Macro focus: How resilient are the GCC economies to the coronavirus recession?

The GCC countries have been hit by the most severe macroeconomic shock in their history as independent nations. The collapse of oil prices earlier this year dealt a heavy blow to oil exporters all around the world. While the GCC countries are among the wealthiest nations on earth, the oil crisis caused their fiscal balances and their current accounts to deteriorate sharply in the face of the twin oil and demand crisis provoked by the coronavirus. Beyond some common features, there are however disparities among the different GCC countries regarding their macroeconomic resilience to the unfolding crisis and the capacity of the governments to deal with its consequences. Leaving apart the case of Dubai and to some extent of Bahrain, which have already initiated transformation agendas – although they might need to refresh these agendas and strategic roadmaps to take into account the structural changes introduced by the pandemic on the regional and global stage -, the other GCC economies must accelerate their efforts to transform their economies, in order to break their dependency on the oil sector, drawing inspiration from other successful economic transitions around the world.

Oil breakevens and twin deficits

One particularly concise way to measure the GCC countries dependence on oil income is through the so-called fiscal and external oil breakevens. In plain terms, these are the oil prices needed to balance respectively the government budget and the current account. The IMF tracks these indicators for all the oil exporting countries.

The external oil breakeven is an indicator on the vulnerability of the currency regime – the peg to the US dollar in this case – to adverse movements in oil prices. We can see that the United Arab Emirates significantly decreased its external breakeven over the last fifteen years bringing it from almost $80 per barrel in 2009 to little over $20 per barrel in 2020. This has been achieved thanks to a higher diversification of exports and to the importance of reexports in the UAE’s trade dynamics. Oman has also managed to decrease its external breakeven from 2015 onward in the aftermath of the 2014 oil counter-shock or oil price collapse. Over the same period, Kuwait displays the opposite trend with the external breakeven rising from little over $20 in 2008 to $45 in 2020. The external breakeven in Kuwait doubled over the considered period, showcasing the increased vulnerability of the country’s current account to external shocks.

The fiscal breakeven is also an important indicator of macroeconomic vulnerability. It should be read together with expenditure to GDP which indicates the size of the government (cf. chart below). Regarding the fiscal breakeven, Saudi Arabia and Oman exhibit higher breakevens than the other GCC countries, although they managed to dicrease them starting from 2015. No wonder these countries exhibit persistently high budget deficits. This is also the case for Kuwait. Although it has a lower fiscal breakeven, Kuwait has also been experiencing growing fiscal deficits due to the outsized importance of government expenditure. On the other side of the spectrum, Qatar has a low fiscal breakeven reflecting a good management of public finances a,d low public expenditure to GDP.

Another way to assess a government’s dependency on oil prices is to look to the non-oil fiscal balance in percent of non-oil GDP. This is akin to the fiscal balance to GDP ratio in a hypothetical situation in which the oil revenue suddenly drops down to zero. Countries that exhibit the highest non-oil deficits are therefore the most vulnerable to oil price shocks. On this reading, among the GCC countries Kuwait and Oman are the most vulnerable countries as their non-oil deficits stand respectively at over -60% and -40% of their non-oil GDP. This indicator barely moved from 2016 onward showcasing the absence of real efforts to reduce the vulnerability and dependency of the economy on oil revenue. In contrast, all the other GCC governments achieved some reduction of their dependency on oil prices. Nevertheless, this effort remains insufficient compared to the Norwegian “gold standard”.

The deficits should be considered against the level of government debt in percent of GDP. In this regard, Bahrain and Oman appear to be the most vulnerable. Over the last five years, following the oil shock of 2014-2015, Government debt has been on the rise across the board with the most impressive increases in Bahrain and Oman, the weakest GCC states from a macro-financial perspective. Given the unprecedented magnitude of the current twin health and oil crisis, debt ratios could rise by another 30 to 60 percent of GDP in the next few years. To contain the rise of government debt while maintaining their currency pegs to the US dollar, the GCC countries will either have to implement a radical overhaul of their public finances or they will be forced to tap into their external assets.

From resilience to transformation

Only a few countries endowed with natural ressources rent managed to transform their economy and to effectively reduce or even to suppress their dependency on the rent. Mexico and Malaysia are often cited in this regard. There are also some useful lessons to be learnt from Kazakhstan and Columbia which remain dependent on natural resources but which managed to upgrade significantly their governance of these resources. How can the GCC countries achieve such a transformation? There is a huge academic literature on this issue but so far this has not translated into successful transformation programmes. Instead of going through this huge literature, I would like to emphasise a few high level principles and highlight some best practices in terms of public governance, based on my experience advising a range of policymakers and governments in the MENA region and beyond.

