## EXECUTIVE SUMMARY

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### INTRODUCTION
- The Gulf Cooperation Council (GCC) growth model has delivered strong economic and social outcomes over several decades while relying on oil as the main source of export and fiscal revenues.
- Governments expanded public sector employment and spending on infrastructure, health, and education, supporting private sector activity—particularly in the nontradables sector.
- Despite reforms (business environment, trade and FDI liberalization, financial deepening, education expansion), export diversification has been limited; the share of non-hydrocarbons output in GDP increased in a manner highly correlated with oil prices.
- International experience shows diversifying away from oil is very difficult and success depends on implementing appropriate policies well ahead of the decline in oil revenues.

### THE CASE FOR ECONOMIC DIVERSIFICATION IN THE GCC
- Rationale for diversification:
  - Reduce exposure to volatility and uncertainty in the global oil market.
  - Create private sector jobs for nationals, especially high-value-added, high-skilled positions.
  - Increase productivity and sustainable growth.
  - Establish the non-oil economy needed when oil revenues decline.
- Features and weaknesses of the current model:
  - Governments receive oil export revenues and distribute them via transfers, public sector jobs, infrastructure, real estate, education, health, and savings (including sovereign wealth funds).
  - Rapid development and improved human development indicators coexist with weak or negative average labor productivity growth.
  - Total factor productivity (TFP) growth for the overall economy and for the non-oil economy has been negative, with only Saudi Arabia experiencing slightly positive TFP growth in the non-oil sector (IMF 2013).
  - Private sector activity remains concentrated in low-skilled nontradables; employment is shifting toward lower-productivity sectors (construction and nongovernment services).
  - Ready availability of low-wage expatriate labor reduces conventional Dutch-disease wage effects but the distribution of oil revenues crowds out non-oil tradables through incentives for firms and workers.
  - The public sector wage bill has become large (in percent of GDP), and the GCC labor force is projected to increase by some 1.2–1.6 million nationals by 2018, creating fiscal and employment challenges (IMF 2013).
  - Historical exposure to oil-price volatility: consumption per capita fell by more than 30 percent after the early 1980s peak and only returned to that level in the late 2000s as oil prices recovered; relative income declined markedly in the 1980s and 1990s.
- International evidence:
  - Higher GDP per capita and lower volatility are strongly positively associated with diversification of output and exports in low- and middle-income countries (Papageorgiou and Spatafora 2012).
  - Diversification links to structural transformation—reallocation from less productive to more productive sectors, notably manufacturing.
  - Export quality upgrading and export sophistication are strongly associated with higher per capita income and subsequent growth (Henn, Papageorgiou, and Spatafora 2013; Hausmann, Hwang, and Rodrik 2007).
- Examples of successful diversification from oil/minerals: Malaysia, Indonesia, Mexico (oil); Chile (copper).

### DIVERSIFICATION IN THE GCC: PROGRESS SO FAR
- Policies adopted:
  - Stable, low-inflation macroeconomic environment.
  - Business climate improvements, infrastructure investment, trade and FDI liberalization, financial deepening, education expansion.
  - National development plans aiming to boost human capital and develop new industries and services for high-skilled labor.
- Outcomes to date:
  - The share of non-hydrocarbons output in GDP has increased steadily but remains highly correlated with oil prices.
  - Progress on export diversification and export quality upgrading has been limited.
  - Private sector continues to serve domestic consumption and investment needs while depending on low-wage foreign labor and employing few nationals.

### A MISSING LINK—CHANGING THE INCENTIVES OF FIRMS AND WORKERS
- Current incentive distortions:
  - Distribution of oil revenues crowds out non-oil tradables production by making nontradables production relatively less risky and more profitable (government spending growth and access to low-skilled, low-wage foreign labor).
  - Nationals often prefer public sector employment due to relatively higher wages and benefits; education choices reflect preparation for public sector jobs.
  - Firms face a risk-return trade-off that favors serving the domestic nontradables market over entering riskier export markets.
- Policy directions to address the missing link:
  - Reorient public spending toward activities that support tradables and export competitiveness.
  - Strengthen private-sector competition and reduce monopoly-related distortions.
  - Develop backward and forward linkages across sectors where comparative advantage exists.
  - Implement labor market reforms to incentivize private sector employment of nationals and improvements in productivity.
  - Support firms in developing export markets and support workers in acquiring relevant skills and education to boost productivity and facilitate export quality upgrading.

