Operating Context


The Bank’s operating environment provides the context for its performance and its ability to deliver value to key stakeholder groups just as much as it derives value from them.

The unprecedented year

For one of the world's largest Islamic banks, global, local and sector-specific trends made substantial impacts during the year under review. Saudi Arabia faced a dual shock of the widening impact of COVID-19 in addition to collapsing oil prices. The World Health Organisation (WHO) declared a pandemic in February 2020 with Saudi Arabia’s Health Ministry announcing the Kingdom’s first case of COVID-19 in March 2020.

Global trends

Faced with the unique challenges that the pandemic presented, governments across the world have responded strongly, introducing accommodative monetary policies to maintain the flow of credit within their economies. Monetary policies adopted by the world’s central banks, softened the negative impact of lockdowns on economic activity following the first wave of COVID-19. Among other actions taken were interest rate cuts, increased spending, forgone revenues (such as tax cuts and fees waived), as well as liquidity support (such as loans, guarantees, and capital injections in the public sector).

The International Monetary Fund (IMF) has warned that ultimately the pandemic could cost the world a staggering USD 28 Tn. in lost output caused by job losses, weaker investment and increasing poverty. In its October 2020 Fiscal Monitor, the IMF projected that government deficits would surge by an average 9% of GDP in 2020, and global public debt would approach a record high 100% of GDP. Employment remains well below pre-pandemic levels with low-income workers, youth, and women being most severely impacted. The IMF estimated an increase of 80 to 90 million in the number of people falling into extreme poverty during the year under review and as many as 150 Mn. by 2021.

Even with a number of vaccines having been developed at a record pace, organisations such as WHO remain cautious about mentioning an end date for the pandemic. With community transmission of COVID-19 expected to continue into 2021, the global banking system may become exhausted and vulnerable to any further shocks due to the continued impact on capital and liquidity buffers.

Equity markets in advanced economies have rebounded (and in most cases have exceeded their levels) from the start of the year. Sovereign bond yields have either declined since June 2020 or remained broadly unchanged. In addition, while asset valuations may remain elevated as a result of policy support, delays in economic recovery are likely to result in periods of volatility or require sharp adjustments in asset prices.

In the short to medium term, governments across the globe will continue aiming for the reinforcement of economies for their safe and successful reopening once the COVID-19 vaccines provide populations with greater immunity against the virus. The IMF estimates that a 1% increase of GDP in public investment, in advanced economies and emerging markets, has the potential to increase GDP by 2.7%, private investment by 10% and the creation of between 20 and 33 million jobs, both directly and indirectly. The IMF suggests that public investment will act as a catalyst for increased private investment.

To reignte economic activity in 2021 and beyond, governments will continue financing projects in health, education and digital, and green infrastructure. They will also keep capitalising on low interest rates and be prudent with public investments in order to finance projects and policies that support the recovery. Governments will need to ensure that debt remains on a sustainable path over the medium-term, being particularly careful in the way taxes are increased.

As cash flows have been under strain from lockdowns and weaker demand, many firms have increased their borrowing beyond an already high debt level. This could cause debt servicing issues in the future. Shocks arising from subsequent global waves of COVID-19 are likely to cause liquidity pressures that will drive many firms into insolvencies. The expansion of fiscal support is also increasing sovereign vulnerabilities and their contingent liabilities.

Upgrading its outlook for economic recovery in the Middle East and Central Asia in its regional outlook report published in January 2021, the IMF predicted a 3.2% contraction for the region as a whole. This projection is 0.9 percentage points higher than the IMF’s October 2020 assessment. The Fund also forecasts oil prices above USD 50 in 2021. Meanwhile, the US economy is estimated to have fallen by 3.4% during 2020, but economic contractions in France, Italy, Spain, and the UK are expected to be around 10%. China is the only major economy forecasted to grow in 2020, with GDP rising by 2.3% before a significant 8.1% jump in 2021.

Sovereign debt levels in both advanced economies and emerging markets are set to increase significantly by the end of 2021 amidst downgrades to potential GDP output, implying a smaller tax base that makes it harder to service the debt.

For the Kingdom, a meaningful recovery depends on a speedy end to the global lockdown and a quick rise in demand for transport fuel. The widening fiscal deficit, high unemployment, and a sluggish non-oil sector pose further challenges.

