In the last few months, there has been a flurry of articles about the Initial Public Offering (IPO) of Saudi Aramco. As the Financial Times has recently noted, ”this is no ordinary IPO … the listing is different to every other in terms of scale, the nature of the offering, the uncertainties around it, the timeline, the process. Nothing about it is comparable’. To this list, one can also add that unlike any other IPO, the partial sale of Saudi Aramco is so closely intertwined with developments in the domestic economy that the two should not be treated in isolation: the current economic reforms and adjustment measures will have a direct impact on the valuation of the company, the timeline and the process of the IPO, and in turn the IPO of Saudi Aramco will determine the pace of economic adjustment, the process and nature of reforms, and above all whether Vision 2030 will succeed in achieving its ultimate goal of economic diversification and creating jobs for the thousands of young Saudis entering the labor market each year.
Economic diversification objective
One key motivation behind the IPO is that ”a successful flotation is essential … to wean the kingdom off oil… which aims to diversify the Saudi economy and create jobs’. But what the IPO will help achieve is diversification of the sources of income (often referred to as financial diversification), which is fundamentally different from ”economic’ diversification. The proceeds of the IPO of Saudi Aramco will most likely be deposited in the Public Investment Fund (a Saudi sovereign wealth fund) to be invested in non-oil industries such as technology, industry and services. The Public Investment Fund (PIF) has already received a 100 billion-Saudi riyal ($27 billion) transfer from official reserves and has recently changed its investment strategy to acquire stakes in high-tech international companies Uber and Softbank. The idea of establishing sovereign wealth funds to diversify sources of income is not new in the region. Other GCC economies such as Kuwait, Qatar and the UAE have quite large and active sovereign wealth funds (SWFs). But as the experience of other neighboring countries has shown (Kuwait and Qatar are vivid examples), diversifying sources of income through SWFs does not necessarily help diversify the economic base and does not create the much-needed jobs especially if the funds are allocated to foreign investments, as the domestic economy may not be deep enough to be able to absorb large investments without affecting its quality and/or as domestic industries face many bottlenecks such as the lack of necessary skills and human capital to absorb large inflow of capital.
The technology sector among the main goals
The recent deal between Soft Bank and the PIF to launch one of the largest tech investment funds in the world could be an indication that most of the investments will be allocated towards tech sectors outside the Kingdom, with limited impact on the real economic structure of the economy. According to a recent report, the PIF has already channeled about $50 billion into investments abroad, the bulk of it into technology with some warning that there is ”a risk that PIF are chasing the bright lights’, and instead ”they need to pay attention to valuations’. The plan is for the PIF to use half the assets not tied up in Saudi Aramco to invest abroad by 2020, up from 5%. Also the record of Middle East SWFs to engage in the governance of their portfolio investments has been poor, which may expose them to serious financial and reputational risks. As recently noted, ”the only way SWFs can safeguard wealth for future generations – fulfilling the purpose for which they were established – is to participate meaningfully in corporate governance’. Another key objective of many SWFs in the region is to earn the government a higher rate of return than on foreign exchange reserves since their investment mandate emphasizes high risk-return profile. But the rate of return on foreign exchange reserves should not be the benchmark for comparison. The topic of the merits of the IPO as a source of finance for Vision 2030 is beyond the scope of this short article, but it is possible to make the following observation. It would be legitimate to consider financing Vision 2030 from borrowing on global markets, and use a risk adjusted sovereign rate as the cost of financing and thus a useful comparison would then be the likely valuation discount rate in the IPO (a measure of the opportunity cost of those funds) against the cost of sovereign borrowing.
The new financial front of the Saudi economy
The recent experience of Saudi Arabia in accessing the bond market has been very encouraging. Last year, the Kingdom managed to raise $17.5 billion in the biggest ever bond sale from an emerging-market (the offer was oversubscribed) with very attractive rates with five year- bonds yielding 135 basis points more than similar-maturity US Treasuries, 10-year notes at a spread of 165 basis points and 30-year securities at 210 basis points. Another important criterion is whether the PIF investments can achieve better social returns through accelerating the diversification of the Saudi economy. Only time will tell. But given that most of the proceeds will most likely be channeled through the PIF, the success of the IPO should not be assessed separately from issues such as the performance of the PIF, its governance structure, the transparency in the decision-making process, the quality of its investment portfolio, the competence of the fund managers, and the accountability of the management team. For instance, the PIF has recently invested $3.5 billion in car-booking app Uber, which according to the Financial Times reflects ”two core mandates of its sovereign wealth fund: generate growth and aid sectors that can help the oil-dependent economy to diversify’. Whether such an investment will succeed in meeting these two objectives should be straightforward to assess.
Supporting the private sector and small- and medium-sized enterprises
While the IPO of Saudi Aramco is meant to underpin the creation of a large SWF, Vision 2030, centered on diversifying the economic base and creating jobs, is rather broad. For instance, Vision 2030 is centered on increasing the role of the private sector and the role of small & medium enterprises (SMEs), which are key to generate jobs outside the public sector. But little support has been provided so far for these sectors. Instead, the private sector continues to be squeezed and the non-oil sector has recently been contracting, with some key sectors such as construction particularly hit hard as a result of reduced activity and delayed payments. The government has also slashed its capital spending which led to the cancelation of many big infrastructure projects. In 2016, gross fixed capital formation contracted by a massive 17.3% compared to a growth of more than 8% back in 2012. Sharp contractions in infrastructure investment will undermine the objectives of Vision 2030, as these projects are essential for diversifying the economy and supporting private sector and non-oil sector growth. The above discussion shows that while there has been massive effort by the government to remove the technical barriers to the IPO, some fundamental questions remain unanswered. One such question is whether the IPO of Saudi Aramco will contribute to economic diversification that is needed to generate the much-needed jobs. The jury is still out there. Given that the partial sale of Aramco will most likely provide the bulk of funds to the PIF, it is quite surprising that PIF investments have not yet come under closer scrutiny.