RIYADH, 18 April 2005 — Oil liquidity affects the economy in a two-step process. First, it enters the economy as new liquidity, and, second, it goes around multiple times to finance economic activity. This two-step process gives each oil riyal a “bang for the buck” that is far greater than its size. In this report, we look at the first step. Oil revenue brought home by the government does not enter domestic liquidity until the government spends it. The government or Aramco, which books the oil export revenues in the first place, could spend part of it abroad or invest it overseas. This part also does not enter domestic liquidity.
According to Saudi Arabian Monetary Agency (SAMA), the government’s net domestic spending (i.e., domestic spending minus domestic revenues) totaled SR224 billion in 2003. Economists call this “high-powered money” because of its ability to create liquidity several times its size. Consider the process as it happens: When the government spends one riyal from its account with SAMA — the government’s banker — it winds up as banking system reserves (the check holder most likely will deposit it into his bank account before spending it). Because of the fractional reserve banking system, banks can lend out the excess over what SAMA requires (7 percent on current accounts and 2 percent on savings/time deposits).
In principle, this on-lending, called the “money multiplier process” can continue until the entire new excess reserves have been exhausted. There is a mathematical formula to calculate how much liquidity this can create in principle. Using the average reserve deposit ratio (6 percent in 2004), we calculate that each new oil riyal of government spending has the power to create up to SR16.6, or over sixteen times in additional liquidity. Thus, the SR224 billion that the government spent in 2003 had the potential to create as much as SR3.7 trillion in new liquidity!! SAMA says that about two-thirds of total government spending is domestic. Thus, between 2002 and 2004, net government spending totaled about SR575 billion, which would have had the potential to create up to SR10 trillion of new liquidity.
Those who wonder where the money for the triple-digit growth in Saudi stocks the last 3 years came from may take pause with this number. Of course, the actual true domestic liquidity created is not as high as the maximum because there are leakages: (i) not all the new high-powered money stays in the domestic economy and (ii) the banking system does not on-lend the money up to the maximum because of the lack of loan demand/appetite. A large part of the liquidity leaks out abroad as private sector spending on imports, overseas investment and foreign remittances. SAMA’s calculations show that in 2003, SR153 billion of high-powered money left the country. Moreover, banks created only SR37 billion in new loans and another SR77 billion was withdrawn by SAMA and the banks, reflected in “other liabilities (net).” Thus, liquidity remaining in the country after leakages was only SR31 billion at the end of 2003.
(Khan H. Zahid is chief economist and vice president at Riyad Bank. He is based in Riyadh.)