## THE NEED FOR A FISCAL ANCHOR AND POTENTIAL FISCAL RULES IN SAUDI ARABIA (1sauea2022002)

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### Overview and motivation
- Oil sector significance and fiscal reliance
  - Oil accounted for about 40 percent of real GDP in the last few years, down from about 45 percent 10 years ago.
  - Oil's share of nominal GDP was about 30 percent in 2021 and is projected to increase to about 40 percent in 2022.
  - Oil revenues averaged 75 percent of total budget revenues since 2010, peaked at 93 percent in 2011, and fell to 53 percent in 2020.
- Historical fiscal volatility and recent behavior
  - Fiscal balances moved with oil prices: deficit of almost 16 percent in 2015 and surplus peaking at almost 30 percent of GDP in 2008.
  - Expenditures declined by almost 3½ percent in 2021 despite oil price increasing by more than 66 percent.
  - 2022 budget envisages substantial reduction in expenditure for 2022 and continued restraint for 2023 and 2024.
- Ongoing reform agenda (Vision 2030-related)
  - Non-oil revenue mobilization (VAT increases, revenue administration reforms).
  - Energy price reforms (gasoline prices capped in mid-2021).
  - Expenditure rationalization and procurement reform, Treasury Single Account.
  - More systematic fiscal risk assessment, improved budget disclosure, strengthened debt management.

### Rationale for a fiscal anchor and preferred frameworks
- Institutional coverage
  - Need to expand fiscal assessment to include the Public Investment Fund (PIF) and the National Development Fund (NDF).
- Role of an anchor
  - Fiscal anchor should complement existing debt-to-GDP ceiling and guide medium-term fiscal framework (MTFF) and expenditure prioritization.
- Fiscal Sustainability Program (FSP)
  - Authorities preparing a FSP to avoid excessive deficits while supporting long-term objectives (infrastructure to support diversification).

### Permanent Income Hypothesis (PIH) as a fiscal anchor
- Advantages for Saudi Arabia
  - Achieves intergenerational equity by leaving future generations financial wealth to sustain fiscal deficits.
  - Creates flexibility in the medium term via a gradual adjustment to the long-term anchor.
  - Promotes a prudent fiscal stance by saving resource revenue to accumulate buffers for "bad" times.
- Alternative fiscal anchors
  - Bird-in-hand (BIH): consume only interest on accumulated financial wealth; example: Norway limits non-oil primary deficit to 4 percent of accumulated financial wealth.
  - Spend-as-you-go (SAYG): procyclical, spends all resource revenues on receipt.
- Modified PIH (mPIH)
  - Allows deviation during a transition period to reach the long-term PIH anchor; can incorporate a fiscal sustainability framework (FSF) that factors in growth dividends from scaled-up investment.

### Key uncertainties and scenario design
- Critical determinants
  - Level of economically extractable reserves and oil prices critically determine long-term sustainable fiscal space.
  - Baseline assumption: assessed reserves of about 260 billion of barrels of oil as of 2021 are exploited.
- Two alternative scenarios examined
  - Demand and supply combination: demand declines due to climate reforms but supply shocks knock out competitors → higher oil prices and considerably higher oil revenue and financial wealth.
  - Demand shock only: collapsing oil prices; low-likelihood illustration including cases where reserves become uneconomic to exploit.
- Policy implication
  - Need for prudent assumptions and regular revisions of PIH estimates, with short- and medium-term flexibility.

### Findings under the baseline PIH anchor
- Transition and balance dynamics
  - Non-oil primary balance would decline from about 29 percent of non-resource GDP in 2022 to about 21 percent by 2028.
  - Transition duration in the baseline is 6 years.
  - Most of the adjustment effort could be delivered by efforts already planned through 2028.
  - Beyond 2028, a gradual adjustment of about ½ percentage point of non-resource GDP annually would be implied, converging asymptotically towards 0.
- Other PIH definitions
  - PIH as constant share of non-resource GDP would require a much sharper adjustment and is less appropriate given Saudi Arabia’s large and long-lived resource base.
  - Targeting a constant annuity per capita is an option but likely requires a longer transition than the 6-year baseline.

### Transition considerations and alternative scenario implications
- Demand shock (pessimistic)
  - Much-reduced fiscal space implies a much larger fiscal adjustment down the road; transition period longer (15 years in alternative scenarios).
  - Adjustment should be gradual to avoid large annual adjustments harmful to growth.
- Supply and demand (optimistic)
  - Much larger fiscal space allows for larger short- and medium-term deficits to support growth and diversification.
  - Adjustment to the PIH norm could start after a period of scaled-up spending; transition extended to 15 years in alternative scenarios.

### Calibration, key parameters and assumptions (as presented)
- Selected Table 2 parameter entries (as presented exactly)
  - Real non-resource GDP growth 2.82.8
  - Nominal non-resource GDP growth4.84.8
  - Population growth 1.01.0
  - GDP deflator inflation2.02.0
  - US GDP deflator inflation2.02.0
  - Real interest rate 3.83.8
  - Nominal interest rate 5.85.8
  - Interest - GDP growth differential1.01.0
  - Steady state government deposit/GDP ratio17.617.6
  - Central government minimum gross debt ratio20.020.0
  - Transition period before sustainability anchor reached 2/6.015.0
- Transition period notes
  - Baseline transition: 6 years.
  - Alternative scenarios: transition 15 years.

### Policy implications and recommendations (fiscal anchor and rules)
- Core policy actions
  - Continue fiscal management reforms and revenue mobilization (non-oil revenue, VAT and administration reforms).
  - Expand fiscal institutional coverage to include PIF and NDF for comprehensive fiscal assessment.
  - Adopt a MTFF and consider an expenditure rule anchored on a PIH/mPIH to:
    - Reconcile stabilization and growth objectives.
    - Provide flexibility during transition to support diversification-related spending.
    - Accumulate buffers to manage shocks and smooth intergenerational consumption.
- Operational recommendations
  - Regularly revise PIH estimates and stress-test assumptions (reserves, prices).
  - Deliver most near-term adjustment through already planned consolidation to avoid abrupt long-term cuts that could harm growth.

