Saudi Arabia - Economic Policy Making

More about the Economy of Saudi Arabia.

Economic Policy after the 1986 Oil-Price Crash

The general thrust of Saudi economic policy underwent a fundamental change after the oil price crash of 1986. The serious depletion of foreign assets, combined with the extensive decline in oil revenues, necessitated a revised economic policy. The depreciation of the United States dollar on international financial markets also hurt Saudi purchasing power abroad. The kingdom's external terms of trade deteriorated rapidly because oil exports were largely denominated in United States dollars, and the bulk of Saudi imports came from countries whose currencies were appreciating relative to the United States dollar.

Reappraisal of the development program became necessary. The most urgent task was shoring up government finances, yet domestic constraints allowed only a few options, especially in terms of raising nonoil revenues. Imposing an income tax, for example, was out of the question partly because of its political dangers in a country where it was an unknown procedure likely to raise questions of income distribution and taxation without representation. Also an income tax appeared impractical because the bureaucratic difficulties involved in collection would be more expensive than the intake would justify. King Fahd's shortlived idea of taxing foreign workers' income was retracted after a public outcry. The government froze some current account spending and cut capital spending, partly by delaying projects and also by canceling some programs. The was informed that subsidies of private sector vast capital expenditures had ended for the present, and, whereas certain major projects would be completed, the governments' emphasis would shift to improving the efficiency and maintenance of its public assets. In addition, major defense contracts would include a provision whereby foreign equipment and service contractors would be required to allocate 35 percent of the cost of their projects or services for industrial investments in Saudi Arabia.

Economic Policy in the 1990s

The government's attempts to deal with the chronic budget deficits, largely through expenditure retrenchment, depletion of foreign assets, and the sale of development bonds, generally helped stabilize its financial situation by the late 1980s. It became clear by 1989 that the economy had weathered some of the other problems, such as the spate of bankruptcies of private companies, the growth of bad banking debts, and the massive outflow of private capital to overseas financial centers that followed the oil-price crash of 1986. During 1989 and 1990, economic planners had renewed optimism. New plans were made to put the oil and nonoil sectors of the economy on a surer footing. The perceived recovery in international oil consumption and prices provided regional policymakers the opportunity to resume spending to promote economic growth. As a result, two major initiatives became the basis of Saudi economic policy.

First, Saudi Arabia unveiled plans to raise crude oil production capacity to between 10.5 million and 11 million bpd by 1995. With the restructuring of the General Petroleum and Mineral Organization (Petromin), the creation of Samarec, which was given control over most of the kingdom's oil refineries, and the announcement of major plan to upgrade domestic and export refineries, a comprehensive picture emerged of the government's effort to promote oil investments. Another indication of Riyadh's intentions came in 1989 when Saudi Aramco purchased 50 percent of Star Enterprises in the United States, a joint venture with Texaco that signaled Saudi Arabia's pursuit of geographically diversified downstream projects.

Second, the government was not eager to continue its expansionist fiscal policies. Despite moderately higher oil prices, military outlays, oil capacity expansion plans, and current expenditures accounted for the bulk of total spending and did not permit a fiscal boost. However, because the nonoil private sector remained largely dependent on government spending, the sharp cutbacks in capital outlays hindered economic diversification. In light of this failure, the government adopted two policies to reorient and revive the private sector.

Financial sector reform was the government's main option. Since 1988 SAMA had made great strides in bolstering commercial bank balance sheets through mergers, debt write-offs, and injection of funds to prevent failures. Subsequently, banking regulations and supervision were tightened and compliance with international capital adequacy requirements enforced. The authorities also encouraged banks to take a more active role in financing private sector investments. The idea of opening a Riyadh stock exchange received renewed interest: the government sanctioned the establishment of the exchange in early 1990 and hinted it could be an appropriate venue for selling government assets.

Protectionism as a policy also gained some popularity during this period. Partly motivated by the impasse in Gulf Cooperation Council (GCC) negotiations with the European Economic Community (EEC), but mainly to protect domestic private investment, Saudi Arabia began enforcing some restrictive tariff and nontariff barriers that had been instituted in the mid-1980s. Under the guise of conforming to GCC-wide levels, Saudi Arabia raised its tariff rates to 20 percent on most items with certain industrial items gaining protection at higher rates. The government also began enforcing nontariff regulations such as preference for nationally produced commodities and the continued application of preference for local contractors, as well as quality standards that favored local production. In addition, the kingdom assiduously protected domestic banks from foreign competition by barring the sale of any foreign financial products and services.

