## EXECUTIVE SUMMARY (_042916)

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### INTRODUCTION
- Paper produced at the request of the Arab Monetary Fund to support a discussion among Arab Finance Ministers on economic diversification in oil-exporting Arab countries.
- Focus countries: Algeria, Bahrain, Iraq, Kuwait, Libya, Oman, Qatar, Saudi Arabia, United Arab Emirates, and Yemen.
- Paper organized in two parts:
  - Part 1: Stylized facts on oil-exporting Arab countries and motivation for diversification; emphasizes heterogeneity across countries and the increasing need for diversification in the context of likely durably lower oil prices.
  - Part 2: Policy discussion on macroeconomic stability, regulatory and institutional frameworks, public sector role, and paths to a more diversified economy.

### KEY FINDINGS / STYLIZED FACTS
- Common challenges:
  - Creating jobs for rapidly growing populations.
  - Insulating economies from oil price volatility.
  - Ensuring sustainable growth once oil resources are depleted.
- Hydrocarbons dominate activity, fiscal revenue, exports, and foreign exchange in all countries (hydrocarbons used interchangeably with “oil”; gas included in some countries).
- Activity and structure:
  - Hydrocarbon and government activities account for the majority of total GDP in all countries except Algeria, Bahrain, Yemen, and the UAE.
  - Example: in Libya the non-oil and non-government share in GDP is about 1/6th of total GDP.
- Fiscal revenue:
  - In 2014, the share of oil revenue in total revenue ranged from 47 percent in Yemen to 94 percent in Iraq and averaged 77 percent across the group.
- Exports:
  - Oil is the main export good in all countries except the UAE.
  - Oil accounts for above 80 percent of total exports in half of the countries in the group, and above 60 percent in all except the UAE.
  - Re-exports accounted 24 percent of total non-oil exports of the UAE in 2014 (UN Comtrade).
- Labor and private sector:
  - Non-oil private sector remains relatively small and has been a limited source of growth and employment; energy sector is highly capital intensive and creates few direct jobs.
  - Nationals in the GCC fill over 70 percent of public sector jobs.
  - About 88 percent of 5.4 million private sector jobs created between 2000 and 2010 were filled by foreign workers (about 85 percent of them with low skills).
- Diversification indicators:
  - Economic complexity, diversity, and export-quality indicators are generally lower in oil-exporting Arab economies than in many emerging market economies and other commodity exporters.
  - Integration in global value chains remains low.
- Volatility and intergenerational equity:
  - Over-reliance on oil exacerbates macroeconomic volatility; oil price drops reduce fiscal revenue and often force cuts in public spending that dampen non-oil sector growth.
  - Hydrocarbon resources in a number of Arab countries could be depleted in the foreseeable future; even countries with large proven reserves should save a larger share of current oil income to promote greater intergenerational equity.
- Security:
  - Restoration of political stability and security is a necessary precondition to economic diversification for countries affected by wars (Iraq, Libya, Yemen).

### MACROECONOMIC PRE-CONDITIONS TO ECONOMIC DIVERSIFICATION
- Insulation from oil price volatility requires:
  - Sound fiscal policy and framework.
  - Effective liquidity management and prudent monetary policy.
  - Supportive financial sector policies and a fairly valued exchange rate.
- Specific public finance actions:
  - Develop a robust fiscal framework, based on a fiscal rule, to help achieve short and long-term objectives.
  - Ensure that the use of oil funds is governed by clear and transparent rules.
  - Improve liquidity management, including liquidity forecasting and the interbank market operations.
  - Develop strong regulatory, supervisory and macro-prudential frameworks to enhance resilience of the financial sector to the volatility of oil prices.
  - Promote a fairly valued real effective exchange rate.

### FISCAL CHALLENGES FROM OIL PRICE VOLATILITY AND EXHAUSTIBILITY
- Price volatility and exhaustibility:
  - Unpredictable oil price fluctuations can be very large and sometimes persistent; expenditure is normally stickier than revenue.
  - Illustrative indicator: the fiscal break-even price for oil-exporting countries. In 2015, none of the oil-exporting Arab countries is estimated to have had a fiscal break-even price below the actual oil price.
  - Trade-off between current distribution pressures (wages, subsidies) and intergenerational equity (health, education, investment, asset accumulation).
- Short-term fiscal consolidation and spending composition:
  - Immediate concern: size of fiscal deficits and their impact on debt sustainability.
  - Policy priorities:
    - Preserve fiscal space for growth-enhancing spending while maintaining fiscal sustainability.
    - Increase non-oil revenue, notably through broadening the tax base (examples: GCC countries considering VAT; Kuwait considering a profit tax; Saudi Arabia considering increases in excises).
    - Expenditure restraint and reorientation toward high-quality investment in infrastructure and human capital.
- Strengthening the fiscal framework:
  - Build appropriate buffers to manage oil price shocks and support long-term sustainability and intergenerational equity.
  - Consider long-term fiscal anchors and possibly a fiscal rule (e.g., based on non-oil deficit consistent with the Permanent Income Hypothesis).
  - Dedicated oil funds governed by clear and transparent rules and fully integrated with the budget.
  - Country example: Qatar established a 10-year cap on public investments and prepared a draft medium-term fiscal framework and showed expenditure restraint even before oil prices fell.
- Effective liquidity management:
  - Many countries faced excess liquidity until recently, weakening monetary transmission and increasing risks of credit booms and inflation volatility; the recent decline in oil prices has contributed to a drying up of excess liquidity.
  - Oil price downturns are typically associated with large drawdowns in government deposits in the banking system, contributing to sharp declines in money supply.
  - Policy tools and recommendations:
    - Better calibrate liquidity for banks, supported by a government savings vehicle that invests externally (sovereign-wealth fund).
    - Enhance liquidity forecasting and implement measures to appropriately calibrate liquidity in banks, including facilities to respond to bank liquidity needs and development of appropriate collateral.
    - Reactivate interbank markets and facilitate implementation of an interest-rate based monetary policy framework.
    - Sovereign-wealth funds invested abroad can insulate domestic liquidity; Bahrain, Kuwait, Libya, Qatar, and the UAE have sovereign wealth funds.
- Financial-sector policies to mitigate macro-financial linkages:
  - Strengthen regulatory and supervisory frameworks and use macro-prudential measures (countercyclical capital and liquidity buffers, dynamic loan-loss provisioning) to increase resilience and reduce procyclicality.
  - Promote portfolio and financial diversification to mitigate concentration risk, particularly in GCC.
- Exchange rate and Dutch disease:
  - Maintain a fairly valued real effective exchange rate; avoid overvaluation that reduces incentives to invest in non-extractive sectors and undervaluation that can cause inefficient allocation.

