These are testing times for Riyadh. Its plans for infrastructure spending are at odds with its need to limit the impact of soaring inflation and meet the rising expectations of its growing, and increasingly youthful, population.

The oil boom of the past five years has ensured strong and sustained economic growth. Real gross domestic product (GDP) grew by 30 per cent between 2003 and 2007, according to credit ratings agency Moody’s Investors Service, while Standard Chartered Bank predicts it will grow by at least 10 per cent between 2008 and 2010.

Despite its growing population, per capita GDP growth has also been impressive. Nominal GDP growth per capita reached SR58,224 ($15,550) in 2007, up more than 75 per cent from SR32,846 in 2002, according to the Saudi Arabian Monetary Agency (Sama), the central bank. Per capita GDP growth will continue at a compound annual rate of 11 per cent until 2010, according to a report published by the local National Commercial Bank (NCB) in June.

Oil has been the crucial element in the kingdom’s economic success. It represented 54.1 per cent of Saudi Arabia’s GDP in 2007, and this year the kingdom can expect to earn $378.65bn from oil, according to a report published by Standard Chartered on 12 June, and based on an average oil price of $114 a barrel for the year.

The rapid rise in oil earnings has swelled the bank account of the Saudi treasury, enabling it to establish a strong foreign exchange position, develop an impressive portfolio of overseas investments, and plough hundreds of billions of dollars into the domestic economy.

But rising oil prices - and the higher earnings that result - are also contributing to one of the greatest threats to the kingdom’s economic well-being: inflation.

Table: Economic indicators

Double-digit inflation

In March, year-on-year inflation reached 9.6 per cent - the highest figure for 27 years - and the next month it hit 10.5 per cent, says Sama. Double-digit inflation is unwelcome for any economy, but for Riyadh, where inflation has averaged 0-2 per cent for many years, it is particularly daunting. Sama insists the inflation rate will fall in the second half of 2008, but analysts are sceptical. Local bank Sabb anticipates average inflation of 7.9 per cent in 2008, compared with 4.1 per cent in 2007.

High inflation in the kingdom is largely a by-product of its economic success. Oil earnings of more than $1bn a day have pushed its capacity to absorb liquidity to the limit. Money supply, measured in its broadest sense, is up more than 25 per cent year on year. “Most of the inflation in Saudi [Arabia] is liquidity-driven,” says Muhammad Malick, senior economist at NCB. “It is more of a monetary issue than an external supply shock.”

The pegging of the Saudi riyal to the dollar limits Riyadh’s flexibility to use monetary policy to deal with rising inflation. The economic downturn in the US means the Federal Reserve is lowering interest rates just when Saudi Arabia would like to raise them.

The kingdom’s interest rate for the second quarter of 2008 was just 2 per cent, and it is expected to fall to 1 per cent by the first quarter of 2009, according to the latest projections from Standard Chartered. In an effort to absorb excess liquidity, Riyadh has instead been forced to raise the capital reserve requirements of its financial institutions.

Although high inflation is commonly associated with the erosion of economic growth, most economists agree that at a macro-economic level, the current rates of inflation are still manageable.

“Like anywhere else, inflation has an impact on the economy because it erodes disposable income, and high inflation creates structural problems in terms of real economic growth,” says John Sfakianakis, chief economist at Sabb.

“But a rate of 9-10 per cent is not very worrisome. If it rose to 20-25 per cent it would be a problem, but I expect inflation to be more subdued in 2009.”

The real problem for Riyadh is the broader impact of inflation on the population. A combination of high domestic inflation and strong global increases in commodities and construction costs has led to rapidly rising prices for basic necessities.

Wheat costs have doubled in less than a year, while rice costs have increased by more than 90 per cent over the past two years, according to Sabb. As the largest importer of foodstuffs in the Middle East, Saudi Arabia is particularly susceptible to the increasing price of these staple products.

A combination of rising global materials costs and a severe housing shortage is fuelling strong real estate inflation. Analysts say there is an existing housing deficit of about 400,000 units in the kingdom, and a real estate report published by NCB Capital in June predicts 1.3 million additional housing units will be required in the next seven years, costing SR680bn. The rental inflation index, which covers rent, fuel and water costs, increased by 17 per cent year on year in April, with the rental component up 20.4 per cent.

“There is a desperate need for low and middle-income housing,” says Sfakianakis. “Only 35 per cent of Saudis own their own homes, with 65 per cent renting, while in the West the reverse is true. This creates a lot of instability in the system, because high demand pushes up rents.”

Although the government’s Eighth Development Plan targets the construction of 1 million housing units by 2009, and the Majlis al-Shura (parliament) is working on a new mortgage law to create a framework for the development of the real estate sector, analysts expect it will be several years before either has a substantial impact on the market.

