Saudi Arabia’s economic recovery this year will most likely follow a gradual, steady track. Economic growth should accelerate following a stagnant and difficult year, inflation will remain at manageable but historically high levels and expansion of the private sector is set to take a turn for the better along with credit expansion at Saudi banks. The government, through a stimulatory public spending program, will continue to lead the pick up in the economy as Saudi oil averages around $74 a barrel and low levels of government debt bolster the Kingdom’s fiscal position. A higher oil price environment will enable Saudi Arabia to experience comfortable budget and current account surpluses.

While many key elements are in place to support a recovery in the Middle East’s largest economy, Banque Saudi Fransi (BSF) reducing slightly its 2010 economic growth forecast for the Kingdom to 3.9 percent from 4 percent based on our view that improvements in business activity will be gradual and cautious. The government’s commitment to counter-cyclical fiscal expansion remains solid.

Banks are likely to loosen up on their reluctance toward lending to the public and private sectors, one barrier that choked the private sector during 2009. Last year, claims on both sectors by banks contracted by almost 5 percent, following growth of 30 percent during 2008. This year, banks will have little choice than to lend more as they emerge from a period of challenging revenues and an unfavorable low interest rate environment.

It was not only banks that stifled nonoil private sector growth in 2009; private Saudi companies themselves shelved many projects as international credit became more scarce, and businesses deleveraged and restructured. Assessing the private sector’s appetite to expand is as important as examining banks’ willingness to lend.

The Saudi government last month revised lower its real GDP growth figure for 2007 to 2 percent (from 3.3 percent) and 2008 to 4.3 percent (from 4.45 percent).

Real economic growth in Saudi Arabia has not surpassed 5 percent since 2005. Expansion of the private sector — which was growing by more than 5 percent per year between 2004-2007 — is also down to levels that are not strong enough to support the amount of job creation Saudi Arabia needs in order to cater to a population that accounts for two-thirds of the Gulf total, and is growing around 2 percent per year. The private sector expanded 2.5 percent in 2009 and the bank anticipates growth to rise to 3.7 percent in 2010.

A measured turnaround

The Saudi economy registered better-than-expected growth of 0.15 percent in 2009, while nominal GDP, subject to oil price fluctuations, contracted around 21 percent, according to government estimates. A smaller-than-anticipated decline in oil sector output of 6.4 percent enabled GDP to grow last year as most major world economies fell into recession. The bank had expected a 9.1 percent contraction in the oil sector, which underestimated Saudi Aramco’s investments in oil sector expansion.

The private sector’s investment appetite subsided and overall domestic demand declined, contributing to low nonoil private sector performance. The private sector expanded 2.5 percent down sharply from 4.7 percent a year earlier. International and local credit was scant and prompted many businesses to postpone and cancel projects as they opted to hoard cash.

BSF is cautiously optimistic that 2010 will witness an improvement in the private sector’s performance. The downside risks BSF foresees are linked to both the willingness of banks to provide credit and on the private sector’s willingness to undertake investments. BSF anticipates private sector GDP will expand at 3.7 percent this year, accounting for more than 47 percent of GDP at constant prices. With oil prices standing around $80 a barrel and key global economies beginning to return to growth, Saudi Arabia, a seminal oil and petrochemical products exporter, is likely to benefit from the improvement in global economic conditions. The bank foresees real growth for the Saudi economy of 3.9 percent this year, including a 4.1 percent rise in real oil GDP activity (accounting for 28 percent of total GDP). GDP growth should rise to 4.8 percent in 2011, the fastest pace in six years, once banking sector and business momentum is back in full swing.

BSF expects the government sector to grow by 4.1 percent in 2010, accelerating slightly from its 4 percent growth level last year, as the state continues to take the lead in the economic recovery. Government sector growth above 4 percent has happened only three times in the last 20 years — 2005, 1997 and 1992.

In the 2010 budget, this expansionary stance culminated in a 13.7 percent rise in projected state expenditures to a record level of SR540 billion. The largest budget in Saudi history is designed to encourage private sector businesses to loosen their purse strings and urge banks, awash with liquidity, to jumpstart lending following a slow 2009.

According to government budget projections, which BSF estimates are based on an average oil price of $44 per barrel for Saudi crude, the state’s fiscal deficit will widen to SR70 billion in 2010 after a smaller-than-expected shortfall of SR45 billion in 2009.

