O ff i ce of t h e C h i e f Eco n o m i s t

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The Saudi Economy: Recent Performance and Prospects for 2008-09 Summary Economic expansion and diversification continue apace in Saudi Arabia and this momentum should be maintained in the period ahead. Global oil prices are expected to remain high, investment in domestic oil and gas production capacity is being ramped up, and the enormous potential of the private sector is being unleashed by fundamental improvements to the business environment. As a result, robust public and private sector investment should underpin real economic growth of 6 percent or more annually over the coming years. ◆

Hydrocarbons will remain the cornerstone of the economy. The sector’s contribution to real GDP is expected to rebound this year in line with a pickup in crude oil output and investment in productive capacity. In nominal terms the sector is expected to grow by as much as one third, as global oil prices are buoyed by market demand, supply concerns, and speculative activity.

◆

The surge in Saudi oil revenue will support further brisk growth in government

spending (around 15 percent both this year and next). Much of this will be directed towards basic infrastructure, but spending on salaries and other benefits, as well as subsidies, will also be raised in a bid to offset the social costs of rising inflation. ◆

Despite the economic stimulus coming from rising government spending, the expanding private non-oil sector is increasingly becoming the driver of growth.

Inspired by properly sequenced and thorough-going economic reforms, both private and foreign investment is surging ahead, most notably in utilities, manufacturing, telecoms, financial services, and the Economic Cities. With economic reform momentum likely to be maintained, the prospects for sustained private investment growth are excellent. ◆

keeping the budget in surplus by as much as 20 percent of GDP both this year and

Howard Handy General Manager Chief Economist +966 1 477 4770 Ext. 1820 [email protected] Keith Savard Director of Economic Research +44 207 6598200 [email protected]

The growth in government spending will prudently continue to lag that in oil revenue, next. The balance of payments position is also exceptionally strong and current account surpluses averaging some 25 percent of GDP in 2008-09 will further boost foreign asset holdings.

◆

The major risk to this buoyant outlook stems from inflation, with consumer price growth likely to average around 8 percent this year. Barring any change of policy, the outlook for prices depends largely on the pace of housing delivery, the course of global commodity prices (especially food), and the value of the US dollar. These conditions

James Reeve Senior Economist +44 207 6598200 [email protected] This and other publications can be downloaded from www.samba.com

may gradually improve in the second half of this year and into 2009, helping to dampen some import prices and subdue wage pressures. Nevertheless, it is likely that

the authorities will continue to weigh their policy options carefully—especially the dilemma presented by the long-standing dollar peg—at a time when economic conditions in US (recession) and Saudi Arabia (boom) are notably divergent.

O ff i ce of t h e C h i e f Eco n o m i s t

April 2008

Key Economic Data and Forecasts

Nominal GDP ($ bn) GDP per capita ($ ‘000)

2005

2006

2007

2008f

2009f

309.9

349.1

376.2

464.5

517.3

13.0

14.2

14.9

17.9

19.3

Real GDP (% change)

6.1

4.3

3.7

6.7

5.9

Hydrocarbon GDP

7.8

0.2

-1.5

7.0

4.0

Non-hydrocarbon GDP

5.2

6.3

6.1

6.5

6.8

Nominal GDP (% change)

23.6

12.6

7.7

23.5

11.4

Hydrocarbon GDP Non-hydrocarbon GDP CPI inflation (% change, average) Hydrocarbon exports ($ bn) Current account balance ($ bn) (% GDP) External debt ($ bn) (% GDP) Fiscal balance (SR bn) (% GDP) Cent gov debt (SR bn) (% GDP)

45.8

14.5

7.5

32.8

8.8

5.4

10.6

8.0

12.5

15.0

0.7

2.3

4.0

8.0

6.4

162.4

188.6

201.8

278.8

300.7

91.0

94.8

75.8

128.1

113.4

(29.3)

(27.1)

(20.1)

(27.6)

(21.9)

33.7

46.9

65.1

74.0

86.2

(10.9)

(13.4)

(17.3)

(15.9)

(16.7)

209.0

270.0

179.0

405.0

420.0

(18)

(20.7)

(12.7)

(23.3)

(21.7)

715.6

713.2

783.7

253.5

239.5

(61.7)

(54.5)

(55.6)

(14.6)

(12.4)

Memoranda: Oil price (Brent $/barrel)

54.4

65.4

72.4

93.0

98.0

(Arab Light $/b)

49.5

60.5

68.4

89.0

94.0

9.5

9.2

8.7

9.3

9.4

1.2

1.2

1.3

1.4

1.4

Crude oil production (m b/d) Natural gas production (m boe/d)

f= Samba forecast. Sources: SAMA; Ministry of Finance and National Economy; Samba

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April 2008

Table of Contents

Summary

1

Key Economic Data and Forecasts

2

The Global Context

4

Output, Investment and The Real Economy

7

Box 1: Hydrocarbons Investment Box 2: Refining and Petrochemicals Projects Box 3: Economic Cities

9 10 11

Fiscal and External Positions

12

Monetary Developments and Financial Markets

16

Monetary Policy Challenges

19

Box 4: The Government’s Anti-Inflation Measures Outlook and Risks

21 23

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April 2008

1

The Global Context

Saudi Arabia commands a pivotal position in the global economy. As both the world’s largest oil producer, and the only one with significant spare capacity, the Kingdom has a substantial influence on the supply (and hence price) of this most crucial resource. In addition, Saudi Arabia is an important exporter of capital. Although an increasing amount of the country’s oil earnings are invested at home, such is the scale of these earnings that the

With nominal GDP projected at around $465 billion this year, Saudi Arabia’s economy is now on a par with that of Switzerland. It accounts for a little more that half of the total output of the GCC and is twice the size of the second largest GCC economy, the UAE.

country has continued to accumulate foreign assets. In 2007, the Saudi Arabian Monetary Authority (SAMA, the central bank) increased its foreign assets by $80 billion. Most of this is likely to have been channelled into US dollar-denominated assets, representing significant support for the greenback at a time when the US external current account remains in large deficit and there are growing uncertainties about US economic prospects. (We will explore Saudi Arabia’s role in global financial intermediation in more detail in a later report.) Finally, the Kingdom’s economy has been growing rapidly in recent years, doubling in nominal terms since 2002. With nominal GDP projected at around $465 billion this year, Saudi Arabia’s economy is now on a par with that of Switzerland. It accounts for a little more that half of the total output of the GCC and is twice the size of the second largest GCC economy, the UAE. It is a major trading nation, and the second largest global source of outward remittances after the US.

Oil prices, food prices, and US interest rates all have an important bearing on Saudi Arabia’s economy As Saudi Arabia’s global economic importance grows, so the gyrations of the world economy are having a more immediate impact on the Kingdom’s economic health. Three variables are foremost: ◆

Global demand. The pace of global economic activity has an important bearing on oil prices, which are in turn the key determinant of Saudi Arabia’s external and fiscal positions, and to a lesser extent its own pace of GDP growth.

◆

US interest rates. Because of the riyal’s peg to the dollar, US interest rates have a significant influence on domestic liquidity conditions.

◆

Global commodity prices. The prices of a range of global commodities have surged, with higher food prices in particular feeding through into sharp rises in Saudi Arabia’s CPI.

Chart 1

Oil Prices (WTI average spot 2004-2008) 100 90 80 70

US$

60 50 40 30 20 10

Source: US Department of Energy

4

Oc t-0 7 Ja n08

-0 7 Ap r07 Ju l-0 7

Ja n

Oc t-0 6

-0 5 Oc t-0 5 Ja n06 Ap r06 Ju l-0 6

Ju l

Oc t-0 4 Ja n05 Ap r05

Ja n04 Ap r04 Ju l-0 4

0

April 2008

Global demand for oil is firm… Global demand for oil is strong. Despite the uncertainties besetting global credit markets, the International Energy Agency (IEA) expects stronger growth in oil demand this year compared to 2007. The organisation anticipates additional demand of 1.7 million b/d in 2008, up from 0.9 million b/d in 2007, reflecting, in the main, continued robust demand, especially for transport fuel, in China and the Middle East. The supply outlook is also tight. Despite prices surpassing $100/barrel, OPEC members remain generally cautious, reflecting their own large and growing budgetary commitments. As such, the organisation decided at its early March summit to roll over its existing quotas until the end of the summer. OPEC insiders indicate that action (i.e. further cuts to quotas) would be taken to defend a price of $80/b. Further potential supply tightness or disruptions could come from a variety of producing nations such as Nigeria, Iraq, Venezuela, and Iran, where politics and/or the policy environment remain unstable. Gains from non-OPEC supply are also likely to be modest as extraction costs continue to rise sharply. Prices have also been pushed higher by speculation in the commodities markets, including oil, as investors look for alternative investments that are largely uncorrelated with fixed income and equity assets. The S&P Goldman Sachs Commodities Index rose by 52 percent in the 12 months to March 26. A widely held view is that when interest rates are lowered more than conditions in the real economy warrant, the resulting concerns over inflation push commodities higher.

