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Saudi Arabia: Selected Issues

Author(s):
International Monetary Fund. Middle East and Central Asia Dept.
Published Date:
October 2015
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Macroeconomic Implications of Labor Reforms in Saudi Arabia1

The recent intensified effort to increase employment of nationals in the private sector through education and training reform and the implementation of a quota scheme (Nitaqat) will have implications for the macroeconomy. Staff’s empirical assessment suggests that replacing low-skilled, low-wage expatriates with nationals will increase wage levels and inflation, but if the skill composition of the national work force improves, productivity could rise and may offset any adverse impact on competiveness. Controlling public employment size and compensation and gradually implementing the quota system will be key to avoid higher costs and disruption to private sector activity.

A. Introduction

1. Like other GCC countries, Saudi Arabia’s reliance on low-wage foreign labor has been a central pillar of an oil-driven growth model that has yielded rapid economic development and substantial improvements in living standards. This model has helped overcome periods of local labor shortages and contain overheating pressures during periods of high oil prices, but it has also created distortions in the labor market, increased the reliance of nationals on public employment, and locked the economy in a low productivity growth pattern. These outcomes in turn have now become a constraint on absorbing the rapidly growing and increasingly well-educated national workforce in the private sector as job creation continues to disproportionately absorb expatriates, resulting in high unemployment rates for nationals, especially among the youth.

2. Realizing such challenges, the authorities have given new impetus to labor market reforms in recent years with the objective of increasing the employment of Saudis in the private sector. A broad reform strategy has been adopted that involves active labor policies, investment in education and training, and a wage policy aimed at raising the wage of nationals in the private sector to making private sector jobs more attractive. It also relies on enforcing a more rigorous quota system that requires companies to employ a minimum number of Saudi workers and limiting access to cheap, low-skilled expatriate workers.

3. Data shows that employment and wage structures and participation rates of women have changed since the implementation of the new initiatives. Over the longer term, meeting the government’s goal of changing the structure of the labor market to one where a larger share of nationals are employed in the private sector at higher wages will have macroeconomic implications. This paper provides background on the labor market structure in Saudi Arabia, highlights the recent labor market reform initiatives undertaken by the government and assesses the early outcomes, and then looks at the potential macroeconomic impact of the reforms.

B. Background: The Employment - Growth Paradox

4. Despite rapid economic growth in recent years, the employment of nationals remains a significant challenge for Saudi Arabia given the rising proportion of youth entering the work force every year. During the 1970s oil boom, the rapid development process increased the demand for labor from the private sector and this could not be met by local sources in terms of the number and skills of the workforce. Foreign workers were therefore used to help address the labor shortages in the private sector, while the public sector became the employer of choice for the national work force. The demographic profile and labor market structure have, however, changed drastically over the years. Population size has tripled since 1975 as a result of natural growth of nationals and the opening of the country to inflows of expatriates. Population structure has tilted toward working age groups which are entering the labor market in rising numbers every year (Figure 1).

Figure 1.Saudi Arabia: Total Population by Age, 1980 and 2015

Source: UN Population Database

5. Private sector jobs continue to largely be filled by foreign workers, while the government remains the largest employer of nationals. Since 2000, the non-oil economy grew on average by over 7 percent a year and created more than 3.6 million jobs in the private sector, but only one fifth of these went to nationals. The employment of nationals in the public sector continued to grow despite the strong growth in private sector job creation (Figure 2, top left panel).

Figure 2.Employment of Saudi Nationals

Source:s Manpower surveys, CDSI; IMF staffcalculations

6. The weak responsiveness of employment of nationals to private sector growth reflects uneven sectoral contributions to growth and employment. The main growth drivers, such as the manufacturing and trade sectors, have contributed far less jobs for nationals compared to expatriates during 2000-14. Job creation for nationals has been concentrated in the government and community service sectors, which contributed more than 70 percent of total jobs created for nationals, but only 15 percent to GDP growth (Figure 2, top right panel). Moreover, job creation for nationals in the private sector has been focused on specific groups, namely males, the older and experienced, and the more educated. For young people and women, job creation has been limited (Figure 2, bottom left panel).

