Turmoil in the Saudi Arabian money markets suggests that financing the government’s budget deficit in an era of cheap oil may not be smooth as banks worry about the risk of a liquidity squeeze.
The government sold SAR 20bn ($5.3bn) of riyal bonds to banks last Tuesday to help to cover a huge deficit caused by low oil prices. It was only the second sovereign bond issue since 2007; the first, placed with quasi-sovereign institutions, occurred in July.
Cash-rich Saudi banks easily absorbed last week’s issue, but money market moves show concern about their ability to absorb the multi-year series of issues that may become necessary if oil prices remain low.
Adding to the jitters is officials’ secrecy about their bond plans. Authorities have privately told banks no more than 40 per cent of the deficit will be financed with bonds; the rest will be covered by running down fiscal reserves.
But authorities have not released a bond issuance calendar or detailed figures for the government’s borrowing requirement.
This has left banks in the dark about how many more bonds they might be asked to buy in coming months and years.
Bankers, therefore, are scrambling to hedge against the risk of a liquidity crunch a year or two from now, causing the Saudi money curve to steepen even as the U.S. curve flattens in anticipation of an interest rate rise this year – an unusual divergence.
The cost of two-year riyal deposits in the interbank market shot up to 1.53 per cent last week from as low as 1.05 per cent six weeks earlier. The cost of swapping fixed for floating payments with a one-year interest rate swap jumped 30 basis points from July.
U.S. RATE PRESSURE
One-year U.S. dollar/Saudi riyal forwards hit 290 points, their highest since March 2003. For most of 2015 they were between zero and 100 points.
The prospect of a U.S. rate rise has added to upward pressure on Saudi market rates, said Anita Yadav, head of fixed income research at Emirates NBD, Dubai’s biggest bank.
“I expect riyal spreads to go higher from here as liquidity in the system becomes tight due to lower oil revenue-related deposits, large local currency bond issuance by the Saudi government and increased demand for hedging from the corporates as U.S. rates begin to rise.”
With Brent oil priced at about $50 a barrel, Riyadh is running an annual state budget deficit estimated by analysts at between $130bn and $150bn.
The 40 per cent issuance ceiling suggests that Riyadh may sell SAR 15bn to 20bn of bonds each month. In June commercial banks had SAR 266bn in central bank bills and non-statutory central bank deposits, suggesting they could buy bonds for a year without cutting loans to private sector companies.
“Given the government’s stated intention to finance 40 per cent of the deficit through issuances, we believe the banks in the kingdom have more than ample liquidity to support this endeavour,” said Anirban Kundu, head of investment advisory services at Saudi Fransi Capital.
The prospect worrying bankers, however, is that unless oil prices rise sharply or the government commits to shrinking its deficit with spending cuts, which it has shown little sign of doing, heavy bond sales may continue indefinitely.
Some bankers think authorities may be reluctant to issue a public issuance calendar because, with oil prices volatile and long-term government spending plans uncertain, they have little clear idea of how many bonds they will ultimately have to sell.
Bankers said that the jump in dollar/riyal forwards was mostly because of changing interest rate differentials, but some attributed it partly to concern that if cheap oil forces Riyadh to keep drawing down its foreign reserves, it might eventually have to abandon the riyal’s peg to the dollar.
“Markets believe there is an increasing chance of the dollar peg being broken in the medium term, given low oil prices and potential strains on the balance of payments,” said James Reeve, deputy chief economist at Samba Financial Group.
“We don’t believe that the peg will be broken,” added Reeve, who predicted that pressure on money market liquidity from the launch of the government bond programme would be offset by reduced private sector credit demand as the economy slows.
As yet, investors are far from panic-stricken about the peg being broken or Riyadh having trouble with its debt. Five-year Saudi credit default swaps (CDS) are up only marginally in the past few weeks and well below 2012 levels.
However, one currency strategist at a foreign bank said the minimal movement in the CDS market is partly down to its lack of liquidity and that CDS spreads could at some point reflect the pressure evident in the currency market.