Articles by Albert Einstein Leadership Beyond Oil: Reappraising The Gulf States

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Beyond Oil: Reappraising The Gulf States

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Further reform will be essential if one of the world?s fastest-growing regions is to seize a broader role in the global economy

The high price of oil presents the leaders of the Gulf Cooperation Council (GCC) states?Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates (UAE)?with a singular opportunity to diversify their economies beyond hydrocarbons. How they manage that opportunity has far-reaching implications not only for their own populations but also for the entire global economy.

The challenge before these leaders is substantial. Unemployment is high, particularly among the young, and in the years ahead the GCC states must create millions of new private-sector jobs. Doing so will require crucial reforms to labor markets and to financial and educational systems.

Can the GCC states do it? Skeptics, noting that countries rich in natural resources?especially oil?often struggle to manage their wealth, argue that the current high prices actually present an impediment to reform. We have a different view: given the growing pressure within the GCC states to reduce unemployment and provide jobs for an unusually young labor force, oil revenues will serve as a catalyst to continue the reforms needed to break away from the boom-and-bust cycles that volatile energy prices create.

Already, the region?s dynamism has fostered some noticeable changes, evident in areas as diverse as the Dubai skyline and greater foreign interest in the region. Foreign direct investment into the GCC, for example, rose from just under $2 billion in 2001 to more than $20 billion in 2005?a trend that will help integrate the GCC?s insular economies into the global economy and provide an additional impetus for reform. Roughly $1 trillion in infrastructure investments are now in the pipeline, and by decade?s end they could total $3 trillion.

Although in recent years the region has posted real growth rates of about 7 percent?low compared with those of China and India?its growth is stronger than that figure suggests. Nominal (rather than real) growth is about 20 percent a year (according to figures from 2003 to 2005)?among the world?s fastest rates. For the GCC, nominal growth more accurately reflects the region?s dynamism, since real growth rates treat oil price hikes as inflation and don?t take into account the fact that much of the revenue that oil producers earn comes in US dollars.

The stakes are high not only for the GCC states but for the rest of the world as well. Beyond the obvious political importance of a stable GCC, developments in the region could shape global investment flows more and more significantly. This influence is already visible. The combination of ever-stronger institutions, ambitious leaders, and sustained oil income?coupled with comparatively lower growth in a more challenging West?has prompted the GCC states to look to the East. Whereas five years ago investment portfolios were predominantly passive and concentrated in North America and Europe, Gulf investors are now hungry to identify opportunities in Asia (and Africa), where they are looking for influence as well as returns. If current trends continue, the Gulf will play a central role in channeling oil income generated in the West to investments in the East. Thus might the GCC states become key players in the financing of a new Silk Road (see ?The new Silk Road: Opportunities for Asia and the Gulf?).

The pressure for reform

During the oil price surges of the mid-1970s and early 1980s, most of the GCC states were newly founded and lacked institutions that could absorb a six-fold increase in revenue. Today, disciplined fiscal regimes and debt reduction policies suggest that the region?s governments have the political will to cope with this latest oil windfall. From 2002 to 2006, annual GCC revenues from gas and oil more than tripled, rising to $325 billion, from $100 billion. During the same period, government spending increased by a comparatively modest 74 percent, to $207 billion, from $119 billion,1 mainly to finance health and education initiatives. In addition, much of the current windfall has been used to cut the region?s external debt, which grew considerably during the 1980s and 1990s. In Saudi Arabia, for example, it fell from a peak of 97 percent of GDP in 2002 to less than 41 percent in 2005, while in Kuwait during the same period it declined to 17 percent of GDP, from 32 percent.

Beyond political will, three powerful factors are pushing reform forward: falling per capita oil and gas production, a growing mass of unemployed youth, and an inefficient financial system that allocates capital poorly.

Not enough to go around

The GCC?s pace of reform has been uneven, and one crucial factor is the ratio between oil and gas production and the number of citizens. Countries with relatively little oil and gas production per citizen will find it increasingly difficult to sustain their standard of living. It may come as a surprise that Saudi Arabia, the world?s largest oil producer, falls in this category: its production per citizen is one-sixth of the UAE?s, so its oil revenues are spread much more thinly across the population.

Saudi Arabia?s rapid population growth far outpaces oil production, and the kingdom faces increasing pressure to reform its economic and social model. In response, it has adopted a two-track approach: fixing the old and creating the new. To fix the old, Saudi Arabia has joined the World Trade Organization, cut import duties, privatized telecommunications, and prepared to liberalize the airline industry. To create the new, it has embarked on a $200 billion initiative to develop new cities and economic zones with regulations that are friendly to the private sector (see below *, ?Creating a new Saudi economy?). Taken together, these initiatives show a major commitment to decentralize power away from the conservative heartland surrounding Riyadh.

Bahrain, which similarly has a low level of oil and gas production per citizen, has also moved forward, embarking on deep political and economic reforms highlighted by the adoption of a constitutional monarchy, in 2002. It held its second parliamentary elections this past November and is modernizing its labor and property markets, as well as its health care and education systems (see ?Meeting Bahrain?s challenges: An interview with Crown Prince Salman bin Hamad Al-Khalifa?).