7. As a result, unemployment remains high among youth and women. The overall unemployment rate for nationals of 11.7 percent masks considerable gender, age, and regional variations. Among females, unemployment stood at about 33 percent in 2014, compared to less than 6 percent for males. Participation of Saudi females in the labor force is also low. Among youth, employment is high and rising (Figure 2, bottom right panel). With over 35 percent of the population still under the age of 19, this working age segment will increase rapidly, underscoring the urgency of tackling youth unemployment. Across regions, unemployment varies considerably being as high as 20 percent in some regions. Gender gaps are much wider than at the national level in some regions. It is worth noting that at 650,000 in 2014, the total number of unemployed Saudis is only one tenth of the total number of jobs held by foreign workers.

8. A number of structural factors have contributed to persistent unemployment among nationals and low substitutability between national and expatriate workers. These include differences in wage and work conditions, especially for low skilled labor, skill mismatches, and the preference of nationals for public employment. Other regulatory and cultural factors affected labor market participation especially for women.

9. Wage differentials between nationals and expatriates in the private sector and for nationals between the public and private sector have contributed to the segmentation of the labor market. These differentials create incentives for private sector employers to hire expatriates and for nationals, particularly those who are less well-educated, to seek jobs in the public sector. Historically, the wage gap in the private sector has been caused by shortages of nationals during the 1980s and an open policy to import foreign workers from countries that have much lower income and wage levels than Saudi Arabia. Along with this, the government has implemented minimum employment shares and wages for nationals in the private sector through a number of Saudization programs implemented since the early 1990s. As a result, wage levels of nationals, are about three times those of expatriates, especially for less educated groups. In the private sector, nationals are mostly concentrated in higher-paid and higher-skilled sectors such as banking and mining (Figure 3, top panels).

Figure 3.Labor Market Indicators

Sources: Manpower surveys, CDSI; GOSI; IMF Staff calculations; Ministry of Labor; Behar, A. and J. Mok (2013), “Does Public-Sector Employment Fully Crowd Out Private-Sector Employment?” IMF Working Paper WP/13/146.

10. There also appear to be skills mismatches. This is evident in the disparities of the education and occupation profiles between employed nationals and expatriates. Whereas the largest occupational group for expatriates, about 30 percent of the total, is in “basic engineering”, for nationals their share in this category is less than 5 percent of their total employment. Their largest occupation, about 33 percent of the total, is in “services”. This occupation profile has changed little over time (Figure 3, bottom left panel).

11. In Saudi Arabia, the role of public sector employment is dominant, employing about 70 percent of the Saudi work force. Nationals, particularly the lower-skilled, appear to have a strong preference for public jobs given the higher wages they earn, and better work conditions (such as the job security, shorter work hours, and longer holidays) compared to the private sector. Public employment opportunities may also have created other distortions by creating a disincentive for nationals to invest in skills that are important for the private sector. More nationals are acquiring education and training in areas to allow them to enter the public sector, mainly in human and social specializations. Recent international evidence (Behar and Mok, 2013) shows that, on average, the creation of a public-sector job comes at the cost of a private-sector job and therefore has no impact on total employment (Figure 3, bottom right panels). This crowding-out effect can occur for three reasons: (i) reduced private sector economic activity; (ii) incentives for individuals to take public instead of private sector jobs; and (iii) skills acquisition by the labor force becoming geared toward what is needed to get a job in the public sector.

C. Recent Labor Market Reforms and Their Initial Impact

12. The authorities have made significant investment in education in recent years. Public spending on education has risen sharply reaching about 8 percent of GDP in 2014, the highest in the GCC. School attainments and technical education have improved including through partnerships with well-reputed international universities (Figure 4). The Saudi education system, however, still lags many other countries in terms of the scores students achieve on internationally standardized tests in mathematics and science (see TIMMS, 2011). Moreover, the education system does not appear at present fully geared towards private sector needs especially of technical and vocational skills.

Figure 4.Public Spending on Education, 2004–14

(Percent of GDP)

Source: World Bank World Development Indicators

13. New labor reform initiatives were introduced recently to increase the employment of citizens in the private sector (Box 1). The reform’s main pillar is the Nitaqat program which imposes minimum shares for nationals that firms have to employ, to be able to access visa renewal and issuance for their expatriate workers, and other services provided by Ministry of Labor. While this paper does not evaluate the merits and design of the program, international experience indicates that a successful model for labor market policies is to “protect workers, not jobs” and to implement quotas gradually. In the GCC, experience indicates tradeoffs and a mixed record of success. Nitaqat seems to introduce more flexibility and targeting compared to previous programs, but as indicated by other research, it has drawbacks. For example, widening the wage gaps and basing the incentive system on facilitating expatriate employment may be at conflict with the program objective of increasing employment of nationals in the private sector (Alsheikh, 2015).

