Saudi Arabia’s New Plan.

August 17, 2016
Editor(s): Sean Brown
Writer(s): Wen Lin Ong, Tony Chen, Alan Lewis, Jake Fava

Deputy Crown Prince Muhammad bin Salman stood confidently before the array of journalists as a beacon of light for the economic depravity that Saudi Arabia was slipping into over the last two years. For a country where 90 per cent of government revenue come’s from the largest oil and gas producer in the world, Saudi Aramco, the remarkable price slump in oil prices from over $100 in mid-2014 to just over $35 today  and somewhat pretentious blowouts of allocated budget deficits almost took the nation down a path of immediate insolvency.

The Deputy Prince himself estimates that this equates to 80 to 100 billion dollars in wasteful, government approved spending, or at least 20 per cent of allocated budget expenditure, amounting to a 15 per cent budget deficit last year. Something needed to be done…

Prior to 1938, Saudi Arabia was known for two things: its vast deserts and holy Islamic sites (CNN, 2003). After the lucrative mining discovery in 1938, Saudi Arabia has been known for primarily one thing – oil. Indeed, the terms Saudi Arabia and oil have become synonymous in modern history. However, in a market climate of declining oil prices, Saudi Arabia has outlined a 14 year plan to wean itself off its dependence on oil and diversify their economy. The economic reform, titled ‘Vision 2030’, is no doubt ambitious and challenging for an economy which has built its foundations on the export of oil (Cook, 2016); yet it is necessary for the long term, sustainability, growth and development of the country.

The Oily Beginning

In March 3rd 1938 in the Arabian Gulf, California Arabian Standard Oil, which later became state owned Saudi Aramco, drilled into the largest source of petroleum ever discovered (National Geographic, 2016). The finding revolutionised the economic and political landscape of the Saudi Arabia, and indeed the entire world. An economy once based on religious tourism, changed towards natural resources. The oil price boom from 2003 to 2013 the nation’s GDP doubled and household income rose by 75% (“Forbes”), allowing for heavy private and public investment in social and manufacturing infrastructure. Today, oil revenue accounts for 93% of the country’s economy (National Geographic, 2016). They presently produce 8 million barrels of oil a day and are the global leader in oil reserves, holding over 25% of the worlds supply – a total of an astonishing 260 billion barrels (Royal Embassy of Saudi Arabia, 2016). Most of these reserves are located in the east coast of the country near the Arabian Gulf, with large onshore refineries in Gahwar and offshore refineries in Safaniya (Royal Embassy of Saudi Arabia, 2016). However, the intricate and technologically advanced system of refineries, pipelines and transportation methods, allows Saudi Arabian oil companies to deliver oil across the country and the globe. To add to their strength and dominance in the industry, Saudi Arabia were a founding member of the Organisation of Petroleum Exporting Countries (OPEC), which aims to ensure a controllable and steady supply of oil in order to eliminate price fluctuations (Royal Embassy of Saudi Arabia, 2016). Evidently, they exert a substantial control over the industry. As such, their plan to distance themselves (even slightly) from the oil industry will reverberate globally.

Other Than Oil… Where’s the Money coming from?

It is important to outline how the Saudi Arabian nation structured its oil industry and economic policy before these Vision 2030 changes come into effect. The oil sector accounts for 80% of budget revenues (“Forbes”). Of course, Saudi Aramco is government owned, and a huge cash cow, but this still clearly presents a kingdom highly dependent upon a single revenue source and raises the question of where other forms of revenue would come from if the lucrative oil were to dry up.

Other forms of domestic taxation levels are very low. While the corporate tax rate sits at a reasonable 20%, and employees pays a social security rate of 9%, the income tax rate is in fact zero. Saudi nationals are admittedly forced to pay a 2.5% tax as mandated by Islamic law (“Saudi Arabia Social Security Rate For Employees | 2006-2016 | Data | Chart”), however this is miniscule in a global context and in total taxation income amounts to less than 5% of GDP (“Saudi Arabia Economy: Population, GDP, Inflation, Business, Trade, FDI, Corruption”).

