Saudi Arabia: On The Road Of Reform

Will a boost in oil production help Saudi Arabia stick to its plans for economic diversification and fiscal reform?

When faced with an economic downturn, the world’s largest oil exporter has a safety valve—more of a spigot, really­—that can be opened to bring in a rush of revenue.

After suffering a historic recession in 2017 (-0.7% GDP growth) amid declining oil prices, Saudi Arabia simply raised production to boost revenues back toward their accustomed level. Along with sustained non-oil-sector growth and improved consumer spending, the adjustment is expected to push GDP growth above 2% in 2018-19; and recent indicators show that the economy is already recovering.

Meanwhile, Saudi Arabia announced an all-time high budget of $295 billion, raising public spending by 7% compared to last year.

“We are determined to go ahead with economic reform, achieving fiscal discipline, improving transparency and empowering the private sector,” King Salman said on national television.

The Middle East’s largest economy is undergoing unprecedented change as it modernizes and diversifies; and the rebound is fairly broad-based, as non-oil sectors chalked up 26% year-over-year growth. Economic diversification, fiscal reform and greater emphasis on private investment—the kingdom’s much-heralded Vision 2030 agenda—are the cocktail Crown Prince Mohammed bin Salman has ordered up to advance the country.

Longer term, the picture is more challenging. Maintaining focus on this complicated transformation is essential; yet Riyadh finds itself—or perhaps has placed itself—in a doubly difficult position, with its grinding war in Yemen and reports that it ordered the death of dissident journalist Jamal Khashoggi, eroding its support in Washington and elsewhere.

“The biggest impact of the recent incidents will not be political but economic,” says Stéphane Lacroix, Saudi expert and professor at Sciences Po in Paris. “To attract foreign investors one needs to project an image of stability, and scandals like these have the opposite effect. It destroys all of Mohammed Bin Salman’s efforts to change the country’s image.”

Following the Khashoggi case, King Salman ordered an unusual cabinet reshuffle. Foreign Affairs Minister Al Jubeir was sacked and replaced by 69-year-old Ibrahim Al Assaf, the kingdom’s minister of finance since 1996.

“Al Assaf is well known by foreign stakeholders who are used to dealing with him,” adds Lacroix. “His nomination is supposed to be a reassuring message to the West.” His ability to push for reform, however, is uncertain. Ibrahim Al Assaf was one of the several hundred high-profile Saudis placed under arrest in Riyadh’s Ritz Carlton under corruption allegations.

MBS, as the crown prince is known, has solid support from the Saudi banking sector, which is well regulated and remains liquid. The country is home to 28 banks, 12 local institutions and 16 branches of foreign banks, including J.P. Morgan Chase, BNP Paribas and Deutsche Bank. Nonperforming loans were a low 1.7 % in the first quarter of 2018, according to the Saudi Arabian Monetary Authority official site, although rising.

By November 2018, banking sector profits stood at $11.7 billion, an 8.1% year-over-year increase. Sector growth is largely driven by Islamic banks, which recorded a 12.3% year-on-year increase in earnings and a 6.4% rise in deposits in the first quarter of 2018.

“The banking sector looks set to benefit from the recovery in the oil prices and the potential emergence of the Saudi economy from recession,” Aljazira Capital, the investment arm of one of the kingdom’s four Islamic banks, said in a recent Saudi banking report. “The sector in the last couple years has faced multiple issues, like higher provision from credit losses, provisions on financial assets, slowdown in deposit growth [and] stagnant loan growth.” The sector’s major challenge, the report says, remains “muted loans growth, which potentially can recover once the economy steps out of recession.”

Austerity Bites

Saudi Arabia began to rethink its fundamentals in 2015, when it implemented fiscal adjustment reforms to cut public spending, create new sources of growth and reduce the state’s overall dependence on oil revenues.

In a country where virtually everything is state sponsored, austerity measures that included subsidy cuts in key utilities—water and electricity—represented a big change. As a result, disposable income has decreased for Saudi citizens while the cost of living has gone up, creating an affordability challenge. In 2017, the king had to reverse some of these measures, and reinstated civil-servant bonuses. But then in January 2018, the government introduced a 5% value-added tax on all goods and services—with a few exceptions, including financial services and public transportation.

Riyadh may want to wean itself off hydrocarbons, but the “safety valve” of oil production is essential to pulling the kingdom through the transition. The kingdom still holds a quarter of worldwide oil and gas reserves; oil accounts for 90% of its export earnings and 40% to 60% of GDP. After boosting production last year, Saudi Arabia’s output may have reached an all-time high of more than 11 million barrels per day in November, industry sources say.

Meanwhile, prices are picking up. After falling below $40 per barrel in 2015, crude oil sold at more than $80 in October 2018. The question is whether, in light of that turnaround, the state will maintain its focus on reform. “Going forward, more-favorable oil prices may weaken the drive to tackle public-sector compensation, which distorts labor market incentives in the country,” the World Bank suggests in its October Saudi Arabia report.

Riyadh remains committed to its Vision 2030, adopted in 2016, which focuses on developing new economic sectors and boosting private investment. By 2020, the kingdom plans to derive some $9 billion to $11 billion of non-oil state revenue from privatization. A large portion of these non-oil revenues is expected to come from public-private partnerships (PPPs). The idea is for private companies to build and operate infrastructure on state-owned land, eventually transferring the assets back to the state. Sectors targeted for PPPs include real estate, transport, renewable energy and new technologies like desalination.

PPPs were under discussion for years, but lack of a strong legal framework made concrete examples hard to find. Last July, Saudi authorities published a draft law enabling foreign investors contracting PPPs to benefit from legal exemptions, especially from real estate ownership and labor laws.

“The government is doing its part of the job. PPPs work very well in the real estate sector,” says Mohamed Badat, chief commercial officer at Bidaya Home Finance, a shariah-compliant mortgage provider—sponsored by the Saudi Public Investment Fund and the Islamic Corporation for the Development of the Private Sector—launched in 2015 to enable home ownership. His company claims to hold a 30% market share among mortgage providers; but he predicts 2019 will be an even bigger year, as the authorities are driving to boost Saudi home ownership to 52% by 2020, compared with 47% today. The government has introduced regulations encouraging the private sector to build houses and provide funding, mortgage solutions and ownership schemes.

“The Saudi government recognizes each family’s aspiration to own a home,” Badat says, “and the important role ownership plays in strengthening family security.”

Fiscal reforms and diversification strategies established when oil prices fell are starting to show positive results. It remains to be seen whether the state’s commitment will falter without the incentive of necessity.