14. Data since 2011 points to mixed results so far. Employment of nationals in the private sector has increased, particularly in the manufacturing, transportation, and services sectors, and nationals have accounted for an increasing share of new jobs created. Overall, however, employment growth has declined owing to a sharp decline in expatriate employment growth (driven by the stricter enforcement of regulations on illegal foreign workers) (Figure 5, top panel). Unemployment has declined slightly and rates among youth continued to edge up. Public employment has continued to rise and the government wage bill reached about 12 percent of GDP in 2014. Other research on the impact of Nitaqat program has reached similar findings. An empirical study by Peck (2014) using firm-level data to 2012 (18 months into the program) found that under the program, 96,000 nationals had been employed in the private sector, but its overall impact on total job creation in the private sector was negative. The paper also points to some evidence that some of firms were able to avoid the system by hiring Saudi workers on a temporary basis in order to avoid penalties. Alshanbri et al. (2015) suggests, based on interviews with HR managers, that barriers to the successful implementation of the program include the skill profiles and high wage requirements of nationals, as well as cultural issues.

Figure 5.Labor Market Response to Recent Initiatives

Sources: CDSI; GOSI; IMF staff calculations

15. The recently introduced de facto minimum wage for nationals has led to an increase in the nationals-expatriates wage gap. The requirement for a minimum wage of SR 3,000 to be paid to earn a full Nitaqat credit has affected over 50 percent of Saudis working in the private sector.2 Wage data from GOSI shows that about 700,000 Saudi workers in the lower wage category saw their wage double in 2013 (Figure 5, bottom panels).

Box 1.Recent Labor Initiatives

The Ministry of Labor launched in 2011 a number of labor initiatives with a view to increasing employment opportunities for citizens in the private sector:

Nitaqat [Zones] Program: the Nitaqat program is a revamped version of the Saudization program that was in place since the 1990s. It introduces a rigorous quota system and incentives based on sector, size, and nationalization performance of private firms. Under Nitaqat, firms are color-coded and classified into categories according to the required ratio of nationals. For example, for a medium size firm in the agriculture sector, these categories are:

Color
Number of nationals/total emplyment0-2 %3%-5%6%-12%13%-19%2%-26%>=27%

Companies in the red and yellow bands are not allowed to renew work permits of expatriates, while firms that meet their targets are given rewards with preferential treatment, mainly facilitating visa renewal and issuing new visas.

De facto minimum wage: Nitaqat requires a minimum wage of SR 3,000 in order for a worker to be counted as a full credit in calculating the Saudization rate in a given firm.

Hafiz: is a jobseekers’ allowance program to provide unemployed Saudis with a monthly allowance of SR 2,000 for a maximum period of one year, conditional on their participation in job search and training activities. Job placement and training services have also been expanded.

Fees imposed on companies with a majority of expatriate workers (SAR 200 per month per foreign worker) are being used to finance an expansion in the scope and duration of wage subsidies for Saudi workers in companies that are compliant with Nitaqat requirements and other labor market programs.

Improvements to the internal mobility and bargaining power of expatriate workers. Expatriate workers in firms that do not meet their Nitaqat requirements are now allowed to change employers freely, while firms that are compliant are allowed to hire more expatriate workers. This is accompanied by stricter enforcement of work permits for foreign workers.

Increasing opportunities for female employment, with specific sectors (e.g. retail) being targeted.

An unemployment assistance scheme has been established to provide a broad social safety net.

D. Potential Macroeconomic Implications of Labor Reforms

16. The availability of low-wage expatriate labor has played an important role in shaping macroeconomic outcomes over the past decades. It removed constraints to private sector growth during the early stages of development, while containing wage and price pressures during upswings in the oil cycle. It has, however, created a pattern of low productivity and disincentives for nationals to build the skills needed in the private sector. Further, public sector employment has reduced incentives for nationals to seek jobs in the private sector. Recent education and labor reforms, intended to alter the structure of the labor market to one with a higher share of nationals working in the private sector, will change these patterns. The immediate impact of the new programs is coming from the Nitaqat program and other active labor policies including the Hafiz program, wage subsidies, and the new de facto minimum wage. Returns to education and skills development will likely take longer to materialize.

