Public Information Notice No. 05/161

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with Saudi Arabia

December 5, 2005

On October 7, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Saudi Arabia.¹

Background

In 2004, supported by record oil revenues and prudent macroeconomic management, economic conditions strengthened further. Real GDP grew by 5¼ percent due to strong growth in both oil and non-oil output, and inflation was negligible (⅓ of 1 percent). Strong growth in oil revenue generated substantial fiscal and current account surpluses and resulted in a large reserve accumulation. Saudi Arabia continued to play a constructive role in ensuring oil market stability by increasing oil supplies, in line with the growing market demand. To this end, the authorities have embarked on a substantial expansion of the country's oil production and refining capacity in the coming years.

The central government fiscal position strengthened further in 2004 on account of record oil revenues and a relatively limited increase in outlays. The fiscal surplus increased to 9½ percent of GDP, up from 1¼ percent of GDP in 2003. Over half of the 2004 fiscal surplus was used to reduce the gross central government debt by 16 percentage points to 66 percent of GDP, while the remaining surplus was placed in a special fund to finance investment in priority areas over a 5-year period. Driven by the favorable developments in the oil market, the external current account surplus increased by 7½ percentage points to 20½ percent of GDP. The Saudi Arabian Monetary Agency's (SAMA) gross foreign assets increased to an equivalent of around 15 months of imports of goods and services.

Broad money grew by about 17 percent, fuelled mainly by the increase in bank credit to the private sector (37 percent). The financial sector continued to perform well, and the stock market remained buoyant. Interest rates started to increase moderately in the second half of the year, while the average riyal-U.S. dollar interest rate differential was allowed to narrow. Bank solvency was adequate, and asset quality and profitability improved. Reflecting the depreciation of the U.S. dollar against other major currencies, the Saudi riyal depreciated by about 8 percent in real effective terms, enhancing the competitiveness of non-oil exports.

Real GDP growth for 2005 is projected to accelerate to more than 6 percent, supported by strong growth in oil and non-oil private sectors (6¾ percent and 6¼ percent, respectively). Economic growth and terms-of-trade gains are expected to boost per capita GDP by 19 percent to above US$13,000 in 2005. Monetary expansion accelerated during the first quarter of 2005 in response to the growing private sector credit demand and is projected to grow by about 12 percent in 2005. The external current account surplus is projected to reach 30 percent of GDP. The central government fiscal surplus is expected to increase further to about 15½ percent of GDP, reflecting a projected 34 percent increase in oil revenues and a limited increase in budgetary spending. Gross central government debt is expected to be reduced further by 19 percentage points to about 45½ percent of GDP.

The impetus added by the private sector to the current growth momentum is attributable to the implementation since 1999 of structural reforms aimed at increasing private sector participation. In order to sustain the momentum, progress continued through privatization of state enterprises, strengthening of insurance and capital market regulations and supervision, financial sector liberalization, and the reform of the legal, regulatory and judicial framework. The Saudiization labor policy, aimed at creating private sector employment for Saudi nationals—through training programs, wages subsidies, and sector specific quotas—continued to be applied in a flexible manner.

Executive Board Assessment

Executive Directors commended the Saudi authorities for their prudent macroeconomic management, the effective use of oil revenues to invigorate the development of the private sector, and the economy's impressive performance. With large current account and fiscal surpluses, reserves have continued to increase, government debt declined, and the stock market has continued to strengthen reflecting growing confidence. Directors noted that the consistent implementation of structural reforms over the past several years has coalesced into a driving force for economic diversification and private sector-led growth, thus creating the basis for increasing employment opportunities for Saudi nationals and enhancing the economy's resilience to oil price shocks.

Directors observed that increased domestic growth and the oil-related terms-of-trade gains in the last three years have helped boost per capita income by 50 percent and strengthened medium-term prospects. These gains notwithstanding, Directors emphasized the need to absorb the rapidly growing Saudi labor force into the private sector by sustaining the implementation of structural reforms. Directors saw the current favorable economic situation as offering an important opportunity for carrying forward the reform momentum while harnessing resources for future generations, and welcomed the authorities' commitment to stay the course of sound economic policies.

Directors commended the authorities for their constructive role in support of oil market stability. They appreciated the authorities' demonstrated readiness to increase production to meet growing global demand and to expand the country's production and refining capacity, which has helped support the ongoing global economic expansion and prosperity. Directors welcomed Saudi Arabia's ongoing investment plans for capacity expansion in oil production and refining activity, and the authorities' commitment to increase further the country's production capacity, if global demand continues to remain strong. They welcomed Saudi Arabia's active participation and leadership role in the Joint Oil Data Initiative and underscored the importance of advancing international efforts in providing accurate and up-to-date petroleum production and consumption data. The authorities were encouraged to make further progress in enhancing transparency.

