The Changing Fortunes of Saudi Arabia
Nick Stadtmiller argues that Saudi Arabia's underlying social contract will soon need to be renegotiated. This is a chapter from the e-book 'The Future of the Middle East' co-produced by Global Policy and Arab Digest, and edited by Hugh Miles and Alastair Newton. Freely available chapters will be serialised here and collected into a final downloadable publication in the spring.
The oil tides of fortune are receding for Gulf Arab countries. The six oil-rich nations of the Gulf Cooperation Council (GCC) enjoyed large fiscal and current account surpluses as oil prices remained strong through the early years of the 21st century, allowing these countries to build massive reserves. After oil prices plummeted from lofty levels in 2014, those surpluses turned into deficits, forcing countries to tap the wealth accumulated during the boom years.
The years of Gulf sovereign wealth funds splashing cash on flashy international investments seem destined to taper off. Instead GCC countries will be more focused internally, developing economies that are less reliant on oil while trying to maintain the prosperity to which GCC citizens became accustomed during the oil boom years. This transformation will, in many cases, require a radical restructuring of the social underpinnings of the economies and change citizens’ economic relationships with the state. GCC countries will also require significant foreign investment, which will force these nations to modernise their economies and their legal underpinnings.
Saudi Arabia is perhaps the most useful illustration of the scale of changes set to take place. The Kingdom is the largest country in the GCC, accounting for roughly half of the bloc’s economic output and 60% of its population, and the most socially conservative. Falling oil prices strained Saudi public finances severely in 2015, and in response the Kingdom announced the following year a raft of measures to restructure the economy.
Long-time observers of the region will no doubt point out that these countries weathered multi-year slumps in oil prices through the 1980s and 90s and were able to muddle through with austerity measures. There was no grand effort to overhaul the economy, or risk societal disruption in the process. In short, the previous response to low oil prices was to batten down the hatches and wait out the storm. Three dynamics in place today make this approach insufficient for today’s challenges.
First, Saudi Arabia has a young and growing population. Nearly one-half of the Saudi population is under the age of 25, per UN Population Division estimates. The number of under-25s in Saudi Arabia, 14 million as of 2015, is over 70% higher than in 1985. The Saudi government must ensure its young citizens have economic opportunities to maintain social stability. There are simply too many youth in the Kingdom to absorb them into bloated government payrolls, especially when government finances are already strained.
In addition, Saudi oil consumption is rising at an alarming rate, reducing the amount left to be exported – and hence crimping foreign earnings. Between 2001 and 2015, Saudi Arabia’s domestic oil consumption grew by at a compound annual growth rate of 6% per annum, based on data from the BP Statistical Review of World Energy. For comparison, world oil consumption grew only 1.4% annually during that same time period, while consumption in OECD countries actually fell modestly. As a result, Saudi oil consumption as a share of domestic production rose to over 32% in 2015. Saudi Arabia consumed just one-sixth of its oil output during the 1980s and 90s, when previous oil price gluts occurred.
Finally, trends in the global energy market threaten the Kingdom’s previous dominance in this arena. New oil finds, most notably shale oil in the United States, are reducing demand for oil imports in the world’s largest economy and elsewhere. The growth of alternative and renewable energy sources, driven largely in response to climate change, will likely lessen the world’s dependence on petroleum-based energy sources in the coming years. All this casts doubt on the long-term reliability of Saudi Arabia’s revenue stream from oil exports, a point that applies to other GCC nations as well.
Saudi authorities realise the need to reform their economy and have announced plans to undertake changes in that direction, spearheaded by Deputy Crown Prince Mohammed bin Salman Al Saud, the current king’s son. The overarching strategy was laid out in Vision 2030, released in early 2016. More specific plans were released shortly thereafter in the National Transformation Plan, which includes quantitative targets to be met by 2020. Taken broadly, these two documents provide a roadmap for lessening the nation’s dependence on oil, growing the private sector, and improving government efficiency whilst maintaining fiscal discipline.
Saudi authorities need to cut wasteful spending and find alternative revenue sources in order to place government finances on a sustainable footing. On the revenue side, the Saudi budget is extremely dependent on oil. In the latter years of the oil boom, between 2012 and 2014, oil revenue accounted for approximately 90% of government revenues. Those revenues have fallen in line with the drop in oil prices. Total government revenues in 2016 were just 40% of their 2012 level, underscoring the volatility of a commodity-dependent income stream.
The government has planned two main sources of additional non-oil revenue for the coming years – a value-added tax (VAT) and increased levies on expatriates in the Kingdom. A 5% VAT is slated to be phased in from 2018, in line with other Gulf countries. Additional fees for sponsoring expatriate labour will arrive in stages over the coming years, reaching up to SAR 9,600 (USD 2,560) per worker, per annum in 2020, with further fees for non-working expatriate dependents. These fees will be especially burdensome on businesses dependent on large numbers of low-wage, low-skilled workers, whose annual take-home salaries are not far away from the proposed fee increases. Authorities pledged not to implement income taxes on citizens or roll out broad-based corporate taxes in the future, so they appear limited to additional taxes on consumption and expatriates if further revenue is required.
