Bank lending should pick up steadily though not significantly, inflationary pressures are expected to moderate on the whole but remain historically elevated, and the government should post sizable budget and current account surpluses that would enable it to further pay down domestic debt and augment its foreign assets store.

Underpinning the optimistic outlook is a view that oil prices are poised to hold ground above $80 a barrel. Other than 2008 when prices soared to record peaks near $150, an average price above $80 a barrel in 2011 would be the highest annual price recorded this decade. Still, oil production, set to rise to 8.48 million barrels per day (mbpd) from 8.2 mbpd in 2010, remains well below the average 9.1 mbpd produced from 2004 to 2008.

The government will thus rely on its own financial muscle and private sector participation to channel economic growth along an upward trajectory. Since the onset of the financial crisis, the state has taken up the slack for keeping the economy in motion. In 2010, the government sector expanded at its fastest pace in 13 years of 5.9%, far outpacing private sector growth of 3.7%.

Relying on government-led growth would not form a practicable policy in the long term and we have already witnessed evidence that the state is eager to re-integrate local and global investors in the development process. This will take time, however, and the 2011 Saudi budget hit another record with planned expenditures. The government has nonetheless deliberately slowed down the pace of growth in spending allocations to minimise overspending and compel private businesses to return to the drawing board.

While private sector GDP growth is likely to rise to 4.2% this year and to 4.5% in 2012, the sector's rate of growth is still lags pre-financial crisis levels and in our view is not high enough to generate an adequate stream of new jobs needed to substantially reduce unemployment and relieve the recruitment strain from government departments.

In the five years to 2008, private sector GDP expanded 5.5% per year on average; between 2009 and 2013 the sector's annual growth should slow to 4.2%, according to our estimates. The government is therefore confronted with a challenge to extensively re-integrate the private sector in development both through public-private partnerships and independently. A major overhaul is needed in private sector job creation for Saudi nationals; in 2009, they accounted for just 9.9% of total private sector employees.

The public sector continues to act as an employer of last resort for Saudis; in 2009 it hired 71,900 Saudis while the private sector's Saudi employment figure fell by 147,576 jobs. The private sector created 821,177 jobs in 2009, according to official data, but solely relies on expatriate labour for expansion, an alarming trend that should be reversed to accommodate the local job market.

On the monetary policy front, we foresee no changes in interest rate policy as the central bank seeks to encourage healthy bank lending, but we could see a slight hike in the  benchmark repurchase rate around 2012 as markets normalise further.
 
State still navigating recovery

On the heels of the financial crisis, the Saudi economy decelerated quickly at the end of 2008 and throughout 2009 due to a combination of factors, including the drop in oil prices and global oil demand, and the cancellation or postponement of tens of billions of dollars in expansion projects. In addition, many local and foreign private sector companies decided to wait out the crisis on the sidelines and credit markets dried as banks contended with a non-performing loan challenge.

With strong oil prices and better demand from Asia in 2010, the Saudi economy worked at jumpstarting the recovery - and 2011 promises to continue cementing this. To support an improvement in the economic climate, the government has pledged to keep spending at historically high levels throughout the 2010-2014 five-year plan, including investment commitments of $385 billion. It continues to overspend its budget by, in the case of 2009 and 2010, 25.5% and 16%, respectively, to ensure funds get where they need to be.

Yet prolonged fiscal expansion would not be healthy for the country, hence the emphasis placed on private sector participation in the five-year plan. The government is aiming for the private sector to grow 6.6% per year during the plan period, the key thrust behind ambitious growth of 5.2% per year. In our view, these growth projections are virtually impossible to achieve if current circumstances persist. We have seen little evidence of efforts to nurture and organize the small- and medium-sized enterprise sector, which would be necessary to generate higher rates of growth.

At present, it is government gross fixed capital formation (GFCF) that has led the way in domestic investments. Between 2000 and 2010, government GFCF surged eight-fold, according to our estimates, while private sector GFCF about doubled. In 2009 state GFCF rose almost 9% as private GFCF fell 2.2%. Private sector capital formation growth rates are likely to pick up in the coming two years as companies offer more expertise and financial support for projects in energy, utilities and infrastructure. However, state investments will continue to dominate the funding space.
 
