The Role of Central Bank of Saudi Arabia in the Global Crisis - Dissertation Example

Table of Contents Introduction 2 Literature review 2 Economic developments of Saudi Arabia during 2008 and 2009 3 The strength of the banking sector of Saudi Arabia 3 Measures of Central Bank in Domestic Market 3 Central Bank’s Instrument 4 Monetary Policy Measures 5 Role of foreign exchange reserves 6 Effective instruments during crisis 6 Saudi Arabia: Financial System Structure 8 Research methodology 9 Data analysis 10 Findings 10 Confrontation in global financial crisis 10 2004 FSAP recommendation 11 Capitalized banking sector 11 Standards and codes assessment 11 Promotion of mortgage and lending 12 Recommendations 12 Legal framework 12 Macro prudential policies 12 Financial safety nets 12 Ensuring fair and sound lending practices 13 Strengthening of institutional investor base 13 Conclusion 13 References 15 Introduction Research has been made on this topic and accordingly to undertake the same, search has been made to gather sufficient data to analyze on the economic health of Saudi Arabia during the global meltdown. The financial turmoil affected almost all the economies around the globe but the Saudi Arabian economy remained to have a positive impact without getting affected much by the turmoil. This fact is quite encouraging and creates an urge to know how they have made it all possible. A proper study has been done on this work by collecting data from different sources. Literature review The experience of the banking system of Saudi Arabia during global financial crisis which ravaged the financial markets globally since mid-2007 is required to be answered. While many economies around the global were negatively and severely affected, especially developed countries, during the crisis in 2008 and 2009 but the Saudi economy has shown resilience and strong growth of the economy. The experience of Saudi Arabia in respect of domestic financial intermediation and international banking was relatively positive during this tough time. Though being affected moderately by the deteriorating conditions of global financial markets, the domestic financial market of Saudi Arabia continuously functioned in an efficient and effective manner. The Central Bank of Saudi Arabia has played a vital role in keeping the strength of the economy during the crisis period. So, the hypothesis to be tested is the measure taken by the Central Bank of Saudi Arabia to maintain sound economic growth during the crisis period also. Economic developments of Saudi Arabia during 2008 and 2009 During the five year period 2004-08, the economy of Saudi Arabia fared well by international standards reflecting 4.4% growth rate in real GDP and 19% average surplus in government fiscal. All economic sectors were propelled with this, especially the banking sector which showered great benefits. In 2008, growth in real GDP was 4.5% with 4.8% growth in oil sector. In 2008, current account surplus was 28% of GDP and trade surplus recorded as 45% of GDP. No external government debt remained with the country. Inflationary pressures declined from with 9.87% inflation in 2008 to 4.4% inflation in September 2009 (Rivlin, 2009). The strength of the banking sector of Saudi Arabia Saudi banking sector showed strong growth and profitability during 2008 and 2009. Rate of return on average equity was 20% which stood at 16% by September 2009. Well capitalized by international standards, Saudi banks showed 16% of capital adequacy ratio in 2008, almost all being Tier I capital. Banks assets were strong with non-performing loans as 1.4 % of total loans and advances during end 2008, which were below 3% during September 2009. Measures of Central Bank in Domestic Market The steps taken by Saudi Government during global financial crisis helped to restore confidence in Saudi banks, the Saudi interbank market and the banking system. Saudi banks proved liquidity to international banks and to each other at competitive rates. SAMA took certain measures. It reduces the statutory deposit ratio for demand deposits to 7% during 2008 and maintained the ratio of 4% time and savings deposits. It reduces the repo rate of 5.50% in 2008 to 2% in 2009 and reverse repo rate from 2% in 2008 to 0.25% in 2009. It reduces the prices of treasury bills by 50 bp lower than the Saudi interbank deposit rate (SIBID). It placed time deposits with domestic banks on behalf of institutions and government agencies for a relatively long period and in coordination with them. Such deposits are considered as customers deposits included in the ratio of loans to deposits, so this measure helped banks to expand credit. An announcement was made by the Supreme Economic Council that Government will continue for guaranteeing the safety of local bank deposits which assured all depositors for a long time not to have any negative sentiment towards Saudi banks. In the global interbank market, SAMA injected dollar liquidity through direct deposits with local banks and foreign exchange swaps. This liquidity injection helped to