Assessing the Importance of Oil and Interest Rate Spillovers for Saudi Arabia1
Oil prices have fallen by over 40 percent since mid-2014 while the Fed is expected in the coming months to begin raising its policy rate at the beginning of a gradual tightening cycle. Given the importance of oil to the economy and the peg of the riyal to the U.S. dollar, these are two key developments for Saudi Arabia. This paper assesses the importance of these shocks to the economy and banking system through a number of methodologies. The main takeaway is that oil prices have typically played a bigger role than interest rates in affecting economic and financial outcomes in Saudi Arabia. While a temporary drop in oil prices would likely have little effect on the economy and banks given the financial cushions that have been built-up, a longer-lasting period of low oil prices would have a more significant impact.
1. Two key features of the Saudi Arabian economy are its dependence on oil and the pegged exchange rate to the U.S. dollar.
Oil revenues account for around 90 percent of central government fiscal revenues and around 85 percent of export revenues, while the oil sector comprises over 40 percent of overall GDP. Further, activity in the non-oil sector is correlated with oil prices through government spending. The importance of oil revenues to the economy has changed little over the past decade (Table 1). Dealing with oil price volatility and uncertainty is a key challenge facing Saudi Arabia and it is important that strong fiscal buffers are built-up in periods of high oil prices to help cushion government spending when oil prices are low. Saudi Arabia has reduced government debt to very low levels and the government had deposits in the banking system equivalent to 56 percent of GDP at end-2014 (Figure 1).
Exchange rate regime. Saudi Arabia has pegged the riyal to the U.S. dollar at a parity of 3.75 since 1986. Given the fixed exchange regime and relatively open capital account, SAMA moves its policy rates closely with the fed funds rate to prevent pressures developing on either side of the riyal peg (Figure 2). The expected increase in U.S. interest rates in the coming years will therefore see SAMA also raise its policy rate and this will feed into other interest rates, although the current high liquidity levels in the bank system may slow the rate of pass-through. The strength of the dollar over the past year has also led to nominal and real effective appreciations of the riyal which is now at its highest level in real terms since 2003 despite the large terms of trade decline in the face of the drop in oil prices.
|Oil Exports/Exports G&S||83.3||82.6||73.8|
|Oil Revenue/Revenue||88.5||89.6||81.0|Figure 1.Oil Price and Saudi Public Debt, 1993–2014
Source: Authorities data
Figure 2.Saudi Policy Rates & Fed Funds Target Rate, 1993–2015
Source: Authorities data
2. With oil prices having fallen over the past year and U.S. policy interest rates expected to move higher in the period ahead, Saudi Arabia is facing two important shocks that will have an impact on the economic outlook. Empirical studies find that the impact of oil prices depends on the importance of oil revenues for the economy and the way oil revenues filter through to the real economy. The size of the government and its fiscal policy, for instance, plays a primary role in determining how oil prices impact the economy (Husain, Tazhibayeva, and Ter-Martirosyan (2008)). In a recent study on Saudi Arabia, Alghaith et al (2014) found a positive and strong impact of oil prices on the economy through government spending. Similarly, for the Kuwaiti economy, Eltony and Al-Awadi (2001) found that oil price shocks were mainly transmitted through government expenditure. Other studies have focused on the effects of oil prices on stock markets and find a positive association in oil exporting countries.2
3. Interest rate changes, on the other hand, have a less significant impact on economic outcomes. Sheehan and Russer (1995), for instance, find that the monetary policy channel in Saudi Arabia has a limited impact on the economy because tighter policy is usually associated with periods of strong growth driven by higher oil revenues. Alghaith et al (2014) find that an increase in the U.S federal funds rate has a small and statistically insignificant impact on Saudi Arabia’s non-oil output, although a significant negative impact on inflation. They argue that higher U.S. interest rates are unlikely to have an adverse impact on the Saudi economy, especially if the increase in the fed funds rate is driven by an improving U.S economy.