### REGULATORY AND INSTITUTIONAL FRAMEWORKS CONDUCIVE TO PRIVATE SECTOR GROWTH
- Business environment and competition:
  - GCC countries’ business climate remains relatively favorable; Algeria, Iraq, Libya, and Yemen rank low in World Bank doing business indicators.
  - Common regional challenges: streamline procedures, e-government, improve insolvency resolution, contract enforcement, minority investor protection, and foster greater access to credit.
  - Reduce regulatory barriers to competition; many sectors are dominated by state ownership causing concentration and inefficiency.
  - Example: Kuwait could benefit from reviewing competition policy law and implementation and policies related to barriers to entry.
- Trade integration:
  - Intra-regional trade flows remain low (about 12 percent on average) and largely consist of trade in oil.
  - Existing agreements (PAFTA, 1997; UEA-GCC, 1998) have not significantly boosted intra-regional trade.
  - Non-tariff barriers (lengthy customs clearance procedures, high number of documents and signatures) remain important barriers.
  - Promote deeper regional integration by reducing these barriers, liberalizing trade services, and strengthening rules applicable to regional trade.
  - GCC countries are more integrated than the rest of the region; some countries (e.g., Bahrain) have seen opportunities from regional business integration with Saudi Arabia, Kuwait, and the UAE.

### LABOR MARKETS, SME FINANCE, AND ACCESS TO CREDIT
- Labor regulations and flexibility:
  - Labor markets are relatively flexible in most GCC countries; regulations are considered restrictive in some areas (Algeria, Kuwait, Oman, and to a lesser extent Saudi Arabia).
  - Reforms underway in several countries:
    - Saudi Arabia: implementing labor market reform to streamline regulations and ease female employment restrictions.
    - Oman: updating the labor law to amend labor dispute resolution, private sector working conditions, and working conditions for women.
  - Recommendation: reforms to increase labor force flexibility while fostering better working conditions and introducing unemployment insurance where absent.
- Access to finance and SME constraints:
  - Low percentage of firms with credit lines or loans; small portion of bank lending goes to SMEs.
  - In Algeria, Iraq, and Yemen, bank lending to private sector only accounts for 10-30 percent of non-oil GDP.
  - Constraints for SMEs: weak credit information, weak creditor rights, insufficient collateral infrastructure.
  - Progress examples:
    - UAE: new law on SMEs and financial infrastructure such as a credit bureau and credit registry.
    - Saudi Arabia: dedicated SME units in banks and a national credit bureau.
    - Algeria: increasing coverage of the credit registry would help SME finance.
  - Policy recommendations: reform financial systems, reduce directed lending, develop domestic securities markets, strengthen credit-assessment tools and creditor rights.

### PUBLIC SECTOR ROLE AND ENABLING PRIVATE-SECTOR GROWTH
- Public sector dominance:
  - Public sector is a dominant allocator of production factors; public enterprises play a very large role even where private sector could provide goods and services.
  - Share of public sector in total GDP remains high in many oil-exporting Arab economies; expansion involves large civil service with generous compensation that reduces incentives for private sector employment and entrepreneurship.
- Policy recommendations to enable private-sector led employment growth:
  - Reduce the size of the public workforce and moderate public wages; implement civil service review to identify nonessential positions.
  - Increase public spending on education where low and enhance quality; orient education and vocational training toward private sector needs and engage private sector in curriculum design.
  - Introduce/improve unemployment insurance schemes to provide minimum income while incentivizing job search.
  - Invest in infrastructure while increasing public investment efficiency and enhance bidding and procurement processes.
  - Reduce excessive monopoly rents in the non-tradable sector by increasing competition and enhancing procurement to boost private sector participation.

### THE ROAD TO A MORE DIVERSE ECONOMY: STRATEGIES AND INDUSTRIAL POLICY
- Innovation dimensions: processes (productivity), products (new sectors), organizations (efficiency).
- Horizontal and vertical diversification strategies:
  - Horizontal diversification: allocate government oil revenues to reduce production costs and raise efficiency in new sectors and encourage entry of new investors.
  - Vertical diversification: move into higher value-added products in mineral and chemical industries.
  - Diversify manufacturing away from oil production and promote deeper integration into global value chains.
- Sequencing and tailoring:
  - Appropriate policy packages and sequencing need to be designed carefully and tailored to each country’s circumstances and capacities.
- Role of targeted industrial policy:
  - Case for industrial policies when dynamic economies of scale, knowledge spillovers, coordination failures, or informational externalities exist.
  - Risks of “picking winners” include reduced incentives for productivity improvements; policies should focus on sectors with clear export potential and strong integration into international value chains.
  - “Soft” industrial policies recommended: increase openness to FDI, set up industrial clusters, develop export processing zones.