mitigate the impact of global events on local market. Since banks were flush with SAR liquidity so no liquid shortage was there in local currency (Bourland, 2008). Central Bank’s Instrument The central bank instruments helped to deal with financial crisis. The nominal interest rates should be reduced closer to zero due to powerful economic shock. The additional monetary stimulus required when policy interest rate is closer to zero can be achieved by the guiding of medium to long term expectations of interest rate, by changing the composition of balance sheet of central bank, by expanding the size of balance sheet of central bank. These measures improve financial conditions beyond short term interbank interest rates. The experience of financial crisis has shown that non conventional tools might be required before policy rates being cut to their lower bounds. During the period of crisis when markets were not normally operating, tensions in euro area interbank market were eased by supplementing longer term refinancing operations. After the collapse of Lehman Brothers, the spread between three month Euribor and overnight interest rate which remains at 10bp in normal times rose to 156 bp on 13th October 2007. This dried up market liquidity and the market participants lose confidence in having lasting effect on the functioning of euro area money market in an orderly manner. But central bank adopted qualitative and credit easing to maintain money market liquidity and stabilizing the credit market. Central banks resorted to QE/CE by purchasing government and non government debt and broadening the scope of eligible collateral. Swapping of US Federal Reserve’s FX with various central banks timely addresses the dollar liquidity squeeze. The application of QE/CE provided liquidity to the system and reduced market stress. SAMA reduced the ratio of statutory reserve requirements on demand deposits from 13% to 2% in a two month period, October-November 2008 on a number of consecutive occasions. SAMA intervened directly in liquidity position on behalf of government institutions by placing deposits with commercial banks. Finally, the Treasury bill rate set to 50 bp lower than Sibor which encouraged banks to lend their corporate customers and individuals (Lebling, 2012). Monetary Policy Measures The financial crisis posed challenges to policy makers on many grounds. The main policy making objective was to avert depression during crisis. Central bank’s zeal to lower interest rates was not constrained by the currency factor. Though Saudi Arabia has no subprime mortgage crisis, the financial turmoil created fears and raising uncertainty in Saudi interbank market. The Saudi interbank offer rate (Sibor) after the collapse of Lehman Brothers rose sharply to more than 200 bp above the reverse repo rate. There were fears of passing of the evaporation of liquidity in international interbank markets to the entire financial system. So, the SAMA intervened quickly and reduced repo rate consecutively several times to restore confidence in local financial market from 5.5% in October 2008 to 200 bp in January 2009 and reduced reverse repo rate from 200 bp in October 2008 to 25 bp in June 2009. There was abundant system liquidity in Saudi Arabia due to brisk government spending and government debt redemption. There was not a problem of interbank lending in local currency because of the significant support measures of central bank like direct placements, repos and purchasing of instruments of money market by central bank. QE/CE was applied which proved instrumental to inject liquidity to the system that reduces market stress. The ratio of statutory reserve requirement was reduced from 13% to 7% by November 2008 (Iztehadi, 2011). Role of foreign exchange reserves During financial crisis, the regulatory agencies in worldwide were having primary goal of enhancing transparency in global financial markets, strengthening international regulatory standards and ensuring that all the markets, their participants and products are regulated appropriately or depending on its circumstances, are subjected to oversight. Moreover, a macro prudential approach has been advised to have national and international coordination between financial institututions for ensuring a system wide approach to financial regulation to deal with systemic risk. Future changes to the regulatory framework should target to minimize the risks not incorporated in previous regulations. Effective instruments during crisis As the conventional instruments were exhausted by central banks; it resorted to QE/CE by broadening the scope for eligible collateral and by purchasing government and non government debt. The US Federal Reserve’s FX swaps with various central banks at the global level to timely address the dollar liquidity squeeze. The application of QE/CE proved instrumental in injecting liquidity to the system and to reduce market stress. Close analysis and monitoring of movements in asset price, emergence of systemic risk and monetary and credit developments is required. In