Saudi Arabia: Selected Issues

Abstract

Saudi Arabia: Selected Issues

Growth in a Low Oil Price Environment1

High oil prices and rapid growth in government spending have been important drivers of growth and have led to an economy where factor inputs rather than productivity and human capital development have supported growth. Looking forward, fiscal consolidation will result in slower economic growth in the near-term, and an acceleration of ongoing structural reforms is critical in spurring stronger productivity growth and private investment to offset slower public investment over the medium term.

A. Introduction

1. The economic structure in Saudi Arabia has evolved over the past 40 years, but growth is still importantly driven by developments in the oil and non-oil government sectors. Strong real oil GDP growth was the key driver of growth in the 1970s and 1980s. Oil GDP grew very strongly in a number of years in the 1970s, but then declined sharply in the 1980s following the oil output cuts in response to the decline in oil prices (Figure 1). The share of oil-GDP in total GDP fell in the 1990s and 2000s from 65 percent to 40 percent. In the 2000s, growth in the non-oil private sector accelerated and its share in overall GDP increased from 20 percent to 40 percent. In recent years, 60 percent of overall GDP is accounted for by the oil and government sectors (Figure 2). Real GDP has become less volatile in recent years as the volatility of oil output has fallen, structural reforms that have been underway since the early 2000s have increased the role of the private sector, and large fiscal buffers have meant that government spending has become more delinked from volatile oil revenues. Overall growth has been stronger in periods of high and rising oil prices than in periods of low and declining prices.

Figure 1.
Figure 1.

Real GDP Growth Rate

(percent)

Citation: IMF Staff Country Reports 2016, 327; 10.5089/9781475544275.002.A003

Sources. Haver and IMF staff calculations
Figure 2.
Figure 2.

Shares and Contributions to GDP

Citation: IMF Staff Country Reports 2016, 327; 10.5089/9781475544275.002.A003

Sources. Haver and IMF staff calculations

B. Low Oil Prices, Fiscal Consolidation, and Growth in the Non-oil Sector

2. Lower oil prices and the associated fiscal consolidation would be expected to reduce growth in an oil exporting country such as Saudi Arabia (Figure 3). Indeed, non-oil growth in most oil-exporting countries slowed between 2014 and 2015 and was below IMF forecasts made in the October 2014 WEO. On average, actual non-oil GDP growth for oil exporters in 2015 was 2.7 percentage points below the one-year ahead projection made by the IMF in October 2014. With oil prices expected to only gradually recover over the medium term and remain well below the levels seen in the first half of 2014, downward revisions to non-oil growth over the medium-term (through 2019) have also been substantial. These downward revisions to non-oil growth are significantly correlated with actual and expected reductions in government spending. Use of fiscal buffers helped Saudi Arabia to delay the need for immediate cuts in government spending in 2015, although expenditure consolidation was underway in the second half of the year. In 2016, the impact on growth in expected to be larger as it includes the lagged impact from consolidation in 2015 along with the consolidation expected in 2016.

Figure 3.
Figure 3.

Impact on Real Non-oil GDP Growth

Citation: IMF Staff Country Reports 2016, 327; 10.5089/9781475544275.002.A003

Sources. Haver, WEO IMF and IMF staff estimates.

3. Looking back at past oil price shocks, the impact on growth in Saudi Arabia has varied depending on whether the price drop is short or long-lived (Figure 4).

  • During the 1980s, the decline in oil revenues was long-lived as prices dropped and Saudi Arabia reduced its oil output. As fiscal revenues declined, the government undertook substantial fiscal consolidation, but the fiscal balance still moved from surplus into a large deficit. The government relied mainly on large cuts to capital spending, although current spending was also reduced. This was associated with a sharp slowing in non-oil growth.

  • During the oil price drops in the 1990s and 2000s, which were relatively short-lived, the drop in oil revenues was quickly reversed. Expenditure adjustment was sharp, but short-lived, in 1998-99, and real non-oil GDP growth only slowed temporarily. In the 2008–09, the large fiscal buffers that had been built-up allowed the government to maintain spending and again non-oil growth only slowed modestly.

Figure 4.
Figure 4.

