Saudi Arabia: reforms are necessary to reduce economic reliance on oil
Lower oil prices put increased pressure on the Saudi economy. Growth is slowing down and the fiscal situation is under pressure. Implementation of the diversification plan (vision 2030) would be a positive factor, but will be difficult to achieve.
Strengths (+) and weaknesses (-)
(+) Strong external and fiscal position
High current account and budget surpluses posted in past years on the back of high oil revenues, have allowed Saudi Arabia to keep public and foreign debt low and build sufficient buffers to weather a period of low oil prices. The net international investment position is 108%-GDP (2015).
(+) “Central bank of oil”
Saudi Arabia’s large spare oil production capacity makes it the world’s only “swing producer” and allows it to influence oil prices. Consequently, Saudi Arabia enjoys significant international clout.
(-) Hierarchical feudal political system limits democratic and social progress
Progress on reforms towards more democracy, as promised in 2003, has been extremely limited and human rights are often violated. The country scores in the bottom 3% in the Voice and Accountability sub index of World Bank’s World Governance Indicators and the trend is downwards.
(-) Narrow economic base
The oil sector accounts for roughly 40% of GDP, 90% of government revenues and 69% of export income, making Saudi Arabia highly susceptible to developments on global oil markets.
1. Economic growth is slowing down as result of lower oil prices
Economic growth in Saudi Arabia (figure 1) slowed to 3.4% in 2015 and is forecasted to slow down further in 2016 (1.1%) on the back of sharply lower oil prices. In 2015, real GDP growth has been primarily supported by increased oil exploration. Going forward, it is expected that oil output will stabilize and so that real oil GDP growth will slow down. The non-oil sector grew by 3.6% in real terms in 2015, which is a marked slowdown from the average 6.4% yearly growth in the period 2000-2014. Growth in the non-oil sector has historically been driven by government spending of the oil revenues. For 2016 and 2017, it is expected that non-oil GDP growth will decelerate further. A successful implementation of the announced reform agenda (see development 3) would be highly beneficial for the non-oil sector outlook. In nominal terms, the impact of the lower oil prices is much more dramatic. Nominal GDP (in local currency) declined by 13.3% in 2015. Also the current account turned negative in 2015 (-5.5%-GDP compared to a 22%-GDP surplus in 2012). Together with a deficit on the financial account of the balance of payments, this partly explains the fall in foreign exchange reserves (-18% over 2015), which are, however, still huge (around 80%-GDP or 35 months import cover). Therefore, external vulnerability remains limited.
2. Currency peg will remain in place
Due to the lower export prices and weaker economic conditions in Saudi Arabia, the pressure increased on the currency peg between the Saudi Riyal and the US Dollar, which has been in place for three decades. Recently, the gap between the forward rate and the spot rate narrowed again. Furthermore, the newly appointed governor of SAMA (the central bank), Ahmed al-Kholifey, stated that peg will remain in place. SAMA also raised its policy rate in response to the US Federal Funds rate rise in December 2015. We do not expect a devaluation, since Saudi Arabia has ample reserves to defend the peg and the country would not gain much from devaluing its currency, because its imports are relatively inelastic. Moreover, the Saudi government plans to partly privatize some state-owned enterprises for which strong investor confidence is crucial.
3. Fiscal position under strain
The decrease in oil prices led to a drastic weakening of the fiscal situation (figure 2), since the Saudi government heavily depends on oil for its revenues (about 90%). Total government revenue fell by 42% yoy in 2015 (23%-GDP from 37%-GDP). In response, the government reduced its spending drastically (12% yoy), but still the budget deficit increased to almost 18%-GDP in 2015. The deficit is paid through both a decrease in currency reserves and the issuance of their first securities since 2007. In the fiscal plan for 2016, the government aims to increase non-oil revenues. They announced the introduction of a value-added-tax (VAT), but this will likely not be implemented before 2017. Moreover, the amount of revenues raised through a VAT would be modest. The government further cut down on fuel subsidies. The Saudi Ministry of Finance expects a deficit of 15%-GDP in 2016, based on 15% lower revenues and 14% lower spending. This forecast seems reasonable given their oil price outlook of between 36.5 and 38 USD. Historically, however, the government usually overspends its budget. Under the current budget, the fiscal breakeven oil price is 67 USD/barrel according to the IMF. As a result of the large budget deficits, government debt is expected to rise quickly, especially since the Saudi authorities stated that they want to limit the use of FX-reserves to finance the budget deficit. When the low oil prices persist around the current level, the government needs to cut back public employment and trim salaries in order to restore a balanced budget. In the short-term, this will however be difficult to achieve without social unrest. Employment by the government was always the first and last choice for the Saudi population, due to the high wages and favourable working conditions. In response to the weakened fiscal outlook, the major credit rating agencies cut the sovereign credit rating of Saudi Arabia.
4. Plan to diminish oil dependence (vision 2030) unlikely to be fully implemented
Last April, the Saudi deputy crown prince unveiled the kingdom’s Vision 2030, an ambitious plan to steer the economy away from its oil dependence. The plan highlights that Saudi Arabia wants to raise its share of non-oil exports in non-oil GDP from 16 percent to 50 percent by 2030, but is silent on how to achieve this target. The most concrete policy measure is a float of around 5% of Saudi oil giant Aramco to fund a sovereign wealth fund that will be used to make necessary investments. We expect that diversification will remain a major challenge, as similar initiatives in the past have failed. Politically, the reform is also challenging as the government faces an inert and conservative bureaucracy and the country lacks the institutional capacity to implement much of the reform that the deputy crown prince laid out. The recent government overhaul, however, signals that the King and the deputy crown prince are determined to reform the economy and, therewith, to strengthen their own positions. Key necessary reforms include a restructuring of the tax system, creating a more productive labour force and an improved business environment.
Saudi Arabia has an oil-based economy under strict government control. The country holds a leading role in the OPEC, as it possesses 16% of the world's total proven oil reserves and is the largest oil exporter worldwide. Huge financial buffers built from oil revenues have turned the country into a strong net external creditor. This is reflected in a strong net external asset position and large net portfolio and other capital outflows on the balance of payments. Saudi Arabia is slowly developing the non-oil private sector in order to diversify its economy and reduce dependence on foreign labour. Expats accounted for almost 30% of the population and 60% of the private sector workforce in 2015, though drastic measures under the Saudization programme have reduced their number to about 9 million. As a main source of remittances and financial assistance to other countries, Saudi Arabia is a regional power. This translates into a structurally negative current transfers balance on the current account. Saudi Arabia has no political parties, its monarchy is hereditary and the political decision-making in the country is dominated by the al-Saud royal family. Royal decrees of 2003 and 2006 promised democratic reforms, but progress has been slow. Councillors are appointed by the monarch in what is basically a hierarchical feudal political system. Similarly, the legal system is far from modern and is largely based on Islamist sharia law. In line with the belief in Islamic religious supremacy, the country has not committed itself to accept any jurisdiction of the International Court of Justice. There is some sectarian violence in the oil-rich Eastern Province, where most of the minority Shia Muslims live. Relations with Iran have been tense for decades, due to sectarian differences, as well as fighting for regional hegemony.