Editor's Note

SUSRIS readers have long benefited from the insights and experience of Brad Bourland who served as Chief Economist of the Samba Financial Group in Riyadh.  The numerous analytical reports, articles and interviews with Bourland in SUSRIS provided hard to come by knowledge of economic performance and developments in Saudi Arabia.  In June Jadwa Investments, a Saudi Closed Joint Stock company, named him as its new head of research and chief economist.  

We are pleased today to share a recent report produced by Jadwa in which Mr. Bourland describes a new phase in the expansion of the Saudi economy, one in which growth based on oil revenues is seen to be shifting more to private sector performance.

SUSRIS wishes to thank Jadwa Investments and Mr. Bourland for permission to share this report with you.  It is provided in two parts due to its length.  Part two is circulated separately in email and posted online (click here for part 1).

The Saudi Economy's Golden Era: Phase Two

Part 2

Monetary policy

The riyal�s peg to the US dollar will remain unchanged at the current level of SR3.75 throughout our forecast period. None of the arguments that have been put forward for an adjustment to the exchange rate are compelling given the cost in terms of monetary policy credibility, lost revenues and damage to non-oil competitiveness. SAMA has consistently stated that it has no intention of altering the existing exchange rate and its vast stock of foreign assets gives it the ammunition to defend the peg. Therefore, while there may be occasional speculative pressure on the peg, it will not change. As a result Saudi interest rates will continue to be broadly in line with corresponding rates in the US.

Advocates of an adjustment to the riyal generally base their views on the need to tackle inflation and a perceived misalignment of the currency following the sharp run-up in oil process. Various alternative exchange rate arrangements have been proposed including a one-time revaluation, the movement to a basket system, or the floating of the riyal. We will examine the exchange rate issue in more detail in a forthcoming report. For now, we have outlined below the reasons that justify our confidence that the riyal�s peg to the dollar will not be changed.

• Official policy: SAMA has stated its commitment to the existing exchange rate arrangement and has the means to fight off any speculation.

• Credibility: If the peg is altered significantly it will damage the credibility of the exchange rate, potentially harming investment and economic growth and causing uncertainly about future changes as oil prices fluctuate.

• Inflation: We do not believe that imported inflation is or will be a major factor behind rising prices in the Kingdom.

• Lost revenue: A revaluation would impair the riyal value of oil revenues and assets denominated in dollars held by the government, banks and companies.

• Non-oil competitiveness undermined. A revaluation would raise the price of many non-oil exports into foreign markets and lower the price of competing imports into Saudi Arabia. 

• Discourages foreign investment: The introduction of exchange rate uncertainty caused by an adjustment to the peg would act as a deterrent to foreign investors. A revaluation would also make foreign investment more expensive.

• Volatility: Allowing the currency to float freely would add another element of uncertainty to an economy that is already vulnerable to oil price fluctuations.

GCC member states are planning to launch a single currency in 2010. Preparations have experienced a variety of setbacks recently and we do not expect a new currency to be in place by the end of our forecast period.

With the dollar peg unchanged, interest rates will continue to closely shadow corresponding rates in the US. There is some uncertainty over the trajectory of US interest rates at present owing to the countervailing forces of inflation above the Fed�s comfort zone and concerns about housing market weakness. It appears likely that these factors will offset each other and rates will be unchanged over the course of 2007. With globalization helping to limit inflation, even under strong growth forecasts interest rates would likely stay lower than 6 percent and with a major slowdown in global growth unlikely, neither will rates decline much. Therefore we see US interest rates remaining in a range of 4-6 percent over our forecast period.

Abundant local liquidity and speculation on revaluation pushed Saudi three-month interest rates below equivalent dollar rates through 2006 and the first half of 2007. Although we expect the local liquidity position to remain strong, the risk premium that usually keeps Saudi rates above corresponding US ones by 25-50 basis points (0.25-0.5 percentage points) will reassert itself.

Fiscal Policy

Increases in government spending will cause the budget surplus to fall in each of the years to 2010, by which time it will have virtually disappeared. The elimination of the surplus should not pose any fiscal problems for several years after that, as domestic debt servicing will be at a comfortable level and a vast stock of foreign assets will provide a substantial cushion in the event of oil price weakness.