A. What Does History Tell us About the Impact of Oil Price Declines and Interest Rate Increases on the Saudi Economy?
4. The event analysis presented below identifies past periods when oil prices have dropped significantly or U.S. interest rates have risen and looks at the behavior of key economic and financial variables during these periods. Such analysis can be useful in identifying the key transmission channels and effects, but has drawbacks in that it is difficult to isolate specific events as in any dynamic economy there are many factors changing at the same time. In earlier periods, the analysis is also hampered by a lack of data.
Episodes of large declines in oil revenue
5. Three periods are identified where oil revenues fell by 50 percent peak-to-trough either because oil prices fell, oil output fell, or a combination of both. These are 1982–86, 1998–99, and 2008–09 (Figure 3). The drop in revenues in the first half of the 1980s proved long lasting, driven in large part by expanding oil production and increased efforts in many advanced countries to improve energy efficiency. Nominal oil revenues only returned to their 1982 level in 2004. The other two events were short-lived and principally reflected a contraction in global oil demand during a sharp slowing in global economic activity (the Asian financial crisis in 1998–99 and the global financial crisis in 2008–09). While there may have been other transmission channels at work during these periods, given the structure of the Saudi economy the oil channel is likely to dominate.
Figure 3.Oil Revenue Declines During the Three Historical Episodes
Note: Year t=0, corresponds to 1982, 1998, and 2009 for the ‘1980s,’ ‘1990s,’ and ‘2000s’ price decline events, respectively.
Source: Country authorities
6. In all three episodes, macroeconomic variables behaved similarly. As oil revenues declined, money and credit growth slowed, export receipts and government revenues fell, and despite a decline in imports and government spending, the fiscal and external balances moved into deficit (or the surplus narrowed considerably). Real GDP declined, driven by a substantial drop in real oil GDP as Saudi Arabia responded to the weakness in global oil markets by cutting production. While slowing, real non-oil GDP growth generally proved more resilient. While data is not available for all three episodes (and hence is not shown), equity prices declined and, with a lag, non-performing loans in the banking sector rose during the latter two periods.3
1982–86: As excess supply developed in the global oil market in the early 1980s, Saudi Arabia began to reduce production, which declined from 10.4 mb/d in 1981 to 3.5 mb/d in 1983. Oil prices also declined over this period, and then dropped very sharply in 1986 as Saudi Arabia increased its production levels. This resulted in a substantial drop in oil revenues and the fiscal and external balances moved into deficit even as the government cut back on spending and imports fell. Credit and broad money growth slowed sharply. Real GDP was severely affected, dropping by a cumulative 25 percent from 1981–85. Initially this was driven by a sharp fall in oil GDP, but non-oil GDP also declined. Ahead of the decline in oil revenues, the government started from a strong fiscal position with a large surplus in 1980–81 and net financial assets that are tentatively estimated to have been around 60 percent of GDP. Nevertheless, and despite sharp government expenditure reductions, these assets were run down by the early 1990s.
1998–99: The Asian financial crisis led to a sharp reduction in the global demand for oil and a large drop in oil prices. Saudi Arabia, together with other OPEC members, reduced production in response (in late 1998 and early 1999). Oil revenues fell substantially in 1998, pushing the current account and fiscal balance into, or further into, deficit. Broad money growth slowed in 1998, and credit growth the year after. Government spending was reduced, and non-oil GDP growth slowed. However, overall GDP growth accelerated slightly in 1998 given increased oil production that year, before turning negative in 1999 as oil production was cut. The starting fiscal position was weak—a deficit of around 3 percent of GDP and outstanding debt of around 70 percent of GDP. This left the government with little option but to reduce spending in the face of the drop in oil revenues.
2008–09: With the onset of the global financial crisis, oil prices dropped sharply and Saudi Arabia, together with OPEC partners, cut production. Export and fiscal revenues dropped sharply in 2009, but government spending growth continued and the decline in imports was more limited than in earlier episodes. The fiscal and external balances declined substantially and credit and money growth slowed. Real GDP declined in 2009 driven by lower oil production, but while slowing from high levels, non-oil GDP growth remained around 5 percent. The starting fiscal position, with a surplus of close to 30 percent of GDP and government net financial assets of around 45 percent of GDP, provided a platform where the government did not need to procyclically reduce its spending in response to the drop in oil revenues.
