Public Information Notice No. 05/3

Public Information Notice: IMF Concludes 2004 Article IV Consultation with Saudi Arabia

January 12, 2005

On December 22, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Saudi Arabia.¹

Background

In 2003, reflecting prudent macroeconomic management and sharply higher oil prices and production, economic conditions improved significantly. Real GDP growth surged to 7.2 percent, while inflation remained subdued. Strong growth in oil revenue generated substantial fiscal and current account surpluses and resulted in a large reserve accumulation. The authorities reaffirmed Saudi Arabia's commitment to ensure oil market stability. To this end, they indicated that, as needed, they would continue to meet higher world oil demand by expanding the country's oil production capacity.

The central government fiscal position improved considerably on account of record-high oil revenues, with the overall balance switching from a deficit of 5.9 percent of GDP in 2002 to a surplus of 1.2 percent of GDP. At the same time, government debt declined by 15 percentage points to 82 percent of GDP. Driven by the favorable developments in the oil market, the external current account surplus more than doubled to about 14 percent of GDP. The Saudi Arabian Monetary Agency's (SAMA) net foreign assets increased to an equivalent of around 11 months of imports of goods and services. Broad money, which grew by about 8 percent, kept pace with the increase in money demand. The financial sector continued to perform well, and the stock market remained buoyant. Interest rates continued their downward trend, while the average riyal-U.S. dollar interest rate differential remained stable. The 2004 Financial System Stability Assessment (FSAP) exercise concluded that the Saudi banking system is stable, profitable, and effectively supervised. Reflecting the depreciation of the U.S. dollar against other major currencies, the Saudi riyal depreciated by about 20 percent in real effective terms during 2002 to August 2004, enhancing the competitiveness of non-oil exports.

In 2004, economic and financial conditions strengthened further as oil prices continued to rise and hit record highs in October 2004 and Saudi Arabia expanded oil output in order to accommodate the growing global oil demand. Accordingly, large fiscal and current account surpluses are expected in 2004, and SAMA's net foreign assets could rise to the equivalent of 15 months of prospective imports. Both oil and non-oil GDP are expected to grow at about 5 percent. Accounting for the positive terms-of-trade effect, real gross domestic income is envisaged to increase by 17 percent.

Progress on structural reforms during 2003 and 2004 remained focused on enacting laws and regulations to expand areas for private sector activities (including foreign direct investment), and on enhancing the legal foundations for the expansion and regulation of financial and capital markets. Concurrently, steps have been taken to facilitate the development of institutions needed to enforce the regulatory framework governing private sector activities and to encourage private sector investment under market-based conditions. The privatization of state enterprises and private sector participation in public sector dominated activities have also been successfully initiated. The Saudiization policy, aimed at creating private sector employment for Saudi nationals, continued to be applied in a flexible and cautious manner. In addition to efforts to increase the employability of the Saudi labor force through training, administrative measures have been initiated to limit employment of expatriate workers in the private sector.

Executive Board Assessment

Executive Directors agreed with the thrust of the staff appraisal. They commended the Saudi authorities for the economy's strong performance, characterized by a marked increase in real GDP growth, low inflation, a declining debt ratio, and stronger fiscal and external positions. Directors attributed these impressive developments to the authorities' prudent macroeconomic management, efficient utilization of oil resources, and steady implementation of comprehensive structural reforms over the past several years. They agreed that the medium-term outlook remains favorable, but noted that high unemployment and a rapidly growing Saudi labor force pose serious challenges. Addressing these problems will require expanding non-oil growth over the medium term and sustaining structural reforms to enhance the competitiveness of the private sector, foster economic diversification, and reduce the vulnerability to oil price fluctuations. Directors encouraged the authorities to take full advantage of the current favorable economic environment to press forward with these reforms.

Directors welcomed the strong turnaround in the fiscal position, which has been supported by the authorities' strategy of saving much of the higher-than-budgeted oil revenues and containing budgetary outlays. They supported the plans to cut subsidies and reduce other nonsecurity current expenditures, while at the same time using higher oil revenues for health, education, and infrastructure development, and for a rapid reduction of government debt. Directors felt that the 2005 budget, which is based on conservative oil revenue projections, will facilitate the achievement of these objectives.

