Saudi Arabia: Financing a future beyond oil

Surging oil prices have provided much-needed relief to Saudi Arabia in recent months. The extra income has so far had little effect on economic growth, which remains sluggish, but it has eased financial pressure on the government, enabled the authorities to begin rebuilding foreign reserves and has bolstered confidence at a time of heightened uncertainty in the kingdom. Meanwhile, as if to demonstrate an undiminished appetite for Saudi risk, foreign banks are lining up to arrange financing for major projects, with several large transactions under discussion last month.

Saudi Arabia depends on oil exports for most of its foreign exchange earnings and close to 70% of its government revenues. With shipments of over 7 million barrels a day, each $1 increase in the price of oil generates at least another $2.5 billion a year in foreign exchange and SR7 billion to SR8 billion in government revenues (assuming that the national oil producer, Saudi Aramco, keeps some of the proceeds). In fact, the average export price of Saudi oil has climbed from a low of less than $11 a barrel in early 1994 to $16.21 during all of 1995 and $17.75 this year (as of early June, according to Saudi American Bank), yielding billions in additional income.

It is not yet clear what the authorities plan to do with this windfall, which is piling up in the kingdom's overseas bank accounts. There have been reports that the defence minister wants to expand the military, while the finance minister would prefer to accumulate foreign reserves. The decision-making process may have been slowed by the illness of King Fahd, who reportedly suffered a debilitating stroke last November. Kevin Taeckner, an economist with Saudi American Bank (Samba), suggests that some of the surplus might be distributed - as a bonus to government workers in compensation for years of frozen pay, and to contractors owed money by state enterprises such as national airline Saudia and the water and electricity utilities.

Most observers doubt that the Saudi authorities will embark on a spending spree. In a major policy change, the government early last year began to cut subsidies and impose charges for public services, belatedly hoping to trim its chronic budget deficit, halt the erosion of foreign assets and strengthen public finances. A younger cabinet of western-educated technocrats appointed by the king last August - which includes a new economic team led by finance minister Ibrahim al-Assaf - appears committed to the same goals. Its first budget, announced on New Year's Day, called for slightly lower revenues of $35 billion in 1996, unchanged spending of $40 billion and a deficit equal to about 3% of gross domestic product (GDP). Final figures for 1995 have not yet been published, but it's believed that both revenues and spending exceeded the original targets, while the deficit was much lower than in previous years. (For planning purposes, the Saudis assumed a highly conservative average oil price of $15 a barrel in 1995 and $14 this year.)

Zero real growth

Last year's public sector price increases were expected to produce revenues equal to more than 2% of GDP and may have done so: inflation shot up to 4% or 5% in 1995 from 1% or less during the previous two years. As a result of these tight fiscal and monetary policies, the economy is now in its fourth consecutive year of zero real growth. Nevertheless, the IMF has urged the government to do more, recommending a spending freeze for the next few years, further cuts in subsidies, higher fuel prices and the introduction of a consumption tax, a business tax and a tax on imported luxury goods in order to eliminate the deficit. Apart from the spending freeze, none of these suggestions was adopted in this year's budget; but foreign observers were not dismayed, attributing the failure to political uncertainty caused by the king's illness. "This budget is intended to hold the line," says a foreign adviser to the government. Moreover, with higher oil prices recently, he adds: "They could come out smelling sweet, if they keep spending down ... This could very well give them a breathing space and room to take bolder measures in 1997."

The budget deficits of the past decade were caused by lower-than-expected oil prices, heavy spending and the enormous costs of the 1991 Gulf War, which expelled Iraqi forces from Kuwait. To finance these deficits the government has issued domestic treasury bonds and bills, fallen into arrears and drawn down the kingdom's foreign assets. The stock of domestic government debt has mushroomed at an alarming rate in recent years and currently stands at 80% of GDP, or over $100 billion, with interest payments now consuming about 10% of the budget. Although as much as 50% of the debt may be held by other government agencies, the overhang is still a major concern because it aggravates the structural budget problem and threatens to crowd out the private sector.

