ECONOMY: Hard talk to defend a hard riyal

11 March 1994

A MAJOR shift has occurred in Saudi Arabian economic policy. The kingdom has signalled that it no longer attaches the importance it once did to fixed oil prices. In contrast, attitudes to the exchange rate have hardened.

This shift in the balance of policy is enormously significant and has major implications for anyone involved with the Saudi economy.

The broad objective of Saudi exchange rate policy is to maintain a stable relationship with the currencies of the other GCC states, minimise exchange risks and maintain the competitiveness of local producers. Although, technically, the riyal has been pegged to the SDR since mid-1981, the Saudi currency in practice has moved with the dollar, the government's intervention currency, a policy pursued by four of the other five GCC states.

The new toughness in Saudi exchange rate policy has emerged in the past nine months as the state of the kingdom's economy hit the headlines.

In summer 1993, articles published on consecutive days by the New York Times reported on the fact, well known to those dealing with the kingdom, that Saudi Arabia had large balance of payments and budget deficits, its financial reserves had fallen drastically since the early 1980s, and that government debt was mounting.

Basically sound

The reports elicited official declarations that the deficits were temporary and that the Saudi economy was basically sound. But the affair attracted the attention of currency speculators who had made spectacular profits out of assaulting the weaker currencies in the European exchange rate mechanism in autumn 1992. The oil price fall provided a further reason to believe the Saudi currency was vulnerable.

Throughout the autumn, waves of selling hit the riyal as speculators banked on the Saudi government seeking to resolve some of its financial problems by devaluing the riyal. History was, perhaps, on their side. The last time the kingdom devalued was in the middle of an even more dramatic oil price slump in 1986.

This time, the central bank, the Saudi Arabian Monetary Agency (SAMA) stood firm, calling in heads of the local banks to underline the official commitment to the present valuation of $1=SR 3.75. Yet, riyal bears remained unconvinced.

The message was driven home on 1 January when the Saudi cabinet approved a budget for 1994 that called for a 20 per cent cut in spending from planned expenditure in 1993 and an elimination of the deficits recorded every year since 1982. In an official report, King Fahd was reported to have told the cabinet that the value of the riyal would be maintained 'without any amendment'.

The words meant that the king was attaching his personal credibility to exchange rate stability. The markets got the message. Speculation against the riyal has largely evaporated.

The affair is a further example of the greater resolve that has entered many areas of Saudi policy since the Kuwait crisis. Observers are impressed that Riyadh is prepared to take on the speculators at a time when capital markets have never been stronger.

It means the kingdom joins Hong Kong as one of a handful of countries pursuing a fixed exchange rate policy. But does it make sense? The economic context suggests not.

Saudi oil production is estimated to have fallen by about 2.5 per cent to about 8.2 million barrels a day (b/d) in 1993 from just over 8.5 million b/d in 1992. However, the real damage has been done by the fall of more than 20 per cent in oil prices over the same period. The kingdom's petroleum exports are estimated to have fallen by at least $6,000 million in 1993 to about $39,000 million.

This was translated almost directly into lower government income which is estimated to have been about $5,000 million less than budgeted in 1993. Cuts in government spending planned in the 1993 budget have not compensated for the fall in state income. As a result, the government is believed to have failed to hit its 1993 budget deficit target. The actual deficit is likely to have been in the range of $4,000 million-8,000 million, below the 1992 level but probably above the target for the year.

This adverse trend inevitably affects the kingdom's balance of payments. The trade balance is estimated to have deteriorated by about $3,000 million- 10,000 million. Even with a large reduction in the services and transfers deficit, it is unlikely the kingdom was able to cut its current account deficit in 1993 to less than $15,000 million.

These trends have undercut the kingdom's net financial position. Bank for International Settlements (BIS) data show a rise in Western bank lending to the kingdom of almost $700 million to $17,344 million in the second quarter of 1993. Saudi deposits with Western banks rose moderately in March-June to $65,074 million but the figure is still about $12,000 million less than a year earlier.

The pressure on the kingdom's finances of the twin deficits - budget and current account - has also been reflected in its international liquidity. In June 1992, Saudi reserves minus gold shifted down structurally well below $10,000 million and they have fluctuated between $6,000 million- 7,500 million ever since.

These trends have inevitably put pressure on the government to take measures to deal with the rising financial deficit.

Two options

Put simply, Riyadh has two options, both with undesirable implications.

It could try to drive up oil prices by at least as much as they fell in 1993. But this would entail cutting production significantly, probably by much more than other oil producers. Some of the market share recovered when Iraq and Kuwait were knocked out of the market in 1990 would be lost. Saudi Arabia would be seen to have resumed its role as swing producer, abandoned in 1986. This option has proved too awful to contemplate.

