Saudi Budget SABB Notes December 2008

SABB Notes 2008 had a budget surplus for the sixth time in a row with a staggering 234.18% surplus over 2007 (SR1.1 tn revenues vs SR510 bn)

Oil price assumption for 2009 is $37 for Saudi oil and $43 for WTI

2008 government spending increased by a staggering 24.4%

2009 budget spending will fall by 6.9% over 2008 actual spending

2009 budget continues its focus on education and healthcare (SR139.1 bn and SR52.3 bn respectively)

Government debt falls down to 13.5% of GDP from 103.5% in 1999 and 19% in 2007

Current account surplus: A record high

A confidence building, expansionary A confident budget with a very manageable deficit budget! On December 22, 2008, the budget for the fiscal year 2009 was announced; it is the largest budget in the economic history of Saudi Arabia. The government budget represents counter cyclical fiscal measures which we believe are reflected in the 2009 budget, adhered to when oil revenue drops. 2008 will be the last surplus year as the country will witness a budget deficit for 2009. We believe that the 24 December 2008 outlined deficit of SR65 bn ($17.3 bn) of the announced budget can Dr. John Sfakianakis Chief Economist be covered by deploying foreign assets. The magnitude of the budget deficit will depend on two things: (A) average oil prices for 2009; (B) Tel: +966 1 276 4602 Email: johnsfakianakis@.com the degree of overspending that will be carried over the announced This and other publications can be 2009 budget. The air of conservatism on expected oil revenues for 2009 downloaded from: www.sabb.com

Budget Surplus

40.0

35.0

30.0

25.0

20.0 Disclaimer 15.0 10.0 % of GDP These notes should be 5.0 0.0 read in conjunction with -5.0 -10.0 the concluding Disclaimer, -15.0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 which forms part of them. Source: SAMA and Ministry of Finance 1 Saudi Budget SABB Notes December 2008

are reflective of the lower oil revenues that Saudi terms even though spending was quite aggressive Arabia will witness in 2009. We are forecasting oil and above everyone’s expectations. Spending hit a revenues not to cross the $120 bn mark. Oil prices record high. Most of the budget surplus was used to are below $40 per barrel, which could have a revenue build up foreign assets at the (SAMA) double whammy as further oil product cuts are and to reduce domestic debt which reached 13.5% of implemented in Q1’09. The budget deficit could be GDP. Per capita GDP rose to SR69,494 ($18,531); supported by deploying foreign assets at this stage the highest since 1981 when the country’s population and could also involve some deficit financing from was 9.8 million compared to 25 million at present. within. The government continues to calculate the budget based on an attainable oil price for 2009. The 2008 Actual Revenues and Expenditure question still remains: what happens to oil prices in Budget Actual % Difference 2010 and the expenditure side of the government? Revenues SR450 bn SR1.1 tr 144.44% By having a fair spending budget given the global Expenditures SR410 bn SR510 bn 24.44% recessionary conditions, the government is sending Surplus SR40 bn SR590 bn 1375% a strong confidence building message that in hard times the state will step in to support the economy. The budget surplus of Saudi Arabia is bigger than We believe that, more than in any other year, the Egypt’s estimated total GDP for 2008 and is more government would have to step in to increase than 60% of the UAE’s estimated GDP for 2008. In spending (both capital and current) not only in adherence to the policy followed during this second support of its development programme, but mainly oil boom, part of the higher-than-anticipated revenue in support of investments which have an immediate in 2008 was used to lift spending above the budgeted positive pass through effect for the private sector. level. The actual 2008 budget surplus has been The government has done exactly that by increasing increased by SR550 bn over the expected surplus spending above trend (c15%) at nearly 25% in 2008. when the 2008 budget was announced a year ago. Growth takes central priority and inflation is less The 2008 budget surplus is at SR590 bn compared of a concern set against a global economic outlook to SR289.7 bn ($77.2 bn) in 2006 which was the for 2009 that looks bleak. Consumer demand in highest ever recorded at that time. The bulk of the the developed countries should be depressed for surplus was used to accumulate foreign assets at the sometime. central bank (SAMA) and to reduce debt. In addition, funds earmarked in the 2008 budget continue to Fiscal performance was the strongest ever recorded be set aside for the Real Estate Development Fund in the history of Saudi Arabia in 2008. As a result, which provides much needed house purchase actual spending in 2008 increased by 24.4% above loans, usually to first time home owners. Also, the its target. Spending was up by 9.44% to the 2007 Saudi Credit and Saving Bank received a capital level compared to the 18.56% level in 2006. The boost of SR10 bn in addition to an estimated SR40 budget surplus of SR590 bn was the largest ever. It bn to be disbursed by Government Specialized was way above the 2007 record figure of SR176.5 Credit Institutions, including the Saudi Industrial bn because oil revenues grew by 35% in nominal Development Fund, Saudi Credit and Saving Bank,

