I. Introduction
The GCC countries face important policy challenges and opportunities in view of an uncertain oil market outlook and the evolving trends in the regional and international economy. These are compounded by domestic developments, particularly the growing number of nationals entering the labor markets. Indeed, the GCC countries are at a cross road. One path, built on insufficient policy response to less favorable external conditions, carries the risk of low rates of economic growth, rising unemployment, and growing financial imbalances and indebtedness. The second, stressing economic adjustment supported by structural reforms, promises financial stability, growing employment opportunities, and sustained economic growth.
Policymakers in the GCC countries recognize the challenges facing their economies. This has been reflected in the renewed emphasis placed on broadening and intensifying the adjustment and reform efforts--efforts that were interrupted by the 1990–91 regional crisis triggered by Iraq’s invasion of Kuwait. Having identified the economic and financial challenges and the appropriate policy response, the issue now is to implement the policy agenda in a decisive and sustained manner.
The economies of the GCC countries share many structural features, face similar constraints, and are influenced broadly by the same set of trends in the world economy. Over the years, the oil income has created a modern physical and social infrastructure and substantially raised the standard of living of the population (Box 1 and Table 1). The countries have established a tradition of open and liberal trade and exchange policies, low inflation, and stable currencies. They also share a relatively narrow nonoil revenue base and large dependence on imports of goods and labor, increasing their vulnerability to adverse exogenous developments.
GCC: Summary Economic and Social Indicators
Most recent estimate (1993).
Latest available annual data during 1980–85.
Latest available annual data during 1970–75.
GCC: Summary Economic and Social Indicators
| Income | Health | Education | |||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Nominal GDP (US$ bill) 1995 | GDP per capita (US$) 1995 | Real GDP growth (%) avg. 1993–94 | Real per capita GDP growth (%) avg. 1993–94 | Life expectancy (years) 1/ | Infant mortality (per 1,000 live births) 1/ | Population per physician (persons) 1/ | Illiteracy % (of population (age 15+) 1/ | Primary enrollment (% school age pop.) (%) 1/ | Secondary enrollment (% school age pop.) (%) 1/ | Pupil- teacher ratio: primary schools 1/ | Pupil- teacher ratio: secondary schools 1/ | ||
| Bahrain | 4.9 | 8,675 | 5.4 | 3.5 | 72 | 17.6 | 799 2/ | 23 | 93 | 97 | 21 | 20 | |
| Kuwait | 25.3 | 18,068 | 19.6 | 11.3 | 75 | 17.2 | 609 | 27 | 61 | 51 | 16 | 11 | |
| Oman | 11.2 | 5,345 | 5.3 | 0.1 | 70 | 29.0 | 1,202 | … | 100 | 57 | 27 | 18 | |
| Qatar | 8.2 | 16,520 | −0.2 | −4.0 | 72 | 19.4 | 665 | 24 2/ | 95 | 82 | 7 | 7 | |
| Saudi Arabia | 124.1 | 6,602 | −0.4 | −3.9 | 70 | 27.8 | 708 | 38 | 78 | 46 | 14 | 12 | |
| United Arab Emirates | 39.5 | 17,194 | −0.2 | −4.4 | 74 | 18.2 | 1,095 | … | 118 | 69 | 17 | 14 2/ | |
| GCC | 213.3 | 8,312 | 2.5 | −1.0 | 72 | 21.5 | 846 | 28 | 91 | 67 | 17 | 14 | |
| Middle East and North Africa | 612.1 | 2,081 | 2.5 | 0.2 | 65 | 52.3 | 3,571 | 45 | 97 | 56 | 26 | 21 | |
| Developing Countries | 5,819.0 | 1,327 | 6.1 | 4.1 | … | … | … | … | … | … | … | … | |
| Industrial Countries | 22,228.3 | 27,101 | 1.8 | 1.2 | … | … | … | … | … | … | … | … | |
| World | 28,876.2 | 5,148 | 2.9 | 1.2 | 66 | 48.0 3/ | 5,860 | … | … | … | … | … | |
Most recent estimate (1993).
Latest available annual data during 1980–85.
Latest available annual data during 1970–75.
GCC: Summary Economic and Social Indicators
| Income | Health | Education | |||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Nominal GDP (US$ bill) 1995 | GDP per capita (US$) 1995 | Real GDP growth (%) avg. 1993–94 | Real per capita GDP growth (%) avg. 1993–94 | Life expectancy (years) 1/ | Infant mortality (per 1,000 live births) 1/ | Population per physician (persons) 1/ | Illiteracy % (of population (age 15+) 1/ | Primary enrollment (% school age pop.) (%) 1/ | Secondary enrollment (% school age pop.) (%) 1/ | Pupil- teacher ratio: primary schools 1/ | Pupil- teacher ratio: secondary schools 1/ | ||
| Bahrain | 4.9 | 8,675 | 5.4 | 3.5 | 72 | 17.6 | 799 2/ | 23 | 93 | 97 | 21 | 20 | |
| Kuwait | 25.3 | 18,068 | 19.6 | 11.3 | 75 | 17.2 | 609 | 27 | 61 | 51 | 16 | 11 | |
| Oman | 11.2 | 5,345 | 5.3 | 0.1 | 70 | 29.0 | 1,202 | … | 100 | 57 | 27 | 18 | |
| Qatar | 8.2 | 16,520 | −0.2 | −4.0 | 72 | 19.4 | 665 | 24 2/ | 95 | 82 | 7 | 7 | |
| Saudi Arabia | 124.1 | 6,602 | −0.4 | −3.9 | 70 | 27.8 | 708 | 38 | 78 | 46 | 14 | 12 | |
| United Arab Emirates | 39.5 | 17,194 | −0.2 | −4.4 | 74 | 18.2 | 1,095 | … | 118 | 69 | 17 | 14 2/ | |
| GCC | 213.3 | 8,312 | 2.5 | −1.0 | 72 | 21.5 | 846 | 28 | 91 | 67 | 17 | 14 | |
| Middle East and North Africa | 612.1 | 2,081 | 2.5 | 0.2 | 65 | 52.3 | 3,571 | 45 | 97 | 56 | 26 | 21 | |
| Developing Countries | 5,819.0 | 1,327 | 6.1 | 4.1 | … | … | … | … | … | … | … | … | |
| Industrial Countries | 22,228.3 | 27,101 | 1.8 | 1.2 | … | … | … | … | … | … | … | … | |
| World | 28,876.2 | 5,148 | 2.9 | 1.2 | 66 | 48.0 3/ | 5,860 | … | … | … | … | … | |
Most recent estimate (1993).
