By Pamela Ann Smith and Moin A Siddiqi

OPEC's Vienna agreement at the end of March, engineered by Saudi Arabia, Venezuela and Mexico, increased collective output by 1.7 million barrels per day (mbd), which should underpin the cartel's new reference price of $20 to $25 a barrel. Every US$1 change in oil price affects official Saudi revenues by $2.7 billion.

Sustained firmer oil prices and a revival in public and private investments will underpin real gross domestic product (GDP) growth of three per cent during this year, and in 2001. Meanwhile, consumer prices will remain relatively low, boosting real disposable incomes.

Crown Prince Abdullah, who now has increased responsibility for the running of day-to-day affairs of the kingdom, has often remarked that the "boom is over". The Cyprus-based bank rating agency, Capital Intelligence, noted: "Saudi Arabia has made a significant shift in its approach to development and finance."

This year, a higher trade surplus may lead to a modest surplus on the current account

The conservative budget for 2000, based on an average price of $14.7 a barrel for Arabian light crude, projected a deficit of Saudi Riyals (SR) 28 billion at the end of last year, equivalent to 4.9 per cent of GDP. However, continued firmer oil prices, coupled with increases in non-oil revenues, will result in a markedly lower fiscal deficit, or even a balanced budget in 2000, or 2001.

Oil windfalls may be used to replenish the kingdom's foreign assets, or to redeem a large proportion of the burgeoning public debt. According to the Saudi American Bank, total domestic debt by end-2000 may rise to SR 639 billion, representing 113 per cent of GDP, and its servicing cost of SR 30 billion, consumes 16 per cent of the annual budget. This in turn undermines the government's capacity to substantially increase capital spending on infrastructural development.

The size of public debt is rising by about five per cent of GDP per annum, and unless the government tackles the problem of chronic budget deficits, the kingdom's real growth will remain below its true potential. The external financial position has improved over the past year. This year, a higher trade surplus may lead to a modest surplus on the current account, as in 1996 and 1997.

Exports of both crude oil and petrochemicals are benefiting from growth revival in the Asia-Pacific region, a major market for Saudi oil, and by an upturn in world trade in 2000. Improving macro-economic outlook and declining budget deficit, coupled with a growing trade surplus, are supportive of the Saudi riyal. By law, the riyal's convertibility and its peg of SR3.75:$1, are underpinned by special forex reserves ($18 billion), and by the central bank's (Saudi Arabian Monetary Agency-SAMA) foreign assets.

Landmark Economic Reforms</p>

The kingdom is classified as a 'state-heavy' economy. The government-owned hydrocarbons and petrochemical industries are the bedrock of the economy, contributing over 40 per cent of GDP, and 95 per cent and 75 per cent of total exports and state revenues respectively. Saudi Arabia is finally taking appropriate measures to reform its relatively closed mixed economy. A consensus is emerging within the House of Saud for implementing genuine economic and institutional reforms, aimed at creating a more open, competitive, investment-oriented economy. The International Monetary Fund has long advocated transition to an efficient market economy, and the World Bank urges major Gulf oil exporters to diversify by increasing investments in non-oil industries.

Policy makers accept the importance of a fully diversified economy, hence reducing over-reliance on a single volatile commodity. The seventh five-year development plan (2000-2005) emphasises continuous diversification, deregulation through an enlargement of the private sector's role, privatisation, and increased Saudisation of the labour force. In August 1999, a Supreme Economic Council (SEC), reporting to the Crown Prince Abdullah, was set up to implement, and monitor economic reforms, with a view to gaining membership of the World Trade Organisation (WTO). Prince Abdullah summarised the kingdom's position: "Globalisation is coming and the world trade agreement will be binding. We are getting ready for it."

The proposed reforms are radical in the context of Saudi conservatism. The main aim of the legal reforms is to improve foreign investment regime by removing rigid administrative obstacles to private external investment. A landmark foreign investment law was ratified by the Council of Ministers in April. A prominent Jeddah-based lawyer described the new law as "the most important piece of business legislation to come out of the kingdom in the last 20 years". Foreign investors will be permitted to own industrial companies, which will receive "equal treatment" with wholly-owned Saudi entities when applying for government soft loans and bidding for public contracts, as well as obtaining tax holidays.