2 Saudi Budget SABB Notes December 2008

Saudi Arabian Agriculture Bank, Public Investment (17.4% growth). Since 2005, total expenditures have Fund, Real Estate Development Fund and the risen by 47.2%. Government spending has increased Government Lending Programme to the beneficiaries at a slower pace than capital spending despite the of their lending programmes. This is a continuation second 5% annual increase in public sector wages. of previous practice in support of specialized The need to see capital spending increase by a development funds. higher rate reflects positively on the government’s commitment to see infrastructure uplifting 2008 was a year of the best fiscal performance ever, throughout the country. as oil export revenues hit a historic high of SR1128.7 ($301 bn), according to preliminary estimates. A Counter cyclical fiscal measures were adopted in the previous record was already set in 2007 in which past and history can have certain repeating facets. oil export revenues were at SR770.6 bn ($205.5 We believe that Saudi Arabia is, for at least next bn) and it’s more than three and half times more year, going to experience a repeat of the 1981-1982 than the 2003 figures. In regional terms, the size of drop in oil and total government revenues. Certainly, the Kingdom’s preliminary oil export revenues for the only downside risk to our forecast is the extent 2008 is staggering: more than 125% of the UAE’s of the global economic recession beyond 2009 expected GDP in 2008 and more than three times the and subsequently the degree to which oil prices size of Qatar’s GDP during the same year. can remain depressed below $50 per barrel. If it’s a simple interruption of one or two years reflected as low oil revenues, then Saudi Arabia is very Are counter-cyclical fiscal well placed to overcome the crisis. If oil prices go measures a bit like those in through a similar low priced scenario witnessed in the slowdown of 1981-1986, then macro-economic the 1980s? difficulties will become far more pronounced. This could be reflected in a drop in real economic A budget surplus of SR590 ($157.3bn) was activity, depressed private sector growth and lower announced for 2008 compared to SR176.5 bn ($47 government spending. However, compared to the bn) in 2007 and SR289.7 bn ($77.2 bn) recorded in early 1980s slowdown, Saudi Arabia today is far 2006. Spending reached SR510 bn over revenues better equipped to weather the low revenue scenario of SR1.1 tn compared to 2007 figures of SR466bn due to its huge foreign assets position and its low over revenues of SR642.8 bn. The surplus was more government debt. Both can be deployed, at different than sixteen times bigger than the year 2003, when intervals, to push ahead with the expenditure the oil boom started. The 2008 budget was based programme outlined by the government and the on projected revenues of SR450bn ($120 bn) and infrastructure projects that need to be undertaken. expenditures of SR410bn ($109.3bn). Spending hit Nevertheless, we do expect total revenues to witness another record high in 2008, increasing by SR100 bn a drop by an estimated 52% in 2009 to an estimated or 24.4% compared to an increase in total spending total of SR525 bn. During 1981-1982, total oil of SR86.3 bn (22.7% growth) for 2007 over 2006 revenues dropped (like at present due to a drop in which witnessed a spending increase of SR58.3 bn prices and several oil production cuts) by 43.4% and

3 Saudi Budget SABB Notes December 2008

total revenues by 34.5% yet government spending 2009: Expenditure declined but not as steep as the decline in total revenues. More importantly, total expenditures fell by The 2009 budget aims at instilling confidence in 14% and capital expenditures fell by 16.6% whereas the economy. The budget is conservative on its current expenditures dropped by 10%. The wage expected revenues but expenditure strong. Budgeted bill which is the bulk of government expenditures expenditure totalled SR475 bn for 2009, an increase has social ramifications and can only gradually of SR65 bn or nearly 16% over budgeted expenditure decline to a certain level. In fact, during the1980s in 2008, in stark contrast to the 7.9% over-budgeted as total government revenues dropped from a high expenditure increase in 2007. The expansionary of SR368 bn in 1981 to SR76 bn in 1986 (a 79.3% nature of the budget is set to provide a fiscal stimulus decline), current expenditures during the same period in line with the government’s plan to support fell by 13%. Likewise, we do not expect current the economy at times when the global economy expenditures to fall steeply even in a low growth is in a recession, global financing is very tight, environment. Despite spending cuts, the government regional financing is difficult and local financing is sector continued to grow as the oil and non-oil reaching capacity constraints. The years of fiscal private sector continued to drop precipitously through restraint, surpluses, foreign asset accumulation and the early to mid-1980s. Real GDP growth for the government debt reduction are all coming handy at a government sector averaged in the period 1982-1986 time when oil export revenues will be depressed for by 4.1% whereas the private sector dropped by at least 2009. -1.7%. Government spending from the budget was declining but real government sector growth played For 2009, spending is budgeted at SR475 bn ($126.6 an important role in keeping the economy more on a bn) compared to revenues of SR410 bn ($109.3 bn), more even keel. resulting in a projected deficit of SR65bn ($17.3 bn) over a surplus of SR176.5 bn ($47 bn) in 2007. The slowdown in spending could be intended to Although budgeted expenditure in 2009 is below combat inflation but it could very well be related to actual spending in 2008, we might not see an overrun the supply bottlenecks in the economy, resulting from corresponding to the historical pattern. The 15.8% the boom, as a large chunk of government spending increase in projected spending between 2008 and is construction related and the construction sector is 2009 is expansionary and aggressive compared to the facing expansion constraints mainly related to labour growth in revenues and suggests that the government issues. The boosted revenue, due to a considerable is going to spend despite the low oil environment. excess in targeted oil receipts, allowed spending to Moreover, the government’s projected differential grow beyond the budget, in line with traditional over- between expenditures and revenues, widened by spending practices (c15% per year). SR65 bn in the 2009 budget compared to SR40 in the 2008 and SR20 bn in the 2007 budget. The government expects revenues to remain within range that could be covered by deploying foreign assets and there is clearly much less concern on the inflation front.

