Chapter

Chapter 1. Soaring of the Gulf Falcons: Diversification in the GCC Oil Exporters in Seven Propositions

Author(s):
Reda Cherif, Fuad Hasanov, and Min Zhu
Published Date:
April 2016
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Author(s)
Reda Cherif and Fuad Hasanov 

Reda Cherif and Fuad Hasanov

The countries of the Cooperation Council for the Arab States of the Gulf (GCC) face a difficult task in refocusing growth models to diversify their economies.1 Yet doing so will reduce their reliance on hydrocarbons, allow the private sector to drive growth, and give people the skills needed to enter the high-value-added jobs those economies would create.

A key challenge is to find ways to develop non-oil tradable sectors, which should support sustainable private sector employment. Currently, however, most export and fiscal revenues in the GCC come from oil and gas sales, which affect economies through government spending, including public investment. The large amounts invested so far have not produced tradable sectors outside of oil and oil-derived products. These offer little export diversification and minimal linkage with the rest of the economy. In addition, the countries in the region cannot keep relying on their public sectors to absorb their own nationals newly entering the labor market. The GCC states also have many foreign workers, mostly low-skilled, and employed in the nontradable sectors rather than non-oil tradables.

Although all GCC countries do share this reliance on hydrocarbons, the difficulties they face in diversifying vary. For Bahrain and Oman, oil reserves could be depleted sooner than for the others, making it more urgent to find other sources of economic growth and export revenues. In Saudi Arabia, though oil reserves will be long-lasting, increasing the employment of nationals in the private sector is a key challenge. As in Saudi Arabia, nationals in Kuwait, Qatar, and the United Arab Emirates work predominantly in the public sector, with little incentive to work in the private sector and invest in developing their skills. Dubai’s economy, by contrast, is more diversified, but its non-oil exports are concentrated in minerals, metals, tourism, and transportation services. That said, all GCC countries need to develop growth models that will allow citizens to continue to enjoy the fruits of development that have come with oil income.

We analyze, in seven propositions, the major economic challenges the GCC countries face. The prevailing oil-reliant growth model in the region has markedly improved development indicators such as health, education, sanitation, and physical infrastructure. But it has also resulted in a decline in economic performance relative to other countries. We argue that a sustainable growth model requires a diversified tradable sector, which is now lacking. Because export diversification takes a long time, it must start now. In contrast with the previous literature, we argue that the standard policy advice—implementing structural reforms, improving institutions and the business environment, creating infrastructure, and reducing regulations—though necessary, will not be sufficient, because of fundamental market failures stemming from Dutch disease.2

To overcome these failures, other countries, including oil exporters, have gone beyond comparative-advantage sectors and targeted high-value-added industries such as manufacturing and innovation, with large productivity gains and spillovers to the rest of their economies. The state has often acted as a venture capitalist and fostered public-private collaboration to achieve sustainable and equitable growth.

We draw lessons from the experience of diversification in oil exporters; in particular, the few relatively successful ones—Indonesia, Malaysia, and Mexico. Success or failure appears to depend on implementing appropriate policies ahead of the fall in oil revenues. Our study of different diversification strategies suggests that a mix of vertical and horizontal diversification seems to be most successful. The former creates linkages in existing industries and the latter diversifies the economy beyond its comparative advantage, with an emphasis on exports and technological upgrading.

Seven Propositions

Proposition One

The prevailing growth model achieved a large improvement in human development indicators, but also reduced relative economic performance.

Ever since oil was discovered in the GCC countries, it has been both a boon and a curse. The flow of oil revenues provided an opportunity to develop economies and improve standards of living. The GCC countries invested heavily in infrastructure and heavy industries, started developing services such as finance, logistics, trade, and tourism; spent considerably on education and health; and provided affordable food and energy to their populations. However, the decline of oil prices in the 1980s–1990s did not pave the way for export diversification—the concept that we argue is most relevant in the analysis of diversification and sustainable growth, as opposed to the share of non-oil GDP. The region’s economies remain as dependent on oil as they were in the past.

The growth model in the GCC consists of extracting oil and producing oil-related products and nontradables while importing most of the tradable goods it consumes.3 Oil exports accounted for more than 60 percent of total exports of goods and services in the GCC in the 2000s, and this share either increased or has not fallen much since the 1980s (Figure 1.1). In contrast, oil export shares fell drastically in oil exporters such as Indonesia, Malaysia, and Mexico. In addition, oil revenues were more than 60 percent of total fiscal revenues in the GCC in 2013.

Figure 1.1Average Oil Exports

(Percent of Total Exports)

Source: IMF, World Economic Outlook database.

Note: UAE = United Arab Emirates. UAE goods and services exports exclude re-exports.

Output composition in the GCC countries varies, but they all share an export composition heavily concentrated in oil, chemicals, and metals such as aluminum. The share of mining/utilities output (in real terms) is above 30 percent in all but one GCC country; Bahrain’s is about 15 percent, similar to Norway’s. Manufacturing shares are smaller than in comparator oil exporters. Starting from a low base, non-oil exports grew about 13 percent per year on average during 2000–10. Compared with the rest of the GCC, the United Arab Emirates has increased its non-oil exports substantially.

The state dominates the economy, receiving oil revenues and redistributing them through different channels. Fiscal policy acts as the main transmission channel of oil price fluctuations to non-oil output (Husain, Tazhibayeva, and Ter-Martirosyan 2008). Government spends a large part of the oil revenues directly and provides for citizens through transfers and jobs in the public sector, which employs the majority of nationals in most GCC countries (IMF 2013a). A part of revenues is invested in mega projects, especially infrastructure and real estate, while the rest is saved; for instance, in the sovereign wealth funds. In addition, most private sector jobs are held by expatriate labor, and most of those workers are employed in low-skilled and low-productivity activities.

The GCC has raised living standards hugely, and human development index scores have improved substantially. Infant mortality has fallen, expected years of schooling risen, and life expectancy increased (Figure 1.2). Even in comparison with oil exporters in the advanced countries, such as Canada and Norway, the GCC countries are performing relatively well.

Figure 1.2Social Indicators

Sources: New York, Department for Economic and Social Affairs; UNESCO Institute for Statistics; United Nations Department of Economic and Social Affairs (2009); and United Nations Development Programme.

Note: GCC = Gulf Cooperation Council, UAE = United Arab Emirates.

In parallel, however, the GCC countries slid in international income rankings. GDP per worker (in purchasing power parity dollars) has fallen, except in Oman and Qatar; standards of living declined as oil prices dropped to their lowest levels in the 1980s–1990s and improved somewhat after oil prices started rising (Figure 1.3). In relative terms, overall performance was even more disappointing. The GCC countries fell substantially in relative income rankings, from about 1.5 to 4 times U.S. income per worker in 1980, for most, to U.S. levels or below in 2010.4,5 Even Qatar, with large gas production and a small population, decreased from more than three times the U.S. level to only about double the U.S. income per worker. Bahrain and Saudi Arabia slid to the 43rd and 31st rank of income per worker relative to the U.S. level in 2010, respectively, from top-10 positions in 1980.

Figure 1.3GDP per Worker, 1970–2010

(Purchasing power parity, 2005 constant dollars)

Source: Penn World Tables 7.1.

The fall in relative income was also accompanied by declining productivity, while real GDP growth was mostly driven by factor accumulation (Figure 1.4). High capital accumulation—including human capital—and population growth contributed to the high growth of output in the GCC, but was not accompanied by increasing relative performance on a per capita basis. Total factor productivity (TFP) declined in all GCC countries during the three decades through 2010.6 TFP in Mexico has also declined, but it grew in Indonesia and Malaysia, increasing the gap between the GCC and other oil exporters. Large accumulations of physical capital contributed to growth in Indonesia and Malaysia and supported TFP growth (see Annex Figure 1.1.1 for other countries).

Figure 1.4Growth Decomposition, 1970–2010

(1970 = 100)

Source: Penn World Tables 7.1.

Note: PPP = purchasing power parity; TFP = total factor productivity; UAE = United Arab Emirates.

Proposition Two

A sustainable growth model requires a diversified tradable sector.

