In the year 2010, the Saudi government is promising to continue being engaged in supporting the economic recovery. The 2010 budget includes a 13.7 percent rise in state expenditures to a projected SR540 billion. In particular, education and manpower development were allocated SR137.6 billion compared with SR121.9 billion in 2009, amounting to a 25.5 percent share of the annual budget. An increase in the defense budget could be anticipated. In 2009, defense spending was allocated SR154.8 billion, almost a third of the budget allocations. A large portion of the defense budget goes toward salary payments which are deployed in the local economy with obvious multiplier effects. The government has been placing greater emphasis on setting up a capital program that generates jobs and prevents the economy from entering into a protracted slowdown.

A welcoming fact about the budget is that capital expenditures have grown at a much faster pace than current expenditures in recent years, rising more than seven-fold between 2000 and 2008. Over the same period, current expenditures advanced 79 percent. This spending pattern stems from the government’s interest in building an efficient and more productive economy over the long term. Although it might be early to judge, government capital expenditure should have an important positive effect on GDP. State spending in Saudi Arabia more than doubled between 2000 — 2009 and we expect the level of spending could more than double again by 2020, depending on how aggressive the government is in expanding the budget going forward.

However, there are clear risks involved with the state spending too much too quickly. The oil price required for Saudi Arabia to balance its budget has been rising as it strives to support a larger population and new infrastructure. The Ministry of Electricity and Water alone projects investments of SR300 billion in electricity generation over the next 10 years to cater to domestic demand growing by 8 percent each year. It is also estimated that by 2020, Saudi Arabia would require investments of close to SR200 billion to increase its water desalination capacity. Sanitation and sewerage spending requirements could add another estimated SR200 billion to the state spending bill over the same period.

A rise in state spending in the medium term is expected as the Kingdom embarks on a $400 billion five-year investment program designed to stimulate the economy as the world recovers from recession. Still, Saudi Arabia is likely to slow the pace of budget growth in the coming years to avoid straining a budget that has more than doubled in size in the last five years. It is no question that the next few years will involve a tremendous degree of state spending that should help support sustainable private sector expansion. What is crucial is that the anticipated trickle-down from the state to the private sector unfolds. Our view is that currently, the knock-on benefits of state spending are, in certain sectors, centering on a few large-sized businesses, making it difficult for small- and medium-sized companies to benefit from public funds pouring into the economy. Public-private partnerships are already taking a prominent role in the water sector, which is encouraging. The multiplier effect for the private sector can be unlocked only if small- and medium-sized business become bigger participants.

Where will the money go?

In 2008, as Saudi Arabia was battling record-high inflation rates, the government pledged to raise wages of public sector employees through a cost-of-living allowance that would add 5 percent to public employee incomes over a period of three years. Next year will be the final year of this program, although even after phasing it out in 2011, we do not expect the wage bill will fall by very much due to a surge in public sector hiring, especially in 2008, when the number of civil service employees (not including the entire government sector) rose by 8.4 percent. That compares with growth rates of between 2 -3 percent between 2000-2007. This could be regarded as a one-off increase given that public sector employment has been historically low and policymakers are aware that public sector is not the employer of last resort. This year, some additional spending on wages will take place as the state includes a 13th month salary, given to public sector employees every three years according to the Hijri calendar. Saudi Arabia’s wage bill is quite high compared with total expenditures. During the pre-boom years, wage expenditures were more than 50 percent of total current expenditures. Now, it stands at closer to 43 percent — a considerable sum given future capital account requirements. Here, we would like to examine some of the key areas of priority emphasized by the government in its 2010 budget allocations.

1. Education and training are allocated SR137.6 billion compared with SR121.94 billion in 2009, an increase of 12.8 percent. Spending is spread across all levels of education, but particular attention is paid to building 1,200 new schools, in addition to the 3,112 schools already under construction. Saudi Arabia also plans to build four new campuses for “newly established universities,” according to the budget. Education spending in the Kingdom has almost tripled this decade, registering annual growth rates of as high as 25 percent in 2005. We anticipate that this level of growth will not be sustainable in the next decade and project that the growth of the budget should level off. Staffing requirements comprise a large part of the education budget.

2. Health and social affairs spending will rise by 51 percent in 2010 to SR61.2 billion, compared with a budget of SR40.43 billion last year, accounting for about 11.3 percent of the budget. The bulk of the increase appears to cover the cost of staffing the large number of hospitals and healthcare centers as the Kingdom continues with plans to modernize the public healthcare system. It plans to build 92 new hospitals.

