Dubai: Saudi Arabia’s domestic borrowing programme to cover the budget deficits arising from oil revenue shortfall is likely to soak up substantial liquidity in the banking system. Analysts say a big shift in assets mix of banks will be positive in terms of asset quality and profitability with limited impact on lending to the private sector.

Analysts from Standard & Poor’s said Saudi Arabia’s banks have enough assets to absorb $75 billion (Dh275.4 billion) to $100 billion of government debt. Saudi banks held about $106 billion in cash, central bank deposits and treasury bills and another $13 billion in non-statutory deposits at the end of June.

Last month, the Saudi Arabian government issued 20 billion riyals (Dh19.56 billion) in local currency debt subscribed by public institutions and local banks. The bonds were issued across three tranches with five-year (1.92 per cent yield), seven-year (2.34 per cent yield), and 10-year (2.65 per cent yield) maturities. The issuance followed a 15 billion riyal private placement with non-bank Saudi Arabian financial institutions in July.

Analysts expect the Saudi government to tap the local currency bond market on a regular basis to tide over the revenue deficit caused by the persistent decline in oil prices, but expect the banking sector to absorb the government debt with ease.

“Saudi Arabia has one of the most liquid banking systems in the Gulf. We believe the banks will accommodate government issuance through a gradual shift from low-yielding, short-term liquid assets and private sector credits to higher-yielding, longer-term government exposures,” said Timucin Engin, an analyst with S & P.

In terms of profitability and balance sheet health, S & P analysts expect exposure to sovereign debt to be positive for Saudi banks.

“We expect this shift to be positive for the banks’ net interest margins (NIMs) and revenue generation. It will also benefit the banks’ capital profiles since the government securities are zero-risk-weighted under Basel,” said Engin.

Although the secure and high-yielding domestic debt instruments are likely to boost the profitability of banks, the net impact is likely to be muted over a longer period as private sector credit losses related to the slowing economy could wipe out some of these gains.

Attractive yield and higher security associated with government instruments are expected to price out private sector borrowers — at least to some extent — resulting in higher borrowing costs for private borrowers.

“We expect corporate bank loan pricing in Saudi Arabia to increase as the sovereign issuance absorbs the excess liquidity in the banking system. We’ve already seen the beginning of this trend in the three-month Saudi Interbank Offered Rate [Saibor]: Over the past 90 days, the three-month Saibor has widened by nine basis points [bps],” said Trevor Cullinan, an analyst at S & P.

Although private sector lending had grown significantly over the past decade, the yield compression in the post financial crisis years has resulted in declining appetite for private sector lending.

Since the financial crisis of 2009, global and local interest rates have declined sharply to historically low levels. NIMs for Saudi banks have visibly shrunk in the past few years in line with declining lending prices and low interest rates, to 2.9 per cent last year from 3.9 per cent in 2009.

Owing to increased competition, corporate pricing has softened significantly in the past few years resulting in visible margin erosion for the banks. As a result, the NIM of rated Saudi banks contracted 100 basis points on aggregate between 2008 and 2014. “We now expect a reversal in this trend because the banks will be able to generate returns on zero-risk-weighted government securities,” Engin said.

Although the cost of funding for the banks is to begin gradually moving upward, asset yields are expected to improve and banks’ NIMs to expand. The overall impact on profitability is expected to be positive as average yield on earning assets for the banks begins to improve gradually as they start shifting from low-yielding, short-term interbank placements to higher-yielding government securities.