Benefitting greatly from rising oil prices and production over the last decade, Saudi Arabia has used its sizeable revenues to build up strong external buffers and drive GDP growth through extensive spending programmes. The decline in oil prices that began in mid-2014, however, has significantly lowered export revenues and brought the era of fiscal surpluses to a close. The altered economic landscape and growing demographic pressures have presented the recently reorganised government with a significant test, and its response has been to set in motion a series of the most wide-ranging reforms in the nation’s history.
The Kingdom is not alone in facing up to a new economic reality. Citizens across the GCC have long been accustomed to generously subsidised fuel, mortgage-free homes and a wealth of public sector job opportunities. Vast oil revenues have allowed governments to drive economic growth through large energy and infrastructure projects, provide extensive health care coverage to citizens and invest in educational facilities to allow young people the opportunity to play a productive part in the modern economy. The sustained oil price drop, however, has left a gap in government finances across the region and has brought into question the ability of Gulf states to provide for the lifestyles their citizens have become accustomed to.
Economic reform became a key phrase in 2015, as governments moved to manage public spending and bridge what had become a stubborn fiscal gap. Diversification of economic activity away from hydrocarbons has been the goal of every GCC country for decades, and some have moved further along this process than others. However, the era of low oil prices has brought greater urgency to this long-term ambition, and nowhere more so than Saudi Arabia – the region’s economic leader – which has made public its intention to reduce its reliance on oil over the next four years. “The country seems to have arrived at something close to a national consensus that the economic status quo is unsustainable, and the government has capitalised on that,” Don Babai, lecturer and research associate at the Centre for Middle Eastern Studies, Harvard University, told OBG.
In 2016 the Kingdom unveiled plans for what will be, if successfully carried out, the most significant reform of the national economy in the country’s eight decades of existence. Its principal blueprint, the Vision 2030 document published in April 2016, calls for a major shift in the way the Kingdom’s economy operates, moving from a system of government-led growth and centralised planning to a more open market framework, where the private sector takes a leading role in economic expansion. “Lower economic growth prospects will mean increased pressure for many players in the private sector. Periods of downturn provide an opportunity to test the strength of the market and allow only competitive companies to survive. This is necessary for any healthy economy,” Ammer Alselham, CEO of Tharawat Holding – a firm specialising in investments in business, technology, food, sports development and real estate – told OBG.
Boosting non-oil revenue, promoting small and medium-sized enterprises, diversifying exports and making the Saudi workforce more productive are also key aims. The country has seen unemployment fall by 0.12 percentage points to 11.51% year-onyear in the first half of 2015. However, improving the participation of women in the labour market and balancing levels of employment between the public and private sectors will also be crucial in achieving the goals of Saudi Vision 2030.
In June 2016 the Saudi government followed Vision 2030 with the publication of the National Transformation Programme (NTP), which establishes the means by which the Kingdom will meet the objectives established in its development blueprint. The NTP, whose architect is Deputy Crown Prince Mohammed bin Salman Al Saud, sets out a number of near-term targets, including cutting public sector wages and tripling non-oil revenues, and lays out the modular form by which each ministry is tasked with separate implementation plans. Importantly, it also sets out the framework by which the implementation of the large number of initiatives that flow from Vision 2030 will be monitored and, if necessary, adjusted (see analysis). NTP is, in a sense, the initial rollout of Vision 2030, establishing shorter-term goals to achieve the overall vision. The aims of the NTP are timed for completion by 2020.
Thanks to abundant hydrocarbons resources, Ministry of Finance planners have historically had little difficulty in balancing the public financial ledger, and between 2010 and 2014 the Kingdom enjoyed a solid period of fiscal surpluses. The effect of lower energy prices began to show in 2014, when the general government budget balance indicated a modest shortfall of 2.3% of GDP, according to a report by Saudi asset management firm Audi Capital. By 2015 the fiscal deficit hit double digits, at 15.4% of GDP. Despite the Kingdom’s bid to protect its share of the oil market by raising production to record levels, low oil prices dragged public revenues down by 42.9% over the year.
This trend has led to an erosion of the nation’s fiscal buffers: official foreign assets under the management of the Saudi Arabian Monetary Agency (SAMA), the nation’s central bank, decreased from $732bn at the close of 2014 to $616bn at year-end 2015 and have continued to decline over the course of 2016. This has also seen Saudi Arabia’s external position switch from a current account surplus of 9.8% of GDP in 2014 to a deficit of 8.3% in 2015, a trend that is likely to continue while oil prices remain low.