Years of bumper revenues during the last oil boom allowed the government to splurge on benefits for its citizens. Saudi citizens currently pay some of the cheapest prices in the world for petrol thanks to government subsidies. Utility bills are also heavily subsidised. This has benefitted not only households but also businesses in energy-intensive manufacturing, which have used cheap energy rather than efficiency to drive profitability. Authorities reckoned these benefits cost the government SAR 300bn (USD 80bn) in 2015.
As part of its Fiscal Balance Programme, the government aims to cut most energy subsidies and bring prices to international market levels by 2020. Cash grants to low-income households will help citizens most affected by the subsequent price rise. For businesses, the government has promised to support industries in the transition to market-based costs through various funding schemes and capacity-building efforts to promote efficiency. However, it seems dubious to expect companies that benefitted from decades of subsidies to become internationally competitive in just a few short years.
Another important area of expenditure overhaul concerns the government wage bill. For years, many Saudi citizens entered the government payrolls in jobs of questionable economic value to the country. Over 15% of all working Saudi citizens were employed in public administration or defence in 2016 – more than 1.8 million people. Public-sector work is also lucrative. A 2015 report by the McKinsey Global Institute estimates that the average wage of a Saudi citizen in the public sector is two-thirds higher than their private-sector counterpart.
Government payrolls were once considered sacred, a practice through which the government shared the oil wealth with its citizens and promoted political stability. The intense pressure on public finances from plunging oil prices in 2014 forced authorities to reconsider this notion. In 2016, a royal decree announced cuts to the salaries of ministers and other high-level officials, as well as scrapping bonuses and other perks for government employees. The National Transformation Plan envisages reducing salaries and wages from 45% of the budget to 40% by 2020, and a slight reduction in the overall nominal wage bill.
All these changes will hit many Saudi nationals hard. Companies face increased labour costs and a rising cost base for energy-intensive industries. Furthermore, with spending on public projects under increased scrutiny, previously lucrative government contracts may no longer be counted on to maintain profitability. Households will see costs rise through the rollback of subsidies and new taxes – even if these are partially offset by targeted cash payments to low-income households. Meanwhile citizens dependent on public-sector salaries will see incomes remain stagnant at best. The hardship to be faced by businesses and individuals may breed enough discontent to make the population restive and resist further changes to the status quo.
It should be clear that the government is not imposing such drastic fiscal tightening simply to attain some ideal of modern economic orthodoxy. Instead the changes were forced on the country as the result of years of profligate government spending followed by a sudden reversal in global oil prices. The Saudi government ran a fiscal deficit of nearly 16% of GDP in 2015, forcing authorities to deplete reserves at an alarming rate. Reforms that could have been rolled in over a decade if implemented during the boom years will now be implemented in less than half that time. There is nothing unique about a government postponing difficult reforms during good times, but that will do little to assuage citizens who must now swallow the bitter pill of austerity.
While the Saudi economy faces a difficult few years ahead, the greater challenge to the society will be to create new economic opportunities to replace the traditional sources of wealth – oil and government. In short, that means improving economic productivity.
Two important reforms could improve the Saudi labour force’s economic potential: increasing the participation of women and educational reform. The labour force participation rate of women in Saudi Arabia is just 20% according to the World Bank, whereas the average for OECD nations is over 50%. Saudi authorities have set a goal to increase the share of women in the labour force to 28% by 2020.
Getting more women into the workforce might appear low-hanging fruit if not for Saudi Arabia’s extremely conservative society. This is a nation where gender segregation is strictly enforced, and non-related men and women are forbidden from mixing in public – creating awkward arrangements where the two sexes are placed in separated workspaces. Women cannot drive in the Kingdom, creating logistical problems over how they would get to and from work. Furthermore, women remain dependent on male-relative guardians, who wield wide authority over them. Families will have to overcome deeply ingrained biases against women working in order for this transition to occur. One thing is certain; bringing more women into the workforce will entail social change as much as economic. Once more women gain economic independence through employment, it is doubtful they will settle for their traditional social position in Saudi society.
Saudi Arabia’s education system needs reform to ensure that young citizens have the right skill sets to enter the private sector in economically meaningful roles. The current system places strong emphasis on religious studies and Arabic, to the detriment of instruction in English, mathematics, and the sciences. Critical-thinking skills are lacking in the curriculum, in favour of rote memorisation. Global benchmarks of standardised test scores show Saudi students far behind their peers in other countries at similar levels of development. As long-time Gulf observer Theodore Karasik opined, ‘The education system is stagnating, producing graduates who do not meet international standards of excellence… But it may take a generation at the very least to rectify the situation.’
Any efforts towards education reform will need to overcome opposition from religious and social traditionalists who will object to the resulting changes in young people’s worldview under a new system. The government has set targets to improve standardised test scores in Saudi schools, but no comprehensive strategy to improve the system has been discussed publicly. Furthermore, even if the education system miraculously reformed overnight, it would take decades for these improvements to feed into economic performance, considering the lag between early education and entry into the workforce.
