Analysis on Saudi Arabias Fiscal Policy and the Oil Prices - Assignment Example

? Analysis on Saudi Arabia's Fiscal Policy and the Oil Prices Table of Contents Executive Summary 2. Introduction 3. 3. Key Fiscal Policy Challenges Stemming From Hydrocarbon Dependence 3.1: General Challenges 3.1.1: Long- Term Issues 3.1.2: Short-Term Issues 4. Reacting To Falling Oil Prices and the Global Economic Downturn 5. The Hidden Energy Crisis 5.1 Overview 5.2 Saudi Arabia Consumption Problem 5.3 Impact on the International Oil Market 5.4 Escalating Demand and Social Insecurity 5.5 The Role of Energy Prices 5.6 The Cost to Society 6. Policy Recommendations 6.1: Shrinking the Government 6.2: Diversifying the Economy 6.3: Energy Prise Reform 6.4: Regulation for Increased Efficiency 6.5: Adding Renewable Source of Energy 6.6: Nuclear Power Ambition Executive Summary The fiscal policy of any nation is the backbone of its prosperous future. The fiscal policies of oil exporting countries are viewed with concern all over the world because oil price is the determining factor of prosperity for all the world’s leading nations. Saudi Arabia is a prominent oil exporter of the world. Its economic policies influence the cost of oil it is exporting directly and the industrial development of many other nations indirectly. Though Saudi Arabia’s fiscal policy is appreciated as a balanced and best one by reputed institutions like International Monetary Fund (IMF), there are countless untold issues hidden under it. Oil is a highly diminishing form of natural energy. The government is taking many productive steps to protect this sustainable energy and thinking about alternate ways of employment, other than oil drilling. The paper discusses the important issues on Saudi Arabia’s fiscal policies and gives useful recommendations to overcome them effectively. Introduction King Abdal Aziz ibn Al Saud created the Saudi Arabia kingdom by uniting several small Arabic nations together in 1932. This Middle East Peninsula covers over 2.23 million square kilometres, most of which are oil rich desserts (Hitti & Abed, 1974). Oil drilling became an important and thriving business in the area by 1950's. Since then drilling oil has been main occupation of the nation for the past 7 decades. All the progressive measures of the government from improving infrastructure to transport facilities depend upon the profits generated by the oil exported to the developed countries. The countercyclical fiscal policies of Saudi Arabia won accolades around the world by the way it handled the global economic downturn in 2008-2009. The savings of the surplus during the last 5 years enabled the government to manage the recession with poise and comfort. But, there were several hidden truths behind this. Thousands of labours or manual workers lost their job in the recession. Planes were booked in bulk to transport these people back to the eastern countries where they came from. Several major construction projects related to the industrial and infrastructure needs of the country were stalled until the world economy regained itself. According to the neoclassical growth model in economy, the long-term growth is determined by continuous supply of productive resources and productivity. The governments expansive spending doesn’t seem to give importance to the productive supplies. If the countries major plans startle, at the minor oil rate infraction due to problems in the world economy, how adverse would the effects be if the sustainable oil is depleted completely. Saudi Arabia cannot take a single stand in this issue. It should consider the stand of its neighbouring countries exporting oil too. Here is a table showing the list of its oil exporting co-countries. Figure Reference: (Sturm, M. Gurtner, Francois & Alegre, J, 2009, p - 8) Considering the fiscal performance of all the major oil dependant countries like Algeria, Nigeria, Russia and Saudi Arabia, the main problems faced by them are 1. The sudden sharp fall of oil price 2. The highly sustainable natural resources 3. The challenges arising out of specific domestic issues (Low cost oil subsidy in Saudi Arabia, internal terrorism in Russia, lack of technology in Algeria) The paper analyses these core issues and provides recommendations on how Saudi government should handle these issues in the future effectively, without affecting the mainstream population’s employment. 3. Key Fiscal Policy Challenges Stemming From Hydrocarbon Dependence The first and foremost challenge is to manage the change in oil price. This can be done by achieving intergenerational equity. That means every citizen should be able to enjoy the same good and facilities available during the prosperous times, even when the oil price is low, without having to pay extra taxes. The government should take steps to ensure there is proper stack of goods purchased and stored during the prosperous times, to handle the insufficiency when the oil price is low. This is easier said than done and is actually quite harder than maintaining a stable economy. But there are ways to do the same effectively. 3.1: General challenges Barnett and Ossowski mentions problems in oil exporting countries arise because the cost of oil is mainly determined by the foreign powers and the source is exhaustible and volatile. Oil sector being the only largest industry in the country, the governments of all the four oil exporting nations should join hands to keep the oil price in check by controlling over drilling and negotiating profitable contracts with the foreigners. 