4 Saudi Budget SABB Notes December 2008

Capital expenditure is set to increase by 36% allocated funds of the budget down from 35% in support of the government’s infrastructure budgeted in 2006 and 2007. programme which should have obvious trickle down effects for the rest of the economy and especially the Education, social and physical private sector. The increase in capital expenditure is a marked departure from previous periods when infrastructure oil revenues dropped dramatically. For example, in the 1998 budget when oil revenues dropped by As with recent years, spending plans prioritise 50%, government spending fell by 14%. Current qualitative improvements to education, social expenditure spending was not released but we do and physical infrastructure. Real GDP per capita believe that they will remain strong given the added improvements can only be made when productivity 5% increment in wages. Also, subsidies which changes are made. It is not only about building received a SR4.4 bn additional funding in 2007 schools, but it is equally important to change the way reaching SR12.8 bn are estimated not to surpass teachers are trained so that the quality of teaching SR17 bn in 2009. Subsidies should not improves. The government is not deaf to these needs grow as aggressively given the but these are generational shifts. Emphasis is also respite in inflationary pressures, but we do not placed on capital programmes that would generate expect that they will be reduced dramatically due to employment opportunities and prevent the economy their socio-economic impact. Defence and security from entering a recession or at least not witness spending figures, which will be made public later an employment reversal, particularly for Saudis. in 2009, could receive an estimated 25% of the Capital spending for 2009 is budgeted at SR225 bn,

Budgeted Spending (2000 - 2009f)

550 500 450 400 350

(SR bn) 300 250 200 150 100 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009f

Source: SAMA and Ministry of Finance

5 Saudi Budget SABB Notes December 2008

up by 36% over last year’s appropriations reflecting 1. Education and manpower development are the authorities concern to push ahead with growth. allocated SR122.1 bn compared to 105 bn in 2008, Actual capital expenditure recorded a rise of 67.9% an increase of nearly 16.2% compared to an 11% in 2007 as a lot of the new infrastructure projects or increase between 2006 and 2007. Capital spending maintenance related ones started against an increase in this sector is budgeted to rise by a staggering of only 34.4% in 2008 compared to 17% in 2007. Spending 13.8% in 2006. Current expenditure registered an is spread across all levels of education, but particular increase of 7.7% in 2007 compared to an increase attention is paid to primary and secondary education of 13.5% in 2006. Current expenditure has made a with some 1,500 new schools in addition to 3,240 noticeable increase during this boom since 2005. schools under construction and the renovation of Between 2005 and 2007 capital spending has 2,000 existing school buildings. In particular some averaged 20% of total spending, which is above SR9 bn will be implemented on the King Abdullah the historic norm. The remaining bulk of budgetary Project for Education Development and on the expenditure is directed to current expenditure, mainly recently created Education Development Holding salaries. Company. This project should be carried over the A 15% public sector salary increase would cost the next six years and will be responsible for creating a state an extra SR48 bn per year. Attentive to the high-tech classroom environment in the Kingdom. needs of the Kingdom, the focus of the 2009 budget More than 400,000 teachers will be trained to handle is based on the same themes of previous budgets, classes in the high-tech style. including education, healthcare, manpower and infrastructure growth.

Budgeted Allocations by Sector

160 140 120 100 80 60 (SR bn) 40 20 0 Education & Manpower Health & Social Dev. Transportation & Telecom Municipal Services

2000 2005 2008 2009 (Budgeted)

Source: SAMA and Ministry of Finance

6 Saudi Budget SABB Notes December 2008

Budget 2009 - Sectorial Allocations 3. Water, agriculture and infrastructure will receive SR35.4 bn, with 73% of that money going towards capital spending. Of this total, SR13.3 bn is allocated Municipality Services Water, Agriculture, 4% Infrastructure 8% Real Estate Fund, to water, sewerage and desalination projects. Water Gov. Credit Institutions 16% and electricity demand is increasing by 7% per year Health & Social Development Transport, adding to the burden of providing additional capacity. 11% Telecommunication 4% In addition, the industrial cities of Jubail and Yanbu will continue receiving budgetary appropriations. Education 29% OtherSectors (incl. Defense) 28% Last year, the two industrial cities received appropriations amounting to SR7.6 bn.

Source: Ministry of Finance 4. Transportation and telecommunications are allocated SR19.2 bn over a budgeted SR12.1 bn For higher education, the new budget includes in 2008. With Saudi Arabia’s 56,000 km paved appropriations for the construction of the new female road network being one of the most modern in the university campus (Princess Norah University) region, financing has been dedicated for new roads in Riyadh, and the Medical City for King Saud totalling 5,400 km – besides the 30,000 km of roads University. Furthermore, the scholarship programme under construction. Development of ports, airports, will continue next year. Over the past four years, the railways and new postal services are also planned. Ministry of Higher Education has paid for 42,000 Saudi students to be educated abroad as part of 5. Municipality services will receive SR19.8 bn the King Abdullah Scholarship Programme. The compared to SR14.9 bn in 2008. New capital implementation of the National Plan for Science and spending will increase by 25% over the budgeted Technology called for a significant boost of SR8bn as amount for 2008. New projects include inter-city the country pushes forward to increase its capacity in roads, intersection and bridges and road lights, these two fields. which should help ease traffic bottlenecks. Traffic bottlenecks are of particular concern as major 2. Health and social affairs spending will be cities like Riyadh and Jeddah as well as Mecca are increased by 51.9% in 2009 to reach SR52.3 bn over reaching capacity limitations. Also, additional funds the budgeted spending of 2008 which amounted to will be allocated for sanitary, trash-collection, and SR34.4 bn. The bulk of the increase appears to cover other environment-related projects. For example, it the cost of staffing the large number of hospitals and was in 2007 that the government agreed to increase healthcare centres. This is in line with the Kingdom’s the Jeddah municipality’s five-year budget of SR450 attempt to modernize the public healthcare system. mn to SR900 mn, something that has made it possible Some 86 new hospitals will start to be built with for the municipality to go ahead with its previously 11,750 bed capacity. Saudi Arabia’s hospital bed-to- planned garbage collection programme that had been population ratio is above the regional average near postponed for the past four years due to the lack of the average but lower than other countries worldwide sufficient funding. that have comparable income levels.

