Thursday, Dec 1, 2022
International Finance
Economy Feature Magazine

GCC establish economic diversification amid Covid-19

ifm-march-2021-feature-gcc-economic-diverification
Oil and gas production continues to represent over 40 percent of GDP in most of the economies

The Gulf Cooperation Council (GCC) economies have been burgeoning over the last few years through various policies focused on economic diversification. However, further diversification is pivotal for a robust future. Over the years, the governments in the Arab countries are working to reduce their economy’s dependence on oil. For many years, oil has been the major source of income for many Arab economies. This longstanding problem is linked to the non-renewable nature of oil resources. The volatility of oil revenues combined with strong demographic growth has brought the issue back into the headlines.

Moreover, since hydrocarbon is the major source of revenue for these countries, tax revenues only comprise a small percentage of the total government income. Corporate and household tax rates in these economies are also on the lower side since hydrocarbon revenues are the preferred source of budget revenue. In recent years, these economies have made significant investments in sectors such as fintech, tourism, hospitality, technology and real estate.

However, the outbreak of the Covid-19 pandemic has mired the diversification ambitions of the GCC economies, which comprises the Kingdom of Saudi Arabia, the Sultanate of Oman, Kuwait, Bahrain, the UAE and Qatar. These governments need to boost investments in industries such as healthcare, technology and telecommunications to fulfil their diversification goals as current efforts are not up to the mark. Export diversification has been limited amid a steady surge in the share of non-hydrocarbon output towards GDP. Further diversification will make these economies less reliant on hydrocarbon output.

The Covid-19 effect has changed the landscape
The Covid-19 pandemic has walloped the oil segment as Brent crude prices slumped to $23 in April 2020, from $64 per barrel at the beginning of 2020. The oil prices are poised to remain below $50 per barrel throughout this year. Therefore, it will affect the GCC nations’ fiscal position, which is expected to run last year deficit budget averaging 9.2 percent and this year’s 5.7 percent.

The sustainability of hydrocarbon revenues has always been a concern for the GCC economies for many years. The oil and gas reserves are expected to be exhausted in the long run. Economies such as Oman are at a very critical stage as reserves are expected to become less within the next 25 years.

Oil revenues are expected to slump due to the possible downturn in the global demand starting around 2040. This will spur clean energy demand and implementation while enhancing storage and efficiency. The GCC nations have already invested in financial assets worth $2 trillion and have also injected capital into their respective sovereign wealth funds for a robust future.

While speaking to International Finance, Martin Hvidt, Associate Professor, University of Southern Denmark said, “The effects of Covid can be two-fold. Firstly, it can delay any current attempts at diversification, simply because the economies lack money or secondly, the Covid, exactly because the economies are stressed (the 2014 oil price collapse + the Covid effects), opens up for hard policy choices. In other words, both the decision-makers and the population likely see themselves in a new situation, where the need to reform the economies through drastic measures become evident for all. So, the situation can be used as a stepping stone for more fundamental reforms, eg. in the labour market.”

According to IMF estimates, before the pandemic, GCC economies will deplete their conserved wealth by 2034, unless they deploy stringent and substantial fiscal and economic reforms. IMF said that international oil companies and producing states have come to recognise that alternative energy sources, alongside greater efficiency, are already eroding demand.

In a report, it said, “While Gulf producers like Saudi Arabia and the UAE are developing new industries in preparation for a post-oil era, they’re not moving quickly enough to avoid running out of cash. Regional governments will likely need to cut spending further, save more and introduce broad-based taxation to make ends meet. A further decline in oil prices this year, in the face of geopolitical tensions and threats the coronavirus poses to growth, is making that task even harder. Should global oil demand trend downward before those plans take root, the countries would have to cope with their longer-term economic problems even sooner. The world’s demand for oil is expected to grow more slowly and eventually begin to decline in the next two decades.”

