In 2016, in the face of low oil prices and rapidly declining foreign reserves in an unsustainable, oil dependent rentier state, the Kingdom of Saudi Arabia (KSA) was faced with two scenarios: an ‘Open Road’ where social and economic reform would transform the country into a diversified, moderate, and prosperous society; or the ‘Rocky Road’, where the sclerotic government would fail to reform and the country could plunge into a deep recession amid rising internal conflict and a monarchy in peril.

Two years later, under the young Crown Prince’s leadership, the Kingdom has chosen to pursue a slight variation of the ‘Open Road’, called the ‘Narrow Road.’ In this scenario, economic diversification and social liberalization reform are achieved, however, accompanied by a more authoritarian, nationalistic state where power is concentrated in the hands of one to push through reform while cracking down on dissent, along the lines of Lee Kuan Yew’s Singapore model. Coinciding with a global economic boom and stable oil price, these policies could boost economic growth, catalyzing new job creation, and entrepreneurial activity.

If Saudi Arabia’s transformation is to be executed successfully and a ‘Narrow Road’ scenario made a reality, policy makers, businesses, and foreign investors will have to navigate indicators, signals, and challenges to reach milestones along the way.

Commitment to change

The most salient indicator is the government’s ability to meet Vision 2030 reform targets. Fiscal consolidation brought a reduction in government spending, slashing of public sector wages, subsidy cuts, expatriate levy, the introduction of a Value Added Tax (VAT), and excise taxes on soda and tobacco. Yet, sensitivity to popular backlash of rising living costs and subdued growth lead to a rollback of some reforms and introduction of allowances.

In parallel, social liberalization—including allowing women to drive, the introduction of entertainment and the defanging of the religious police—was enacted to ‘revert’ the Kingdom to ‘moderate Islam.’

Both segments of reform were enabled by another indicator: increasing authoritarianism wrapped in Machiavellian flair. To push through these changes, King Salman and Crown Prince Mohammed bin Salman dismantled the governing system of consensus among various royal fiefdoms and restructured it with the concentration of power to one: the Salman branch.

This autocratic liberalization illustrates zero tolerance for opposition, and included the jailing of dissenters from civil society, the royal family, the government and clerical establishment, as well as an anti-corruption crackdown that reached the last segment of society, the private sector.

Whether or not these stakeholders choose to accept the new paradigm or attempt to harness potential popular discontent that arises down the line, stakeholders will have to be monitored in anticipation of a bigger milestone: Mohammed bin Salman’s succession to the throne. As of now, the consolidation of power, popular youth support, and newly installed cabinet of a younger generation of princes should ensure a smooth transition.

Economic indicators

Although abiding by reforms that upend cradle-to-grave welfare has proven a challenging balancing act for the government, they were still able to almost halve the budget deficit in 2017 to 8.9 percent from 15 percent in 2015. However, if the government is to reach its 2.7 percent growth target (IMF forecasts 1.6 percent) in 2018 under an expansionary budget and stimulus package totaling $300 billion, after a—0.5 percent contraction in 2017, it will have to rely on stronger oil (still 60 percent of government revenue) and non-oil revenue, while raising more debt. The amended Fiscal Balance Program II’s shifting ambitious targets and fiscal neutrality to 2023 highlights flexibility in this context, but future amendments or missed budget deficit targets will hamper progress.

As a result, oil price volatility and inflation are key indicators. Saudi Arabia has been able to steer OPEC and Russia production cuts to drive oil prices to 3-year highs ($70 a barrel). However, Russia and the US will overtake the Kingdom as the globe’s largest oil producers, with resilient US shale ramping up production and capable of shocking the oil markets again, especially if OPEC projections of increasing global demand fall short. OPEC will hope that its members’ full compliance in 2017 continues throughout 2018, and no members feel pressure to exit cuts early, with an eye on the next meeting in June.

Furthermore, after experiencing deflation amidst recession in 2017, the introduction of taxes and allowances—not to mention Citizen Account enrolled in by half the native population—is expected to stoke inflation to 5.7 percent. The Saudi Riyal-US Dollar peg may come under increased pressure, amidst a declining dollar, and the Saudi Arabian Monetary Authority (SAMA) may be compelled to increase interest rates, stifling growth. More than two hikes by the US Federal Reserve may see a 25 basis point increase in the Saudi repo rate, affecting the cost of funding in KSA. This leads us to another indicator: credit growth and liquidity in the banking sector.

Saudi banking deposits have been under strain as the government has drawn down cash whilst lending has been declining for the past 10 months. A spike in the SAIBOR (interbank rate) will indicate a further liquidity squeeze. If the private sector is to drive growth, especially through small and medium sized enterprises (SMEs), then credit growth will be integral.

Private sector job creation

SMEs currently make up 21 percent of GDP with a target of reaching 34 percent by 2030. As is the case in developed markets such as the US and China where SMEs make up 50 percent of their economies, they will lead private sector growth and job creation under the Kingdom’s transformation. The budget and Public Investment Fund (PIF) stimulus are positive milestones that allocate a significant amount to SME development while banks are expected to provide further funding, and a recently established Nomu parallel market at the Tadawul offers further financing avenues.

If Saudi Arabia is to reach the goal of 1.2 million private sector jobs by 2030, cut unemployment to 9 percent from 12.8 percent and increase private sector contribution from 40 percent to 65 percent of GDP, then a key indicator is the number of SMEs established in that time, which will likely have to be about 20 percent of the 1.2 million jobs target.

