Saudi Arabia: The Oil Malediction

8 months ago Alger Mag Editor 0

Saudi Arabia has relied on oil exports to generate growth throughout its contemporary history. With the petroleum sector accounting for 45 percent of its GDP, close to 80 percent of budget revenue, and 90 percent of export revenues, Saudi Arabia is a kingdom whose fate relies on the price of oil. The substantial drop in oil prices since June 2014 and the ensuing drop in revenues has placed the kingdom in a quandary.

In October 2016, Saudi Arabia’s $17.5 billion debt offering set an emerging market record, surpassing Argentina’s $16.5 billion offering earlier this year. The kingdom is expected to use the capital to curtail a historically high budget deficit – amounting to 15 percent of its GDP in 2015. The shock in oil prices has placed Saudi Arabia’s only major source of revenue in jeopardy. Now, economic diversification is required to avoid a crisis.

Starting in 2003, Saudi Arabia and other OPEC nations maintained strict control over oil supply, due to which oil prices almost quadrupled from $30 to $110 per barrel over the next decade. This translated into high revenues for the kingdom, making it the world’s 19th largest economy by 2014. During this time, it was able to channel these revenues into massive developmental programs that targeted healthcare, education, infrastructure and social welfare. The benefits reaped from the resulting growth were substantial. These included a reduction in infant mortality to a third of its previous level, a tertiary education level that rivals that of nations like Germany, and a degree of urbanization that is larger than some western nations – with 83 percent of Saudi citizens living in cities. The economic and social progress made by Saudi Arabia is imperiled as a result of the oil price drop.

Prior to the US Shale boom of 2011, the growth of world oil production mirrored that of Saudi Arabia’s production trend. This dominance changed as US oil production increased from nearly 5.6 million barrels per day in August 2011 to 9.1 million barrels by May 2016, which resulted in the US driving world oil production. Saudi refusal to reduce production resulted in a glut of oil supply in the world market, as demand has not been following the global supply trend, prices have halved since the second half of 2014. This new paradigm of oil prices raises three key issues that Saudi Arabia needs to address.

First, Saudi Arabia needs to reduce their reliance on oil and develop new sources of revenue. With global production being driven by the US and prices projected to stay low over the next few quarters (World Bank projects $55 per barrel in 2017), Saudi Arabian finances are struggling. A large budgetary deficit, reduction of government salaries, and lower public sector bonuses are just the tip of the iceberg in Saudi Arabia’s attempt at fiscal consolidation. The kingdom needs new sources of revenue, which it attempted to find through the most recent debt offering and the upcoming initial public offering of Saudi Aramco. In addition to these more obvious solutions, the development of the Saudi private sector and the increased dynamism of the Saudi economy could generate large revenue streams for the kingdom. From 2003–2013, the non-oil private sector outperformed the economy as a whole. Manufacturing, mining, tourism, retail trade, construction, and services are potentially profitable industries for the kingdom. The kingdom can increase foreign direct investment, and provide domestic funding for the development of enterprises. The establishment of a sovereign wealth fund is a good first step. The transition into diverse sources of revenue will provide the capital that Saudi Arabia needs to keep its economy afloat in the coming years.

Second, Saudi Arabia incurred high costs due to subsidies and large social programs. The conventional response for nations in the face of reduced income is to levy higher income and property taxes and to cut costly social programs. However, Saudi Arabia does not levy income tax on its citizens and offers large subsidies on most essential utilities – fuel subsidies by themselves have been estimated to cost the government more than $50 billion this year. Public sector salaries, bonuses, and jobs have already been cut, and are likely to be reduced further. Any decisions to levy additional taxes or cut subsidies would not be received well, but fiscal frugality needs to be prioritized in order to focus resources on productive assets.

Third, Saudi Arabia boasts a large and growing population between ages 15 and 30, but still has a low labor force participation rate – as low as 41 percent in recent years. During the kingdom’s years of glory, it created a large public sector that provided cushy jobs to a large number of graduates and provided snug pensions to all retirees. This comfortable living standard led to a low labor force participation rate, especially low among the working age youth who did not see a reason to find employment. Less than half of the Saudi working age population actually works, and a growing young population increases the jobs that would need to be created to absorb the influx of new labor force participants. The kingdom should provide greater incentives for young people to participate in the workforce and ensure that private and public sector jobs are available to them. The resulting rise in productivity and in collected government revenues would greatly boost the economy, having the dual benefits of creating additional sources of revenue and increasing wages.

These goals can be achieved with pragmatic state planning, along with the blessing of economic and political stability. In recognition of these challenges, it is equally important to acknowledge that Saudi Arabia is a vastly wealthy kingdom, possessing one of the world’s largest foreign exchange reserves. But in the short run, Saudi Arabia still relies too heavily on the price of oil. Negative effects of commodity reliance do not make for a new story, and will certainly not be an old story anytime soon. Saudi Arabia has the resources to transition its economy off of oil by creating new industries, cutting down on frivolous expenses, and encouraging greater labor force participation. In doing so the kingdom can transform into a truly modern economy and prevent the oncoming breakdown.

Citations:

http://www.bloomberg.com/news/articles/2016-10-19/saudi-arabia-poised-to-sell-record-17-5-billion-sovereign-bonds

http://www.worldbank.org/en/news/press-release/2016/10/20/world-bank-raises-2017-oil-price-forecast

(Image courtesy: thespeaker.co)

By: Mihir Baxi