Saudi public debt and sukuk in a time of COVID-19 and low oil prices

The volatility in crude oil market dynamics is matched only by the volatility in the politics of oil especially between two of the largest producers in the world – Saudi Arabia and Russia, with another, the US, feigning to play the role of a disinterested broker and facilitator.

The toing and froing from production hikes in March to record cuts agreed on April 9 at an OPEC+ meeting, with the Kingdom, according to Saudi sources, consenting to cut back its output from 12mn barrels per day to just under 8.7mn bpd and Russia from 10.4mn bpd to around 8.4mn bpd, has merely served to contribute to market uncertainty, with Mexico threatening to opt out of any such deal and Washington’s favourite pariah states Iran and Venezuela (boasting the world’s largest proven oil reserves) subject to US sanctions.

Whoever advised Saudi strongman Prince Muhammed bin Salman (MBS) in pursuing the Kingdom’s current seemingly chaotic and contradictory oil policy must have a Machiavellian streak in him. The UN Department of Economic & Social Affairs in early April, for instance, warned that “the global economy could shrink by almost 1% this year – 0.9% – due to the COVID-19 pandemic, instead of growing at a projected 2.5%.”

World output could contract further if imposed restrictions on economic activities and lockdowns extend to the third quarter this year and if fiscal responses introduced by countries across the world to mitigate the socio-economic impact of coronavirus (COVID-19) don't work things could get worse still.

The multifaceted crisis will have a big impact on Saudi Arabia’s public debt strategy and its socio-political structures – much more so than in other countries.

House of cards

The Kingdom is like a pack of cards, with each one representing a policy. This pack, however, has a surfeit of jokers – eight key ones to be precise. To what extent they affect the very foundations of the House of Salman’s polity and finances remains to be seen.

The first is the collapse of oil prices, which in late March hit a nadir of $22 per barrel. The benchmark Brent Crude Oil Futures on April 9 stood at $31.48 per barrel, well below the $65 per barrel of only a few weeks ago and a far cry from the $165 per barrel of the halcyon days in June 2008.

The second is the extent of the GDP growth slowdown in China, where the coronavirus originated. China is the Kingdom’s largest oil and petrochemical export market. In 2018, China, according to official Saudi data, topped the main import source for the Kingdom at 15.4% of total imports – the next largest being the US at 13.6%. Similarly, China was the second largest export market for the Kingdom at 11.7%, just behind Japan with 12.2%.

The third is the unsustainable cost – both in terms of resources and casualties – of Riyadh’s brutal proxy war in Yemen, which has turned out to be a foreign policy disaster.

The fourth is the cost of bailing out the economy and the private sector to mitigate the impact of COVID-19. Saudi Minister of Finance Mohammed Al-Jadaan introduced a SAR120bn ($31.88bn) rescue package in late March complete with exemptions, deferments and handouts. Al-Jadaan, upon launching the mitigation package, hinted that “some budget appropriations will be reviewed and reallocated to the sectors most in need in the current situation, including allocating additional funds to the health sector.”

The fifth is the impact on the Kingdom’s multi-trillion riyal KSA Vision 2030, which has reportedly been dogged by delays and a cornucopia of inefficiencies largely due to its sheer ambition and size. KSA Vision 2030, according to MBS, “is an ambitious yet achievable blueprint, which expresses our long-term goals and expectations, and reflects our country’s strengths and capabilities.” There is already talk of scaling down some of the infrastructure and development projects.

The sixth is the cutting down to size of the US oil shale industry, whether unwittingly or unintentionally and perhaps to the chagrin of its strongest supporter, President Donald Trump. The shale industry is in retreat because it cannot survive at oil prices hovering between $25 and $35 per barrel. In early April, US shale driller Whiting Petroleum became the first major casualty of the COVID-19 crisis, filing for Chapter 11 bankruptcy protection amid the slump in oil prices.

The seventh is the ability and capacity of the major global economies, especially the US, China, Japan, EU, the UK and others, to rebound and recover from the COVID-19 crisis. The major gatekeepers of the international economic and financial system – the World Bank/IMF, OECD, the Basle Committee, etc – all agree that recovery will be slow, sluggish and fragmented.

