The Economy of Dubai

By Raimundo Soto

The success of Dubai in using resource rents for economic development and higher welfare, nevertheless, does not rule out the fact that some of the symptoms of the resource curse are present. There are three important weaknesses in the sustainability of Dubai’s development path that the authorities would have to address.

 

In less than fifty years, Dubai transformed from a small fishing and trading village into an integrated, modern, and vibrant economy. Camel herds were replaced by endless caravans of shiny luxurious 4x4s, tents folded as skyscrapers rose from the sand, and small souks were replaced by the world’s largest malls.

Development in Dubai was sparked by oil richness but, unlike other countries and emirates in the Arabian Gulf, it has successfully diversified away from hydrocarbons with the creation of world-class clusters of financial services, tourism, and trading activities. It is estimated that, as of 2015, oil-related activities would amount to less than 5% of total production in the emirate.

Dubai has also escaped the pervasive “oil curse”, that is the paradoxical case where countries endowed with abundant natural resources suffer from long-standing economic malaises that inhibit their economic and social development. This oil curse operates through varied mechanisms. One mechanism is when the significant inflow of currency brought upon by exporting oil appreciates the currency and reduce the profitability of other economic sectors, thus weakening the productive basis of the economy. Some countries – such as Algeria or Venezuela – literally export only hydrocarbons and nothing else. Economists have labelled this the Dutch Disease, a term coined in 1977 by The Economist to describe the decline of the manufacturing sector in the Netherlands after the discovery of the large Groningen natural gas field in 1959. However, no such effect has been observed in Dubai, largely because the dirham has been successfully pegged to the US dollar since the early 1980s, thus avoiding currency misalignments.

Another channel runs via lowering physical capital accumulation. High resource rents usually fuel consumption booms and tend to depress national saving. In turn, this leads to lower than optimal accumulation of capital, in particular in non-oil sectors or in infrastructure. During the oil rush of the 1970s and 1980s, when most Arab Gulf countries favoured a model based on a welfare state and a large public sector to absorb the national labour force, Dubai, on the contrary, adopted a strategy based on investing oil revenues on infrastructure and diverse industries, resisting the pressure to have a large, overstaffed public sector. According to the World Economic Forum, in 2015 Dubai had better infrastructure levels than Japan, the US and all of the European Union.

A third mechanism operates when significant natural resource rents in conjunction with institutional weaknesses (including ill-defined property rights, imperfect or missing markets and lax legal structures) lead to rent-seeking on the part of producers, thus diverting resources away from socially profitable activities. In extreme cases, civil wars break out for the control of such rents. In less extreme cases, the struggle for resource rents may lead to hoarding of economic and political power in the hands of elites that, once in power, would use the rents to placate their political supporters and thus secure their hold on power. Extensive rent-seeking breeds corruption, distorts the allocation of resources and reduces both economic efficiency and social equity. Again, this is not the case of Dubai: according to Transparency International, in 2015 Dubai ranked among the 25 less corrupt economies in the world, on a pair with France.

The success of Dubai in using resource rents for economic development and higher welfare, nevertheless, does not rule out the fact that some of the symptoms of the resource curse are present. There are three important weaknesses in the sustainability of Dubai’s development path that the authorities would have to address.

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Productivity

Economic growth was mainly induced by a significant accumulation of physical capital and massive inflow of foreign workers and not by achieving higher productivity levels.

Employment in Dubai expanded from around 200 thousand in 1985 to 1.75 million in 2015, mostly low-skilled workers from the Indian subcontinent (India, Bangladesh, Sri Lanka, Pakistan, and Nepal). There are also a significant number of very high-skilled expatriates from the UK and continental Europe, usually employed in top management positions. Oil-money as well as ample access to international financial markets have been used to finance both productive investments and extravagant initiatives. And while there are many successful stories – such as the world’s largest man-made port at Jebel Ali or Dubai’s international airport – others attest to the contrary. None more representative than the mega-housing project where hundreds of artificial islands were built in the shape of continents that went bankrupt in 2009 and is slowly being swallowed by the waters of the Arabian Gulf. The bottom line is that massive accumulation of resources is not synonymous with improved efficiency: in fact, total output per worker has remained stagnant for a long period of time, as shown in the figure below.