addition to above, the ratio of statutory reserve requirements on demand deposits was reduced by SAMA, on a number of consecutive occasions in 2008 from 13% to 7%. SAMA also intervened directly in liquidity position by placing with commercial banks the deposits on behalf of government institutions (Katusa, 2012). (Source: International Monetary fund, 2012). Saudi Arabia: Financial System Structure (Source: International Monetary fund, 2012). The above chart shows the capital adequacy ratios from years 2007 to 2010 during the period of shock (Bennington, 2011). Research methodology This project is entirely based on secondary data. For this, information from various journals, bulletins, articles has been compiled. Such data are obtainable more quickly and are much cheaper than primary data and may also be available when primary data is not obtainable. It is much economical by saving expenses and efforts and time. It helps to collect primary data more specifically since it enables to judge the gaps and deficiencies and additional information which are required to be collected. It gives the basis to compare the data which has been already collected by the researchers. It is important to undertake this research as it addresses issues to how to tackle and manage the economy during global financial meltdown. The effective measures taken by Central Bank of Saudi Arabia have enabled them to maintain a sound economy during the period of crisis. It reflects the strength of Kingdom’s banking sector. The Saudi banking sector continued showing strong growth and profitability during that period. Data analysis The entire study is based on qualitative methods and mainly secondary sources. Through qualitative research it has been possible to analyze the strength of the Arabian Kingdom in maintaining its sound position during crisis. Data has been collected mainly from secondary research for the study. Information on the economic position of Saudi Arabia has been gathered from in-depth secondary research especially on governments and leading research organization’s publications. It has been possible to collect sufficient secondary data to undertake this project. The sources from where such data has been arranged are quite authentic, valuable and reliable. All the information arranged has been compiled and then analysis has been made on the basis of such reports which clearly justifies the fact that Saudi Arabian kingdom maintained a very good economy in the global financial crisis also. The effective measures taken by the central bank of Saudi Arabia has led them to go a long way in maintaining their healthy environment in the economy. Findings Confrontation in global financial crisis Before the crisis year, the balance sheet of government was strengthened by the authorities and the resilience of financial sector was also enhanced by them. The authorities were allowed by the available fiscal space in order to reduce substantially the crisis impact. The initial effect due to the political instability in the region was also contained. 2004 FSAP recommendation Numerous steps were undertaken for strengthening regulation and bank supervision and securities activities. Capitalized banking sector Considering almost all of the individual shocks, the aggregate solvency ratio stayed at 8 percent. But the system could have vulnerability to deep and prolonged decline in oil prices, if accompanied with slowdown in the activities of domestic economy. This would create insolvency in the banking system but would have modest recapitalization cost in macroeconomic terms (Gavin, 2012). Standards and codes assessment Since 2004 FSAP, banking regulation and supervision have been showing improvements. Introduction of Basel II by the Saudi Arabian Monetary Agency (SAMA) and using Pillar 2 requirements increased improvements in bank’s capital planning and risk management. There has been an introduction of risk-based approaches in supervision. The new Basel III requirements have also been actively introduced by SAMA. A strong regulatory program has been developed by the Capital Market Authority within a short time period fully implementing most of the international standards. The existing legal framework has been covering the critical aspects concerning payment and securities settlement system, though there is no comprehensive law concerning payment systems. Promotion of mortgage and lending The target is of SME lending and expanding mortgage to meet employment challenges and key housing to maintain financial stability. Recommendations Legal framework Revisions are needed to the Banking Control law (BCL) to provide formal independence to the bank supervisors in SAMA envisaged with international standards. The existing law has not been countable to effective supervision. Further concern is required to be addressed in lending of bank towards large corporate groups which are prominent in the economy of Saudi Arabia. It accounts for supervision in large exposures and stronger regulation in lending to related party (Hinds, 2010). Macro