The Iraqi invasion of Kuwait halted the miniboom that these policies had fostered. In the immediate wake of the invasion, the government faced two tasks. First, it had to deal with the massive outflow of assets from the domestic banking sector by liquidating the commercial banks (which lost more than 12 percent of their deposits within the first month of the crisis), encouraging a repatriation of private assets, and restoring the confidence of foreign creditors, who had canceled lines of credit as a precautionary measure. The monetary authorities reversed most of the hemorrhage caused by the loss of confidence in the Saudi riyal. Second, the government was obliged to raise oil output to levels unseen since the early 1980s. Saudi Aramco had to respond to a serious crisis without an adequate assessment of its overall production capacity. It quickly became apparent that Saudi Arabia had sufficient capacity to replace the bulk of the 4.5 million to 5 million bpd of Iraqi and Kuwaiti oil embargoed by the UN. Output rose rapidly to 8.5 million bpd, which restored some calm to the international oil market; however, by the end of 1990, oil prices were nearly double those in June 1990.

Supporting the United States-led multinational forces, however, placed an enormous burden on the government's budget. The deficits for 1990 and 1991 reached record levels, so the fiscal authorities were forced again to engage in further external asset drawdowns, increased volumes of development bond sales, and a novel feature: external borrowing from commercial banks and export credit agencies. Saudi Arabia was a prominent member of the World Bank but because of the nation's high per capita income, it was not entitled to borrow from that organization. Most of the major projects envisaged before August 1990 were preserved, however. But external borrowing had gained credence as the means to fund not only budgetary shortfalls but also the capital programs of major public enterprises. Notably, Saudi Aramco did not scale back its crude-oil capacity expansion plan. Rather, it appeared that new ways of financing were being sought from foreign commercial banks, multinational companies, and the domestic private sector. Sabic also moved to raise capital overseas, while Saudi Consolidated Electric Company (Sceco), the electricity conglomerate, requested foreign suppliers to help finance its expansion program.

The fiscal crisis did not cause economic problems for the private sector because the government's reduction of its budgeted expenditures was slight. Moreover, domestic government spending in support of the war effort surged, and many Saudi companies benefited from war-related contracts. Also, as a result of Operation Desert Shield and Operation Desert Storm, the more than 600,000 troops of the multinational forces increased domestic spending on consumer goods. This spending offset the effects of the fall in the number of foreign workers after the government expelled more than 1 million Yemenis, Palestinians, Sudanese, and Iraqis because their countries had not condemned the Iraqi regime. The miniboom, which was interrupted by the Iraqi invasion, was revived by this increase in government spending, and then received further stimulus by three other factors. First, the protection of the kingdom by United States forces and the perception that this would continue enhanced private sector confidence in the government. The private sector again repatriated capital, and the stock market boomed, with share issues rising to unprecedented levels. Second, changing regional politics encouraged many firms, which had set up manufacturing and processing plants for the domestic market, to seek sales in Iran, Turkey, and Central Asia. Third, the government cut domestic fees and utility charges almost in half. This increased subsidy was targeted to lower- and middle-income Saudis but had the net effect of raising domestic disposable income. As a result, it was seen by some people as a serious attempt by the monarchy to head off growing domestic demands for political participation.

Economic policy making

The economic philosophy of the Saudi Arabian royal family has not changed since the reign of Abd al Aziz, but the economic role of the government has grown tremendously. The stated goal of Saudi rulers has been to improve the economic conditions of the country's citizens while retaining the society's Islamic values. Imbedded in this social contract, however, is the issue of political control. The Al Saud recognized that the key to political power in the kingdom lay in replacing the old economy with lucrative new economic opportunities for the country's citizenry.

In the early stages of the kingdom, the only nontraditional economic opportunities for Saudi citizens were linked to employment in the military, distribution of land, and some modest contracts and commissions. Abd al Aziz had limited means. His revenue was adequate to allow only minimal government functions, not, to undertake economic and social projects. Development of the country's oil resources resulted in some wage payments to Saudis and local purchases of goods and services by foreign oil companies, but the impact on the Saudi economy was initially minor. The main beneficiary of oil exports was the ruling family and its tribal allies. Until the 1970s, oil income increased slowly, and the government usually operated under financial constraint. The government's economic decisions were largely those of determining priorities among alternative uses of limited resources. Government structure and subsidiary economic organizations also evolved slowly. In 1952 the Saudi Arabian Monetary Agency (SAMA) was created to serve as the central bank, and in 1962 the General Petroleum and Mineral Organization (Petromin) was formed.

Economic Policy During the Oil Boom, 1974-85

In the early 1970s, the economic situation changed dramatically. Oil exports expanded substantially, royalty payments and taxes on foreign oil companies increased sharply, and oil-exporting governments, including the kingdom, began setting and raising oil export prices. Saudi Arabia's revenues per barrel of oil (averaged from total production and oil revenues) quadrupled from US$0.22 in 1948 to US$0.89 in 1970. By 1973, the price had reached US$1.56 and soared to US$10 and higher in 1974 following the Arab oil embargo introduced to pressure Western supporters of Israel during the October 1973 War. In 1982 the average export price per barrel of oil reached well above US$30. Between 1973 and 1980, government oil revenues jumped from US$4.3 billion to US$101.8 billion. At last the higher oil revenues gave Saudi officials the means to make major structural changes in the economy.

