INTERNATIONAL. Soaring oil prices between 2002 and mid-2008 strengthened the dominance of oil revenues in the GCC economies, a report from the Carnegie Middle East Center said today.

In the report, Ibrahim Saif explains that the top priority for the Gulf Council Cooperation (GCC) countries should be improving economic governance to better manage existing oil revenues and attract foreign direct investment (FDI). With a comfortable cushion of foreign reserves, the risk for short-term instability is low; however, the current system of low taxes, combined with a rigid approach to foreign labour and generous public spending is unsustainable.

The oil share in the economy increased from 30.8% of GDP in 2002 to 40% in 2006. Oil revenues constituted 86% of total government revenue in 2006 in comparison to the 2002 figure of 77.4%. Over the same period, the oil contribution to exports also increased from 61% to 67%. These figures suggest that, despite efforts at diversification, the GCC countries are increasingly dependent on a single source to generate revenues, thus making them continuously vulnerable to oil price fluctuations.

However, the aggregated averages conceal important inter-country differences. While the share of oil revenues to total government revenues has increased in Bahrain, Kuwait, Saudi Arabia, and the UAE, it has decreased in Oman and Qatar.

Old challenges, changing dynamics

The increased levels of public spending channeled at modernizing the infrastructure has been a significant factor in the diversification of GCC countries toward the non-oil sector. Moreover, the deregulation of important sectors such as the financial sector, education, and tourism has attracted a wider spectrum
of investors, thus compelling the private sector to strengthen its competitive capacity.

It is important to note that these statistics only measure the direct role of oil in the economy. If the indirect impact of oil revenues on the service and industrial sectors is factored in, the contribution of oil to GDP will be much higher, thus further underlining the importance of oil in the economy. The indirect contribution of oil revenues will be explored by shedding light on the role of oil revenues in the development of the non-oil sectors and the implications of that for public policy, monetary policy, and fiscal policy.

The relationship between the oil and non-oil sectors in the GCC economies is interactive and dynamic. Driven by oil revenues, the non-oil sector in some countries has succeeded to reduce dependence on oil. However, it is still not clear to what extent growth in the non-oil sector is independent of growth in oil revenues. Given the uncertain nature of future energy prices, this raises serious policy challenges regarding the enabling conditions that must be nurtured for non-oil growth to be less dependent on oil revenues.

The continuing dependence of GCC countries on oil exports and oil revenue during this period is the result of high oil prices, not of a failure to develop the non-oil sector of the economy. In fact, the annual growth rate of the non-oil economy (sometimes referred to as the non-hydrocarbon economy) over the period 2002-2006 surpassed that of the oil economy. The annual growth in the non-oil sector averaged 7.72%. This growth resulted in an increase of the non-oil sector share to the total share of the economy from a low level of 4.4% in 2002 to 7.8% in 2007.

At country levels, the data indicates that the growth of Qatar, Kuwait, and the UAE has been associated with a strong growth in the non-oil sector where the average per capita of oil and gas is much higher than the rest of the GCC countries. These economies have been keen about adopting economic policies toward the diversification of their revenue sources. On the other hand, the Saudi government has been trying to encourage non-oil sectors through various means, but it continues to exhibit a relatively modest growth rate with the oil sector surpassing the non-oil by only a slight margin.

Bahrain and Oman reflect a rather different picture. Their oil sector registered negative growth rates over the observed period, thus suggesting that poorly resourced countries are unable to benefit from the hike in the prices of oil and natural resources. Both countries suffer from a rapid decline in oil reserves and a small production capacity. Oil experts emphasise the need for the two countries to invest in enhanced oil recovery methods. The observed growth rate in Bahrain and Oman was mainly driven by non-oil sectors such as financial services and construction.

The non-oil sector greatly benefited from better targeted public spending and sharp increases in capital spending channeled toward modernizing the industrial infrastructure and the deregulation of key sectors. A rapid population growth, especially in Saudi Arabia (4.6%) and the UAE (3.1%), required higher capital expenditure on housing and utilities. New roads, railways, ports, and airports were constructed in order to accommodate growing volumes of trade inside and outside the region. Moreover, the non-oil sector benefited from the deregulation of the finance, tourism, and education sectors. For example, Saudi Arabia
granted ten licences to foreign banks to open branches in the country after 2003. Prior to this date, banks were regulated by a 1976 law that required banks operating in the country to have a majority of Saudi shareholdings. Qatar and the UAE both undertook deregulation in the education sector with the opening of several branches of reputable international universities; a step that is expected to pave the way for establishing a niche market in education at the regional level.

Unlike the 1970s oil boom, the private sector played a more active role in the 2002–2008 boom. The non-oil growth in the GCC countries was driven by a newly emerging private sector. The private sector evolved from a merely rentier private sector into a sector run by competent entrepreneurs who find themselves forced to compete more aggressively in order to win contracts and ensure business access.