prudential policies Steps are being taken by SAMA in increasing staff having technical background required for stress testing, allowing stress testing exercises for considering wide range of shocks like liquidity shocks. Stress testing is required to be conducted on regular basis incorporating lessons into supervisory actions and prudential rules. Financial safety nets It is required to establish a formal legal framework for bank resolution. Steps should be taken to introduce liquidity forecasting and to develop a robust yield curve. Ensuring fair and sound lending practices Recommendations in the field of housing include consumer protection norms, prudent regulation on mortgage lending, and improving loan recovery in mortgages, loan origination and sound funding arrangements for long term. Strengthening of institutional investor base Important contributions could be made by foreign institutional investors to market development and price discovery. The role of two large pension funds in the development of capital market could be enhanced by way of disclosing further their investment policies (Hamidy, 2011). Conclusion In spite of the financial crisis, Saudi Arabia’s excellent liquidity, cash flow and oil profits throughout the decade has always left the kingdom in a strong position. Financial analysts of Jadwa Investment Company projected rise in economic growth to 3.8% in 2010 from 0.15% in 2009. There exists a quiet confidence amongst the Riyadh and Jeddah financial insiders that the Saudi economy will grow continuously on the back of aggressive government spending improving conditions of private sector. Overall, lack of urgency which Saudi Arabia showed in response to financial crisis is understandable. In the dark days of 2008, when the mortgage system of United States was unraveled, when global capitalism was on brink, when Lehman Brothers collapsed, Saudi Arabia’s oil wells kept pumping ignoring the chaos. Saudi Arabia was affected adversely by the extreme fluctuations in oil prices during the crisis, still it cannot be overlooked that over 20% of world’s proven oil supplies this kingdom holds. The economic growth of Saudi Arabia was actually better than some of the developed economies that sunked into negative growth. In the Asian crisis of 1997, the Arab world was less affected with international financial crisis as compared to the other regions of world. With the exception of oil sector, the Arab world has been less integrated into the international economy than most of the other regions. The Arab states do not significantly exports non oil products, so they have less exposure to the contraction of world trade. Authorities in Saudi Arabia implemented myriad measures in preventing systemic banking crisis and to shore up confidence. It included introducing blanket deposit insurance, injecting capital into banks and providing liquidity. Budget surpluses of Saudi Arabia enabled it to reduce internal debt. Above all, the measures introduced in Saudi Arabia has always led it to be in the forefront and always gaining investor’s confidence avoiding the chaos of global financial turmoil (Drine, 2010). References Rivlin, P. 2009. The impact of Global Economic Crisis On The Arab World. Available at: http://www.jewishpolicycenter.org/967/global-economic-crisis-arab-world. [Accessed on 23 Feb. 2013]. Bourland, B. 2008. Saudi Arabia and the Global Financial Crisis. Available at: http://www.susris.com/articles/2008/ioi/081216-jadwa-bulletin.html. [Accessed on 26 Feb. 2013]. Lebling, R. W. 2012. Saudi Arabia’s Energy Crisis. Available at: http://ncusar.org/blog/2012/05/saudi-arabias-energy-crisis/. [Accessed on 26 Feb. 2013]. Ijtehadi, Y. 2011. Saudi Arabia’s Other Major Crisis. Available at: http://www.businessinsider.com/saudi-arabias-other-major-crisis-2011-7. [Accessed on 26 Feb.2013]. Katusa, M. 2012. Islamic Revolution in Saudi Arabia Would Send Crude Oil to $300. Available at : http://www.marketoracle.co.uk/Article36782.html. [Accessed on 26 Feb. 2013]. Bennington, A. 2011. Saudi Arabian Unrest: Thumbnail Summary of a Potential Crisis. Available at: http://www.cnbc.com/id/42014306/Saudi_Arabian_Unrest_Thumbnail_Summary_of_a_Potential_Crisis. [Accessed on 26 Feb. 2013]. Gavin, J. 2012. SAUDI ARABIA: A place in the sun. Available at: http://www.emergingmarkets.org/Article/3102669/SAUDI-ARABIA-A-place-in-the-sun.html. [Accessed on 26 Feb. 2013]. Hinds, M. 2010. Saudi Arabia: What are the effects of the global financial crisis on Saudi Arabia’s economic prospects. Available at: http://blogs.lse.ac.uk/ideas/2010/03/saudi-arabia-what-are-the-effects-of-the-global-financial-crisis-on-saudi-arabias-economic-prospec. [Accessed on 26 Feb. 2013]. Hamidy, A. A. 2011. The global financial crisis: impact on Saudi Arabia. Available at: http://econpapers.repec.org/bookchap/bisbisbpc/54-21.htm. [Accessed on 26 Feb.2013]. Drine, I. 2010. Impact of the Global Economic Crisis on the Arab Region. Available at: http://www.wider.unu.edu/publications/newsletter/articles/en_GB/05-06-2009/. [Accessed on 26 Feb 2013]. Read More