Below is a breakdown of some of the key trends the bank expects in nonoil economic sectors this year:

Finance

Finance sector GDP growth rates continued their declining trend in 2008-2009 as both bank profit and asset growth registered weak performance. The growth rate dropped to 2.8 percent in 2008 and 1.8 percent in 2009. Last year, in particular, bank lending to the private sector slowed to a crawl. Despite being awash with liquidity, bank claims on the private sector rose only 2 percent, down from 27 percent expansion a year earlier. Total domestic credit growth (including lending to public entities) fell about 5.4 percent last year.

As risk appetite among banks cautiously returns this year, the bank expects the finance, insurance and real estate sector will grow 3.8 percent in 2010, more than double its rate of growth last year.

BSF does not expect any change to SAMA’s (Saudi Arabian Monetary Agency’s) exchange rate policy in 2010.

Construction

Saudi Arabia’s construction sector grew 3.9 percent in real terms in 2009 — faster than growth of 2.2 percent registered a year earlier. This is partly a reflection of the knock-on affect of government infrastructure spending. In bank’s view, a lot of work remains to address growing demand for housing which BSF estimates, given prevailing conditions, at 255,000 residential units per year for the next five years. The kingdom’s real estate sector is still suffering from a shortage of housing units, a fact that has shielded it from the sharp price corrections experienced in neighboring countries, particularly the United Arab Emirates. The demand for new housing will continue, steered by the indigenous population.

Manufacturing

In 2009, manufacturing sector GDP growth slowed sharply to 1.7 percent from almost 6 percent in 2008. This decline in output is understandable given the general deceleration in the domestic economy, in addition to a slowdown in demand for goods, particularly petrochemical products, globally. The value of petrochemical and plastics exports from Saudi Arabia, for instance, fell 21.5 percent between January and September of 2009, according to preliminary data of the Central Department of Statistics (CDSI). The bank anticipate the manufacturing sector’s output will rise to 4.1 percent in 2010 as petrochemical output increases on the back of higher oil prices and new production volumes reach fruition.

Wholesale trade

Wholesale and retail trade is likely to witness GDP growth rates of 3.6 percent this year, compared with 1.97 percent in 2009, according to BSF estimates. Saudi Arabia’s exports are highly dependent on the price of and demand for oil. Oil exports accounted for 85 percent of a total estimated $153 billion in 2009. Nonoil exports, primarily petrochemicals and derived products, have performed well over the past few years in line with global demand and the Kingdom’s competitive advantage. However nonoil exports were not isolated from the global economic downturn, falling about 16 percent in 2009.

Letters of credit against the import of items such as food, automobiles and machinery are likely to track the performance of private sector expansion and private consumption. The bank expects imports, which fell 21 percent to $80.3 billion in 2009, to climb to $94.7 billion in 2010.

BSF anticipates that Saudi Arabia’s current account surplus will rise to SR98.7 billion this year, or 6.2 percent of GDP, compared with SR76.7 billion last year on the back of higher oil income.

Electricity

The electricity, gas and water sector grew 3.4 percent in 2009, down from an expansion at constant prices of 6.7 percent a year earlier, and we expect this sector to grow by a solid 4.3 percent this year. As demand for utilities rises in the coming years, greater government and private funds will be allocated to efforts to improve output and address growing demand. In 2008, electricity generation grew 5.7 percent, and domestic demand for utilities is growing by 8% per year.

Transport

BSF expects the transport and communications sector to grow 4.8 percent this year, having been the fastest-growing sector last year, at 6 percent. The Saudi telecoms sector has expanded quickly with the introduction of two mobile phone operators to compete with the incumbent Saudi Telecom Co. in recent years. Zain Saudi Arabia, the Kingdom’s third mobile phone operator, reached 6 million subscribers in November, and total Saudi mobile phone subscriptions exceeded 41 million at the end of the third quarter.

Agriculture

Agriculture GDP is likely to grow 0.5 percent in 2010 according to our estimates, up from growth of 0.2 percent last year. While the rate appears low at first glance, it is in line with the state’s policy of moving away from agricultural production toward importing key commodities, including wheat. Saudi Arabia is giving up a 30-year program to grow its own wheat as part of a government strategy to change its water usage habits by phasing out water-intensive crop production.