…and is likely to remain so We expect this upsurge in hedging activity to ease over the coming months, particularly as the global credit crisis abates. Going forward, therefore, commodity price trends are likely to be more heavily influenced by real activity in the global economy. If the US economy slides into a deep recession, an extended period of subpar global growth could put appreciable downward pressure on commodity prices, including oil. However, if the US slowdown is less

Oil market fundamentals will remain tight, and we forecast an average spot price for Saudi crude of around $89/barrel for 2008. Based on expectations that the US economy will be recovering in 2009, oil prices should edge up further to an average of about $94/barrel next year.

pronounced and reasonably short-lived, as seems more likely, global growth could return to trend, or move even higher, helping to lift commodity prices again. On balance, the likelihood is that oil prices will remain elevated for some time (futures contracts for December 2010 were trading above $99/b in mid-March). There may be some softening of prices as speculation by hedge funds unwinds and US demand eases, but the broad market fundamentals will remain tight, and we forecast an average spot price for Saudi crude of around $89/barrel for 2008. Based on expectations that the US economy will be recovering in 2009, oil prices should edge up further to an average of about $94/barrel next year.

US monetary policy has loosened dramatically… From Saudi Arabia’s perspective, the aggressive easing of monetary policy by the US has posed challenges. The US Federal Reserve has reduced its primary policy rate by 300 basis points (bps) since September 2007, most recently by 75 basis points in March. With the Saudi riyal pegged to the US dollar, SAMA has had to follow suit, reducing its reverse repo (deposit) rate at a time of surging liquidity in the Saudi economy. Though the transmission mechanism has been weakened by commercial banks’ abundant local liquidity, the necessary reduction in Saudi rates has been inopportune given rising domestic inflation, and has necessitated accompanying increases in bank reserve requirements.

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US Federal Funds Rate Chart 2 6

Basis points hundred

5

4

3

2

Feb-08

Jan-08

Mar-08

Oct-07

Dec-07

Sep-07

Nov-07

Jun-07 Jul-07

Aug-07

Feb-07

Apr-07 May-07

Mar-07

Jan-07

Dec-06

Oct-06 Nov-06

Jul-06

Aug-06 Sep-06

Apr-06

May-06 Jun-06

Feb-06

Jan-06

Mar-06

Dec-05

Oct-05

Sep-05

Nov-05

Jun-05 Jul-05

Aug-05

Feb-05

Apr-05 May-05

The outlook for US interest rates is likely to continue to weigh on the value of the dollar and this in turn will have implications for Saudi Arabia.

Mar-05

1

0

Source: Bloomberg

…and the stance is unlikely to tighten until 2009 The Federal Reserve seems unlikely to reverse its policy easing in the near term. Indeed, there may yet be further (modest) rate cuts, as the central bank attempts to restore liquidity and confidence in credit markets. However, participants are increasingly concerned about emerging inflation in the US, and the loosening bias is unlikely to be maintained into 2009.

The outlook for US interest rates is likely to continue to weigh on the value of the dollar and this in turn will have implications for Saudi Arabia: a weak dollar (and hence riyal) makes some imports more expensive (those not priced in dollars). A weak riyal also reduces the “send home” value of many expatriates’ wages, prompting some to demand higher riyal salaries as compensation. These influences add to domestic inflationary pressures. Chart 3

Saudi Arabia Import Price Index

Percent Change

12

7

2

-3

2001

2002

2003

2004

2005

2006

2007

2008

Source: Institute of International Finance

Global food prices have been soaring… As noted above, global commodity prices have been soaring. Saudi Arabia clearly benefits from elevated oil prices, but it suffers from higher imported food prices, with food and beverages accounting for 26 percent of its consumer price index. The Economist commodity-price index for March 17 records a 62.1 percent increase in global food prices in dollar terms compared to a year earlier. Much of this reflects the downward drift of the dollar, but even in euro terms the index for all items was 12.6 percent ahead (the euro index is not disaggregated).

6

April 2008

There are a number of factors at play here. As with oil, speculators have been bidding up food prices in an effort to offset the decline in prices of financial assets. Emerging markets have also been stockpiling food to hedge against future scarcity. In a related move, a number of large food producing countries have imposed export tariffs in a bid to ensure that their home markets are well supplied. Unusually volatile weather patterns in a number of producing countries, most notably Australia, have also contributed to higher prices. Perhaps the most important driver is the squeeze on arable land prompted by the switch to biofuel production in key food producing nations, such as the US and Brazil. Longer term factors include more diverse food demand from the world’s population, as more people become urbanized (for example, the UN forecasts that China’s urban population will increase by some 63 percent, or 320 million people, by 2030.)

…with direct implications for Saudi inflation The surge in global food prices has been directly registered in the Saudi consumer price index. The latest CPI shows that food prices rose by 13 percent in the twelve months to February (despite significant government subsidies). None of the factors listed above is likely to abate over the coming year, and further upward pressure on Saudi food prices appears inevitable.

2

Output, Investment and The Real Economy GDP and Inflation (percent change)

Real GDP (at 1999 prices) Hydrocarbon Non-hydrocarbon Nominal GDP (at current prices)

Saudi Arabia is in the midst of a broadly-based economic expansion. Much of the impetus is coming from the government; however, the private sector has also been energized by significant and sustained structural reform, which has given greater clarity to the investment climate.

CPI inflation (average) CPI inflation (end year) Memoranda: Nominal GDP (US$ bn) Nominal GDP per capita (US$)

2005

2006

2007

2008f

6.1 7.8 5.2

4.3 0.2 6.3

3.7 -1.5 6.1

6.7 7.0 6.5

23.6

12.6

7.7

23.5

0.7 0.7

2.3 3.9

4.0 6.5

8.0 6.6

309.9 12,988

349.1 14,218

376.2 14,888

464.5 17,864

f = Samba forecast. Sources: SAMA; Samba

The economy is booming Saudi Arabia is in the midst of a broadly-based economic expansion, which we expect to continue for the next two years at least. Leading growth sectors include oil and gas, utilities, manufacturing (including refined products and petrochemicals), mining, construction, transport & communications, and financial services. Much of the impetus is coming from the government, which is determined to boost hydrocarbons capacity and further improve the country’s infrastructure. However, the private sector has also

been energized by significant and sustained structural reform, which has given greater clarity to the investment climate. With inflows of foreign direct investment (FDI) also buoyant,

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April 2008

private demand is an increasingly important growth driver. All of this has been underpinned by the near-relentless rise in global oil prices, which breached $105/barrel in January 2008, and

We expect real GDP growth to gather pace this year, reaching 6.7 percent. This partly reflects the rebound in oil output, but real nonhydrocarbon growth, which better expresses the buoyancy of the private economy, is also set to show strong growth.

reached $110/b in mid-March, before cooling to around $105/b by the end of the month. With oil prices set to remain high and reforms likely to deepen, we expect real GDP growth to gather pace this year, reaching 6.7 percent, up from an estimated 3.7 percent in 2007. This partly reflects the rebound in oil output, but real nonhydrocarbon growth, which better expresses the buoyancy of the private economy, is also set to show strong growth of around 6.5 percent.

Chart 4

Real GDP 20

15

Percent Change

10

5

0

-5

2002

2003

2004

2005

2006

2007

2008

-10

Oil

Non Oil

Overall GDP

Sources: SAMA, Samba

Oil output is edging up… The oil sector remains the linchpin of the economy, providing the financial underpinning to investment spending and broader economic confidence. Real crude output contracted slightly in 2007, in line with the Kingdom’s OPEC commitments, but production is edging up again. Latest data from Middle East Economic Survey (MEES) show Saudi production at 9.2 million b/d in February, some 5.7 percent ahead of the 2007 average, and marginally ahead of the end-year figure. We expect production to edge up this year to around 9.25 million b/d, on average, some 6.3 percent ahead of last year.

…and hydrocarbons investment is robust Hydrocarbons growth will be supported by substantial ongoing investment in the sector over the medium term. Saudi Arabia plans to boost its capacity to supply the world with additional crude oil in order to meet still-firm global demand, and is working on expanding the capacity of a number of existing oilfields, as well as bringing untapped reserves of both oil and gas on stream (see Box 1).