The reversal of the Kingdom’s recent history of fiscal surpluses has been met with a swift response from the government. While Saudi Vision 2030 and the NTP represent the nation’s medium- to long-term solution to its challenges, the measures being taken in the short term are in many ways just as bold. For example, a royal decree issued in October 2015 brought an abrupt halt to the generous pipeline of public spending, placing a cap on current spending; freezing new contracts and all purchases of government cars, furniture and other equipment; and halting the hiring of new public sector employees. This effort was rewarded by a 12.6% contraction of total public expenditures in 2015, an impressive turnaround from the 13.7% expansion of expenditures seen in 2014.
The 2016 budget demonstrated the government’s willingness to follow through on its fiscal reform, even by addressing state subsidies. This is a politically challenging area that nations across the GCC are being compelled to look at given the new economic landscape. Announcing the budget in late 2015, the Ministry of Finance stated that petroleum, water and electricity subsidies would gradually be adjusted downward over the coming five years.
Capital expenditure is another area of the 2016 budget where the government sought savings, a move that has resulted in the cancellation or delay of a number of large infrastructure developments, including the financial restructuring of the Makkah Metro network project. Some military acquisitions were also put on hold, while the foreign aid budget was reduced and the $6bn foreign scholarship programme for Saudi students was trimmed back.
In terms of revenue, the Kingdom has a number of options it can pursue to shore up government coffers, particularly in the area of taxation. Saudi Arabia, like many countries in the GCC, is renowned for its low tax burden: there is no personal income tax for residents or foreign nationals, and outside the hydrocarbons sector corporate taxes run to a modest 20% levy on income for non-Saudis with a share in resident companies; this falls to 2.5% for citizens. Furthermore, there is no capital gains tax on shares purchased after 2004, and no capital duty, stamp duty or payroll tax. The lenient taxation framework has been a boon for businesses operating in the Kingdom. The World Bank’s 2016 “Doing Business” report found that corporate taxation of all kinds represented just 15% of profits on average, compared to a MENA average of 32.1% and 48.8% in Germany. The era of light-touch taxation may be coming to an end, however, as the state’s efforts to balance the budget continues. For example, an annual 2.5% tax on undeveloped plots of 10,000 sq km or more was approved by the Cabinet in June 2016 as part of the NTP.
The 2016 budget also introduced the idea of a tax on sweets and tobacco, and the NTP reiterates that taxes will be levied on “harmful products”. The latter initiative also makes reference to a personal income tax, which has traditionally been an unapproachable topic in the region. Such a measure is unlikely to be introduced in the short term given the political challenges that would result from such a move, but Saudi citizens and businesses will soon feel the effects of another major tax initiative.
In February 2016 GCC ministers signed off on a long-anticipated framework for a value-added tax that will be implemented across the region from January 1, 2018. While each member state is free to establish its own exemptions from the tax, the IMF has stated that the 5% level recently agreed upon could bring in extra revenue worth 1.6% of GDP in Saudi Arabia’s case (see analysis).
Bridging The Gap
Saudi Arabia’s fiscal consolidation, although significant, is not sufficient to close the fiscal gap in an era of low oil prices. Therefore, the nation has had to consider other funding options in a bid to meet its financial obligations. The 2015 deficit was financed mainly by a sizeable drawdown of foreign assets and the ramping up domestic debt issuance, which rose to $26bn over the year. This gave the country a gross public debt figure of 5.8% of GDP by the end of 2015, up from 1.6% a year earlier. While this was a notable rise, the Kingdom’s public debt remains modest by global standards. For example, Germany’s central government debt stood at 71.2% of GDP in 2015, while that of the UK reached 89.2%.
Appetite For Debt
While high debt-to-GDP ratios have been a burden on advanced economies since the onset of the global economic crisis in 2008, the Kingdom’s low level of public debt means it has considerable room to manoeuvre before it faces similar pressures. Interestingly, one of the key initiatives of the NTP is a widening of the debt-to-GDP ratio to 30%, which represents a significant policy shift on the part of the government and will allow it to bridge its fiscal shortfall over the coming years.
The IMF expects gross public debt to expand rapidly from 5.8% of GDP in 2015 to 17.2% in 2016 and 25.8% in 2017. Moreover, while in 2015 the Kingdom relied on local debt to complement its drawdown of reserves as it balanced its books, in 2016 it signalled its intention to go to the international markets for the first time. This is new territory for Saudi Arabia; however, the enthusiasm with which foreign banks such as Bank of Tokyo-Mitsubishi, HSBC and JPM organ entered into a $10bn syndicated loan deal with the Kingdom in April 2016 suggests there is considerable appetite for Saudi debt. The loan, with a five-year tenor, was regarded by many as a useful step before the commencement of the international bond programme, and was raised to $10bn from an original target of between $6bn and $8bn following the deal’s oversubscription.
