In its latest Economic and Financial Review of Saudi Arabia, National Bank of Kuwait (NBK) examined how the world’s largest oil exporter has prospered and put on its best economic performance in two decades as a result of the recent oil boom. Indeed, Saudi Arabia has become one of the fastest-expanding economies in the region, with real economic growth averaging an estimated 6% over the past four years, compared with a 1.4% average growth over the previous 10 years. Nominal gross domestic product (GDP) reached $311 billion in 2005 and is estimated to have increased 11.2% in 2006. Given that this growth was in great measure export driven, the country has amassed almost $200 billion in foreign assets in the past four years, paid down public debt, and funded a massive investment boom not seen in almost three decades. The varied nature of the investment projects, ranging from oil, gas, petrochemicals and industrial projects to new whole economic cities, promises to raise the absorptive capacity of the economy, unlike in previous oil booms.
The growth momentum was slower in 2006, at an estimated 3.4%, because of a smaller increase in oil prices and production. The negative wealth effect of a sharp drop in local equity prices that wiped out roughly 60% of market capitalization between February and December 2006 may have also dampened consumer and investment spending. However, higher public spending and investment in the hydrocarbon sector, coupled with a rapid increase in the employment of nationals and expatriate labor, ameliorated the impact of the drop in the stock market. In nominal terms, the non-oil private sector maintained a growth rate of 6.9%, near the average for the 2003–2005 period, which was more than double the growth registered in the previous 10 years. Furthermore, the private sector’s contribution to the non-oil economy remained largely stable, accounting for 63% of non-oil GDP, in line with its performance since 1992. However, with the rise in oil GDP, the private sector’s contribution to the overall economy fell from 41% in 2002 to below 30%.
Looking forward, NBK believes Saudi Arabia has the potential to continue to grow rapidly—driven by the strength of global energy demand, substantial public and private investment, an improving business environment benefiting from liberalization and privatization initiatives, and a rapidly growing population enjoying higher purchasing power.
According to NBK, barring a major conflict in the region, economic growth dynamics are likely to maintain their course in 2007 fueled by sustained high levels of oil prices and by the investment boom that reflects rising confidence in the economy’s future prospects. Nominal GDP growth is expected to reach 10% while real growth could falter to around 4%, though the contribution of the private sector may still grow at 6% in real terms.
The boom could see more than $300 billion spent on various sectors of the economy in the next five years, according to NBK estimates. This investment would include projects in the oil and gas sector, energy and infrastructure, and real estate, as well as an estimated $80 billion to be invested in six planned economic cities throughout the Kingdom. To accommodate these investment plans, the government has already announced that it will spend in the next year $33.7 billion, or one-third of its 2007 budget, on new and ongoing projects. As a result, the Saudi market continues to appeal to a wide range of investors for direct and/or portfolio investments. Continued regulatory reforms and improvements will be key to attracting these investments into the Kingdom.
Nonetheless, Saudi Arabia continues to face several challenges, not the least of which is the demographic bulge. With more than 40% of its nationals under the age of 20, the country faces a challenge similar to that faced by other Gulf Cooperation Council (GCC) members, that of creating sufficient jobs for its youth to lower the unemployment rate among nationals that is estimated at higher than 15%. Considering that total employment grew at 14% in 2005, the main obstacle does not lie on the demand side, but rather with the ability of Saudi Arabia to develop its human resources in such a way as to make a better match between the skills and expectations of nationals and the new jobs being created, according to NBK report.
A lesser, although rising, risk is inflation. Inflationary pressures have started to emerge with the general price level up 2.2% in 2006, the highest rate since 2000.. With soaring economic growth and faster increases in food prices and rents, inflation is expected to rise to around 3% in 2007. The inflationary environment engulfing the GCC has prompted increased coordination between SAMA and Ministry of Finance, even though Saudi Arabia continues to have low inflation in both in absolute terms as well as when compared with other GCC member states.
NBK's report notes that geopolitical risks pose another challenge, though perceptions of such risks diverge when viewed from a local or foreign perspective. Security, regional stability, or the standoff between Iran and the international community over its nuclear program are likely to keep tensions high in the region. However, one has to keep in mind that to the extent that the shipping routes out of the Gulf are not affected and Saudi oil facilities remain secure, even an open conflagration is unlikely to change the macroeconomic dynamics of the country. If anything, oil prices are more likely to shoot up when nervousness increases, allowing the Kingdom’s export receipts to rise and support the growth environment.
The performance of the non-oil sector has reflected the relative success of the government’s efforts to diversify in NBK's view. Liberalization measures, subsidized financing, and export-promotion policies no doubt contributed to the 6.8% real growth in this sector in 2005, its highest rate yet. Telecommunications, for example, has been one of the fastest-expanding sectors in Saudi Arabia and is a strong candidate for further expansion. The sector’s low penetration rates leave much room for participation from the private sector. The increase in projects in the transport sector, such as the construction of the first railway link between the Red Sea and the Arabian Gulf, in addition to two more railway projects, which will add 3,900 kilometers to the standing network, should result in accelerated growth in 2006 and beyond. Similarly, banking and insurance have been strong growth areas where greater openness and an improved operating framework are expected to lead to further efficiency gains.
Other sectors experiencing strong growth included construction and real estate. These have benefited from a combination of higher government spending on new projects, a rapidly expanding population, and the 2000 real estate legislation allowing foreign ownership. Nonetheless, the housing boom in the country has not been able to combat the housing shortage as demand continues to outpace supply. Wholesale trade and retail trade have also performed strongly following the end of the war in Iraq in 2003 that saw trade activities between the two countries soar.
