With Saudi Arabia’s Crown Prince Mohammed bin Salman in Washington at the start of his long U.S. tour, there have been no shortage of good analyses written about what’s at stake and the motivations for the trip and Saudi social and economic reform – my favorites include those by Karen Young and Alastair Newton, as well as broader assessments of macro and regional policy by Steffen Hertog and Gregory Gause. Despite adding to the deluge, I’m going to weigh in also, to focus on some tradeoffs that may not get much public air time on the trip but will be important for assessing developments in coming months and years. These include the balance between local and foreign investment asset allocation, role of the private sector and local market development. Foreign investors salivating over some of the new opportunities should pay attention to the tradeoffs to better align their interests.
With policies changing fast in Saudi Arabia (much much faster than long-time watchers ever expected and something for which authorities have to be lauded), authorities may have to choose between their overlapping goals including attracting capital, getting the highest valuations for their assets, adding local jobs, involving the private sector, gaining the higher financial and political returns, as well as meet their regional political goals which include countering Iran. In fact, achieving many of the other developments suggest that the involvement of the private sector, at least the local one is the goal that is likely to take a backseat as more and more spending and development is done by government or quasi-governmental bodies. This isn’t in itself necessarily a bad thing or a new thing, as government spending has long been a catalyst for local growth, but it does suggest tradeoffs that will need to be resolved.
The trip may bring to the fore tradeoffs about foreign asset management, local economic goals in both countries and the distribution of returns, but is unlikely to resolve them, and instead is likely an opportunity for MBS to roll out some of the bilateral mercantilist policies that the Trump administration favors (though has struggled to implement with countries like China).
Figure 1: FX reserves (USD billion)
Saudi U.S. Asset portfolio. The Saudi Public Investment fund is the new fund in town and is the key vehicle for diversifying within Saudi Arabia’s USD assets. After a significant drawdown of savings in 2014-6, including some of the US bonds and public equity held by Saudi Arabia, the country’s external accounts are close to balance as the trade surplus is offset by more modest capital outflows. With oil prices now at a level that pays for Saudi Arabia’s imports but doesn’t allow much space for new foreign asset accumulation, Saudi Arabia will be more likely to redeploy existing U.S. funds into perceived higher yielding assets and those that meet its economic agenda. In other words, its holdings of US Treasurys (and publicly traded US corporate bonds and equities) are likely to drop in favor of adding other USD-denominated assets including strategic stakes, a transition that many of its peers in the GCC underwent or at least tested some years ago. This will also include some board stakes and investments that raise additional regulatory scrutiny, not only in the U.S. but elsewhere. In doing so, Saudi Arabia would be following a well trodden path towards more direct investment rather than just investing widely in traded assets.
This tradeoff fuels another one – the split between foreign and domestic investment in the portfolio of the PIF and its role in the broader Saudi investment plan. A sizeable portion of the estimated $200 billion in AUM of the PIF represents domestic pools of capital including those designated for social infrastructure such as education. The PIF is not only quickly scaling up its portfolio of foreign strategic stakes but also is being designated as a primary vehicle for key domestic projects and may be tasked with co-investing with inward investment to Saudi Arabia (like other funds like Russia's RDIF). This means the organization has to juggle a range of different mandates at the same time. It is thus part of the broad centralized nature of the decision making process in the office of the crown prince and thus may face challenges in interacting with other entities including other parts of the economy ministry, central bank among others.
Fast-moving central implementation vs predictable (decentralized) institutions: A key driver of the fast pace of implementation has been the centralization of policy in the office of the crown prince and his designates, with only a few lead institutions. New entities including the entertainment vehicle, the military investment vehicle have been created. This centralization has prompted a quick moving passage of legislation, but implementation is more challenging given the need to bring the bureaucracy along. A key test case remains the new anti-corruption apparatus and future legal process – establishing clear rules could increase confidence of the local private sector and also foreign investors, many of whom remain concerned about further reprisals despite dismissals from political bodies like the chamber of commerce. Similarly the management of the stakes in companies yielded to the government bodies as part of the last crackdown will be key measures to watch. Centralization of policymaking and the recurrence of the same effective names is nothing new in the gulf, though it takes on a different guide in a country like Saudi Arabia with a larger labor pool to choose from. How Saudi Arabia decentralizes after the past centralization will be key.
The scale of investment including high profile projects like NEOM and broad localization goals suggest that Saudi Arabia needs to attract foreign portfolio and direct investment capital. Still there may be some capacity constraints in absorbing it even in a country as relatively large and populous as Saudi Arabia (compared to some of the smaller GCC peers like the UAE, Kuwait and even Qatar).
Military and Nuclear equipment: The military ties between Saudi Arabia and the U.S. are long standing, and have increased in recent years despite a greater push from Saudi Arabia to seek goods from a range of different markets including European and Asian suppliers and to ask all of these producers to consider producing more in Saudi Arabia to meet jobs requirements. With the Chinese piloting some equipment co-investment and transfers, expect the U.S. military contractors to follow suit, though it remains to be seen how many Saudis will be employed. Watch also for the details on any nuclear program – U.S. interests are loath to see it go to an Asian or European competitor but it remains to be seen that congress will support enrichment programs. Negotiations will likely continue just as efforts to “fix” the Iran deal continue. It could be an issue that divides the republican party.
