WP/15/8

SAMA Working Paper :

Challenges to Production Base Diversification

in Saudi Arabia*

November 2015

Ahmed Al Bakr

Economic Research Department

Saudi Arabian Monetary Agency

The views expressed herein are those of the author(s) and do not necessarily reflect the
position of the Saudi Arabian Monetary Agency (SAMA) and its policies. This Working
Paper should not be reported as representing the views of SAMA.

*Translated from Arabic

 Contents

Subject Page

Abstract ……………………………………………….………………..…4

1. Introduction………………………………………………………..……6

2. Why Does the Kingdom Need to Diversify Its Production Base?...........7

3. The Growth Model of the Kingdom of Saudi Arabia……………….….7

4. Challenges to Production Base Diversification in the Kingdom….……8

5. The Role of Production Base Diversification and Increased Export

Quality in Economic Growth Sustainability………...……………….……9

6. Production Base Diversification in the Kingdom’s National

Development Plans.….…………………………………………………..10

7. The Role of the Public and Private Sectors in Production Base

Diversification……………………………………………………………11

8. The Role of SMEs in Diversifying the Production Base………….…..13

9. Challenges to Labor Market and Production Base Diversification...…15

10. The Role of FDI in Diversifying the Production Base………………16

11. Experiences of Some Countries in Production Base Diversification..18

12. Results and Recommendations..………………………………..……22

References ………………………………………………………………24

2
 Tables and Charts

Chart 1: Non-oil Exports Contribution to GDP…………………...………10

Chart 2: SMEs’ Contribution to GDP and Employment in 2013………....13

Chart 3: SMEs Loan Portfolio by Economic Activity in the Kingdom in

June 2015 ………………………………………………………………...14

Chart 4: Breakdown of SMEs Operating Under FDI by Economic Activity

in 2013...………………………………………..…..……………...……..17

Chart 5: Net Foreign Investment as a Ratio of GDP in 2013 …………..…18

3
 Challenges to Production Base Diversification in Saudi Arabia1

Abstract

Production base diversification is one of the most important economic

strategic objectives adopted by the Development Plans in the Kingdom.
Countries with an abundance of only a few natural resources are obsessed
with diversifying their production base, since they are vulnerable to
economic crises due to their heavy reliance on natural resource revenues to
fund their public budgets.

For instance, there are major oil-dependent countries that may face
difficulties due to low oil prices. In GCC countries in general, and in Saudi
Arabia in particular, progress is being made in the area of economic
diversification, but it is still below expectations. There is no room for
theorization; the current circumstances and the sudden crises that began to
appear without warning have pushed economic analysts to constantly call
for accelerating the pace of production base diversification and
reconsidering government support.

The frequency of such calls has recently increased in view of the great
plunge in oil prices that have dropped more than 50 percent in only a few
months. This paper reviews the challenges to production base
diversification in two major trends: on the demand side, by reforming the
general framework for macroeconomic management and, on the supply
front, by developing human capital, reforming the public sector, reducing
labor market distortions and building an industrial base to boost exports.
The paper also suggests that the success achieved in diversifying the

1
Author Contacts: Ahmed al-Bakr, Economic Research Department, SAMA, PO Box 2992, Riyadh
11169, e-mail: [email protected].

4
production base by some countries centers around the government's support
for SMEs.

For these reasons, a general commission has been recently established

for SMEs in the Kingdom to monitor their performance, enhance their
exports and conduct a review process to assess finance schemes and
channels available for those enterprises through directing finance for the
manufacturing of medium and high-tech export-competitive commodities.
This effort should not only focus on the volume of financial aid, but also on
its infrastructure and channels, concentrating on the financing of high value-
added activities, such as industry and others areas. However, with regard to
the Kingdom, SMEs have been focusing on low value-added activities such
as trade, building and construction, which has led to the importation of
mostly unskilled foreign labor, resulting in a higher level of foreign workers'
remittances. This has minimized those enterprises’ contribution in growth
and employment.