3.1.1: Long- term issues What happens when there is no more oil to drill one fine day? The developed countries will switch to some other alternate means of power source. But, what about the 27 million people whose life source depends upon oil? The government should make sure a particular amount of wealth is accumulated during the 'oil age' to be distributed to its citizens in the time of 'post oil-age'. They should start investing in various economic assets and encourage their countrymen to do the same. Alternate means of employments should also be created. In short, oil wealth should be simply transformed into financial wealth. The figure shown below illustrates the same. Figure Reference: (Sturm, M. Gurtner, Francois & Alegre, J, 2009, p - 17) This is not an impossible task, if the government plans accordingly. With a country were agriculture production is very little, government should come up with new ideas to promote tourism, manufacture and market, products which will sell in the domestic as well as international markets and educate people on various technologies other than oil drilling. How exactly can the government do this without investing expansively? This question is the base for this paper. Whether to invest the oil wealth in industries generating new employments and alternate means of living or save the money and pass it on to the upcoming generations instead of oil wealth is a million dollar question. The fiscal policies of Saudi Arabia largely depend upon the answer for this question. The government did try investing in various other industries with the money earned in the past five years. But, the recession affected them badly, making many leaders reconsider their decision. Financial asset accumulation is gaining importance in the past couple of years. The graph is a representation on maintaining fiscal revenue generation through asset accumulation. Figure Reference: (Sturm, M. Gurtner, Francois & Alegre, J, 2009, p - 18) 3.1.2: Short Term Issues The major short term issues faced by the oil exporting countries including Saudi Arabia are the unpredictable oil prices and the volatility in the market. We have to examine the government expenditure and the non-Oil GDP in the country to know how the investments influence the country’s economy. If we examine the economy of Saudi Arabia using the time-series method, we can see government spending has largely affected all other industries other than the oil in the period starting from 1969 - 2005. Though the expenses were generally non-profitable, the capital expenditure exceeds the current expenditure, most of the time, making it a very low growth sector. Consider the government spending on education sector and infrastructure. Building schools and colleges help create many teachers and scholars and introduce new technologies to the nation. It is a low or no growth investment in monetary terms, but is profitable in terms of creating employment and more tax- paying citizens. Investing in infrastructure creates many new factories, which yield revenue to the government, but it will take a long time to regain the capital invested. The volatile price of the oil market and the constant changes in the government policies about spending on other areas will lead to a pro-cyclic pattern which will hinder the long term investment planning adversely. Considering the volatile nature of the oil prices, many sheiks prefer to save their money in the available from of gold or wealth, instead of investing it in industrial sectors and waiting patiently amidst million if's and don’ts for profit. Their concern on how to depend upon such slow growth markets cannot be neglected. But the government should encourage them do so for the benefit of the public and compensate them through grants. How to make the non-oil GDP of the country increase steadily? A linear adjustment method where the profits earned through the sector will be left untouched and the surplus in the oil market will be used to improve them for a short period will help. Once the industries like military and education sector has grown to a considerable level, the GDP earned by them will be equivalent to that of the oil GDP. While many experts still feel the linear adjustment model will consume too much considering its minimal returns, it is the only productive way to bring up other industries other than the oil sector in these countries. Requesting the major world economies to finance the deficits during the delicate times and compensating them in times of surplus production with oil prices is another method suggested. But, it has its limitations as well because, the oil prices get low only if the developed nations themselves face critical economic issues. There is no guarantee they would be able to help in such situations. 