Editor's Note

SUSRIS readers have long benefited from the insights and experience of Brad Bourland who served as Chief Economist of the Samba Financial Group in Riyadh.  The numerous analytical reports, articles and interviews with Bourland in SUSRIS provided hard to come by knowledge of economic performance and developments in Saudi Arabia.  In June Jadwa Investments, a Saudi Closed Joint Stock company, named him as its new head of research and chief economist.  

We are pleased today to share a recent report produced by Jadwa in which Mr. Bourland describes a new phase in the expansion of the Saudi economy, one in which growth based on oil revenues is seen to be shifting more to private sector performance.

SUSRIS wishes to thank Jadwa Investments and Mr. Bourland for permission to share this report with you.  It is provided in two parts due to its length.  Part two is circulated separately in email and posted online (click here for part 2).

The Saudi Economy's Golden Era: Phase Two

Saudi Arabia has enjoyed four years of strong growth driven by rising oil revenues. We now perceive the growth driver shifting to the private sector, marking a new phase in a period of sustained high growth in the Saudi economy. We expect the following themes to dominate the economic and investment environment in the years to 2010:

• Private sector growth: Megaproject implementation, broad liberalization and enhancements to the business environment will push real non-oil private sector growth up to an average of nearly 8 percent. Growth will be fastest in manufacturing, communication, finance and construction.

• Relatively low inflation: Inflation should peak this year at around 4 percent before failing gradually. Given the rapid pace of economic expansion, this is low. Rents will take over from food prices as the main source of inflation through 2010. Heightened competition will lower the prices of a variety of goods and services, such as telecoms, financial services and transportation.

• No change to the riyal peg: None of the arguments put forward for an adjustment to the exchange rate are compelling given the cost in terms of monetary policy credibility, lost revenues, damage to non-oil competitiveness and foreign investment. SAMA has consistently stated that it has no intention of altering the existing exchange rate arrangement and its vast stock of foreign assets gives it the ammunition to successfully defend the peg from any speculation.

• Spending not saving: Increasing import-driven project spending means that the years of large financial and trade surpluses and rapidly accumulating foreign assets have passed. Nonetheless, continued high oil prices will allow further growth in government spending without the budget falling into deficit.

• Steady share price gains: With last year's collapse seemingly behind us, the conditions are in place for steady gains in the stock market. Several blue chip companies are undervalued and many other of the larger listed companies are trading at fair value. The positive macroeconomic backdrop means that profits growth is likely to average 10-15 percent per year, leading to a similar rate of increase for the TASI.

The fundamental dynamics supporting the strong outlook for the economy have been set in motion by reforms that have already been enacted and an investment boom that can not be stopped in its tracks. While there are some risks to our view, we do not foresee anything that would significantly alter the positive underlying story.

Growth

Saudi Arabia's economic boom will continue until at least 2010. After four years of exceptional growth in oil revenues driven by external factors, domestic demand will take over as the main engine of growth for the period 2007-2010. High Oil revenues have stimulated massive project spending. In addition, important steps have been taken to improve the business environment. With further reform anticipated, oil prices expected to remain high and a supportive global backdrop, we believe that the Kingdom is set for its strongest period of non-oil growth since the 1970s.

The table below shows how the economic boom over the period 2007-2010 will differ from that of the preceding four years. The first phase of the boom was an oil story. At an average of 8.4 percent, the oil sector was the fastest growing over this period. By contrast, we expect oil to be the slowest growing sector between 2007 and 2010, at just 0.7 percent. Instead, manufacturing, transport, and communication, finance and construction will lead the way.

The following factors underlie our expectation of exceptional non-oil growth over 2007-2010.

• Megaprojects: Figures vary widely for the value of projects on the table owing to escalating costs, but it is certainly above $300 billion. Oil and gas, defense, petrochemicals, infrastructure and real estate account for the bulk of project spending. The heavy role of the private sector means that projects are generally based on sound commercial projects.

• Liberalization: Liberalization of the financial service and telecom sectors will spur competition, resulting in a higher quality and broader range of services at lower cost. As virtually all companies and consumers use financial and telecoms services, these benefits will be felt throughout the economy, generating further economic momentum.

