Saudi Arabia is experiencing its first major economic recession in two decades. Despite a massive cutback in spending, the government has had to cut into its rapidly diminishing financial reserves and to rely on its heavily subsidized private sector to sustain its high standard of living.

Officially, the kingdom is confident that it will weather the abrupt drop in oil revenues, which are down $70 billion since 1981, without upheaval. Most western diplomats and economists agree, while cautioning that the country will probably not reach the bottom of the slump until mid-1985. Not until then, they say, will the likely level of Saudi oil production for the next few years become clearer and, with it, the size of the budget the government can afford. Only at that point should the lasting implications for government and society of "the normalization," as some Saudi officials euphemistically call their recession, become evident.

What is clear already, however, is that the cutback in income is having a profound impact on the pace and way of doing business here as well as provoking new uncertainties and tensions that this wealthy society has not had to confront in recent years.

The government, meanwhile, is counting in the burgeoning private sector to serve as the new motor of economic activity -- a task its spokesmen say it is not yet ready to shoulder alone.

Fierce competition has set in among Saudi businessmen and royal family members, and between Saudi and western firms, for shrinking slices of the once ample Saudi development pie. There is a feeling among the foreigners that, as one put it, "the royal princes are using their shoulders and elbows to get contracts while others cannot."

The evidence suggests, however, that even the hundreds of royal princes who are in business are having their troubles and are not immune to the new economic realities that have befallen the kingdom. Charges of Cover-Up

The full dimensions of the recession are still not clear, and many western economists and businessmen say they believe that the government is deliberately covering them up to contain fears and discontent and prevent a flight of money.

"A lot of people didn't expect the recession to be so long lived or to go so deep," said one economist. "They also expected the government to bail them out."

Instead, the government seems to be allowing a kind of survival-of-the-fittest struggle to take place, even forcing the issue by demanding public competition for contracts and awarding them strictly to the lowest bidder -- a far cry from the old Saudi norm.

This new practice has relieved pressure on King Fahd from other powerful members of the royal family to award contracts on the old patronage basis.

With the government's slowdown of payments, postponement of new projects and repeated rebidding of contracts, many companies, Saudi and foreign, have fallen on lean times. Acute cash-flow problems are common now, and at least 300 companies went out of business last year, according to Commerce Ministry figures. Empty store fronts, especially in Jeddah, indicate that many small shops have closed, too.

Foreign workers are full of tales of firms unable to pay wages for months or of sudden cuts by a third or a half in salaries. They say Filipinos and Pakistanis, once regarded as among the cheapest labor, are being replaced by even less expensive Bangladeshis and Sri Lankans.

Among the bankruptcies was the American-Saudi construction firm Carlson al-Saudia, which had won a $136 million subcontract to build 400 villas at the King Saud University here.

The Saudi Investment Bank, in which Chase Manhattan Bank has a 20 percent interest, also has fallen on hard times, registering a 70 percent drop in profits last year. At least two more of the 11 private banks operating here are having similar problems.

American companies, a U.S. Embassy official said, are "hanging on but threatening to leave. If the economy slides further, I would expect that."

"There are fewer American companies and fewer Americans in Saudi companies," Keith Poulin, head of the U.S. businessmen's group in Riyadh, said. "The Saudis have less money. They can't afford the Americans any more."

Abdullah Dabbagh, secretary general of the Councils of Saudi Chambers of Commerce, sees the shakeout "as a very healthy development."

"What happened in the boom years was that everyone became a businessman," he said. "There were too many companies, 5,000 in construction alone. The economy is much more efficient and competitive now."

A longtime American businessman here called the recession "a good thing for the Saudis," that would bring them down to "normal" economic realities -- 10 to 15 percent profits rather than 50 percent.

One noticeable change in doing business here, he remarked, was the turnabout in the relative importance of the three main factors previously involved in winning contracts: price, quality and "your prince." Before, price was not important but quality and above all pull with a member of the royal family were essential.

"Today, price is the most important thing, quality next and 'your prince' last," he said.

The biggest uncertainty hanging over the kingdom today is its future share in the increasingly unpredictable world oil market.