Latest available annual data during 1980–85.
Latest available annual data during 1970–75.
The major policy challenge in the period ahead is to exploit further the countries’ economic and financial attributes by effectively addressing macroeconomic imbalances, correcting remaining structural rigidities, and reducing the vulnerability of the economies. While differences between the GCC countries with regard to resource endowment, foreign reserves cushion, and economic diversification are likely to influence the speed and the depth of the required policy effort, there are enough similarities to discuss a broad common strategy.
The organization of the paper is as follows. Economic developments and policies since 1980 are briefly reviewed in Section II. The impact of the GCC’s external environment is discussed in Section III. Section IV discusses the medium-term economic prospects and the broad outlines of a common adjustment and reform strategy. Finally, the implications of adjustment in the GCC countries on the rest of the MENA region are discussed in Section V.
GCC at a Glance
The GCC countries:
• Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates (U.A.E).
Area and population:
• The countries have 2 percent of world’s total land area, and their combined population of 25.7 million accounts for less than 1 percent of total population of the world. Population growth in the GCC countries (3.5 percent per annum) is higher than the world average (1.7 percent per annum). Nonnationals comprise on average about one-third of the population in the GCC countries. About 43 percent of the population is below the age of 15, and 60 percent is below the age of 25.
Petroleum and gas:
• The GCC countries hold 53 percent of world’s proven petroleum reserves and account for 24 percent of world’s production, and 40 percent of exports of petroleum. The countries hold 14 percent of world’s proven natural gas reserves.
GDP:
• In 1995, per capita income in the GCC countries ranged from US$5,345 in Oman to US$18,068 in Kuwait, compared with the world average of US$5,148.
Social indicators:
• Life expectancy (72 years) in the GCC countries is higher than world’s average (66 years). Other social indicators are also very favorable: literacy rate exceeds 70 percent; infant mortality rate is less than half of the world average; the physician-population ratio is about 7 times better than world average; and primary school enrollment corresponds to 90 percent of school-age population, with female enrollment being almost equal to that of males.
II. Overview of Economic Developments and Policies. 1981–95
Since the substantial increase in international oil prices during the 1970s, economic developments and policies in the GCC countries can be broadly divided into four periods (Table 2):
GCC: Basic Economic indicators, 1975–94 1/
GDP-weighted averages.
Excluding Kuwait.
GCC: Basic Economic indicators, 1975–94 1/
| 1975–80 | 1981–85 | 1986–89 | 1990–91 2/ | 1992–94 | |||
|---|---|---|---|---|---|---|---|
| (In percent per annum) | |||||||
| Real GDP growth | 9.6 | −2.7 | 1.7 | 8.9 | 1.7 2/ | ||
| Oil | … | −11.7 | 9.4 | 18.5 | 0.2 2/ | ||
| Non-Oil | … | 4.5 | 1.2 | 4.7 | 1.9 2/ | ||
| Inflation | 10.7 | 0.5 | 0.6 | 3.2 | 1.4 | ||
| (In percent of GDP) | |||||||
| Budget | |||||||
| Total revenue | 55 | 51 | 38 | 38 | 35 | ||
| of which: oil and gas revenue | … | 37 | 23 | 30 | 27 | ||
| Total expenditure | 45 | 52 | 50 | 52 | 46 | ||
| Current | … | 24 | 35 | 36 | 38 | ||
| Capital | … | 21 | 13 | 7 | 7 | ||
| Overall surplus/deficit (−) | 10 | −1 | −4 | −13 | −10 | ||
| Balance of payments | |||||||
| Exports | 78 | 62 | 49 | 56 | 50 | ||
| Imports | 44 | 51 | 46 | 49 | 48 | ||
| Trade account surplus | 34 | 11 | 3 | 7 | 2 | ||
| Current account surplus/deficit (−) | 19 | 7 | −1 | −7 | −6 | ||
| Overall surplus/deficit (−) | 3 | 1 | −2 | .. | −3 | ||
GDP-weighted averages.
Excluding Kuwait.
GCC: Basic Economic indicators, 1975–94 1/
| 1975–80 | 1981–85 | 1986–89 | 1990–91 2/ | 1992–94 | |||
|---|---|---|---|---|---|---|---|
| (In percent per annum) | |||||||
| Real GDP growth | 9.6 | −2.7 | 1.7 | 8.9 | 1.7 2/ | ||
| Oil | … | −11.7 | 9.4 | 18.5 | 0.2 2/ | ||
| Non-Oil | … | 4.5 | 1.2 | 4.7 | 1.9 2/ | ||
| Inflation | 10.7 | 0.5 | 0.6 | 3.2 | 1.4 | ||
| (In percent of GDP) | |||||||
| Budget | |||||||
| Total revenue | 55 | 51 | 38 | 38 | 35 | ||
| of which: oil and gas revenue | … | 37 | 23 | 30 | 27 | ||
| Total expenditure | 45 | 52 | 50 | 52 | 46 | ||
| Current | … | 24 | 35 | 36 | 38 | ||
| Capital | … | 21 | 13 | 7 | 7 | ||
| Overall surplus/deficit (−) | 10 | −1 | −4 | −13 | −10 | ||
| Balance of payments | |||||||
| Exports | 78 | 62 | 49 | 56 | 50 | ||
| Imports | 44 | 51 | 46 | 49 | 48 | ||
| Trade account surplus | 34 | 11 | 3 | 7 | 2 | ||
| Current account surplus/deficit (−) | 19 | 7 | −1 | −7 | −6 | ||
| Overall surplus/deficit (−) | 3 | 1 | −2 | .. | −3 | ||
GDP-weighted averages.
