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May 13 2008

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Saudi Arabia: Country outlook

OUTLOOK FOR 2008-09

• No fundamental threat to the rule of the Al Saud family is expected over the outlook period. Some gradual reforms will take place but will be limited by the Al Saud's desire to maintain power, internal unity and clerical support.
• The rising cost of living will be a source of discontent, along with youth unemployment, perceived corruption and opposition to the country's relationship with the US.
• Saudi Arabia will remain concerned about Iran's nuclear programme but will seek to maintain an outwardly cordial relationship, although this will be complicated by the political tensions in Lebanon.
• Economic growth will remain robust in 2008-09, largely driven by strong government and foreign investment and by a gradual pick-up in oil output.
• High international oil prices will generate large current-account and fiscal surpluses despite surging import spending and an expansionary fiscal policy. The government will increase subsidies and public-sector pay.
• Inflation will rise to an average of 9.8% in 2008-09. The Economist Intelligence Unit judges that there is a 30% chance of a currency revaluation taking place, which would only temporarily address inflation.

DOMESTIC POLITICS: The king, Abdullah bin Abdel-Aziz al-Saud, will maintain a cautious approach to economic and political reform. This reflects his overarching need to balance the interests of other senior members of the royal family, some of whom are more conservative than he is, and to maintain the traditional consensus with the influential Sunni clerical establishment (the ulema). However, this does not mean that he is averse to change, just as long as it does not compromise Al Saud control, cause deep divisions within the family, or dramatically undermine the leading role of the state in the economy. One of the king's advantages is that his reputation for personal piety and integrity has earned him the respect of most of the ulema. He is also relatively popular among the wider public, although some resentment of Al Saud family rule will persist, mainly over the cost of living, high youth unemployment, corruption, and the ruling family's close relationship with the US. However, public support for armed opposition remains limited, and there does not appear to be any plausible alternative national leadership around which dissidents could unite.

INTERNATIONAL RELATIONS: The political stand-off in Lebanon is adding to tensions between Saudi Arabia and Syria, and may complicate Saudi Arabia's relations with Iran. Saudi Arabia objects to Syria's interference in Lebanon, which has been without a president for several months amid a stand-off between the government of Fouad Siniora, which is backed by the US and Saudi Arabia, and the opposition, which is dominated by Hizbullah, a Shia group supported by Iran and Syria. The Saudi foreign minister, Prince Saud al-Faisal bin Abdel-Aziz al-Saud, has warned Iran that its relations with Arab countries would be affected if Iran is seen as having supported what he called a coup by Hizbullah. (Together with other pro-Syrian militias, Hizbullah attacked buildings belonging to Lebanon's governing "March 14th" movement in the Lebanese capital, Beirut in May.) Saudi Arabia is concerned by Iran's nuclear programme and by its heightened influence in Iraq since the US-led invasion of 2003 but also seeks to maintain at least outwardly cordial relations with the Islamic Republic. It would be wary of the possible regional consequences of any US attack on Iran, which could prompt Iranian retaliation against the US's allies in the region. Regardless of the result of the US presidential election later in 2008, the US will remain the kingdom's most important strategic partner and a leading supplier of arms.

POLICY TRENDS: Saudi Arabia appears unlikely to increase oil output significantly in 2008 despite continued rises in international oil prices. Intense speculative activity in the oil markets has encouraged the Saudi view that the current elevated level of international oil prices is largely delinked from market fundamentals. Domestically, the government wants to develop the non-oil economy, in order to reduce the country's dependence on crude oil and its consequent vulnerability to oil price shocks. Also, given persistently high unemployment, the government is keen to develop skilled sectors that could provide desirable jobs for nationals. With oil prices forecast to stay high, government spending is expected to remain the principal driver of growth. Non-oil private-sector activity will also broaden and deepen, albeit partly on the back of government contracts. State-owned firms will seek public-private partnerships, and some will be partly privatised, mostly through initial public offerings on local stockmarkets, which are a means of redistributing some of the public wealth. However, the state is likely to remain the largest shareholder in strategic firms.

INTERNATIONAL ASSUMPTIONS: Against a backdrop of slowing US real GDP growth (which the Economist Intelligence Unit forecasts at 0.8% in 2008), the US dollar is expected to remain relatively weak against several major currencies in 2008-09, and so the Saudi riyal will also continue to depreciate against the euro and, from 2008, the yen. We forecast that the price of dated Brent Blend will average US$91.3/barrel in 2008 and US$85/b in 2009, given a continued mismatch between demand and supply as well as speculative trends.

ECONOMIC GROWTH: Throughout 2008-09 high levels of public expenditure will bolster domestic confidence and private consumption. These will be further buoyed by ongoing private-sector credit expansion. Robust confidence will also continue to support investment, particularly in projects in upstream gas, oil refining, power and water. Foreign direct investment in 2006 reached US$18.3bn, compared with US$12.1bn in 2005. The non-oil private sector is forecast to expand by some 7% a year in 2008-09. Nonetheless, the oil sector is still crucial to economic performance, and oil output cuts in 2007 constrained overall growth, which we estimate was 3.5%. Assuming that oil production picks up again in 2008 on the back of stronger world demand, growth is expected to recover to 6% in 2008 and 5.6% in 2009.

INFLATION: The continued boom in domestic demand, coupled with strong monetary growth, supply bottlenecks, high international commodity prices and a weak dollar-pegged currency, will ensure that consumer price inflation remains well above historical levels in 2008-09 despite increased subsidies. The official cost of living index was up by 9.6% year on year in March, the highest figure for over two decades. We expect inflation to average 10% in 2008, as rising oil export revenue is injected into the money supply through increasing government spending. In addition, supply bottlenecks, especially in housing, are unlikely to abate. A further weakening of the dollar and rising international commodity prices will contribute to imported inflation. However, we forecast that a stronger dollar and a decline in world commodity prices will help to reduce average inflation to 9.5% in 2009.

EXCHANGE RATES: There is some speculation that the Saudi Arabian Monetary Agency (SAMA ; the central bank) will upwardly revalue the riyal's peg to the dollar, which has been set at SR3.745:US$1 since 1986. However, we believe that SAMA will seek to avoid this, given its long-standing commitment to the peg, which acts as a nominal anchor to reassure foreign investors and limits exchange-rate risk to the country's main export, oil, which is traded in dollars. The main argument for an upward revaluation is that it would dampen the imported inflationary pressure that has resulted from the weak dollar. However, import prices are only one of several factors contributing to inflation.

EXTERNAL SECTOR: Oil market developments will remain the primary determinant of current-account trends, and oil will continue to account for the vast majority of export earnings. Higher oil prices in 2008 are forecast to take goods export revenue to US$289bn, from an estimated US$230bn in 2007. In 2009 goods export earnings are projected to fall back slightly, to US$279bn, because of lower oil prices. This assumes gradual increases in oil output in both years. Import spending is forecast to expand by some 30% a year over the outlook period, compared with an estimated 27% in 2007, as a result of domestic demand growth, large-scale capital investment and robust commodity prices. In 2008 the expected further weakening of the US currency will also push up import prices in dollar and dinar terms. Yet this will still leave a trade surplus of US$181bn in 2008 and US$139bn in 2009.