Directors endorsed the authorities' decision to utilize a part of the higher oil revenues to increase social expenditure and improve the much needed physical infrastructure, and at the same time further strengthen the fiscal position through debt reduction. The use of fiscal surpluses for further reducing government debt would enhance private sector confidence and create fiscal space for sustaining a significantly higher social spending in health and education and the infrastructural development program. Directors welcomed the compilation of data at the consolidated general government level.

Directors observed that the favorable fiscal outlook offers both opportunities and challenges over the medium term. Executing effectively the large increase in the planned social and capital outlays and managing the sizable surpluses would be the key challenges. Directors endorsed the staff recommendation for a medium-term fiscal framework formalized in a transparent way to limit the adverse impact of oil revenue fluctuations and improve expenditure prioritization. In this connection, they were encouraged by the authorities' willingness to consider the possibility of establishing an investment fund for future generations. Directors also encouraged the authorities to reduce gradually the implicit subsidies for electricity and water utilities through price rationalization and to adjust domestic energy prices broadly in line with international market developments. Noting the recent increase in public sector wages and the large wage bill, several Directors stressed the importance of containing the growth of recurrent outlays.

Directors commended the authorities for their effective supervision of the banking system, which has resulted in the development of well-managed, profitable, and financially sound institutions. While noting the limited direct exposure of the banking system to the equity market, Directors observed that the authorities need to be cautious in light of the continuing strong increase in stock prices. They commended the authorities for the steps already implemented, and encouraged them to further strengthen prudential oversight on stock market-related lending and on consumer lending. In this context, Directors also cautioned about managing domestic liquidity in a manner to balance the growing needs of the rapidly expanding private sector against the risk of asset price inflation. Developing additional market-based instruments was seen as helpful in this context.

Directors noted that the Saudi financial system faces the challenge of effectively intermediating the massive financing needs of the large private sector investment projects. The ongoing financial system liberalization undertaken by the authorities will enhance competition and could be further deepened over time to create a framework more conducive to financial innovation. Development of primary and secondary markets in corporate bonds will be critical in meeting this medium-term challenge. Directors commended the authorities for taking important steps to enact legislation compliant with international standards on Anti-Money Laundering/Combating Financing of Terrorism.

Directors supported the authorities' prudent conduct of monetary policy, which also entails increasing domestic interest rates in line with international developments in the interest rate structure. This policy is consistent with the exchange rate peg, and has contributed to Saudi Arabia's remarkable degree of price stability. Directors endorsed the authorities' decision to keep the current pegged exchange rate regime unchanged in the period leading to the Gulf Cooperation Council (GCC) monetary union in 2010. They also supported the authorities' intention to keep an open mind toward 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 GCC countries. They encouraged the authorities to sustain the process, by focusing on the integration of financial markets and the establishment of a common monetary authority in order to ensure a smooth transition to the monetary union by 2010.

Directors congratulated the authorities on the strong response of the private sector to the reforms implemented in recent years, and noted that sustaining the current momentum will be key to the success of the authorities' medium-term growth strategy. Tapping the potential of non-oil sectors will require putting in place the necessary infrastructure and legislative and regulatory reforms to foster foreign and domestic investment. Directors welcomed the recent progress with Saudi Arabia's accession to the WTO, including the bilateral agreement signed with the United States, which would contribute to create a business environment conducive to increased private sector investment.

Directors endorsed the authorities' emphasis on education and training of nationals, and their intention to pursue the Saudiization labor policy in a flexible manner. The focus on education and training would help better align the skills of the Saudi workforce with the demands of the labor market and the private sector. Directors welcomed the recent approval of the Labor Law, which would help enhance labor mobility and flexibility in employer-employee relationships.

Directors welcomed the authorities' progress in improving the quality and coverage of economic statistics. They encouraged the authorities to improve further the compilation of national accounts and general government statistics, and to participate in the Fund's General Data Dissemination System. Directors supported Fund technical assistance in the areas of balance of payments, and financial and monetary statistics.

Directors expressed their appreciation to the Saudi authorities for their significant development assistance to low-income countries, including through the Heavily Indebted Poor Countries Initiative, and welcomed the authorities' commitment to continue such support.