Policy Challenges in the Gulf Cooperation Council Countries

IV. Policy Issues and a Medium-Term Adjustment Strategy

Bringing all the elements together, the GCC countries would be expected to be impacted at best neutrally by trends in the international trade and financial markets. The benefits from regional developments would be less direct and of a long-term nature. At the same time, in view of a generally subdued oil market outlook, there is a considerable downside risk that would continue to expose the GCC countries to unfavorable fluctuations in the terms of trade.

On the basis of broadly unchanged policies, it is projected that real output growth in the GCC countries as a group would be of the order of 2 percent per annum through the rest of this decade, below the rate of population growth of 3.5 percent. Some GCC countries have already aimed at balanced budgets by the end of this decade, but for the other countries, the fiscal and current account deficits would remain of the order of 10 percent of GDP on the basis of present policy stance. Unless addressed through appropriate policies, the emerging imbalances would further drain official foreign assets and increase internal and external indebtedness--thereby mitigating against private sector confidence and self-sustaining growth. The slow economic growth and insufficient economic diversification would also limit the absorption of a rapidly increasing indigenous labor force.

Although all GCC countries would be affected by these adverse trends, there would be differences between countries. These depend on the degree of their reliance on oil income, levels of official reserves, the extent of diversification of their economies, and the size and growth of population.

The authorities in the GCC countries are aware of the challenges facing their economies, with recent policy initiatives in a number of countries intensifying important changes in macroeconomic objectives and priorities. This is illustrated, for example, by the recent adjustment strategies adopted by Kuwait, Oman, and Saudi Arabia, which share three elements:

• Elimination of budget deficits and structural improvements in the budget, supported by an appropriate monetary policy.

• Market-based policies and structural reforms to promote private sector activity, particularly in the context of the initial dampening effect of fiscal correction and the reduction in subsidies and protection.

• Manpower and incomes policies to facilitate the productive absorption of a rapidly increasing national labor force.

These elements are mutually reinforcing, are pointed in the right direction, and are properly cast within a medium-term context. Their implementation will reduce the vulnerability of the GCC countries to oil market developments and position the countries to benefit from the favorable trends in the world economy.6

1. Financial policies

a. Fiscal policy

Over the medium term, fiscal policy should aim at eliminating the budget deficit in a sustained manner so as to ensure a comfortable foreign reserve position and limit official external indebtedness. The recent budgets in a number of GCC countries reflect intensified efforts to mobilize non-oil revenue, as expenditure cuts of the magnitude required would be difficult. Further cuts in capital expenditure may not be feasible, or indeed desirable, in view of the need to replenish the aging capital stock. As such, a durable fiscal consolidation requires a balanced approach between revenue and expenditure and between expenditure components, as well as structural improvements in the budget to reduce the nondiscretionary element of expenditure and make revenue more responsive to economic activity.

(i) Expenditure policies

In the GCC countries, pressures on current expenditure typically arise from the government wage bill, requirements for defense and security, and from subsidies and entitlement.

The large and growing government wage bill reflects the traditional role of the Government as the dominant employer in the economy, as well as wage awards which over time have created a large wage differential in favor of the public sector. Wage policy in the future needs to be combined with reform of the civil service to address the problem of overemployment which has emerged in the government sector.7

Expenditure for defense and security needs is considerable. Several GCC countries envisage some reduction in this spending over time without undermining their security needs.

The subsidy system in the GCC countries has evolved over the years within the broad objectives of distributing the oil wealth to the population and supporting private sector economic activity. Together with other protective policies, subsidies benefiting both consumers and producers have aimed at ensuring low and stable prices for essential foodstuffs and basic services, achieving social objectives in the health and education areas, and promoting basic industries and supporting specific sectors for strategic reasons (e.g., food production for security reasons).

Explicit subsidies through the budget have generally included cash payments to farmers to maintain high procurement prices and to utility companies to cover their operating losses. While the magnitude of explicit budgetary subsidies in the GCC countries (about 2-3 percent of GDP) is not large by international comparisons, there are substantial implicit subsidies in the form of free or below-cost provision of government services (utilities, education, health, transportation, and sector-specific inputs). Implicit subsidies are also provided through low petroleum product prices in some GCC countries and through subsidized long-term loans.

It has generally proved difficult to quantify the magnitude of implicit subsidies or their effectiveness. Nevertheless, it is recognized that many of the implicit subsidies have involved substantial hidden costs in terms of resource misallocation, wasteful use, and production inefficiencies. A comprehensive plan to rationalize subsidies over the medium term would involve adjusting agricultural procurement prices to international levels; raising utility rates; and introducing or increasing fees and charges on government services. The impact of higher prices on the vulnerable social groups could be mitigated through well-targeted income transfer programs, which would be less costly and more equitable and transparent. Finally, plans to reduce subsidies and protection in general should also take into account intra-GCC considerations in order to prevent sudden shifts in capital and production between the countries.

