S&P Downgrades Saudi Arabia to 'A-/A-2'; T&C Assessment Trimmed to 'A' (OIL) (USO)

RATING ACTION

On Feb. 17, 2016, Standard & Poor's Ratings Services lowered its unsolicited long- and short-term foreign- and local-currency sovereign credit ratings on the Kingdom of Saudi Arabia to 'A-/A-2' from 'A+/A-1'. The outlook is stable.

At the same time, we revised downward our transfer and convertibility (T&C) assessment on Saudi Arabia to 'A' from 'AA-'.

As a "sovereign rating" (as defined in EU CRA Regulation 1060/2009 "EU CRA Regulation"), the ratings on the Kingdom of Saudi Arabia are subject to certain publication restrictions set out in Art 8a of the EU CRA Regulation, including publication in accordance with a pre-established calendar (see "Calendar Of 2016 EMEA Sovereign, Regional, And Local Government Rating Publication Dates," published Dec. 22, 2015, on RatingsDirect). Under the EU CRA Regulation, deviations from the announced calendar are allowed only in limited circumstances and must be accompanied by a detailed explanation of the
reasons for the deviation. In this case, the reason for the deviation is our recent revision of our global oil price assumptions.

The next rating publication on Saudi Arabia is scheduled for April 8, 2016, in our calendar.

RATIONALE

In mid-January 2016, Standard & Poor's lowered its oil price assumptions for average Brent by about $20 per barrel (/bbl) over 2016-2019. We now assume $40/bbl in 2016, with a gradual increase to $50/bbl in 2018 and beyond. Current prices for crude oil in spot and futures markets are about 70% below mid-2014 levels, when prices began to slide. When we last reviewed Saudi Arabia (see "Ratings On Saudi Arabia Lowered To 'A+/A-1'; Outlook Remains Negative," published Oct. 30, 2015), we expected Brent oil prices to average $55/bbl in 2016 and $70/bbl by 2018.

We do not expect the agreement on Feb. 16, 2016, between oil ministers from Qatar, Russia, Saudi Arabia, and Venezuela to freeze oil output at the levels reported in January to have a material impact on our oil price assumptions. The first market reaction to this news was a further decline in oil prices. Onthe supply side, we note that the freeze would take place at already record high levels of output for Russia and Saudi Arabia. In addition, we understand the agreement is conditional on other producers also freezing production. We view such a change in policy direction as unlikely in Iran and Iraq. On the demand side, we see China's economic slowdown and debt load as a continuing top global risk. Our long-term oil price assumptions will continue to be informed by our view of the marginal cost of oil production.

In October 2015, we stated that we could lower the ratings on Saudi Arabia if the government did not achieve a sizable and sustained reduction in the general government deficit. In our view, and in light of our updated oil price assumptions, the general government deficit will likely average about 9% of GDP in 2016-2019, approximately 2% of GDP higher than our October projections.We have also increased our forecasts for the annual change in general government debt (which is our preferred fiscal metric because in most cases it is more comprehensive than the reported headline deficit) to about 7% of GDP. We take into account the measures included in the government's 2016 budget. We acknowledge both upside potential and downside risk to these forecasts. Upside potential principally stems from oil prices, while we see downside risk principally in the scale of the fiscal consolidation and the broader impact it will likely have on the economy. We note in particular the rising challenge the government faces in reversing the marked deterioration in Saudi Arabia's fiscal balance.

The government has budgeted for a central government deficit of about 13% of GDP in 2016 compared with 15% in 2015, with revenues falling by 16% and expenditures by 14%, compared with the 2015 outturn. This modest deficit adjustment reflects the government's desire to support economic growth, in our view.

We believe the budget to be based on an oil price of about $45/bbl. The government has established a support provision line within the budget of Saudi Arabian riyal (SAR) 183 billion (8% of GDP or $49 billion equivalent), which it could use to redirect capital and operating expenditures to both ongoing and new projects and to meet any emerging expenditure needs. We expect the government's fiscal consolidation plan will likely include postponing some capital spending projects, increasing non-oil revenues, and controlling current expenditures. The government has embarked on a program of subsidy reform, with fuel, water and electricity prices set to rise gradually over the next five years. As a result, we understand it will reduce subsidies that amounted to about 8% of GDP in 2015. Concurrently, through increased utility tariffs, we expect to see stronger profitability at government-related entities, in turn resulting in higher dividends for the government.

On the revenue side, we understand that the imposition of taxes on undeveloped plots of land in urban areas to encourage their development is at an advanced stage. The government may also look at imposing value-added tax. However, we think this is likely to be a medium-term project, in line with discussions already under way with other members of the Gulf Cooperation Council customs union (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and United Arab Emirates).

Oil major Saudi Aramco has also confirmed that it has been studying various options to allow broad public participation in its equity through the listing in the capital markets of part of its shares or a bundle of its downstream subsidiaries. The timing of implementation of this proposal remains unclear and we have not factored it into our projections. In our view, given the strategic importance of Saudi Aramco and the perceived reluctance of the company to reveal geological, operational, or financial specifics in the past, we see an IPO of the company as less likely than the listing of its downstream subsidiaries. If these plans come to fruition, the related receipts could provide significant support to the government budget.