250,000 Saudis enter the job market each year, and the public sector can no longer absorb them as they attempt to reduce their bloated wage bill that amounts to 13 percent of GDP and 60 percent of government expenses. Therefore, the government would do well to avoid crowding out the private sector in emerging industries such as tourism and entertainment, and rather prioritize the completion of enabling infrastructure such as the new Jeddah Airport, Riyadh & Jeddah Metros and Haramain Train from Makkah to Madinah, while improving the ease of doing business and establishing free zones.

Yet, a concerning signal is the omnipresence of the PIF. Under the mandate of “spearheading” private sector development and a preferred vehicle for government investment, efforts such as the establishment of new state agencies and partnering up with multinationals entering the market risks limiting local private sector growth. Maintaining a high proportion of the work force in the public sector magnifies the structural challenge of a shortage of skilled human capital in the private sector—which could be addressed by skills/knowledge transfer from new partners—where Saudization efforts are already stymied by a skills-labor market mismatch.

Privatization and foreign investment

This sentiment is echoed in the privatization program. The Kingdom needs to successfully complete something of the $200 billion privatization of state assets—and/or the $100 billion Aramco IPO—in 2018 if foreign investors are to take it seriously and much needed funds are to be raised. However, early indications of a delayed and unwieldy sale process among various assets have rankled investors. While it varies by industry, a theme has appeared: the government, by means of the PIF, will likely retain shares in most assets, with the private sector generally relegated to minority shareholder status (unless a sector has been granted 100 percent foreign ownership such as healthcare and retail). This flashes another signal: given the restructuring of power to King Salman and the Crown Prince, buying in to this program is essentially buying in to the Crown Prince.

The way the anti-corruption crackdown has unfolded solidifies the ‘state as a capitalist,’ China-esque approach the Kingdom is taking. Whilst the anti-corruption crackdown is a positive milestone that addressed endemic corruption anathema to investors and citizens, levelled the playing field and added over $100 billion to state coffers, in doing so the state kneecapped major private sector players. Will they now return to business as usual to drive private sector growth? The specter of another opaque anti-corruption probe that leads to a potential business partner incarceration or nationalization will hover over investors in the short term, even if beneficial in the long term.

That said, market liberalization measures are a positive signal that put Qualified Foreign Investors at all-time highs. This emphasizes how big the Kingdom can become as an investment destination. Its economy almost equals the combined GDP of the rest of GCC, and its population is 48 percent more than the total combined population of other GCC states. It also has the largest stock market with a capitalization of $440 billion and expectations to surpass $1 trillion within five years. Moreover, Saudi Arabia has the youngest population in the region with about 60 percent under 30, and is one of the world’s fastest urbanizing countries. The impending windfall in passive funds from the addition to the MSCI Emerging Markets and FTSE Russell Indices along with strong credit ratings are boons. The legal reforms including a bankruptcy and procurement law breed confidence. Foreigners can now invest up to 49 percent in the Tadawul. As a result, investors will want to get back in the ‘investment line’ even if a particular indicator or signal gives them temporary pause amidst their pursuit of stability, predictability and transparency.

Foreign policy

Foreign policy challenges abound. They include the expensive and deadly intervention in Yemen either coming to a peaceful conclusion, becoming a protracted conflict or an escalation of hostilities. This could lead to an escalation beyond proxies and directly with Iran. Yemen is currently in turmoil as UAE-backed southern separatists and the Saudi-backed Hadi government clash while the Iranain-backed Houthi insurgency remain despite ending their alliance with Saleh loyalists.

The blockade of Qatar by the Saudi-UAE bloc has done little but deteriorate the GCC alliance while pushing the state towards Iran and Turkey. In the pursuit of cracking down ostensibly on terrorist financing and eradicating threats of political Islam, tensions may lead to further regional destabilization and friction with the United States. A friction that could heat up if US plans to move its embassy to Jerusalem proceed, pressuring Saudi action for a Palestinian solution.

Lastly, while the acknowledgement of failed checkbook diplomacy in Lebanon and the rise of Hezbollah may warrant action, the approach taken by the Kingdom and ensuing international debacle is a glaring black eye that stakeholders may wish to avoid repeating.

All this ultimately encompasses the restructuring of the social contract. Instead of the current cradle to the grave welfare (in exchange for lack of representation), the populace is not receiving much in the way of new assurances. Healthcare and education continue to be provided by the state, despite being open to privatization, with the largest allocated budgets after defense spending. However, a housing shortage of 1.5 million homes remains. A key element of Lee Kuan Yew’s success with Singapore was pumping money in to public housing and ensuring the majority of citizens owned their homes. Vision 2030 targets the development of 1.5 million homes by 2030, with the Kingdom allocating $17 billion to the housing sector in 2018. Additionally, they have rolled out a new mortgage law, introduced REITs, and enacted a 2.5 percent White Land Tax on undeveloped lands to spur construction. Keep an eye on this indicator under a new social contract.

The new social compact

To provide a semblance of a new social compact, it behooves the government to institutionalize reform and cooperation between the four pillars of society. The establishment of a National Economic Development Council (NEDEC) comprising of representatives from the private sector, government, clerical establishment, and civil society would be a step in achieving this. It could act as a deliberative body that provides legislative suggestions to the Shura Council and Council of Economic and Development Affairs (CEDA). In this context, it would benefit a growing private sector to establish its own Saudi Private Sector Association (SAPSA) to ensure its voice has weight.

The ‘Narrow Road’ scenario is long and winding with many challenges and opportunities ahead. It will take scenario planning by all actors and a deft handling of domestic and exogenous shocks to successfully execute the Kingdom’s transformation.

Alex Damianou is a macroeconomic and geopolitical consultant, focusing on emerging markets. Follow him on Twitter @alex_damianou.

Image: Photo: A Saudi trader observes the stock market on monitors at Falcom stock exchange agency in Riyadh, Saudi Arabia February 7, 2018. REUTERS/Faisal Al Nasser