Saudi Arabia: Riyadh’s Strategic Gambit

Published on January 15, 2016
SGH Insight
SGH Insight
"And finally, on another market point of interest, Riyadh is not going to devalue the Riyal or alter its currency peg (see SGH 11/23/15, “Saudi Arabia: A Devalued Riyal Peg Highly Unlikely”)."
Market Validation
(Bloomberg 3/1/16)
Contracts used to bet whether Saudi Arabia and the United Arab Emirates will allow their dollar-pegged currencies to weaken fell to the lowest levels since December.

One-year forward contracts on the Saudi riyal were poised for the biggest drop in a month at 3:48 p.m. in Riyadh, according to data compiled by Bloomberg, heading for the lowest finish since Dec. 28. Similar contracts for the U.A.E. dirham retreated to a three-month low on a closing basis.

Ever since Riyadh’s decision earlier this month to execute Nimr al-Nimr, a Shia cleric who was a Saudi national, the intense rivalry between Saudi Arabia and Iran for regional dominance across the Gulf, through which more than a third of the world’s oil supply flows, has intensified with little scope for tensions to scale down any time soon.

With questions hanging over global growth and new lows for oil prices being set nearly every day, as someone remarked to us recently, we are all oil traders now, whether we realize it or not, and that includes the Federal Reserve and the other main central banks. And there is nowhere a more crucial, but hard to read player on the global stage right now than the ruling House of Saud.

A few key points:

*** First, despite alarming headlines to the contrary, the probabilities of a “hot” war across the Gulf between the two rival powers is low, as is a revolt among the Shia who live in Saudi Arabia’s Eastern Province, home to the Kingdom’s massive oil complex. Second, Saudi Arabia is maintaining its current oil policy to maximize market share and output, while Iran is set to soon send an estimated 500,000 additional barrels per day into the world’s oil market — meaning there is little new on the supply side from the Gulf at least to trigger a near term bullish case for oil prices. And finally, on another market point of interest, Riyadh is not going to devalue the Riyal or alter its currency peg (see SGH 11/23/15, “Saudi Arabia: A Devalued Riyal Peg Highly Unlikely”). ***

*** That said, the tail risk of an “accident” or a mis-calculation in the coming months should not be under appreciated, especially with ISIS looking to inflame the already heated sectarianism ravaging the region. What’s more, Riyadh’s regional proxy wars with Iran have recently suffered setbacks, both in Yemen, where its military offensive has stalled, and in Syria, where the near collapse of Saudi-backed rebels leaves ISIS as the sole counterforce to the Iranian and Russian-backed regime of Bashar al-Assad. And the Saudi efforts to lead a Sunni-NATO” to combat terrorism is leaving key allies wary of its barely concealed anti-Iran orientation, and indeed, there are inherent dangers in framing nearly every foreign policy move in such stark sectarian terms as the Saudis have been doing that may prove hard to contain or reverse. ***

*** Concerns are especially rising over the enormous power given by the near 80-year-old King Salman bin Abdul Aziz to his ambitious but inexperienced 30-year-old son, Prince Mohammed bin Salman, the Deputy Crown Prince and Defense Minister, who also oversees the Royal Court as well as all economic policy, including Saudi Aramco. While the rumors of rivalry between Prince Mohammed and the Crown Prince, Mohammed bin Naif, are invariably overstated, their relationship is probably the key driver to near term political risks in Saudi Arabia and the region. A turn for the worse in the King’s health or a major setback in the Kingdom’s sweeping economic reforms or its aggressive regional security policies could trigger a period of succession instability not seen since the schism between King Saud and Crown Prince Faisal fifty years ago. ***

*** To be fair, much of the current Saudi policies enjoy widespread popular support at home, and so much of its economic policies are long overdue. And the Saudis are seasoned veterans of Mideast politics, and breakthroughs may still come in either or both Yemen or Syria. Furthermore while the inevitable rivalries between MbS and MbN, as the Crown Prince and Deputy Crown Prince are referred to in diplomatic circles, are triggering anxieties among the Kingdom’s closest allies in Washington and the European capitals, as well as in the more Sunni moderate states, we still very much doubt the Al Saud will in the end allow a succession fight to emerge on the death of King Salman, certainly not in public. ***

