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from Project on Middle East Political Science

A landing strategy for Saudi Arabia

POMEPS

This chapter is part of POMEPS Studies 33: The Politics of Rentier States in the Gulf. Download the full PDF here.

With rising population and incomes, the “rentier” mode of development in Saudi Arabia has long been unsustainable. While the issue of fiscal stabilization will occupy policy-making in Saudi Arabia in the short and medium terms, the long-term challenge of finding new sources of growth to complement oil has only been made starker by the recent drop in oil prices. Analysis of the prospects for such reforms in KSA has long been divided between two opposite camps: those who believe that the inadequacies of the rentier model will necessarily usher a doomsday scenario sooner or later, regardless of economic policies; and those who believe the impending crisis can be met by moving from the current mono-sector economy to a modern and diversified knowledge based economy OECD-style.

The optimistic scenario recommends that KSA becomes some form of Dubai on steroids, where Saudi youth ends up managing hordes of migrants in a super competitive economy driven by private initiative and serving as a bridge between East and West (Vision 2030). Steffen Hertog’s paper carefully dissects why this vision remains a fantasy. Given the Saudi starting point, with a large population and an economy structurally dependent on oil, it would take many decades before KSA can ween itself out of oil and insure a good standard of living to its growing population by diversifying its production in other competitive areas. No easily discernible economic policy could deliver the needed transformations before the crisis point arrives.

The doomsday scenario also makes unrealistic assumptions, however. The oil shock of 2014, coming on the heels of a post-Arab Spring fiscal expansion, has caused a large deficit in the government budget. Given its existing reserves, KSA can borrow abroad and sell assets to theoretically finance at least 10 years of deficits at the current level. The government could therefore continue kicking the can down the road for a while without considering serious reforms, but this would lead down the road to bankruptcy. However, it is not realistic to assume a continuation of the current socio-economic path, even as it becomes increasingly apparent that it leads into a wall. Too many interests have skin in the game to allow such a disastrous scenario to unfold unopposed.

While the first pessimistic scenario is more likely than the second dream scenario, both fail to draw the contours of a reasonable vision for KSA in an age where oil revenues will remain sizable but not sufficient to sustain the past model of development.

Youth employment and rentier adaptation

To develop a reasonable landing scenario, it is necessary to be clear on its objectives. There is no value to diversification of exports per se, at least as long as oil revenues are sufficient to cover import needs. Rather, the key goal for KSA should be to gainfully employ its educated youth in high enough productivity jobs. While it made sense in the past to import labor to build the country, by now, there are cohorts of educated Saudi students coming out of school that need to be gainfully, and productively employed. The situation is thus profoundly different, and it requires profoundly different economic incentives and structures.

The existing economic model has become anachronistic. It is only a bit of a caricature to state that the current growth model rests on a two separate deals: one deal with businesses for a free hand at importing labor from abroad, and one with citizens for guaranteed public sector jobs and life-long support. With its current population of 20.8 million (General Authority for Statistics 2018), it can be computed, based on World Bank data (World Bank Indicators, 2018), that oil revenues were only $6,600 per capita in 2016, compared to about twice as much in 1990, on the eve of the previous oil crisis. KSA has clearly outgrown the current arrangement.

The government is no longer hiring all Saudis who are willing to work. Already, unemployment is officially at 12.8 percent, 33.1 percent for women, and 31.3 for youth (age 25-29), and rising (General Authority for Statistics 2018).

Oil rents are not sufficient to finance anything close to current consumption levels for the population, and this can only get worse over time in the absence of a new source of growth.

The main problem with the current economic path is that under the current system, nationals are simply not employable in large numbers in the private sector. Dwindling oil revenues will provide less income to nationals over time. If cheap labor continues to be freely imported, Saudi will continue to shun working in the private sector until they become much poorer. Significant policy reforms are needed to offer them incentives to join the labor force well before their incomes decline to expat wage levels – which tend to be the lowest global wages at any level of skills.

