Will Saudi Arabia end its addiction to oil?

Optimism over the Saudi national vision is premature.

On 25 April, Saudi Arabia unveiled its national vision, a set of goals it wants to achieve by 2030. A central theme in the Vision 2030, a brainchild of the Deputy Crown Prince Mohammad bin Salman, is putting an end the country’s chronic reliance on oil. Some have lauded the announcement as the long-awaited push Saudi Arabia has always needed. Others called it a mere public relations exercise. On balance, caution must be the order of the day. Any claims that Saudi Arabia is already on track to end its “addiction to oil” in the next few years are premature for four reasons.

1. Announcing a national vision is not new in this region. In fact, Saudi Arabia is a late joiner. Bahrain, Kuwait, Oman, Qatar and the United Arab Emirates (ie all other Gulf countries) have all published their own national visions years ago. The publication did not ensure timely implementation or immunity from the decline in oil prices.

2. Vision 2030 is a set of long-term goals or targets, not a concrete plan of how to achieve them. A plan should be released in May/June under the title of National Transformation Plan after a few months’ delay. But to put it briefly: a vision is not a plan; and having a plan does not guarantee execution.

3. Execution of any plan is likely to prove difficult. There are signs of difficulty even this early in the process. Only days before the announcement of the vision, the Saudi water and electricity minister was fired following public outcry over higher utility tariffs. Public dissatisfaction could intensify as more difficult measures are rolled out.

4. One of the most headline-grabbing measures—the plan to replace oil revenues with the proceeds from a $2 trillion sovereign wealth fund—is unrealistic. Even if the fund reaches the required size and somehow manages to increase the share of its foreign investments to half from 5% currently (domestic holdings are mostly oil related), an optimistic return of 7% on overseas assets would generate only $70bn per year. This would not be enough to replace oil revenues and finance the expected budget deficits, which together totalled $216bn in 2015 for example. 

Overall, the attempt to transform Saudi Arabia’s economy away from its oil dependence is needed, and steps taken towards this are positive. But a viable plan is required to show how this ambitious target can be achieved. Even then, the actual implementation of the plan will be key.

The Saudi fiscal plan is more austere than Greece

The Saudi austerity plan is too stringent and, if implemented, could be damaging for growth.

The fall in oil prices has hit Saudi public finances. The government’s budget balance switched from a surplus of 6% of GDP (a measure of the size of the economy) in 2013 to a large deficit of 15% in 2015. At this level, the Saudi budget deficit is unsustainable.

In an interview with Bloomberg last week, the Saudi deputy crown prince, Mohammed bin Salman, and his team reiterated their plans to achieve a balanced budget by 2020. If this plan is implemented, Saudi Arabia will embark on an austerity programme more stringent that the one which had sent Greece into a depression. And it will be executed under more challenging economic conditions that the ones Greece had faced. The plan could prove more damaging than helpful for the Saudi economy. Therefore, it is unlikely to be strictly implemented.

What is the Saudi plan on the deficit?

- Mohammed bin Abdulmalik Al-Sheikh, a Minister of State, said during the Bloomberg interview that: [B]y 2020, our plan is that we will have a balanced budget.”

- This echoes what was said in an earlier interview with the Economist: “he [Mohamed bin Salman] plans to balance the budget in five years.”

How do they plan to balance the budget?

- Through raising $100bn of additional non-oil revenue by 2020. The new sources of revenue include the introduction of a value-added tax (VAT) and other fees and the removal of subsidies.

- Assuming no additional oil revenue (“We try to focus on the non-oil economy,” bin Salman said), and public spending that is fixed at 2015 levels, the additional $100bn of non-oil revenue should be enough to balance the books.

How large is this austerity programme?

- A move from a deficit of 15% of GDP to a balanced budget within five years is very large.

- Such programme would be more stringent than the austerity programme which had sent the Greek economy into a depression. Greece reduced its budget deficit from 15% of GDP in 2009 (similar to Saudi Arabia today) to a deficit of 4% five years later (Saudi Arabia plans 0%).