### BOX 2 — KEY FINDINGS AND STATISTICS ON DIVERSIFICATION IN NATIONAL PLANS
- Strategic intent:
  - National strategies emphasize diversification to promote sustainable development, reduce dependence on oil revenues, and increase private sector job creation for nationals (examples cited in source: Saudi Arabia’s long-term strategy 2025; Vision 2020 in Oman; Vision 2021 in the United Arab Emirates; Vision 2030 in Bahrain; Qatar National Vision 2030).
  - Recognize GCC economies are high-income and unlikely to follow low-cost manufacturing-led diversification; focus on high-paying private sector jobs in high-value-added sectors.
- Policies being implemented:
  - Stepped-up investments in education, including science and technology and technical and vocational education.
  - Sector development (financial sector in Bahrain; airlines and logistics in Qatar and the United Arab Emirates; downstream petrochemicals and mining in Saudi Arabia; SME sector in Oman and other countries).
  - Investments in physical infrastructure and legal/regulatory improvements (including free trade zones).
  - Encouragement of entrepreneurship and innovation via ICT, finance access, and R&D spending.
- Gaps and emphasis needed:
  - Export diversification and quality upgrading need stronger emphasis; limited discussion exists of diversifying exports per se and using export quality upgrading to build human capital and access new technologies.
- Quantitative findings (preserve numeric values exactly):
  - GCC non-oil output growth averaged 6.8 percent during 2000–13.
  - The share of the non-oil sector in total real GDP rose by 12 percentage points to 70 percent (driven mainly by Saudi Arabia and the United Arab Emirates).
  - Regression evidence: the relationship of non-oil GDP growth to oil price growth is five times stronger than it is to oil price levels.
  - Employment, 2000–2010: about 7 million jobs were created in the GCC (excluding the United Arab Emirates), of which 5.4 million were in the private sector.
    - Nearly 88 percent of these private sector jobs were filled by foreign workers (about 85 percent of them being low skilled).
    - Nationals filled over 70 percent of public sector jobs.
    - Nationals in the private sector are employed in high-paying jobs (e.g., financial services) or in supervisory positions in low-productivity sectors (construction, trade, transportation).
  - Non-oil exports and composition:
    - Total non-oil exports (goods and services) rose from 13 to 30 percent of non-oil GDP between 2000 and 2013.
    - Non-oil goods exports rose from 8 to 23 percent of non-oil GDP over the same period.
    - Manufacturing exports (as percent of non-oil GDP) increased most in the United Arab Emirates and Saudi Arabia, followed by Oman.
    - Except for Bahrain and the United Arab Emirates, manufacturing exports are concentrated in chemicals.
  - Export concentration and quality:
    - Oil products constituted over 80 percent of total goods exports.
    - The Theil index indicates limited progress toward export product diversification since 1990: export diversification increased in the United Arab Emirates and Oman; Saudi Arabia and Kuwait experienced greater export concentration; Bahrain and Qatar saw little change.
    - Indicators of export quality have shown only slight improvements since the early 2000s and remain low compared with other regions.
  - Services exports and trade barriers:
    - Services exports have stagnated as a share of total non-oil output overall, despite some growth for Oman, Qatar, and the United Arab Emirates from a low base.
    - The ratio of services exports to non-oil GDP in other countries increased initially, then declined after 2006.
    - The GCC is ranked as having the highest Trade in Services Restrictions Index in the world.
  - Financial and fiscal diversification:
    - Gross international reserves topped $906 billion by end-June 2014, about 55 percent of the region’s GDP (up from $75 billion or 20 percent of GDP in 2000).
    - Combined assets of GCC Sovereign Wealth Funds stood at an estimated $2.4 trillion (as of July 2014).
    - Oil-related receipts constituted almost 80 percent of total budget revenue in 2013.
    - Non-oil revenue remained largely unchanged as a share of non-oil GDP at about 20 percent, but its share in total revenue fell from nearly 30 percent in 2000 to 22 percent in 2013.
  - Fiscal multipliers and spending volatility:
    - Espinoza and Senhadji (2011) estimate long-run fiscal multipliers for non-oil GDP in the GCC: 0.3–0.7 for current expenditure and 0.6–1.1 for capital spending.

### LESSONS FROM BOX 5 — EXPERIENCES WITH DIVERSIFICATION IN OIL-EXPORTING COUNTRIES
- Key obstacles to diversification:
  - Economic volatility from oil revenue reliance.
  - Corroding effects of oil revenues on governance and institutions.
  - Risks of overvalued real exchange rates (traditional Dutch-disease issues).
- Lessons from successful cases (Malaysia, Indonesia, Mexico, Chile):
  - Diversification often took a long time and frequently accelerated when oil revenues fell.
  - Success involved creating incentives for firms to develop export markets and for workers to acquire relevant skills.
  - Policy instruments included industrial clusters, horizontal and vertical linkages, foreign capital to promote technology transfer, export subsidies/tax incentives/access to finance, and investments in training.
- GCC-specific assessment:
  - Business climate rankings: United Arab Emirates 12th, Qatar 16th, Saudi Arabia 24th in Global Competitiveness Report 2014–15; all GCC countries among top 46.
  - Remaining challenges: contract enforcement, insolvency resolution, restrictive labor regulations, inadequately educated workforce, inefficient bureaucracy, limited access to finance.
  - Trade and FDI: creation of free trade zones; GCC Free Trade Area with a common external customs tariff in 2003; envisioned GCC Customs Union beginning January 2015; intraregional trade remains limited.
  - Sectoral FDI composition examples:
    - Saudi Arabia (2010): ~20 percent of FDI inflows in chemicals and refined petroleum products; another fifth in construction.
    - United Arab Emirates (2011): one-fifth of FDI inflows to construction, one-fifth to finance, 10 percent to wholesale and retail trade.
    - Qatar (2011): 4 percent of FDI inflows went to trade-related activity.
  - Education:
    - Adult literacy rates over 90 percent and youth literacy rates over 97 percent.
    - Public spending on education averaged 3.9 percent of national income (2004–13) versus a global average of 4.6 percent.
    - Aggregate years of schooling and early childhood enrollment still low in relative terms; TIMSS scores indicate comparatively low academic achievement.
  - Industrial policy and clusters:
    - Investments in chemicals and energy-intensive sectors have diversified production and exports but produced few links to the rest of the economy; local sourcing and R&D remain limited, yielding limited productivity gains and spillovers.
- Missing link reiterated:
  - Supportive policies have not been sufficient given high and persistent oil revenues; the distribution of oil revenues alters incentives, favoring nontradables and public employment, discouraging nationals from private-sector skill investment and entrepreneurship.
  - Evidence of factor income shares: for five GCC countries where data are available, about 75 percent of national income goes to capital (gross operating surplus) and about 25 percent to labor; for Saudi Arabia, the share of income going to capital in the non-oil private sector is estimated at 75 percent.
  - Public sector wages and benefits, nonwage benefits, working hours, and job security create strong disincentives for nationals to seek private sector employment.