8

April 2008

Box 1: Hydrocarbons Investment Saudi Arabia is the world’s largest producer of crude oil, and is the only country with significant spare production capacity (presently around 2 million b/d). To help meet the

expected increase in global demand, Saudi Aramco is in the midst of a major investment program to expand production and refining capacity, and expects to have production capacity of 12.5 million b/d in place by 2009 (from 11 million b/d in 2006). The gross increase in capacity will be 2.7 million b/d, but this will be partially offset by 1.2 million b/d in lost output from aging fields; currently, two-thirds of Saudi Aramco’s upstream capital expenditure goes towards maintaining existing levels of production, according to officials. Heavy crude is also being pursued more aggressively: by 2011 the offshore Manifa field could be producing as much as 0.9 million b/d of heavy crude, with further capacity additions likely from the Zuluf and Marjan fields. As well as exploiting existing fields more intensively, Aramco is utilizing more advanced techniques in order to exploit less accessible oil, for example by using steamflooding to dislodge heavy crude under the Gulf. Yet the search for additional crude is increasingly being overshadowed by the need to

find new gas deposits. Gas is the key feedstock for much of the Kingdom’s industrialization, and its scarcity is a potentially significant constraint on the kingdom’s economic growth. Demand from the power and petrochemicals sectors, as well as industry, is robust: dry gas demand is increasing at a rate of 6 percent a year and is expected to reach 590 million cm/d by 2030, from the current 155 million cm/d. Some industrial projects, including the Jubail II petrochemicals development, have experienced delays because of a shortage of feedstock. The economic rationale for many of the Kingdom’s Economic Cities rests in part on access to cheap gas. Saudi Aramco plans to raise gas reserves by more than 20 percent in the next five years and says it will drill 307 new development wells, including 67 exploratory wells, in its existing production areas between 2007 and 2011. Such is the demand that it is venturing into little-

The broad goal is to make the Kingdom the Gulf’s industrial hub, supported by a thriving services sector…The government is encouraging the private sector to take the lead on much of this industrialization push, and partnering with it in the provision of key infrastructure and services.

explored areas, such as the Red Sea and the Nafud basin in the north. Foreign firms are continuing to explore in the Rub al-Khali (Empty Quarter), though so far with little success.

Nonoil investment is also surging… Nonoil investment is also buoyant, and is likely to remain so over the medium term. The strength of global oil prices might be unsettling investors and consumers in the rest of the world, but in Saudi Arabia it has provided the government with ample financial resources to support the development of the nonoil economy while shoring up confidence in the private sector. The broad goal is to make the Kingdom the Gulf’s industrial hub, supported by a

thriving services sector. Mindful of the inefficient spending that marked previous periods of high oil prices, the government is encouraging the private sector to take the lead on much of this industrialization push, and partnering with it in the provision of key infrastructure and services. Investments to be implemented under Public-Private Partnership (PPP) terms in 2007-12 are expected to amount to at least $250 billion.

…underpinned by significant and sustained reforms Private investors have also benefited from significant progress on structural reform over the past five years, involving liberalization, greater transparency, and the reduction of red tape. This has bolstered private confidence to the extent that in real terms, private nonoil sector

9

O ff i ce of t h e C h i e f Eco n o m i s t

April 2008

growth has outpaced public nonoil growth for each of the past seven years. Moreover, the government’s appetite for reform has not been dimmed by the large gains in oil revenue, indicating that reform momentum can be sustained over the medium term.

Construction is also forging ahead in the designated Economic Cities, though soaring international raw materials prices, scare labour and a weak US dollar have led to cost overruns and project delays.

Large-scale private investment is most visible in manufacturing (including petrochemicals and oil refining), and real estate. Riyadh, in particular, is in the midst of a frenetic period of construction of private and commercial real estate in a bid to meet spiralling demand from new entrants to the Saudi market. Separately, construction is also forging ahead in the designated “Economic Cities” (see box). The main brake on growth is the rapid run-up in construction costs. Soaring international raw materials prices, scare labour (particularly engineers, architects and project managers), and a weak US dollar have led to cost overruns and project delays.

Box 2: Refining and Petrochemicals Projects Parallel to its oil capacity expansion efforts, Saudi Aramco is engaged in a significant expansion of its refining capacity as it bids to maximise the returns available from its reserves of heavy crude (the Kingdom’s current refining capacity is around 2.1 million b/d, or about 20 percent of crude capacity). However, as in virtually all of Saudi Arabia’s economic sectors, spiralling costs and shortages of labour are constraining progress. Two new refining plants that Saudi Aramco is planning to build with France’s Total (at

Jubail) and the US’s ConocoPhillips (at Yanbu) have each risen above $10 billion from initial estimates of around $6 billion. This reflects rising raw materials costs, scarce skilled labour, and a weakening US dollar, which has served to push up import costs, as well as the complexities of the two projects themselves. Total is understood to be committed to its project, though Conoco’s position is unclear. Final decisions on both projects are expected by the middle of 2008. The oil ministry is also seeking to develop a plant at Jizan, in the far southwest. There has been strong foreign interest in the scheme, though domestic investors have been less enthused. Foreign investors may have their eye on strategic access to the Saudi energy sector, rather than with the profit margins on refinery projects per se, which remain thin. One way of adding value to refinery projects is to combine them with petrochemicals plants. This is the template for what is potentially Saudi Arabia’s most ambitious industrial project, at Ras Tanura. With an estimated total cost of at least $22 billion, it would be one of the largest industrial projects ever undertaken, involving the upgrade of the existing 0.55 million b/d Ras Tanura refinery and the establishment of a grassroots petrochemicals plant, producing more than 30 different products. The project would be a joint venture between Saudi Aramco and the US’ Dow Chemical Company, though a final decision on Ras Tanura is still some way off. One major combined refinery and petrochemical complex is already nearing completion. By the end of this year the Petro-Rabigh complex is due to be commissioned. Construction costs at the plant, which spreads over eight square miles and involves 38,000 workers, have doubled to $10 billion because of materials and labour shortages. The complex is now 20 percent owned by the Saudi public, following its successful partial flotation in early February. Saudi Aramco and Japan’s Sumitomo Chemical each own 37.5 percent of the stock. Both Petro Rabigh and Ras Tanura are symbolic of Saudi Aramco’s efforts to develop a role in more complex petrochemicals production.

10

April 2008

Box 3: Economic Cities The public private partnership (PPP) model that characterizes the government’s approach to infrastructure development is central to the blueprint for the ongoing development of the Kingdom’s Economic Cities. There are seven cities planned: at Dammam on the Gulf coast; Hail in the centre of the country; Sudair, also in the centre; Tabouk in the extreme northwest; Knowledge Economic City (KEC) near Medina in the west of the country; King Abdullah Economic City (KAEC) at Rabigh on the Red Sea; and Jizan Economic City in the extreme south west. The authorities project that once established, the cities will collectively contribute $170 billion to GDP and provide 1.5 million jobs. The authorities view the cities as an important means of generating jobs in more remote areas of the country where unemployment rates are particularly high. These cities are based on the “clustering” concept, whereby firms in a particular sector are encouraged to congregate together to take advantage of natural resources, shared infrastructure, concentrated human capital, and other benefits. In the case of the Kingdom’s Economic Cities, the main advantage is low-cost energy. For example, a new aluminium smelter located in one of the cities should have access to feedstock at a price equivalent to only around 7 percent of overall costs. This compares to 17 percent in Germany and 38 percent in China. The KAEC, which is in the most advanced stage of development, appears well placed, enjoying close proximity to both Jeddah’s deep water port and the Petro-Rabigh integrated refining and petrochemicals complex, which will provide feedstock for KAEC’s industrial activities. Similarly, the site at Sudair is intersected by a planned north-south railway, while Saudi Aramco’s east-west oil pipeline will also run through the industrial area. However, some of the more geographically remote cities have so far struggled to attract substantial private sector interest (especially from Saudi firms).

Services growth is also strong Saudi Arabia’s accession to the WTO in 2005 has also spurred significant private investment in services. Investment banking has witnessed particularly pronounced growth, with the Capital Markets Authority (CMA) licensing around 80 new investment banks (many of which are joint ventures with foreign firms) over the past couple of years. Existing Saudi commercial banks are

Saudi Arabia’s accession to the WTO in 2005 has spurred significant private investment in services.

also ramping up investment as they seek to expand their retail activities. In addition, competition and new investment is marked in air travel, telecoms, and insurance. The latter has been bolstered by the passage of laws making certain types of insurance compulsory. Elsewhere, real estate services have recorded significant growth on the back of the ongoing construction boom.