Real GDP, Oil Revenues and Expenditure Changes During Periods of Oil Price Declines

(In percent)

Citation: IMF Staff Country Reports 2016, 327; 10.5089/9781475544275.002.A003

Note: Year t=0, corresponds to 1982, 1998, 2009 and 2014 for the ‘1980s,’ ‘1990s, ‘2000s,’ and ‘2014-15’ price decline events, respectively.Sources: Haver and IMF staff calculations.

4. The negative impact of lower oil prices on private sector activity was stronger in some sub-sectors than in others during past episodes (Figure 5). During the shock in the 1980s, activity slowed in most sub-sectors, but the construction, finance and real estate sub-sectors were most affected as capital expenditure was cut. These two sectors contributed on average 5 percentage points to the overall decline in non-oil private sector GDP during 1983–86. In the 1990s and 2000s, the slowdown in growth was most marked in the construction and manufacturing sectors, while the trade and hospitability sector was little affected during these years. More generally, since government spending was maintained in the 2000s, the impact on growth in most sub-sectors was contained.

Figure 5.
Figure 5.

Sector Contributions to Non-oil Private Sector Growth

(in percent)

Citation: IMF Staff Country Reports 2016, 327; 10.5089/9781475544275.002.A003

Sources. Haver, WEO IMF and IMF staff estimates.

5. Fiscal multipliers estimated for Saudi Arabia and the GCC generally indicate that capital spending has a larger impact on non-oil growth than current spending (Box 1). Espinoza and Senhadji, 2011, estimate spending multipliers for Saudi Arabia on data from 1975 to 2009. They find a short-term multiplier of 0.2 and a cumulative long-run multiplier of 0.5 for total spending, with a higher multiplier for capital spending. Multipliers used in SAMA’s macroeconomic model are similar to the Espinoza and Senhadji estimates (Table 1). Re-estimating the same model using the recently revised and updated GDP data for the period 1980–2015, suggests somewhat lower multipliers (Box 1). Looking at estimates of fiscal multipliers for the GCC as a whole—where the panel of data may allow more precise estimation than the relatively limited data sample for an individual country—suggests a range from 0.2 in the short run to 1.4 cumulatively, maximum over a 2–4 year period.

Estimating Fiscal Multipliers for Saudi Arabia

Model: The VAR model specified by Senhadji and Espinoza (2011) for Saudi Arabia is re-estimated on revised and updated data. This model links real world real GDP growth, Saudi real government expenditure growth (with nominal expenditure deflated by the non-oil GDP deflator) and Saudi real non-oil GDP growth (Figure 2). The model is estimated with annual data from 1980-2015, using two lags as identified by various lag selection criteria. The identification procedure is based on a Choleski orthogonalization, with world growth ordered first to capture the impact on demand side factors affecting oil revenue through oil production and oil prices. No significant endogeniety of fiscal policy is assumed and hence fiscal variables are ordered before non-oil growth- expenditure allocations are made at the start of the year and are not affected by growth in that year. The model is estimated separately for current and capital expenditures.

Results: For each specification, since the variables are converted to growth rates, impulse responses can be interpreted as elasticities and used to estimate the multiplier for each expenditure type. The impulse responses show that the impact of an increase in non-oil GDP has little effect on government expenditures even after a few years, confirming the prior view of little endogeniety in fiscal policy. The multiplier estimate for current spending is higher at 0.3 in the short term and 0.5 cumulated over 2 years, while the multiplier for capital spending is lower at 0.2 in the short run and 0.8 cumulated over three years. Lower multiplier for capital spending compared other estimates in the literature (paragraph 4) may be due to its high import content in terms of goods and services and labor.

Estimated Cumulative Fiscal Multipliers for Saudi Arabia

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Multiplier is computed by dividing the standardized impluse responses/ elasticities by the ratio of real expenditure to real non-oil GDP.

A03ufig1

Impulse Response of Non-oil Growth to Expenditure Shocks 1/

Citation: IMF Staff Country Reports 2016, 327; 10.5089/9781475544275.002.A003

1/ Variables are in growth rates and the impluse responses are cumulated. Impluses are presented for a one standard deviation shock of the orthogonized errors.
A03ufig2

Real GDP and Government Expenditure

Citation: IMF Staff Country Reports 2016, 327; 10.5089/9781475544275.002.A003

Table 1.

Fiscal Expenditure Multipliers

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Sources. IMF publications, SAMA and IMF staff estimates.