- It would also be more austere that the programme implemented by the Conservative-led government in the UK, where the budget deficit went from 13% of GDP in 2009 to 4% in 2014.

What is the likely economic impact of the Saudi austerity plan?

- Judging by the experiences of Greece and the UK, the plan is likely to be quite damaging for growth in Saudi Arabia.

- Moreover, the Saudis will be implementing their austerity measures under more difficult conditions than the ones either Greece or the UK had faced.

- While their governments were engaged in austerity, the central banks in both Greece (the Euro Area) and the UK reduced interest rates in an attempt to boost growth by stimulating lending and investments.

- Saudi Arabia does not have that luxury. Saudi interest rates are linked to the US because of the currency peg to the US dollar. Indeed, when the US raised interest rates in December, the Saudis swiftly followed.

- US interest rates are expected to rise over the medium term, which means that Saudi rates will also rise, increasing the cost of borrowing for households and businesses and inhibiting consumption and investment.

- The private sector is unlikely to step in to fill the hole left by the government. It will face increasing costs as subsidies are removed and VAT is implemented.

What is the way forward?

- Saudi Arabia needs to reduce its budget deficit. A deficit as large as 15% of GDP cannot be sustained beyond a few years.

- But the plan to balance the budget in five years is too ambitious and could be damaging for growth and counter-productive for debt sustainability. It is therefore unlikely to be strictly implemented.

- The optimal speed of fiscal consolidation is somewhere between the two extremes of doing nothing and doing too much too fast. Let’s leave identifying this speed to future work.

The McKinsey blueprint for Saudi Arabia

McKinsey makes sensible high-level recommendations but falls short on the implementation details.

A few weeks ago, the deputy crown prince of Saudi Arabia, Muhammad bin Salman, gave an interview to The Economist. The interview created headlines because it outlined the young prince’s ambition to transform the Saudi economy. Bin Salman’s vision was clearly influenced by a recently-published report from McKinsey, a management consulting firm. In fact, the prince, who is an avid reader of consultants’ reports, mentioned the McKinsey report during the interview. Understanding this report therefore sheds light on the advice Saudi policymakers are getting.

What is McKinsey saying? It says that Saudi Arabia can increase the income of its citizens by developing its non-oil sectors. Some of the discussion on the potential of certain sectors to grow is insightful, as in the case of the automotive industry. McKinsey argues that Saudi Arabia has the ingredients to develop this industry given the size of its domestic market, the growth in neighbouring countries and the lack of manufacturing hubs in the region. But in other cases, the imagined potential is unrealistic. For example, McKinsey claims that Saudi Arabia can increase the number of religious tourists five-fold to 50m by 2030 by sustaining all year round the number of pilgrims seen during the Hajj season. And I want to have Christmas every day, please.

That said, the overall case for the potential of the economy to grow is convincing. The question then is how to do it. Economies grow by either increasing the number of people working, or by making working people more productive. McKinsey suggests that the former can be achieved by encouraging more Saudis to participate in the labour market. The participation of women, in particular, is very low. Only 18% of working-age Saudi women participate in the workforce compared with 51% in Indonesia, 44% in Malaysia and 29% in Turkey. McKinsey also suggests that productivity can be boosted by allowing more competition (which would push firms to perform better in order to survive), reducing restrictions on foreign labour to move between jobs, and increasing the productivity of workers through education and training.

But this is where the report falls short. It is all good recommending increased competition in the product market or more flexibility for foreign workers, but the current state of affairs is in place because there are vested interests benefiting from it. Likewise, it is easy to recommend boosting productivity through education and training but Saudi Arabia already spends a quarter of its budget on education with meagre results. Saudi students underperform their international peers in standardised tests, and the university dropout rate is close to 50%.

I would have expected more practical recommendations from a firm like McKinsey given its global reach, its work across different sectors and its “micro-to-macro” approach to economics. I would have expected them to provide insights and lessons from success and failure stories where countries tried to overcome vested interests, increase competition or boost productivity through education and training. The insights on how to achieve these objective are unfortunately lacking in the report.

So overall, the report makes all the sensible high-level recommendations but falls short when it comes to practical implementation.

Why are markets negative about the Saudi budget?