 

Certainly, some sectors in Dubai are highly productive (e.g., financial sector, logistics, air transport) and can compete in international markets: air transport and the financial sector clearly stand out. Nevertheless, other sectors such as construction, host-telling, and retail lag significantly behind. These sectors employ thousands of unskilled expatriate workers and tend to have very low labour productivity. Here lies one of the key questions for Dubai’s development and for economic policy: if the emirate has no limitations in terms of access to capital and technology and if it is able to attract the best of human capital from anywhere in the world, why would it choose to organise production so as to be of low productivity and value added?

The answer lies in the peculiar structure of the labour market that characterises not only Dubai but all Gulf countries. Dubai’s workforce is largely shaped by two concurrent phenomena: the sponsorship system (kafala, in Arabic) governing the employment of expatriates and the protection system for nationals embedded in both the Emiratization program and public employment policies. The kafala has been instrumental in bringing in massive amounts of low-skilled expatriate workers that enter the country under the sponsorship of an Emirati national or Emirati-controlled firm. Since workers cannot change sponsor unless they obtain written consent from its current sponsor, employers enjoy market power and collect sizeable economic rents: the incentive to hire more workers than machines is thereby clear. Certainly employers in Dubai pay substantially more than what these workers could earn in their country of origin, but it is still less than the value of their contribution to production. And because extracting rents is easier the less skilled is the worker, production tends to be not only labour-intensive but also of low productivity. Not surprisingly, the above-mentioned most productive sectors operate mainly in free-trade zones where the kafala (and other regulations) is not binding.

Emirati nationals, on the other hand, are not subject to the sponsorship system but are protected by the rules and regulations emanating from the Emiratization program. These shelter them from openly competing with expatriates in the labour market but, at the same time, they also reduce their employability, particularly that of young and inexperienced workers. Since the private sector cannot afford the relatively more expensive national workers, Emirati are mainly employed by the public sector (around 80% are civil servants). Nationals fresh from high schools or universities face much higher unemployment rates, particularly females which are now timidly entering the labour market. The response of the authorities in Dubai – as elsewhere in the Gulf Cooperation Council (GCC) economies – has been to impose labour quotas on the private sector: private firms are mandated to reserve a certain fraction of their manpower for nationals or face a fine and, eventually, closure.

One can safely conclude that the sponsorship system is a factor inhibiting technological change because in keeping wages low it has not given entrepreneurs incentives to acquire more advanced technologies.

The duality of the labour market is an issue that needs addressing. It may be the case that the path chosen by the authorities is not the best. In keeping the sponsorship as a centrepiece of economic policy, the authorities might have considered that a more flexible labour market would increase costs and reduce the profitability of firms, thereby hampering investments in new, more efficient technologies. Yet, historically, it is when labour becomes scarce and wages soar that entrepreneurs implement new technologies to replace workers by more efficient technologies and machines. Dubai’s story also refutes the connection between higher labour costs and lower investment: private sector profits in Dubai grew significantly since the 1990s and employment expanded massively, but this did not lead to investment in better technologies and labour productivity stagnated. One can safely conclude that the sponsorship system is a factor inhibiting technological change because in keeping wages low it has not given entrepreneurs incentives to acquire more advanced technologies. The sponsorship system might have served Dubai in the past, but its time has come to be replaced by a modern labour structure.

 

Vulnerability

Dubai exhibits significant vulnerability to oil shocks and domestic production is volatile despite its limited dependence on the hydrocarbon sector.

In spite of oil being unimportant to Dubai, its economic activity has been largely affected by oil-price cycles. One could think this as a consequence of being integrated to oil-rich Abu Dhabi and certainly there may be some effects but they are of secondary importance. The true reason, indeed, lies in the absence of automatic stabilisers in the economy and the inability to organise macroeconomic policies to isolate economic activities from cycles in the global economy.

In its early days as an independent country the United Arab Emirates (UAE) authorities decided to peg its currency to the US dollar, thereby relinquishing monetary and exchange rate policies and confining the authorities with fiscal policies as their main policy instrument. But fiscal policy in Dubai is incapable of stabilising the economy since the main automatic stabilisers – income and value-added taxes – are conspicuously absent. These ad-valorem taxes automatically dampen the effects of economic cycles because in the upswing tax collection mechanically increases while in downturns collection decreases. In Dubai, the tax system cannot perform its countercyclical role since it is largely based on fixed fees and rental prices and not on ad-valorem levies. Furthermore, government expenditures tend to be highly pro-cyclical as a result of the lack of modern consolidated, multi-annual budget procedures. The bulk of fiscal adjustments is borne by capital expenditures – always easier to adjust than laying off public servants – thus potentially hampering long-run growth.

