Saudi GDP II : Productivity & Capital Stock

In my last post I discussed Saudi’s simple GDP dynamics. Yet we did not discuss anything other than oil fluctuations and its relationship with growth rate of GDP and the importance of looking at growth rather than levels of GDP. Nor did we consider the important distinction between nominal and real GDP. Where real GDP is adjusted for inflation. In this post we do. We also make some adjustments to our GDP variable, looking closely at GDP per person to give us a clearer picture about the well-being of individuals. Below is the inflation adjusted gross domestic product for Saudi Arabia from 1970-2014.Rplot05.png

Factors of production

Playing around with more R and some data I provide some interesting visuals that asks important questions.  Before we do that, we need to refresh our memory about a certain element that constitutes the production process in a country. When talking about an economy’s output of goods and services, it is agreed that it depends on its quantity of inputs. These inputs are called the factors of production. An economy’s ability to turn these factors/inputs into output is represented by a production function.

The two most important inputs in production are capital and labor. Capital refers to the set of tools/machines/equipment that workers use, and Labor is the time people spend working. Another important element exists in the production process is the Total Factor Productivity (TFP). TFP is the portion of output that is not explained by the amount of input used in production. It determines how efficient inputs are utilized in production. The graphic below illustrates the process of converting inputs into outputs.

prod

Consider three economies, that have the same level of inputs 100 Labor and 100 Capital, but they differ in productivity. The table below shows how TFP plays a role on output. Country A has a TFP of 1 and correspondingly its output is 10,000. Country B has a TFP of 1.2, suggesting it can convert its inputs more effectively and can produce 2,000 more output than country A. Country C has a TFP of 1.6 and therefore is the most efficient country that yields the highest output.

prod2

Total Factor Productivity (TFP)

Now that we have a solid introduction to these factors let us consider again the Saudi case. Using the Federal Reserve data of St. Louis that acquired the TFP data on Saudi Arabia from the “Next generation of the Penn World tables” .(TFP is indexed to USA =1). We plot the Productivity level on the left, and Productivity change on the right, of Saudi Arabia against time (1970-2014).TFP

Now, let’s plot the productivity change on top of Real GDP change. Consider the graph below, we can see below that Real GDP moves close with productivity. The rough estimated correlation is 0.6.Rplot03

Plotting the GDP per person against TFP (Below). We see that as productivity goes up we expect to see higher GDP per person. In other words, the more productive Saudis are, the more incomes they will earn.RGDP Per capita with TFP

Capital Stock 

Let us shift our focus to another aspect of the production function, Capital stock for Saudi Arabia. The capital stock is simply the amount of capital stock in Saudi Arabia across time. Consider the left graph that depicts capital stock levels and right graph capital stock change.

Capital stockCapital stock has been increasing since the 70s with the similar story of the dip in the 80’s, that followed a continuous rise. Now let us examine how changes in capital stock goes with output or Real GDP. Below we plot real GDP per person against change in capital stock. We see a somewhat linear relationship; the estimated correlation coefficient is 0.62.new

These visuals tells us that our production function story is relatively true, that is increases in capital and productivity are associated with higher incomes for people. We will refrain from discussing the labor input for another post.

To conclude

Let us see how it all adds up together. Below we plot real GDP per person on top of TFP (left graph).We see that there has been a close association from 1971-2000: the correlation between TFP and Real GDP per person is 0.95 (1971-2000).

lastone

This association departs in 2000, we see that after 2000 productivity did not catch up with the rise in GDP. This tells us something about the structure of Saudi’s economy, which is a natural resource dependent country. We also plot to the right the change in capital stock on top of TFP, we see that up to 90’s there was a close association between changes in capital stock and TFP: from (1971-1990) the correlation coefficient  is 0.95. The departure of the associations entails an interesting story. Despite the rapid increase in capital stock, Saudi’s productivity has remained within [1.0-1.5] range. Whether that is normal standards or not we can clearly see that dynamics of production have changed.