### Box 2 — Alternatives Measures of the PIH: computation and implications
- Core PIH relationship
  - PD = (r − γ) W
  - PD: permanent primary deficit; r: nominal interest rate; γ: parameter determining returns and wealth evolution.
- Three γ specifications and implications
  - γ = π (inflation rate): primary deficit constant in real terms; financial wealth grows with inflation.
  - γ = g (non-resource GDP growth): wealth and primary balance constant in percent of non-resource GDP.
  - γ = π + n (inflation + population growth): wealth and primary balance constant in real terms per capita.
- Adjustment paces illustrated
  - About 1 percent of non-resource GDP annually to achieve a PIH anchor of a constant deficit in percent of non-resource GDP.
  - ½ percent annually to achieve a PIH anchor that keeps the deficit constant in real terms (thus declining in percent of non-resource GDP).
- Risk management and rule design takeaways
  - Prudent assumptions for underpinning parameters (e.g., long-term oil prices).
  - Allow fiscal rules to permit buffer use and outline responses to sudden shocks.
  - For temporary/mild shocks, use buffers (liquid assets or low public debt); for large/persistent shocks, reassess PIH and adjust fiscal stance.

### Fiscal rules and design options for Saudi Arabia (Box 2 & Box 3 lessons)
- Design principles
  - Anchor rules on net financial wealth of the public sector to focus on long-term sustainability and intergenerational equity.
  - Integrate sovereign wealth funds (SWF) into fiscal rule design; avoid SWF independent spending authority that creates extra-budgetary quasi-fiscal operations.
  - Rules should be numerically clear, simple, avoid undue constraints, and preserve flexibility and escape clauses.
  - Supporting institutions: fiscal transparency, independent oversight, adequate public financial management.
- Rule options evaluated
  - Price smoothing rule: may help smooth volatility but can exacerbate procyclicality; not well suited alone for commodity exporters.
  - Expenditure rule anchored on non-resource primary balance: recommended approach implemented via PIH norm after transition period, supported by:
    - (i) a ceiling on expenditure growth, and
    - (ii) a target on net financial assets (strengthenable with a debt brake).
- Expenditure cap counter-factual
  - Capping real expenditure growth at 4 percent (roughly the average observed over 2003–21) would have better stabilized spending versus a revenue smoothing rule and could have generated buffers of about 50 percent of non-resource GDP (difference between actual spending 2003–21 and spending under the 4 percent cap). This is indicative, not a projection or recommendation.
- Forward-looking calibration
  - Under the baseline, authorities may consider a cap on real expenditure growth of 1 ½ percent annually (after 2028) to implement the PIH anchor after a 6-year transition.
  - With revenue measures, a cap of about 2 percent annually is noted elsewhere as an alternative calibration path.
  - Implementing these caps can be eased by strengthening public expenditure management to improve spending quality.

### The cap to get the adjustment — revenue measures, shock handling, and buffers
- Revenue assumptions and implications
  - VAT rate tripled from 5 to 15 percent.
  - Under IMF baseline projections, tax-to-GDP ratio stable at about 14 percent by 2027.
  - Comparative benchmarks: Emerging economies about 18 percent of GDP; G20 about 22 percent of GDP.
  - Simulation assumption: total non-oil revenue increases gradually over 10 years from 18 percent of non-oil GDP in 2027 to 20 percent in 2037.
  - Implication: with these revenue measures, real expenditure growth could be roughly capped at 2 percent until new revenue level reached.
- Principles for shocks and escape clauses
  - Escape clauses essential for counter-cyclical interventions; rule must accommodate positive and negative shocks.
  - Positive shocks: apply expenditure growth cap to limit excessive spending growth.
  - Negative shocks: one-off shocks may warrant continuation of spending plan; large negative shocks may require counter-cyclical support beyond the cap via a predefined escape clause.
- Example simulation: temporary negative shock (2026)
  - Shock: 30 percent reduction in oil prices in 2026 relative to baseline.
  - Resulting revenue loss: 6 percent of non-resource GDP.
  - If spending plans unchanged: permanent decline in financial wealth of about 6 percent of non-resource GDP.
  - Context: staff estimates total wealth about 640 percent of non-resource GDP by 2026; such a shock would have marginal long-term impact.
  - Decision rule: assess whether to (i) revise PIH benchmark and cap or (ii) absorb shock using buffers.
- Buffer and debt-brake design elements
  - Define a floor on net financial assets (NFA); when NFA falls below threshold, automatic adjustment reduces spending and increases NFA.
  - Calibration guidance: standard deviation of oil revenue over past ten years about 25 percent of GDP; assuming a 3-year medium-term framework, adequate buffers could amount to 75 percent of non-resource GDP.
  - Buffers composition: not only financial assets—keeping gross public debt low preserves borrowing capacity; high-cost borrowing is costly relative to holding financial assets.
- Persistent/large shocks
  - Trigger re-assessment of PIH and use escape clause to suspend rule application if needed.
  - Example: large permanent “demand” shock could require capping expenditure growth at -4 percent annually after a 6-year transition to adjust to reduced fiscal space.