Figure 4.Economic and Financial Developments Around the 1982–86 Decline in Oil Prices
Source: IMF staff calculations; Haver
Figure 5.Economic and Financial Developments Around the 1998–99 Decline in Oil Prices
Source: IMF staff calculations; Haver
Figure 6.Economic and Financial Developments Around the 2008–09 Decline in Oil Prices
Source: IMF staff calculations; Haver
8. These episodes emphasize the common channels of transmission of the decline in oil revenues to the Saudi economy, but also highlight important differences. The starting fiscal position is clearly one important determinant of the macroeconomic and financial impact. The government was able to cushion the impact of falling oil prices on non-oil activity by drawing on buffers to maintain expenditure in 2008, but from a weaker starting position in 1998, the government cut back expenditure which hurt non-oil growth. Another is the persistence of the oil price decline—if it is long-lasting, the impact on the economy is greater and even strong initial buffers can be used up quickly.
Episodes of increasing U.S. interest rates
9. Periods of rising U.S. interest rates have often occurred at the same time as increasing oil prices (Figure 7). These periods are not particularly useful in shedding light on the possible consequences of higher interest rates at the current juncture. Rather, the analysis identifies two periods when the Fed was tightening policy and oil prices remained broadly flat. In the first episode, U.S. interest rates increased from 6.5 percent in February 1988 to 9.75 percent in February 1989, while oil prices were more or less unchanged. In the second episode, interest rates rose from 3 percent in January 1994 to 6 percent in February 1995.
Figure 7.Oil Price and Interest Rates, 1975-2015
Source: US Federal Reserve; IMF calculations
10. These two episodes of rising U.S. interest rates do not yield clear conclusions on the impact on the Saudi economy (Figures 8–9). While higher interest rates do appear to be associated with a slowing in deposit and credit growth, the behavior of non-oil GDP is different across the two episodes. Further, the impact on inflation is not clear cut.
Figure 8.Economic and Financial Developments Around the 1988–89 Tightening of U.S. Monetary Policy
Source: IMF staff calculations; Haver
Figure 9.Economic and Financial Developments Around the 1994–95 Tightening of U.S. Monetary Policy
Source: IMF staff calculations; Haver
B. Econometric Analysis of the Oil and Interest Rate Links in the Saudi Economy
11. In this section, two VARs are used to assess the impact of lower oil prices and higher interest rates on the Saudi economy and banking system. First, the macro-financial links are investigated using a quarterly VAR. Second, an annual panel VAR is run to look at the determinants of credit quality and deposits in the banking system.
Macro-financial links—A VAR analysis
12. A quarterly VAR was estimated to look at the impact of oil prices and interest rates on the Saudi economy. Two global variables—the real oil price and the U.S. Fed Funds rate—and a number of Saudi Arabian economic and financial variables are considered in the model. These variables are: real equity prices, real private sector credit, real government spending (all deflated by the CPI), CPI inflation, and real non-oil GDP. The models are estimated on quarterly data from 1995Q1 to 2014Q4, with annual series for real non-oil GDP and real government spending interpolated using a quadratic trend given a full quarterly time series is unavailable for either variable.
13. The main results from the models are as follows:
Oil prices have a significant and sustained impact on key economic and financial variables (Figure 10). A one standard deviation negative shock to oil prices (equivalent to a 14 percent drop in oil prices) reduces equity prices, credit, government spending, inflation, and real non-oil GDP growth. The impulse responses indicate a peak impact of 5 percent, 1.1 percent, 0.8 percent, 0.2 percent, and 0.1 percent, respectively, after a 1–5 quarter lag, with some of the impacts sustained for several quarters.