1. Focusing on transformation not on diversification

Diversification is perhaps one of the most overused concept in the economic discourse on the MENA region. There is no doubt that reducing the share of the oil sector in GDP desserves attention from policymakers. However, diversification is not a driver of economic efficiency. The key concept in this regard is structural transformation. The growth super-cycle of the 2Ks translated into economic diversification in the narrow sense. Oil income was recycled in non tradable sectors such as construction, hospitality and retail and the share of oil in percent of GDP was reduced across the board, as oil production volumes stagnated in most countries – or even fell in some countries. Meanwhile, the share of tradable sectors such as manufacturing fell in percent of GDP. Hence, in most MENA countries, economic diversification has not been matched with structural transformation.

In addition, the dependency of an economy to the oil sector is much more pernicious than what is suggested by the size of this sector in overall value added. Indeed, the most salient feature of oil-based economies is the close relationship between oil prices, public spending and the credit cycle. The growth of the non oil sector is highly correlated with oil prices through the impact of oil revenues on government expenditure and credit growth. A good illustration of this point is Dubai whose economy is highly dependent on oil price developments, despite the insignificant share of oil in percent of total value added.

2. Balancing cyclical pains with structural gains

As I have already mentioned before, in most oil exporting countries, government expenditure tends to move in tandem with oil prices. This so-called fiscal pro-cyclicality gives rise to frequent “booms and busts”. By deciding to triple VAT rates in July – from 5% to 15% – two years only after introducing VAT, Saudi Arabia surprised and shocked many observers with this measure. This is has been perceived as a pro-cyclical policy that would aggravate the sharp cyclical downturn caused by the coronavirus recession. However, despite its inflationary effect and negative impact on demand in the short term, this decision is consistent with the need to increase non-oil revenue and to reduce the dependency of the Saudi Treasury on oil. One additional step would be to decouple in a more systematic way government expenditure from oil revenues by introducing a fiscal rule, that would allocate oil revenues in excess of some price threshold to a stabilisation fund or directly to the country’s sovereign wealth fund, the PIF. According to economist John Hartwick, an exhaustible rent must be entirely saved and invested in the non-oil economy. Only Norway fully applies the “Hartwick rule” so far. Over the last twenty years, Russia and other oil-exporting countries such as Malaysia and Mexico have also moved in this direction. However, among the GCC countries, only Kuwait applies a watered-down version of an oil rule.

3. Prioritising sensible projects over mega-projects

Following the 2014 oil price collapse, the GCC countries have embarked in strategic transformation and diversification programmes. In Saudi Arabia, Vision 2030 relied heavily on government funding of these programmes – directly or through the Public Investment Fund (PIF). However, thus far, the Saudi government has failed to convince international capital and domestic private capital to co-invest alongside government entities in these programmes. Domestic investors continue to favour rent-recycling activities such as retail and real estate which offer faster and less riskier returns on capital. Therefore, in the current environment, it would be advised to review all the mega-projects and to shelve those that do not match sensible expectations of return and spillover on the rest of the economy in terms of employment and value added.

4. Overcoming resistance to change

It is difficult to keep strategic focus. Both economic theory and historical experience teach us that there is a dynamic inconsistency or incoherence between political cycles and economic cycles. Overcoming political economy traps is an important part of the change equation. Political economy specialists have long refleted on those issues. Yet they convey a static image of reform as the solution to a dilemma-like problem: “how to move a group or polity from stage A to stage B without destroying the internal cohesion of the group which is based on long standing values and beliefs ?” This approach ignores the capacity of a system/society to change its underlying beliefs, for example in relation to work ethics or risk-taking. Most political economy frameworks are static in essence referring to the so-called Washington Consensus, a set of ready-made recipes that constitutes a sort of “neoliberal gospel”.

In contrast, the East Asian experiences of economic development insist more on the overall process than on the outcome of reforms. First and foremost is the idea that it is necessary to keep a strategic focus over the medium to long term while preserving the flexibility to adapt to shocks and to correct the initial strategy. This is obvious in the Singaporean and Malaysian experiences for example. In addition, successful past reform experiences show that change cannot be forced upon a society, it can only be incentivised. Otherwise there is an increasing risk of backlash, which could eventually lead to backpedaling on reforms and even to a return to the statu quo ex antes. There are many examples in history of this reversal of earlier reform endeavours followed by counter-reforms from the Moghol Empire in India after the death of Akbar to Tsarist Russia under Nicolas I and under Nicolas II, especially after Stolypin’s assassination by a left-wing radical in 1911), not to mention the failure to embrace reforms in Late Qing China. While they can impulse change, Governments need not direct structural change at all stages of economic development. They need to design the right incentives to encourage the the private sector. They can help private investors by de-risking the inherently high level of risk involved in innovation and competitive advantage discovery. More on this can be found in my book, Arab Economies on the move, published in French with a foreword by former WTO Director-General, Pascal Lamy. An English edition of the book will be released later this year.

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