Jobless youth

The GCC has one of the world?s youngest and fastest-growing populations for example, 61 percent of Saudi Arabia?s population is under 25 years old, compared with 50 percent of India?s, 39 percent of China?s, and 30 percent of Europe?s.2 A young labor force is normally an asset, since it replenishes the private sector and drives economic growth. But young GCC nationals face a future of underemployment or no employment at all; the educational system has failed to prepare them for the rigors of working in the private sector.

During the oil booms, the GCC states offered their nationals work in government offices or government-owned entities, often with salaries twice those that the private sector paid for jobs at similar skill levels. But now the public sector is saturated. The number of jobs in it has not kept pace with the growth of the workforce, nor wages with inflation.

Unemployment and underemployment have therefore grown at an alarming rate. Official statistics put the Saudi unemployment rate at 11 percent in 2005, while the unemployment rate among 20- to 24-year-old men was 28 percent. Unofficial estimates put overall unemployment in Saudi Arabia, Bahrain, and Oman?the three GCC states facing the greatest pressure?at 15 percent or more, and unemployment among 16- to 24-year-olds at more than 35 percent.

The task of job creation will be a massive one. Over the past ten years, the private sector has created about 55,000 medium- and high-skilled jobs a year. To absorb the number of GCC nationals with a secondary-school degree or higher, the annual figure must rise fivefold, to almost 300,000. To provide a living wage, these jobs must pay at least twice what private-sector jobs do now.

Starved of capital

In a region flooded with excess cash, weak capital markets and banks prevent adequate funds from reaching small and midsize businesses, which in most economies are the engine of growth, innovation, and employment. The GCC?s financial system instead channels funds to large government-owned enterprises and to elite businesses, while starving others.

As in many emerging markets, a substantial part of the problem is the inability of local banks to assess credit risk accurately, for the region lacks credit bureaus, asset registrars, or local credit-rating agencies. Without this kind of infrastructure, banks manage risk by channeling funds to safer borrowers, such as state-owned enterprises and large companies. The GCC?s nascent capital markets, which are insufficiently liquid and rife with inefficiencies, exacerbate the problem.

Priorities to create a modern economy

The GCC?s $2 trillion to $3 trillion oil windfall over the next decade presents an opportunity to take on the monumental challenge of creating 300,000 high-quality private-sector jobs annually at twice the current salaries. Although the early signs are promising, the region?s efforts have only begun. To seize the opportunity, the GCC must make much-needed reforms in three vital areas: labor markets, education, and financial markets. Only then can it build modern economies that create value through productivity rather than distributing wealth earned from a depleting resource.

Labor market reform

Most of the world?s countries run tight immigration policies but create flexible labor markets. They make it hard to obtain work permits but relatively easy to switch jobs once a permit has been granted. High immigration barriers protect national workers, and foreigners get permission to take jobs only when local skills?usually high-level ones?are clearly in short supply. Thus, the interests of citizens come before those of corporations.

The GCC model is quite the opposite: immigration policies are flexible, labor markets rigid. Foreigners account for at least 40 percent of the GCC?s labor force and in some countries hold 90 percent or more of all private-sector jobs. The result is a ?race to the bottom,? with businesses searching the world for the cheapest sources of labor rather than investing in building the skills of the national workforce and increasing that country?s labor productivity. Access to an almost infinite supply of low-cost labor may benefit businesses in the short run, but that course is unsustainable because it harms the prospects of young nationals, who are usually the last choice of private employers.

Painful and fundamental labor reform is therefore needed to free the private sector?s job-creating power (see ?Getting labor policy to work in the Gulf,? coming mid-February). To support higher wages for nationals, productivity?particularly labor productivity?must increase substantially. Yet over the past decade, the private sector?s productivity has declined by 20 to 35 percent because companies rely on low-cost labor and shun capital investments that generate more productive, higher-value-added (and better-paying) jobs.

The first step in reforming labor markets is to tighten immigration policies in order to wean employers from this dependence on foreign workers. Another step would be to increase the cost of foreign labor?for instance, by levying a tax on those who employ them. Such taxes would help governments manage the inflow of cheap foreign labor and encourage private companies to invest in labor-saving technologies and to create higher-value-added jobs. Governments will also have to focus on building the skills and capabilities of national workers to prepare them for the private sector?s less forgiving environment.

Labor market reform is likely to become the single biggest driver of change in the Gulf. Young job seekers will find it increasingly difficult to accept the idea that the only private-sector jobs in fast-growing economies are designed for expatriates, with salaries that don?t meet local standards. This reality alone should steel GCC leaders to continue the painful but vital changes. In addition, international pressure for fundamental reform will grow, for as GCC states integrate themselves further into the global economy and seek trade agreements with other nations, their labor policies will come under greater scrutiny, and external pressure will build to bring their labor markets up to global standards. The direction of change is clear, though the speed of reform is not.

