The Gulf Economies' Long Road towards better Diversification

The Gulf Economies' Long Road towards better Diversification

Bassam Fattouh and Manal Shehabi
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In order to reduce their dependence on the oil sector, the Gulf countries should implement microeconomic reforms, such as those aimed at increasing industrial competitiveness, labor market reform, and the development of a private sector

For decades, economic diversification has been a key goal for the Gulf oil exporting countries, as evidenced by their various national development plans. For countries that are highly reliant on oil export revenues, achieving this goal is seen by policymakers as essential for both political and economic security and for sustainability. Some Gulf oil exporters have made progress in diversifying their economic base away from the oil sector over the past few decades. Nevertheless, most indicators of economic complexity, diversity and export quality continue to be lower in oil-exporting Gulf economies than in many emerging market economies, including other commodity exporters. For the Gulf economies, the biggest challenges have been to diversify the sources of government income, for instance through raising additional revenues by taxing individuals and businesses, and to generate non-oil export revenues through building export-oriented industries. But why is economic diversification an ever more important priority for the Gulf States? Are they really as undiversified as widely believed? If so, how can they achieve a more meaningful diversification?

The urgent need to diversify

For an oil-dependent economy, the dilemma is as follows. On the one hand, the oil sector remains very profitable and is likely to enjoy higher margins per unit of expenditure than any industries into which most governments might aim to diversify. The large flow of oil rents also promises enviable wealth to fund growth and development and support generous welfare systems. On the other hand, from a developmental and sustainability perspective, heavy reliance on oil export revenues is uncertain and volatile, owing to challenges relating to the nature of the oil industry and the major transformation of global energy markets.  

 

First, oil prices fluctuate widely and are highly volatile, so reliance on oil revenue does not generate a stable or predictable source of income. This also means that in some countries with large populations. oil rents might not be big enough to provide sufficient income or a sufficiently extensive welfare system to support growing populations and their need for infrastructure, health care and education.  Second, the oil industry is capital intensive in nature and therefore does not generate enough jobs for the hundreds of thousands entering the labor market each year.  Third, oil demand is not expected to increase strongly over the next two decades as there has been a paradigm shift about the future prospects of global oil demand. While in the past it was widely accepted that oil exports were not sustainable due to the exhaustibility of the resource base, it is now clear that the more serious factor threatening sustainable oil exports is a potential fall in global oil demand. Technological improvements, acceleration in efficiency measures and changing social preferences and government policies aimed at addressing climate change and air pollution are all expected to slow oil demand growth globally. The concept of ‘peak oil demand’ has become more accepted, with many scholars, company executives and policymakers predicting a peak within the next decade.

 

Yet the reality is that no one knows when or whether oil demand will peak, because projections to that effect are highly sensitive to underlying assumptions. Thus, it is difficult to draw firm conclusions about the speed of the current energy transition. However, regardless of when oil demand peaks, the debate, in light of current energy trends, places the topic of diversification in a new light. Creating new and more secure revenue sources now becomes an ever more urgent priority, as governments are faced with the imminent reality that while oil revenues might drop significantly, and might do so considerably faster than previously anticipated, government spending is expected to continue to rise. These economies have very generous and costly welfare systems that are rooted in their political–economic structures. Gulf oil producers have competing priorities, some of which such as the funding of enviable social welfare measures which underpin their societies, tend to take precedence over others. These social welfare measures span a wide array of areas such as housing support, guaranteed public sector employment, energy subsidies, employment support and other allowances. The costs of these welfare programs are very high and the subsidies are among the highest in the world.

 

These subsidies are also highly energy intensive, and that reduces the share of oil production available for exports. Very generous energy subsidies and almost free access to energy have contributed to making Gulf oil exporters among the highest global energy users per capita. Domestic consumption is also high, given the energy needed to deal with a very hot climate that lasts for months, and with the high requirements for water desalination in a very water-scarce region. This means that, even in the unrealistic scenario of a constant oil price and stable demand, local consumption will continue to increase, driven by growing populations and improved income.