Inflation & Monetary Policy
As the government responds to the effects of low oil prices, it faces the challenge of protecting the public from sharp increases in the cost of living. To date, however, the government’s reform process has had a modest effect on inflation. The cost of living index rose by 2.2% during 2015, but posted a 3.3% year-on-year increase in August 2016 due to a 50% cut in petrol subsidies at the close of 2015 and the doubling of Customs fees on tobacco products in March 2016. Beyond the transport and tobacco segments, housing, water, electricity, education and health showed significant increases over the same period.
The sharp drop in oil prices in the second half of 2014 and the continued low-price environment present throughout 2015 has led to speculation that Saudi Arabia would abandon its currency peg to the US dollar, currently fixed at SR3.75:$1. The central bank, however, was quick to stamp out what it considered to be a misunderstanding of the situation. The Kingdom’s reliance on oil exports is a strong argument for maintaining the dollar peg, as abandoning it would run the risk of increasing inflation volatility, as well as reducing certainty for trade and investment. “The dollar peg is a key fundamental underpinning our monetary policy and our financial system. Don’t expect this to change anytime soon,” Mohammed bin Dawood, CEO of Al Rajhi-Invest, told OBG. Historically, the IMF has concurred, but in its 2015 Article IV consultation with the Kingdom, it suggested that the peg be reviewed periodically, given the “evolving structure of the Saudi economy due to ongoing labour market reforms and efforts to increase diversification”.
In the meantime, the existence of the currency peg means that Saudi Arabian monetary policy will continue to be coordinated closely with the decisions of the US Federal Reserve. Accordingly, in December 2015 SAMA raised its reverse repo rate by 25 basis points to 0.50% – a move that followed the US interest rate hike in the same month, and marked the first raise made by the regulator since January 2009.
The IMF’s reference to the evolving structure of the Kingdom’s economy speaks to the renewed determination on the part of the government to diversify economic activity. For now, however, oil retains its dominant position in public finances, and despite lower energy prices, oil revenues accounted for around SR444.5bn ($118.5bn) of the SR608bn ($162.1bn) government revenues in 2015, about 73% of the total, according to the Ministry of Finance. As per the “BP Statistical Review of World Energy 2016”, the Kingdom held around one-fifth of global oil reserves (266.6m barrels) at the end of 2015, and therefore hydrocarbons extraction will continue to play a major role in the economy, even as the government shifts the national economic base towards non-oil activity.
Recent years have seen the country concentrate its efforts on boosting oil production in a bid to maintain market share against encroachments from other producers, most notably new streams resulting from the fracking revolution that has taken place in the US. Saudi Arabia increased its production of crude oil by 4.9% in 2015 to 3.7bn barrels, according to SAMA, around two-thirds of which were destined for Asia. Saudi Aramco also has plans to double its gas production over the next decade, intending to use the extra volume in the domestic power sector to release more crude for export.
Looking to the non-oil sector, the Kingdom already has a broad base of economic activity from which to diversify over the coming years. The lower oil prices of 2015 meant that the non-oil sector claimed 75% of nominal GDP in 2015, up from 58% in the previous year, according to SAMA. In 2015 the Kingdom’s mining sector saw significant growth, with investments worth over $67bn. Recognising the sector’s economic potential and in an effort to create a more diversified economy, Saudi Arabia has made the development of the mining industry a strategic objective of the NTP.
Trade and services also account for a large share of non-oil economic activity, contributing 51.8% to nominal GDP in 2015. This segment includes a growing travel industry, which saw the number of airport passengers rise by 9.6% over the year to 82m, as well as similar increases across key indicators such as cargo handled (up 14.1%) and tourist spending (up 6.3%). Manufacturing, a key target of the Kingdom’s new strategy, provides the second-largest share of the nation’s GDP, contributing 12.3% to the total in 2015. The number of industrial units, industrial workers and related indicators like power generation all saw increases over the year. The construction sector, which accounted for 6.7% of GDP in 2015, also expanded, growing by 5.3% against 4.8% in 2014. Oil and gas projects claimed the largest proportion of activity in the sector, at 47%, followed by hospitality (21%) and residential real estate (16%).
The anticipated development of the Kingdom’s non-oil economy will also significantly alter the nation’s trade patterns. The shipping of crude oil accounts for the bulk of Saudi Arabia’s export activity, with mineral products making up 75.3% of the total in 2015, according to the General Authority for Statistics (GaStat), the newly reorganised successor to the Central Department of Statistics and Information. GaStat provides comprehensive, reliable, up-to-date statistics and services in line with international standards, and developing a modern statistical service to support public and private sector decision-making. “We are in the midst of a three-year transition process, upgrading the capabilities and offerings of GaStat. This will benefit both the public and private sectors, which will now be able to find the data they need in a single place,” Fahad Altekhaifi, president of GaStat, told OBG.