Excluding Kuwait.
• In the early part of the 1981–85 period, historically high--albeit declining--oil prices increased export receipts, allowing the GCC countries to record large external current account surpluses and to build up foreign reserves. The policy objectives of improving the social and physical infrastructure, diversifying the economic base, and containing inflationary pressures were addressed through a two-pronged strategy. First, with a view to insulating their economies from foreign inflation, the GCC authorities abandoned the link between their currencies and a depreciating SDR, and established a de facto peg with the U.S. dollar which led to a significant real effective appreciation of all GCC currencies (Chart 1). Second, expenditures on development projects increased, and some countries actively pursued policies to promote basic industries based on their vast hydrocarbon resources.
GCC Real Effective Exchange Rates, 1980–95
(1980=100)
Sources: IMF, Information Notice System, WEO, and International Financial Statistics.The sizable budget surpluses started to diminish from 1982 as expenditures continued to increase while revenues declined due to the steep slide in oil prices (Chart 2). While some countries had large budgetary deficits in 1984–95, the region as a whole recorded an annual average deficit of only 1 percent of GDP and an external current account surplus equivalent to 7 percent of GDP during 1981–85. Foreign reserves positions were very comfortable and inflation decelerated to an average rate of less than 1 percent per annum, but real output contracted.
• With the continued erosion of oil prices during 1986–89, economic conditions weakened further and large internal and external financial imbalances emerged. In response, the authorities implemented adjustment policies involving primarily cuts in expenditure, particularly capital outlays which declined from an average of 21 percent of GDP during 1981–85 to 13 percent of GDP during 1986–89. Adjustment was further facilitated by the significant real effective depreciation of GCC currencies.
Despite the expenditure cuts, and given the severity of the decline in oil revenue, the aggregate budget deficit increased to 4 percent of GDP during 1986–89, while the external current account position shifted to a deficit of 1 percent of GDP during the same period. External borrowing by some GCC countries limited the drawdown in foreign reserves.
• The adjustment process was interrupted by the regional crisis of 1990–91. Notwithstanding the sharp jump in oil prices in the initial phases of the conflict and the higher oil production in some countries, crisis-related expenditures and transfers created significant pressures on the budgets and external current account positions of the GCC countries.
Those countries directly involved in the conflict suffered the worst: the budget deficit in Kuwait exceeded an estimated 100 percent of GDP in 1990–91; that of Saudi Arabia increased to 17 percent of GDP in 1991; and the combined external account deficits of the two countries amounted to US$54 billion in 1991 alone. Excluding Kuwait, the aggregate external current account deficit of the GCC countries increased to 7 percent of GDP, and their combined official foreign reserves declined further.
• The GCC countries emerged from the Gulf crisis in a weaker economic and financial position at a time when the resumption of the adjustment process was further complicated by the continued downward slide in oil prices and a slowdown in global economic activity. Economic growth in the GCC moderated to an average of 2 percent per annum in 1992–94, real per capita GDP declined, and the lingering expenditures and transfers related to the conflict prevented significant reductions in the internal and external imbalances (Chart 3–5).
GCC: Selected Economic Indicators, 1991–94
(Annual percent changes)
Sources: IMF, Staff Country Reports, various issues.GCC: Savings and Investment Balance, 1991–94
(In percent of GDP)
Source: IMF, World Economic Outlook.GCC: Fiscal and External Sector Developments, 1991–94
(In percent of GDP)
Source: IMF, World Economic Outlook.For the region as whole, the average budget deficit in 1992–94 (10 percent of GDP) was higher than that of pre-crisis period (4 percent of GDP), despite the much lower levels of capital expenditure. Similarly, at 6 percent of GDP, the aggregate external current account deficit was higher than the average during the 1986–89 period (1 percent of GDP) and foreign reserves positions eroded further. By 1994, although the stock of external debt stabilized at about 12 percent of GDP, debt service payments had increased sharply.
From 1995, most GCC countries intensified their adjustment efforts in response, inter alia, to an unfavorable oil market outlook. In particular, Kuwait, Oman, and Saudi Arabia introduced medium-term plans incorporating balanced budgets by the year 2000, as well as measures to promote private sector growth and human resource development (see Boxes 2–4). In other countries, similar policies are under consideration or are being formulated.
While the recent initiatives have significantly strengthened the adjustment process that began in the mid-1980s, the nature and extent of emerging challenges are also different in at least two important areas:
• The fiscal deficits have become more structural in nature. In earlier periods, fiscal retrenchment was carried out through cuts in development expenditure without seriously affecting the growth prospects. In the meantime, the maintenance costs have increased, and there is a need to replenish the aging capital stock. In addition, the investment income, which in some GCC countries comprised a large share of government revenue, has declined while debt servicing has increased. Expenditure on social sectors has increased in line with a growing population, and outlays on defense and security have remained high. Pressures on expenditure also come from a large and growing government wage bill.
Kuwait
1. Fiscal adjustment
Kuwait’s draft Five-Year Development Plan (1995/96–1999/2000) aims at a fiscal balance by the year 2000. Revenue measures envisaged include the introduction of a sales tax, increases in customs duties, and corporate profit taxation. As regards expenditure, the aim is to control the growth of wages and salaries and maintain sustainable levels of capital expenditure.
2. Diversification and private sector participation
The annual real GDP growth over the plan period is projected at 1.3 percent. The Plan aims to promote the role of the private sector in production and investment through deregulation and human resource development. It is also intended to extend the privatization program to major entities and large corporations. Steps have been taken recently to allow some foreign investment and private sector participation in petrochemical activities. Consideration is also being given to liberalizing foreign participation in drilling and exploration activities in the oil sector.
3. Labor market
Employment policies will aim to absorb the growing number of Kuwaitis entering the labor market, while reducing employment in the public sector. The Plan aims to increase the ratio of Kuwaitis in the work force from 16 percent to 19 percent. The authorities intend to limit the immigration of low-skilled expatriates. Further, foreign firms that are awarded government contracts are required to invest 30 percent of the contract value in joint ventures with Kuwaiti-owned firms (“Offset Program”).