By employing its nationals more productively, KSA can aspire to become a normal oil economy – one that exports mostly oil, but that derives much greater national income from the work of its population. This would require radically scaling back the massive import of foreign labor. In the Norway model of a normal oil economy, Saudi workers would replace expats over time, mainly in the private service sector. The economy would remain dominated by oil. Many public sector firms will continue to play an important economic role, employing specialized Saudi workers (in the oil sector, health, academia, telecom, finance).

The current labor arrangements place a heavy disincentive on nationals from joining the labor force. Yet, huge gains could be made if they were instead encouraged to do so, both because national labor is grossly under-employed, but also because it is increasingly well educated, thus increasing the opportunity cost of low participation. Currently, only 40.3 percent of the working age is in the labor force, and only 35.1 percent of the population works (the rest is unemployed) – see General Authority for Statistics 2018. This compares to employment rates of about 60 percent in the OECD. Low national participation rates are largely due to very low participation by women (17.4 percent), but men’s participation is not high by international standards either at 62.1 percent (General Authority for Statistics 2018).

Employing young Saudi women and men productively would create a great boost of growth, and it would save on foreign exchange now being remitted by expats abroad. At the end of this transition, millions of expats would have returned to their home countries. The Saudi economy will then become possibly smaller than it is today, but it will be employing a large share of its own population productively. It may have a lower GDP, but it would have a larger National Income. Oil will remain central, but it will have a much larger multiplier effect in terms of national income.

In a normalized Saudi economy, one can envisage that in the next phase (say the next 10 years), a large share of the Saudi labor force (say half) will remain employed in government. In such an economy, except in a few areas of comparative advantage, not many firms would produce globally competitive tradables. Those that do compete globally now will be unlikely to survive given that unskilled wages will rise, and on the fiscal front, subsidies will fall and taxes will be introduced. Perhaps a select few tradable sectors could develop, such as religious tourism and sectors with linkages to petroleum. Together with oil, these would generate foreign exchange earnings of 40 to 50 percent of GDP, which under normal conditions, should be sufficient to finance the needed imports of a normalized economy.[1]

To give a sense of magnitudes of the potential gains if national labor was employed more effectively, a simple projection model suggests that with participation rates growing from 40 percent to 60 percent of the working age population, and unemployment dropping to its natural rate, non-oil national income would more than double if the additional workers join the non-oil sector at current productivity levels. Improvements in labor productivity would add to this growth rate further. Altogether, it can be estimated that this addition to national wealth would ultimately be comparable in magnitude to the kingdom’s oil wealth itself.

Obstacles to transitioning to a normal economy

There are multiple political economy challenges to the establishment of such a “normal” Saudi economy. The economic elites would want to keep their privileged access to cheap foreign workers. They will hesitate to make the investments needed to create jobs with the level of productivity that can make them attractive to Saudi workers. They will claim that the quality of the education and the attitudes of the population are not favorable to their employment. National workers will resist working in the private sector at wages lower than those their parents earned in the public sector. In time, as they become less dependent on rent distribution, they will start questioning the autocracy of their rulers.

Besides political economy issues however, the main economic challenge of the transition to a normal economy is to create productive jobs. It is easy enough to just create jobs – in the public sector and security forces, or by replacing migrants in labor-intensive private sector occupations. To pay the youth in ways that preserve their consumption levels close to those of their parents, the first method would expand fiscal deficits and raise public debt. The second method would lead to higher non-tradables prices if productivity does not rise, which would erode the standards of living of the whole population.

For labor productivity to rise, private investment will have to rise. Indeed, private sector firms will need to not only pay sufficiently to attract Saudi workers, but they also will need to invest in more capital and skill-intensive production methods, and to start training their workers so they can improve their productivity. In the service sector in particular, labor-intensive jobs now manned by expats need to disappear and be replaced by more productive jobs occupied by Saudis. Each Saudi worker would need to be equipped with skills and machines to accomplish the tasks being delivered now by several departing low-wage expats in order to be able to earn a multiple of their unskilled wages. There are two key challenges to such a scenario.