### The banks’ liability and asset rates (monetary spillovers and banking sector implications)
- Definitions and stylized behavior
  - Liability rate: interest expense scaled by interest-bearing liabilities.
  - Asset rate: total interest income scaled by interest earning assets.
  - Both move strongly with nominal policy rates given the peg to U.S. policy rates; spread between asset and liability rates underlines bank margin dynamics.
- Empirical strategy and sample
  - Panel vector autoregression for spillovers (quarterly 2018Q1-2021Q4); dependent variables include non-oil GDP growth, stock indices, long-term sovereign yields.
  - Bank-level panel analysis covers 2003-2021; baseline dependent variables include changes in liability and asset rates, ROE, credit growth, and change in NPLs.
- Key spillover findings (threshold at $45 per barrel)
  - When oil prices < $45 per barrel and Fed tightens:
    - Non-oil GDP growth declines by about 0.16 percent.
    - Equity prices drop by about 2 percent when oil prices are low and increase by 1.5 percent when oil prices are above the $45 threshold.
    - Sovereign yields increase by about 55 basis points for GCC countries when oil prices are low (94 basis points in Saudi Arabia), and by 46 basis points when oil prices are high (78 basis points in Saudi Arabia).
  - When oil prices are high, Fed tightening effect on Saudi Arabia is negligible.
- Pass-through estimates (selected results)
  - A 100 basis point rise in U.S. rates associated with:
    - Saudi banks’ liability rates rising by 51 basis points (coefficients around 0.488***, 0.491***, 0.550**, 0.512**).
    - Saudi banks’ asset rates rising by close to 57 basis points (coefficients around 0.461***, 0.467***, 0.581***, 0.574***).
  - Observations: liability-rate regressions 169; asset-rate regressions 170.
- Bank profitability, credit growth, and asset quality
  - ROE: Δ Federal Funds Rate coefficients 0.020***, 0.020***, 0.021***, 0.018**; observations 180.
  - Credit growth: aggregate impact limited when oil prices high; banks with high liability pass-through (LPT) see credit growth hamper under tightening and low oil prices.
    - Selected coefficients: Δ MP -0.042, -0.080, -0.156; interaction terms vary (observations 138).
  - Asset quality (Δ NPLs): coefficients mixed and generally not significant; observations 154.
- Robustness
  - Results hold when using Wu-Xia shadow Fed funds rate, U.S. 10-year yields, and additional controls (government spending, U.S. growth).
- Concluding implication
  - Saudi policy rates follow U.S. rates; bank liability and asset rates move strongly with U.S. policy.
  - Oil prices modulate how U.S. rate changes affect non-oil GDP growth and banking performance.
  - In high oil price environment, negative spillovers from U.S. policy normalization to Saudi Arabia are limited.

### Annex I — model calibration (DIGNAR-19) and scenario results
- Scenarios considered
  - Baseline
    - Aligned with July 2022 Article IV macroframework.
    - Assumes GFCF growing about 6 percent in nominal terms.
    - Partial Vision 2030 reform implementation delivering medium-term non-oil GDP growth of 4 percent.
  - Moderate NIS investment scale up with stronger reform implementation
    - Investment increases 9 percent on average annually after 2022.
    - Reforms: (1) public+PIF investment scale-up 2.4 percentage points of GDP in 2022 and 5 percent of GDP in 2023-2026; (2) public investment efficiency +20 percentage points; (3) fiscal reforms improving fiscal balance by 0.5 percent of GDP by 2026; (4) labor supply +2 percentage points by 2026.
  - NIS pure investment scale up
    - NIS investment targets fully met: 13 percent annual growth specified in NIS; structural reforms as in baseline.
  - NIS investment scale up combined with reforms
    - Full NIS targets met and reform scenario implemented.
- Quantitative projection highlights
  - Non-oil potential output growth (2026)
    - Reform + full NIS: 8.8 percent in 2026 (vs 4 percent baseline).
    - Moderate investment + reforms: 7.7 percent in 2026.
  - Contribution breakdown (2026, reform vs baseline)
    - Investment ramp up dividends: 2.7 percentage points.
    - Labor market reforms dividends: about 0.5 percentage points.
    - Public investment efficiency gains: about 0.8 percentage points.
    - Fiscal measures drag: 0.4 percentage point.
  - Combined reform package: medium-term increase in non-oil real GDP growth of 4.8 percentage points relative to baseline.
  - Private investment: up to 13.2 percentage point increase relative to baseline under reform scenario.
  - GFCF as share of GDP: reform scenario GFCF reaches 29 percent of GDP in 2026 (Vision 2030 target 30 percent reached earlier than 2030 under reform scenario).
- PIF assets under management
  - Authorities expect PIF assets from around SAR 2.3 Tr currently (about 60 percent of GDP) to SAR 4 Tr in 2025 (about 90 percent of GDP).
  - Achieving such growth organically requires PIF returns consistently twice the size of the economy’s growth rate; otherwise targets may be unattainable without additional fiscal support.
- Multipliers and sensitivity
  - Preferred multiplier: 1.5.
  - Alternative multipliers: 1 and 2.
    - Multiplier = 1 → additional boost 2.9 percentage points (relative to baseline).
    - Multiplier = 2 → boost 4.5 percentage points.
  - Green investments multipliers range [1.1 – 1.7]; fossil fuel projects [0.4 – 0.7].
- Model and calibration highlights (DIGNAR-19)
  - Model: Dynamic General Equilibrium small open economy (DIGNAR-19).
  - Key calibrated values (Table 1: values in percent)
    - Potential real GDP growth rate: 3.2
    - Exports to GDP ratio: 33.0
    - Imports to GDP ratio: 16.9
    - Private investment to GDP ratio: 13.3
    - Public investment to GDP ratio: 12.1
    - Public consumption to GDP: 20.0
    - Total public revenues to GDP ratio: 40.0
    - Share of labor taxes in total public revenue: 10.0
    - Share of consumption taxes in total public revenue: 20.0
    - Share of government natural resource revenues in total government revenues: 57.3
    - Public debt to GDP ratio: 25.2
    - Private foreign debt to GDP ratio: 53.8
    - Value added of the natural resource sector: 40.0
    - Real interest rate on domestic debt: 1.0
    - Initial return on public capital: 25.0
    - Public Investment efficiency: 70.0
    - Depreciation rate of public capital: 7.0
    - Investment adjustment costs: 5.0
  - Initial rate of return on standard infrastructure investment set at 25 percent; initial efficiency of public investment set at 70 percent.
- Policy implications from model
  - Reform sequencing and completeness matter: full reform package yields long-lasting growth; pure investment surge has a hump-shaped impact peaking early.
  - Partial implementation still yields substantial, sustained non-oil potential growth gains.
  - Assess and monitor project-level multipliers; heterogeneity across projects and Giga-project risks.
  - Improve public investment efficiency via procurement rationalization and PIMA-guided measures (example calibration uses +20 percentage points).
  - Fiscal reforms (tax efficiency, wage bill rationalization) contribute to gradual fiscal balance improvement (0.5 percent of GDP by 2026).
  - Labor market reforms to raise labor force participation (including Saudi women) can boost labor supply by 2 percentage points by 2026.
  - Strengthen PIF and NDF project evaluation (Risk Committee, Impact Assessment Methodology).
  - Direct investments toward R&D and technological upskilling; national RDI plan targets annual spending 2.5 percent of GDP on R&D by 2040.
- Data gaps and monitoring needs
  - More detail on PIF’s financial relationship with central government and debt issuance plans needed to assess PIF asset trajectories under different oil price scenarios.
  - Monitor absorptive capacity and heterogeneity in project returns to manage risks and optimize growth outcomes.