E. Fiscal Implications

17. With a young and growing population and rising participation rates, especially amongst women, the need to create jobs for nationals will continue in the coming years. Table 1 presents projections for the Saudi work force and unemployment under different scenarios for the future growth in the number of new labor force entrants. Given the current age structure and assuming a further increase in participation, between 1.6 and 1.8 million nationals will enter the labor force over the next 6 years. The higher number is derived based on the estimated growth in the working age population and a continuation of the recent increase in the participation rates, while the lower number assumes that the increase in participation rates will continue but at a slower pace as the initial impact of the initiatives introduced by the Ministry of Labor to increase female participation slow. Figure 6 decomposes the growth in the number of new labor market entrants into the change in working-age population segment and the increase in participation rates, showing the large contribution of the latter in recent years.

Table 1.Employment and Wage Bill Projections 2015–20Thousands unless otherwise specified
20142020 baseline
Scenario 1*Scenario 2**Scenario 3***
Saudi labor force5577718073897389
Employed in public3270406640664420
Employed in private1656204021112111
Unemployed65110731212858
Unemployment rate (percent)11.714.916.411.7
Wage bill/GDP (percent)11.913.613.614.7
Source: Authorities and staff calculations

Assumes fixed share of nationals in the private sector as in 2014 at around 21 percent, and labor participation rate continues its recent improvement but at a slower pace, so number of new entrants is 1.6 million over next 6 years. Public employment growth stays at 3.7 percent. Wage rates are assumed to grow by 2 percent annually in all the scenarios.

Assumes continued improvement in the share of nationals in the private sector to reach 23 percent by 2020 and recent trend in the growth of number of entrants to continue at same pace. Public employment growth stays at 3.7 percent annually

Assumes government aims to keep unemployment at 2014 level, by increasing public employment growth to 5.2 percent annually.

Source: Authorities and staff calculations

Assumes fixed share of nationals in the private sector as in 2014 at around 21 percent, and labor participation rate continues its recent improvement but at a slower pace, so number of new entrants is 1.6 million over next 6 years. Public employment growth stays at 3.7 percent. Wage rates are assumed to grow by 2 percent annually in all the scenarios.

Assumes continued improvement in the share of nationals in the private sector to reach 23 percent by 2020 and recent trend in the growth of number of entrants to continue at same pace. Public employment growth stays at 3.7 percent annually

Assumes government aims to keep unemployment at 2014 level, by increasing public employment growth to 5.2 percent annually.

Figure 6.Decomposition of Growth in Labor Market Entrants

(Percent)

18. Based on past trends, the private sector will not create enough jobs to absorb the new labor market entrants. Given the staff’s projections for non-oil growth for 2015–20, past trends would suggest that the private sector would create around 1.7 million jobs and employment of nationals in the private sector would increase by between 380,000-450,000 depending on whether the share of new jobs going to nationals stays at its 2014 level of 21 percent or continues to increase in the coming years as it has done in recent years as a result of labor market reforms, to reach 23 percent in 2020.3 If we further assume that government will hire nationals at a growth rate of 3.7 percent annually as expected in the baseline, 800,000 Saudis will be absorbed into the public sector. This would then leave between 450,000-700,000 Saudis unemployed, and the unemployment rate would range from 14.9 to 16.4 percent by 2020 (Table 1, scenarios 1 and 2).

19. In the absence of reforms to increase the employment of nationals in the private sector, unemployment rates among nationals would rise or the government would have to absorb new labor market entrants into the public sector and see the wage bill increase further. The baseline projections in the previous paragraph will not only result in higher unemployment, but also result in a higher wage bill of close to 14 percent of GDP by 2020. Further, if the government aims to keep the unemployment rate constant at its 2014 level, employment growth in the public sector would need to be 5.2 percent annually during 2015–20 and this would increase the wage bill to about 15 percent of GDP by 2020 (Table 1, scenario 3).

