Cracking the Arab World’s Development Puzzle: Oil or Politics?

By Ibrahim Elbadawi and Hoda Selim

Is the Arab World cursed by its own institutions rather than by oil wealth? These institutions, which have predated oil discoveries, have shaped economic incentives that affect how oil revenue is collected and used, and in turn influenced economic outcomes. Over time, the interaction between oil and politics became intertwined, preventing economic development in Arab countries. As low oil prices risk becoming a new normal, political reforms with checks and balances can turn the curse into a blessing.

 

Introduction

Despite massive hydrocarbon endowments, Arab economies have neither achieved economic prosperity nor became developed. With oil and natural gas discoveries taking place since the first half of the 20th century, Arab countries account for 7 out of the 13 members of the Organization of the Petroleum Exporting Countries (OPEC). They hold close to half of global oil reserves and a quarter of natural gas reserves. They control close to a third of oil production and 14% of natural gas production. And even though the per capita income of some Arab oil-producing economies is high, they would be considered less developed than Norway, a country with more limited oil resources and even Japan, a country without any natural resources. More worryingly, some oil exporters like Sudan and Yemen remain among the world’s poorest economies and have experienced episodes of violent conflict. More importantly, the low oil price environment, considered by some forecasters to be the new norm in the medium-term, raises the question of whether current income levels could be sustained in the future.

Many academics have attributed this disappointing performance to a “curse” which refers to the paradox that countries with an abundance of natural resources often fail to grow as rapidly as those without such resources (Sachs and Warner, 1994). The initial interpretation of the curse rested on pure economic grounds arguing that large resource windfalls lead to Dutch disease, overall macroeconomic volatility and debt overhang, among other ills. Yet this explanation fell short of explaining the successful economic performance of Norway, the world’s seventh largest oil exporter and fourteenth largest oil producer. Chile is another good example of an emerging country which is the world’s largest producer and exporter of copper. This realisation motivated a new strand of the literature that argues that “the curse is real but conditional on the presence of bad institutions” (Collier and Goderis, 2007; and, Elbadawi and Soto, 2016).

 

Dispelling the Oil Curse Myth

Despite their diversity in size, demographics and wealth, the macroeconomic performance of Arab countries has been generally vulnerable to the ebbs and flows of oil prices (Table 1 below). Yet, this article argues that the Arab world is cursed by weak institutions rather than by oil. In particular, weak political institutions have predated resource discoveries and over time have been able to shape economic incentives that affect how resource rents are collected, allocated and used, and therefore influenced economic outcomes (Galal and Selim, 2013). Over time, the interaction between oil and politics became intertwined, preventing these countries from embarking on a sustainable development path. In fact, there is a positive association between oil rents and limited freedom in political rights and civil liberties. More worryingly, Figure 1 (below) shows that oil-rich Arab countries lag behind using these two measures. In 2014 out of the 205 countries covered by Freedom House, 88 were considered “free”, of which none is an Arab oil-rich economy. Only one country is considered partly free, Kuwait. Moreover, most countries, especially in the GCC have not any undertaken meaningful political reform since the 1970s.

 

Table 1. Selected macroeconomic indicators during oil booms and busts

Source: Authors’ calculations based on WEO and WDI databases, 2014.

 

Figure 1. Hydrocarbon rents and Freedom House Scores, 2014

Source: Freedom House and WDI databases

 

As hydrocarbon revenues account for at least two-thirds of their fiscal revenues, many GCC oil-rich governments can afford not only to apply low tax rates but also efficiently redistribute these revenues through labour markets to national citizens in the form of well-remunerated public sector jobs and other generous social welfare schemes with the ultimate aim of fostering social stability and authoritarian rule.