Diversification ambitions must turn real
The diversification ambitions of the GCC economies have been driven by a slump in hydrocarbon reserves and revenues while motivating the economies to develop products outside the oil and gas segment. The private segment activity in the economies still depends on government-backed projects and consumption that are backed by the revenues generated from the oil and gas sector. The policymakers must float alternate ideas without depending on the oil and gas segment and also overcome the flaws of the previous diversification plans.

The GCC economies must avoid projects that require support from the government or subsidies, and are expected to diversify their revenue streams through sovereign wealth funds. Economies should encourage their citizens to get involved in wealth and economic diversification efforts, which also include savings and investments.

Martin Hvidt said that diversification is a process, that inevitably demands significant changes in society. Diversification can only be achieved if the private sector comes to play a much more prominent role in the economic landscape of the Gulf countries. As such diversification implies that the state-led approach, where very large parts of the economy are tied to public sector spending must imply changes. This might be uncomfortable for the current rulers in that the changes in the social contract (could imply less support for the rulers) and also for the private sector which is used to a different mode of operation. One major change will be to provide incentives for the nationals, that are the citizens of the Gulf countries, to seek jobs in the private sector.

He said, “So far public sector jobs are preferred, due to better pay, shorter working hours etc. As such, for diversification to work, incentives must be changed, so private sector employment is a real alternative to the national population. Other challenges include the size of the economies and the size of the markets, the low technological level among the national population as a consequence of former rentier policies etc. Saudi has a good potential to build a domestic sector, that can be provided with domestic products (market of 30 million inhabitants), while Qatar, Bahrain etc. are small indeed.”

Resources are bliss for the GCC
Natural resources are abundant among the GCC economies. They can enhance the lives of their citizens, develop their infrastructure, and assure a robust future without dependence on oil. In terms of infrastructure, the nations have built modern cities and established a solid foundation for future economic development. The HDI of GCC economies is above 0.8, placing them collectively ahead of other Middle Eastern and MENA economies.

But still, GCC economies have not fully utilised their resources to fulfil diversification goals. The economies are stubbornly dependent on hydrocarbons despite good sustainability ideas and economic development strategies.

The economies have to replace fossil fuel production with goods and services that are not dependent on the oil sector. Furthermore, the government must replace revenues attracted from the oil segment with revenues derived from the non-oil segment including other activities such as boosting non-oil exports and FDI followed by moderating government spending.

Oil and gas production continues to represent over 40 percent of GDP in most of the economies despite making some progress in the past few years. However, the numbers are less in the UAE with 30 percent followed by 18 percent in Bahrain.

Economic activities such as construction and infrastructure development are still fostered by the revenue generated from the oil and gas segment. Bahrain’s GDP contribution from the oil and gas segment is less because its majority of the oil reserves are depleted. However, economic activity still runs strong because of the oil segment.

Hydrocarbon accounts for 70 percent of the total revenue except for the Kingdom with 68 percent and the Emirates with 36 percent. However, there are many diverse revenue streams in the two nations which are attracted by economic activities related to oil and gas.

How can GCC economies succeed?
Firstly, the economies will have to eliminate or cut the structural barriers towards innovation, enhance local capabilities and inject capital in R&D. The economies must establish a top-notch infrastructure that fosters technology and innovation at the same time, particularly in areas such as digital infrastructure and clean energy. There should be competition in the delivery of services to consumers and businesses.

The economies must cut regulatory barriers towards the implementation of cutting-edge technologies such as advanced analytics, drones and AI. For example, implementing robust data protection regulations to maintain a stable baseline, while encouraging consumers to safeguard their data and use new technologies. The government should enhance the quality of local education by focusing on topics such as technology, maths, science including soft skills such as problem-solving, creativity and many more.

Martin Hvidt, said, “Market size is an important factor. Thus UAE (ten million) and KSA (30 million) are best positioned to build a diversified economy, that initially aims to supply the local market. Furthermore, quite a bit of diversification has already taken place in these countries in sectors such a building material, food supply, tourism and within or related to the oil and gas sector, for eg. aluminum smelting, petrochemicals etc.”