One of the more interesting trade trends of recent years is the relative increase of non-oil exports from Saudi Arabia as a percentage of total trading activity. In 2011 non-oil exports accounted for 12.5% of all goods and services exports, as per data from GaStat, By 2014 the share of non-oil exports had increased to 16.3% of the total, and by 2015 its claim had risen to 21.8% – although this substantial rise was largely the result of declining oil prices throughout 2015 that undercut the value of the Kingdom’s most valuable export. Nonetheless, whatever the future trajectory of spot prices in the oil market, the determination of Saudi Arabia to diversify its economic activity means its non-oil exports are likely to account for a larger share of the total over the coming years. The chemical sector represents a useful starting point for government planners seeking to broaden the range of products exported by Saudi Arabia, and in 2015 chemicals accounted for 7.7% of all exports, followed closely by plastics, which accounted for 7.6% of total exports for that year.
Other sectors in which Saudi Arabia has developed a useful level of export activity include base metals; prepared foodstuffs and beverages; live animals and animal products; machinery and electrical equipment; articles of stone, plaster, cement, asbestos, mica ceramics and glassware; and textiles.
Private Sector Powers
In implementing its radical development strategy, the government intends to harness the power of the private sector. To this end the NTP aims to boost foreign investment from $8.1bn in 2015 to $18.7bn by 2020. Building on the Kingdom’s reputation as an investment destination is therefore a priority, and one that might prove challenging given the decline in foreign direct investment (FDI) seen in recent years.
According to the Saudi Arabian General Investment Authority, FDI flows to the Kingdom peaked in 2008 at $36.5bn, and since that time have shown a steady downward trend, falling to $8bn in 2014 but increasing slightly to $8.1bn the following year. Similarly, data from the UN Conference on Trade and Development, the UN body responsible for dealing with international trade issues, shows that the number of greenfield investments undertaken by foreign investors in Saudi Arabia has been decreasing in recent years, from 139 in 2012 to 87 in 2014. While similar patterns of FDI retrenchment have been observed across emerging markets in the wake of the global liquidity crunch of 2008, the lack of a discernible recovery in FDI flows has caught the attention of the government.
Vision 2030 calls for the increase of FDI from its current level of 1.25% of GDP to an “international level” of 5.7% by pursuing a broad range of development goals, from increasing the skillset of the domestic workforce to improving institutional connections between the Kingdom and international markets. The state’s task is greatly assisted by a number of fundamental market characteristics, which together establish the nation as a place of interest for foreign investors, such as an extensive transport infrastructure, a range of international trade agreements, political stability and a framework of subsidies on inputs like electricity.
Moreover, the government has already put in place numerous incentives for projects that satisfy the Foreign Capital Investment Code, such as exemption from Customs duties on machinery and equipment, and is likely to continue its drive towards a more favourable investment environment as it sets about implementing its new strategy. In the meantime, domestically generated private investment has begun to diversify away from the traditional private equity approach – which remains at a relatively nascent stage in the Kingdom – to include increasingly large volumes of venture capital and angel investment activity (see Alternative Investments chapter). “Health care, education, mining and mergers and acquisitions are currently among the most promising investment opportunities in Saudi Arabia, thanks in part to the new impetus provided by Vision 2030,” Mohammed Al Nahas, governor of the Public Pension Agency, told OBG.
The government has been compelled to dig deep into its foreign reserves to meet its fiscal obligations in the last year. However, Saudi Arabia entered this period from a strong position, and despite the erosion of its fiscal buffers, it remains a net external creditor, with official foreign assets covering the stock of gross external debt more than nine-fold as of mid-2016, according to Bank Audi.
The process of fiscal tightening that the government began in 2015 has continued in 2016 – for which there is a projected fiscal deficit of $87bn, representing a 12.5% decrease on the 2015 level – and is likely to stay in place under the Kingdom’s reformist system. In the short term, the banking sector and investment community will keep a sharp eye on global oil prices, which have long been the main factor determining the direction of the economy.
Brent oil prices broke through the $50 barrier in the first half of 2016, and Jadwa Investment’s 2017 forecast sees Brent at $55 per barrel, an upward revision of $11 from its earlier estimate, though this did not take into account the price freeze announced by OPEC in September 2016, which could result in the emergence of even higher prices.
According to the IMF’s October 2016 “World Economic Outlook” the Kingdom’s economy should continue to expand, with 2% GDP growth forecast for 2017. Over the long term, the extent to which the government can succeed in its plans to reform the economy will be key to the Kingdom’s economic sustainability. Monitoring the implementation and progress of the NTP and the longer-term Vision 2030 strategy will therefore be priorities for the both public and private sectors (see analysis).
“Easily accessible and up-to-date information plays a key role in the business decision-making process. When businessmen have the statistics they need, they feel more comfortable investing,” GaStat’s Altekhaifi told OBG. As the new government strategies are rolled out, this information will be key in driving and evaluating the Kingdom’s progress.
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