Double-digit growth in government expenditure is expected in each year of our forecast, but this is likely to be contained to less than 15 percent. The government has stated on several recent occasions that it is trying to limit the inflationary impact of its spending and it is notable that the 13 percent budgeted rise in 2007 is relatively conservative given the run-up in construction and raw material costs.

Spending trends are likely to be in line with recent years with defense, education, and healthcare accounting for the largest allocations. Plans are in place for large capital expenditure in order to upgrade the social and physical infrastructure. Greater private sector involvement in infrastructure projects, education and healthcare should gradually ease the burden on the public sector.

Oil will remain the source of around 90 percent of revenues. After an anticipated fall of over 10 percent in 2007, owing to lower production and prices, oil revenues are expected to rise modestly over the remainder of our forecast period as production is increased. Non-oil revenues are predicted to climb as a result of rising investment income and customs revenues. No new taxes or changes to existing tax rates are anticipated.

Over the first phase of the oil boom, much of the budget surplus was used to cut domestic debt. We think that the government will be comfortable with domestic debt at around 15-20 percent of GDP and therefore do not expect much further repayment. We believe that the bulk of the future budget surpluses will be saved.

External trade

In the first phase of the current boom the story for trade and external capital flows was one of export revenues being deposited with SAMA, leading to a massive accumulation of foreign assets. In the second phase of the boom it will be one of the export revenues being spent. Most megaprojects are heavily dependent on imports. Around two-thirds of project related capital goods will be imported. Much of the related expertise also needs to be imported, as does more low-skilled labor. Payments for these goods and services will be the main forces driving down the current account surplus.

Import growth is expected to average 15 percent per year between 2007 and 2010, with capital goods accounting for most of this expansion. The annual rate of growth is likely to decline over the forecast period as the bottlenecks that have caused the recent run-up in raw material costs ease. Growth in imports of consumer goods should be strong, in line with the healthy performance of the non-oil economy.

Payments for foreign services will rise owing to strong demand from local companies and a lack of domestic expertise. Shortages of skilled professionals are likely to persist in a wide range of areas, forcing local firms to turn to foreign providers. Many skilled foreign nationals will be lured into the Kingdom and with further influx of low skilled labor (particularly construction workers) under way, outflows of expatriate remittances are forecast to rise.

Oil will remain the dominant source of revenues. After falling in 2007 owing to lower production and prices, oil export revenues will rise over the remainder of our forecast period, though they will be below their peak of $189 billion in 2006. Non-oil exports are forecast to increase at a much less rapid rate than in recent years. Although there will be sizeable growth in the volume of non-oil exports (especially petrochemicals), international prices are likely to fall. Nonetheless, non-oil exports in 2010 will be three times the level of 2002. Investment income (earned on Saudi Arabia�s foreign assets) will be the other main source of income. Revenues from this source will rise in line with the continued accumulation of foreign assets.

How to use these themes to invest

The macroeconomic and stock market conditions are in place for steady gains in share prices on the Saudi stock market. At mid-year 2007 the major downturn appears to be over. Many listed companies can reasonably be considered to be at fair value or undervalued. In particular, the 10 largest companies by market capitalization trade collectively at a price-to-earnings (P/E) ratio of 13; for the top 25 stocks, the P/E is 14. The remaining 68 stocks trade at a collective P/E ratio of 34, which we view as overvalued.

Because the stock market index, the TASI, is an all-share index weighted by market capitalization (meaning every stock in the market is part of the index and its weight in the index is determined by its capitalization), the stocks with large market capitalizations mainly determine the movements of the index. As the large-cap stocks appear reasonably valued, the TASI is in our view not likely to decline much further from the lows it recently established in the upper 6,000s. Nonetheless, smaller stocks could still decline sharply because of their high valuations, though this would not be reflected in a similar move in the index. For investors therefore, the Saudi market has become a �stock-pickers� market, meaning choose carefully, as many stocks are likely to continue sharp declines as others move up.

