* Foreign reserves drop as finance ministry covers deficit
* Could eventually cause concern over Saudi currency
* Ex-official suggests creation of two sovereign funds
* Reform would decouple state spending from oil price
* Signs that government more willing to consider change
By Andrew Torchia
DUBAI, Aug 12 (Reuters) - A former senior official at Saudi Arabia's central bank says he believes the kingdom may soon change the way it manages its oil wealth as part of efforts to protect its financial reserves in an era of cheap crude.
The Saudi Arabian Monetary Agency (SAMA) manages the vast bulk of petrodollars earned by the world's top oil exporting country; net foreign assets at the central bank totalled $664.5 billion in June.
Khalid Alsweilem, who managed the assets as chief investment officer at SAMA, argues the arrangement is dangerous because the finance ministry can draw freely on the reserves when it wants to cover budget deficits caused by periods of low oil prices.
Since last year, exactly that has been happening: SAMA's foreign assets have been shrinking at an annual rate of about $120 billion. If that pace continues, reserves could in a few years reach a level at which financial markets start to question Saudi Arabia's ability to support its currency.
So Alsweilem is proposing an alternative: the creation of two sovereign wealth funds which would be shielded from direct use by the finance ministry, plus the introduction of rules to decouple the level of state spending from oil revenues.
"There's an inherent conflict of interest in the current model which we need to remove," Alsweilem, now a fellow at the Harvard Kennedy School's Belfer Center in the United States, told Reuters in a telephone interview.
Alsweilem published his proposals last month in a paper titled "A Stable and Efficient Fiscal Framework for Saudi Arabia", which he said was intended to feed into a growing debate about fiscal management among the kingdom's policymakers.
Any change to how Riyadh manages its money could affect fund managers around the world, particularly in the United States. SAMA's assets are held mainly in the form of low-risk foreign securities such as U.S. Treasuries and deposits at banks abroad; the vast majority are believed to be in U.S. dollars.
Analysis of Saudi finances:
Alsweilem is proposing the creation of a separate sovereign Stabilisation Fund, which would have a liquid, low-yielding portfolio of assets, and a Savings Fund, which would invest in riskier assets and thus have higher returns over time.
The government's annual spending would be based on a percentage of the previous year's spending, a percentage of the value of the Stabilisation Fund, and a transfer equal to the long-run average real return of the Savings Fund.
Alsweilem, who said he left SAMA in 2012 partly because he wanted the freedom to push publicly for such reform, argued it would smooth fluctuations in state spending while reducing the risk of big drops in foreign assets.
Calculations in his paper indicate Saudi Arabia would have had net foreign assets of $1.87 trillion at end-2014 if his reforms had been adopted in 2005, instead of the roughly $750 billion which was the case.
It is not certain that Riyadh will build up the political momentum for such a big change. The Shura Council, a state advisory body, discussed a proposal for a new sovereign fund last year but reached no conclusion.
Saudi billionaire Prince Alwaleed bin Talal publicly urged the government to create a new fund to earn higher returns on its reserves, but Finance Minister Ibrahim Alassaf insisted last December there was no need for one.
However, Alsweilem said the chances of reform were now "very high, much higher than before". He cited the creation of a new Council of Economic and Development Affairs by King Salman, who took the throne in January.
The council, chaired by Salman's son Prince Mohammed bin Salman, provides a top-level forum to consider reforms.
In March, a royal decree shifted authority over some big institutional funds, such as the Public Investment Fund, from the finance ministry to other ministries - a sign, Alsweilem said, of pressure for change within the government. (Editing by Mark Heinrich)