The Kingdom of Magical Thinking

Widely assumed to be a fabulously wealthy welfare state, Saudi Arabia is in fact an economic basket case waiting to happen.

In 1935, an oilman visiting the Middle East reported back to his headquarters, "The future leaves them cold. They want money now." Although the temptation of overspending has repeatedly undermined oil-rich governments from Caracas to Tehran, Saudi Arabia avoided this trap over the last decade through fiscal discipline that has kept its expenditures below its swelling oil receipts.

But in a recent report striking for the candor of its unpalatable conclusions, Saudi investment bank Jadwa laid out the kingdom's inexorable fiscal challenge: how to balance soaring government spending, rapidly rising domestic oil demand, and a world oil market that gives little room for further revenue increases. And that was before the recent economic turmoil knocked $20 per barrel off oil prices.

Saudi Arabia's government spending, flat since the last oil boom in the 1970s, is now rising at 10 percent or more annually. And it will rise faster still: The House of Saud's survival instinct in the wake of the initial Arab revolutions led King Abdullah to announce $130 billion of largesse in February and March. The resulting increases in government employment and salaries can be cut only at the cost of more discontent.

And that's only what the kingdom is spending on its "counterrevolution" at home. Saudi Arabia will pay the lion's share of the pledged $25 billion of Gulf Cooperation Council aid to Bahrain, Egypt, Jordan, and Oman. With Iraq, Syria, and Yemen likely flashpoints yet to come, the bill will only increase. Already, nearly a third of the Saudi budget goes toward defense, a proportion that could rise in the face of a perceived Iranian threat.

Meanwhile, fast-growing domestic demand poses a serious threat to oil-export revenues. The kingdom is one of the world's least energy-efficient economies: With prices fixed at $3 per barrel for power generation and $0.60 per gallon of gasoline, Saudi Arabia needs 10 times more energy than the global average to generate a dollar of output. Subsidized natural gas, too, is in short supply, undermining an economic diversification drive focused on petrochemicals. As much as 1.2 million barrels per day (bpd) of oil are burned for electricity to meet summer air-conditioning demand, yet Jeddah, Saudi Arabia's second-largest city, still suffers frequent power cuts. By around 2026, Jadwa projects that domestic consumption will be over 5 million bpd, exceeding exports, which will never again reach their 2005 peak.

This combination of higher spending and lower exports shortens Saudi Arabia's time horizon. Usually considered, on shaky evidence, to be a "price moderate" within OPEC, the kingdom now requires $85 per barrel to balance its budget. That figure will rise to $320 by 2030, according to Jadwa. (Of course, just because the Saudis need a certain oil price to balance the budget does not mean they can get it. Higher prices today come at the inevitable cost of future revenues, as economic growth is reduced and consumers choose more efficient vehicles.)

Savings cushion the budget for now. But the experience of the last oil price cycle is likely to recur: $180 billion of assets in 1980 had become $176 billion of debt by the end of 2002, and despite the oil-price crash, Riyadh was able neither to cut spending nor to grow a viable non-petroleum economy. This time, Jadwa foresees that the Saudi Arabian Monetary Agency will be forced to draw down its $500 billion of foreign assets to the point where, by 2030, the country's fiscal position will be under severe strain.

So far, the kingdom has been fortunate. This decade's rapidly rising spending was enabled when Saudi Arabia's main OPEC rivals, Venezuela, and Iran, left the field clear due to underinvestment in and mismanagement of their oil industries. Along with the war in Libya, this has allowed Saudi production to increase to its highest level in 30 years while prices have remained strong. But the good times will soon come to an end.

Oil prices have again, as in 2008, been allowed to get too high, too fast. The renewed economic downturn, combined with fears of overheating in China and other emerging markets, has only sharpened this challenge. Growing efficiency, demographics, and alternatives mean that OECD oil demand is probably in a slow, long-term decline, while non-OPEC supply is proving more robust than expected, with strong growth in Brazilian pre-salt oil and North American unconventional shale oil and oil sands.

And, for the first time since Oil Minister Ahmed Zaki Yamani did battle with the Iranians in the 1970s, Saudi Arabia faces a real challenger within OPEC. Even if Iraq's ambitious plans are only half-realized, it will soak up more than half of global demand growth. Its vast, low-cost reserves make major production increases attractive even if they reduce prices. For its own reasons, Iran seeks to undermine Iraqi stability, but that would hardly be a palatable outcome for the Saudis either.

And that's not all: Angola also has room for further growth; Muammar al-Qaddafi's impending defeat may restore some of Libya's production; and, with Hugo Chávez suffering from cancer, Venezuela's oil policy may change after the 2012 election.