7 Saudi Budget SABB Notes December 2008

2009: Revenues Oil: Never say never again

Revenues for 2009 are budgeted at SR410 bn. These This year has been a year of extreme revisions to are conservatively calculated given the fluctuation world oil demand. There is little doubt that demand in oil revenues expected for 2009. More than 88% for oil is expected to decline for 2008, the first time of this total is likely to be derived from oil, above since 1983 according to IEA data. For 2009, the U.S. the historical norm. The 2009 budget is based on Department of Energy expects worldwide oil a price of $37 per barrel of Saudi ($43 for WTI) at demand to fall by 450,000 barrels per day. OPEC an average 2009 production of 7.7 million barrels expects demand to be nearly flat (falling by 150,000 per day. We are not eliminating the possibility of an barrels per day) from 2008 to 2009. It is most likely output increase by Saudi Arabia at the second half of that the IEA will downward revise its demand the year but at the moment it appears remote. Saudi forecasts in early 2009. Clearly, oil prices defied Arabia maintained a conservative oil price for the those who were ready to call a paradigm shift only budget during the most recent oil boom. Up until too early. The so-called commodities super-cycle 2004 Saudi Arabia’s budget was based on an oil price was fed in part by demand but was helped to below $30 per barrel for WTI and it was only since overshoot due to speculation. The downward 2006 that it witnessed a rise above $40 per barrel. pressure we are now witnessing is similarly exaggerated. The availability of cheap credit fuelled that upward push, and the lack of credit going forward will keep it at reduced price levels.

2008 Preliminary Results

2008 2008 Actual SABB forecast

Real GDP (% change) 4.20 4.90 Nominal GDP (% change) 22.00 30.40 Inflation (%) 9.20 9.70 Current Account Balance (SR bn) 564.80 537.40 Government Spending (SR bn) 510.00 474.60 Government Revenues (SR bn) 1,100.00 963.43 Budget Surplus (SR bn) 590.00 559.70 Oil Exports (USD bn) 300.98 297.50

8 Saudi Budget SABB Notes December 2008

We are not born contrarians but we think that there Compliance will play a focal role but tends to is too much pessimism and too much optimism weaken during times of global economic slowdown. about oil prices in 2009. Either the call by some is for oil prices to average $25 per barrel for the next Saudi Arabia has cut its oil production more abruptly year or for oil prices to be at $65-75 per barrel. We within the last five months than it did in 1998-1999 do believe that global markets are short-sighted and when it reduced its daily production from 8.7 million some are hoping to have prices at below $75 per barrels in February 1998 to 7.4 million barrels by barrel in the hopes of a quicker global economic June 1999. For Saudi Arabia to reduce its own oil recovery. Although it is not improbable for oil production below 7 million barrels, as implied by prices to touch the levels of the pessimists, oil will OPEC’s most recent decision, will be difficult. rebound to a higher level but not reach the level of Hence, we realistically expect Saudi Arabia to the optimists. We forecast Saudi oil to average $37 average its oil production by around 7.8 million. The per barrel ($43 for WTI). Saudi oil production has major risk to our oil production forecast is on the fallen from a high of 9.7 million per day since the downside in the event of further deterioration in the summer to 8.2 million per day and is expected to fall global economy. by another 200,000 barrels by year-end.

The recent move by OPEC to announce cuts in Budget allocation Algeria of 2.2 million barrels, and despite a near term downward reaction, it does lead to volume In continuation to 2008 allocations, Saudi Arabian being taken out of the market. Although compliance Airlines again leads the way, receiving SR19.5 bn, a will be an important issue, if not the focal point, 12.1% increase. However, in percentage terms, the a 50-70% compliance with such a decision by Q1 ‘09 highest increase is that of the Red Crescent Society, would entail a substantial drop in demand. This does a surprising 122%, or SR1.4 bn in comparison not mean that OPEC will stop here. OPEC will most to 2008 SR630 mn, followed by a good 78.9% probably carry out another quota reduction decision. increase on the Food and Drugs Authority allocation.

2007 2008 2009

Amount (Million Amount (Million Amount (Million Riyals) % Share Riyals) % Share Riyals) % Share

Human resources development 96,483 25.39% 104,600 25.51% 139,100 29.28% Transport + telecommunication 11,329 2.98% 12,143 2.96% 19,200 4.04% Economic resources development 13,902 3.66% 16,317 3.98% Health services & Social Development 31,010 8.16% 34,426 8.40% 52,300 11.01% Infrastructure 5,188 1.37% 6,385 1.56% 35,400 7.45% Municipal services 13,576 3.57% 14,954 3.65% 19,800 4.17% Defense and national security 132,922 34.98% 143,336 34.96% Public administration, public security and General Items 61,756 16.25% 63,031 15.37% Government Specialized Credit Institutions 1,026 0.27% 479 0.12% 75,000 15.79% Subsidies 12,808 3.37% 14,329 3.49% 134,200 28.25%

Total 380,000 100.00% 410,000 100.00% 475,000 100.00%

9 Saudi Budget SABB Notes December 2008

Furthermore, funds for Saline Water Conversion These are preliminary figures as they are again Corporation and Railways Organization increased revised mid-year. A slight change in real GDP is by 51.3% and 39.3% respectively. Allocations always encountered as in the balance of payments on universities grew by almost 27%. The sum of accounts and inflation. budgeted funds for higher education has risen to SR26.9 bn from that of SR21.2 bn in 2008 with Jouf University and King Saud University being on top Real GDP growth of the league with percentage increases of 51.2% and 46.7% accordingly. The newly founded General Preliminary real GDP growth was estimated at 4.2%. Authority of Survey will receive some SR176 This is higher than the rate recorded in 2007 (3.4%) mn.(See Annex.) due to the oil production increases Saudi Arabia carried out until this summer. Thereafter, Saudi 2008: Macro-economic Arabia began a series of oil cuts which are estimated to reach 8 million by year-end. Real GDP lost more performance than 1% from its final tally due to a reduction in oil production. However, real GDP growth declined The budget contained the government’s preliminary due to a drop in non-oil private sector growth which figures for the macro-economic performance for the eased at 4.3% over 5.8% for 2007. Non-oil private year, in terms of real and nominal GDP, inflation, sector contribution to GDP accounted for 46% in current account surplus and broad money supply. 2008, adding to the downward pressure on real GDP.

