Saudi Arabia is in the midst of two wars.
The first is a very real shooting war in neighboring Yemen. While the second is the oil share war it’s waging against other oil producers, including the United States.
Both of these wars are taking their toll on the Saudis.
You see, oil accounts for 80% of government revenue and 45% of its gross domestic product (GDP).
The International Monetary Fund estimated that the breakeven price of crude oil for the Saudis’ budget in 2014 was $106 per barrel.
But those days of $100-plus oil are gone. And with oil prices dropping by more than half since those highs, Saudi Arabia’s government income is drying up.
Growth in its $745 billion economy is expected to slow this year to 2.8%, down from 3.5% last year.
And to make matters worse, the S&P just cut its credit rating on the country from AA-to A+.
Saudis’ Budget Hole
Somehow, the Saudis are keeping up domestic spending to keep the population happy. The monarchy has spent its way through Arab Spring to quell any unrest and continues to spend heavily.
Energy subsidies alone, at about $3,400 per person this year, will cost the Saudis $106 billion in 2015.
This combination of continued spending and lower revenues has blown a $130 billion hole in the government’s budget this year. Looking at it another way, the fiscal deficit will be about 20% of GDP.
The Saudis have plugged part of that hole by selling about $27 billion worth of government bonds domestically this year.
They’ve also begun bringing overseas assets home. It’s estimated that the Saudis’ sovereign wealth fund pulled $70 billion from overseas money managers in the past six months or so.
But it’s just not enough. The Saudis have been forced to start burning through their large foreign exchange reserves. And they have the world’s third-largest pile, behind China and Japan.
Only last August, these reserves stood at $737 billion. Now they’re down to about $662 billion as of the end of August.
The country is burning through its foreign currency reserves at a record pace.
Think the Unthinkable
Things have gotten so bad, some are starting to think the unthinkable.
That is, the Saudis will break the peg between the riyal and the U.S. dollar. It has stood at 3.75 riyals to one dollar for nearly three decades!
A devaluation makes sense for the Saudis, as it would provide them with some temporary relief from budget pressures. Their expenses are in riyal, while their revenue is in dollars. So a relative boost in the value of the dollar would be welcome.
But the problem is financial players would then bet on a further decline in the riyal. Defending the currency may then accelerate the decline in foreign exchange reserves. Ask China about that scenario.
Treasuries and Petrodollars
Some may rejoice at the troubles the Saudis brought on themselves. After all, you reap what you sow.
But hold your cheers – their troubles could affect the United States, and not in a good way.
Most of the Saudis’ reserve assets are in U.S. dollars and U.S. Treasuries. In other words, these are largely petrodollar reserves.
The petrodollar was born in the early 1970s. It was formulated by former Secretary of State Henry Kissinger and the Saudis.
The United States agreed to protect the House of Saud with a commitment to its political and military security. In exchange, the Saudis agreed that all oil sold would be sold solely in U.S. dollars.
So no U.S. dollars and no access to most of the world’s oil. Thus the dollar became the world’s must-hold currency.
Wall Street has been talking about how this Saudi withdrawal of petrodollar liquidity is slamming the emerging markets. And it’s no doubt affecting global liquidity and stock markets, too.
But a high percentage of petrodollars are recycled into U.S. Treasuries. At the moment, the lack of petrodollars flowing into Treasuries is being obscured by fears of global recession and money managers parking their funds in Treasuries.
Even so, a recent Federal Reserve study is illuminating. It estimated that if foreign official inflows into Treasuries were to drop in any given month, the five-year Treasury rate would rise by 40 to 60 basis points in the short term.
We have nothing to worry about… yet.
The Saudis will likely sell bonds internationally in 2016 to help fund their deficit. And they still have sizeable reserves that can see them through for several more years.
But if oil prices don’t rebound, anything is possible. Including a black swan event surrounding the petrodollar, still shrouded in fog, that may sink investors.
Good investing,