Oil revival steering growth

Although a cautious atmosphere prevails, the scope for enthusiasm is wide due to oil market fundamentals. High oil prices translate into robust revenues for the kingdom, buying it some time to bring round private capital.

Oil sector GDP growth is likely to expand 3.5% this year, up from about 2.2% in 2010, owing to a rise in production and persistent growth in global demand. The Energy Information Administration (EIA) forecasts world oil consumption will grow 1.45 mbpd in 2011 to 88.02 mbpd, with almost 37% of new demand arising in China. This marks a slowdown in consumption growth from 2.02 million bpd in 2010 and yet illustrates an overall positive trend. The EIA anticipates another 1.6 mbpd of consumption growth in 2012. Saudi oil production is likely to grow 3.5% this year to 8.48 million barrels per day, according to our forecasts.

With oil prices now within striking distance of $100 a barrel, Saudi Arabia is well positioned to reap great advantages. As of November, the Saudi Arabian Monetary Agency (SAMA) had accumulated SR1.64 trillion ($433.7 billion) in foreign assets, taking the stash back to pre-2009 levels. We project that by the end of 2011, the kingdom will have built its foreign assets to $470.8 billion, a record level and more than 98% of GDP.

Real GDP growth for the Saudi economy should climb to 4.2% this year, including the 3.5% rise in oil GDP activity (accounting for 27.1% of GDP). We anticipate GDP growth will rise to 4.4% in 2012, the fastest rate of growth since 2005, once lending activity returns to normal and private sector companies take meaningful steps to improve their contributions.

Growth of the government sector - which accounted for just under 24% of GDP in 2010 - should slow slightly to 5.3% this year from 5.9% last year, as the private sector relieves some of its funding burden. Including last year, government sector GDP growth exceeded 5% only three times in the past two decades.

Substantial fiscal outlays have supported growth. The 2011 budget includes expenditures of SR580 billion for 2011, although we expect actual expenditures of closer to SR676 billion - indicating 16.6% overspending. The state's 2010 fiscal surplus, at SR108.5 billion or 6.7% of GDP, was more than double our forecast. We anticipate the surplus fall to SR93 billion, or 5.2% o GDP, this year due to a 4.6% increase in revenues to SR769 billion.
 
 
Reinforcing the private sector

The private sector's growth rate will be motivated by higher oil price environment, increased demand for petrochemicals and continued state stimulatory spending. Private sector companies spent much of the past two years de-leveraging and regrouping, and many of them should begin to pursue expansion again this year.

This will necessitate that they obtain some funds from banks and from equity and bond markets - all of which should be accommodating. Numerous sovereign and corporate issuers have already exploited better bond pricing as yields declined.

This month, the civil aviation authority indicated a plan to issue $4 billion of Islamic bonds to help finance airport projects. Saudi International Petrochemical Co also wants to raise at least $400 million this quarter to finance the first ethyl acetate plant in the region, while in December Saudi Electricity Co. (SEC) finalised a 15-year Islamic financing worth $1.33 billion to fund projects designed to build power generation capacity.

We expect that state firms will work to involve private companies more thoroughly in their projects. SEC for one, is hoping the private sector will contribute about $24 billion of the $80 billion projected investment bill it envisions will be necessary to boost power generation capacity to at least 70,000 megawatts by 2020 from 50,000 MW now.

Following is a discussion of some of trends we foresee taking place in Saudi Arabia's key non-oil private sectors this year.
 
Finance

The finance sector has suffered from low rates of growth in recent years and 2010 did not diverge from this trend. Up to November, cumulative bank profits reached SR24.22 billion, down 10.8% from SR27.15 billion in November of 2009. Net earnings of Saudi banks have fallen in each year since 2006 after soaring 185% between 2004 and 2006. Cumulative bank profits at the end of 2010 were lower than they were in 2005 - when profits of banks leapt 54% from the year earlier. The low interest rate environment has encroached on bank profitability.

