Ibrahim Al Hunaishel

The Saudi economy has been on an upward growth trajectory in recent years, expanding by 2.7% in 2013 and 3.6% in 2014. This has been primarily driven by the non-oil sector, which has grown at a rate of at least 5% per year in the decade to 2014. For its part, the oil and gas sector also saw modest improvement in 2014, expanding by 0.8% year-on-year (y-o-y).

While the Kingdom entered the period of lower oil prices in the second half of 2014 with virtually no debt and plentiful foreign reserves, the government is conscious of the need to diversify the economy away from oil in order to secure its long-term prosperity.

The transformation into a knowledge economy envisaged by Saudi Arabia’s leadership will require investment in areas ranging from infrastructure to innovation, creating opportunities for foreign investors to participate in the process through the provision of hardware and expertise in fields as diverse as railway equipment and health care training. In many sectors this is already under way.

Growth

In its April 2015 “World Economic Outlook”, the IMF downgraded Saudi Arabia’s GDP growth forecast to 3% in 2015 – 1.5 percentage points lower than in its October 2014 projection – with growth expected to reach 2.7% in 2016. However, the fund attributed nearly half of this reduction to the country’s GDP rebasing exercise. The Central Department of Statistics & Information (CDSI) adjusted the base year for real GDP calculations from 1999 to 2010, which resulted in a jump in the oil sector’s contribution to GDP, from 21% to 43%, at the expense of other, better-performing sectors. The oil sector’s heavier weighting, coupled with weaker crude prices, resulted in the downward revision of the country’s outlook.

Jadwa Investment put its growth estimate at 3.3% for the year as of May 2015, driven primarily by non-oil sector growth, which could reach 4-4.5% y-o-y. Government spending, which is expected to see a 4% bump, according to John Sfakianakis, Middle East director at UK-based investment manager Ashmore Group, will also help fuel growth. Fahad Al Turki, Jadwa Investment’s chief economist and head of research, was slightly more bullish, predicting growth of 5.3% y-o-y in the non-oil sector.

Liquid Gold

Accounting for nearly half of the Kingdom’s output in real terms as of end-2014, the oil and gas industry is set to remain the largest sector of its economy for the foreseeable future. In a May 2015 report, Jadwa Investment predicted that the oil and gas sector would grow by 1.6% in 2015, virtually unchanged from 1.7% in 2014.

Oil production is projected to rise by 1% y-o-y to 9.8m barrels per day, as Saudi Arabia remains determined to preserve its global market share against a backdrop of lower oil prices, volatile suppliers like Libya and rising domestic consumption, which was up around 25% in 2014. On the gas side, additional output is set to come from the Hasbah and Arabiyah fields in the east of the country, and from the Shaybah field in the Empty Quarter, provided the projects come on-line as scheduled.

Spending Money

Total government spending will be equivalent to 42.8% of GDP in 2015, compared with an average of 31.9% over the last decade.

Budgeted investment spending was reduced by 35% to SR185bn ($49.3bn). While this was the first cut since 2002, investment spending remains 36% higher than in 2010. In response to scepticism that Saudi Arabia would be able to sustain its historically high levels of government spending given the fall in oil prices, Al Turki underscored the government’s track record of delivering on its spending promises. “We have seen repeatedly that the Saudi government’s words are backed by actions, such as when the late King Abdullah bin Abdulaziz Al Saud promised stimulus packages in 2009 and 2011, and yet previously the ratings agencies have been slow to act on these statements,” he told OBG.

According to Hamad Al Bazai, vice-minister of finance, the budget increases for 2015 should be read primarily as a signal of the government’s continuing commitment to improving the infrastructure and human development. “Money that has already been earmarked for major infrastructure spending, such as housing and transport projects, is secure,” Al Bazai told OBG. The planned levels of government spending should also be enough to sustain the momentum in Saudi equities and the private sector, according to Sfakianakis, who told OBG, “Few other countries could sustain spending at this level.”