Perhaps the eighth and the ‘Mother of all Jokers’ in the pack is the impact of the above scenarios on Saudi Arabia’s revenues and ultimately its stubbornly entrenched budget deficit. The Debt Management Office (DMO) of the Saudi Ministry of Finance (MoF) has a multi-prong strategy of raising more funds from the financial markets through increased domestic and international sukuk (Islamic trust certificates) issuances, in addition to international conventional bonds and drawing down on its sovereign wealth fund (SWF) assets.

Rising debt in a sea of oil

Finance Minister Al-Jadaan, at the launch of the COVID-19 package, reassured that “the government has considerable ability to diversify sources of financing between public debt and government reserves to adequately tackle the emerging challenges. This allows positive intervention in the economy in the right way and at the right time, while limiting the impact on the government's goals in maintaining fiscal sustainability and economic development in the medium and long term.” That is easier said than done.

The Kingdom, due its geopolitics and position as a major oil exporter, is beholden to manifold internal and extraneous pressures, some of which are beyond its control.

International rating agency Fitch Ratings last October downgraded Saudi Arabia’s long-term IDR to ‘A’ from ‘A+’ with a Stable outlook precisely to reflect “increased geopolitical and military tensions in the Gulf region, and its revised assessment of the vulnerability of Saudi Arabia's economic infrastructure, and continued deterioration in its fiscal and external balance sheets.” In early April, Moody’s downgraded the outlook for the banking systems of the six Gulf Cooperation Council (GCC) countries – Saudi Arabia, UAE, Qatar, Kuwait, Bahrain and Oman – to negative from stable.

“Oil prices are substantially below those required to balance the budgets of GCC states. This will weigh on government revenues and lead to spending cutbacks that will rein back growth in the non-oil sectors of the economy where the banks do most of their business. Banks will face a reduced flow of deposits as falling oil prices squeeze government revenues – the largest depositor in most GCC banking systems,” observed the rating agency in its latest report.

With oil prices set to remain low for the foreseeable future, Saudi Arabia’s public fund-raising options remain limited. Personal income tax and social security contributions will stay off the table because they are too politically sensitive in an absolute monarchy, which has refined state welfare dependency into a fine art.

The Saudi establishment is also reluctant to draw down on its sovereign net foreign assets (SNFA), which according to Fitch will be at an expected 74% of GDP in 2019, despite a fall from 87% of GDP in 2017 and a peak of 112% of GDP in 2015. The international reserve position, the main driver of SNFA, is strong (at an anticipated 22 months of external payments in 2019). Total SAMA (Saudi Arabian Monetary Authority) reserves, according to the MoF 2020 Budget Statement, reached approximately SAR1.9tn ($499bn) in November FY2019.

In addition, Riyadh has strong ambitions for its sovereign wealth fund (SWF), the Public Investment Fund (PIF), whose assets under management (AUM) currently stand at $320bn. It wants to transform the PIF into the world’s largest single SWF at $2tn, funded largely from proceeds of a minority stake in the giant state oil company Saudi Aramco.

In November 2019, the MoF initiated a plan by Saudi Aramco to sell a 1.5% stake, or about 3bn shares, at an indicative price of SAR30-32. The domestic IPO was valued at SAR96bn ($25.6bn), which gave Saudi Aramco a market value of $1.6-$1.7tn.

This valuation raised eyebrows among would-be international investors and together with the onset of the COVID-19 crisis and its impact on Japan and China, the Kingdom’s two largest oil export markets, and the subsequent volatility in oil output and collapse in oil prices, has scuppered at least for the foreseeable future any chance of a follow-up IPO in the international market. The Saudis had originally targeted selling off a 5% stake comprising a 1.5% offering to domestic investors and 3.5% to international investors.

The 2020 Saudi budget has inevitably been overtaken by recent events. Crucially, that budget was focused on KSA Vision 2030 projects, and projected total expenditures at SAR1,020bn ($270.98bn), and revenues at SAR833bn ($221.30), leaving a projected budget deficit of SAR187bn ($49.68bn, or 6.4% of GDP). The expectation then was that actual expenditures and revenues would be more balanced, with the deficit shrinking over the next four years and fully balanced by 2023.

The MoF has already revised this ambition, conceding that the deficit will increase and will take longer to overcome given the current oil market and global economy dynamics. Minister Al-Jadaan’s own medium-term real GDP growth forecast is 2.5% per annum.

