Looming deficits highlight shortcomings of Saudi economic model

Economists are predicting that Saudi Arabia will be in deficit within the next few years – perhaps as early as 2015. While the government has enough reserves to deal with several years of deficit, the need for economic diversification is ever more pressing. Published in Gulf States News, 6 February 2014

There is a growing expectation that, within a year or two, the Saudi government will be spending more than it earns. In a research note published in January, Saudi Arabia’s Samba Financial Group became the latest to make the prediction, saying that, in its view, a fiscal deficit was likely as early as 2015. Others have also added their voices to the chorus. Riyadh-based Jadwa Investment thinks it will happen by 2016, and at least one major international bank predicts a deficit “within two to three years”.

In itself, a fiscal deficit should not cause too much concern. The government has some $979bn in net foreign assets, according to Samba, and it could easily issue more bonds if it so desired. According to the International Monetary Fund (IMF), the government’s gross debt is just 3.5% of GDP, and the country is rated favourably by the major credit ratings agencies.

Even so, it is troubling that Riyadh could run deficits when oil prices are so high. Economists estimate the budget break-even price for 2014 at around $80-$85/bbl, but this will rise in the coming years as spending grows. At the same time, actual oil prices are expected to fall from their current level of around $105/bbl as supplies from Iran, Iraq and Libya ramp up alongside North American shale production. The result could be Saudi budget deficits when oil is trading well above $90/bbl. Whether this will concentrate minds in Riyadh and prompt more economic and social reforms remains to be seen.

“It’s a wake-up call that they could be running a fiscal deficit when oil is at $95 or $98 a barrel,” said James Reeve, deputy chief economist at Samba, which is predicting the country will be in the red to the tune of 2% of GDP in 2015, and 4% the following year. “I don’t think the government is going to be able to rein in spending at a greater rate than oil prices decline, so you can expect further fiscal deficits beyond 2016. Not massive, alarming ones – perhaps around 5% of GDP.”

Such deficits may be affordable, but they highlight fundamental problems with the country’s economic model and the difficulty in reforming it. Reliance on oil revenues is perhaps inevitable given the extent of the country’s natural resources, but Saudi Arabia also leans heavily on foreign labour in the private sector while a growing number of locals take well-paid jobs in the state sector, if they work at all. Added to this is the generous welfare state, which the government must maintain or risk social unrest. Thus, the authorities have painted themselves into a fiscal corner in which they need ever higher oil revenues just to maintain the status quo.

The solution is economic diversification and more locals in private sector jobs, but the government’s track record is patchy. There have been some notable reforms in the labour market in recent years, designed to push expatriates out of the country and more locals into the private sector. On the surface, there has been some success – around 1m expats are thought to have left the country in 2013 and, according to local media, several hundred thousand more have since been deported. But getting more Saudi nationals into the workforce is harder, and efforts to impose local staff quotas on companies through the Nitaqat programme introduced in 2011 has prompted scepticism and criticism.

“Companies manipulate the system to give the impression that they have helped Saudis get employed,” said one unnamed Shura Council member quoted by the Arab News on 29 January. A day later, the same newspaper reported that the National Anti-Corruption Commission (Nazaha) had complained about the labour ministry’s failure to reduce unemployment, and that the number of new foreign workers’ visas equalled the number of expatriates who had left since the Saudisation programme began.

Changing strategy?

Diversifying the economy has proved even harder, with oil revenues still making up around 90% of total government revenues. At the same time, government spending has been rising. Jadwa expects total government expenditure to be SR932bn ($249bn) in 2014 – twice the level it was in 2007 and four times as much as in 2002. “The alarming issue is not that the country is running a deficit; a lot of countries run a deficit,” said Fahad Al-Turki, head of research at Jadwa, who is predicting a deficit in 2016 of around 1% of GDP. “What’s concerning is the strong growth in government spending over the past ten years and the reliance on one source of income. If this will be a concern in 2016 when they run a deficit, then it should be a concern now.”

There are some signs Riyadh is adapting its strategy. Growth in capital spending has been slowing, although it is still high. And the government has moved some projects off-budget by using funds held at the Saudi Arabian Monetary Agency (Sama), the central bank. At the end of December, the central bank was holding SR479bn that is earmarked for government projects such as a large housebuilding programme and the Riyadh Metro.

The capital spending that is left still accounts for 30% of the budget, but, even if it is scaled back, existing projects could feed into higher current spending in the future. “Once all the projects finish, they will add to the current spending in terms of maintenance and operations,” Al-Turki pointed out.

There is also the danger that any cutbacks could undermine the rest of the economy. “Much of the non-oil economy is driven by government contracts. That’s fine when government spending is going up, but it is not clear how much of the private sector will perform when the government stimulus is eased,” said Paul Gamble, director of the sovereign group at Fitch Ratings.

Current spending, including wages and subsidies, is even harder to reduce than capital expenditure, and pressure for more subsidies can emerge from almost anywhere. For example, Qatar Airways and the new Saudi Gulf Airlines have reportedly delayed launching domestic services until they are given subsidised fuel prices that allow them to compete more easily with Saudia.

Saudi Arabia has been here before. It ran deficits for most of the 1980s and 90s and, by 1999, the government had gross debts of SR625bn, equivalent to around 100% of GDP at the time, according to the IMF. The big difference is that oil prices were below $20/bbl for much of that time. If Riyadh wants to avoid a return to that position, it will need to redouble its reform efforts. The choices aren’t appealing but, the longer it leaves it, the harder it will be.

“In the 1990s we went through a period when Saudi Arabia had a debt to GDP ratio of around 100% or more and very low reserves. We were relying on one source of income then and we still rely on one source of income,” Al-Turki said. “We need to take action now because [otherwise] there will be a repeat of the situation in the 1990s.”