Strategy Note / Saudi Arabia

Saudi pares fiscal deficit, hits consumer, prepares for long oil war, splits GCC

  • Fiscal measures equate to 4% of GDP, shaving about a third off the 2020 deficit
  • Saudi consumer hit: 15% VAT (from 5%), end of public worker cost of living allowance, job losses, salary cuts
  • Implications: Partly addresses Russia fiscal advantage in oil war, pressures expat remittances, may split GCC further

The fiscal cuts announced by Saudi Arabia on 11 May equate to c4% of GDP and a prior fiscal deficit of 12.6% (2020 forecast from IMF). The measures include a VAT hike (from 5% to 15%), ending a cost of living allowance for public sector workers and project spending delays. The VAT increase is, in our view, unlikely to be reversed and could equate to 4% of GDP in annual recurring fiscal revenue.

We draw the following domestic, regional and global implications.

(1) Saudi consumer – This is another blow to consumer spending growth that has already decelerated very sharply (following the oil price fall and Covid-19 disruption to retail and tourism): the hike in VAT and the removal of public sector cost of living supplemental allowance compounds the effect of job losses, and the removal of private sector salary and hours cuts (of up to 40%), and likely job losses (particularly in the expatriate labour force).

(2) Saudi income tax – The existing VAT framework (reporting requirements, auditing procedures) allowed for rapid implementation of an increase in the tax rate. Longer-term, this is another indicator that wider corporate and personal income taxes are an inevitable part of the non-oil fiscal armoury.

(3) Saudi political risk – The centralisation of power under Crown Prince Muhammad bin Salman has demonstrably dealt with dissent in the wealthier segment of society and projected a mix of nationalism, security, social reform, the liberalisation of entertainment, and targeted welfare to preserve social stability among the less affluent mass population. Of course, domestic political threats remain ever present and a much weaker economic climate increases vulnerability. But we reiterate our view that as long as the Crown Prince retains monopolistic control over the military and security apparatus and the US remains a key supporter, then the risk of social discontent turning into something which puts the succession or the regime at risk remains a very low probability.

(4) Saudi equities – The local Tadawul index is down 20% year to date, broadly in line with MSCI EM (down 18%). Banks, Cement, Chemicals, and Consumer Non-Food have, in general, under-performed Aramco, Consumer Food, Healthcare and Telecom. Trailing price/book of the index is 1.6x, merely a 7% discount to the 5-year median. We are not that enthusiastic about Saudi equities relative to alternatives in the Middle East (Egypt), oil exporters (Kazakhstan), large and liquid EM (Technology). Within the narrow peer group of the GCC, Qatar is better able to withstand the current crisis environment (with greater firepower for fiscal stimulus) but when conditions normalise (in terms of Covid-19) we see more low-hanging fruit for non-oil diversification in Saudi.

(5) Saudi US$ sovereign debt – The 2028 3.625% Saudi US$ sovereign bond, rated A1 by Moody’s and A by Fitch, currently has a mid-yield to maturity of 2.8%, broadly in line with the start of the year but down from a mid-March peak of 4.3%. The current z-spread of 229bp is over 300bp narrower than EMBI (compared to about 180bp narrower at the start of the year). Clearly, actions which rein in fiscal deficits should be positive for fixed income investors.

(6) GCC disunity and competition – A common framework for 5% VAT across the GCC was agreed in June 2016. But implementation has been very uneven with Saudi and the UAE moving ahead first in January 2018, Bahrain in January 2019, and with Kuwait, Oman and Qatar yet to implement. A differential of 15% at one end (Saudi) and zero at the other (eg Qatar) creates a substantial competitive disadvantage when it comes to cost and attractiveness of doing business. This is another example of a lack of coordination in the GCC: a strain most evident in the Qatar blockade and one that is likely to worsen for this regional bloc – as it is for others like the EU – through the Covid-19 and oil crises.

(7) Oil price – This partly addresses one of the weaknesses of Saudi in fighting with Russia over the power to set the marginal price of oil: Russia entered the oil price war with much lower fiscal break-even oil price (approximately US$40 versus US$85 for Saudi). This could be interpreted as Saudi preparing itself for lower oil prices for much longer.

(8) Remittances in oil importers (and labour exporters) – GCC remittances (of which Saudi accounts for over half) equate to a substantial portion of GDP (approximately 2% to 8%) for the likes of India, Bangladesh, Philippines, Lebanon, Sri Lanka, Pakistan, Jordan and Egypt. Pressure on overall economic growth and consumer growth in particular usually negatively impacts the expatriate community disproportionately (because they do not represent as politically important a constituency as the citizen base).

