Editor's Note:

On Monday the Obama Administration announced a plan to deal with bank "toxic" assets. Reactions to the plan were largely positive with markets rallying and what was characterized by the "CBS Evening News" in this way, "The Treasury put out the details today of a plan to rescue America's banks, and Wall Street responded with two thumbs up and a triple-digit rally."

Today we are pleased to share for your consideration a report by Jadwa Investment Chief Economist Brad Bourland on the implications of these developments on the Saudi economy. You can find links to the many reports Mr. Bourland has shared with your through SUSRIS following his latest report which was released on March 24, 2009.

Global markets have responded strongly to two major economic policy initiatives announced by the US government that aim to remove toxic mortgage assets from the financial sector and lift the economy. The US Treasury�s plan to deal with toxic financial assets held by banks was unveiled on Monday. Central to the plan is the creation of investment partnerships between the government and private sector investors. Initially, the government has allocated $75-$100 billion of capital, which combined with private sector money and borrowing facilities provided by the Federal Reserve and the Federal Deposit Insurance Corporation, could generate a pool of around $500 billion (which could be raised to $1 trillion) to buy bad real estate loans held by banks. The different public-private partnerships will bid for the bad assets that banks wish to dispose of and the private sector partner will manage the assets its partnership acquires. The Treasury plan also includes a new lending program to support private sector purchases of certain types of mortgage-backed securities. An effective mechanism to dispose of the bad loans on bank�s balance sheets is vital to restoring the health of the banking sector, a key condition for economic recovery. The plan addresses a hurdle that hampered previous attempts to tackle problem assets by using a private sector bidding process to determine a market price for the loans and securities. The plan has been well received by the markets and early pledges of support by large investors are encouraging. Its ultimate success will depend on the amount of private sector participation and whether banks and investors can agree on a price at which the asset sales can take place. On Wednesday the Federal Reserve took further aggressive action to try to revive the economy. The main measure the Fed announced was that it would buy $300 billion worth of US government debt over the next six months. It also raised its planned purchases of mortgage-related debt by $750 million to $1.25 trillion and broadened the assets that would benefit from the TALF (Term Asset-Backed Securities Loan Facility; which supports the issuance of securities based auto, student and credit card loans). The Fed�s moves aim to reduce interest rates and therefore encourage lending as well as lowering debt servicing costs. The purchases will focus on bonds with maturities of 2-10 years as interest rates over these periods have not fallen as much as those for short-term borrowing. While government bond yields fell on the announcement, there is no guarantee that this will translate into higher demand for borrowing given the huge economic uncertainty. Nonetheless, it is another clear signal of Fed�s determination to do all it can to revive the economy at a time when government action is taking time to gain traction.

Market reaction to the recent policy moves varied between asset classes. Not surprisingly, yields on US government bonds fell sharply (the yield on the 10-year US government bond had its largest one-day fall in 20 years on Wednesday). Inflation concerns stemming from the rapid growth in money supply required to purchase the debt triggered a plunge in the dollar, which recorded its largest ever weekly loss against the euro of nearly 5 percent. Commodity markets focused on the potentially healthy impact on the economy and as a result oil prices (WTI) moved above $50 per barrel for the first time since the end of November. Profit taking after a recent rally meant that global equity markets were less affected by the Fed�s decision, though they responded strongly to the toxic asset plan (the US Dow Jones industrials index was up by almost 7 percent on Monday). Higher oil prices and gains on global markets have supported the Saudi stock market, which has been up in seven of the last eight sessions, a rise of nearly 11 percent. Implications for Saudi Arabia Monetary policy in Saudi Arabia shadows that in the US owing to the exchange rate peg to the dollar and the lack of capital controls (in normal circumstances a notable difference between US and Saudi interest rates would trigger capital flows into the country where rates were higher). In the statement accompanying Fed�s recent actions it indicated that interest rates would stay around zero for some time to come and it instead would focus on other monetary policy tools to stimulate the economy. As Saudi Arabia�s economy and financial sector is in a far healthier condition than that of the US, it will not undertake any of the less conventional monetary policy measures used in the US. The current very low level of interest rates is suitable for the Saudi economy, but we think that rates would need to rise in the Kingdom well before they do in the US due to the large difference in the relative health of the two economies. While the current period of excessive investor caution allows some room for higher interest rates in the Kingdom (as US investors will demand much higher returns to move money abroad), this flexibility is limited. A sustained period of low rates could have negative repercussions for inflation. Lower commodity prices and the stalling of economic activity are pushing down inflation across the globe at present and further declines are likely. However, domestic inflationary pressure, stemming from the undersupply of accommodation and other bottlenecks in the economy, remains. If combined with very low interest rates, renewed dollar weakness and an eventual jump in global inflation once recovery takes hold, then inflation in Saudi Arabia could take off again in the second half of 2010.

Source: Jadwa Investments