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Eurobond premium required for fiscal slippage risk We expect large and regular sovereign eurobond issuance going forward to support FX reserves and domestic liquidity but weigh on regional bond spreads if risk appetite does not hold up or fiscal slips. EMBIG index inclusion is unlikely, in our view. Saudi Arabia CDS premium to Qatar and likely larger issuance size suggests Saudi External Debt (EXD) is likely to be issued at a premium to Qatar. Saudi Arabia international bond issuance latest in wave of Gulf supply Local press suggests that Saudi Arabia is gearing up for a large international bond issuance program (USS10-15bn issuance target this year), which, if confirmed (the government neither confirmed nor denied , should add to the sizeable sovereign bond supply pipeline this year. So far, we have seen USS$17.1bn in gross and net supply from the Gulf Cooperation Council (GCC) countries. Assuming Saudi Arabia issues US$15bn and accounting for planned issuance from Dubai and Bahrain and excluding Kuwait, the rest of this year should see a further US$16.5bn in gross issuance and US$16.1bn in net issuance. This would bring the total gross and net GCC sovereign bond issuance to US$33.6bn and US$33.2bn this year respectively. Seminal potential bond issuance has multi-pronged implications If confirmed, this could be a seminal event and mark the first time for the Saudi government to issue external bonds. It would allow for participation of foreign investors as domestic debt is being sold to Saudi banks and funds. External issuance should diversify funding sources, lock in still low interest rates, support SAMA's Fx reserves and support domestic liquidity; the latter two macro variables have weakened this year. External issuance would also imply the presence of an underlying asset that could theoretically trigger CDS contracts, as opposed to the current situation. Investment grade status to be retained despite likely further rating cuts A prolonged oil price downturn is likely to continue to put downward pressure on Saudi Arabia’s credit rating in the medium-term. On average, the GCC has benefited from three notch rating upgrades over the period 2002-10 prior to the start of the Arab Spring. Saudi Arabia was upgraded six times, from Baa3 to Aa3, by Moody's over the period starting from 1999, while it was upgraded two and three notches by S&P and Fitch over the period starting from 2003/2004 respectively. Moody’s has thus in the past preserved Saudi Arabia’s investment grade rating at the bottom of the cycle, as government debt to GDP stood at 103% of GDP and SAMA’s foreign assets at US$17bn (10% of GDP) in 1999. EMBIG Index inclusion is unlikely EMBIG index inclusion is unlikely, in our view. Estimated 2013 (US$25,140) and three- year rolling GNI per capita (US$23,090) data likely suggests Saudi Arabia does not meet EMBIG income index inclusion criteria, in our view. Saudi Arabia would however likely be eligible for Barclays EM Hard Currency Aggregate Index, based on its IMF classification as a non-advanced country (noting that the index provider has moved away from solely using rating for EM country classification). This suggests that Saudi policy-makers need to articulate a comprehensive, timely and credible medium-term fiscal policy to facilitate wide take-up from domestic, regional and international investors, in our view. Pricing matters Saudi Arabia CDS premium to Qatar, relative credit metrics and likely larger planned issuance size suggests Saudi EXD is likely to be issued at a premium to Qatar, in our view. The closest regional peers to Saudi Arabia (A1/A-/AA-) are likely Qatar (Aa2/AA/AA) and Abu Dhabi (Aa2/AA/AA). Qatar’s existing external debt curve makes it a potentially 34 GEMs Paper #26 | 30 June 2016 38 Merrill Lynch HOUSE_OVERSIGHT_016144