Below we present charts on Saudi consumer and corporate confidence metrics, GCC fiscal forecasts (prior to the April OPEC+ deal and most of the crisis stimulus or austerity actions), global oil exporter fiscal break-even oil prices and tax revenues, and recent performance of Saudi equities and sovereign US$ debt.

Related reading

GCC: The Gulf is not a safe haven unless (at least) oil prices recover, 1 April 2020

Oil spat turns into a splat: A reminder of the winners and losers in EM, 21 April 2020

Kuwait, GCC: The expat debate stirs again, 15 April 2020

GCC: Sovereign wealth warning from the IMF (again), 7 February 2020

If remittances drop 20% who is exposed in emerging and frontier markets?, 29 April 2020

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Macro Analysis / Russia

Russia: Federal budget deficit widens on healthcare and social support

ING Think
15 June 2020

The 5M20 budget fulfillment is generally in line with our expectations of the federal budget deficit widening to around RUB5.0 trillion (4-5% GDP) in 2020. With the ongoing anti-crisis mode and upcoming 1 July nationwide voting on constitutional amendments proposed by the president, spending growth is set to remain high, while the revenue side is likely to remain under pressure on the sharp decline of economic activity in 2Q20. 

Regional budgets are important sources of state spending on education, housing, non-pension social payments, and healthcare (regional spending on those account for 63% of total consolidated spending on such items), and are likely to suffer from the likely drop in profit tax, personal income tax, and property tax (together they account for almost 80% of the regional tax revenues). This means higher regional dependence on transfers from the federal budget as well as regional debt placement, however, this option is only available to a limited number of regions.

A widening in the non-oil budget deficit will be financed by additonal local debt placement (we see it at around RUB3.5 trillion this year), while fuel revenue undercollection (RUB1.5 trillion) could be financed via spending of the National Wealth Fund, a sovereign fund.

An acceleration in budget spending as well as an increase in the debt placement programme maay serve as an additional argument in favour of a gradual approach to reduce the key rate by the Bank of Russia.

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Macro Analysis / Global

Banks face headwinds from shaky emerging market government finances

  • Covid-19 lockdowns have put pressure on EM sovereign finances; banks could be asked to take some of the strain
  • GCC banks appear susceptible to higher taxes (Saudi Arabia recently hiked VAT); Bangladesh banks already heavily taxed
  • Banks in Oman and Sri Lanka appear to have capacity to hold more sovereign debt; Nigeria and Pakistan banks less so
Rahul Shah @
Tellimer Research
19 June 2020

Recent budget announcements (Kenya and Mauritius in Africa, Bangladesh and Pakistan in Asia) highlight the strain caused by Covid-19 lockdowns on emerging market finances. While government spending is increasing to lessen the economic hardship, income is falling as economic activity declines. In this context, we think bank shareholders could once again find themselves in the firing line.

Banks are already exposed to the economic downturn through lower revenues, higher risk costs and tighter liquidity. In addition, regulators have adjusted loan contract terms in most markets so that borrowers may enjoy payment holidays or even lower interest rates.

Banks could face higher taxes and/or be asked to hold more sovereign debt

Tighter sovereign finances could result in two additional claims to which bank shareholders would be exposed. The first is that governments may raise taxes on the banking sector in order to plug fiscal gaps. While governments so far seem content with raising taxes on consumer staples such as telcos, tobacco and alcohol, past experience (such as the super taxes in Pakistan, or the debt repayment levy in Sri Lanka) suggest banks could also find themselves in the firing line.

Which banks could be most exposed to higher tax rates?

Comparing 2020f projected fiscal deficits with last year’s effective tax rates for our banking coverage highlights GCC markets along with Egypt as being potentially most at risk (ie names in the lower left quadrant of Figure 1 below).

Saudi Arabia recently hiked its VAT rate to 15% (from 5%), which could bring in additional revenues equivalent to 4% of GDP. Looking outside the GCC region, we note that Nigeria has already put in place measures to increase the tax burden on its banks via higher VAT (5% from 0% for online transactions, and 7.5% from 5% for other service fee income) and revocation of the tax-exempt status of government securities from 2022. Kenya in 2018 increased the excise duty charged on bank fees from 10% to 20%, which brought in KES8.3bn in receipts that year, equivalent to around 5% of the banking industry’s pre-tax profits. Another example is Egypt, which has introduced a less favourable tax regime for banks’ T-bill holdings. The chart below suggests that other tax-raising measures in these markets cannot be fully discounted.