(ii) Revenue policies

The revenue structure in GCC countries has been dominated by oil receipts and, until recently, investment income associated with wealth generated by past oil income. The narrow tax base--consisting mainly of import duties, income taxes with limited coverage, and fees and charges--is further constrained by substantial exemptions. Consequently, non-oil revenue in the GCC countries on average amounted to only 8 percent of GDP in 1992-94—below comparable levels in other developing countries.8

Revenue policies should be directed not only at mobilizing non-oil revenue in the short run, but also at improving the buoyancy of tax revenue. This would require a reform of the existing tax and nontax revenue sources as well the introduction of new broad-based taxes.

Collections from import taxes could be increased in some countries by raising the tariff rates as a part of harmonization of tariffs in the GCC countries, and by eliminating most tariff exemptions; for other countries, such harmonization is likely to imply constant or declining tariff receipts.9 Similarly, the coverage of excises could be expanded and consideration be given to the introduction of selective excises on luxury goods. Most GCC countries have already initiated increases in user fees and utility prices; over the medium term, these would need to be adjusted sufficiently to reflect the cost of service. Finally, tax revenue and the tax structure would benefit from the introduction of a broad-based consumption tax, a turnover tax, and from expanding the scope and coverage of the existing income taxes.

b. Monetary and exchange rate policies

The monetary policy in the GCC countries has been essentially targeted at maintaining the stability of the exchange rate as a nominal anchor for the economy. In turn, this policy has contributed to a low and stable rate of inflation and maintained private sector confidence. In view of the free mobility of capital, the de facto pegging of the national currencies to the U.S. dollar has also required the domestic interest rates to track closely the movements of U.S. dollar interest rates. Within this framework, the domestic demand for liquid assets regulates total liquidity through changes in net foreign assets of the banking system.

In the process of maintaining stable parities with the U.S. dollar, the GCC countries have also established stable cross rates between their national currencies. GCC-wide coordination has been facilitated by continuous dialogue between the country authorities on issues related to monetary policy and regulatory activities.

Looking ahead, unless there is a significant fiscal correction, pressures on monetary policy are likely to increase. Monetary policy cannot and should not be expected to substitute for fiscal restraint without affecting the exchange rate regime. Indeed, an integrated and balanced policy mix would require fiscal consolidation to be supported by an appropriate monetary policy in order to ensure price and exchange rate stability and maintain private sector confidence.

2. Growth policies, economic diversification, and structural reforms

The experience of the GCC countries in diversifying their economic structure and reducing their reliance on oil revenue falls into three broad categories:

• In some GCC countries, such as Kuwait, the emphasis has been on downstream diversification through asset acquisitions in other countries.

• In some other countries, such as Saudi Arabia, economic diversification was carried out through developing a domestic non-oil sector with significant participation by the private sector.

• Other countries followed a mix of these two policies, broadly defining their strategies on the basis of their oil resource profile, foreign exchange reserves, and investment opportunities at home.

In almost all countries that followed a domestic investment policy, the development of the non-oil sector focused on petrochemical industries and other oil-based industries in which the countries had a clear comparative advantage. However, the petrochemical industries remained vulnerable to oil market developments and to restrictive trade practices in the main consuming regions. Moreover, most of the large non-oil industries remained in the public domain, reflecting the authorities' policy toward strategic industries and foreign participation, as well as the massive capital requirements that limited private sector entry. In agriculture and manufacturing, where private sector participation was significant, production was supported by various subsidies and incentives that burdened the budget and distorted the relative price structure.

Against this background, a major challenge facing the GCC countries is to maintain high rates of economic growth through market-based policies at a time when the growth impulse from the oil sector would be expected to weaken; government expenditure cutbacks would have an initial adverse impact on non-oil economic activity; and pressures to create employment opportunities at home would likely increase. Recognizing that in the future, the private sector would be called upon to contribute a larger share in economic activity and job creation, the authorities are encouraging private sector participation.10

Creation of a stable macroeconomic setting is a necessary condition for private sector confidence, but this in itself may not be sufficient to pursue a policy of economic diversification based on private sector initiative. A sustained and efficient diversification of the economy calls for strengthening of policies regarding subsidies and protection, privatization, and pricing of public services and utilities. It must also be supported by deeper and more efficient domestic financial and equity markets and a more flexible labor market.

The subsidy and incentive programs of some GCC countries should be reassessed within development and sectoral priorities with the recognition that the temporary protection offered by implicit subsidies may in fact delay efficient economic diversification. As discussed earlier, the policy focus should be on sharply reducing producer subsidies and curtailing protection in general, beginning with areas where the economy already enjoys a comparative advantage in production (e.g., petrochemicals).