This, naturally, raises the key question of why would a country organise fiscal policies in such a way to allow passing oil-induced fluctuations directly to its internal economy thereby hampering long-run growth. In particular, it is difficult to understand why have GCC authorities consistently postponed the implementation of value-added taxes, an issue under discussion for at least a decade.

Whatever the reasons for the current policy design, fiscal reforms in Dubai cannot be postponed. During the heydays of oil prices, the exuberance of economic activity could easily mask fiscal inefficiencies. Nowadays, the prospects are for a long period of depressed oil prices, slower economic activity, and more unstable global markets. Fiscal latitude is largely gone in Dubai and the shadow of its large external debt lurks over.

 

Accountability

Contrary to its historical reliance on the private sector, to a large extent economic growth in Dubai in the decade leading to the global crisis was driven by massive government investment.

In fact, government investment was in the hands of largely unsupervised government related entities (GREs) operating in real estate and construction. These entities are responsible for a myriad of Dubai’s iconic buildings such as the Burj Khalifa (the tallest building on earth), the Palm Jumeirah (an artificial archipelago created using land reclamation), and the Burj Al Arab (a luxury hotel in the shape of the sail of a ship). But GREs are also responsible for the development of the highly successful industries such as Emirates Airlines, Emirates Aluminium, Dubai Ports, and Jebel Ali Free Zone (JAFZA). There is no doubt of the formidable entrepreneurial capacities of these entities.

Government investment was in the hands of largely unsupervised government related entities (GREs) operating in real estate and construction.

The increasing importance of GREs in key economic sectors, nevertheless, has become a major weakness of Dubai’s economic strategy. On one hand, to maintain the soundness of fiscal policy additional efforts are needed to mitigate the risks arising from both the timing and amounts of the debt repayments and the perception of opaqueness in the performance of most GREs. According to the IMF, the debt of Dubai GREs stood at around 70% of Dubai GDP in 2015 and their debt-servicing capacity is relatively low. Total public debt (including GREs’ debt) is high at 126 percent of Dubai’s GDP, with large maturities due by 2018 (US$51.6 billion of Dubai’s debt will come due in 2016-18).

On the other hand, economic incentives are needed for such GREs to perform efficiently and, most importantly, to avoid the implicit guarantee of government bail-outs every time they run into trouble. GREs, which largely enjoy monopolistic power and privileged access to land, crowd-out the private sector which finds itself unable to compete with firms that have preferential treatment. The development of businesses in Dubai is not only about allowing investors to operate in good conditions but also about setting rules of the game that are clear, transparent and conducive to an environment where only the most productive businesses survive. Producers – both private and public – must be free to fail because what matters for development is not more business, but more productive businesses. Predicting which businesses will be best for Dubai is not a task for the government but it can help in preparing and levelling the ground and it can even facilitate the development of certain sectors: ultimately competition will reveal what works and what don’t.

It has become a cliché to say that a country or a society is “at a turning point”. In Dubai’s case the cliché is certainly appropriate. After a very successful run of fifty years of sustained economic growth, the development strategy needs an overhaul. A substantial one, capable of overturning the dismal productivity record of the economy, that can provide for effective isolation for oil-price fluctuations and instil discipline and accountability to the government’s most formidable arm: its entrepreneurial capacity. There is no time to waste on changing gears: so far, Dubai has enjoyed the benefits of being the first to develop in the Gulf of Arabia, but other emirates and Gulf economies – such as Qatar, Bahrein, and Kuwait – are not far behind.

 

Featured image courtesy: Info About Industries of World

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About the Author

Raimundo Soto is Associate Professor of economics at Pontificia Universidad Católica de Chile. He received his PhD in economics from Georgetown University. Professor Soto served as president of the Chilean Economic Association and, between 2010 and 2012, he was Director of International Development at the Dubai Economic Council. His most recent publication is The Economy of Dubai published by Oxford University Press in 2016.