The U.S. fed funds rate is found to have a short-lived, but statistically significant impact on equity prices, non-oil real GDP growth, and inflation (Figure 11). The impulse response functions indicate that a one standard deviation positive shock to the fed funds rate, which is a rise of 35 basis points, reduces equity price growth by 0.5 percent and real non-oil GDP by 0.1 percent, respectively, in the first quarter, and CPI inflation by 0.1 percent for three quarters. The immediate impact on non-oil GDP found in the VAR is hard to reconcile with the likely relatively slow pass-through of higher U.S. rates into domestic lending rates and may be due to the interpolated nature of the quarterly data.
Figure 10.Impact of Oil Prices on Real and Financial Variables
Source: SAMA; authors’ calculations
1/ Shows response to a one standard deviation shock to oil prices. All variables in log differences.
Figure 11.Impact of Fed Funds Rate on Real and Financial Variables
Source: SAMA; authors’ calculations
1/ Shows response to a one standard deviation shock to oil prices. All variables except fed funds rate in log differences.
A closer look at the banking sector
14. Interactions between real and financial factors are important in a changing oil price environment. Econometric estimates suggest the existence of macro-financial feedback loops in Saudi Arabia (Figure 12). A panel VAR model was estimated using variables in real terms capturing macroeconomic developments (the growth rates of oil prices and nonoil private sector GDP) and bank balance sheet conditions (NPL ratios and the growth rates of credit and deposits).4 Consistent with results reported in the accompanying paper (IMF, 2015), NPL ratios rise after the growth rates of oil prices and non-oil GDP decline (the latter through lower credit growth). Deposit growth declines as do the growth rates of non-oil GDP and credit. So, for example, a 1 percent decline in oil prices leads to a 0.3-0.4 percent decline in credit growth, a 0.1-0.2 percent decline in deposit growth, and higher NPLs. There is a feedback effect within bank balance sheets, as solvency risk and liquidity risk reinforce each other (higher NPLs lead to lower deposit growth and vice versa through a reduction in credit growth).
Figure 12.Macro-Financial Feedback Loops in Saudi Arabia
Note: Panel VAR with one and two lags. Annual data 1999-2014. Bank level data for NPL, deposits, and credit. Numbers represent a percent response to a 1 percent shock, except for NPL ratio where shock and response are in percentage point.
C. Model Simulations of the Impact of Lower Oil Prices on the Saudi Economy
15. G20MOD, a module of the IMF’s Flexible System of Global Models, can be used to assess the impact of lower oil prices on the Saudi economy. G20MOD is a 25-bloc global general equilibrium model encompassing each of the G-20 countries and 5 additional blocs that effectively complete the rest of the world (see Andrle and others, 2015, and the annex for features salient to these simulations). To broadly mimic the decline in oil prices to date and the partial recovery priced into futures markets in the coming years, an initial 40 percent decline in oil prices is simulated with one-half of this decline being subsequently reversed (Figure 13).
Figure 13.Impact of Lower Oil Prices in Saudi Arabia—Results from G20MOD
Source: IMF G-20 Model.
16. The model results are consistent with the earlier analysis and emphasize the importance of the fiscal policy response in determining the initial impact on the real economy. As oil prices decline, export and fiscal revenues decline relative to the baseline, and the fiscal balance and current account weaken. The extent of this weakening depends on the response of government spending. If the government initially maintains spending in nominal terms (rising as a percent of GDP given the fall in nominal GDP) and uses its buffers to finance the large deficit, the impact on real GDP is initially more limited. If it undertakes an upfront fiscal adjustment, the short-term impact on real GDP is larger, but the widening of the deficit and use of the fiscal buffers more limited. Real GDP falls below the baseline since consumption and investment decline as consumers and firms respond to the decline in government spending and national wealth. The impact on real GDP is affected by the composition of the fiscal adjustment. Cuts in transfers have the least effect on real GDP, followed by reductions in current expenditure and increases in distortionary taxes, with the greatest impact being from cuts in spending on infrastructure. Imports contract, partly offsetting the impact of the decline in oil revenues on the current account balance. As real GDP falls, inflation eases (the oil price drop does not affect inflation because domestic energy prices are fixed). Since the nominal exchange rate is pegged to the U.S. dollar, the policy rate does not respond to the weakening domestic economy and the downward pressure on inflation, pushing up the real interest rate which further weakens private consumption and investment. Over time, the rebound in oil prices partially reverses some of the initial impact on real GDP and other variables, and in the case of the upfront fiscal adjustment, expenditure is able to return closer to original levels, and offset some of the loss of real GDP.