### INTEGRATION INTO GLOBAL VALUE CHAINS (GVCs) AND FDI
- GVC integration:
  - Many oil-exporting Arab economies are at the beginning of the process of integrating into global value chains; share of foreign value added in exports remains significantly low.
  - Deeper GVC integration requires exploiting comparative advantage (geographic position, labor intensity), improving technological capacity, higher technical and managerial skills, and competitive wages.
- Country cases:
  - Morocco (Plan Emergence): newly developed industries (automobile, aeronautics, electronics) represented 28 percent of Morocco’s exports as of 2014; traditional sectors textiles 17 percent, phosphate 19 percent (2014); tourism ~10 million tourists per year.
  - Malaysia: moved from 33 percent of GDP from primary commodities in 1980 and 77 percent of exports to diversified manufacturing through Industrial Master Plans (Industrial Master Plan 1: 1986–95; Industrial Master Plan 2: 1996–2005; Industrial Master Plan 3: 2006–20).
- Attracting FDI in non-oil sectors:
  - Oil and gas has been the largest beneficiary of FDI in most oil-exporting Arab countries (example: in Oman around 50 percent of FDI is invested in the oil sector).
  - Policy recommendations: lower entry requirements, create investment-promotion intermediaries, streamline tax structures, eliminate or limit majority-domestic-ownership requirements that deter FDI (except possibly for strategic sectors).
- Empirical cumulative FDI flows (2003–May 2015, Billions of USD):
  - Petroleum: 200.6
  - Real estate: 147.7
  - Chemicals: 76.3
  - Tourism: 50.0
  - Minerals: 46.9
  - Other: 212.6

### CONCLUSION: CHALLENGES, PRECONDITIONS, AND PRIORITIES
- Core challenges:
  - Job-creation.
  - Macroeconomic volatility from oil prices.
  - Depletion of oil resources.
- Observations:
  - Oil sector generates few jobs directly; government sector tends to be the largest employer and offers better compensation than the private sector.
  - Over-reliance on oil exposes revenue and output to oil-price fluctuations; developing adequate non-oil sectors before reserves are depleted is necessary.
- Preconditions for diversification:
  - Strengthen macroeconomic stability.
  - Improve regulatory and institutional frameworks to make markets more flexible and competitive and to spur innovation.
- Policies and strategies to create dynamic tradable sectors:
  - Develop local technological capability.
  - Promote processing of natural resources.
  - Improve competitiveness of non-oil exports.
  - Broaden export base through integration into global value chains to encompass higher value-added activities.
- Security and heterogeneity:
  - Diversification will not be successful without security; conflicts in Iraq, Libya, and Yemen severely disrupt activity and weaken investor confidence.
  - Policies should be tailored to country-specific circumstances and capacities; the recent decline in oil prices has made diversification more urgent.
  - Demographic concern: young and growing labor force; unemployment for youth and women remains high in many countries.
  - Policy balance: safeguard fiscal sustainability while facilitating economic diversification.

*Source: EXECUTIVE SUMMARY and selected excerpts, Economic Diversification in Oil-Exporting Arab Countries (International Monetary Fund, _042916).*

### EXECUTIVE SUMMARY __________________________________________________________________________ 3

### EXECUTIVE SUMMARY

### INTRODUCTION
- Paper produced at the request of the Arab Monetary Fund to support a discussion among Arab Finance Ministers on economic diversification in oil-exporting Arab countries.
- Focus countries: Algeria, Bahrain, Iraq, Kuwait, Libya, Oman, Qatar, Saudi Arabia, United Arab Emirates, and Yemen.
- Paper organized in two parts:
  - Part 1: Stylized facts on oil-exporting Arab countries and motivation for diversification; emphasizes heterogeneity across countries and the increasing need for diversification in the context of likely durably lower oil prices.
  - Part 2: Policy discussion on macroeconomic stability, regulatory and institutional frameworks, public sector role, and paths to a more diversified economy.

### KEY FINDINGS / STYLIZED FACTS
- Common challenges across oil-exporting Arab countries: creating jobs for rapidly growing populations; insulating economies from oil price volatility; ensuring sustainable growth once oil resources are depleted.
- Dominance of oil in activity, fiscal revenue, exports, and foreign exchange in all countries (hydrocarbons used interchangeably with “oil” in the paper; gas included in some countries).
- Activity: Hydrocarbon and government activities account for the majority of total GDP in all countries except Algeria, Bahrain, Yemen, and the UAE. Example: in Libya the non-oil and non-government share in GDP is about 1/6th of total GDP.
- Fiscal revenue: In 2014, the share of oil revenue in total revenue ranged from 47 percent in Yemen to 94 percent in Iraq and averaged 77 percent across the group.
- Exports: Oil is the main export good in all countries except the UAE; oil accounts for above 80 percent of total exports in half of the countries in the group, and above 60 percent in all except the UAE. Re-exports accounted 24 percent of total non-oil exports of the UAE in 2014 (UN Comtrade).
- Non-oil private sector remains relatively small and has been a limited source of growth and employment; energy sector is highly capital intensive and creates few direct jobs.
- Employment situations vary: some GCC economies rely on foreign labor for private-sector jobs while other oil exporters must meet needs of fast-growing domestic labor forces.
- Economic diversification levels: indicators of economic complexity, diversity, and export quality are generally lower in oil-exporting Arab economies than in many emerging market economies and other commodity exporters; integration in global value chains remains low.
- Over-reliance on oil exacerbates macroeconomic volatility: oil price drops reduce fiscal revenue, often forcing cuts in public spending that dampen non-oil sector growth and strain sustainability of public employment.
- Resource depletion and intergenerational equity: hydrocarbon resources in a number of Arab countries could be depleted in the foreseeable future; even countries with large proven reserves should save a larger share of current oil income to promote greater intergenerational equity.
- Security prerequisite: restoration of political stability and security is a necessary precondition to economic diversification for countries affected by wars (Iraq, Libya, Yemen).