Private consumption growth is picking up again… Data on private consumption are limited. SAMA data show that consumer lending grew by just 1 percent in 2007, following a slight contraction in 2006, possibly pointing to wariness among consumers following the 60 percent decline in share values in 2006 (150 percent of GDP from peak to trough), as well as rising inflation. However, using consumer lending as a proxy may be somewhat misleading since Saudi consumers have low levels of debt, and are able to finance consumption in other ways, while SAMA has placed restrictions on commercial banks’ lending to individuals.

11

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Going forward, private consumption should be supported by declining deposit rates (especially in real terms), increases in public sector salaries and other benefits, and the flourishing private sector. More generally, it seems that the “wealth effect” of the stock market crash on consumption was less pronounced than expected, reflecting the fact that most Saudis entered the market through underpriced IPOs.

…which should find its way into firmer import demand The expected pickup in private consumption growth will be expressed partly in additional real import demand. This is already strong, reflecting the substantial inputs of primary and intermediate goods required by an industrialization program of this size and scope. Real export growth will be determined largely by Saudi Arabia’s (and OPEC’s) judgement of global oil demand, along with the global petrochemicals market (which should remain tight). Given this, real exports should show moderate growth, but with import demand continuing to surge, the contribution from net exports will remain firmly negative.

3

Fiscal and External Positions

The near relentless rise in global oil prices has generated substantial and continuing surpluses in both the budget and the balance of payments. These surpluses are expected to grow further in 2008.

Central Government Budget, Developments and Outlook (SR billion)

The near relentless rise in global oil prices has generated substantial and continuing surpluses in both the budget and the balance of payments. These surpluses are expected to grow further in 2008.

2005a

2006a

2007a

2008b

2008c

Total revenue (% of GDP)

564 49

660 51

622 44

450 26

919 53

Total expenditure (% of GDP)

347 30

390 30

443 31

410 24

514 30

217 18

270 21

179 13

40 2

405 23

475 41

375 29

267 19

-

253 15

Balance (% of GDP) Memorandum: Gross domestic debt (% of GDP) a = actual; b = budget; c = Samba forecast.

Sources: SAMA; Ministry of Finance and National Economy; Samba.

The fiscal position is sound… We have covered the government’s 2007 fiscal performance in a previous report (January 5: Saudi Arabia’s 2008 Budget, 2007 Performance), but it is worth reflecting on the main parameters. In essence, the fiscal position remains extremely robust. Scope for discretionary spending has increased with the reduction of interest payments and the quality of spending has improved with much higher allocations for social sector programmes and capital spending.

12

April 2008

The government recorded a fiscal surplus of SR 179 billion ($48 billion) in 2007, equivalent to as much as 13 percent of GDP. Nonetheless, this was around one third lower than in 2006, mainly because of a 7 percent decline in oil income (as Saudi Arabia withheld more oil from global markets in line with its OPEC commitments). Also, spending growth accelerated to around 14 percent as capital investments were stepped up. As in previous years, the bulk of the surplus was used to pay down domestic debt (to around 19 percent of GDP) and augment official foreign assets. The authorities could have paid down more debt had they wished, but

have decided to maintain a certain level for liquidity management purposes. With large public sector deposits in the banking system, net domestic debt is heavily negative. Chart 5

Central Government Domestic Debt 100

Percentage of GDP

80

60

40

20

0

-20 2002

2003

Gross debt

Further gains in oil prices and higher oil production should generate an astonishing 48 percent gain in central government revenue opening the way to a record fiscal surplus this year.

2004

2005

Govt Deposits with Banking System

2006

2007

Net debt

Source: SAMA

…and another record surplus is in prospect for 2008 The 2008 budget indicated that current spending would tighten somewhat. However, growing concerns about the path of domestic inflation prompted the authorities to increase social spending in the early part of the year. With capital spending set to remain strong, we think overall spending will accelerate this year to about 16 percent. Despite this, further gains in oil prices and higher oil production should generate an astonishing 48 percent gain in central government revenue opening the way to a record fiscal surplus this year (23 percent of GDP). In addition to the central government surplus, the Public Pension Agency and the General

Organization for Social Insurance also have large cash surplus positions. However, these institutions have unfunded actuarial gaps, owing mainly to recent increases in the minimum pension and generous early retirement provisions. The authorities are aware of this underfunding and are reviewing the pension law to address long-term issues.

The external position is also robust Saudi Arabia’s external position remains robust and is expected to continue firming during 2008. The current account surplus stood at an impressive 20 percent of GDP in 2007, according to our estimates, despite an increase of more than one third in payments for imports (associated mainly with higher prices for raw materials and food). Also, export earnings growth was more subdued last year, at around 8 percent, as the further rise in global oil prices was partially offset by reduced crude output.

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O ff i ce of t h e C h i e f Eco n o m i s t

April 2008

The current account surplus is a measure of the increase in net foreign assets abroad, which takes the form of net outflows from the private sector, and the accumulation of official foreign

The current account surplus is a measure of the increase in net foreign assets abroad, which takes the form of net outflows from the private sector, and the accumulation of official foreign assets.

assets. The current account surplus remains large, despite the surge in domestic investment, because the absorptive capacity of the economy is limited relative to the scale of the oil windfall. The composition of foreign assets is discussed briefly below.

Current Account (US$ billion) 2005

2006

2007

2008f

Trade balance Exports Oil Non-oil Imports

126.9 181.5 162.4 19.0 -54.5

148.5 209.2 188.6 20.6 -60.7

143.5 225.5 201.8 23.7 -82.0

207.3 307.3 278.8 28.5 -100.0

Services (net)

-22.0

-36.4

-51.4

-64.2

Incomes (net)

0.0

-2.8

-1.3

0.8

Transfers (net)

-14.0

-14.6

-15.0

-15.8

Current account balance (% GDP)

91.0 29.3

94.8 27.1

75.8 20.1

128.1 27.6

f = Samba forecast. Source: SAMA; Samba.

Import demand from industrial users will remain brisk this year, while consumer demand should also continue its recovery. Nor is there likely to be any softening of raw materials costs. Nevertheless, export earnings should rebound forcefully this year, as the average price of crude surges once again, and as global petrochemicals demand continues to firm. This will push the trade surplus to a new record of some 45 percent of GDP. Chart 6

Export Revenue & Import Spending 360

310

US$ Billion

260

210

160

110 60

10 2002

2003

2004

Merchandise exports

2005

2006

2007

2008

Merchandise imports

Source: SAMA, Samba

The invisibles deficit is expected to continue widening, pulled by spiralling costs for professional services. Gulf-wide demand for the limited pool of project managers, engineers, architects and finance professionals is at an all time high, and salaries have been substantially inflated, particularly in Saudi Arabia. Outflows of expatriate remittances are also expected to remain firm, given buoyant economic conditions, keeping the transfers balance solidly in

14

April 2008

deficit. Profit repatriation by foreign firms operating in the kingdom is also gathering pace, reflecting both the booming economy and the substantial inflows of foreign direct investment witnessed in recent years. However, the income account will likely move into surplus this year, reflecting enhanced earnings from the country’s ever increasing (and increasingly diversified) stock of net foreign assets. In concert, these trends indicate that the country will record a

current account surplus of around $128 billion, or 28 percent of GDP in 2008.

FDI inflows are surging… Analysis of the capital account is hampered by incomplete data. Gross inward direct investment reached $18 billion in 2006, according to SAGIA data, and is likely to have grown in 2007 given the appetite of foreign firms for Saudi PPP initiatives. Outward FDI flows are not recorded, but are likely to be significant. There are no data on portfolio flows: foreigners are barred from direct investment in the Saudi stock market, but can enter the market through mutual funds. The long-mooted lifting of restrictions on foreign entry to the stock market would clearly stimulate significant portfolio inflows. Outward portfolio flows are certainly substantial, reflecting both the purchase of foreign equities by public sector entities and growing private investment in regional and global bourses. Egypt, Morocco and Jordan have been increasingly strong magnets for Saudi investors, and are expected to remain so.