6. It is also possible that the fiscal multipliers change over time depending on the conditions in the economy and the type of spending undertaken. For example, part of the increase in government expenditures in recent years has been spent on land acquisition for the Mecca and Medina expansion projects which may have very low multipliers if the sellers save the receipts. Further, there has been a substantial increase in military spending which likely has a high import content, which would mean even lower multipliers and limited pass-through to private sector growth.

7. Fiscal reforms should yield long-term gains and improve efficiency even though they incur short-term costs. For instance, while the impact on growth from energy price reforms could be negative in the short run, estimated real income gains from improved efficiency, even after consumers are compensated, range between 1.5–2.1 percent of GDP for Saudi Arabia in the long-run (see IMF 2015b). Similarly, improving the efficiency of capital spending would be important to maximize the growth dividend. IMF (2015) argues that the growth impact of closing the public investment efficiency gap could be substantial. The study finds that a one-off 1 percent of GDP increase in public investment increases output by just 0.3 percent in countries in the bottom efficiency quartile, but 0.6 percent for countries in the top efficiency quartile. The period of strong reforms seen in Saudi Arabia in the first half of the 2000s had a substantial positive effect on productivity growth.

C. The Impact of Low Oil Prices and Fiscal Consolidation on Potential Growth

8. Non-oil growth in Saudi Arabia has been driven by capital and labor inputs rather than productivity growth in recent years (Figure 6). A growth accounting approach is used to estimate the role of factor inputs and total factor productivity (TFP)- a measure of how efficiently capital and labor inputs are being used in the production process (Solow,1957).2 Both capital and labor inputs have been the main drivers of non-oil growth, while TFP has made a small or negative contribution for most periods, including since 2010. Growth of labor and capital inputs has been strong due to the large increase in foreign workers in the private sector and the strong growth in public capital stock since mid-2000s as the government used the opportunity of rising oil revenues to boost its investment in infrastructure.

9. With public investment falling as fiscal consolidation proceeds, it is likely that without reforms to boost productivity growth, potential non-oil sector growth will slow. Using staff projections of trend growth in the capital stock, labor force and TFP, potential growth in the non-oil sector is projected to slow to 2.4 percent on average during 2016–21. Growth in the public capital stock is expected to slow to an average of about 2 percent during this period compared to 13.2 percent on average during 2009-2015. Similarly, using an HP filter, trend growth is estimated to slow from an average of 5.6 percent during 2009–15 to 3.5 percent over the medium term (Figure 7, right panel).

Figure 6.
Figure 6.

Estimating Potential Growth

Citation: IMF Staff Country Reports 2016, 327; 10.5089/9781475544275.002.A003

Figure 7.
Figure 7.

Actual and Potential Non-oil Growth

Citation: IMF Staff Country Reports 2016, 327; 10.5089/9781475544275.002.A003

10. Measures to improve productivity, encourage private investment, and increase labor force participation will be critical to limit the slowdown in potential growth in the coming years. Structural reforms that improve TFP growth and increase employment from past trends would help offset the projected decline in potential growth that is being driven by fiscal consolidation. If TFP growth increases to 1.3 percent a year, same as the average in 2000–08, a period of significant structural reform in Saudi Arabia, and employment continues to growth at 4 percent, then non-oil potential growth could be increased to an average of 5.4 percent during 2016–21 (Figure 7, left panel). Maintaining employment growth at 4 percent as public sector employment slows with fiscal consolidation will require stronger employment growth in the private sector going forward (Box 2).

Employment in a Low Growth Environment

Despite stronger growth contributions by the private sector in recent years, employment of nationals in the private sector has remained weak. Over last few years, the main growth drivers, such as the manufacturing and trade sectors, have contributed to far less jobs for nationals compared to expatriates. The real non-oil private sector grew on average by over 7 percent a year since 2005 and created more than 3.6 million jobs, but only one fifth of these private sector jobs went to nationals. 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. The weak responsiveness of employment of nationals to private sector growth reflects the uneven sectoral distribution of national employment.