Goods and services play a major role in economic diversification
Middle Eastern economies largely produce goods and services, mainly for domestic consumption. The goods and services include business services, manufactured goods, agricultural products, etc. However, the majority of the citizens and ex-pats living in the Middle East are driven by the vast quantities of imported goods and services. Therefore, domestic goods and services will not replace the exported ones soon.

To achieve economic diversification, new goods and service should be produced other than hydrocarbons and their derivatives, that can be imported outside the GCC. In this context, the Middle Eastern economies have to buckle up their seats to achieve what they want.

In 2018, 90 percent of total exports in Kuwait and Qatar comprised hydrocarbons and related products. While more than 80 percent of total exports happened in the Kingdom and the Sultanate. Furthermore, 50 percent of the total exports were carried out in the Emirates and Bahrain.

FDI is vital too
FDI is a powerful tool in measuring a nation’s potential competitiveness, which reflects the ambitions of foreign companies to invest in an economy or not. FDI is lagging among the GCC nations. Only these two economies’ FDI inflows (as a share of GDP) that were higher than the world average of 2.5 percent between 2015 and 2019: the Emirates and the Sultanate.
The GCC nations’ FDI net inflow was only 1.1. percent of GDP, which is less than the half of global average. The weak inflow so FDI is due to a volatile business environment in most of the GCC nations. Therefore, firms that don’t have great insiders may find it difficult to enter the market.

Moreover, frequent policy change also affects the whole scenario which may bring limitations on work permits from specific economies, limitations of abroad fund transfer and cutting off economic ties with neighbouring economies. This kind of policies often possess a threat to international, and even local, businesses in terms of policy uncertainty. GCC nations had the luxury of making arbitrary policy decisions and even costly policy mistakes when revenue from oil and gas were flourishing. However, the scenario has changed and has compelled the economies to be more responsive to the needs and concerns of investors.

The road ahead for the GCC?
Martin Hvidt said, “Fundamentally it is all a matter of implementing policies while they still have income from oil and gas which can finance such policies and thus can ease the transformation from non-diversified economies to diversified ones that build on the normal way economies without abundant natural reserves operate under, that is where the educational level, skills, and hard work of the population are the main drivers behind the wealth of the countries. So, the overall blueprint – at least in our neoliberal era – to implement structures in the economy that facilitates incentives to produce. As a part of the diversification strategy, several countries aim to become knowledge-based economies. Qatar, UAE and KSA are moving forward in this direction. Most visibly UAE has created the Mars mission (they have placed a spacecraft in orbit around Mars just this week) to inspire their young generations to pursue studies within STEM sciences. And so, does KSA. At the heart, the futuristic city NEOM under construction is an attempt to make a huge laboratory that can train the youth in the knowledge base or what is now called Fourth Industrialisation Revolution technologies.”

The GCC governments have a great chance to bolster their diversification ambitions as they have learnt a strict lesson from the pandemic which hampered the global oil industry. Therefore, the governments can plan and take stringent measures that are buoyant, diversified and based on innovation and research.

With the current global scenario, the GCC economies are expected to ramp up their economic diversification efforts. Policymakers must think out of the box to do something new and innovative to generate quick results. They can cut down on budgets and instead prioritise the development of vital elements needed to build a robust and effective post-hydrocarbon economy.

GCC nations have to further cut down public services, benefits and limit employment opportunities for rent-seeking in the private segment; to establish a resilient post-oil future. The GCC governments should ramp up their efforts to integrate both women and youth into the labour market and float new incentives to push nationals to work for the private sector. Most importantly, the governments should invest in reskilling and retaining their workforce.

It will be interesting to watch how GCC economies respond towards economic diversification in the coming years. If the GCC economies are successful in establishing non-oil economic diversification then the rest of the world is expected to see the brand-new Middle East.

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