IV LESSON UNLEARNED: SAUDI DEVELOPMENT PLANNING AND FISCAL REALITY, 1985-90

In the spring of 1985, the Saudi government announced its fourth five-year development plan. The timing was inauspicious. The 1970-75 plan was announced when demand for Saudi oil was rising rapidly. The 1975-80 plan was announced in the aftermath of the 1973-74 oil shock, a massive increase in oil revenues, and publication of numerous projections forecasting continued expansion of demand for Saudi oil and ever-higher (real) oil prices. The 1980-85 plan was announced in the midst of the oil shock of 1979-80, a further massive increase in oil revenues, and another flood of forecasts predicting an expanding stream of oil revenues at least until the end of the century. But the 1985-90 plan had a more difficult birth: it was formulated in the midst of a severe economic contraction resulting from sharply lower demand for Saudi oil coupled with declining prices.

Saudi Arabia's gross domestic product (GDP) had declined from a peak of $156 billion in 1980 (and about the same in 1981) to $87 billion in 1985-a calamitous 45 percent drop. Saudi oil export revenues had plummeted from a peak of $111 billion in 1981 to $25 billion in 1985. Few countries, if any, have experienced such a meteoric rise and fall in national income in so short a time span. This was mainly due to the changes in world oil markets: the continued improvement in energy efficiency, the displacement of oil by other sources of energy, and the steady growth in non-OPEC supplies. But the Saudi situation was severely aggravated by its role as the swing producer in OPEC, attempting to balance overall supply and demand for OPEC oil by reducing its own output. Other members of OPEC were discounting on a large scale in order to maximize sales. The result was that OPEC output (excluding Saudi Arabia) had declined 37 percent from 21.7 mbd in 1979 to 13.6 mbd in 1980; Saudi output had dropped 62 percent from 9.8 to 3.7 mbd.

What is particularly noteworthy is that despite the sharp fall in revenues, the new development plan called for average annual public expenditures of $55 billion in 1985-90. In FY1984, the base year of the new plan, government oil revenues were less than $34 billion, including transfers of profits to the treasury from the two state-owned oil companies. The planners projected that demand for Saudi oil would rise by over 30 percent in the latter half of the 1980s and that prices would stabilize at their 1984 level of about $28 a barrel. In other words, the planners contemplated few additional spending cutbacks. They believed that the large deficits that had prevailed in 1983 and 1984 would be erased by higher oil revenues.

The 1985-90 plan emphasized even more strongly the crucial importance of economic diversification, focusing on development of industry and, to a lesser extent, agriculture. The planners stated:

Owing to its potential ability to be both a saver and producer of foreign exchange [i.e., the production of import substitutes as well as exports] manufacturing must take central place in the economic diversification [sought] in the Fourth Plan [1985-901 and beyond.

The plan envisioned a very high annual growth rate in manufacturing (including oil refining) of 15.5 percent. The completion of a number of petrochemical projects and new oil refineries, mainly for export, as well as other manufacturing units during the latter half of the 1980s was expected to give a strong boost to the industrial sector. Modern agriculture was expected to expand rapidly with an eye toward import substitution. The current account deficit in 1984, the base year of the plan, was unusually large-$18.4 billion. The expansion of exports (oil and non-oil) and reduction of imports through import substitution was expected to steadily reduce the deficit so that by FY1989, a surplus would again emerge. Presumably the export surplus would rise in the 1990s.

Saudi planners stressed the paramount importance of private sector investment, especially in industry. Traditionally, the private sector had sought quick profits mainly in commerce and real estate. Much of the wealth of the private sector was held abroad. The new awareness of the planners that public funds (i.e., oil revenues) were limited made it all the more important that the private sector make long-term investments in industry. The projects budget was expected to be smaller than in the peak years of the early 1980s but still substantial, and would focus on electric power, water supplies, the construction of industrial estates in various parts of the country, and the continued expansion of health, education, and other social services. The military budget (including an unspecified amount for foreign aid) would average $22 billion per annum in 1985-90. In FY1984, the base year of the plan, military outlays were $19 billion and foreign aid $3 billion. In other words, the planners projected a continuation of the high level of military spending that had prevailed in the first half of the 1980s.

The planners gave high priority to reducing the foreign labor force from 2.7 million in FY1984 (60 percent of total employment) to 2.1 million (49 percent of total employment) in FY1989. Total employment would drop by 226,000 but the employment of Saudi nationals would rise from 1.8 to 2.2 million by displacing foreign workers. To achieve planned growth in GDP (both in the oil and non-oil sectors) while cutting overall employment, Saudi planners envisioned a strong rise in labor productivity (output per employed person) averaging 4 percent per annum. The bulk of the decline in employment would be in the unskilled categories, reflecting the projected decline in construction where the workers were almost all foreign. Total employment in the public sector would be unchanged, with Saudis steadily displacing foreigners.