### CONCLUSIONS AND POLICY RECOMMENDATIONS
- Overarching policy thrust:
  - Diversification is paramount to reduce exposure to oil-market volatility, create private-sector jobs for nationals, raise productivity, and ensure long-term sustainable growth.
  - Continue macroeconomic stability and business climate reforms, but crucially change incentives so tradables production and export-oriented activity become more attractive relative to nontradables and public employment.
- Specific recommendations:
  - Macroeconomic policy framework:
    - Further refinements to fiscal and macroprudential policy frameworks could help reduce macroeconomic volatility (Arvai, Prasad, and Katayama 2014).
  - Business climate and infrastructure:
    - Address remaining weaknesses (contract enforcement, insolvency resolution).
    - Ensure large public investments are efficient and support the tradables sector (Albino-War and others 2014).
  - Development of SMEs and trade policy:
    - Facilitate SMEs’ access to finance and support, especially in tradables and high-value-added industries.
    - Implement the Gulf Common Market launched in 2008; strengthen Arab-Arab integration and pursue further free trade agreements.
    - Encourage FDI to strengthen manufacturing and technology bases.
  - Incentives for nationals to work in the private sector:
    - Limit government employment—place firm limits on public sector jobs and wages; conduct civil service reviews to eliminate nonessential positions as they become vacant.
    - Strengthen social safety nets—introduce unemployment insurance, job search support, and training vouchers similar to Belgium and Germany to support retraining and skills acquisition.
    - Ensure education and training systems provide skills needed for private sector employment; invest in teacher quality, early childhood education, apprenticeships, and vocational programs (evidence: more than two-thirds of 15- to 16-year-olds in Switzerland enter apprenticeship programs; more than half of students in Germany are apprentices (Nash 2012)).
  - Corporate policies to promote exports and technology:
    - Provide export insurance guarantees, financing, and business support services for exporters.
    - Develop venture capital, university-linked incubators, and R&D funds to support technology transfer and commercialization.
    - Foster linkages between state-owned enterprises, multinationals, and SMEs.
  - Competition, state-owned enterprises, and market structure:
    - Address monopoly rents in nontradables; review competition policy law and implementation; reduce trade barriers; review government procurement to increase competition.
    - Limit the reach of SoE activities and enforce competition policies to integrate private firms through backward and forward linkages.
  - Labor mobility, expatriate wages, and productivity incentives:
    - Increase foreign worker mobility (ongoing in some countries) to raise expatriate wages and narrow wage differentials with nationals, reducing incentives for low-productivity production and increasing incentives to hire skilled workers and invest in technology.

*International Monetary Fund — CONCLUSIONS AND POLICY RECOMMENDATIONS*

### EXECUTIVE SUMMARY _______________________________________________________________________________ 4

### EXECUTIVE SUMMARY

### INTRODUCTION
- The Gulf Cooperation Council (GCC) growth model has delivered strong economic and social outcomes over several decades while relying on oil as the main source of export and fiscal revenues.
- Governments expanded public sector employment and spending on infrastructure, health, and education, supporting private sector activity—particularly in the nontradables sector.
- Despite reforms to strengthen the business environment, liberalize trade and FDI, deepen the financial sector, and expand education, export diversification has been limited while the share of non-hydrocarbons output in GDP has increased in a manner highly correlated with oil prices.
- International experience shows that diversifying away from oil is very difficult and success depends on implementing appropriate policies well ahead of the decline in oil revenues.

