As a member of the G20 and the world’s 17th-largest exporter, Saudi Arabia is an economic powerhouse. Classified as a high-income nation by the World Bank, its population of over 30m has established a consumer market in which domestic and global businesses have prospered. The exploitation of its hydrocarbons resources has driven growth for decades, and the nation’s trading status has been augmented by its geographic advantage as a connector of three continents as well as its proximity to the Red Sea – through which 10% of world trade travels.
Nevertheless, during this period of low oil prices the Kingdom faces a number of economic challenges. Saudi Arabia’s economy contracted for the second quarter in a row in the second quarter of 2017, according to General Authority for Statistics. According to the 2018 budget, GDP declined by 0.8% year-on-year (y-o-y) during the first half of 2017, and was estimated to have contracted by 0.5% by the end of the year.
The negative trend is primarily the result of an agreement between the Organisation of the Petroleum Exporting Countries (OPEC) and non-OPEC countries to limit oil production, yet it serves as a reminder of the Kingdom’s economic reliance on oil revenues – one it is presently trying to mitigate through a historically significant economic diversification programme. Saudi Arabia does not face this challenge alone: the sustained reduction in oil prices has brought about a hole in the public finances of oil-producing countries across the region, and brought into question a paradigm in which GCC citizens have been accustomed to subsidised fuel, mortgage-free homes, a plethora of public sector job opportunities and generous levels of disposable income. Consequently, economic reform is taking place in many Gulf countries, and the long-standing goal of diversifying revenues away from hydrocarbons is more pre-eminent than ever.
In Saudi Arabia a two-tiered economic strategy is directing this process of reform. The Kingdom unveiled its macro-level economic strategy in 2016: Vision 2030 established a roadmap of the broad regulatory, budget and policy changes that will be implemented over the coming decade as the nation sets about reducing its reliance on crude oil, which accounted for 43.6% of GDP and the majority of revenues between 2010 and 2015, according to the Saudi Arabian General Investment Authority. The 84-page plan offers a number of intriguing insights into the Kingdom’s economic future. Key initiatives include a privatisation programme, which would see the divestment of a number of state-owned giants, such as the partial listing of Saudi Aramco; the creation of the world’s largest sovereign wealth fund; and increased participation of women in the job market.
The strategy establishes a number of bold targets, which, if met, will radically reshape the economy. The most significant of these are: the anticipated boost of non-oil government revenue from SR163bn ($43.5bn) to SR1trn ($266.6bn) by 2030; raising the contribution of small and medium-sized enterprises (SMEs) to economic output from 20% to 35% in a bid to diversify exports; establishing the country as one of the 15 largest economies in the world; localising 50% of its sizeable military spending; establishing special zones, such as a separately regulated entity in the King Abdullah Financial District, and other zones in logistics, tourism, industry and finance with “special commercial regulations to boost investment opportunities”; reducing unemployment from 11.6% to 7%; revamping the education system; and raising levels of home ownership.
Shortly after the publication of Vision 2030, the government gave its approval to the National Transformation Programme (NTP), a more detailed policy document that outlined a plan for government ministries’ work towards the Vision 2030 goals over the shorter term. An update to the NTP, rebranded as the NTP 2.0, was announced in September 2017. The new version of the plan still runs to 2020, and will later be followed by versions for 2025 and 2030. By December 2017 exact details of the plan had not been released, but it is expected that privatising efforts, creating more private sector jobs and reducing unemployment will still remain core elements of the NTP 2.0. Although the updated version of the plan will track progress across 10 government entities, rather than 24, the plan still adopts a modular approach, with each ministry following an action plan developed after a consultation process that involves public and private sector input. For example, as of the original NTP, the Ministry of Finance is working to reduce spending on public sector salaries, and the application of new taxes and fees; the Ministry of Justice is improving contract enforcement and cutting resolution times for commercial cases to 395 days from 575 days; the Ministry of Energy, Industry and Mineral Resources is raising non-oil exports, increasing dry gas production and working with partners to boost power plant generation; and the Saudi Commission for Tourism and National Heritage is to raise the number of employees in the sector from 830,000 to 1.2m. Riyadh-based Jadwa Investment forecast the cost of the original NTP at SR447bn ($119.2bn), with the private sector contributing 40% of that, though this may change when details of the NTP 2.0 come to light.
The NTP is one of 12 short-term Vision Realisation Programmes (VRPs) that will be implemented to meet the longer-term Vision 2030 targets; of these, only the NTP, the FBP and the Public Investment Fund Programme have been introduced so far. It is expected that the details of the remaining programmes will be gradually released by mid-2018.