The need for broader structural reforms

So how should Gulf oil exporters feed the above trends and challenges into their strategic thinking and economic diversification agenda? To answer this question, it is essential to first explore the state of diversification in the Gulf States. Are the economies of the Gulf States as undiversified as has been proclaimed in popular discourse, and how can they achieve meaningful diversification?

 

While the dominant view holds that these economies are not diversified, an examination of economic data at the macro and sectoral levels over the last four decades indicates a more nuanced picture. The Gulf States have, in fact, succeeded in diversifying their economic base, as evidenced by growing non-energy sectors, which have increasingly contributed to value added economic production, employment, and consumption. In most of these economies, at least one third, and in most cases one half, of gross domestic product is generated by non-energy sectors. But what the data also show is that this diversified base makes a minimal contribution to either export earnings or fiscal diversification and, therefore, to economic sustainability. So why have these economies failed to achieve diversification of earnings, despite higher economic diversification? This failure is due to various structural constraints and economic distortions. These factors include:

- The non-energy sector, although sizable, is largely geared towards non-tradables, so it contributes little to export earnings.

- The fiscal structure is designed to rely heavily on oil revenue with few other sources. In this structure, the private sector and individuals contribute negligible shares to government revenue, while all public and private sectors as well as individuals receive pervasive subsidies instead.

- Large fiscal commitments cause fiscal rigidities that limit the scope and flexibility of public expenditure. These rigidities stem first of all from the large size of current expenditure and the significant public sector wage bill. For example, in Kuwait, current expenditure constitutes 80 percent of government expenditure, and half of this expenditure funds the public sector wage bill. Second, rigidities are caused by large transfers and subsidies to households and firms. Despite some recent energy pricing reforms throughout the region, these rigidities persist and in many cases attempts to reduce them have been faced with political opposition.

- Capital is captive in capital-intensive public-owned energy industries or is largely funneled to investments abroad in sovereign wealth funds and the Gulf States have some of the largest sovereign wealth funds globally. As such, there is limited capital available to support non-energy industries and their growth.

- In addition to a high degree of specialization in hydrocarbons and this sector’s dominance over trade, the Gulf Cooperation Council (GCC) economies are constrained by public sector dominance. The public sector dominates economic production, capital formation and employment.

- Public sector employment policies emphasize guaranteed employment to nationals and offer salaries exceeding those in the private sector for similar levels of education and technical training. These policies result in bloated public sectors and disguised unemployment, together with a very high public wage bill. This structure also offers limited incentives for nationals to move to the private sector, even in the presence of wage equalization mechanisms under nationalization schemes.

- Another result is a highly segmented labor market where, in effect, there are two separate labor markets. Throughout the Gulf, expatriates comprise the majority of the labor force (83 per cent in the case of Kuwait in 2015), the majority of whom are employed in the private sector at lower wages than nationals at the same skill level. These expatriates are also employed on flexible labor contracts, so they can be let go or leave their jobs, and their employment is dependent on employer sponsorships. Importantly, access to expatriate labor offers large economic efficiency gains and an adjustment mechanism for the economy during times of oil price shocks. As such, there is little incentive for the private sector to employ national labor. Similarly, as mentioned above, nationals are largely concentrated in the public sector and enjoy guaranteed jobs with inflexible contracts. Therefore, the non-energy sectors offer little contribution to local employment growth.

- Finally, Gulf economies are dominated by oligopolistic firms. While it is natural for all economies to have oligopolies, short-run oligopoly rent is destroyed in the long run by competition-induced innovation. But this has rarely occurred in the Gulf States. While the small size of their economies, coupled with efficient technology, would tend to lead to the emergence of oligopolies or monopolized industries, oligopolies are particularly pervasive in the industries of all Gulf economies. This is problematic to the extent that oligopolies distort markets and prices, and their sustained rents engender strategic behaviours that limit creative destruction and detract from growth-enhancing innovation. Governments in the GCC have adopted plans to increase industrial competitiveness and expand the private sector, yet reform attempts have had limited success and are politically sensitive.

