Saturday, 30 April 2016

Will Saudi Arabia end its addiction to oil?

Optimism over the Saudi national vision is premature.

On 25 April, Saudi Arabia unveiled its national vision, a set of goals it wants to achieve by 2030. A central theme in the Vision 2030, a brainchild of the Deputy Crown Prince Mohammad bin Salman, is putting an end the country’s chronic reliance on oil. Some have lauded the announcement as the long-awaited push Saudi Arabia has always needed. Others called it a mere public relations exercise. On balance, caution must be the order of the day. Any claims that Saudi Arabia is already on track to end its “addiction to oil” in the next few years are premature for four reasons.

1. Announcing a national vision is not new in this region. In fact, Saudi Arabia is a late joiner. BahrainKuwaitOmanQatar and the United Arab Emirates (ie all other Gulf countries) have all published their own national visions years ago. The publication did not ensure timely implementation or immunity from the decline in oil prices.

2. Vision 2030 is a set of long-term goals or targets, not a concrete plan of how to achieve them. A plan should be released in May/June under the title of National Transformation Plan after a few months’ delay. But to put it briefly: a vision is not a plan; and having a plan does not guarantee execution.

3. Execution of any plan is likely to prove difficult. There are signs of difficulty even this early in the process. Only days before the announcement of the vision, the Saudi water and electricity minister was fired following public outcry over higher utility tariffs. Public dissatisfaction could intensify as more difficult measures are rolled out.

4. One of the most headline-grabbing measures—the plan to replace oil revenues with the proceeds from a $2 trillion sovereign wealth fund—is unrealistic. Even if the fund reaches the required size and somehow manages to increase the share of its foreign investments to half from 5% currently (domestic holdings are mostly oil related), an optimistic return of 7% on overseas assets would generate only $70bn per year. This would not be enough to replace oil revenues and finance the expected budget deficits, which together totalled $216bn in 2015 for example. 

Overall, the attempt to transform Saudi Arabia’s economy away from its oil dependence is needed, and steps taken towards this are positive. But a viable plan is required to show how this ambitious target can be achieved. Even then, the actual implementation of the plan will be key.

Monday, 18 April 2016

Iran-Saudi competition poses a risk to oil market recovery

An escalation of the Iranian-Saudi competition could decelerate the ongoing rebalancing in the oil market.

Oil markets are rebalancing. US production is falling and demand is proving resilient. The misalignment between demand and supply is being reduced as a result. The hope was that the meeting between some of the world’s largest oil producers in Doha on April 17 would help accelerate the rebalancing process. Despite scepticism about the actual impact on demand/supply balances, the optimists felt encouraged by the willingness of the producers to sit together and address the problem. Indeed, the early signs of a deal were positive and oil prices rallied ahead of the meeting.

But while expectations about the impact of the Doha summit ranged between neutral and positive before the meeting, the assessment of its no-deal outcome was decidedly negative. The meeting showed that the competition between Iran and Saudi Arabia is spilling over to the oil market. If this translates into an escalation of the market share war between the two countries, then the ongoing rebalancing in the oil market could be derailed.

What are the signs of increased Iranian-Saudi competition in the oil market?

First, there were reports of a price war between the two countries. Following the lifting of its sanctions in January, Iran has been offering aggressive discounts on its oil in order to gain market share in Asia.

Second, the non-participation of Iran’s oil minister in the Doha meeting, after weeks of speculations, showed that Iran was not willing to join other producers in freezing its output. Perhaps convincingly after years of sanctions.

Third, the comments from the Saudi Deputy Crown Prince, one day before the meeting, emphasising his refusal to participate in any production freeze unless Iran joins in. He also threatened to increase production by one million barrels per day immediately. “I don’t suggest that we should produce more, but we can produce more,” the prince was reported to say. 

If this threat is implemented, it can flood the oil market with yet more supply. But it is not expected to, because it is in nobody’s interest to do that. Nonetheless, it would be worth watching production data closely in the coming months.

Monday, 11 April 2016

The Saudi fiscal plan is more austere than Greece

The Saudi austerity plan is too stringent and, if implemented, could be damaging for growth.

The fall in oil prices has hit Saudi public finances. The government’s budget balance switched from a surplus of 6% of GDP (a measure of the size of the economy) in 2013 to a large deficit of 15% in 2015. At this level, the Saudi budget deficit is unsustainable.

In an interview with Bloomberg last week, the Saudi deputy crown prince, Mohammed bin Salman, and his team reiterated their plans to achieve a balanced budget by 2020. If this plan is implemented, Saudi Arabia will embark on an austerity programme more stringent that the one which had sent Greece into a depression. And it will be executed under more challenging economic conditions that the ones Greece had faced. The plan could prove more damaging than helpful for the Saudi economy. Therefore, it is unlikely to be strictly implemented.