3. Water, agriculture and infrastructure will receive SR46 billion next year, up from SR35.4 billion in 2009. This includes allocations to water, sewerage and desalination projects. Water and electricity demand is increasing by about 7 percent per year, exerting a greater burden to enhance capacity. In addition, the industrial cities of Jubail and Yanbu will continue to receive budgetary appropriations.

4. Transportation and telecommunications are allocated SR23.9 billion, over a budgeted SR14.6 billion in 2009. Financing has been dedicated to projects including the building new roads spanning 6,400 kilometers.

5. Municipal services will receive SR21.7 billion compared with SR16.5 billion in 2009. New projects include inter- city roads, intersections and bridges. Traffic bottlenecks have been an ongoing concern in Riyadh, Jeddah and Makkah, which are reaching capacity limits.

The rapid rise in Saudi state spending this decade has been prudent and sustainable due to the significant rise in oil prices to record levels in 2008. But a subsequent oil price slump into the early part of 2009, triggered by the global financial crisis, highlighted the Kingdom’s vulnerability to big swings in oil prices. Saudi Arabia’s ace was its foreign assets. What has distinguished this oil boom for Saudi Arabia is the Kingdom’s ability and willingness to save a large proportion of its oil revenues. This year, the foreign assets held by SAMA are likely to amount to SR1.5 trillion — more than 110 percent of GDP. That compares with foreign asset holdings amounting to 27.7 percent of GDP at the beginning of the oil price rally in 2003. The authorities have taken adequate measures recently to rein in some seasonal expenditures, particularly subsidies that have been piling on fiscal pressure. The rice subsidy which was in place for two years and set to be abolished as of December 2009 cost more than SR1.1 billion every year. In January 2009, meanwhile, government subsidies on barley were cut to $80 per metric ton from $200, while subsidies on feed corn and other animal feed ingredients were also decreased. The political economy of subsidies is complex and powerful in Saudi Arabia, hence the existence of some steep subsidies. Subsidies for utilities and petroleum products are becoming increasingly costly with a high opportunity cost. Water and electricity tariffs are among the lowest in the world at SR0.10 per cubic meter and SR0.12 per kilowatt-hour, respectively.

Revenues from the export of crude oil accounted for 89 percent of total Saudi revenues in 2008, second only to Kuwait in the Gulf Arab region in terms of the degree of dependence on hydrocarbon exports. The Kingdom has been actively striving to boost the role of the non-oil sector by pouring funds in infrastructure projects and taking the necessary steps in providing the right skills in order to create more job opportunities. Due to these efforts, we expect Saudi Arabia’s reliance on crude oil revenues to decline slightly over the next 10 years to 84 percent in 2015 and 81 percent in 2020. With the non-oil sector still contributing less than a fifth to public revenues in 2020, the Kingdom will remain vulnerable to oil price fluctuations as it supports its growing spending needs. Saudi Arabia has long approached its fiscal position using a counter-cyclical approach — whereby the state saves and invests cash in lower risk assets during periods of high oil prices and draws on these savings during periods of depressed oil prices. With public spending levels now reaching record heights, it will become increasingly important for the government to adopt prudence, while sustaining a high enough level of fiscal expansion to support the demands of its growing population.

Saudi Arabia’s planned budgetary expansion and high fiscal spending is justified as the global economy tries to pick up its recovery pace. The Saudi population is growing at a rate of more than 2 percent each year and is expected to rise to 29 million by 2015 and almost 32 million by 2020, according to our projections. In the latest budget, Saudi Arabia raised its expenditure target by 13.7 percent to SR540 billion in 2010 from 475 billion in 2009, marking the largest budget outlay in the country’s history. Overall, Saudi Arabia has plenty of room to maneuver its budget in the next few years, but there are certain risks associated with continuous high spending which we highlight by developing scenarios of what the budget could look like in 2015 and 2020. It looks increasingly likely that annual public spending will near or cross SR1 trillion by 2020. This is a very big burden that must be approached with caution if Saudi Arabia wants to avoid entering another cycle of fiscal deficits. The kingdom posted budget deficits in all but one year between 1983 and 2002. To explore the risks Saudi Arabia faces if it expands its budget too quickly, we have developed three possible scenarios for what the Kingdom’s budget could look like by 2015 and 2020, depending on the pace at which Saudi Arabia will allow its spending to rise. Our first assumption is based on oil price expectations of the International Energy Agency (IEA) in its 2009 Global Energy Outlook. The IEA, which advises 28 industrialized countries, assumes oil prices of $102 a barrel in 2015 and $131 billion of 2020 in a reference scenario, which is based on the assessment that oil prices will rebound as global oil demand recovery outpaces the growth in capacity. However, in an alternate turn of events, called the 450 scenario, the IEA assumes oil prices will rise to $102 a barrel in 2015 and then remain flat to 2030 due to weaker demand as climate policies weigh on fossil energy use. As a result, we also make assumptions about the potential implications for the Saudi budget of a sustained period of oil prices at or below $80 a barrel.

