Public Information Notice No. 07/131

Public Information Notice: IMF Executive Board Concludes 2007 Article IV Consultation with Saudi Arabia

October 23, 2007

On September 17, 2007, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Saudi Arabia.¹

Background

Saudi Arabia's macroeconomic performance remained very strong in 2006. Although real GDP growth decelerated to 4.3 percent as oil production contracted by 1.5 percent in line with OPEC's decision to cut output, non-oil growth accelerated to 6.3 percent, supported by an expansionary fiscal policy and buoyant private sector activity. Despite higher import prices, average inflation remained at 2.2 percent, owing to the flexible and open labor market, open trade system, and administered prices for fuel and utilities. The Saudi authorities continue to support oil market stability through the implementation of a US$80 billion investment program to increase oil production capacity to 12.5 million barrels per day (mbd) by end-2009, expand gas processing facilities, and increase oil refining capacity at home and abroad by 43 percent to reach 5.9 mbd. They are also actively considering additional investments aimed at expanding oil production capacity to 13.1 mbd by 2013.

In addition to the large investments in the oil and gas sectors, planned investments to be implemented under public-private partnerships, mostly in infrastructure, real estate developments, and hydrocarbon-based manufacturing industries, during 2007-12 are expected to reach US$220 billion. These projects, as well as large fiscal expenditures to finance ambitious social programs and infrastructure investment, would help achieve the government's objectives to diversify the economy and raise the living standards of the population. Implementation of these home-grown policies would, as a byproduct, contribute to the reduction of global imbalances through higher imports of goods and services.

Driven by higher oil prices, the external and fiscal positions strengthened further in 2006. The external current account surplus reached a record level of US$95.5 billion (27.4 percent of GDP) despite a 29 percent increase in imports of goods and nonfactor services. The net foreign assets of the Saudi Arabian Monetary Agency (SAMA) increased by US$70.9 billion, to reach US$221.4 billion or 19.3 months of prospective imports of goods and services. The overall fiscal surplus of the central government increased further to reach 21.4 percent of GDP, notwithstanding the expansionary fiscal stance reflected in the rapidly rising expenditure and the widening of the non-oil fiscal deficit to about 50 percent of non-oil GDP. This large overall surplus enabled the authorities to reduce the central government's gross domestic debt by 11 percentage points to 27.9 percent of GDP.

Monetary expansion accelerated again in 2006, with broad money growing by 19.3 percent, mainly due to the increase in government expenditure. The net foreign assets of the banking system rose sharply, reflecting higher government deposits, the shortage of riyal-denominated assets, and a narrower or negative differential between the riyal and dollar interbank deposit rates. SAMA delayed adjusting its policy rate to the Fed Funds rate, thus resulting in a negative interest rate spread between the riyal and the dollar in the second half of the year, to prevent an economic slowdown in the midst of the stock market correction. Tightening of prudential measures and a fall in credit demand slowed down private sector credit growth to 9.2 percent. The riyal depreciated by 0.5 percent in real effective terms, reflecting the movement of the dollar against other major currencies and the low inflation in Saudi Arabia. Following a three-year bull run, the stock market index fell by more than 50 percent in 2006. The banking system remained sound due to the preemptive tightening of prudential measures. Both SAMA and the Capital Market Authority continue to expand their supervisory capacity to deal with the increased number of market participants.

Benefits of the structural reforms initiated in the late 1990s have spurred broad-based non-oil private sector growth, which has outpaced public and oil sector contributions to overall growth for the past 6 years and is expected to remain the engine of growth in the medium term. Non-oil exports increased by more than 20 percent per annum during 2000-06 and improvement in the business environment fueled investors' confidence, resulting in an increase in foreign direct investment from US$0.2 billion in 2000 to US$18.3 billion in 2006. The authorities recently initiated a National Industrial Cluster Development Program, with the aim of diversifying the economy and balancing regional growth. The authorities have relaxed the Saudiization targets for various sectors, aimed at creating private sector employment for Saudi nationals, in order to accommodate the growing demand for labor associated with the implementation of large investment projects.

The outlook for 2007 remains favorable. Real GDP growth is projected at 4.1 percent despite an expected additional small contraction in oil output to 9.1 mbd. Increased public expenditure, improved business climate, and continued investors' confidence are expected to help further accelerate non-oil growth to 6.6 percent. Since the growth of imports and nonfactor services is expected to remain robust at 21 percent, the current account surplus is projected to decline to US$69.4 billion or 19 percent of GDP, and SAMA's net foreign assets are projected to increase by US$44 billion to reach US$266 billion or 20 months of imports. The overall fiscal surplus is projected to decline, but will remain substantial at 15.7 percent of GDP, and public debt is envisaged to contract further to 21.7 percent of GDP. Inflation is expected to increase slightly to 3 percent.