Also, partnerships between the private and public sectors became more widespread, which improved the quality of the projects being implemented in the region. During the 1970s oil boom, the rapid increase in
revenue led at times to the implementing of hastily planned and poor quality infrastructure and service delivery projects. Recent projects in infrastructure and utilities were more carefully selected and according to a predetermined framework and were linked to the macroindicators.

This difference has roots in the weak institutional capacity of the GCC countries in the 1970s, which resembled that of early-stage developing countries. GCC countries now have in place systems that can cope with the oil windfalls with significantly lower public debt ratios.

Public spending and the social contracts

Fiscal policy in the GCC countries has been expansionary and has been utilized to sustain the social contract between state and society. Public spending has been the primary tool used to influence economic performance. This has remained the case even after oil prices dropped from an average of US$108 in 2008 to a forecast US$75 per barrel in 2009. The fiscal surplus will drop nearly 28%; however, the GCC countries will finish the ongoing projects without difficulties.

Public spending is instrumental to understanding the dynamics of growth and oil revenue distribution in the GCC countries. On average, domestic taxes amounted to less than 5% of the GDP, thus constituting
a very low share of the governments’ revenue. In Kuwait, for example, the tax revenue makes up around 1% of GDP. This means that GCC countries rely on rent made from the export of oil in order to generate revenue for financing public spending.

One can reasonably conclude that public spending rather than taxation policy has been utilised as a distributive mechanism in the GCC countries. During the 1970s oil boom, GCC countries launched ambitious programmes of public spending on infrastructure and services. With the relative decline in oil prices during the 1980s and 1990s, GCC countries faced increasing problems that led to intensifying budget deficits, thus crippling the government’s ability to face turbulent social problems. Unemployment rates were remarkably high: 15% in Saudi Arabia and 17.5% in Bahrain and Oman. Governments found themselves in a vicious spiral driven by the necessity to reduce budget deficits—thus public spending—and the social pressure to provide public services. This unsustainable situation exerted an increasing pressure on governments to
rethink their economic and social policies.

For better or for worse, the 2002 spike in oil prices allowed GCC countries to avoid going into a domestically challenging area of restructuring. Governments resorted to simply increasing domestic spending on current and capital expenditures by allocating more resources to health, education, and
wages for nationals. Hence, the oil boom delayed some of the economic reform measures that the GCC countries had contemplated prior to 2002: increasing the level of domestic taxation, opening up some sectors, and implementing policies aimed at increasing nationals’ employment in the private sector.

The relaxed fiscal policy was reflected in a policy of minimal taxation. GCC countries have a very narrow domestic tax base; yet, given the accumulated foreign reserves, it is very unlikely that this source of government revenue will be tapped more significantly in the near future—even with the recent drop in
oil prices. According to the Index of Economic Freedom 2008, most of the GCC countries enjoy a very high degree of “fiscal freedom” measured by tax revenue to GDP. The rate is highest in Bahrain with 5.5%, 5.1% in Saudi Arabia, 4.6% in Qatar, 2.1% in the UAE, and only 2.8% in Oman—even though Oman is not an oil rich country. In Kuwait, this ratio was 1%, the lowest in the region.

This minimalist taxation policy is part of the informal social contract between the state and society in most GCC countries, where states choose not to tax their citizens. In return citizens do not participate effectively in decision-making but enjoy the benefits of oil revenues. The absence of real participation has important implications on transparency and good governance. Kuwait, which has regular meaningful elections and a powerful parliament, is the exception to this rule—although quality of governance there, too, remains low.

So despite the rise in energy prices that lasted a relatively longer period (2002 to mid-2008) than the volatile rise and fall of oil prices between the 1970s and 1980s, most of the GCC countries were nevertheless conservative in expanding public expenditures and accumulating reserves and were keen on paying back
some of their internal and external debt. Therefore, the 2002–2008 public spending expansion was associated with a relatively stricter public policy to reduce public debt.

After 2002, GCC countries managed to control public debt—reduced it to an average of 20.4% of GDP in 2006 compared with an average of 69.9% in the 1998–2002 period. Saudi Arabia registered the
highest debt-to-GDP ratio in 2006 with a 28% level; they were followed by Bahrain with 23.3%; Kuwait had the lowest at 8.5%. This conservative approach stems from past lessons from the 1970s oil boom when
the GCC countries found themselves accumulating high levels of external and internal debt relative to their GDP.

Given the accumulated current account surplus, GCC countries could easily afford to repay their domestic debt. However, they did not do so. This was in order to preserve stock of government securities and bonds that could be used at later stages for monetary purposes, like setting a benchmark for interest
rates and absorbing excess liquidity from the financial markets.

Although GCC countries followed a more prudent policy with the use of oil revenue, their fiscal policy still needed to address a number of key challenges: 1) designing measures to avoid the inflationary pressure of public spending; 2) enhancing the efficiency and transparency of public expenditure; and 3) adopting steps to diversify sources of revenue away from oil. In order to respond to these challenges, the GCC countries needed to strengthen their fiscal administrative capacities by introducing international best practices concerning budget preparation and expenditures monitoring. These issues did not seem to have
primacy given the relaxed fiscal position the GCC countries enjoyed during the period under review.

