Beyond Austerity

Despite a year of increasing pressure and concerns, the Saudi financial sector remains resilient.

Four years after the launch of Vision 2030—Crown Prince Mohammed Bin Salman’s ambitious economic development blueprint—the world’s second-largest oil producer was ready to reap the fruits of economic diversification. A simplified corporate legal framework was meant to attract pools of foreign investors; a new tourist visa was geared to lure flocks of visitors; and liberalized culture laws were supposed to bring cinema, concerts and other cultural events to the Saudi public. 

The icing on the cake: Riyadh was looking forward to welcoming leaders of the world economy to the Group of 20 summit scheduled for November. But of course, Covid-19 radically altered the calendar and much else about the outlook for Saudi Arabia. 

As the months went by, the kingdom was hit by a dual shock of the pandemic and falling energy prices. In April, Brent crude traded below $20, its cheapest price since the 1990s Asian financial crisis. To cushion the shock, the world’s biggest oil nations, Saudi Arabia included, agreed to a historic production cut of about 10% of global output. 

Meanwhile, Covid-19 lockdowns paralyzed nascent sectors of the economy including transport, hospitality and entertainment. When the numbers are in, GDP growth is expected to have plummeted to negative 5.4% in 2020, says the International Monetary Fund. The budget deficit is expected to widen to 12.8% of GDP, from 4.5% in 2019, reflecting a 33% drop in oil revenue, according to Fitch Ratings. While Saudi Arabia has posted a deficit every year since oil prices started to decline in 2014, the further drop in hydrocarbon revenues is forcing the Middle East’s largest economy to accelerate fiscal reforms.

 Austerity measures have included government spending cuts and new taxes. In July, the authorities increased the recently introduced value added tax (VAT) on transactions from 5% to 15%. While this boosted business until June as customers rushed to buy expensive items such as cars and watches before the tax rise became effective, sales then fell back.

If oil prices pick up, the fiscal deficit should narrow to 5% of GDP by 2022 and achieve balance the following year, says Fitch. “However, further waves of the coronavirus, either in Saudi Arabia or elsewhere, and continued oil market weakness could upend these forecasts,” the agency said in its most recent report.

Banking Sector Stays Strong

Despite a year of increasing pressure and concerns, the Saudi financial sector remains resilient. While the Covid-19 crisis impeded growth in banking assets and profits, industry watchers are optimistic that with strong capitalization and liquidity, it can minimize the effects.

“Overall profitability for the past nine months has decreased by only 6.4% among Saudi banks despite 41.4% growth in impairment losses. This is comparatively low with other developed economies mainly due to the fact that two-thirds of the banks’ funding is free of cost” says Ovais Shahab, head of Financial Services for the Saudi Levant Cluster at KPMG. “The government’s stimulus program resulting in an interest-free liquidity of 110 million Saudi riyals to commercial banks has further added to the benefit, and banks were able to reduce impacts of Covid-19 on their profitability.”

In March, the Saudi Arabian Monetary Authority (SAMA, the state’s central bank) rolled out a $14 billion stimulus package, mainly channeled through liquidity injections and interest-free bank deposits. The money then trickled down to support the real economy.

“The banks and the authorities worked very closely together to ensure that credit lines stayed open and liquidity remained ample to support commercial activity,” says Rania Nashar, CEO of Samba Financial Group. “Of course, there has been corporate distress, but overall system liquidity has been very good, and the economy has held up much better than seemed likely in the early part of the year.”

Higher-than-expected lending growth in 2020 was predominantly driven by government support for mortgages and financing for small and medium-size enterprises (SMEs).

“Mortgage has been the real growth opportunity for Saudi banks in recent past and key players have managed to report a consistent double-digital growth,” says Shahab. As part of its vision for economic development, the Saudi leadership aims to boost homeownership from 47% to 60% over the next decade. As construction of thousands of new houses is carried out through public private partnerships (PPPs), banks will provide loans to new tenants.

“There is still enormous pent-up demand among Saudi nationals for housing, and banks will continue to tap into this demand,” says Nashar.

In the medium term, however, lending growth is expected to slow down as the housing market matures and support facilities for SMEs come to an end.

“Lower interest rates, slow growth and the higher cost of risk will put pressure on Saudi banks’ profitability,” says Mohamed Damak, senior director of Financial Institutions at S&P Global Ratings. “That said, we expect Saudi banks will be able to navigate these headwinds and maintain a return on average assets of about 1.2% in coming years, although that is below banks’ historical performance.”

Competition Ratchets Up

Compared with other Gulf Cooperation Council countries, Saudi Arabia is relatively underbanked, with around 30 licensed banks for 34 million inhabitants. But as the population grows and the country opens up, the financial sector will feel the pressure both to expand and provide higher-quality service.

