Structural Transformation Options of the Saudi Economy Under Constraint of Depressed World Oil Prices.

• Author: Soummane, Salaheddine

1. INTRODUCTION

   The implications of global mitigation policies for oil-exporting countries of the Middle East have generated considerable attention. There is a large consensus in the literature that a scenario of ambitious mitigation would depress oil prices. The drop is of 27% by 2030 in the Sustainable Development Scenario (SDS) of the International Energy Agency (IEA, 2017) compared to its less stringent New Policies Scenario (NPS). There is also widespread agreement that mitigation policies at global scale will reduce global oil demand. Comparatively, how demand for the conventional oil of the Middle East and thus how export revenues of Middle East producers may evolve, is less clear-cut. Johansson et al. (2009) and Persson et al. (2007) project gains as carbon pricing would drive unconventional resources out of the market under the condition of low oil-demand elasticity. Conversely, Bauer et al. (2016), Edenhofer et al. (2014), Waisman et al. (2013) estimate that oil-exporting countries in the Middle East will lose from the implementation of global mitigation policies, as will all oil-exporters.

   The Kingdom of Saudi Arabia (KSA) is notoriously exposed to both volume and valuation risks, as oil revenues generated over 80% of both the country's exports and fiscal earnings between 2009 and 2018 (SAMA, 2018). Consequently, the KSA's communications to the United Nations Framework Convention on Climate Change (UNFCCC) have argued that global climate policies would deteriorate its economic outlook (Saudi Arabia, 2005; 2011; 2016a). Some strategies could mitigate adverse climate-policy effects on oil revenues (e.g., quota agreements to sustain prices, price cuts to increase market shares or monetary compensation under the climate-negotiation process) but may prove challenging to implement and transitory at best. Pershing (2000), Hvidt (2013) and Van de Graaf and Verbruggen (2015) affirm that economic diversification is the only viable development strategy for oil-exporting countries facing the structural decline of oil rent prompted by global low-carbon transition.

   Economic diversification away from oil extraction has been a constant objective of KSA policymakers since the 1970s (Saudi Arabia, 2016a). Most plans have focused on the development of energy-intensive industries to exploit the country's competitive advantage on energy costs. The latest plan--called Vision 2030--outlines a more comprehensive transformational strategy to drive the Saudi economy away from oil dependence (Saudi Arabia, 2016b). Although Vision 2030 expects oil and gas extraction to maintain an important role in the Saudi economy, the transformative aspect of the plan sets the relative weight of that activity to decrease as investment flows towards non-oil sectors. Besides, the plan orients diversification less towards energy-intensive industries and more towards services. Additionally, diversification beyond energy-intensive activities is the cornerstone of the KSA Nationally Determined Contribution (NDC) to the Paris Agreement (Saudi Arabia, 2015). However, Saudi NDC also considers an alternative scenario of limited diversification focused on energy-intensive industries.

   The objective of the present paper is to assess the economic, fiscal, social and environmental implications of diversification of the Saudi economy under two scenarios reflecting those of the Saudi NDC. The test of two strategies is justified by the fact that successive development plans have so far failed to foster the emergence of a competitive non-oil private sector (Albassam, 2015), and that the latter objective continues facing considerable challenges, mostly regarding job creation (IMF, 2016a).

   The methodological challenge of modeling the Saudi economy has been taken up in recent years. Al-Thumairi (2012), Al-Hawwas (2010) and De Santis (2003) assess static counterfactual scenarios, mostly of oil price shocks, with conventional computable general equilibrium (CGE) models. Blazquez et al. (2017) implement a stylized dynamic equilibrium model to estimate the long-run welfare impact of renewable energy penetration. Gonand et al. (2019) model overlapping generations in a similar dynamic framework to explore the long-run consequences of energy pricing reforms.

   Compared to this corpus, our contribution is to implement a dynamic economy-wide model adapted to KSA macroeconomics, calibrated both statically and dynamically on hybrid economy/energy data and backed by bottom-up energy modeling (Ghersi, 2015; Hourcade et al. 2006). In this spirit, Soummane et al. (2019) developed the KLEM-KSA model to investigate the macroeconomics of reduced Saudi oil-export income at the 2030 horizon. They showed that structural weakening of the oil price would slow down Saudi growth and increase unemployment, while significantly cutting down trade-surplus accumulation and increasing the public debt. They then demonstrated how domestic energy-pricing reforms could mitigate some of these losses if they were partly recycled in higher investment, irrespective of their impact on energy intensity. The level of aggregation of their analysis only allowed for crude descriptions of both production activities (two aggregate sectors) and the secondary distribution of income (rough estimates of public budget balances, no assessment of debt accumulation).