Technology focus and technology transfer: A big part of the U.S. visit includes stops in Silicon Valley, where MBS is likely to check in on existing investments, announce new ones, look to consider new ones and encourage tech companies to set up operations in Saudi Arabia. Many of the existing investments include at least implicit quid pro quo considerations that would encourage local investment. At this point, the focus on the tech investments seems to be primarily about having marquee investments and greater clout with technology transfer secondary. Again this is a key area of diversifying within the USD portfolio. Expect the Saudis to seek assurances that their pledges will be allowed to go ahead in the environment where more tech deals are blocked.
Local issuance goals - for Capital raising or local transfers: While the focus has been on the Aramco IPO, Saudi Arabia is becoming a more major player in EM/Frontier credit and equity may follow. Already in 2017, the GCC, led by Saudi Arabia was one of the dominant USD debt issuers and along with Argentina one of the largest at a time when many countries are focused on local issuance. Although Saudi Arabia and peers are off index (not in the JPM sovereign indices), they are an increasing part of an asset class that has been facing lower issuance. Watch for this to continue in 2018 despite the rise in oil prices, leveraging the interest of USD-tied investors including many in Asia.
Privatization on the equity side is key too. Expectations have already been lowered about the timing and near-term international footprint of the Aramco IPO, especially during the British leg on the trip. Explanations for the delay vary but mostly seem to reflect questions about valuation, transparency and local market development. Recent statements from the Aramco leadership point to concerns about NYC cases against major oil companies, while concerns linger about litigation related to JASTA and some U.S. activists are hoping for a chance to use competition rules on OPEC. Beyond concerns about disclosure and price, it remains to be clear how the Saudi authorities will approach the IPO and which of the priorities will win the upper hand. Is the primary goal to unlock capital to re-capitalize the Public investment fund and other projects? How does that interact with or interfere with securing a high valuation? Is Aramco comfortable with So far, the only thing that seems clear is that there will eventually be a local IPO, which is hoped to boost liquidity on the Tadawul (a challenge since the drop in oil revenues which reduced, and which could serve in part as a wealth transfer to select Saudis as IPOs have done in the past. The recent announcement that oil revenues in excess of the budget will find their way to the PIF, may relieve some of the pressure to issue equity in the near-term.
This week, President Trump announced plans to introduce new tariffs for selected steel and alumnium goods, using the justification of the Section 232, the national security exemption. The move, set to be implemented next week, was swiftly condemned by a wide range of U.S. trading partners, including Canada, Mexico and South Korea, several of whom are currently negotiating with the U.S. Following past tariff increases, and a very busy trade calendar, the move is likely to amplify volatility in markets, including FX. I look in this post at the looming elements of a busy trade calendar and consider some impacts on growth, inflation and broader policy.
Several factors may amplify the impact of trade friction - the precedent of using the national security exception, the seeming lack of coordination within the administration and with other ongoing trade negotiations. If implemented, the move would likely add to distortions in metal prices, amplify input costs in the United States, and add to uncertainty for businesses in the U.S. supply chains. The additional grit of trade friction may add transactions costs and uncertainty at a time when global trade growth may already start to moderate (2019+)
Increased targeted tariffs and trade restrictions should not be a surprise. After all, President Trump (and Candidate trump) was very insistent that he wanted tariffs, and fair trade. The choice of the largest tariff size (big beautiful tariffs) was more of a surprise, as is the use of the WTO’s national security exemption at a time when members of the national security infrastructure were loath to see a risk - particularly since much of the current products come from Canada. By using this measure, the U.S. is calling into question elements of the WTO regime and more generally the rules based system it helped created.
Several other trade related measures include.
Any tit for Tat is likely to add trade friction and raise questions about any inflection point for global trade. its worth noting that these measures come at a time of robust global trade and demand and that's unlikely to change in the near future. However the pace of global growth is likely to slow in 2019 and especially beyond due to higher rates and cost of capital, the struggles in growing above potential growth. Global trade flows have been strong and relatively resilient to protectionist threats (in part because these threats hadn’t been converted to action). It might be less resilient going into 2019, when global growth is likely to moderate from the current above potential pace.
The move has not only been questioned abroad, but also at home, including by many Republicans especially in the Senate, who fear the price impact on American consumers and businesses reliant on imports (including food processing many manufacturers and even the energy sector). If the U.S. was moving ahead with even its small infrastructure plan, it could have a greater cost uncertainty and impact - however the Senate suggests no vote on infrastructure this year. Corporate outcry could result in some adjustment of the measures, but the general direction in policy seems clear. Expect more targeted measures - and greater price and demand uncertainty.
The move complicates an already contentious set of negotiations between the NAFTA partners, who seem to have made little progress in the last round of talks, not least because the U.S. representative focused on rules of origin was recalled early. The 232 tariffs may well reflect some desire to play hardball in these negotiations, and to deflect from what seems to be a wave of defections from the White House and pressure on those close to the president. Expect Senate hearings on extending TPA authority past July (the measure that allows an up or down vote) to be even more difficult.
My baseline view continues to be a continuation of NAFTA talks into H2. As the U.S. and Mexican elections approach, the risk is that the talks will be put on hold to allow new leaders to play a role. They may shift to a lower profile pace. Meanwhile the ongoing trade frictions add to come concerns I have expressed about the pace of growth going into 2019 and cost dynamics. Tariff imposition could amplify price pressures at a time when demand has been picking up and the labor market is tightening.
Several factors suggest that the rate of growth of U.S. imports is likely to moderate this year, at least in volume terms. The weakening of the U.S. dollar is likely to increase costs, dampening import incentive. There doesn’t seem likely to be a major food supply shortage. Some of these trends are likely to offset what otherwise would be an increase in imports due to strong growth and rather expansionary fiscal policy.
Rachel's musings on macroeconomic issues, policy and more.