In this weak institutional step, oil wealth turned Arab governments into rentier states by providing the means to buy off political consent with economic privileges. As hydrocarbon revenues account for at least two-thirds of their fiscal revenues, many GCC oil-rich governments can afford not only to apply low tax rates but also efficiently redistribute these revenues through labour markets to national citizens in the form of well-remunerated public sector jobs and other generous social welfare schemes with the ultimate aim of fostering social stability and authoritarian rule. The absence of significant political unrest in most GCC economies (with the exception of Bahrain) amid regional turmoil over the past 5 years speaks for that. More concretely, when political unrest mounted in 2011, oil revenues allowed GCC governments to generously appease citizens. Kuwait and Bahrain responded by giving out cash, Bahrain and Oman provided public sector jobs, and Saudi Arabia and Oman raised workers’ wages and benefits. According to Hertog (2012), Saudi Arabia approved an increase in expenditure by US$130 billion to finance the creation of 120,000 new public sector jobs, building 500,000 houses, setting a minimum wage of US$800 in the public sector, provided a one-time bonus to incumbent civil servants and created an unemployment assistance scheme. More generally, the choice of the government to provide high pay to nationals has led to high-reservation wages and creates a disincentive for nationals to invest in skills that are demanded by the private sector. This labour market segmentation crowds out private business and contributes to high unemployment (Alsheikh and Erbas, 2016).

Yet, while it is optimal for resource-rich traditional GCC rulers who govern small populations to offer investment in infrastructure and public sector jobs to effectively remove the incentive to revolt, poorer rentier states with larger populations like Algeria, Yemen and Sudan are only able to maintain political stability through a repressive security apparatus and have indeed experienced conflict, violence and social unrest at some point in time (Ali and Elbadawi, 2016).

 

The Economics of the Political Curse

Arab economies remain heavily dependent on oil in several aspects including domestic production and export earnings as well as fiscal revenue as mentioned before. In fact, oil exports account for above 60% of total exports. Moreover, the oil sector accounts for the majority of GDP, except in Algeria, Bahrain and Yemen and the UAE. More alarmingly, with a few exceptions being Oman, Qatar and the UAE, the manufacturing sector has either shrunk or stagnated over time, especially in countries where exchange rate overvaluation was persistent and/or significant (Selim and Zaki, 2016). And even in countries which have undertook diversification efforts, the size of the manufacturing sector remains remarkably suppressed (less than 11% of GDP) relative to their wealth. Bahrain is an exception where the manufacturing sector accounts for 15% of GDP but has slightly declined over time. More worryingly, Suliman (2016) shows that the discovery of oil in Sudan in the late 1980s quickly displaced cotton, as the leading export crop, shifting the economy from a relatively diversified agricultural base to oil dependence and almost eliminating its manufacturing sector.

Meanwhile, economic performance was disappointing. On the one hand, GCC growth was more severely affected by oil volatility but large oil wealth has maintained the financial sector quite liquid which in turn has been able to allocate ample resources for investments, particularly in infrastructure. On the other, limited resources may have somewhat shielded growth in the populous economies from significant volatility but they have contributed to devastating economic consequences, whether in terms of excessive borrowing, Dutch disease and limited savings (table 1). Unlike the GCC countries, they have failed to use their natural capital to develop the required physical capital to promote much needed economic diversification. As a result, these economies suffer from massive deficiencies in infrastructure investments and an underdeveloped financial sector.

 

Escaping the Curse

In order to escape the curse and achieve sustained growth and development, first and foremost, Arab countries must introduce effective political reforms accompanied by strong system of political checks and balances to limit abuse of political power and hence the misuse of resource rents.

Large oil resources, like those present in the Arab world, are a blessing. They have contributed to better standards of living and have most certainly widened the set of policy choices: they did better than they would have done without resource rents. Notwithstanding this improvement, the economic performance of Arab oil-rich countries has been disappointing, even in the absence of a counterfactual. The modest economic progress made cannot be blamed only on the way the economy was managed or simply on the abundance of oil. It can however be blamed on weak political institutions. In order to escape the curse and achieve sustained growth and development, first and foremost, Arab countries must introduce effective political reforms accompanied by strong system of political checks and balances to limit abuse of political power and hence the misuse of resource rents. As a second best, the adherence to the Extractive Industries Transparency Initiative (EITI) which provides a global standard for transparency in the oil industry and the National Resource Charter (NRC) which offers more comprehensive principles for governments and societies on how to best harness the opportunities for development generated by extractive commodity windfalls, can serve as anchors for enhancing transparency and accountability.

