Saudi Arabia is about to enter a critical period. In question is whether the modernizers will be able to sustain the drive towards a market-oriented, private-sector-driven economy favourable to foreign investment or whether the kingdom will remain inward-looking and government-dominated.
The evidence at present is finely balanced but the consensus among western and Saudi bankers is that ultimately the government has little choice. It needs foreign investment to provide a significant proportion of the $175 billion required in the next 20 years to meet the country’s power and water needs and it needs the private sector to provide jobs for young Saudis. With 73% of the population aged under 29, including 38% born since the Gulf War, that requirement will become even greater in the next decade.
However, many initiatives, which bankers had expected to be well advanced by now, remain either blocked by social conservatives, mired in the Saudi bureaucracy or delayed by complex negotiations as the government’s focus remains on the political fallout from the terrorist attacks on New York in September 2001.
Gas project runs out of steam
In particular, the gas initiative, under which western oil companies were set to invest $20 billion to $25 billion to explore and gain access to natural gas to be used in downstream petrochemicals projects, appears to have stalled.
| Al-Assaf | ||||||
Saudi and western bankers are also still waiting for long-expected legislation on capital markets, insurance and taxation. At least here there is growing confidence that the capital markets legislation, including the creation of an independent regulator, will be published later this year and that the government will go ahead with its plans to privatize part of Saudi Telecommunications. “The pace of reform was slow in the first half of the year but the signs are that it is picking up in the second half,” says Brad Bourland, chief economist at Saudi American Bank (Samba).
The case for reform does have powerful supporters, headed by crown prince Abdullah bin Faisal bin Turki Al-Abdullah Al-Saud and including the Saudi Arabian Monetary Agency (SAMA), the finance ministry and most leading Saudi bankers and businessmen.
David Hodgkinson, managing director of Saudi British Bank, argues that the commitment to reform is genuine. “Three years ago there was a great scepticism about the prospects of liberalization,” he says. “We can now see tangible evidence that this policy is becoming a reality and there is an absolute commitment to this process from the top. Saudi Telecommunications (STC) has been corporatized. There will be an independent public offering and then the government will have to give some idea when the market will be opened to competition.”
Slowing the pace of change have been political developments, particularly strains in relations with the US, which, since the terrorist attacks on New York have inevitably become a much more important issue for the Saudi government. As a result, other matters, such as economic reform, have received a lower priority. “Everything is now taking a back seat to politics,” says a Saudi financier.
There is no doubting the strength of anti-American feeling in Saudi Arabia. This sentiment has gathered momentum following the recent legal action in the US demanding that Saudi institutions pay compensation to the victims of the New York attacks. Feelings were exacerbated still further by the report of Washington think-tank the Rand Corporation, which branded Saudi Arabia as the “kernel of evil”.
One of the Rand Corporation’s executives briefed the Pentagon, arguing that “the Saudis are active at every level of the terror chain” and suggested that Saudi oilfields and financial assets should be seized if the Saudis did not “stop backing terrorism”.
Even though the Rand Corporation’s assessment was rejected by the Bush administration, it has had a considerable impact in Saudi Arabia, which until four months ago had been regarded as the closest ally of the US in the region.
During a visit to Washington earlier in the year, president George W Bush and crown prince Abdullah struck a deal under which the Americans would pressure the Israelis while Riyadh would bring the Arabs to the peace table.
Analysts believed that this deal would allow the focus to shift back to the domestic agenda for the second half of the year. Current thinking is that this is unlikely to happen.
Saudi bankers believe that this, perversely, will benefit the House of Saud. They say that the criticism from Washington will help unite the country behind the ruling family instead of demonizing them through association with the US at a time when anti-American sentiment is growing.
There is no doubt that hostility towards the US and to a lesser extent the UK is running high. There is anecdotal evidence to suggest that Saudis are boycotting American goods and services such as fast-food outlets.
Companies have also been removing the word “American” from their names or making clear that they had nothing to do with the US. Bankers, though, from both local and international joint ventures say that they do not believe reports that Saudi British Bank and Samba have lost business or that customers have moved their accounts to other banks.