   Comparingly, our modeling breaks down energy supply into four sectors and non-energy activity into nine sectors, thereby allowing exploration of diversification options. It also extends to the secondary distribution of income between households, firms, public administrations and the rest of the world, thus producing original outlooks on the Saudi national debt and its distribution across domestic agents. With this tool, we produce dynamic outlooks at medium-term horizons of yet unexplored macroeconomic scenarios combining sectoral diversification, energy-pricing and public budget reforms.

   The rest of our paper is organized as follows. We present our modeling method in Section p. In Section p, we describe two mitigation scenarios inspired by the Saudi NDC, then comment on scenario results in Section 4 We conclude and highlight policy implications in Section 5.

2. THE IMACLIM-SAU MODEL

   2.1 Salient features

   IMACLIM is an economy-wide model representing the supply and demand of goods and services, with the specific purpose of articulating with engineering representations of the energy system to produce consistent energy-economy outlooks (Ghersi, 2015; Hourcade et al., 2006, Ghersi and Hourcade, 2006). IMACLIM exists in a global multi-regional version (Crassous et al., 2006; Sassi et al., 2010) and in country-specific versions currently covering France (Hourcade et al., 2010; Le Treut, 2017; De Lauretis, 2017), South Africa (Sellers et al, 2015), Brazil (Lefevre et al., 2018) and India (Gupta et al., 2019, 2020).

   The application of IMACLIM to Saudi Arabia, IMACLIM-SAU, is a dynamic simulation model picturing economic growth in yearly time steps as resulting from exogenous assumptions of labor endowment and productivity (the Harrod-neutral assumption on technical progress). The vector of domestic outputs at year t, Y is a function of the stock of capital of the labor force L and of the intermediate consumption of energy and non-energy resources. Capital stock dynamics follow the standard accumulation rule [Please download the PDF to view the mathematical expression] with S the depreciation rate, constant over the modeled horizon. Investment /, is the amount of non-energy output used to build up K at period /. Beyond these core Solow-Swann specifications and similar to other country versions, IMACLIM-SAU deviates from the CGE standard by four salient features. (1)

   Firstly, IMACLIM-SAU calibrates on original hybrid data reconciling national accounting statistics with energy flows and prices statistics. This allows maintaining dual accounting of energy flows in physical and monetary units backed by statistically relevant, agent-specific prices. Hybrid accounting has a significant bearing on benchmark ratios crucial to macroeconomic analysis: the cost shares of energy in productions, the budget share of energy for households and the breakdown of energy consumptions and [CO.sub.2] emissions across sectors and agents (Combet et al., 2014; Le Treut, 2017).

   Secondly, IMACLIM-SAU treats as exogenous all variables pertaining to the energy system. This feature stems from the model being designed to couple with bottom-up energy expertise (Ghersi, 2015). IMACLIM-SAU thus traces growth trajectories building around exogenous energy flows. The cost structure of energy supply beyond its own energy intensity, as well as the specific margins on all energy sales, are also exogenously adjusted to match assumptions on the dynamics of annualized investment, operational expenses, domestic consumer prices and trade prices. Such specifications allocate part of value-added to constrained energy expenses and part of primary factor endowments to constrained energy supply volumes. These constraints on volumes, costs, and prices weigh on economic growth.

   Thirdly, IMACLIM-SAU simulates suboptimal growth pathways. One first deviation from optimal growth is that IMACLIM-SAU is a simulation model that builds on exogenous investment pathways not explicitly reflecting the intertemporal optimization of some welfare indicator. A second deviation is that the model, on top of exogenously constraining energy markets, considers imperfect non-energy markets in the form of both mark-up pricing and underutilization of labor. On the labor market, the inertia of real wages prevents full clearing i.e. induces equilibrium unemployment specified through a 'wage curve' correlating the unemployment rate and the real wage (Blanchflower and Oswald, 2005). The specification captures well the characteristic rigidity of Saudi wages (Devaux, 2013).

   Lastly, IMACLIM-SAU is carefully adapted to Saudi...