It is likely 2011 will go down in history as a challenging year for Saudi Arabia’s King Abdullah bin Abdul-Aziz al-Saud. The Arab uprisings have seen long-time allies ousted; Shia-Sunni tensions in neighbouring Bahrain grow, prompting Riyadh to offer military support; and have brought near social and economic collapse in neighbouring Yemen.

A lot of the growth is directly attributable to the private sector, but indirectly still based on state spending

Steffen Hertog, London School of Economics

On top of this, a June Opec meeting ended in acrimony as Riyadh tried, and failed, to get member states to agree on an increase in production quotas. Popular unrest has also become more visible in the kingdom, with small protests being held across the country in recent months, and protesters reportedly shot in the Eastern city of Qatif earlier this year. Meanwhile, the imagination of the international press has been caught by a small movement of women that have taken to the roads in protest over legislation that bans them from driving.

Economic fallout

The worst is yet to come for Riyadh. If economists, bankers and academics who specialise in the country are correct, the kingdom will become more dependent on state spending, as private-sector growth falters. Even oil revenues are not enough to foster sustainable growth and stave off mass unemployment.

The fallout of the Arab uprisings for Riyadh will not be political, but economic. Steffen Hertog, a lecturer at the UK’s London School of Economics and an expert on the Saudi economy, believes by 2015, Riyadh may need an average oil price of $120-130 a barrel just to break even if current spending trends continue. Even in an age of $100-plus oil, this is a tough challenge.

The regional political turmoil did not cause the kingdom’s economic problems. Rather, it cast the final blow to plans to scale back the role of the state in the economy and boost the role of the private sector. Those plans were first fomented between 1998-2002, when oil contracts on international markets rarely rose above $25 a barrel and fell as low as $8.64 a barrel.

Then Riyadh found itself overcommitted to spending both domestically and abroad, with public debt soaring to 100 per cent of gross domestic product (GDP) in 1999. Government spending outstripped revenues by 3.7 per cent of GDP on average, in the four years to 2002. 

With little fiscal room for manoeuvre, Riyadh initially cut back spending and opened its doors to outside investors. The plan was to create private-sector jobs for Saudi citizens, while weaning them off their dependence on the state. Radical reforms were proposed: taxation; immigration reform to boost non-oil revenues and create more opportunities for locals; as well as the creation of a national franchise to make the population feel more involved in the decisions being made at the top. Municipal elections were first held in 2005.

But Riyadh’s problems balancing the books were largely ended by rising oil prices and a burgeoning industrialisation programme. In 2005-08, when the value of crude oil only seemed to go up, the deficits of the previous decades were turned into surpluses that averaged 20 per cent of GDP, as revenue rose.

Government spending also rose, as did foreign direct investment into the country, largely into major oil, gas and petrochemicals schemes. In 2010 alone, inflows of capital totalled about $40bn, up from $35bn in 2009.

“On the face of it, the economy is in good shape, but there are serious structural weaknesses in its makeup,” says James Reeve, London-based assistant general manager and senior economist at local bank Samba Group.

Saudi Arabi’s non-oil deficit

A key issue that is often neglected, Reeve says, is the country’s non-oil fiscal deficit – a gauge of the state’s dependence on oil revenue. According to Samba, the deficit grew steadily from about 20 per cent of non-oil GDP in 2002 to 67 per cent in 2010. It forecasts the deficit could top 80 per cent this year. “It shows the government’s exposure to a sustained or severe downturn in the oil markets,” he says.

Figures from Riyadh-based Banque Saudi Fransi show that in 2010, about 80 per cent of state revenues came from oil and gas exports, down from 90 per cent in 2009. Those revenues are mainly used to generate employment. Hertog says about 43 per cent of government expenditure in 2009 went on public-sector wages.

“The share of wages in the Saudi budget is almost uniquely high among developing and developed countries,” he says. Typically, current spending – on payroll and expenses – is protected within the country’s budgets, while capital expenditures – on projects – is more susceptible to fluctuations in income.

The kingdom’s response to the recent unrest was typical of this model; it announced an extra $130bn in spending, which included an additional month’s pay for state employees and plans to build 500,000 affordable homes. The payout is likely to be prioritised over the housing. “They have always protected the public payroll,” says Hertog. “They have added new people every year at least since 1969 when records began, even at times of fiscal crisis.”

