Less than 10 years ago, Saudi Arabia required an oil price of just $24 a barrel to balance its budget. These days, the scale of its spending commitments calls for a price of around $84 a barrel to avoid going into the red.
With state spending the central driver of economic activity, the recent downward pressure on oil prices has exposed the Saudi economy’s vulnerability to a souring global environment, and raised questions about the viability of continued dependence on a single commodity – crude oil – that remains highly sensitive to economic conditions.
After Standard & Poor’s downgraded the US government’s credit ratings in early August, oil prices dropped nearly $10–15 a barrel. For Saudi Arabia, which pumps nearly 10 million barrels a day, the impact was immediate.
The Saudi government still boasts a range of economic superlatives: surging oil export revenues contributed to a positive budget balance of 6.7% last year, and real GDP growth is on course for 5.6% this year, according to forecasts from Saudi-based Jadwa Investment Bank. But the feel-good factor is palpably absent in Riyadh.
The Tadawul, the Saudi stock market, was the first to register the chill winds of the global economic turmoil during the summer. The index fell 6.5% in August, as concerns about the global economy pulled down share prices.
The major concern is that if global economic turmoil drags on in the large emerging economies, this would have a sharper impact on oil demand. “If oil prices were to fall below $60 a barrel, that would be a challenge for the kingdom because the last four years’ expansion in fiscal policy has pushed the price of oil needed to balance the budget higher than $70 a barrel,” says Said al-Shaikh, a senior economist and member of the Majlis al-Shura (Saudi Arabia’s consultative council).
With public spending set to rise by $51 billion in 2011, to $219 billion, the government has little room for manoeuvre if oil prices average below the $80–90 a barrel that they have since the S&P downgrade.
Despite the massive revenues at Saudi Arabia’s disposal, Jadwa Investment forecasts that it will show a fiscal deficit by 2014. According to SAMBA Group, the non-oil deficit grew from about 20% of non-oil GDP in 2002 to 67% in 2010 and could exceed 80% this year.
“The oil price has to be recognized as a risk in the sense that, as oil has been the motor of economic development over the last few years, it has taken Saudi Arabia to a much greater level of energy intensiveness,” says Jarmo Kotilaine, chief economist at Jeddah-based National Commercial Bank.
The fiscal system relies more heavily on oil than it used to and, consequently, on a higher break-even oil price. The Saudi system’s capacity to absorb oil price volatility is diminishing: “If the kingdom is at $84 a barrel to break even, then the margin of error is shrinking,” says Kotilaine.
But with anticipated revenues this year of $252 billion, yielding a likely budget surplus of 6.4% of GDP, predicts Jadwa, no one is ringing alarm bells just yet.
The Saudis’ calculation is that even if there is some volatility in prices, it will be limited in duration.
Moreover, the government can easily handle the fiscal effects through the substantial bank of reserves built up during the good times. Saudi fiscal policy is pursued on a counter-cyclical basis, running budget surpluses when times are good, to allow for deficit spending to keep the economy on a steady growth track when global demand for oil weakens.
The substantial rise in revenues is attested to by the Saudi Arabian Monetary Agency’s (SAMA) expansion of net foreign assets, which rose above $500 billion for the first time in July 2011. The pace of growth in SAMA net foreign assets has picked up this year, rising by $55 billion between January and July – the fastest growth on a six-month basis since December 2008.
If oil prices fall below $84 a barrel, the government could draw down its foreign assets to finance spending, as it did last in 2009.
There are other straws of comfort: the $84 a barrel price to balance the budget is based on oil production of 8.8 million barrels a day, but recent figures suggest output is averaging around one million b/d higher than that; Saudi oil production rose to close to an all-time high in June of 9.8 million b/d.
“Not only are oil prices at comfortable levels, but production is close to an all-time high,” says Paul Gamble, head of research at Jadwa Investment.
GROWTH
Saudi policymakers now want to speed up economic growth through increased public expenditure.
King Abdullah bin Abdul-Aziz issued a statement of intent in February and March, while much of the Arab world was buffeted by protests fanning out from Tunisia. Acutely conscious that social pressures could bring the fires home, Abdullah announced by royal decree two massive supplementary spending packages with a total value of SR500 billion ($133 billion), the largest component of which was SR250 billion towards public housing.
Some of the fiscal pain will be dissipated by the phasing of the housing spend over seven years. “Because of the scale and timeline of spending commitments made in the spring, the government still has a lot of fiscal discretion,” says Kotilaine.
The spending commitments – which included an additional two months of salary for government employees on top of a 15% pay rise – still represent a major drain on the public purse.