*Source: IMF staff estimates (1sauea2022002).*

### References ______________________________________________________________________________ 20

### THE NEED FOR A FISCAL ANCHOR AND POTENTIAL FISCAL RULES IN SAUDI ARABIA

### Overview and motivation
- Oil remains critical: oil accounted for about 40 percent of real GDP in the last few years, down from about 45 percent 10 years ago; oil's share of nominal GDP was about 30 percent in 2021 and is projected to increase to about 40 percent in 2022.
- Oil revenue concentration in fiscal revenues: oil revenues averaged 75 percent of total budget revenues since 2010, peaked at 93 percent in 2011, and fell to 53 percent in 2020.
- Historical fiscal volatility: fiscal balances varied with oil prices — surpluses during booms and deficits during low-price periods; e.g., deficit of almost 16 percent in 2015 and surplus peaking at almost 30 percent of GDP in 2008.
- Recent improvement in expenditure behavior: expenditures declined by almost 3½ percent in 2021 despite oil price increasing by more than 66 percent; 2022 budget envisages substantial reduction in expenditure for 2022 and continued restraint for 2023 and 2024.
- Ongoing reforms under Vision 2030: non-oil revenue mobilization (VAT increases, revenue administration reforms), energy price reforms (gasoline prices capped in mid-2021), expenditure rationalization and procurement reform, Treasury Single Account, more systematic fiscal risk assessment, improved budget disclosure, strengthened debt management.

### Rationale for a fiscal anchor and preferred frameworks
- Need to expand institutional coverage for fiscal assessment to include the Public Investment Fund (PIF) and the National Development Fund (NDF).
- Fiscal anchor should complement existing debt-to-GDP ceiling and guide medium-term fiscal framework (MTFF) and expenditure prioritization.
- The authorities are preparing a Fiscal Sustainability Program (FSP) to avoid excessive deficits while supporting long-term objectives (infrastructure to support diversification).

### Using the Permanent Income Hypothesis (PIH) as a fiscal anchor
- Advantages of PIH for Saudi Arabia:
  - Achieves intergenerational equity by leaving future generations financial wealth to sustain fiscal deficits.
  - Creates flexibility in the medium term via a gradual adjustment to the long-term anchor.
  - Promotes a prudent fiscal stance by saving resource revenue to accumulate buffers for "bad" times.
- Alternatives described:
  - Bird-in-hand (BIH): consume only interest on accumulated financial wealth; prudent but inflexible; Norway example limits non-oil primary deficit to 4 percent of accumulated financial wealth.
  - Spend-as-you-go (SAYG): procyclical, spends all resource revenues on receipt.
- Modified PIH (mPIH): allows deviation during a transition period to reach the long-term PIH anchor; can incorporate a fiscal sustainability framework (FSF) that factors in growth dividends from scaled-up investment.

### Key uncertainties and scenario design
- The level of economically extractable reserves and oil prices critically determine long-term sustainable fiscal space.
- Baseline assumption used: assessed reserves of about 260 billion of barrels of oil as of 2021 are exploited.
- Two alternative scenarios considered:
  - A combination of demand/supply shocks: demand declines due to climate reforms but supply shocks knock out competitors, resulting in higher oil prices and considerably higher oil revenue and financial wealth for Saudi Arabia.
  - Demand shock only: collapsing oil prices; a low-likelihood illustration of broader cases including reserves becoming uneconomic to exploit.
- Need for prudent assumptions and regular revisions of PIH estimates, with flexibility over short and medium term.

### Findings under the baseline PIH anchor
- Under a PIH anchor defined as constant in real terms with a transition period:
  - The non-oil primary balance would decline from about 29 percent of non-resource GDP in 2022 to about 21 percent by 2028.
  - Transition duration in the baseline is 6 years (corresponding to the horizon of IMF baseline projections and incorporating fiscal consolidation efforts under way since 2016).
  - Most of the adjustment effort could be delivered by efforts already planned through 2028.
  - Beyond 2028, a gradual adjustment of about ½ percentage point of non-resource GDP annually would be implied, converging asymptotically towards 0.
- PIH defined as constant share of non-resource GDP would likely require a much sharper adjustment and be less appropriate given Saudi Arabia’s large and long-lived resource base.
- Targeting a constant annuity per capita is an option but likely requires a longer transition than the 6-year baseline.

### Transition considerations and alternative scenario implications
- Demand shock scenario (pessimistic):
  - Much-reduced fiscal space implies a much larger fiscal adjustment down the road; transition period is longer (15 years in alternative scenarios).
  - Adjustment needs to be gradual to avoid large annual adjustments harmful to growth.
- Supply and demand scenario (optimistic):
  - Much larger fiscal space allows for larger short- and medium-term deficits to support growth and diversification.
  - Adjustment to the PIH norm could start after a period of scaled-up spending, implying a longer transition (15 years in alternative scenarios).

### Calibration, key parameters and assumptions (as presented)
- Table 2 entries (as presented in source):
  - Real non-resource GDP growth 2.82.8
  - Nominal non-resource GDP growth4.84.8
  - Population growth 1.01.0
  - GDP deflator inflation2.02.0
  - US GDP deflator inflation2.02.0
  - Real interest rate 3.83.8
  - Nominal interest rate 5.85.8
  - Interest - GDP growth differential1.01.0
  - Steady state government deposit/GDP ratio17.617.6
  - Central government minimum gross debt ratio20.020.0
  - Transition period before sustainability anchor reached 2/6.015.0
- Notes on transition periods:
  - In the baseline, the duration of the transition is 6 years.
  - In the two alternative scenarios, the transition is much longer (15 years), reflecting either a need for a larger adjustment (demand shock) or scope to delay adjustment after a period of scaled-up spending (supply and demand scenario).