Inflation

After soaring to a record 9.9 percent in 2008, inflationary pressures subsided in 2009 due to slower domestic demand, lower global commodity prices, a retreat in food prices and a decline in domestic rents. The circumstances created deflationary trends in some Gulf countries, particularly Qatar, although we do not foresee a substantial decline in inflation in Saudi Arabia this year. BSF expects Saudi annual inflation to average 4.3 percent this year, compared with 5.1 percent in 2009.

A pick up in global demand for energy, as well as petrochemicals, bodes well for the Kingdom’s macroeconomic fundamentals, which remain among the most robust in the Middle East region. Against the backdrop of these prime conditions for growth, policymakers should not lose sight of the productivity trends that have implications for real wealth creation and real per-capita increases. Productivity in the government sector has been declining since 2004, with a particularly sharp drop in 2008 as a large increase in state employment numbers took place without a simultaneous gain in output of government services. The government added 69,726 civil service employees in 2008 — the biggest year-on-year climb in the work force in more than two decades. The move coincided with a drop in the official Saudi unemployment rate to 9.8 percent that year from 11.1 percent in 2007. The government’s addition of 66,851 Saudi employees in 2008 compared with a smaller 63,436 hired by the private sector. The increase in public employment can be partly explained by the state’s overall expansive role in the economy. While new hiring of civil service employees has succeeded at easing employment bottlenecks, productivity levels in the public sector have declined in the recent past. During the 1990s up to 2003, fluctuations in the civil service work force were on par with government services GDP growth.

After 2004, however, government services GDP growth witnessed a sharp slowdown while the number of state employees surged — a trend that has hurt productivity.

Improving productivity has implications on a country’s GDP. While boosting employment numbers leads to a one-time upward shift in GDP, it is per-unit labor improvements that have the potential to lead to higher salaries, retain higher profits and reduce costs. These surpluses are channeled back into the economy through higher consumer spending, exports and business investment — hence their broader contribution to improving overall economic output.

Private sector

While private sector GDP continues to grow, the sector’s productivity — real non-oil private sector GDP divided by the total number of employees in the private sector — has tapered off in recent years. Productivity of the private sector jumped 23 percent between 1999 and 2007, according to our calculations. But in 2008, it fell 2 percent from levels recorded in 2007. Declines in private sector productivity are most evident in a few key sectors: 1) finance, insurance and real estate; 2) construction; and 3) agriculture.

Productivity in the agriculture sector retreated 24.6 percent between 2006 and 2008, while over the same period, employee productivity in the construction sector declined by 12.5 percent and finance, insurance and real estate sector by 7.7 percent. In the mining and quarrying sector, which includes oil and gas, productivity eased by a smaller 3.9 percent over the three years.

Productivity levels in the manufacturing sector, on the other hand, advanced 7.3 percent over the same period, while electricity, gas and water sector productivity rose 13 percent, wholesale and retail trade by 15.9 percent and transport and communications by 8 percent. The financial sector has been behind a good degree of the decline in private sector productivity. Banks in Saudi Arabia have struggled since profit growth levels peaked in 2005 at a sector-wide rate of 54 percent. While bank profits jumped another 35 percent in 2006, the sector’s overall profits have fallen more than 23 percent between 2007 and 2009, primarily due to a stock market crash that occurred in 2006 and the global financial crisis that began in mid-2008.

The subsequent drop in profit growth in 2006 and 2007 coincided with slower growth in GDP, although a rise in bank assets, as well as a huge number of new branch openings (65 in 2006 and 64 in 2007), enabled the sector to keep GDP growth rates from falling too quickly. A decline in productivity in the construction sector since 2004 happened due to the fast expansion in the predominately expatriate labor force, without an equivalent addition in output.

The construction sector is poised to continue experiencing high rates of single-digit growth. Waning agriculture productivity, meanwhile, has happened due to the sector’s declining output and high labor content.

It is likely that overall private sector productivity in Saudi Arabia gained slightly in 2009 due to an anticipated slowdown in the growth of the private sector work force resulting from the economic downturn. Between 2006 and 2008, the number of employees in private sector enterprises in the Kingdom grew 16 percent, according to Ministry of Labor data. Banque Saudi Fransi expects the number of new employees in the private sector advanced by a much slower 1.2 percent in 2009, thus enabling a slight rise in overall productivity numbers. However, if the private sector work force expanded by 2.6 percent or more last year, productivity levels in the private sector would have fallen again in 2009.