Sustainable growth is driven to a large extent by export diversification and the sophistication of the country. Hausmann, Hwang, and Rodrik (2007) and Cherif and Hasanov (forthcoming) show empirically that export sophistication is one of the major determinants of growth, accounting for initial conditions, institutions, financial development, and other growth factors. Jarreau and Poncet (2012), using regional Chinese data, reach the same conclusion, but emphasize that it is the domestic firms’ export activities that have the largest effect on subsequent growth. Foreign firms mostly contribute to export upgrading. Papageorgiou and Spatafora (2012) also indicate that export diversification in low-income countries is one of the major determinants of growth and is associated with the decline in the volatility of GDP per capita in developing economies. Their study finds that quality upgrading, especially in manufacturing, is positively correlated with growth. Since export sophistication is crucial for growth, the manufacturing sector, with its high potential in this area, represents an important sector to focus on. Moreover, Rodrik (2011) shows that labor productivity in manufacturing industries converges across countries, independently of initial conditions.

To create sustainable growth, a country needs to constantly produce new goods and adopt and develop new technologies. Lucas (1993), in the seminal paper “Making a Miracle,” argues that constantly introducing new goods, rather than only learning on a fixed set of goods, is needed to generate productivity gains for a sustained growth miracle. Learning by doing (learning on the job) is one of the most important channels for accumulating knowledge and human capital in this process. Producing the same set of goods would rapidly lead to stagnation in productivity. In contrast, introducing new goods and tasks would allow managers and workers to continually learn and move up the “quality ladder.”7 To do this on a large scale, Lucas argues, the country must be a large exporter.

Declining productivity and relative income stagnation in the GCC can be explained by the nondiversified export base and stagnating export sophistication. As the studies just mentioned show, sustainable growth depends importantly on export sophistication and new goods production. Compared to commodity exporters such as Indonesia, Malaysia, and Mexico, the GCC countries’ export sophistication is low and has not improved much over the years (Figure 1.5).8 Productivity gains were negative over the period.

Figure 1.5Goods Exports Sophistication, 1976–2006

Sources: Hausmann, Hwang, and Rodrik (2007); and World Bank.

Note: PPP = Purchasing Power Parity; UAE = United Arab Emirates.

The comparison of Bahrain and Singapore offers a stark example of the distinction between export diversification and output diversification. The output compositions of the two countries are comparable overall (Figure 1.6). Starting at comparable shares, the mining sector share increased in Bahrain from the 1990s relative to Singapore’s. The manufacturing share in Bahrain is similar to that in Singapore, while the share of construction is slightly greater. In contrast, exports in Bahrain are almost exclusively concentrated in oil and metals (more than 95 percent), which is vastly different from the diversified export base of Singapore, where the manufacturing sector accounts for more than 60 percent of total goods’ exports (Figure 1.7). In addition, manufacturing in Bahrain is mostly aluminum and other metals, which is not necessarily the most conducive to the introduction of new goods and tasks and moving up the quality ladders that Lucas (1993) advocated. Even when Bahrain’s exports of services (transportation, travel, communication, and insurance) are taken into account, oil still represented more than one-half of total exports of goods and services in 2010.

Figure 1.6Bahrain and Singapore: Output Structure, 1990–2011

Sources: Country authorities; and United Nations Statistics Division database.

Figure 1.7Bahrain and Singapore: Export Structure, 2008

Source: Country authorities.

In a similar vein, output diversification and non-oil growth are misleading indicators of diversification and sustainable growth. The example of Bahrain shows that a relatively diverse output composition does not necessarily imply export diversification. The export structure is a proxy for tradable production, the main source of productivity gains for sustainable growth. In fact, TFP declined in the GCC countries during 1980–2010, despite high non-oil growth over the same period, ranging from about 4 percent in Saudi Arabia to 10 percent in Qatar. This increase in non-oil GDP, however, is mostly due to oil revenues channeled to the economy through fiscal and related private spending. Non-oil GDP comprises energy-intensive and resource-related industries such as metals and petrochemicals, as well as construction and services, such as retail and restaurants, transport and communications, and social services. High non-oil growth in these economies is not an indicator that growth could be sustained in the long term, or, if oil prices were to fall, for a sustained period.

The literature on diversification in the GCC suggests that past attempts have yielded few benefits. Hvidt (2013), analyzing the national visions of the GCC governments, argues that the implementation of these plans is plagued with many obstacles. These include barriers to interregional trade, the duplication of economic activities across the GCC, and political environments in which governments tend to revert to patronage and increased government spending rather than follow through on tough reforms. Poor diversification in the GCC, according to Looney (1994), can be explained by the lack of an overall industrialization strategy, Dutch disease, the reliance on migrant labor, and inadequacies of incentives in production and exports. To fight the oil curse, Elbadawi (2009) suggests a stable macroeconomic environment, rules-based fiscal policy, and sound economic and political institutions for the management of oil rents. El Beblawi (2011) stresses that natural-resource-based industries and import substitution industries such as food processing and construction materials are not sustainable growth drivers. Nabli and others (2008) discuss the need to promote horizontal policies and improve governance.

Heavy industrialization strategies in the GCC, in chemicals and energy-intensive sectors such as aluminum, helped diversify production and exports, but had several shortcomings. These industries are capital intensive and have resulted in few linkages to the rest of the economy. Local sourcing of tradables in support of the heavy industries was not developed, and most of the complex technology is still imported. Although some technology was acquired (such as Saudi Basic Industries Corporation’s 2007 acquisition of GE Plastics), there was not much technology transfer to the rest of the economy. The productivity gains and spillovers were limited. The employment opportunities available in these capital-intensive industries are small. In addition, the exports of oil derivatives such as petrochemicals are strongly correlated with oil prices, in turn hampering the reduction of high export income volatility. Recent attempts at creating industrial clusters, technology parks, and other manufacturing industries have yet to yield substantial results.

Service sector exports have grown strongly in a number of countries in the region, though the development of services may not be sufficient for sustainable growth. The GCC countries have developed tourism, logistics, transportation, and financial services. The development of services resulted in output diversification, but most of these services rely mainly on low-skilled labor (such as tourism and transportation) and would not attract nationals. Low-skilled activities such as restaurants and transportation are less conducive to sustained productivity gains, and cannot be the engine of a sustainable growth strategy for high-income countries such as the GCC. In addition, the amount exported is insufficient to cover imports. In the United Arab Emirates, exports of services barely covered a quarter of imports of services in 2011, and the net service balance has been negative since 1990, despite the growth of exports. In Bahrain, the net service balance is positive, but only covered about a third of goods imports in 2011.

The focus on such sectors is not sufficient for countries with larger populations to reduce their dependence on volatile oil prices and decrease unemployment. In theory, high-value-added sectors and the associated high-wage jobs exist in both the tradable and nontradable sectors. But for an economy to generate sufficient jobs in high-value-added nontradables (such as software or design), it needs to create a network of interlinked tradable and nontradable sectors. It is unlikely that existing high-value-added sectors such as finance, insurance, and managerial jobs can absorb the massive number of entrants projected. As Arezki and others (2009) show, specialization in tourism yields limited growth benefits. For instance, an increase in the tourism sector share of exports by 8 percent (one standard deviation in a sample of more than 80 countries over 1980–90) increases growth by only one-half percentage point a year. Nor would the sector help absorb a labor force of nationals with high reservation wages. Even the finance sector, paying high wages, is not enough to generate sufficient employment. Bahrain’s finance sector, about 17 percent of GDP, directly employed less than 10 percent of nationals in 2012, similar to London’s share of the finance and insurance sector.

Proposition Three

Both the initial technological gap and the size of oil revenues determine the chances of success or failure at diversification in oil-exporting countries, while policies adopted magnify or mitigate this effect.

During the past decades, oil exporters diversified their economies with different degrees of success. Countries such as Algeria, Congo, Gabon, the GCC countries, and Yemen have not developed many tradables, but Malaysia, Indonesia, Mexico and others have increased their export sophistication and developed manufacturing industries. We argue that the relative success or failure in diversification stemmed mainly from the manifestation of a crowding-out of the tradable sector, which could be described as a type of Dutch disease, while the policies that were pursued magnified or mitigated this effect. Broadly speaking, Dutch disease is the crowding out of the tradable sector as a result of oil revenues compared to the counterfactual of no oil revenues.9 In the following we will use Dutch disease to describe this crowding out of the tradable sector, although not necessarily linked to real exchange rate movements.

