JEDDAH, 17 October 2005 — The borrowing boom, rising equity and real estate markets, growing corporate earnings and stepped up business investments are central to the current cycle of liquidity and economic growth. However, the impact of higher oil revenues on the domestic economy this year has yet to fully demonstrate its impetus. The broadest money supply aggregate (M3) grew by 19.1 percent in 2004, the highest level of growth seen since the first oil boom a quarter century ago. The liquidity expansion last year was even faster than the 16.8 percent growth recorded in nominal GDP. Like last year, a key driver to economic growth this year is the liberal expansion of bank credit, which is also impacting liquidity. Higher oil revenues and business investments have also started penetrating into the domestic economy. The large capital expenditure by the government along with the upcoming investments in mega projects by Saudi Aramco, Saudi Basic Industries Corp. (SABIC) and private sector businesses are expected to reinforce the current cycle of monetary expansion in the years ahead.

In the first eight months of 2005, the liquidity measured by M3 expanded nearly 6.9 percent over its level on Dec. 31, 2004 and its strong growth is still intact at 16.0 percent in the 12 months to August 2005.

In absolute terms, the money supply aggregate (M3) stood at SR524.3 billion at the end of August 2005, compared with SR490.3 billion on Dec. 31, 2004, suggesting a net expansion of SR34.1 billion in the first eight months of this year, on top of SR78.5 billion witnessed in 2004. The current pace of liquidity growth is expected to continue during the remaining four months of this year with the money supply aggregate M3 forecast to reach SR555 billion by end of December 2005, representing nearly 13.2 percent growth over the closing level of 2004. This will be an equivalent to SR65 billion in net expansion, sustaining the current economic growth momentum going forward.

Creation of Money Through Bank Credit

The creation of money by banks generally means the creation of some form of debt which is normally used by the public to make payments and to settle debt. In the process, bank lending re-emerges as deposits. The portion of banks’ contribution to the liquidity growth can be measured through the industry’s overall credit expansion in relation to the resources available for lending. At the end of August 2005, banks’ portfolio of loans and advances rose by 23.9 percent to SR411.5 billion, from SR332.1 billion by end December 2004, suggesting a net credit expansion equivalent of SR79.4 billion in the first eight months of this year in relation to the total expansion of SR85.2 billion for the whole of 2004. In 2004, of the SR85.2 billion worth of expansion in bank credit, nearly 80.2 percent (SR68.3 billion) was due to expansion of deposits, redemption of investments, and changes in net-foreign assets. The remaining 19.8 percent (SR16.9 billion) of the total loans was largely attributed to the banks’ creation of new money. Any other new money emanating from higher oil revenues and consequently increased state spending should have also been reflected in the expansion of bank deposits.

During the first eight-month of this year, of the SR79.4 billion in net-increase in banks’ lending, nearly 44.7 percent of the total was funded by the net expansion of deposits, around 12.2 percent encashment of maturing Government bonds, and about 15.5 percent drawdown in net-foreign assets. The remaining 27.7 percent was due to the creation of new money by banks which include any increase in capital and reserves, and the portion of deposits created by the lending process.

In all, banks’ contribution to liquidity expansion occurs through industry’s overall loans-to-deposit ratio, which stood at 77.2 percent in 2004 and further rose to 88.4 percent in July 2005. This implies that for each SR100 of total deposits, the banks lent out SR88.4 during the January-August 2005 period, and SR77.2 in the entire 2004.

Liquidity Growth Across Components

The sum of currency in circulation and demand deposits or non-interest bearing deposits (NIBs) makes up the narrowest money supply aggregate (M1). In 2004, the stock of M1 had a strong growth of 21.6 percent or an absolute expansion of SR48.3 billion to reach SR271.3 billion. This was primarily attributed to 26 percent growth in demand deposits, which accounted for nearly 43 percent of the total money supply (M3). In the first eight months of 2005, the pace of growth in M1 was slower at 1.8 percent, but year-on-year growth was still high at 13.3 percent to stand at SR276.1 billion by the end of August 2005. This resulted mainly from a solid rise in demand deposits or non-interest bearing account (NIBs) by 15.1 percent or an amount of SR28.5 billion over August 2004.

The currency in circulation or currency outside the banking system, shrank 2.3 percent in the first eight months of 2005, after a strong 8.5 percent upsurge in 2005. The introduction of internet banking and the popularization of ATMs has caused currency in circulation to decline from 9.1 percent of nominal GDP in 1999 to just 6.4 percent in 2004 and further down to 5.1 percent in August on the projected GDP for 2005.

Solvency Indicators of the Saudi Economy

The money supply aggregate (M2), which is the sum of M1 and time & savings deposits, having strongly expanded by 20.5 percent last year continued well into 2005, recording lower growth at 5.9 percent in the first eight months of this year. However, year-on-year growth is still intact at 16.1 percent reaching SR432.1 billion in August 2005.

In any economy, excess money supply (M2) normally leads to rising consumer inflation, builds speculative bubble in stock prices, and undermines the external value of national currency and thus impairs the solvency of that country. By end of August 2005, Saudi Arabia was maintaining aggregate foreign exchange reserves of SR646.4 billion, with SAMA holding the bulk 70.2 percent of the total, followed by Autonomous Government Institutions (AGIs) 24.4 percent, and local commercial banks 5.4 percent. The Kingdom’s huge foreign exchange reserves held at the end of August 2005 demonstrates that for each SR100 within the Saudi monetary system in the form of M2, the country holds SR150 in foreign exchange reserves. This reflects the high degree of solvency of the Saudi monetary system, which is central to the exchange rate stability and lower inflation.

— (Dr. Said Al-Shaikh is chief economist at the National Commercial Bank in Jeddah)