20. Successful labor reforms that lead to an increase in employment of nationals in the private sector could reduce potential unemployment and the fiscal burden. Using the projections in the previous paragraphs, if, for example, labor market reforms were to increase the share of nationals employed in the private sector by 10 percentage points from its current level to 32 percent by 2020, this would result in 1.2 million jobs going to nationals out of the 1.7 million projected to be created in the private sector by 2020. Under this scenario, unemployment would decline to 5.1 percent, assuming the government continues to hire nationals at same rate as in the baseline scenario (Table 2, scenario 4). Reforms could alternatively allow the government to reduce the growth of hiring in the public sector to less than 2 percent annually and this would keep both the wage bill and unemployment rate around their 2014 levels (Table 2, scenario 5 and Figure 7). A larger increase in national employment in the private sector would result in lower unemployment and/or a lower public sector wage bill.

Table 2.Employment and Wage Bill Projections 2015–20Thousands unless otherwise specified
20142020 under reforms
Scenario 4*Scenario 5**
Saudi labor force557773897389
Employed in public327040663576
Employed in private165629472947
Unemployed651375866
Unemployment rate (percent)11.75.111.7
Wage bill/GDP (percent)11.913.612.1
Source: Authorities and staff calculations

Reforms lead to higher share of nationals in the private sector by 10 pp. Assumes no change in growth of public employment of 3.7 percent annually. Calculations of wage bill assumes growth of 2 percent in wage rates.

Reforms lead to higher share of nationals in the private sector by 10 pp. Assumes government reduces growth of public employment from 3.7 to less than 2 percent annually.

Source: Authorities and staff calculations

Reforms lead to higher share of nationals in the private sector by 10 pp. Assumes no change in growth of public employment of 3.7 percent annually. Calculations of wage bill assumes growth of 2 percent in wage rates.

Reforms lead to higher share of nationals in the private sector by 10 pp. Assumes government reduces growth of public employment from 3.7 to less than 2 percent annually.

Figure 7.Saudi Arabia: Unemployment and Government Wage Bill in 2020

(Wage bill as percent of GDP; Unemployment rate as percent of labor force)

Source: IMF staff calculations

F. Impact on Wages, Inflation and Real Exchange Rate

21. Expatriates have helped dampen the inflationary impact of higher growth during oil cycles and helped limit real exchange rate appreciation. Inflation has been low in Saudi Arabia despite strong growth, and has remained below that of trading partners. This has limited the appreciation of the real effective exchange rate. While a number of policies have contributed to this trend, including the credibility of the exchange rate peg, the almost fully elastic supply of foreign labor has limited wage pressures, and remittance outflows have reduced domestic demand for nontradable goods and services.

22. The first channel of impact on prices will be through wages which will increase in response to policies aiming at increasing the attractiveness of private sector jobs for nationals. Employment of nationals in the private sector is correlated to their wage level, which means that average wages will have to increase to attract more nationals (Figure 8). The impact on total costs could be large in some sectors, depending on the share of workers’ compensation in operating costs, which ranges from less than 10 percent to over 75 percent in some service sectors. Under a scenario where labor market reforms increase the share of nationals in the labor force by 10 percentage points (from 22.4 percent to 32.4 percent), and using current wage gaps, operating costs in the private sector could rise by up to 3 percent. The cost-push impact on inflation will depend on size of operating costs in total production costs and on the pass through of these costs to final prices.

Figure 8.Employment and Wages of Nationals in the Private Sector

(Ratio)

23. Staff estimates find that changes in the size of the expatriate workforce have an impact on inflation along with food prices. A higher share of nationals in the workforce compared to expatriates will likely reduce the restraining effect that the ready availability of expatriate labor has on inflation. To estimate the possible impact on inflation, a VAR relating CPI inflation to food price inflation (FP), non-oil GDP growth (GDPGR), the change in the effective nominal exchange rate (DNEER), and growth of expatriates in the workforce (EXPATGR) was estimated using annual data from 1980-2014. The results suggest that a one percent increase in the growth of expatriates in the workforce reduces inflation by about 0.1 percent after one year and this effect fades over time (Figure 9, bottom right panel). This impact from expatriate labor on inflation is consistent with other findings for the GCC (IMF, 2014) and Espinoza et al. (2013)

Figure 9.Impulse Response of Inflation

(Red lines represent +/− two standard errors around the mean- blue line)

Source: IMF staff calculations.