…and the foreign asset position is robust Data for official foreign exchange reserves fail to capture the buoyant external position. SAMA data show that official foreign reserves, excluding gold, rose to $33.8 billion by the end of 2007, equivalent to only 2.7 months of imports of goods, services and incomes. But the country’s robust external position is reflected in SAMA’s holdings of net foreign assets. In 2007 these assets grew by 36 percent ($80 billion) to reach $301 billion (80 percent of GDP, or 20 months of import cover), and had reached $319 billion by January of this year. It is

noteworthy that SAMA’s accounting of its assets is at book value, and is therefore likely to understate the value of its portfolio. Holdings of foreign securities account for the bulk of SAMA’s foreign assets but (in common with other central banks) there is no breakdown by asset class. While an increasing proportion is probably held in emerging market securities, the bulk of SAMA’s assets is believed to be US dollar-denominated and fairly liquid. Private foreign asset holdings are even more difficult to gauge, either by size or asset class. Traditionally, individual Saudis have tended to favour euro- or sterling-denominated assets,

There has been a tightening of project finance conditions for much of the Gulf as the full impact of the global credit squeeze kicked in. Thus, an increase in Saudi project finance costs seems likely in 2008.

with a strong preference for real estate.

External debt has picked up, but remains low We estimate that total external debt increased to just over $65 billion at the end of 2007. Rapid economic growth means that external debt is equivalent to only 17 percent of GDP. Moreover, given SAMA’s buildup of foreign assets, net debt is heavily negative and diminishing. There is no central government external debt, and the rise in external debt has been driven largely by corporates raising finance for investment. Data to the end of the third quarter of 2007 show no deterioration in appetite for Saudi project finance deals: cross-border loans from BIS reporting banks grew by 16 percent between the second and third quarters, reaching $58 billion. However, since then there has been a tightening of project finance conditions for much of the Gulf, as the full impact of the global credit squeeze kicked in. Thus, an increase in Saudi project finance costs seems likely in 2008.

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O ff i ce of t h e C h i e f Eco n o m i s t

April 2008

4

Monetary Developments and Financial Markets

Chart 7

Money Supply and Domestic Credit 50

12 month percent change

45 40 35 30 25 20 15 10 5

Source: SAMA

M3

Dec-07

Sep-07

Jun-07

Mar-07

Dec-06

Sep-06

Jun-06

Dec-05

Mar-06

Sep-05

Jun-05

Mar-05

Dec-04

Sep-04

Jun-04

Dec-03

Mar-04

0

Private sector credit

M3 growth is brisk… Monetary aggregates have continued to expand at a rapid pace. Central bank data show that the broadest measure of money supply, M3, expanded by almost 24 percent in the twelve months to January 2008, a sharp pickup on the 19.6 percent registered in December. The driver has been the increased monetization of government oil revenue to finance higher fiscal spending. The banking system’s gross foreign assets have risen sharply, albeit erratically, reflecting higher government deposits, and a negative differential between riyal and dollar interbank deposit rates. …and private sector credit has picked up These developments have underpinned the rebound in private sector credit, which has undergone something of a roller-coaster ride over the past five years. The frenzied rush to invest in the stock market in 2004-05 saw private sector credit balloon, with the twelvemonth growth rate regularly exceeding 40 percent during this period. The tightening of personal lending criteria by SAMA in December 2005, allied to the sharp correction in the equity market a few months later, saw private sector credit growth plummet in the second half

Consistent with the riyal’s peg to the dollar (which remains a central tenet of policy) SAMA has been obliged to match the US Federal Reserve’s policy easing, which has seen the Federal Funds rate decline by 300 bps since September 2007.

of 2006 and into 2007. However, lending to the private sector (particularly firms) has since rebounded, growing by 26.6 percent in January 2008, up from 21.4 percent in December 2007. This was despite the central bank’s imposition of higher reserve requirements in November (from 7 percent to 9 percent) and again in January (to 10 percent). The reason these moves have had little impact on bank lending is that the Kingdom’s commercial banks are highly liquid. Average loan-deposit ratios of 78 percent indicate that banks are sitting on considerable surplus liquidity, which remained the case even after the reserve requirements were raised.

US interest rate policy is fuelling liquidity growth The situation has been further complicated by reductions in US interest rates. Consistent with

the riyal’s peg to the dollar (which remains a central tenet of policy) SAMA has been obliged to match the US Federal Reserve’s policy easing, which has seen the Federal Funds rate decline by 300 bps since September 2007. SAMA has left its repurchase rate, which guides lending rates in the Kingdom, untouched (at 5.5 percent). However, in order to ward off speculative inflows 16

April 2008

that would put upward pressure on the peg, SAMA has been forced to cut its reverse repo rate (the rate of interest that commercial banks receive on their deposits with SAMA), to 2.25 percent. With less incentive to hold money with SAMA, and in the context of a limited government debt market, banks have sought to find more profitable avenues for their funds, thereby stoking liquidity in the wider economy. Nevertheless, the impact of this has been less than it might have been, since lending opportunities are constrained by central bank limitations on the size and tenor of consumer loans, while credit to the corporate sector remains abundant. Disaggregation of the central bank data shows that commercial bank lending has been directed mainly towards firms, rather than households. Although lending to households for consumption has increased in nominal terms (albeit slightly), it has declined as a proportion of overall lending to around 32 percent at end-2007, from around 42 percent at end-2005 when lending for stock market investment was at its height, and central bank rules on personal lending for consumption had yet to be tightened.

The banking system remains sound In general terms, the banking system remains sound. It has withstood ripples from the global credit squeeze, and is in a strong position to confront any worsening of the global financial crisis that might occur. Exposure of Saudi banks to sub-prime debt or structured investment vehicles is thought to be modest, and capitalization is high at an average 21.9 percent. Moody’s Investors Service estimates non performing loans at 1.8 percent, and these are well provisioned. Though asset quality remains in principle vulnerable to a deterioration in oil prices, the robustness of the economy and the financial fundamentals leaves significant room for manoeuvre. More generally, risk management practices are deemed to be satisfactory and are improving in the lead up to the introduction of Basel II. Overall, the regulatory environment is one of the best in the region.

Profitability should improve as the impact of the stock market correction recedes and banks take advantage of a dynamic business environment Comprehensive 2007 figures have not yet been released, but it appears that average return on equity for the banking system held up well last year at about 25 percent, compared with

With the economy growing by almost a quarter in nominal terms this year, and bank assets accounting for less than 50 percent of GDP (compared with 90 percent in the UAE), there is enormous scope for banking sector growth.

over 30 percent in 2006 (nominal aggregate profits were down around 15 percent in 2007). Diminished profitability mainly reflects the impact of reduced stock market brokerage fees, as well as lower deposit rates in the interbank market. (Although the stock market correction occurred in 2006, trading volume held up reasonably well that year as investors exited the market, helping to support brokerage and advisory income.) Stock market income has also been impacted by the arrival of new brokerage companies. Nevertheless, a number of the leading Saudi banks reported an increase in fourth quarter profits as the stock market revived. The stock market’s performance in the first quarter of 2008 has been volatile, but the positive medium term outlook for corporate profitability suggests that banks’ income from the equity market should grow. Diminished brokerage income has led banks to refocus on core activities. As noted above, corporate lending, though highly competitive, is robust and is likely to remain so given the outlook for growth and investment. Retail lending has been constrained by specific curbs placed by SAMA on personal lending, and by uncertainties in the consumer sector stemming from the 2006 stock market crash and higher inflation. Yet with the economy growing by

almost a quarter in nominal terms this year, and bank assets accounting for less than 50 percent of GDP (compared with 90 percent in the UAE), there is enormous scope for growth.

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April 2008

Saudi banks have started segmenting their customer base, and are tailoring different products and services to each segment (e.g. premier banking for high net worth individuals, as well as youth, women’s, and expatriate services). Credit card lending is also being developed: though still tiny as a proportion of overall lending to the private sector, credit card lending grew by 21 percent in the fourth quarter of 2007.

The burgeoning demand for housing finance from an overwhelmingly young population, allied to the banks’ ability to take payments directly from salaries, gives strong growth potential for mortgage lending.

Mortgage market offers great potential One obvious area of untapped potential is mortgage provision. A long-awaited mortgage law is yet to be ratified (owing in part to collateral issues) but there are indications that a law will be passed some time in 2008. The burgeoning demand for housing finance from an overwhelmingly young population, allied to the banks’ ability to take payments directly from salaries, gives strong growth potential.

Islamic banking is also a key growth sector Saudi banks have already realized strong growth in Islamic banking business. Moody’s estimates that more than 80 percent of consumer lending in the Kingdom is now structured under Islamic terms. Demand for Islamic products in the Kingdom extends across the full gamut of financial services, including project finance, and should be a strong source of asset growth in the medium term.

