Against a backdrop of global high oil prices, hydrocarbons will remain the cornerstone of the Saudi economy. The sector's contribution to real GDP is expected to rebound this year in line with a pickup in crude oil output and investment in productive capacity. In nominal terms the sector is expected to grow by as much as one third, as global oil prices are buoyed by market demand, supply concerns, and speculative activity. In Samba's report on the Saudi economy dubbed “The Saudi Economy: Recent Performance and Prospects for 2008-09,”it said the huge oil revenue the Kingdom enjoys at present would further witness brisk growth in government spending on basic infrastructure of 15 percent for this year and next. However, despite the government stimulus, the expanding private non-oil sector is increasingly becoming the driver of growth brought about by “properly sequenced and thorough-going economic reforms.” The growth in government spending will prudently continue to lag that in oil revenue, keeping the budget in surplus by as much as 20 percent of GDP both this year and next. The balance of payments position is also exceptionally strong and current account surpluses averaging some 25 percent of GDP in 2008-09 will further boost foreign asset holdings. The report, headed by Samba's chief economist Howard Handy, said though that inflation poses a major risk to this otherwise buoyant outlook. “The major risk to this buoyant outlook stems from inflation, with consumer price growth likely to average around 8 percent this year. Barring any change of policy, the outlook for prices depends largely on the pace of housing delivery, the course of global commodity prices (especially food), and the value of the US dollar. These conditions may gradually improve in the second half of this year and into 2009, helping to dampen some import prices and subdue wage pressures.” “The surge in global food prices has been directly registered in the Saudi consumer price index. The latest CPI shows that food prices rose by 13 percent in the twelve months to February (despite significant government subsidies). None of the factors listed above is likely to abate over the coming year, and further upward pressure on Saudi food prices appears inevitable.” The report further said that although an increasing amount of the country's oil earnings are invested at home, such is the scale of these earnings that the country has continued to accumulate foreign assets. In 2007, the Saudi Arabian Monetary Authority (SAMA, the central bank) increased its foreign assets by $80 billion. Most of this is likely to have been channeled into US dollar-denominated assets, representing significant support for the greenback at a time when the US external current account remains in large deficit and there are growing uncertainties about US economic prospects. (We will explore Saudi Arabia's role in global financial intermediation in more detail in a later report.) The report noted that the Kingdom's economy has been growing rapidly in recent years, doubling in nominal terms since 2002. With nominal GDP projected at around $465 billion this year, Saudi Arabia's economy is now on a par with that of Switzerland. It accounts for a little more that half of the total output of the GCC and is twice the size of the second largest GCC economy, the UAE. It is a major trading nation, and the second largest global source of outward remittances after the US. Oil prices, food prices, and US interest rates all have an important bearing on Saudi Arabia's economy. As Saudi Arabia's global economic importance grows, so the gyrations of the world economy are having a more immediate impact on the Kingdom's economic health. Three variables are foremost: q Global demand. The pace of global economic activity has an important bearing on oil prices, which are in turn the key determinant of Saudi Arabia's external and fiscal positions, and to a lesser extent its own pace of GDP growth. q US interest rates. Because of the riyal's peg to the dollar, US interest rates have a significant influence on domestic liquidity conditions. q Global commodity prices. The prices of a range of global commodities have surged, with higher food prices in particular feeding through into sharp rises in Saudi Arabia's CPI. Despite the uncertainties besetting global credit markets, the International Energy Agency (IEA) expects stronger growth in oil demand this year compared to 2007. The organisation anticipates additional demand of 1.7 million b/d in 2008, up from 0.9 million b/d in 2007, reflecting, in the main, continued robust demand, especially for transport fuel, in China and the Middle East. The supply outlook is also tight. Despite prices surpassing $100/barrel, OPEC members remain generally cautious, reflecting their own large and growing budgetary commitments. As such, the organisation decided at its early March summit to roll over its existing quotas until the end of the summer. OPEC insiders