Taking the show on the road

So what are the realistic public debt raising options for Riyadh to finance its economy during and post-COVID-19 dispensation?

The facts speak for themselves. The Saudi Ministry of Finance is pursuing a diversified fund-raising strategy comprising the issuance of sovereign global bonds, especially US dollar-denominated ones aimed largely at US investors; the issuance of sukuk in the international markets; and perhaps most importantly, the issuance of regular riyal-denominated domestic sukuk, which are aimed only at selected local institutional investors and priced more efficiently, thus bringing down the cost of financing.

The Kingdom is a latecomer to the sukuk market, having issued its debut global sukuk in April 2017. Domestic sukuk followed in July 2017 after the DMO established the unlimited Saudi Arabian Government Saudi Riyal-denominated Sukuk Programme, under which all the Kingdom’s sovereign domestic sukuk issuances are issued. According to the DMO, the aim “is to issue and offer, at its discretion, sukuk in multiple issuances to investors, as part of the DMO’s role in securing Saudi Arabia’s debt financing needs with the best financing costs; contributing to the fulfilment of the objectives of the Ministry’s Fiscal Balance Programme; and to the development of the Saudi sukuk and Islamic capital market.”

Riyadh has taken the market by storm by becoming the most prolific issuer of sukuk in the world in less than three years. In the first three months of 2020, the DMO has raised SAR26.784bn ($7.12bn) through the issuance of three consecutive monthly sukuk offers. The latest one was on March 26, when the MoF raised SAR15.568bn ($4.14bn) through a 3-tranche issuance ranging in maturities of 5, 10 and 30 years. These are fixed-rate papers and priced at a coupon rate depending on the maturity. The January 7-year tranche was priced at 2.47% per annum and the February 4-year tranche carried a 3% coupon rate.

Last year, the DMO issued twelve consecutive monthly domestic sukuk from January to December 2019 with an aggregate annual volume of SAR69.839bn ($18.61bn). This is a SAR23.054bn ($6.15bn) year-on-year increase on 2018. The MoF also raised $2.5bn though an international sukuk in 2019, thus bringing the US dollar equivalent raised through sukuk to $21.11bn.

In addition, the Kingdom also issues conventional bonds as part of its diversified fund-raising strategy. In January 2020, the DMO issued its sixth international bond to date – a $5bn three-tranche multi-tenor offering under Saudi Arabia’s Global Medium-Term Note Programme. 

This fund-raising strategy will continue for the next few years as the Kingdom tries to grapple with the vagaries of oil market dynamics, the impact of COVID-19, regional geopolitical tensions especially with Iran and to a lesser extent Qatar, and reining in the budget deficit.

In its latest Article IV Consultation with Saudi Arabia last September, the Executive Directors of the International Monetary Fund (IMF) confirmed that “the DMO of the Saudi Ministry of Finance has published an Annual Borrowing Plan and issuance calendar for domestic debt for the first time; extended the yield curve through the issuance of a 30-year sukuk; established the primary dealer system, and the first foreign investor has been permitted into the debt market. The domestic investor base is also being broadened through the issuance of small denomination sukuk. The CMA indicated that work is underway to launch a derivatives market by year-end as part of reforms to further deepen the domestic financial market.”

The longer sukuk maturity, according to the DMO, “will help develop the pricing process for Saudi sovereign issuances through building up a yield curve for longer tenor issuances of up to 30 years, which would support infrastructure projects, as well as public and private sector debt issuances, and also serve as a reference point to price mortgage and savings products by having it as a risk-free point on which price models are based on, and will also provide new investment products for the local market, creating a new investor base such as pension funds, endowments and insurance companies.”

Saudi Arabia remains predominantly an oil-based economy, and it would be foolhardy to write off the Kingdom. The country possesses around 18% of the world's proven petroleum reserves. Saudi Arabia is the world’s largest oil exporter, with expected 2020 crude oil production of nearly 10.5mn bpd, and exports of nearly 7mn bpd alongside substantial exports of refined products. It ranks as the largest exporter of petroleum, with the oil and gas sectors accounting for about 50% of its GDP and 70% of its export earnings. Saudi Arabia is also rich in other natural resources such as natural gas, iron ore, gold and copper.

Saudi Arabia Fact File – Selected Economic & Financial Indicators

Source: IMF/World Bank Group 2019 Article IV Consultation Report  *Projected