First, there is a need to improve substantially the business climate and to enlarge access to credit so as to allow for the formation of new firms that can innovate and create the needed highly productive jobs. More targeted industrial policies can help speed up the adjustment of SMEs to the new input price structure. For new SMEs that disrupt the labor-intensive way of doing business to play a leading role in the transformation of various industries toward more productive structures, there is a need to encourage the (creative) destruction of the old inefficient firms, so that the new firms have space to increase their market shares.

Second, the required investment will generate large new aggregate financing needs. To create about one million jobs every five years, they can be of the order of $0.5 trillion over ten years.[2] These funds will have to come from the national banking and financial sectors, FDI, or from public funds. At the macro level, this creates a trade-off with the speed of adjustment. Large amounts of public financing of deficits will end up crowding out funds that need to go instead to the private sector. Given that the private investment required for a successful structural reform strategy is large, there is therefore a global finance trade-off. In our back of the envelope calculations, it would not be possible to wait 10 years to adjust while at the same time creating one million new good jobs. Thus, slowing adjustment too much will constrain how much can be invested to upgrade jobs and improve labor productivity.

The considerations above, both financial, and political, suggest that the reform program would ideally advance at a deliberate but gradual pace, taking advantage of the existence of a sizable fiscal space to smooth the cost of reforms over time but at the same time moving deliberately along a pre-set multi-year agenda. It is true that cases where ambitious reforms were carried-out gradually way before crisis point have been historically rare. Moreover, the challenge of foresight and restraint is contrary to the rentier tendency for expenditures to rise to the level of revenues, “kicking the can” as long as possible. But countries with significant fiscal space and a clear understanding of their need to change their growth path in fundamental ways are also rare. And it is precisely this coincidence that sets KSA apart.

Important elements of the reforms needed for KSA to become a normal economy are already in place. Vision 2030 focuses on many aspects of this agenda. Taxes are rising and subsidies are coming down slowly. Saudization policies, which were started a decade ago, are becoming more binding, and expats are becoming more expensive and are starting to leave in droves. And strong policy signals have been sent to encourage more innovative SMEs to enter domestic markets. But overall, the program projected by Vision 2030 is not sufficiently focused on the creation of jobs for nationals and is overly concerned with an unattainable diversification agenda. As such, it remains blurred and lacks credibility. This is partly to be expected as structural reforms of this magnitude necessarily involve trial and error. But it is now apparent that it is not realistic, nor necessary, to aim at a rapid and brutal fiscal stabilization. Instead, to send an unmistakable signal that productive jobs are the priority, Saudization policies would need to become more ambitious. At the same time, there is a need for a much more ambitious effort to improve the business climate, which remains opaque and constraining, and to open up the access to finance, which is now severely restricted for new firms. It is also becoming clear that risky mega-projects (such as Neon city) that could easily turn into white elephants should be replaced by pragmatic industrial policies that help whole sub-sectors to modernize rapidly and adjust to new input prices.

For any of this to happen, the most immediate challenge is for the Saudi elite and increasingly restive population to coalesce around a reasonable landing strategy, as opposed to pie-in-the sky plans that do not amount to a credible plan around which economic and political actors can get organized.

General Authority for Statistics, Kingdom of Saudi Arabia, 2018:  https://www.stats.gov.sa/sites/default/files/labor_market_q3.pdf

World Bank. World Bank Indicators, 2018. 

https://data.worldbank.org

[1] In comparison, Norway’s imports to GDP ratio is 35%. Its exports to GDP ratio is about 50% GDP, like KSA. Its exports include Crude Petroleum ($22.7B) (https://atlas.media.mit.edu/en/profile/hs92/2709/), Petroleum Gas ($21.6B) (https://atlas.media.mit.edu/en/profile/hs92/2711/), Non-fillet Fresh Fish ($5.24B) (https://atlas.media.mit.edu/en/profile/hs92/0302/), Refined Petroleum ($3.23B) (https://atlas.media.mit.edu/en/profile/hs92/2710/), and Raw Aluminium ($2.59B) (https://atlas.media.mit.edu/en/profile/hs92/7601/).

[2] This assumes that each job requires on average an investment in machinery of $250,000, which is 20 times an average wage.

Recommended citation

Diwan, Ishac. “A landing strategy for Saudi Arabia.” Project on Middle East Political Science, January, 2019