### MACROECONOMIC PRE-CONDITIONS TO ECONOMIC DIVERSIFICATION
- Insulation from oil price volatility is necessary and requires:
  - Sound fiscal policy and framework.
  - Effective liquidity management and prudent monetary policy.
  - Supportive financial sector policies and a fairly valued exchange rate.
- Specific recommended public finance actions:
  - Develop a robust fiscal framework, based on a fiscal rule, to help achieve short and long-term objectives.
  - Ensure that the use of oil funds is governed by clear and transparent rules.
  - Improve liquidity management, including liquidity forecasting and the interbank market operations.
  - Develop strong regulatory, supervisory and macro-prudential frameworks to enhance resilience of the financial sector to the volatility of oil prices.
  - Promote a fairly valued real effective exchange rate.

### REGULATORY AND INSTITUTIONAL FRAMEWORKS CONDUCIVE TO PRIVATE SECTOR GROWTH
- Strong regulatory and institutional frameworks needed to unlock private sector potential.
- Key reforms and measures:
  - Streamline government bureaucracy.
  - Reduce regulatory barriers to competition, including reviewing competition policy laws and their implementation.
  - Promote greater trade integration.
  - Review labor regulations to enhance labor market flexibility where needed (e.g., streamline regulations, facilitate labor dispute resolution, and set incentives for higher women participation in the labor force) while fostering better working conditions.
  - Reduce directed lending and develop domestic securities markets to increase access to finance.
  - Improve creditor assessment tools and infrastructure and creditor rights to enhance access to credit, especially for small and medium enterprises (SMEs).

### A PUBLIC SECTOR THAT ENABLES PRIVATE SECTOR GROWTH
- Public sector should enable, not compete with, private sector:
  - Reduce the size of the public work force and the premium of public over private sector wages for comparably qualified employees. Implement civil service review.
  - Increase public spending on education if it is low.
  - Enhance the quality of education, including orienting education and vocational training towards skills needed by the private sector.
  - Introduce/improve unemployment insurance schemes to ensure the unemployed receive minimum income but have proper incentives to look for work.
  - Invest in infrastructure while increasing the efficiency of public investment.
  - Enhance bidding procurement processes.
- Reducing excessive monopoly rents in the nontradable sector by increasing competition and enhancing bidding/procurement would help boost the private sector.

### THE ROAD TO A MORE DIVERSE ECONOMY
- Economic diversification requires innovation in:
  - Processes (to enhance productivity).
  - Products (to sustain growth in new sectors).
  - Organizations (to produce more efficiently).
- Strategies to foster tradable, dynamic new sectors:
  - Foster horizontal diversification by allocating government oil revenues to reduce production costs in new sectors and raise their efficiency while encouraging entry of new investors.
  - Enhance vertical diversification in existing sectors by moving into higher value-added products in mineral and chemical industries.
  - Diversify manufacturing away from oil production.
  - Promote deeper integration in global value chains by enhancing efficiency in production, bolstering managerial quality, improving technological capacity and ensuring wage competitiveness.
  - Improve the climate for FDI, including in non-oil industry, by lowering entry requirements, creating investment promotion intermediaries and streamlining tax structures.
  - Enhance labor market competitiveness through greater focus on wage growth in line with productivity.
- Sequencing and country tailoring: The appropriate policy package and sequencing of reforms need to be designed carefully and tailored to each country’s specific circumstances and capacities.

### KEY RECOMMENDATIONS (SUMMARIZED)
- Macroeconomic pre-conditions:
  - Develop fiscal rule-based framework; transparent governance of oil funds; improve liquidity management; strengthen financial sector regulation; maintain fairly valued real effective exchange rate.
- Regulatory and institutional reforms:
  - Streamline bureaucracy; reduce regulatory barriers to competition; promote trade integration; labor market reforms to enhance flexibility and female participation; deepen domestic securities markets; improve creditor rights and SME finance.
- Public sector reforms:
  - Reduce public workforce size and wage premium; civil service review; increase and improve education spending and vocational alignment; introduce/improve unemployment insurance; invest efficiently in infrastructure; enhance procurement.
- Structural and sectoral policies:
  - Improve FDI climate; promote global value chain integration; support horizontal and vertical diversification strategies; promote manufacturing diversification; align wages with productivity.

*Source: EXECUTIVE SUMMARY, ECONOMIC DIVERSIFICATION IN OIL-EXPORTING ARAB COUNTRIES (INTERNATIONAL MONETARY FUND).*

### Box 1. Measuring Economic Diversification: Concepts and Indicators

### Box 1. Measuring Economic Diversification: Concepts and Indicators

### Overview
- Economic diversification can be defined and measured in various ways. Beyond simpler measures of sectoral diversification, this box measures diversification through four specific indicators from the literature.

### Economic Complexity Index
- Measures the number of products made by an economy and controls for the likelihood that the same product is also made by others.
- Countries that produce goods or services that are not made elsewhere receive higher complexity scores than countries whose products are widely manufactured.
- Relies on international trade data and is based on the assumption that countries will export most high-quality products, and thus, trade data will reflect overall production within the economy.
- Example: Germany and Japan have high scores because they manufacture a wide array of products that very few countries can make.