In the post-WTO membership period, Saudi companies will also be fully taxed

At present, only Saudi companies enjoy preferential treatments in areas such as soft loans from the Saudi Industrial Development Fund and access to lucrative governmental contracts. The tax regime is also being revised to give equal treatment to foreign companies. Currently, non-Saudi firms, classified as those with above 50 per cent foreign ownership, pay a higher corporation tax of 45 per cent after the expiry of their initial 10-year tax holiday, while 100 per cent Saudi-owned companies pay a negligible amount of tax. New corporate tax rates on foreign companies will be reduced to 25 to 30 per cent. In the post-WTO membership period, Saudi companies will also be fully taxed. Other revisions to the Saudi legal code will permit non-Saudis to own both commercial and residential property in future, without the need for local sponsorship. These measures should help foreign investors, who have cited punitive corporate tax rates and ownership restrictions on Saudi real estate as major deterrents to future investment. The government is also planning to extend tax-holidays to 15 years for mostly high-tech projects and to provide financial incentives for research and development.

Protracted WTO Negotiations

The government is completing protracted negotiations for entry into the WTO and has hopes of becoming a full member of the international trading organisation later this year, or in 2001. Discussions are focused on sensitive issues such as the restructuring of the trade regime, in order to comply with the requirements of the Uruguay free trade agreement. These requirements include the gradual dismantling of trade barriers and the reduction of Saudi import tariffs (which currently stand at 12 per cent) over the eight-to-10-year transition period, eventually exposing local industries to international competition.

Other contentious issues include industrial subsidies to state-owned petrochemical industries and fiscal incentives to majority Saudi owned joint ventures in the form of cheap power, water and land rent. A subsidy regime contradicts the WTO's principle of equal treatment of local and foreign investors. The kingdom is also expected to open its closed services sector, including banking, insurance and telecoms, to inward foreign investment. The Saudi government wants a longer grace period for implementing trade liberalisation and for dismantling subsidies. These sensitive areas may delay Saudi Arabia's entry.

The first tranche of 24 million shares in Saudi Telecommunications Company (STC) will be sold on the stock market in the second-half of 2000

Membership of the WTO, when it is achieved, will raise Saudi Arabia's profile in the international investment community, helping to attract more foreign direct and portfolio investments. Its petrochemicals industries will gain access to lucrative European Union markets. However, more fundamental fiscal reforms like the imposition of personal income tax on Saudi nationals, or the progressive dismantling of consumer subsidies may be politically difficult to implement.

Privatisation drive

The main objective of the privatisation programme is to improve the efficiency of parastatals - mainly utilities - and rationalising public expenditure. Meanwhile, receipts from sell-offs could be used to redeem the national debt. Crown Prince Abdullah declared privatisation the "strategic choice" for the kingdom. He is keen to encourage more private investment in infrastructure and management projects. The power and telecoms sectors have been corporatised, ahead of their privatisations later this year.

The first tranche of 24 million shares in Saudi Telecommunications Company (STC) will be sold on the stock market (advised by US investment bank JPMorgan) in the second-half of 2000. There is a possibility of foreign operators acquiring a 20 to 40 per cent stake in STC, which is capitalised at $2.67 billion. Meanwhile, the four major regional power utilities (central, east, west and south) are being merged within the Saudi Electricity Company (SEC). A local banker explained: "The SEC is to be set up with a capitalisation of $8.9 billion, and then rearranged into transmission, generation and distribution businesses, which may then be sold off separately."

According to the Ministry of Industry and Electricity, the power industry needs a sizeable investment of $110 billion by 2020 in order to triple present capacity. Following a recent privately financed $2 billion build-own-operate(BOO) power station at Shuaiba, the government plans construction of two more independent BOO power projects. Privatisation of Saudia, the national airline and Saudi Arabian Mining Company are expected by 2002. The government's stakes in cement companies Qassim and Yanbu, and the Saudi Fisheries company are sheduled to be floated on the stock market in the near future. Meanwhile, Saudi Basic Industries Corporation (SABIC), which is 70 per cent state-owned, may invite local investors to acquire stakes in its various manufacturing subsidiaries.

Liberalising foreign portfolio investment

A total stock of net foreign direct investment (FDI) of $7.88 billion into Saudi Arabia, between 1990-98 remains low compared with flows to south east Asia. Joint-venture projects represented over half of FDI. The United States is a major investor, with $2.25 billion invested in about 267 projects.