A03ufig3

Contribution of Sub-sectors to Overall Real GDP Growth

(in percent share)

Citation: IMF Staff Country Reports 2016, 327; 10.5089/9781475544275.002.A003

A03ufig4

Sectoral Contribution of Nationals and Expatriates Employed in the Private Non-oil Sector to Total Employment Growth

(in percent share)

Citation: IMF Staff Country Reports 2016, 327; 10.5089/9781475544275.002.A003

Unless further reforms are introduced to increase the employment of nationals in the private sector, the unemployment rate among nationals could rise significantly over the medium term, if the absorption of nationals by the government is limited. The table below presents projections for the Saudi work force and unemployment for 2021 under different scenarios using assumptions on population growth and participation rates to estimate the number of new labor force entrants. Under these assumptions, around 1.7 million people are projected to enter the labor force by 2021. In scenario 1, employment of nationals in the public sector is assumed to continue to grow at 4 percent a year based on past trends and the increase in employment of nationals in the private sector is projected using the private non-oil growth rates in the staff’s baseline scenario and the recent elasticity of national employment in the private sector to private non-oil growth. Given the expected slowdown in growth in this scenario, the private sector does not create enough jobs to absorb the new labor market entrants and unemployment increases to 17.2 percent by 2021. However, the need to contain the wage bill would hinder the government from increasing employment at the rate in scenario 1. Scenario 2 assumes a slowdown in the annual growth of national employment in the public sector to 2 percent. With this assumption, the unemployment rate increases further to 23.5 percent. Reforms to increase the share of nationals working in the private sector will therefore be crucial to contain unemployment. Scenario 3 shows that with public sector employment increasing by 2 percent a year, to keep the unemployment rate at 11.5 percent in 2021 (which is still high compared to the targeted reduction in unemployment rate to 9 percent by 2020 in the NTP), 1.1 million jobs will have to be created for nationals in the private sector between 2016 and 2021. To achieve this target, reforms are needed to increase private non-oil growth, increase the elasticity of private sector employment of nationals to non-oil private sector growth sharply (and unrealistically) from 0.74 (average for the past 5 years used in scenarios 1 and 2) to 3.2, or to substitute nationals for expatriate workers in existing jobs (assuming this has no impact of total jobs available). In reality, some combination of these three will likely be needed to keep unemployment from increasing.

Saudi Arabia- Employment of Nationals 2015-2021

Thousands unless otherwise specified

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Assumes national labor force to increase in line with increase in labor participation rate from 40 percent to 43.5 percent and a 3.1 percent annual increase in national population. Employment of nationals in the public sector continues to growth at an annual rate of 4 percent and the share of nationals in the private sector is assumed to remain unchanged at 21 percent.

Additionally assumes employment growth of nationals in the public sector to reduce by half to 2 percent.

To keep unemployment rate constant at 11.5 percent compared to 23.5% in scenario 2, the responsiveness or elasticity of private sector employment to non-oil output needs to increase from 0.74 historically to 3.2. Alternatively, the share of nationals in the private sector employment needs to increase by 10 pp from 21 percent historically to 31percent.

Source: Country authorities and IMF staff calculations.

11. G20MOD, a module of the IMF’s Flexible System of Global Models (Appendix I), can also be used to assess the impact of lower oil prices and fiscal consolidation on growth in Saudi Arabia and the role that structural reforms could play in offsetting this impact (Figure 8). Four scenarios are considered to assess these policies. In each scenario, oil prices drop by 60 percent, broadly what has been seen since mid-2014. The first scenario looks at the impact on the economy if the fiscal deficit does not adjust. The second looks at the impact of a fiscal consolidation of roughly 10 percent of GDP. The third and fourth scenarios look at the role that structural reforms to boost labor force participation and productivity would need to play to offset the negative effects of fiscal consolidation on real GDP by 2021.

  • In the first scenario, primary expenditure is reduced by 6 percent of GDP, but with the sharp decline in oil revenues and rising borrowing costs, even by 2021 the fiscal deficit is still high. The sharp increase in government debt results in higher risk premium and an increase in borrowing costs, which together with the reduction in government spending results in a drop in real GDP of about 10 percent below the baseline (the interpretation of this is that if real GDP was growing by 5 percent a year on average during 2016–21, after the oil price drop it would grow on average by 3.3 percent).

  • The second scenario assumes the fiscal deficit declines by 10 percent of GDP as spending and transfers decline. While these additional fiscal measures reduce output in the short-term below that in the first scenario, over the longer-term, lower government debt reduces risk premium and boosts growth above the first scenario. The decline in sovereign risk premium reduces real interest rates which stimulates private investment. At the same time, the lower burden of interest payments creates fiscal room.

