April 2013

Report Series

Saudi Arabia: Interest Rate Outlook, 2013-15 Executive Summary

Office of the Chief Economist Economics Department Samba Financial Group P.O. Box 833, Riyadh 11421 Saudi Arabia [email protected] +9661-477-4770; Ext. 1820 (Riyadh) +4420-7659-8200 (London) This and other publications can be Downloaded from www.samba.com

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In this note we consider the outlook for Saudi interest rates, given their importance to businesses and consumers, and the fact that the key interbank rate, SIBOR, has moved higher over the past 12 months. We find that the main drivers of SIBOR are the US policy rate and Saudi domestic credit growth. The correlation between SIBOR and LIBOR is found to be weak, at least in recent years.

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We assume no change to the riyal’s peg to the US dollar, meaning that Saudi rates will remain intimately tied to the outlook for the US economy. Some fear that the US and Saudi economies will move out of synch as the Kingdom orientates itself more towards the fast-growing countries of Asia. However, this presupposes that oil prices will continue to climb, putting pressure on the US consumer just as the Saudi economy is booming (similar to the situation in 2007-08). We do not share this view and expect the surge in shale oil from North America to put downward pressure on prices in the medium-to-long term.

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The US policy rate is tied to employment growth, with an explicit jobless rate target of 6.5 percent. On current trends this target will be met by late-2014. However, we do not expect the Fed Funds target rate to be raised until mid-2015. This point will mark the start of a new tightening cycle, which will eventually take US rates back up to more “normal” levels of 3-5 percent. The Saudi reverse repo rate (the Kingdom’s key policy rate) will closely follow this cycle.

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Meanwhile, Saudi domestic credit growth has been strong over the past year, and has been the main reason for the uptick in SIBOR. We think credit growth will ease in 2013-15 as a gradual drift in oil prices crimps public investment and private confidence.

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Given the above, we expect SIBOR to decline from about 1 percent at end-2013 to 0.8 percent by end-2014. We anticipate a 50 basis point rise in policy rates in 2015 which will more than offset the impact of weakening domestic drivers, and SIBOR is expected to end 2015 at 1.2 percent (not far removed from the current level).

April 2013

Introduction In this note we consider the outlook for Saudi interest rates, given their importance to businesses and consumers. We think such a consideration is timely given that a) the Kingdom’s main market interest rate has ticked up over the past year or so, and b) there is growing speculation about when US interest rates might begin to rise again given the recovery in the American economy. First, we will consider what drives Saudi interest rates, before assessing their likely evolution over the next few years. Data on lending rates are limited, so we will consider the outlook for the 3 month Saudi Interbank Offered Rate (SIBOR). This is the key interbank rate in the Kingdom, and the benchmark for commercial and consumer lending rates—that is, commercial and consumer rates are set with reference to SIBOR. But SIBOR itself is governed by the Kingdom’s base or policy rate. The key policy rate in Saudi Arabia is the reverse repo rate (RR), set by the Saudi Arabian Monetary Agency (SAMA). The RR is the rate that Saudi commercial banks get on their deposits with SAMA. Changes in the RR add or remove liquidity from the market by making it more or less attractive for banks to hold deposits with SAMA. As such, the RR has a direct influence on SIBOR.

Interest Rate Drivers 1.

US Policy Rate

The US policy rate provides the floor for Saudi rates The RR is set with reference to the US Federal Funds target rate, the policy rate which governs short term interest rates in the US. This is because of the Saudi riyal’s peg to the US dollar, which has been in place since June 1986. Given the peg, and the fact that Saudi Arabia has a relatively open capital account, SAMA’s ability to set short-term interest rates independently is limited. As such, when the US Fed Funds rate changes, SAMA usually responds with an equivalent change shortly after. If it does not, then widening interest rate differentials could potentially attract “hot money” flows either into or out of the country, putting pressure on the peg (see Box 1, below). Box 1: Constraints Imposed by the Fixed Peg The constraints posed by the exchange rate peg were laid bare in 2007-08, when US policy rates were cut rapidly in an effort to mitigate the impact of the gathering financial crisis—a crisis that was already sucking the US economy into recession. Saudi Arabia, by contrast, was enjoying the impact of exceptionally high oil prices and the domestic economy was booming. However, inflation was also a growing concern in the Kingdom and—all other things being equal—SAMA would have liked to have kept interest rates high (if not raise them) to head off growing price pressures. Instead, it was obliged to reduce the reverse repo rate, a move that only served to stoke