• WTO membership: WTO membership since December 2005 has to date little direct effect on the economy. This will change. As the sustainability of the current period of strong economic performance becomes evident, more and more foreign companies will enter the Kingdom. The opening of foreign banks is an important step in this regard.

• Economic policy reforms: Further supportive economic policy reforms are likely. New company and contract laws are planned, commercial courts will be beefed up and standards of corporate governance should rise. Although a GCC single currency is not expected by 2010, the single market (allowing free movement of labor and capital) is still on course for the end of 2008. Finally, GCC trade deals with the EU and some Asian countries are a possibility.

Supply bottlenecks will place a ceiling on how fast the economy can grow. The project boom extends throughout the GCC and with demand also growing rapidly in China and India, raw material prices have shot up. As a result, some projects will be scaled back and others may be postponed until prices ease. Major skill shortages have also emerged. Structural deficiencies hindering the local labor market will not be overcome by the end of the decade, forcing companies into strong competition with those from elsewhere in the region to attract skilled labor.

Manufacturing is forecast to be the fastest growing sector over the period to 2010. This will be led by petrochemicals, which in turn is dominated by Sabic. Sabic, in conjunction with foreign and local partners, has three massive petrochemical projects -- Yansab, Sharq and Kayan -- set to come on stream over 2008 and 2009. A variety of smaller, though still substantial, plants will further boost Sabic's production over the years to 2010. In addition, Saudi Aramco will enter the petrochemicals sector through the $10 billion Petro-Rabigh complex, which is likely to commence production around the turn of 2009. Other smaller operators will contribute further increments in output.

Availability of feedstock and escalating costs will be issues in the petrochemical sector over the next few years. Although non-associated gas has been found in the Empty Quarter since foreign companies were awarded exploration blocs in 2003, it will not enter the petrochemical production chain by 2010. Instead, some of the new facilities will use liquids as feedstock (naphtha at Petro-Rabigh and propylene at Yansab and Kayan). Sharply rising costs and shortages of equipment and human resources have the potential to delay some projects, though as most of the major projects commenced relatively early in the current cycle of region-wide capacity expansion and have costs locked in, we do not think any will be derailed.

The outlook for the kingdom's smaller manufacturing industries is also positive. A significant increase in cement production capacity will be completed in 2009, allowing local firms to benefit more fully from the ongoing construction boom. Strong local demand and high international prices will continue to stimulate metal production and a major metal refining project is likely to come on stream around 2010.

While the investment boom will provide a supportive backdrop for transport and communications, it is recent deregulation that should make this sector grow by over 9 percent per annum over the period to the end of 2010. During the first half of 2007 three new fixed-line providers were licensed, breaking the monopoly of Saudi Telecom (STC), and a third mobile license was awarded.

The new mobile operator, MTC of Kuwait, is likely to begin operations toward the end of the year. Existing operators STC and Mobily have begun price cutting to preserve market share and with competition set to intensify, further rapid growth in the take-up of mobile phone services is expected. Although Mobily has gained 6.5 million users since it won the second license in 2004, mobile penetration was only 82 percent at the end of 2006, compared to over 100 percent in Qatar and Bahrain and 127 percent in UAE.

It will take longer for the fixed-line operators to become functional. The new entrants are expected to start operations in the second half of 2008 and Kingdom-wide coverage is not anticipated for a further seven years. As part of the process, two of the new operators were awarded licenses for radio spectrum technology (facilitating wireless Internet connectivity). Fixed-line connectivity is low at 16.4 percent, compared to 30 percent in UAE, and demand for new lines is strong, particularly to enable Internet access. The new fixed-line operators will take over as the engine of growth momentum in the telecoms sector toward the end of our forecast period.

Liberalization will contribute to robust growth in the transport sector. The two low-cost domestic airlines that began services earlier this year will scale up their operations and in response national carrier, Saudi Arabian Airlines, has indicated that it will launch a low-cost service. Transport will also benefit from a rising volume of trade and the huge amount of raw materials that have to be moved to construction sites throughout the Kingdom as part of the investment boom. Enhancements to physical infrastructure through the completion of major rail, port and airport expansions will further stimulate growth in transport.

Finance is expected to be one of the most dynamic sectors over the next five years. Recent liberalization has opened the banking and insurance industries and forthcoming legislation is set to boost the nascent mortgage market. Greater competition is expected to stimulate a broadening and deepening of financial services. However, the influx of new entrants is causing significant skill shortages that will prevent the financial sector from growing at double-digit rates. 

