Saudi Arabia diversifying at home and increasing foreign links

For many decades Saudi Arabia has built its financial reserves with the proceeds of oil exports, while its increasingly affluent consumers have established the country as a significant importer of goods and services. However, lower oil prices have eroded the Kingdom’s healthy trade surplus, reminding countries around the world of the importance of having a diversified export base. Saudi Arabia’s newly formulated economic strategy aims to do just that, and targets an increase in foreign direct investment (FDI) inflows to accomplish some of its goals. The coming years are likely to see considerable alterations to both the investment environment and the mechanisms that govern trading activity, as authorities aim to translate the strategy to reality.

Trading Activity

With reserves totalling 266.5bn barrels, Saudi Arabia is the owner of 15.6% of the world’s total oil stocks, according to figures from the “BP Statistical Review of World Energy” report from June 2017. In November 2016 the Kingdom’s oil production was 10.7m barrels per day (bpd) and the US was pumping 8.6m bpd (see Energy chapter), placing the two countries among the top oil producers in the world.

However, while the US is also one of the biggest consumers of oil – accounting for 20% of global oil imports – Saudi Arabia’s smaller population allows it to export a much larger proportion of what it extracts, a capability that has allowed the country to operate a positive trade balance for decades. This performance has even been maintained during the recent period of subdued oil prices: in 2011 the Kingdom hit a trade balance high of SR874.2bn ($233bn), according to the General Authority for Statistics, and with international oil prices at record lows in 2016, it nevertheless managed a positive trade balance of SR162.8bn ($43.4bn).

The export of Saudi crude oil reflects the particularly large role foreign trade plays in the Kingdom’s economy, with merchandise trade as a proportion of GDP standing at 48.6% in 2016, according to the World Bank. The dominance of oil exports in the trade mix also accounts for the volatility of this data point: in 2014, for example, when average crude prices were considerably higher, foreign trade stood at 68.3% of GDP.

Oil Strategy

Despite this, Saudi Arabia has made concrete progress in broadening its export base in recent years, a process which started with investments in downstream activity related to oil, such as refining and manufacturing petrochemicals products. The bulk of this activity is overseen by Saudi Aramco, one of the most well-known companies in the Middle East – the planned flotation of 5% of the company’s shares on domestic and foreign stock exchanges was one of the principal talking points of the market in 2017. Saudi Aramco is the world’s single largest oil company, according to the US Energy Information Administration, managing the Kingdom’s production of a range of crude oils.

The current production strategy is focused on boosting output of the lighter grades and drilling at new fields to compensate for natural declines in maturing fields. The slowing, however, is minimal: the Ministry of Petroleum and Mineral Resources – now called the Ministry of Energy, Industry and Mineral Resources – has stated that oil fields in Saudi Arabia have decline rates of no more than 2% per year, and Saudi Aramco maintains that – unlike elsewhere in the region – its fields do not require enhanced oil recovery techniques.

More than 70% of Saudi crude is processed at Abqaiq, which is the world’s largest oil processing facility and crude stabilisation plant, with a capacity of more than 7m bpd. Saudi Arabia’s eight domestic refineries have a combined throughput capacity of approximately 2.5m bpd, and the country continues to invest in integration and capacity-building projects. These include joint ventures with international energy companies such as China’s Sinopec, ExxonMobil and Shell. The bulk of both crude exports and refined products are shipped to Asia. The Americas is the second-biggest importer region of Saudi crude, while Europe is the second-largest destination for the Kingdom’s refined products.

Beyond Oil

Saudi Arabia’s drive to diversify its economic base means that boosting non-oil exports has become a key priority for the government. In this effort, the nation starts from a low base. In its April 2016 report “Economic Diversification in Oil-Exporting Arab Countries”, the IMF’s export diversity index gives the Kingdom a similar score to that of Algeria, at 0.15 out of 1. Neighbouring UAE and Bahrain began their diversification efforts earlier, which was reflected in their scores of 0.45 and 0.5, respectively.

The task of moving away from a reliance on oil output is enshrined in Saudi Vision 2030, the blueprint for economic development, with specific shorter-term targets outlined in the National Transformation Programme (NTP) 2020. Announced in 2016, the NTP aims to increase the value of non-oil exports from SR185bn ($49.3bn) to SR330bn ($88bn) by 2020. This initiative will include increasing the number of exporters in the country from 1190 to 1500 in line with the broader aims of boosting manufacturing capacity and promoting strategically important markets.

Decreasing oil dependence is the joint task of a number of ministries. The Ministry of Economy and Planning is charged with upgrading the framework that governs the many processes associated with exporting, while the Ministry of Commerce and Industry (MCI) is to promote exporters and their products electronically, and establish an export processing zone to attract industries geared towards international sales.

