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Monetary Experience of an Oil Economy

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
December 1965
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Anwar Ali and Said Hitti

The kingdom of saudi arabia covers nearly 1,000,000 square miles—i.e., nearly four fifths the area of India. It is a large but arid land; indeed the paucity of water was—until the discovery of oil—the most important geographical fact about Saudi Arabia. There are no rivers or lakes in the country and wells in the oases are virtually the only source of water in all parts except South Hejaz and Asir, the high mountain region where rainfall averages 10-12 inches annually. Only very limited agriculture can be sustained by these water supplies. The total cultivated area is less than 300,000 hectares, barely 0.13 per cent of the total area. Dates are still the most important agricultural crop, though small quantities of wheat, barley, rice, and fruits and vegetables are also grown. Given adverse and harsh natural conditions for agriculture, it is not surprising that a large part of the population (no census has yet been taken but estimates range from 4 to 6 million) is nomadic or seminomadic and that until the discovery of oil the average standard of living was very low indeed.

In sharp contrast to the simple and austere life of some three decades ago, Saudi Arabia today is one of the most prosperous and economically fast-growing areas in the Middle East. At the root of this prosperity is oil. Saudi Arabian crude oil reserves, estimated at about 60 billion barrels in 1963, stand second only to those of Kuwait. Although oil in Saudi Arabia was discovered in 1932, its commercial exploitation started only in 1938, and the quantities produced remained small until the end of World War II. Since then the growth in oil production has been very rapid, rising from about 20 million barrels in 1945 to nearly 700 million barrels in 1964. The Government’s oil revenues, which barely exceeded US$10 million in 1946, amounted to well over $500 million in 1964. The social and economic transformation of Saudi Arabia owing to the sudden increase in oil income has been dramatic, with the process of change and modernization from a traditional and tribal way of life being compressed into a very short period.

SAUDI ARABIA

Within a decade of the commercial exploitation of oil, a beginning was made toward setting up the administrative machinery of a modern government. A modern capital has been built at Riyadh, and the groundwork laid for a transportation network with the construction of a railroad from the east coast to the capital, the establishment of the Saudi Arabian Airlines, and the construction of roads in many parts of the country. More recently, following a strengthening of the financial position of the Government, the acceleration of economic development has been accepted as a principal goal of national policy.

Monetary History

In the economic sphere, the rapid change is clearly reflected by the evolution of the monetary system. As late as 1950, Saudi Arabia was on a silver standard. The Saudi Arabian riyal was a coin with a silver content equal to its monetary value, and its rather wide fluctuations in value were related mainly to the international price of silver and the large seasonal demand during the Pilgrimage season. The inconvenience of such a bulky legal tender had also become evident. Between 1952 and 1955, Saudi Arabia experimented with a bimetallic standard, minting both gold and silver coins. During this period the exchange rate of the silver riyal vis-à-vis gold and foreign currency was kept fairly steady, at about SRls 3.75 per U.S. dollar. But the sharp rise in the international price of silver in 1955 tended to drive silver coins out of circulation, and they were increasingly replaced by Pilgrims’ Receipts, the paper money that was first introduced in 1953 to facilitate transactions during the Pilgrimage. During the years 1956-57 difficulties arose; the Kingdom’s exchange system developed considerable strains owing to imbalance in the government budget and large creation of credit. Exchange control had to be imposed to meet the serious balance of payments pressures, but it did not function effectively in the absence of basic remedial measures. A systematic stabilization program during 1958-60 helped to restore internal monetary balance, and finally the exchange rate was stabilized at a new level (SRls 4.50 per U.S. dollar) and controls were abolished. The formal acceptance by Saudi Arabia in March 1961 of the obligation of the convertibility of the Saudi Arabian riyal under Article VIII of the Fund’s Articles of Agreement symbolizes the present strong position of the Saudi Arabian currency. A new paper riyal, replacing the Pilgrim’s Receipts, was introduced in June 1961. The transition from a silver standard to a fully convertible paper currency through bimetallism, exchange control, and floating exchange rate thus took place in less than a decade—a remarkable acceleration of monetary evolution.

Exchange Crisis

The study of the monetary and exchange crisis that threatened the Saudi Arabian economy during 1956-57 and the stabilization program that followed provide a clear illustration of the interdependence of internal and external monetary balance, and stresses that proper budgetary policies and stability are essential for economic development.

In a way, the seeds of the monetary and exchange crisis were sown by the rapid growth of the oil income itself. The Government’s oil income has shown a large growth since the end of World War II, but the most rapid growth occurred between 1950 and 1955, when oil revenues increased from $57 million to $341 million. This was a period in which the full impact of the new prosperity began to be felt widely. Unfortunately, just as the government spending programs were becoming attuned to a continuing rise in revenues, oil income leveled off. Whereas in the four years preceding 1955 these revenues grew threefold, in the next four years they did not increase at all and in fact showed a small decline. Before the implications of the changed situation were fully realized, the Government had acquired a debt of nearly SRls 1,800 million, somewhat exceeding a year’s revenue. Net indebtedness of the Government to the Saudi Arabian Monetary Agency (the central bank) alone amounted to about SRls 700 million by late 1957.

This large credit creation by the central bank was reinforced by a steep rise in commercial bank loans to the private sector. In the course of a mere two years (1956 and 1957) the total credit expansion amounted to nearly SRls 1,000 million, a sum greater than the country’s total money supply at the end of 1955.