### THE CASE FOR ECONOMIC DIVERSIFICATION IN THE GCC
- Rationale for diversification:
  - Reduce exposure to volatility and uncertainty in the global oil market.
  - Create private sector jobs for nationals, especially high-value-added, high-skilled positions.
  - Increase productivity and sustainable growth.
  - Establish the non-oil economy needed when oil revenues decline.
- Features and weaknesses of the current model:
  - The government receives oil export revenues and distributes them via transfers, public sector jobs, infrastructure, real estate, education, health, and savings (including sovereign wealth funds).
  - Despite rapid development and improved human development indicators (HDI scores, infant mortality, expected years of schooling, life expectancy), average labor productivity growth has been weak or negative.
  - Total factor productivity (TFP) growth for the overall economy and for the non-oil economy has been negative, with only Saudi Arabia experiencing slightly positive TFP growth in the non-oil sector (IMF 2013).
  - Private sector activity remains concentrated in low-skilled nontradables; employment is shifting toward lower-productivity sectors (for example, construction and nongovernment services).
  - The ready availability of low-wage expatriate labor reduces conventional Dutch-disease wage effects but the distribution of oil revenues crowds out non-oil tradables through incentives for firms and workers.
  - The public sector wage bill has become large (in percent of GDP), and the GCC labor force is projected to increase by some 1.2–1.6 million nationals by 2018, creating fiscal and employment challenges (IMF 2013).
  - Historical exposure to oil-price volatility: consumption per capita fell by more than 30 percent after the early 1980s peak and only returned to that level in the late 2000s as oil prices recovered; relative income declined markedly in the 1980s and 1990s.

- International evidence (Box 1):
  - Higher GDP per capita and lower volatility are strongly positively associated with diversification of output and exports in low- and middle-income countries (Papageorgiou and Spatafora 2012).
  - Diversification is linked to structural transformation—reallocation from less productive to more productive sectors, notably manufacturing.
  - Export quality upgrading and export sophistication are strongly associated with higher per capita income and subsequent growth (Henn, Papageorgiou, and Spatafora 2013; Hausmann, Hwang, and Rodrik 2007).

- Examples of countries that diversified successfully away from oil/minerals:
  - Malaysia, Indonesia, and Mexico (oil); Chile (copper).

### DIVERSIFICATION IN THE GCC: PROGRESS SO FAR
- Policies adopted:
  - Stable, low-inflation macroeconomic environment achieved.
  - Business climate improvements, infrastructure investment, trade and FDI liberalization, financial deepening, and education expansion implemented.
  - National development plans aim to boost human capital and develop new industries and services for high-skilled labor.
- Outcomes to date:
  - The share of non-hydrocarbons output in GDP has increased steadily but remains highly correlated with oil prices.
  - Progress on export diversification and export quality upgrading—key ingredients for sustainable growth—has been more limited.
  - Private sector continues to serve domestic consumption and investment needs while depending on low-wage foreign labor and employing few nationals.

### POLICIES TO SUPPORT DIVERSIFICATION IN THE GCC
- Policies identified and implemented include:
  - Improving the business environment and reducing regulations.
  - Investing in infrastructure and human capital.
  - Increasing financing for companies, particularly small and medium-sized enterprises (SMEs).
  - Liberalizing trade and foreign direct investment (FDI).
  - Deepening the financial sector.
  - Implementing national development plans focused on skills and industry development.
- Limitations of these policies:
  - While necessary, such measures will not be sufficient unless the underlying incentive structure for firms and workers is reformed to favor tradables and export-oriented activity.

### A MISSING LINK—CHANGING THE INCENTIVES OF FIRMS AND WORKERS
- Current incentive distortions:
  - Distribution of oil revenues crowds out non-oil tradables production by making nontradables production relatively less risky and more profitable for firms (due to government spending growth and access to low-skilled, low-wage foreign labor).
  - Nationals often prefer public sector employment because it offers relatively higher wages and benefits; education choices reflect preparation for public sector jobs.
  - Firms face a risk-return trade-off that favors serving the domestic nontradables market over entering riskier export markets.
- Policy directions to address the missing link:
  - Reorient public spending toward activities that support tradables and export competitiveness.
  - Strengthen private-sector competition and reduce monopoly-related distortions.
  - Develop backward and forward linkages across sectors where comparative advantage exists.
  - Implement labor market reforms that incentivize private sector employment of nationals and improvements in productivity.
  - Support firms in developing export markets and support workers in acquiring relevant skills and education to boost productivity and facilitate export quality upgrading.

### CONCLUSIONS AND POLICY RECOMMENDATIONS
- Diversification is paramount to reduce exposure to oil-market volatility, create private-sector jobs for nationals, raise productivity, and ensure long-term sustainable growth.
- Required policy approach:
  - Continue macroeconomic stability and business climate reforms.
  - Focus policy efforts on changing incentives for both firms and workers so that tradables production and export-oriented activity become more attractive relative to nontradables and public employment.
  - Implement a combination of public spending reorientation, competition-enhancing reforms, linkage development, and labor market reforms to achieve a durable shift toward diversified, higher-productivity economic activity.

