The Saudi Arabian Cabinet's approval of the country's National Transformation Program 2020 (NTP) is credit positive for the sovereign and banks because it offers a credible path to achieving fiscal and economic diversification away from oil, Moody's Investors Service said in a report published on Thursday. The government aims to reduce its reliance on oil revenues and make government finances more resistant to future fluctuations in oil prices. Historically, oil- and gas-related revenues have accounted for around 90% of government revenues in Saudi Arabia. "Even if only partially implemented, the plan will benefit Saudi Arabia's credit profile by supporting the country's fiscal and economic strength," said Steffen Dyck, vice president -- senior credit officer and co-author of the report. "We also expect the development of the non-oil economy to benefit Saudi banks' revenues in the next five years because credit growth in Saudi Arabia has historically been correlated to the non-oil GDP growth." The five-year program starts this year and consists of 178 strategic objectives, with nearly 400 indicators and 350 targets used to define the 2020 goals and measure progress. The objectives can be broadly grouped into three categories: public sector and fiscal reforms; economic diversification and improvements in the business environment; and social reforms. Many of the objectives fall into more than one category. Planned reforms up to 2020 that will target material improvements in productivity and competitiveness will likely improve the operating environment for banks. Moody's also expects a number of initiatives to push banks to accelerate a diversification of their loan portfolios away from the corporate sector and into real estate and lending to small- and medium-sized enterprises (SMEs). "Over the short term, we can expect that the plan to further cut subsidies and collect a number of new taxes, which typically have more immediate effects than structural reforms, can have a positive effect on government revenues and liquidity placed in the domestic banking system," said Olivier Panis, vice president -- senior credit officer and co-author of the report. "This could ease the liquidity tightening observed since the beginning of last year." In the longer term, Moody's expects that a lower fiscal dependence on oil revenues and a more diversified economy will also reduce volatility in Saudi Arabia's economic growth, lead to more predictable government revenues and spending, and in turn create a business environment that is less exposed to event risk. However, judging from historical experience and taking into account the political and logistical challenges, implementation risks are high. In addition, scaling back the government and public sector's role in the economy could also create new risks for the banks because the direct or indirect exposure to government risk will gradually be replaced by the private sector, which will materially evolve in the near future. The strategic objectives can be broadly grouped into three categories: public sector and fiscal reforms; economic diversification and improvements in the business environment; and social reforms, with many objectives falling into more than one category. We have examined the potential impact of the NTP on the sovereign and the Saudi banking system and conclude the following: Approval of the NTP is credit-positive for the sovereign because the plan offers?a credible path to achieving fiscal and economic diversification away from oil and will improve competitiveness. While we see significant implementation risks, we believe that, even if only partially implemented, the plan will benefit Saudi Arabia's credit profile by supporting the country's fiscal and economic strength. The development of the non-oil economy in Saudi Arabia will also be credit positive for banks because it will boost credit growth, which has historically been closely correlated to non-oil GDP growth. Similarly, a number of planned reforms through 2020 target material improvements in productivity and competitiveness, which will likely improve the operating environment for banks. We also expect a number of initiatives to push banks to accelerate a diversification of their loan portfolios away from the corporate sector and into real estate and SME lending. However, a downsizing of the government and public sector's role in the economy could also create new risks for the banks because the direct or indirect exposure to government risk will gradually be replaced by private sector risks, which will likely increase asset quality volatility, though diversification should help diffuse the pressure. Benefits of the NTP for the Sovereign The NTP aims to triple non-oil revenues to SR530 billion (22% of GDP) by 2020 from SR163.5 billion in 2015 through income taxes on non-Saudi nationals, increased "sin" taxes on tobacco and sugary drinks and other sales taxes, higher government fines and fees, and a value added tax, among other measures. This will reduce the government's reliance on oil revenues and make government finances more resistant to future fluctuations in oil prices. Moreover, because we expect that at least over the early years of the NTP economic growth will remain largely driven by government spending, a broader revenue base will make the economy more resilient to future oil price swings. Saudi Arabia is particularly vulnerable to oil price declines because oil- and gas-related revenues have historically accounted for around 90% of