Saudi Arabia and the Game of Dominoes

Coflicts Forum Weekly Comment, 21-28 August 2015

That the drop in the price of oil is hitting Saudi revenues hard is a commonplace. But crude oil is no ordinary asset, and its unique place in the global financial system means that its collapse is having, and will have, much wider repercussions than mere revenue loss for Saudi Arabia. In short, the direct revenue losses attributable to a lower price for oil are only one part of the picture - and perhaps are not the part that may ultimately impact most on the Kingdom. These other 'global factors' stemming from the structural role of oil in the global system are as important - and may become more important - than the impact of revenue loss alone.

One such ‘ global’ aspect is that the oil and commodity price rout is making many countries’ pegged exchange rates increasingly unviable (including that of Saudi Arabia and UAE), and this weakening in exchange rates is leading to capital flight, asset sales, and the consequent further depletion of reserves (through protecting the value of the currency) – thus exacerbating and magnifying the simple fact of revenue loss due to lower crude prices.

But more than this, the oil collapse has triggered a negative feedback loop, by which falls in assets such as oil and other commodities, in themselves, are contributing towards undermining confidence in a wider class of financial assets, including equities and bonds. The recent Shanghai equities meltdown erased $5 trillion in asset values – equivalent to twice the size of all stocks traded in Brazil, India, Russia and South Africa. Stock markets in the Middle East, including in Saudi Arabia were also hit by a loss of confidence. Citi Bank is forecasting a revenue shortfall for Saudi Arabia amounting to 22% of GDP for this year, which will almost certainly require both a cut-back in expenditure and asset sales. Here the ‘global aspect’ is that once a major asset such as crude implodes, the sale of other assets to fill the revenue gap, or to fight capital flight – at a time of mature, inflated financial bubbles in the global system – can set off a ‘falling domino effect’ on confidence. Saudi Arabia along with other Middle Eastern states, such as Egypt, will be especially vulnerable to any wider shaking of confidence in the global financial system.  The geopolitical implications are profound: states which depend mainly on state handouts and repressive security apparatus may not survive the consequences.

For the last thirty years, a policy of unprecedented monetary stimulus has had as its primary object the maintenance of high asset values. However, key parts to the pantheon of assets have been, (and some still are), in free fall.  For any economy (which is to say all economies invested in loose monetary policies) for which ‘confidence’ is almost entirely reliant on high asset prices -  such tumbles, in (if even only a few) structurally key asset prices, inevitably places question marks over the valuations of other assets that may have to be liquidated to cover losses in the key strategic asset: oil and commodity prices have been plummeting. But this understanding of the structural role of oil as a financial asset is not widely recognised. On the contrary, mainstream opinion largely concluded that the drop in the oil price is equivalent to putting cash back into the consumers’ pocket, via lower gasoline prices, and is therefore ‘a good thing’. Ditto for commodities.  Saudi Arabia’s sale of equities precisely to fill such gaps has adversely affected confidence in its market as a whole.

For decades, the energy ‘producers’ re-cycled their (then) huge surpluses into US dollar assets. This created both liquidity in western markets, and strengthened the price of dollar denominated assets. More crucially, it helped pump up the value of the dollar relative to other currencies: all positive attributes, from a Washington perspective, to keeping dollar hegemony (and its reserve currency status) in place.  Rising, and high oil and commodity prices have, in short, created a virtuous circle of increasing liquidity, and demand for US dollars and asset prices, from the perspective of western global asset markets.

But, if this re-cycling process counts as a virtuous circle on the way up, it is anything but on the way down (i.e. when classes of assets are falling in price). The crash in the price of a strategic asset knocks over other asset dominoes as it falls. For Saudi Arabia, the renown Saudi tweeter, Mutjtahid, has reported, this is already underway:

The reason [for the big drop in the Saudi stock market] is that the [state] pension fund together with the public investment fund sold some of its largest shareholdings - following an order by Mohamed bin Salman, in order to provide cash flow to the state. These two funds represent the largest investors in the Saudi market: Mohamed bin Salman (the king’s son), gave the sell order (as head of the Economical and Development  Council), in order to secure governmental cash flow, in place of selling bonds (which he considers demeaning to the financial standing of the state).  The next step will be to sell the government’s share in SABIC [the leading Saudi industrial chemical company] and electricity and telecommunications as the reserves are completely dry (Mujtahid wrote on 22 August 2015).