The severity of the crowding out of the tradable sector depends both on the amount of the oil revenues and the initial technological gap or distance to the technology frontier (Cherif 2013).10 Oil exporters can be classified along two dimensions shown in Figure 1.8, in which the real value (deflated by the U.S. consumer price index) of machinery and transport equipment exports per capita in 1970 is used as a proxy for the initial level of technology.11 Four groups of oil exporters are distinguished: low tech (initially) and low revenues (such as Algeria, Angola, Republic of Congo, Ecuador, Indonesia, Malaysia, Mexico, Nigeria, and Venezuela), low tech and high revenues (Bahrain, Gabon, Kuwait, Libya, Oman, Qatar, Saudi Arabia, and UAE), high tech and low revenues (Canada), and high tech and high revenues (Norway).12

Figure 1.8Initial Machinery Real Exports per Capita (1970) vs. Oil Revenues (1970–2012)

Sources: Feenstra and others (2005); and IMF, World Economic Outlook database.

Overall, the performance of oil exporters has followed this typology (see Figure 1.9):

  • Canada, a high-tech/low-oil-revenue country, did well in increasing its technological development proxied by real machinery exports per capita.
  • In contrast, Norway, which received large oil revenues and is technologically sophisticated, did not increase its exports per capita as much and actually fell from above the U.S. level in 1970 to below it in 2000.
  • Low-tech countries with large oil revenues did not do as well. Out of nine countries, Oman and the United Arab Emirates increased their exports more than others, but only to about the 1970 U.S. level.
  • Lastly, among low-tech/low-oil revenue countries Indonesia, Malaysia, and Mexico succeeded in diversification compared with Algeria, Nigeria, and Venezuela. Although Indonesia’s machinery exports did not increase as much as Malaysia’s and Mexico’s, its export sophistication improved significantly. Both indicators improved substantially in Mexico. Malaysia stands out for its significant improvement both in export sophistication and machinery exports, reaching levels close to Canada’s.

Figure 1.9Machinery Real Exports per Capita (1970 vs. 2000) vs. Oil Revenues (1970–2000)

Sources: Feenstra and others (2005); and IMF, World Economic Outlook database.

To sum up, high-tech countries were better prepared for coping with Dutch disease and were already diversified before receiving oil revenues. However, as oil revenues increased, the odds of success were overwhelmingly against the low-tech countries, such as the GCC countries. In the low-tech/low-revenue quadrant, we contend that the policies pursued put these countries on different and diverging development paths.

One would think the high-tech countries such as Norway, with an already diversified export base, could escape Dutch disease. But as it received much bigger oil revenues than Canada, Norway fell prey to Dutch disease, despite its strict rules designed to sterilize most of the oil income. In 2012, manufacturing hourly wages were the highest in the world and about double those of the United States or Japan, according to the U.S. Bureau of Labor Statistics. Unit labor costs increased by 50 percent in the 2000s, whereas they declined in Germany and Sweden. In addition, Norway’s annual average hours per worker declined to about 1,400 in 2012, down 600 hours since 1960, according to Norway’s State Statistics Bureau, the third fewest hours worked in the Organisation for Economic Co-operation and Development.

Norway’s export sophistication has been on a declining trend since the late 1970s, despite its relative increase in machinery exports per capita. The rapid decline coincided with the spike in oil prices in the late 1970s, but then export sophistication recovered slightly in the period of very low prices through to the mid-1980s. Since then, sophistication has been declining. One could argue that incorporating services in the measurement of export sophistication would mitigate the observed decline. But the largest service export is maritime transport, the incorporation of which is unlikely to reverse the decline. In addition, neighboring Denmark witnessed a slight increase in sophistication during 1976−2006, despite starting with higher export sophistication. The gap with Norway widened substantially. Interestingly, Malaysia, which stood at about 45 percent of Norway’s level in the mid-1970s, caught up by the late 1980s, and was about 65 percent higher by the mid-2000s.

It could be argued that the few success stories among oil exporters are in the group of countries where the size of oil revenues received was not large enough to crowd out their non-oil tradable sectors. In other words, they stood a fighting chance at diversifying their economies. As the performances within this group show, however, policies did matter. Norway’s case suggests that at much earlier stages of development, the potential effect of large revenues is likely to be detrimental to the tradable sector, as observed in many Middle East and North African oil exporters.

The experience of oil exporters suggests that very few countries—Indonesia, Malaysia, and Mexico—successfully diversified (see Annex 1.2). These countries prepared the ground before the dwindling of oil revenues occurred. Although the three increased their export sophistication, they have yet to achieve the successes of Korea and Singapore, and remain dependent on natural resources, to a significant extent.

Malaysia, one of the earliest oil exporters to scale down its import substitution strategy in the 1970s, has relied on an export promotion policy (Jomo and others 1997). The country successfully expanded its export base as well as the sophistication of its manufacturing sector. Today, manufacturing represents more than a third of all its exports (and three-quarters if one includes refining and other natural-resource-related manufacturing). To achieve this goal, it used a multifaceted approach by (1) selectively encouraging foreign direct investment (FDI) in exports, especially in electronics; (2) relying on free trade zones; (3) offering lower taxes; and (4) providing a stable business environment and an educated workforce with competitive wages. The country has promoted specific strategic industries to achieve the maximum technological transfer possible. It relied on both horizontal and vertical development of industries and natural-resource-related industries (Yusof 2012; Jomo and others 1997). And it used active state intervention to spur growth in sectors it deemed important, in effect acting as a “venture capitalist.” In parallel to rapid physical accumulation, human capital accumulation was very important. The Malaysian state also used public agencies to enforce a continuous retraining and skill upgrading of employees.

With the collapse of oil prices in the 1980s, Indonesia adopted a set of policies meant to attract foreign capital in export-oriented manufacturing. The main instruments of this policy were the creation of free trade zones, tax incentives, the easing of tariff restrictions and non-tariff barriers, as well as the largest exchange rate devaluation among developing nations in the 1980s (Jomo and others 1997). The result was substantial growth in labor-intensive manufacturing (textiles, footwear, electronics, and so on) because of the attractive level of wages. During the liberalization of the 1980s, the government performed a “strategic retreat” and retained several strategic projects, in particular in steel and the aircraft industry. Jomo and others (1997) note that Indonesia’s experience also shows that, with government commitment, a complex technology industry was successfully started from scratch in what was a poor nation at the time. Indonesia today is part of a selected group of developing economies with clusters of aircraft maintenance and aircraft parts manufacturing. The creation of the national champion, albeit at a large cost, did facilitate the establishment of this cluster.

Like Indonesia, Mexico started with labor-intensive industries and moved to more sophisticated production. The country also relied on free trade zones focused mainly in labor-intensive industries (mostly foreign owned). It did help increase exports, but firms did not climb the value-added ladder and had weak linkage with the rest of the economy.

The upgrading of Mexico’s industries is evident in the automobile industry over the past 15 years. In 2012, employment in the sector in Mexico surpassed that of the U.S. Midwest (40 percent of North American employment in Mexico versus 30 percent in the Midwest) and is expected to continue rapid growth. Obviously, the North American Free Trade Agreement and exchange rate depreciation in the 2000s helped propel FDI into the country from automotive companies planning to export to the United States. However, the policies adopted by different states in Mexico in pursuit of building manufacturing clusters and their performance in productivity and quality upgrading are important. In particular, the State of Guanajuato followed what can be described as a purpose-specific investment strategy in parallel with strong incentives to attract firms. In infrastructure, the state built a 2,600-acre interior port, customs facilities, a railroad depot, and link to the local airport (Cave 2013). Nearby, there is also a polytechnic university to supply engineers, and the state gives incentives to firms to send workers for training abroad. The state has attracted foreign firms by providing tax incentives, but, more interestingly, by acting as an active consultant.