GDP per Capita

16,000

14,000

12,000

10,000

(USD) 8,000

6,000

4,000

2,000 2000 2001 2002 2003 2004 2005 2006 2007 2008

Source: SAMA and Ministry of Finance

10 Saudi Budget SABB Notes December 2008

Lower than expected non-oil private sector growth increase against 4.7% in 2007. The wholesale, retail, is of concern despite high government spending. restaurants, and hotels sector saw a decline in growth, The non-oil private sector growth will find it hard to reaching 4.2% against 6.2% in 2007. Wholesale attain the same growth as in 2008. and retail have performed well all the way until Q3 ‘09 after which a marked decline in spending Transport and communications was the fastest began, reflected in lower sales for gray and white growing sector, at 11.4%, spurred by the rapid goods alike. This scenario is set to continue in 2009. increase in mobile phone use due to greater Business confidence levels look pale (see November competition, lower tariffs and greater internal trade Q4 ‘08 SABB Business Confidence Index). Finally, and mobility of citizens. The non-oil industrial finance, insurance and real estate fell by 2.2% against sector grew by 5.4% which is lower than the 8.6% it 3.7% in 2007. witnessed in 2007. Petrochemicals and plastics which comprise more than 50% of non-oil exports should have offered a nice run for export earners but are set Nominal GDP growth to fall in 2009.The slowdown in the non-oil industrial sector is set to continue in 2009. The construction Nominal GDP growth reached 22% as oil prices sector grew by 4.1% which is a substantial drop remained robust, yet very volatile, through 2008. from the 7.1% witnessed in 2007. The electricity, Nominal GDP reached SR1.753 bn (US $467.5 bn), gas and water sector grew by 6.3% which is an making Saudi Arabia not only the biggest economy in the GCC but the biggest in the Middle East.

SAMA Managed Foreign Assets

600 546

500

400 359.8

271.7 300 193.7

(USD bn) 200 128 98.1 100

0 2003 2004 2005 2006 2007 (Oct) 2008

Source: SAMA and Ministry of Finance

11 Saudi Budget SABB Notes December 2008

An ace up the sleeve? clearly less of concern for the authorities in Q4 ‘08. Foreign Assets Saudi Arabia will become a net importer of deflation which will be reflected in imported prices. Lower domestic demand will put further downward It might be a surprise to many but Saudi Arabia’s pressure in 2009. Real estate prices are already on a foreign assets are an advantage that many would corrective trajectory which will also deflate domestic now covet. A year ago, the region was in a global prices further. acquisition spree and many were those who were ready to criticise the authorities as well as SAMA for not becoming similarly aggressive in their Current account surplus: outward investments. SAMA’s «conservative» A record high outlook has proven them right as capital preservation has been maintained now that the economy is facing considerable export revenue headwinds. The current account surplus reached SR564.8 bn There are those who might explain Saudi Arabia’s ($150,6 bn) compared to the SR354.3 bn ($94.5 ability, and SAMA’s, to maintain its foreign assets bn) in 2007. In 2009 Saudi Arabia is still expected and accumulate them as part of some unintended to have a current account surplus albeit a drop by consequence. This is incorrect. SAMA is the only more than 80%. Although a full breakdown is not central bank that has the required institutional history provided, it can be assumed that higher imports could to remember that when there is an oil boom there is account for a slightly lower current account surplus. an oil bust that follows at some point. Saudi Arabia Oil export receipts appear to have increased to a will be able to amply deploy some of its estimated preliminary estimate of SR1128.6 bn ($300.9 bn). $546 bn in total foreign assets (October 2008) They could very well increase by another $5 bn by managed by SAMA to cover the government’s outlay year-end and would show up in the revised figures programme. It is important to note that in 2007 alone through 2009. Although oil production fell, oil prices Saudi Arabia received SR56 bn in investment income went on an unexpected bull-run for part of the year. from abroad. We expect investment income to reach Non-oil exports also performed extremely well, more than SR101 bn. Some of that income can be increasing by 10% to SR115.0 bn from SR104.46 bn deployed (with some impact on the current account in 2007. We believe that the increase was mainly due balance) as well as deploy capital from principal to a rise in the value and volume of exports. With the foreign assets to cover the Kingdom’s expenditure region booming in 2008, the value and volume of requirements. construction materials, agriculture and food products as well as petrochemicals helped increase non-oil exports to a historic high. Imports grew by 12% in Inflation 2008 to reach SR610.0 bn. We do not expect the volume of exports to be sustained in 2009, and we do Consumer price inflation reached 9.2% up from anticipate a lower import bill due to lower demand 4.1% in 2007. We do not see any inflationary risks but also lower import prices. Also, the economy has in 2009. On the contrary, inflationary concerns have reached what we believe are capacity constraints in its absorptive capacity for import.