Oman
1. Fiscal adjustment
Oman’s Five-Year Development Plan (1996–2000) targets a balanced budget by the end of the plan period. While oil revenue is expected to increase due to higher output, revenue from gas and other sources during the plan period are also projected to be 25 percent higher compared to the 1991–95 period. At the same time, under the Plan, expenditure on defense and security will be reduced by about 10 percent and development expenditure will be lowered by 13 percent, compared to the 1991–95 period.
2. Diversification and private sector participation
The Plan projects a growth of 25 percent in GDP over the five years, and aims to raise the contribution of the non-oil sector to GDP from 65 percent in 1995 to 69 percent by the year 2000 through market-based policies. The Plan envisages that local and foreign private sector investment would account for more than one-half of total investment during 1996–2000.
3. Labor market
As part of the efforts to promote Omanization of the labor force, the authorities have established employment targets for nationals and have raised taxes related to employment of expatriates. Moreover, the Plan has allotted some 15 percent of the public investment budget toward human resource development.
Saudi Arabia
1. Fiscal adjustment
Saudi Arabia’s Sixth Development Plan (1995–2000) aims at eliminating the budget deficit by the year 2000. It is intended to raise non-oil revenue through adjustments in fees and charges for publicly supplied goods and services, and to improve revenue collection. Expenditures are to be curtailed without regard to oil price developments; specific measures include cuts in explicit and implicit subsidies, reprioritization of projects, and rationalization of expenditures.
2. Diversification and private sector participation
Real economic growth is targeted at 3.8 percent per annum during the plan period. The Plan calls for a restructuring and diversification of the economy to reduce dependence on the oil sector and increase private sector participation in the economy. To support the process, it is intended to complete ongoing infrastructural projects that could facilitate private sector activity. The divestiture program will focus on electricity, telecommuni-cations, airlines, and the Saudi Arabian Basic Industries Corporation. Vulnerable social groups would be protected by direct income transfers and social security payments.
3. Labor market
The Plan calls for development of human resources to meet skill requirements of the economy and to facilitate Saudiization of the labor force. Education and training efforts will focus on the skill requirements of the private sector. The liberal policy toward expatriate labor will be maintained.
• The GCC countries are undergoing major demographic changes characterized by a rapidly growing and young population, with important implications for the labor market. Traditionally, the government sector has absorbed a large number of new entrants to the labor force, reflecting the policy of guaranteed employment, higher wages, and the social status and other benefits associated with government employment. Fiscal constraints limit this possibility at a time of increasing number of entrants into the labor market. The policy challenge in the period ahead therefore is to meet the dual objectives of maintaining high levels of employment while reducing the role of the public sector in favor of the private sector.
III. Oil Market Outlook, Global Setting, and Regional Developments
1. Oil market outlook
The economic outlook of the GCC countries, including ability to meet their major challenges, will be shaped most directly by factors influencing the demand for oil and oil products. Oil and gas revenue account on average for about 75 percent of total government revenue, and such exports comprise 65 percent of total exports (Chart 6). While there are variations among countries, these shares are nevertheless significant in all countries.
GCC: Oil and Gas Revenue and Exports
Sources: IMF, WEO database; and staff estimates.• Average of the GCC countries.Besides the obvious impact on government finances and the balance of payments, changes in oil earnings have broader implications for domestic economic activity in the GCC countries. Non-oil economic activity is heavily influenced by domestic government expenditure, which itself is dependent on oil revenue. Moreover, most large-scale economic activities in the public domain (petrochemicals and oil-based basic manufacturing) are closely linked to developments in the oil sector.
The continuing weakness in real oil prices reflects structural changes in the international oil market reinforced by (i) technical innovations involving both a lower energy intensity in production and a greater substitution of other energy sources; and (ii) increases in global oil reserves and oil production outside the GCC/OPEC area.
As the structural elements are unlikely to be reversed over the medium term, the outlook for oil prices in the period ahead depends most directly on the pace of economic recovery in the major consuming regions and on the increase in supplies from non-OPEC sources. An added uncertainty is the possible re-entry of Iraq as a major exporter of oil, which would have a dampening effect on oil prices to the extent that the additional supplies could not be accommodated by lower output from other producers.
Most analysts seem to agree that the combination of slow increase in global demand for oil, higher output from other regions, and increased market penetration by non-OPEC countries will dampen oil prices and limit gains in market share by the GCC countries in the period ahead. On this basis, the GCC countries’ average oil export price is projected to rise only marginally in nominal terms—thus declining in real terms--and export volumes expand by only 1 percent annually through the end of this decade.
In the process, while the GCC countries would contribute about one-half of total OPEC output, OPEC output as a share of global demand for oil is expected to decline from about 40 percent in 1995 to 37 percent by the end of the decade.
2. International economic environment
Against the backdrop of an uncertain oil market, adjustment efforts in the GCC countries are being implemented within an international economic environment that is undergoing fundamental changes on several fronts. 1/ Two trends are of particular importance:
• First, the ongoing global trade liberalization is expected to gradually lead to lowering of tariffs; dismantling of nontariff trade barriers; reduction in producer subsidies; expansion of trading blocks; and the strengthening of the institutional framework under the auspices of the World Trade Organization. 2/
• Second, the continuing globalization and integration of financial markets will further facilitate private capital flows and create new financing options for many developing countries, along with greater risks.
There would naturally be short-term costs associated with the resulting resource reallocation, but these trends also offer significant potential for welfare gains in developing countries if proper conditions are in place. The basic and perhaps most important requirement is a stable domestic macroeconomic setting. Within this framework, a large and adaptable trade sector and a sufficiently diversified economic base would be required in order to benefit from a rapidly changing international trade environment. Moreover, the benefits to the economy from closer links to international capital markets could only be maximized through a diversified domestic financial sector and open and well-functioning markets that are well supervised and regulated.