The emphasis on the contribution of the private sector is the most important philosophical shift in the Kingdom’s new strategy, and is the aspect of Vision 2030 that is of most interest to both domestic and foreign investors. Some areas of the Saudi economy have recently been opened up to significant amounts of private sector expertise and capital, a trend most clearly seen in the General Authority of Civil Aviation’s gradual transformation from its role as regulator and operator to one of regulation only. The new economic strategy envisages an acceleration of this process, based on a privatisation programme that includes one-off sales of prominent state assets as well as the opening up of entire sectors to increased private sector participation.
Of the former, the much-anticipated flotation of the state-owned petroleum and natural gas company, Saudi Aramco, has come to symbolise the Kingdom’s new willingness to grant the private sector more access to the country’s economy. The government is expected to divest itself of 5% of Saudi Aramco, and plans to channel at least half of the proceeds into domestic investment. The energy giant will be listed on the Saudi Stock Exchange (Tadawul) as well as one or more foreign exchanges, and the offering is expected to raise up to $2trn – making it the biggest flotation in history. Other state assets that have been earmarked for potential sales include the Saudi Postal Corporation, Saudi Arabian Airlines, Saudi Electricity Company and Sadara Chemical, which is a joint venture between Saudi Aramco and Dow Chemical.
However, while the Saudi Aramco initial public offering (IPO) is attracting the attention of the world’s financial media, the more significant event from a long-term perspective is the August 2017 formation of the National Centre for Privatisation and Public-Private Partnerships (NCP). The new body has been charged with overseeing a wholesale transfer of government assets to the private sector, in areas as varied as transport, agriculture and housing. Two sectors are already providing the banks and investors with capital placement opportunities: as well as the recent opening up of the airport operations segment, the health care sector is undergoing a process of gradual corporatisation and thereby acting as a pathfinder for the wider privatisation drive. The harnessing of private sector capital in this way offers numerous advantages. In addition to bringing capital, global private sector interests transfer useful skills to both the public and private sector workforces. By co-opting the private sector into more areas of the economy, the government is also granted the ability to pursue its development plans without excessively increasing its capital expenditure. These efforts will be furthered by the Privatisation Programme, one of the coming VRPs, which will be chaired by Mohammed Al Tuwaijri, the new minister of economy and planning.
The twin goals of rationalising capital and current spending, and boosting revenue have become an increasingly salient concern since late 2014, when global oil prices began their precipitous descent. That year saw a modest deficit of 2.3% of GDP in the government’s budget, according to a report from Saudi asset management firm Audi Capital, but by 2015 the budgeted fiscal shortfall had hit double digits, at 15.4% of GDP. Consequently, the Kingdom was compelled to dip into its foreign reserves to meet spending commitments, resulting in official foreign assets declining from $732bn at end-2014 to $616bn in 2015, and continuing to ease in 2016. By the first quarter of 2017 net foreign assets had fallen below the $500bn mark for the first time since 2011, according to central bank data. This trend has highlighted the importance of the Kingdom’s ongoing process of budget reform, which aims to both cut spending and boost revenue in a bid to balance the books.
In 2015 the government placed a cap on current spending; temporarily halted the inking of new contracts and all purchases of government cars, furniture and other equipment; and instituted a hiring freeze on new public sector employees. This effort was rewarded by a 12.6% contraction in total public expenditure in 2015, an impressive turnaround from the 13.7% expansion seen in 2014. In 2017 the government felt comfortable enough with its reform process to loosen its grip on capital spending, adopting a mildly expansionary budget stance; it committed to SR890bn ($237.3bn) in spending compared to SR840bn ($224bn) the previous year. The government’s continued determination to support private sector growth through targeted spending is demonstrated by the hike in capital expenditure from SR76bn ($20.3bn) in 2016 to SR260bn ($69.3bn) in 2017, according to Jadwa Investment, as well as the SR43bn ($11.5bn) allocated to NTP initiatives – SR30bn ($8bn) of which is categorised as capital spending.
The 2017 budget also included details of a new Fiscal Balance Programme (FBP), a VRP that aimed to balance the budget by 2020, and comprised measures promoting non-oil revenue and enhancing efficiency in fiscal spending. A reform of energy and utility prices accounts for the bulk of the planned savings over this period, which extends a first phase of price adjustments that took place in 2016. In its 2017 Article IV Consultation, the IMF commended the government’s fiscal reforms: “Fiscal consolidation efforts are beginning to bear fruit, and progress with reforms to improve the business environment are gaining momentum.” However, the IMF added that Saudi Arabia could also slow the balancing process down and extend its target to 2023 – a measure the authorities confirmed they were considering, and later adopted in the 2018 budget and update to the FBP.
