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By Khalid Bhatti 06/05/2016

Will the diversification drive revive the ailing economy?

Many experts and commentators are debating the all important question that how the Saudi arabian economy is going to survive in the long run if the oil prices remains low for a longer period of time? For many experts the answer is simple, Saudi economy will be in serious trouble but some experts are saying that Saudi economy will not face a serious situation in short and medium term. Even though in last few  weeks, oil prices have recovered a little bit ground and the talks about 10$a barrel or 20$ a barrel is no more there. It is not only Saudi Arabia who is in trouble because of falling oil prices but all the other big oil producing countries are also feeling the pain.

Saudi Arabia is a country which relies on oil for more than 80% of its revenues. Saudi Arabia and other big oil producing countries depends entirely on oil revenues for their social programmes and development projects. The dramatic drop in the oil prices have already slowed the economy. The government announced big cuts in the spending and impose ban on signing new contracts without the approval of the finance ministry. The construction industry is going to hit hard as the result of new measures and cuts. The saudi government ran a record budget deficit of nearly $100 billion last year and has been seeking ways to narrow the gap. It is laying plans to boost non-oil revenues with taxes, but that will take years to have much impact, leaving spending cuts as the main way to bring the state expenditures under control. Low oil prices not only just squeezing Saudi Arabia’s domestic budget but also forcing the government to impose austerity on a country which is not familiar with it. It can also severely effect the Saudi support for foreign projects in different countries.

Saudi Arabia announced this week swingeing budget cuts for 2016 to address an alarming deficit of 15% of GDP run up this year. Subsidies for water, electricity and petroleum products are likely to be cut, and government projects reined in. The cuts and austerity will severely affect the public sector and development projects.

But overseas beneficiaries will face some austerity too. For years, Saudi Arabia has used its oil wealth to support friends and allies around the world, including media organisations, think tanks, academic institutions, religious schools and charities. Countries that have traditionally benefited from Saudi largesse include Pakistan  Jordan, Lebanon, Bahrain, Palestine and Egypt. But now the “IMF has raised the prospect that Saudi Arabia could go bankrupt in five years without changes to its economic policy”,which is less likely and an over statement of the situation at the present time but still this will force the government to make cuts in support to foreign allies. Egypt’s black-hole economy is potentially the kingdom’s most expensive foreign policy commitment. In recent years, Saudi Arabia has donated billions in cash and oil products but, despite this, the Egyptian economy, battered by war, terrorism and political instability, is facing an acute foreign currency shortage. Speculation is mounting that Saudi financial support to Egypt is starting to dry up – something the Egyptian authorities have denied – and that this is damaging the bilateral relationship.

There have been some signs of tension. In July, Egypt’s oil minister said he had no objections to importing crude oil from Iran, a move sure to ruffle the Saudis. In September, the Saudi journalist Jamal Khashoggi – known for his closeness to the Saudi state – raised eyebrows when he said the new Egyptian culture minister, Hilmi al-Namnam, who is well known for his secularism and dislike of Wahhabi Islam, should never have been appointed.

So far, the Saudi authorities have given few clear signs about how they are planning to respond to the oil price crisis, let alone lay out a long-term plan for a post-oil Saudi Arabia. Options under consideration are thought to include cutting construction projects, energy subsidies and public sector wages, introducing new taxes and privatisations, and issuing debt. The government want to attract the foreign investment in different sectors of the economy and might further cut the private sector wages. The workers will bear the brunt of the economic crisis. The Saudi government is also planning to introduce the remittance tax on the foreign workers.   Another possibility foreign observers have posited is that the Saudis will be forced to unpeg the Riyal from the dollar, although given the potential this would have for uncontrollable knock-on effects on the rest of the economy, this seems likely to be a last resort. Cuts impacting on ordinary Saudis are something the government will be keen to avoid to maintain political stability, so industry, the public sector and foreign allies are likely to bear the brunt of the economic burden.

Saudi Arabia, the world’s largest oil exporter and OPEC’s most influential member, could support global oil prices by cutting back its own production, but there is little sign it wants to do this.

There could be two reasons – to try to instil some discipline among fellow OPEC oil producers, and perhaps to put the US’s burgeoning shale oil and gas industry under pressure.

Although Saudi Arabia needs oil prices to be around $85 in the longer term, it has deep pockets with a reserve fund of some $620bn – so can withstand lower prices for some time. “In terms of production and pricing of oil by Middle East producers, they are beginning to recognise the challenge of US production,” says Robin Mills, Manaar Energy’s head of consulting. If a period of lower prices were to force some higher cost producers to shut down, then Riyadh might hope to pick up market share in the longer run. However, there is also recent history behind Riyadh’s unwillingness to cut production. In the 1980s the country did cut production significantly in a bid to boost prices, but it had little effect and it also badly affected the Saudi economy.

