Saudi Arabia's 2008 Budget

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Item of Interest
December 12, 2007

Saudi Arabia's 2008 Budget.

Saudi Arabia's 2008 Budget
Brad Bourland

Editor's Note:

Today for your consideration we present a Jadwa Investment report on the Saudi economy, "Saudi Arabia's 2008 Budget." The report is the latest in a series of insightful documents prepared by the office of Jadwa's Chief Economist & Head of Research Brad Bourland. Links to previous reports and related items below.

We thank Jadwa Investment and Mr. Bourland for producing these informative reports and allowing us to share them with you.

The government's budget for the 2008 fiscal year (31 Dec 2007-30 Dec 2008) was endorsed by the Council of Ministers on December 10. It maintains the focus on enhancing infrastructure and as usual is based on a prudent oil price assumption. For 2007, restrained spending growth and high oil revenues caused another large budget surplus and the economy performed strongly. The highlights are:

A projected SR40 billion ($10.7 billion) budget surplus for 2008, based on revenues of SR450 billion and spending of SR410 billion. Defense and security, education and healthcare remain the main focus of government spending. Capital spending grows at a faster rate than current spending, reflecting the official policy of enhancing infrastructure.
A budget surplus of SR178.5 billion in 2007, with revenues at SR621.5 billion and expenditure at SR443 billion. This was well above the surplus of SR20 billion projected in the budget because of substantially higher than budgeted oil revenues. Spending exceeded its target by SR63 billion (17 percent), broadly in line with the historical level of overspending. Spending was up only 13.5 percent on the 2006 level.
Restraining the growth in government spending is important to tackling inflation. Given the run up in costs associated with capital spending, spending growth of 13.5 percent underscores the government's seriousness in controlling inflation. This is particularly notable as some of the excess spending was the result of a 13th month salary to public sector employees (this occurs every three years, but is not included in the budget projections).
Preliminary data indicates that 2007 was another year of strong economic performance. Real GDP growth slowed to 3.5 percent, which we believe was the result of lower oil production. Non-oil sectors recorded robust growth, with total private sector GDP climbing by 5.9 percent. Non-oil exports jumped by 24.9 percent and the current account surplus remained very high, at $92 billion. The inflation rate is put at 3.1 percent for the year, but this is inconsistent with the monthly data, which puts the average for the first 10 months of the year at 3.7 percent.

The budget once again appears to be based on a conservative oil revenue assumption. We think that oil production of 9.1 million barrels per day at a price for Saudi oil of $45 per barrel ($49 per barrel for WTI) is consistent with the oil revenue projection in the budget. As we expect Saudi oil to average $72 per barrel during 2008, we forecast a budget surplus of SR187 billion, well in excess of the budgeted figure, even though spending is likely to exceed its target.

The 2008 budget
The 2008 budget is restrained. Despite global oil prices approaching $100 per barrel, we estimate that it is based on an oil price of only $45 per barrel, which should ensure that another large surplus is recorded. Spending is projected to grow by only 7 percent and remains focused on enhancing physical and social infrastructure.

Expenditure
Total expenditure for 2008 is budgeted at SR410 billion. This is only a 7 percent increase on the SR380 billion budgeted for 2007 and represents a SR33 billion decline on actual 2007 spending. Total capital spending has been raised to SR165 billion, more than double the 2006 level. Although data is not published in the budget, we believe that defense and security account for the largest component of government spending, at around one-third of the total. The budget statement contains details on the following spending areas:

Education and manpower development spending is increased to SR105 billion, up SR8.3 billion on the budgeted figure for 2007. Total capital spending in the sector is lifted by SR10 billion to SR39 billion. Funding has been put in place for 2,074 new schools, seven technical institutes for girls and 16 vocational training centers, among others. With capital expenditure increasing, a cut in current expenditure on education and manpower (which includes wages, supplies and operations and maintenance) of SR2 billion has been budgeted.
Health and social affairs has been allocated SR44.4 billion, a SR4.9 billion increase on the budgeted figure for 2007. Capital spending for this sector has been raised by 13 percent in order to finance the building of eight new hospitals and 250 primary care centers, in addition to the 79 hospitals currently under construction. Some existing healthcare facilities are to be expanded. Total budgeted spending on health and social affairs has nearly doubled since 2005.
Water, agriculture and infrastructure spending has been increased by 15 percent to SR28.5 billion. New capital projects account for the bulk of this spending.
Transportation and telecommunications receive SR16.4 billion, up SR2.8 billion on the budgeted amount for 2007. Roads totaling 7,300 kilometers are to be added to the 24,000 kilometers of roads currently under construction.