12 Saudi Budget SABB Notes December 2008

Broad money supply 2009: A slowdown is unavoidable Broad money supply (M3) expanded by 14% in 2008 during the 10 months to the end of October. Money We expect a year of slower performance in 2009. supply growth should subside but its velocity would Consumer spending should slow down as pessimism depend on the growth of government investments and unfolds. We anticipate oil production to fall in 2009 spending as well as lending growth of local banks which will translate into lower real GDP growth. to the private sector. We expect the latter to slow The current account balance will drop substantially down from a high of more than 32% year-to-date to with a surplus maintained. Inflationary pressures are around 10% but money supply will depend on the certain to subside in 2009. Inflation will still remain availability of credit facilities to the private sector. above historical lows but its decline will depend Lower money supply growth should put downward on domestic demand, the extent of the correction pressure on inflation. During the slow years of the in real estate prices and subsequently rents, lower 1990s, money supply grew by approximately 6-7%. import costs and finally the ability for banks to have aggressive lending patterns in a low interest rate environment. The issue will be the pace of the lower import costs and the pass through effect to the final consumer. We believe that the latter will witness a slowdown even if interest rates are fast

Government Domestic Debt

140

120

100

80

60 % of GDP 40

20

0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Source: SAMA and Ministry of Finance

13 Saudi Budget SABB Notes December 2008

falling. Going forward, our preliminary forecast for forecasts for nominal GDP, government revenues, 2009 is as follows: real GDP of 0.8% and inflation budget surplus, oil exports and current account of 4.8%. Real GDP would obviously change in the surplus. We were close in estimating real GDP event of a change in average oil output for 2009 growth; we forecasted a growth rate of 4.9% beyond our forecast or in the event of robust private compared to the official rate of 4.2%. In 2007, we sector growth. There are two downward risks: had overshot our GDP forecast by 0.2%. We were (A) the amount of spending and overspending the a bit better in predicting real non-oil private sector government will undertake in the coming fiscal growth assumptions. We had predicted a 5% growth year; and (B) how will the private sector feel the rate for the 2007 non-oil private sector, which was trickle down of government spending and how far lower than the 4.3% that was announced earlier. Our will it contract in 2009. We believe that the private inflation forecast for 2008 was again very close to sector will undergo one of its toughest years in its the announced figure. We had forecasted inflation recent past. to reach 9.7% in 2008 against an official estimate of 9.2%. Our government spending forecast was Finally, forecasting in an oil based economy is SR474.6 bn with the announced figure being SR510 not simple. Predicting oil price movements and bn. In addition, our budget surplus estimate of production includes many unpredictable factors. SR559.7 bn was not that far off from the announced Very few predicted the rise in oil prices to reach figure of SR590 bn. Finally, we had forecasted oil around $147 per barrel as oil markets behave in export revenues to reach SR1116 tn ($297.5 bn) and a very volatile manner. We predicted oil prices to preliminary figures show that revenues will amount behave robustly in 2008 which did not distort our to SR1128.7 tn ($301 bn).

Real Government vs Private sector growth

10.0 8.0 6.0 4.0 2.0 0 -2.0 -4.0 % Growth change -6.0 -8.0 -10.0 1982 1983 1984 1985 1986

WƌŝǀĂƚĞƐĞĐƚŽƌͲйŐƌŽǁƚŚ WƵďůŝĐƐĞĐƚŽƌͲйŐƌŽǁƚŚ Source: SAMA

14 Saudi Budget SABB Notes December 2008

What can be done to avoid Kingdom has earmarked over the next four years. systemic risks? Some of these credit issues can be facilitated by: (A) The state boosting its role as a project financier We don’t believe that turbulence in global financial (through institutions such as the Public Investment markets is necessarily all that bad for Saudi Arabia. Fund). As sources of international funding are very In many ways, it brings certain realisation to policy- limited, the state could invest in key strategic areas of makers and businessmen alike that the “good times” the economy similar to investment projects planned can’t always last forever. For the policy makers, it in the U.S., Europe and China. Also the government is an opportunity to re-prioritise projects and place can provide funding by issuing development bonds in particular focus on projects (both state and private- order to fund a lot of the planned projects. sector led) that have direct impact on diversification and employment generation. For the government (B) The banking system in Saudi Arabia is not the biggest lesson that could be drawn is that of witnessing a liquidity problem, there is surplus anticipation. For businessmen, it is an awareness of liquidity in the banking system. Banks are challenged the need for investments to be re-prioritised on finite to find long-term deposits to structure their balance sources of credit and that bubbles do burst. For the sheets for optimal growth and have to rely on short private sector, the biggest lesson that could be ones. Helping banks increase their loan-to-deposit learned is planning for the lack thereof. The private ratio so as to maintain their lending capacity to the sector is particularly affected during this global crisis private sector is also crucial. Banks are challenged as their investments have been negatively impacted to find long-term deposits (sticky deposits) and abroad, in the region and within the Kingdom. these need to grow if the loan-to-deposit ratio is not We have never lost sight that the state in Saudi violated. SAMA has been quite creative in trying Arabia plays the most critical role as a provider of to address the issue of credit capacity constraints in confidence, and it is now more so than any other time the banking system. We have been noticing lately that the state needs to step in. We believe that Saudi that government entities which have limited long- Arabia today is very well placed to ponder about term deposit constraints like GOSI, PIF and the the pace and direction of the development model Public Pension Funds have been placing deposits in but certain steps have to be taken to address short to the banking sector. This is a welcome first step that medium term issues, including: allows SAMA to manage liquidity quite well but also generate long-term assets. Private sector growth - Turbulence and credit tightness in international will not be easily attained if private sector credit financial markets will increase dependence on allocation is curtailed. The burden of development local financing. We do not expect that global will lie on the public sector and that would have credit tightness will unwind in 2009, resulting in serious crowding out effects if structural changes project finance uncertainty for large infrastructure are not enforced. Credit to the private sector, which and development related projects. Domestic had increased over 500% during the period 1976-81, banks do not have the capacity to withstand the grew only at an annual rate of less than 4% per year financing needed for the $400 billion projects the over the next five years.