When prices fall as far and as fast as they have over the past two years–dropping some $85 a barrel–shock waves are felt around the world. The Saudi riyal, on the other hand, remains pegged to the strengthening dollar. It’s true that the Saudis still have more than $620 billion in reserves, which they can use to maintain stability. But that’s about $100 billion less than they had last year. Unless oil rebounds–a lot–Saudi Arabia’s problems will grow. In Saudi Arabia, concerns are growing that the death of the current King could create open conflict over the process of succession to a new generation of princes.

Saudis, who have traditionally outsourced security to Washington. But the U.S. now no longer needs nearly as much Saudi oil as it once did, and the Obama Administration is increasingly reluctant to get more deeply involved in Middle East hot spots. At the same time, the lifting of sanctions on Iran, the great Saudi rival, will bring one million new barrels of oil per day to the marketplace, shifting global market share, and the Middle East’s balance of power, in Iran’s direction. Saudi Arabia, a declining power at the heart of an increasingly combustible region, risks burning down its neighbors’ houses too. Saudi Arabia relies on oil for 80% of its budget revenues. There is no other industry to speak of, a full fifty years after the oil bonanza began. Citizens pay no tax on income, interest, or stock dividends. Subsidized petrol costs twelve cents a litre at the pump. Electricity is given away for 1.3 cents a kilowatt-hour. Spending on patronage exploded after the Arab Spring as the kingdom sought to smother dissent. The International Monetary Fund estimates that the budget deficit will reach 20% of GDP this year, or roughly $140bn. The spending spree is coming to an end. There will be huge pressure on the government to cut and reduce subsidies.

Saudi Arabia has launched a costly war against the Houthis in Yemen and is engaged in a massive military build-up. In last few years, Saudi Arabia has increased its defence spending and continue to import the arms on a massive scale. Saudi Arabia is the fifth largest defence spending country in the world.  The Saudi royal family is leading the Sunni cause against a resurgent Iran, battling for dominance in a bitter struggle between Sunni and Shia across the Middle East. “Right now, the Saudis have only one thing on their mind and that is the Iranians. They have a very serious problem. Iranian proxies are running Yemen, Syria, Iraq, and Lebanon,” said Jim Woolsey, the former head of the US Central Intelligence Agency.

The other big problem is the capital outflow from the country.The capital outflow begin after the Arab Spring, with net capital outflows reaching 8pc of GDP annually even before the oil price crash. The country has since been burning through its foreign reserves at a vertiginous pace. The reserves peaked at $737bn in August of 2014. They dropped to $672 in May. Now stands at $620 billion. At current prices they are falling by at least $12bn a month.

Khalid Alsweilem, a former official at the Saudi central bank and now at Harvard University, said the fiscal deficit must be covered almost dollar for dollar by drawing down reserves. The Saudi buffer is not particularly large given the country’s fixed exchange system. Kuwait, Qatar, and Abu Dhabi all have three times greater reserves per capita. “We are much more vulnerable. That is why we are the fourth rated sovereign in the Gulf at AA-. We cannot afford to lose our cushion over the next two years,” he said.

Standard & Poor’s lowered its outlook to “negative” in February. “We view Saudi Arabia’s economy as undiversified and vulnerable to a steep and sustained decline in oil prices,” it said. Mr Alsweilem wrote that Saudi Arabia would have an extra trillion of assets by now if it had adopted the Norwegian model of a sovereign wealth fund to recyle the money instead of treating it as a piggy bank for the finance ministry. The report has caused storm in Riyadh. “We were lucky before because the oil price recovered in time. But we can’t count on that again,” he said.

The Saudis are now trapped. Even if they could do a deal with Russia and orchestrate a cut in output to boost prices – far from clear – they might merely gain a few more years of high income at the cost of bringing forward more shale production later on. Yet on the current course their reserves may be down to $200bn by the end of 2018. The government can slash investment spending for a while – as it did in the mid-1980s – but in the end it will be forced to introduce more drastic cuts and severe austerity which can bring tensions and political instability in the country. A crisis in the construction industry will force the companies to retrench workers. The Saudi state which is the biggest employeer of the local Saudi population will not be in a position to provide jobs on the scale of pre crisis level. This will create more unemployment. Thousands of foreign workers will lose their jobs including Pakistanis. If the oil prices remained around $45 or $50 per barrel for a longer period of time than Saudi Arabian economy faces a gloomy picture. Saudi Arabian economy is the least diversified in the Gulf and faced with a great challenge to diversify its economy to avoid a recession and a possible slump in the long run in the epoch of low oil prices.

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