This week's announcement that subsidies on rice and baby milk are being introduced will add to the subsidy bill, which was SR7.5 billion (2 percent of total spending) in 2006. Subsidies will hold prices down, but place an additional burden on government spending as well as creating distortions in the economy over the long term.

Revenues
Total revenue for 2008 is budgeted at SR450 billion. Around 85 percent of this will come from oil, although an official breakdown is not available. In line with standard practice the oil price and production numbers the revenue projection is based upon have not been disclosed. We calculate that an average price of $45 per barrel for Saudi oil (equivalent to $49 per barrel for WTI) and production of 9.1 million barrels per day would be sufficient to achieve the budgeted projection.

Saudi Arabia has been gradually increasing the oil revenue projection used in the budget as international oil prices have climbed. For the decade to 2004 we estimate that the oil price assumption used in the budget averaged just over $16 per barrel, around one-third of the 2008 level. There has been a structural shift in international oil prices over this period and the gap between the budget price and the actual oil price remains comfortable.

Indeed, the 2008 revenue projection is only $2.5 per barrel above the number that we believe was used for the 2007 budget. This is even though the oil price was slipping towards $55 per barrel as last year's budget was being prepared, while it was surging to nearly $100 per barrel as the current budget was being drawn up.

Non-oil revenues have increased in recent years in line with a pick-up in corporation tax receipts stimulated by the booming economy and greater income earned on the government's investments. This trend is likely to continue in 2008 despite a slight fall in customs revenues, as duties on a variety of products are trimmed in line with WTO commitments. The budget did not contain any new policies to increase non-oil revenues.

Jadwa's budget forecast
We forecast a budget surplus of SR187 billion in 2008, well above the projection in the budget. This is because we think oil revenues will substantially exceed the budgeted total (see below). We forecast total oil revenues to the budget of SR620 billion. With non-oil revenues contributing SR77 billion, we forecast total revenues of SR697 billion.

Jadwa's oil market outlook for 2008

We forecast Saudi crude to average $72 per barrel in 2008 (equivalent to $76 per barrel for WTI). Average Saudi oil production is forecast to be 9.1 million barrels per day, virtually the same as in late 2007.

Oil prices approached $100 per barrel in late 2007. We expect that the price will exceed this level, although not on a sustained basis, during 2008, assuming there is not a major disruption to supply.
Opec in late 2007 decided not to add production to the market, signaling comfort that prices around $90 per barrel were not harming global economic growth or demand for oil. Our view is that Saudi Arabia would nonetheless prefer to see oil prices around $70 per barrel.
A recession in the US could temporarily bring prices down to around $50 per barrel, but probably not much lower and probably not for more than a few months.

We see the major risk to our forecast being on the upside, stemming from a major supply disruption in one of the producing regions, such as Nigeria, Venezuela, Iraq, or Iran where there is currently anxiety about supply.

Although nothing has been mentioned in the budget, we think there is a chance that the government will take steps to offset the impact of rising inflation on public-sector incomes, especially as some private sector companies have announced substantial pay raises over the past few weeks. This could either be in the form of a public-sector pay rise or a further expansion of subsidies. Actual spending is generally around 15 percent above the budgeted level, but the prospect of higher pay for government workers means that we expect the budgeted figure to be exceeded by over 20 percent.

Budgetary performance in 2007
Fiscal performance was outstanding in 2007. The budget surplus of SR178.5 billion was the third largest ever. It was below last year's record figure of SR270 billion because spending grew by a greater amount than revenue. Oil revenues fell compared with 2006, owing to lower production, but they were still much higher than the budgeted level. Spending hit a record high. Most of the budget surplus was used to build up foreign assets at the central bank (SAMA) and to reduce domestic debt.

