4 May 2108

In April 2016, Saudi Crown Prince (Deputy at the time) Mohammed bin Salman (MBS) announced his Saudi Arabia 2030 economic strategy.  The ambitious plan has two major objectives.  First of all, the collapse in oil prices after 2014 requires a major overhaul of Saudi fiscal policy to reduce the huge budget deficit.  Even more radically, the program aims to reduce the nation’s reliance on oil, especially through a dramatic expansion of private sector economic activity.  What are the chances of success?  Sceptics say they have heard this all before: every Five Year plan since 1970 has aimed to reduce the nation’s dependence on black gold, and failed to do so.  Also, resentful Royal family members suggest the plan is simply a power grab by an ambitious, young Prince, and point to last November’s detainment of numerous Royals at the Ritz Hotel and subsequent arrests on corruption charges to support this view.  On the other hand, backers of the program suggest it is an inevitable, belated response to irreversible shifts in global energy markets.

Two years on, it worth taking a look at how MBS’s plan is progressing.  What is becoming clear, however, is that for the plan to succeed, a radical reworking of Saudi Arabia’s “social contract”, which has defined the relationship between the Royal family, the clerics, and the general public in recent decades, will be required.  During the Arab Spring of 2011, the Saudi government was able to increase spending dramatically, which helped maintain relative political stability.  At that time, however, oil prices were near $100.  With lower oil prices here to stay, navigating the social and economic transitions ahead will require even more political skill than before.

Oil Dependence: Breaking Up is Hard to Do

Putting Saudi Arabia into a broader international context helps one appreciate the enormity of the task the Prince is undertaking.  The following Chart, for instance, illustrates that oil accounts for over 30% of GDP.  Indeed, prior to the decline in petrol prices it exceeded 40%. Indeed, this is nearly double the dependency of its Gulf neighbours, e.g. UAE and Oman.

However, it does not stop there.  In the past, Saudi Arabia’s government finances have been almost fully reliant on oil, which accounted for nearly 90% of overall revenues as recently as 2014.  Again, the Kingdom ‘s government is far more reliant on oil than its regional neighbours, and far more so than countries like Russia, Mexico, Ecuador or Indonesia.  The same is true of KSA’s balance of payments.  Again, in 2015 oil exports accounted for nearly 90% of sales abroad.

Weaning oneself off the black stuff is not easy or quick.  For instance, both Russia and Mexico set this priority decades ago.  In Mexico, a far more diversified industrial economy than KSA,  meaningful progress has been achieved; nevertheless, oil still accounts for over 20% of public sector revenues. Russia has been less successful: after decades of effort (e.g. talk, mostly), oil still represents roughly 50% and 30% of government revenues and exports respectively (not to mention gas and other natural resources).

McKinsey Global Institute — the consulting firm upon whose advise much of the Vision 2030 plan is based — highlights the shortcoming of Saudi Arabia’s reliance on one commodity.  Even during the boom decade prior to 2014, productivity growth lagged well behind both the USA and other emerging market economies. Saudi efficiency gains even lagged well behind those in other oil-reliant nations, such as Russia and Nigeria.  Indeed, even within the Kingdom, productivity advances in the overall economy were far below those in the private sector — highlighting the relative inefficiency of the oil-dependent state sector, and the priority placed on expansion of the private business.

To be sure, shifts in global energy markets are a key rationale for attempting to both reduce the reliance on oil and promoting the private sector. The discovery of US shale is a game-changer. Even though Saudi Arabia still has the largest stock of reserves, production in both Russia and the USA is now higher.  Indeed, the US share of oil production has nearly doubled in the past decade (to 14%), while KSA’s share has slipped from 14% to 12%. In addition, technological advances allow US producers to quickly alter output according to market conditions.  Despite the recent run-up in prices (perhaps reflecting the possibility of American’s withdrawal from the Iran nuclear deal), lower oil prices appear here to stay (I am assuming a medium-term average quote of  roughly $60pb).

Further impetus for the shift away from oil stems from Saudi Arabia’s imminent demographic bubble. The Chart illustrates that the proportion of the Saudi population below 25 years old is amongst the world’s highest.  McKinsey estimates that Saudi Arabia’s working-age population could expand by 6million by 2030.  Even during the oil boom decade, KSA produced “only” 4.7  million jobs, of which only 1.7 were filled by Saudi nationals. Clearly, the oil-driven state sector will not be able to meet the coming demand for jobs.

Fiscal Adjustment: Dramatic Shift in Priorities Required

The oil-dependent Saudi fiscal position collapsed along with petrol prices — swinging from a surplus of 6% of GDP to a deficit of nearly 18% of GDP between 2013 and 2016.  Not surprisingly, the aim of Saudi 2030 is to balance the budget by 2023 and to increase non-oil revenues to over 25% of GDP (from 5%).  This is intended to allow the government to dramatically increase capital investment in support of an expansion of the private sector.  One advantage the Kingdom enjoys is a very healthy starting position (see Chart below). Despite a spending surge during the oil boom era, large surpluses allowed the government to eliminate government debt.  Indeed, after allowing for the government’s deposits at the central bank SAMA, the public sector held net assets totalling over 50% of GDP in 2013.

Therefore, the government has the fiscal space to pursue its budget objectives over the medium term, which should help minimise the economic headwind from fiscal austerity.  However, nothing short of a dramatic shift in spending priorities will be required to achieve the Vision’s objectives.  So far, the news is mixed.  On the plus side, the deficit has declined from 18% of GDP in 2016 to 9.3% last year. However, the 2017 shortfall exceeded the initial target of 7.5% , and I expect the red ink to remain above 7% of GDP in 2018 (see next Chart).  Moreover, virtually all the of the budgetary improvement has resulted from savage cuts in public investment — declining from 16%  in 2014 of GDP to 6% now . Hardly in line with the Vision!

