Country of the month: Saudi Arabia

The skyline of
Saudi Arabia’s
capital, Riyadh,
with the 99-storey
Kingdom Tower
in the distance.

Saudi Arabia is attempting to transform its economy from petro-state to economic hub, and looking for investors to take part in its planned makeover. It’s not a straightforward transformation, however, as the kingdom has come up against a complicated IPO and its own grisly human rights abuses, which could give global investors pause.

Oil and Saudi Arabia are synonymous. The country has about 16% of the globe’s proven petroleum reserves and it’s the world’s largest oil exporter. The resource accounts for about 90% of export earnings, funds about 87% of the country’s budget and contributes 42% of its GDP.

A decade ago, the Saudis depended on triple-digit oil prices, says Omar Faruqui, portfolio manager at Heirloom Investment Management in Dubai. It’s since cut back and introduced new revenues, including a value-added tax. Now he says the country could balance its budget in a price range of US$75 to $80 per barrel. Oil has been trading at an average of about US$70 this year, but there’s reason for the Saudis to be optimistic.

“Prices are going to go beyond US$80,” says Fareed Mohamedi, managing director of SIA-Energy International, in Washington, D.C. Political issues in Iran, Venezuela, Nigeria and Libya have tightened supply.

Still, Saudi Arabia’s monarchy has seen the perils of depending on a single commodity. Crown Prince Mohammed bin Salman’s Vision 2030, announced in 2016, is a plan to diversify the economy and develop sectors including technology, telecommunications, manufacturing and finance in the next two decades. The country is investing billions and aims to make its Public Investment Fund the world’s largest sovereign wealth fund.

State companies will be created to invest in non-oil sectors, namely banks and infrastructure such as ports, airlines and highways, explains Mohamedi. “Eventually, part of the infrastructure companies would be privatized.”

Saudi Arabia is working on attracting foreign investment in nearly every sector, and reshaping its bureaucracy and market to be more transparent and welcoming to outsiders. The country recently dropped the requirement that retail and consumer businesses be 25% Saudi-owned, but there are still hurdles. Foreigners are barred from investing freely in several industrial and service sectors, including oil and gas exploration.

Vision 2030 is meant to raise the standard of living and create jobs—20,000 of them by 2020. GDP per capita rose 26.6% between 2007 and 2017, but has plateaued since 2015. Unemployment has risen to a record 12.9% this year, and is even higher among youth.

Higher employment would unlock an economic cycle that provides further opportunities for investors, says Faruqui. He suggests tracking Saudi banks and consumer companies—two sectors that will benefit first as incomes rise.

IPO postponed

Bin Salman, commonly referred to as MBS, planned to raise funds for Vision 2030 by taking state-owned Aramco, the world’s most profitable oil company, to market. When he announced plans for an IPO in 2016, the 5% stake in Aramco was reportedly valued at US$100 billion, which would have made it the biggest IPO in history and given the company a total value of US$2 trillion.

Once thought to be imminent, the IPO has been delayed several times. MBS now says it will take place by 2021.

Citing anonymous government officials, Reuters reported in August that MBS’s father, King Salman, was behind the decision to delay the IPO. Possible reasons included worries the valuation was too high, concern over losing control of a strategic asset and hesitancy over growing scrutiny of Aramco’s finances.

Mohamedi, a former senior consultant for Aramco, doesn’t think transparency was an issue.

“The company has had an autonomous role from the government, and it has a board which includes government officials but also foreign private executives like JP Morgan and others,” he said. “Those guys were always given a full disclosure of the company’s activities.”

With the Aramco IPO delayed, MBS must look elsewhere to fund Vision 2030. That appears to be the motivation behind another Aramco deal, says Mohamedi.

Aramco is now working on buying Saudi Basic Industries Corporation. SABIC is the world’s fourth-largest petrochemical manufacturer and the largest company on the Saudi stock exchange, Tadawul. The Saudi Public Investment Fund (PIF) owns 70% of the company’s shares.

Mohamedi estimates Aramco would have to borrow as much as US$70 billion to buy PIF’s portion. The investment fund could then use that money to fund Vision 2030 projects.

MBS told Bloomberg in early October that the PIF would receive the $70 billion from the SABIC sale as well as the $100 billion the government expects to raise from the Aramco IPO. But the Saudi government will now keep the Aramco shares following the IPO, instead of transferring the shares into the PIF.