Educational reform

GCC schools at all levels are failing to produce students with the skills and attitudes a modern productive economy requires. Part of the oil windfall should therefore be spent on improving the quality of schools, from kindergarten through higher education, including vocational education (see ?Improving education in the Gulf,? coming in mid-March). Simply buying more equipment or hiring more teachers won?t solve the problem, because the GCC already has some of the world?s lowest student-teacher ratios. Instead, governments must focus on improving the quality of teaching by setting up better training programs for teachers and paying them (and administrators) enough to make those jobs desirable. Independent third parties should inspect schools and develop examinations for students to help ensure that educational institutions perform well against clear standards and that low-performing institutions improve. In addition, school curriculums must reflect the future demands of a modern private economy.

Educational reform is a sensitive topic in many places. In the GCC, religious and cultural influences make it especially difficult. Despite these unique challenges, most GCC states have started to improve their educational systems. In the UAE, for example, Abu Dhabi has formed an alliance with Singapore?s National Institute of Education (NIE), which will provide teacher training.

Financial markets

We estimate that by allocating funds to the best opportunities and by nurturing capital-starved small and midsize businesses, reformed GCC financial systems could create more than two million new jobs in the region over the next decade. These jobs would come in part from efforts (such as those in Bahrain and Dubai) to create credit bureaus for regional markets, but deeper and more efficient capital markets would have the biggest impact.

Equity markets in the GCC are reasonably well developed; their market capitalization rose from $135 billion in 2001 to $694 billion in December 2006, an annual average growth rate of 39 percent. As a percentage of GDP, that level of market capitalization is much higher than even the hottest emerging markets, such as China and India, can boast; indeed, it is more in line with levels in mature developed markets. Yet the GCC?s equity markets could develop further if its governments supported them more directly?by floating shares of government-owned companies, for instance, or by encouraging state investment companies to trade more actively. Both moves could create much-needed market liquidity. Greater transparency and better protection for investors, as well as enforcement of sound corporate-governance standards, would help reduce speculation and free investors to base their actions on market fundamentals.

Governments should also bolster the region?s small and relatively illiquid bond markets by issuing bonds regularly to establish a yield curve and to help markets price debt adequately. This step may sound unnecessary given the current fiscal surpluses throughout the GCC, but Singapore has shown that a disciplined public-debt program can have powerful effects even in such comfortable situations.

Although much remains to be done, most GCC states have taken initial steps to address some of these issues: for example, Saudi Arabia, with the region?s largest capital market, created an independent Capital Market Authority in 2004. This new body is redrafting the kingdom?s capital markets laws according to international standards. Similar efforts are under way in the UAE and are planned for Qatar.

The region?s leaders are increasingly confident that it will soon take a broader role in the global economy, beyond gas and oil. It is already one of the world?s fastest-growing regions. Further reform is essential, however, if its economies are to evolve beyond hydrocarbons.

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*Creating a new Saudi economy

Saudi Arabia is undergoing a remarkable economic transformation that few outside the GCC have noticed. By building six new cities in different regions of the kingdom, its leaders are creating the foundations of a modern economy driven by private investors.

Within a decade, the six cities will become the main vehicle for attracting domestic and foreign investment, with desirable living and working conditions for about 2.5 million people, or about one Saudi national in ten. The cities will also promote economic development in regions that have until now largely been ignored and help decentralize and balance the economy. Investments in these economic centers are expected to total more than $200 billion. The Saudi Arabian General Investment Authority (SAGIA), the project?s regulator, promoter, and administrator, is learning from Dubai?s experience in creating a new economic and regulatory environment.

The largest of these centers will be King Abdullah Economic City, extending along 35 kilometers (22 miles) of shoreline near the city of Rabegh and designed to house more than 1.5 million people. Our forecasts indicate that about 800,000 jobs will be created there, with a massive seaport, light industries, facilities for tourism, and financial services. Two other cities have already been launched officially. Prince Abdulaziz bin Mousaed Economic City (in the northern province of Hail) will emphasize agri-business, mining, and manufacturing. Knowledge Economic City (in Madinah) will focus on academic institutions, research, and the kingdom?s Islamic heritage. Recently, plans for three more economic cities were announced, most notably the Energy Economic City (in the Eastern Province), which alone will have a population larger than neighboring Bahrain.

Behind this project stands a diverse group of private-sector investors, including the UAE real-estate giant Emaar Properties, Saudi Savola, and financial investors such as Gulf Finance House and Rakisa Holding. One of the conditions for participating in the project is that 30 percent of the shares of the developers involved must be offered to the public, including a broad range of Saudi private investors. The initial public offering of King Abdullah Economic City, the first to reach the market, was heavily oversubscribed, and share prices more than quadrupled in the first three months.

This Article is authored / contributed by ▸ Albert Einstein who travels from Ulm, Germany. Albert is available for Professional Training Work both Virtually and In-Person. ▸ Enquire Now.