So large a creation of purchasing power inevitably led to serious balance of payments disequilibrium. For Saudi Arabia the impact on the external sector was particularly heavy because the base of home production is very narrow and the country depends very heavily on imports. Thus, the severe pressure on the foreign exchange resources was a direct consequence of excessive credit expansion mainly to finance the budgetary deficits. By 1957 official foreign exchange reserves were practically exhausted and stringent exchange controls covering all transactions were introduced. Meanwhile, the free market rate of the riyal had fallen to the equivalent of 16 U.S. cents (the lowest rate in its history), compared with the official parity of 26% cents (SRls 3.75 = $1). Because the dependence on imports is so great, the impact of import restrictions and the depreciating exchange rate was quickly evident in sharply rising prices. Loss of confidence in the currency was an important factor leading to capital flight. This in turn led to a further deterioration in the balance of payments and curtailment of private investment activity. On all counts, therefore, monetary chaos was threatening to jeopardize the long-term development and economic stability of the Kingdom.

Stabilization Program

Conscious of the grave economic consequences of continuing this situation, the Government arranged for an Executive Director of the International Monetary Fund, accompanied by the Director of the Fund’s Middle Eastern Department, to visit Saudi Arabia and examine the situation. A stabilization program was then formulated, which the Government of Saudi Arabia announced in June 1958.

The first phase of the program aimed at removing the fundamental source of economic difficulties, the budget deficit. Surpluses were planned, and the retirement of outstanding debt over a period of years was provided for. The program sought to put the exchange system on a more realistic footing and to reduce the impact of import restrictions. A double exchange rate system was introduced; on the selling side the official rate of exchange (SRls 3.75 = $1) was applied only to essential consumer goods (foodgrains, milk, textiles, medicines, vegetable fats, cattle, and sheep) and capital goods. Foreign exchange for all other imports and for other purposes could be obtained without restriction from a free market which was recognized and fed by the Monetary Agency so far as was consistent with a policy of strengthening the official foreign exchange reserves.

The program for stabilization was pursued by the Government, headed by Prince Faysal (then the Prime Minister and now the King), with a determination which brought the inflationary situation to an end. In the two-year period between the end of 1957 and the end of 1959, the government indebtedness to the Monetary Agency was virtually eliminated. This was rendered possible almost entirely by holding expenditures in check and using the exchange profits from the sale of foreign exchange in the free market for debt reduction.

Since the basic cause of the internal monetary imbalance was being eliminated, the foreign exchange position took a steady turn for the better. With the repayment of government indebtedness to the Agency, which received priority over other debts, the Agency’s gold and foreign exchange holdings recorded an increase of SRls 644.6 million over the two years ended December 1959. Along with the strengthening of the reserves, the free market rate of the riyal was steadily strengthened by the Agency from SRls 5.50 to SRls 4.75 per U.S. dollar. The increased availability of foreign exchange through the Monetary Agency and the improving exchange rate achieved a stabilization of consumer goods prices, after the prices for many items had fallen by between 15 per cent and 20 per cent.

Exchange Reform

The stabilization program entered into its second and final phase early in 1960 with a major exchange reform which restored a unitary exchange rate and eliminated imports and payments controls. The new par value of the riyal was fixed at 0.197482 grams of fine gold or SRls 4.50 = $1, more or less the level at which the free market rate had stabilized in the preceding months.

The adoption of the new par value was based on the recognition that further appreciation of the exchange rate above SRls 4.50 = $1 would have accentuated deflationary tendencies then evident in the economy. By 1960 the domestic economic situation had adjusted to the new rate. On the other hand, the restoration of the original parity of SRls 3.75 = $1 would have had adverse effects on government revenues; the exchange profits made by the Government had become an important source of income during 1958-59, and an attempt to balance the budget at the old rate of exchange would have left little or no margin for the expansion of development activity. For social reasons it was decided to continue the subsidy on the imports of foodgrains, livestock, drugs and medicines, vegetable oil, and powdered milk. The subsidy at present takes the form of cash payments representing the difference between the old and the new rate, and is now available irrespective of the quantity of imports, which had been restricted previously.

Economic Development

The successful completion of the stabilization program has marked the beginning of a new chapter in the history of Saudi Arabian economic progress. All government debt, external as well as internal, had been fully retired by the end of 1962. Since then, the Government has continued to match receipts and expenditures in its budgetary estimates, and has achieved considerable surpluses in actual accounts. It has also been able to adhere to the 100 per cent gold and foreign exchange cover requirement for note issue instituted at the beginning of 1960.

Achievement of domestic monetary stability has been reflected in the decline in the outflow of private capital since 1960. In the more secure financial conditions that now exist domestic savings are flowing increasingly into domestic investment. In the public sector, the most important feature of government budgets has been the earmarking of increasingly large portions of revenues for development projects. The size of the development budget, representing mostly government investment in fixed assets, has grown manyfold in recent years. The 1965 budgetary plans provide for development expenditure accounting for over one third of the estimated total government outlays. This does not include government spending on education and health, which exceeds one sixth of the current budget.

Saudi Arabia’s position as a developing nation is, of course, an unusual one in that the major impediment to economic growth is not financial. It lies in the need to discover, appraise, and exploit natural resources, in order to reduce the great dependence on oil. Without the discovery of additional underground water supplies, for example, no major expansion in domestic agriculture can be planned. For industrial and mineral development, the apparent investment opportunities must be fully studied and closely scrutinized before large sums of money can be committed. These studies and surveys are being carried forward with a sense of urgency. In the meantime, the emphasis of the development program is on improving transport, communications, health, and education. The Government is also encouraging private business, for example, by liberalizing the Foreign Investment Law.

Although Saudi Arabia’s position as a rich developing country is unusual, its difficulty in achieving monetary stability was not; it might be said to be normal. So the measures and methods it adopted are still instructive. Certainly, on the basis of the expected continuing increase in oil income and the financial and development policies that have evolved in recent years, its prospects for further economic advance are encouraging.

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