### IMF Export Diversification Index
- Calculated using trade data and is a combined measure of the ‘extensive’ and ‘intensive’ dimensions of diversification (also available as separate indices).
- Extensive export diversification:
  - Reflects an increase in the number of export products or trading partners.
- Intensive export diversification:
  - Considers the shares of export volumes across active products or trading partners.
- Interpretation:
  - A country is less diversified when export revenues are driven by only a few sectors, trading partners, and/or total market share is low.
  - Countries with a large number of exports and trading partners improve their extensive diversification, which in turn provides resilience to market or trading-partner shocks.
  - Claiming greater market share (by product or country) increases intensive diversification, which confers greater pricing power and integration into supply-chains.
- Construction:
  - The Theil index, a measure of inequality, is calculated for the intensive and extensive components of each country/year pair and summed to create a synthetic indicator.

### IMF Export Quality Index
- Describes the average quality within any product category.
- Baseline methodology (see Henn et al., (2013) for more details) estimates quality based on trade price, which is calculated in turn based on three factors:
  - product unit value relative to market prices;
  - exporter income per capita (as a proxy for differences in production technologies);
  - the distance between importer and exporter.

### Manufacturing Value-Added Gini
- A Gini index constructed on the relative value-added of different manufacturing industries within an economy.
- Data source: 2015 UNIDO INDSTAT4 Industrial Statistics Database, which provides manufacturing data disaggregated at the ISIC 3-digit level, including the total value added of each industry classified.
- Interpretation:
  - A score of 0 indicates complete equality between industries’ value-added within an economy.
  - A score of 1 indicates the complete dominance of only one industry.

*Box 1. Measuring Economic Diversification: Concepts and Indicators.*

### 14.      Oil-exporting Arab economies face a number of competing fiscal objectives in both

### 14.      Oil-exporting Arab economies face a number of competing fiscal objectives in both the short and long term

### Fiscal challenges from oil price volatility and exhaustibility
- Unpredictable oil price fluctuations can be very large and sometimes persistent; expenditure is normally stickier than revenue, so most volatility in oil revenue tends to translate into the fiscal balance in the short term.
- Illustrative indicator: the fiscal break-even price for oil-exporting countries (level of oil prices below which budget deficits occur absent a reduction in expenditure).
  - In 2015, none of the oil-exporting Arab countries is estimated to have had a fiscal break-even price below the actual oil price.
- Exhaustibility of oil reserves requires balancing current distribution pressures (wages, subsidies) against intergenerational equity (higher quality spending in health, education, and investment and accumulation of assets to sustain per-capita spending after reserves run out).
- Trade-off: how much to save versus spend of current oil revenue, considering intergenerational equity and price volatility to create buffers.
- Empirical point: countries that scaled up spending at a gradual pace, and those that have stabilization buffers are better prepared to manage sharp falls in prices. (See IMF Fiscal Monitor, October 2015.)

### Short-term fiscal consolidation and spending composition
- Current low oil prices exacerbate challenges and call for fiscal consolidation that is as growth friendly as possible.
- Immediate concern: size of fiscal deficits and their impact on debt sustainability.
- Policy priorities:
  - Preserve fiscal space for growth-enhancing spending while maintaining fiscal sustainability.
  - Increase non-oil revenue, notably through broadening the tax base.
    - Example initiatives mentioned: GCC countries considering adopting a VAT; Kuwait considering introduction of a profit tax; Saudi Arabia considering increases in excises.
  - Expenditure restraint and reorienting composition toward high-quality investment in infrastructure and human capital to bolster productive capacity and support diversification.
- Risks: responding to distribution pressures by raising current spending while curtailing investment during downtimes can lower potential growth and reduce competitiveness of the private non-oil sector (e.g., raising reservation wages).

### Strengthening the fiscal framework
- Need for a robust fiscal framework to navigate short- and long-term considerations:
  - Build appropriate buffers to manage oil price shocks to mitigate overspending in good times and overconsolidating when oil prices fall.
  - Support long-term sustainability and intergenerational equity.
- Elements of a stronger framework:
  - Long-term fiscal anchors and possibly a fiscal rule (e.g., based on non-oil deficit consistent with the Permanent Income Hypothesis).
  - Dedicated oil funds governed by clear and transparent rules and fully integrated with the budget.
- Country example: Qatar established a 10-year cap on public investments and prepared a draft medium-term fiscal framework and showed expenditure restraint even before oil prices fell.
- Even countries with large proven reserves and a budgetary surplus might need additional efforts to promote greater intergenerational equity.

### Effective liquidity management
- Objective: shield domestic liquidity needs from oil revenue fluctuations.
- Problems:
  - Many oil-exporting Arab economies faced excess liquidity until recently, weakening monetary transmission and increasing risks of credit booms and inflation volatility.
  - The recent decline in oil prices has contributed to a drying up of excess liquidity in many oil-exporting Arab economies (e.g., Algeria, the GCC); concern that liquidity might become too tight in some countries.
  - Oil price downturns typically associated with large drawdowns in government deposits in the banking system as governments attempt to sustain spending—contributing to sharp declines in money supply (both net foreign assets and net domestic claims decline).
  - Commercial banking systems could face liquidity crunches as deposits dry up, leading to sharp interest rate surges; tight liquidity could affect private sector credit growth, especially as government borrowing from the banking system picks up.
- Policy tools and recommendations:
  - Better calibrate liquidity for banks, supported by a government savings vehicle that invests externally (sovereign-wealth fund).
  - Enhance liquidity forecasting and implement measures to appropriately calibrate liquidity in banks, including facilities to respond to bank liquidity needs and development of appropriate collateral.
  - Reactivate interbank markets and facilitate implementation of an interest-rate based monetary policy framework.
  - Sovereign-wealth funds invested abroad can insulate domestic liquidity from large swings in oil revenue.
  - Note: Among oil-exporting Arab countries, Bahrain, Kuwait, Libya, Qatar, and the UAE have sovereign wealth funds.