  • The third scenario assumes an increase in the labor force participation rate of 7 percentage points and increased employment by about 13.5 percent. This offsets a little more than one-half of the real GDP loss by 2021. This increase in the labor force participation rate, however, is high compared to the maximum historical increase of 4.6 percentage points experienced in a 6-year period in the last decade.

  • The fourth scenario adds to the third scenario an assumed increase in TFP growth which closes the remaining real GDP gap relative to the initial baseline. TFP growth rate would need to increase by 0.8 percent a year on average to achieve this.

Figure 8.
Figure 8.

Impact of Oil and Fiscal Reform Scenarios – Results from G20MOD

Citation: IMF Staff Country Reports 2016, 327; 10.5089/9781475544275.002.A003

Source: IMF staff calculations.

D. Structural Reforms to Boost Productivity and Growth

12. Structural reforms have been ongoing in Saudi Arabia since the early 2000s, although the pace of reforms has generally slowed in times of higher oil prices. These reforms have included accession to the WTO, privatization of state-owned assets, education reforms, and ongoing efforts to improve the investment environment. Saudi Arabia has made some progress in reducing regulatory barriers and improving the business environment. The introduction of the new companies’ law, which reduces the administrative burden on SMEs, strengthens minority shareholder rights, and improves corporate governance, is a step in the right direction. To increase the contribution of the SME sector, the SME Authority has been set up to oversee all government policies affecting the SME sector and reduce the legal and administrative burden of setting up a business, along with continuation of the Kafalah loan-guarantee program. Moreover, a number of sectors have been opened to foreign investment, especially in the early 2000s, and the Saudi Arabian General Authority (SAGIA) introduced several measures aimed at simplifying licensing procedures for foreign companies planning. A number of state assets have been privatized (see accompanying paper on Privatization and PPPs in Saudi Arabia: Past Experience and Way Forward). There has been continued progress with educational reforms, though these will have to be more broad-based and will take time to filter into the workforce. Also, work is ongoing on a new insolvency law and stronger contract enforcement.

13. Recently, the government has been pursuing a growth strategy through the G20 framework working group where reforms are focused on three broad areas of economic diversification, labor markets, and education (Table 2). These structural reforms are expected to deepen as the new policies highlighted by the National Transformation Plan (NTP) underpinning Vision 2030 are rolled-out. One of the key economic targets of the NTP is to increase the share of the private sector to 65 percent of GDP from 40 percent currently; the SME sector contribution is targeted to be increased from 20 percent of GDP to 35 percent.

14. Several large industrial projects aimed at developing the non-oil sector are underway and close to completion. The aim is to produce high value-added export products and increase domestic energy production capacity. Table 3 presents a list of some major projects that is expected to stimulate non-oil sector growth in the near term.

Table 2.

Selected Structural Reforms Under Implementation in Saudi Arabia as Part of the G-20 Framework Working Group

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Source: Saudi Arabia’s Adjusted Growth Strategy, 2015 for the G20 Framework Working Group.
Table 3.

Major Industrial Projects in Saudi Arabia

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Source: Country authorities.

15. These ongoing reforms and further measures to boost productivity, raise the employment of nationals in the private sector, and encourage private investment in the non-oil sector will be critical to offset the impact of lower oil prices on the economy. In the area of doing business, enforcing contracts, protecting investors, resolving insolvency, trade, and starting a business are areas that deserve attention (Figure 9). These areas will be particularly important for attracting foreign investment which also provides the opportunity of knowledge transfer which could help boost productivity. The development of a local private bond market would also help support private investment. Increased competition, particularly in a number of service and professional sectors, could help boost productivity growth. A greater focus on the quality of education and skills development in areas needed by the private sector would help increase employment and productivity, and other labor market reforms which incentivize both workers and private firms to increase employment of nationals are critical (IMF, 2014).

Figure 9.
Figure 9.

Doing Business Indicators, 2015 vs 2016

Citation: IMF Staff Country Reports 2016, 327; 10.5089/9781475544275.002.A003

Sources: Doing Business 2015–16 and World Bank.