Local trends

Saudi Arabia’s robust fiscal and foreign currency reserve buffers and relatively low debt obligations have strengthened the Kingdom’s ability to withstand the impact of the COVID-19 outbreak and the low oil prices. In its 2021 budget statement, Saudi Arabia’s Government has estimated expenditure for the fiscal year 2021 at SAR 990 Bn., a decline of 7.3% from the estimated expenditures for FY 2020, with the Government remaining committed to enhancing spending efficiency, despite the volatility in the oil market. The IMF has observed that, like Saudi Arabia, oil exporters have on average deployed smaller fiscal packages which prioritise spending on health. Despite the display of some resilience, further budget cuts (except for basic needs) and reduced Government subsidies or other revenue-raising measures are expected to continue at a gradual pace. With the Government’s ability to borrow more, given its low debt/GDP relative to other countries, total public debt is expected to reach SAR 854 Bn. or 34.3% of GDP in FY 2020 and approximately SAR 937 Bn. or 32.7% of GDP in FY 2021. Government reserves balance is expected to remain at SAR 346 Bn. at end 2021.

Sovereign ratings S&P Moody’s Fitch
Long-term rating A- A1 A
Outlook Stable Negative Negative

The IHS Markit Saudi Arabia Purchasing Managers’ Index (PMI) recorded its lowest ever score of 42.4 in March 2020. It significantly improved over the year to 57.0 by December signifying an improvement in operating conditions in the non-oil private sector economy. This was the highest reading since January 2020 indicating improved business conditions. The Ministry of Finance (MoF) sees real GDP declining by 3.7% in 2020, led by a decrease in both the oil and non-oil sectors. Meanwhile, the inflation rate reached an average of 3.4%, following the impact of shocks such as the increase of the Value Added Tax (VAT) rate to 15%.

The MoF expects real GDP growth to reach 3.2% in 2021. This forecast is based on the expectation that COVID-19 restriction measures will be less severe, going forward, and that an improvement in the Kingdom’s trade balance will have a positive impact on the domestic economy. In collaboration with OPEC+ countries, the Kingdom has used its leadership position in OPEC to work towards more stable oil markets. Saudi Arabia utilised its presidency of the G20 to strengthen policies that support global economic growth and mitigate the impact of the crisis on less developed countries. Recovering oil markets, the government stimulus package and effective containment measures have resulted in an uptick for business activity and spending, particularly following the easing of lockdown measures and restrictions since June 2020. Inflation is forecast by the MoF at 2.9% for 2021. The biggest downside risk is a renewed slowdown in global economic activity as large oil inventories remain a concern.

In addition, the Ministry of Finance announced a Private Sector Financing Support Programme as well as another in support for the healthcare sector totalling about SAR +350 Bn. to support business activity and mitigate the economic impact of COVID-19.

These included direct transfers, financing facilities, deferrals of some taxes and fees, liquidity injections and partial coverage of private sector workers’ pay which together eased pressures, to some extent, and sped up the economic recovery.

The positive impact of these measures were evident by improvement in the PMI, economic growth of 1.2% in the third quarter compared to the second despite a contraction of 4.2% on a yearly basis, and strong consumer sentiments remaining steady for December 2020 as per the January 2021 IPSOS Primary Consumer Sentiment Index. In the latter, Saudi Arabia takes second place globally with 82% of consumers believing that the Kingdom is heading in the right direction. Cuts to the base interest rate helped support the non-oil economy. The Saudi Riyal peg is expected to remain in place despite oil price pressures. These were created to support the most affected private sector activities and their Saudi employees.

Following these and other initiatives such as the Government’s support of the health sector in combating the virus, the Kingdom’s budget deficit is expected to increase to SAR 298 Bn. for the financial year 2020. While the Government will aim to reduce the budget deficit to SAR 141 Bn. or 4.9% of GDP by 2021, a gradual decline to 0.4% of GDP is expected by 2023.

Total revenues for 2021 are expected to reach SAR 849 Bn., an increase of 10.3% over 2020 estimates, while total expenditures are expected to reach SAR 990 Bn. despite an increase in pandemic-related spending. Additional budget allocations to the tune of SAR 159 Bn. for 2020 were directed towards the health sector and for the accelerated payment of private sector dues. Savings due to cancelled, extended, or deferred budgeted operational and capital expenditures partially offset some expenses by SAR 111 Bn.