The Saudi government believes that US exports to Saudi Arabia, which dropped by 43% in the first half of the year, are now starting to grow again. “Statistics from the US census show a drop in US exports to Saudi Arabia due to the decline in machinery and transport equipment and chemicals categories, both of which occupy a large share of US exports to Saudi Arabia.
“It is not clear that the drop is a reflection of the events of September 11 or is due to some other factor. Nevertheless, by May 2002 US exports to Saudi Arabia approximated to the level before September 11,” says Ibrahim Al-Assaf, the minister of finance and national economy.
Saudis, along with many other Gulf Arabs, have been reluctant to visit the US. The number of Saudis travelling to the US for family holidays has fallen by 40%, a figure that Saudi travel agents say underestimates the scale of the downturn – last year 52,000 Saudis visited the US, spending $400 million. These figures are confirmed by the significant growth of tourism within Saudi Arabia and reports from Gulf states, such as Dubai and Bahrain, that visitor numbers from the kingdom have increased.
| Key economic figures | |||||||
| 96 | 97 | 98 | 99 | 0 | 1 | 02(e) | |
| Real GDP (% change) | 1.4 | 2.6 | 2.8 | -0.8 | 4.9 | 1.2 | 0.2 |
| Oil price – Saudi average ($/barrel) | 19 | 18.25 | 11.5 | 17.45 | 27 | 21.5 | 21.75 |
| Current account (as % of GDP) | 0.44 | 0.18 | -8.99 | 0.25 | 8.28 | 7.79 | 5.74 |
| Budget balance as % of GDP | -3.2 | -2.6 | -8.4 | -5.6 | 6.4 | -3.6 | -2.8 |
| Government domestic debt as % of GDP | 84 | 87 | 116 | 119 | 87 | 90 | 95 |
| Source: Saudi American Bank | |||||||
Repatriating US investments
Many Saudi investors who had previously automatically put their money into US shares and property are now reassessing their strategies amid concern over the American lawsuits and the hostile attitude to the Middle East of some elements of the Bush administration. More than $100 billion had been moved out of the US market in the past two years. Much of this money is now invested in European markets or Middle Eastern projects.
The reasons, say bankers, are more to do with market performance than politics. They point to a series of events, whose cumulative effect has dented confidence in US markets. Other factors apart from the US law suit include the collapse of share prices, the belligerence of the US government followed the September 11 attacks, the question marks about US accounting practices and the strengthening of the euro. Low interest rates have also acted as a disincentive to keeping money on dollar deposits.
There is some evidence that newly generated private-sector surpluses are being invested locally in equities and property. “The Saudi stock market has rebounded sharply, up 14.6% in the first half of 2002, and the real-estate market is strong,” says Bourland. “This activity is fuelled by ample local liquidity, a condition created by a combination of low interest rates and firm oil prices but not by a large repatriation of Saudi wealth from abroad, despite a popular perception that this is the case.”
The most serious consequence of the heightened political uncertainty in the Middle East in the aftermath of September 11 is that Saudi Arabia’s attempts to attract foreign investment have not been as successful as the government had hoped.
This has focused attention on the gas initiative, whose success, say bankers, is not only vital to the local economy but essential to convey to western companies a broader message that Saudi Arabia is still open for business.
Negotiations with the leading international oil giants, which began in 1998, had progressed smoothly until June 2001 when memoranda of understanding were signed with eight companies, which agreed to participate in three core ventures in the west, east and south of the country.
The delay has come in the project definition programme, which was meant to have lasted six months but is not yet complete. There is now little chance that the initial investment in gas exploration will begin on schedule towards the end of this year.
The content of the latest round of talks in June and July between the Saudi government and the leading international oil companies has been shrouded in secrecy. But it appears that high-level meetings between senior Saudi figures and the oil company consortium, in which Exxon-Mobil has the largest stake, have enabled some progress to be made. “There appears to be a greater readiness to get things done,” says a Riyadh-based banker.