Strapped for cash, the government also accumulated huge arrears in the form of unpaid bills to suppliers, contractors and farmers, causing a severe liquidity squeeze throughout the economy. Last year, the authorities began to address this problem by issuing promissory notes to these involuntary creditors, who have converted the notes into cash by selling them to the banks at a discount. No information has been published about the scale of this programme, but market rumours indicate that nearly SR20 billion ($5 billion) of notes have been issued to date. The current official policy is to meet obligations in cash, but there are said to be large arrears still outstanding from ministries and state enterprises, and fresh arrears in some areas such as pharmaceuticals (possibly related to complaints by some suppliers that the notes are un-Islamic and unacceptable).

Finally, the government drew on its enormous foreign assets, which fell sharply until recovering somewhat recently as a result of higher oil prices. For example, Saudi Arabia's official reserves (excluding gold) totalled just under $10 billion in February this year, compared with $5.9 billion at the end of 1992 (and $25 billion in 1985). Similarly, the kingdom's total foreign assets probably stood at more than $90 billion at the end of last year, compared with $78 billion at the end of 1992 (and $154 billion in 1983), with assets managed by the Saudi Arabian Monetary Agency rising to perhaps $75 billion and the net foreign assets of commercial banks falling to $15.6 billion. (The government has negligible external debt, since it is reluctant to borrow abroad).

Barring another oil price collapse, Saudi Arabia's external accounts should continue to improve, with declining current account deficits and mounting foreign assets; last year's current account deficit of $4 billion to $5 billion was the lowest since 1990. Indeed, some economists think the deficit may approach zero this year, or even turn into a small surplus for the first time since 1982. Taeckner of Samba estimates that oil exports could generate close to $50 billion (compared with $44 billion last year), while non-oil exports could bring in $5.5 billion (compared with $5 billion). Based on previous trends, other receipts might include $3 billion of shipping fees and $5 billion of investment income, giving the kingdom total current earnings of around $63 billion. That would be enough to cover its main outlays: $25 billion of merchandise imports, $20 billion of "services" (which include foreign military purchases) and $15 billion of remittances repatriated by foreign workers.

The country's prospects are clouded by some uncertainties. On the political front, foreign observers have expressed concern about the successor to King Fahd (with one account claiming that the ailing monarch wanted to abdicate recently but could not because of squabbling among his brothers); signs of domestic disaffection (dramatized by a fatal bombing in the capital last November, for which four young Saudis have been executed, and another on the east coast late last month); and regional tensions (ranging from unrest in neighbouring Bahrain to the election of a hard-line government in Israel). On the economic front, there is concern that oil prices could slide when Iraq resumes limited exports later this year under an agreement with the UN.

New team's challenge

However, at least until the most recent bombing, Saudi investors seem to have discounted these concerns. In the local money market, according to Samba, short-term riyal interest rates have remained about level with or even slightly below US dollar rates in recent weeks, in stark contrast to bouts of uncertainty during 1993 and 1994, when they temporarily rose much higher. Growing oil revenues may have provided reassurance. Another reason for the equanimity seems to be confidence in the new cabinet appointed last August, including an economic team of younger, brighter, less political figures with international experience and "excellent economic credentials", according to a foreign official.

Their immediate challenge is to cut the budget deficit. The government is committed to a balanced budget: it is a principal stated aim of the current five-year plan. But it will be difficult to achieve. As Moody's Investors Service said in a recent commentary, further budgetary restraint will "test the government's willingness and ability to impose a measure of austerity on a population long accustomed to a social safety net that is among the most generous in the world". Moreover, with wages and interest accounting for much of current spending, and public investment already pared back, the authorities have little choice but to concentrate on boosting revenues. Defence spending might offer room for cuts. A US government estimate put Saudi military spending at $20.5 billion in 1993 - equal to 41% of government spending and nearly 10% of GDP, both among the highest ratios in the world - although it appears to have fallen since then.

The new economic team must also tap more reliable streams of income. As Moody's points out, the basic dilemma facing the world's largest oil exporter is that it cannot convert its vast petroleum reserves into higher revenues because increased production immediately puts downward pressure on prices. Meanwhile, oil prices could fall at any time, for other reasons beyond its control. "You can't continue to depend on an unstable source of revenue: the oil price is high now, but it will come down," says a senior foreign official. "If you're unable to bring about a significant reduction in living standards for your people and you don't want to draw down your reserves further - which you shouldn't, given the openness of the economy - you've got to do something about the structure of the budget, to develop a stable source of revenues." That means broad-based taxation, which has been anathema in tax-free Saudi Arabia until now.