Local banks are well placed to meet new competition The development of retail services and the strong growth in Islamic services have strengthened the franchises of the existing Saudi banks, notwithstanding the potential for increased competition from newly-arrived foreign institutions. Over the past couple of years, ten GCC and foreign banks have established operations in the Kingdom, including major global players such as Deutsche Bank and JP Morgan Chase. Consequently, competition is likely to increase, but will probably be concentrated in particular areas such as project finance, investment banking, and asset management. Global players will be able to utilise economies of scale when bidding for project finance deals, allowing them to provide longer term and cheaper finance. However, local Saudi banks should still retain a strong competitive advantage in the rapidly expanding domestic economy, particularly if the global credit crunch causes global banks to rein in non-core lending.

The stock market is emerging from a turbulent period… Many of the new entrants to the financial services sector are clearly focusing on brokerage and wealth management services attached to the Saudi stock market (the Tadawul). The market witnessed a rapid run-up in prices in the final quarter of last year, with the Tadawul All Share Index (TASI) gaining 41 percent on the back of further sharp gains in oil prices, strong corporate performances, and gradually improving consumer sentiment. Although still well down on the peak reached in early 2006 (20,000), the TASI had reached 11,800 by mid-January, a big improvement on the 7,000-8,000 floor that had defined most of 2006 and 2007. However, the shallowness of the market was highlighted again on January 19 when SABIC’s failure to beat analysts’ expectations about its fourth quarter performance triggered a 19 percent slide in the TASI over just three days. Fears about a possible US recession and its impact on global oil and petrochemical demand sparked further sell-offs in mid-February, though another rise in oil prices saw a slight rebound in early March. In late March the TASI was trading at 9,500, around 13 percent higher than a year earlier, but still some way below the mid-January high.

18

April 2008

Chart 8

TASI Monthly Perforamce, 2006-2008 19000

16000

13000

10000

7000

4000

Mar-08

Jan-08

Nov-07

Sep-07

Jul-07

May-07

Mar-07

Jan-07

nov-06

Sep-06

Jul-06

May-06

Mar-06

1000

Source: Samba

…but a strong IPO pipeline and solid demand suggests a recovery this year Notwithstanding the bourse’s gyrations, IPO supply and demand remain strong, and are likely to pick up this year. Saudi investors offered SR76 billion for IPOs in 2007, compared to SR43 billion in 2006. The prospects for 2008 remain good: the Zain Telecom IPO, which came in the midst of the early-year market turbulence, was 183 percent oversubscribed, and attracted subscriptions from almost a third of the population. Other planned or likely offerings include the petrochemicals project, PetroRabigh; mining group Maaden; Enmaa Bank; Saudi Arabian Airlines; and the Tadawul itself. With bank deposit rates low and declining, local interest in these IPOs is likely to be strong.

With the authorities firmly committed to maintaining the fixed peg to the US dollar, and in a context of free capital flows, monetary policy options to stem robust liquidity growth are extremely limited. The picture is further complicated by the continuing pickup in government spending.

5

Monetary Policy Challenges

Challenges are heightening Economic policy challenges have been heightened by the pickup in inflation, which reached 8.7 percent (year on year) in February. While not especially high in comparison to some of Saudi Arabia’s GCC peers, this level is well beyond historical norms and has generated considerable debate about appropriate policy responses. With the authorities firmly committed to

maintaining the fixed peg to the US dollar, and in a context of free capital flows, monetary policy options to stem robust liquidity growth are extremely limited. The picture is further complicated by the continuing pickup in government spending (projected at 16 percent this year) as the government continues to boost investment and raise public sector wages.

Inflationary pressures are mounting… Inflation has picked up markedly in the past two years, a phenomenon that is new to Saudi Arabia. Historically, the rate of domestic inflation has been kept low by an open trading system that has allowed much of the growth of domestic demand to be satisfied by imports while an abundant supply of expatriate workers helped to keep local wages within bounds.

19

O ff i ce of t h e C h i e f Eco n o m i s t

April 2008

Chart 9

Monthly Consumer Price Index 10 9

12 month percent change

8 7 6 5 4 3 2

Feb-08

Dec-07

Jan-08

Oct-07

Nov-07

Sep-07

Jul-07

Aug-07

Jun-07

Apr-07

May-07

Feb-07

Mar-07

Jan-07

Dec-06

Oct-06

Nov-06

Sep-06

Jul-06

Aug-06

Jun-06

Apr-06

May-06

Feb-06

Mar-06

Jan-06

1 0

Source: SAMA

A multiplicity of factors— domestic and external—has contributed to the increase in inflation.

Having been negative in the first five years of the decade, average consumer price inflation accelerated to 2.3 percent in 2006, and further to 4 percent in 2007. Monthly and quarterly changes have been even more pointedly upwards. Data for February (the latest available) show that 12-month CPI inflation reached a record 8.7 percent. Meanwhile, wholesale price inflation averaged 5.8 percent in the fourth quarter of 2007, up from 2.6 percent in the fourth quarter of 2006.

The pickup in inflation is attributable to a number of factors. ◆

First, the Saudi economy is booming. Investment has surged and has spread from the energy sector to a range of other sectors (such as real estate, transport, communications, trade, and financial services). This has generated substantial demand for increasingly scarce resources, such as labour and raw materials straining supply chains and pushing up prices.

◆

Second, and related to this, specific bottlenecks have emerged in key sectors— especially housing—with the influx of expatriate personnel. The supply of housing has also been constrained by shortages of certain building materials, such as steel. Strains in the housing market are confined to specific cities (most notably Riyadh), but the rental element of the consumer price index surged by 18 percent in the twelve months to February, and with a heavy weighting in the overall CPI, the impact on national inflation is marked.

◆

Third, shortages of skilled personnel have caused salaries to rise sharply in certain sectors. This is most notable in construction and finance, where a scarcity of skilled professionals—a Gulf-wide issue—is pronounced. These shortages raise costs and contribute to second-round effects as higher salaries feed through into increased consumption and asset prices. The situation has been exacerbated by the decline in the value of the riyal against some currencies (notably those of India and the Philippines) which has led to demands for higher salaries to offset the exchange rate loss.

◆

Fourth, global food prices have risen sharply. Prices of wheat have been forced up by the shift to biofuel production in some countries, restrictions placed by key producers on exports (in order to combat domestic shortages), and unusual global weather patterns.

20

April 2008

◆

Finally, in addition to the various supply factors noted above, demand conditions within the Saudi economy have remained robust given the rapid growth in liquidity and the policy priorities that have been pursued (as discussed further below).

…and the authorities’ policy options are constrained What can be done to stem this upward pressure on prices? To begin with it should be stressed that inflationary pressures are often a challenge for fast-growing emerging economies, where supply constraints are more pronounced than in mature economies. Moreover, in the current environment of rising global inflation the issue becomes even more pressing, especially for an open economy like Saudi Arabia where imports of goods and services account for as much as 35 percent of GDP. As noted earlier, escalating global food prices are a particular burden for

Whereas a seizing up of credit and liquidity conditions and the spectre of recession in the US have driven the Fed on a course of aggressive monetary easing, Saudi Arabia’s economic boom and inflationary pressures would ideally motivate a tightening of monetary conditions. Instead, however, SAMA has been obliged to cut deposit rates in line with the US.

Saudi Arabia given the heavy weighting of food in the CPI (more than a quarter).

In addition, the adherence to the fixed dollar peg has been a complicating factor in at least two ways. First, the weakness of the US dollar (which has recently touched its lowest point against major currencies since the breakdown of the Bretton Woods Agreement in 1971) has contributed directly to imported inflation. Second, the peg has precluded the use of monetary policy—commonly the first recourse of central banks—as a counter-inflationary tool. Whereas a seizing up of credit and liquidity conditions and the spectre of recession in the US have driven the Fed on a course of aggressive monetary easing, Saudi Arabia’s economic boom and inflationary pressures would ideally motivate a tightening of monetary conditions. Instead, however, SAMA has been obliged to cut deposit rates in line with the US. As an alternative, SAMA has increased reserve requirements for commercial banks. Yet this has had only a marginal impact on commercial banks’ activities since most banks are highly liquid. In the face of the constraints on monetary policy, another option would be to rely on fiscal restraint to subdue domestic demand. However, fiscal policy is also constrained in the current environment. Not only is the country’s development strategy based on a substantial increase in capital investment, particularly infrastructure (which will eventually help alleviate supply bottlenecks and pave the way to sustainable growth) but a retrenchment of current spending at a time of soaring oil revenues and domestic inflation would be socially unpopular and divisive. In the circumstances, the authorities have adopted a range of specific measures aimed at combating the impact of inflation on Saudis, including a hike in public sector wages—see Box 4.

