If you frequent these pages, you’re probably well aware that the Saudis are in trouble.
Exactly a year ago, Riyadh decided to embark on an epic quest to send crude prices plunging on the way to, i) bankrupting the US shale complex and ii) achieving “ancillary diplomatic benefits [7],” like tightening the screws on Moscow’s energy-dependent economy in hopes of forcing Putin to give up Assad.
Long story short, the kingdom’s plan didn’t work.
Thanks to ZIRP, legions of yield-starved investors in the US ensured that capital markets remained open to otherwise insolvent drillers, allowing US producers to stay in business longer than the Saudis anticipated. Meanwhile, not only did Putin not give up Assad, he actually sent the Russian air force to Latakia and to add insult to injury, Moscow’s warplanes are now bombing Saudi-financed Sunni militias in Syria.
Meanwhile, slumping crude prices wreaked havoc on the kingdom’s finances. As we’ve documented extensively, the Saudis are now staring down a deficit on both the fiscal and current accounts with the former amounting to some 20% of GDP and the latter representing the first negative balance in at least 15 years.
Weighing on the budget deficit is a laundry list of generous subsidies designed to prevent an Arab Spring-type event from coming to Riyadh and the necessity of preserving the riyal peg. Here's what we mean by "generous" subsidies (left pane compares price of petrol and diesel in the UAE versus Saudi Arabia):
And here's a look at the pressure on the peg (i.e. market expectations as telegraphed by 12-month SAR forwards):
[8]
So what's a despotic, puritanical Islamic monarchy to do? Well, you can tap the debt markets to offset the FX reserve burn and indeed Riyadh has already gone that route, but as we noted earlier this month, it's not clear how far they'll ultimately want to push that given that projections already have the country's debt-to-GDP ratio climbing from basically zero to more than 33% by 2020:
[9]
Another option is to simply cut expenditures and if that's not feasible, you can always just stop paying people. Indeed, reports now suggest that Riyadh is delaying contractor payments by as much as six months in the face of the acute cash crunch. As Bloomberg reported last month [10], "companies working on infrastructure projects have been waiting six months or more for payments as the government seeks to preserve cash. Delays have increased this year and the government has also been seeking to cut prices on contracts."
Of course when you delay payments to private sector businesses you run the risk of derailing an economy already beset by crimped government finances. "Payment delays could slow the completion of projects under construction, including the $22 billion Riyadh metro, and curb the expansion needed to create jobs for a rising population," Bloomberg observed, adding that "in the past, government spending has been a catalyst for growth."
Well don't look now, but money markets are tightening dramatically in the kingdom as deposits dry up. The 3-month Saudi Interbank Offered Rate has jumped 13 bps in November to its highest level since early 2009.
[11]
Here's more from Bloomberg [12]:
Income from oil and related products contributes more than 80 percent of Saudi government revenue, and crude’s 37 percent plunge over the past year is poised to result in a 10-fold increase in the country’s budget deficit. That’s squeezing liquidity in the banking system, with demand deposits dropping 4.7 percent in October, as those of businesses, individuals and government entities slumped.
"The drop in deposits in October, in absolute amount, is probably the biggest since the 1990s," Murad Ansari, a bank analyst at EFG-Hermes Holding SAE, said by phone from Riyadh on Monday. "There are payment delays from the government to contractors, which is one of the reasons for the decline in private sector deposits, and public sector deposits are shrinking as the government is running a deficit."
In short, the Saudi economy is gradually grinding to a halt, which is what happens when you deliberately tank the commodity that accounts for more than three quarters of government revenue and when government spending is the linchpin for economic growth. While it's not clear how much of this is "priced in" so to speak, you'll note that there's not a lot of breathing for the Saudis in terms of avoiding a recession in the not-so-distant future (right pane shows Deutsche Bank's estimate for growth in 2016 is just 1.4%):
So either Riyadh backs an output cut this Friday, the kingdom abandons the dollar peg, or both, but what's clear is that the current arrangement isn't even remotely sustainable, and if the war in Yemen drags on, the pressure on the fiscal account and on the SAMA reserve warchest will only grow.
Good luck Salman, you're going to need it.