15 Saudi Budget SABB Notes December 2008

(C) There could be an encouragement for banks to opportunity for the state to push ahead with many issue bonds purchased by the government in support of its infrastructure projects. of the funding base of the banks. Creating a medium to long term debt market should be the goal behind - Housing projects for low-income Saudis have such a step, as well as a secondary market. Long term to continue as they have important income and debt creation would allow banks to restructure their social ramifications. We continue to believe that lending facilities from short term to more long-term housing for the medium-income citizens also dated ones. Also, debt should also be allowed to rise needs to also be addressed with the state playing above paid up capital. Growth at the moment is now a central role. a priority for everyone. The economic difficulties of the mid-1980s led to a significant increase in banks capital with the encouragement of SAMA. During There is no doubt in our mind that the authorities the period 1988-93, seven of the 12 Saudi Banks took the appropriate fiscal corrective measures to increased their capital through new share flotation. provide confidence in the market. We have been As a result, the capital and reserves for the banking calling for an expansionary budget since the outset system had doubled from SR15 bn at end of 1988 to of Q4 ‘08 reflecting on the negative messages we SR30 bn by end of 1993. have been receiving via our business confidence surveys. Now it is up to the government to actually spend the money in 2009 and create the mechanisms - The government during these challenging times for the private sector to benefit from the spending needs to continue to pay contractors on time in outlays of the state. Of particular importance is order to push important trickle down payments the SR225 bn in capital expenditure set out by the to sub-contractors as well as the rest of the 2009 budget where the bulk of it should involve the economy that feed into the contracting sector. private sector. Certainly, we are not out of the global Contractors play an important role in providing economic recession and we cannot foretell what will trickle down cash into the economy. Up happen in 2010. It could be another difficult year front deposits of 20% that are now paid by which Saudi Arabia should be able to weather albeit the government could increase. The cost of anemic growth. construction has subsided and should offer an

Mr. Turki Al Hugail Research Analyst Tel: +966 1 276 4974 Email: [email protected]

16 Saudi Budget SABB Notes December 2008

Annex – Budget Allocations to Semi-Autonomous Institutions (SR Million) 2009 Description 2003 2004 2005 2006 2007 2008 2009 % change

Saudi Arabian Airlines 11,280 12,580 13,595 15,663 15,632 17,400 19,503 12.1

General Sea Ports Authority 455 437 466 548 683 827 1,067 29.1

Grain Silos and Flour Mills Org. 451 457 506 632 682 915 935 2.3

Saline Water Conversion Corp. 2,245 2,350 2,256 2,978 3,926 5,053 7,646 51.3

Royal Commission for Jubail and Yanbu 2,273 2,439 2,729 4,015 4,579 5,584 6,718 20.3

General Org. for Military Industries 716 774 793 870 925 1,063 1,206 13.4

King Abdulaziz City for Science and Tech. 504 516 520 599 705 858 1,115 30.0

Saudi Red Crescent Society 295 340 418 510 587 630 1,399 122.0

General Saudi Railways Organization 145 143 421 730 795 824 1,147 39.3

Saudi Arabian Standards Org. 87 98 105 124 141 156 162 3.7

Telecommunications & IT Authority 80 100 185 300 280 300 396 32.0

Saudi Arabian General Investment Authority 80 80 83 98 142 104 136 31.6

Supreme Tourism Commission 125 150 157 185 222 347 385 10.9

Saudi Geological Survey 111 111 117 148 148 146 165 12.5

General Administration Institute 203 202 200 248 268 288 340 17.8

General Organization for Technical Education 1,540 2,004 2,488 3,309 3,412 3,434 3,735 8.8

King Saud University 2,403 2,420 2,608 3,117 3,189 3,698 5,424 46.7

King Abdulaziz University 1,538 1,500 1,602 1,903 1,895 2,468 2,907 17.8

Imam Muhammad bin Saud University 1,250 1,170 1,223 1,500 1,629 1,866 2,193 17.5

King Faisal University 773 867 994 1,273 1,335 2,165 2,741 26.6

King Khalid University 422 469 599 662 763 1,399 1,975 41.2

King Fahd University for Petroleum and Minerals 574 622 681 781 785 822 921 12.1

Umm Al-Qura University 745 673 754 993 999 1,493 1,694 13.4

Islamic University 288 310 317 407 407 431 494 14.6

Pension Fund 29,480 32,730 ------

Qassim University - 309 378 659 710 1,096 1,297 18.3

Taif University - 122 178 303 367 775 936 20.7

Taiba University - 178 257 345 404 890 1,151 29.3

Jizan University - - - 151 220 541 721 33.1

Jouf University - - - 130 190 459 695 51.2

Hail University - - - 135 155 481 588 22.3

Tabuk University - - - - 104 364 500 37.4

Baha University - - - - 101 324 446 37.8

Najran University - - - - 113 320 399 24.6

Northern Border University - - - - - 316 444 40.6

Norah bin Adbulrahman University - - - - 1,123 1,358 1,426 5.0

Food and Drugs Authority - - - 96 129 220 394 78.9

Saudi Postal Organization - - - 1,329 1,469 1,516 1,796 18.5

Civil Aviation Organization - - - 2,737 3,063 4,764 5,150 8.1

King Faisal Specialist Hospital - - - 2,519 2,691 3,364 3,879 15.3

Human Rights Commission - - - - - 52 56 7.0

General Commission for Housing - - - - - 69 74 7.4

General Authority of Survey ------176 -

Source: Ministry of Finance 17 Saudi Budget SABB Notes December 2008

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18 Flashnote abc Global Research

Economics EMEA/Middle East Saudi Arabia’s fiscal package

No panacea  Saudi Arabia faces its largest deficit in a decade this year

 Funding is available, but a 50% drop in revenues will weigh on expenditure plans

 Spending is still likely to rise but the stimulus will be insufficient to prevent economic growth from slowing sharply

No panacea The 2009 budget is the first in five years to anticipate a deficit. Significantly, the budget included a very large increase in budget allocations despite also anticipating that weaker oil prices would lead to a sharp drop in fiscal revenues. However, the conclusion that the budget was highly expansionary – a Gulf equivalent of the fiscal stimulus packages being announced around the world – seems premature.