A new Bureau of Capital and Operational Spending Rationalisation Unit will seek further spending efficiencies and attempt to put an end to the budget overruns which have become the norm since the turn of the century. Poorer Saudi households will be protected from these austerity measures by the Household Allowance Programme, which will provide cash transfers to eligible families according to variables such as family size and exposure to new levies.
The government intends to boost revenue, meanwhile, by focusing on new taxation measures. The introduction of excise duties in 2017 is expected to add an additional SR12bn ($3.2bn) in income, while revenue estimates for the new value-added tax (VAT) system run to around SR15bn ($4bn), making it the single biggest driver of revenue growth.
The Kingdom, along with some other GCC states, began to implement a VAT from January 1, 2018. The low starting rate suits Saudi Arabia well: the nation has never had a general sales tax, and therefore a higher rate would leave it vulnerable to inflation. The proposed 5% level was backed by the IMF in August 2015, when the fund estimated that even this modest rate would bring in extra revenue worth 1.6% of GDP in Saudi Arabia’s case. As well as direct taxation, the government has sought to boost revenue and encourage the hiring of more Saudi citizens by introducing an expatriate levy. The new measure applies a variable rate for expats, which depends on the number of dependants, starting in 2017 at SR100 ($27) per dependent per month and increasing to SR400 ($107) per month in 2020. By 2017 the government’s reform efforts were becoming increasingly apparent on the national balance sheet; the second quarter budget performance report showed a 6% y-o-y increase in government revenue and a 1% drop in expenses, leading the fiscal deficit to decline to SR46.5bn ($12.4bn), from SR58bn ($15.5bn) in the second quarter of 2016.
Bridging The Gap
The budget deficit and declining reserves have encouraged the Kingdom to find innovative ways to bridge the fiscal gap. In October 2016 Saudi Arabia began to take orders for its first international bond sale, an event which sparked considerable investor enthusiasm. Orders for the deal reached $67bn, allowing the government to borrow more than it had originally planned, moving the sale from a $15bn offering to a new total of $17.5bn. The healthy order book also meant the government sold its debt at a more favourable price: the five-year, 10-year and 30-year bonds were sold at yields of 2.375%, 3.25% and 4.5%, respectively, all lower than initially forecast. The rates were also significantly lower than the average 5.2% yield of bonds tracked on JPM organ’s emerging market bond index, a reflection of Saudi Arabia’s status as a G20 economy with an “A”-rating from the three major credit ratings agencies.
In April 2017 the country diversified its funding base still further, with the well-received issuance of its first US dollar-denominated sukuk (Islamic bond). Investor orders exceeded $33bn, allowing the country to sell two, $4.5bn tranches with tenors of five and 10 years at below-benchmark rates.
The Kingdom’s successful tapping of global capital markets is significant from the perspective of system liquidity, in that it potentially allows the government to draw down less of its deposits held with domestic banks. It also takes pressure off the domestic sovereign debt issuance programme, which drains further liquidity from the system.
The Kingdom’s second dollar-denominated bond sale came in September 2017, with the government raising $12.5bn in tranches of five-year, 10-year and 30-year notes. Once again, appetite for the sovereign debt was high, with investors submitting around $40bn in bids. The 2018 budget announced that the government would issue SR134bn ($35.7bn) in new bonds in 2017, which Jadwa Investment estimated would establish the 2017 year-end public debt level at approximately SR450bn ($120bn), or 17.2% GDP, up from SR317bn ($84.5bn) in 2016.
Inflation & Monetary Policy
The process of economic reform has yet to have a significant impact on the nation’s inflation rate. The cost of living index rose by 2.2% on average in 2015, and in the first four months of 2016 it increased by 4.3% as a result of a 50% cut in petrol subsidies at the close of 2015 and the doubling of Customs fees on tobacco products in March 2016. Nevertheless, price pressures were contained, remaining in low single digits at 3.5% for the year, according to the World Bank. According to government statistics, the cost of living index registered a y-o-y decline of 0.3% to October 2017, but it is expected that higher consumption rates in the fourth quarter will reduce the negative inflation.
