Saudi Arabia must persist in its diversification drive

Diversification is one of the basic principles of sustainable economic development. Diversifying the goods and services an economy produces, as well as its trading partners, enhances resilience to economic fluctuations. This is especially the case for countries whose main source of income is a finite and depleting natural resource.

Diversification also speeds the development of economic activities that address the population’s basic needs: job opportunities, food, health, education, and housing.

A quick look at the structure of the Saudi economy reveals that the Kingdom’s national income still relies on one commodity; oil. 

It accounted for about 40 percent of GDP in the third quarter, as Chart 1 shows. (Government services comprised 13.8 percent of GDP, and the various private-sector industries accounted for the rest.) 

Moreover, non-oil sectors are often ultimately dependent on the oil industry. Such sectors range from refineries to construction.

Note: “Mining and Quarrying” includes oil and gas in all charts.

Saudi Arabia has worked to diversify its economy since the 1970s through its five-year development plans, but there have been limits to change. 

As the nation successfully diversified vertically – building refining and petrochemical sectors – oil’s contribution to GDP gradually declined through the 1990s and 2000s. 

It shrank to 42 percent by 2012, where it has approximately – and stubbornly – remained, as horizontal diversification outside sectors that depend on oil directly or indirectly has been slow. 

This is mainly due to the weak coordination of fiscal policy with development plans: oil revenues and their accumulated surpluses sometimes went towards wasteful current spending at the expense of investment.

Additionally, as the Kingdom aimed to meet international commitments to maintain stability in oil markets, it sometimes produced more crude than it otherwise would have. 

This resulted in more revenue than could be efficiently absorbed locally – and thus, surging public and private consumption drove up imports. In some years, this even exceeded the value of oil revenues. This negatively affected local productive structures – especially in the absence of a clear policy to support local production.

Oil prices are also volatile, influenced by external factors that the nation cannot control. This volatility feeds through to the economy, as Chart 2 shows. As oil prices plunged at the start of the pandemic, so did sectoral GDP linked to oil. This also hit sectors sensitive to oil-funded government spending.

In 2016 Saudi Arabia announced the Vision 2030 diversification strategy. It contains 13 programs aimed at exploiting the nation’s potential in different fields, from minerals to technology. Financial and economic policies will be designed to increase the pace of foreign investment flows.

Despite the oil sector’s large share of GDP, it does not have the ability to absorb the nation’s growing labour force. It will keep shaping the Saudi economic structure, favoring energy-intensive activities, such as oil refining, petrochemicals, cement, iron and aluminium. 

These industries constitute a major, capital-intensive diversification. But they also  generate fewer job opportunities than some other sectors. This has led to limited development of Saudi Arabia’s human capital.

Job opportunities have thus been concentrated in government – including the civil service, security and the military. State employment is estimated at 3.2 million people; employee compensation is equivalent to about half of total government revenue.

Our final two charts address a measure of economic diversification in Saudi Arabia compiled by the Observatory of Economic Complexity (OEC). 

Chart 3 shows that as Saudi GDP rose in the 15 years to 2010, the economy in fact became less diverse. 

Since then, the diversification index has rebounded. However, as Chart 4 shows, Saudi Arabia’s economic diversity is well behind that of South Korea, Mexico and Malaysia; the latter nation even started from a lower base than Saudi Arabia in 1996.

This shows what is possible. Saudi Arabia must persist in its diversification drive.