Tight spending, higher oil revenues drive Saudi fiscal improvement in H1

Saudi fiscal

JEDDAH — Tight spending and higher oil revenues drive Saudi fiscal improvement in 1H17, Bank of America Merrill Lynch’s report Emerging Insight: Saudi Arabia revealed.

The 2Q17 fiscal deficit stood at SR46.5bn (“$12.5bn), with 1H17 deficit standing at SR73bn annualizing SR145bn ($39bn). The financing for the budget deficit was taken from the government's reserves account at SAMA (SR15bn) as well as external borrowing (international sukuk of SR33.7bn; $9bn). Simplistically, the fiscal deficit target of the authorities (SR198bn; 7.8% of GDP) could be within reach for 2017 at the current pace excluding any off-budget spending and seasonality, “well below our expectations of SR326bn (12.8% of GDP) and last year's outturn of SR416bn (17.2% of GDP),” the report said.

The increase in fiscal oil revenues over 1H17 appears due to a mix of higher oil prices and a higher payout ratio from Saudi Aramco. Oil revenues are 70%yoy higher in 1H17 despite the OPEC production cuts thanks to higher oil prices as well as a higher fiscal transfer ratio from Saudi Aramco. The fiscal transfer ratio has been pro-cyclical to oil prices and is broadly in line in 1H17 with the ratios achieved at similar levels of oil prices. While Saudi crude oil exports are down by 0.4mn bpd in 1H17 compared to 1H16, oil prices are $12/bbl higher over the same period. The additional export revenues (SR58.6bn) represent c70% of the year-on-year increase in fiscal oil revenues (SR82bn), suggesting a higher payout ratio from Saudi Aramco as oil prices recovered.

As 1H17 fiscal oil revenues have reached roughly 44% of the budget target, this suggests that the budgeted proceeds of domestic energy subsidy reform for 2017 could be relatively minor, or that the first phase of energy pricing reform program could take place late in the year.

As anticipated, the retroactive (to 1 January) fiscal regime change for Saudi Aramco in late 1Q17 has not changed the government fiscal intake. As the tax rate in the oil sector was brought down from 85% to 50%, fiscal oil revenues would likely have benefited from higher dividends instead. According to the press, authorities are considering a proposal to replace the current fixed royalty system (20%) on the oil sector with a more flexible system that would increase it automatically if oil prices rise significantly, Bank of America Merrill Lynch said.

Non-hydrocarbon fiscal revenues to increase going forward - Non-oil revenues are somewhat lower year-on-year in 1H17 but should increase materially starting from 2018 onwards as fiscal reforms kick in. 1H17 non-oil revenues stood at 45% of the budget target. In the meantime, the excise tax on soft drinks, tobacco and energy drinks as well as the fee on dependents of expatriate workers could add in SR7.5bn of non-oil revenues in 2H17. The introduction of VAT, the introduction of an expatriate worker levy, the possible introduction of tariffs on luxury products and the increase in fees on dependents of expatriate workers could add SR80bn ($21.3bn; 3.0% of GDP) to non-oil revenues in 2018.

Moreover, the report noted that spending discipline remains on track. “Authorities appear to have underspent the budgeted target, helping improve fiscal accounts. While the authorities' track record has been one of overspending in recent years, the 1980s did see instances of underspending. This was in years where the realized oil price turned out to be lower than the estimated budgeted oil price, somewhat similar to the current situation,” the report said.

Compared to the targeted budget spending of SR890bn, spending stood at only SR381bn (43% of target). All of the budget sectors saw realized spending come below the 50% mark versus the targeted level. Underspending was most pronounced in infrastructure and transportation, and economic resources. Military, security and regional administration stood at a combined 44% of budgeted spending although it is unclear if this can be sustained going forward.

Capex likely slowed down but could rebound - Infrastructure underspending suggests that capex spending may have been slowed down over 1H17. Furthermore, capex may have already been tightly budgeted in 2017. This is because the previously off-budget government capex spending from the budget surplus fund appears to be now taking place on-budget. Spending from the budget surplus fund (largely the metro project) was material last year at SR25bn ($6.6bn; 1% of GDP). The announced restart to the $26.6bn Grand Mosque expansion project, which was halted in late 2015, is likely to push capex higher going forward.

Reported fiscal spending may exclude SR20bn of arrears to contractors repaid over 1Q17. The larger drawdown of government deposits in SAMA in 2H17 compared to the reported financing suggests some off-budget spending of around SR20bn, the report noted.

Spending discipline may be tested going forward - Spending discipline may be tested in 2H17 due to seasonality as well as the reversal of public sector allowance cuts on a retroactive basis (cSR7bn). The reintroduction of the public sector allowances (SR7bn) and the introduction of military personnel one-off bonus (SR4bn) in April 2017 should have started to be included in 2Q17 data. However, this may have been accommodated within the budget envelop. The introduction of the Household Allowance Program (at a cost of SR25bn) as well as linkage of gasoline and diesel to reference prices (with potential revenue of SR22bn) appears to have been both delayed. Nevertheless, the delay is fiscally neutral for now.

Tight spending suggests non-oil economic activity is likely to remain fragile. The non-hydrocarbon real GDP growth stood at 0.6%yoy in 1Q17 (private non-oil sector: 0.9%yoy; public non-oil sector: -0.1%yoy). This suggests that the economy may not avoid a headline recession this year as the OPEC-mandated oil production cuts drive real GDP growth to negative territory. Although political developments and seasonal increase in domestic energy consumption may have delayed the next leg of fiscal reforms, we still expect the latter to take place by year-end. Positively, the imposition of the expatriate dependent fee (part of the planned fiscal reforms) went ahead on schedule on 1 July. The weak economy complicates the government's plans to implement further fiscal reforms. This may suggest a more back-loaded path for fiscal consolidation or the concurrent introduction of a private sector support package alongside fiscal reforms.

The report further said the improvement in the fiscal balance suggests that capital outflows remain the main driver of the Fx reserves loss. Central government deposits at SAMA declined by $17.9bn over 1H17, while SAMA Fx reserves declined by $35bn. The large $18bn acquisition in foreign currency and deposits in 1Q17 despite achievement of a current account surplus may be outflows linked to repayment of government arrears.

Fx reserves held steady at c$500bn in June due to a mix of factors. On the negative side, banking sector foreign liabilities dropped by $2.1bn during the month. Also, private sector deposit dollarization increased from 7.6% to 9.8%. As private sector SR deposits dropped by $2bn but private sector Fx deposits increased by a much larger $7.8bn during the month, this suggests that dollarization was not the major driver of the build-up in private sector Fx deposits. To the extent these Fx deposits were repatriated from abroad or fresh inflows, this may have supported SAMA Fx reserves.

SAMA Fx reserves were also likely supported by the $3.9bn drop in the foreign assets of independent institutions and agencies managed off-balance sheet by SAMA. Outstanding repo liabilities of SAMA increased by $4.7bn, supporting an increase in the liquidity of domestic banks and the full reversal of the increase in interbank lending towards SAMA after the international sukuk issuance in April. — SG