In summary, the main policy lessons from the diversification experiences of relatively successful oil exporters are as follows:

  • Import substitution strategies created mostly inefficient firms because they were not encouraged to compete on international markets. Instead, they relied on a captive domestic market and imported inputs and technology. A focus on competing on international markets and an emphasis on technological upgrading and climbing the value-added ladder are crucial.
  • Malaysia’s policy mix, involving investment in higher-value-added, comparative-advantage industries (such as natural-resource-related manufacturing) and going beyond comparative advantage (electronics) was the most successful.
  • Comparing the experience of Malaysia to that of other oil exporters shows that it is more important for the state to actively encourage the supply of inputs in target industries (such as skilled labor, infrastructure, consulting) than to impose price distortions to protect an industry (tariffs and price controls).
  • Indonesia and Mexico show that relying mostly on low wages and labor-intensive manufacturing eventually leads to limited productivity gains. Mexico’s experience shows that efforts to attract FDI need to be directed toward the creation of industrial clusters.

Proposition Four

Export diversification must start now.

The GCC countries enjoy high standards of living and very long horizons of oil reserves, so one could argue there is no urgency to start diversifying economies. However, we contend that implementation of a true diversification strategy is urgently needed.

It would take 20 to 30 years to achieve high export sophistication. The few successful oil exporters prepared their non-oil export base for decades before they could take off when oil revenues dwindled. Malaysia started its export-oriented strategy in the early 1970s, for example, and experienced rapid growth in export sophistication in the 1980s–1990s. Despite the rapid pace, it took more than 20 years to reach a level of sophistication comparable to some advanced economies.

The experience that oil exporters went through in the 1980s–1990s is a cautionary tale of reduced spending, falling standards of living, and increased debt levels. The oil exporters went through a long recessionary cycle—measured by consumption per capita developments—that lasted 30 years. Consumption per capita on average fell about 20 percent from the 1980 peak, returning to this level only in the late 2000s as oil prices recovered (Figure 1.10). Continuing with the implementation of the same model (extracting oil, saving part of it in a sovereign wealth fund, and investing mostly in infrastructure without focusing on tradables) is likely to be suboptimal for social welfare. Even if the GCC countries tackled subsidy and tax reforms and managed to create more fiscal space, this would not be sufficient to diversify the tradable sector, which is crucial for sustainable growth (see proposition five).

Figure 1.10Real Consumption per Capita and Real Oil Price, 1980–2010

Sources: IMF, World Economic Outlook database; and Penn World Tables 7.1.

Note: Data come from a sample of oil exporters. PPP = purchasing power parity, NFA = net foreign assets.

Proposition Five

The standard policy advice—implementing structural reforms, improving institutions and business environment, investing in infrastructure, and reducing regulations—is very important, but may not be sufficient to spur tradable production, because of market failures.

Macroeconomic stability, minimum state intervention, and an enabling environment conducive to investment in both physical and human capital are the main ingredients of the standard growth policy prescription for sustainable economic growth. It consists of tackling what is described as “government failures” by Stern (2001) and Rodrik (2005). These failures could stem from the associated high inflation, monopolies, investment impediments, uncertainty regarding property rights, and other types of government-driven distortions. Reforms are ongoing in the GCC to address these issues, yet there has been little progress in export diversification in most countries (see proposition three). Although there is still room for improvement along those dimensions, especially in the legal and bankruptcy framework and cumbersome business regulations in some countries, can the lack of progress in increasing non-oil exports and manufacturing output be attributed to government failures alone? We contend that the binding constraint to developing the non-oil tradable sector lies also in market failures and that tackling both government and market failures is necessary for true development to take place in oil-exporting economies.

A growing body of literature points to the need to rethink industrial policy. It invites economists not to rule out industrial policy as a tool because badly designed industrial policies failed in the past (typically import substitution strategies in the 1970s). Pioneers in the revival of industrial policy include Alice Amsden, Ha-Joon Chang, Ricardo Hausmann, Jomo, Sanjaya Lall, Jose Antonio Ocampo, and Dani Rodrik. The gist of their arguments is that economies face multiple market failures that impede their industrialization.13 Economies could be trapped in a suboptimal state, not only as a result of distortions imposed by the government or government failures, but as a result of market failures due to learning externalities or coordination failures (Rodrik 2005).

Market failure based on a learning externality14 implies that firms do not internalize productivity gains, leading to lower allocation of resources into high–productivity sectors. As Matsuyama (1992) argues, some activities, typically manufacturing, entail higher productivity gains for an economy than other traditional activities such as nontradable services or agriculture. Firms may not be fully aware that these productivity gains lead to lower output in high-productivity sectors and lower relative incomes over time. The learning externality could also involve spillover effects in which productivity in other sectors increases, while firms are unable to extract the pecuniary benefit from the spillover effect (such as manufacturing’s spillover effect on agriculture). In this case, the resource allocation into the traditional sector would also be higher than would otherwise be socially optimal (Rodrik 2005).

The coordination failure is based on the idea that a modern sector (such as manufacturing) needs to reach critical size for a firm to enter it. It would be profitable for a firm to invest in a modern sector only if enough firms were investing simultaneously in other modern sectors. The mechanisms proposed in the literature to explain the spillovers differ (such as demand spillovers). However, they could be summed up as related to reaching a critical market size to justify investment in complex technologies (for example, automotive and aircraft). If many firms invest together in modern sectors, described as the “big push,” the economy reaches a higher level of productivity and development. But the existence of market failures requires state intervention to reach a socially superior outcome, with the type depending on the market failure. One could reinterpret the failure of import-substitution strategies as one of misidentifying market failures.

We argue that the GCC countries, and probably other oil exporters, are not plagued so much by “government failures” as by “market failures,” though the two are often closely linked. Three arguments indicate that the binding constraint on firms in the GCC, impeding diversification, is not related to government failure:

  • The GCC countries have achieved very high infrastructure quality scores and other business quality indicators. Their successes are striking in comparison with other oil exporters that have done poorly in indicators of the ease of doing business, but much better in promoting export sophistication, such as Indonesia and Mexico (Figure 1.11).
  • Norway and more recently Canada (Stanford 2012) could not escape Dutch disease, although government failures are basically nonexistent there, in particular in comparison with developing nations. If such advanced economies with a strong record of institutions, governance, skills, infrastructure, and other ingredients of an enabling environment are not immune to Dutch disease, it is highly likely that developing oil-exporting countries are not, either. Moreover, trying to reach their level of institutional quality and openness would certainly not be enough to develop the tradable sector. As Henry and Miller (2009) show, Barbados and Jamaica’s real GDP per capita diverged after independence as they pursued different economic policies despite a similar institutional environment, geography, and colonial and legal heritage.
  • Diversification in successful oil exporters was taking place as oil revenues were slowly declining. The institutional reforms would have taken a relatively long time to materialize as the diversification process was ongoing. The International Country Risk Guide’s bureaucratic quality indices for Malaysia and Saudi Arabia were similar and did not change through the 1980s–1990s as Malaysia was developing its tradable sector, while the quality index was lower for Indonesia.

Figure 1.11Governance and Institutions Indicators

Sources: Fraser Institute; World Economic Forum, Global Competitiveness Indicators (2013–14); and World Bank, Doing Business Indicators.

Note: UAE = United Arab Emirates.

We identify the market failures preventing these economies from developing their tradable sectors. As discussed in proposition three, Dutch disease would lead to a learning failure if firms did not fully recognize the tradable sector’s higher potential productivity gains. This is a variant of failure caused by a learning externality, according to the taxonomy of Rodrik (2005). As discussed in proposition three, oil exporters are trapped in a vicious circle in which their relative productivity, or technological gap, in the tradable sector keeps deteriorating. This market failure seems to be the most significant of the theories advanced in the literature.

However, one needs to identify the exact channel relevant for the GCC.15 We suggest a novel channel of transmission of the Dutch disease in the GCC, and the key to understanding it is the attitude of firms, especially conglomerates. For small and medium-sized enterprises (SMEs), many potential hurdles complicate development of exportable goods—among them access to financing, lack of skills, and poor business services support. In contrast, conglomerates in the region are large, decades-old corporations with access to land, financing, government connections, and the ability to import both skilled and unskilled labor. Moreover, they have access to world-class infrastructure and operate within trade agreements that give access to most advanced markets. In other words, they would be shielded from most forms of government failure or even known market failure, in particular coordination failure. So why do they not diversify into tradable goods as the Korean conglomerates did a few decades ago?