Although Saudi Arabia's fiscal profile has weakened on a flow basis, on a stock basis it remains strong, in our view. Net general government assets (that is, the excess of liquid fiscal financial assets over government debt) peaked at 124% of GDP in 2015, partly due to the estimated 13% decline in nominal GDP. We forecast that the government's net asset position could decrease to 79% of GDP in 2019. Consequently, Saudi Arabia is entering a period of adverse terms of trade from a strong position.

Over the next three years, we expect Saudi Arabia will finance its deficits, combining drawing down of fiscal assets and issuing debt. For the purposes of calculating the annual change in government debt, we have assumed an even split between asset draw-downs and debt issuance, implying an average increase of about 7 percentage points of GDP in nominal gross general government debt per year. Such a split would also imply that Saudi Arabia would report gross liquid financial assets of 110% of GDP by 2019, versus 129% at year-end 2016. These fiscal assets include the central government's deposits and reserves on the liabilities side of the balance sheet of the Saudi Arabian Monetary Agency (SAMA, the central bank), government institutions' deposits, and an estimate of investment income. We also include an estimate of government pension funds' liquid assets.

In Saudi Arabia, the hydrocarbon sector accounted for about 28% of nominal GDP in 2015 by our estimate, down from 42% in 2014 due to the sharp fall in oil prices. Before the drop, the sector represented about 80% of exports and three-quarters of government revenues. Given the kingdom's high dependence on hydrocarbons, we have revised downward our forecasts for economic growth and fiscal and external positions to incorporate the lower expected oil prices. Since our October 2015 review, we have reduced our real GDP growth forecasts for 2016-2019 to an average of 2% a year from about 3%, while our GDP per capita estimate for 2016 is $18,900, down from $21,300. We anticipate that the GDP deflator will remain negative in 2016, at minus 8%, compared with minus 16% in 2015, alongside population growth of about 2%.

We estimate that trend growth in real per capita GDP, which we measure using 10-year weighted-average growth, will amount to about 0.5% during 2010-2019, which is below that of peers that have similar GDP per capita.

Furthermore, we now anticipate larger current account deficits, equivalent to 14% of GDP in 2016, compared with 6% of GDP in our October review. Saudi Arabia's external accounts mirror, in many ways, its fiscal accounts. Like the fiscal accounts, they shift based on prices of hydrocarbons. Similar to its fiscal position, Saudi Arabia maintains strong external buffers. We expect Saudi Arabia's liquid external assets, net of external debt, will average about 270% of current account receipts (CARs) over 2016-2019. The kingdom's gross external financing needs are slightly above 40% of the sum of usable reserves and CARs over 2016-2019, suggesting very strong external liquidity.

King Salman acceeded to the throne in January 2015. He is the sixth son of King Abdulaziz Al-Saud, who established the kingdom in 1932. In April, King Salman named his nephew, interior minister Mohammed bin Nayef as crown prince, first in line to the throne. The king has also named his son, Mohammed bin Salman, the defense minister, to the position of deputy crown prince and consequently second in line to the throne.

We analyze Saudi Arabia as an absolute monarchy in which decision-making resides with the king and the ruling family. In our view, the opacity of decision-making and reconciling intra-family issues around succession reduce the predictability, timeliness, and effectiveness of the kingdom's economic policy choices. Two new councils, the Council for Political and Security Affairs and the Council for Economic and Development Affairs, have been created to form government policy more efficiently. Power is devolved to the crown prince and deputy crown prince, who respectively head these two bodies. The king approves the decisions of the councils. Broader institutional checks and balances are still at incipient stages of development.

Given the Saudi riyal's peg to the U.S. dollar, we view monetary policy flexibility as limited. The long-standing currency peg helps to anchor the population's inflation expectations, but binds Saudi Arabia's monetary policy to that of the U.S. Federal Reserve. We expect that the peg will be maintained over the next few years. At a time of already significant change and regional geopolitical instability, politically conservative regimes such as those in the GCC are unlikely to increase uncertainty about their economic stability by amending this fundamental macroeconomic policy (see "Middle East And North Africa Sovereign Rating Trends 2016," published Jan. 18, 2015). Consequently, the riyal's real effective exchange rate has appreciated by 16% since early 2014 and stands approximately 40% over the December 2007 level, according to Bruegel data. The riyal's long-term real effective appreciation since 2007 has been the most pronounced among all GCC sovereigns. In our view, this indicates an ongoing deterioration of international competitiveness of the country's modest tradables sector, which is likely to dampen non-oil GDP growth, absent any offsetting factors such as improved efficiency or technological capacity. We estimate reserve coverage (including government external liquid assets) at a very high 115% of the monetary base and 22 months of current account payments in 2019.

Notwithstanding Saudi Arabia's limited monetary flexibility, we regard the Saudi financial system as strong. We classify the banking sector of Saudi Arabia in group '2' under our Banking Industry Country Risk Assessment methodology, with '1' indicating the lowest risk and '10' the highest.

OUTLOOK

The stable outlook reflects our expectation that the Saudi Arabian authorities will take steps to prevent any further deterioration in the government's fiscal position beyond our current expectations.

We could lower our ratings on Saudi Arabia if we observed further deterioration of public finances beyond our current expectations that could lead to a drop of liquid government financial assets to below 100% of GDP. The ratings could also come under pressure if we observed a significant increase in domestic or regional political and economic instability.

We could raise the ratings if Saudi Arabia's economic growth prospects improved markedly beyond our current assumptions.

KEY STATISTICS

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RATINGS SCORE SNAPSHOT

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