2007 Budgetary data
	Budget	Actual	Difference
Revenues	400	621.5	55%
Expenditures	380	443	17%
Deficit	20	178.5	793%

Total revenue exceeded the budgeted level by 55 percent. This was due to higher than budgeted oil revenue. We estimate that the 2007 budget was based on an average price for Saudi oil of $42.5 per barrel. With a few weeks of the year left, it seems likely that Saudi oil will average closer to $70 per barrel. Total revenue was more than three times greater than it was in 2002.

Actual expenditure surpassed its budgeted total by 17 percent, though it was up only 13.5 percent on actual spending in 2006. The latter number is very significant. Controlling spending growth is one of the few options the government has to tackle inflation and ministers have noted that they are influenced by this consideration when they make their spending decisions. Nonetheless, there is a pressing need to improve physical and social infrastructure and with raw material prices surging, the costs of doing this have increased greatly. In our view restricting spending growth to 13.5 percent illustrates the government's seriousness in tackling inflation.

The bulk of the surplus was used to build up foreign assets at SAMA. Over the first ten months of this year (the latest available data), SAMA's net foreign assets increased by $50 billion (SR186 billion) or 23 percent, to $271 billion. This is not far below the total assets of the banking sector and equivalent to almost three-and-a-half-years worth of import cover. The income earned on these reserves is expected to hit $15 billion this year, more than half the total for all non-oil exports.

Government debt has been cut by SR99 billion to SR 267 billion (19 percent of GDP). All government debt is domestic and is held by either the commercial banks or the two state pension funds, GOSI and the Public Pension Agency. Commercial bank claims on government and quasi-government, the closest proxy to their holdings of government debt, have actually risen very slightly (by just SR1 billion) over the first ten months of the year, so as has been the case in recent years, it seems that the government has been repaying debt to the pension funds. We believe these repayments take the form of a swap, with the pension funds exchanging government debt for assets that are managed by other government agencies.

Why some government debt is necessary

The government has more than enough reserves to pay off its entire debt, yet it continues to use more of the budget surplus to build up these reserves than to cut debt. Many people assume that debt is bad and that it should be eliminated. It is certainly the case that too much debt is a bad thing and the debt situation in the late-1990s (when debt was nearly 120 percent of GDP) was a concern. However, there are a number of good reasons why the government needs some debt and why repaying it all would have a negative impact on the economy. In particular:

Debt is an important tool for monetary policy. Banks invest in government debt because it has a very low risk of default. So by issuing debt, the government can absorb liquidity from within the banking sector and therefore reduce the growth in lending and ultimately inflation. Conversely, when the government repays debt held by commercial banks, it frees money for them to lend, which will stimulate economic growth, but can also feed into inflation.
Government debt provides a vital guide for the pricing of debt issued by local corporations, as corporate debt is sold at a premium over the lowest risk debt in the country, which is government debt. We expect the issuance of sukuk (Islamic bonds) to take off as corporations diversify their sources of funding. This process might be hindered if there was a further substantial reduction in government debt.
Government debt is a virtual risk free investment that is necessary to limit volatility in investment portfolios (which is essential for banks and pension funds). In the Saudi case, all bonds are denominated in riyals, so there is no foreign exchange risk for buyers.

Saudi Arabia's debt position is now comfortable. Around 70 percent of outstanding debt is owed to government agencies (the pension funds) and so does not pose any financial risk. In addition, all of the debt is domestic, so there is no exchange rate risk. We think that the government will be comfortable with domestic debt at 15-20 percent of GDP and it may well be that domestic debt rises over the medium term even though the budget is likely to remain in surplus.

SR25 billion of the surplus will be allocated to the Real Estate Development Fund over a five year period. This fund provides low-cost housing loans and the large allocation is a clear indication that the government is aware that rising rents are hurting the population.