Box 4: The Government’s Anti-Inflation Measures The government has recently instituted a number of measures aimed at reducing inflation or alleviating the inflationary burden on consumers. At end-March, import tariffs on wheat products were eliminated, while duties on food products such as frozen poultry, dairy goods, and vegetable oils were reduced to 5 percent from around 20 percent. Tariffs on building materials were also lowered. These measures followed an earlier package, introduced in late January, which included: (1) an annual 5 percent increase in public sector salaries for the next three years, and a 10 percent increase in social insurance benefits, (2) an increase in the government’s share of the cost of a range of fees and charges (including those for ports, passports, traffic licences, and residency permits, (3) a number of structural initiatives, aimed at increasing access to housing: for example, a National Housing Agency will be established; construction of

21

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April 2008

approved public housing projects will be expedited; and approval of the mortgage law will be fast-tracked, and (4) steps to promote market competition, including a review of the agencies system.

Some downward pressure on prices should be generated by the government’s decision to effectively reduce the price of some of its services, although their aggregate weighting in the overall CPI is relatively small. Similarly, the cuts in import tariffs should help to reduce the relative price of some foods, while giving a simultaneous fillip to the building industry. However, these initiatives have an associated fiscal cost, as do the increases in public sector wages. Though the wage award (at 5 percent) is below the prevailing rate of inflation and is modest compared with other pay awards in the Gulf, this measure will of course add to current spending, and thereby has the potential to raise inflationary pressures in the near term More encouraging are the measures to increase housing supply, and make the market more responsive to consumers’ needs. In this regard, the approval of the mortgage law would be particularly helpful in helping to broaden home ownership, and so ease some of the pressure on the rental market. Just as important is the effort to increase the housing stock by speeding up public housing construction, though delivery will be constrained by the availability of raw materials and labour. On balance, therefore, the impact of these measures on inflation is likely to be neutral, with the reduction of certain costs and efforts to improve the housing market broadly offsetting the impact of higher government spending on aggregate demand. Given this, and absent any adjustment to the exchange rate peg, inflationary pressures seem likely to continue.

SAMA has firmly ruled out a change in the pegging arrangement for the time being…

The Saudi authorities have been unwavering in their commitment to the dollar peg.

Given the unprecedented strength of Saudi Arabia’s external position and the sustained elevation of oil prices, there have been intermittent bouts of speculation in anticipation of a change in the exchange rate regime, either through a one-off revaluation, or by pegging to a basket of currencies. However, the authorities have been unwavering in their commitment to the peg. SAMA’s vice governor recently stated that the central bank was not “emotionally or politically committed to the dollar…it just happens to have been serving our economic interests and continues to do so.” Indeed, the dollar peg has served the country well for many years, shoring up private sector confidence in an environment of uncertainty and volatility associated with oil earnings. A stable exchange rate has given investors (both domestic and foreign) confidence when calculating expected returns and helped underpin price stability over a long period. The maintenance of the riyal’s dollar peg at its current value has been premised on the following points: ◆

A reconfiguration of the dollar-riyal peg could be destabilising to the global economy and would likely add to the woes of the dollar in the current uncertain environment.

◆

A change in Saudi Arabia’s exchange rate arrangement would likely prompt changes by others in the GCC and further complicate plans for the introduction of a single GCC currency in 2010.

22

April 2008

◆

Saudi Arabia’s external trade is overwhelmingly dollar-based, with oil exports and a sizeable share of imports priced in the US currency.

◆

There are concerns that a revaluation could compromise the Kingdom’s success in attracting foreign direct investment (a central goal of economic policy) since foreign investors appear to be comfortable with the stability that the peg affords.

◆

A revaluation is seen as a threat to the competitiveness and viability of the country’s non-oil export sector, the development of which has long been at the centre of Saudi economic policy.

◆

A revaluation would entail a deterioration in the riyal value of the country’s oil earnings, and official and private holdings of foreign assets.

◆

The authorities have laid emphasis on their assessment that inflationary pressures are being generated primarily by domestic bottlenecks that are largely unrelated to the exchange rate.

…but options will be kept under review Each of these points has been (and will continue to be) the subject of discussion and debate both within the GCC and more widely, as has the issue of adherence to the peg in a climate of global economic uncertainty and dollar weakness. Going forward, the issue is certain to remain under close scrutiny both at the official level and on the part of market participants.

Going forward, it will be opportune for the GCC countries to review their recent experiences and to consider the range of policy choices before them as they pursue ever closer economic integration. In particular, the opportunity cost of the loss of monetary policy independence at a time of rising inflation will deserve review.

If, as seems likely, the dollar’s descent gives way to a levelling off or even a partial recovery in its value, it will be opportune for the GCC countries to review their recent experiences and to consider the range of policy choices before them as they pursue ever closer economic integration. In particular, the opportunity cost of the loss of monetary policy independence at a time of rising inflation will deserve review. Some of the other considerations that have guided exchange rate policy in Saudi Arabia might also be revisited in light of the strength of the Kingdom’s external and fiscal positions, the prevalence of more flexible exchange rate regimes in other successful emerging markets, and the ongoing changes in the structure of Saudi Arabia’s external trade and financial flows.

6

Outlook and Risks

The economy’s fundamentals are strong Saudi Arabia’s economic prospects are excellent. Oil prices are high, and are likely to remain so; public and private investment is booming and is largely well conceived; private consumption is recovering and liberalization is continuing. As such, GDP growth is expected

to gather pace this year, reaching 6.7 percent in real terms. In 2009, base effects will mean that oil sector growth is less pronounced, but with private consumption continuing to firm, overall growth is expected to reach almost 6 percent. Inflationary pressures remain a concern, and are likely to continue increasing in the first half of 2008, before easing somewhat in the second half and into 2009.

Year-to-year movements in nonoil growth are revealing an encouraging degree of decoupling from the oil economy. Whereas five years ago, the ebb and flow of nonoil economic activity was closely linked to the rise and fall of global oil prices, the overall economic performance is now in a more stable and sustainable phase of private sector-led growth. This is partly because oil prices have been rising to ever higher thresholds, but it is

23

O ff i ce of t h e C h i e f Eco n o m i s t

April 2008

also because the government, through an extensive and ongoing programme of liberalisation, has encouraged the private sector to become the driver of investment.

Whereas five years ago, the ebb and flow of nonoil economic activity was closely linked to the rise and fall of global oil prices, overall economic performance is now in a more stable and sustainable phase of private sector-led growth.

Clearly, the link between economic dynamism and oil prices has not been completely severed: at the very least, high oil prices give private investors confidence that public spending on roads, bridges, ports and other infrastructure will be maintained. Yet we believe that the government

has created the fiscal space to maintain spending even if oil prices slip quite markedly.

Chart 10

Fiscal Revenue and Expenditure 1000 900 800

SR Billion

700 600 500 400 300 200 100 2002

2003

2004

Total Revenue

2005

2006

2007

2008

Total Expenditure

Source: SAMA, Ministry of Finance

The government has created the fiscal room for sustained growth… In contrast with previous oil booms, the government has been more measured in raising spending, thereby creating room to pay down domestic debt and build up foreign assets. This strategy has given the government greater fiscal flexibility and a substantial resource base to maintain spending in the face of potential future shocks, including a decline in oil prices. Moreover, prices would have to fall significantly before it would be necessary to draw down assets. Based on annual expenditure growth of 15 percent (slightly above the average for the preceding three years) we estimate that the price of Saudi crude would need to sink to $49/barrel to trigger a budget deficit in 2008. For 2009 the figure is $52/b. Even then, a drawdown in assets would not be necessary, since there is plenty of latent demand for government debt. As it is, we anticipate a fiscal surplus both this year and next, averaging around 23 percent of GDP. Mindful of SAMA’s liquidity management needs, the government is unlikely to reduce

its domestic debt much further, and the bulk of this surplus will be used to fortify the country’s foreign asset position. The oil sector will remain the central contributor to GDP, and its contribution is expected to rebound in 2008. We expect oil production to edge up this year to average around 9.25 million b/d, some 6.3 percent ahead of 2007. With investment in oil and gas capacity continuing to expand at a rapid pace, the contribution from the hydrocarbons sector is expected to rise by 7 percent. The contribution from oil and gas will be less marked in 2009 (reflecting the higher base) but is still forecast to increase by around 4 percent in real terms, as production responds to a further pickup in global demand.