 

 

SAUDI GDP: Using R visualization

There is an important distinction to be made when anyone examines Gross Domestic Product (GDP). Before we go deeper let’s clarify what it means. Gross domestic product is the monetary value of all the finished goods and services produced in a country in each year. It entails all private and public consumption, investments, adding exports and subtracting imports. Simple equation illustrates,

GDP = C + I + G + (EX-IM)

GDP is an important indicator of economic health of a country, used by many as proxy for standard of living. Is it the full picture? what about the pulse of the economy?

Note: arguments that relate how GDP does not capture standard of living is for another post.

I will consider the case for my country Saudi Arabia. The graph below shows the GDP level for Saudi Arabia across time (in millions), specifically 1970-2016.SAUDIGDP1970-2016

We see a rise from 1970 level compared with 2016 level, a large dip in the 80s, and a somewhat steady continuous rise. Consider now the growth rate of GDP. The growth rate of the economy is the percentage change of the GDP from one year to the next. Which explains how fast an economy is growing.

Gdp Growth 1960-2017.png

The graph above shows the growth rate of 46 years of Saudi Arabia. This graph does does not look as consistent as we thought it is by checking the first graph, when looking only at GDP level. Growth rate tells us a different story about the pulse of the economy, one that is far more interesting than the GDP level, where the only story is during the 80’s, which we can relate to in the growth picture. In that time frame Saudi’s GDP year on year declined by 20%.

Moreover, considering the case for Saudi we can see that it is far from being consistent or stable. However, if one would look at the level of GDP Saudi starting in 1970 compared to 2016 we can safely say that on average the growth rate for 46 years was 3.7%. Yet that is far from the truth now isn’t it.

Saudi GDP.png

As we know Saudi’s GDP stems from its oil production, then there must be a considerable effect from the oil price fluctuations. Oil prices are very volatile, check the two comparisons below. The left graph depicts the price of oil since 1986, where the right graph entails the change of oil prices year on year. We see that oil is very volatile across time.

Rplot03

Now let’s see how oil price fluctuations looks with Saudi GDP growth. Below we can see that there exists some sort of lag effect from oil prices on GDP. By lag I mean it might be that last year oil price change effects the following year in GDP growth.Oil GDP growth 86 vs Oil price change.png

There exists an intimate relationship between the change in oil price and GDP growth for Saudi Arabia. When one looks at GDP level we do not see the whole picture of the pulse of the economy. For a natural resource driven country we see plenty of volatility from its reliance on oil as main source of income. Yet we can conclude that in the long run (46 years) Saudi has grown on average 3.7% per annum.

Update* June 20th 2017

I acquired data that explains this relationship better. As the graph below shows, the Real GDP Growth of the Saudi Economy and Oil Sector growth. They exhibit a 0.77 correlation which indicates the intimacy mentioned previously.

Saudi RGDP growth and oil sectory growth.png

The white tax on undeveloped land in Saudi Arabia has been implemented.

According to a recent post by ARGAM “http://www.argaam.com/en/article/articledetail/id/477846“, the white tax on undeveloped land has been implemented.

I am in full support of this policy, since the government is trying to incentivize owners of land to develop their lands in order to reduce the shortage in the housing market that is propping up house prices. Which also safeguards fair competition and it combats
monopolistic practices in the housing market (since paying a 2.5% tax on property that does not generate cash flow seems to be a like a drain on a landowner’s account balance).

There has been substantial amount of literature and research on the issue of land inequality, such that a small percent of people own a large percent amount of land. This inequality should not be taken lightly. Many publications in top economic journals have discussed the implications on society and the economy when high levels of land inequality exists. Some findings even suggest that land inequality by itself promotes stagnation in economies that seek to develop into industrialized ones.

The ideal situation would be that house prices decline, then the incentive of owning a piece of land falls and that in turn, causes people with wealth to dwell into other businesses that can generate fair returns and economic activity.