D. Conclusions and Policy Implications
17. The decline in oil prices and the expected increase in U.S. interest rates will have implications for the future path of the Saudi economy. The analysis in this paper makes it clear that oil prices are a key determinant of macroeconomic and financial outcomes in Saudi Arabia. The impact of higher interest rates is harder to determine, but while interest rates may be a less important determinant of activity than oil prices, there is still likely to be some effect on the economy.
18. The duration of the oil price decline will be a key factor in determining the economic and financial impact on Saudi Arabia. Substantial fiscal and financial buffers have been built-up in recent years, and these can be used to smooth the impact of lower oil prices in the near-term. However, a longer-lasting decline in oil prices will require fiscal adjustment, which will impact growth and the banking sector.
19. Fiscal, financial, and structural policies will be important in managing the impact of lower oil prices and higher interest rates. While the substantial fiscal buffers mean there is no need for a knee-jerk reduction in fiscal spending, a medium-term fiscal consolidation plan needs to be established and a gradual adjustment started. This will allow the government to continue to focus on key development priorities while reducing medium-term fiscal risks that would build if spending does not adjust over time to lower oil prices. On the financial sector side, careful monitoring of the banking and broader financial system is needed to identify any emerging stresses at an early stage so that prompt policy actions can be taken as needed. On the structural side, continued reforms to support the diversification of the economy away from oil would provide a boost to non-oil growth and help offset the impact of weaker government spending.
This annex provides a broad summary of G20MOD, a module of the IMF’s Flexible System of Global Models (FSGM). The model is presented in greater detail in Andrle and others (2015).
1. G20MOD is an annual, multi-economy, forward-looking, model of the global economy combining both micro-founded and reduced-form formulations of economic sectors. G20MOD contains individual blocks for the G-20 countries, and 5 additional regions to cover the remaining countries in the world. The key features of a typical G20MOD country model are outlined below, noting any special circumstances that are applied for Saudi Arabia.
2. Consumption and investment have microeconomic foundations. Specifically, consumption features overlapping-generations households that can save and smooth consumption, and liquidity-constrained households that must consume all of their current income every period. Firms’ investment is determined by a Tobin’s Q model. Firms are net borrowers and their risk premia rise during periods of excess capacity, when the output gap is negative, and fall during booms, when the output gap is positive. This mimics, for example, the effect of falling/rising real debt burdens.
3. Trade is pinned down by reduced-form equations. They are a function of a competitiveness indicator and domestic or foreign demand. The competitiveness indicator improves one-for-one with domestic prices—there is no local-market pricing. For Saudi Arabia, most exports are oil, so competitiveness changes play a small role in the model.
4. Potential output is endogenous. It is modeled by a Cobb-Douglas production function with exogenous trend total factor productivity (TFP), but endogenous capital and labor. For Saudi Arabia, potential output also moves one-for-one with the long-run average production of oil (but not cyclical swings in oil production).
5. Consumer price and wage inflation are modeled by reduced form Phillips’ curves. They include weights on a lag and a lead of inflation and a weight on the output gap. Consumer price inflation also has a weight on the real effective exchange rate and second-round effects from food and oil prices. Given that energy prices in Saudi Arabia do not respond to global oil price developments, there is no feed-through from oil price changes to CPI inflation in the Saudi Arabia bloc. While the role of expatriate labor in Saudi Arabia is not directly modeled, the effects are approximated by having a low-weight on the output gap.
6. Monetary policy is governed by an interest rate reaction function. For most countries, it is an inflation-forecast-based rule working to achieve a long-run inflation target. For Saudi Arabia, the monetary reaction function defends its fixed nominal exchange rate against the U.S. dollar. This means in tandem with the risk-adjusted uncovered interest rate parity condition, Saudi Arabia must, in the face of shocks, set its monetary policy interest rate equal to that of the United States in order to defend its peg.