The current state of the market, combined with the macroeconomic forecast outlined above, shapes our view of the performance of the market to 2010. As with the aftermath of other major sell-offs, we expect the Saudi-market to remain in a consolidation phase through 2010. Because of the strong macroeconomic fundamentals, however, we expect steady, if unspectacular, gains. Profit growth for listed companies should range from 10-15 percent per year, and that should be the gain expected for the index annually as well, as we expect the market to trade at a similar P/E ratio for some time. We would not be surprised to see the P/Es of large-cap stocks rise into the higher teens, or in market jargon, to experience �multiple expansion� in 2009 and 2010, as optimism about the economy continues to build and as the 2006 crash is put further behind us. An annual rise of 10 percent in the TASI from a fair-value level we currently put at 7,500, would place the index at 9,980 at year-end 2010. An annual rise of 15 percent from our fair value level would put the TASI at 11,4000 at end-2010. We think this range is a reasonable expectation to work from.

How can investors profit in this market over the next 3 years? We advise:

• Focus on larger companies with reasonable valuations.

• Pay attention to objective research for �buy� recommendations. The days of everything moving up are over for the time being. While large companies are currently more cheaply priced, there are some �hidden gems� among the smaller stocks on the market, with good profitability and strong competitive positions in fast-growing sectors of the economy.

Also, work the macroeconomic themes to your advantage:

• There will not be a revaluation of the riyal. This favors companies that exports, as the competitiveness of their products will not be harmed by the exchange rate. It also helps projects and companies that count on foreign spending and investment, such as travel and tourism, the economic cities, and petrochemical megaprojects. Conversely, if you thought importers, such as retailers and distributors would be getting a boost in profits from a revalued riyal, it will not happen.

• In general, inflation will subside. This should help share prices because high inflation reduces the price that investors will pay today for future company earnings. However, continued high growth in rents will put pressure on the profitability of companies that have high rental expenses. While inflation at the consumer level will be contained, prices for goods at the corporate level (�wholesale� price inflation) will be higher, hurting some companies in sectors such as construction and building materials. 

• Continued economic reform means increased competition in some sectors. For example, while we expect high growth in financial services, the rapid opening of the market and influx of foreign players will inevitably erode the profitability of existing banks.

Risks

There are risks to be healthy outlook for the Saudi economy that we have detailed in this report, but nothing significant enough to alter the underlying positive story. Much of the momentum for th years to 2010 comes from reforms that have already been enacted and can not be reversed (WTO accession, telecoms and financial service liberalization) and an investment boom that can not be stopped in its tracks.

The principal risks to our forecast that we have identified are as follows:

• Oil prices: Oil prices are volatile. The oil market is subject to a multitude of risks, both downside and upside. The table below shows how the economy would perform if WTI averaged $40/b (equivalent to $38/b for Saudi crude oil), through 2010 rather than our forecast of $60/b.

 

Economic performance under a lower oil price
	2007	2008	2009	2010
Central scenario - WTI averages $60 per barrel
Real GDP growth (%)	2.7	6.3	6.2	5.2
Inflation (%)	3.5	3.3	2.7	2.2
Fiscal balance (% GDP)	9.5	6.4	2.9	0.2
Current account balance (%GDP)	15.9	13.4	11.5	9.3
Exchange rate (SR/US$)	3.75	3.75	3.75	3.75
Low oil price scenario - WTI averages $40 per barrel
Real GDP growth (%)	0.2	2.7	3.8	3.3
Inflation (%)	3.3	3.0	2.4	1.9
Fiscal balance (% GDP)	-4.4	-5.7	-5.4	-4.1
Current account balance (%GDP)	-0.8	-1.4	0.6	1.0
Exchange rate (SR/US$)	3.75	3.75	3.75	3.75

Under the lower oil price scenario the fiscal and external positions both deteriorate markedly. There is limited scope for an adjustment in project spending and related imports in the near term, as it is generally easier to complete a part-built project rather than put it on hold. Furthermore, an oil price of $40 per barrel would not affect the commercial viability of most oil, gas, petrochemical and metals projects. By the end of the forecast period we expect that spending would have adjusted to the lower oil price. The deficits anticipated would be comfortably financed by a drawing down of reserves. The growth of those sectors reliant on the project flow would be affected by 2010, but for those where the growth dynamic is driven by reform (such as telecoms and financial services), the impact of a lower oil price would be minimal. An oil price of $40 per barrel would also imply lower oil production, as OPEC would be cutting quotas to try to raise prices.

