Saudi Arabia's Bond Success Hides Its Financial Peril

(Bloomberg View) -- Saudi Arabia's first-ever foray in international credit markets was undoubtedly a success. There were four times as many buyers as needed for its $17.5 billion bond issue, which surpassed all other benchmarks of previous emerging-market bond offerings. The conventional wisdom is that it validated Deputy Crown Prince Mohammad bin Salman's overarching plan to wean the kingdom of oil and move it toward more a balanced, technologically driven economy.

In truth, the bond sale was a rare bright spot in a series of economic and geopolitical missteps that have not only plunged Saudi Arabia into budgetary chaos but also weakened its grip on global oil markets. The Saudis are well aware of this -- witness the firing this week of Finance Minister Ibrahim al-Assaf despite the triumphant bond sale his ministry oversaw. 

Riyadh is facing a sandstorm of economic and social challenges. The two-year decline in crude prices has left it with huge budget deficits: $98 billion last year and a projected $87 billion in 2016. This has forced the kingdom to tap into its cash reserves, which have declined from $732 billion at the end of 2014 to $562 billion last month. Last year, the International Monetary Fund predicted that if Saudi Arabia continued its current fiscal path, it could burn through its entire foreign exchange reserves by 2020.

This has shocked the kingdom into austerity. Government payrolls have been slashed and subsidies removed. Over the last few months, capital expenditures have been cut by more than 70 percent. In 2013, government debt to gross domestic product ratio stood at 2.2 percent, per Moody's Corp. By 2017, it is forecast to be 22 percent; by 2020, 30 percent. 

And while the government might try to blame market forces beyond its control, clearly the Saudi economy has been a victim of its own mismanagement and geopolitical maneuvering. Back in December 2014, the Iranian economy was reeling from nuclear sanctions, it wanted to get the best price it could from what little oil it could sell on the market. Many of OPEC's non-Arab members also wanted higher prices and were pushing for a production cut. But the Saudi oil minister at the time, Ali Al Naimi, refused.

There were two reasons. The first had to do with Iran: The Saudis wanted to squeeze Tehran to change its regional policies vis-a-vis the civil wars in Yemen and Syria, and to further isolate the Iranians by taking over their market share within OPEC.

The other was directed at North America: The Saudis wanted to deal a fatal blow to U.S. shale production, which largely relies on expensive hydraulic fracking to thrive. The Saudi calculus at the time was if it flooded the market with enough excess crude, the price would drop precipitously, thus rendering North American shale production cost prohibitive. This worked -- but only partially

Opening the tap hurt Saudi Arabia's economy far more than it had anticipated. Iran's regional policies have not changed: It hasn't ended its aid to the Houthis in Yemen or pulled back its support for President Bashar al-Assad in Syria. Both those conflicts remain frozen. And, despite Riyadh's financial woes, it surpassed Russia last year as third largest military spender in the world.  

Furthermore, since Iran came to a nuclear deal with the West it has not only recaptured its market share, but is also producing more crude than at any point over the past five years. In a reversal of fortune, it's now the Saudis who are trying to persuade the Iranians to agree to a production cut when OPEC meets Nov. 30, and it's the Iranians (and Iraqis) who are balking.

At the same time, even though the recent Saudi energy policy has hurt North American shale producers, a rise in crude prices will cause hydraulic fracking to once again pick up. It's clear the kingdom overplayed its energy card and is now paying a steep price for it.

Many economists would argue that it was only a matter of time before Riyadh embarked on wholesale reforms to restructure its economy and society. After all, oil will eventually run out. With energy markets changing yearly and the global economy in flux, Mohammad Bin Salman has embarked on a plan to open his country by targeting foreign investment, easing social restrictions and transforming Saudi Arabia into a knowledge-based economy. The centerpiece of the plan is to sell off between 1 percent to 5 percent of Saudi Aramco, and use its proceeds to create the world largest sovereign wealth fund.

Yet with all the fanfare surrounding so-called Vision 2030, it is still unclear how it will address the Saudis' most pressing problem: unemployment. Two thirds of the population is under the age of 30. Riyadh needs to create 3 million new jobs by 2020. Currently youth unemployment stands at a staggering 30 percent. With the fundamentalist Wahhabi interpretation of Islam emanating from Saudi mosques and schools, a large pool of unemployed youth could be susceptible to extremism.  

The government is banking on removing red tape and bureaucracy to make its economy more attractive to foreign investment and fostering public-private partnership to spur entrepreneurship. The question is whether such a wholesale transformation is achievable without sparking social and political unrest that could threaten the stability of the kingdom.

The bond sale alone doesn't provide much insight. In a world of low returns and slow growth, sophisticated investors are always looking for yield. Saudi bonds give them that, issuing 5-year, 10-year and 30-year notes at 2.6 percent, 3.41 percent and 4.63 percent, respectively. However, one would be hard pressed to find any fund managers or institutional investors who would say they exposed themselves to that debt out of a belief in Riyadh's ability to reinvent itself from a petro-state into a market oriented economy. More likely, they scooped up these bonds because of the oil reserves Saudi Arabia has under the ground.

The kingdom faces daunting structural challenges. With the Aramco IPO and more bond issues to come next year, both investors and the global elite want to see Riyadh succeed. If so, appetite for further investment in both people and the economy will grow. Time and a restive populous are not on its side.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story: Amir Handjani at ahandjani@gmail.com.

To contact the editor responsible for this story: Tobin Harshaw at tharshaw@bloomberg.net.

For more columns from Bloomberg View, visit http://www.bloomberg.com/view.