There is a need for more productive investments that will enhance the kingdom's industrial capacities. Its present fixed investment-to-GDP ratio of 20 per cent falls short of the average rate of 25 per cent deemed necessary by the International Finance Corporation to sustain a robust pace of GDP growth over the long term.

Higher flows of FDI could contribute toward improving the kingdom's economic base by increasing the inputs of advanced technologies and managerial expertise into non-oil projects, the key to future job creation for nationals. About 40 per cent of the indigenous population is under the age of 14 and, on present trends, four million young Saudis are projected to enter the labour market over the next decade.

Unemployment among young people, including graduates, is an economic and social concern of the authorities. The government is establishing a powerful new General Investment Authority, with overall responsibility for providing the mechanism to encourage inward investment.

Future FDI by foreign energy companies will receive a higher priority in the area of exploration and development of upstream natural gas reserves, which are assessed at 5.79 trillion cubic metres, the world's fifth-largest. In addition, new FDI is also being encouraged in petrochemicals, power generation and desalination plants. The objective is to achieve future non-oil industrialisation, based on greater exploration and production of mostly untapped gas reserves. The kingdom's immense oil reserves of 261.5 billion barrels will, however, remain closed to international oil majors for the foreseeable future.

The kingdom is slowly opening its largely closed stock market to attract flows of foreign portfolio investments. Non-Saudis from outside the GCC states will be able to invest in local shares through 12 open-ended mutual funds, offered by the 10 Saudi banks. These mutual funds are valued at $600 million, which is modest compared with a total Saudi market capitalisation of $61 billion, as of end-1999. Recently, leading banks have been marketing new mutual funds, targeted at foreign investors.

WTO membership will increase competitive pressures on Saudi banks, which in turn, will benefit clients

Although the Saudi market has the largest capitalisation in the Arab world, and is based on sophisticated clearing and settlement systems (with T+1 settlement and plans to move to T+ 0 settlement this year), it is not a stock market in conventional terms. The market is based on a fully electronic interbank trading system, supervised by the central bank. The government is planning to set up a formal stock exchange and appoint an independent regulator. New laws will restrict 'hot money', ie speculative inward and outward capital flows, as in Chile.

A more liberal and broader market with more opportunities could attract a greater part of the estimated $500 billion-worth of Saudi private offshore assets, and encourage highly paid expatriate executives to invest in a revitalised stock market. Every year, outward workers' remittances amount to some $14 to $15 billion, with adverse effects on the balance of payments.

Healthy Banking Sector

Capital Intelligence comments: "Saudi Arabia has one of the best-managed banking systems in emerging markets, with good regulation, disclosure and transparency." It has upgraded the rating for seven major Saudi banks to A minus, above the kingdom's sovereign ceiling of BBB+. These banks are the National Commercial Bank, Saudi American Bank, Riyad Bank, Al Rajhi Banking & Investment Corp (ARBIC), Saudi British Bank, Arab National Bank and Al Bank Al Saudi Al Fransi.

Moody's Investors Service of the US notes: "Saudi banks weathered the 1998-1999 oil price downturn to emerge stronger and leaner following cost-cutting and extra provisioning." Generally, major banks are adequately capitalised, and profitable, thanks to good asset quality. Thus the system is well placed to benefit from a surge in business activity. WTO membership will increase competitive pressures on Saudi banks, which in turn, will benefit clients.

Outlook For Reforms

The adjustment process might be difficult. Until now, the kingdom's relatively closed economy, has been cushioned from the realities of international business. In the past, gradual change, rather than rapid implementation of new policies represented the Saudi system. However, a new realism and a desire to fully integrate within the globalised economy, commensurate with its rich resource base, may accelerate economic reforms. If landmark reforms are fully implemented over the medium-term, then the kingdom's economic and institutional infrastructure will be radically different and more in tune with global norms. The central bank report comments: "In light of globalisation, there is a need to strengthen and speed up privatisation programmes and encourage and increase domestic savings and foreign investment in productive sectors." Sustained higher oil prices should not derail commitments to genuine reforms. The World Bank warns that failure to take the right measures would only exacerbate future fiscal and structural imbalances.

Equally important, administrative capacities should be fully developed in order to efficiently implement far-reaching reforms.

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