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inflation. Observing this, many investors concluded that the US and Saudi business cycles were hopelessly out of synch and that the exchange rate peg was unsustainable. They calculated that SAMA was bound to break the peg and allow the riyal to float higher in a bid to reduce import prices and capital inflows, and thereby dampen inflation. Thus, during 2007-08, as oil prices surged and the US subprime crisis worsened, “hot money” flows from abroad poured into Saudi riyal deposits keen to take advantage of the apparently inevitable revaluation. In the event, the revaluation did not happen. SAMA defended the peg by meeting all demands for additional riyal liquidity, while simultaneously setting higher reserve requirements for banks and selling riyal-denominated bonds in a bid to keep inflation in check. In fact, inflation continued to rise and it is quite likely that defence of the peg would have become unsustainable had it not been for global financial turmoil, which began to look critical by the second quarter of 2008. This sent foreign investors fleeing for the perceived safety of dollar assets and pressure on the peg quickly subsided. Nevertheless, the episode underscores the deep-rooted importance of the peg to the Saudi economy (not just monetary policy), something that foreign investors underestimated. The currency peg will remain in place for the long term The currency peg imposes monetary constraints but its value as a nominal anchor for the economy should not be underestimated

Despite the constraints outlined in Box 1, we think the peg will stay in place for the foreseeable future. Saudi Arabia’s export earnings are denominated in dollars and the peg gives a degree of certainty to firms and households, which is important given their dependence on imports. Yet, a further bout of tension similar to that which emerged in 2007-08 cannot be ruled out. Indeed, research by the IMF suggests that the US and Saudi business cycles are likely to become increasingly out of synch as the Kingdom continues to orientate its economy towards the rapidly growing East Asia region, where demand for crude oil is brisk and likely to remain so. At the risk of oversimplifying its argument, the IMF believes that this process will mean that high real oil prices (driven by the booming Asian economies) will sap consumption in the US through higher gasoline prices. This in turn will likely impel the Federal Reserve to cut short term interest rates. SAMA would be obliged to follow suit and cut rates at a time when its own economy (presumably) is likely to be booming thanks to high oil prices. This would in turn stoke inflation. US and Saudi economic cycles are unlikely to move out of synch Yet this argument appears to overlook the impact of the US shale oil revolution. The surge in oil supply that this revolution is generating is likely to exert downward pressure on global oil prices in the long term, in our view. This means that US households will be less vulnerable to consumptionsapping gasoline spikes. This reduces the likelihood of acute monetary policy conflicts of the type seen in 2007-08; however it does not preclude periods of divergent economic performance with some attendant policy problems (see below). 3

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2. LIBOR SIBOR’s relationship with LIBOR has weakened A secondary influence on SIBOR is US dollar LIBOR (London Interbank Offered Rate). LIBOR is the key global interbank rate, reflecting the level of liquidity in the global banking system. The rate has come under scrutiny in recent years given that some banks have been found guilty of manipulating it to suit their market positions. This aside, LIBOR’s influence on SIBOR appears to be weakening. At the height of the financial crisis in 2008, the two rates both spiked higher and then fell as global central banks pumped out liquidity. But since then, the relationship between the two has been looser, with a fairly volatile spread. Indeed, since early 2012 the spread has widened, with SIBOR trending higher and LIBOR heading in the opposite direction (the correlation since May 2009 is less than 0.1).

Saudi banks are not dependent on international wholesale markets for dollar funding

A weaker relationship is logical: Saudi banks are not dependent on international interbank markets for hard currency funding. If short term dollars are needed they can go to SAMA, which has access to substantial foreign assets. Long term dollar funding might be a different matter, and a few banks have issued foreign currency bonds. But in general, Saudi banks’ foreign assets outweigh their foreign liabilities by a considerable margin. In this sense, the spike in SIBOR during 2008 was not so much a reflection of actual tightness in the Saudi interbank market (though the exit of speculative capital will have contributed), but a general fear of the unknown as credit markets in developed countries seized up.

3. Domestic Demand for Credit The recent uptick in SIBOR is mainly attributable to domestic credit demand The final influence on SIBOR, and probably the most telling (at least in the short run) is domestic demand for credit. In the past couple of years the correlation between these two variables has been very strong (0.985 since September 2011), with an increase in domestic credit demand tending to push up rates. Again, this makes sense, since an increase in demand for money will raise its “price” (all other things being equal). The uptick in SIBOR in 2012 was mainly due to an acceleration of bank lending to the private sector, which gathered to a double-digit pace. Changes in deposit growth appear to have less bearing on SIBOR, though deposits do have some value as a “leading indicator” of lending growth. (Saudi banks traditionally have a surplus of deposits, but trends in deposit growth still tend to foreshadow changes in lending.)