24. Gradualism in implementation of labor market policies will help ease the inflationary impact. The impulse response functions from the VAR can be used to estimate the potential impact of a lower share of expatriates in the labor force as a result of labor reforms. A gradual decline in expatriate employment growth annually over 2015–20, from the recent average of 3.5 percent annually to 1.5 percent will increase the ratio of nationals in the private sector by 10 percentage points. The impact on inflation will be small each year, around 0.2-0.4 percent. By averaging over the cycles, these estimates, however, may mask the role the ready availability of expatriate labor plays in containing inflation at times of strong demand pressures in the economy.

25. Replacement of expatriates could also lead to real exchange rate appreciation. The impact works through changing the proportion of domestically spent income out of total income generated in the country and the size of remittances, which are leakages that reduce aggregate demand and pressures on domestic prices. This impact is consistent with findings of econometric work on other oil-exporting, labor-importing countries. Prasad et al. (2013) link the real exchange to its determinants including the size of remittance outflows and find that the latter leads to depreciation of the real effective exchange rate in this group of countries.

G. Productivity and growth

26. Growth in Saudi Arabia has been strong in recent years, but productivity growth has generally been slow. High population growth and the chosen growth model, whereby strong growth has been underpinned by the availability of relatively low skilled, low-cost foreign labor, has contributed to this pattern. The growth in the non-oil sector has been mainly driven by factor inputs, capital investment and labor, while total factor productivity (TFP)—a measure of how efficiently capital and labor inputs are being used in the production process—has generally made a small contribution. Saudi Arabia, however, compares favorably to other GCC and some oil exporting countries, and productivity growth has improved in recent years as a result of increased investment in education and infrastructure (Figure 10). Nevertheless, labor productivity growth still lags behind other oil exporting countries (IMF, 2014).

Figure 10.Labor Productivity,1 2000–13

(Average annual change in percent)

1 Productivity defined as non-oil real GDP per worker, except for Canada, Russia, Malaysia, Mexico, and migrant receiving countries for which non-oil GDP data were unavailable (GDP was used instead). Data for Qatar are from 2006–12; latest data for Saudi Arabia is from 2012.

27. Ongoing reforms will affect productivity and growth. To assess the potential impact, this section empirically estimates the role of factor inputs and total factor productivity via a growth accounting approach based on the Cobb-Douglas production function, Solow (1957). Starting with the following presentation of the function:

where ΔLn(Yt) is output growth in period t, Δln(kt) is the capital accumulation rate in period t, ΔLn(Lt) is employment growth in period t, and ΔLn(At) is TFP growth. The cost share of capital, α is assumed to equal 0.4, a value that is commonly used in empirical work. The initial capital stock is estimated using perpetual inventory method (Harberger, 1978). The contributions of capital, labor, and TFP to non-oil sector growth for the period 1990 onwards and for two sub-periods, 1990–99 and 2000–14, are estimated and presented in Table 3, top section.

Table 3.Average Contribution to Non-Oil Sector Growth(Percent)
Cost Share of Capital (α) = 0.4
1990-992000-2014
Growth2.96.8
TFP−0.41.0
Capital2.03.0
Labor1.32.8
Cost Share of Capital (α) = 0.68
1990-992000-2014
Growth2.96.8
TFP−1.20.3
Capital3.45.0
Labor0.71.5
Source: IMF staff calculations.
Source: IMF staff calculations.

28. TFP growth has improved and became positive in the 2000s, compared to the 1990s. The contribution of TFP remains small, however, compared to labor and capital factors. An alternative specification, where the cost share of capital is estimated directly from the data was also looked at. Using this methodology, the results are qualitatively the same, although TFP growth is estimated to have been smaller in both periods, while capital growth contribution has increased, (Table 3, bottom section).

29. Labor productivity, measured by unit labor real output, in the non-oil sector has picked-up in the 2000s, but remained flat for the economy as whole (Figure 11). A number of factors may have contributed to productivity enhancement in the non-oil sector including increased investment in infrastructure, investment in education, accession to the WTO and liberalization reforms in the 2000s.