At first glance, the GCC countries with their open and liberal trade regimes and a large external trade sector appear to be well-placed to benefit from the global trade reforms. However, the conventional measures of the degree of openness and the extent of integration of the GCC economies with the rest of the world need qualification. While in the GCC countries the share of total external trade to GDP (almost 100 percent in 1992–94) is probably among the highest in the world, and per capita exports (US$4,000 in 1994) reach the levels of industrial countries, these measures of openness are heavily influenced by oil trade (Chart 7).
GCC: Composition of Trade
(In percent; 1991–94 averages)
Source: United Nations, Trade Analysis and Reporting System.Given the present production and export structure, the direct benefits to the GCC countries from the global trade reforms are likely to be limited, at least initially:
• On the export side, the reforms would be neutral to GCC exports of oil and oil-related products and, under the existing restrictions on GCC exports of petrochemical products, the benefits would be small. Other exports and re-exports are largely to other countries in the region and are unlikely to be affected directly by global trends.
• On the import side, the anticipated gradual reduction in food subsidies in the European countries is expected to raise the cost of food imports. However, the impact on the GCC countries would be relatively small as some countries are becoming increasingly self-sufficient in basic foodstuffs, or rely to a large extent on food imports from the region.
Accordingly, the global trade reforms would be expected to have at best a neutral impact on the GCC countries in the short run, while the longer-term benefits would depend on the success of efforts to diversify the economies.
Despite liberal exchange policies, the links between the equity markets in the GCC countries and the international capital markets have not been strong because (i) there are restrictions on direct foreign participation in domestic equity markets; (ii) the financing requirements of a dominant public sector have been typically met through bank borrowing; and (iii) equity markets have been dominated by a few large--and mostly closed and family-owned--private sector companies. 1/ At the same time, excluding joint ventures in the oil and gas sectors, direct foreign investment in the GCC countries have been insignificant because of the small domestic market, public sector control on major operations (e.g., petrochemical industries), and the high cost of production. 2/ As such, the direct benefits to the GCC countries from a closer integration of capital markets would only be significant if the domestic markets become more diversified and open.
3. Regional developments
There are two important developments shaping the Middle East. First, the prospects of a comprehensive, just, and durable solution to the Arab-Israeli conflict has raised optimism for reallocating over time resources in some countries from military expenditure to more productive uses at a time when investment disincentives associated with sociopolitical risk factors would be reduced. 1/ Second, the recent European Union (EU) initiative aimed at promoting investment flows, removing trade barriers, and creating free trade zones has improved the prospects for a closer economic integration between Europe and the countries in the Mediterranean basin.
The resolution of the Arab-Israeli conflict would be expected to expand trade and investment opportunities in the Middle East over time, particularly joint-venture projects. Indeed, some GCC countries have already explored such projects in the energy field. The overall benefits would, of course, be much smaller than those that could accrue to the “front line states” from the resolution of a prolonged and costly conflict.
The direct positive spillover to the GCC countries from the closer integration between some countries in the region and Europe would be relatively small at the outset. The EU initiative does not cover the GCC countries at this time. Moreover, the taxation of petroleum imports remains a highly contentious issue in the discussions between the GCC and EU countries. Nevertheless, there could be some indirect effects from the expected broader implications of closer economic links between some of the Middle Eastern countries and the EU.
IV. Policy Issues and a Medium-Term Adjustment Strategy
Bringing all the elements together, the GCC countries would be expected to be impacted at best neutrally by trends in the international trade and financial markets. The benefits from regional developments would be less direct and of a long-term nature. At the same time, in view of a generally subdued oil market outlook, there is a considerable downside risk that would continue to expose the GCC countries to unfavorable fluctuations in the terms of trade.
On the basis of broadly unchanged policies, it is projected that real output growth in the GCC countries as a group would be of the order of 2 percent per annum through the rest of this decade, below the rate of population growth of 3.5 percent. Some GCC countries have already aimed at balanced budgets by the end of this decade, but for the other countries, the fiscal and current account deficits would remain of the order of 10 percent of GDP on the basis of present policy stance. Unless addressed through appropriate policies, the emerging imbalances would further drain official foreign assets and increase internal and external indebtedness--thereby mitigating against private sector confidence and self-sustaining growth. The slow economic growth and insufficient economic diversification would also limit the absorption of a rapidly increasing indigenous labor force.
Although all GCC countries would be affected by these adverse trends, there would be differences between countries. These depend on the degree of their reliance on oil income, levels of official reserves, the extent of diversification of their economies, and the size and growth of population.
The authorities in the GCC countries are aware of the challenges facing their economies, with recent policy initiatives in a number of countries intensifying important changes in macroeconomic objectives and priorities. This is illustrated, for example, by the recent adjustment strategies adopted by Kuwait, Oman, and Saudi Arabia, which share three elements:
• Elimination of budget deficits and structural improvements in the budget, supported by an appropriate monetary policy.
• Market-based policies and structural reforms to promote private sector activity, particularly in the context of the initial dampening effect of fiscal correction and the reduction in subsidies and protection.
• Manpower and incomes policies to facilitate the productive absorption of a rapidly increasing national labor force.
These elements are mutually reinforcing, are pointed in the right direction, and are properly cast within a medium-term context. Their implementation will reduce the vulnerability of the GCC countries to oil market developments and position the countries to benefit from the favorable trends in the world economy. 1/
1. Financial policies
a. Fiscal policy
Over the medium term, fiscal policy should aim at eliminating the budget deficit in a sustained manner so as to ensure a comfortable foreign reserve position and limit official external indebtedness. The recent budgets in a number of GCC countries reflect intensified efforts to mobilize non-oil revenue, as expenditure cuts of the magnitude required would be difficult. Further cuts in capital expenditure may not be feasible, or indeed desirable, in view of the need to replenish the aging capital stock. As such, a durable fiscal consolidation requires a balanced approach between revenue and expenditure and between expenditure components, as well as structural improvements in the budget to reduce the nondiscretionary element of expenditure and make revenue more responsive to economic activity.
(i) Expenditure policies
In the GCC countries, pressures on current expenditure typically arise from the government wage bill, requirements for defense and security, and from subsidies and entitlement.