This paper also concluded that those countries that have succeeded in
achieving the objective of diversifying their production base are those that
are successful in selecting high value-added foreign direct investment
(FDI), so that they can diversify their exports, attract and train national
labor, utilize leading technology and give their exports a regional
competitiveness. The paper also pointed out that FDI in the Kingdom is
concentrated in services activity (construction, maintenance and operation),
i.e. activities with a high number of foreign labor and high use of subsidized
energy resources. Furthermore, FDI in non-oil manufacturing industries
remains weak. A large part has gone to investment in chemicals and refined
petroleum products, which make the Kingdom’s economy even more
susceptible to global energy market fluctuations.

5
 The paper also concluded that expediting and streamlining supportive
measures for businesses that export high value-added commodities, through
strengthening forward linkages (e.g., research, development and
manufacturing) between large institutions on one hand and SMEs on the
other, represents a real window to production base diversification. Such
actions also enhance backward linkages (such as transport, supplies and
storage) and establish industrial and commercial relationships between
large institutions and multinational companies, on the one hand, and SMEs,
on the other. This will eventually result in bringing technology and product
development in the environment of a single activity (converting industrial
cities into productive conglomerates), benefiting from experiences of other
countries, reforming the labor market and raising productivity.

1. Introduction
Every step made towards production base diversification can be
considered a real achievement that we should build on continuously,
especially in view of global competition. Every achievement in this area,
regardless of how modest it is, also represents a direct safeguard for the
future of the Saudi economy in general and the economic potentials that are
inherent in this economy. Actions speak louder than words since we will
end up with the inevitable result; work and action advance our productivity
regardless of its level and momentum. Hence, the need to develop sources
of income and production persists. This subject deserves more deliberation
and attention at all levels of governmental and the private sector. Attaining
this vital goal would increase the country's ability to raise levels of public
and private investment and consumption, in addition to financing
maintenance and replacement requirements in infrastructure, whether
physical, social, environmental or industrial.

6
2. Why Does the Kingdom Need to Diversify Its Production Base?

Saudi Arabia’s current economic structure is still heavily dependent on

oil. There is no other alternative better than production base diversification
that would provide more jobs in the private sector, while also boosting
competitiveness and productivity. Such diversification would also achieve
sustainable growth and establish an industrial economy in the Kingdom that
will be significantly more stable and less volatile, particularly in the future
when oil revenues begin to decline. Lack of such diversification would
hinder the country’s advance to becoming a medium or even a high-income
nation.

3. The Growth Model of the Kingdom of Saudi Arabia2

The Kingdom’s prevailing growth model depends mainly on oil

revenues that are redistributed in the economy via government spending on
goods, services and employee salaries. Part of this spending relates to
citizens’ wages and payroll in the public sector and is classified as a
consumption expenditure, while another part of it relates to capital spending
on development projects, infrastructure and social services. This kind of
spending goes to the payment of private sector contracts and profits. After
four decades of oil exports, this sector’s activity is still concentrated in three
main areas: construction, services, and the importation and marketing of
foreign products under Commercial Agency Law. This was achieved
through the use of two main factors, (1) huge government spending in times

2
Al-Khatir, Khalid, “Challenges to Oil Prices Plunge and Economic Diversification in GCC Countries”,
(2015).

7
of oil abundance and (2) cheap and intensive production factors (e.g. capital,
cheap energy inputs and low-skilled foreign labor, most of whose income is
lost to the domestic economy through workers’ remittances abroad).

Saudi Arabia’s economic future depends on building human capital,

innovation and technological development, while the current model adopted
in the Kingdom depends on two factors: generous government spending and
intensive production factors. Most of the output of this growth is
represented in higher real estate prices, accompanied by an unjustified
increase in population due to huge import of foreign labor that does not
generate human capital accumulation, lead to technological development
and industrial transformation, or contribute to building a knowledge-based
economy or diversifying exports. Perhaps this situation may end up in a
bubble, followed by a recession for a long time until oil prices rise again.

4. Challenges to Production Base Diversification in the Kingdom

The challenges to production base diversification in the Kingdom are

twofold. First, on the demand side, there needs to be reform in the general
framework for macroeconomic management, and secondly, on the supply
front, developing the accumulation of human capital, reforming the public
sector, eliminating labor market distortions and building an industrial base
to boost exports.