The Saudis may not be selling dollar denominated assets (because of prior understandings with the US government that these should not be sold without US consent), but other energy or commodity producers inevitably will be just so doing. China is an energy consumer, rather than a producer, but the fall in the key strategic price of oil has indirectly led to her selling an estimated $106 billion in US paper (into the market, over the last two weeks) - to prop up the value of the Yuan.

A secondary, (but key) effect of the drop in the price of oil has been the weakening of all ‘emerging market (EM)’ currencies relative to the dollar (the value of the dollar historically has an inverse relationship to the price of oil).  This had left the pegged Yuan overvalued against the dollar (an appreciation of 20%, by some calculations) relative to other weakening currencies. Yet the Yuan has, until now, remained pegged to this rising dollar (for decades).  Unsurprisingly, China has chosen finally to devalue the overpriced Yuan, but in so doing, has been compelled to intervene in the foreign exchange market, selling massively its stock of US Treasuries – in order buy Yuan - to  counter a currency flight that nearly overwhelmed its ability to stabilise its currency.  The geo-political implication of this ‘float’ is important: major sales of US Treasuries will affect America’s and Europe’s ability to continue to pursue their present monetary policies.  And for the future, it suggests that China will lean more to Russia as a source of crude supply (rather than Saudi Arabia), if only because Russia already has an agreement to accept payment in Yuan, rather than dollars.

Here China is not alone. Kazakhstan has had to abandon its dollar peg (and devalue too), and both the Saudi and the UAE dollar pegs look vulnerable, as the 12 month forward contract rate for both currencies imply that markets expect these currencies too to de-couple from their pegs - and to devalue. Such circumstances (possible exit from pegged rates) are almost always accompanied by capital flight and a rapid depletion of foreign exchange reserves. It will not be China and Kazakhstan alone who will be selling dollar-denominated reserves to bolster their currencies after severing from the dollar peg, but other producer currencies too (including perhaps Saudi Arabia in the not too distant future).

Pressure building on Saudi Riyal – 12 month forward contracts: see Zero Hedge blog 

Kazakh Prime Minister Karim Massimov told Bloomberg last week that the world has entered "a new era" and that soon, any and all, petro currency dollar pegs are set to fall like dominoes. "At the end of the day, most of the oil-producing countries will go into the free floating regime, including Saudi Arabia and the United Arab Emirates”, Karim Massimov said. "I do not think that for the next three to five, maybe seven years, the price for commodities will come back to the level that it used to be at in 2014."

But there is another aspect which is more specific to the Gulf States:  Namely, that the petrodollar re-cycling mechanism - in parallel - has turned negative.  David Spegel, global head of emerging market sovereign and corporate Research at BNP has written, "At its peak [in 2006, when crude was said to be heading to $200, per Goldman Sachs], about $500 billion a year was being recycled back into financial markets [from energy producers]. This, [2014, has been] the first year in a long time that energy exporters will be sucking capital out" -- Spegel acknowledged that the net withdrawal was small [$7.6 billion]. But he added: "What is interesting is they are draining rather than providing capital that is moving global liquidity. If oil prices fall further in coming years, energy producers will need more capital, even if, just to repay bonds."  Bloomberg has calculated that the “oil industry needs half a trillion dollars to endure price slump … there is $72 billion in oil-related debt maturing this year, $85 billion in 2016 and $129 billion in 2017, and a total of $550 billion in bonds and loans through 2020”.

What the petrodollar ‘reversal’ more indicates is that, unlike the 1998 crisis, Middle East producers are now fiscally committed to the hilt: More ‘government jobs’ have been to be created (and more are required); more housing; more subsidies (because of increasing use of gasoline and electricity); more education, etc., etc.  And the expected standard of living by Gulf citizens is now far above what it was in 1998.

