At an economic forum in Saudi Arabia, delegates mill around a model city, admiring its ultramodern, dome-shaped sports stadium, yachts sailing in the estuary, luxurious villas looking out over the Red Sea and a huge state-of-the-art port decked out with shore cranes.

“Welcome to the city that embraces the future,” a voice booms in a nearby conference room, where four video screens broadcast computer-generated images of the King Abdullah “economic city”.

The $26.7bn (€20.2bn, £13.6bn) project is the largest single investment in Saudi Arabia and is the showpiece of the government’s efforts to diversify its economy. Five other similar cities are planned in different regions of the kingdom, as it attempts to utilise its extraordinary oil boom to spur private-sector growth and create industry where today there is only desert.

Get it right and it would have far-reaching implications for the development of the conservative kingdom, helping stabilise the economy and lessen the shocks of oil slumps.

Get it wrong and the government’s efforts to tackle unemployment and expand the private sector will be severely hampered.

“We have always believed in free trade … but we needed to open up further,” says Fawaz al-Alamy, Saudi’s chief technical negotiator for World Trade Organisation accession. “We found out after the previous boom and the last decline that oil is a volatile commodity and we cannot keep a country hostage to it.”

After the Saudi boom of the 1970s and early 1980s, gross domestic product growth in the Gulf’s largest economy dwindled to about 1 per cent annually, while population growth soared to about 4 per cent. During the current boom, its real GDP annual growth bounced back to between 4.2 and 6.4 per cent, with the size of the economy swelling from $188.5bn in 2002 to $348bn last year. Economists say nominal growth, a more accurate indicator, has been double-digit.

After years of budget deficits, the government is now flush with petrodollars and was able to announce a record budget surplus of $70.7bn last year. Economists expect economic activity to be robust this year, even if real GDP growth slows on a reduction in oil output.

Yet even with its abundant wealth, the world’s largest oil exporter faces tough challenges as it seeks to expand the private sector and reform the education system and labour market, which will be crucial to ensuring young Saudis find roles outside the public sector.

The issues confront all Gulf states but in Saudi Arabia they are perhaps more acute as the kingdom is the Gulf’s most populous nation, and reforms could face resistance from the highly influential religious establishment. And, in spite of producing about 9m barrels per day, Saudi Arabia’s oil production per national citizen is lower than four of the other five members of the Gulf Co-operation Council, according to McKinsey and Co, the international consultants.

Saudi officials say they have already begun the diversification process, citing the kingdom’s accession to the World Trade Organisation in December 2005 and the acceleration of economic liberalisation. Since then, non-oil exports have increased by 13 per cent annually to more than $20bn, while foreign direct investment has increased by 250 per cent to more than $5.6bn, Mr Alamy says.

Much of the investment still focuses on the oil sector but a key element of the government’s strategy to spread funds wider is the construction of the economic cities, including King Abdullah City, to attract foreign and domestic investment, broaden economic activity throughout the kingdom and create hundreds of thousands of jobs.

The plan, officials say, is to build on reforms and leverage the state’s competitive advantages – targeting energy-intensive industries, such as aluminium, steel and plastics, and utilising its location on the Red Sea.

Sagia, the investment authority, is even looking to tap into the kingdom’s role as host of Islam’s two holiest sites. King Abdullah City’s port will be designed to cater for 300,000 Hajj pilgrims, and a new city on the edge of Medina will be seeking to attract Islamic investment, says Fahd al-Rasheed, deputy governor at Sagia.

“It’s based on economic rationale,” he says. “We have 25 per cent of the oil reserves in the world but only 2 per cent of the energy-intensive industries. For example, a major component for producing aluminium is energy and we know that we are 31 per cent cheaper than the US and Europe.” One goal, he says, is to corner 15 per cent of the aluminium market by 2020. Saudi Arabia’s current share is negligible.

By the time the cities are complete in 10 to 15 years, their combined GDP is targeted at $150bn in today’s terms, with the creation of 1.3m jobs and a total population of 4.5m.

“The cities are designed in a way so that you establish the industries, that brings jobs, they bring families, they start buying real estate, they start requiring restaurants and shopping malls, so there’s a virtuous circle of real estate and job creation,” Mr Rasheed says.

Some $100bn will be invested in infrastructure alone and the government is seeking private sector investment to finance the projects, with Sagia acting as regulator and promoter. Emaar Properties, the Dubai-based group, is a significant shareholder in Emaar Economic City, which is spearheading the King Abdullah city project.

The targets are ambitious and some question whether the conservative nature of the state – where women are banned from driving and segregated in most work and social places – will enable it to compete with more liberal Gulf countries in terms of foreign investment.

Security will be another factor in a country where extremists have attacked foreign workers in recent years. Four Frenchmen were killed this week.

However, Brad Bourland, chief economist at Samba Financial Group, says the cities concept can work and adds that Saudi business will be a key factor in their potential success.

“There won’t be any big white elephant projects built in the desert,” he says. “The decisions will be driven by businessmen, so I think they are quite viable.”

He adds that the government is managing its oil wealth well so far, reducing debt and spending cautiously so as not to exceed the state’s absorption capacity.

“Four years into the first oil boom, the country had a current account deficit, so although revenue grew tremendously in the 1970s, imports also shot up,” Mr Bourland says. “It is quite the opposite this time and imports as a percentage of oil revenue have actually declined. There is not a conviction that oil prices will stay high for ever.”

But he warns it is unrealistic to expect the kingdom to reduce its oil dependency. “Oil is just too big,” he says. “The best you can do is try to smooth it out.”

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