• Global economy: The global economy faces a variety of risks, the most significant for Saudi Arabia being that of a slowdown in the US economy. A recession of the US would impact the oil price. During the modest recession in 2000, the oil price fell from $36 per barrel in November 2000 to about $28 per barrel in February 2001. A similar proportional decline in oil prices in today�s market over the course of a shallow recession in the US would take about $15 per barrel off oil prices, depending on several factors, such as OPEC supply management.

• Rise in global long-term interest rates: Long-term interest rates are at unusually low levels. If the yield curve steepens it would significantly increase the cost of borrowing for Saudi companies. If this were combined with the return of emerging market risk premiums to historical norms then Saudi borrowers could be facing long-term rates much higher than their current levels. In such circumstances, there would likely be a slowdown in the amount of new private sector investment. Projects already under way should be less affected as most have secured long-term financing.

• Loss of spending discipline: The only significant Saudi-specific economic risk looking ahead is that government spending runs well above our expectations. We are not greatly concerned by this possibility given the government�s acknowledgement of the importance of controlling expenditure and the major role played by the private sector in many of the major public-sector projects. Private-sector enterprises should be more responsive to higher costs and will adjust their spending plans accordingly, though there may be some problems where large projects have commenced without being able to secure all the necessary inputs. A final consideration is that even if individual projects appear viable, the multitude of projects under way through the GCC may lead to overcapacity in certain sectors, such as petrochemicals. 

• Political/security events: Saudi Arabia is in a volatile region. It also faces domestic political and security issues. It is therefore subject to a variety of potentially destabilizing events. The initial result of any such event would be a spike in the oil price, which would boost the Kingdom�s finances. However, the increased perception of risk would have a damaging impact on foreign investment over the longer term. While event risk is very real, the economy has thrived in recent years despite heightened regional tensions and an exodus of expatriate workers following a series of attacks in 2004.

We have deliberately concentrated on the downside risks to our forecast. There are, however, a variety of possible events � higher oil prices, faster global economic growth, rapid decline in the prices of raw materials, alleviations of skill shortages and a resolution of regional disputes � that would make the economic picture even stronger.

Part 1 of this report is provided in a separate email and online (Click here).

For comments and queries please contact:
Brad Bourland
Head of Research
[email protected]  

Head Office
Phone: +966 1 279-1111
Fax: +966 1 279-1571
P.O. Box 60677, Riyadh 11555
Kingdom of Saudi Arabia
http://www.jadwa.com

Disclaimer of Liability (from Jadwa.com) 

Unless otherwise stated, all information contained in this document (the �Publication�) shall not be reproduced, in whole or in part, without specific permission of Jadwa Investment.

Jadwa Investment makes its best effort to ensure that the content in the Publication is accurate and up to date at all times. Jadwa Investment makes no warranty, representation or undertaking whether expressed or implied, nor does it assume any legal liability, whether direct or indirect, or responsibility for the accuracy, completeness, or usefulness of any information contained in the Publication. It is not the intention of the Publication to be used or deemed as recommendation, option or advice for any action(s) that may take place in the future.

SUSRIS thanks Jadwa Investment and Mr. Bourland for permission to reprint this document.

About

Brad Bourland is head of research at Jadwa Investment, Riyadh.  From 1999 through 2007 Brad was the Chief Economist at Samba Financial Group, formerly Saudi American Bank, in Riyadh, where he published regularly on issues related to the Saudi and global economies and the world oil market. He appears frequently in the domestic and international media and is a regular public speaker. Before joining Samba, Brad spent an 18-year career as diplomat, economist, and manager with the U.S. Department of State. During the last three years of his diplomatic career he was in Riyadh as the American Embassy's First Secretary responsible for financial affairs, where he analyzed the Saudi economy for the U.S. Government and conducted financial aspects of US-Saudi relations. Brad has his BA and MA magna cum laude from the University of Utah, and is a CFA (Chartered Financial Analyst) charterholder.

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About Jadwa Investments

Jadwa Investment is a Saudi Closed Joint Stock company operating under the supervision of the Saudi Arabian Capital Markets Authority (CMA). Under the CMA decision published on August 21, 2006, Jadwa was awarded a license to offer all types of investment services including: dealing, managing, custody, arranging and advising.  [more]