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Interest Rate Outlook

US policy rate is unlikely to rise until mid-2015

The primary influences on SIBOR, and by extension all Saudi interest rates, are therefore the US Fed Funds target rate and domestic credit demand; LIBOR is found to have a weak and apparently declining influence. The Fed Funds rate has a periodic “step change” impact, while credit demand has a more gradual but ongoing influence. What then, is the outlook for these key variables? The US Fed Chairman has linked any change in the Fed Funds Rate to an improvement in unemployment Starting with the US Fed Funds rate, the chairman of the Federal Reserve, Ben Bernanke, has explicitly linked changes in monetary policy to the rate of employment growth and inflation. Specifically, Mr Bernanke said that the Fed Funds target rate will be raised once unemployment falls to 6.5 percent, or if the Fed’s forecast for inflation exceeds 2.5 percent. Inflation is currently low, at about 2 percent, and inflation expectations are well grounded. There is little evidence of wage or cost pressures outside of isolated sectors and the Fed has signalled that it does not expect its own inflation forecast to exceed the 2.5 percent threshold any time soon. Thus, the rate of employment growth appears key. Extrapolating from the current rate of jobs growth, the unemployment rate could well breach the 6.5 percent threshold as early as late-2014. However, most expect that even if this were to happen, the Fed would resist raising rates for some months if only to make sure that the sub6.5 percent rate was durable. Indeed, in early March Mr Bernanke told a conference that a “premature” rise in policy rates would carry the risk of “short circuiting the recovery”. Thus, it seems likely that the Fed Funds target rate will probably be raised (by 25 basis points) sometime in mid2015. An equivalent increase to the Saudi RR would follow shortly thereafter. This would presumably be the start of a tightening cycle—assuming that the US economy continued to strengthen—which could take US base rates back up to more “normal” levels of say 3-5 percent within a few years. Saudi credit growth likely to slow in 2014-15 The outlook for Saudi credit growth is more difficult to call. As noted above, the rate of commercial bank lending to the private sector has been gathering pace, reflecting a buoyant nonoil economy. But is this set to continue?

Domestic credit growth has been strong, but is likely to moderate as weaker oil prices weigh

We think on balance that credit growth is likely to slow in 2013-15, though this will be more obvious in the second half of the forecast period. Saudi banks are said to be shifting towards a more conservative stance this year, at least on the corporate side, having booked quite large assets in 2012. Granted, there was a backlog of projects last year, which are likely to be released in 2013, and many of these will require an element of bank finance. But banks appear to be focusing on retail lending, which has been the engine of profit growth recently. Underlying drivers for retail lending are good: strong demographics and high nominal public sector wage growth have kept retail sales running at 25-30 percent growth (in real terms) for a number of

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years now. New legislation governing leasing should also be supportive, especially for the auto sector. Yet we think that the expected moderate drift in oil prices will a) put some pressure on the Saudi fiscal position, leading to some scaling back of public sector project growth, and b) begin to impinge on private sector confidence, which might crimp both private project growth and consumption, particularly as we move into 2014-15. There is therefore a danger that the reverse repo rate will be raised in mid-2015 at a time when demand in the economy is already slackening. An increase in base rates might well exacerbate any slowdown. However, given the number of variables and uncertainties over the period, this represents a risk rather than a likelihood.

End period

SIBOR Fed Funds Target Saudi Reverse Repo Domestic credit growth (% ch)

2013 1.0 0.25 0.25 13.0

2014 0.8 0.25 0.25 10.0

2015 1.2 0.75 0.75 8.0

Conclusion: Interest Rate Forecast We see SIBOR moving up to 1.2 percent by end-2015 Drawing the analysis together, we can set out our interest rate forecast as follows: 

A fresh tightening cycle in the US is set to begin in 2015, and SAMA’s reverse repo will follow suit, pushing SIBOR higher. We anticipate a 50 basis point increase in the US Fed Funds rate in 2015

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Demand for credit is likely to remain relatively strong for most of 2013 (growing by 13 percent full year), but should begin to slacken towards the end of this year and into 2014-15 as oil prices drift lower and public sector investment growth cools

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Thus we see SIBOR ending 2013 more or less where it is now at around 1 percent, before easing to around 0.8 percent by end2014

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The drift in SIBOR is set to continue until H2 2015 when two 25 basis point increases in policy rates will feed through. This will more than offset the drift in domestic demand and push SIBOR up to 1.2 percent by end-2015 (though this is not far removed from the current rate).

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James Reeve Deputy Chief Economist [email protected] Andrew B. Gilmour Deputy Chief Economist [email protected]

Disclaimer This publication is based on information generally available to the public from sources believed to be reliable and up to date at the time of publication. However, SAMBA is unable to accept any liability whatsoever for the accuracy or completeness of its contents or for the consequences of any reliance which may be place upon the information it contains. Additionally, the information and opinions contained herein: 1.

Are not intended to be a complete or comprehensive study or to provide advice and should not be treated as a substitute for specific advice and due diligence concerning individual situations;

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Samba Financial Group P.O. Box 833, Riyadh 11421 Saudi Arabia

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