MENA: What to Make of the Region’s Diversification Drive?
Faced with fluctuating oil prices and other uncertainties, the oil-rich countries of the Middle East and North Africa (MENA) have made efforts to diversify their exports in order to reduce their dependence on oil revenues. Some of these efforts have been underway for decades. In recent years, pressures to diversify have been rising amid the sharp fall in oil prices since mid-2014 and the increasing threat posed by alternative sources of energy. Although diversification efforts have achieved some success, as we will highlight in this note, the results have been disappointing overall, raising concerns about the economic models of the region’s hydrocarbon-rich economies as well as broader stability within the region.
- The impetus to reform has gained added urgency…
While the concept of diversification has been on the agenda of MENA countries for quite some time, it is only now that the process has meaningfully started to gain traction. In our minds, there are essentially three factors that lie behind this push:
i) Faltering oil prices
Oil revenues are less certain than they once were. Following the shale revolution in the US, the price of oil has declined sharply since 2014 from a figure north of US$100/barrel to around US$60/barrel presently. Wars, political uprisings, and other disasters have disrupted the flow of oil exports from many countries, making oil prices volatile. Lower oil prices and greater volatility have prompted oil producers to tighten their budgets, make socially and politically sensitive cuts in subsidies and raise taxes. Some countries, including Saudi Arabia, have been forced to resort to borrowing from the international capital markets. Further downward pressure on oil prices is likely once oil production resumes in Iran, Libya and Venezuela, all of which have restrained output for various reasons.
ii) Need to foster jobs growth
Job creation has become a mounting concern in many MENA countries. A growing number of young people are unemployed, which is creating social and political tensions. Members of the Gulf Cooperation Council (GCC) countries, not least Saudi Arabia, need to create jobs for thousands of unemployed nationals seeking public sector jobs that pay more than jobs in the private sector.
iii) Environmental concerns
Countries around the world face growing demand to reduce the use of fossil fuels in light of concerns over climate change and environmental degradation. Mindful of this, oil-producing countries fear the shift away from fossil fuels pose an existential risk and that reserves will get stranded underground. While the factors noted above are widely applicable across oil-based MENA economies, the key point to note is that there are rather sharp variations in terms of these countries’ oil dependency (see Chart 1).
2. But reform progress is likely to remain rather tepid thanks to inherent constraints
The goal of diversification, as alluded to above, is not new to the MENA region. Indeed, many oil exporters have been pursuing diversification strategies for years, though with mixed results. Efforts have included state-centred industrial policies to diversify exports and initiatives to expand the role of the private sector. Some efforts to diversify have succeeded. Dubai diversified horizontally across sectors, for example, and Abu Dhabi vertically diversified across the hydrocarbon sector. There have also been unsuccessful cases, including high-cost import-substitution projects that wasted public resources. Many countries have tried successfully to generate income through investments in their sovereign wealth funds.
The decline in oil prices since 2014 has intensified pressures to restructure and diversify. Most MENA oil exporters have been developing strategies for putting their fiscal houses in order, promoting more sustainable development and creating jobs. With respect to the former, it is important to highlight that not only have steps been taken to pare back public spending – including by making cutbacks in sensitive areas such as fuel and utility subsidies – there have also been incremental changes to the tax system through, for example, the introduction of a sales tax in the UAE and Saudi Arabia.
Many oil producers have also put in place diversification strategies. Of these, Saudi Arabia’s Vision 2030 is perhaps the best known and most ambitious. Some of its key targets include the following:
- Increase the share of the private sector in GDP from 40% to 65% of GDP by 2030;
- Increase SME contribution to GDP from 20% to 35%;
- Raise the share of non-oil exports in non-oil GDP from 16% to 50%;
- Increase non-oil government revenue from SAR 163bn to SAR 1trn;
- Increase foreign direct investment from 3.8% to 5.7% of GDP;
- Increase the assets of the Public Investment Fund (Saudi Arabia’s sovereign wealth fund) from SAR 600bn to in excess of SAR 7trn, including through a public offering of part of Saudi Aramco, the national oil company.
Such plans, while they look impressive on paper, in our minds are overly ambitious. The key point to note is that, unlike fiscal reforms, structural reforms of the sort outlined above as well as being painful to implement, will by their very nature take considerable time to reach fruition in the MENA region, especially given the dominant role played by the oil and gas and related sectors within these economies (see Chart 2). Within the Saudi Arabian context, repeated delays to the IPO of Saudi Aramco – which is seen as the cornerstone of the Saudi government’s Vision 2030 programme – on, among other things, valuation concerns, are in our minds somewhat troubling, though efforts are underway once again to push ahead with this goal in the near-term. Failure to see through on this front will in our opinion be a big setback in any attempts to diversify the Saudi economy as Saudi Aramco is the country’s national oil champion and hence its reform is of vital importance in order to raise the necessary proceeds to kick-start the process of weaning the Saudi economy’s addiction to oil and boosting the prospects of the non-oil sector going forward.