At a time where Saudi is facing rapid structural changes, those who have exploited the less fortunate finally must pay up.

Understanding the Oil and Saudi Dilemma

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The Black Gold

Oil is undoubtedly the most important natural resource of the industrialized world, due to its vast functions for most technological, and manufacturing processes for many different sectors. Thus, its price plays a major role for most economies. Saudi Arabia, being blessed with such vast oil rich lands, accounted for 18.5% of total crude oil exports worldwide in 2014. It has been the most dominant player in the oil production market since the 1960’s; back then it co-created the organization of petroleum exporting countries (OPEC), a monopolistic cartel that united the five top oil producing countries –Iran, Iraq, Saudi Arabia, Kuwait, and Venezuela. OPEC exploited its power to control the market and gain supernormal profits by limiting overall supply. By 1973, OPEC has become a 12 country band accounting for two-thirds of the world’s oil production; and by 2010, 79.6% of the world’s oil reserves was under OPEC member nations. In 2014, oil came crashing down, (as figure above shows), from an overall increase in supply, with weak demand especially from the Asian markets. These  realities wreaked the oil market causing it to fall from a peak of $115 in mid 2014 to a mere $30 in 2016. This has led to financial turmoil for OPEC countries. Not only are less affluent OPEC members such as Venezuela hurt by the lower oil prices, but even rich Gulf States, including Saudi Arabia.

 

An Oil Party

Shale oil, oil found within rock fragments, was discovered in the 20th century and was seen as a gold mine of oil. However, the technologies needed to extract it was not available and was too costly when it was. In 2009, horizontal drilling, a drilling process in which the well is turned horizontally at depth, bundled with hydraulic fracturing, using pressurized water and liquids to break rock fragments to extract oil and gas, have become cost and operationally efficient to be used assuming oil levels remain above $45. This led to an ocean of investment into shale oil fields and created a new key and major player in the oil market.

 

EXCEL
Saudi(Orange-line) increased production, while oil prices(Blue-line) was plummeting.

Saudi fights back

For Saudi Arabia, oil accounted for roughly 80% of its exports and thus, the so called “Black Gold” source of revenue for the country, has turned from being its greatest feat to its greatest threat. Moreover, Saudi Arabia’s strategy towards declining oil prices have been surprising. Referring to the graph above, unlike most of the other countries, Saudi Arabia, extracts oil at a price of $8 in comparison to the world average of $40.This cost-advantage has allowed Saudi to boost production levels to further drive prices down to drive out competitors while maintaining minimal profits, however not enough to maintain a balanced budget. We can observe a simple decision tree in the chart below to better understand the decision behind the strategy.

Decision Tree Saudi
The best decision was  Saudi to not cut its production to yield                                              [Increase Price and Gain Market Share]

Is the Oil party over?

The amount of Shale Oil Rigs have decreased by 70% since 2014 but production of existing rigs have increased and thus overall, production capacity has not fallen significantly. However, R&D into oil fields have ceased to exist with many firms selling exploration lands at huge discounts. Moreover, Blackrock, the world’s largest asset management firm, has announced that if prices remain low in 2016, over 400 companies will declare bankruptcy and all other firms will have to take loans and lay off a large chunk of their workforce.  If oil companies default on their loans, banks get affected,  causing a domino effect throughout the economies of the world.

Competitors and the world have been enduring much more than Saudi and OPEC have expected. This has caused oil economies (OPEC) to use their foreign assets (figure below for Saudi’s NFA) to fund their budget deficits which for Saudi was at 15% in 2015. Other examples of large downfalls is the Russian Rubble depreciating by 70% since 2014 and Venezuela’s inflation reaching 140% in 2015.

SAUDI net foriegn assets

 

Time to diversify?

