With Saudi Arabia scrambling to respond to surging US shale production in what many analysts warn is a lose-lose decision, as either Saudi Arabia will lose market share under the current status quo, or government revenue will tumble should the Vienna 2016 production cut deal be cancelled, moments ago Fitch poured some fuel on the fire, when it downgraded the Saudi Kingdom from AA- to A+, as a result of the country's soaring deficit, declining reserves, and a deteriorating balance sheet.
Fitch Downgrades Saudi Arabia to 'A+'; Outlook Stable
Fitch Ratings-Hong Kong-22 March 2017: Fitch Ratings has downgraded Saudi Arabia's Long-Term Foreign and Local Currency Issuer Default Ratings (IDRs) to 'A+' from 'AA-'. The Outlooks are Stable. The issue ratings on Saudi Arabia's senior unsecured foreign-currency bonds have also been downgraded to 'A+' from 'AA-'. The Country Ceiling has been downgraded to 'AA' from 'AA+' and the Short-Term Foreign and Local Currency IDRs have been affirmed at 'F1+'.
KEY RATING DRIVERS
The downgrade of Saudi Arabia's Long-Term IDRs reflects the continued deterioration of public and external balance sheets, the significantly wider than expected fiscal deficit in 2016 and continued doubts about the extent to which the government's ambitious reform programme can be implemented.
Government deposits declined by SAR240bn to SAR841bn (35% of 2016 GDP) between June 2016 and January 2017, only about half the peak level of SAR1,643bn in August 2014, although this decline partly reflects transfers between the government and the Public Investment Fund (PIF). General government debt rose to 9.7% of GDP, from 4% in 2015. This included sales of local-currency bonds during the first three quarters of last year and a USD17.5bn Eurobond issued in October. The government balance sheet remains strong relative to 'A' and 'AA' category peers but will become less of a support for the rating unless the deterioration in public debt dynamics is arrested.
The deterioration in the government balance sheet reflects the large central government budget deficit of SAR416bn or 17.3% of GDP in 2016, up from SAR362bn in 2015 and much higher than the budget target of SAR326bn. The deterioration was mainly due to the clearance of arrears on capital expenditure of SAR75bn. The arrears arose in 2015 because payments for many projects were halted while the government was seeking greater visibility on the entirety of outstanding project commitments.
In its budget for 2017, the government has targeted a central government deficit of SAR198bn or 7.7% of GDP for 2017. The main factors behind the improvement will be the rise in crude oil prices, which will more than offset the effect of OPEC production cuts on government oil revenue, and the absence of further arrears payments. According to the budget, oil revenue will rise by SAR151bn in 2017 which is in line with our projections. The government projects a decline in expenditure, mainly because it expects no further need for arrears clearance and no further accumulation of arrears. We expect the central government deficit to fall to 9.2% of GDP in 2017 and 7.1% of GDP in 2018. This will again be financed by some further run-down in deposits as well domestic and international issuance. As a result, general government debt will rise to 14.5% of GDP in 2018.
The government has already taken several fiscal consolidation measures, including cuts in civil service allowances and a hike in administered utility prices. Further measures are being implemented under the government's consolidation plan, the Fiscal Balance Programme (FBP), which targets to eliminate the fiscal deficit by 2020. According to the FBP, phased hikes in regulated energy and water prices will bring additional revenue of SAR209bn per year in 2020. Gradual implementation of non-oil revenue measures (including a levy on expats to be phased in over several years and a value-added tax to be introduced at the beginning of 2018) will bring SAR152bn and operational and capital expenditure control will also be enhanced. To raise the social acceptance of these measures, an allowance for the poorest households with an annual cost of ultimately SAR60bn-SAR70bn per year in 2020 will be phased in.
These measures will help to contain further balance sheet erosion, but in Fitch's view it is unlikely that they will all be achieved. The FBP itself is ambitious and comes together with reforms to reduce Saudi Arabia's oil dependence, including the IPO of Saudi Aramco planned for 2018 and an ambitious privatisation agenda (our fiscal forecasts contain no IPO/privatisation receipts as these will probably be transferred to the Public Investment Fund) as well as numerous sectoral initiatives. The commitment of the political leadership to the reform programme is very strong. However, in Fitch's view, the scale of the reform agenda risks overwhelming the government's administrative capacity. In addition, the economy may not be able to absorb rises in administered energy prices, which could severely affect energy-intensive industries, or the planned expat levies, which could undermine large parts of the domestic private sector.
On the external side, partly as a result of the fall in government deposits, the Saudi Arabian Monetary Authority's (SAMA) net foreign assets fell USD49.5bn or 7.7% of GDP between June 2016 and January 2017 to USD555bn. We estimate the current account deficit at 6.1% for all of 2016, down from 8.7% in 2015, reflecting largely the rise in oil prices. The reduction in government imports of goods and services during the build-up of arrears in the first three quarters, which improved the current account further, was probably reversed in 4Q16 as the arrears were cleared. The deficit in 2017 will fall further to 3% boosted by higher oil prices.
Saudi Arabia's ratings also reflect the following rating drivers:
GDP grew by 1.4% in 2016 according to preliminary data, with a rise in oil sector GDP of 3.4% and an increase in the non-oil sector by just 0.2%. Weak non-oil growth reflected the liquidity crunch due to the delay of government payments during the first three quarters of last year and the increased uncertainty as a result of the reform efforts, which may have held back investment. In 2017, oil production will be scaled back as a result of the OPEC production cuts, with Saudi Arabia committed to cutting its production by 323b/d. Fitch expects the non-oil sector to grow by 1.4%, supported by arrears payments in late 2016 and early 2017 and a slower pace of fiscal consolidation. After turning negative in January 2017, inflation is likely to be boosted by rises in excise taxes, utility price hikes and the VAT introduction but will remain moderate given limited demand pressures.
Fitch views Saudi Arabia's banking sector as strong and stable. Fitch's banking sector indicator for Saudi Arabia remains 'a', which is one of the strongest indicators for all Fitch-rated sovereigns and weaker only than Australia, Canada, Singapore and Sweden. The non-performing loan ratio, at 1.4%, and the capital adequacy ratio, at 17.5% in 4Q16, remain very healthy despite the more difficult economic environment. Banking liquidity tightened up to 3Q16, but these pressures eased due to the clearing of government arrears, measures taken by SAMA and increased confidence following the successful Eurobond issuance in October. Nonetheless, private sector credit growth slowed to 1.8% in January 2017, down from 8.1% in June 2016, due to tighter lending conditions by banks and the weak investment environment.
Geopolitical risks remain high relative to 'A' category peers. Saudi Arabia and its allies are fighting a war against Houthi rebels in Yemen and an end to the conflict remains elusive. Tensions with Iran, Saudi Arabia's main regional rival, also persist and could escalate, although direct military conflict remains highly unlikely. The line of succession has been clearly defined, but Fitch believes rivalries within the royal family could become a source of instability. Austerity measures, although very carefully phased in and combined with offsetting citizen account benefits, could raise discontent among the population but major sustained civil unrest remains unlikely.
Income per capita is in line with the 'A' category median, but the World Bank governance indicator and the business climate are well below the medians for 'A' category peers.