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ANALYSIS

Saudi reforms to continue: report

RIYADH, April 24, 2017

The introduction of excise taxes in Saudi Arabia is likely to bring in annual revenues of SR8-10 billion ($2.1-2.7 billion; 0.35 per cent of GDP), according to government estimates, said a report.

While the 2.5 per cent real estate white land tax kicked in late March, proceeds of the tax are likely to accrue to the Ministry of Housing for real estate related projects, according to Bank of America Merrill Lynch’s (BofAML) Global Economic Weekly report.

The introduction of the balanced Nitaqat Saudization scheme in mid-December could require hiring of c250,000 Saudis to maintain unchanged compliance levels, supporting consumption but weighing on corporate profits.
    
Next reform catalyst likely in 2H17

“The next round of planned fiscal reforms from 2H17 could confirm the reform orientations of the government. This is especially so as the impact of changes to electricity and energy prices appear material, in our view,” BofAML said in the report.

The government has not yet officially decided on the reference prices to link domestic energy, water and electricity administered prices to, but appears to be mulling bringing energy product prices to their export price levels (and electricity and water prices to cost recovery levels, presumably). However, the net proceeds of the reform are likely to be much smaller as the government intends to compensate the household and private corporate sectors for the impact of these measures. These additional reform revenues (which would exclude electricity and water reforms as they are roughly budget neutral) need to be up-streamed by Aramco to the sovereign, meaning only a portion of these will likely show up on the fiscal side (due to taxation and dividends).

A SR200 billion private sector stimulus and support scheme could be announced in the coming future. The scheme could entail access to subsidized credit, likely through Specialized Credit Institutions (SCIs), through directed disbursement to strategic sectors or entities with targets linked to energy efficiency, and through continued honouring of existing contracts predicated on cheap feedstock. We expect some fiscal cost to arise from the scheme, not the least to accommodate capital to be deployed to the support fund or in the SCIs.

Government plans suggest steep increases to electricity, water and domestic energy prices over the period to 2020 (possibly in two steps). Illustratively, the gap to US gasoline prices is 104-145 per cent. For diesel, prices would need to rise 254 per cent to reach US prices. Water and electricity prices would need to increase by 50-187 per cent to reach US levels. The government expects the cumulative inflation impact of these measures to 4.8ppt to inflation, according to our reading of the Fiscal Balance Program 2020, while we expect a cumulative 7ppt impact from the changes cited above.

The government expects gross cumulative savings of SR171 billion ($45 billion; 6.4 per cent of GDP) from these measures over the period to 2020, in addition to SR38 billion from the first wave of the energy and water price reform implemented in December 2015. In comparison, the government expects the household cash allowance program to cost SR60-70 billion by 2020, suggesting net energy, electricity and water reform proceeds of SR134 billion ($35.7 billion; 5 per cent of GDP), according to authorities. This excludes the cost of private sector compensation schemes as well as proceeds from other non-oil revenue reforms.

Aramco tax reform unlikely to lead to major fiscal gap

The announced hydrocarbon sector tax reform with retro-active effect from 1 January is unlikely to lead to a major fiscal gap but this fiscal structure change may help Aramco achieve a higher equity valuation all things being equal. Statements in the local press by energy policy-makers suggest that the lost tax cuts will likely be offset by increased and stable dividends, as well as increased investment income from the Public Investment Fund (PIF) who will likely hold Saudi Aramco shares going forward. Stlll, it may make the receipt by the government of fiscal oil revenues lumpier, depending on the timing of the dividends, and may thus impact domestic liquidity accordingly.

We estimate ‎the reduction in the tax rate from 85 per cent to 50 per cent alongside the listing of a 5 per cent stake and the adoption of an offsetting (in relation to Aramco) dividend‎ policy may lead the government to only lose to minority shareholders 1.75 per cent of Aramco's post-tax annual net income. For argument's sake, assuming that Aramco's post-tax net income is an illustrative $100, the government's tax intake under the previous fiscal regime was US$85 and, for convenience, we assume there was no dividend. With the reduction in the tax rate, Aramco would need to pay out US$35 in dividends to its shareholders for the new fiscal regime to be neutral on Aramco. The 5 per cent listed equity stake suggests that the government would retain US$33.25 of the dividend while $1.75 of the dividend would flow to minority shareholders.