This shift may explain why Saudi Arabia may not enjoy the same safe outcome as it did in 1998 (the oil price was near its lowest in more than a decade, cash reserves were being depleted, emerging markets were in turmoil and Saudi Arabia was beginning to panic. “It was a very scary moment,” said Khalid Alsweilem, former head of investment at the Saudi Arabian Monetary Agency, the country’s central bank. “And luckily at that point, oil prices started going up. Not by design, by good luck”.

CitiBank’s forecast for Saudi Arabia is stark: “For Brent to average US$54 per barrel in 2015. At this price, we expect total Saudi government revenues to fall by some 41% in 2015. We believe that as a result it is highly likely that Saudi will cut expenditure sharply next year. According to our calculations, if Saudi Arabia were to maintain the same level of spending this year as it did last year, the budget deficit would balloon to US$130bn, or 22% of GDP. This would be unsustainable, in our view, with fiscal reserves covering just three years of such levels of expenditure. It would also be three times the level of deficit the government has budgeted for. We therefore think it is likely that total expenditure will shrink by around 20%, bringing the overall deficit to 13% of GDP”.

This CitiBank estimate may sound reasonable (and already there are reports of Saudi planning to scrap $102 billion from its capital expenditure budget – see here).  But does the budget constitute a true picture of Saudi government spending?  The nenowned Saudi commentator, Mujtahid regularly provides us with instances where large sums of government revenue simply are being moved ‘off balance sheet’ (either to fund foreign policy initiatives or into personal pockets), and are therefore no longer available to meet budgeted government expenditure.

Saudi Arabia is also engaged in four ‘wars’ (Yemen, Syria, Iraq and Libya) and is also invested in seeing that President Sisi’s government does not implode. Are all these expenditures budgeted?  Some of the Yemeni military costs may have a budgetary heading (but probably not all), but in the case of Syria, Saudi Arabia’s spending has ballooned in the attempt to overthrow President Assad. Is this budgeted? Is this Intelligence Service expenditure included, or is it off-balance sheet (as it is in many states)?  We do not know, but what seems clear is that, so far, Mohammad bin Salman shows no sign of curtailing expenditure on his prestige projects -- rather the reverse.

What must be added to the economic risk inherent in these military initiatives is the unquantified political risk too. Saudi Arabia may be economically heavily extended, but it is also politically over-extended with its credibility riding on the outcome of its various wars to "roll back Iranian influence".

What does all this mean for the Middle East politically?  It means that possibly Mohammad bin Salman may have no choice but to change policies (financial force majeure), or face the prospect of growing internal instability. For China, the abandonment of its peg signals (and is symbolic of) something that no one in the Gulf can readily ignore: that China will not be the economic boat that will float the entire becalmed global economy.  Moreover, it speaks plainly of a global demand that is shrinking. (And declining commodity prices, container rates, shipping charters and all other measures of trading activity give the substance to the fact).

The first half of 2015 has seen the worst decline in world trade since the 2009 crisis, according to World Trade Monitor: in the first quarter of 2015, the volume of world trade declined by 1.5 percent, while the second quarter saw a 0.5 percent contraction (1.1 percent growth in annual terms), which makes the first six months of 2015 the worst since the 2009 collapse. This reality suggests that any attempt by crude producers to try to push up prices is likely to fail – so long as global demand remains weak – and unless some major producer of crude collapses into political turmoil, and thus exits the market. Rather, as suggested above, the imperative for producers is more likely be to fill the gaps in their national budgets: i.e. to produce to the maximum.

This economic cold wind will affect all regional states, including Iran. If  the P5+1 deal survives congress (as, for now it seems that it will), it seems unlikely that Iran will experience the economic bonanza that some were predicting for 2016. For sure, the lifting of sanctions will help the economy,  but perhaps by not as much as the authorities are hoping (and on which, President Rouhani is counting).  Iran, nonetheless, is perhaps better placed than others; paradoxically as a result of the very sanctions imposed on it, and the discipline learned from it, Iran is less exposed than others to the ‘virtual’ global financial economy, and has spent the years under sanction instead, on trying to revivify and re-orientate a real economy.  It will not fare as well as some may expect, but nor will it be plunged as deeply into the crisis that others may face.