The other point worth deliberating on here is relates to the social dimension of diversification, namely the need to secure the buy-in from the domestic population in order to push ahead with painful reforms aimed at putting energy-dependent MENA countries on a more sustainable or sounder longer-term footing going forward. While experience of countries like Iraq suggests that such support is not always easy to garner, such a “consultative” approach would go some way towards giving the reform process greater legitimacy and holds particular relevance in case of public sector reforms given the fact that this sector employs a significant share of people in the region relative to its global peers (see Chart 3).
A final consideration worth noting here is that although the recent drive towards diversification – be it in the form of, for example, public sector reforms or moves towards greater privatization – is now widely accepted across the MENA region, the process of realizing this goal is fraught with difficulties. This is not least because it is contingent on the need for greater transparency and/or scrutiny of these countries’ underlying economic/financial health, something they have been reticent to do at least until now. This is particularly true of the GCC countries – and most notably Saudi Arabia – which in the past as well as being reluctant to reveal the actual scale of its foreign asset holdings, was also coy about disclosing the ultimate oil reserves of Saudi Aramco. While this has now started to change with the planned IPO of Saudi Aramco – which has forced the country to open its books to outside investors – the crucial point to note is that this process is being embraced rather reluctantly.
3. Our views on the key priorities ahead
While there are many barriers to the reform process in the MENA region, as we elaborated above, this section will seek to lay out our views on what the key reform priorities in the region should be going forward. In our view for any reform agenda in the MENA region to bear fruit, it will have to address deep structural issues and key weaknesses in the current economic model. Reforms should centre on the institutional and regulatory framework, the labour market, growth and productivity and other aspects related to sustaining long-term growth.
i) Creation of fiscal rules
The UAE has introduced a medium-term fiscal framework (MTFF) at a federal level while local governments are working on developing something akin to this at the local level. Similarly, Saudi Arabia, as part of its latest transformation plans, has embarked on efforts to strengthen its budget preparation process with the aim of adopting an MTFF eventually. Other MENA countries are also preparing for various forms of the fiscal framework. In our view introducing such rules will help the conduct of fiscal policy by establishing clear rules and objectives for government budgeting and spending. Such frameworks should help improve the efficiency of spending and address the pro-cyclicality of fiscal policy. Therefore, the benefits of adopting these rules will likely materialise in the medium to long-term when the macroeconomic system becomes more robust in the face of external shocks.
ii) Sovereign wealth fund frameworks
Sovereign wealth funds (SWFs) provide another key macroeconomic management tool that can be used to achieve greater fiscal consolidation and increase national savings rates. MENA countries – and more specifically those within the GCC – have some of the world’s largest SWFs, with some estimates suggesting that they have in the region of US$2tn of assets under management. During the latest oil price slump, a few GCC countries tapped their SWFs to finance budget deficits (e.g. UAE and Oman). The majority preferred to either draw from their FX reserves or issue external debt or both. By establishing clear fiscal rules for depositing into and withdrawing from SWFs, these funds could act as stabilizing tools for GCC economies through boom and bust cycles.
iii) A more conducive environment for private sector growth
To diversify away from oil, GCC countries will have to adopt policies that are conducive to the growth of the non-oil sector. Macroeconomic stability is a precondition for any future policy, including sound fiscal and monetary policies that reassure the private sector of the government’s ability to stabilize the economy in the face of external shocks, especially those stemming from oil markets.
Moreover, continuing to improve the regulatory and institutional framework is crucial to improving the business climate in these countries. Regulations that reduce barriers to competition and market entry could help attract more FDI inflows and foster the growth of new industries.
iv) Labour market reforms
Education and training should be geared to future job requirements. GCC countries spend generously on education, but this does not guarantee efficiency or quality of spending. More targeted spending is required. The experience of Asian countries shows that high spending on education in the early stages of development and emphasising quality teaching of maths, science and critical thinking can result in high economic and social returns in the long-term. Additionally, the ongoing introduction of policies that increase female participation in the labour market is highly desirable. In particular, policies geared towards enhancing female mobility (e.g. their ability to travel abroad for study or travel purposes) should have a significant impact on the long-term growth of these economies.
v) Industrial policy
Industrial policy should focus on developing new sectors with high export potential and strong integration with global supply chains. These sectors should be supported by policies fostering innovation and linkages with other sectors of the economy. This is particularly important to achieve the diversification agenda set by many MENA countries. Such sectors would facilitate knowledge transfer to the domestic economy and thus help enhance productivity in the long-term. Moreover, knowledge-based sectors that provide high paying jobs could create incentives for MENA nationals to acquire the right skill set and seek jobs outside the public sector.
4. Concluding thoughts/remark
While the need for diversification/reforms across oil dependant MENA economies has been apparent for a long time, they were able to continue in the absence of such measures thanks in large part to high oil prices. With this no longer the case – and a lower for longer mentality regarding oil prices had taken hold – the urgency for reforms has clearly stepped up recently. While we welcome this, other barriers to reform are still there and only those countries that are able to withstand this will be to adopt the sort of deep-seated reforms that will allow these economies to genuinely diversify.
Source from: MERatings