For the GCC, we argue that oil revenues skew the risk-return trade-off between the tradable and nontradable sectors (Cherif and Hasanov forthcoming). Suppose an entrepreneur has to decide whether to enter either the tradable or nontradable sector. The tradable sector is exposed to international competition and requires many years of investment with highly uncertain returns, though the potential for productivity gains is higher. Given high enough oil revenues, the “insurance” mechanism would be at work, and the nontradable sector would be far more attractive to enter than the tradable sector. Access to imported labor would not change this mechanism and would only affect the scale of the output of nontradable goods and profit margins. It could in fact fuel a vicious circle of a further increase in demand for nontradable goods because of the inflow of expatriate workers.

Paradoxically, the government could exacerbate market failure in this environment by engaging in big investment projects in infrastructure, which are by nature nontradable, over multiple years. Commitment to build infrastructure is laudable and most developing economies consider it a priority for development. But if the current binding constraint on producing tradable goods is not infrastructure, the resources may be put to better use developing tradables. In fact, large infrastructure projects may exacerbate the crowding-out of the tradable sector by further increasing risk-adjusted returns in the nontradable sector for monopolistically competitive or oligopolistic firms. The mechanism we described would also apply to SMEs, few of which enter tradable sectors, even when some of the standard hurdles facing them are eased. Government funding programs to encourage SMEs are mostly concentrated in services sectors such as transportation, retail, and restaurants.

Proposition Six

Governments need to change prevailing incentive structures.

The fiscal policies GCC countries follow have helped create very generous social systems, but with limited incentives for risk taking. As noted in proposition one, many nationals in the GCC countries are employed by the public sector, where average compensation is relatively high. In the United Arab Emirates, for instance, it is about $4,500 a month compared with less than $2,000 a month in the private sector (IMF 2013a). Energy subsidies represent about 10–20 percent of GDP in the GCC countries, reaching about 30 percent in Bahrain (IMF 2013b). In addition, the legal retirement age is relatively low in the GCC. For instance, Saudi Arabia has a defined benefit system with retirement age of 60 for men and 55 for women, at the low end of the range (IMF 2012). It is even lower, at around 50–55, in Bahrain, Oman, and Qatar. Pension benefits are also high, with a replacement rate of 80 percent in Bahrain, for instance (World Social Security Forum 2013).

The risk-return trade-off channel described in proposition five also applies to the labor market. A risk-free strategy in which nationals can join the public sector for a relatively high salary and generous compensation and benefits does not encourage the uncertain path of entrepreneurship or employment in the tradable sector.16 Working in the private sector entails higher probability of job loss, longer hours, and maybe even lower pay. The structure of the labor market does not encourage investment in human capital either. If the possibility exists of getting a risk-free job with lifetime employment, generous pension, and relatively high compensation, then the risk-adjusted returns on education need to be very high to justify this investment. In turn, the lack of skills would prevent the private sector from creating enough high-productivity/high-wage jobs to attract workers. The outcome becomes self-reinforcing: the private sector will not create high–productivity jobs given the lack of skills, and the workforce skill set will not improve given a lack of “learning by doing” in high-productivity jobs. So, how can the state change the incentive structure to encourage private sector employment?

The public sector should not be the employer of first resort, offering relatively high compensation and benefits compared with most of the private sector. Government should place firm limits on public sector jobs and wages and clearly communicate to workforce entrants that they should not expect one.

This needs to be matched by programs to ensure that the training and support needed to work in the private sector are available. As in Belgium and Germany, vouchers could be used for training programs on starting a business, accounting and finance, legal issues, information technology and other applied professions, apprenticeship training systems, and vocational education. Safety nets also need to be in place to provide the unemployed a minimum income (as well as the incentive to search for employment).

These approaches would reduce the need to absorb new workers into the public sector, reducing the wage bill, and by reducing the bloated public sector, increase efficiency without disrupting public services. An assured minimum income would also encourage risk taking and, coupled with training programs, provide the necessary support for entrepreneurs.

To attract nationals into the private sector, salaries need to be more competitive, calling for high-value-added jobs and reforms in public employment policy. And to generate such jobs, the private sector has to move from its current business model of reliance on unskilled cheap labor in low-value-added sectors (such as retail, restaurants, transportation, and so on) to more advanced sectors. But this transformation could initially require attracting high-skilled labor and entrepreneurs from other countries, and active policies to create a high-skilled and dynamic national labor force.

Improving skills and changing attitudes should be tackled early; changing incentives as more workers enter the private sector and improving their skills is not enough. Growing evidence suggests that the quality of early childhood education has long-lasting outcomes (Heckman 2008), while Heckman, Pinto, and Savelyev (2013) show that a good-quality early education also has long-term positive effects on test scores. More importantly, Heckman (2008) shows that a program works through its positive effect on noncognitive skills: that is, children with a good early education scored higher on tests later because of more positive social behavior and more academic motivation rather than through higher intelligence. And the positive effects, not limited to labor market outcomes, also included healthier behavior.

In the GCC, even though governments have spent substantially on education and increased years of schooling, education outcomes are still low. GCC countries spend more than 4 percent of GDP on average on education (Saudi Arabia and the United Arab Emirates spend 5.0–5.5 percent of GDP, above the average of high- and middle-income countries; IMF 2013a). Spending per capita is even higher than in most developing economies. However, educational achievements are not in line with this investment, while the average years of schooling is still significantly below that of developing economies (Figure 1.12).

Figure 1.12Education: Years vs. Quality of Schooling

Sources: Trends in International Mathematics and Science Study (TIMMS); United Nations Development Programme.

The amount and quality of early childhood education could be another factor explaining poor results later in life. Several GCC countries have low enrollment rates in early childhood education (Figure 1.13), and countries with the highest enrollment rates in this group also tend to have the highest test scores in secondary school, as shown in Figure 1.12. Student achievement is also highly correlated with teacher quality. This, suggest Dolton and Marcenaro-Gutierrez (2011), depends on how high teachers are in the income distribution of their country. Wages paid have a direct causal effect on teacher motivation, in line with efficiency-wage theory, but they could also act as a proxy for the quality, length of training, and the selectivity of the hiring process. Higher teacher quality also provides a channel for tackling low test scores and the quality of education in general.

Figure 1.13Pre-Primary School Statistics, 2000–11

Source: United Nations database.

Note: GCC = Gulf Cooperation Council, UAE = United Arab Emirates.

Changing societal attitudes toward private sector employment is important, and Korea’s experience shows how current attitudes can change. Korea’s Saemaul Undong is one social program that changed attitudes and created a link between social and economic development (Kwon 2010; see Chapter 10). It was initially meant as a rural development tool in the early 1970s, but, owing to its success, was rapidly expanded to incorporate urban communities and the public administration.

The program first encouraged communities to undertake small-scale projects to improve their surrounding environment, then to invest in income-generating projects and infrastructure. Government funded and provided the organizational framework, such as type of projects, leadership, accountability, and regional/national coordination, and provided technical assistance. Although the concrete achievements of the program were impressive, the long-term objective was to change social attitudes by encouraging communities to work together, develop self-help, and eventually build the will to contribute to the development of the country.17 Saemaul Undong “was in a sense, a movement for spiritual reform of Korean people, and has achieved a lot in this respect. It changed people’s attitude from laziness to diligence, from dependence to self-reliance, and from individual selfishness to cooperation with others” (Choe 2005).

The social development literature considers Saemaul Undong a role model and an important ingredient of Korea’s success (Choe 2005; Kwon 2010). However, the specific conditions of each society should be taken into account when applying programs like the Korean one (Kwon 2010). Even so, Korea’s experience shows that through concrete community projects, taking socioeconomic context into account, governments can spur a spirit of self-reliance, innovation, and entrepreneurship. But for this to happen, governments themselves need to change the way they approach development.

Proposition Seven

The state could act as a venture capitalist and foster public-private collaboration to design and implement strategies that go beyond comparative-advantage sectors and target high-value-added sectors with large potential spillovers and productivity gains.