### Policy implications and recommendations
- Continue fiscal management reforms and revenue mobilization (non-oil revenue, VAT and administration reforms).
- Expand fiscal institutional coverage to include PIF and NDF for comprehensive assessment of fiscal position.
- Adopt a medium-term fiscal framework (MTFF) and consider an expenditure rule anchored on a PIH/mPIH to:
  - Reconcile stabilization and growth objectives.
  - Provide flexibility during transition to support diversification-related spending.
  - Accumulate buffers to manage shocks and smooth intergenerational consumption.
- Regularly revise PIH estimates and stress-test assumptions (reserves, prices) to ensure fiscal plans remain sustainable under alternative scenarios.
- Deliver most of the near-term adjustment through already planned consolidation to avoid abrupt long-term cuts that could harm growth.

*Sources: IMF staff estimates.*

### Box 2. Alternatives Measures of the PIH

### Box 2. Alternatives Measures of the PIH

### How to compute the Permanent Income Hypothesis (PIH)
- Framework: total financial wealth of the country, W, earns a return given by the nominal interest rate r, which can be used to finance a primary deficit (PD, the permanent income).
- Core relationship presented: PD = (r − γ) W
- The parameter γ determines how returns and wealth evolve and therefore the permanent primary deficit.

### Three alternative specifications for γ and their implications
- γ = π, where π is the inflation rate.
  - Government consumes the fraction (r − π) W of the return and leaves the residual, π W, to accumulate more wealth: W_{t+1} = (1+π) W_t.
  - Financial wealth grows with the inflation rate and is constant in real terms; by extension, the primary deficit is constant in real terms.
- γ = g, where g is the growth rate of the non-resource GDP.
  - Leaves both wealth and the primary balance constant in percent of non-resource GDP.
- γ = π + n, where π is the inflation rate and n the population growth rate.
  - Leaves wealth and the primary balance constant in real terms per capita.

### Application to Saudi Arabia (2022) and methodological considerations
- Applying the alternative γ choices to the PIH from 2022 for Saudi Arabia yields different outcomes (table/figure referenced in source).
- Stress-testing and reassessment:
  - The underpinning methodology and assumptions on parameters are critical for assessing fiscal space over the long term.
  - Risks on assumptions underpinning the PIH, including growth and the implied fiscal adjustment, require careful analysis.
  - Authorities should regularly assess how the underpinning PIH may have changed and whether revisions to the PIH are warranted.

### Risks, transition paths, and scenarios for fiscal adjustment
- Fiscal adjustment design:
  - Examples assume a transition of 6 years (15 in the two alternative scenarios) to create space for gradual fiscal adjustment.
  - Two illustrative adjustment paces:
    - About 1 percent of non-resource GDP annually to achieve a PIH anchor of a constant deficit in percent of non-resource GDP.
    - ½ percent annually to achieve a PIH anchor that keeps the deficit constant in real terms (thus declining in percent of non-resource GDP).
  - A gradual adjustment would leave fiscal space to support public investment in the short and medium term and time to design supporting fiscal reforms (e.g., non-resource revenue mobilization or expenditure rationalization).
  - Scenarios to factor: adjustment not fully implemented; adjustment implemented but not delivering expected savings.
- Re-assessment triggers and buffers:
  - Uncertainty about long-term parameters warrants regular PIH reassessments.
  - Policy design recommendations:
    - Use prudent assumptions for underpinning parameters (e.g., long-term oil prices).
    - Allow fiscal strategies and fiscal rules to permit use of buffers and outline fiscal responses to sudden shocks.
    - For temporary or mild shocks, use buffers (liquid assets or low public debt) to smooth shocks and maintain spending plans.
    - For large and persistent shocks, reassess the PIH and adjust the fiscal stance to ensure sustainability.

### Importance of the interest rate–growth differential (r − g)
- Key principle: higher interest rate increases the permanent deficit that can be financed by returns on accumulated financial wealth; higher GDP growth lowers the deficit.
- Implication: boosting long-term growth may require increased public investment (infrastructure and human capital), which translates into higher future income and affects the sustainable deficit.
- Risk management: regularly check whether public spending is efficient in supporting growth and diversification; inefficient spending could lower non-resource growth versus expectations and reduce the sustainable deficit. Conversely, high-quality public spending could raise growth potential and catalyze private investment.

### Fiscal rules to support the long-term anchor
- General design considerations for resource-rich countries:
  - Fiscal sustainability and rules should be articulated around an objective set in terms of net financial wealth of the public sector.
  - Rules need flexibility: preserve counter-cyclical space and define escape clauses.
  - Sovereign wealth funds (SWF) should be integrated into the design of fiscal rules.
  - Supporting institutions are essential: fiscal transparency, independent oversight, adequate public financial management.
- Box 3 (elements for effective fiscal rules) highlights:
  - Rules should be numerically clear, simple, avoid undue constraints, and preserve flexibility for counter-cyclical policies.
  - Buffers and escape clauses reinforce rules’ effectiveness and credibility, especially given large oil revenue swings.
  - Transparency, independent oversight, and public engagement enhance compliance and credibility.

### Options for Saudi Arabia: lessons and rule design
- High-level lessons:
  - Fiscal rules should anchor on net financial assets to focus on long-term sustainability and intergenerational equity.
  - SWF: use for stabilization and intergenerational equity; avoid ad-hoc use and ensure SWF have no independent spending authority that would create extra-budgetary quasi-fiscal operations.
- Policy options evaluated:
  - Price smoothing rule:
    - May help smooth volatility but can exacerbate procyclicality in some cases.
    - Not well suited on their own for commodity exporters given large, persistent shocks.
    - Can be mitigated by companion rules (e.g., floor on net financial assets).
  - Expenditure rule anchored on a non-resource primary balance goal:
    - Recommended approach: implement PIH norm after a transition period supported by two numerical rules:
      - (i) a ceiling on expenditure growth, and
      - (ii) a target on net financial assets (can be strengthened with a debt brake).
    - An expenditure growth cap can provide counter-cyclical support and help develop MTFF/MTEF and PFM improvements.
- Counter-factual evidence and buffer generation:
  - Counter-factual exercise: capping real expenditure growth at 4 percent (roughly the average observed over 2003–21) would have better stabilized spending relative to a revenue smoothing rule and could have generated significant buffers.
  - Illustration: such stabilization under the cap could have generated buffers of about 50 percent of non-resource GDP (difference between actual spending 2003–21 and spending under the 4 percent cap). This is indicative and not a projection or recommendation.
  - Calibration of buffers depends on social preferences for risk and on rules for when buffers are used and when budgets must adjust after large and persistent shocks.
- Forward-looking calibration for Saudi Arabia:
  - Under the baseline, authorities may consider a cap on real expenditure growth of 1 ½ percent annually (after 2028) to implement the PIH anchor after a 6-year transition.
  - Assumptions behind the illustrative cap:
    - Non-resource revenue remains constant as a share of non-resource GDP.
    - Expenditure gradually declines as a share of non-resource GDP.
    - With the assumed non-resource GDP growth rate of 2.8 percent (Table 2), the adjustment needed would be achieved.
  - With revenue measures, a cap of about 2 percent annually is noted elsewhere as an alternative calibration path.
  - Implementing these caps does not necessarily require complex or painful fiscal measures; strengthening public expenditure management to improve quality of spending can mitigate real-term impacts.