### Financial-sector policies to mitigate macro-financial linkages
- Oil price shocks can amplify vulnerabilities through macro-financial linkages:
  - Upturns: deposits increase, excess liquidity, potential credit booms—particularly in real estate—ballooning bank balance sheets and asset bubbles.
  - Downturns: rapid reversals can amplify strains in the financial sector and real economy.
- Recommended financial policies:
  - Strengthen regulatory and supervisory frameworks.
  - Use macro-prudential measures to shield the economy from financial shocks resulting from buildup of vulnerabilities.
  - Implement countercyclical macroprudential policies to mitigate credit and liquidity risk generated by feedback loops between oil prices, bank balance sheets, and asset prices.
    - Specific measures: countercyclical capital and liquidity buffers and dynamic loan-loss provisioning in good times to increase resilience and reduce procyclicality between asset prices and credit.
  - Promote portfolio and financial diversification to mitigate concentration risk, particularly in GCC.

### Exchange rate and Dutch disease considerations
- Maintain a fairly valued real effective exchange rate to support diversification.
  - Overvaluation (Dutch disease) reduces incentives to invest in non-extractive sectors by causing real appreciation and distorting relative prices of tradable vs non-tradable goods.
  - Undervaluation may yield short-term gains but can cause inefficient resource allocation and support firms that are less competitive than foreign peers.

### Regulatory and institutional frameworks conducive to private-sector growth
- Business environment improvements needed to promote private sector development and economic diversification:
  - For GCC countries business climate remains relatively favorable; other oil-exporting Arab countries (Algeria, Iraq, Libya, and Yemen) rank low in World Bank doing business indicators.
  - Common regional challenges: increase efficiency of government administration (streamline procedures, e-government), improve legal framework (insolvency resolution, contract enforcement, minority investor protection), foster greater access to credit.
  - Government efforts should ensure private enterprises operate in an efficient, transparent, and streamlined environment.
- Reducing regulatory barriers to competition:
  - Many sectors are dominated by state ownership, creating concentration and inefficiency that impede private sector development.
  - Review regulations to increase competition and strengthen competition authorities and laws to open markets to private enterprises.
  - Country example: in Kuwait, reviewing competition policy law and implementation and policies related to barriers to entry could help increase competition.
- Trade integration to support export diversification:
  - Arab countries are fairly integrated through labor mobility and infrastructure but intra-regional trade flows remain low (about 12 percent on average) and largely consist of trade in oil.
  - Existing agreements (PAFTA, 1997; UEA-GCC, 1998) have not significantly boosted intra-regional trade.
  - Non-tariff barriers (lengthy customs clearance procedures, high number of documents and signatures) remain important barriers.
  - Promoting deeper regional integration requires reducing these barriers, liberalizing trade services, and strengthening rules applicable to regional trade.
  - GCC countries are more integrated than the rest of the region; some countries (e.g., Bahrain) have seen opportunities from ongoing regional business integration, particularly with Saudi Arabia, Kuwait, and the UAE.

*Source: _042916 - 14.      Oil-exporting Arab economies face a number of competing fiscal objectives in both (IMF).*

### 25.      Reviewing labor regulations can also help foster greater private-sector led job

### _042916 - 25.      Reviewing labor regulations can also help foster greater private-sector led job

### Labor regulations and labor market flexibility
- Findings:
  - Labor markets are relatively flexible in most GCC countries, but regulations are considered restrictive in some areas as evidenced by the Executive Opinion Survey undertaken by the World Economic Forum (Figure 4).
  - In Algeria, Kuwait, Oman and, to a lesser extent, Saudi Arabia, insufficient labor market flexibility is seen as a hindrance.
  - Various degrees of labor market reforms are underway in a number of countries:
    - Saudi Arabia: implementing labor market reform to streamline regulations while seeking to improve work conditions; regulations on female employment have been eased, with more sectors being opened for their employment.
    - Oman: updating the labor law governing Omani and foreign workers by amending issues related to labor dispute resolution, working conditions in the private sector, and working conditions for women.
  - Recommendation: Other oil-exporting Arab economies would benefit from reforms in labor regulations aiming to increase labor force flexibility while fostering better working conditions and introducing unemployment insurance schemes where they do not exist.

### Access to finance and SME constraints
- Findings:
  - Inadequate access to finance is a key factor inhibiting private sector development.
  - The oil-exporting Arab countries have a relatively low percentage of firms with credit lines or loans from financial institutions, and only a small portion of bank lending goes to SMEs.
  - In Algeria, Iraq, and Yemen, bank lending to private sector only accounts for 10-30 percent of non-oil GDP.
  - Financial constraints tend to be more binding for SMEs: weak credit information and creditor rights and an insufficient collateral infrastructure are main reasons for banks’ reluctance to lend to SMEs.
  - Progress examples:
    - UAE: issued a new law on SMEs and established financial infrastructure such as a credit bureau and credit registry.
    - Saudi Arabia: establishment of dedicated SME units in banks and of a national credit bureau.
    - Algeria: increasing the coverage of the existing credit registry would help foster greater access to finance for SMEs.
- Policy recommendations:
  - Further efforts to reform financial systems, reduce directed lending, and develop domestic security markets to support private sector financing.
  - Strengthen financial infrastructure such as credit assessment tools and creditors’ rights to ease SMEs’ access to finance.
  - Country-specific measures:
    - Algeria: foster development of the local debt market to diversify financing options for the corporate sector.
    - Iraq: continue to lift restrictions placed on private banks in obtaining government business.