So far we have argued that for GCC countries to achieve sustainable growth a dynamic non-oil tradable sector needs to emerge. We also inferred from the experience of oil exporters in general and the GCC in particular that the main impediment to the emergence of the non-oil tradable sector is not a government failure, but rather a market failure, requiring a redeployment of state intervention. We also argued that it was urgent to start implementing policies to tackle this challenge. This leaves us with the question of how the state should help the process of diversification, in addition to changing the incentive structure in the economy. It is imperative to note that implementing the policies formulated in this proposition without simultaneously tackling the change in the incentive structure of the society, as discussed in proposition six, will not work. Without the right change in incentives, the policies proposed would be unlikely to produce the much-needed tradable sector and could lead to destructive misallocation of resources.18

The seemingly commonsense answer would be to focus on sectors where the GCC countries have “comparative advantage.”19 But the comparative-advantage theory ignores the fact that to develop new industries a country needs to accumulate industry-specific capital and knowledge. A central assumption of modern comparative-advantage theory is that the same technology is freely available to every country. The only barrier that prevents the poorest developing economy from producing aircraft, robots, or satellites, say, is the capital-to-labor ratio. It ignores the importance of experience in technology acquisition, or learning by doing, and that capital accumulation does not necessarily imply developing new industries. For instance, the GCC countries accumulated impressive general-purpose infrastructure such as roads, ports, and airports. A large buildup of residential and commercial real estate in the GCC would also amount to capital accumulation. Even in a standard Ricardian comparative-advantage framework, Krugman (1987) shows that in the presence of learning externalities (learning by doing), there is a justification for infant industry protection policies. Young (1991) further shows that in a growth model with learning by doing, a country starting with a lower initial level of knowledge would grow less in free trade equilibrium than in equilibrium without trade. Essentially, producing goods in the sector in which learning by doing has been exhausted without attempting to produce goods with learning externalities, would lower growth.

There are also GCC-specific arguments against a pure comparative-advantage strategy. Studies based on “revealed comparative advantage” usually indicate that GCC countries should invest in relatively low-value-added industries such as agro-industry, basic metal manufacturing, and animal skin and leather products. It could be argued that a relatively poor economy could focus on such sectors and approach the upgrading of the industrial sector gradually. However, given that the GCC countries are already high-income countries, it seems unlikely that focusing on these sectors would prevent them from sliding further down the income ladder as they did in the past decades. These low-value-added sectors would not attract enough national workers to tackle the pressing employment issue. In the description of Chang and Lin (2009), the question is not whether comparative advantage should be defied or not, but how far from comparative advantage a state should push.

In vertical diversification, the GCC countries have already made significant investment in refining, aluminum smelting, fertilizers, and petrochemicals. As the example of Malaysia showed, the important element is to build domestic capabilities and enter into downstream and upstream activities such as medical materials based on rubber, research in biotechnology engineering to improve palm production, and the international diversification of Petronas, the state oil company (Jomo and others 1997). The emphasis for the future should be on building linkages with the rest of the economy and technological transfer and upgrade.

This could involve creating networks of suppliers around the existing exporting industries. The oil extraction and refining industries, for example, require a large number of manufacturing inputs (machinery, metals, pipes, platforms) as well as high-value-added services (software, geological surveys, engineering studies) with high employment potential. These industries would have the advantage of geographic proximity and knowledge of the specific needs and expected demand.

In this respect, Norway’s state policies to develop an oil and gas suppliers’ cluster in the 1970s represent an interesting case study. First, the government intervened directly in the procurements of oil operators. The Norwegian Petroleum Code required that operators communicate their lists of bidders to the government, which in turn had the authority to impose the inclusion of Norwegian firms in the list and even to change who was awarded the bid (Leskinen and others 2012). Second, the licensing process required foreign operators to come up with plans to develop the competencies of local suppliers (Heum 2008). Third, starting in the late 1970s, the government ruled that a minimum of 50 percent of the research and development needed to develop a field take place in Norwegian entities (Leskinen and others 2012). Although the restrictions were lifted in 1994 when Norway signed trade agreements with the European Union, the government continued after 1997 to support the suppliers though the INTSOK foundation to encourage them to internationalize their activity. Eventually the suppliers’ cluster became highly successful, including on international markets, spanning a large array of high-value-added industries related to the subsea, geology, and seismic fields; developed the required skills; and directly employed about 114,000 workers in 2009, or more than five times the employment of operators in the oil and gas sector (Sasson and Blomgren 2011a, 2011b).

In Singapore, to create “system integrators”—large firms to spearhead sector development—clusters, and “global brands” in the tradable sector, as well as to direct state-owned enterprises (SOEs) to produce tradables, the state itself became what Mazzucato (2013) calls “the entrepreneurial state.”20 Pure coordination failures as discussed in the literature require a “system integrator” or industrial beachheads to provide a “big push” (Murphy, Shleifer, and Vishny 1989) for firms to enter this market. The bigger the technological leap (or the further from the comparative advantage), the bigger the risk and the time it would take to discover the true outcome (Rodrik 2005; Chang and Lin 2009). Horizontal diversification has usually focused on tradable manufacturing and high-tech innovation sectors, including high-skill services. High-tech sectors, or innovation sectors, have large spillover effects on job creation, as shown by Moretti (2012). The growth of global value and supply chains could further support entry of firms and countries to produce specific goods (such as the Asian supply chain). In the current globalized world of trade in tasks and intermediate goods, global value chains are opening up a new avenue for countries to join high-value-added goods production chains.

Entry into the tradable sector provides potentially high returns over the long term, but at high risk in contrast to nontradables that provide high returns in the short term at lower risk. Relevant examples of the risk-return trade-off are Nokia’s mobile unit (part of a logging company at the time), which incurred losses for about 20 years, and Toyota, with losses for 30 years, before becoming profitable (Chang and Lin 2009). In contrast, Malaysia’s tire industry, for example, did not manage to take off (Jomo and others 1997), showing the importance of competing in international markets and enforcing accountability.

To address the risk-return trade-off in favor of the tradables, governments have used subsidies to support exporters and taxes on firms in the nontradables. The key element in providing support, however, whether to private firms or SOEs, is to make sure that the top management is responsible for the funds they receive, and, if needed, could be fired for nonperformance (Chang 2007). Substantial subsidies and tax breaks are given to large corporations even in advanced economies with the best business environment possible, like the United States and the European Union. As reported by the nonprofit organization Good Jobs First, Boeing had 137 subsidies and tax breaks worth about $13 billion. Alcoa, an aluminum company, received $5.6 billion; Intel, about $4 billion; and Dow Chemical, $1.4 billion over the past decades. According to the World Trade Organization, Airbus received about $18 billion from European governments in the 1990s to the mid-2000s.

Insurance for the tradable sector and access to financing are a second set of policies that countries have used. These are provided through development banks, venture capital funds, and export promotion agencies. Given the long horizon of potential returns and the high risk involved, cheap credit, grants, and access to equity funding would facilitate risk-return trade-off choices conglomerates and SMEs would have to make. There are programs to support innovation through early-stage financing to SMEs in most advanced economies. Lerner (1996) shows empirically that firms that benefited from the U.S. Small Business Innovation Program, which provided more than $6 billion in funding between 1983 and 1995, grew significantly faster than comparable firms. After the failure to attract multinationals to a newly created Science Park in 1980, a Taiwanese venture capital initiative provided financial incentives and tax credits to encourage the setup of firms (Kuznetsov and Sabel 2011). A seed fund provided matching capital contributions to private venture capital funds. Two funds were established and run by U.S.-educated Chinese invited to relocate there. The venture proved successful, and large banks and firms started creating their own venture capital funds. Even conservative family conglomerates followed suit and started investing in information technology businesses. By the late 1980s, the growth in the venture capital industry was well under way.

The creation of special economic zones, industry clusters, incubators with university links, and the promotion of entrepreneurship constitute a third set of policies that countries have used to promote the development of tradables. Special economic zones have helped tackle countries’ specific binding constraints such as land rights and legal/bankruptcy frameworks. Similar to Singapore’s Jurong Town Corporation, which specialized in urban planning and made Singapore a location choice for foreign investors, special economic zones would provide business services and support in a short period of time; for instance, to acquire land, facilities, lease agreements, and approval of plans (Minli 2008). Incubators with university links, coupled with research and development funds, would support the promotion of technology transfer and commercialization. Kuwait and Saudi Arabia, for example, have very low research and development spending compared with other oil exporters (Figure 1.14). Another important factor is the link between universities and industry. A relevant example is the Massachusetts Institute of Technology’s Technology Licensing Office, which facilitates investment in the development of discoveries and inventions at the university. In 2012, about 200 patents were issued and 16 funded companies established.