Reforms in the general framework for macroeconomic management

(demand policies) aim at strengthening macroeconomic stability. In
essence, this framework is a set of main macroeconomic policies used in
aggregate demand management, namely fiscal policy, monetary policy and
exchange rate policy.

8
 In the area of supply policies, general framework reforms to strengthen
macroeconomic stability should be accompanied by parallel reforms on the
supply side, along with diversification of the production base and sources
of income away from the hydrocarbon sector and associated industries.
Overall, the diversification of production structures represents a long-term
challenge that requires the following: developing human capital buildup,
reforming the public and private sectors, and building an industrial base that
supports the process of diversification.

5. The Role of Production Base Diversification and Increased Export

Quality in Economic Growth Sustainability

Empirical studies have shown a strong correlation between production

base diversification and sustainable economic growth in low and medium-
income countries. Higher and less volatile levels of national income are
correlated with the diversification of production and exports. Moreover, the
diversification of production is closely associated with a similar
diversification of exports; this link is one of the results of the structural
transformation of the economy, due to the dynamic reallocation of resources
from less productive sectors to more productive ones. High income levels
are correlated with sophisticated high quality exports. Exports can be a
significant channel to move forward in the use of modern technology and
knowledge and scientific sources. Aghion and Howitt (1992)3 stress the
importance of innovation and moving up the quality ladder and indicate that
achieving human capital buildup, boosting productivity level and moving
up the quality ladder requires that the country be exporting on a large scale.

3 Aghion and Howitt (1992), Significance of Innovation.

9
Facts also show that raising the quality level of exports is strongly
associated with high per capita income.

6. Production Base Diversification in the Kingdom’s National

Development Plans

Long-term economic and social development strategies in the Kingdom

emphasize the importance of economic diversification. These strategies are
aimed at enhancing sustainable development, reducing reliance on oil
revenues and creating more jobs for citizens in the private sector. Economic
diversification is a significant stepping-stone to achieve all three goals
mentioned above.

Chart 1: Non-oil Exports Contribution to GDP

Ratio of Industrial Actvity Contribution to GDP

Ratio of non-oil exports in GDP
Ratio of non-oil exports to total exports

20.0%

15.0%

10.0%

5.0%

0.0%
Five Years 2014 2013 2012 2011 2010
Average

Source: Central Department of Statistics & Information.

Chart 1 shows that the average of non-oil exports contribution to GDP for
the past five years stood at 7 percent; the average of non-oil exports
contribution to total exports amounted to nearly 13 percent, and the average
manufacturing activity contribution to GDP stood at 11 percent. These
indicators, which can be considered as a benchmark for the performance of

10
policies aimed at production base diversification, remain somewhat modest
when compared with those of countries such as Malaysia, Korea, Japan,
Singapore, and China. Thus, the need arises to find urgent solutions that will
support production base diversification. Although there are some
differences in the diversification strategy formulas among countries, and
there is no clear and unified recipe for success, policies whose effectiveness
was tested on the global level include the following:

√ intensifying investments in the field of education in general, including

science, technology, technical and vocational education areas;

√ developing industry and supporting its activities, along with providing

infrastructure (land, tax exemption and energy);

√ investing in infrastructure and strengthening the legal and regulatory

environment to reduce the cost of doing business and industrial activities;

√ encouraging entrepreneurship and innovation through improving access

to information, communications technology and finance, as well as
increasing spending on research, growth and development aspects; and

√ focusing on raising the quality level of exports and their diversification to

align them with economic strategies, which represent channels to build
human capital and facilitate access to new technologies that are essential for
increasing productivity rates.

7. The Role of the Public and Private Sectors in Production Base

Diversification

In the public sector, following up the implementation of development plans

and ongoing assessment of the effectiveness of economic policies to achieve

11
the objective of production base diversification is of strategic significance
to the Kingdom. Here, the role of the government is to reform the market
through business services, vocational and industrial training programs, in
addition to providing incentives for on-the-job training by companies.
However, the success of these efforts requires good determination,
communication with employers, providing the necessary environment for
the market, skills transfer and enticing creative competition. It also requires
employing qualified persons with innovative and development inclinations,
investing in industrial facilities, using e-learning, achieving a stable,
economic environment with low inflation rates, expanding the scope of
education sector, removing obstacles to FDI and deepening the financial
sector. Government may also help strengthen ties between government-
owned companies and multinational enterprises on the one hand and SMEs
on the other hand, in order to promote development in export goods to attain
its desired objectives.