Looking further ahead, Saudi Arabia's biggest challenge will be finding ways to cope with the rapid growth of its labour force. According to the World Bank, the population of 18.6 million people - more than half of which is under 20 years of age - is expanding by over 3% a year, creating ever-larger demand for consumer goods, public services and, above all, jobs. "In the long term, they must accelerate growth to at least the same rate as the population growth rate, which will require significant structural change in the economy," says one observer.

But it is not clear where this economic growth will come from. The government sector has already stopped providing any new stimulus for higher demand. The private sector may not be capable of creating enough job opportunities, even though it has developed fast in recent years and now accounts for 30% of GDP - but only about $1.5 billion of annual exports, when petrochemicals are excluded. Moreover, any sustained increase in private investment outside the capital-intensive oil and petrochemicals industries will probably require more rational pricing policies, greater openness towards foreign investment and a more plentiful supply of skilled labour. Even then, real wage levels will fall if the population continues to grow faster than the economy.

As a senior foreign adviser to the Saudi government puts the problem: "The dilemma the economy will encounter even after the adjustment is complete is: where do you go from here?"

Banks adjust to the competition

Saudi Arabia is relaxing its attitude to foreign investment - if not foreign ownership - as its emerging private sector, faced with government austerity and domestic banks' lack of funding capacity, looks for alternative sources of project finance

Saudi Arabian banks will generate record profits again this year, even though the economy is in its fourth year of stagnation. Endowed with large amounts of free deposits, reflecting Islamic strictures against the payment of interest, and buoyed by increased liquidity, the banks have stepped up their investments in domestic and foreign bonds. Meanwhile, Saudi companies are increasingly looking abroad for funds, hoping to take advantage of highly competitive conditions in the syndicated loan market, and some banks have proposed the creation of a Saudi Arabia fund through which foreigners could invest in local stocks.

Saudi Arabia's 12 commercial banks have traditionally played a limited role, mainly providing short-term trade finance and collecting deposits which they placed abroad. Government lending institutions have been the primary source of domestic credit, recycling oil revenues on subsidized terms. But this pattern has changed in recent years, as the government itself has been obliged to borrow from the banks and the private sector has grown in importance, financed in part by short-term bank loans. At the same time, tight domestic liquidity has intensified competition among the banks, spurring them to draw down their foreign assets, invest in new technology and adopt more sophisticated management systems.

On paper, Saudi banks are among the most profitable, liquid and highly capitalized in the world. According to the Saudi Arabian Monetary Agency (Sama), their average risk asset ratio was 19.9% in March this year, compared with a recommended minimum of 8% under the Basle capital adequacy guidelines. But when they initiated coverage of the kingdom and its banks recently, both Moody's and Standard & Poor's (S&P) seemed to discount the numbers, focusing instead on the country's economic and financial vulnerabilities. Moody's assigned a sovereign ceiling of Baa3 to the kingdom, its lowest investment-grade category, placing the world's leading oil-exporting nation on a par with Slovakia and Poland.

It also awarded financial strength ratings to four banks, ranging from C+ for Saudi American Bank (Samba), to a lowly D+ for United Saudi Commercial Bank (USCB). Similarly, while noting the strengths of the banking system, S&P said its main concern was "that Saudi Arabia remains a risky place to lend money", given the economic and legal uncertainties.

At the end of last year, the 12 Saudi banks reported combined shareholders' equity of $9.7 billion and customer deposits of $63 billion, of which around 44% were in the form of non-interest-bearing demand deposits. (According to the Bank for International Settlements, non-banks in Saudi Arabia also held another $25 billion in bank deposits abroad.) Loans amounted to only $40 billion, while total assets stood at $93 billion, of which about 30% were held abroad, compared with nearly 50% a few years ago. During the year, the banks earned a record $1.4 billion on operating revenues of $3.3 billion, for a system-wide profit margin of 44%, and net profits rose by a further 17% in this year's first quarter.