The large and growing government wage bill reflects the traditional role of the Government as the dominant employer in the economy, as well as wage awards which over time have created a large wage differential in favor of the public sector. Wage policy in the future needs to be combined with reform of the civil service to address the problem of overemployment that has emerged in the government sector. 1/
Expenditure for defense and security needs is considerable. Several GCC countries envisage some reduction in this spending over time without undermining their security needs.
The subsidy system in the GCC countries has evolved over the years within the broad objectives of distributing the oil wealth to the population and supporting private sector economic activity. Together with other protective policies, subsidies benefiting both consumers and producers have aimed at ensuring low and stable prices for essential foodstuffs and basic services, achieving social objectives in the health and education areas, and promoting basic industries and supporting specific sectors for strategic reasons (e.g., food production for security reasons).
Explicit subsidies through the budget have generally included cash payments to farmers to maintain high procurement prices and to utility companies to cover their operating losses. While the magnitude of explicit budgetary subsidies in the GCC countries (about 2–3 percent of GDP) is not large by international comparisons, there are substantial implicit subsidies in the form of free or below-cost provision of government services (utilities, education, health, transportation, and sector-specific inputs). Implicit subsidies are also provided through low petroleum product prices in some GCC countries and through subsidized long-term loans.
It has generally proved difficult to quantify the magnitude of implicit subsidies or their effectiveness. Nevertheless, it is recognized that many of the implicit subsidies have involved substantial hidden costs in terms of resource misallocation, wasteful use, and production inefficiencies. A comprehensive plan to rationalize subsidies over the medium term would involve adjusting agricultural procurement prices to international levels; raising utility rates; and introducing or increasing fees and charges on government services. The impact of higher prices on the vulnerable social groups could be mitigated through well-targeted income transfer programs, which would be less costly and more equitable and transparent. Finally, plans to reduce subsidies and protection in general should also take into account intra-GCC considerations in order to prevent sudden shifts in capital and production between the countries.
(ii) Revenue policies
The revenue structure in GCC countries has been dominated by oil receipts and, until recently, investment income associated with wealth generated by past oil income. The narrow tax base--consisting mainly of import duties, income taxes with limited coverage, and fees and charges--is further constrained by substantial exemptions. Consequently, non-oil revenue in the GCC countries on average amounted to only 8 percent of GDP in 1992–94--below comparable levels in other developing countries. 1/
Revenue policies should be directed not only at mobilizing non-oil revenue in the short run, but also at improving the buoyancy of tax revenue. This would require a reform of the existing tax and nontax revenue sources, as well as the introduction of new broad-based taxes.
Collections from import taxes could be increased in some countries by raising the tariff rates as a part of harmonization of tariffs in the GCC countries, and by eliminating most tariff exemptions; for other countries, such harmonization is likely to imply constant or declining tariff receipts. 2/ Similarly, the coverage of excises could be expanded and consideration be given to the introduction of selective excises on luxury goods. Most GCC countries have already initiated increases in user fees and utility prices; over the medium term, these would need to be adjusted sufficiently to reflect the cost of service. Finally, tax revenue and the tax structure would benefit from the introduction of a broad-based consumption tax, a turnover tax, and from expanding the scope and coverage of the existing income taxes.
b. Monetary and exchange rate policies
The monetary policy in the GCC countries has been essentially targeted at maintaining the stability of the exchange rate as a nominal anchor for the economy. In turn, this policy has contributed to a low and stable rate of inflation and maintained private sector confidence. In view of the free mobility of capital, the de facto pegging of the national currencies to the U.S. dollar has also required the domestic interest rates to track closely the movements of U.S. dollar interest rates. Within this framework, the domestic demand for liquid assets regulates total liquidity through changes in net foreign assets of the banking system.
In the process of maintaining stable parities with the U.S. dollar, the GCC countries have also established stable cross rates between their national currencies. GCC-wide coordination has been facilitated by continuous dialogue between the country authorities on issues related to monetary policy and regulatory activities.
Looking ahead, unless there is a significant fiscal correction, pressures on monetary policy are likely to increase. Monetary policy cannot and should not be expected to substitute for fiscal restraint without affecting the exchange rate regime. Indeed, an integrated and balanced policy mix would require fiscal consolidation to be supported by an appropriate monetary policy in order to ensure price and exchange rate stability and maintain private sector confidence.
2. Growth policies, economic diversification, and structural reforms
The experience of the GCC countries in diversifying their economic structure and reducing their reliance on oil revenue falls into three broad categories:
• In some GCC countries, such as Kuwait, the emphasis has been on downstream diversification through asset acquisitions in other countries.
• In other countries, such as Saudi Arabia, economic diversification was carried out through developing a domestic non-oil sector with significant participation by the private sector.
• Other countries followed a mix of these two policies, broadly defining their strategies on the basis of their oil resource profile, foreign exchange reserves, and investment opportunities at home.
In almost all countries that followed a domestic investment policy, the development of the non-oil sector focused on petrochemical industries and other oil-based industries in which the countries had a clear comparative advantage. However, the petrochemical industries remained vulnerable to oil market developments and to restrictive trade practices in the main consuming regions. Moreover, most of the large non-oil industries remained in the public domain reflecting the authorities’ policy toward strategic industries and foreign participation, as well as the massive capital requirements that limited private sector entry. In agriculture and manufacturing, where private sector participation was significant, production was supported by various subsidies and incentives that burdened the budget and distorted the relative price structure.
Against this background, a major challenge facing the GCC countries is to maintain high rates of economic growth through market-based policies at a time when the growth impulse from the oil sector would be expected to weaken; government expenditure cutbacks would have an initial adverse impact on non-oil economic activity; and pressures to create employment opportunities at home would likely increase. Recognizing that in the future, the private sector would be called upon to contribute a larger share in economic activity and job creation, the authorities are encouraging private sector participation. 1/
Creation of a stable macroeconomic setting is a necessary condition for private sector confidence, but this in itself may not be sufficient to pursue a policy of economic diversification based on private sector initiative. A sustained and efficient diversification of the economy calls for strengthening of policies regarding subsidies and protection, privatization, and pricing of public services and utilities. It must also be supported by deeper and more efficient domestic financial and equity markets and a more flexible labor market.
