Why Gulf economies need a transformed role for the state

Gulf governments responded quickly and decisively to the shock of the pandemic with lockdowns among the toughest in the world, according to the Oxford Stringency Index, and as cases dropped, only the UAE has suffered a significant resurgence so far.

Although economic policies have eased to support businesses and households, with central banks cutting interest rates, liquidity provided to banks, and an encouragement to defer loan payments for borrowers, fiscal policy has played an important, but lesser role.

With the loss of oil revenues putting a strain on public finances and with many people employed in public sector jobs, there was less need for a countercyclical fiscal policy response than elsewhere. Nonetheless, tax payments were deferred, funds reallocated to health spending, and targeted support provided for households through income and employment protection programs.

The lockdowns had a severe effect on the region’s non-oil economy. While recent data suggests the contraction in 2020 was somewhat less than the 5.7 per cent projected by the IMF in the October 2020 Middle East Regional Economic Outlook, it was still sizeable.

But with infections remaining relatively low, vaccinations commencing, travel reopening, and sizeable economic support in place, the stage is set for a better 2021 with 2.9 per cent non-oil growth forecast in the Gulf this year – slightly higher than anticipated overall GDP growth at 2.3 per cent because oil production is likely to remain subdued under the OPEC+ agreement.

Key takeaways from the twin-crises

The pandemic has reaffirmed economic challenges facing the Gulf, not altered them. It has confirmed the importance of having strong fiscal and financial buffers to manage the impact of oil price volatility and to push forward diversification efforts.

Short-term fiscal dynamics in Bahrain and Oman were difficult before the COVID-19 crisis and have become more so since, although important steps are being put in place to bring about needed adjustment. While for all the Gulf countries the peak in oil revenues predicted to be a couple of decades away may now occur sooner if a ‘green’ global recovery emerges.

Efforts to transform Gulf economies may be more challenging if foreign capital and skilled foreign labour become harder to attract, and the labour-intensive tourism and hospitality sectors which are central to most diversification plans face significant issues until confidence in travel is fully restored.

But the importance of a more diversified economy remains undimmed, so the reforms underway since the oil price crash in 2014 – many under the banner of various ‘vision’ programs – need to continue to be driven forward as the pandemic subsides. The pace, sequence, and timing will be paramount to their success.

Strong public sector balance sheets have allowed most Gulf countries the flexibility to run large fiscal deficits during the crisis. The region-wide fiscal deficit is estimated at 9.2 per cent of GDP in 2020, up from two per cent of GDP in 2019.

Financed from the drawdown of assets and new borrowing, fiscal buffers provide critical insurance against the need to tighten fiscal policy in a countercyclical way. Gulf governments and quasi-government entities were among the largest borrowers in international markets in 2020, with government debt issuance alone at over $50 billion and total debt issuance more than three times this amount.

Reform priorities

As the effects of COVID-19 wane, fiscal deficits need to be reduced and the structure of revenues and expenditures realigned, which will continue to alter the relationship between the state and its citizens.

The introduction of new taxes – excises, the value-added tax, and possibly income taxes as announced in the case of Oman – the phasing-out of energy price subsidies, and ultimately the scaling back of large public sector wage bills are all needed to keep the government budget on an even keel. Kuwait, Qatar, and UAE have more breathing space given their higher per capita resource revenues.

Reductions in select capital expenditures would also support fiscal balancing across the GCC. Scaling down of large capital spending projects which do not contribute to essential infrastructure would be prudent.

Ultimately, if diversification is to succeed, the relationship between state and private companies will need to change. Private companies are accustomed to building up business from government contracts or by selling goods and services to ‘national’ households who are disproportionately the recipients of public sector wages.

The ready supply of low-wage expatriate labour means good profits are made but productivity is generally low and appears to have declined further over the past decade. For private companies, expatriate labour has been more attractive than national labour because expatriates work longer hours for lower wages and have limited bargaining power under the Kafala sponsorship systems, although these systems are now beginning to be reformed.

Incentives for companies have pointed heavily to a focus on non-traded rather than more competitive-traded sectors. But the challenges are intertwined because the government remains the employer of ‘first and last resort’ for nationals, making meaningful headway on fiscal reforms more difficult.

Without a more dynamic private sector creating jobs for nationals, reforms to scale back public employment will not be socially or politically palatable. Labour market policies need to encourage nationals to work in the private sector and companies to hire them, while continuing to attract the high-skilled foreign labour needed to support the diversification plans.

Governments can galvanize behavioural change. They should clearly communicate that public sector job opportunities will be limited in the future given fiscal constraints. This would help reduce the reservation wage for nationals to take private sector jobs and, in turn, support the employment nationalization policies.

Companies also need to do more to offer attractive working conditions, such as on-the-job training, more flexible work arrangements, and a greater focus on career development.

Reforms are ongoing to encourage greater national female participation in the workforce. Important gains have been made, although female participation still remains far too low in most GCC countries, at 32 per cent on average, compared to 82 per cent for men. Just from the economic side, this low female labour force participation results in a significant loss of output and income.

Important reforms encouraging a fairer and more competitive market for expatriate workers are underway and need to be broadened and deepened. The Kafala system has effectively been dismantled in Qatar and significant reforms have been announced in Saudi Arabia, but the extent of actual change will depend on implementation on the ground.

Increasing foreign direct investment (FDI) is understandably a central goal given the technology transfer it can bring, but Gulf residents do hold significant assets overseas which, under the right conditions, could at least in part be attracted back into investments for financial and physical capital. These investments can spur the creation of well-paying jobs that are attractive to nationals if skills and human capital are developed at the same time.

An evolved role for the state

Stable and predictable policy environments as well as reduced geopolitical risks – the recent GCC reconciliation agreement is important in this regard – help minimize transaction costs and provide an environment attractive to foreign and domestic investors.

Enabling private investment into a greener recovery propelled by digitalization and new technologies further improves prospects for developing a less government-dependent private sector across the GCC. This enables governments to transition away from being owner, producer, and distributor to being arbiter, regulator, and facilitator.

The role of the state in developing and diversifying economies is critical. State-run entities have the financial firepower and political support to make large investments and take risks that the private sector is unable or unwilling to do, but they may also take on projects where there is no market test before large sums of money are committed. State intervention also risks crowding out the private sector.

Striking the right balance is essential. The state should primarily focus its efforts on providing quality infrastructure, a sound legal and regulatory framework, and appropriate time-limited financial incentives to private sector investors where needed.

If direct investments are to be made by the state, they should be in areas where the private sector will not tread in the early stages of development, should be subject to rigorous cost-benefit analysis to ensure they add value rather than become a drain on state resources, and should have a plan for how the state will eventually exit and allow greater private involvement.

The views expressed are those of the authors and do not represent the views of the IMF, its Executive Board, or IMF Management.