By the end of June licenses had been awarded to 56 investment companies and another 50 applications were being examined. While the bulk of the new entrants are focused on wealth management, strong demand for corporate advisory and project finance and the increasing take up of mutual funds provide fertile ground for the larger of the new companies. In anticipation, several major foreign banks have already formed partnerships with new investment companies. Consolidation among the investment companies appears inevitable over time.

While the existing commercial banks may suffer from the new competition, they will continue to prosper. Lending to the private sector is expected to recover after a stock-market induced slowdown last year, while the healthy outlook for the non-oil private sector should stimulate a pickup in lending to corporations. With local banks remaining cash rich, they will probably expand their footprints abroad. 

Banks should also benefit from a rapid expansion of the mortgage market. The enactment of a mortgage law over the forecast period should clarify the legal framework. Other issues hampering the development of the sector, such as the supervisory framework, property registration and the absence of sufficient long-term financing for lenders, are likely to spur rapid growth in the provision of housing finance well before all the above barriers have been cleared.

Liberalization will drive strong growth in the insurance sector. In October 2006 licenses were awarded to 13 insurance companies as part of a restructuring of the industry. Plans for universal health insurance (currently only 5 percent of the population are covered) provide a major dynamic for the sector. The bulk of the new insurance companies are joint ventures with foreign partners.

Construction will be one of the main beneficiaries of this phase of the economic boom. All of the $300 billion or so of projects that have been announced have a construction element and for infrastructure and real estate developments, particularly the planned economic cities, this is substantial. Construction growth will remain high as more and more projects enter their implementation phases. 

While there may be a downturn in certain parts of the property market owing to local and regional factors (land prices in prime areas of Riyadh and Jeddah have risen rapidly and real estate prices look set for a correction in Dubai) this will not disrupt the momentum within the sector. However, shortages of skilled labor and high raw material costs will limit the pace of growth.

New investment will support solid growth in electricity, gas and water. A model for private sector participation via independent water and power projects has been developed and several major projects are underway. The bulk of new capacity is set to come on stream during 2009 and 2010 and prior to this growth in supply may struggle to keep up with growth in power demand of around 7 percent per annum. Development of power-hungry industries and population pressures should stimulate further investment in the generation, transmission and distribution infrastructure over the forecast period.

The strong outlook for the non-oil economy should bolster consumer confidence and provide a healthy backdrop for wholesale and retail trade. Preliminary 2006 GDP data show that growth in the sector did not slow owing to the collapse in share prices (despite earlier indications to the contrary). Nonetheless, now that consumers' attention has shifted from the stock market, retail spending is likely to pick up in the near term. Faster job creation and higher salaries in the private sector should continue to support the retail sector over the forecast period. An easing of ownership restrictions on foreign retailers by the end of 2008 in accordance with the WTO deal may encourage new entrants in subsequent years. 

Despite continued double-digit growth in spending, we expect that the government sector will remain a relative drag on growth. Output of government services has risen, notably in 2006, reflecting higher allocations to healthcare and education, but actual output of government services continues to be some way below increases in government spending. We do not expect major improvements in productivity in the public sector and therefore forecast that growth in the government sector will slow in line with slowing growth in government expenditure.

Performance of the agricultural sector will remain weak. Owing to pressing demands elsewhere, the government will continue to discourage the production of water-intensive crops. this is in addition to its commitment to the WTO to lower support for the sector. With foreign competition likely to benefit from the dismantling of domestic support, agriculture is likely to be the only significant area of the economy negatively affected by Saudi Arabia's WTO membership. We forecast that agricultural growth will fluctuate near the 1.5 percent level, depending on the weather conditions.

Inflation

Inflation is inevitable in a rapidly growing economy such as Saudi Arabia. When supply can not keep up wth demand, prices will rise. this has already happened. Annual inflation hit an 11-year high of 3.6 percent in January, compared to an average of just 0.7 percent in 2005. Bottlenecks associated with the rapid pace of growth will take some time to erase, but the near-term outlook for some of the other factors that have pushed up inflation is more promising. While certain price rises have attracted headlines, for us the real story is that inflation is already near its peak and as such will be remarkably low for a country experiencing such a strong and broad-based economic expansion.