However, the performance of individual institutions varied widely. Al-Rajhi Banking & Investment Corporation, which enjoys the lion's share of free deposits as the kingdom's only so-called Islamic bank, reclaimed the lead as the most profitable player, displacing Samba for the first time in four years. At the other extreme, Bank Al-Jazira, which has been struggling under new management to overcome a legacy of bad loans, managed only to break even, while Saudi Dutch Bank plunged into the red after writing off investment portfolio losses. National Commercial Bank (NCB), the country's largest bank, achieved above-average earnings growth, as did Riyad Bank, the second largest.

Long-term future

In terms of profitability, net operating income as a percentage of operating revenues ranged from a startling 79% at USCB to 41% at NCB (excluding Saudi Dutch and Al-Jazira). In terms of liquidity, the loans to customer deposits ratio varied from 34% at Saudi Cairo Bank to 109% at Al-Rajhi. And in terms of asset quality, according to figures compiled by Capital Intelligence, the ratio of non-performing loans to total loans ranged from 3.2% at Saudi British Bank to 58.6% at Al-Jazira (although there is no standard definition for non-performance).

Looking forward, local bankers seem optimistic, despite the fact that liquidity is still constrained by government austerity, and public sector delays and delinquencies. "Businesses have adjusted," explains one. "Before, when we had a real liquidity crunch, they drew down their bank lines of credit for working capital or as a cash reserve. Since then, companies have worked down their inventories and they're now very cautious about selling to or doing business with the government." Meanwhile, some money is coming from the government and deposits are growing again. "The banks are really stepping up competition to provide a greater range of asset-liability products to their customer base," says another senior banker in Riyadh. "They regard the present difficulties as temporary and are looking to the longer-term future."

At the same time, a growing number of Saudi companies and joint ventures are planning expansions or new facilities. In the past, such investments might have been financed in part by cash or credit from the government, which typically owned all or part of the venture, directly or indirectly. Today, companies are exploring alternative financing methods which have not been used in the kingdom before, such as off-balance sheet build-operate-transfer schemes to develop new public infrastructures and international syndicated loans to finance commercial projects. Foreign banks are lining up to arrange and underwrite such facilities, with Japanese banks again active in the country, making aggressive bids and placing margins under pressure. "You'd think foreign bankers would be a little more cautious," says a local bank official. "But if you look at the larger petrochemicals projects, they're very competitively priced. Foreign banks seem to be quite eager to lend: the competition is tough."

Major syndications

"Pricing has come down significantly, not only for Saudi Arabia but for the [syndicated loan] market as a whole; therefore, it's a good time to borrow instead of using shareholders' equity as they have in the past," says a banker in London. Moreover, the borrowers are usually well-regarded export-oriented names with firm markets, strong parent companies and balance sheets that are not over-leveraged. As for the political uncertainties, he adds: "Banks take a longer-term view, happily. The country still has huge natural resources and people feel comfortable with the way they're handling things at present: it's all being done with a minimum of fuss and a remarkable measure of continuity, which banks find encouraging." In at least one respect, however, there seems to be a lack of continuity: JP Morgan, which prized its special relationship with the kingdom, has been absent from recent deals, prompting speculation that its access may have stemmed from personal ties between long-time former Saudi finance minister Mohamed Ali Aba al-Khail and former Morgan vice-chairman Rodney Wagner, both of whom retired recently.

The first major international syndicated loan to finance a Saudi project was signed last year, providing $700 million for eight years to the Saudi Petrochemical Company (known as Sadaf), a joint venture between Saudi Basic Industries Corporation (Sabic), which is 70%-owned by the government - and Shell Oil Company. The deal was conceived by local and regional banks, but the original participants couldn't come up with the full amount and close it, perhaps because of unfamiliarity with large-scale, long-term project lending. In the end, after long delays, Citibank and Chase Manhattan were invited to join the syndicate, the loan agreement was made subject to UK rather than Saudi law and the loan was priced at Libor plus 125 basis points.