Executive Board Assessment

Executive Directors commended the Saudi Arabian authorities on the continued strengthening of economic performance during the past year, underpinned by buoyant private sector activity, prudent economic policies, and a further increase in oil prices. High oil revenue contributed to increasing fiscal and external current account surpluses and a further buildup of SAMA's net foreign assets, while activity in the non-oil economy gained further momentum.

Directors noted that the economic outlook remains positive, grounded in the ongoing efforts to expand oil sector capacity and to further improve the climate for private sector investment and economic diversification. They noted that a sustained broad-based expansion of non-oil activity, through continued implementation of structural reforms, would be key to creating employment opportunities for the rapidly growing Saudi labor force over the medium term. Directors therefore welcomed the top priority that the authorities assign to job creation and strengthening education and training.

Directors commended the Saudi authorities for their intention to continue supporting oil market stability through a substantial planned expansion of crude oil production and refining capacity, despite rising costs. They observed that implementation of Saudi Aramco's ambitious US$80 billion investment plan, in preparation for the future call on Saudi oil over the medium and long term, would support global oil market stability.

Directors noted that Saudi Arabia's economic policies have been consistent with its commitments in the context of the Multilateral Consultation process aimed at the reduction of global imbalances. While the authorities' investment policies are driven by domestic needs to meeting objectives of sustaining and diversifying economic growth, and increasing living standards of the population, implementation of these policies would, as a by product, contribute significantly to the reduction of global imbalances through higher imports of goods and services. Directors also commended the authorities for continuing to provide generous assistance to developing countries through bilateral aid and debt relief.

Directors noted that the recent fiscal surpluses have significantly enhanced Saudi Arabia's fiscal flexibility and long-term fiscal sustainability. They supported the use of fiscal revenues for promoting private sector growth, alleviating poverty, and meeting social needs. Efficient implementation of the spending plans over the medium term will require, however, a significant strengthening of public expenditure management. In this vein, Directors welcomed the authorities' decision to adopt the Government Finance Statistics Manual 2001 framework and encouraged them to accelerate the preparations for a medium-term fiscal framework. While broadly supporting the country's expenditure priorities, Directors encouraged the authorities to replace the petroleum product subsidies with targeted direct social assistance. Directors supported the planned investments under public-private partnerships, but noted the importance of managing properly the underlying contingent liabilities.

Directors observed that, despite higher import prices, inflation remains on the whole low, owing to the flexible labor market, an open trade system, and administered prices for fuels and utilities. They called for utilizing liquidity management instruments more effectively to contain the risk of inflation; and analyzing the factors underlying the shortage of financial instruments, with a view to eliminating impediments to their issuance. Directors commended the authorities for the planned implementation of Basel II principles by January 2008. Some Directors encouraged the authorities to phase out the ceilings and restrictions on bank lending. Regarding the stock market, Directors noted the significant gains made in strengthening capital market regulations, and urged the authorities to allow full access to the stock market by foreign investors to improve market depth and efficiency.

Directors noted the staff view that the Saudi riyal appears to be moderately undervalued at present. Many saw this as a transitional phenomenon reflecting the positive terms-of-trade shock. Several other Directors considered that the riyal is broadly in line with fundamentals. More generally, however, Directors acknowledged the margins of uncertainty in making such assessments, and pointed to the methodological difficulties in determining equilibrium exchange rates, particularly for an oil-exporting economy such as Saudi Arabia facing volatile oil prices. Further, they noted that any undervaluation of the real effective exchange rate can be expected to reverse in the near term as the external current account surplus declines in response to the authorities' expansionary fiscal stance and the investment programs that have been launched. Directors also considered that the current pegged exchange rate regime has served the economy well, although a few Directors were of the view that a more flexible exchange rate would help reduce fluctuations in the face of oil price volatility. Directors noted the authorities' decision to maintain the regime unchanged in the period leading to the monetary union of the Gulf Cooperation Council (GCC) while keeping an open mind about the choice of the exchange rate regime under the prospective monetary union.

Directors observed that, despite the significant gains made on key issues, achieving the GCC monetary union by 2010 would be increasingly challenging, and would require accelerating the implementation of the remaining important steps. In particular, efforts would need to be intensified to reach agreements on the nature and scope of the union's monetary authority, and the harmonization of key regulatory and supervisory frameworks and of statistical methodologies.

Directors encouraged the authorities to continue to design a package of "second generation" structural reforms for exploiting the growth potential created by the successful completion of the 1999 structural reform program and high oil prices. Directors noted that further liberalization and modernization of the legal and institutional framework will be critical for private sector activities, and urged the authorities to expeditiously approve and implement the mortgage, agency, and company laws. Directors also encouraged the authorities to closely monitor the tightening labor market conditions to ensure smooth implementation of investment projects.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.