*Source: IMF staff compilation from "EXECUTIVE SUMMARY" of the IMF document on Economic Diversification in the GCC (canonical URL provided with the content).*

### Box 2. Economic Diversification in National Development Plans in the GCC

### Box 2. Economic Diversification in National Development Plans in the GCC

### Overview and strategic intent
- Long-range economic and social development strategies in the Gulf Cooperation Council (GCC) countries emphasize economic diversification to: promote sustainable development, reduce dependence on oil revenues, and increase private sector job creation for nationals (examples in source: Saudi Arabia’s long-term strategy 2025; Vision 2020 in Oman; Vision 2021 in the United Arab Emirates; Vision 2030 in Bahrain; Qatar National Vision 2030).
- Policymakers recognize GCC economies are high-income and unlikely to follow low-cost manufacturing-led diversification paths; diversification must therefore create high-paying private sector jobs for nationals in high-value-added sectors.
- Diversification efforts are geared toward boosting national human capital and developing high-productivity industries and services requiring high-skilled labor.

### Policies being implemented (drawn from international experience)
- Stepped-up investments in education, including in science and technology and technical and vocational education.
- Development of specific sectors and industries (examples: financial sector in Bahrain; airlines and logistics in Qatar and the United Arab Emirates; downstream petrochemicals and mining in Saudi Arabia; SME sector in Oman and other countries).
- Investments in physical infrastructure, and strengthening the legal and regulatory environment to reduce the cost of doing business (including through free trade zones).
- Encouragement of entrepreneurship and innovation through improved access to information and communication technology, finance, and greater spending on research and development.

### Gaps and emphasis needed
- Export diversification and quality upgrading could be better emphasized. Limited discussion exists of diversifying exports per se, and of using export quality upgrading and increasing export sophistication to build relevant human capital and access new technologies to increase productivity.
- Export-quality upgrading is important to achieve growth-enhancing structural transformation and to reverse weak trends in productivity growth.

### Diversification in the GCC: progress so far — key findings and statistics
- GCC non-oil output growth averaged 6.8 percent during 2000–13.
- The share of the non-oil sector in total real GDP rose by 12 percentage points to 70 percent (driven mainly by Saudi Arabia and the United Arab Emirates).
- Regression evidence: the relationship of non-oil GDP growth to oil price growth is five times stronger than it is to oil price levels, implying progress toward genuine output diversification has been modest.
- Employment, 2000–2010: about 7 million jobs were created in the GCC (excluding the United Arab Emirates, for which data are unavailable), of which 5.4 million were in the private sector.
  - Nearly 88 percent of these private sector jobs were filled by foreign workers (about 85 percent of them being low skilled).
  - Nationals filled over 70 percent of public sector jobs.
  - Nationals in the private sector are employed in high-paying jobs (e.g., financial services) or in supervisory positions in low-productivity sectors (e.g., construction, trade, and transportation).
- Non-oil exports and composition:
  - Total non-oil exports (goods and services) rose from 13 to 30 percent of non-oil GDP between 2000 and 2013.
  - Non-oil goods exports rose from 8 to 23 percent of non-oil GDP over the same period.
  - Within non-oil goods exports, manufacturing exports (as percent of non-oil GDP) increased most in the United Arab Emirates and Saudi Arabia, followed by Oman.
  - Except for Bahrain and the United Arab Emirates, manufacturing exports are concentrated in chemicals, a concern because chemicals are likely oil-related and may not reduce economic volatility.
- Export concentration and quality:
  - Oil products continued to dominate the export basket (constituting over 80 percent of total goods exports).
  - The Theil index indicates limited progress toward export product diversification since 1990: export product diversification increased in the United Arab Emirates and Oman, but Saudi Arabia and Kuwait experienced greater export concentration, and Bahrain and Qatar little change.
  - Indicators of export quality have shown only slight improvements since the early 2000s and remain low compared with other regions.
- Services exports and services trade barriers:
  - Services exports have stagnated as a share of total non-oil output overall, despite some growth for Oman, Qatar, and the United Arab Emirates from a low base.
  - The ratio of services exports to non-oil GDP in other countries increased initially, then declined after 2006.
  - The GCC is ranked as having the highest Trade in Services Restrictions Index in the world (limited services trade).
- Financial and fiscal diversification:
  - Gross international reserves topped $906 billion by end-June 2014, about 55 percent of the region’s GDP (up from $75 billion or 20 percent of GDP in 2000).
  - Combined assets of GCC Sovereign Wealth Funds stood at an estimated $2.4 trillion (as of July 2014).
  - Oil-related receipts continued to dominate budget revenues in the GCC (almost 80 percent of total revenue in 2013).
  - Non-oil revenue remained largely unchanged as a share of non-oil GDP at about 20 percent, but its share in total revenue fell from nearly 30 percent in 2000 to 22 percent in 2013.
- Fiscal multipliers and spending volatility:
  - Espinoza and Senhadji (2011) estimate long-run fiscal multipliers for non-oil GDP in the GCC: 0.3–0.7 for current expenditure and 0.6–1.1 for capital spending, suggesting significant growth impact from fiscal expenditure volatility.