Calibrating to the 2016 fiscal oil revenues that stood at $87.7 billion, the lost fiscal revenues in this case would amount to $1.75 billion (c0.25 per cent of GDP). In our view, this loss could be covered through greater external bond issuance, or, over time, through greater investment income proceeds from the Public Investment Fund (PIF), partially seeded through the potential IPO proceeds. However, investment income may increase only gradually, and the redeployment of potential IPO proceeds by the PIF in external markets through the acquisition of foreign assets could likely offset over time the build-up of SAMA FX reserves implied by the potential listing of Saudi Aramco.

The upcoming Aramco Board meeting is to take place in Shanghai on May 10 (rather than in Saudi Arabia) and may be linked to a strategic initiative to attract Chinese state investment in the potential IPO, according to local press. If so, this may cement oil trade relations between the two countries and help replenish SAMA FX reserves.

Heavy external debt issuance pipeline to continue

We expect continued large sovereign issuance of external debt‎, supplemented by issuance from Saudi Aramco and the Ministry of Housing. Saudi Aramco privately placed in early April a US$3 billion SR-denominated 7-year sukuk domestically as part of a SR37.5 billion ($10 billion) sukuk program. Pricing was 15bps over 6-month Saibor. In comparison, the Saudi government's last issuance of floating-rate 7-year bonds was priced at 10-15bps below 3-month Saibor. International sukuk and external conventional bond programs for Saudi Aramco may follow, according to local press.

The setup of the Saudi Real Estate Refinancing Company (SRERC) is likely to entail regular conventional bond issuance, possibly guaranteed by the Ministry of Finance at first, then the issuance of securitized mortgage-backed securities to support development of the mortgage market. A first conventional government-guaranteed bond issue of $1-2 billion appears likely by 3Q17.

Following the issuance of a $9 billion international sukuk, we expect the government to resume issuing domestic debt over 3Q17, then issue a conventional international bond of at least $15 billion in size in 4Q17. The sukuk bond spreads currently trade in line with similar maturities Saudi government conventional bonds. Although this may reflect international bondholders perceptions of the hybrid Islamic structure, the sukuks appear cheaply priced to the curve as GCC sovereign sukuks have typically traded 15bps tighter than their conventional peer instruments.

Domestic liquidity to tighten modestly

The resumption of domestic issuance in 3Q17 is likely to modestly tighten domestic liquidity. The domestic banking sector liquidity has improved, with excess deposits at SAMA standing at SR109 billion in February, compared to SR54 billion in September 2016 and to an average of SR75 billion in 2014. With the deceleration in private sector credit growth and some stabilization in private sector deposits, the overall Loan-to-Deposit (LDR) ratio stood at 88.1 per cent in February, from 90.3 per cent in September. The targeted payment of cash allowances to Saudi households from 3Q17 onwards should support deposit formation, although a portion is likely to be utilized to meet higher bills.

Following SAMA interventions, suspension of domestic issuance and government repayment of arrears, the Saibor-Libor spread is back to 60bps, in line with its historical average. It is thus unlikely to narrow further from current levels in the near-term in a similar fashion to its behaviour post November issuance of external debt. Furthermore, government entities have supported the improvement of domestic liquidity through de-dollarization and shifting to time-deposits. Dollarization of government entities has dropped to 6.3 per cent in February, from 22.7 per cent in June 2016 prior to the start of SAMA interventions. The SR55 billion drop in FX deposits of government entities since June 2016 was accompanied by a simultaneous increase of their time deposits and demand deposits by SR21 billion and SR11 billion respectively over the same period. The increase in time deposits minimizes the risk of deposit drawdown to subscribe to debt issuance.

FX outflows have not yet abated

A significant portion of the $21.7 billion FX reserves drawdown year-to-date was likely due to financial outflows, possibly due to ongoing repayment of arrears. In comparison, the central government deposits drawdown at SAMA reached $13.3 billion year-to-date, annualizing in line with our budget deficit forecast of $85 billion (12 per cent of GDP). Private sector repatriation flows could nevertheless arise if the government's reform program brings up domestic investment opportunities. As the current account was in a minor surplus over 2H16, it is crucial that FX outflows do not further offset fiscal reforms. – TradeArabia News Service




Tags: Saudi Arabia | reforms | Taxation | FX |

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