Non-Oil Growth

Continued government expenditure, coupled with corporate lending and robust domestic consumption, should deliver non-oil private sector growth of around 5% in 2015, down from an average of 7.2% since 2010. A slight y-o-y uptick in the purchasing managers’ index, from 58.4 in the first quarter of 2014 to 58.8, reflects overall private sector confidence, while strong cement sales, which were up 14.2% y-o-y, suggest that the large construction sector has overcome the challenge posed by labour reforms in 2014. In the first half of 2015 consumer spending got a boost from the two-month salary bonus awarded to citizens upon the accession of King Salman bin Abdulaziz Al Saud. Meanwhile, in the financial sector, net credit issued increased by SR8bn ($2.1bn) in 2014 to SR133bn ($35.4bn), as firms sought to take advantage of low interest rates, according to data from the Saudi Arabian Monetary Agency (SAMA), the Kingdom’s central bank.

Fiscal Figures

The 2015 budget includes SR860bn ($229.2bn) in planned expenditures, an increase of just 0.6% over the previous year’s budget. However, real spending was much higher in 2014 – over budget by 29%, at SR1.1trn ($293.2bn). While this was largely in line with the Kingdom’s tendency to overspend, expenditure may be more restrained in 2015 given weaker oil prices. With government investment spending set to fall, the slight increase in the 2015 budget is a result of a hike in current spending, which rose 18% y-o-y to SR675bn ($179.9bn).

Subsidies & Energy Efficiency

A significant portion of the government’s current spending is absorbed by subsidies. However, rather than tackling subsidies directly, Sfakianakis told OBG that he expects the government will try to address issues like domestic energy consumption by promoting efficiency measures, such as through the construction of the Riyadh Metro. The prospect of subsidy reductions does seem unlikely, as an increase in petrol prices would adversely affect too many businesses for this to be an attractive policy. The government could consider raising electricity and water rates for commercial property in parallel with its energy efficiency programme.

The Kingdom has one of the highest per capita energy consumption rates in the world and the high level of domestic consumption represents a significant opportunity cost. In addition to highly subsidised utility prices for consumers, demand is being driven by a growing population – in 2014 the Kingdom had a total population of 30.77m and the population is forecast to reach 33m by 2020 – and the expansion of energy-intensive industries.

Financing the Deficit

Due primarily to lower oil prices, the government expects to post a fiscal deficit of approximately SR145bn ($38.6bn) in 2015 – its first since 2011. This figure assumes a 16.4% y-o-y drop in revenues. In order to finance the deficit, the government has the option of issuing debt or drawing on its considerable foreign reserves, which stood at SR2.68trn ($714.2bn) at end-2014.

Philipp Schonbrunn-Knappman, head of economic affairs at the German embassy in Riyadh, pointed out to OBG, “Many other countries would be envious of Saudi Arabia’s fiscal position.” The government took advantage of its solid credit profile, low debt levels of 1.6%, reserves equivalent to 97% of GDP and the current low interest rate environment by issuing new debt for the first time since 2007 in mid-July 2015 (see Capital Markets chapter). The issue will help to reduce the pressure on foreign reserves as the main deficit-financing tool. “The issuance of sovereign debt will also contribute to more prudent conduct of monetary policy by providing an additional and useful tool to manage domestic liquidity,” noted Jadwa Investment. In addition, debt issuance will also benefit the capital markets, as it will help to build a yield curve against which corporate bonds can be priced. However, this could see public debt rise to 9.6% of GDP, or SR244bn ($65bn), by the end of 2015.

Monetary Policy

As of mid-2015 SAMA’s key policy reverse repo rate remained unchanged at 0.25% for the sixth consecutive year, while the repo rate stood 175 basis points above the US federal funds rate. Money supply growth reached 11.9% in 2014, up slightly over the 10.9% recorded in 2013. With US interest rates expected to increase as early as the second half of 2015, Saudi Arabia will likely need to do some monetary tightening of its own due to the riyal’s peg to the dollar. However, SAMA will be looking to balance the need for an interest rate rise against the effect such a move would have on domestic credit growth – particularly at a time when lower oil prices may lead to an easing in economic growth.

Inflation

Muted global growth and falling import costs due to the stronger dollar have limited external inflationary pressures (as oil revenues are dollar-denominated), with the likely rise in interest rates in 2015 set to reinforce this trend. However, higher food and housing prices should continue to exert upward pressure, particularly given that food accounts for 22% of the Kingdom’s consumer price index.

Although the government has announced that it plans to introduce a tax on unused land in urban areas in a bid to accelerate the construction of housing, this is unlikely to reduce inflation in the housing market in the near to medium term. As such, Jadwa Investment put headline inflation at around 2.5% in 2015, sustained partly by continuing rises in residential rental costs, according to Sfakianakis.