The Kingdom also employs a fixed exchange rate, 3.75 Saudi Riyals for 1 USD, and has done so since 1986 (Ellyatt). This naturally provides certainty for the oil producing sector, and has arguably been an important base for allowing it to reach such a grand scale. Nonetheless, there are some claims that with falling oil prices the government may not have sufficient funds to hold up the peg and eventually float of the Riyal. Saudi Arabia however is in a very tight situation regarding any such float. While it runs a high trade surplus with oil exports, which would naturally benefit from a cheaper currency, like many Middle East nations it imports 80% of all food (as well as machinery and capital for the oil industry) (Taha). Therefore, consumers could be especially impacted by such a move.

There are also significant tariffs and barriers for firms wishing to engage in trade with Saudi Arabia. As a member of the Gulf Cooperation Council there is a 5% tariff imposed upon all imports, bar a few exceptions such as livestock and aircrafts. For firms competing with local industry this rate rises, for instance a 40% tariff upon imported dates. The religious government also controls the inflow of certain demerit goods with a 100% rate upon tobacco products. In the insurance and banking sector, these barriers become far more pronounced (“Saudi Arabia”). All insurance companies in the country must be joint-local operations with foreign equity limited to 60% (the remaining 40% must be sold on the Saudi stock exchange). The same equity cap holds for Merchant Banks (“Saudi Arabia”). This builds a picture of an economy which is heavily monitored by the government, and domestic firms are given a strong leg up against foreign competitors.

So What’s the Plan?

Whilst the specific details of his major economic overhaul and seismic stepping stone plans have not been released, Prince Mohammed has daringly announced a headwind of front-page worthy policies as if he were the ring leader of the richest circus of them all. Experts around the world have become enthralled in vigorous debate, forecasting the prince’s shake-up to the nation’s historical suckling of the oil teat.

Rock the Boat to Make it Float (or Whatever Floats Your Boat)

Arguably the biggest shock announcement was the proposed Initial Public Offering of a small portion of the oil monstrosity Saudi Aramco. Estimated to be the most highly valued company in the world, the plans to float just under 5 per cent the company comes as a complete surprise to investors given its notorious secretive state of affairs, with Prince Mohammed planning to open the said “ultra-secretive…financial books” (Quartz). Ironically, little much else has been said about the IPO, with hopes that the 5-year National Transformation Plan soon to be announced will shine some light on the oil spill, given the prince’s desire to see the float happen by 2017, which could see it valued at over 2 trillion dollars (Reuters).

In addition, Prince Mohammed plans to expand the boundaries of production of the company, seeking to move from the second largest refiner to the largest petrochemical refiner (perhaps for the nation’s desire of grandeur). The move seems somewhat counterintuitive given his audacious plan for the nation to be non-reliant on the liquid gold for governance and economic stability by 2020 (Bloomberg, Quartz). However, cash is required for the estimated 4 trillion dollars of investment expected by analyst firm McKinsey over the next 15 years (The Economist). And this is not all Prince Mohammed has planned for Aramco: a desire to diversify the company into an energy and industrial conglomerate that innovates in energy sources is part of the grander scheme to steer the economy away from oil.

Diversify, Diversify, Diversify

It would seem that the prince is taken a liking to the basic teachings of finance. The divergence from oil means that the Prince must find cash from other areas, if at least to sustain the royal family’s lavish lifestyle. He sees this though the rapid injection of assets into the Public Investment Fund (PIF), a pre-established fund by his father with an aim to incentivise innovation and investment. It is expected that the fund will be valued at least 2 trillion dollars and pushing towards 3 trillion, more than doubling the Norwegian sovereign wealth fund (Guardian) and thus fittingly making it the world’s largest sovereign wealth fund. This goal will largely be kick-started by the Aramco float, to which will allow the nation to technically make investments the source of Saudi government revenue, not oil,” within 20 years (Bloomberg). However, it must be noted that at least initially, such investment revenue will be largely reliant on the performance of Aramco, given that its shares will be transferred to the PIF.