*Source: Box 2. Alternatives Measures of the PIH (1sauea2022002).*

### 25.       The cap to get the adjustment

### 25.       The cap to get the adjustment

### Revenue measures and implications for the expenditure cap
- VAT rate tripled from 5 to 15 percent.
- Under IMF baseline projections, Saudi Arabia is expected to have a tax-to-GDP ratio stable at about 14 percent by 2027.
- Comparative benchmarks cited:
  - Emerging economies: about 18 percent of GDP.
  - G20: about 22 percent of GDP.
- Simulation assumption on non-oil revenue mobilization:
  - Total non-oil revenue increases gradually, over 10 years, from 18 percent of non-oil GDP in 2027, to 20 percent in 2037, reflecting a mix of tax policy and tax administration measures.
- Implication for the expenditure rule:
  - With the above revenue measures, the expenditure rule would follow a less constraining path, where real expenditure growth could be roughly capped at 2 percent until the new revenue level is reached.

### Principles for dealing with shocks (escape clauses and flexibility)
- Key lessons:
  - Escape clauses are essential in dealing with shocks (to have room for counter-cyclical interventions, to revisit the expenditure cap ceiling when needed).
  - The rule needs to be able to accommodate both positive and negative shocks.
- Positive shock handling:
  - Apply the expenditure growth cap to limit excessive growth of spending following positive surprises (notably positive surprises on oil revenue).
- Negative shock handling:
  - One-off shocks could warrant continuation of the spending plan as defined in the medium-term fiscal strategy.
  - Negative shocks may require counter-cyclical support beyond automatic stabilizers (e.g., COVID19 pandemic), which could increase spending beyond the rule ceiling and thus require a predefined escape clause.

### Example: smoothing a temporary negative shock (simulation results)
- Shock modeled:
  - A negative shock on oil prices in 2026: a 30 percent reduction compared to the baseline.
  - Resulting revenue loss: 6 percent of non-resource GDP.
- Fiscal and wealth outcomes if spending plans are kept unchanged:
  - Permanent decline in financial wealth of about 6 percent of non-resource GDP.
  - Reduction of total net wealth available to finance future deficits by this amount.
- Context on fiscal space:
  - Staff estimates: Saudi Arabia would still have a total wealth of about 640 percent of non-resource GDP by 2026, so even a shock like this would only have a marginal impact on the long term.
- Strategic implication:
  - Each large shock—temporary or not—should be assessed to determine whether it warrants (i) revision of the underlying PIH benchmark and consequently the cap on real expenditure growth, or (ii) can be fully absorbed by using available buffers.

### Strengthening the rule via explicit fiscal buffers and debt-brake-like mechanisms
- Proposed buffer design elements:
  - Define a floor on net financial assets of the government (NFA); when NFA falls below the threshold, automatic adjustment measures would kick in to reduce spending and increase NFA.
  - The appropriate floor depends on social aversion to risk and the volatility of oil revenue.
- Calibration guidance from past volatility:
  - Over the past ten years, the standard deviation of oil revenue (in percentage of non-resource GDP) is noted as about 25 percent of GDP.
  - Assuming a medium-term framework of 3 years, adequate buffers to guard against oil revenue fluctuations could amount to 75 percent of non-resource GDP.
- On the composition of buffers:
  - Buffers need not be kept only as accumulated financial assets; keeping gross public debt low preserves borrowing capacity and rapid market access.
  - Caution: borrowing at high interest rates could be costly relative to holding financial assets at lower cost.

### Persistent and large shocks: revisiting the PIH and escape clause function
- In the case of persistent and large oil revenue shocks:
  - The parameters of the fiscal rule and the underpinning Permanent Income Hypothesis (PIH) could be revisited.
  - An escape clause could be triggered to suspend the application of the rule in case of a large and persistent shock.
- Example outcome under a large permanent “demand” shock:
  - After a transition period of about 6 years, expenditure growth would need to be capped at -4 percent annually to ensure the non-resource fiscal balance adjusts to a considerably reduced fiscal space.
- Roles of an escape clause in such events:
  - Allow authorities to reassess the PIH norm.
  - Reassess the transition period needed to achieve the PIH.
  - Ensure that the cap on expenditure growth is consistent with fiscal sustainability.

*Source: IMF staff estimates.*

### 11. The banks’ liability and asset rates

### 11. The banks’ liability and asset rates

### Definitions and stylized behavior
- Liability rate: interest expense scaled by interest-bearing liabilities.
- Asset rate: total interest income scaled by interest earning assets.
- Both liability and asset rates tend to move strongly with nominal policy rates given the peg to U.S. policy rates; the spread between asset and liability rates underlines bank margin dynamics.

### Empirical evidence of monetary spillovers on Saudi economy
- Method: panel vector autoregression (baseline follows IMF (2014)); dependent variables include non-oil GDP growth, stock market indices, and long-term sovereign bond yields. Controls include U.S. effective Fed Fund rates, VIX, domestic inflation and oil prices.
- Sample: quarterly data 2018Q1-2021Q4; sovereign yields proxied by bonds ranging from 5- to 13-year maturity; average time to maturity in sample is less than 10 years.
- Key threshold: oil price cutoff at $45 per barrel.
- Main findings:
  - When oil prices are less than $45 per barrel, Fed tightening amplifies spillovers:
    - Non-oil GDP growth in Saudi Arabia declines by about 0.16 percent.
    - Equity prices drop by about 2 percent when oil prices are low and increase by 1.5 percent when oil prices are above the $45 threshold.
    - Sovereign yields increase by about 55 basis points for GCC countries when oil prices are low (94 basis points in Saudi Arabia), and by 46 basis points when oil prices are high (78 basis points in Saudi Arabia).
  - When oil prices are high, the effect of Fed tightening on Saudi Arabia is negligible.