16. Privatization and PPPs have been part of Saudi Arabia’s broader effort to increase the role of the private sector in the economy. The overall impact of these policies has been positive and the private sector role has been rising gradually since the early 2000s. Nonetheless, the size of the government remains large in terms of its stake in public enterprise and its spending and investment. The hydrocarbon sector remains largely government owned and run, while outside the non-hydrocarbon sector, the government retains large stakes in sectors such as petrochemicals, telecommunications, financials, and utilities. Capital expenditures are large by international standards, and the role of the private sector in infrastructure investment remained limited.

17. The recently announced NTP envisages a greater role for the private sector. The NTP has outlined reforms and policies that could help expand the size of the private sector and more broadly diversify and transform the economy. The plan envisages a greater role for the private sector, including through privatization and expanding the use of PPPs, with a view to increasing efficiency and productivity and increasing job opportunities for nationals in the private.

18. In terms of the sequencing of these structural reforms, it is important that a focus is put on those that can have a relatively quick positive impact on growth. Recent cross-country evidence suggests that policies to boost trade and FDI have the potential to significantly boost productivity and output, and the gains appear to materialize rather quickly within one to five years (IMF 2016). More generally, this research has also found that product market reforms, which include deregulating retail trade, professional services, telecommunications, the utilities sectors, and certain segments of transportation sector have an expansionary effect on output in the short-term through their impact on investment for credit-constraints firms and by improving productivity. Labor market reforms, however, often have a short-term growth cost, although this will depend on the exact type of reform. Raising the cost of labor will likely reduce growth in the near-term, whereas easing restrictions on female participation would have a positive effect on growth. Similarly, to give the corporate sector time to adjust, it will be important to phase-in reforms gradually those reforms which increase their input cost and discourage future investment. Also, with the planned fiscal adjustment, other reforms that are growth-friendly or at least do not further add to the negative short-term effects of fiscal policy should also be implemented.

19. The growth impact of the government’s reforms will also depend on how the reforms are prioritized, sequenced, and implemented. While very much needed, fiscal consolidation will likely have a negative effect on growth in the near-term, although the size will likely depend on the composition of the adjustment. It will therefore be important that fiscal reforms are introduced over a period of time so the economy does not suffer a large shock. Further, the broad array of reforms laid out by the NTP will need to be carefully prioritized and sequenced in order to help reduce the risks of implementation bottlenecks, minimize potential negative short-term economic and employment effects, and reduce the risk of pushback and reform fatigue from the population. Poor sequencing and implementation will not only weaken the effectiveness of the reforms, but will also increase the risks that they are reversed at a later date. Besides, the government will need to carefully assess its own implementation capacity and ensure coordination to effectively deliver on the planned reforms within the time period envisaged.

E. Conclusion

20. Lower oil prices and fiscal consolidation are resulting in slower economic growth. Non-oil growth has already weakened over the past year, and is likely to slow further in 2016, while employment of Saudi nationals in the private sector has come to a halt. In 2016, the impact on growth in expected to be much larger as it includes the lagged impact from consolidation in 2015 along with the consolidation expected in 2016. This weakening economy provides the backdrop against which the structural reforms would need to be implemented.

21. Going forward, an acceleration of ongoing structural reforms is critical to spur stronger productivity growth and private investment to offset slower public investment. Structural reforms have been ongoing in Saudi Arabia, but will need to deepen. Vision 2030 and the NTP have outlined reforms and policies that could help expand the size of the private sector and more broadly diversify and transform the economy. In terms of the sequencing of these reform measures, it is important that a focus is put on those that can have a relatively quick positive impact on growth. Poor sequencing and implementation will not only weaken the effectiveness of the reforms, but will also increase the risks that they are reversed at a later date.

Appendix I. A Summary of the IMF’s G20MOD Module of FSGM

This annex provides a broad summary of G20MOD, a module of the IMF’s Flexible System of Global Models (FSGM). G20MOD is a 25-bloc global general equilibrium model encompassing each of the G-20 countries and 5 additional blocs that effectively complete the rest of the world. The model is presented in greater detail in Andre and others (2015).

1. G20MOD is an annual, multi-economy, forward-looking, model of the global economy combining both micro-founded and reduced-form formulations of economic sectors. G20MOD contains individual blocks for the G-20 countries, and 5 additional regions to cover the remaining countries in the world. The key features of a typical G20MOD country model are outlined below, noting any special circumstances that are applied for Saudi Arabia.