Around SR195 billion of the pledge will be spent this year, predicts Riyadh-based SAMBA Group, pushing total spending up to SR840 billion in 2011 – equivalent to 43% of GDP or more than a third higher than the previous year.
The danger is that a toxic mixture of rising government spending, slower increases in oil output and rising domestic crude consumption could put the country on a path to escalating long-term debt.
“It’s simply not viable to continue raising expenditure year after year, as once the commitments are made, it’s hard to pull back,” says al-Shaikh. “Oil prices could still fall back to $60–70 so it’s advisable for the government to be cautious about their spending in the medium to long term. Foreign reserves could still be depleted as they were in the 1980s and 1990s.”
Another key concern on the fiscal side is the rising domestic consumption of oil and gas, which is reducing the amount of oil available for export. Consumption is growing at about twice the rate of non-oil GDP growth.
“Government spending will continue to rise, and at the same time we’re seeing rapid growth in domestic oil consumption and little prospect of a significant increase in oil production. If you put these factors together, you are on a potentially worrying trajectory when it comes to break-even oil prices,” says Gamble.
The Saudi proclivity for spending also begs the question as to how effective these public-sector outlays will be in generating a better bang for their buck. The Saudis’ track record in this regard is not compelling.
“You have to ask how good the government is at meeting the goals that it sets itself. Since it is now looking at a more inclusive growth paradigm – addressing unemployment, job creation, the huge housing issue – this is becoming particularly important,” says Kotilaine.
Some of the expenditure’s effectiveness will be eroded by the inflationary impact of salary hikes. Many Saudis complain that the government is giving them more money, but they are getting less for it.
Inflation moved up slightly to 4.9% in July from 4.7% in June. Along with elevated housing cost inflation, food price rises could make it more difficult to stabilize inflation.
It is an issue that is close to the government’s heart. The authorities reportedly requested one major Saudi dairy company to forgo a SR1 rise in the price of milk this year, wary of the impact on the consumer.
DOLLAR PEG
The weakening US dollar is another source of external pressure on Saudi Arabia. The dollar’s slide is a source of vexation for an economy whose main export commodity is priced in dollars, and calls into question a monetary policy that firmly anchors the riyal to the dollar.
The policy has been framed to enable interest rate risk premiums over the dollar to be kept low and ensure investors have the confidence to commit long-term funds at attractive interest rates.
Though the S&P US credit downgrade is negative for the dollar and therefore the riyal too, it is unlikely to lead to a loosening of the exchange rate peg any time soon. The dollar peg continues to make sense as a source of stability and predictability in an environment of elevated uncertainty.
“If they were to depeg, it is not clear that it would do the country any good because any exchange rate basket would still be heavily dollar weighted. Depegging would add an element of exchange rate uncertainly that isn’t there at the moment,” says Gamble.
However, the US downgrade does challenge SAMA’s broader strategy of parking its savings in US Treasuries. Even if depegging is off the agenda, SAMA may be inclined to look again at its policy of keeping reserves in US fixed income securities, largely at the short end of the curve.
US government bonds constitute the bulk of SAMA’s net foreign assets. “Keeping these in US dollars and in Treasuries has been safe, but there is a problem in valuation over the long term. With the value of the dollar depreciating, the value of these assets will also depreciate,” says al-Shaikh.
With $200 billion at its disposal, SAMA has enough ammunition to protect the riyal. For the remaining $300 billion, al-Shaikh advises the government to think about diversifying away from the dollar and into other currencies – and countries.
“Future excess revenues should be invested in real assets, maybe in other countries than the US, just as the Abu Dhabi Investment Authority and the Kuwait Investment Authority have been doing,” he says.
Unlike Qatar and Abu Dhabi, Saudi Arabia does not have a formal sovereign wealth fund to invest across currencies and asset classes. But the advantages in terms of risk diversification and the protection of asset values, especially if the dollar weakens further, may ultimately make that a compelling proposition for Saudi policymakers.
Despite the choppy economic climate, there is no sense of panic in Riyadh. The kingdom’s fundamentals remain solid, and other positives have emerged to the fore this year, such as a pick-up in bank lending to the private sector, which rose by 1.5% in July, the second-fastest rate since the global financial crisis – lifting the year-on-year increase to nearly 9%.
But an economic policy that relies heavily on the state purse, which in turn depends overwhelmingly on the contribution of oil revenues, remains a fragile platform on which to base long-term growth.
As the kingdom’s young population expands, and domestic consumption of oil increases, Saudi strategists need to be making plans for future decades now.