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useful and relevant pricing benchmark in this regard, in our view. The Qatar 10-year sovereign bond currently trades at yields of 3.0%. However, Saudi CDS has been trading c65bps wider of Qatari CDS, which would suggest a 10-year Saudi bond yield of c3.65%. Current CDS spread levels suggest potential for some notch downgrades from Saudi Arabia’s current rating, as the market prices in issuance risk, volatile oil prices, hedging flows relative to the USD peg and the banking sector off-balance sheet wrong-way exposure risk. Saudi forwards, rates and CDS remain under pressure Domestic rates are under pressure with the 5y IRS spread over US at historically elevated levels due to structurally tighter liquidity. Budget consolidation could help take some of the pressure off as it would imply lower debt issuance needs. However, it would also imply lower deposit formation in domestic banks as fiscal retrenchment will impact private sector economic activity. Greater risk premium, issuance pressures and tighter liquidity will also keep CDS spreads elevated until oil recovers. Hedging against SAR devaluation risks remains strategically attractive given the risk- reward ratio. Data suggest a strained backdrop for external and domestic liquidity reflecting the combination of private sector dollarization, possible capital outflows, weakening deposit formation and the move higher in interbank rates. However, SAMA has already intervened through macro-prudential tools and may do so again if needed. Chart 32: Market remains nervous on Saudi Arabia Chart 33: A pronounced increase in SAR swap spreads vs USD 3 ———=|mplied appreciation in 1-yr SAR fwd (%) r 160 e EEN Spread (rhs) be —— Oil prices (US$/bbl, rhs) L 449 cellent 120 5 200 100 4 80 150 60 . 100 40 2 20 : 50 0 ~~ womoereawrwTwodoOrkriWDWDowrNnnnowtwo o mAaponededdaca @ 2 6o¢ &@& © OO ff ee &' = = = fee eee eee ee eS 2 oS Se 2 0 0 SSSSSSSSSSSSSSSSSSSS Jan-02 Jan-04 Jan-O6 Jan-08 Jan-10 Jan-12 Jan-14 Jan-16 Source: Bloomberg BofA Merrill Lynch Global Research. Source: Bloomberg BofA Merrill Lynch Global Research. OS merrill Lynch GEMs Paper #26 | 30 June 2016 35 HOUSE_OVERSIGHT_016145