Despite the ambitious efforts envisioned in the development plan to diversify the Saudi economy, the second half of the 1980S underscored the reality that Saudi Arabia remained overwhelmingly dependent on oil. The regime espoused development of private enterprise, but the engine of economic growth was government spending, based largely on oil revenues. Because of this single source dependence, the bottoming out of the oil market in this period was a crushing blow not only to the development plan but to the Saudi economy in general.

NO MORE SWING PRODUCERS

The year 1985 was a turning point. Oil sales and revenues plummeted as prices softened. Budget and balance of payments deficits rose and financial reserves rapidly shrank. Other OPEC members had started to offer discounts below officially declared cartel prices in order to bolster sales, and at the same time non OPEC supplies were continuing to grow. In response, the Saudis began to trim prices in some barter deals and sell refined oil products at market prices. But most Saudi crude oil was still being offered at official OPEC prices, which were higher than those charged by its rivals. By the summer of 1985, Saudi production had fallen to a disastrous 2-2.5 mbd, a level not seen for twenty years. At the OPEC meeting in July 1985, the Saudi oil minister declared that his country would no longer accept the role of swing producer. This was an effort to relieve the special burden on Saudi Arabia that had seen its drop in output far exceed the overall drop in OPEC output. In July 1985, the Saudis threatened to boost output to 4.3 mbd (about 2 mbd above its then-current levels) and cautioned its OPEC colleagues that unless others curbed their output, prices might drop drastically from the official price of $28 to $18-19 per barrel. However, none heeded the warning. The Nigerian oil minister stated flatly in mid-1985 that "there is not a single OPEC country that is not violating the rules" by exceeding production quotas and discounting prices.

This deteriorating situation prompted the Saudis to effectively abandon all price constraints in the fall of 1985 in the hope that the increase in the volume of sales would more than compensate for lower prices and oil export revenues would increase.3 But the Saudis miscalculated. Other oil exporters did not reduce their output to make room for Saudi oil. Instead, those with spare capacity raised production in the hope that a larger volume of exports would compensate for declining prices. This only generated a greater glut of oil that began to assume flood dimensions. Prices fell precipitously in 1986, reaching lows of $8-10 a barrel during the summer months, as compared to an average $27 in 1985. The Saudi oil minister had projected that prices would fall to $18-19 a barrel; in reality, they fell to about half that level. Instead of increasing oil revenues, the new policy made a bad situation worse.

At the OPEC meeting in August 1986, the fractured cartel decided to re-institute production quotas, which had been effectively abandoned since late 1985, and reduce overall OPEC output in an attempt to raise prices. The agreement was stillborn. Almost immediately, a number of countries, including Saudi Arabia, Kuwait, the United Arab Emirates, Venezuela, and Indonesia, produced beyond their quotas. This was more or less the pattern that continued throughout the latter half of the 1980s. OPEC meetings took place every three or six months and production quotas were set. More often than not, this was followed by a progressive erosion of the agreements as various members with spare capacity found it in their interest to exceed their quotas.

For the Saudis, a number of factors helped to keep a bad situation from becoming catastrophic. Until mid-1988, when the Iran-Iraq cease-fire was implemented, the bombing of each country's oil installations by the other restrained overall OPEC output. Moreover, following the sharp decline in world oil consumption in 1980-83, consumption rose in the second half of the 1980s, stimulated in part by lower oil prices. Between 1985 and 1990 annual oil consumption rose by 2.2 percent, a far smaller growth rate than the pre-1973 7-8 percent, but a significant change from the absolute decline in the first half of the decade. More rapid economic growth in the major oil-consuming countries contributed to the upward trend in oil demand and helped to sustain and even raise prices somewhat between 1987 and 1989. Average annual prices, which had peaked at $32-34 per barrel in 1981-82, declined to $27 in 1985, plummeted to $14 in 1986, and then climbed upward to $18 in 1987. In 1988-89, prices ranged between $14 and $17 and then dropped sharply during the first half of 1990 to a low of $14 in June.

Similarly, Saudi oil production, which had declined sharply to 3.7 mbd in 1985, rose to 5.3 mbd in 1986. This was a consequence of its aggressive marketing policy, which included the abandonment of OPEC prices. In 1987-1989, output ranged between 4.6 and 5.5 mbd, or about half of the peak levels in 1979-1981. The much smaller volume of exports, coupled with lower prices, reduced oil export revenues drastically from a peak of $1 1 1 billion in 1981 to just $18 billion in 1986-the lowest point since 1973. In 1987-1989, annual oil revenues ranged between $20 billion and $24 billion.