The society encompassed factions eager to promote the modernization program, as well as some elements within the royal family and the religious community who feared the social consequences of rapid economic transformation. Others, mainly from the technocratic elite, were concerned about the economic consequences of such a rapid expansion in expenditures. One choice facing policymakers in the early 1970s was whether to restrict oil production to a level that was adequate to finance limited economic and social development or to allow production at a level that would meet world demand for crude oil. Choosing a relatively high production level would force a decision on whether to use resulting revenues for rapid domestic economic and social development or long-term investments abroad. There were other policy choices. Those people who wanted to keep oil in the ground, except for that needed for limited development, argued strongly that this policy would best preserve the country's resources for future generations.

The choices appear to have been made by 1974 at the latest, although the decision-making process was not always clear or discernible. One issue was clear, however: domestic economic policy did not drive oil production and export policies. The Al Saud pledged to keep oil flowing at moderate prices, commensurate with world needs, arguing that the kingdom was as dependent on the stability and prosperity of consuming nations as those nations were on Saudi oil. Moreover, if Saudi Arabia wanted to ensure that oil would remain the energy source of choice, moderate prices were essential. In addition to framing the issue in purely economic terms, the decision had a geopolitical dimension: since World War II the kingdom had linked itself with the West and was eager to honor its pledge as a loyal ally on the international and regional level. This position was also reflected in its relations with Aramco. Saudi officials argued that the kingdom had avoided nationalization, opting instead for a gradual takeover of foreign oil companies operating within Saudi borders. Despite these attempts to moderate oil prices, the supply-and-demand fundamentals of the international oil market combined with the changes in ownership of downstream assets to raise international oil prices, creating enormous pressures on the domestic front to invest rising oil revenues in developing the country's economic and social infrastructure.

By the mid-1970s, the government had decided to use most of the growing oil revenues for a massive development effort. An important part of that effort was to industrialize, largely by investing in processing plants that used the country's hydrocarbon resources. This policy meant at least a decade of very large investments to build the plants and the necessary infrastructure. It meant financing and building the gas-gathering system, the pipelines for gas and crude oil to bring the raw material to the two chosen main industrial sites--Al Jubayl (or Jubail) and Yanbu al Bahr (known as Yanbu)--and building the industrial sites themselves. The development effort also included many other projects, such as the huge and costly airports at Riyadh and Jiddah, hospitals, schools, industrial and plants, roads and ports. By the mid-1980s the massive expenditures totaled US$500 billion.

The decision to increase the country's oil and gas resource development through downstream investments in refineries and petrochemical plants was logical considering the country's resource endowment. Three factors motivated such a strategy. First, downstream investments were capital-intensive, which fitted Saudi Arabia's small population and large oil revenues. Second, more value-added income would be extracted and retained, thereby maximizing Saudi revenues through the export of more refined petroleum products instead of crude oil. Moreover, the natural gas that had been largely wasted before the 1980s would be processed and used.

Third, some Saudi planners saw industrialization as another opportunity to widen the sphere of economic activity for foreign and domestic private firms. Participation of foreign private sector firms was crucial from the outset. Saudi Arabia invited several international oil companies to invest in joint ventures in the new export refineries built in the kingdom during the late 1970s and early 1980s. Furthermore, participation by international petrochemical companies was necessary to obtain the technology needed. There was also the issue of access to the markets of the West: Saudi planners anticipated regulatory and trade problems by exporting petrochemicals to markets that already had made substantial investments in the petrochemical industry. Saudi planners therefore hoped that, with the help of foreign multinationals, they could fit Saudi petrochemical output into international distribution networks.

On the domestic front, the state would build the basic industries, the crucial first step in the chain of industrial processing. Through loans and other incentives, the state would foster the growth of specific private sector industries that would be at the lower end of the industrial process. Over a period, the planners anticipated that the state-owned conglomerates might be partially privatized.

A large part of the funds spent on development programs were intended to promote private sector investment and to support future consumption. Starting in the mid-1970s, the government decided that an adequate infrastructure was essential to the kingdom's future development. Providing this infrastructure included revamping and building electricity, water, sewerage, desalination, and telecommunication systems. Moreover, it entailed creating airports and ports and laying a vast network of roads. In terms of generating and distributing electric power, the government assisted private companies building and operating its electricity network through concessionary capital loans and continuing operating subsidies. Apart from upgrading distribution facilities for water, the government built several desalination plants and drilled wells, built dams, and installed pumps. Telecommunications were quickly brought to international standards, allowing Saudi Arabia to handle all its communication needs in local and international telephone, telegraph, maritime, and television distribution services, via cable, satellite, and terrestrial transmission systems. Under King Faisal ibn Abd al Aziz Al Saud (1964-75), there was a massive increase in government spending on education to an annual level of about 10 percent of the budget.