government revenues. In fact, even with oil prices at half their 2013 levels, hydrocarbon revenues accounted for the bulk of the Kingdom's revenues in 2015 (If the government fully implements its planned revenue diversification reforms, we calculate that, by 2020, non-oil revenues will account for 57% of total government revenues. This will help stabilize the government's revenue streams during future oil price volatility. On the expenditure side, the government plans to reduce spending on wages and salaries to SR456 billion by 2020, from a baseline of SR480 billion, supported by a 20% reduction in the total civil service workforce and improved performance evaluations of government employees. The NTP also targets a reduction in water and electricity subsidies that will lead to an additional SR200 billion in savings through 2020. The Ministry of Health plans to keep operating expenditures for in-patient treatment constant in nominal terms. Another goal is to reduce the number of social security beneficiaries by getting individuals who are of working age back to work. Finally, various ministries have been tasked with improving spending efficiencies, reducing budget overruns and increasing internal revenue generation. Planned privatization measures include raising the share of utility, infrastructure and social services delivered and facilities operated by the private sector, focusing on desalination and waste water treatment, power generation, postal services, education, health, as well as transport infrastructure like roads, railways and ports. The plan does not include a specific target for total revenue generation from the privatization of government assets. Nevertheless, reforms aimed at improving the business environment and competitiveness and fostering private-sector development will support Saudi Arabia's economic strength. Strategic objectives in the NTP that will contribute to enhancing Saudi Arabia's economic resilience include reducing the economy's dependence on the oil and gas sector, expanding the private sector's role in the economy, including in the services sector, and improving the overall business environment. The authorities have yet to announce concrete numerical targets for the proportion of non-oil GDP (59% of nominal GDP on average between 2010 and 2015) and private-sector contributions to the overall economy, but they have said that the private sector will contribute up to 40% of the NTP's initiatives. Improvements in the business environment center around legal processes, reforms to the property sector, increased implementation efficiency of government projects, improving the quality of the national labor force through education and training, as well as raising female labor force participation. However, some areas, such as the focus on fostering locally produced value-added, support for national companies, Saudization of certain sectors, and planned taxation of foreigners could reduce the Kingdom's appeal to foreign investors. Benefits of the NTP for Saudi Arabia's Banking Sector We expect the development of the non-oil economy to benefit Saudi banks' revenues in the next five years because credit growth in Saudi Arabia has historically been correlated to the non-oil GDP growth. As the Saudi authorities expect the private sector to fund around 40% of the 2016-2020 initiatives, we expect Saudi banks to be key sponsors of the NTP program. In the longer term, we expect that a lower fiscal dependence on oil revenues and a more diversified economy would also reduce volatility in economic growth, lead to more predictable government revenues and spending, and in turn to a business environment less exposed to event risks. We also note that several key performance targets, which are intended to increase the productivity and competitiveness of the Saudi economy, will likely improve the operating environment for banks. Among these initiatives, the objectives to increase property ownership registration or reduce the number of cases per judges in main courts, will likely create a more favorable environment ?for creditors and banks in particular. Saudi Arabia's plan includes 218 reforms that target an improved business environment and higher competitiveness, which should attract domestic and international investment and contribute positively to the banks' operating environment. We expect a number of other initiatives to support the diversification of Saudi banks' loan portfolios, which have historically been heavily skewed towards the corporate sector (68% in 2015), leading to high asset concentrations – a common feature across GCC banks. With close to SR60 billion of public financing planned for the development of access to housing in the next five years (about 22% of total NTP planned government financing until 2020, which excludes the 40% expected private funding), the ambition is to boost retail real estate financing from financial institutions to 15% of total lending in 2020 from 8% currently. This will allow banks to reduce their loan concentrations by increasing significantly a portfolio that is granular and secured. The NTP also projects that the contribution of SMEs to non-oil GDP should moderately increase to 35% in 2020 from 33% currently, with further support from banks and other non-bank financial institutions. This will also contribute to the diversification of banks' portfolios, although it may also increase asset risks unless covered by some forms of guarantee mechanisms such as the existing Kafalah SME loan guarantee program.