Forced to revise their planning in view of the far lower level of oil revenues, the Saudi authorities cut back further on certain expenditures. According to published budgets, outlays on projects, which had been as high as $35 billion in the early 1980s, were steadily reduced to $7 billion in 1988; foreign aid was pared from an annual level of over $7 billion in the early 1980s to less than $2 billion in the later 1980s; and the announced military budget was cut from an annual level of about $19 billion in the first half of the 1980s to $13-14 billion in the second half of the 1980s. The deficits according to the published budgets-were reduced from an unprecedented $20 billion in 1986 (the equivalent of 27 percent of GDP) to $8 billion in 1989 (9 percent of 6DP). However, as noted earlier, Saudi Arabia maintains considerable "off-budget" expenditures, particularly with respect to arms purchases abroad. Other off-budget outlays included subventions for the royal family and some elements of foreign aid. As a 1988 report of the U.S. embassy in Riyadh noted, "Defense and security, wages for Saudi [public sector] employees, and social welfare programs underwent no real cuts." In other words, the authorities felt that further cutbacks in public spending were not politically feasible. The report also noted that payment delays to contractors were continuing and that "firms were frequently asked to settle for less in order to be paid and, sometimes, payment delays [were used as] a means of extracting additional services from the contractor." For the most part these were foreign contractors.

The fluctuating situation with Saudi budgets in 1988 led one respected journal to label the process as "chaotic." It noted that the initial announcement of the 1988 budget stated that projected expenditures would be $37.5 billion; a few days later this was amended to $39.4 billion without any explanation. In fact, the increase followed an outcry from Saudi businessmen complaining about a proposed tax on foreign workers; the tax was rescinded within days of its announcements

Within a relatively short time, Saudi budget deficits were soon followed by sizable balance of payments deficits ranging from $9 billion to $13 billion annually between 1985 and 1989. Until 1987, the deficits were covered by drawing on foreign assets. As a result, central bank foreign assets, which had peaked at about $145 billion in mid-1982, dropped to $61 billion at the end of 1989. In reality, the decline was far steeper, since aid to Iraq and to some of the poorer Arab countries was officially listed as loans and was included in the central bank portfolio as foreign assets. By the end of 1989, actual foreign assets held by the central bank (e.g., U.S. government bonds, as well as those of other Western countries) probably amounted to no more than $30-35 billion.

The deteriorating financial situation presented Saudi leaders with a real dilemma. Saudi tradition looks askance at deficits, more so at borrowing to cover deficits, and even more so at foreign loans. This view was expressed very clearly by the king in his presentation of the budget for 1987: "The government has tried its best in these difficult circumstances to keep the welfare of its citizens in mind while not burdening itself with loans, either external or internal." In other words, rather than cut spending any deeper, and thereby further depress living standards, the government would continue to cover deficits by drawing down financial reserves, as it had been doing since deficits emerged in 1983. But as financial reserves reached dangerously low levels, the government abandoned its policy against borrowing. A royal decree published in January 1989 stated that the deficit would be covered by borrowing "so that the citizens can enjoy prosperity." In fact, borrowing had begun in 1988-only a year after the king had told his people that this would be avoided. The Economist noted that the last time Saudi Arabia had borrowed was in the 1950s, reminding readers of the political ramifications of borrowing: "King Saud, whose extravagance made this necessary, was gently asked to resign in 1964."

In order to cover the deficits of the late 1980s, the government issued bonds. By the end of 1989, outstanding bonds were valued at about $20 billion, of which about 75 percent were acquired by various government agencies, mainly pension funds, and almost all of the remainder by local commercial banks. Evidently, pension funds had to liquidate foreign assets in order to finance the purchase of Saudi treasury bonds. The private sector, excluding banks, purchased negligible amounts. Prior to the Gulf War, there was very little foreign borrowing. Examples of what did occur include a 1989 loan of E2 billion (approximately $3.2 billion) to cover payments to British arms contractors that a barter deal for 400,000 barrels of oil per day did not fully pay for. Also, the Public Investment Fund, a Saudi governmental agency, reportedly borrowed $650 million in 1989 from a number of foreign banks, and there were unconfirmed press reports that the central bank was selling gold from its reserves.

The large-scale liquidation of foreign assets, as well as declining interest rates abroad during the 1980s, aggravated Saudi Arabia's fiscal problems. Government investment income from its holdings abroad had risen sharply from $1 billion in 1974 to $14 billion in 1983. Subsequently, however, there was an almost steady decline to $3 billion to $4 billion per annum in the late 1980s. Sharply lower oil revenues, combined with much diminished investment income, had a powerfully negative impact on the budgets. The reluctance to impose taxes and the downward inflexibility of government spending because of internal political and social constraints made deficits an almost inevitable outcome.

Deficits produced a recession whose negative impact was felt by many if not all Saudis, despite government efforts to insulate the population from the economic downturn. The U.S. embassy in Riyadh reported a significant increase in unemployment, especially among high school and university graduates. The government urged the private sector to hire more nationals, but with little effect. The budget for 1990 called for additional job openings in the already over staffed military and civilian bureaucracies in order to reduce the level of unemployment.6 This would, of course, aggravate the budgetary situation, but unemployment is a more immediate political danger for the regime than deficits.