Foreign banks are expected to play a major role, and SAMA is simplifying the application process and regulations to make Saudi Arabia as attractive as possible. Last year, Credit Suisse and Standard Chartered entered the Saudi market, and it appears that the central bank will be issuing more licenses.

“The entry of international banks in Saudi Arabia is expected to be eventful, and while they are likely to leverage on global connect, new product solutions and enhanced customer experience, they are likely to face competition with large banks having established customer loyalties. Most of the retail depositors are less likely to shift solely on the basis of better interest rates or additional services being offered free of charge; they will benchmark their overall experience with the new normal in the market. It will bring a very healthy competition to the market,” says Shahab.

Perhaps anticipating stepped-up competition, Saudi Arabian banks are regrouping as well. In December 2019, the merger of Alawaal Bank and the Saudi British Bank (SABB) brought structural change to the financial sector, and more consolidation is expected in the coming months. Next in line is National Commercial Bank’s (NCB) expected acquisition of Samba Financial Group in a $15 billion deal. If the merger goes through, the new entity will be the Middle East North Africa region’s third-biggest bank, with over $220 billion in assets.

“We are very excited about the prospect of creating a national champion bank for Saudi Arabia,” says Nashar. “We think Samba and NCB have great complementarity and the potential economies of scale should mean a greater array of services for our clients at a lower cost.”

The merger would boost the creditworthiness of both institutions, Damak adds. “The banks’ core profit–generating activities are likely to complement each other, with retail accounting for roughly 50% of NCB’s operating income and corporate lending accounting for 43% of Samba’s,” he says.

While recent years have brought a wave of bank mergers in the GCC economies, Saudi banks remained relatively modest in size and focused on the local market. Today, they are looking to scale up. Now, more small and medium-size Saudi lenders are expected to merge or sell operations to a foreign bank in order to better compete and grow.

“Saudi Arabia needed to have a player in the top three regional banks. I think with this deal we are getting there,” says Shahab. “What is also interesting to note is that NCB has operations in Turkey [and] Samba is present in Pakistan and the United Arab Emirates, so we are expanding horizons even beyond the Middle East.”

Banking on Tech

As Saudi Arabia attempts to move away from oil dependency, moving its financial sector to the cutting edge will be a key part of the strategy. As in other parts of the world, the Covid-19 crisis accelerated the agenda.

“[The] pandemic significantly accelerated the digital agenda of Saudi banks and last nine months have changed more than years of quest. Customers were required to visit branches for opening accounts or requesting for credit facilities–but loc-down made them realize that a virtual onboarding is a business imperative going forward,” says Shahab. 

In the long run, developing financial services also means using tech tools to reach out to a wider range of Saudi nationals and residents.

“In Saudi Arabia, only around a quarter of customers interact digitally with their banks,” says Nashar, and this despite having one of the highest mobile-phone penetration rates in the world. “What this suggests to me is the huge potential of fintech to make a real difference to the economy.” Cross-border money transfer is one area that Saudi fintechs are looking at especially hard, given that the kingdom is the world’s second-largest remittances market.

In the race to innovate, SAMA stepped up its game last January when it started granting banking licenses to digital payment providers and fintechs; tens of digital financial service companies now operate in Saudi Arabia. Most of them are homegrown, but a few are international partnerships, including the UK’s Finablr, which recently bought a majority stake in Saudi e-wallet BayanPay, and regional players such as the UAE’s Tabby and Kuwaiti telecom provider Zain.

For banks as for every other part of the economy, however, economic growth is key—and growth still depends on oil. Provided the pandemic fades and oil prices pick up, growth is expected to come back and exceed 2% in 2021.

“Saudi Arabia’s heavy reliance on crude oil exports is a weakness during low oil prices,” says Ravi Bhatia, director of Sovereign and International Public Finance Ratings at S&P Global Ratings, “but conversely, a strength during high oil prices and high demand. The kingdom’s large, growing population will also lead non-oil growth and, if managed effectively, could be a strength.”

With Covid-19 vaccines becoming available and governments—including Riyadh—knee-deep in fiscal stimulus expenditures, banks and investors will need to make an additional risk calculation in 2021: of the likely damage once governments wind down their economic support programs.

“As we approach the end of 2020, banks will be closing their annual results for one of the most uncertain financial year in recent times. A robust assessment of credit risk provisions of customer will be the most significant challenge,” says Shahab. “The absence of updated and reliable financial information of customers when they are still under the stimulus programs at the year-end would pose more challenges to unfold customer defaults that may have already occurred. A proactive dialogue with all the customers, especially in the distressed industries, is imperative to avoid unpleasant surprises next year.”