*** Instead, our sense is that the senior Princes will fairly quickly rally round a consensus King, whomever may control the primary levers of power in the Army, National Guard, the internal security forces, or in the flow of cash stipends. We think the notions that the aging King and his young son Prince Mohammed may try or even could push aside the Crown Prince in the near future is far too speculative; and if King Salman should pass away any time within the next 18 months, the throne is more likely than not to pass fairly smoothly to Crown Prince Mohammed bin Naif, who still seems to have the solid backing of a majority of the senior Princes — and the Americans as well, who however strained political relations may be, are still the pivotal security factor in the calculations in the House of Saud. ***

Nevertheless, this new strategic narrative being written in Riyadh for the Kingdom and the Mid-east is almost certain to add a larger than ever geopolitical risk to oil prices and indeed to the international financial markets this year that will need to be closely monitored.

An Unprecedented Consolidation of Power

Rumors and predictions of the imminent fall of the House of Saud have littered outside media reports for decades. But if there is anything the Al Saud do well, it is keeping a firm grip on power, having lost control over the central Nejd plain of central Arabia but once in 300 years, and firmly maintaining its sway over the territory of modern state of Saudi Arabia since it was founded in 1932 by King Abdul Aziz bin Saud.

Indeed, defying the concerns over whether or when to make a necessary generational jump in the succession from the sons to grandsons of bin Saud, Crown Prince Salman bin Abdul Aziz, the sixth and presumably last of the bin Saud sons to rule, smoothly assumed the Saudi throne in January a year ago on the passing of his half-brother, King Abdullah, with Abdullah’s selection of Deputy Crown Prince Muqrin bin Abdul Aziz moving up the ladder behind Salman to become the Crown Prince.

But what stood out was how quickly King Salman moved to shake up the political line-up in the royal succession. Traditionally a King names his Crown Prince to ensure continuity, and in recent transitions, a deputy Crown Prince as well. But this time, King Salman moved quickly to push aside Crown Prince Muqrin, whose mother was Yemeni and lacked deep Family support. Without much fanfare, he stepped down and made way for the long awaited generational jump when King Salman named his full brother’s son, Interior Minister Mohammed bin Naif, as his Crown Prince instead.

Breaking the tradition of the stability in line of succession was enough of a shock, but what was truly unexpected was the even more dramatic elevation by the King of one of his own sons, Prince Mohammed bin Salman, whose mother came from the important al-Hajami tribe in the northern Nejd and is said to be a favorite among Salman’s wives.

Though barely 30 years old, the ambitious but inexperienced Prince was not only named Deputy Crown Prince, but maintained the important Defense Ministry, as well as put in charge of the Royal Court, the most powerful advisory body in an absolute monarchy, and meaning he could control who has access to the King. Prince Mohammed was also given charge of a new Council of Economic and Development Affairs, which was created to better coordinate and streamline the economic policy making process, as well chair of the Public Investment Fund. The young prince was also put in charge of another newly created Supreme Council atop the Saudi Aramco Board of Directors.

In effect, the young Prince Mohammed, surrounded by a very small body of Western-trained advisors with input from McKinsey, the consulting firm, now oversees Saudi defense policy, most notably the military offensive in Yemen, and all domestic economy planning, including control over the budget, and in setting Saudi oil policy. It marks an unprecedented concentration of power in a single Prince, and an inexperienced young one at that.

So with the King controlling the money, his son defense, and the key oil and economic ministries, and Mohammed bin Naif the interior ministry and its extensive surveillance network (his brothers are also Governors of the important Eastern Province and the Medina province), only the powerful National Guard among the key power centers of the Kingdom remains in outside hands, under Prince Miteb bin Abdullah, the son of the late King Abdullah. All the other branches of the Al Saud, including the sons of the other al-Sudeiry brothers Sultan and Fahd, as well as the al-Faisals, were all left out of the key ministries, cabinet posts or provincal capitals.

The unprecedented consolidation of power and decision making, and Prince Mohammed’s rise out of seemingly nowhere, came so quickly and without the usual extensive internal Family consultations that it triggered highly unusual public letters of protest last spring from disgruntled members of the Royal Family. The grumblings quickly disappeared, and for now, the peace of the Al Saud is essentially being maintained by the distribution of cash through real estate sales or contracts and, above all, by the cash stipends set aside since 1937 from the oil revenues each year to be dispensed at the King’s prerogative to the thousands of Al Saud princes.