Job creation

One concern with lower productivity levels is what this could mean for job creation in the coming years. The private sector will be the Kingdom’s predominant engine for Saudi employment generation in the years to come. When non-oil private sector growth loses steam, fewer employment opportunities are created for nationals, especially the onslaught that will be looking for jobs over the next decade. The Kingdom’s population of 25 million includes 11.38 million — 46 percent — youth (aged 15 — 39), and another 32 percent is children aged 0 to 14. Private sector growth rates have fallen quickly since 2006, when the sector expanded 6.1 percent, the fastest pace of growth since 1982, the tail end of the previous oil boom. But since 2006, growth rates slipped to 5.5 percent in 2007, 4.8 percent in 2008 and 2.5 percent in 2009.

Private sector expansion began falling before the global financial crisis came into full swing. At the beginning of the decade, lower private sector growth rates correlated with higher unemployment rates among Saudi nationals. When private sector growth fell in the past two years, however, unemployment levels fell, too.

With the state unable to absorb a good deal of the expected onslaught of new job entrants, lower private sector growth rates between 2007-2009 could signal that unemployment rates may begin rising again in the coming years. According to Central Department of Statistics labor force surveys in 2007 and 2008, clerical and service jobs witnessed the highest increase in annual additions — although it is difficult to ascertain the level of nationalization in the private sector. Unemployment among men declined to 250,402 in 2008 from 295,473 in 2007, while female unemployment was virtually unchanged at 167,660. Most females who are unemployed held bachelors degrees, while most unemployed men held a secondary degree, followed by intermediate and primary degree holders.

Labor market

The private sector productivity issue once again raises questions about how effective the multiplier effect of government spending has been. According to basic Keynesian multiplier theory, government spending should generate many cycles of spending that increase employment (income), consumption and savings. As the spending unfolds, different segments of the economy benefit. For instance, when SR30 billion is committed to infrastructure projects, such as building a university or a bridge, hundreds of millions of riyals goes toward pure labor costs, generating purchasing power among the work force and promoting consumption. Money sloshing around the economy also creates jobs, leading to a new round of spending. Job creation is a short-term multiplier and creating a well-rounded education system is a longer-term multiplier. In Saudi Arabia, it is the labor make up of the private sector that constrains the multiplier. The private sector is currently entangled in low-wage equilibrium, meaning salaries paid to employees in this sector are relatively low. This limits the potential for a higher multiplier on employment and, consequently, on consumption and savings. BSF thinks that improving the level of education by hiring better-trained teachers could lead to better long-term multiplier benefits than continuing a tradition of hiring additional foreign labor. If the national work force is the dominant player in the private labor market, the trickle down affect of government spending would certainly be deepened.

In the bank’s view, the most crucial impediment to fully realizing the potential of short- and long-term multipliers is the structure of the labor market. Gross fixed capital formation is showing signs of continuous growth, which is positive for business activity.

FDI

The main deterrent of FDI (foreign direct investment) into Saudi Arabia in 2009, then, was not oil prices but risk aversion among banks. “The number of international banks willing to lend to projects in GCC (Gulf Cooperation Council) countries has shrunk sharply: Only 12 banks were actively seeking project finance deals there at the end of 2008, down from 45 in 2006,” UNCTAD (United Nations Conference on Trade and Development) said. Still, the Saudi government continued in 2009 a plan to raise oil production and refining capacity in order to cater to growing global demand from Asia anticipated a few years down the line. During the latter part of the year, Saudi Arabian Mining Co. (Maaden) and US firm Alcoa agreed to form a joint venture to build a $10.8 billion aluminum smelter. ExxonMobil Chemical and SABIC (Saudi Basic Industries Corp.) also agreed to set up joint-venture plants to produce synthetic rubber, at an anticipated project cost of $5 billion, while Aramco awarded Halliburton a five-year oil field service contract to develop wells at South Ghawar. A real estate sector downturn in the Gulf region, particularly centered on the UAE emirate of Dubai, is also likely to have cut into foreign investments into Saudi real estate during 2009 as investors stood on the sidelines to watch for signs the price correction was bottoming out. Such investments are also likely to rise in Saudi Arabia’s undersupplied real estate market this year, however, much focus has turned to the Kingdom as the region’s key domestic demand story. With these developments, 2010 promises to witness a small comeback in FDI following a weaker 2009.

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