The oil boom has produced a significant improvement in external and fiscal positions. Budget surpluses materialized four years in a row despite a continuous and rapid increase in expenditures. The Ministry of Finance estimates that the surplus achieved in 2006 was $70.7 billion (20% of GDP), compared with a $58 billion surplus in 2005. The surpluses were used to reduce the public debt, accumulate government reserves, and finance investments in priority areas such as infrastructure and human resource developments. As a percentage of GDP, public debt fell sharply, from 92% in 2003 to 30% by the end of 2006. The net foreign assets of the Saudi Arabian Monetary Agency (SAMA) quadrupled in the span of four years, reaching $221 billion at the end of December 2006, roughly 64% of the country’s GDP. For 2007, the budget surplus is expected to exceed last year’s level as rising costs appear to be delaying the implementation of some capital projects.
NBK notes the external sector also reveals a similarly healthy outcome. The current account surplus more than tripled over the last four years and is almost 10 times the level that prevailed in 2001, jumping from $28.1 billion in 2003 (13% of GDP) to $95.4 billion by the end of 2006 (28% of GDP). This strong performance primarily reflects exceptionally high levels of merchandise exports. On average, exports grew 31% per annum during the last four years, while imports increased 19% per annum. In light of such developments, Moody’s, the international credit-rating agency, raised Saudi Arabia’s sovereign rating to A3 from Baa2, and back up to A2 in October of 2006, while Standard and Poor’s raised it to A+ from A.
In general, Saudi Arabia’s monetary policy has remained directed toward promoting economic growth, maintaining the exchange rate peg to the U.S. dollar, and price stability. The 19.3% growth in the money supply (M3) in 2006 was the highest in decades, reflecting the accommodative stance of monetary authorities that allowed the banking system to provide needed liquidity to support the strong expansion in the economy.
The growth in liquidity was primarily the outcome of a significant expansion in net foreign assets (NFAs) arising from the conversion of government oil revenues in foreign currency into domestic currency. NFAs increased 53% in 2006, following 30% average annual growth since 2002. The bulk of these assets were held by the Saudi Arabian Monetary Agency mainly in the form of foreign securities and deposits abroad. Meanwhile, net domestic assets dropped for the second year in a row, largely reflecting rising government deposits and the reduction in holdings of government securities by local banks.
Tighter regulations on consumer lending introduced in November 2005 and the steep correction that took place in the local equity market during 2006 caused growth in private sector credit to slow down to 9.8% in 2006, following increases of 39% and 37% in the previous two years, according to NBK.
Concern over the proportion of new credit in the form of consumer loans and margin financing was behind such tightening measures that also caused spreads between Saudi riyal and U.S. dollar deposits (in favor of the riyal) to widen to near 50 basis points just before the correction in the equity market. However, the situation started to reverse with spreads plunging below zero by the second quarter reflecting easing liquidity constraints and SAMA refraining from raising interest rates in tandem with the U.S. Federal Reserve in both March and May of 2006. Some attribute SAMA’s inaction at the time to concerns over the weak sentiment prevailing in the wake of plunging equity prices. The negative carry spreads of Saudi riyals may have been behind the lower speculation about the possibility of a riyal revaluation compared to some other Gulf currencies. Historically, interest rates in Saudi Arabia track U.S. dollar rates by virtue of the dollar peg. Indeed, riyal rates have been trending upward since 2003, and deposit rates in 2006 were on average 1.0% to 1.25% higher than in 2005.
As mentioned earlier, slower growth in credit during 2006 was in part related to the local stock market. The three-year rally over the period 2003–2005 saw the market advance 500% and an extreme overvaluation of Saudi equities, which led to a market crash in late February of 2006. By the end of 2006, the market retreated nearly 60% from its peak and continued to trail downward to shed another 8% in the first six months of 2007 as measured by the MSCI Saudi Arabia Domestic Index. Underpriced initial public offerings (IPOs), ample bank credit, surging corporate profitability, and a positive macroeconomic picture had combined to drive investor confidence to exuberant levels and valuations to new territory by year-end 2005.
NBK report mentioned that the continued absence of a real institutional participation in the Saudi market allows retail dominance, which results in high volatility and prevents market consolidation. Moreover, while the Saudi market continued to bleed, trading activity remains fervent. Today, valuation levels in the Saudi market look more reasonable, but remain expensive compared with its GCC counterparts. While some companies are beginning to look attractive from a valuation standpoint, high market volatility has sidelined long-term, value-oriented investors. A series of reform measures introduced in mid-2006 to reinstate confidence in the Tadawul market are expected to help market maturity and efficiency in the long run. However, opening the door for non-Saudi investors, individuals, and institutions is key to a mature and efficient market.
With virtually most listed companies, with the exception of a handful of large players in the petrochemical and telecommunications sectors, exposed to local equities, growth in corporate profits slowed to 13% in 2006 from an annual average of 52% in the previous three years. Banks that derived a big part of their operating income from trading-related activities including margin lending and brokerage services did not see the impact until the first quarter of 2007, when net profits of eight leading Saudi banks fell 21% from a year ago. The impact of the correction on real economic activity is likely to be limited, given the strong underlying growth momentum.
© 2007 Al Bawaba (www.albawaba.com)