### Implications for the banking sector — overview
- Substantial heterogeneity in banks’ funding structures:
  - Some banks rely heavily on uncompensated (non-interest-bearing) demand deposits; others have funding costs that oscillate with policy rates.
- Bank-level panel analysis covers 2003-2021.
- Baseline dependent variables: changes in liability and asset rates, return on equity (ROE), credit growth, and asset quality (change in NPLs).
- Main explanatory variable: change in the U.S. Federal Funds Rate. Specifications include bank fixed effects; standard errors clustered at the bank level.

### Pass-through from U.S. rates to Saudi bank rates (table summary)
- Estimated pass-through (selected results):
  - A 100 basis point rise in U.S. rates is associated with:
    - Saudi banks’ liability rates rising by 51 basis points (reported coefficients around 0.488***, 0.491***, 0.550**, 0.512** across specifications).
    - Saudi banks’ asset rates rising by close to 57 basis points (reported coefficients around 0.461***, 0.467***, 0.581***, 0.574*** across specifications).
- Controls appearing in specifications include Δ Oil Price ($), Log (Uncertainty Index), and Crisis Dummies.
- Observations: liability-rate regressions 169 observations; asset-rate regressions 170 observations.
- R-squared ranges reported (examples): liability regressions 0.176–0.193; asset regressions 0.211–0.268.
- Note: Robust standard errors shown in parentheses in original tables; significance indicated as *** p<0.01, ** p<0.05, * p<0.1.

### Banks’ profitability (ROE) and U.S. policy rates
- ROE regressions (Table 3) show a positive and statistically significant association:
  - Δ Federal Funds Rate coefficients: 0.020***, 0.020***, 0.021***, 0.018** across four specifications.
  - Observations: 180 in each specification.
  - R-squared reported: 0.078, 0.386, 0.393, 0.408 across specifications.
- Interpretation: upward shifts in U.S. interest rates are associated with rises in return on equity, consistent with a high proportion of non-interest-bearing deposits and/or pass-through to customers.

### Credit growth and asset quality
- Historical pattern:
  - Limited aggregate impact of monetary tightening on credit growth when oil prices were high (periods 2004-2007 and 2015-2018).
  - Tightening episodes combined with low oil prices tend to negatively impact credit growth.
- Liability pass-through (LPT) measure:
  - LPT is estimated as the coefficient from regressions of change in a bank’s liability rate on change in U.S. Federal Funds Rate.
  - Banks with LPT close to 1 are “sensitive”; those close to 0 are “insensitive.”
  - LPT is closely associated with the interest-bearing fraction of deposits, though banks with similar fractions can have different LPTs due to deposit franchise strength and share of deposits in total liabilities.
- Credit growth regressions (Table 4, selected coefficients):
  - Δ MP coefficients: -0.042, -0.080, -0.156 (across columns).
  - (Δ MP)*(LPT Dummy): 0.097 (col 2), -0.762*** (col 3).
  - (Δ MP)*(LPT Dummy)*(Oil): 0.981*** (col 3).
  - Observations: 138; R-squared: 0.023, 0.025, 0.087 across columns.
- Asset quality regressions (Table 5, selected coefficients for Δ(NPLs)):
  - ΔMP: -0.074, 0.031, 0.009 (columns 1–3).
  - (ΔMP)*(LPT Dummy): -0.243, 0.061 (columns 2–3 as presented).
  - (ΔMP)*(LPT Dummy)*(Oil): -0.338 (column 3).
  - Observations: 154; R-squared: 0.044, 0.057, 0.065 across columns.
- Interpretation:
  - At the aggregate level, credit growth is generally not affected by U.S. tightening; however, for banks with high LPTs, tightening can hamper credit growth in an environment of low oil prices.
  - No significant impact of U.S. monetary policy tightening on asset quality (change in NPLs), even for banks with higher LPTs.

### Robustness checks
- Replacing effective federal funds rate with Wu-Xia shadow Federal Funds rate for ZLB periods: main findings hold.
- Using increases in U.S. 10-year Treasury yields as alternative proxy for U.S. monetary policy: results remain robust.
- Adding controls such as government spending and U.S. growth rate: main results still hold.

### Concluding remarks (implications)
- Saudi policy rates broadly follow U.S. policy rates; bank liability and asset rates move strongly with U.S. policy rates given the peg.
- The level of oil prices plays a central role in modulating how U.S. interest rate changes affect non-oil GDP growth and banking sector performance in Saudi Arabia.
- High oil prices and associated liquidity are likely to mitigate negative spillovers from U.S. policy rate normalization to Saudi Arabia; in the current environment of high oil prices, expected changes in U.S. policy rates are not expected to negatively affect Saudi Arabia’s economy.

*Source: 11. The banks’ liability and asset rates — IMF chapter content (PDF filename: 1sauea2022002 - 11. The banks’ liability and asset rates).*

### Annex I for key assumptions used for the calibration of the Saudi economy). We consider three

### 1sauea2022002 - Annex I for key assumptions used for the calibration of the Saudi economy). We consider three

### Scenarios considered
- Baseline
  - Aligned with the macroframework underpinning the July 2022 Article IV Consultations.
  - Assumes GFCF would keep growing at a rate of about 6 percent in nominal terms.
  - Assumes some partial implementation of the structural reforms under Vision 2030, delivering a medium-term non-oil GDP growth of 4 percent.
- Moderate NIS investment scale up with stronger reform implementation
  - Investment increases of 9 percent on average on an annual basis after 2022 (which, if sustained until 2030, would cover about 90 percent of the planned investments under the NIS).
  - Reform measures adopted in four areas:
    1. Larger scale-up in combined public and PIF investment of 2.4 additional percent of GDP in 2022 and 5 percent of GDP in 2023-2026.
    2. Improvements in public investment efficiency set to increase by 20 percentage points.
    3. Fiscal reforms yielding a gradual improvement of the fiscal balance of 0.5 percent of GDP by 2026.
    4. Labor market policies boosting labor supply by 2 percentage points by 2026 relative to the baseline.
- NIS pure investment scale up
  - Assumes NIS investment targets are fully met and follow the 13 percent annual growth rate specified in the NIS.
  - Implementation of structural reforms assumed to be the same as in the baseline.
- NIS investment scale up combined with reforms
  - Assumes full NIS investment targets met and that all policies envisaged in the reform scenario are implemented.