Bankers say there are some issues of substance, including doubts about access for the companies to sufficient gas for their downstream petrochemicals projects. There is also said to be a dispute over the rate of return, with Saudi Arabia saying that 10% is enough while the companies are sticking out for 18%.
But there may also be a deeper, political split. There have also been reports, to which bankers give some credence, that Saudi Aramco, the state-owned monopoly oil producer, is unhappy that the international oil companies will be allowed back into the kingdom for the first time in 20 years. Consequently, it is alleged, Saudi Aramco is trying to impose a deal that would be unacceptable to the oil companies.
The majority view among both Saudi and foreign bankers and businessmen is that a deal will be done as neither side can afford to let the negotiations collapse. The oil companies are unlikely to get another opportunity to return to the lucrative Saudi market and the government has invested prestige in the project.
The core ventures have already been defined. The foreign consortia will be allowed to find and develop gas for domestic use in electricity generation, desalination and petrochemicals. They will be expected to participate in both upstream gas development and downstream projects. Gas exports will not allowed, but any natural gas liquids captured as part of the development can be marketed overseas.
The project is not only important as a symbol of Saudi Arabia’s new openness. It will also create jobs, particularly from businesses that are set up as a result to take advantage of the abundance of cheap electricity and gas.
“It is very important that this project goes ahead,” says Talal Al-Qudaibi, president and chief executive of Riyadh Bank. “We are the leading bank in project finance and we see many business opportunities which will benefit the private sector and the country.”
The successful conclusion of these talks will be of vital importance for the Saudi Arabian General Investment Authority (SAGIA), which is headed by one of most commercially minded and western-oriented of the kingdom’s senior government officials, crown prince Abdullah.
SAGIA has spent recent months trying to stimulate interest from local and foreign investors by explaining to them the opportunities available under some of the most generous foreign investment laws in the region, introduced a couple of years ago to replace some of the most restrictive ones. The old laws were in part responsible for Saudi Arabia’s inability to attract more than $31 billion of direct investment between 1973 and 1998.
The new laws remove the requirement for companies based in the kingdom to be majority owned by Saudi nationals. The tax regime for foreign investors has also been made much more accommodating, visas are simpler to acquire and it will eventually be easier for overseas companies and individuals to own property in Saudi Arabia.
Other measures introduced by the government include a reduction in import tariffs from 12% to 5%. Ministers have also set the longer-term goal of joining the World Trade Organization.
Pressure for liberalization
SAGIA has issued licences for more than 900 projects, worth $11.3 billion, since it was created in April 2000. However the bulk of this money has come from just a few projects, including a $2 billion desalination plant, planned by Sumitomo of Japan and a $1 billion petrochemicals plant, proposed by Chevron Phillips of the US.
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Mobile revolution: Investors sought for Saudi Telecommunications |
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Saudi ministers say they are prepared to consider further changes in the law if that proves necessary to encourage foreign investment. They are already under pressure to reduce the number of activities, totalling 22 including telecommunications, from which international business is currently excluded.
According to Al-Assaf: “The changes that have been introduced in the foreign investment law are substantial and seen by international investors as encouraging. This has enhanced the atmosphere for foreign direct investment. As regards further changes, should requirements for changes arise given the dynamic nature of international investment settings, they will be considered.”
The most positive sign for the modernizers in Saudi Arabia and for foreign investors is that the government looks certain to press ahead with the sale of a stake in Saudi Telecommunications, which Al-Assaf says is “planned for before the end of the year”.
This will be a significant development. Although Saudi Arabia has privatized the operations of its ports, progress towards selling off other state-owned industries, such as national airline Saudia, has been slow.
Gulf International Bank (GIB) has been awarded the mandate to arrange the sale of Saudi Telecommunications through the Arab world’s largest-ever initial public offering. Between 10% and 30% of the company, which has an estimated market value of $12 billion to $14 billion, will be sold.
The timing may not look propitious in view of the financial difficulties and stock market declines of leading telecoms in Europe and the US but brokers have no doubt that the issue will be quickly and fully subscribed, in part from funds that are held overseas by high-net-worth individuals.