Which banks will be asked to fund sovereign deficits?

A longer-term impact comes from increased reliance of bank funding by EM sovereigns. As well as crowding out private sector lending, banks carrying more government debt on their balance sheets make their risk profiles more closely intertwined. Even if such instruments carry zero risk-weights, particularly for the most indebted sovereigns, they are anything but, as the recent example of Lebanon spectacularly highlights.

We think banks in Oman and Sri Lanka could be increasingly called upon to carry more sovereign debt assets, particularly given that the likely increase in global sovereign issuance could lead international investors to become more discerning. We note that Sri Lanka banks are currently barred from holding USD sovereign debt, but they continue to invest in LKR-denominated government bonds.

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Macro Analysis / Russia

Russia lockdown: The impact after three weeks

  • Rescue package assessment varies from 1.8% to 2.8% of GDP, however direct injections are only 0.3% of GDP
  • Russian stimulus package stays at low end of countries list in 2020
  • Russian has a structural advantage under Covid-19 which mostly damages SMEs and big cities
Natalia Orlova @
21 April 2020

As the Russian rescue package is only 2-3% of GDP, including 0.3% of GDP for direct measures, expectations for 2020 GDP growth have been cut to a 5.5% contraction by the IMF and to 2.0% y/y by the local consensus. We assess that the lockdown currently costs the Russian economy 0.5% of its annual GDP per week. As Covid-19 hits the economy via a contraction of services, i.e. it affects mostly SMEs and big cities, thus Russia’s weak SME segment and the low concentration of population in big cities could limit the scale of the economic losses. At the same time, we are seriously concerned about the implications for the longer-term: funding of the National Projects, previously seen as pillars of the Russian growth case, now risk being diverted to social purposes.

Rescue package assessment varies from 1.8% to 2.8% of GDP, however direct injections are only 0.3% of GDP: Since the end of March, President Putin has made four public addresses; his first speech on 25 March and his last address on 15 April were particularly dedicated to economic rescue measures. Russian officials provide a very different assessment of these measures: the Economy Minister came with a 1.8% of GDP figure (around RUB2.0tn) while the Finance Minister talked about a 2.8% of GDP rescue package and total stimulus of 6.5% of GDP (considering funding for the budget deficit). The difference in estimates is not surprising. The initial package announced on 25 March, which focused on introducing tax and banking holidays, was generally based on the idea that part of the cost could be allocate to rich tax payers: President Putin has announced an increase in the tax rate from 2% to 15% for recipients of dividends on offshore accounts and the introduction of 13% income tax on income from deposits above RUB1.0mn. But, when this comes to implementation, it turns out that some of measures will be implemented differently from how they were announced. For example, the taxation of large deposit holders will be applied only if the interest rate on deposits exceeds the key policy rate, which neutralize completely the sense of this measure. Second, to apply for a loan holiday the size of the retail loan should be relatively small – the ceiling level was initially set at RUB1.5mn for mortgage loans while the country’s average size is RUB2.2mn; this reduces substantially the effect of the measure. Finally, of all the measures announced, as of now, are only a small portion represents the direct state injection – in our view, this is around 0.3% of GDP, while the rest of the package is tax holidays, bank loan holidays and also numerous guarantees provided by the state in different areas. Even if the new measures announced on 15 April contain larger direct support, i.e. support to be provided to the regions, our general take from the cabinet action is that it still intends to spend as little as possible while being able to officially refer to a substantial rescue package.

Russian stimulus package stays at low end of countries list in 2020: As opposed to the 2008 experience when Russia spent around 40% of its $250bn stabilization fund and was among the countries with the largest rescue package with 5.2% of GDP support measures (see Figure 1), the current announced support does not look impressive (see Figure 2). For instance, in the US, the fiscal measures alone represent around 11% of GDP and Germany came with a package of 4.9% of GDP; Russia is also lagging behind some Latin American countries like Brazil and Chile, as well as Saudi Arabia. On top of that, central banks across the world came with monetary policy easing; the EM universe this time as opposed to 2008 has also responded by easing their monetary policy framework. Out of 22 EM countries, some 13 have cut rate their key policy rates since the end of 2019, whereas in 2008, 15 countries out of this group reacted with an increase in the key policy rate. The Central Bank of Russia kept its policy rate unchanged in March 2020; at the very same time as the ruble exchange rate drops in line with the decline in oil prices and as the share of foreign investors on the local OFZ market stays at around 31% (32% reported as of the beginning of this year), the chances of a further rate cut are increasing.

