THE Saudi economy is finishing off 2010 in better form than it started due to healthy oil prices, recuperating business and financial activity, improved trade and tourism, and inflationary pressures that are beginning to taper off from summer peaks. Oil prices have averaged a secure $78.76 a barrel in the first 11 months of 2010, almost 30 percent above prices during the same period last year. Along with growing global energy demand, robust oil prices are strengthening the Kingdom’s fiscal position and outlook and enabling the state to continue engaging thoroughly in the economic recovery process.

Government sector GDP growth rates in the first half of the year exemplify the fundamental role played by state and quasi-state investors in the economy. Nominal GDP of the government sector expanded 13.5 percent in the first six months, more than double the private sector’s rate of growth at current prices. While state-led growth is likely to continue in 2011, we do see the starting signs of greater involvement by the private sector, although its reintegration into economic activity is likely to take place slowly over the next two to three years.

Against a backdrop of a relatively inactive, deleveraging private sector, the government’s fiscal expenditures will continue to expand, although we have reason to believe the pace of expansion may slow in the coming years. Authorities are becoming more cognizant of the fact that higher spending raises the risk for fiscal deficits in the medium term, especially as the oil price needed to balance the budget has leapt to $72 a barrel this year. We have raised our state revenue forecast to SR658.9 billion this year as a result of sustained higher oil prices. Following this revision, and a reduction in our expenditures forecast, it looks likely that Saudi Arabia will swing a surplus in 2010 amounting to 2.5 percent of GDP.

Accelerating price pressures due to a combination of global and local factors have characterized 2010. High soft commodity prices, continued real estate supply constraints and imperfect domestic competition came together to nudge Saudi inflation to 6.1 percent in August for the first time in 18 months. Inflation rates dipped back below 6 percent since then, and we anticipate the deceleration in inflation rates will continue in 2011 as a consequence mainly of high base effect adjustments for rents and stabilizing food prices. Although rents are poised to continue climbing month on month, the rate of annual increase is set to decline, thus removing a great deal of the burden on the annual inflation rate. Our forecast of 5.3 percent inflation in 2010 remains intact, and we foresee inflation subsiding in 2011 to 4.7 percent, against a prior estimate of 5.1 percent.

The very guarded pick up in bank credit growth is poised to continue in the coming months, prompting us to reduce our 2011 forecast for growth in bank claims on the private sector to 8.5 percent from 12.2 percent. Momentum behind credit growth is likely to continue to lag until a substantial pipeline of project financing is integrated into bank balance sheets and the private sector moves toward expansion financed through a combination of equity and debt. These trends should start to unfold in the second half of 2011 and encourage a return to double-digit rates of credit growth in 2012 and 2013.

Reduced inflationary pressures and expectations for a stronger US dollar in 2011 will relieve speculation that Saudi authorities will rethink a long-standing policy of pegging the riyal to the dollar. Credit Agricole CIB, our joint-venture foreign partner, expects the euro-dollar to end 2011 at 1.18, signaling a serious trend reversal. Euro weakness is likely to result from the spillover effect from debt-troubled nations elsewhere in the euro zone as well as a robust US economic outlook.

A weaker dollar tends to raise the cost of imports into Saudi Arabia, particularly for food items, but it also increases the appeal of non-oil exports to global customers and makes tourism into the Kingdom, primarily for religious purposes, more affordable for those whose currencies strengthen against the greenback. November’s Haj pilgrimage illustrated this strong demand, with preliminary estimates indicating a record number of pilgrim visits. This is bound to have a positive ripple effect on the wider services and hospitality sectors for this year and 2011.

As we stated briefly in our November Monetary Watch, inflationary pressures in Saudi Arabia — now the highest in the Gulf — are poised to decline in 2011, leading us to reduce our inflation forecast for next year to 4.7 percent from 5.1 percent. We anticipate inflation will average 5.3 percent in 2010, higher than 2009’s 5.1 percent.

The primary downward pressure should stem from falling rental inflation. The rent and utilities index, which comprises about a fifth of the index, is likely to record average inflation of 9.5 percent this year, although next year we see the rate falling to 6.7 percent. While we still expect moderate month-on-month gains in rental inflation, the annual rate of rental inflation is likely to decline during 2011 due to the higher base effects. In 2009, rental index inflation averaged 14.3 percent, down from about 18 percent in 2008.

We are also anticipating a slowdown in home furniture inflation, and in other expenses and services, which together comprise more than 20 percent of the index. The largest weighting in the Saudi cost of living basket is food and beverages, accounting for almost a third of the total. Food price trends are somewhat more difficult to predict because they depend on movements in global commodity prices, and may also be influenced by fluctuations in the US dollar. When the dollar is weaker, this raises the cost of importing food into Saudi Arabia, heightening imported inflation. A stronger US dollar in 2011 and some softening in food commodity prices should be anticipated, although food inflation rates will likely hover in a similar range as this year. Any decline in food price inflation will be slight given price stickiness.

In recent months, data of the Food and Agriculture Organization show some food prices, particularly sugars and cereals, are on the rise again, although there is evidence that food prices are near peaks and are unlikely to face significant upward pressure in 2011. Saudi Arabia's food price index broadly tracks trends in the FAO food price index, albeit much more moderately. Sustained higher food prices globally are likely to be offset by the stronger dollar, and while we expect food inflation to rise in the first part of 2011, it should ease during the second half of next year. Food and beverage inflation in 2011 is likely to be slightly lower than the projected 6.2 percent average we foresee for this year, although the index has varied widely in recent years based on global circumstances. In 2008, food and beverage inflation averaged around 15 percent and fell to 2 percent in 2009.

Money supply growth in the Kingdom, traditionally a contributor to inflation, is beginning to pick up due to greater lending and economic activity in general, although remains far from levels that we expect would lead to a build up in inflationary pressures. In September, M3 money supply growth was 5.1 percent, compared with between 10 percent and 27 percent in every month between 2005 and the end of 2009. By comparison, M3 money supply growth averaging 5 percent this year and 9.6 percent next year, according to our forecasts, would have a much less-pronounced impact on inflation rates.

(To be continued)

— John Sfakianakis is chief economist at Banque Saudi Fransi, Riyadh.