Riyal World

While Saudi Arabia has the riyal pegged at 3.75 to the dollar, the currency climbed as high as 3.7605 in early 2015 – its highest level since January 2010, according to Reuters. This volatility has been attributed to falls in the Saudi stock market in the fourth quarter of 2014 and increased speculation due to the drop in oil prices. Meanwhile, the Saudi-led intervention in Yemen prompted a further spike in the dollar-riyal one-year forward rate in March 2015. However, industry analysts see little prospect of the peg being abandoned any time soon.

Al Turki told OBG, “In the past there have been moments when the government might have considered revaluing the currency, such as in the late 1990s, when the government’s reserves were low, or when inflation spiked in 2007, but doing so now would not make sense. Among the reasons for this is that abandoning the peg would devalue Saudi Arabia’s holdings of foreign sovereign bonds.”

Ratings

Saudi Arabia’s stability and strong fiscal position have earned the Kingdom a credit rating of “AA-” and “AA”, from the rating agencies Standard & Poor’s (S&P) and Fitch, respectively, while Moody’s has rated the Kingdom’s debt “Aa3”. However, in February 2015 S&P cut its outlook for the Kingdom to negative, warning that “given its high dependence on oil, Saudi Arabia’s currently very strong fiscal position could weaken owing to the oil price decline.”

Besides a sustained fall in oil prices, negative sentiment and a US interest rate hike, which could lead to a curtailing of credit to the Saudi private sector, represent the greatest risks to the economy. Jadwa Investment also warned that “the fluid regional political situation will continue to make foreign investors wary and may negatively affect the sales of companies that export to the region, increasing the risk of stock market and oil price volatility.” To take pressure off its foreign currency reserves, the Kingdom issued sovereign debt in July 2015 – the first time the country has done so since 2007.

Employment

According to CDSI data, the overall unemployment rate remained virtually unchanged at 11.7% throughout 2013 and 2014.

Among Saudi nationals, the unemployment rate for men fell from 6.1% in 2013 to 5.9% in 2014, while the rate for women declined from 33.2% to 32.8%.

However, overall youth unemployment increased slightly over the same period, from 28.4% to 28.6%.

“The government has an important role to play in getting Saudi youth more interested in working for the private sector in order for Saudiisation to succeed,” Osama Mansouri, advisor to the minister of economy and planning, told OBG, highlighting a key component of the government’s employment policy. However, according to Jeff Geiger, commercial officer at the US embassy in Riyadh, amongst Saudis returning from studying abroad there is a strong preference for taking jobs in the public sector, with many of these students favouring engineering-related subjects over law and medicine.

The planned transition to a knowledge economy should assist in this regard by helping to create better-paid private sector jobs in areas such as the legal profession. Even so, Mansouri expects Saudi Arabia will continue to need significant numbers of foreign workers for some time to come, although the share of skilled workers should increase.

Indeed, Omar Bahlaiwa, the secretary-general of the Committee for International Trade at the Council of Saudi Chambers and the former secretary-general of the Council of Saudi Chambers, told OBG that the Saudi Arabian government is sensitive to the need to manage Saudiisation carefully in order to avoid hurting the private sector.

Diversification

Economic diversification is another of the principal long-term economic challenges facing the country. According to Saudi Arabia’s 10th Development Plan, which runs from 2015-19, in order to move towards greater diversification, renewed emphasis will be placed on education and private sector development (see analysis).

“We have seen progress made in areas such as promoting efficiency in domestic energy consumption and the advancement of Saudiisation in the private sector, but diversification of government revenues is still lacking. However, we expect this will be addressed in due course as well,” Al Turki told OBG.

According to Schonbrunn-Knappman of the German embassy, the Colleges of Excellence Programme, under which foreign private companies are brought in to deliver vocational training courses that match up with the needs of the job market, is a good example of the government’s determination to improve the quality of technical and vocational training in the Kingdom as part of its broader economic diversification efforts (see Education & Training chapter).

The US embassy’s Geiger echoed this view, telling OBG that he sees the Kingdom making “great progress” in education, both within the country and through the King Abdullah Scholarship Programme, under which there are currently 85,000 students in the US alone. “In contrast to some other nationalities, the majority of Saudis who study in the US return home afterwards and bring skills with them,” he pointed out.

