AS location is the best asset when putting a price on real estate, so oil is the key to understanding the value of the Saudi economy. Great strides have been made to diversify the economy and the non-oil, non-government sector now accounts for 45 per cent of gross domestic product (GDP).

But oil is the mainstay of the state budget and government spending is the most powerful driver of economic activity. Though the sharp decline in oil prices has knocked a hole in the budget for this year the authorities are convinced that any downturn will be manageable.

'This is not the first time oil prices have fluctuated,' Finance & National Economy Minister Ibrahim al-Assaf said in late March. 'We have faced more difficult challenges and overcome them in the past and I believe we are now in a better position to face them than we have been...short-term developments have not fundamentally altered the long-term growth rate...despite current instability in the oil markets, the economic fundamentals are sound.'

That they are now in sound condition owes much to the tighter management that Al-Assaf has brought to government finances. It is also due to the windfall from higher oil revenues that accrued in 1996-97. Some of the windfall was used to pay down domestic debt and clear arrears to farmers, contractors and government suppliers. Liquidity rose and the economy grew by a nominal 7 per cent in 1997. The outlook for this year is for little or no growth in the economy; Henry Azzam, chief economist at National Commercial Bank in Jeddah, forecasts nominal GDP growth of 0.3 per cent in 1998.

Oil prices lie at the root of the difficulty. Compared with an average of $18.08 a barrel for Arab light in the first five months of 1997, this year's average price was just $11.93. At its lowest ebb in March, Arab light dipped briefly below $10 a barrel before starting a tentative recovery when the Riyadh pact to cut oil production was agreed. In force since 1 April, the pact has managed to cut global oil supplies by about 1 million barrels a day (b/d). But the jury is still out on whether the cuts are enough.

Added to the impact of lower prices, the Riyadh pact commits Saudi Arabia to reduce production. With export volumes of 7.5 million b/d and an average price of $13 a barrel, oil export revenues could fall to about SR 135,000 million ($36,000 million) this year compared with actual oil revenues of SR 199,000 million ($53,000 million) in 1997. The actual receipts from oil sales were well above expectations in 1996-97 due to high prices and the budget for this year had anticipated oil revenues of about SR 165,000 million ($44,000 million), based on an oil price of $14.50 a barrel. Both figures now look optimistic, leaving the government with a potential revenue shortfall of about SR 30,000 million ($8,000 million) to cover.

In response to this challenge the government is moving first to restrain spending. Al-Assaf has made it clear that this is the preferred option and there will be delays to the signing of new contracts and a stretching out of existing ones where possible. Big savings are also expected in the defence budget with the delaying of new equipment purchases. Kevin Taecker, economist at Saudi American Bank in Riyadh, expects actual budget spending after savings to be about SR 186,000 million ($49,600 million), which is about SR 10,000 million ($2,670 million) below projected expenditure. 'Half of these cuts are going to be on foreign suppliers,' says Taecker. 'A lower oil price does not come through as a tightening of local liquidity, it hits foreign suppliers and a few contracts.'

The 1998 budget deficit will be at least double the SR 18,000 million ($4,800 million) that was anticipated in the budget statement. To finance the deficit the government is expected to boost its domestic borrowing with more bond issues on offer to the banks and the government's own pension and social security funds. 'We still have some appetite,' says the general manager of a leading bank. 'We took a lot last year and it will depend on loan demand.' Existing bonds pay 30-40 points above Sibor. There was an enthusiastic uptake of the floating rate notes in Saudi riyals that were issued in 1997 and bankers say demand for these instruments would be strong because of the uncertain outlook for interest rates.

Washington-based Petroleum Finance Corporation calculates that the scale of the extra borrowing this year will raise the level of the government's domestic debt to about SR 127,000 million ($34,000 million) - nearly 90 per cent of GDP (Saudi Arabia, MEED Special Report, 27:3:98, page 10). The only outstanding international borrowing is a $5,000 million sovereign loan secured last November to fund aircraft purchases by national carrier Saudi Arabian Airlines. At 20-22 basis points over Libor, the borrowing was very keenly priced. 'There was a window of opportunity - it was an excellent deal for Saudi Arabia,' says the general manager of a bank in Riyadh.

Domestic revenues and investment income typically account for less than a quarter of government revenues and there have been no moves to raise domestic receipts since 1995 when charges were increased for a variety of services. There is scope for further increases in domestic air fares, electricity and water prices, but there is no personal taxation and corporate taxes on local companies are minimal. However, the authorities have given no indication that any new revenue raising measures are planned.

While an economic downturn is anticipated, it is not yet apparent to most observers in Saudi Arabia. 'My sense is that there is a slowdown in the domestic economy but it isn't uniform so it isn't widely perceived as yet,' says a bank economist. 'Some sectors are seeing a slowdown and my guess is that it will become clear in the second half.'

The depth and length of any downturn will depend on oil price trends in the second half of the year and beyond. 'If you take the optimistic view, Saudi Arabia has had two strong years so the ability in the short term to take the downturn is very good,' says a bank general manager. 'But, are we on the verge of a cyclical downturn with lower demand for oil and petrochemicals? Nobody knows the answer, but it'll be clearer in six months time.'