The subsidy and incentive programs of some GCC countries should be reassessed within development and sectoral priorities with the recognition that the temporary protection offered by implicit subsidies may in fact delay efficient economic diversification. As discussed earlier, the policy focus should be on sharply reducing producer subsidies and curtailing protection in general, beginning with areas where the economy already enjoys a comparative advantage in production (e.g., petrochemicals).
Together with policies already under way to enlarge the scope of activities of the private sector, it is important to intensify divestiture policy. The GCC countries have limited experience with privatization up to now. In Kuwait, privatization has involved sales of shares of certain enterprises held by the Kuwait Investment Authority on behalf of the Government. In Saudi Arabia, so far, 30 percent of shares of the Saudi Arabian Basic Industries Corporation have been sold to the private sector.
A broader privatization program aiming to create a more efficient economic system should be geared toward not only higher private sector activity, but also private sector decision making and majority ownership, tapping its dynamism, creativity, and entrepreneurial skills. This should proceed in tandem with a further liberalization of foreign direct investment to allow majority ownership. The proceeds from privatization should be used to retire public debt.
In addition to a sound regulatory framework, the success of the privatization programs is predicated on transmitting the right price signals to the market. A number of GCC countries have identified public utility companies as possible targets for privatization. This would require a prior adjustment in prices to ensure self-financing and reduce the burden on the budget in the future.
The GCC countries have small, but growing, domestic equity markets. 1/ In the future, these markets would be called upon to play a more active role in resource mobilization and increased equity financing for the private sector. In fact, this would be a key element for the success of the privatization program which, in turn, would contribute to its efficiency by increasing its size and depth. Increased investment opportunities at home would also help in attracting substantial savings held by GCC citizens abroad. The recent successful floating of public shares on the local markets (in Bahrain, Oman, Qatar, Saudi Arabia, and the U.A.E.)--and their oversubscription in some cases--suggests that substantial resources could be raised through the local markets. 1/
There are a number of factors that are essential for larger capitalization and greater efficiency of equity markets in the GCC countries:
• First, it is important to have in place an appropriate regulatory framework and tax measures to discourage speculative portfolio flows and maintain private sector confidence.
• Second, well-functioning equity markets would benefit from a broader participation of domestic enterprises as well as foreign investors.
• Finally, the development of integrated equity markets in the GCC region would require greater coordination of regulatory and supervisory frameworks and an easier flow of capital between the countries.
Given equity market developments, the banking system has been instrumental in mobilizing and allocating domestic savings. The supervisory and the regulatory frameworks have been strengthened, and banks have improved their capital position in line with international standards on capital adequacy. In addition, the participation of foreign banks through joint ventures with local banks and the development of the offshore market in Bahrain have enhanced the depth and sophistication of the banking sector in the GCC countries.
As the domestic financial system would be expected to provide a key supportive role in the process of economic diversification and growth, there are a number of issues to be considered in order to strengthen its intermediation role:
• First, a more diversified banking sector would benefit from a greater participation of foreign banks.
• Second, serious consideration should be given to the competitive auctioning of short-term as well as long-term government debt instruments to tap private savings at the opportunity cost of capital; this would also provide indications of resource cost for corporate borrowing and develop indirect instruments of monetary control.
• Third, to compete with banks, the specialized credit institutions should become more autonomous and commercially oriented, providing credit at market-determined rates.
• Finally, consideration could be given to developing alternative instruments of assets diversification (e.g., mutual funds).
3. Labor market policies
Most GCC countries have segmented labor markets with limited labor mobility. This reflects wage rigidities, skills mismatch, and institutional and cultural factors. Better educated new entrants to the national labor market have been traditionally attracted to the public sector because of higher wages and benefits, job security, and social status associated with government employment. At the other extreme, private sector activities have relied heavily on imported labor that is readily available on the basis of fixed-term contracts, and at wages in many cases lower than those in the public sector. 1/ Moreover, the geographical diversification of imported labor in recent years has acted to reduce average wages for unskilled labor and helped in protecting external competitiveness.
In the period ahead, the labor market conditions for the GCC nationals are expected to tighten in view of a rapidly growing indigenous population with higher expectations and a youthful age profile. A number of GCC countries have initiated policies to replace foreign workers with nationals by establishing limits on hiring expatriate workers, setting minimum quotas for hiring nationals, and raising the cost of employment of nonnationals. While these measures would appear to increase employment possibilities for the nationals in the short run, it may be counterproductive in the long run in the absence of downward flexibility of wages. In addition, these policies are likely to be resisted by private sector employers who lose their employment flexibility and face higher labor costs.
Mandatory employment measures are not a good substitute for increased wage flexibility and integration of labor markets. Over time, public sector wages should be allowed to adjust to market forces, and private sector employers should be allowed to hire the best available labor, both national and foreign, at market wages. Over the medium term, productivity gains would also be expected to reduce the demand for low-skill labor and provide a better match between skills of national labor and the available jobs in the private sector. Finally, education and training should continue to be geared toward meeting the future job requirements of the economy, reducing the emphasis on high-skill training, and encouraging creativity and productivity. The experience of a number of dynamic Asian economies has shown that emphasizing spending on education and training in the initial stages of development results in high private and social returns.
V. Regional Implications of Adjustment in the GCC Countries
Given the traditional links to the rest of the MENA region, economic diversification and fiscal retrenchment in the GCC countries would be expected to influence the economic performance of the rest of the region through a number of channels: the flow of workers’ remittances, financial aid, merchandise trade, as well as the flow of investment to the region.
• Employment opportunities in the GCC countries for foreign labor are likely to become more limited in the short run. The contraction of the oil sector would initially dampen non-oil activities, and large-scale infrastructure development has reached saturation in several countries. Moreover, there is a recent trend in the GCC countries to substitute Asian workers for workers from the region. In addition, as mentioned earlier, most of the GCC countries have initiated long-term programs of nationalization of their labor force through employment policies.
