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Saudi hedges in vogue as sov bond looms

Saudi Riyadh px230 for GC

Abundant oil reserves transform a country’s economy. The results are not always positive — some sovereigns suffer from the “Dutch Disease”, which inhibits exports of non-oil goods through an appreciation in the real exchange rate. But overall natural resources, in particular oil and gas, prove to be a boon for the lucky country’s finances.

Gavan Nolan, IHS Markit

Saudi Arabia is a notable example of a previously poor country that has benefited highly due to the discovery of oil reserves. But a wealth of black gold can also breed dependence, as the Saudis know all too well. The recent decline in the price of crude has cut the government’s main source of revenue and led to the budget deficit ballooning to 15% of GDP in 2015. Foreign reserves, though still comparatively large, have depleted rapidly.

A change in economic strategy was, therefore, inevitable. The Saudi government announced plans earlier this year to diversify the economy and reduce reliance on oil. As part of the strategy, government debt will increase to 30% of GDP by 2020 from the current 7.7%. An international bond issue — the first in Saudi history — is imminent, with the latest reports suggesting that it will be sold in September.

The fall in the oil price and the prospect of Saudi debt hitting the capital markets has had a marked impact on the sovereign’s credit default swap. Five year spreads widened sharply in the latter half of 2015 and the first-quarter of this year, hitting 208bp, the first time spreads have surpassed 200bp since the financial crisis in 2009. They are now trading around 155bp, a partial recovery no doubt triggered by the stabilisation of oil prices around $40-$50.

But it is the CDS net notional outstanding that really shows how Saudi’s new financial strategy is affecting credit. In August last year net notional was $450m, a figure little changed from levels three years previous. However, since then net notional has climbed steadily and exceeded $1bn for the first time earlier this month. This would be a notable trend in isolation but in the context of the broader CDS market, it is extraordinary.  

This time last year total CDS net notional was $1.64tr; the latest figures show it has declined to $1.54tr. Much has been written about the slowdown in the single name market, but the appetite for Saudi CDS shows that there is still a strong demand for a product that is specifically designed to hedge credit exposure. 

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