4. Reacting To Falling Oil Prices and the Global Economic Downturn Can oil exporting countries prevent budget deficits even the oil prices are falling? They can until a point known as “fiscal break-even" occurs. Small countries like Nigeria have low break-even points, while Russia, Saudi and others have higher break-even points. Though the oil prices continue to stay low, the 2009 budgets of many major oil exporters like Saudi Arabia showed lots of interests in further investments. This is possible because many investors have accumulated large amount of foreign assets during the surplus time. They have very low debts and are ready to compromise a percentage of oil profits to bridge short term volatilities and avoid pro-cyclicality of fiscal deficits. Though this reflects in rising inflation, and the fiscal adjustments prove very difficult, the companies are willing to do the same to avoid debt and the overall growth of the nations. Saudi Arabia is very keen on diversifying its economy and believes it is the best way to handle volatile oil prices in the long run. The IMF clearly stated the Saudi governments so called 'second-generation reforms' in all sectors like education, judiciary and technology will help them boost the private sector and pave way for a liberalised and open trade system. This will lead to massive growth of many non-oil sectors in a few years time (Kamco, 2011). Considering inflation, the ever increasing food products price will make it touch a record 6% (Albawaba, 2011). The housing rates will be very high, and all general non-oil commodities cost will rise. But, the inflation will start to decrease, once the oil prices starts to increase again. Though the prices won’t come down massively, people will have enough money to buy what they want. Saudi Arabia willingly takes this risk keeping in mind the long term priorities of the nation. To handle the near-term price rise, the government aims in lending more credits for small and medium enterprises, housing sectors and maintain an overall positive business environment in both the oil and the non-oil sector. 5. The Hidden Energy Crisis 5.1: Overview Amidst all praises for Saudi Arabia's foresight on future and dedication in framing the public beneficial fiscal policies, there arises a non avoidable question - what is the motive? Do they really go out of the way to incur the high inflation rate and minimal profits because of national concern or are they forced to do so by some unavoidable reason? These questions haunt the minds of several experts and other oil-exporting countries all over the world. Is there a hidden crisis and if so, what is it? How will it affect the world oil prices? Lahn and Stevens elaborates on the same in their paper “Burning oil to keep cool”. Believe it or not, Saudi Arabia does not have enough oil to meet its domestic needs, leaving alone the exports. Drilling oil has adverse environmental effects. Over drilling for decades, have left the area like a burning furnace, that all the energy produced is in-turn used to operate air-conditioners and coolers to stay alive from being fired by the hot sun. Electricity shortages are already rampant in many areas of the country. The developing tourism sector which draws revenues through massive hotels and resorts, consume power like a hungry dragon. Saudi Arabia’s demand for oil and gas is growing by 7% per year and it will double in a decade, if the non-oil sector investments continue to grow in the same phase. The country is in a crucial position, unable to fulfil its own domestic needs because the oil reserves have already been dug to the core. The country is under pressure to find an alternate means of revenue other than oil export and hence such massive but productive compromises. 5.2: Saudi Arabia Consumption Problem Oil balance as a business–as–usual trajectory Figure Reference: (Lahn, G & Stevens, P, 2011, p-2) Saudi Arabia consumes nearly one quarter of its own oil production. Look at the graph given above. Most of the oil and gas used by the locals are sold at a very cheap rate. Many non-oil oriented industries like schools and hospitals get huge subsidies on the fuel used. If the local consumption of oil and gas continues to grow at an alarming rate, the country will be importing oil by 2038. The figure above shows how the oil exports will decline with time. The government is trying frantically to curb the population, find new oil reserves and use alternate methods of cooling systems in the five star hotels and resorts spurting out like a rainy season mushroom anywhere and everywhere in the country. These tourism attractions are advised to showcase the ethnic living style of the country rather than feature themselves as ultimate luxury houses. Fiscal Deficit on a business as usual trajectory Figure Reference: (Lahn, G & Stevens, 2011, p-3) The chart above shows how the monetary earnings from oil keep decreasing year by year. The Saudi Arabian kingdom is becoming highly dependable on the foreign debts to maintain the investment, important for diversifying the economy. Out of the 27 million populations, nearly 8 million are emigrants and they have all the lucrative jobs available in the market. Nearly 20% to 30% of Saudi’s population is aged below 14. Unemployment will be a serious problem in a decade when they are ready for the labour market. So curbing the investments in non-oil sector is no option. This is another main reason Saudi Arabia's fiscal policies give ample importance to new industries. Figure Reference: (Lahn, G & Stevens, 2011, p-5) This chart shows the per capita power consumption of all major world countries. We could see that Saudi Arabia even exceeds US power usage marginally, though it is much smaller than the US geographically. The country comes second to Canada in power consumption. Most of the power in Canada is used for heating residential and official structures while most of the power in Saudi Arabia is used to cool the same. 5.3: Impact on the International Oil Market Saudi Arabia