Why the Saudis will either blink…or collapse

In Free by Cam Hui

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As Saudi Arabia`s budget has come under pressure from low oil prices, I see that the Kingdom (KSA) has announced a diversification initiative into IT, healthcare and tourism (via CNBC):

Saudi Arabia outlined ambitious plans on Monday to move into industries ranging from information technology to health care and tourism, as it sought to convince international investors it can cope with an era of cheap oil.

A meeting and presentation at a luxury Riyadh hotel was held against a backdrop of low oil prices pressuring the kingdom’s currency and saddling it with an annual state budget deficit of almost $100 billion – the biggest economic challenge for Riyadh in well over a decade.

Top Saudi officials said they would reduce the kingdom’s dependence on oil and public sector employment. Growth and job creation would shift to the private sector, with state spending helping to jump-start industries in the initial stage.

“It’s going to switch from simple quantitative growth based on commodity exports to qualitative growth that is evenly distributed” across the economy, said Khalid al-Falih, chairman of national oil giant Saudi Aramco.

The competitve advantage of nations

What KSA faces is a classic problem in development economics. How do you create new industries and employment in an economically depressed region?

For that answer, I turn to Michael Porter, the author of The Competitive Advantage of Nations, and Jane Jacobs, whose work included The Economy of Cities and Cities and the Wealth of Nations. Porter`s analysis is more businesslike and his analysis was at the national level, while Jacobs was more academic while her unit of analysis was the city-state, but the message was the same. Porter`s framework of how countries moved up the value-added chain is highly instructive, with examples like Japan and South Korea leveraging their competitive advantage of low-cost labor to eventually become high value-added designers (think Samsung and Sony). Further, Porter wrote about the importance of industry clusters in spurring innovation.

What can Saudi Arabia offer? Do they think they can build a Silicon Valley or a biotech or healthcare behemoth in the desert? What are the competitive advantages and industry clusters that they can build on?

Sure, I can understand tourism as a growth driver, as Mecca is a magnet of steady visitors on the Hajj. Beyond pilgrims, however, Saudi Arabia doesn’t sound like a natural spot for tourism.

The idea of state spending to jump-start these initiatives are likely to fail. I am not necessarily saying that government shouldn’t use fiscal policy to spur growth, but the underlying approach is wrong. As an example, the US government has put military bases in fairly remote spots to boost employment and appease the local Congressional representative, but few of those efforts has built long lasting employment beyond services dependent on the base. On the other hand, selective efforts such as the combination of academic-private partnerships and initiatives like the DARPA challenge has yielded innovation.

There is a right way and wrong way to design industrial policy. Saudi Arabia is going about it the wrong way. A more sensible way is to encourage industries where KSA has a natural competitive advantage and build on it. Tourism is one. Others might include the encouragement of an industry cluster in energy services, either in the form of oil extraction engineering services or refining and processing.

Remember Chinese rebalancing?

What KSA is attempting is a form of economic rebalancing through industrial policy, which is a very tough road to take.Consider China, which has largely gotten the direction of policy right in their strategy of rebalancing growth away from credit-driven infrastructure growth to a more sustainable consumer-led growth model.

As my chart of New (consumer) China vs. Old (financial) China pairs show, rebalancing is continuing. Given the kind of market angst that surround the outlook for Chinese growth right now, this road isn`t exactly a smooth one.

 

 

I can only conclude that the Saudi economic diversification initiative is likely to fail. If KSA persists in its policy of maintaining low oil prices and believe that diversification will cushion the blow, it risks a collapse of its fiscal house and perhaps a political collapse of the House of Saud as well.

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