Oil-rich countries are battling to reform their countries, lowering oil dependency. Saudi Arabia is implementing policies under the new King to diversify the economy, and promote growth of the private sector. The Finance Minister Ibrahim Al Assaf stated on national television during an interview, that the ministry is willing to guarantee bank loans on small and mid-sized businesses, also known as SME’s. In response to a fearful market where banks might be hesitant to lend. By easing credit, young Saudi entrepreneurs will be able to start new businesses and grow current businesses at a faster rate than it normally would.

Furthermore, another initiative that Saudi is considering to implement is to privatize some of the government-owned entities, such as electric companies, airlines, and others. The most controversial privatization proposition, that created a thrill in markets, is the possibility that Saudi might initiate an IPO for Aramco, considered to be the most valuable company in the world, it aims to generate an excessive amount capital.

Saudi Arabia’s oil reign will definitely be marked in history as one of the major and most successful players in the oil market. However, times have changed as technological advances in clean, and renewable energy  develops, along with breakthrough in innovative oil extraction methods. Saudi Arabia must break the dependency on oil, and diversify its economy. To make it less susceptible to volatile oil prices, so it can preserve safety and stability for generations to come. 

The Unemployment Paradox

“A man willing to work, and unable to find work, is perhaps the saddest sight that fortune’s inequality exhibits under the sun.” – Thomas Carlyle

Unemployment by definition is probably one of the main issues in any developed/developing nation with its right mind should have in its agenda in policy-making. Well think of it as this, the more people work, the more they can spend, the more they spend the more economic activity can occur and other businesses gain from this spending, and that increases their standard of living, it’s a virtuous cycle!

Unemployment however is a moody child deprived of sugar, it wants something in exchange for something else, aim for the short-run and you could hurt the long run. Enforce wages you could cause more unemployment, form unions and collective bargaining that sets wages above the equilibrium level and you could find yourself at a monopolistic labor supply.

Even at periods of high unemployment some governments issues an unemployment insurance, to help its people cope with the situation, which if a person is unemployed they get paid for the amount for some of the time they are unemployed, text books and studies have shown that long periods of unemployment insurance can cause even more unemployment. The problem and issue of unemployment can be mind-boggling, however many factors come in play and the role of government is vital.

If the goal is to substantially lower the natural rate of unemployment, policies must aim at the long-term unemployed., because these individuals account for a large amount of unemployment. Yet policies must be carefully targeted, because the long-term unemployed constitute a small minority of those who become unemployed. Most people ho become unemployed can find work within a short time. (Mankiew-Macroeconomics p190)

The graph depicts the following. (for savvy economic readers, I chose to post a typical S&D graph to help illustrate the results of price floors, rather than incorporating the wage rigidity graph)

  • The vertical Axis labeled Price, by price I mean the price of hiring labor, or think of it as salaries/wages. The Horizontal Axis labeled Quantity(In labor).
  • Supply of Labor(Red Color) shows the positive relation it has with price and as price goes up more, more people are willing to work.
  • Demand for Labor(Blue color)shows the negative relation it has with price and as price goes up, less firms are willing to hire labor.
  • The equilibrium level is the Market clearing Price & Quantity. labeled QE & (E)equilibrium price.

When governments, unions, or any institution intervene on the labor market and enforce a price floor above the Equilibrium level, which means a minimum wage, or minimum salary that is above the initial equilibrium price (Point of intersection QE&QP).This in fact does two things in the short run. The first thing it does is that it creates a (surplus) that can be shown in the graph a red inverted triangle. Quantity supplied is now greater than Quantity demanded, which means the amount of people willing to work at this price exceeds the amount firms are willing to hire at this price level. This in  fact causes an imbalance between the forces in act.

In simpler terms: Lets say you have a firm and you have a budget of $10,000/month to hire workers each month. People are willing to work for $500/month, so that means that you can hire 20 workers each month for your operation. Now suppose the government wants to create a price floor and wanted to increase wages for workers and imposed a minimum $1000/worker to help workers earn more. Your firm’s budget is still $10,000/ month, however now you can only hire 10 workers.

So 10 people are happier and another 10 are sad, its a trade-off, fair or not depends on where you stand my friend.