The MCI is undertaking a range of other initiatives as well, such as automating export processes and training Saudi enterprises in export activity, including the development of e-learning. To date Saudi Arabia’s non-oil exports have been dominated by a small number of products. In FY 2016/17 plastic and rubber articles was the single largest export category, accounting for 36% of the total, according to the General Authority for Statistics. The second-largest category was chemicals products, which made up nearly 30% of the total. The remaining 40% was distributed across a range of sectors, all of which could be expanded by the government’s new strategy. These include base metals (8.3%), transport equipment and parts (7.9%), and machinery and electrical equipment (4.5%).

Import Substitution

One way of encouraging production across a wider array of activities is through promoting locally manufactured goods in the domestic market. The NTP adopts a policy of import substitution, with the aim of “reducing dependence on imports and creating job opportunities”. Currently, slightly more than one-third of products consumed in the Kingdom are domestically produced. The NTP strategy foresees this figure increasing to more than 50%, or SR270bn ($72bn) worth of goods, by 2020.

Ramping up manufacturing is a prime place to start in this effort, and the NTP has identified pharmaceuticals and renewable energy as two promising sectors where Saudi Arabia might be able to reduce imports. In the meantime, the Kingdom continues to import many of the products sought by its young and expanding population. Domestic appetite for sophisticated hardware means that machinery and electrical equipment was the largest category of imported goods in FY 2016/17, accounting for 21.9% of the total.

Similar levels of demand for personal transport, construction machinery and new modes of mass transit, meanwhile, have established the transport equipment and parts category as the second-largest group of imports, at 18.1%. This was followed by chemicals products (9.4%) and base metals (9.3%).

The bulk of Saudi Arabia’s imports come from non-Arab Asia, the source of 35.2% of the total in August 2017. The Kingdom’s second- and third-largest import regions are the EU and North America, supplying 23.5% and 15.2%, respectively. As of August 2017 Saudi Arabia’s top-five import partners were China, the US, the UAE, South Korea and Germany.

Trade Agreements

Saudi Arabia has a number of long-standing bilateral and multinational trade agreements that have helped to develop its trade portfolio. Building upon this framework is an important part of the Kingdom’s trade strategy, and therefore a continuous process. In March 2017, for example, Saudi Arabia inked an agreement with Indonesia to encourage bilateral trade and share trade database knowledge. However, many of the most important trading relationships between global firms and Saudi businesses come as a result of the Kingdom’s membership in the GCC. As such, the country benefits from the 2002 economic agreement signed between the Gulf nations, which is crucial to intra-regional trade, and the external agreements the GCC has made with other economic blocs and individual trade partners.

Bloc Deals

One of the most recent of these is the free trade agreement (FTA) between the GCC and Singapore, implemented in January 2015 after nearly a decade of negotiations. The new agreement removes tariffs from 93.9% of Singaporean goods imported into the GCC, with a further 2.7% to be removed in 2018. In return, all GCC imports into Singapore are granted zero-tariff status. Further FTAs in the pipeline include the final implementation of an agreement with the European Free Trade Association, comprising Norway, Ireland, Liechtenstein and Switzerland, which has been in discussions since the 1990s.

Negotiations to establish an FTA between Turkey and the GCC are also under way, while in May 2017 China called for a speeding up of discussions to conclude a similar arrangement. Australia and New Zealand are also possible candidates for a full FTA with the GCC, with both countries signalling a desire to rekindle former negotiation efforts in recent years.

Additionally, more trade interest has come from Malaysia, which indicated in 2015 that it hoped to resume talks with the GCC that began in 2011.

Talks for an EU-GCC agreement were also revived in 2017. Negotiations for an FTA between the two blocs first commenced in 1990; however, talks were halted in 2008 after the GCC member states withdrew due to disagreements regarding export tariffs and associated political demands being made by Brussels. In January 2017 the EU said it hoped to restart negotiations with the Kingdom on the FTA, and that there was mounting “political momentum” behind a deal.

Saudi Arabia’s membership in other multinational trade organisations grant it additional advantageous connections with global markets. Its position within the Greater Arab Free Trade Area, for example, provides it privileged access to markets in 17 states across the MENA region. The Kingdom has also been a member of the World Trade Organisation (WTO) since 2005, the joining of which signalled the starting point for the country’s gradual economic opening.

Improving Transport Infrastructure

Saudi Arabia’s ability to capitalise on its global connections depends in large part on growing its transport infrastructure. One of the strategic pillars of Saudi Vision 2030 is the transformation of the Kingdom’s “unique strategic location into a global hub connecting three continents”. According to the strategy, the government plans to work with the private sector, both domestic and international, to help it improve internal transport capacity and cross-border links.