Figure 1.14Research and Development Expenditures

(Percent of GDP; Averages)

Source: World Bank, World Development Indicators.

Experience suggests that specific-purpose investment is needed to develop a skilled workforce. This is a fourth set of policies. The development of general infrastructure and education is important but not sufficient, and a focus on specific-purpose investment is key (Chang 2007). For instance, creating industry clusters necessitates human capital skills relevant to the sector, such as engineering and computer science, along with the required infrastructure and industrial facilities. The polytechnic institute in Guanajuato, Mexico, for example, was created to provide skilled labor geared toward the industrial park outside the campus gates. Internships at auto companies and continued applied education equipped students with skills needed in the industry. As the 2013 survey of 150 executives of fast-growing companies in the United States has shown, a skilled workforce and quality of life were major reasons they located their companies where they did, while taxes and business-friendly regulations were not significant factors (Mazerov 2014). These are the two key elements needed to create industry clusters.

One could argue that the lack of human capital skills is a reason not to pursue many high-value-added and complex activities and to wait until they eventually emerge. However, it is learning by doing or learning on the job that builds up the needed skills. The comparison of Malaysia and Chile since the 1970s provides a good example. While Malaysia has clearly outperformed Chile on export growth and sophistication over the past decades, Malaysia had a significantly less educated workforce. It only caught up in the 2000s.

Universities can also provide relevant skill sets relatively quickly, as Ireland did in the late 1970s. The Irish Development Agency negotiated agreements with electronics firms that substantially increased the demand for electrical engineers. The short-term solution to fill in the gap was to train science graduates through one-year courses, with the expansion of technical programs, courses, and degrees in the longer term. Apprenticeship programs and vocational training need to be formally set up to further increase human capital and skills needed for the targeted industries and clusters. For instance, more than two-thirds of 15- to 16-year-olds enter apprenticeship programs in Switzerland, while more than half of students are apprentices in Germany, with only 25 percent going to college (Nash 2012). In Germany, the retail trade and manufacturing are the largest employers. Government could provide incentives such as directly subsidizing the cost to firms for “hard-to-place” apprentices, as in Germany (Aivazova 2013). The requirement to develop local talent and local suppliers, as is done in Norway, would further produce the needed skill set.

More generally, government can foster linkages between SOEs, multinational companies, and SMEs to promote the development of tradables and exports. A potential way to achieve this is to create a program similar to Ireland’s National Linkage Promotion Program (1987–92). Started by the Industrial Development Authority, the program brought together multinationals and potential suppliers to facilitate local sourcing. The government instructed various agencies to help SMEs to navigate through the bureaucracy, to collaborate, and provide an effective service for SMEs that could be fine-tuned depending upon the needs of customers and suppliers. The multinational companies targeted were in the electronics industry and were lobbied extensively to support the development of local firms. They contributed costs for the first two years of the program and provided technical assistance for SMEs, together with state technical agencies. The SMEs were thoroughly assessed before they could participate in the program and were selected together with multinational companies. In the five years of the program’s operation, multinational companies increased locally sourced materials from 9 percent to 19 percent of their purchases.

The GCC countries have pursued some of the policies mentioned in this chapter—such as the creation of special economic zones, links between universities and businesses, skills development, SME funds, development banks, export promotion agencies, and, more recently, clusters. However, these policies have yet to deliver the desired results.

Conclusion

In this chapter, we have described the main features of the prevailing economic model in the GCC, which relies on oil as the main export and a concentration of economic activity in the low-skilled nontradable sector. We observed that over the past decades this economic model yielded important achievements in human development and infrastructure development. However, in relative economic performance, the model led to stagnation and GCC countries are being outperformed by other countries.

A growing body of literature shows that the lack of a dynamic non-oil tradable sector is the main issue hindering the GCC economic model. We studied a set of oil exporters and inferred from this that Dutch disease is a powerful force at play, which was only mitigated by an initial high level of technology. The few successes at diversification took place only amid dwindling oil revenues combined with decades of adequate policies to prepare the ground.

We contend that a strategy to diversify the non-oil tradable sector must be implemented now, even for the richest GCC countries. We argue that the main hurdles facing diversification in the GCC stem from market failures, rather than government failures, with the incentive structure in society needing to be changed. Although there is room for improving the business environment, infrastructure, skill sets, and institutions, these are unlikely to be enough to spur non-oil exports on their own. To do so, the governments need to change the incentive structure of the economies to encourage individuals to work in the private sector, and to encourage firms to look beyond the confines of domestic markets and seek new export opportunities. Improving the quality of education, especially in early childhood, and implementing a social development program are important elements of changing incentives.

Beyond this, experiences in other countries show that a diversification policy has often followed a mix of vertical diversification in existing export industries and horizontal diversification in suppliers’ clusters for those industries, and industrial beachheads into high-value-added and innovation sectors. Crucially, this policy should be implemented in tandem with changing the incentives for workers and firms to achieve the desired results. These countries have used a combination of policies to achieve these results, including the use of venture capital funds, development banks, and export promotion agencies, combined with skills development and the emphasis on technological upgrading and competition in international markets. In the GCC, some degree of coordination on diversification strategies would be helpful to ensure that countries do not all develop in the same area and thereby risk crowding each other out.

Annex 1.1. Main Economic Characteristics of Oil Exporters
Annex Table 1.1.1Oil Exporters: Selected Economic Indicators
Population

(million)
GDP per Capita

(PPP, $)
Percent of Commodity/

Oil Revenues in Total

Fiscal Revenues1
Percent of Oil Exports

in Total Exports of

Goods and Services
1970Latest219702010Latest2Latest2
Bahrain0.21.221,65423,10172.369.0
Kuwait0.73.9102,99741,24081.786.2
Oman0.73.26,11822,39086.165.6
Qatar0.11.979,555136,24864.774.8
Saudi Arabia6.429.616,82920,18981.883.1
UAE0.29.024,06260,17580.630.5
Algeria13.638.14,0666,26363.293.0
Angola6.020.82,3135,10880.296.5
Azerbaijan9.39,47483.3
Brunei Darussalam0.451,53244,55591.988.3
Canada21.335.217,72637,10419.5
Chad3.611.08791,33161.279.0
Congo, Republic of1.24.21,3482,25474.483.7
Ecuador5.914.92,9166,22733.249.4
Equatorial Guinea0.873713,958158.497.9
Gabon0.71.68,2819,89660.480.4
Indonesia120.3248.08163,96617.78.6
Iran28.777.18,4809,43237.960.7
Iraq34.82,7794,53791.297.2
Kazakhstan17.212,30352.358.3
Libya2.06.526,81419,49196.096.8
Malaysia10.530.02,04611,95610.3
Mexico50.9118.26,82111,93912.2
Nigeria55.2169.31,5721,69580.191.6
Norway3.95.117,98050,48823.0
Russian Federation141.415,06829.847.8
Syria6.621.41,7533,79318.526.4
Timor-Leste1.21,119
Trinidad and Tobago1.311,11030,74949.328.4
Turkmenistan5.715,63549.791.4
Venezuela10.230.09,3669,07130.494.3
Yemen26.72,39346.251.4
Sources: IMF, World Economic Outlook (WEO) database and Regional Economic Outlook: Middle East and Central Asia (REO); and Penn World Tables 7.1.Note: MENA = Middle East and North Africa, UAE = United Arab Emirates, PPP = purchasing power parity.

Oil revenue data for MENA and Central Asian countries are from the REO; commodity revenue data for other countries are from the WEO.

Latest = 2013, except Syria = 2010.

Sources: IMF, World Economic Outlook (WEO) database and Regional Economic Outlook: Middle East and Central Asia (REO); and Penn World Tables 7.1.Note: MENA = Middle East and North Africa, UAE = United Arab Emirates, PPP = purchasing power parity.