It is also understood that many of the other senior Princes are simply standing aside to see how Deputy Crown Prince Mohammed bin Salman fares over the next year in all his portfolios of power and the intended sweeping economic policy changes. It is noteworthy that his inexperience has shown at times, and it can be a thin line between boldness and recklessness in the best of situations, and nowhere more so than in such a remarkably conservative society or a slow-moving consensus style of decision making that has defined the Kingdom for generations.

But for now, the young Prince, whose ambitions are matched by what is said to be a voracious appetite for policy detail and planning, and for a boldness in decision making, is in fact quite popular. His public profile has been constant in recent months, and his pronouncements on both economic policy and the air campaign in Yemen — sold mostly as an effort to roll back “Iranian expansionism” – play well with the populace. All that, taken together, is what more than anything is fueling the speculation in Riyadh that he hopes to quickly position himself to be named as Crown Prince by his father before the King passes away.

But if he fails to consolidate his position and alliances with the other branches within the Al Saud before his father, said to be suffering from dementia, passes away, the betting is that Crown Prince Mohammed bin Naif may shunt him aside and realign the succession much in the way Salman did. While he has powerful brothers, like Fahad bin Naif, who is Governor of the important Eastern Province, Prince Mohammed bin Naif lacks a son, making it all the more likely he will reach out to other branches within the Family to build his network of support. Indeed, the 56-year old tough Interior Minister is said to enjoy widespread support across the Al Saud branches (and with the Americans as well).

Or for that matter, the succession could go smoothly with both MbS and MbN, as they are known, quickly aligning and simply stepping up the ladder of Saudi power, with so much of the continuity paved by plenty of cash and contracts to keep the equilibrium of interests within the senior ranks of the Family. No one, not even for most of those inside the Family can know in advance how the next succession will play out.

But the point is, King Salman set a precedent in ousting the assumed Crown Prince Muqrin, who had been lined up in the succession by the previous King, a first time it has happened since bin Saud himself passed the throne to his son Saud in 1953. It means almost by default the stability in the next succession of the Saudi throne is not entirely an assured thing.

And it is against this political backdrop of royal politics that the two pillars of the Kingdom’s high stake ambitions in its “new strategic narrative” should be assessed.

“Transformation Plan 2020”

On the domestic economic front, assisted by a trusted coterie of Western-trained technocrats and input from McKinsey consultants, Prince Mohammed is putting the finishing touches on a sweeping “Transformation Plan 2020,” an economic blueprint to a radical reform of the Saudi economy to make it more competitive.

The fiscal year 2016 budget, announced in late December, gave a taste of the new austerity that is coming to Saudi Arabia. To close a budget shortfall of 16% deficit to GDP ratio, the government is planning to cut spending by about 14% to $224 billion from 2015’s $260 billion levels, in part by slashing subsidies on electricity to the biggest consumers and a doubling of gasoline prices for everyone. In five years, the plan is for Saudi consumers to pay market-level prices for energy. The government will also introduce new user fees and sales taxes, albeit no income taxes, to gin up some additional non-oil revenues.

But with this year’s revenues expected to total only around $137 billion, a forecast budget shortfall of another $87 billion will have to be financed by a mix of renewed borrowing on the domestic market, tapping the international capital markets, and of course, another rundown in the Kingdom’s reported $620 billion in foreign reserves, all that after burning through around $100 billion in just last year alone.

And to cut government spending so sharply so quickly will also rapidly slow private sector growth, probably to lower than the estimated 2.3% this year from the 3.4% achieved last year. To an extent, Saudi Arabia’s longer term economic plan, in trying to transit from an oil-dependent, high subsidy economy, mirrors the difficulties of China’s planned transition from investment-led to domestic demand driven growth, at least in the sense of how difficult it will be.

What’s more, this year’s bite of austerity is only the beginning. The collapse in oil prices, at least initially, were for the most part seen as a Godsend by most of the economic and finance technocrats in Riyadh – a useful crisis to force through long overdue economic reforms, however painful. Into the leadership vacuum has stepped the young Prince Mohammed.

In the longer term, under some the proposals Prince Mohammed has already disclosed, the government will aim to limit the growth in public sector spending and reduce the dependence on the public sector to generate business activity and jobs – two thirds of Saudis work in the public sector, at relatively high salaries, or what is in effect a hidden unemployment benefit — with the economy steadily diversifying away from oil, boosted by selling off public utilities or Saudia, the national airline, to put those companies under private, profit-driven management.

