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Generations yet unborn may someday study Saudi Arabia’s record-setting $17.5 billion bond issue, but not, probably, because it turns out to be a great investment.
More likely, it could come to epitomize the way investors in a time of extremely low interest rates became willing to run multiple, hard-to-fathom risks in exchange for minimal compensation.
To be clear, from the Kingdom’s point of view the deal, struck on Wednesday, is a resounding success. Not only was it the biggest emerging market sovereign bond issue ever; it was, due to very heavy demand, priced at interest rates well below initial indications and its reception touched off a resounding rally in Saudi assets.
Yet investors are making loans of up to 30 years to a kingdom in a dangerous part of the world, with potential domestic political concerns, huge budget shortfalls and an economy almost entirely dependent on depressed energy prices over which it has less and less control.
That’s before we get to interest rate risk or the risk that Saudi Arabia decides not to hold the pegged value of its riyal against the dollar. Remember, while the Kingdom pumps oil priced in dollars, it does not print them.
“You are just not being paid enough for the inherent risk associated with the Kingdom,” said Steve Hanke, a professor of applied economics at Johns Hopkins with long and deep experience as both an investor and a sovereign economic adviser.
The bond’s 30-year tranche yields 210 basis points over Treasuries, or 4.6 percent, while a five-year portion currently yields about 2.6 percent. Ten-year bonds yield 3.41 percent.
With the price of oil low and Saudi middle-classes greatly dependent on often unproductive jobs in government, the Kingdom racked up a budget deficit last year equal to 15 percent of GDP. While the bond was touted as helping to foment a sort of industrial revolution, as it attempts to diversify away from petrochemicals, the sigh of relief in financial markets was not based on expectations of future productivity but rather that the deal can finance about a third of next year’s budget deficit.
Even with oil having staged a modest rally with Brent crude now at $51 per barrel, an International Monetary Fund Report released on Wednesday said Saudi Arabia would need to achieve an average price next year of $77.70 per barrel to break even in fiscal terms. The IMF also sees a fiscal deficit next year equal to 9.5 percent of output, down from 13 percent this year.
That’s just next year. Discounting the risks of energy prices and new forms of energy (remember shale oil, anyone?) out to 30 years is quite another matter.
TAKE THE MONEY AND RUN?
While most analysts acknowledge the risks of the uncertainty of the price of oil for Saudi Arabia, Hanke sees a further and perhaps more profound risk over the uncertainty of the regime, arguing that the Saudis’ willingness to pump even at low prices shows in part that they themselves are discounting a non-minimal chance of losing power over the medium term.
His analysis is that this indicates a preference to bank, or spend, the value of the Kingdom’s natural resources today because of concerns over who might control them in the future.
“This is a major factor behind the increased maxing out of capacity in Saudi Arabia,” Hanke said in an interview.
“There’s a lot of princes who are worried about the future and they want cash in the pocket now. They want to pump oil – that’s take the money and run. They want to sell the oil company – that’s take the money and run.” (here)
Saudi officials are working toward a planned 2018 IPO of about 5 percent in state oil company Saudi Aramco for something on the order of $100 billion, part of an ambitious plan to reduce dependence on energy by 2030. The country is working to cut back on spending, this week cutting ministerial pay by 20 percent. About two-thirds of working Saudis serve in the official sector, a statistic illustrating the huge hurdles facing any economic transformation.
To be sure, with no elections and a long record of tight control, the ruling House of Saud gives the appearance of stability. Even putting aside all of the idiosyncratic Saudi risk this deal carries, perhaps the most obvious and profound is interest rate risk. While margins float above Treasuries, there can be no doubt that after years of sub-par growth and extraordinary monetary policy, investors around the world are reaching for yield. That sort of herding behavior is self-perpetuating while it lasts but also self-feeding when it turns.
Like the Petrobras 100-year bond from earlier this year, the Saudi $17.5 billion blockbuster has the feel of being one for the ages.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)
(Editing by Dan Grebler)
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