Saudi Arabia may succeed in reducing its deficit, but it will probably experience anaemic growth in 2016.

The announcement of the Saudi budget on 28 December created a contradiction. On the one hand, the announced budget deficits, while large, were much smaller than expected. The Saudis’ preliminary estimates suggest a deficit of 367bn riyal in 2015, lower than the International Monetary Fund’s (IMF) forecast of 511bn riyal. Similarly, the Saudi budget points to a deficit of “only” 326bn riyal in 2016, compared with the IMF’s expectation of 468bn. On the other hand, the market reaction to the smaller deficit numbers was negative. The Saudi stock market fell sharply after the announcement. Why is there such a contrast between the positive deficit data and the negative market reaction? I believe two reasons are behind this.

First, markets fear that the large spending cuts will lead to slower growth in 2016. The budget slashes spending by 13.8% between 2015 and 2016. This is much larger than the IMF’s expectations of cuts around 5.7%. We can adjust the IMF’s forecast for Saudi growth in 2016 by taking into account the new, smaller spending figures. The result is growth of 1.4% in 2016 instead of 2.2% previously forecast—a significant deceleration from the 3.4% growth recorded in 2015.

Second, markets interpreted the news about subsidy cuts, which accompanied the budget, rather negatively. Saudi Arabia removed some of the subsidies on water, fuel and electricity, leading to significant price increases almost overnight. There is no question that the subsidy system is inefficient and wasteful. But markets might have interpreted the measures as an act of desperation in response to low oil prices. In addition, these measures are likely to lead to even lower growth, as the resulting price inflation will leave the population with less income to spend on other items.

Are markets concerns overstated? Concerns about the ability of Saudi Arabia to run large deficits or maintain the value of the currency are exaggerated: Saudi Arabia still possesses very large reserves at its disposal. But markets concerns about the impact of spending cuts on growth are legitimate. Saudi Arabia may succeed in reducing its deficit, but it will probably experience anaemic growth in 2016.

What does the Saudi budget say about oil prices in 2015?

Despite the tough rhetoric, Saudi Arabia may need to cut its oil production to avoid making a sizeable budget hole even bigger

Oil market observers have been keenly waiting for the 2015 Saudi budget announcement. The price of oil assumed for the budget was supposed to indicate the likelihood of an OPEC production cut this year—a higher price assumption suggesting a higher probability of a cut. But when the budget was announced, there was considerable disagreement about the oil price assumption used by the Saudis. Some thought it was in the range of $55 to $63; others believed it was $75; still others reckoned it was close to $80.

The reason behind the disparity is that the Saudis do not explicitly publish the oil price projection on which they base their budget. In fact, they are very terse when it comes to publishing their sources of expected revenue and how much of it comes from oil versus non-oil sources. Therefore different analysts use different assumptions about non-oil revenue, total oil production and exports to back out the assumed oil price.

This has not only led to a wide range of estimates for the oil price used in the budget, but also to contradicting hypotheses about what the Saudis and OPEC are likely to do next. The total revenue figure published by Saudi Arabia is in fact consistent with two contradictory scenarios.

1. The status quo. In which the current production and export levels are projected to continue into 2015. This requires a price of around $60 per barrel to get the total revenue figure announced by the Saudi government. 

2. An OPEC cut. In which Saudi Arabia cuts its production and exports by around 1m barrels per day as part of coordinated cuts by OPEC members. This gives an oil price of around $72 per barrel.

While both scenarios are consistent with the $190.7bn total revenue number announced in the budget, the first one may not be feasible under current market conditions. If the Saudis continue to pump oil at the existing rate, then the market will probably be significantly oversupplied in 2015. This would result in a further fall in oil prices from their current levels (which are already below $60), and the $60 price used in the status quo scenario may not be achievable. This would lead to an even higher deficit than the $38.6bn the budget assumes. On the other hand, the OPEC cut scenario and its price assumption seem more in line with the 2015 expected demand and non-OPEC production growth.

So for all their tough rhetoric against production cuts, the Saudis may end up reducing their  oil production to avoid making a sizeable budget hole even bigger.