But in an extremely rare interview with the Western press, Prince Mohammed went even further, announcing the intentions to privatize Saudi Aramco, much to the stunned surprise of senior Aramco officials who were hearing of the plan for the first time and were horrified in equal measure by the Prince’s mention of weeding out corruption.

The lure of such a high profile privatization may help dampen some of the speculative pressure on the Saudi riyal, and in time, privatization proceeds will help finance the budget in coming years. But few inside or outside Aramco think there is likely to be any sort of IPO of Saudi Aramco or any of its subsidiaries any time soon. For one, if it was ever offered to international investors, they would have to assume their shareholder rights would preempt the Kingdom’s national security interests, which is not likely to happen.

And in any case, the Kingdom could never disclose the sort of detailed information a share prospectus would require on Saudi Arabia’s proven reserves or its actual production, while domestic refineries are understood to book losses due to controlled product pricing, not to mention the means and amounts of oil revenues going directly to the Royal Family that have been dispensed by the King as he sees fit every year soon after Standard Oil first discovered oil in 1938 in Al Hasa.

So the surprise mention of an Aramco privatization by Prince Mohammed in his Economist interview has probably raised more questions than it has provided answers. Indeed, as needed and impressive as the Transformation Plan 2020 may be when it is formally announced, it for now is deepening the skepticism over just how far or how fast the Kingdom’s economic planners can really go in the intended transformation of the Saudi economy.

Many of the economic reforms being mapped out have admittedly been on the table for decades, and Prince Mohammed is giving voice to what just about everyone knows needs to be done. But there is a delicate balance in the trade-off that that has been at the heart of the Al Saud power: in return for unquestioned loyalty to its absolute rule, Saudi citizens get jobs, a cheap cost of living, free health care, ample housing support, nearly unlimited business opportunities (if they don’t intrude on the business turf of a senior Prince) in what is one of the world’s most capitalist systems — and no income taxes, plus safety and political stability amid a sea of chaos in the region.

So such a dramatic change in the social compact will inevitably raise questions over just how hard or how fast the young Prince and his technocratic coterie of advisors can really push the “transformation.”

A Strained Regional Containment Strategy

The same questions likewise hang over the Kingdom’s newly more muscular foreign policy approach to the region. But first, any account of Riyadh’s efforts to assert a Saudi leadership for the Sunni Arab world would have to start with the apparent divergence in strategic interests between the Kingdom and Washington under the Obama Administration.

For the Saudis, the turn of events ever since the differences with Washington over Egypt’s Hosni Mubarak, over Syria and, above all else, the shock secret negotiations with Iran to cut a deal to lift the sanctions in return for an end, or at least a long delay, in its development of nuclear weapons, have gone from bad to worse.

The depth of the Saudi anger was not so much in the deal over nuclear weapons per se, but in what it implied about a US willingness to envision a Mideast in which Iran would return to stage as a major power player; a common refrain in the circles of power in Riyadh was that the Americans could simply no longer be trusted short of an outright invasion of the Kingdom or threat to the oil fields.

By the time King Salman came to power, the senior leaders of the Al Saud were already moving towards a new strategic narrative, one in which they would have to adopt a far more muscular, go it alone regional strategy to contain what it perceived as Iranian expansionism. The analogy the Saudi planners use is George Kennan’s famous strategy of “containment” of Soviet expansionism at the outset of the Cold War. Saudi Arabia would assume the leadership of the Sunni Arab world to limit any further advances by Iran into the Arab world, like in Bahrain for instance.

And like the Cold War, there would be multiple proxy wars fought between the two rival regional powers, with Saudi Arabia taking the lead in a coalition of Sunni countries to counter the Iranian intrusions and, above all, to oust Syrian President Assad, who as an Alawite (an offshoot branch of Shia Islam, like the Zaidi offshoot practiced by the Houthis in Yemen), was seen as the linchpin to Iranian “machinations” in the Sunni Arab countries.

The US, and indeed, the rest of the world as well as Sunni Arab countries most on the front line of the Syrian civil war like Jordan, are however far more concerned with ISIS and its Wahhabi-rooted terror ideology. The Saudis continue to dismiss the link between ISIS extremism and their own austere Wahhabi theology, or its promotion abroad.