Saudi Arabia is not alone in suffering high inflation. In the UAE, inflation hit a 19-year high of 10.9 per cent in 2007, Kuwait’s reached 9.5 per cent year on year in January, and in Qatar it averaged 14.75 per cent for the first quarter of 2008. But their relatively small populations make it easier for the state to protect people from the worst effects of inflation.

There are an estimated 300,000 locals in the Qatari workforce, the vast majority of whom work for the state, so it is relatively simple for Doha to improve the lot of its people by increasing public sector wages. A similarly small state-employed labour force in the UAE has enabled Abu Dhabi to increase public sector wages by 70 per cent.

In contrast to its neighbours, Saudi Arabia’s demographics make it all the more susceptible to the impact of inflation and less able to do anything about it. The kingdom’s population is almost three times the size of the rest of the GCC’s combined, and in recent years it has been growing at a rate of 2.5 per cent a year.

Growing population

Between 2000 and 2005 alone, the total Saudi population increased by more than 50 per cent, and by 2050 it is expected to more than double from the current 24 million. It also suffers from a marked skew towards younger members of the population, with more than 70 per cent below the age of 30 and more than 85 per cent under 40.

Despite strong growth in recent years, the kingdom still has the lowest per capita GDP in the GCC, and the situation is exacerbated by strong income disparities, an estimated 15 per cent unemployment rate, and limited structures for state support for the unemployed.

The gap between the expectations of the broader population and the capacity of the state to address their economic concerns is also growing. When poorer Saudis witness the country’s huge oil earnings and see their neighbours transferring the benefits of their economic good fortune to the broader population, they feel entitled to expect the same treatment.

“There is a disconnect that has to be addressed between the participants in the boom and society at large,” says Sfakianakis. “When people see oil prices of $130 a barrel, they want to see the trickle-down. Previous oil booms have enabled Saudis to go from living in tents to owning cars and homes.

“Now there is an expectation that the current boom will have a similar impact on living conditions. But it is not so easy to go from houses to palaces.”

The structure of its economy means that Riyadh cannot afford to be so free as its neighbours with its fiscal spending. “The public sector in Saudi Arabia is the same size as that in all the other GCC states put together,” says Sfakianakis. “There are close to 1.8 million people working for the state, so if Riyadh did the same as the UAE, inflation would spiral and the economy would be in fiscal deficit.”

As a result, Riyadh faces a difficult challenge. It rightly recognises that introducing substantial wage increases and subsidies would throw the economy into a damaging downward spiral of high inflation and reduced growth. But it is mindful of its responsibility to alleviate the plight of poorer segments of its population.

The limited scope for formal political opposition in the kingdom puts the onus on the government to provide for its people to prevent social discontent spilling over into action. While Riyadh has largely overcome the security concerns of 2003-05, economic hardship is a well-known breeding ground for civil unrest.

The government has adopted a twin approach to tackling the problem. On the one hand, it is doing what it can to alleviate the pain of inflation for its population within its fiscal constraints. The cabinet is implementing a 17-point scheme to tackle the impact of inflation, based on a report by the Advisory Commission for Economic Affairs, part of the country’s Supreme Economic Council. Under the programme, the government has increased public sector wages by 5 per cent and reduced customs duties on 180 major foodstuffs, consumer goods and construction materials for a three-year period.

The state is set to spend more than SR12bn on subsidised food prices in 2008 alone, in addition to SR7.9bn in indirect subsidies for utilities. Spending on wages is set to increase to 16 per cent of the government budget, up from 14 per cent in 2007.

Riyadh has also announced plans to set up a holding company to invest in overseas agricultural and livestock projects to improve its security of food supply.

At the same time, the government is investing in the development of infrastructure and promoting economic diversification as a means of providing employment and ensuring long-term sustainable economic growth.

According to Gulf projects tracker MEED Projects, schemes worth a total of $476bn are under way. The plans include six new economic cities, which will cost at least $70bn, as well as a series of industrial clusters throughout the kingdom and a swathe of transport projects, including a $15bn rail network expansion, a $5bn rail link between the east and west coasts, and several other schemes to improve communications between the kingdom’s main urban and industrial centres.

Developing tourism

The government is also trying to develop its tourism infrastructure, which will not only increase inward investment into the country but will also be an important creator of jobs. According to government targets, the tourism sector will generate $66.2bn in revenues by 2016, compared with $34.7bn today.

All this infrastructure spending exerts inflationary pressure on the economy, especially given that the value of the main construction contracts awarded equates to little more than a quarter of total projected expenditure.

The challenge Riyadh faces in the months and years ahead is to find a balance between investing in the infrastructure necessary to underpin economic growth in the future and ensuring that it does not have a damaging impact on inflation. It will not be easy.

“It is difficult to find the right balance between spending and low inflation,” says Sfakianakis. “It must differentiate between its spending plans and prioritise the areas where it can achieve productive growth.”