In the private sector, the increase in its contribution to the national

economy is directly related to the requirements of the production base
diversification. This, in turn, is linked to the level of the private sector’s
efficiency and ability to manage various production units in light of market
economy conditions and mechanisms. It is widely accepted that increasing
the contribution of the private sector and developing its institutions will
improve the market economy environment and will further liberalize the
economy in terms of ownership, employment, trade and competition.
Therefore, the competitiveness of the national economy will improve to
accelerate the achievement of the objective of the production base
diversification.

12
8. The Role of SMEs in Diversifying the Production Base

Many studies have stressed the correlation between developing SMEs

and economic growth because they are closely interrelated. For example,
the dynamics of SMEs contributed to the rapid growth of the economies of
China and Taiwan in their early stages through manufacturing activity.
Those SMEs provided the bulk of jobs in these two countries.

Chart 2: SMEs’ Contribution to GDP and Employment in 2013.

100%
88%
90% 84%
79%
80%
70%
60%
60%
46% 46% 48%
50%
40%
40% 33%
30% 25%
20%
10%
0%
Saudi Arabia UAE Singapore Japan South Korea

Contribution in GDP Contribution in Employment

Source: World Bank.

Chart 2 shows that SMEs’ contribution to GDP and employment in some

countries is significant; note that South Korea’s contribution ratio reached
48 percent and 88 percent, respectively, during 2013. This was attributable
to the government’s support for these SMEs, supervision of their
performance, support for their exports and a focus on finance infrastructure
rather than its absolute volume. It was also due to the existence of
specialized agencies or bodies dedicated to the support of industrial
enterprises and their exports (thus creating a suitable environment for
competition), facilitating the supply of highly skilled labor, and forming
effective industrial facilities as in Japan, Singapore, Malaysia and others.

13
SMEs’ contribution to GDP and employment in Saudi Arabia amounted to
33 percent and 25 percent respectively in 2013. These are considered to be
rather low rates when compared to some other countries. This is because of
several factors, including:

√ SMEs finance as a ratio to total private sector’s finance does not exceed
3 percent. This is low compared to ratios recorded in developed countries,
where it amounts to nearly 30 percent (Source: SAMA).

√ SMEs finance concentrates on low value-added activities (trade and

construction). Those activities will increase import of low skilled foreign
labor and increase transfers that will lead to a decline in its contribution in
growth and employment. Chart 3 shows a breakdown of SMEs by economic
activity in the Kingdom.

Chart 3: SMEs Loan Portfolio by Economic Activity in the Kingdom

June 2015.

35% 33%

30%
26%
25%
20%
20%

14%
15%

10%
6%
5%

0%
industry Construction Commerce services other
and building:

*Source: SAMA.

√ Much legislation and many laws are needed to increase the contribution
of SMEs in GDP and employment.

√ There is weak cooperation and coordination among concerned authorities

in their unification efforts.

14
√ There is evidence of a weak institutional approach and management in
SMEs’ feasibility studies.

√ Communication with big companies is another weakness.

√ This is all exacerbated by a labor force with low skills, training and little
knowledge of using modern technology.

9- Challenges to Labor Market and Production Base Diversification

The oversupply of free or subsidized public services or cheap energy to

private sector consumers has negative effects. Not only does it lead to
wasteful and excessive consumption, but it also results in distortions in the
labor market. Government intervention may not be sufficient to achieve the
desired objectives (Saudization of the workforce and increased levels of
industrial output) and may not address the root of the problems effectively.
Such interventions may only deal with some of the minor symptoms.
Although these policies may push private companies to hire more Saudis to
meet the minimum requirements and avoid sanctions, they do not provide
incentives for investing in high-tech manufacturing needed to diversify
exports, boost competition and provide more permanent jobs for citizens.
This is supported by recent findings showing that the number of new foreign
workers entering the labor market has been much more than the number of
Saudis; in other words, the gradual and selective reduction of expatriate
workers has not yet been achieved. One possible reason for this is that the
education and training institutions in the Kingdom may not be satisfactorily
responding to the scientific and technological demands of the labor market.
As a result, the ratio of Saudis who have education in science and
technology stands at 9 percent while the ratio is 70 percent in Singapore.

