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Making it in the desert kingdom

Source: The Economist –

Factory-building may not be the best way to diversify the economy

SWEET-TOOTHED locals cheered when Mars, an American confectioner, opened its first factory in Saudi Arabia in December. The kingdom’s policymakers cheered too. It was a sign of progress in their drive to create a more extensive and sophisticated manufacturing industry as a way of reducing dependence on oil, which accounts for 45% of GDP and 80% of government revenues. Manufacturing’s share of GDP has long been stuck at around 10%, and much of that has involved making pretty basic stuff like bulk chemicals.

For all the country’s huge reserves of cheap crude, the recent slump in the oil price makes that seem a sensible aim. Yet there are good reasons to question whether manufacturing is the right sector to seek to expand, and whether Saudi Arabia is a good place to locate factories.

The government is throwing money at its policy. It is investing more than $70 billion in building up to six new “economic cities” with modern infrastructure and business-friendly regulations. Mars put its factory in one of them, King Abdullah Economic City, on the Red Sea coast (pictured). It hopes these cities will host clusters in which firms from a particular industry huddle together, their proximity boosting their productivity and creativity.

The country is not starting from scratch. It is already strong in plastics and petrochemicals. SABIC, its largest public company, is one of the world’s biggest producers of these; and Saudi Aramco, the national oil company, is building a $20 billion petrochemicals plant in a joint venture with an American giant, Dow Chemical. Several large aluminium producers have already set up shop, including Alcoa of America, since Saudi Arabia has the two ingredients needed to produce the metal: bauxite ore and cheap electricity. Some fairly big Saudi food manufacturers already export around the region, such as Almarai, which produces milk and baby formula among other things, and Savola, whose mainstay is edible oils.

The government now wants to attract companies that will turn plastics into packaging, aluminium into car parts (or even fully assembled cars) and basic foodstuffs into strong consumer food brands. Some of the world’s big carmakers, which are switching from steel to aluminium for bodywork, are said to be looking at Saudi Arabia as a manufacturing base. Indian-owned Jaguar Land Rover has been in talks with the government since 2012, as yet without a result.

The size and wealth of the regional market ought to make it attractive for the motor industry: around 4m cars a year are bought in the Middle East and north Africa, making it a bigger market than Germany, with about 3m sold each year. Within the region Saudi Arabia is the largest market, with annual sales of about 1m. And sales are expected to keep growing across the region: the Boston Consulting Group reckons they could reach 9m by 2020. Luxury models—far more profitable than mass-market ones—are in particular demand.

Saudi officials argue that besides lots of rich consumers, their country has a central location, between Europe and Asia, and cheap and plentiful (expatriate) labour. But some analysts doubt if all this adds up to much of a competitive edge. “China is hard to compete with on scale and cost; places such as Germany have the high-tech market; the region doesn’t consume that much; and the currency is pegged to the dollar, so America dictates the terms of trade,” says Meda al-Rowas of IHS, a research outfit.

What is more, Saudi Arabia is a difficult place to do business. Regulations can be cumbersome and unpredictably enforced, and as yet it is unclear how much companies locating in the economic cities will be spared this problem. Foreign and domestic businesses alike need to attract skilled foreign workers. But these are often put off by the country’s strict social rules—especially women, who are banned from driving and must wear the abaya, a full-length black dress, in public. The only way to give staff a bit of freedom from all this is to locate manufacturing plants in closed compounds, though this is hardly a good way to attract foreign talent.

The government has lots of big contracts to hand out as sweeteners to foreign investors. But it tends to restrict these to the top firms in any particular industry. Foreign firms have to employ a certain proportion of Saudis, and it is hard to get ones with the right skills. Many firms depend on public spending, which provides little incentive to be innovative.

Saudi Arabia has a rival in its attempt to become the region’s manufacturing base: the United Arab Emirates. It does not have quite as much money to splash about, but it has many of the same advantages and fewer of the disadvantages. For instance, the UAE’s constituent emirates are better regulated, mostly more open to the outside world and less socially conservative. Abu Dhabi, one of the largest, has already attracted some foreign firms to make parts from aluminium and plastic composites. Boeing plans to start making some aircraft components there. Abu Dhabi and another of the emirates, Dubai, have become important global aviation hubs, which makes them attractive locations for the regional operations of all sorts of manufacturers, not just aerospace firms.

In any case, says John Sfakianakis, a Riyadh-based economist, most of the types of manufacturing the Saudi government wants to promote will do little to develop the economy. Many of them are dependent on cheap energy and therefore, he argues, not really a diversification from oil. Also, manufacturing does not create many jobs and would thus do little to provide work for the burgeoning population.

There are some signs that the government is becoming more realistic in its ambitions. An official involved in the industrial-development programme says that a plan to create a cluster of domestic-appliance makers has been dropped. Ms Rowas thinks that instead of aiming to attract large-scale industrial plants, the government would do better to promote smaller firms in such areas as telecommunications and IT services. Jeddah already has a bunch of firms creating online content and smartphone apps, and Saudis are voracious internet users.

As ever, officials can look to examples where governments’ efforts to create industrial clusters have worked—electronics in Taiwan, or shipbuilding in South Korea, perhaps. But the list of failures is longer. Opening up the economy and cutting bureaucracy for all kinds of businesses would be a surer route to success.

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