Summary of budget and medium-term projections for 2021-2023

SAR Bn. Actual
Total revenues 906 927 833 770 849 864 928
Total expenditures 1,079 1,059 1,020 1,068 990 955 941
Budget deficit 174 133 187 298 141 91 13
Percentage of GDP (%) -5.9 -4.5 -6.4 -12.0 -4.9 -3.0 -0.4
Public debt 560 678 754 854 937 1,013 1,026
Percentage of GDP (%) 19.0 22.8 26.0 34.3 32.7 33.3 31.7
Government reserves at SAMA 490 470 346 346 280 265 265

Source: Saudi Arabia Budget Statement Fiscal Year 2021

There are, however, significant downside risks, given the high level of uncertainty surrounding both global and local authorities’ ability to contain the virus over the coming months. Despite approvals for a number of vaccines coming through towards end 2020, the roll out has been neither as fast nor as efficient as predicted. New mutated variants of the virus also threaten to intensify and prolong the impact of the pandemic on the economy.

Stimulus measures adopted to mitigate the impact of COVID-19 are expected to be relaxed as the Kingdom's economy continues to improve. To guard against any other unexpected local or international economic shocks, the Government will maintain fiscal flexibility.

Sector-specific trends

By containing costs and continuing to focus on non-oil revenues, the Government will be able to support its commitment to fiscal sustainability and spending efficiency over the medium-term. With the rise of public debt, the Government will also focus on privatisation and Public Private Partnerships (PPPs). Some of the largest recipients of public expenditure will continue to be education, healthcare and social development, defence and infrastructure.

Banks in Saudi Arabia are facing a negative outlook due to the impact of COVID-19, oil shocks, and market volatility. Yet, they are expected to remain largely profitable, liquid and well capitalised. This resilience is in spite of pressure due to slowing government and public-sector deposit inflows, lower corporate profits and falling household savings capacity.

Positives for the sector include high profitability supported by high margins, low cost of funding and limited competition. The generally strong capital and liquidity position of banks at the onset of COVID-19 and a material strengthening of banking regulations over the past decade also contributed towards the comparative robustness of this sector. SMEs are vulnerable to the impact of COVID-19 but, while the Government has recently introduced measures to improve their access to financing sources, the banking system’s exposure to this segment over the past few decades has been limited.

Nevertheless, profitability of the banking sector is expected to weaken with subdued credit demand and the weakening operating environment which will weigh on the banks' loan books, with problem loans expected to increase, mostly in the construction and commerce, oil and gas, tourism, hospitality, household consumption, and entertainment sectors. In addition, with declining oil prices constraining government treasuries, the strong funding profile of the Kingdom’s banks will come under pressure. Concentrations of large financings to single borrowers and to single sectors remain a key concern, particularly when there is a shock to the economy. Saudi banks' strong capital ratios provide good loss-absorbency as borrowers come under stress.

In terms of the outlook, decelerating economic activity is expected to further weigh heavily on the sector’s asset quality and profitability. Moody’s estimates a slight increase in funding costs due to tighter funding conditions. With large volumes of non-interest bearing deposits in the system however, Saudi Arabia is expected to maintain lower funding costs in comparison to other Gulf Cooperation Council (GCC) countries. As surplus liquidity transitions from low-yielding short-term placements to higher-yielding long-term sovereign debt, costs will continue to be contained and interest margin pressure will be moderated in part by increasing investment income. Nevertheless, the banking sector’s net profit will feel the weight of impairment and provisioning costs.

In September 2020, Moody’s Investor Services projected that the use of more Sharia compliant finance by both households and corporate entities within the Kingdom would continue its upward trajectory over the short-term. The firm estimates Islamic financing in the Kingdom to reach around 80% of system-wide loans, boosting Saudi Arabia's position as the world's largest Islamic finance market.

The increase in overall credit growth in 2020 was supported by a surge in the mortgage market which went a long way towards countering any adverse effects to overall profits coming from margin compression and muted credit growth in other lending products. With capitalisation levels comfortably above regulatory requirements, the potential for lending remains strong. Saudi retail mortgages are likely to continue as a key driver of credit contributing towards the growth of assets in the banking sector.

With low-cost deposits expected to continue making up a majority of deposits, the funding profile of banks will come under pressure as competition for these deposits intensifies. Liquidity buffers, however, are expected to remain robust, with the Kingdom’s banks comfortably surpassing Basel III's Liquidity Coverage Requirement. Further, in March 2020, the Basel Committee’s oversight body, the Group of Governors and Heads of Supervision (GHOS), approved measures to allow added operational capacity for banks to be able to counter possible financial instability due to the impact of COVID-19 on the global banking system.

While the headline for the first half of 2020 may have been the Government’s emergency response to COVID-19 and declining oil prices, it remained focused on economic diversification away from the oil sector. Saudi Arabia’s 2021 budget also reveals a strong focus on achieving fiscal stability and sustainable long-term economic growth even as the impact of the pandemic and oil market volatility shows no immediate sign of abating.

GRI 201-4