The government will have to give a clear idea before the sale of how quickly it expects to open the sector to competition. The first step will be for the sale of the second mobile phone licence, which will be followed by licences for data communications. It is likely to be several years before competition is introduced into the fixed- line business.
Stock exchange overhaul
Investors are also waiting for further evidence of how Saudi Arabia intends to open up its electricity sector to private generation. Final decisions are expected early next year on the industry, which is now primarily operated through Saudi Electricity Company (SEC); this is a consolidation of The Electricity Corporation and the 10 electricity companies previously operating in the kingdom.
The next step is likely to involve dividing the industry into generation, transmission and distribution systems and the introduction of private power plants, which will supply the system.
The present plan is to have a number of generation companies, including one holding the existing generation assets of SEC, which will sell to a transmission company that is responsible for the national grid. Electricity will be sold on to four regional distribution companies and directly to industrial corporations.
The plans for privately driven power water and telecommunications companies will, however, remain little more than a pipe dream unless there is an efficient, well-regulated stock exchange. Riyadh bankers are becoming increasingly frustrated at the continued delay in the introduction of new regulations, which they had expected to see towards the end of last year.
Al-Assaf is confident that there will soon be progress on the stock market law, which is currently being reviewed by the Shuria Council. “The legislative process has no defined time frame but I hope the law will be enacted before the end of this year,” he said.
Full details of the law have yet to be published but bankers have welcomed the principles underpinning it, particularly the creation of an independent regulator, which they say will give the market genuine transparency and establish a disputes committee that has clear responsibilities.
“The key elements of the new law will be an independent securities regulator, the Securities&Exchange Commission. The SEC will be empowered to license and regulate a stock exchange and non-bank financial intermediaries and empowered to authorize and regulate the offering of securities to the public,” says Al-Assaf.
In addition, bankers believe the law will make it possible for some of the large international investment banks, such as Nomura or Deutsche Bank, to enter the kingdom through a joint venture, which will offer broking, advisory and asset management services.
Banks already operating in the country will also be encouraged to participate in the exchange but they will have to separate out their investment banking activities.
Gloom-glee cycle belies need for structural reform
Short-term sentiment on the Saudi Arabian economy has recently moved sharply every six months between depression and euphoria. But these mood swings cannot disguise the government’s failure until now to resolve the major challenges of unemployment and structural imbalances.
Prospects at present are looking a lot rosier than at the start of the year. Then lower oil prices and production and forecasts of a 2% contraction in GDP led economic analysts to predict a $7.9 billion current account deficit. They also warned that that budget deficit would be worse than the $12 billion predicted by the government.
Markets were initially shocked by the $12 billion forecast because this included large reductions in spending and came after a $6.7 billion deficit for 2001, which was itself higher than expected because of the government failure to control spending.
Since then the international economic climate has turned out better than expected, leaving Ibrahim Al-Assaf, the finance and national economy minister, to conclude that “by the end of the year we are now envisaging a relatively better budget scenario”.
Al-Assaf attributes the turnround to an “expenditure tightening policy, focusing on the most productive sectors” and higher oil prices which had a “positive effect on the budgetary accounts. Revenue increases have been higher than budget projections.”
Brad Bourland, chief economist at Saudi American Bank (Samba), now expects the deficit to be nearer $5 billion than $12 billion. He also says that real GDP growth is likely to be slightly positive. He says this figure had been boosted by “Saudis staying at home and spending within the kingdom. This should fully offset any contraction in the oil sector occurring due to the OPEC-mandated production decline.”
The reluctance of Saudis to take their holidays overseas should also help enable the government to run a current account surplus for the third year in a row rather than the predicted deficit.
However this better news cannot obscure the underlying problem of structural imbalances in the economy, including the overwhelming share of the budget now consumed by salaries and debt repayment compared with the relatively small amount invested in much-needed infrastructure projects. A serious attempt is being made to address these problems but some of the structural reforms are taking longer than expected to put in place.