The Saudis' dilemma is this: They hold nearly all OPEC's spare capacity, their essential weapon for keeping the cartel in line. June's "worst meeting ever" was actually a victory for Saudi Oil Minister Ali al-Naimi. Opposition by Iran, Venezuela, Libya, and others to a production hike left him free to increase output as far as he chose. Yet Saudi Aramco, the country's monopoly state oil company, has few drill-ready development projects. Plans announced in 2008 to take Aramco's capacity to 15 million bpd have not been implemented, and the only big project under way, the giant Manifa heavy oil field, with about 900,000 bpd, will mostly serve domestic needs.

So what should the Saudis do? Setting a credible target, say $70 per barrel, and defending it by creating new spare capacity would reduce long-term prices. By enduring some pain themselves and drawing down their vast savings, they would burn off high-cost competition, punish OPEC rivals that are ignoring quotas, and damage archenemy Iran. Yet they are understandably reluctant to spend billions of dollars on new fields at a time of wavering demand.

Ambitious plans for nuclear and solar power are no panacea. Saudi Arabia has no competitive advantage over other countries in alternative energy. If it succeeds in reducing oil use in transportation, other countries can too -- so who will be buying Saudi oil?

The black hole in current policy discussions is improved energy efficiency. Raising domestic fuel prices would cut demand, allow development of higher-cost gas resources, and free up more oil for export. "Smart" subsidies or cash transfers could offset the price hikes for vulnerable groups.

A lower oil-price target would have to be combined with domestic spending restraint. The Saudi government cannot forever be the employer of last resort; reshaping education and labor policy to bring more Saudi citizens into the private sector would ease some social pressures. Between 2005 and 2009, 2.2 million private-sector jobs were created, but only 9 percent went to Saudi citizens.

Tinkering is not enough. Without radical reforms, Saudi leverage within OPEC will be increasingly constrained. The kingdom's regional power will weaken, precisely at the time when it is attempting to step up its role. And in the long term, its economic and social model will come under intolerable strain.

Yet the crisis is still too far away, the lure of easy oil money too strong -- and the policy changes required demand deft execution untypical of Saudi bureaucracy. As Machiavelli cautioned, "There is nothing more difficult to take in hand, more perilous to conduct, or more uncertain in its success, than to take the lead in the introduction of a new order of things."



All Quiet on the Northern Front

In banning innocuous tourism websites, "seditious" anti-capitalist books, and information about Pyongyang, South Korea's intelligence service is acting a lot like its brother to the north.

Sometime last year, in an office buried within South Korea's national security establishment, a bureaucrat scanning the Internet for threats must have clicked a button, thereby banning the website of Koryo Tours inside the country.

It wasn't until this January that Nick Bonner, head of British-owned, Beijing-based Koryo Tours, learned the news. Bonner founded the tourist agency in 1993, transforming it into the clear leader in the tightly circumscribed field of North Korean tourism. Fewer than 2,000 Westerners are estimated to visit the country each year, and Koryo takes in roughly 50 to 60 percent of them. Last year, the company brought around 1,300 Western tourists to the North. On the occasion of North Korea's so-called Mass Games in Pyongyang this month, Koryo is conducting a half-dozen package trips for 300 to 400 intrepid travelers.

Bonner, who has also produced three documentaries about North Korea, became fascinated with the country on a spontaneous trip to Pyongyang in 1993. By developing a close working relationship with the North's state-run Korea International Travel Company, he has gained unprecedented access for Koryo -- opening up new travel destinations in the North, screening films such as Bend It Like Beckham for the public, and organizing international sports exchanges.

For the South Korean National Intelligence Service (NIS), the country's chief spy agency, this was all too cozy. Invoking the National Security Law, the NIS claimed Koryo's website was spreading propaganda about North Korea. Although it is highly unlikely, if Bonner were charged criminally for violating the law, he could face up to seven years in prison.

And what was the nefarious deed that would justify this? Bonner would later learn that certain pictures on Koryo's website that supposedly portrayed North Korea unrealistically, including one of a smiling man of indeterminate nationality playing golf, had raised the ire of South Korean intelligence officials.

In censoring and controlling the flow of information reaching its citizens, the democratic South is mirroring -- albeit to a lesser degree -- the notoriously closed North.

The relationship between the North and South has worsened since North Korea's sinking of the South Korean corvette Cheonan and its shelling of Yeonpyeong Island last year -- and, more recently, another live-fire incident in the Yellow Sea and reports that a North Korean assassination team was targeting the South's defense minister. As tensions rise, Lee Myung-bak's conservative government in Seoul is wielding the National Security Law to cut off even ostensibly innocuous attempts at engagement and understanding.

Before South Korea achieved its inchoate democracy in the early 1990s, the National Security Law was used by successive military governments to detain, torture, and sometimes kill student dissidents and others thought to have pro-North Korean sympathies. The law can be radical, broad, and arbitrary in its application.