A closer look at the budget shows that while the sums allocated by the ministry of finance for spending in the 2009 budget are higher than those proposed for 2008, the total is lower than actual expenditure last year. If the government were to stick to the budget in full, expenditure would actually fall 7% y-o-y. We are not suggesting that expenditure will fall. Public spending in the kingdom has run well ahead of target for many years, as it almost 12 January 2009 certainly will in 2009. We do believe, however, that the sums allocated in the budget

Simon Williams* should be taken as no more than a loose guide to spending trends. Economist HSBC Bank Middle East Ltd Our expectation is that while policymakers will allow spending to rise, it will not be by +9714 423 6925 the eye-catching 16% figure highlighted in the budget. We are cautious of spending simon.williams@.com intentions, in part because the government would struggle to disburse an additional USD22bn (a 16% increase on last year’s outlays and the equivalent to 7% of total View HSBC Global Research at: domestic demand) effectively within a 12-month time span. http://www.research.hsbc.com *Employed by a non-US affiliate of More significantly, we believe the speed with which Saudi Arabia’s fiscal revenue HSBC Securities (USA) Inc, and is not registered/qualified pursuant to NYSE position has deteriorated, and uncertainty as to how far earnings may yet fall, will and/or NASD regulations encourage restraint. Oil makes up roughly 90% of the government’s revenue base, and Issuer of HSBC Bank Middle East Ltd working with our assumption that Brent will average USD45/b in 2009 and that OPEC report: production cuts will be maintained throughout the year, we expect Saudi Arabia’s fiscal Disclaimer & earnings to fall by close to 60% y-o-y. This pace of decline is without precedent and is Disclosures likely to constrain policymakers, who have keen memories of the chronic deficits run This report must be read throughout the 1980s and 1990s. with the disclosures and the analyst certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it

Economics EMEA/Middle East abc 12 January 2009

Dramatic revenue decline will weigh on spending growth, but not reverse it

350 40 300 30 250 200 20 150 10 100 - 50 - (10) 2003 2004 2005 2006 2007 2008 2009

Govt revenue (USD, bn) Ex penditure (USD, bn) Balance (% GDP)

Source: SAMA, HSBC

Against this backdrop, our projection that government spending will rise by some 8% is bold. However, the kingdom’s fiscal performance over the past five years has been so strong (the budget has generated a cumulative surplus since 2003 of more than USD350bn) that policymakers have room for manoeuvre. Recurrent spending will rise – the government is already committed to increasing public sector salaries – but the most marked gain is likely to come in capital expenditure focused strongly on physical and social infrastructure.

We expect this to leave the government with a budget deficit of around 7% of GDP. The shortfall is the largest in a decade but amounts to just one-fifth of the surplus recorded last year, and near-term funding should not prove problematic. During the oil boom years, the government paid down its debt stock from over 100% of GDP to just 15%, giving it ample scope to raise funds locally. To avoid crowding out the private sector, the government can also elect to draw on foreign assets currently worth in excess of USD400bn.

The increase in public expenditure – and the government’s readiness to run deficits after years of surplus – will offer some support to the domestic economy. We continue to look, however, for a sharp slowdown in the pace of economic growth. Provisional economic growth data for 2008 issued with the budget was disappointing. Headline growth reached only 4.2% last year, short of market expectations and below the six-year average for the oil boom period. Private sector growth was recorded at just 4.3%, the slowest pace of increase since 2003.

2 Economics EMEA/Middle East abc 12 January 2009

Non-oil growth will weaken for a third consecutive year

8 100

6 80

4 60

2 40

0 20 2003 2004 2005 2006 2007 2008 2009

Real grow th (%, LHS) Non-oil grow th (%, LHS) Av g oil price (RHS, Brent USD/b)

Source: SAMA, HSBC

While growth in government recurrent and capital spending will afford some support to private sector activity over the coming year, it is unlikely to offset the growing difficulties consumers and corporates face accessing finance, and will not reverse fragile private sector sentiment. With OPEC-mandated production cuts weighing heavily on oil sector output, we expect overall growth to fall below 1% this year, with the risks to our forecast weighted strongly to the downside.

3 Economics EMEA/Middle East abc 12 January 2009

Disclosure appendix

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This report is designed for, and should only be utilised by, institutional investors. Furthermore, HSBC believes an investor's decision to make an investment should depend on individual circumstances such as the investor's existing holdings and other considerations.

Analysts are paid in part by reference to the profitability of HSBC which includes investment banking revenues.

For disclosures in respect of any company, please see the most recently published report on that company available at www.hsbcnet.com/research.

* HSBC Legal Entities are listed in the Disclaimer below. Additional disclosures 1 This report is dated as at 12 January 2009. 2 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its Research business. HSBC's analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBC's Investment Banking business. Chinese Wall procedures are in place between the Investment Banking and Research businesses to ensure that any confidential and/or price sensitive information is handled in an appropriate manner.

4 Economics EMEA/Middle East abc 12 January 2009

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