Together with policies already under way to enlarge the scope of activities of the private sector, it is important to intensify divestiture policy. The GCC countries have limited experience with privatization up to now. In Kuwait, privatization has involved sales of shares of certain enterprises held by the Kuwait Investment Authority on behalf of the Government. In Saudi Arabia, so far, 30 percent of shares of the Saudi Arabian Basic Industries Corporation have been sold to the private sector.

A broader privatization program aiming to create a more efficient economic system should be geared toward not only higher private sector activity, but also private sector decision making and majority ownership, tapping its dynamism, creativity, and entrepreneurial skills. This should proceed in tandem with a further liberalization of foreign direct investment to allow majority ownership. The proceeds from privatization should be used to retire public debt.

In addition to a sound regulatory framework, the success of the privatization programs is predicated on transmitting the right price signals to the market. A number of GCC countries have identified public utility companies as possible targets for privatization. This would require a prior adjustment in prices to ensure self-financing and reduce the burden on the budget in the future.

The GCC countries have small, but growing, domestic equity markets.11 In the future, these markets would be called upon to play a more active role in resource mobilization and increased equity financing for the private sector. In fact, this would be a key element for the success of the privatization program which, in turn, would contribute to its efficiency by increasing its size and depth. Increased investment opportunities at home would also help in attracting substantial savings held by GCC citizens abroad. The recent successful floating of public shares on the local markets (in Bahrain, Oman, Qatar, Saudi Arabia, and the U.A.E.)--and their oversubscription in some cases--suggests that substantial resources could be raised through the local markets.12

There are a number of factors which are essential for larger capitalization and greater efficiency of equity markets in the GCC countries:

• First, it is important to have in place an appropriate regulatory framework and tax measures to discourage speculative portfolio flows and maintain private sector confidence.

• Second, well-functioning equity markets would benefit from a broader participation of domestic enterprises as well as foreign investors.

• Finally, the development of integrated equity markets in the GCC region would require greater coordination of regulatory and supervisory frameworks and an easier flow of capital between the countries.

Given equity market developments, the banking system has been instrumental in mobilizing and allocating domestic savings. The supervisory and the regulatory frameworks have been strengthened, and banks have improved their capital position in line with international standards on capital adequacy. In addition, the participation of foreign banks through joint ventures with local banks and the development of the offshore market in Bahrain have enhanced the depth and sophistication of the banking sector in the GCC countries.

As the domestic financial system would be expected to provide a key supportive role in the process of economic diversification and growth, there are a number of issues to be considered in order to strengthen its intermediation role:

• First, a more diversified banking sector would benefit from a greater participation of foreign banks.

• Second, serious consideration should be given to the competitive auctioning of short-term as well as long-term government debt instruments to tap private savings at the opportunity cost of capital; this would also provide indications of resource cost for corporate borrowing and develop indirect instruments of monetary control.

• Third, to compete with banks, the specialized credit institutions should become more autonomous and commercially oriented, providing credit at market-determined rates.

• Finally, consideration could be given to developing alternative instruments of assets diversification (e.g., mutual funds).

3. Labor market policies

Most GCC countries have segmented labor markets with limited labor mobility. This reflects wage rigidities, skills mismatch, and institutional and cultural factors. Better educated new entrants to the national labor market have been traditionally attracted to the public sector because of higher wages and benefits, job security, and social status associated with government employment. At the other extreme, private sector activities have relied heavily on imported labor that is readily available on the basis of fixed-term contracts, and at wages in many cases lower than those in the public sector.13 Moreover, the geographical diversification of imported labor in recent years has acted to reduce average wages for unskilled labor and helped in protecting external competitiveness.

In the period ahead, the labor market conditions for the GCC nationals are expected to tighten in view of a rapidly growing indigenous population with higher expectations and a youthful age profile. A number of GCC countries have initiated policies to replace foreign workers with nationals by establishing limits on hiring expatriate workers, setting minimum quotas for hiring nationals, and raising the cost of employment of nonnationals. While these measures would appear to increase employment possibilities for the nationals in the short run, it may be counterproductive in the long run in the absence of downward flexibility of wages. In addition, these policies are likely to be resisted by private sector employers who lose their employment flexibility and face higher labor costs.

Mandatory employment measures are not a good substitute for increased wage flexibility and integration of labor markets. Over time, public sector wages should be allowed to adjust to market forces, and private sector employers should be allowed to hire the best available labor, both national and foreign, at market wages. Over the medium term, productivity gains would also be expected to reduce the demand for low-skill labor and provide a better match between skills of national labor and the available jobs in the private sector. Finally, education and training should continue to be geared toward meeting the future job requirements of the economy, reducing the emphasis on high-skill training, and encouraging creativity and productivity. The experience of a number of dynamic Asian economies has shown that emphasizing spending on education and training in the initial stages of development results in high private and social returns.

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