June 7, 2016

This Time We Mean It: Staying the Course on Economic Reforms

A man works on construction of the Kingdom Tower in Jeddah, Saudi Arabia. (AP Photo/Hasan Jamali)

This post is part of an AGSIW series on Saudi Vision 2030, a sweeping set of programs and reforms adopted by the Saudi government to be implemented by 2030.

Saudi Arabia released its long awaited National Transformation Program on June 6. Among the reforms planned to roll out in just under four years, by 2020, are cuts to government subsidies and salaries, and a reliance on the private sector to fund new initiatives (particularly in non-oil tradable sectors) and create jobs. Analysts at Abu Dhabi Commercial Bank estimate that the fiscal consolidation measures amount to close to SAR 400 billion (around $100 billion) over five years, equivalent to approximately 2.5 to 3 percent of gross domestic product per year.

Meanwhile, oil is edging up, hovering around $50 per barrel. If oil prices continue to increase, will the reform agenda emerging in Saudi Arabia and across the Gulf Cooperation Council continue? What is at stake if it does not? These are critical questions as Gulf oil and gas exporters must choose between short- and long-term goals.

World Bank, IMF, Haver Analytics, Bloomberg.

World Bank, IMF, Haver Analytics, Bloomberg.

World Bank, IMF, Haver Analytics, Bloomberg.

World Bank, IMF, Haver Analytics, Bloomberg.

The short-term priority is to steady the fiscal deficits that have pummeled Gulf states this past year, with all six of the GCC member states facing persistent deficits since 2015. World Bank researchers identify the problem of deficits, but also the continued dependence on carbon resources as the dominant source of revenue. Economic diversification is not a priority when oil prices are high or climbing – unless we look to the future and the problem of continued demands on government expenditure.

The long-term goal is, therefore, more complicated: The Arab Gulf states have an employment crisis, driven by a state-led growth model that used cheap imported labor and cheap energy (diverted from possible export revenue) to build infrastructure and a bloated public sector to subsidize income for nationals. The model created many good things, but it is not sustainable. The demographic bulge of a young, better-educated (than their parents and grandparents), and socially mobile population demands high wages and opportunity. The state cannot simply continue to create jobs with low productivity, starving the private sector of potential innovators and keeping wages artificially high.

This time is different because the last time the GCC states faced declining oil revenue and economic downturn, their fiscal spending commitments were much lower, their populations were smaller, and their integration in both the Middle East and North Africa regional economy and global economy was less interdependent. The effects of a GCC economic contraction are more severe on remittance flows, from the advent of large expatriate labor populations, and foreign aid and investment to recipient states across the Middle East, North Africa, and Asia.

In a new study by the International Monetary Fund, researchers point to the last economic downturn when oil prices collapsed in 1986, and slowed economic growth through the early 1990s, as the region’s “Greatest Depression,” in which per capita consumption fell by nearly 20 percent and did not recover until the late 2000s, during the most recent oil boom. In fact, as Reda Cherif and Fuad Hasanov argue in the IMF study and an earlier paper, the relative income of GCC countries has fallen in the last 30 years, as low productivity has dampened growth potential. GDP per worker (in purchasing parity dollars) has dropped, and GCC states have deteriorated in relative income rankings since the 1980s to U.S. levels or below (for most) by 2010. Qatar even decreased from three times the U.S. level to double the U.S. income per worker from 1980 to 2010. Total factor productivity (TFP) declined in all of the six GCC countries over the last three decades through 2010.

The evidence suggests that as the Gulf states have grown wealthy, and grown in population size, these are tougher economies in which to live and work. People’s lives have improved, in terms of education and access to social services, yet the effort to generate wealth and productivity is limited.

Reda Cherif and Fuad Hasanov, IMF

Reda Cherif and Fuad Hasanov, IMF

The need for reform, as the NTP suggests, is a total realignment of government intervention in the domestic economy, starting with employment, but also targeting energy production, infrastructure investment, and institutional changes to the legal and business environment. These are goals, with a short timeline, and a project management approach to governance, with 178 “strategic objectives,” 371 “indicators” of change, and 346 “targets.” It will certainly take a number of public employees, and quite a few consultants, in the new Strategic Management Office to keep track of these metrics. Some of the targets for 2020 are more modest, or at least suggest the difficulty of cutting “red tape” inside Saudi Arabia. For example, one of the economic goals is to reduce the percentage of delayed state projects to 40 percent from 70 percent. This one indicator illustrates the problem with productivity, as the World Bank and many others have recognized as declining across the GCC since the 1980s.

Chart 6

Explanations for the drop off in productivity and the depth of the diversification challenge include: the heavy hand of the state and lack of distribution of wealth, the weak ability of the state to manage its fiscal policy and save for downturns, and institutional barriers to open markets. If the GCC states are to improve diversification efforts through the non-oil tradable sector, focusing on exports and technology upgrades, there will have to be a drastic change to public sector employment patterns, preferences, and wages. The NTP acknowledges this challenge, perhaps for the first time putting the private sector at the center of a recovery. This is a difficult proposition, especially at a moment of fiscal retrenchment. The NTP seeks to rely on the private sector to create 450,000 jobs by 2020, presumably many of those job seekers will be former public sector employees. The NTP sets a target of 40 percent of government expenditure going toward public sector wages, a decrease of only 5 percent. Public sector salaries make up significant parts of GCC states’ fiscal outlays; even in the best case of diversification in the GCC, the emirate of Dubai spends as much as 30 percent of government budget outlays on public sector salaries. As the NTP itself acknowledges, the international benchmark is closer to 15 percent of government spending directed toward public sector salaries.

As others have noted, the reform agenda now, including Saudi Arabia’s Vision 2030, closely resembles earlier national development plans and diversification goals set out by many of the GCC states since the 1990s. The plans that began in the 1990s reveal some of the challenges of the state’s direction of diversification when an oil boom or recovery gets in the way. Oman 2020 is one key example in which subsidies and public sector wages have been difficult to winnow down, even before the dramatic oil price decline, according to plan.

Security and geopolitical strategy are also getting in the way of progress on jobs and private sector investment. Saudi Arabia continues to prioritize its market competitiveness against Iran, lowering its prices to European oil buyers to crowd out Iranian exports. The Saudis have effectively created demand by squeezing out higher price producers in shale, while simultaneously keeping prices low by refusing to lower production and giving competitive deals to buyers even as the market edges up.

Any reform agenda includes competing interests. For the Arab Gulf states, this is a critical moment, one that may be complicated by a more accommodating oil price. At the heart of the reforms, and the National Transformation Plan set forth by Saudi Arabia, is a discussion of work – work and productivity and one’s place in society. It is very clear that even if oil wealth were perpetual, there is a diminishing return on productivity. This discussion could not come at a more opportune time. It will be leadership that determines if the reforms are meaningful.

Market Watch is a weekly blog conceived by AGSIW Senior Resident Scholar Karen E. Young seeking to provide insights from the crossroads of Gulf politics and finance.