Figure 11.Labor Productivity in Saudi Arabia, 1990–2014

(SAR thousands)

30. Investment in education and skills could further improve productivity. Saudi Arabia has invested heavily in education in recent years and made impressive progress in expected years of schooling which increased from 5.8 to 8.7 between 1990 and 2013, although measured educational outcomes are less favorable. To estimate the role of education, we use an augmented Solow growth model with human capital, (Mankiw, 1994). The production function that includes human capital can be written:

Where H is human capital, measured by average years of schooling as a proxy for skills. By dividing equation (2) by L, labor productivity growth (yt) can be presented as a function of physical capitalization as measured by the change in the capital-labor ratio (kt) and human capital as measured by improvement in years of schooling:

Table 4 presents the contributions to the growth using cost share of capital, α= 0.4. Results show that education has contributed positively to labor productivity and played a more important role than physical capitalization. The contribution of TFP in productivity growth is also small but has improved in recent years. When parameters are derived from a regression, the value of a is estimated at 0.64 and the contributions change, although they keep same pattern of improvement in recent years. Specifically, capital/labor ratio seems to play a larger role in explaining improvement in labor productivity, while education contributes less. The role of TFP improves but remains negative in the second period.

Table 4.Contribution to Labor Productivity(percent)
Cost Share of Capital (α) = 0.4
1990-992000-2014
Productivity Growth0.92.1
TFP−1.40.1
Capital labor ratio1.11.0
Human capital1.21.0
Cost Share of Capital (α) = 0.64
1990-992000-2014
Productivity Growth0.92.1
TFP−1.6−0.2
Capital labor ratio1.81.7
Human capital0.70.6
Source: IMF staff calculations.
Source: IMF staff calculations.

31. The results suggest that improvements in education and skills of nationals should help strengthen productivity performance over time. As improvement in quantity of education as measured by years of schooling is reaching its limits, the recent increased investment in education should continue to be focused on improving the outcomes of the education and skills development and aligning them with private sector needs and on directing more share of this investment to technical and vocational training.

H. Policy Recommendations and Conclusions

32. Firm control of public employment and compensation is needed to encourage people to seek employment in the private sector. A clear sign from the government that the public sector can no longer be the employer of first and last resort would help set expectations of people entering the workforce. This could be combined with a civil service review to help identify positions that are essential for the provision of government services and those that are not.

33. Gradualism in substituting foreign workers would help limit any potential disruptions to economic activity and pressures on wages and prices. Currently, the skill profiles of nationals are not in line with private sector needs, especially for basic technicians and basic supporting engineering skills, and private sector needs will continue to rely on expatriates in the near term. Building skills is a slow process and will require continuous efforts to transform the education and training systems to be demand driven, and encourage more Saudis to pursue vocational and technical programs. These factors should be taken into account in the design and enforcement pace of the Nitaqat quotas. Other research suggests a need for gradualism in the implementation of employment quotas to preserve the incentives for qualified candidates to invest in skills (Fryer and Loury, 2005).

34. Wage gaps will need to narrow to increase the employment of nationals in the private sector, but this will need to go in tandem with changes in productivity and skill composition. Narrowing wage differentials can be achieved by targeting high-skilled, high-wage expatriate workers through fees on low skilled labor, leveling the playing field in the labor market for nationals and expatriates with regard to regulations and work conditions, and allowing more labor mobility to increase productivity and wages of expatriates. Naidu et al. (2014) find evidence on the latter in the UAE where reforms to increase expatriates mobility have increased their earnings and reduced demand to import new immigrants. The wage subsidy programs implemented by the government can be useful not only to support the acquisition of job skills, but also to narrow the wage differentials. For more details on ways to reduce wage differentials in the GCC and international experience, see IMF (2014).

35. Macroeconomic policies will need to adapt to a labor market where overtime the role of foreign labor may diminish. If the labor market becomes less flexible and less able to play its historic role of helping contain overheating pressures, alternative instruments will be needed. Under the current exchange rate peg, the main instrument will be fiscal policy. Smoothing expenditures and building buffers during oil price booms would reduce overheating pressures and keep inflation under control. Reforms to strengthen the fiscal framework and adopting a medium term framework would support policy and delink expenditure from oil revenue swings. Reducing rigidities in the budget through lower wage and subsidy bills would facilitate the work of fiscal policy and free resources for more productive spending. Over the longer term, greater exchange rate flexibility that would allow a more independent monetary policy could help manage economic cycles and cushion the economy from external shocks.

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Prepared by Gazi Shbaikat.

Employers can count a Saudi as a “full employee” only if the wage is SR 3,000. For employees earning less, they are considered only “half” a Saudi employee.

Total employment creation (for nationals and expatriates) in the private sector will be around 1.7 million. The calculation uses latest GDP growth projections for 2014–20, and assumes a fixed elasticity of employment to growth as in previous years- the average for the past 5 years is 0.84 percent.

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