Saudi planners also saw the need for a subsidy program to supplement direct government outlays. The major reason was income distribution. Although direct grants to average citizens would have been most efficient, the logistics involved would have been difficult. Conversely, waiting for the oil expenditures to reach this economic and social objective might have created additional social tensions. Therefore, the government adopted a widespread subsidy program for utilities, fuels, agriculture, social services (both private and public), the industrial sector, and several other areas. Beyond income distribution, the rationale of the subsidy program was the need to promote nonoil development through cheap loans, technical assistance, industrial and agricultural incentives, and preferential buying of domestic products by the government. The subsidy program was also designed to improve education and health services.

The massive development effort entailed many risks. The size of the effort and the technology involved required the participation of a huge number of foreign workers for a long period, with the potential of disrupting the society. The pace of modernization was also economically disruptive. Some observers questioned whether Saudi refineries and petrochemical plants would be efficiently managed and prove competitive within a reasonable time. By the early 1980s, the country encountered economic and social tensions--such as the inflation of the mid- 1970s, the takeover of the Grand Mosque in Mecca in November 1979, and disturbances in the Eastern Province in 1979-80--that dissipated only late in the 1980s.

Another risk of the massive development effort was the loss of control over expenditures or inadequate justification of investments. The sudden easing of financial constraints in the mid-1970s permitted consideration of projects too lavish or too large earlier. The forced development of the capital at Riyadh was a sentimental and political decision that required large expenditures to bring such necessities as water, electricity, communications, and housing inland to a capital far from the economic centers of the country. The huge airports at Riyadh and Jiddah (built at a reported cost of US$3.2 billion and more than US$5 billion, respectively) were architectural monuments, but whether they were a wise use of the patrimony of future generations was unclear.

The rapid rise of public purchases and contracts after 1974 caused foreign businessmen to flock to the kingdom. Because Saudi agents were usually essential, foreign businessmen frequently paid them large fees, to be recovered in the contract they were seeking. The Saudi business sector viewed these practices from a perspective different from that of some outside observers: agent fees and influence peddling were called corruption by visiting journalists but were judged less harshly domestically, although there was some unease. Some Saudis criticized agent fees frequently granted to the wealthy, especially people related to the royal family. The perceived costs, combined with growing criticism at home, eventually prompted the government to restrict the use of agents and fees on some defense contracts and to take other measures to control costs.

Looking back at this huge effort in the early 1990s after several years of stagnant public investment, the picture was mixed. On the one hand, the infrastructure had stood the test of time and provided the citizenry with world-class facilities. On the other hand, maintaining these investments, some of which lacked a direct financial payback, despite their more general economic uses, has been costly. More problematic may be the public perception that authorities, having fostered such dependency on government largess, found it extremely difficult to reduce services.

Several other infrastructure problems became apparent. First, the vast majority of expenditures were concentrated in a few cities, predisposing these metropolitan areas to more rapid economic growth. Second, infrastructural support systems were programmed at an early stage of the country's development, rendering some obsolete in the early 1990s. Third, some of the facilities seemed to have been built as an end in themselves, leading to unnecessary waste and continuing maintenance costs.

The most entrenched problem from the period of rapid development of the mid-1970s to the early 1980s stemmed from the government's willingness to subsidize production, consumption, and investment. The objectives for subsidies were threefold: encouraging nonoil economic activity, meeting social goals, and distributing income. The subsidy program may have created greater problems than were earlier anticipated. Saudi planners never thought that oil revenues would constrain expenditures to the extent that they did in the late 1980s and early 1990s. Efficiency requires that subsidies be applied directly at the source. Most Saudi production subsidies have been indirect subsidies, which have reduced the cost to consumers of electricity and other industrial inputs, leading to unnecessary waste. The industrial sector has thereby become a relatively inefficient producer and has made little effort to wean itself from government assistance.

Nowhere was this problem more prevalent than in the agricultural sector where national security was the original objective in raising output. Saudi Arabia became self-sufficient in several major food grains but the cost to the budget and the ecology could not be justified. First, international experience has shown that food embargoes have generally failed unless accompanied by a major military campaign. Second, savings on food purchased from overseas could easily have been invested in inventory to safeguard against an external threat. Third, no social benefit emanated from such a program. Agricultural employment continued to decline, and large conglomerates, rather than peasant farmers, profited from most subsidies. Fourth, subsidies could have been related to more appropriate production methods that promoted water conservation.

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