What is the Saudi plan on the deficit?

Mohammed bin Abdulmalik Al-Sheikh, a Minister of State, said during the Bloomberg interview that: [B]y 2020, our plan is that we will have a balanced budget.”

- This echoes what was said in an earlier interview with the Economist: “he [Mohamed bin Salman] plans to balance the budget in five years.”

How do they plan to balance the budget?

- Through raising $100bn of additional non-oil revenue by 2020. The new sources of revenue include the introduction of a value-added tax (VAT) and other fees and the removal of subsidies.

- Assuming no additional oil revenue (“We try to focus on the non-oil economy,” bin Salman said), and public spending that is fixed at 2015 levels, the additional $100bn of non-oil revenue should be enough to balance the books.

How large is this austerity programme?

- A move from a deficit of 15% of GDP to a balanced budget within five years is very large.

- Such programme would be more stringent than the austerity programme which had sent the Greek economy into a depression. Greece reduced its budget deficit from 15% of GDP in 2009 (similar to Saudi Arabia today) to a deficit of 4% five years later (Saudi Arabia plans 0%).

- It would also be more austere that the programme implemented by the Conservative-led government in the UK, where the budget deficit went from 13% of GDP in 2009 to 4% in 2014.

What is the likely economic impact of the Saudi austerity plan?

- Judging by the experiences of Greece and the UK, the plan is likely to be quite damaging for growth in Saudi Arabia.

- Moreover, the Saudis will be implementing their austerity measures under more difficult conditions than the ones either Greece or the UK had faced.

- While their governments were engaged in austerity, the central banks in both Greece (the Euro Area) and the UK reduced interest rates in an attempt to boost growth by stimulating lending and investments.

- Saudi Arabia does not have that luxury. Saudi interest rates are linked to the US because of the currency peg to the US dollar. Indeed, when the US raised interest rates in December, the Saudis swiftly followed.

- US interest rates are expected to rise over the medium term, which means that Saudi rates will also rise, increasing the cost of borrowing for households and businesses and inhibiting consumption and investment.

- The private sector is unlikely to step in to fill the hole left by the government. It will face increasing costs as subsidies are removed and VAT is implemented.

What is the way forward?

- Saudi Arabia needs to reduce its budget deficit. A deficit as large as 15% of GDP cannot be sustained beyond a few years.

- But the plan to balance the budget in five years is too ambitious and could be damaging for growth and counter-productive for debt sustainability. It is therefore unlikely to be strictly implemented.

- The optimal speed of fiscal consolidation is somewhere between the two extremes of doing nothing and doing too much too fast. Let’s leave identifying this speed to future work.

Sunday, 3 April 2016

Iraq on track for a much-needed IMF loan

Iraq could secure a loan from the IMF before the end of the year.

The International Monetary Fund (IMF) completed the first review of its staff-monitored programme with Iraq last week. The programme is an agreement to monitor the implementation of the Iraqi government’s economic agenda and does not involve any financial assistance. But four reasons suggest that it may well be converted to a full-fledged loan even before it expires at the end of this year.

1. Iraq has large financing needs. The fall in oil prices has reduced the government’s revenue leading to a large budget deficit, forecast by the IMF to be 10% of GDP in 2016. Lower oil prices have also reduced export revenue, leading to a large external deficit of around 6% of GDP in 2016 (see chart).

2. Iraq has limited options for financing. The attempt to borrow from financial markets last year fell through due to weak investor appetite.  Reserves can finance the external deficit for roughly three years, but at the risk of depletion and potential devaluation. Indeed, the central bank has been using its reserves to finance nearly half of the deficit. This left the government with little choice but to accumulate significant arrears to finance some of the other half.

3. Iraq is making some progress in meeting the IMF’s targets. The review has shown that three out of the five quantitative targets were met, with a fourth narrowly missed. The only failure was the inability of the government to avoid arrears. The programme had also structural targets related to surveying and measuring the exact size of accumulated arrears and to look into the financial health of state-owned banks. Good progress has been made on these targets according to the IMF, although only one of them was met.

4. The IMF is likely to be lenient with Iraq. Any decision may well involve a bias to help Iraq at this difficult moment, especially given its war with the Islamic State in Iraq and Syria (ISIS). 

So a full-fledged IMF programme involving a loan may materialise before the end of the year, perhaps even as early as June, barring a complete political collapse in Iraq. The programme could mobilise as much as $15bn over three years from the IMF as well as other institutions and governments. In return, it would require the government to cut spending further, which may prove painful. But it could also help the country avoid devaluation, given that the IMF still views the exchange rate peg to the dollar as the only constant in an otherwise messy and highly uncertain environment.