Saudi Arabia: Fighting fires on many fronts

The Saudi government may be in the midst of one of the most transformational periods in its history, but the reverberations have not yet been felt by the citizen on the street.

“Our discussions with a broad range of ‘average’ Saudi residents suggest that the general population is not worried yet,” stated Dubai-based Shuaa Capital in a recent report on the country.

“While the hike in fuel price in particular was a regular talking point, Saudi residents in general do not expect the prevailing macro environment to have a significant impact over their lives, particularly over the longer term,” it added.

Saudi citizens may have been shielded from one of the worst crises in global oil markets in several decades, but changes of larger proportions are coming that will likely reverberate through every aspect of their lives.

Under King Salman bin Abdulaziz Al Saud, his son — deputy crown prince Mohammad Bin Salman Al Saud — has embarked on an aggressive retooling of the country.

Apart from a more muscular and aggressive foreign policy, the young prince is rolling out the ambitious National Transformation Plan (NTP) — launched in June — that will likely alter the structure of the economy and reduce the country’s dependence on crude oil receipts within a few decades.

Read more: In depth: Saudi prince unveils plans to end “addiction” to oil

But it’s a tough ask. Previous efforts to make structural changes to the Saudi economy have failed, as the lure of crude oil revenues has compelled authorities to continue to monetise the world’s second largest reserves in the world.

The deputy crown prince himself has decried the country’s “addiction” to oil, which has delayed much-needed reforms and ignored parts of the economy.

Enter the NTP — part of the grand Saudi Vision 2030 document — that will transform 24 key government bodies, across many economic and development sectors.

“Accordingly, a number of ministries, institutions, and government entities underwent a restructuring process to align them to the requirements of this phase,” the government said in its report.

Wall Street bank JP Morgan says demanding cross-agency collaboration, the lack of which has been criticised by stakeholders, is a positive that should boost the economy.

“We think even a partial achievement of these objectives by 2020 creates longer term macroeconomic sustainability,” the bank’s equity strategist David Aserkoff said in a report.

Key goals of the NTP include cutting unemployment to under 7 per cent; rising to become the 15th largest economy in the world (from its current position as the 19th largest economy); raising the private sector’s contribution from 40 per cent to 65 per cent of GDP; raising the share of non-oil exports in non-oil GDP from 16 per cent to 50 per cent; and expanding the sovereign Public Investment Fund’s assets to SAR7 trillion ($1.87 trillion), from SAR600bn ($160bn).

A number of reforms are already under way. The Capital Market Authority recently issued new rules permitting foreign institutional investors to buy shares directly in initial public offerings.

Read more: Saudi to let foreign institutions buy shares in IPOs

Previous policy limited foreign institutions to buy IPO shares on a case-by-case basis, but they could invest in local IPO funds. The reforms are part of the government’s preparation to list major entities, such as state oil giant Saudi Aramco, on the Tadawul but also cross-list on foreign exchanges.

In addition, the Saudi cabinet recently approved 100 per cent foreign ownership of retail and wholesale operations in the country. Previously, nationals were required to own at least 25 per cent of the company.

That is just the tip of the iceberg. The NTP eyes rapid privatisation of sea and airports, certain government services, and a whole host of sectors including electricity, education, healthcare and other infrastructure projects.

Selling the family silver

A central plank of the strategy is to privatise key government entities, including the crown jewel, Saudi Aramco – the world’s largest crude oil producer.

The partial listing of Aramco as early as 2018 is expected to value the company at around $2 trillion, and will be the first major test for the deputy crown prince, as he shakes up entrenched interests and long-standing traditions within Saudi culture.

Read: Saudi Aramco eyes 2018 for mega IPO – CEO

But restructuring the economy comes at a time when the near-term direction of crude oil prices remains uncertain, putting pressure on the government’s finances.

“Growth trajectory may be hampered by the implementation of the NTP,” according to Standard Chartered Bank.

Implementation of the NTP could weigh on growth in the next couple of years since it targets curtailing public sector spending and generating savings for the government.

“Offsetting the impact of this consolidation on economic growth will require more efficient and productive public spending, broadening the productive base of the non-oil economy, and raising the contribution of private-sector and foreign investment to growth,” SCB analyst Dima Jardaneh said in a report.

“It will take time for these factors to have a meaningful impact on economic growth, in our view.”

It’s also unclear how the NTP’s ambitious fiscal targets will be met, according to ratings agency Fitch.