Bank asset growth has also fallen markedly in Saudi Arabia. As of November, total bank assets grew 2.3% from the end of 2009 - positioning banks for their slowest rate of asset growth since 1990. Between 2005 and 2009, bank assets grew 16.8% per year, on average.

Given the weak statistics, it is no wonder the finance sector's GDP growth rate slowed to just 1.4% in 2010, according to initial estimates. That is below the 3.7% growth recorded in 2009 and is the slowest pace of expansion for the sector since 1998. By comparison, the finance sector's growth rate was as high as 6.4% in 2005 at the peak of bank profitability.

Then, the 2006 stock market crash revealed the vulnerability and exposure of Saudi banks to equity investments and banks' profits and the sector's growth took a hit. The equity crash and the financial crisis, which compelled lenders in the kingdom to take large provisions to guard against bad debt, have obliged banks to rethink how they do business, and particularly to whom they lend funds. Private sector lending fell in tandem from double-digit growth rates in most years of the past decade to a slight contraction in 2009. Bank lending failed to gain considerable momentum in 2010, touching a lower-than-expected 6%.

We do not expect to witness a return to double-digit rates of loan growth before 2012, with a fuller recovery in 2013, as a stream of project financing deals bolsters the balance sheets of banks. Meanwhile, lenders have focused more attention on their retail businesses. The number of new branches opened in 2009 and 2010 was 19-fold higher than 2005 at the peak of bank profitability.

Despite persistent caution, we expect a good turnaround in credit growth this year as there is adequate pent up demand to support growth in bank claims on the private sector of 9.1%, including private sector credit growth of 8.8%. Total bank credit, including to state enterprises, should grow 8.6%. These factors support our finance sector GDP growth forecasts of 2.7%. We do not foresee any change to SAMA's exchange rate policy in 2011. The US dollar remains well below the key 1.50 mark vis-à-vis the euro, last crossed in late 2009 when oil prices were about $20 lower than they are now. Hence, we do not anticipate the return of speculation on a change in currency policy. Interbank rates have remained mostly steady during 2010. The three-month interbank offered rate stood at 0.75% in early January, little changed on the year.

Interest rate policy is likely to remain static this year, although SAMA does have some freedom to modify rates independent of U.S. policy. It has been more than two years since the Fed reduced rates to 0-0.25%; interest rates in the United States and other advanced economies are likely to remain unchanged this year.
 
Construction

Growth of Saudi Arabia's construction sector fell to 3.7% in 2010 from 4.7% in 2009, according to the initial estimates. With the scale of construction taking place on the ground, the sector's growth appears underestimated and the rate could be revised upward as the year progresses. Cement sales grew 13% in 2010, slightly slower than the 16% growth recorded in 2009.

We project an upturn in construction activity in 2011 supporting growth of 4.2% as more real estate projects reach fruition as builders take steps to bridge the gap between supply and demand. Work on major infrastructure projects in energy, utilities and infrastructure also carries on across the country. In the holy city of Makkah, billions of dollars are

being funnelled into residential and hotel projects to cater to growing religious tourism. The Royal Mecca Clock Tower across from the Grand Mosque in Mecca is just one of many such ventures in the holy city, where an abundance of cranes are now erected in the vicinity of Islam's holiest site.

Construction activity is principally backed by state infrastructure spending and a deficit in available housing. In its 2010-2014 development plan, the government targets construction of one million housing units, or about 200,000 per year. With the market undersupplied, real estate prices faced upward pressure last year. The BSF H2 real estate survey showed the median price of a large apartment in 12 Saudi districts surveyed climbed 4.7% from the first half of the year, while villa prices were up an average of 9.5%. Similar price trends can be expected in 2011 as the demand-supply mismatch continues and investors prepare for the launch of Saudi Arabia's much-delayed mortgage law.
 
Manufacturing

Saudi Arabia's manufacturing sector made a good comeback in 2010, growing 5% after real GDP expansion slowed to just 2.3% in 2009, the lowest rate of growth since 1991. Manufacturing utilises comparative advantages in labour, energy and capital inputs.