The NTP has further refined this ambition, charging the Ministry of Transport with improving the sector’s infrastructure. This effort involves the speeding up of transport projects, which have historically been vulnerable to delays. The NTP aims to reduce the percentage of behind-schedule transport projects to 25% of the total by 2020, from a baseline of 60%.

While it intends to maintain control over 95% of road-building projects, the government has established a target of 50% private sector involvement in the development and operation of railways, and a 70% private sector target for port projects.

As well as accelerating the development of new infrastructure, the government intends to boost the efficiency of the existing network. An overhaul of the Saudi Ports Authority, a reduction in the average stay of containers at domestic ports, and an increase in scheduled rail trips between Dammam and Riyadh are all key elements of the plan.

The success of these measures will be judged over the coming years, but traders are already relatively well served by the existing transport infrastructure. The extensive road network expanded at a rate of more than 11% per year in the two decades leading up to 2011, according to Kuwait Financial Centre.

Going Places

The transport system is currently being augmented by a number of new intercity rail projects. In July 2017 the Saudi Railways Organisation conducted the first trial run of the new Haramain High Speed Rail, which connects Medina, King Abdullah Economic City, Jeddah and Makkah along the Red Sea coast. The train is to be connected to the capital via the Saudi Landbridge project, the detailed design for which was completed in May 2017. To be developed on a build-operate-transfer basis, the project will see 950 km of double track laid across the desert from the Port of Jeddah to Riyadh. From there, goods can either be shipped onwards to the Gulf city of Damman on the existing rail network, or further inland on the 2400-km North-South Line which, when completed, will allow goods to be moved as far north as the Jordanian border – where a new international link will be created.

Existing international gateways include Jeddah Islamic Port, the largest container port in the Kingdom with a capacity of 5m twenty-foot equivalent units per year, and the King Abdulaziz Port in Dammam, the nation’s principal facility on the east coast. Industrial and commercial ports at Yanbu and Jubail, and the facilities at Jizan, Dhiba and Ras Al Khair add further connectivity. Trade hubs for air freight, meanwhile, are located at four international airports, which are also the recipients of large-scale investment: in June 2017 the SR27bn ($7.2bn) expansion of King Abdulaziz International Airport in Jeddah was reported to be 88% complete, while Riyadh’s main airport, King Khalid International Airport, is currently undergoing a terminal expansion project (see Transport chapter).

Foreign Direct Investment

Growing infrastructure and trade links will also help attract additional FDI. Much of the private sector involvement the government hopes to attract in the coming years is expected to come from outside the country. The NTP aims to increase FDI inflows from a baseline figure of SR30bn ($8bn) to SR70bn ($18.7bn) by 2020. Meeting this objective will require building on the Kingdom’s existing strengths, which include being one of the most politically stable nations in the region; enjoying good diplomatic relations with countries with large pools of investor capital, such as the US; and having an economy that has garnered strong ratings from major credit agencies, even during an era of lower oil prices: “A-” from Standard & Poor’s, “A+” from Fitch and “A1” from Moody’s, as of late December 2017.

The Kingdom is the largest economy in the MENA region and the 20th-largest economy in the world, according to the World Bank. It is also home to one of the biggest consumer markets in the region. The more than 32m inhabitants in the Kingdom make it an attractive destination for some of the world’s largest consumer-targeted companies, including Pfizer, GlaxoSmithKline and GE Healthcare.

The US is Saudi Arabia’s largest source of FDI inflows, accounting for 13.7% of the total in 2015, according to the Arab Investment and Export Credit Guarantee Cooperation. Kuwait, supplying 9.9% of inflows, is the second-biggest origin of FDI, followed by France (9%), Japan (8.5%) and the UAE (7.4%). In terms of target sectors, contracts accounted for the largest share of FDI in 2015, at 20.9%, followed by the real estate sector (12.4%), the chemicals and oil industry (8.6%), and transport, storage and communications activity (7.2%).

Despite its many advantages, however, Saudi Arabia faces a considerable FDI challenge. According to the UN Conference on Trade and Development, FDI flows to the Kingdom peaked at $36.5bn in 2008 and have since shown a steady downward trend, falling to $7.5bn in 2016. Similarly, the number of greenfield investments undertaken by foreign investors in Saudi Arabia has been declining in recent years, from 146 in 2012 to 90 in 2016. A reduction in FDI flows was seen across emerging markets in the wake of the 2008 global financial crisis, and reversing this trend has become a main priority for the government.

As FDI inflows have been decreasing, FDI outflows have been trending upward in recent years, mainly due to investment activities taken by the Public Investment Fund. FDI outflows increased by 55% to $8.4bn in 2016.