“The economic impact of such a fiscal tightening would be so severe that in Fitch’s view the fiscal objectives will probably have to be scaled down,” says Jan Friederich, senior director at Fitch.

“In addition, the broad range of other social and economic objectives and the complexity of implementation may overwhelm the administrative capacity of the government.”

Fiscal cushion vulnerable

Since Saudi Arabia and its OPEC members decided to launch a market share war in November 2014, crude oil prices have declined by more than 50 per cent, at one stage hitting a decade-low, and tumbling below $30 per barrel.

The Saudis calculated that once high-cost producers were eliminated, the kingdom and its low-cost producing counterparts would be left standing to share the spoils. But it has not quite worked out that way, with US shale producers especially resilient and nimble.

During the oil war that has lasted more than a year and a half, Saudi Arabia’s official reserves have shrunk from $732bn at the end of 2014 to $570bn in June.

They will decline to $451bn by the end of 2017 if current economic conditions persist, forecasts boutique investment house Jadwa Investment.

It must be said, however, that this figure still stands way above the $419bn required by the International Monetary Fund’s Assessing Reserve Adequacy metric – a key measure by the institution to assess a country’s financial strength and ability to withstand fiscal shocks.

While Standard Chartered Bank expects Saudi reserves to rise to $800bn by 2020 as oil prices recover, the kingdom’s vulnerability to terms-of-trade shocks leaves its reserves open to considerable balance-of-payments drains.

Oil prices of around $50 per barrel over the next four years could reduce net foreign assets to $370 bn, and a worst-case scenario of $30 per barrel till 2020 would deplete net foreign assets to $69.4bn, SCB estimates.

“This illustrates that using foreign reserves to finance recurring current account deficits is unsustainable; the government therefore urgently needs to consolidate its fiscal position and diversify foreign-currency receipts to be better prepared to withstand potential future shocks,” SCB analyst Dima Jardaneh wrote in a report.

Saudi Arabia also finds itself in a bind as it balances a strategy of squeezing out high-cost producers with the need for higher oil prices to fetch a higher IPO price when it is eventually floated on the public markets.

Rumble in the oil market jungle

The NTP was built under the assumption of oil prices of $30 per barrel, which suggests that the Saudi authorities are factoring in a period of sustained low-oil prices.

This is why they have embarked on an aggressive plan to raise market share in China, India, South Korea and Japan, in a bid to elbow out competition from Russia, Iran and Iraq.

In recent years, Russia has been the most formidable competitor to Saudi Arabia in China as the battle for market share hots up in the biggest oil demand growth country in the world.

Saudi Arabia has historically led the pack in China, but exports have – on balance – been relatively flat in the past few years, despite the strong showing in aggregate Chinese crude imports.

The kingdom has involuntarily forfeited its once commanding grip on the Chinese market, with Russia being the primary beneficiary. Chinese crude imports have increased by a massive 630,000 bpd so far this year, and Russia has captured more than 215,000 bpd of the incremental growth.

“How have the Saudis fared? Not very well. Actually, quite miserably,” says Michael Tran, analyst at RBC Capital Markets.

“Crude exports from the kingdom to China have, in fact, contracted over the past year. In other words, not only has Saudi been losing incremental share to Russia, but financially imperiled countries such as Venezuela and Brazil have also captured market share at their expense.”

Meanwhile, Iran has also aggressively carved out a bigger piece of the Chinese market and is now approaching 10 per cent, compared to less than 5 per cent during the years it was hamstrung by Western sanctions.

Fighting fire

Saudi Arabia has historically been seen as sleeping giant, punching below its weight and content to work behind the scenes and away from the limelight of the global media.

But the deputy crown prince has woken up the slumbering dragon at a time when the kingdom finds itself fighting for regional political dominance with Iran, battling for market share with a host of competitors and engaged in a war in neighbouring Yemen.

And while these external challenges are enough to keep the authorities busy, Mohammad Bin Salman Al Saud is also in the midst of an internal retooling of the economy – and success is hardly guaranteed.

In a note to its clients, frontier market investment research house Natixis said: “The path ahead may not be an easy one as the wide range of social reforms that implicitly derive from the economic objectives of Vision 2030 may find some resistance in a highly bureaucratised society, within the ultra-conservative clericals and even within the royal family as they may come to toggle a long-dated scheme of favouritism-for-loyalty.”

While the deputy crown prince may be able to fend off challenges from oil competitors, fighting long-entrenched positions and dogmas at home may well turn out to be the deputy crown prince’s biggest challenge.