These factors suggest that with reduced reliance on foreign labor, the larger share of adjustment would possibly fall on workers from the region. In addition to the direct balance of payments impact, there would also be effects on investment and growth associated with the loss of remittances, as these flows have traditionally financed small-scale private investments (mostly in construction) in the recipient countries.
• Over the past two decades, the GCC countries have been an important source of financial support for many countries in the region, both directly through grants and soft loans, and indirectly through contributions to regional and Arab multilateral development institutions. 1/ During the 1974–94 period, concessional financial assistance from the GCC countries to other developing countries totaled about US$90 billion, representing 3 percent of donors’ GDP. Budgetary constraints have made it difficult to maintain high levels of official financial assistance. Further expenditure restraints would be expected to result in relatively limited, though still sizeable in absolute terms, aid flows to the countries in the region.
• During 1991–94, the other countries in the MENA region accounted on average for 2–3 percent of total GCC merchandise trade (Chart 8). GCC imports from other MENA countries were dominated by food products, while mineral fuels and foodstuffs comprised the bulk of its exports to the region (Chart 9). In addition, only a few countries in the MENA region accounted for a significant share of trade with GCC (Chart 10). Looking forward, the expansion of domestic economic base and export diversification would be expected to lead, over time, to higher exports from the GCC countries to the other countries in the region, particularly in areas where the GCC countries have a clear comparative advantage (e.g., secondary and tertiary petrochemical products).
• Finally, in several countries in the region, the prospects of macroeconomic stability, supported by simplification of investment procedures and the lowering of the barriers to entry of foreign capital would offer opportunities for increased investment by the GCC countries. Moreover, the prospects of peace in the region, combined with sound economic and financial policies, would improve investment incentives and create opportunities for regional joint projects that have not been fully exploited because of sociopolitical risks. Although most GCC countries would be expected to pursue economic diversification based on domestic investment, their comfortable overall capital position would still allow large investments in the region. There are only a few other capital surplus economies in the region that could benefit from the opening of equity markets and privatization programs in the GCC countries.
GCC: Direction of Trade
(In percent; 1991–94 averages)
Source: IMF, Direction of Trade.GCC and the rest of MENA: Composition of Trade
(1991–94 averages)
Source: United Nations, Trade Analysis and Reporting System.GCC and the rest of MENA: Direction of Trade
(1991–94 averages)
Source: IMF, Direction of Trade.See also El-Erian (1996) and IMF (1995).
See Goldin, Knudsen, and van der Mensbrugghe (1993); and Chabrier, El-Erian, and Moalla-Fetini (1995).
See Azzam (1995a) and El-Erian and Kumar (1995).
By some estimates, private capital flows to the GCC countries have comprised 1–2 percent of total capital flows to all developing countries. See Bates (1994) and Hovaguimian (1994).
Adjustment and reform policies in the GCC countries are also discussed by Azzam (1995b).
Employment policies are discussed in more detail below.
Although in some other oil producing countries the share of non-oil revenue to GDP is comparable to that of GCC countries (e.g., about 9 percent in Iran and Indonesia), the average revenue to GDP ratio in upper middle income developing countries is about 27 percent.
Under the planned GCC tariff harmonization, rates would be reduced to a range of 4–8 percent for most imports. Currently, with a uniform tariff rate of 4 percent, only the U.A.E. is in that range.
Investment and growth policies and issues related to human resource development are discussed in World Bank (1995a).
As reported by Azzam (1995b), total capitalization in the GCC markets in 1994 was about US$67 billion, with Saudi Arabia accounting for 57 percent of the total. Market capitalization in GCC was equivalent to 35 percent of total GDP, compared with 50 percent in other developing countries.
See Azzam (1995a) for a review of capital markets of the GCC countries.
According to Ali (1995), the share of foreign workers in total labor force in the GCC countries varies from 40 percent in Bahrain to 83 percent in Kuwait.
References
Ali, H. (1995), “GCC states: Need for unified labor market,” Arab News, October 3, 1995.
Azzam, H. (1995a), “Gulf Capital Markets: Development Prospects and Constrainst,” in Development of Financial Markets in the Arab Countries, Iran and Turkey, ed. by Economic Research Forum, Cairo.
Azzam, H. (1995b), “GCC: Adjustment and Reform in the 1990s,” paper presented to the Middle East Panel of the International Economic Association Congress, Tunis, December, 1995.
Bates, S. (1994), “Investment: A European View,” paper presented at the London Conference on Financial Markets in the Middle East, April 1994.
Chabrier, P., M. El-Erian, and Moalla-Fetini (1995), “The Implications of the Uruguay Round for the Arab Countries: A General Analysis,” in El-Naggar (ed.).
El-Erian, M. (1996), “Middle Eastern Economies’ External Environment,” Middle East Policy, Volume IV, Number 3, March 1996.
El-Erian, M. and M. Kumar (1995), “Emerging Equity Markets in Middle Eastern Countries,” Staff Papers, Vol. 42 No. 2
El-Naggar, S. (ed.) (1993), Prospects for Arab Economic Development, Washington, D.C.: International Monetary Fund.
Fischer, S., D. Rodrik, and E. Tuma (1993), The Economics of the Middle East Peace, Cambridge, MA: MIT Press.
Goldin, I., O. Knudsen, and D. van der Mensbrugghe (1993), Trade Liberalization: Global Economic Implications, OECD/World Bank.
Hovaguimian, A. (1994), “The Role of Financial Institutions in Facilitating Investment and Capital Flows,” in El-Naggar (ed.).
IMF (1995), “Macroeconomy of the Middle East and North Africa: Exploiting Potential for Growth and Financial Stability,” October 1995.
van den Boogaerde, P. (1991), “Financial Assistance from Arab Countries and Arab Regional Institutes,” IMF, Occasional Paper, No. 87, September 1991
World Bank (1995a), “Claiming the Future: Choosing Prosperity in the Middle East and North Africa,” October 1995.
World Bank (1995b), World Development Report 1995.