The existence of the currency peg with the dollar means that Saudi Arabian monetary policy will continue to be coordinated closely with the decisions of the US Federal Reserve. Accordingly, in December 2015 the Saudi Arabian Monetary Authority (SAMA) raised its reverse repo rate by 25 basis points to 0.5%, a move that followed a US interest rate hike the same month and the first raise made by the regulator since January 2009. Since then, domestic interest rates have continued to track movements of the Federal Reserve. While this arrangement provides important stability and predictability with regard to the Kingdom’s currency, it has also resulted in an approximately 40% real appreciation in the country’s effective exchange rate against major trading partners since July 2008, according to the World Bank.
Oil exports continue to play a dominant role in Saudi Arabia’s public finances. The 2018 budget estimated that in 2017 revenues from oil would reach SR440bn ($117.3bn) – an increase of 32% on 2016 – while non-oil revenues for the year were expected to come in at SR256bn ($68.2bn). As proprietor of nearly 16% of the world’s oil stocks and one of the two-biggest oil producers on the planet, according to the BP’s “Statistical Review of World Energy 2016”, Saudi Arabia has managed to successfully leverage its hydrocarbons exports to maintain a healthy trade balance even during this period of subdued oil prices. In 2011 the Kingdom hit a recent trade balance high of SR874bn ($233m), according to the General Authority for Statistics, and with oil prices at record lows in 2016, it nevertheless managed a positive trade balance of SR162.8bn ($43.4bn).
Hydrocarbons extraction will continue to play a significant role in the economy even as the government shifts the national economic base towards non-oil activity. Recent years have seen the Kingdom concentrate its efforts on boosting oil production in a bid to maintain market share against encroachments from other producers, most notably the new streams resulting from North America’s fracking revolution. In 2016 the Kingdom’s daily oil production hit its recent peak of 10.4m barrels per day (bpd), up from 8.2m bpd in 2010, and production cuts agreed with OPEC and non-OPEC countries in 2017 resulted in only a minor slowdown, to 10.0m bpd. 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.
Nevertheless, diversifying economic activity away from oil remains the overriding concern of the government, and it pursues this objective from an economic base that is broad by regional standards. After oil and gas production, manufacturing activity is the second-largest contributor to the Kingdom’s GDP, accounting for nearly SR310bn ($82.6bn), or 12% of the SR2.6trn ($693.2bn) total in 2016, according to SAMA. The latest data from the Saudi Industrial Property Authority shows the number of industrial, service and logistics contracts increased by 1.2% in 2016, despite the challenging economic environment.
The Kingdom is also home to an advanced financial services sector that includes domestic banks, which are in some cases regional giants, and the largest stock exchange in the GCC, which is rapidly moving towards acquiring the coveted MSCI emerging market status. In 2016 the finance, insurance, real estate and business services activity of the Kingdom was a close third after manufacturing in its contribution to GDP, generating more than SR237bn ($63.2bn), or 2.7% of the total.
The fourth GDP component, according to SAMA’s classification, is the wholesale, retail, restaurants and hotels sector, which is being driven by the high level of disposable income enjoyed by Saudi consumers, and contributed more than SR228bn ($60.8bn) to GDP in 2016. Construction and building also plays an important role in the Kingdom’s economy, generating approximately SR121bn ($32.3bn) in 2016, and is expected to remain an economic stalwart over the coming years as the Kingdom continues to invest in its infrastructure and housing stock.
The Kingdom’s process of fiscal reform is starting to pay off: the 2018 budget forecast the fiscal deficit would narrow from 12.8% of GDP in 2016 to 7.3% in 2018. Economic growth projections from domestic and regional institutions, however, remain modest. Most outlooks, including that of the World Bank, see a contraction in the hydrocarbons sector due to OPEC-agreed production limits having a negative effect on GDP expansion. The World Bank projects overall GDP will grow by 0.6% and the non-oil economy will expand by 2.1%. A more recent assessment by the IMF in October 2017 forecast overall economic growth would slow from 1.7% in 2016 to 0.1% in 2017, and saw a 1.2% expansion of non-oil activity. The IMF expects growth to pick up in the medium term as state fiscal and economic reforms take effect. For its part, the 2018 budget expected real GDP growth to have eased to -0.5% in 2017 but would rebound by 2.7% in 2018.
Indeed, all estimates for 2017 expected a low-growth scenario, with improvements in 2018 as the fiscal retrenchment eases and oil prices continue their modest recovery. From a financial stability perspective, the Kingdom is well positioned to ride out the challenging economic period.
The World Bank is of the view that fiscal deficits are not likely to pose sustainability challenges in the short term, but it notes that the continued erosion of foreign reserves and increasing levels of public debt have the potential to cause issues in the longer run. In this context, the successful implementation of VRPs, which the government views as its route to fiscal sustainability, is of paramount importance.
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