Directors stressed that the authorities' medium-term fiscal strategy will need to be supported by fiscal reforms on both the expenditure and revenue sides, and by improved budget management. In this regard, they urged a comprehensive civil service reform, continued privatization and corporatization of state enterprises to reduce the public sector payroll, and better targeting of subsidies and transfers. They welcomed the intention to adjust petroleum product prices more in line with international prices. Directors also encouraged the authorities to broaden the indirect tax base and to diversify fiscal revenues. A number of Directors encouraged the authorities to develop a formal medium-term budget framework with a well-defined fiscal rule, which, if based on continued conservative but realistic oil revenue assumptions, would help smooth expenditure. In this context, a few Directors suggested establishing an oil stabilization fund that would set aside a portion of oil revenue under transparent rules for future generations.

Directors commended the authorities' prudent conduct of monetary policy, which has contributed to price stability and has supported the exchange rate peg to the U.S. dollar. They generally endorsed the authorities' decision to keep the current exchange rate regime unchanged in the period leading to a monetary union with Gulf Cooperation Council countries, as well as their intention to keep an open mind on the choice of the exchange rate regime under the prospective monetary union. Directors welcomed the considerable progress that has already been made toward economic and financial integration among the GCC countries, and recommended the development of policy coordination mechanisms and an early agreement on the convergence criteria for key macroeconomic variables in order to support the transition to monetary union, planned for 2010.

Directors welcomed the conclusion of the Financial Sector Assessment Program that the Saudi banking system is stable, profitable, and well supervised. They commended the authorities for the steps already taken to enhance the resilience of the financial system, and encouraged them to implement the remaining FSAP recommendations. Directors welcomed the recent establishment of a Capital Markets Authority under the new Capital Markets Law, which will help strengthen management and operations of the stock market. Noting the continuing strong increase in stock prices, Directors highlighted the need for vigilance about bank exposure to stock market-related lending, including consumer lending. They supported the development of secondary bond markets, which will contribute to financial deepening and enhance the growth-promoting role of the financial sector. Directors welcomed the recent strengthening of the law on anti-money laundering and the issuance of its implementation rules, and looked forward to further progress toward full compliance with the FATF 40+8 recommendations.

Directors emphasized that generating employment for the fast growing Saudi labor force and reducing the prevailing high level of unemployment will continue to remain a priority for Saudi Arabia. They endorsed the strategy to reform the labor market through skills development, portability of pension benefits, and flexible enforcement of Saudiization policy with due consideration given to safeguarding economic efficiency. Directors noted that early adoption of the planned Labor Law will help enhance labor mobility and provide greater flexibility in employer-employee relationships.

Directors welcomed the steady progress in trade liberalization and the authorities' commitment to sustain the pace of structural reforms to give a renewed impulse to the expansion of non-oil economic activity. They were encouraged by the increasing role of the private sector through privatization, divestment, and opening up of sectors previously dominated by the public sector. Directors looked forward to further progress in this area, including through encouraging foreign participation and privatizing the utility sector. The ongoing efforts at institutional and legislative reforms, including the recent adoption of the Competition Law, should help create a level-playing field between domestic and foreign companies and attract foreign direct investment. Directors urged the authorities to expedite the enactment of the Company Law and the Agency Law to foster private sector growth, as well as to strengthen their efforts to enhance corporate governance.

Directors praised the authorities for their leadership role in ensuring oil market stability. They appreciated the authorities' efforts to meet growing global demand for oil by increasing production when needed, and by making necessary investments to improve output and production capacity. They also welcomed Saudi Arabia's active participation in the Joint Oil Data Initiative and continued efforts to improve the transparency of oil data and to enhance cooperation between consumers and producers.

Directors welcomed the authorities' continuing efforts to improve the coverage, quality, and timeliness of economic statistics, as well as the compilation, provision, and dissemination of economic data. They encouraged the authorities to participate in the Fund's General Data Dissemination System. Many Directors considered that macroeconomic policy formulation and fiscal policy effectiveness would benefit from an analysis based on the consolidated general government operations, and from increased transparency in accounting for oil revenues. Directors supported Fund technical assistance in the area of statistics.

Directors expressed their appreciation to Saudi Arabia for its significant development assistance to low-income countries, including through the HIPC Initiative.

It is expected that the next Article IV consultation with Saudi Arabia will be held on the standard 12-month cycle.