### Public sector role and enabling private-sector growth
- Findings:
  - The public sector is a dominant player in oil-exporting Arab countries and a catalyst in the allocation of production factors; public enterprises play a very large role even in areas where the private sector could provide goods and services.
  - The share of the public sector in total GDP remains high in many oil-exporting Arab economies; expansion of the public sector involves large-size civil service with generous compensations.
  - Public sector wage policies reduce incentives to seek private sector jobs or launch businesses:
    - Nationals in the GCC fill over 70 percent of public sector jobs.
    - About 88 percent of 5.4 million private sector jobs created between 2000 and 2010 were filled by foreign workers (about 85 percent of them with low skills).
  - Excessive attractiveness of public employment exacerbates skills mismatches for the private sector; better public-sector employment opportunities increase incentives to invest in skills demanded by public service rather than private sector needs.
- Policy recommendations to enable private-sector led employment growth:
  - Reducing the excesses of public employment:
    - Progressive reduction in the size of the public workforce and public wage moderation to rebalance relative prices of labor in public and private sectors and align public sector wages to productivity.
    - Conduct a civil service review to identify nonessential positions that should not be renewed when they become vacant.
  - Orienting education and vocational training toward skills needed in the private sector:
    - Increase public spending on education in some countries.
    - Improve quality of education and better tailor it to private sector needs through coordinated efforts among public sector, private sector, and youth associations.
    - Engage the private sector in the design of curricula for vocational and tertiary education.
  - Providing unemployment insurance:
    - Implement unemployment insurance schemes so the civil service is not used as the employer of last resort; ensure minimum income while setting incentives to look for employment.
  - Public sector delivery of infrastructure and procurement:
    - Deliver basic infrastructure and ensure competitive public procurement policies.
    - Reduce infrastructure bottlenecks that hinder private sector capital formation.
    - Reduce excessive monopoly rents in the non-tradable sector by increasing competition and enhancing bidding procurement processes.

### Economic diversification: strategies and considerations
- Findings:
  - Economic transformation paths differ from historical advanced-economy patterns; in many oil-exporting Arab economies, services already dominate employment and a substantial fraction of labor in that sector is on government payroll.
  - Some diversification progress has occurred but is uneven:
    - Bahrain: developed banking and financial services, particularly Islamic banking.
    - UAE: developed a commercial ship repair sector.
  - Labor productivity growth due to reallocation across sectors has been low; aggregate productivity gains have come mostly from within-sector productivity growth.
  - Countries with the lowest productivity gains (except Yemen) tend to have the largest share of foreign workers who on average are low-paid, low-skills, and low-productivity.
- Policy cautions and targeted industrial policy:
  - There can be a case for industrial policies when:
    - dynamic economies of scale or knowledge spillovers affect a sector;
    - coordination failures prevent a sector from developing; or
    - informational externalities prevent development.
  - Risks: “Picking winners” can lower incentives to seek productivity improvements and international competitiveness if it leads to excessive government protection.
  - Recommendations:
    - Carefully focus industrial policies on sectors with clearly high export potential and strong integration into international value-added chains.
    - Support such sectors with policies that foster innovation and backward linkages.
    - Implement “soft” industrial policies such as increasing openness to FDI, setting up industrial clusters, and export processing zones.
- Diversification approaches:
  - Vertical diversification:
    - Focus on sectors where countries have immediate comparative advantage (e.g., Algeria: potential for vertical integration into higher value-added products in mineral and chemical industries).
    - Note: vertical strategies may not significantly reduce dependence on oil.
  - Horizontal diversification:
    - Expand activities beyond related sectors across businesses not necessarily connected to oil.
    - Government spending choices affecting production costs in new sectors can encourage investor entry.
    - Example: Algeria’s agribusiness sector and tourism show likely large untapped potential.

*Source: Excerpt from IMF chapter on Economic Diversification in Oil-Exporting Arab Countries*

### 39.      Global value chains are an additional mechanism through which firms in oil-exporting

### 042916 - 39.      Global value chains are an additional mechanism through which firms in oil-exporting

### Integration into Global Value Chains (GVCs)
- Finding: Global value chains are an additional mechanism through which firms in oil-exporting Arab countries could access the world market and technologies.
- Finding: Many oil-exporting Arab economies still find themselves at the beginning of the process of integrating into global value chains.
- Finding: With exports dominated by oil, the share of foreign value added in exports remains significantly low.
- Finding: The depth of integration in global value chains and/or the speed at which oil exporting countries (with hydrocarbon exports greater than 25 percent of total exports) join networks of supply chains is relatively lower.
- Policy implications:
  - Further integrating global value-added chains would require deep exploitation of comparative advantage—including geographic position and labor intensity.
  - Improvement in technological capacity, greater efficiency in production, higher technical and managerial skills, and competitive wages are needed.

### Manufacturing structure and GVC depth
- Finding: Exports dominated by hydrocarbons imply low foreign value added shares and relatively low depth of integration in global value chains for hydrocarbon-exporting countries compared with non-hydrocarbon exporters.
- Empirical note: Charts referenced use sources including the UNIDO INDSTAT 4 database and the EORA database; staff estimates and WEO are also used to illustrate sectoral composition and the relationship between the log of non-oil GDP per capita and share of foreign value added in exports.