2. Consumption and investment have microeconomic foundations. Specifically, consumption features overlapping-generations households that can save and smooth consumption, and liquidity-constrained households that must consume all of their current income every period. Firms’ investment is determined by a Tobin’s Q model. Firms are net borrowers and their risk premia rise during periods of excess capacity, when the output gap is negative, and fall during booms, when the output gap is positive. This mimics, for example, the effect of falling/rising real debt burdens.

3. Trade is pinned down by reduced-form equations. They are a function of a competitiveness indicator and domestic or foreign demand. The competitiveness indicator improves one-for-one with domestic prices—there is no local-market pricing. For Saudi Arabia, most exports are oil, so competitiveness changes play a small role in the model.

4. Potential output is endogenous. It is modeled by a Cobb-Douglas production function with exogenous trend total factor productivity (TFP), but endogenous capital and labor. For Saudi Arabia, potential output also moves one-for-one with the long-run average production of oil (but not cyclical swings in oil production).

5. Consumer price and wage inflation are modeled by reduced form Phillips’ curves. They include weights on a lag and a lead of inflation and a weight on the output gap. Consumer price inflation also has a weight on the real effective exchange rate and second-round effects from food and oil prices. Given that energy prices in Saudi Arabia do not respond to global oil price developments, there is no feed-through from oil price changes to CPI inflation in the Saudi Arabia bloc. While the role of expatriate labor in Saudi Arabia is not directly modeled, the effects are approximated by having a low-weight on the output gap.

6. Monetary policy is governed by an interest rate reaction function. For most countries, it is an inflation-forecast-based rule working to achieve a long-run inflation target. For Saudi Arabia, the monetary reaction function defends its fixed nominal exchange rate against the U.S. dollar. This means in tandem with the risk-adjusted uncovered interest rate parity condition, Saudi Arabia must, in the face of shocks, set its monetary policy interest rate equal to that of the United States in order to defend its peg.

7. There are three commodities in the model—oil, metals, and food. This allows for a distinction between headline and core consumer price inflation, and provides richer analysis of the macroeconomic differences between commodity-exporting and importing regions. The demand for commodities is driven by the world demand and is relatively price inelastic in the short run due to limited substitutability of the commodity classes considered. The supply of commodities is also price inelastic in the short run. Countries can trade in commodities, and households consume food and oil explicitly, allowing for the distinction between headline and core CPI inflation. All have global real prices determined by a global output gap (only a short-run effect), the overall level of global demand, and global production of the commodity in question.

8. Commodities can function as a moderator of business cycle fluctuations. In times of excess aggregate demand, the upward pressure on commodities prices from sluggish adjustment in commodity supply relative to demand will put some downward pressure on demand. Similarly, if there is excess supply, falling commodities prices will ameliorate the deterioration.

9. In Saudi Arabia, oil is the only commodity that is produced and exported, and is a dominant feature of the model. Exports of oil respond largely to Saudi production decisions. Eighty-five percent of oil revenues are assumed to accrue to the government, the remainder to Aramco, the state oil company. This means that oil price fluctuations affect government revenues, but have little effect on household wealth as households have no direct ownership stake in the oil sector. Oil prices also have little effect on households’ and firms’ decisions, as oil prices are held fixed domestically. The government, which has a large stock of financial assets, is assumed to set long-run fiscal policy with the aim of maintaining this asset stock, although in the short-run fiscal policy can result in significant deviations away from this target.

10. Countries are largely distinguished from one another in G20MOD by their unique parameterizations. Each economy in the model is structurally identical (except for commodities), but with different key steady-state ratios and different behavioral parameters. As noted above, the parameterization of Saudi Arabia is strongly determined by the fact that its economy is dominated by oil.

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1

Prepared by Malika Pant (MCD), Keiko Honjo (RES), Salah Alsayaary, and Fares Rawah (both SAMA).

2

The Cobb-Douglas production function is defined as ΔLn(Yt) = ΔLn(At) + αΔLn(Kt) + (1-α)ΔLn(Lt), 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 is assumed to be 0.4 (see 2013 Selected Issues Paper, “Productivity Growth And Potential Ouput In Saudi Arabia.”)

Saudi Arabia: Selected Issues
Author: International Monetary Fund. Middle East and Central Asia Dept.