Since 1981, Saudi production has dropped dramatically from 9.8 million barrels a day to fewer than 5 million last year, and last month Petroleum Minister Ahmed Zaki Yamani said it had been only 3.6 million a day in September. Oil revenues have plummeted from $110 billion in 1981 to $41 billion last year. Budget Policy: Tighten Strings

As a result, the government budget, as published at the start of the Saudi fiscal year in April, has become almost meaningless, with the Finance Ministry simply holding the purse strings tight until it figures out what is available.

Just what constitutes the minimum production level required to meet the cost of basic necessities in the kingdom remains a subject of much speculation and changing estimates. Last year, 4.5 million barrels a day was regarded by many western economists as the line below which the government could not go without tapping too heavily its financial reserves.

That was when day-to-day government expenditures and defense -- the two "untouchable" items -- were estimated at about $53 billion a year.

Even with a slightly higher average daily production, the government had to take about $17 billion out of its foreign exchange holdings last year to meet its expenditures of $63.8 billion.

There are reports that the government is tapping its reserves for another $20 billion this year. If so, this would bring its reserve holding -- amounting to $150 billion in April 1982 -- down to less than $100 billion by March.

While still a huge holding by most standards, this rate of drawing down reserves could not go on much longer. There is speculation that the government will adopt, for the next few "lean" years, a $40 billion austerity budget -- another cut of at least $20 billion in actual spending.

"The Saudis haven't had enough experience with belt-tightening yet," said one western economist. "The economy is on extended credit right now. It's living on reserves and promissory notes."

Western analysts say that so far it does not appear that the recession has impinged seriously on any "vital domestic interest" -- meaning those of the royal family, Islamic religious leaders or the big business families whose support is crucial.

In October, the Saudis changed the mix of their oil blend, raising the percentage of lower priced heavy crude, a move interpreted by other producers as an attempt to capture a larger share of the glutted oil market by reducing the effective price.

This led to price cuts by Norway, then Britain and Nigeria. Only a full-scale diplomatic campaign led by Yamani with non-OPEC producers such as Egypt, Mexico and Norway, plus an OPEC agreement to slash its daily production level of 17.5 million barrels by 1.5 million, has prevented a further slide in prices. Reliance on Private Sector

If there is another cut in prices or Saudi Arabia's OPEC quota -- now set at 4.35 million barrels a day -- the government will have to take more drastic measures than it has so far to cope with its falling revenues.

The government is now counting heavily -- some say unrealistically -- on its growing private sector to take up the slack. Last year for the first time, the non-oil private sector accounted for more than half of Saudi Arabia's $115 billion gross domestic product and grew 5 percent, largely through the boom in farming here and the start-up of the Saudi petrochemical industry.

Abdulaziz Zamil, the minister of industry, said the 1,500 private manufacturing industries are "very active" and now capable of taking on the burden of spurring economic development. Their total exports last year reached $5.7 billion, he noted.

"If the private sector can do it, why should we the government do it?" he asked in an interview. "We don't want to force the pace of development any more."

In August, the government decided to withdraw its 14 percent participation in the new National Industrialization Corp. being created by a group of private Saudi investors to spur new industries.

Official policy now, Zamil said, is to limit government activity to pointing out the business opportunities available to potential Saudi and foreign investors, such as setting up car and truck assembly plants and petro chemical industries.

Other Saudi and western analysts of the private sector, however, do not share Zamil's assessment of its strength and viability, particularly at a time of sharp recession.

They point out that its growth rate has depended on billions of dollars of government spending, direct and indirect subsidies and interest-free loans, particularly in agriculture.

The whole new petrochemical industry -- the mainstay of the private sector -- will generate only $2 billion to $3 billion in foreign earnings when it becomes fully operational, they note. This would be the equivalent of only 300,000 additional barrels of oil a day for a year.

"We did not really have enough time to develop the productive sector," lamented Mahsoun Jallal, chairman of the National Industrialization Corp. "We needed another 10 years of boom."

The mood of the private sector toward risk-taking and new investment in the uncertain climate will become clearer soon, when 75 percent of the corporation's shares go on the market to help raise $171 million in start-up capital.

"We are keeping our fingers crossed," Jallal said, summing up the attitude of many in government and private business about the many uncertainties facing the kingdom today. Next: A changing society CAPTION: Charts 1 and 2, Saudi Oil Production and Revenues; Picture, Ahmed Zaki Yamani . . . revenues drop $70 billion in three years.