 

Thus, what the GCC economies need is not just diversification, but better economic diversification that can reduce the dependence of exports and government budgets on the oil sector. Meaningful diversification can be achieved by removing some or all of the constraints above. Such moves would include microeconomic reforms such as those aimed at increasing industrial competitiveness and labor market reform. But it is also necessary to develop a private sector that increases its share of employment of locals and contributes to fiscal diversification. Yet reforms must also be politically viable and should avoid undermining political stability in these countries. Thus, diversification is a complex process and requires broad reforms that go beyond the economic sphere.

The role of the energy sector

Economic diversification in the Gulf States should also build on their intrinsic strengths and must go hand in hand with adaptation to current energy trends and a reassessment of the role of the energy sector in their economies. After all, the oil sector will continue to dominate the Gulf economies because there is no alternative industry on which governments can rely to generate either exports or government revenues. Also, as low-cost producers with some of the largest reserve bases, GCC oil producers are expected to fill the supply–demand gap by investing heavily in their oil sector.

 

That said, the oil sector needs to play a more active role in the diversification process. This involves, for instance, extending the value chain beyond simply producing crude oil and exporting it to international markets. By extending the value chain, Arab producers can create different types of jobs in new industries, industries whose product prices are not highly correlated with oil prices. In the past, the focus has been on exporting basic petrochemicals (for instance, converting ethane to ethylene), exports which did not generate much of the expected benefits for two reasons. First, the prices of basic petrochemical products are highly correlated with oil prices. Second, the refining and petrochemicals industries are also highly capital-intensive industries and don’t generate many jobs. Therefore, the recent emphasis in some of the GCC countries has been on extending the value chain to more complex petrochemical products, and even to finished products manufactured in industrial parks that attract both the private sector and foreign direct investment. Adding more stages to the oil value chain in this way not only generates more jobs but different types of jobs, such as service sector work that includes trading, marketing and sales, procuring and logistics, while also supporting accounting, finance, and human resource management.

 

In addition, regardless of the speed of the energy transitions, GCC governments should pursue policies aimed at optimizing the use of the resource base and reducing the domestic consumption of energy. These policies would include the implementation of energy efficiency measures, rationalizing domestic energy consumption, reforming energy prices and the power sector and diversifying the energy mix by increasing the shares of gas and renewables. Given the challenge that Arab oil exporters face in providing low-carbon solutions, they might tackle this challenge through enhancing the importance and role of the knowledge economy.

 

In this regard, Gulf States should not miss out on the renewables revolution. Renewables are at an inflection point. While there are many uncertainties induced by the energy transition, there is almost a consensus among forecasts provided by various organizations that the share of renewables in the energy mix will rise. The high levels of irradiation  throughout these countries, and of wind potential in some, create a unique opportunity for the Gulf economies to exploit their renewable resources to their full potential, to serve rising domestic demand whilst also harmonizing with the changing global energy landscape in which renewables are fast becoming mainstream. In doing so, Gulf economies should rethink their energy models to include renewables, in order to help meet domestic demand and free hydrocarbons for export, rather than simply aiming to replace their oil exports with renewables exports, as renewables generate almost no rents and thus will not ensure fiscal sustainability. In the long run, economic diversification of earnings remains the main adaptation strategy that these economies need to pursue.

Conclusions

In short, what the GCC economies need is not just economic diversification, but “better” economic diversification that can remove some or all of the constraints above and support the growth of non-energy sectors that will contribute to both diversifying earnings and reducing economic exposure to oil price and oil demand shocks. A reconsideration of the role of the energy sector in the economy is also required. After all, the real problem lies in the economic and political structures and in policies surrounding the energy sector; these factors not only constitute barriers to meaningful diversification, but also limit this sector’s contribution to broader and deeper diversification.