The efficiency of constrained monetary policy

Monetary policy in the GCC countries has been constrained as a result of the tight link between the GCC and the US economy through the pegging of their currencies to the US Dollar. Additionally fiscal, not monetary, policy has been the primary tool that has been utilised to influence economic performance.

With the exception of Kuwait, the exchange rates of the GCC country currencies are pegged to the US Dollar. Though this policy prevents central banks from utilising domestic interest rates as a monetary tool to control inflation, it does have merits. Given the importance of oil revenues, the pegged regime serves to stabilize exports as well as government revenues. Moreover, it has a significant role in enhancing the credibility of monetary authorities and restricting currency speculation.

However, during 2002–2008 there was a widening discrepancy between the business cycle in the GCC countries and the US economy—coupled with the sharp decline in the value of the US Dollar in comparison to the Euro and other major currencies. This triggered a debate over the appropriateness of the current
monetary policy. The US economy had begun to slow and show signs of impending recession as early as mid-2007; this led to the easing of monetary policy and the reduction of interest rates. The GCC countries were thus forced to reduce interest rates as well though their economies were already overheated and suffering from inflationary pressure.

A high rate of inflation and a low nominal interest rate resulted in a negative real interest rate, thus spurring rapid credit growth and adding fuel to already rapidly expanding domestic demand.

With the even more severe economic slowdown of 2008, it is expected that the GCC countries will register a slowdown in credit growth during the second half of 2008 and into 2009. This, combined with the recent strengthening of the dollar and the decline in commodity prices, should dampen inflation and make monetary policy more efficient.

The GCC countries are not expected to alter their current exchange rate policy given that, as an IMF report (2008) argues, nominal effective exchange rates have not shown a high degree of appreciation vis-à-vis other currencies. This implies that the impact of the exchange rate on inflation is limited and the current trade-off in favor of stability is worth pursuing. This line of argument is even more convincing after the global financial crisis and the strengthening of the U.S. dollar against other currencies.

Another explanation for this decision is related to political considerations, (close GCC–U.S. relations that make it more difficult to abandon the peg or even to diversify the asset portfolio). While this is understandable, it should still be possible for GCC countries to at least partially diversify their assets,
which will reduce both vulnerability and market volatility.

Most credit in the GCC countries is in the form of personal loans, indicating public confidence in the performance of the economy and an increased demand. This is triggered by higher wages that encourage consumption and enhance the creditworthiness of individuals before credit institutions.

Even though credit ratios have been increasing over the past years, they are still considered low if compared to developed countries. In the EU and the United States, for example, credit-to-GDP exceeds 100% and 141% respectively. Rapid credit expansion can undermine the quality of banks’ portfolios if the capacity of these banks to assess the creditworthiness of borrowers fails to keep pace with the growth of lending; these warnings proved accurate in the financial meltdown of September-October 2008.

In the GCC, the estimates of capital adequacy (the ratio of capital-to-risk-weighted assets) ranged from 16.7% in the UAE to 21.9% in Saudi Arabia. This figure stands at a much higher level than that required by the Bank of International Settlement upon which the soundness of the banking sector is assessed. The
over-conservative attitude by banks reflects the region’s higher economic and geopolitical risks. In the wake of the global economic crisis, GCC banks have remained well capitalized and profitable, with a ratio of nonperforming loans to total loans of less than 5%. And with a few exceptions, they have limited
exposure to complex products based on mortgages.

Moreover, monetary authorities reduced interest rates and introduced measures to provide liquidity
to the banking system. Some of these measures were in contrast with measures introduced earlier: an increase in reserve requirements and guarantees on bank deposits. These were adopted to cool down the overheated economy and to absorb some of the excess liquidity in the market.

Deposits in the GCC countries are mostly of a short-term maturity, making it difficult for banks to make long-term loans. During most of the period under study, banks preferred to extend loans in seemingly secure markets, such as real estate where they were guaranteed with strong collateral. This resulted in an overexposure to the real estate market, and thus correcting this market was made more difficult since banks portfolios were not adequately diversified. In response, GCC governments need to facilitate the development of new tools that allow banks to engage in issuing corporate bonds and venture capital.

Also there is a need to create credit bureaus that can more effectively assess risk. This must be associated with strong regulatory institutions in order to avoid fluidity or abuse in the bond market. This has become more pertinent after the global financial crisis that has revealed how devastating the weakness
of regulations can be.

In sum, monetary policy in GCC countries suffers by varying degrees from serious limitations in its ability both to influence business decision makers (banks) and to contain inflation. Partially for these reasons, the GCC countries still rely on fiscal not monetary policy as the main macro tool to control inflation.

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