Privatise to Climatise

Cash is the key stimulus for growth, with the Prince planning to at least part-privatise many of the government holdings across a variety of sectors. Health care, education, defence and private land holdings in the Mecca (estimated to be worth up to 10 billion dollars – The Guardian) have all been targeted as potential revenue raisers, with an incentive to make such areas more efficient and innovative in the wake of a shifting economy and contribute to PIF. Diversification of revenue will also come from the introduction of a VAT on accessories and luxury items, as well as taxes on sugar and energy drinks (The Economist). A greater focus on non-oil revenue sources could see up over 250 billion dollars raised in 2030, compared to only 43.6 billion last year, according to the Prince’s figures (The Economist).

The Prince’s plan is not all economic based though, with a plan to nudge the nation’s culture into a far more liberal affair. Conferring greater rights on women as a means of increasing their participation in the nation (QZ), reforming education to relive the focus on religion and invigorate interest into innovative fields and encourage greater domestic development of military technology are key but hidden cogs to his governing machine. However, the nation patiently waits to hear just how Price Muhammad will stir the pot for the better in the wake of a culture steeped in tradition and a heavy hand of governance from the higher powers.

The Difficulties

The significant short-term drop in state revenue given by the plan will challenge Saudi’s ability to meet its existing and extensive welfare outlays, however. Of course, an easy solution would be to decrease the size of these benefits and Saudi’s 2016 budget includes subsidy cuts on petrol, electricity and water in addition to introducing new taxes on luxury goods and tobacco (“The Saudi Blueprint”, 2016). In turn, however, this sudden revision in the social contract between the ruling monarchy and its citizens is likely to be met by strong resistance by the population at large, especially given the stark distinction between the existing high-subsidies no-tax status quo and Saudi Vision 2030’s proposed higher tax and low subsidies (Al-Khatteeb, 2015).

Second, the timing of this economic reform coincides unfortunately with a tumultuous political landscape in Saudi Arabia, where the country is waging an ongoing and costly war with neighbouring Yemen (Shapir, 2016). Even with the plan’s main source of funding — the ownership transfer of Saudi Aramco — USC Professor Muhammad Sahimi remains sceptical of the country’s ability to carry through with the full extent of the plan given the financial constraint imposed by Saudi’s existing commitments to regional allies including Egypt, Jordan and Bahrain (Cook, 2016). Furthermore, an added concern relates to the country’s relatively underdeveloped technology base, which may limit the extent to which the structural reform can occur (Cook, 2016).

Summed up succinctly by the Deputy Crown Prince, his plan to reform the country’s oil-based economy aims to achieve the three key pillars — “vibrant society”, “thriving economy” and “ambitious nation” (Cook, 2016). Especially in light of the plummeting oil prices, Saudi Vision 2030 will theoretically sever the country’s unhealthy dependency on oil revenue. This will occur via subsidy-cuts and higher taxation to reduce the existing budget deficit, as well as investing in non-oil industries to diversify official revenue sources. However, given the likely backlash to such austerity measures, not to mention Saudi’s technological and financial constraints, it remains to be seen whether Prince Muhammad’s plans will prove effective in lifting his desert kingdom from its economic woes.

The CAINZ Digest is published by CAINZ, a student society affiliated with the Faculty of Business at the University of Melbourne. Opinions published are not necessarily those of the publishers, printers or editors. CAINZ and the University of Melbourne do not accept any responsibility for the accuracy of information contained in the publication.

Meet our authors:

Sean Brown
Wen Lin Ong
Tony Chen
Alan Lewis
Jake Fava