Why Saudi Arabia Must Not Delay Energy Price Reforms

KSA Crown Prince Mohammed bin Salman - Faye Nureldine AFP Getty Images

Speculations abound about the Kingdom of Saudi Arabia(KSA) delaying scheduled energy price reforms as committed to in its 2016 National Transformation Plan (NTP). The NTP medium-term plan that aims at diversifying the economy away from its heavy dependence on oil. The reforms aim to gradually reduce energy price subsidies and bring prices of all energy products to international levels by the year 2021. However, recent statements by Saudi officials including the Minister of Finance Mohammed Al-Jadaan and the Minister of Energy Khalid Al Faleh, seem to give credence to speculations about possible delays in implementing the planned price reforms.

This, if it comes to pass, will more likely result in postponement of full price liberalization beyond the originally set date of 2021. More importantly it will raise the level of uncertainty about government commitment to the reform agenda. Especially after recently backtracking on similar reforms to the labor market. In a measure to rationalize public expenditures and narrow the wage gab between the private and public sectors, the Kingdom removed bonuses and allowances to public sector employees in September 2016, only to turn back and restore them seven months later in April 2017.

The marked economic slowdown over the period 2016-2017 is thought to be the main reason behind those policy revisions. Indeed, actual growth in Gross Domestic Product (GDP) was only 1.7 percent in 2016, while Non-Oil GDP (the non-oil economy) came at a meager 0.2 percent, well below the 1.6 percent expected by the IMF in its 2016 economic growth forecast for KSA. Worse still, the 2017 medium-term economic outlook does not promise any appreciable improvement in growth levels. Of particular concern is the low growth rates of the Non-Oil Economy, which is counted upon to be a source and a driver of growth if the NTP is to achieve its economic diversification objective, Figures 1 & 2.

The Non-Oil Sector is counted upon to generate sufficient employment opportunities for new labor market entrants and decrease the ranks of the unemployed among Saudi youths. Failing to meet this challenge will exasperate already high unemployment among Saudi nationals and increase the risks of social instability.

Holding the partial price reforms, which have been implemented so far, responsible for the disappointing economic performance is hardly justifiable for the following reasons:

A. The partial reduction in energy price subsidies was not the only measure taken during the period which would depress economic growth. For since the large drop in oil prices in 2014, the Government made substantial spending cuts in late 2015, followed by adopting a tighter budget for 2016. Moreover, after announcing its long-term Vision 2030; a program to reform and diversify Saudi Arabia’s oil-dependent economy, in mid-2016, the government went on to announce a Fiscal Balance Program (FBP), which outlined a strategy for balancing the budget by 2019. A strikingly unrealistic target, which requires closing a budget deficit gab of around 17 percent of GDP in a mere three-years period. Especially, when no help can be expected from depressed oil prices to buttress oil revenues. These fiscal measures taken almost simultaneously were the case of “too much-too soon”, were sufficient to choke the growth of an economy that long enjoyed an accommodating fiscal policy.

B. Adopting fiscal tightening measures while simultaneously cutting price subsidies reflect a lack appreciation for the pains and sacrifices that the process of economic transformation would entail. The Government did not even see the need to adopt necessary measures to offset the impact of higher energy prices on the economic and social sectors. On the contrary, it expected the Non-Oil Sector to quickly adjust to the new environment and lead economic growth. According to the 2016 IMF Staff Report, the now discredited 2016 forecast was thought then by Saudi authorities to be too pessimistic. “They expected the ongoing expansions in the petrochemical, utility, and mining industries and a pickup in visitors to Mecca and Medina to have a larger impact on non-oil growth while they thought the impact of fiscal consolidation would be limited given the composition of adjustment and the scope for improving spending efficiency”.

C. Policy makers did not sufficiently appreciate the strong coupling between the Oil and the Non-Oil sectors. This coupling is not only due to the government’s budget heavy reliance on oil export revenues, as generally assumed, but also because the Non-Oil Sector is highly energy intensive and structurally defined by the Oil economy. The main constituent industries of the Non-Oil Sector are: the petrochemical industry, water desalination, power generation and other energy intensive heavy industries. Those industries, along with other sectors such as transport, have come of age in an environment of heavily subsidized prices extending over more than three decades. This extended low price environment has substantially influenced the factor- composition and business culture of the Non-Oil Sector.

D. Saudi policy makers did not sufficiently appreciate the scope and complexity of the restructuring process that the NTP would require from the Non-Oil Sector. For this sector to form a base for further economic diversification away from oil, it needs to be transformed into more energy efficient and productive sector to be able to survive and grow in the new subsidy-free environment. Furthermore, the process of adaptation to the new environment would require new investments, upgrades in the managerial and technical skill sets, and most importantly sufficient time that can extend for years.

Consequently, successfully planning and implementing these investments, along with marshaling other resources, would require, above all, a firm and an unwavering early commitment to the reforms from the government and all other stake holders. Furthermore, the firmness of the reform program is also required to enhance the confidence of domestic and foreign investors who are called upon to build the new diversified economy. It further contributes to the economic viability of investments in low energy intensive and high value-added economic activities, long crowded out by more profitable investments in energy intensive activities due to low subsidized energy prices.

While firm commitment to the scheduled reforms is judged to be vital for a successful economic and institutional transformation, it is also important for government policy to support the economy in its transition and adaptation to the new market price environment. The government is already taking measures to help low and middle-income consumers cope with higher energy prices, while a special agency was established and made responsible for improving energy efficiency in government buildings and plants. This however is thought to be insufficient to offset the economic and business effects of higher prices, since low energy efficiency permeates all economic and social sectors. Consequently, the business and residential sectors will need financial and technical assistance to improve energy efficiency and reduce rising energy bills. On the other hand, energy providers need to improve their productivity and efficiency toward reducing the cost of service.

Considering the present outlook for the oil markets, KSA will not be able to rely, in the medium term, on sizable growth in its oil export revenues to cover the additional needed expenditures. Based on forecast oil price and production for the medium term, the Oil Sector cannot be counted upon in enabling the government to balance the budget by 2019 while keeping its stated commitments to the reform agenda, Figure 3.

Luckily however, the Saudi Government, according to the 2017 IMF Report, enjoys a strong financial position which makes it an attractive borrower in international financial markets. External debt represents only about one third of total government debt, while total dept is very low; about 13 percent of GDP at end-2016. Furthermore, KSA's net foreign assets are high, standing at around $530 billion or about 32 months of imports at end-2016.

These strong policy buffers should allow the authorities to relax the fiscal policy by moving their budget balancing target to further years as needed. Thus enabling them to keep the reform agenda firm and the vital economic transformation process on track.

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