Meanwhile, most private-sector investment has gone into projects that are in some way dependent on oil and gas. Figures from the state inward-investment agency Saudi Arabian General Investment Agency show this ranges from refining and petrochemicals to energy-intensive industries such as metal production. These industries are made competitive by access to cheap feedstocks provided by state energy company Saudi Aramco, which mostly charges only the “marginal” cost – the production cost – to consumers.

All of this, says Hertog, means the main drivers of economic growth in Saudi Arabia are government spending on wages, energy subsidies and a business climate made attractive by a lack of taxation. “A lot of the growth is directly attributable to the private sector, but indirectly still based on state spending,” he says.

Industrial growth in Saudi Arabia

Meanwhile, the industrial growth seen over the first decade of the 21st century is unlikely to be matched over the next 10 years. Much of that development was based around access to cheap gas, particularly ethane, a key building block for basic plastics.

In turn, much of the supply of that feedstock came from associated gas, which is produced at the same time as oil. Oil giant Saudi Aramco, which controls allocations of gas to industry, has not committed new volumes to a major industrial project since 2007.

“Saudi Aramco wants to push forward with industrialisation as it has been, but its competitiveness hasn’t come from having a skilled, hard-working population, but on its competitive feedstock advantage, which is unsustainable,” says Samuel Ciszuk, a London-based Middle East analyst at the US’ IHS Global Insight. “It looks like industrialisation has been creating jobs, but they have based it all on an even bigger reliance on hydrocarbons.”

Paul Hodges, chairman of UK petrochemicals consultancy International Echem, says the issue in the future for petrochemicals producers will not be so much of using new, less profitable feedstocks, such as naphtha, as recognising where demand lies. This, in turn, will come down to the ability of employees to adapt to changing markets.

“The Saudis, because of their strategic advantage, their route to China, have had an opportunity,” says Hodges. “But they aren’t going to maintain it through price, they will have to do it by assessing the need.”

Meanwhile, the more the economy grows, and the greater the spending power of Saudi nationals, the greater consumption of oil and gas, which Saudi Aramco sells domestically at the marginal cost of production. The more the population consumes, the less there is available for export and, hence, to generate government revenues.

The kingdom’s young population is quickly growing. Banque Saudi Fransi estimates 66 per cent of the country’s indigenous population of 18.5 million people are under the age of 30, a figure that will only increase in coming years. The overall population is growing at 2.3 per cent a year, according to the Washington-headquartered World Bank. That young population will need jobs.

Knowledge stagnation in Saudi Arabia

The kingdom has invested heavily in education: an estimated 100,000 Saudi students are being sponsored to attend academic programmes abroad, of whom about 10,000 return home every year, while up to 130,000 students graduate annually from domestics institutions.

“So far, the government has tried to absorb [the graduates] into the bureaucracy,” says Madawi al-Rasheed, a Saudi-born academic and expert on society in the kingdom, currently working at King’s College London, in the UK. “That creates an unhealthy situation. The private sector is not absorbing graduates either.”

As jobs in the public sector are relatively well paid and tend to offer high levels of security, the incentives for graduates to look to the private sector are limited.

“Saudis right now don’t have many incentives to develop skills,” Hertog says. “Good education is not only a supply issue; it is also a demand issue. Right now the public sector is more attractive as employer and does not require cutting-edge education.”

In June, new employment regulations were unveiled aimed at creating incentives for Saudi nationals to join the private sector – and forcing the sector to employ them. Firms will be assessed on how many locals they employ. If they do not meet the required standards, they face being shut down. The labour ministry has already forecast that 30-40 per cent of small and medium-sized enterprises, key drivers of economic growth, could fold as a result.

As long as oil prices remain high, the underlying issues of the Saudi economy are unlikely to cause problems. Even then, the government has paid down much of its debt and has huge cash reserves. “There will be no urgency as long as there is money to be distributed and there is foreign help,” says Al-Rasheed.

But if there is a fall in demand or an increase in production, or both, the government could face serious difficulties in restructuring the economy. “They are OK for the next five years,” says Hertog. “[But] there is a potential long-term fiscal threat if oil prices should fall substantially, as they have locked in their spending at a very high level.”