has the capacity to produce 12.5 million barrels of oil per day (mb/d). At present it produces mostly crude oil and natural gas liquids measuring around 10 mb/d. Nearly 6 - 7 million barrels of the day's total production are exported. If Saudi Arabia's domestic consumption continues to grow at the same level, the country will be forced to reduce its exports to 3 million barrels per day. This will put a dead end to Saudi's regulatory dominance over the world oil market, affecting the oil prices in the world market drastically. Countries like Iran and Iraq will be forced to dig more and more by the foreign investors. There would be no one to regulate the price and havoc will break loose if Iran and Iraq doesn’t comply with the western norms and requirements. However Saudi government is confident that they have plans to increase the oil production from the current rate to 10.9 mb/d of oil and NGLs by 2020 and 11.6 mb/d by 2025. They believe this extra oil will be enough to meet the domestic needs and the export level will continue as ever, reassuring Saudi Arabia’s prominent position in the world as one of the major oil exporter in Middle East. 5.4: Escalating Demand and Social Insecurity Air conditioners in Saudi Arabia consume up to 52% of the total electricity produced in the county. Most of the oil and gas in the country is used to produce electricity. Water is another quickly diminishing source in the country. Ample water is required to produce electricity, which hinders the growth of minimum agricultural lands in the country. They are forced to use the underground water at high cost. The second major field consuming oil and gas in Saudi Arabia is the automobile industry. Currently, there are only 230 vehicles per 1000 people, but the estimate is expected to double and triple within the next decade. The government is digging in new ways to multiply electricity production with minimum water usage constantly. Nearly 50,000MW23 of electricity is produced per year. But, many areas go without power during the summer season. Living beneath 50 degree hot sun is no easy task. Children are affected by sun strokes quite easily and the elderly suffer numerous inconveniences. A wide spread annoyance and insecurity prevails throughout the country during summer, when enough electricity isn’t supplied to the public. People start criticizing and demand the government to attend the local needs first instead of earning through exports. 5.5: The Role of Energy Prices To curb the above mentioned protests against the government, Saudi government introduced very low cost gas and diesel in the country. The chart below shows the diesel and gasoline prices country wise. Most of the Asian countries price their oil three to four times higher than Saudi Arabia. When questioned about such low prices, Saudi Arabia demonstrated to WTO that as a dominant oil producer of the world, they feel legible to give their own citizens, best quality oil at the most affordable price possible. . Even when the ‘inefficient fossil fuel subsidies’ issue was raised in the G20 summit, the Saudi authorities shielded themself claiming the price they supply gas to their own citizens isn’t ‘inefficient’ to them. Figure Reference: (Lahn, G & Stevens, 2011, p-11) If the Saudi Arabia government continues to distribute oil at a low cost for a long time, it will be hard to curb the practice later. The people who use this fuel in the subsidy amount aren’t the extended family of the sultans who never have to pay for the benefits. It is the lower middle class and the poor people who rely on them. They use the oil and gas to cook and cool their living place. Encouraging them to buy the essential oils for a long time in a low cost and increasing its cost suddenly after a certain period will affect them drastically 5.6: The Cost to Society What is actually wrong with a nation supplying low cost fuel to its citizens? The idea isn’t as light as it seems. There are many skin deep problems associated with it 1. Only low quality fuel is given out as subsidy. Mostly the poor get to use it. It increases pollution massively and takes a toll on the user’s health and the general public health when used in increasing number of vehicles. 2. The price of a barrel of oil produced in the neighbouring UAE is seven times higher than that of the oil available in Saudi Arabia. This leads to high range smuggling across the border, affecting the economy of other countries as well as posing a serious threat to Saudi Arabia's law and order. 3. Saudi Arabia wants to sustain most of its foreign clients by providing low cost fuel to them and make them dependable on it for a long time. Former subsidizing moves similar to this have only resulted in dramatic failure. Experts warn Saudi Arabia to wake up now before it is too late. 6. Policy Recommendations Bringing down the power subsidies will cause lot of insecurity and unrest among the citizens. Hence, the government should come up with alternate means to handle the issue and improve its fiscal policy. Here are some recommendations. 6.1: Shrinking the Government Size Using the endogenous growth model and the Vector autoregressive (VAR) analysis, some experts state that the size of the government is directly linked with a countries economic growth. With the huge budget deficit, Saudi Arabia will not be able to cut down on debts and frame progressive fiscal policies, if a major share of the countries earning is spent on the government itself. Shrinking the government size would spare millions, as it will cut down ample subsidies and resources used by the government officials and employees. The amount spared should be used on productive investments, including rehabilitating the unemployed (Ghali, 1997). 