### Country cases: Morocco (Box 2)
- Background: Morocco historically depended on agriculture, phosphate, tourism, fishing and seafood; reliance on phosphate and rains exposed the economy to external shocks.
- Policy action: In 2008, the government launched a Plan Emergence to widen the production base, increase export products, and improve resilience to external shocks.
- Outcomes (as of 2014 and 2010–14 period):
  - Newly developed industries (automobile, aeronautics, and electronics) represented 28 percent of Morocco’s exports as of 2014.
  - Traditional sectors: textiles 17 percent; phosphate 19 percent (as of 2014).
  - Tourism: Approximately 10 million tourists visit the country per year.
  - Geographic diversification of exports: share of exports to the euro area declined from 69 percent to 56 percent between 2003 and 2013.
  - Exports to Latin America grew from 3 percent to 7 percent of total Moroccan exports between 2003 and 2013.
- Remaining challenges:
  - Agriculture accounts for only 14 percent of GDP but continues to employ about 45 percent of the labor force.
  - Unemployment remains relatively high, especially for youth.
- Policy recommendations:
  - Additional strategies to further diversify and reallocate labor to higher productive sectors.
  - Improvement in agricultural techniques and irrigation systems.
  - Further reforms in business climate, education and judiciary systems to increase private sector competitiveness.
- Expectation: Continued flow of FDI to new sectors is expected to support their expansion over the medium term.

### Country cases: Malaysia (Box 3)
- Background: In 1980 primary commodities accounted for 33 percent of GDP and 77 percent of exports.
- Policy action: National Industrial Policy and three Industrial Master Plans (Industrial Master Plan 1: 1986–95; Industrial Master Plan 2: 1996–2005; Industrial Master Plan 3: 2006–20) that promoted manufacturing, processing of natural resources, cluster-based development, SMEs, research and development, technology, logistics, and marketing.
- Outcomes:
  - Horizontal diversification: increasing share of manufacturing and services; less reliance on commodities.
  - Vertical diversification: move into high technological activities, reducing the share of commodities in exports.
  - Manufacturing developed through resource-based industries: petrochemicals, refined petroleum, palm oil, rubber gloves, tires and prophylactics products.
- Benefits observed from well-designed industrial policies:
  - Deepened structural linkages and improved production function.
  - Increased profitability of firms, higher wages (for private workers), and higher tax revenue.
  - Raised productivity across the board including in agriculture.
  - Preservation of macro stability.

### Attracting FDI in non-oil sectors
- Finding: Attracting foreign direct investment (FDI) in non-oil sectors would support broad-based economic growth.
- Finding: The oil and gas sector has been the largest beneficiary of FDI in most oil-exporting Arab countries.
  - Example: In Oman around 50 percent of FDI is invested in the oil sector.
- Rationale: Specialization and entry into specific segments of global production chains could benefit from FDI while improving export quality and sophistication, and accelerating technology and knowledge transfers.
- Policy recommendations to improve FDI climate in non-oil industries:
  - Lowering entry requirements.
  - Creating investment promotion intermediaries.
  - Streamlining tax structures.
  - Eliminating or limiting requirements of majority domestic ownership that deter FDI (except possibly for strategic sectors).

### Empirical FDI by sector (Arab Oil-Exporters' Cumulative FDI Flows, 2003–May 2015)
- Sectoral cumulative FDI flows (Billions of USD) as presented:
  - Petroleum: 200.6
  - Real estate: 147.7
  - Chemicals: 76.3
  - Tourism: 50.0
  - Minerals: 46.9
  - Other: 212.6

### Conclusion: challenges and policy priorities
- Core challenges (paragraph 41):
  - Job-creation.
  - Macroeconomic volatility from oil prices.
  - Depletion of oil resources.
- Observations:
  - The oil sector generates few jobs directly.
  - The government sector tends to be the largest employer and offers better compensation than the private sector.
  - Over-reliance on oil exposes revenue and output to fluctuations in oil prices.
  - Oil is exhaustible; developing adequate non-oil sectors before reserves are depleted is necessary.
- Preconditions for diversification (paragraph 42):
  - Continue to strengthen macro-economic stability.
  - Improve regulatory and institutional frameworks to make markets more flexible and competitive and to spur innovation for goods, services, and job creation.
- Policies and strategies to create dynamic tradable sectors (paragraph 43):
  - Develop local technological capability.
  - Promote processing of natural resources.
  - Improve competitiveness of non-oil exports.
  - Broaden export base through integration into global value chains to encompass higher value-added activities.
- Security and country heterogeneity:
  - Finding (paragraph 44): Diversification will not be successful without security; conflicts in Iraq, Libya, and Yemen severely disrupt activity and weaken investor confidence.
  - Recommendation: Restoring stability and security should be a first order priority to economic diversification.
  - Finding (paragraph 45): Policies should be tailored to country-specific circumstances and capacities. The recent decline in oil prices has strained government resources, making diversification more urgent.
  - Demographic concern: The labor force is young and growing; unemployment for youth and women remains high in many countries.
  - Policy balance: Policymakers need to safeguard fiscal sustainability while pressing forward to facilitate economic diversification.

### Appendix — Technical notes (selected)
- Estimate of government GDP:
  - Gross value-added (GVA) of an industry = total sales minus cost of intermediate inputs.
  - GDP of an industry = GVA + taxes on products − subsidies on products.
  - For public administration services, measurable sales do not exist; government value-added proxied by government wages due to lack of data on depreciation of government assets for Arab oil-exporters.
- Arab oil exporters manufacturing value-added Gini (methodology summary):
  - Analysis reproduces Imbs and Wacziarg (2003) using UNIDO (ISIC-3) data for 1990–2011 covering 137 economies and 23 manufacturing subsectors.
  - Gini coefficient computed for sectoral value-added shares; lower Gini indicates more equal sectoral distribution and more diversified economy.
  - Staff analysis finds increasing diversification with income on average, with some reversal but not a strong “U-shaped pattern.”
  - Oil-exporting Arab economies tend to lie outside the expected curve (by more than two standard deviation): relatively high income per capita but low degree of economic diversification as indicated by the Gini coefficient.
  - Possible explanation: high income levels reflect natural endowments rather than structural transformation.

*International Monetary Fund — Economic Diversification in Oil-Exporting Arab Countries (excerpts provided in source content)*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2016/_042916.pdf_