis have “played a waiting game,” Robert Burgess, Deutsche Bank AG’s chief economist for emerging markets in Europe, the Middle East and Africa, said from London. “The budget for next year is going to be a very important milestone that the markets are going to be focusing on quite intently.”
With oil prices down by more than half over the past 12 months to below $50, Saudi Arabia faces many of the same financial problems it did in 1998.
The difference is the sheer cost of maintaining the state as an employment machine and guarantor of the riches that Saudis have become accustomed to since the last squeeze. Subsidized gasoline costs 16 cents per liter and while there’s the religious levy called zakat, there is no personal income tax in the nation of 30 million people.
“The Saudi government can’t continue to be the employer of first resort, it can’t continue to drive economic growth through the big infrastructure projects and it can’t keep lavishing on subsidies and social spending,” said Farouk Soussa, chief Middle East economist for Citigroup Inc. in London.
So here too, we’re seeing flashbacks of 1998, and indeed the size of the projected fiscal deficit is huge and some estimates for the current account deficit have increased markedly just over the last 60 days.
[29]
And as Barclays notes, the country’s debt-to-GDP ratio is set to increase by a factor of ten by the end of 2016 as the Kingdom moves to offset the FX reserve burn.
The authorities are deploying a range of instruments to finance their growing deficits. As we expected last November, they have dipped into their central bank’s (SAMA) FX reserves which have fallen by USD60bn in H1 15. Much of the fall in SAMA’s reserves can be explained by the government’s drawdown of its deposits at SAMA by almost USD82bn in H1 15 (Figure 4). The authorities have also re-initiated local bond issuance for the first time since 2007, indicating they would aim to finance 40% of the deficit through tapping local liquidity. They have thus raised SAR35bn in local debt so far; and we expect another SAR126bn (USD33.4bn) in issuance by year-end, which could raise Saudi Arabia’s total public debt from its low of 1.6% of GDP at end-2014 to 8.2% at the end of this year and 16.5% in 2016 (Figure 5) given our base case oil price assumptions.
[30]
Barclays continues: "A prolonged period of no adjustment and lack of any signal in that direction could heighten perceptions of risk regarding the sustainability of Saudi Arabia’s fiscal path, and undermine the credibility of its FX regime and eventually its medium-term creditworthiness outlook." So while most analysts don't see the peg falling in the near future - despite the widest divergence between 12-month forwards and the spot rate since 2009 - a lack of fiscal adjustment combined with stubborness when it comes to production could put the FX regime in the crosshairs, or, as Barlcays puts it, "given its fiscal challenges, Saudi Arabia will need to continue maximizing its revenues from its oil exports [but] this may not be so straight forward given the Kingdom’s stated petroleum strategy to defend Saudi market share and the market share of other 'high efficiency' producers, which would involve a longer process to balance the surplus in the market."
Indeed, expectations for devaluation have grown after Fitch cut the country's outlook to negative from stable on Friday. As Reuters notes [31], "one-year dollar/riyal forwards were quoted at 340 points [on Sunday], their highest level since March 2003."
Not only that, but the country's share of crude exports is under threat from the rise of the dreaded petroyuan. Once more, from Barclays: "After all downside risks to China’s growth persist and Saudi Arabia’s crude export market share with China has been facing competition from other suppliers, notably Russia, Iraq and Angola. With the devaluation of the yuan, Chinese imports of crude oil from Russia are likely to benefit as Russia began to accept payments in yuan last year." As a reminder, we discussed this at length back in June in "Historic Shift: Russia Overtakes Saudi Arabia As China's Number One Oil Supplier [32]."
[33]
Finally, as we warned back in February, "few actually grasped the implications of what plunging oil really means in a world in which this most financialized of commodities plays a massive role in both the global economy and capital markets, not to mention in geopolitics, with implications far, far greater than the amateurish 'yes, but gas is now cheaper’ retort." And when all is said and done, the real question may be this: what happens socially and politically in EM oil producing states when, after years of depressed prices, the coffers finally run dry? And on that note, we give the last word to Citi's Farouk Soussa who said the following about the prospects for fiscal retrenchment in Saudi Arabia:
"These are things that are absolutely politically explosive. You’ve gotten accustomed to a certain lifestyle and that lifestyle is far in excess in terms of luxury that was prevailing in 1998."