The return in domestic and global demand for petrochemicals helped reinvigorate the sector in 2010. Profits of Saudi Basic Industries Corporation (SABIC) surged 46% in the third quarter and 27% in the fourth quarter, above expectations as sales volume for plastics and petrochemicals improved and energy prices rose broadly. In the year to November, petrochemical exports soared more than 60% and plastics exports more than 45%, according to preliminary CDSI non-oil export data. Profits of all listed petrochemical firms almost tripled last year.

This year should witness a similar scenario. The petrochemical sector is likely to reap the benefits of higher energy prices and the continued demand growth from Asia. We anticipate manufacturing GDP growth will climb to 5.1% this year. From 2004 and 2008, manufacturing GDP expanded 6.3%, on average, so the improvement this year would not yet take it back to pre-financial crisis levels.

At home, output will get a boost from the giant, SR20.6 billion Ma'aden phosphates plant as commercial production starts in Q3 2011. Located at Al Jalamid, the phosphate mine and beneficiation plant will produce 3 million tons per year of di-ammonium phosphate fertiliser, representing about 10% of global demand.
 
Wholesale and retail trade

Wholesale and retail trade GDP growth should speed up to 4.7% this year from 4.4% in 2010 as a consequence of better consumer demand. The sector's GDP expanded more than 6% in each of 2006, 2007 and 2008, before growth slowed to just 2.5% in 2009. Consumer demand in Saudi Arabia is much more price sensitive than is the case in most set to grow 4.5% in 2011 after expanding 24.6% in 2010. Non-oil exports, meanwhile, should maintain growth of around 13.2% in 2011, on par with expansion in 2010.

Imports have taken longer to recover. In 2010, initial estimates show imports advanced less than 1% from 2009. We anticipate that 2011 import flows will moderately improve as retailers and wholesalers build inventories in order to Gulf countries, although it rests on a solid foundation of a population exceeded 27 million - representing almost 60% of the total Gulf population. As a consequence of this, and the population's young age demographic, consumer demand has continual potential to expand.

Trade flows out of Saudi Arabia improved markedly in 2010, gaining 23% on the year earlier, when export revenues had tumbled almost 40%. Strong oil revenues and the rise in non-oil trade mentioned earlier should give export revenues another 6.6% boost in 2011, our forecasts show. Saudi exports are highly dependent on the price of and demand for oil; oil exports accounted for 86% of total estimated export revenues of $236 billion last year. Oil export revenues are meet growing domestic demand. A majority of company leaders who responded to our Q1 Business Confidence survey said they would raise inventories in the next two quarters.

The state's expansion plans also necessitate a greater volume of building material and machinery imports this year as construction projects progress. In the first 11 months of 2010, there were 24.9% more new letters of credit issued against the import of goods than the year earlier. Imports are likely to track private consumption patterns in 2011 and as a result, we forecast imports will rise to SR97.4 billion this year, almost 12% above SR87 billion in 2010.

With higher imports, slower export growth and a continual rise in workers' remittances, Saudi Arabia's current account surplus will likely fall slightly in 2011 to SR236.81 billion, or 13.2% of GDP, from a higher-than-expected surplus of SR260.9 billion in 2010 (16% of GDP). In the foreseeable future, we do not expect the current account surplus to exceed 24% of GDP as it did in each year between 2005 and 2008.
 
Electricity, gas and water

The electricity, gas and water sector has continued to sustain economic growth of upwards of 6% throughout the financial crisis due to a government commitment to build power generation and water desalination capacity. Expansion at constant prices was 6% for the sector in 2010, the fastest rate of growth for any sector, and we except the growth rate will rise to 6.2% this year.

High annual population growth rates and the escalation of industrial production have led to a rise in domestic demand for utilities of about 8% per year in recent years, and growth should resume at 7.6% per year through to 2032.