Government Incentives

Since its accession to the WTO in 2005, the Kingdom has been increasingly open to foreign investment, and the Saudi Arabian General Investment Authority (SAGIA) is the government body charged with overseeing that function. Its Investment Centre acts as a contact point for investors seeking a licence to operate in the country, and as a facilitator in gaining the necessary permissions from ministries and state departments. SAGIA draws potential investors’ attention to incentives, including the right to own 100% of their Saudi business in a range of sectors, the availability of water, power and telecommunications utilities at competitive rates, and government-assisted project finance options, such as loans of up to 75% of project costs from the Saudi Industrial Development Fund.

The government has sought to create a level playing field for foreign investors by granting those projects that satisfy the Foreign Capital Investment Code the same privileges as domestic capital. This includes exemption from Customs duties on machinery and equipment, the ability of licensed companies to own property directly and the absence of a minimum capital requirement for limited liability companies. The Kingdom offers a favourable tax framework, which makes no claims on personal income and places a flat rate of 20% on the corporate profits of international investors.

If implemented successfully, the NTP will further add to Saudi Arabia’s attractiveness as an investment destination. Its 178 strategic objectives, to be undertaken by 24 different government bodies, offers a holistic reform agenda that will have an effect on almost every aspect of economic life in the Kingdom in the coming years. The government has already launched two legislative reforms that have substantially enhanced the nation’s investment framework: a new Companies Law has replaced a decades-old piece of legislation and made it both simpler and cheaper to start and operate a business in Saudi Arabia; and new corporate governance rules have brought the framework that governs the operations of the nation’s listed companies in line with international best practices (see analysis).

In The Ranks

The NTP establishes its own performance criteria, but for many observers, progress in trade and investment reform is best tracked with global indexes. In regards to trade, “The Global Enabling Trade Report 2016” by the World Economic Forum (WEF) ranked the Kingdom 67th out of 136 countries on its enabling trade index, down from 56th in 2014.

Despite incremental improvements in the domestic market, the rapid emergence of other economies – such as those of sub-Saharan Africa – means that further acceleration of reform efforts is required for the Kingdom to maintain its relative standing.

The country scored particularly well on transport infrastructure, with its road system ranked second behind the US for speed between major cities. However, market access and border administration remain the Kingdom’s weaker points. Only 27% of imports enter the country duty free, facing high border compliance costs and time-consuming procedures, while exports also see relatively high tariffs.

On the investment side, Saudi Arabia was ranked 92nd out of 190 nations in the World Bank’s 2018 “Doing Business” report, gaining two places from the previous year. The country’s biggest move came in the area of protecting minority investors, where it climbed 53 places. According to the World Bank, minority investor protection was strengthened by increasing shareholder rights and role in major decisions, clarifying ownership and control structures, requiring a higher level of corporate transparency and regulating the disclosure of transactions with interested parties. The Kingdom also performs well in categories including registering property (24th), dealing with construction permits (38th) and obtaining electricity (28th). However, there is room for improvement in the areas of resolving insolvency (168th), trading across borders (161st) and starting a business (135th).

Workforce

Foreign investors also report concerns regarding some aspects of the labour market, particularly the process of Saudiisation, which since 2005 has sought to establish a 75% Saudi workforce through quotas for national hiring in some industries. This in part led to the country being ranked 105th for labour in the WEF’s 2016 report. Another trend, that has arisen since the fall of international oil prices in late 2014, is delayed government payments to contractors. However, with the NTP in place, there has been a concerted effort to address this issue. In November 2016 the government made a payment of SR40bn ($10.7bn) to private contractors, covering approximately 25% of the total due from various government agencies. At that time the Council for Economic and Development Affairs pledged to pay down the amount owned to contractors.

In January 2017 this undertaking was reinforced by Mohammed Al Jadaan, the minister of finance, when he vowed that all private sector payments would henceforth be made within 60 days.

Outlook

Saudi Arabia’s historically important reform of its economy is well under way, and a number of challenges related to trade and investment are already being addressed. Over the next three years the legislative, regulatory and policy changes proposed by the NTP will have a notable effect on the investment climate and the ability of Saudi businesses to export their products to global markets.

Vision 2030 has placed trade and investment at the centre of the country’s development plan for the next decade, aiming to take advantage of the Kingdom’s strategic geographic location to increase FDI to 5.7% of GDP in little over 10 years. The Vision 2030 strategy also addresses the Kingdom’s future trading activity, establishing a goal of building on and creating new global ties, while also reinvigorating regional connections. The report reads, “We will seek to effectively link with other countries in the region through enhanced logistics services and new cross-border infrastructure projects, including land transport projects with Africa through Egypt. Logistical and trade exchanges will be streamlined, further cementing our pre-eminent position as a major trade hub.” The roadmap has been clearly laid out, the key now is implementation.