It is clear from the breakdown in the table above that inflation currently comes from three sources. Thus, there is no generalized rise in prices. On the contrary, prices of some goods and services are falling. The three areas experiencing significant inflation are:

• Food prices: Rising food prices are a global phenomenon. This has been exacerbated by local factors including a cold winter, the reduction of agricultural subsidies in line with WTO commitments and concerns about bird flu.

• Jewelry prices: Jewelry is the main component of the �other expenses and services� category of the cost of living index. The increase in jewelry prices reflects higher international gold and silver prices.

• Rents: Rents are the major new sources of inflation in the Kingdom. Prices of prime real estate and certain types of accommodation (such as expatriate compounds) have risen much faster than the headline growth in rents, but outside of the main cities, most rents are stable.

Food and jewelry price inflation is expected to ease. For jewelry this is already happening. Gold and silver prices are not far from their highs of last year, but in measuring inflation it is the annual rate of increase that is relevant and this is not expected to approach anything like the 35 percent average for 2006. It appears that a shift in global production and consumption habits will lead to a period of higher than average increases in food prices. However, some of the recent food price rises are the result of poor growing conditions, which we assume will normalize over the forecast period.

Rents are forecast to become the leading source of inflation over the years to 2010. An influx of expatriate workers stimulated by the economic boom and rapid growth in the national population will exacerbate an existing shortage of accommodation. This will be compounded by internal migration to the big cities. Although a large amount of real estate is being developed, this will take time to come onto the market. Rental inflation is forecast to peak at an annual average of 7 percent in 2008. The rate of increase will vary substantially with the type of property and its location. Higher rents will raise costs for businesses across all sectors; those businesses with pressure on margins are likely to pass these costs on to consumers in the form of higher prices.

The skill shortages and escalating costs that are restraining growth will have an impact on inflation, but it is likely to be modest. This is because the cost of living index measures the prices that final consumers pay for the goods and services they purchase. Very little of the output from those sectors hitting capacity constraints is sold directly to final consumers. For example, the bulk megaproject output is exported (in which case foreign consumers absorb the rise in costs) or sold at a fixed price (the producer absorbs the rise in costs). In orders, such as financial services, the shortages are driven by greater competition, which will put downward pressure on prices. Nonetheless, given the extent of the run-up in costs, some pass through to the cost of living index is inevitable.

We believe it is a similar story for imported inflation, with most of the costs resulting from the recent weaknesses of the riyal being absorbed (in this case by importers) rather than being passed on to consumers. The riyal is likely to remain on a downward trend, but only for goods where there is no competition from local or US providers will rising import costs be fully passed on to consumers.

While the economy will face continuing price pressures over the years to 2010, the following factors will ensure that inflation remains contained:

• Government-controlled prices: Prices of various consumer staples, utilities and foodstuffs (including petroleum, natural gas, water, electricity, bread, flour and milk) are controlled by the government. We do not foresee changes to the prices of any of these goods.

• Cheap and abundant expatriate labor: A large and growing pool of expatriate workers keeps labor costs low and stable. Although the government may aspire to reduce the number of foreign workers, implementation of much of the investment boom is reliant on cheap unskilled and semi-skilled imported labor.

• Heightened competition: The introduction of new competition in a variety of sectors will inevitably lower prices. This occurred after the launch of the second mobile phone service, and we expect that the entry of a third mobile provider will drive down prices further. Fixed line and other telecoms costs (such as Internet access) should fall once the new licenses begin operations. The expected entrance of more foreign companies will intensify competition in many parts of the economy and play an important role in controlling inflation.

Inflation has become a prominent issue, but it will not be a major problem. Rising food prices catch consumers� attention as similar baskets of food products are bought on a regular basis and so price changes are readily apparent. By contrast, stable and even falling prices for goods such as electronics, clothing and furniture tend to be noticed less as purchases are made irregularity and the goods are highly differentiated. While bottlenecks in the economy and high global commodity prices will continue to cause a period of well above average inflation, structural factors will keep inflation low on a regional and global basis. Inflation is already near its peak and as the bottlenecks ease, it will fall.

Part 2 of this report is provided in a separate email and online (Click