Peak power demand jumped 85% in 1999-2008 and the kingdom's power demand could grow to more than 120,000 megawatts by 2032 from capacity of about 50,000 MW now. In the fourth quarter, the new Riyadh PP10 power plant should come on-stream, its first phase totalling 799 MW poised to enter commercial operation in mid-2012, adding a further 941 MW by mid-2013. Available water per capita, meanwhile, dwindled by almost a quarter in the past decade, which has necessitated a push to boost water desalination capacity.

We estimate public and private sectors will need to invest SR1 trillion to build capacity in power and water through 2032 just to keep up with demand. Measures to curtail overuse are therefore crucial. In July 2010, SEC raised tariffs for commercial and industrial users by 9.6%, while excluding residential users from the change. The company is still selling electricity 3.5% below production cost. Similar fee adjustments can be expected in the future as the state

seeks to rationalise the use of power, water and fuel domestically.
 
Transport, storage and communications

The transport and communications sector is likely grow 5.9% this year, having been the second-fastest-growing private sector last year, at 5.6%.

The telecoms sector has expanded quickly in recent years with the introduction of two mobile phone operators to compete with the incumbent Saudi Telecom. Home to more than 27 million people, the Saudi market offers the greatest subscriber potential in the Gulf region, in addition to tremendous roaming revenues generated in relation to the millions of people who visit the kingdom to perform the hajj pilgrimage or lesser umrah pilgrimage.

Third operator, Zain Saudi Arabia, widened its network coverage last year and built its customer base to more than 8 million, about 2 million more than it had a year earlier. Etihad Etisalat (Mobily), the second operator, also posted a record profit in Q3, up 41% on the year, while incumbent Saudi Telecom's Q3 profit also surpassed expectations.

Transport projects have, meanwhile, been a top priority for the government, which allocated SR25.2 billion of its 2011 budget to transport and telecommunications investments, up 5% from 2010 allocations. The plan includes a strategy to lay down 6,600 kilometers of new roads, build four new airports and rebuild the King Abdulaziz International Airport.

Saudi Arabia further plans to increase its grains storage capacity by 550,000 metric tons within three years to guard against price rises. Presently maintaining stock of 1.4 million tons, the kingdom would add capacity at ports in the King Abdullah Economic City, Yanbu and Dhiba under this scheme.
 
Agriculture

Agriculture GDP is likely to grow 0.7% in 2011 according to our estimates, compared with about 0.5% last year. The kingdom continues to be a sizable producer of foodstuffs, but the agriculture sector has not grown as swiftly as it used to due to a state policy to phase out certain water-intensive agricultural production, such as wheat. As Saudi Arabia moves toward importing key commodities including wheat, the agriculture sector's GDP will continue to grow only marginally and possible contract.
 
Community, social and personal services

This sector's growth is likely to rise to 4.3% in 2011 from an estimated 3.8% last year, according to our forecasts. Health and social affairs is a crucial policy focus for the government, which raised its allocation for these areas of spending by 12% in the 2011 budget to SR68.7 billion. The funding would go toward building new hospitals and primary care centres in addition to financing various socially relevant activities, such as funding poverty reduction programmes and building sporting clubs and social welfare offices.

Saudi Arabia's services industry also derives benefits from religious tourism. Last year's hajj pilgrimage attracted a record number of pilgrims. Some 2.79 million people performed hajj, up 20.6% from the year earlier, including 1.8 million non-Saudi residents, according to CDSI data.
 
Inflation

Inflationary pressures continue to stem from domestic triggers, including rent and higher goods and services costs, and elevated global food price inflation. After hitting an 18-month high of 6.1% in August, inflation moderated and averaged 5.4% in 2010, three percentage points above the year earlier. Price pressures are likely to ease slightly this year due to comparatively lower rental inflation, although food price inflation could remain elevated due to global price pressures.

We expect annual inflation to average 5.1% this year, historically high for a country that experienced average inflation of 0.8% between 1990 and 2006. Inflation does not pose the same degree of societal risks that it did in 2007 and 2008, when it reached double digit levels for the first time in three decades at a time when the purchasing power was weak due to US dollar frailty. In November, the government announced it would not phase out an inflation allowance that had raised salaries of state employees by 15% over the last three years in order to help them cope with rising prices, without consequently stoking inflation.