Meanwhile, non-capex spending has continued to rise inexorably from 23% to 28% of GDP by 2017.  The biggest culprit is wages, which account for a staggering 47% of government spending (see above), as nearly two-thirds of Saudi employment is in the public sector!  Likewise, military/security spending represents over 10% of GDP (30% of public spending).  With regional tensions remaining acute, military spending cuts seem unlikely, despite the bloated budgets (Chart below). Not much left for vital education and health.

After three years of austerity, however, fiscal policy will be eased in 2018, although higher oil prices will lower the deficit to 7.5% of GDP.  The government recognises the role austerity played in the meagre 1% advance in non-oil GDP last year — below the forecast of 1.7% , and certainly not what’s needed to achieve the doubling of GDP the Vision aspires to.    Public sector investment, for example, will rise 15% this year . The government has made progress in increasing non-oil revenues — from 5% to 10% of GDP so far — through an introduction of 5% VAT, levies/taxes on expat salaries, and cuts in subsidies on domestic energy and water use.  However,  as a result of public unhappiness about higher utility costs, recently measures have been taken to cushion the impact on lower-income families.

The government is responding to public complaints about austerity, and making use of its favourable initial fiscal position: e.g. delaying the date for a balance budget from 2020 to 2023. However, spending priorities must change radically, especially big and unpopular cuts in public sector jobs and pay.  If policies remain unchanged, I still expect government net government debt to rise to 20% of GDP by 2023 (from nil now). Without pay cuts, higher investment will lead to net debt approaching 40-50% of GDP (still manageable, but not desirable).

Improving Business Climate: Social Contract  Must Shift Dramatically

McKinsey projects that $4-trillion in new investment and 6 million new jobs for Saudi nationals will be needed to attain the Vision’s objectives.  What is evident from the budget analysis is that the government can not be relied on for either, especially in an era of low oil prices: public jobs must be cut and investment is still far too small. Thus, improving the private sector business climate is central to the success of the Crown Prince’s strategy.  The World Economic Forum highlight impediments to private investment: labour market reform and education need to be top priorities.

Historically, the Saudi government/Royal family has maintained the loyalty of the population by providing high-paid, lifetime  public sector jobs. And, for their allegiance the  clerics played a large role in education and maintaining social norms.  The viability of this “social contract” is now in doubt.

The WEF highlights the numerous unique features of KSA’s labour market.  For instance, nearly 70% of Saudi nationals work in the public sector, where pay is nearly double the level in the private sector! Nearly 90% of private sector jobs are filled by expats, who are paid far less than Saudis (Chart above).  Unemployment is now nearly 13% (the goal is 7%), and has risen during the past year of weak growth.  The gender jobless gap is enormous: 7.5% for males and 33% for females. Youth unemployment is 23%, 35% for young women.  Labour market reform is critical to reaching the Vision 2030 growth/employment objectives.  Key will be creating an environment in which higher paying, private sector jobs lure Saudis from stable, relaxed government roles.

The WEF also identifies the deficiencies of the educational system, where the clerics have huge influence.  To be sure, much progress has been made. Literacy is now nearly universal.  The gender gap also has been virtually eliminated.  As sign of progress, nearly all girls now receive at least a primary education, while only 18% of women over 65 years of age were similarly educated. Despite wider access, however, workers do not have the skills businesses require.  For example, recent surveys suggest that Math and Science skills are amongst the lowest in the world. Here a gender gap does exist, as the majority of girls study arts, humanities, and education while boys focus on business, tech, and engineering.

The success of MBS’s strategy will require a greater economic role for women. Indeed, the goal is to lift female participation from 22% to a still modest 30%.  Women are currently a wasted resource: they are educated to a high level, but their participation is well below the 80% for men.  The ending of the driving ban  this June is a meaningful step in the right direction.

Improving the business and private investment climate is a long-term project, but early indications suggest there is a long way to go.  First of all, non-oil GDP advanced a mere 1% last year.  Likewise, despite recent gains, non-oil exports still remain only near 2014 levels. Moreover, the IMF reports that foreign direct investment  has been negligible in recent years. More broadly, since peaking in 2014, SAMA international reserves have decline by roughly $250bn, despite a cumulative current account deficit of only $75bn.  This suggest that even Saudi investors have been taking their money abroad.  Fortunately, this trend appears to have  stabilised in recent months.

Strategic Implications

• In June, I expect MSCI will announce a plan to add KSA to the Emerging Market index by 2019. In the year prior to being added to the index in 2014,  Qatar and UAE outperformed by 40%.  But, oil prices were over $100! Even if KSA is giving a 0.5% index weight, this could attract over $100bn, or 25% of current market capitalisation.  This should lead to some out-performance.  But, progress on the Vision’s agenda will be the key driver.
• Despite the numerous possible advantages of greater exchange rate flexibility, e.g. promoting non-oil sector competitiveness, the uncertainty caused by abandoning the dollar link would prove counter-productive.  I do not expect any change for the next few years at least.
• The Aramco IPO will be a reform litmus test.  The  local market is to too small to absorb the full amount.  Floating on a major market will require greater transparency.    Looking for a private placement, e.g. in China,  would be a step in the wrong direction.  Questions about US investors’ appetite to hold Aramaco shares after 9/11 make Hong Kong or Japan markets (large consumers of Saudi oil) likely candidates.