“By our estimation, some 85% of this year’s oil revenues received by the ministry of finance will be consumed by government salaries and interest on the debt,” says Bourland. The ministry of finance says that the current debt is $171 billion, a figure that will grow by this year’s deficit of at least $5 billion.
At the same time, unemployment is expected to remain constant at 15% of the labour force. But, with 38% of the population born since the Gulf War, the economy needs to generate more than 5% growth just to meet the increase in the size of the workforce.
With a debt burden growing every year that passes – the one exception was 2000 when high oil prices produced the first surplus in 20 years – the need to generate revenue from structural reform becomes ever greater. This means the transfer of infrastructure projects to the private sector, privatization of state-owned companies and the possibility of some form of direct taxation.
While progress in some of these areas has been slow, there have been positive signs from the ability of the private sector to sustain its expansion despite the downturn of the global economy towards the end of last year and this year. In the past two years the contribution of the private sector has exceeded analysts’ expectations.
The share of the non-oil private sector in total GDP rose to 44.7% last year compared with 35.6% in 1980 and 29.3% in 1970. Al-Assaf says that there are “substantial reasons to believe that this process will continue”.
He says that the structural reforms introduced so far by the government have “boosted private sector involvement and helped diversify the productive base”. However he accepts that “we are aware that to cope with the challenges posed by global economic changes, further efforts are needed”.
Sabic: globalizing petrochemicals
Basic Industries Corporation (Sabic) is preparing to make further international acquisitions to build on the purchase of Dutch company DSM Petrochemicals earlier this year, its first venture outside the Gulf.
Sabic, which financed the deal through a e2.35 billion financing package lead managed by JPMorgan, regards the purchases as the first step towards transforming the company, which presently has interests in Saudi Arabia and Bahrain, into a global petrochemicals industry leader.
Mohammed Al-Mady, Sabic’s managing director, tells Euromoney that DSM Petrochemicals, now called Sabic EuroPetrochemicals, will be “a springboard to Europe”.
He says: “The addition of DSM polymer assets has moved Sabic up to eleventh in the global petrochemical industry, besides ranking it as the third and fourth global player in polyethylene and polypropylene respectively.”
This success is a vindication of the Saudi government’s strategy of creating a heavy industry, which would help the economy diversify from its reliance on oil.
Sabic’s 16 major production complexes in the kingdom employ more than 11,000 people and more than 3,400 companies use Sabic products, which are also widely exported.
Further purchases look likely. Al Mady says: “Geographical diversification is the key to being effective in a global market” as it provides much closer access to local customers and expertise. “We are in discussions with our neighbours in and outside the region,” he says.
International expansion is not coming at the expense of the domestic market. Sabic, which is the most valuable quoted company in Saudi Arabia and the largest non-oil company in the region, is continuing to expand and expects to meet its 48 million tonne annual capacity target for 2010.
“The polymers market is one of the best opportunities for Sabic to advance its presence in the international market and will be strongly marketing our polymers products,” says Al-Mady.
One of the keys to the company’s success has been a refusal to compromise on investment in research and development. It has the largest polymer/plastics fabrication laboratory in the Middle East in Riyadh and has also established technology centres in Houston, Texas, and Valadora, India.
Competition heats up in bank sector
Saudi Arabia’s banks have been investing heavily in new products and delivery channels as they prepare for more intense competition from regional and international financial institutions.
The award of licences to Bahrain-based investment bank Gulf International Bank (GIB), which won the mandate to arrange an IPO for Saudi Telecommunications, and Dubai-based universal financial institution Emirates Bank International (EBI), shows that the authorities are prepared to encourage new participants in the market.
The arrival of GIB and EBI is unlikely to be the end of the story. Saudi Arabia is at an advanced stage of negotiations to join the World Trade Organization, whose rules include the opening up of financial markets. Saudi Arabia’s finance minister, Ibrahim Al-Assaf, says that “more licences will be issued to those that meet the banking criteria”.
Western banks will also be able to enter the kingdom as non-bank financial intermediaries (NBFIs), once the capital market law has been passed. “These entities will be able to engage in activities such as brokerage and corporate finance which today are regarded as solely banking business. However, these NBFIs will not be licensed to accept deposits,” said Al-Assaf.