Saudi authorities have set a goal of creating 1.2 million private-sector jobs for citizens by 2020. This effort runs in parallel with other attempts to boost the non-oil private portion of economic output, which accounted for just half of 2016 GDP. Inevitably entrepreneurship will play a role in creating many of these jobs. While the government is planning initiatives to support small- and medium-sized enterprises (SMEs), the current operating environment is not conducive to this economic activity. Saudi Arabia ranked 94th globally in the World Bank’s 2017 Doing Business survey. For starting a business, the Kingdom ranked 147th; in trading across borders, 158th; and in enforcing contracts, 105th. Clearly much needs to be done on legal and institutional reform to incentivise entrepreneurship.
Another adjustment impacting the Saudi economy concerns its nascent need to attract foreign capital. After nearly twenty years of consecutive current account surpluses, the largest Gulf economy has become synonymous with exporting capital through investments in developed nations. Since 2015, the Saudi current account has been in deficit, and the IMF forecasts this situation will persist for at least the next five years. The laws of international economics require that current account deficits be financed through foreign investment. There are three principal areas in which Saudi Arabia will require foreign capital: privatisation, debt, and foreign direct investment (FDI).
Perhaps the boldest plank of the transformation programme announced so far is the sale of a minority stake in the Saudi Arabian Oil Company, popularly known as Aramco, the national oil company. If the crown jewel of the country’s petroleum resources is open to foreign investment, then it is hard to imagine any other state-owned enterprise off-limits.
Current plans call for a dual listing of a minority stake in Aramco on the local bourse and one or more international exchanges. Listing on a foreign exchange will force Aramco to comply with international practices in dealing with shareholders, even if they are minority owners. The Aramco privatisation will also herald a new era of transparency for the oil giant, as its oil reserves will likely have to be independently audited for the first time. Aramco stands to become an important test case for further privatisations of state-owned enterprises. Any public company selling stakes to foreign investors will need to open up their finances and decision-making processes to outsiders, when for years management were accustomed to dealing privately with a small, closed group of stakeholders.
Saudi Arabia has recently stepped into the international debt markets, selling dollar-denominated bonds and borrowing from global banks in 2016. This trend will only gather momentum as borrowing needs persist. Saudi authorities plan to quadruple the government debt-to-GDP ratio in the coming years to 30%. While the Kingdom’s early forays in global borrowing were successful, it is unlikely to be smooth sailing forever. As other emerging markets have learned through experience, international investors are notoriously fickle, and free-flowing cash can suddenly dry up if and when global risk appetite wanes.
In addition to selling financial securities abroad, Saudi Arabia needs FDI. A 2015 analysis by the McKinsey Global Institute identified USD 4 trillion of investment opportunities through 2030 for the Saudi economy, across eight sectors, to supply the private-sector jobs and growth necessary to wean the Kingdom off its oil dependence. Inevitably much of this capital will come from foreign sources. The Saudi economy requires foreign cash to make investments of this magnitude, and it needs foreign know-how to develop new industries and modernise existing ventures.
Foreign investment in Saudi Arabia will only be successful if investors find an amenable business environment. Up until now, much of the FDI into Saudi Arabia has been limited to large-scale ventures between multi-national companies and big national enterprises – foremost in petrochemicals. Private-sector driven growth will require a bottom-up approach and likely entail many smaller-scale investments. Unfortunately Saudi Arabia is a notoriously difficult place to secure government approvals for business unless one knows the right people, and personal relationships usually trump procedures written on paper. Foreign companies may see the system as a hidden tax and ensure they have the right locals on the payrolls to grease the wheels of commerce. However, it will be difficult to attract widespread investor attention unless procedures for permits are made more transparent and implemented in practice.
Clearly there is no quick or easy way for Saudi Arabia to modernise its economy. Years of oil surpluses gave authorities little incentive to strive for efficiency, leaving a legacy of byzantine institutions and a population dependent on government munificence. The old order also allowed society to remain extremely conservative and resist foreign influence. Economic reform for Saudi Arabia also means social reform; many social ties underpinning the old economy will inevitably be transformed in the process of modernisation.
On a deeper level, the fundamental relationship between the state and the citizen requires rethinking. The so-called ruling bargain between Gulf monarchs and their populations calls for the rulers to provide and the citizenry to acquiesce, a system that has seen decades of largely uninterrupted stability. Saudi Arabia’s reform plans envisage – and indeed require – citizens taking personal responsibility for their own livelihoods and economic futures. It is difficult to imagine a more educated, worldly population in control of their own economic destinies continuing to accept the old political and social mores.
Nick Stadtmiller is a US-based analyst focusing on economic trends impacting the GCC. He worked in the region for eight years, including two years as an advisor with a branch of the Dubai government and a six-year stint with one of the UAE's largest banks. Nick has a BA from Northwestern University and an MSc from Kings College London.