Second, the reform of fiscal institutions would improve resource management, achieve more savings, and release resources for the diversification of the non-oil sector. Because oil is an exhaustible resource, oil countries need to save. Collier (2016) estimates that the GCC must save 30% of their hydrocarbons fiscal revenues starting 2013 which needs to rise to 100% by 2083. The investment of these revenues in financial assets abroad (given few opportunities for domestic investments) through sovereign wealth funds (SWF) is sufficient to ride out revenue volatility. Populous economies which have shorter resource horizons need to save 50% of their hydrocarbons fiscal revenues which needs to rise to 100% by 2043. These countries need both a SWF and a Sovereign Development Fund (SDF) to invest the majority of their wealth in domestic infrastructure either in the form of physical assets or in human capital through improving health care and education of citizens, a process sometimes called “investing in investing” (Collier, 2016). These countries would also greatly benefit from implementing more effective public spending programs to ensure that resources are allocated towards high-quality public investment projects and avoid white elephant wasteful projects.

Moreover, the adoption of fiscal rules would allow governments to determine how much of their resource revenues they can safely spend through the annual budget with the aim of smoothing revenue volatility and potentially mitigating discretionary interventions by governments (Schmidt-Hebbel, 2016). To this end, countries would benefit from setting a target for the structural budget balance on the basis of an estimate of the long-term oil price.

Third, current exchange rate levels are considered to be overvalued in most oil-rich Arab economies, suggesting targeting a competitive real exchange rate to promote non-oil exports. Fourth, another challenge specific to the GCC is to raise educational quality, skills development to raise productivity in order to make nationals more competitive for private sector hiring. As for the populous countries, they need to initiate an aggressive program to encourage economic diversification. To this end, governments should focus on simplifying the complex doing business procedures and improving infrastructure.

To conclude, the best way to turn the curse into a blessing in the Arab World is to improve on the prevailing political institutions, which form the deep roots of the curse and have contributed to poor economic outcomes. Current low oil prices present a window of opportunity for policymakers to undertake many reforms that would embark their economies on a sustainable development.

 

About the Author

Ibrahim Elbadawi is the Managing Director of the Economic Research Forum as of January 2017. Previously, he was Director at the Economic Policy & Research Center, the Dubai Economic Council and Lead Economist at the Development Research Group of the World Bank. He was Research Director of the African Economic Research Consortium (Nairobi). He published on macroeconomic and development policy and the economics of civil wars and post-conflict transitions. He holds a PhD in economics and statistics from North Carolina State and Northwestern universities.

Hoda Selim is a Senior Economist at the Dubai Economic Council since 2016. Previously, she worked at the Economic Research Forum in Cairo and the World Bank’s Cairo Office. Her recent research focuses on the macroeconomics of oil management and the political economy of development. She holds a PhD from Sciences Po Paris in France.

 

References
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10. Schmidt-Hebbel, Klaus. 2016. “Fiscal Institutions in Resource-Rich Economies: Lessons from Chile and Norway.” In I. Elbadawi and H. Selim, eds., Understanding and Avoiding the Oil Curse in Arab Resource-rich Economies. New York: Cambridge University Press and the Economic Research Forum.
11. Suliman, Kabbashi. 2016. “Understanding and Avoiding the Oil Curse in Sudan.” In I. Elbadawi and H. Selim, eds., Understanding and Avoiding the Oil Curse in Arab Resource-rich Economies. New York: Cambridge University Press and the Economic Research Forum.

 

The views expressed in this article are those of the authors and do not necessarily reflect the views or policies of The World Financial Review.