### Dubai case (Box 3): lessons and limitations
- Dubai transformed rapidly despite few natural resources; favorable location, openness, and capital and labor inflows supported development in aluminum, transportation (Emirates Airlines), ports (Jebel Ali), finance (Dubai International Financial Center), tourism (more than 500 hotels).
- Real GDP in Dubai grew on average by about 9 percent per year during 2000–13, compared with a GCC average of 5.6 percent.
- Exports (including re-exports) grew by an average of 30 percent from 2000 to 2011 as the economy developed.
- Challenges:
  - Productivity did not grow; labor productivity declined during the real estate boom.
  - Concentration in sectors with limited productivity growth (tourism, retail trade, construction) is a major explanation for low productivity gains.
  - Exports are concentrated in gold and jewelry and tourism and transportation services; despite strong growth, exports are insufficient to cover imports.
  - Replicating Dubai’s model across the whole country or region may be difficult given geographic and functional limitations.

### Policies to support diversification and implementation experience
- Policies implemented for many years include:
  - Providing a stable macroeconomic environment.
  - Strengthening the business environment.
  - Investing in infrastructure, education, and skills.
  - Targeting development of specific sectors.
  - Promoting entrepreneurship through SMEs.
- Macroeconomic outcomes:
  - GCC countries have achieved strong growth combined with relatively low inflation; inflation volatility has been low but growth volatility elevated.
  - Volatility of government spending is high and contributes to growth volatility.
- Business environment reforms:
  - Reforms have streamlined legal and regulatory frameworks (start-up and licensing procedures, competition policies, investor and consumer rights, bankruptcy and company laws).
  - Financial market infrastructure has been enhanced to improve credit information and transparency.
  - SME support measures include affordable bank loans, loan guarantees, feasibility studies, and establishment of national SME development funds (example: Kuwait).

*Source: Box 2. Economic Diversification in National Development Plans in the GCC, _sdn1412.*

### Box 5. Experiences with Diversification in Oil-Exporting Countries

### Box 5. Experiences with Diversification in Oil-Exporting Countries

### Overview and key obstacles
- Achieving economic diversification in oil-exporting countries is a difficult task; historical experience offers few examples of successful diversification away from oil, particularly when the oil production horizon is still long.
- Key obstacles often hindering diversification:
  - Economic volatility induced by reliance on oil revenues.
  - Corroding effect of oil revenues on governance and institutions.
  - Risks of overvalued real exchange rates (traditional Dutch-disease issues).
- Success or failure appears to depend on the implementation of appropriate policies ahead of the decline in oil revenues.
- Many oil-exporting countries (for example, Algeria, Congo, Ecuador, Gabon, the GCC countries, Nigeria, Venezuela) have had limited success in diversification.

### Lessons from successful commodity-exporting countries
- Countries cited as having had relative success: Malaysia, Indonesia, Mexico; Chile had some success diversifying away from copper.
- Common themes in diversification successes:
  - Diversification took a long time and often took off only when oil revenues began to dwindle. Example: Malaysia started its export-oriented strategy in the early 1970s, experienced rapid growth in export sophistication in the 1980s–90s, and it took more than 20 years to reach a level of sophistication comparable to some advanced economies.
  - Successful countries focused on creating incentives to encourage firms to develop export markets and to support workers in acquiring skills and education for jobs in expanding areas.
  - Creating a stable economic environment and a favorable climate for doing business was paired with targeted incentives.

### Policy instruments and strategies used in successful cases
- Making investments in high-productivity industrial clusters, even when no prior comparative advantage existed.
  - Early experience showed import substitution or reliance on labor-intensive manufacturing led to inefficient firms with limited scope for income and productivity gains.
  - Malaysia, Mexico, and Indonesia shifted approach to focus on specific manufacturing clusters, increasing export sophistication.
  - Chile used export subsidies and public-private partnerships to establish new firms and upgrade technical skills in specific sectors.
- Developing horizontal and vertical linkages from industrial clusters to expand employment potential and upgrade technology.
  - Malaysia entered downstream and upstream activities based on rubber and palm oil to build linkages and upgrade research capabilities and technology.
  - Mexico developed linkages around the automobile sector.
- Using foreign capital to promote technological transfer.
  - Indonesia in the 1980s attracted foreign capital through free trade zones, tax incentives, easing of tariff restrictions and nontariff barriers.
  - Mexico’s accession to NAFTA played an important role in attracting FDI that facilitated development of the automobile sector.
- Using export subsidies, tax incentives, and access to finance to facilitate risk taking by entrepreneurs, especially SMEs.
  - Export subsidies and tax incentives can help reduce risk for entrepreneurs in infant industries.
  - Chile provided financial assistance to SMEs and monitored performance through a specialized development agency; Malaysia also focused on SME development.
  - Incentives were paired with measures to hold firms accountable for export performance.
- Making investments in training to ensure availability of high-skilled workers.
  - Malaysia and Mexico focused on training workers, upgrading skills, and sponsoring workers for foreign training; over time these investments built a high-skilled workforce.