But the agreement quickly fell apart. According to one banker, Sadaf "bitterly complained" about the pricing, "literally as we were signing", arguing that it was "much too high". Another banker concedes that "the pricing was rich", but claims it was important at the time to get the financing committed, even though it "set an unfortunate benchmark for the country". In any case, Japanese banks are said to have later approached Sadaf offering to refinance the deal on better terms. As a result, some members of the syndicate offered to reprice the loan at Libor plus 85bp, and it was expected that a new agreement would be signed late last month. (Sadaf has not yet drawn on the facility.)

Despite all its problems, the Sadaf transaction represented an important turning point. "It showed there was a willingness on the part of Saudi projects to consider external financing, and that the borrower and Sabic would countenance the use of UK law to govern documentation. That's made it easier for others to be done," says a London-based banker. "In addition, borrowers saw that the participation of large foreign banks could overcome the lack of funding capacity; that the process was not hugely more onerous in terms of structure and documentation, as they had feared; and that it could even be cheaper than just using local banks."

Recently, Saudi Aramco Mobil Refinery Company (known as Samref) achieved even finer terms when it borrowed $225 million for five years at Libor plus 40bp in a syndicated loan arranged by Chase and Banque Nationale de Paris to finance refinery expansion. The borrower is a joint venture between Mobil Oil Company and Saudi Aramco - the state-owned national oil company - but the loan does not carry any guarantees from the parent companies. "This is a very significant benchmark transaction which obviously reflects the quality of the joint-venture partners," says one of the arrangers. "Pricing is very significantly down and the banks remain reasonably relaxed, certainly with regard to these big projects, because they've been shown to be properly executed and they're adding value which increases the economic activity of the country. I think banks like that and are happy to take part in that."

As Euromoneywent to press, the government-owned Saudi Consolidated Electric Company (Sceco-East) for the eastern part of the country was about to award a mandate for a $500 million, 11.5-year financing. Three groups of local, regional and international banks had reportedly bid for the transaction, which seemed likely to provide the borrower with 10-year funding at Libor plus between 80bp and 85bp in return for allowing the lenders to attach revenues payable to it by Saudi Aramco in case of default. Unlike the country's seven other electricity companies, Sceco-East is considered creditworthy because it serves the oilfields and industrial installations concentrated along the Gulf coast, counting Aramco as one of its largest customers (and suppliers).

Other transactions in the works include a $500 million to $600 million financing for a new petrochemicals plant to be built by a joint venture between Chevron Corporation and local investors - with Chase awarded the mandate - and a potential financing of as much as $1 billion for Saudi Yanbu Petrochemical Company, a joint venture between Mobil and Sabic, with Chase also rumoured as the adviser.

However, there were no reports of financing proposals for the national airline, Saudia, which last year agreed to buy 61 Boeing and McDonnell Douglas aircraft for upwards of $7 billion over five years. The Saudi government adamantly refused to support the purchase with a sovereign guarantee, making it impossible for the US Export-Import Bank to extend loans or loan guarantees, and it appears that the financially weak carrier will make some initial purchases with cash provided by the government and then try to arrange local financing. "It's still a mystery how that's going to work," says a foreign banker in Riyadh.

Inward investment plans

In another innovative proposal, a consortium including two US companies, Bechtel and Parsons, and Sabic is said to have offered to create a utility which would take over responsibility from the government for supplying electricity and water to the kingdom's two showcase industrial cities, Yanbu (on the west coast) and Jubail (on the east coast), where most of Sabic's plants are located, in effect privatizing these services. According to unconfirmed reports, the consortium would agree to invest up to $6 billion or $7 billion in the venture in return for "realistic tariffs", with the ultimate aim of selling shares in the company to the Saudi public. However, the sensitivity of permitting foreign ownership of a utility and the complexities associated with unravelling subsidized tariffs will probably delay any decision on whether to approve the project.

The government may also drag its feet on a proposal by some banks to create a Saudi Arabia fund, listed in London or Luxembourg, that would enable foreigners to invest indirectly in Saudi stocks. Currently, foreign ownership is generally prohibited, although proponents argue that an offshore mutual fund structure would not give foreigners direct ownership of the shares. The IMF has urged the Saudi authorities to pursue privatization more aggressively, liberalize foreign investment, and encourage faster development and opening of the local stock and bond markets, in order to attract more private capital inflows, but any change will probably not come quickly.

Compiled and written by Katharine Morton