The alternative is to hold output around present levels, take a realistic view of oil prices and slash the deficit. This would cause problems for the kingdom's bloated bureaucracy, the main source of employment for Saudi nationals. But it has the attraction of sending a signal to present and potential creditors as well as to the World Bank that the kingdom was committed to a prudent fiscal policy.

The limited details of the 1994 budget so far made public suggest that the government has chosen the second route. The programme calls for spending to be cut to match the anticipated level of income, projected at SR 169,200 million for 1994.

The budget decrees also announced that SR 43,000 million had been allocated for projects and operations and maintenance. This compares with SR 53,000 million in the 1993 budget. Development agencies financing private industry, agriculture and real estate will provide loans worth SR 7,870 million. This refers to the budgets of the Saudi Industrial Development Fund (SIDF), the Saudi Arabian Agricultural Bank, the Saudi Credit Bank and the Real Estate Development Fund. The total is virtually unchanged from the 1993 budget which envisaged total lending by these agencies of SR 8,000 million.

The budgets of 22 government agencies, including national airline Saudia, the Saline Water Conversion Corporation (SWCC), the Royal Commission for Jubail & Yanbu and the universities, were set at a total of SR 28,388 million. This is 9 per cent lower than the 1993 budget for these agencies, but the cuts are not consistent. Saudia, which is due to confirm a major aircraft order this year, has been given 7 per cent more than last year.

Observers were impressed by the declaration of intent, but sceptical that a cut in spending on the scale announced could be implemented in just 12 months. Yet the indications from Riyadh suggest that the Finance & National Economy Ministry is bringing spending departments to heel. Ministers have been calling in senior officials and telling them their budgets have been cut by 20 per cent.

Overtime working, a standard procedure in Saudi government, would not be allowed and there would be no bonuses paid in 1994. 'Civil servants are being told that if they don't like it, they can resign,' says a businessman who works closely with the government.

In an effort to reduce the impact of the financial squeeze, Saudi Arabia has reached an agreement to reschedule the payments due to five US companies for defence equipment ordered in the early 1990s. The deal, signed in January, calls for $6,000 million of payments due in 1994-95 to be deferred, in part through the instrument of a commercial loan.

Businesses supplying the government hope that a high proportion of the cash flow savings needed this year will be achieved in this way, rather than through cuts in real activity. But it is accepted as inevitable that there will be fewer contract opportunities from the state in 1994.

And yet, business confidence remains surprisingly solid. The private sector, which accounts for more than two-thirds of economic activity, is liquid and is continuing to invest. This is keeping the cost of money down.

Spending slowdown

The slowdown in government spending will hit weaker businesses, and company failures are likely. But the view is that the banking system and most local businesses will weather the public-sector spending squeeze.

There is unlikely to be any growth in gross domestic product (GDP), which the Finance Ministry tentatively estimated to have expanded by 1 per cent in 1993. Non-oil GDP growth, which was 5.1 per cent in 1993, is likely to slip in the year ahead.

So there is no crisis, yet the government's reluctance to devalue is still a puzzle. A devaluation would immediately increase the domestic purchasing power of oil revenues, perhaps enough to eliminate deficits without the need for a spending cut that might throw the economy into depression.

Part of the answer is Riyadh's distaste for sudden shifts in policy. In a country where King Fahd has been a cabinet member for more than 40 years and most ministers have been in office since the mid-1970s, caution is a highly prized virtue.

A more complete answer may be found in an examination of the income distribution consequences of devaluation. Cutting the value of the riyal may boost the competitiveness of Saudi exports, but it would drive up the price of imports which account for the overwhelming majority of the goods and services consumed by Saudi households. Devaluation at a stroke would produce an almost proportionate reduction in living standards for the average Saudi citizen.

Putting up the price of imports would also cut demand, a development that would hit the profits of the business community, most of which is heavily dependent on income derived from bringing foreign goods into the kingdom. Investors who have repatriated capital since the early 1990s as dollar interest rates fell would experience a nasty capital loss.

In total, devaluation would benefit government and the kingdom's trading counterparts but at the expense of the of income and savings of Saudi households and businesses. Whatever its long-term and dynamic merits, devaluation is too high a price to pay in present circumstances, the Saudi government appears to have concluded.

Is a fixed exchange rate indefinitely sustainable? Clearly not, but the authorities hold a firm grip over most of the institutions that dominate the market for the Saudi currency, a factor that gives Riyadh much greater influence over the riyal than a superficial assessment of the market would suggest.

But, as with any policy that bucks the market, there is a price to be paid. A strong riyal makes it hard for local manufacturers to compete with foreign imports and break into overseas markets. The government recognises this through a generous system of industrial incentives (see Industry). Experience suggests that such incentives have offset at least part of the competitive disadvantage caused by a hard riyal. However, the future poses a different and more testing challenge that official resolve alone may be unable to overcome.

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