MBS said the SABIC deal would close in 2019. He also told Bloomberg the deal was a precursor to the Aramco IPO, explaining that integrating the two companies’ chemical-making capabilities would strengthen Aramco over the long term.

If Aramco were to turn to the debt markets for money to buy SABIC, it could be an opportunity for foreign investors to access the Saudi market while enjoying the security of a stable, asset-backed business. Faruqui says he’s reserving judgment until terms are announced, but adds that yields for such a safe investment would likely be low.

Generally, investors looking for Saudi bonds have few options. “There is no fully developed corporate bond market,” notes a 2017 U.S. State Department brief.

Index milestone

Next year the kingdom will be included in MSCI’s indexes, a move that is expected to bring about US$40 billion into the country. Anticipation has already pushed up local stock prices.

“I’ve seen a number of other countries around the world go through this journey. As soon as you get MSCI-ready, there’s a bit of excitement, then there’s a bit of a lull, and slowly but surely, the active and passive investors arrive,” says Faruqui.

MSCI will include 32 Saudi firms, with a weight of about 2.6% in its emerging market ETF.

There is already a Saudi-specific MSCI ETF. As of June, it had US$269 million in assets, up from US$2.2 million two years ago. Other firms, including FTSE Russell, Franklin Templeton and Invesco, plan to include Saudi Arabia in their indexes, or already have.

The politics of investment

Though Saudi Arabia has worked to welcome outsiders, some of its actions have given investors pause.

In 2017, a government anti-corruption team detained dozens of royal family members and ministers for months. Many were never charged. Fareed Mohamedi of SIA-Energy International likens the detention to a shakedown, and says it’s part of Crown Prince Mohamed bin Salman’s plan to restructure government from a patronage system into a technocracy. His methods have spooked foreign investors, Mohamedi says.

The situation worsened in October after gruesome details emerged about the murder of Saudi journalist Jamal Khashoggi in his country’s consulate in Istanbul. The Saudis admit the journalist—a critic of the kingdom’s rulers, particularly MBS—was killed in the consulate but their explanations have varied.

The controversy has garnered scrutiny from the international investment community, Mohamedi says, making foreign investors “extremely critical” about the potential success of MBS’s reforms. “There was always a certain hesitation coming out of the shakedown, but now with this [Khashoggi] incident, it’s like, ‘Oh my God, there’s really something going on here,’ ” he says.

Foreign investment in Saudi Arabia has shrunk. Between 2015 and 2017, it dropped from US$8.1 billion to US$1.4 billion, and the Khashoggi affair has the potential to spook investors further.

Formerly, the kingdom’s foreign policy was measured, says Faruqui, but that’s changed under the crown prince.

Saudi Arabia has been involved in a brutal proxy war against Iran-backed rebels in Yemen since 2015, creating a humanitarian crisis. This summer, the Canadian government called on the kingdom to release a group of jailed human rights advocates. The Saudis responded by recalling thousands of students studying in Canada, barring future business relations, halting wheat imports and cancelling flights between the countries. Both countries have pulled their ambassadors.

The basics

Official name: Kingdom of Saudi Arabia

Capital: Riyadh

Head of state: King Salman

Government type: Absolute monarchy

Population: 32.9 million (2017)

Citizenship: By birth or adult naturalization after 10 years of residence; dual citizenship only with permission of the prime minister

Currency: The exchange rate is fixed at 3.75 riyals to US$1. In 2010, Saudi Arabia—along with Qatar, Bahrain and Kuwait—created a joint monetary council with the goal of establishing a joint currency. Economic pains and logistics have slowed that project.

Sources: World Bank, Saudi Arabia Ministry of Interior

Economy

GDP (purchasing power parity): US$1.77 million (2017)

GDP growth: 1.8% (est. 2018)

Inflation rate: 2.2%

GDP per capita: US$53,844.70 (2017)

Unemployment rate: 12.9%

Stock of direct foreign investment: US$232 billion (2017)

GDP by sector

GDP Saudi Arabia Agriculture: 2.6%

Industry: 44.2%

Services: 53.2%

Sources: World Bank, CIA World Factbook, Saudi Arabia Monetary Authority, Santander

Taxation

Income

Corporate

Natural gas sector: 30%
Oil and hydrocarbon sector: Regressive from 85% to 50%
Non-oil-and-gas business: For a Saudi, 2.5% for the share of a resident company; for a non-Saudi, 20% for the share of a resident company

Personal: 0%

Capital gains