15
 In summary, negative factors such as 1) low productivity, 2) adopting
employment policies to only meet regulatory quotas and requirements to
avoid sanctions, 3) the shortage in skilled labor, 4) lack of incentives to
enhance skills level, and 4) the excess of subsided goods and services such
as energy and transport will prevent the market from generating a
competitive environment to encourage industry and achieve the cherished
objective of production base diversification.

10. The Role of FDI in Diversifying the Production Base

The Middle East has attracted a reasonable share of foreign direct

investment (FDI), partially due to the improved business environment in
many economies. This is also the case in Saudi Arabia when its new laws
entered into force in 2000. The economic equilibrium programs and the
Foreign Capital Investment Law are considered among the main significant
tools of the Kingdom’s policy to encourage joint ventures and achieve
economic diversification. Recent FDI has been concentrated in the services
sectors in the domestic market (business services and contracting) and on
sectors that overuse resources and foreign labor, while FDI in non-oil
manufacturing industries has remained quite modest.

16
 Chart 4: Breakdown of SMEs Financed by FDI
by Economic Activity in 2013.

35%
31%
30%
30%
25%
25%

20%

15% 14%

10%

5%

0%
industry Contracting Commerce other

Source: General Investment Authority.

As shown in chart 4, the share of contracting services amounted to 31

percent, followed by trade services with 30 percent and industry
(manufacturing) activity with 14 percent. Based on such shares, it is
necessary to reconsider those activities and the value they add to GDP and
employment. The manufacturing sector indicates a relatively low
distribution in terms of FDI. Furthermore, investment in this sector is
concentrated in chemicals and refined petroleum products, which makes
them vulnerable to the fluctuations in the global energy market. Therefore,
FDI should be directed to value-added industrial activities that will lead to
export diversification, greater employment of the national labor force, and
a higher level of regional export competition, so that the real objectives of
FDI, especially production base diversification in the Kingdom, would be
achieved.

17
 Chart 5: Net Foreign Investment as a Ratio of GDP in 2013.

Direct foreign investment (net inflows) as a ratio of GDP in 2013

6.0%

5.0%

4.0%

3.0%

2.0%

1.0%

0.0%
Bahrain Kuwait Oman Saudi United United Turkey Malaysia India South
Arabia Arab States Korea
Emirates

2010 2011 2012 2013

Source: World Bank, 2013.

11. Experiences of Some Countries in Production Base Diversification

South Korea

In 1970, exports of textiles, wood, wigs and shoes were salient

characteristics of the Korean economy. In 1980, those exports shifted to
iron, steel and shipbuilding, and then to the exports of computers,
automobiles, electronics and telecommunications.

The factors that helped to achieve diversification in South Korea included

the following government actions:

√ Paying attention to the financing of manufacturing activity since 1970.

Korea’s domestic savings were low at that time, but were strengthened due
to external grants, borrowing and financial transfers.

√ Enabling rapid diversification and enhancing the country’s capability to

increase its international competitiveness by activating the concept of a

18
"knowledge economy". This was achieved through universal education,
improving its quality and implanting a willingness to learn. The ability and
willingness to do hard work and abide by industrial discipline were also
keys to this success.

√ Pushing companies to make use of incentives offered to them when they

show ingenuity in manufacturing and exporting, and addressed those
obstacles hindering this, which led to the adopting of new technologies and
the attainment of high levels of productivity.

√ Encouraging manufacturing research and reinforcing intellectual property

rights.

√ Putting an ongoing assessment system in place that was directed at both

existing and newly established SMEs.

√ Making use of performance enhancement programs.

√ Giving educational and training programs for owners of SMEs.

√ Setting up and equipping an advisory unit that performs an onsite visits to

project to attempt to improve productivity.