### GCC-specific assessment: business climate, trade, FDI, education, and industrial policy
- Business climate:
  - In the Global Competitiveness Report 2014–15, the United Arab Emirates is ranked as the 12th most competitive economy out of 144 countries, followed by Qatar (16th) and Saudi Arabia (24th), with Bahrain, Kuwait, and Oman also ranking among the top 46 countries.
  - World Bank Doing Business Indicators rankings are also strong for the GCC.
  - Remaining challenges across the GCC include contract enforcement and resolution of company insolvency (especially in Saudi Arabia and the United Arab Emirates).
  - Businesses report restrictive labor regulations, an inadequately educated workforce, inefficient government bureaucracy, and some lack of access to finance as key inhibiting factors.
- Trade and FDI:
  - Measures taken: creation of free trade zones (United Arab Emirates), establishment of the GCC Free Trade Area with a common external customs tariff in 2003, envisioned GCC Customs Union beginning January 2015, participation in Pan-Arab Free Trade Area, discussions on FTAs with the European Union and India.
  - Export environment improvements noted, but intraregional trade within the GCC remains limited due to similar export structures and lack of product complementarity.
  - Sectoral composition of FDI inflows and limited technology transfer:
    - Saudi Arabia (2010): some 20 percent of FDI inflows were concentrated in chemicals and refined petroleum products activities; another fifth went to construction.
    - United Arab Emirates (2011): one-fifth of FDI inflows targeted the construction sector, another one-fifth targeted the finance sector, and 10 percent targeted wholesale and retail trade.
    - Qatar (2011): only 4 percent went to trade-related activity.
  - Conclusion: sizable share of FDI inflows has not been associated with improvements in export quality and sophistication.
- Education:
  - School enrollment and literacy rates have increased; average adult and youth literacy rates are over 90 percent and 97 percent, respectively.
  - Public spending on education in the GCC as a share of national income (2004–13) averaged 3.9 percent, relative to an average global spending ratio of 4.6 percent.
  - Aggregate years of schooling and enrollment rates in early childhood education are still low in relative terms; standardized test scores (TIMSS) reveal a comparatively low level of academic achievement.
  - Recommendation: effectiveness of increased expenditures in education and skills needs to be carefully monitored; targeted investments to address skills shortages among nationals may be useful where industrial clusters are developed.
- Industrial policies and clusters:
  - GCC countries have developed oil-related industries, tourism, logistics, transportation, business, and financial services (examples: Bahrain offshore financial sector; UAE and Qatar airlines and logistics; Saudi Arabia developing industrial and economic cities; Kuwait developing downstream oil industries; Qatar establishing industrial cities).
  - Hvidt (2013) suggests investments in chemicals and energy-intensive sectors have helped diversify production and exports but industries have few links to the rest of the economy; local sourcing of tradables has not been developed and most complex technology is still imported because investment in research and development is low.
  - Result: limited productivity gains and spillovers; small employment impact of capital-intensive industries.

### The missing link: incentives for firms and workers in the GCC
- Despite many supportive policies (stable macroeconomic environment, strengthened business climate, trade and FDI liberalization, deeper financial sector, emphasis on education), these have not been sufficient to create a dynamic tradables sector in the presence of high and long-lasting oil revenues.
- The distribution of oil revenues affects incentive structures and crowds out non-oil tradables production:
  - For domestic firms: availability of government contracts in the non-traded sector provides healthy profits at relatively low risk compared with export-oriented activities.
  - For national workers: relatively higher wages available in the public sector are more attractive, particularly for lower skilled workers.
  - These effects are self-reinforcing: lack of high-paying private sector jobs discourages nationals from acquiring skills for private sector roles; immigration systems that may discourage high-skilled expatriate labor leave firms unable to produce higher-value-added tradables.
- Conventional Dutch-disease effects (wage-induced crowding out) have not been evident in the GCC because the ready availability of low-wage expatriate labor has meant oil wealth has not pushed up wages in the private sector.
- Factors that make producing nontradables more attractive in the GCC:
  - Rapid growth in government spending on infrastructure and wages has contributed to strong growth in low-value-added sectors (construction, trade and retail, transport, restaurants), shifting activity into mostly low-skilled sectors and contributing to declining labor and total factor productivity.
  - Availability of low-wage, low-skilled foreign workers has helped firms extract large rents; reservation wages of low-skilled foreign workers are often set in their home countries and may lie below their marginal product.
  - The GCC immigration system does little to attract high-skilled, high-productivity workers because employer sponsorship does not distinguish between high- and low-skilled workers and provides employers limited flexibility to attract top talent.
- National accounts evidence:
  - For five GCC countries where data are available, a high proportion of national income, about 75 percent, goes to capital (gross operating surplus) and only a small portion goes to labor (about 25 percent).
  - For Saudi Arabia, the share of income going to capital in the non-oil private sector is estimated at 75 percent.
- For workers:
  - High-paying public sector jobs create a strong disincentive for nationals to seek private sector employment or become entrepreneurs.
  - Average wages in the public sector are often several times those of the private sector, particularly for low-skilled workers (IMF 2013).
  - Nonwage benefits, working hours, and job security are also more attractive in the public sector; an overwhelming majority of nationals work in the public sector and public sector hiring has continued at high levels.
  - Weaknesses in quality of education and training systems adversely affect the risk-return trade-off for nationals seeking private sector jobs; educational outcomes lag behind other countries and pose obstacles for skills investment and private sector hiring.