Assuming oil

at $100

Assuming the former scenario, that oil prices will rise above $100 a barrel by 2015, our key findings are that if Saudi Arabia pursues aggressive spending growth of 15 percent per year between 2011 — 2015 and 10 percent between 2016 — 2020, it is likely to post a steep budget deficit of SR149 billion by 2020, the biggest in its history. Our analysis includes assumptions about Saudi Arabia’s oil production, the level of domestic consumption, and the population.

We do not think it is likely that Saudi Arabia will sustain such high levels of overspending beyond the next few years. The government has committed to aggressive spending over a five-year period ending 2013. After that, it is likely the pace of budget expansion will fall considerably if not stagnate. According to our findings, should state expenditures grow at slower rates of between 3 percent and 10 percent per year over the next decade, Saudi Arabia should be able to support a growing budget with expenditures above SR1 trillion by 2020. Saudi government departments have also developed a habit of overspending. The Kingdom has exceeded its expenditure targets by more than 15 percent, and in many cases more than 20 percent, in each year this decade. Such heavy levels of overspending will become unsustainable in a matter of years without tapping debt markets and we expect the government will be compelled to either curtail its spending targets or need to find ways to bring actual spending more in line with its budget allocations. In 2009, the government spent 16 percent more than it had planned. We expect the level of overspending to fall to 14.5 percent in 2010 and to fall to low single-digit levels by 2015. The level of overspending could also fall quickly in the coming years as the government insists on its departments meeting, not exceeding, set expenditure quotas. One way to achieve this would be for the government to move toward creating endowments for each ministry so as rid of their annual budgetary dependence. This requires a change in the way budgetary endowments are carried out but also the functioning of ministries. It is a bold step that is forward looking and it places greater burden on the capacity of ministries and government agencies to act as investment institutions than simply endowment allocators. This is currently being tried out with one Saudi institution, KAUST (King Abdullah University of Science and Technology) which is operating on an endowment basis. We are in no way proposing that Saudi Arabia’s institutions are ready to carry out such tasks now and it would take many years for capacity building to take shape but it is an idea. What if oil prices touch extremes? While Saudi Arabia should be able to comfortably boost state spending in the next decade, any budgetary expansion should be approached with caution. Saudi Arabia’s budget is likely to have grown by seven-fold in the quarter-century to 2020. To sustain this degree of fiscal expansion, Saudi Arabia will require higher oil prices to balance its budget in the coming years. Assuming that oil prices stand at $70 in 2015 and $80 in 2020, Saudi Arabia will be unable to balance its budget if expenditures rise at an annual rate of 10 percent per year to 2015 and 5 percent per year to 2020. Assuming this scenario, by 2020, Saudi Arabia’s budget deficit would reach a steep SR103.2 billion. At the other extreme, should oil prices rally to new heights and rise to $150 a barrel by 2015 and $200 a barrel by 2020, the Kingdom would bring in surpluses far exceeding SR1 trillion by the end of the forecast period even with bullish levels of state expenditures. Discussing these two extremes highlights a key point — the Saudi economy will continue to be heavily reliant on hydrocarbons even as more prominence is placed on expanding the role of the non-oil sector. This leads us to call for greater emphasis to be placed on private-sector job creation as the hydrocarbon sector would be unable to absorb the impending onslaught of job seekers. The burden will fall on the private sector to create the jobs, which will be among the biggest challenges facing Saudi policymakers in the years to come.

(Concluded)

(John Sfakianakis is group general manager and chief economist at Banque Saudi Fransi, Riyadh)