### Major quantitative findings and projections
- Non-oil potential output growth outcomes (comparison to baseline)
  - Reform + full NIS investment scale-up could raise non-oil potential output growth to 8.8 percent in 2026, compared to 4 percent in the baseline.
  - Moderate investment scale-up coupled with reforms could boost non-oil potential growth to 7.7 percent in 2026.
- Contribution breakdown (2026, reform scenario relative to baseline)
  - Investment ramp up dividends: 2.7 percentage points.
  - Labor market reforms dividends: about 0.5 percentage points.
  - Gains in public investment efficiency dividends: about 0.8 percentage points.
  - Fiscal measures drag: 0.4 percentage point.
- Combined effect of the reform package
  - Could deliver a medium-term increase in non-oil real GDP growth of 4.8 percentage points relative to baseline.
- Private investment
  - Private investments are expected to increase by up to 13.2 percentage point relative to the baseline under the reform scenario.
- GFCF as share of GDP
  - Under the reform scenario, GFCF would reach 29 percent of GDP in 2026.
  - Vision 2030 target of reaching an investment share of GDP of 30 percent would be reached earlier than 2030 in the reform scenario.
- PIF assets under management assumptions and challenges
  - Authorities expect PIF’s assets under management to grow from around SAR 2.3 Tr currently (about 60 percent of GDP) to SAR 4 Tr in 2025 (about 90 percent of GDP).
  - Achieving such growth organically would require PIF to consistently deliver returns twice the size of the economy’s growth rate; otherwise, announced targets may be unattainable without additional fiscal support.

### Investment multipliers, sensitivity, and uncertainty
- Preferred calibration multiplier: 1.5 (model leads to a multiplier of 1.5).
- Alternative specifications considered: multipliers of 1 and 2.
- Sensitivity of reform scenario to multiplier choice (additional boost in non-oil potential growth relative to baseline)
  - Multiplier = 1 delivers an additional boost of 2.9 percentage point.
  - Multiplier = 1.5 (preferred) shown in figures.
  - Multiplier = 2 could deliver a boost of 4.5 percentage points.
- Factors affecting multipliers and efficiency
  - Multipliers higher when current capital stock is low or when monetary policy is close to the zero lower bound.
  - Absorptive capacity can constrain efficiency of large investment scale-ups.
  - Green investments may have higher multipliers ([1.1 – 1.7]) versus fossil fuel projects ([0.4 – 0.7]).

### Model description and calibration (DIGNAR-19)
- Model: DIGNAR-19 (Debt Investment Growth Natural Resources and COVID-19) — a Dynamic General Equilibrium (DGE) model for a real small open economy; extension of DIGNAR and DIG frameworks.
- Main channels determining public investment multiplier:
  1. Growth-investment nexus (public capital raises productivity of private factors).
  2. Fiscal response required to maintain debt sustainability.
  3. Potential for crowding-in and crowding-out of private investment.
- Public capital accumulation and effective public investment efficiency parameter (휖∈(0,1]) determine translation of public investment into public capital stock.
- Calibrated parameter highlights (Table 1: values in percent)
  - Potential real GDP growth rate: 3.2
  - Exports to GDP ratio: 33.0
  - Imports to GDP ratio: 16.9
  - Private investment to GDP ratio: 13.3
  - Public investment to GDP ratio: 12.1
  - Public consumption to GDP: 20.0
  - Total public revenues to GDP ratio: 40.0
  - Share of labor taxes in total public revenue: 10.0
  - Share of consumption taxes in total public revenue: 20.0
  - Share of government natural resource revenues in total government revenues: 57.3
  - Public debt to GDP ratio: 25.2
  - Private foreign debt to GDP ratio: 53.8
  - Value added of the natural resource sector: 40.0
  - Real interest rate on domestic debt: 1.0
  - Initial return on public capital: 25.0
  - Public Investment efficiency: 70.0
  - Depreciation rate of public capital: 7.0
  - Investment adjustment costs: 5.0
- Initial rate of return on standard infrastructure investment set at 25 percent; initial efficiency of public investment set at 70 percent.

### Policy implications and recommendations
- Reform sequencing and completeness matter: full reform package yields long-lasting growth; pure investment surge has a hump-shaped impact peaking early.
- Even partial implementation (moderate investment plus reforms) yields substantial and sustained increases in non-oil potential growth.
- Need to assess and monitor project-level multipliers; large heterogeneity expected across projects, especially Giga-projects with high risk/high return profiles.
- Improve public investment efficiency through procurement rationalization and PIMA-guided measures to raise efficiency (example calibration uses a 20 percentage point improvement).
- Fiscal reforms (closing tax efficiency gap, rationalizing high wage bill) contribute to gradual fiscal balance improvement (0.5 percent of GDP by 2026).
- Labor market reforms to boost labor force participation (including Saudi women) to increase labor supply by 2 percentage points by 2026.
- Careful evaluation and monitoring by PIF’s Risk Committee and NDF’s Impact Assessment Methodology are critical to maximize medium-term risk-adjusted returns.
- Directing investments toward R&D and technological upskilling in strategic sectors (hydrogen, electric vehicles) could generate upside risks in the long run; a national RDI plan (unveiled July 2022) targets annual spending of 2.5 percent of GDP on research and development by 2040.

### Concluding remarks and data gaps
- Accurate assessment of the NIS depends on careful monitoring of project delivery and implicit multipliers.
- More details on the PIF financial relationship with the central government and debt issuance plans are required to better assess PIF asset trajectories and available investment capacity under different oil price scenarios.
- Monitoring absorptive capacity and heterogeneity in project returns is essential to manage risks and optimize growth outcomes.

*Source: IMF staff estimates and projections (Annex I, DIGNAR-19 model calibration and scenario analysis).*

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_Source: https://www.imf.org/-/media/files/publications/cr/2022/english/1sauea2022002.pdf_