Saudi Arabia’s banks are now well placed to meet any challenge, having upgraded their delivery channels and broadened their range of lending, savings and investment products, including taking the first steps towards creating mortgage products, and made a major commitment to Islamic banking.
Banks are also looking to increase their fee-based income. “Our fee income has been rising steadily from SR17 million in 1997 to SR25.7 million [$6.8 million] in 2001,” says Talal Al Qudaibi, president and chief executive of Riyad Bank.
The major remaining doubts are about the prospects for National Commercial Bank (NCB), which is still suffering from the damage done to its reputation from its ownership by the Mahfouz family, which is linked to a charity that the US Treasury has labelled as a front for Al-Quaeda.
NCB, which is now majority state-owned and has excluded the Mahfouz family from any role in management, has however made significant steps towards restoring credibility and its current financial operations are more transparent and profitable. The bank is much more assertively managed, has a leading role in consumer lending and has set the target of an initial public offering, though no date has yet been set.
Saudi banks have retained their international relationships despite the fallout from the September 11 terrorist attacks. The impact on their business has been much less than expected. The banks have been helped by the higher than expected rise in oil prices, which has resulted in substantial injections of liquidity into the economy and enabled the private sector to be more resilient than expected.
“Our initial plans erred on the side of caution and we were surprised by the robustness of the market,” says David Hodgkinson, managing director of Saudi British Bank.
That strength has continued into this year. Net income rose by 4% in the first quarter with a drop in commission income more than compensated for by a sharp cost reduction.
However, bankers expect that the rest of the year will be more difficult, not least because most of the banks are offering a range of top-quality products. “Competition is getting tougher, while there is a lot of liquidity around and interest rates are low,” says Mike de Graffenried, managing director at Saudi American Bank (Samba).
The banking sector has changed beyond recognition in the past few years. Management structures and strategic goals have been overhauled. ANB, for example, has pursued a long-term strategic initiative to move away from the traditional transaction-based culture to customer relationship management and focused on boosting revenue, which grew by 35.7% between the first quarters of 2001 and 2002.
High-tech delivery
All the banks are offering electronic delivery channels, which are proving extremely popular with a predominantly young Saudi population. At NCB, for example, 67% of transactions go through alternative channels and phone banking is used 700,000 times a month. All the banks report increased use of internet and mobile phone banking.
Though there has been growth in corporate business, with some banks starting to be active in the small and medium-size companies sector, the focus remains predominantly on the retail lending sector. It has done so since the Saudi Arabian Monetary Agency (SAMA) decided to pay state employees’ salaries into bank accounts, sparking off a dramatic growth in salary-based lending.
Competition for this sector of the market remains strong, with banks vying to provide the best terms. But bankers remain convinced there is no danger of the market overheating. “Banks are still underlent,” says Al Qudaibi. Bankers are also providing services to Saudi women, an increasing proportion of whom work or have access to inherited money.
The banks are also responding to the growing demand for Islamically structured products and are mounting a strong challenge to an area that until recently was dominated by Al Rajhi Banking&Investment Corporation. Al Rajhi, like other Islamic banks, has found its profits squeezed by low interest rates.
Islamically compatible mutual funds are proving increasingly popular but the major long-term growth is expected to be in the mortgage market, where Saudi British has led the way with a Sharia-compliant mortgage.
Customers have to make a down payment of 25%, while the loans for the balance is effectively an Islamic lease with an option to buy. “This has gone very well. The limitation is the shortage of ready-made houses,” says Hodgkinson.
The amount of mortgage finance, both conventional and Islamic, will grow. The main problem remains Saudi law, which is still unclear about the rights of bankers to repossess in the event of a default. Bankers also remain unconvinced that the courts and the police would be prepared to enforce any law that was introduced.
However, they say that in the long term there is no alternative as the Saudi government tries to find ways of financing housing accommodation for a population that is both young and dependent on comparatively few wage earners.
The number of dependants for each wage earner is five, twice that of Europe and 2.4 times the world average.