IMF forecast of a 5.5% GDP contraction for Russia in 2020 is well below the 2.0% contraction projected by the local consensus: The very modest cabinet response to the crisis has pushed global experts to take a very negative view on Russia’s growth outlook. According to the IMF forecast, under the 3.0% contraction of global GDP projected for 2020, the Russian economy should contract by 5.5% y/y, very close to 6.1% contraction projected for advanced economies. The experience of 2009, when Russian GDP contracted by 7.8% y/y versus a 0.1% contraction for the global economy, seems to be a strong benchmark for the international community; however, since then, Russia has become less dependent on global markets because of the sanctions. Even at the level of budget dependency on oil, the federal budget in the last two years was balanced at $49/bbl, one of the lowest breakeven levels among oil-producing countries. It remains to be seen if this isolation could play in favor of Russia during the current crisis, but this assumption could be quiet plausible. The Russian consensus, collected at the beginning of April by the Development Center of HSE, was much more optimistic: according to the poll, the consensus estimated Russia’s contraction at 2.0% y/y for 2020, including an 8.1% y/y decline in 2Q20 followed by a 2.6% y/y contraction in 3Q20. We are expecting Russian GDP to contract by 6% in 2Q20 – however this is under the assumption that the Russian lockdown will be eased from the May holidays, which remains to be seen. Our expectations for April is a GDP contraction of 20% y/y.

Russian has a structural advantage under Covid-19 which mostly damages SMEs and big cities: There are two structural aspects of the Russian economy which could ease the economic consequences of Covid-19 as opposed to advanced countries. Firstly, as the current lockdown affects mostly the services sectors, it mainly hits SMEs as opposed to large companies. However, Russia historically has run a very modest share of SMEs in its GDP structure: it is considered to represent only 20% of total output. Even within this segment, Russia runs relatively big companies as opposed to other countries: from a total of 18 mn people employed in SMEs in Russia only 1.4% of these employees are working in very small enterprises (employing 1-9 people) well below the level seen in countries, which are suffering from the pandemic. Secondly, the current crisis is considered to be a crisis of big cities, where the virus is spreading rapidly and where the largest share of services is concentrated. In Russia, only 25% of the country’s population live in cities >1 mn population and the average size of population in >1 mn cities is only 2.5mn in Russia, the lowest across peers. In today’s context, the low concentration of the Russian population seems to be an advantage.

Cost of a tight lockdown for Russia is 0.5% of annual GDP per week: As the duration of the lockdown is difficult to forecast, we decided to focus on the cost of the lockdown in weekly terms. Since 25 March Russia was in two weeks of light lockdown with only restaurants, non-food retailers and entrainment/tourism industries being officially closed. Starting 15 April, Moscow has introduced an electronic QR-code pass for people to move around and the lockdown started to affect a wider list of industries. The transportation sector is under pressure through the entire period of the global lockdown. Given the structure of Russian GDP (see Figure 7) and assuming a 60% drop of activity in affected sectors during the week of the light lockdown we assess a weekly economic loss from the lockdown at 0.3% of annual GDP. The tight lockdown with the 80% collapse of output causes an economic loss of 0.5% of annual GDP per week. Put simply, a month of tight lockdown reduces Russian GDP by 2.0% in annual terms - this roughly corresponds to the drop of April’s GDP by 20% y/y which we target.

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Macro Analysis / China

China: more loans point to a recovery, PBoC on hold

ING Think
10 July 2020

PBoC controls liquidity not to fuel asset markets

Undiscounted bills grew aggressively to CNY218 billion in June from CNY83.6 billion in May, this implies tight liquidity conditions at the end of the half-year.

This is because the People's Bank of China has not flooded the market with liquidity. It only cut interest rates for loans targeted at SMEs and the agricultural sector.

The PBoC does not want to create more liquidity to fuel the asset markets, including the real estate market and stock markets.

We expect the PBoC will continue to control liquidity, leaning towards a tighter stance rather than an easier one, if asset prices continue to rise rapidly. As such, we believe that the PBoC may not ease further unless there is severe damage to the economy either from foreign demand or inefficient stimulus. Foreign demand could continue to be dismal due to a faster increase in Covid-19 cases in the US. Domestically, we had worried about slow infrastructure growth but today’s credit data implies that growth in infrastructure projects should pick up soon. 

As such, our conclusion on monetary policy is that there is a high chance that the PBoC will put broad-based liquidity easing and interest rate cuts on hold, and focus more on helping lending to SMEs and agricultural activities.

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