indicate that action (i.e. further cuts to quotas) would be taken to defend a price of $80/b. Further potential supply tightness or disruptions could come from a variety of producing nations such as Nigeria, Iraq, Venezuela, and Iran, where politics and/or the policy environment remain unstable. Gains from non-OPEC supply are also likely to be modest as extraction costs continue to rise sharply. Prices have also been pushed higher by speculation in the commodities markets, including oil, as investors look for alternative investments that are largely uncorrelated with fixed income and equity assets. The S&P Goldman Sachs Commodities Index rose by 52 percent in the 12 months to March 26. A widely held view is that when interest rates are lowered more than conditions in the real economy warrant, the resulting concerns over inflation push commodities higher. “We expect this upsurge in hedging activity to ease over the coming months, particularly as the global credit crisis abates. Going forward, therefore, commodity price trends are likely to be more heavily influenced by real activity in the global economy. If the US economy slides into a deep recession, an extended period of subpar global growth could put appreciable downward pressure on commodity prices, including oil. However, if the US slowdown is less pronounced and reasonably short-lived, as seems more likely, global growth could return to trend, or move even higher, helping to lift commodity prices again,” the report said. On balance, the likelihood is that oil prices will remain elevated for some time (futures contracts for December 2010 were trading above $99/b in mid-March). There may be some softening of prices as speculation by hedge funds unwinds and US demand eases, but the broad market fundamentals will remain tight, and we forecast an average spot price for Saudi crude of around $89/barrel for 2008. Based on expectations that the US economy will be recovering in 2009, oil prices should edge up further to an average of about $94/barrel next year. From Saudi Arabia's perspective, the aggressive easing of monetary policy by the US has posed challenges. The US Federal Reserve has reduced its primary policy rate by 300 basis points (bps) since September 2007, most recently by 75 basis points in March. With the Saudi riyal pegged to the US dollar, SAMA has had to follow suit, reducing its reverse repo (deposit) rate at a time of surging liquidity in the Saudi economy. Though the transmission mechanism has been weakened by commercial banks' abundant local liquidity, the necessary reduction in Saudi rates has been inopportune given rising domestic inflation, and has necessitated accompanying increases in bank reserve requirements. The Federal Reserve seems unlikely to reverse its policy easing in the near term. Indeed, there may yet be further (modest) rate cuts, as the central bank attempts to restore liquidity and confidence in credit markets. However, participants are increasingly concerned about emerging inflation in the US, and the loosening bias is unlikely to be maintained into 2009. The outlook for US interest rates is likely to continue to weigh on the value of the dollar and this in turn will have implications for Saudi Arabia: a weak dollar (and hence riyal) makes some imports more expensive (those not priced in dollars). A weak riyal also reduces the “send home” value of many expatriates' wages, prompting some to demand higher riyal salaries as compensation. These influences add to domestic inflationary pressures. Saudi Arabia clearly benefits from elevated oil prices, but it suffers from higher imported food prices, with food and beverages accounting for 26 percent of its consumer price index. The Economist commodity-price index for March 17 records a 62.1 percent increase in global food prices in dollar terms compared to a year earlier. Much of this reflects the downward drift of the dollar, but even in euro terms the index for all items was 12.6 percent ahead (the euro index is not disaggregated). There are a number of factors at play here. As with oil, speculators have been bidding up food prices in an effort to offset the decline in prices of financial assets. Emerging markets have also been stockpiling food to hedge against future scarcity. In a related move, a number of large food producing countries have imposed export tariffs in a bid to ensure that their home markets are well supplied. Unusually volatile weather patterns in a number of producing countries, most notably Australia, have also contributed to higher prices. Perhaps the most important driver is the squeeze on arable land prompted by the switch to biofuel production in key food producing nations, such as the US and Brazil. Longer term factors include more diverse food demand from the world's population, as more people become urbanized (for example, the UN forecasts that China's urban population will increase by some 63 percent, or 320 million people, by 2030.) __