Entrepreneurship

Another important goal of the government’s diversification programme is fostering an entrepreneurial culture. “Saudi Arabia has a rich trading history running through its heritage,” John Mercer, advisor to the King Abdulaziz City for Science and Technology Badir Programme for Technology Incubators, told OBG. “But entrepreneurship in the 21st century – particularly in the field of technology – is very different to the kind of entrepreneurship that it takes to be a successful trader.”

Mercer argues that technology entrepreneurs require both technology and business skills that an MBA course alone will not teach them. In trying to create more entrepreneurs, Saudi Arabia faces the challenge of overcoming its strong public sector culture, which Mercer suggests has historically mitigated some of the incentives that would otherwise have encouraged entrepreneurship.

Added to this is a lack of local role models for budding entrepreneurs, although Mercer told OBG that this situation was gradually improving. “The consequence of this is that a lot of Saudi Arabian technology entrepreneurs tend to copy ideas from abroad rather than come up with their own ideas,” Mercer said. “The lack of market validation is an additional problem, as what we see is entrepreneurs developing products that are valid solutions to problems, but those problems are not significant enough for the solution to be commercially viable.”

Innovation

Conscious of the need to create a broader innovation ecosystem to support the development of entrepreneurs, in December 2014 the government launched Technovia, with the aim of furthering technology innovation and commercialisation capacity. Technovia will bring together Saudi Aramco, which will provide funding for projects, and some of the Saudi Arabia’s leading research institutions, such as the King Abdulaziz City for Science and Technology (KACST), the King Fahd University of Petroleum and Minerals, and the King Abdullah University of Science and Technology (KAUST).

David Dausch, technical director at RTI International and part of the Technovia alliance, told OBG that until recently, the necessary infrastructure was lacking to help innovators scale up their ideas. “For example, there was a lack of service providers who could help inventors manufacture prototypes of their products, which prevented their ideas from ever being commercialised,” Dausch explained. Mercer agreed, but was optimistic about this changing, pointing to the Badir Advanced Manufacturing Incubator and the support it can now offer in terms of industrial design, prototyping and production design. “The goal of the Kingdom’s research and development (R&D) sector should be to create collaborative research programmes with industry that highlight technical challenges and create intellectual property (IP) that is more industry-driven and can be commercialised. This way we can achieve the most tangible economic benefits from R&D investments,” said Halim Hamid Redhwi, CEO of Dhahran Techno Valley Company, part of the King Fahd University of Petroleum and Minerals and charged with a mandate to advance and commercialise the university’s IP.

SME

As elsewhere in the world, access to finance is a challenge facing many small and medium-sized enterprises (SMEs) in the Kingdom, as commercial banks prefer to lend to established companies with a track record of generating revenues and profits (see Banking chapter). To alleviate this problem, the Saudi Credit & Savings Bank operates with the stated aim of providing “interest-free loans for small enterprises, employers and emerging trades to encourage them to run their own businesses independently”. However, Mercer told OBG that obtaining such loans can still be a lengthy process, though steps are being taken to address this.

As for venture capital funds – a potential source of financing for the Kingdom’s SMEs – according to Mercer, while these funds invest heavily, this is mainly aimed at property and rarely extended to start-ups without much revenue. To bridge the funding gap, groups of angel investors are starting to emerge, though Mercer cautions that “there is still some way to go” before they attain the necessary scale.

TAQNIA

Working alongside the emerging angel investors is TAQNIA, a government organisation owned by the Public Investment Fund that invests in select local and international R&D projects that have the potential to further the country’s economic growth and self-reliance. As of mid-2015, TAQNIA was working to develop and implement a total of 29 business opportunities across the Kingdom, collaborating via joint ventures with international technology leaders as well as local industrial investors. “Materials science, renewables and water technologies are among the sectors in which we believe Saudi Arabia has a competitive advantage, and so these are the focus of our work,” Abdulelah Al Nemr, industry operations manager at TAQNIA, told OBG.