6.2: Diversify the Economy Sustaining the available oil energy and thinking about means to preserve the best for the future will also help. This can be done, only if the oil export revenues are substituted by the other non-oil industries GDP. As discussed earlier, Saudi Arabia aims in doing the same either willingly or non- willingly. But, it should take up a few more measures to effectuate the same like the ones mentioned below 1. The Saudi government should continue its linear adjustment efforts, though it might pose tough challenges for a substantial period to boost diversification of the economy. 2. Be liberal in opening the domestic markets to foreign exports in non-oil sectors. 3. The government should encourage various industries like manufacturing and tourism 4. Should take steps to improve both public and private sector and establish good co-ordination between them (Joharji & Starr, 2010). 6.3: Energy Price Reform The Saudi Government does not want to increase the oil price directly. Instead, they plan on increasing the electricity rates. The price rise will be applicable to both the citizens as well as the industries. A 25 - 30% increase in the electricity should help the country improve its GDP and manage its debts efficiently. 6.3: Regulation for Increased Efficiency National Energy Efficiency Programme (NEEP) was formed in 2002 with the sole aim of creating awareness among the public about the efficient energy uses and encouraging the manufacture of low energy consumer products in the market. Now renamed as Saudi Energy Efficiency Centre (SEEC), the organization plays a key role in labelling products which are energy efficient. They train various types of households and industries on the gains about using energy efficiently and educate them on efficient usage of natural resources like electricity, oil and water. 6.4: Adding Renewable Source of Energy Words Saudi Arabia is gearing with full force to harvest its other abundant form of natural energy, solar power. Sunlight is definitely a rich source of power whose efficiency was untapped for a long time. The Saudi Aramco and many other universities are teaming up with each other to build laboratories to research further on this matter. The countries first solar power station was built in Farasan Island in October 2011. A highly technological institution known as King Abdullah City for Atomic and Renewable Energy (K.A.CARE) was established to encourage new innovative researches on the solar field. The country is encouraging investments and researches on other alternative energy sources like wind energy too. 6.5: Nuclear Power Ambitions Saudi Arabia is keenly interested in using the nuclear power to meet the countries growing power requirements. With Iran as its model, K.A.CARE has planned to set up nearly 16 nuclear reactors in the next two decades. Saudi Arabia was concerned about the safety of the nuclear reactors for a long time. But, as it saw the neighbouring UAE flourishing with the energy created from nearly 4 nuclear reactors, it shed all initial inhibitions and granted the construction of the project. On completion, these nuclear reactors should be able to take care of nearly 20 % of the country’s total electrical needs. Saudi Arabia’s fiscal policies not only affect a single nation or the Middle East. As a major oil exporter of the world, any minor changes in the economic policies of the country will affect the world as a whole. At present the government has enough plans in hand to stay stable even if the oil deposits wear out in the near future. They also take best efforts to increase oil production and maintain the oil price rate with their innovative plans. We can only hope for the best and wish all their efforts materialize in an effective way. References 1. ‘Fiscal stimulus policy aided Saudi economy 2011’, Albawaba . Retrieved September 27, 2012 from http://www.albawaba.com/fiscal-stimulus-policy-aided-saudi-economy-382710 2. Ghazi A. Joharji & Martha A. Starr, ( 2010), ‘Fiscal policy and growth in Saudi Arabia’, p -13 3. Ghali, K. (Dec 1997), ‘Government Spending and Economic Growth in Saudi Arabia’, Journal Of Economic Development, vol. 22, no. 2, p-165. 4. IMF report commends Saudi fiscal policies 2009. Retrieved September 27, 2012 from http://www.saudiembassy.net/latest_news/news08190901.aspx 5. Lahn, G & Stevens, P (Dec, 2011), ‘Burning Oil to Keep Cool The Hidden Energy Crisis in Saudi Arabia’, The Royal Institute of International Affairs, Chatham House, London. 6. Hitti, S & Abed, G (1974), ‘The Economy and Finances of Saudi Arabia’, International Monetary Fund. Vol. 21, No. 2, pp. 247-306. 7. ‘Saudi Arabia Economic Brief and Outlook’, (2011), Kamco Research. Retrieved September 27, 2012 from http://www.menafn.com/updates/research_center/Saudi_Arabia/Economic/kamco150611e.pdf 8. Sturm, M. Gurtner, Francois & Alegre, J (2009), ‘Fiscal policy challenges in oil-exporting countries a review of key issues’, Occasional Paper Series, European Central Bank, Frankfurt. 9. Villafuerte, M & Lopez-Murphy, P (Feb, 2010), ‘Fiscal Policy in Oil Producing Countries during the Recent Oil Price Cycle’, Fiscal Affairs Department. Read More