19
 Lessons from South Korea experience
in diversifying its production base

Business
Support Institutionalized Finance
environment

Working under an
e-commerce
Connection of large administrative diversification and
and developing
companies to SMEs directing finance
technology umbrella, executing
specialized programs
and cooperating with
universities

Malaysia

Malaysia achieved the best results in diversifying its production base

from that of a rural resource-based economy during the 1950 -1960
period, when the share of manufacturing was less than 10 percent of
exports. At that time, primary commodities accounted for 80 percent of
its total exports. In 1970, the government began to pay more attention to
the role of the private sector through supporting SMEs, attracting FDI
and encouraging it to develop commercial manufactured goods via
assembling, processing, and enhancing exported goods.

How did Malaysia achieve this diversity? The answer to this question
can be summed up in the following points:

√ Benefiting from South Korea's strategy and its pattern of a vertically

integrated industrial policy, which was adopted in 1980.

20
 √ Developing manufacturing production related to machineries,
automobiles, steel, cement and petrochemicals (again imitating the
Korean model).

√ Removing customs barriers and setting controls for the import of

machineries and equipment to support the competitiveness of local
industries.

√ Developing industrial plans (e.g., the Second Industrial Master Plan,

1996-2005) for further technology enhancement.

√ Providing multiple channels to attract FDIs and direct them to high-

tech activities and providing the necessary finance.

√ Supporting programs that gave the labor force high skills, spending on
research and development, and promoting the entry of new industries to
the country, resulting in an increase in the level of productivity.

Lessons from the Malaysian

experience in diversifying its
production base

Business
Support Institutional Work Finance
environment

Creating trade Developing Government

Sharia-compliant
linkages between exports, activating support for SMEs
finance
multinational technology use as a national
companies and SMEs and technical program
support

21
 12. Results and Recommendations

The Saudi government should take the following steps:

√ Provide support to restructuring the most suitable sectors to create

more jobs for citizens and contribute to diversifying the production base.

√ Evaluate and review the current finance schemes for SMEs in order to
direct them to supporting high-tech export goods industries.

√ Establish industrial and commercial conglomerates between large

institutions and multinational companies, on the one hand, and SMEs,
on the other, to enhance technology transfer and product development at
the environment of a single activity (converting industrial cities to
productive conglomerates).

√ Streamline forward linkages (research, development and

manufacturing) between large institutions and SMEs; and enhancing
backward linkages (transport, logistics and storage).

√ Focus on the industrial sector to introduce linkages in a chain of unified

production, distribution and marketing.

√ Study carefully and benefit from the experiences of other countries

(such as Malaysia, South Korea and Singapore) that have managed to
diversify their production base away from the oil sector. The experiences
of oil-producing countries such as Chile, Venezuela and others can be
utilized.

√ Minimize the private sector’s reliance on the public sector, reversing

the penchant of the private sector to depend too heavily on public sector
activities and spending plans.

22
 √ Develope industrial plans, such as the Malaysian Industrial Master
Plan, (1996-2005) for further technology enhancement.

√ Put sophisticated and advanced economic data base and information

systems in place to strengthen the management of economic activities
and provide production-related information and data.

23
 References

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LDCs: Stylized Facts and Macroeconomic Implications.” Staff Discussion Note
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Henn, Christian, Papageorgiou, Chris, and Spatafora, Nikola. 2013. “Export

Quality in Developing Countries.” Working Paper 13/108, International
Monetary Fund, Washington.

Sherif, Reda, and Hasanov, Fuad. 2014. “Soaring of the Gulf Falcons:
Diversification in the GCC Oil Exports in Seven Propositions.” Working Paper
14/177, International Monetary Fund, Washington.

Espinoza, Raphael, and Senhadji, Abdelhak. 2011. “How Strong Are Fiscal
Multipliers in the GCC? An Empirical Investigation.” Working Paper 11/61,
International Monetary Fund, Washington.

Callen, Tim, Cherif, Reda, Hasanov, Fuad, Hegazy, Amgad, and Khandelwal,
Padmaja. 2014. “Economic Diversification in the GCC: Past, Present, and
Future.”, International Monetary Fund, Washington.

Riyadh Economic Forum. 2013, “Developing the Role of SMEs in the National
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Al-Khatir, Khalid. 2015. “Challenges to Oil Prices Plunge and Economic

Diversification in GCC Countries”, The Arab Center for Research and Policy
Studies.

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