Meanwhile, through its investment arm, TAQNIA formed a partnership with Riyad Capital in early 2015 to launch the first venture capital fund in the Kingdom comprising both public and private investors. The fund, with initial capital of SR500m ($133.3m), will invest in SMEs in the ICT, advanced materials, and energy and sustainability sectors, both in Saudi Arabia and abroad. The fund managers plan to engage with local institutions like KACST and KAUST, in addition to working with international experts. The investment portfolio is expected to deliver sustainable financial returns, while at the same time supporting the transfer of foreign expertise to the Kingdom and accelerating commercialisation of Saudi innovations. According to Yousef Alyousefi, TAQNIA’s investment director, a prime example of the type of business TAQNIA is looking to invest in is companies that produce membranes for water desalination.

Efficiency Drive

Generous continuing support for innovative ventures from state bodies like TAQNIA is being balanced by a new focus on efficiency across all levels of government. Mansouri explained to OBG that after years of focusing purely on development, the government is now equally focused on promoting efficiency. “For example, if existing hospitals can be made to work more efficiently, then we will not need to build as many new ones. Similarly, improving road safety is another efficiency measure we are pursuing, as it reduces the pressure on other parts of the system caused by traffic accidents,” he explained. As part of its efforts to promote efficiency, Saudi Arabia has also engaged international partners like the World Bank. Productivity and labour practices, particularly in the state sector, are two areas with significant scope for further reform that could raise the Kingdom’s growth potential. However, it will be important for the government to adopt a coordinated approach to tackling these issues. “Labour reform must be carried out in tandem with the private sector,” Sfakianakis told OBG.

Transparency

The drive for greater efficiency could also lead to more transparency in government spending, particularly when it comes to off-budget expenses. Items such as foreign aid and loans, which totalled SR162.7bn ($43.4bn) between 1994 and 2012, could be scrutinised more closely in the future, particularly if oil prices remain low. As an indication of the government’s determination to drive improvements in this area, Al Bazai told OBG that a senior committee in the Royal Court now oversees the execution of government-funded projects, and that tighter auditing of government contractors is being applied. “Cost, time and quality are the three criteria against which the efficiency of government project execution is now being judged,” Al Bazai said.

A key initiative has been the rollout of e-government in public tendering. “E-government will make the system fairer and more efficient, as well as create an environment that is more attractive to foreign contractors,” Khalid Al Mehaisen, president of the National Anti-Corruption Commission, told OBG.

The deployment of e-government should also facilitate other processes for foreign investors coming to the Kingdom – for instance, by streamlining the visa application process and reducing the paperwork needed to open a business.

The National Anti-Corruption Commission, known by its Arabic acronym Nazaha, is also working to improve transparency and reduce financial and administrative corruption. Established by royal decree in 2011, Nazaha focuses on twin strategies of enforcement and prevention, acting as a channel for citizens to report violations and investigating current laws to close loopholes that facilitate abuses of power.

Women Workers

Change is also under way in terms of female participation in the workforce, which has climbed from 12% in 2009 to 17.6% in 2014. Some suggest that additional measures can be taken to accelerate this progress. “One important step to get more women into the workforce is to ensure easy access to appropriate transportation, to be able to go to work and back home easily and to move around whenever necessary,” Hoda Al Helaissi, a member of the Majlis Ash-Shura, told OBG. “We should also raise awareness among women about their rights. It is essential to introduce judiciary reforms to facilitate women’s issues in the courts.” There may be even greater scope for women to actively participate in the economy either as entrepreneurs or investors. “There are already more women than men graduating from the Kingdom’s universities, and many of these women have savings deposited in banks or invested in property. Getting these women to invest in new ventures can be a way of getting them to consider becoming entrepreneurs in their own right,” Mercer told OBG.

Meanwhile, new laws that would regularise the status of home-based businesses are being considered. This could create an added boost for female entrepreneurs. There are already a number of examples of successful home-based businesses run by women that have recently emerged, such as a handicraft cooperative in Qassim.

However, these types of enterprises would benefit from the additional support of non-governmental organisations that can provide professional guidance, such as marketing expertise.

Outlook

Underemployed women are just one element of Saudi Arabia’s untapped wealth in human capital that the government is determined to develop.

Investment in both education and innovation should eventually deliver a diversified economy, offering Saudi nationals greater employment opportunities in the private sector. In the meantime, the Kingdom’s strong fiscal position, buoyed by the potential for a new sovereign debt offering, should enable the government to maintain spending even in the face of lower oil prices, ensuring that the Middle East’s largest market retains its appeal to foreign investors. This is particularly important as the country opened its financial markets to qualified foreign investors.