The importance of project finance in steering bank credit revival is once again highlighted as key to credit recovery. In a new report prepared by Banque Saudi Fransi (BSF) economic research team, it said however, that financing mandates will only pick up momentum towards the end of 2010 and 2011, later than initially expected, due partly to project delays and renegotiations. The depth of the project finance pipeline over the next two years will then act as a crucial gauge as to when domestic bank credit growth is unlocked, Dr. John Sfakianakis, BSF chief economist said in the report. For the sake of cost efficiency and ease, the government has been extending billions of riyals in interest-free loans to state-linked entities in order to keep strategic projects - such as the Al Haramain high-speed railway and electricity expansion projects - on track. With the cost of bank credit remaining at elevated levels (rising between 50 to 200 bps over the past few months), drawing on public foreign assets to bankroll projects does make sense, especially as the state strives to keep expansion on target during a period of global bank risk aversion. “This is a slippery slope, however, and the state risks tipping the balance out of banks' favor if it does not tread carefully. We have argued in the past that the government is able to shoulder the burden of expansion costs in the short term, but to ensure adequate job creation for Saudi Arabia's growing population, the private sector must take a bigger role in investment,” the report said. After all, it is the private sector that can create jobs for young Saudis not the public sector. The state has done more than enough to provide financing with the help of PIF and others, but banks need an environment where they are able to lend without duress. The government decided in April to extend a SR15 billion interest-free loan to state-run utility Saudi Electricity Co to enable it to pursue new power projects, including expansion of the Rabigh power plant that is designed to support Makkah and Madinah. The SEC financing case may be unique given the challenges it faces to speed up its expansion capacity projects. The report said “there is a fine line between the extent of the role the government should play in financing projects before it begins to impinge on banks and, more importantly, crowd out most of the private sector.” “It may be prudent to explore alternative ways to finance strategic projects. The challenge is that certain businesses are close to breaching single obligor limits of banks (25 percent of a bank's equity), which can easily be surpassed given the scale of some projects. To avoid this, project timetables will need to be extended or the overall size of projects scaled down - neither of which seems probable. An alternative would be for authorities to offer future invoices or IOUs on some mega projects conditional on extending payments - a mechanism utilised in the 1990s for some infrastructure projects such as the Qassim Highway. Under such a scheme, the obligor is the government and funds are considered investments on a bank's balance sheet. Another option would be to collateralise credit facilities in the form of guaranteed deposits based on project progression. Cash collateral has zero risk.” The government may in any case opt to return to financial markets as pricing becomes more competitive. SEC priced its third Sukuk, or Islamic bond, this month at 95 bps above the Saudi interbank rate - 68 percent cheaper than the yield of its last bond in 2009. Taking robust economic fundamentals into consideration, stagnancy in bank credit is not commensurate to the size of local banks, their liquidity and the macroeconomic well being of the country. Unlike other Gulf states where banks continue to suffer the consequences of sharp property market corrections and corporate defaults, Saudi Arabia has fared very well, the report further said. Its property market is undersupplied, prices are resilient and home finance accounted for only 2.6 percent of total bank loans as of March. Private companies have de-leveraged and, unless there is a drastic shift in global circumstances, there should be no new large skeletons of bad debt hiding in the closet. High creditworthiness as a concept could no longer simply be defined by the length of the relationship, or wealth and social importance of the family. As these new policies fall into place, the credit cycle will turn and loan expansion at Saudi banks should register modest month-on-month growth by the second half of the year, yielding overall annual credit growth of 8 percent, the report noted. Credit growth could have expanded faster had there been a viable SME sector to lend to, although at the moment, this reality is not attainable in Saudi Arabia. Credit recoveries need not stem from large-scale private sector recuperation - they can also result from lending to SMEs if banks adopt more diversified credit portfolios. A catalyst for a large part of the loan growth this year will be retail banking, cited as a key growth strategy among banks striving to tap high population growth and address underdeveloped retail penetration. In the years preceding the financial crisis, most loan growth was linked to project financing and corporate credit, but consumer banking has taken a bigger role since. The economic environment is clearly much better than it was six months ago, especially after oil prices held above $80 a barrel in March and April. With May's commodity sell off due to global contagion worries, crude prices promise to be volatile, but not necessarily fiscally concerning. Oil above $60 a barrel buttresses Saudi Arabia's strong revenue position and encourages a healthy recuperation in foreign trade and personal consumption. Anything above $70 a barrel, moreover, enables the Kingdom to keep spending high while generating generous fiscal surpluses. Saudi Arabia's medium-term prospects are cautiously optimistic given the outlook for oil demand and prices. OPEC member states have been incrementally raising output to meet growing