Economic performance in 2007
Preliminary macroeconomic performance data contained in the budget show that 2007 was another strong year for the economy. Real GDP growth eased to 3.5 percent. On the face of it, this growth rate is not impressive. It is the lowest rate since 2002 and compares with real growth of 4.3 percent last year. However, this is entirely due to a decline in oil output following the implementation of Opec production cuts in late-2006 and early-2007. In contrast, the private sector grew at 5.9 percent. Transport and communications was the fastest growing sector, at 10.6 percent, spurred by the rapid increase in mobile phone use and the liberalization of domestic air travel. The non-oil industrial sector expanded by 8.6 percent.

Nominal GDP growth also slowed, to 7.1 percent. Again this was the result of lower oil production, although the rise in oil prices meant that the oil sector grew by 8 percent in nominal terms. Nominal growth in 2007 was the slowest since 2002; over the five years since then the size of the economy has more doubled.

Inflation jumped to 3.1 percent. The rise in inflation, which averaged 0.0 percent in the decade to the end of 2006, has been one of this year's main economic stories. It is principally the result of supply bottlenecks putting upward pressure on rents and a combination of global and local factors pushing up food prices. However, the figure in the budget is inconsistent with the monthly data. Monthly inflation data has only been published for the first ten months of the year. The figure presented in the budget implies that inflation averaged 0 percent in the final two months. The non-oil GDP deflator eased to 1.6 percent from 2.1 percent. This decline is puzzling, as the non-oil deflator is generally a more accurate measure of inflation, as it considers the prices and volumes of all goods consumed in the economy, whereas the consumer price index looks at a set basket of goods and services.

The current account surplus fell to SR344.4 billion. Although down from last year's record total of SR371 billion, it is still exceptionally high on an historical basis. A full breakdown of the current account is not provided, but it can be derived from the data presented that the deterioration in the surplus was caused by higher imports. Total imports of goods and services climbed by 20.5 percent to SR512 billion. Non-oil exports performed very strongly, jumping by 24.9 percent to SR106.8 billion, helped by higher international prices for petrochemicals and associated by-products.

The outlook for 2008
Economic performance in 2008 will be along similar lines to 2007. The non-oil economy will be the main engine of economic growth, high oil prices will generate large budgetary and current account surpluses, and inflation will remain well above historical norms. In most cases the headline numbers will show some improvement. For example, higher oil prices and production will offset rises in spending and imports to lift the budget and current account surpluses. However, the continued surge in rents will knock on to other prices, lifting inflation further. Nonetheless, performance will be strong and the growth dynamic within the private sector will help diversify the economy and provide more job opportunities.

The table below contains our key forecasts for 2008. We will provide a more detailed economic outlook for 2008 in a forthcoming report.

2007 results and 2008 Jadwa forecasts
	2007 Actual	2008 Jadwa forecast
Real GDP (% change)	3.5	6.1
Nominal GDP (% change)	7.1	10.7
Inflation (%)	3.1	4.5
Current account balance
(SR billion)	344	357

December 2007
For comments and queries please contact:
Brad Bourland
Chief Economist and Head of Research
jadwaresearch@jadwa.com
Head office:
Phone +966 1 279-1111
Fax +966 1 279-1571
P.O. Box 60677, Riyadh 11555
Kingdom of Saudi Arabia
http://www.jadwa.com

Reprinted with permission of Jadwa Investment.

About Brad Bourland
Brad Bourland is head of research at Jadwa Investment, Riyadh. From 1999 through 2007 Brad was the Chief Economist at Samba Financial Group, formerly Saudi American Bank, in Riyadh, where he published regularly on issues related to the Saudi and global economies and the world oil market. He appears frequently in the domestic and international media and is a regular public speaker. Before joining Samba, Brad spent an 18-year career as diplomat, economist, and manager with the U.S. Department of State. During the last three years of his diplomatic career he was in Riyadh as the American Embassy's First Secretary responsible for financial affairs, where he analyzed the Saudi economy for the U.S. Government and conducted financial aspects of US-Saudi relations. Brad has his BA and MA magna cum laude from the University of Utah, and is a CFA (Chartered Financial Analyst) charterholder.

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