*Source: Box 5. Experiences with Diversification in Oil-Exporting Countries (from the provided IMF content).*

### CONCLUSIONS AND POLICY RECOMMENDATIONS

### CONCLUSIONS AND POLICY RECOMMENDATIONS

### Macroeconomic policy framework
- While growth has been strong and inflation low, further refinements to the fiscal and macroprudential policy frameworks could help further reduce macroeconomic volatility (Arvai, Prasad, and Katayama 2014).

### Business climate and infrastructure
- Remaining areas of weakness, including strengthened abilities to enforce contracts and resolve insolvencies, should be addressed.
- Large public investments are being made to develop infrastructure. Care is needed to ensure that this spending is efficient, and that it will help develop and support the tradables sector (Albino-War and others 2014).

### Development of SMEs and trade policy
- Continued facilitation of SMEs’ access to finance and other forms of support, especially in tradables and high-value-added industries, are important for further developing this sector.
- The implementation of the Gulf Common Market launched in 2008 (with the objectives of the free movement of factors and production and goods and services), stronger Arab-Arab integration, and further free trade agreements would help strengthen trade.
- Encouraging FDI to strengthen the manufacturing and technology base is another important element.

### Incentives for nationals to work in the private sector
- The question is whether further improvements in the macroeconomic and business environments, and further development of infrastructure, will encourage diversification without a change in the underlying incentive structures of the GCC economies. At present, workers and firms do not have strong incentives to work and produce in the tradables sector. Addressing these incentives is a crucial step—“a missing link”—in encouraging further diversification.
- Measures to strengthen incentives and abilities of nationals to work in the private sector include:
  - Limiting government employment—Firm limits need to be placed on public sector jobs and wages, and it should be clearly communicated to people that they should not expect to obtain a public sector job. Transitioning to a model with smaller public sector employment could be accomplished in the context of a civil service review to ensure that nonessential positions are eliminated as they become vacant.
  - Strengthening social safety nets—Rather than using public sector employment as a safety net, unemployment insurance and job search support needs to be in place to ensure that those without a job have a minimum income level and the incentives to search for employment. As in Belgium and Germany, vouchers could be used for various training programs, apprenticeships, and vocational education to support retraining and skills acquisition where needed.
  - Ensuring that the education and training systems provide workers with the skills needed for private sector employment—Oil revenues can be used to increase investment in education and skills development. Further, improving the quality of schools and universities and creating apprenticeship and vocational programs could provide the relevant skill sets.
    - Improvements to teacher quality and early childhood education can help boost student achievement and change societal attitudes (Dolton and Marcenaro-Gutierrez 2011; Heckman 2008).
    - Footnote: More than two-thirds of 15- to 16-year-olds in Switzerland enter apprenticeship programs, while more than half of students in Germany are apprentices (Nash 2012).

### Corporate policies to promote exports and technology
- Enact specific measures to encourage firms to export, including the provision of export insurance guarantees and financing for those engaged in export activities, as well as other business support services.
- Develop a venture capital industry; incubators with university links, coupled with research and development funds, would support the promotion of technology transfer and commercialization.
- Foster linkages between state-owned enterprises, multinational companies, and SMEs to promote the development of tradables and exports.

### Competition, state-owned enterprises, and market structure
- Identify and address factors that may inhibit firms’ incentives to move into tradables production, including:
  - The ability to extract monopoly rents in nontradables sectors. Indicators suggest that the degree of local competition intensity varies across the GCC, with Qatar, Saudi Arabia, and the United Arab Emirates scoring well, but Bahrain, Oman, and particularly Kuwait doing less so (Figure 12).
  - A review of competition policy law and its implementation, efforts to reduce barriers to trade, and a review of whether government procurement procedures are ensuring an adequate range of companies bidding for government contracts could all help increase competition in GCC markets.
  - The presence of large state-owned enterprises (SoEs) and their wide-ranging mandates. Many SoEs dominate non-oil exports; with large SoEs dominating entire sectors, barriers to entry may prevent private firms from competing on a level playing field.
    - Diversification could benefit from reducing barriers to competition (Figure 13) and integrating the private sector, particularly through backward and forward linkages in upstream and downstream input industries.
    - Limiting the current reach of SoE activities and enforcing competition policies can further incentivize the private sector and attract FDI and technology into the expansion of the non-oil tradables sectors.

### Labor mobility, expatriate wages, and productivity incentives
- The ability to pay less than domestic market wages to expatriate workers under the sponsorship system reduces incentives for higher-productivity production.
- Allowing greater mobility of foreign workers, which is under way in some countries, will ultimately result in their wages increasing and the wage differential with nationals narrowing. This result will reduce incentives for low-productivity production and increase incentives for hiring more-skilled workers and investing in technology to help boost productivity.

_International Monetary Fund — CONCLUSIONS AND POLICY RECOMMENDATIONS_

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/sdn/2014/_sdn1412.pdf_