I received a firsthand education in the law. While serving a prison term for an unrelated smuggling charge in South Korea in the mid-1990s, we inmates were given a list that outlined the National Security Law's prohibitions against "stories that praise or support communism or socialism." That restriction is at least clearer than the injunctions against "stories that can create chaos" and "stories that are critical of society and can prompt disobedience." Technically, the copies of Ayn Rand, Friedrich Nietzsche, and even Walt Whitman in my cell violated the law.

The Constitutional Court in Seoul last year upheld a military ruling that labeled 23 books "subversive" and off limits to soldiers. The list included a book by South Korean economist Ha-Joon Chang, a well-known academic who holds a post at the Cambridge University, titled Bad Samaritans: The Myth of Free Trade and the Secret History of Capitalism.

As Seoul tightens its grip on cyberspace, Koryo's website has not been the only victim. The Korea Times reported that, in the first half of 2010, South Korean police ordered various websites to delete more than 42,000 posts deemed to be supportive of North Korea -- 100 times the number from five years earlier. Just this month, a South Korean naval officer who taught Korean history was put on trial for downloading allegedly pro-North Korean materials.

Bradley Martin, a longtime Korea watcher and author of Under the Loving Care of the Fatherly Leader: North Korea and the Kim Dynasty, said that the Lee government's fears are, in part, justified. "Young South Koreans over the decades have proven remarkably susceptible to pro-North propaganda," he said. "The choice for the Southern government lies somewhere between opening up completely to pro-North information flows and hoping its subjects learn how to sift true from false, on the one hand, and barring all such flows, on the other hand."

In calibrating that choice, however, it's all too easy for a conservative Seoul to overreach. That's when entities like Koryo, that are not propagandists or advocates for the North's political system, get swept up in the clampdown.

The National Security Law's ambiguity is the reason that it poses such a threat to freedom of speech. "The law forbids 'anti-state activities,' which has generally meant discouragement of praise for the North, but which can be interpreted to mean anything that doesn't portray North Korea in the most critical and negative light," said Charles Armstrong, a Columbia University history professor and director of its Center for Korean Research.

There's the rub.

Back at Koryo Tours, Bonner and his small staff were stunned by the ban. "No Internet access in the North and banned in the South!" he said in an email message to me.

South Koreans are legally barred from going on such tours, though for a time they could go on day trips to the North Korean city of Kaesong, just on the other side of the demilitarized zone, and were able to take tours to the Kumgang mountain resort in the southeast corner of the North. Both of those tours were suspended in 2008 amid rising tensions involving, among other issues, the killing of a South Korean tourist by a North Korean guard in the Kumgang area.

Although the website blackout will not greatly affect Koryo's business, as it does not take on South Korean clients, Bonner saw it as a grave step away from engagement. "There was clearly an interest in South Korea to find out more about life in the North," he said. "It's a slap in the face for the 20 years of work we have done, which we hope is part of a process towards stability and understanding."

In a meeting with South Korean authorities this May, Bonner reiterated that Koryo is simply a business, not a front, and does not endorse the North's ideology. But he also tried to comply, removing from the website photos that appeared propagandistic or that featured the North Korean military, as well as a link to the state-run Korean Central News Agency. But these steps were all for naught -- Seoul refused to lift the ban. "[I]t seemed they were objecting to the entire site, really," Bonner said.

Koryo's website does have a sanitized feel -- no surprise for a company trying to convince people to visit North Korea. It presents a controversy-free, somewhat airbrushed image of the Hermit Kingdom, mentioning nothing about the country's human rights violations, prison camps, or nuclear weapons program.

But shutting out Koryo for remaining impartial on the political rivalry between the North and South is a new step for Seoul. Jim Hoare, who ran the British Embassy in Pyongyang from 2001 to 2002, has watched closely as the Lee administration attempts to reverse nearly 20 years of increasing openness to information about the North. "I think that what we are seeing is a steady move to try to put pressure on any organization that has links with [North Korea]," Hoare said.

"The trouble is that once a decision like this is taken, it's very hard to get it changed," Hoare continued. Under the current government in Seoul, "Who would want to appear to be soft on [the North]?"

As for doing business with Pyongyang, Bonner's conscience is clean. "We work in North Korea but do not work in South Korea tourism," he said, "so it is not surprising that we have developed strong links with our Korean colleagues in the North."

He also praised his colleagues in North Korea's state-run travel agency as "great people" and "trustworthy." He said that they worked "on a person-to-person level; this is not on a governmental/political level, and we have clearly demonstrated what can be achieved."

In the tense atmosphere on the Korean Peninsula, however, a conservative Seoul seems to have little use for those trying to build bridges to Pyongyang.