Instead, the Saudi contention is that the road to destroying ISIS only runs through Damascus, and that it was Assad’s brutal killing of hundreds of thousands of Sunni Syrians that has been feeding the fervor of the Sunni youth joining the ISIS ranks. In equal measure, the same goes for the way Sunni Iraqis were so mistreated under the Shia rule of then Iraqi Prime Minister Nouri al-Maliki, which drove many disgruntled Sunni Iraqi army officers into the Islamic ranks. That Assad’s downfall would also break the strategic link between Iran and its Hezbollah allies in Lebanon and help to undermine the grip of the Iranian theocracy in Tehran was the ultimate strategic objective.

In any case, the Saudis’ Syria policy has clearly stalled for now, if not failed. The intervention of the Russians — to whom King Salman had sent his son Prince Mohammed last year to dangle a failed deal on oil and energy investments in return for abandoning Assad and the Iranians — and the vastly expanded inflow of Iranian tools as well as arms and money, alongside its allies in Lebanon’s Hezbollah fighters, have clearly changed the facts on the ground to turn the tide of the civil war against the secular and Islamic rebel forces supported by Saudi Arabia and its allies.

A similar fate has so far blunted Saudi strategic objectives in its massive air strikes in Yemen since March of last year. The Saudis had hoped to not only destroy most of the Houthi rebel strategic assets like armor, munition dumps, and especially its inventory of Scud missiles, as well as reverse a rebel advance on the southern port city of Aden, which they largely succeeded in doing.

But the envisioned follow-up in negotiations for a new power sharing deal brokered by the Omanis with the Saudis holding most of the high cards has yet to pay off. The deal was mostly premised on the former Yemeni President Abdullah al-Saleh, who was ousted in 2012 when the Saudis withdrew their support and cash payments used to buy tribal loyalty, agreeing to pull his Army regulars and tribal fighters away from their alliance of convenience with the Houthi in return for his son Ahmed sharing in the new power arrangements. Instead, despite the best efforts by Oman as a broker to peace talks, the discussions have gone nowhere, and the Saudi Arabian offensive is effectively stalled.

And ultimately, with the air war sold to the Saudi public as mostly being about a push back against “Iranian expansionism,” the Iranians probably have just as much or more incentive to continue to support the Houthis in what ways they can, however peace negotiations work out.

One last regional initiative is also, to date, lacking momentum. In December, again it would be Prince Mohammed who announced a newly formed, 23 Sunni nation alliance to mount a sustained counter terrorism campaign. The new alliance would be led by the Saudis, with an operational headquarters in Riyadh.

But again, like the later announcement of a possible privatization of Aramco, there was far less there than meets the eye. Several countries that had signed up, for instance, have since distanced themselves from their commitments, not knowing what the Saudis intended on working towards an eventual military capability, as something of a “Sunni Nato.” And on just that point, the absence of invitations to the scheme to Shia countries like Iraq or Iran was telling.

Foremost among those are Egypt and Turkey, which would be the key allies in such an alliance, and seem to have distanced themselves essentially because they do not share the extent of Saudi Arabia’s absolute strategic obsession to contain or limit Iran’s entry back into the fold of Mideast politics.

The Risks in Elevated Sectarianism

The Saudis have elevated the anti-Shia sectarian rhetoric to its maximum volume in recent months, most obviously in justifying to its public (ignoring the rest of the world for now) the execution of the Saudi dissident Shia cleric Nimr al-Nimr. To some extent, the sectarianism is helping to foster a national identity, unless of course you are a Saudi Shia in the Eastern Province who is barred from taking a senior position in Saudi Aramco, the Saudi university system, much less the government.

There is also an argument heard in some Riyadh circles that the Saudi embrace of such fierce sectarian rhetoric is also a way to co-opt the violent appeal of ISIS by showing there is a more mainstream means to counter competing religious ideologies. It is a thin case to be made, for sure, and it is a far cry from the efforts by the late King Abdullah, whose religious credentials no one could challenge, to reach out to the Shia community in his multiple “inter-faith dialogues.”

It is also one that can be dangerous in fast becoming so hard to contain or reverse once taken too far. That perhaps, more than anything else, is what alarms Saudi Arabia’s friends and allies abroad.

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