The state's stimulatory spending program has not created notable inflationary pressures in goods, services and wages because state investments have complemented the lack of private sector investment, rather than competing with it. Saudi Arabia has benefitted from excess labour and services capacity in the region, where some other economies faced more severe slowdowns.

Food inflation - comprising almost a third of the cost of living basket - is likely to hover around 6.9% in 2011. Global prices for wheat, corn and rice rose 26% between June and November 2010, pushing their index to an all-time high in December, according to the Food and Agriculture Organisation (FAO). Prices of cereals, particularly wheat, rose in H2 2010 due to severe drought and fires in major wheat producers Russia and Ukraine, while Canada was also hit with bad weather.

Rice crops, a staple for Saudi consumers, are also facing difficulties, prompting the FAO to give a less optimistic forecast for global rice production in November than it did in June. The FAO expects global rice trade to decline 2% in 2011 as major exporters, including Pakistan, Cambodia, Egypt and Vietnam, face supply constraints. This could translate into higher prices domestically. Aside from global factors, the dynamics of wholesale food production and distribution have contributed to market imbalances.

Inflation could get some downward pressure from the other expenses and services category, accounting for 14% of the index. Gold and jewellery comprise a large weighting in this basket and should undergo a corrective phase as global inflationary concerns subside.

Rent and utilities inflation, about a fifth of the index, should fall to 7.8% in 2011 from 9.5% last year, continuing on a declining trend since inflation in the index peaked at almost 20% in mid-2008. Given the market's inadequate supply, upward revisions are plausible. In our latest business confidence index, however, business executives said they expected inflation rates to decline in the coming six months.
 
Domestic debt

One unforeseen feature of this year's budget announcement was the state's reduction of public debt in 2010 to SR167 billion from SR225.1 billion a year earlier. As countries the world over grapple with rising debt-to-GDP ratios, Saudi Arabia reduced its debt ratio to 10.2% from 16% a year earlier. In 2003, the debt-to-GDP ratio was 82%.

The move was an attempt by the government to demonstrate the extent of its fiscal health even as it pursues record budget expenditures. All Saudi government debt is domestic, held by the two state pension funds and local banks. We anticipate the government will continue to service public debt this year, reducing its burden to SR145 billion, or 8.1% of GDP.
 
Outlook and challenges

With a strong oil price backdrop, 2011 promises to be a positive year for the Saudi  economy, one marked by solid economic growth rates, manageable inflation and twin fiscal and current account surpluses.
 
In 2012, the economy should encounter a more promising outcome, with real GDP growth accelerating to 4.4%, including expansion of 4.5% of the private sector as the government sector pulls back further. Bank credit growth to the private sector would return to low double-digit levels and robust oil prices and greater global demand would necessitate a gain in crude oil production, leading to smaller but sizeable fiscal and current account surpluses amounting to 4.1% and 11.3% of GDP, respectively. We also foresee inflationary pressures easing further in 2012, according to initial indications. With improved lending and faster money supply growth rates, the central bank should be comfortable in raising its repurchase rate by 50 basis points for the first time in three years.

For the time being, a reluctant private sector and disinclined banks have placed enormous pressure on state enterprises to mobilise funds in order to plug the financing gap. The state's aggressive spending programme has provided a backdrop for private sector momentum, but private firms have not yet regained their place in the development process.

In this regard, a great deal needs to be done to revive the small and medium-sized enterprise (SME) segment, which should be instrumental in any economic recovery. The government should devise strategies to encourage SMEs and enable them to become beneficiaries of public funding, which has tended to profit only a small number of very big private sector players.

In its five-year plan, Saudi Arabia set as one of its objectives the need to nurture and organise the SME segment through a series of state and private initiatives designed to boost the segment's contribution to non-oil GDP. Without a drastic improvement in the encouragement and integration of SMEs, the private sector will struggle to exceed 5% growth in the coming years, although such growth rates are necessary to create jobs, the most serious challenge facing the economy today.