7. There are three commodities in the model—oil, metals, and food. This allows for a distinction between headline and core consumer price inflation, and provides richer analysis of the macroeconomic differences between commodity-exporting and importing regions. The demand for commodities is driven by the world demand and is relatively price inelastic in the short run due to limited substitutability of the commodity classes considered. The supply of commodities is also price inelastic in the short run. Countries can trade in commodities, and households consume food and oil explicitly, allowing for the distinction between headline and core CPI inflation. All have global real prices determined by a global output gap (only a short-run effect), the overall level of global demand, and global production of the commodity in question.
8. Commodities can function as a moderator of business cycle fluctuations. In times of excess aggregate demand, the upward pressure on commodities prices from sluggish adjustment in commodity supply relative to demand will put some downward pressure on demand. Similarly, if there is excess supply, falling commodities prices will ameliorate the deterioration.
9. In Saudi Arabia, oil is the only commodity that is produced and exported, and is a dominant feature of the model. Exports of oil respond largely to Saudi production decisions. Eighty-five percent of oil revenues are assumed to accrue to the government, the remainder to Aramco, the state oil company. This means that oil price fluctuations affect government revenues, but have little effect on household wealth as households have no direct ownership stake in the oil sector. Oil prices also have little effect on households’ and firms’ decisions, as oil prices are held fixed domestically. The government, which has a large stock of financial assets, is assumed to set long-run fiscal policy with the aim of maintaining this asset stock, although in the short-run fiscal policy can result in significant deviations away from this target.
10. Countries are largely distinguished from one another in G20MOD by their unique parameterizations. Each economy in the model is structurally identical (except for commodities), but with different key steady-state ratios and different behavioral parameters. As noted above, the parameterization of Saudi Arabia is strongly determined by the fact that its economy is dominated by oil.
AlghaithN.A.Al-DarwishP.Deb and P.Khandelwal2014 “Monetary and Macroprudential Policies in Saudi Arabia” in Saudi Arabia: Tackling Emerging Economic Challenges to Sustain GrowthIMF.
BjørnlandHilde C.2009 “Oil Price Shocks and Stock Market Booms in an Oil-exporting Country,” Scottish Journal of Political Economy56 pp. 232–254.
EltonyM. and M.Al-Awadi.2001 “Oil Price Fluctuations and Their Impact on the Macroeconomic Variables of Kuwait: A Case Study Using a VAR Model,” International Journal of Energy Research25 pp. 939–959.
HusainA. K. Tazhibayeva and A.Ter-Martirosyan2008 “Fiscal Policy and Economic Cycles in Oil-Exporting Countries,” IMF Working Paper WP/08/253.
International Monetary Fund (IMF)2015 “Assessing the Resilience of Saudi Banks to Weaker Economic Conditions,” Saudi Arabia Article IV Consultation Selected Issues IMF country ReportWashington.
ParkJungwook and R.Ratti2008 “Oil Price Shocks and Stock Markets in the US and 13 European Countries,” Energy Economics30 pp. 2587–2608.
SheehanR. and J.Russer1995 “A Vector Autoregressive Model of the Saudi Arabian Economy,” Journal of Economics and Business90 pp.79–90.
Prepared by Goblan Algahtani, Nayef Alsadoum (both SAMA), Tim Callen (MCD), Ken Miyajima (MCM), Dirk Muir (RES), and Ben Piven (MCD).
For example, see Park and Ratti (2008), Bjørnland (2009) who test for the impact on Norway’s stock market. Wang et al. (2013) show that the oil market has a significant impact on the stock market and that the contribution of oil prices shocks on the stock market is stronger in oil exporting countries.
The bankruptcy of two large non-listed conglomerates in 2009 contributed to the increase in NPLs in the 2008–09 period.
NPL ratios are used without a logit transformation. Bank-by-bank data comprises annual data for 12 banks taken from Bankscope for the period 1999–2014.