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Government arrears to contractors could be significant
We estimate the range of unpaid capex for 2015 to be SAR23bn-SAR100bn (US$6bn-US$27bn or 1-4.3% of 2015 GDP). At the very minimum, unpaid capex could be around SAR23bn. This is the amount of additional loans taken out by construction contractors over 2015 compared to 2014. Total construction loans were SAR106bn in 2015 versus SAR83bn in 2014. Contractors likely did not go to obtain alternative bank funding for the same amount as the delayed payments from the government, suggesting delayed payments should be larger than SAR23bn, in our view.

By the same token, the 2015 budget outturns imply capex was down by 45% to SAR205bn versus 2014 levels of SAR370bn. This is of course unlikely as construction grew by 5% in real terms in 2015. Correcting the 2015 budget by the likely underreporting (an additional SAR100bn in spending, assuming it was all capex-related), then capex spending was likely down by SAR65bn (17%) in 2015. This would be in line with the c15%yoy drop in construction awards as reported by MEED.

In comparison, government overdues in the healthcare sector are much smaller. Based on the disclosures of two listed healthcare groups, we estimate the growth of government receivables owed to them alone is SAR0.4bn. We estimate the total sector government overdues to private healthcare operators could be 2-3 times this level.

IOUs to serve multiple purposes
IOUs could support simultaneously the multiple needs of the government, domestic banks and contractors, in our view. The government will be able to conserve fiscal reserves and restructure the maturity of its outstanding dues. Domestic banks would substitute corporate credit risk with sovereign risk and improve asset quality, while contractors could improve their liquidity and working capital position by cashing in early on the IOUs. We believe most of the contractors impacted could be domestic ones, and we presume these IOCs would be issued in domestic currency. Furthermore, to the extent these IOUs are structured as tradable instruments, this could better distribute risk in the financial sector to those agents more capable or willing to hold it.

Domestic liquidity could be eased, but Fx outflows may not subside
The impact of IOUs on domestic liquidity will likely depend on the issuance mechanism, of which we have little visibility for now, though this could likely ease domestic liquidity. We would however expect subsequent Fx reserves losses due to an increase in demand for Fx consequent to the liquidity injections (a 50% leakage would for instance lead to US$13.5bn loss in Fx reserves at the high-end of the estimated arrears range).

One possibility for the mechanism would be for banks to extend more secured credit to contractors using the IOUs as collateral. In this case, domestic liquidity is likely to remain tight as the banking sector balance sheet would stay stretched. Another, perhaps more likely, option would be for banks to accept IOUs as deposits. Contractors would then be able to transfer IOUs to their trade creditors and withdraw cash regularly, with the total amount being likely a portion of the face value of the IOUs. Banks would hold new government instruments on the asset side of their balance sheet. This mechanism could also be structured as a simple sale of the IOUs to domestic banks (with a haircut), which domestic banks would accommodate through equivalent changes on the asset side of their balance sheet, without the creation of additional liabilities.

In the latter option, to avoid straining the banking sector liquidity, the deposits withdrawal or in effect the increased money in circulation would likely require monetary accommodation from SAMA, in our view. We believe this could take the form of liquidity injection, possibly through repo operations for the IOUs. Although unconventional, this

Merrill Lynch
GEMs Paper #26 | 30 June 2016
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