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…and investment in a range of sectors will continue to gather pace Public and private investment in power generation, manufacturing, transport and communications, real estate and financial services is particularly pronounced, and is likely to gather pace as the construction of the Economic Cities moves forward. Though the cities are still in the formative stages, they will clearly be an important catalyst of construction in the years ahead. Consumption growth is likely to be more sedate, constrained by limits on consumer credit, and the possibility that wage adjustments will not be fully reflective of inflation. Nevertheless, public sector salaries should continue to trend upwards, and with low interest rates (and increasing competition in the banking sector) providing a supportive environment, private consumption growth should gain in strength, and support a flourishing of wholesale and retail trade. Real export growth will be boosted by the rebound in oil production, and by continued strong output of petrochemicals (SABIC is now one of the world’s leading petrochemicals producers.) However, real import demand driven by demand for capital goods, durables and food will remain brisk, and will act as a significant drag on overall economic growth in both years.

Balance of payments outlook is robust The balance of payments outlook is robust. We expect the export price of Saudi crude to

average $89/barrel this year, up from $68.5/b in 2007, a 30 percent increase. Prices are expected to soften slightly in the second quarter of this year owing to cyclical factors, and an easing of US demand. However, prices will be kept high by further strong growth in demand from East Asia and the MENA region, ongoing tightness in supply, global refining constraints, political uncertainties in some producing countries, and continued—albeit diminishing—speculation in commodities. These dynamics are unlikely to change fundamentally in 2009, and with US growth recovering, the average price of Saudi crude should climb to around $94/barrel. With oil output edging up, and petrochemicals earnings also growing, this should allow overall export earnings of around $307 billion this year, rising to $335 billion in 2009. Merchandise import demand will remain strong this year, growing by some 22 percent to just over $100 billion. Buoyant industrial demand will be the driver, though elevated global commodity prices will also play their part. The same dynamics will apply in 2009, when spending is expected to reach some $126 billion. Yet the gains in oil earnings will be such that the trade surplus is expected to reach 44 percent of GDP in 2008—a record. With oil price growth softening somewhat in 2009, and import spending remaining firm, the surplus will ease to a still-substantial 40 percent of GDP. The trade surplus will be only partially offset by higher invisibles outflows. The key components here will remain demand for professional services and remittances outflows,

The current account surplus will surge to 28 percent of GDP in 2008, from 20 percent of GDP in 2007.

both of which are expected to gather pace over the next two years. These trends indicate that the current account surplus will surge to 28 percent of GDP in 2008, from 20 percent of GDP in 2007. The surplus should fall back to a still-impressive 22 percent of GDP in 2009. Based on 2009 oil prices, and assuming incremental gains in oil production, the current account position would move into deficit by 2012; however, we would anticipate adjustments to public investment before it reached that point.

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FDI inflows will remain strong Meanwhile, gross inflows of foreign capital are set to increase. Inward foreign direct investment will continue to quicken as a variety of infrastructure and manufacturing projects take root. Debt inflows should also pick up: available data show that foreign banks’ appetite for Saudi risk appears to have held up reasonably well, given the global credit crunch, though the outlook remains uncertain. Meanwhile, domestic banks will continue to borrow abroad in order to diversify their sources of financing and to address asset-liability mismatches as their long-term lending increases. Consequently, total external debt is expected to rise from an estimated $65 billion at the end of 2007 to $74 billion at the end of 2008, reaching $86 billion by the end of 2009. Nevertheless, the country’s strong economic performance will keep the debt stock below 17 percent of GDP. In any event, we expect that the bulk of the country’s aggregate current account surplus (forecast to reach around $240 billion) will be used to increase the Kingdom’s holdings of foreign assets and the country will remain a net creditor.

But there are a number of challenges and risks to the Saudi economy The volatility of oil prices presents a perennial risk to economic performance; however the immediacy of this risk has receded as prices have climbed, and as the country’s foreign asset position has strengthened. Oil prices would have to fall precipitously (to around $50$60/barrel) to trigger any stress in either the fiscal or external positions. All reasonable supply and demand scenarios suggest that this is extremely unlikely. Financing Saudi Arabia’s industrialization programme should therefore present few difficulties.

We believe that the Saudi banking system and the economy more generally are well-equipped to meet potential challenges stemming from a further deterioration in global credit markets.

Economy is well-equipped to withstand any worsening of global credit crunch We believe that the Saudi banking system and the economy more generally are well-equipped to meet potential challenges stemming from a further deterioration in global credit markets. Saudi banks are well capitalized, and have large domestic asset bases. Their exposure to global credit markets—and in particular to dubious assets such as structured investment vehicles—is thought to be minimal. Equally, the authorities’ large foreign asset base is likely to be of extremely good quality. As noted above, a severe squeeze in OECD banks’ non-core lending might have some impact on Saudi project finance deals, but access to the Saudi market is highly prized by many international financial institutions, and credit flows seem likely to be maintained even if the price of this credit increases. Moreover, domestic finance is cheap and plentiful. In any event, we expect the global credit squeeze to begin to ease over the next few months, as the full impact of aggressive US policy easing begins to be felt, and confidence is restored. The outlook is supported by the US nonfinancial corporate sector, which remains in very good shape, indicating that any US economic slowdown is likely to be relatively short-lived.

Tackling unemployment will take time Unemployment continues to pose a challenge to the authorities. The latest official estimate puts joblessness among nationals at 12 percent, about a percentage point higher than previous estimates. Unemployment is significantly higher among young people – possibly as high as 25 percent for the 20-29 age group. In recent years, the government has invested heavily in vocational training for its citizens, and has nudged school curricula towards a greater focus on technical and scientific subjects in a bid to make Saudi nationals more suitable for private sector employment. These efforts, which 26

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have met resistance from the conservative establishment, should yield results in the long term. However, equipping Saudi nationals with more appropriate skills does not address the large difference in wage expectations between local and expatriate job seekers. Wage differentials vary greatly from sector to sector, but in general Saudis expect to earn around three times as much as their expatriate counterparts to do the same job.

The main risk to the positive outlook stems from inflationary pressures, which are likely to increase at least through the first half of this year.

Inflation is the most pressing issue The main risk to the outlook stems from inflationary pressures, which are likely to increase at least through the first half of this year. Maintenance of the dollar:riyal peg will require SAMA

to match further prospective cuts in US interest rates, while the weak dollar will keep upward pressure on the domestic prices of key imported goods. Meanwhile, the local housing market is expected to remain tight for the next two years at least. Nevertheless, the dollar should begin to show some recovery in the second half of 2008 which, in tandem with some easing of commodity price growth, will begin to reduce imported price pressures and might help to dampen wage demands. Taken together, these trends indicate that average consumer price inflation will rise to around 8 percent in 2008, with a year-end figure of about 6.5 percent. With some Fed tightening expected in 2009, import price growth and wage demands should continue to abate. However, with domestic demand buoyant and the local housing market remaining tight, average inflation in 2009 will remain high in historical terms at an average 6.4 percent (the year-end rate should be around 6 percent). Continued price pressures will keep attention focused on the issue of the dollar peg. From Saudi Arabia’s perspective, there may be a number of reasons for keeping the peg to the dollar intact. However, a serious downside, which will become even more compelling in the event of continued dollar weakness, is the loss of monetary policy independence and the risk that reliance on alternative measures like subsidies or price controls could further distort relative prices. By the same token, reliance on public sector pay increases can only be a stopgap rather than a cure for inflation owing to their potential to add to demand and price pressures. In short, keeping in lockstep with the dollar could lead to a situation where higher

rates of inflation are inevitable and inflationary expectations become entrenched.

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This publication is based on information generally available to the public from sources believed to be reliable and up to date at the time of publication. However, Samba is unable to accept any liability whatsoever for the accuracy or completeness of its contents or for the consequences of any reliance which may be placed upon the information it contains. Additionally, the information and opinions contained herein: 1. Are not intended to be a complete or comprehensive study or to provide advice and should not be treated as a substitute for specific advice and due diligence concerning individual situations; 2. Are not intended to constitute any solicitation to buy or sell any instrument or engage in any trading strategy; and/or 3. Are not intended to constitute a guarantee of future performance.

Samba Financial Group P.O. Box 833, Riyadh 11421 Saudi Arabia

Accordingly, no representation or warranty is made or implied, in fact or in law, including but not limited to the implied warranties of merchantability and fitness for a particular purpose notwithstanding the form (e.g., contract, negligence or otherwise), in which any legal or equitable action may be brought against Samba.