demand despite the group keeping its output target unchanged since December 2008. Saudi crude oil production rose in March to 8.26 million barrels per day from 8.13 million barrels per day in February - 2.7 percent higher than the first quarter of last year. Still, a sustainable recovery in the United States and Asia is important for oil demand more broadly. Saudi Arabia has acted as a balancer of global oil supply because it maintains 1.5 - 2 million barrels per day of spare capacity, developed following investments of $63 billion in the last five years. The Kingdom plans to invest a further $107 billion in the next four years in energy projects. The cost of drawing each barrel from onshore and offshore wells has risen substantially, the oil minister said last month. In 1998, extracting oil from the onshore Shaybah field cost $5,000 per barrel of daily capacity. Eleven years later, it cost double that for the onshore Khurais field and triple that for the offshore Manifa field. Higher output and oil prices have enabled the Saudi Arabian Monetary Agency (SAMA) to quickly replenish its foreign asset holdings. SAMA's net foreign assets in March amounted to SR1.56 trillion, bringing them back to the levels of a year ago. The central bank had drawn down foreign assets by 7.5 percent, or SR122.3 billion in 2009, to help fund budgetary requirements during a period of depressed oil prices. At the height of the draw-down in September 2009, SAMA's net foreign assets were 14 percent off peak levels hit in November of 2008 - a year that saw oil prices swing as high as $147 a barrel before plunging below $40 a barrel in a matter of months. Far less dependent on exports to Europe than countries in North Africa, Saudi Arabia could see its trade flows improve as the euro weakens further versus the dollar, although exports to the euro zone (accounting for 10.6 percent of the total) could get hit. European banks will continue to approach the Gulf with risk aversion, compounding the hesitancy to free up bank credit. On a micro level, as European bank valuations drop, this will create a negative wealth effect on Gulf sovereign wealth funds and investors at large. Saudi Arabia relies very little on European leverage for financing various expansion projects and its banks have limited exposure to Europe. But deleveraging among global peers could prompt local banks could hold on abandoning risk aversion policies. Most Saudi banks, meanwhile, hold more US paper than European paper. Bank for International Settlements data for the fourth quarter of 2009 show European banks have around $174 billion of Gulf exposure, US banks $34 billion and UK banks $83 billion. Of this total cross-border banking exposure in the Gulf, half is with the UAE, 16 percent with Saudi Arabia and 17 percent Qatar. Keeping volatile global conditions in mind, public investments remain strong albeit signs of gradual recuperation in private investment. The country awarded SR20.9 billion in development contracts in the first quarter - down almost 50 percent from the year earlier, although we expect this level to ramp up later this year. Current account data also look more robust than previously expected. In revised numbers released by SAMA, the current account surplus was SR99.4 billion in 2009, up from a prior state estimate of SR76.7 billion. The gain resulted from stronger export revenues of SR711 billion, 3 percent more than earlier expected, including oil export revenues of SR609.7 billion - 6 percent higher than the prior estimate. In view of rising imports and higher oil output and prices, we are raising our 2010 current account surplus forecast to SR173 billion, or 10.9 percent of GDP. The state, through specialized credit agencies like the Public Investment Fund (PIF) and the Saudi Industrial Development Fund (SIDF), has offered generous financial support to keep key infrastructure projects on track. By the end of March, the value of these independent organizations stood at SR585.29 billion, down 7.3 percent from 2008, according to SAMA data. Expansionary spending should, in theory, boost confidence of private sector investors in the economy and catalyze bank credit. But despite all of the ingredients for a perfect recipe of bank credit revival appearing to be in place, lending continues to be listless. Typical reasons given for languishing bank credit growth are 1) banks are implementing tighter conditions on relationship lending; and 2) private-sector companies are not seeking loans as they focus instead on reducing their debt positions. These two reasons tell part of the story, but they omit two additional crucial components outside of banks' control. Firstly, state intervention with interest-free financing, while advancing official development ambitions, fails to persuade banks to jumpstart lending; the state is leaving little room for banks to partake in strategic projects in sectors such as utilities and transport. “It may be prudent to reassess the state's business model to strike better balances between government involvement and private sector participation on the one hand, and interest free lending and more costly bank credit on the other. In the medium term, the economic costs of failing to involve banks will outweigh any savings in financing. The government should avoid creating a scenario where it is forced to carry the burden for economic development by crowding out most private participants in favor of a select few,” the report added. Participation of mid-segment companies, including contracting firms, should be emphasized while efforts made to achieve local content sourcing. Mid-level contractors could be granted contracts directly from the government rather than only through subcontractors, as often happens now, BSF said. Mega projects may need to be recalibrated to allow a wider pool of private participants. Secondly, the state is re-thinking large-scale, low-risk expansion projects (particularly in energy), forcing delays in project roll outs that also impedes efforts to widen the project financing pool for banks until 2011.