Oil revenue data for MENA and Central Asian countries are from the REO; commodity revenue data for other countries are from the WEO.

Latest = 2013, except Syria = 2010.

Annex Table 1.1.2Oil Exporters: Reserves, Horizon, and Production
Year Oil was

First Discovered

or Produced1
Current Production

(million barrels per day)
Reserves as of

end-2012 (billion

barrels)
Oil Horizon at Current

Production Rate

(years)
Bahrain20.10.16.2
Kuwait19383.1101.588.9
Oman0.95.516.3
Qatar19352.023.933.3
Saudi Arabia193811.5265.963.2
UAE19583.497.879.3
Algeria19561.712.220.1
Angola19551.812.719.5
Azerbaijan0.97.022.0
Brunei0.21.119.0
Canada3.7173.9127.3
Chad0.11.540.8
Congo, Republic of0.31.614.8
Ecuador19210.58.244.7
Equatorial Guinea0.31.716.5
Gabon0.22.022.4
Indonesia0.93.711.2
Iran19083.7157.0116.9
Iraq3.1150.0131.9
Kazakhstan1.730.047.6
Libya19591.548.087.2
Malaysia0.73.715.6
Mexico2.911.410.7
Nigeria19562.437.242.2
Norway1.97.510.7
Russian Federation10.687.222.5
Syria0.22.541.8
Timor-Leste20.10.00.0
Trinidad and Tobago0.10.818.8
Turkmenistan0.20.67.4
Venezuela19142.7297.6299.1
Yemen0.23.045.6
Sources: BP Statistical Review 2013 data workbook; Energy Information Administration.Note: UAE = United Arab Emirates.

Data are from the Organization of the Petroleum Exporting Countries. Algeria: first commercial discovery year; Angola: year oil first produced; Ecuador: first productive oil well year; Iran: year first oil well drilled; Kuwait: year first commercial oil well drilled; Libya: year first productive oil well struck; Nigeria: year oil first discovered; Qatar: year oil exploration began; Saudi Arabia: year oil first struck; UAE: year first commercial oil discovered; Venezuela: year first commercial oil well drilled.

Current production and reserves data for Bahrain and Timor-Leste from Energy Information Administration, International Energy Statistics platform.

Sources: BP Statistical Review 2013 data workbook; Energy Information Administration.Note: UAE = United Arab Emirates.

Data are from the Organization of the Petroleum Exporting Countries. Algeria: first commercial discovery year; Angola: year oil first produced; Ecuador: first productive oil well year; Iran: year first oil well drilled; Kuwait: year first commercial oil well drilled; Libya: year first productive oil well struck; Nigeria: year oil first discovered; Qatar: year oil exploration began; Saudi Arabia: year oil first struck; UAE: year first commercial oil discovered; Venezuela: year first commercial oil well drilled.

Current production and reserves data for Bahrain and Timor-Leste from Energy Information Administration, International Energy Statistics platform.

Annex Figure 1.1.1Selected Countries: Growth Decomposition, 1970–2010

(1970 = 100)

Source: Penn World Tables 7.1.

Note: PPP = purchasing power parity; TFP = total factor productivity.

Annex 1.2. Diversification Experience of Oil Exporters

Diversification Trials and Failures

Low-tech/high-oil-revenue countries, particularly Algeria, the GCC, and Venezuela, tried to diversify and industrialize early on and went through three major phases in their approach to export diversification. However, they mostly failed to truly diversify their exports away from oil.

The first phase of the diversification process, taking place in the 1960s–1970s, could be characterized by an oil boom, import substitution policies, and the “heavy-handed” state. Nationalization policies of the late 1950s to the early 1960s expanded the state and the use of central planning. Price controls and production subsidies became widespread. Production was concentrated in state-owned enterprises (SOEs). High tariffs and other protection measures (such as licenses) insulated SOEs from international competition as the state pursued import substitution policy. SOEs were not expected to export, unlike their counterparts in Southeast Asia. The spike in oil prices in the 1970s provided a large flow of oil revenues that could be transformed into an industrial base. In fact, high investment rates followed, in the range of 40 percent of GDP and above, higher than in Korea at the time. The oil revenue transformation into fixed investment spending relied heavily on SOEs as well.

With the strong influence of the state in economic affairs, vertical policies and heavy industrialization were the hallmark of the diversification strategies of this period. Algeria invested in iron and steel, chemicals, and construction materials (Gelb and others 1988). Venezuela built SOEs in steel, aluminum, petrochemicals, oil refining, and hydroelectric power (Di John 2009). Energy- and capital-intensive heavy industries in the Gulf States concentrated in petrochemicals, chemical fertilizers, steel, and aluminum. In joint ventures with foreign companies, Qatar spearheaded the creation of petrochemical, fertilizer, and steel industries in the early 1970s (UN 2001). Saudi Basic Industries Corporation, established in 1976, pursued import substitution projects such as chemicals, plastics, and building materials, followed by large-scale petrochemical projects in the late 1970s and early 1980s (Hertog 2011). Dubai (DUBAL) and Bahrain (ALBA) ventured into aluminum smelting and aluminum rolling industries. Cheap energy and feedstock made these SOEs profitable. For instance, Saudi Basic Industries Corporation was profitable once its large petrochemical plants became operational by the mid-1980s. In contrast, SOEs in Algeria, Venezuela, and Libya mostly ran deficits. Without the pressures of international competition and the need to improve productivity, these deficit-running industries could survive as long as oil prices were high.

During the second phase of the diversification process, as oil prices collapsed in the 1980s–1990s, oil exporters had to adjust their spending and shifted course to pursue liberalization policies. The heavy industries’ reliance on imported intermediate goods and inputs did not survive the collapse of oil prices, especially since the goods produced could not be exported to fill the income gap created by falling oil prices. By the mid-1980s, most oil exporters abandoned the import substitution approach in favor of a more flexible economy. Tariffs and price regulations were dismantled or reduced and public enterprises were closed down or privatized to a large extent. This period also saw a drop in the average investment as a share of GDP as the large current account deficits accumulated during the oil slump had to be absorbed. Despite large real exchange depreciation, non-oil exports did not increase much, as there was no industrial base to take advantage of improved competitiveness. Hausmann, Rodriguez, and Wagner (2006) show that out of ten oil exporters that experienced export collapses in 1981–2002 (Algeria, Bahrain, Ecuador, Indonesia, Mexico, Nigeria, Oman, Saudi Arabia, Trinidad and Tobago, and Venezuela), only Indonesia and Mexico managed to develop non-oil exports and grow their economies. Both of these economies had a sufficient non-oil tradables base to increase their non-oil exports.

Henry (2009) argues that it was the reversal of industrialization policies during the bust years that resulted in the failure of the industrialization projects in Algeria. After the death of Algeria’s president, Houari Boumediene, in 1978, industrializing technocrats lost their protection and industrialization projects from tires and trucks and automobiles to cement and gas liquefaction plants were stopped. The argument went that the previous policies resulted in a series of disconnected projects that did not produce intra-industry linkages and exchanges of goods and services. However, policies of deregulation, restructuring, and selling of SOEs have not improved the outlook. The deregulation of state monopolies produced a handful of well-connected importers that further discouraged local producers. The manifestation of Dutch disease was the result of policies rather than oil rents per se (Henry 2009).

In contrast, political fragmentation contributed to the failure of heavy industrialization policy in Venezuela. Di John (2009) argues that the populist, clientelist, and factionalized political system of the post-1960s did not bode well for the heavy industrialization projects that required a centralized power capable of mobilizing resources and effectively monitoring these projects. In the 1960s, manufacturing output was growing in chemicals, metals such as steel and aluminum, and metal-transforming industries. The government recognized that import-substitution industries needed to export to continue to grow. In 1973, the Fondo de Exportaciones (FINEXPO, the state export credit fund) provided numerous export credits to help firms enter foreign markets. Most of the support went to manufacturing firms, especially the chemical, aluminum, and steel sectors, but was erratic. Non-oil exports were dominated by these sectors and to a lesser extent, by transport equipment. Despite the non-oil export growth, heavy industries ran into problems. SOEs borrowed heavily in dollars, and external debt skyrocketed. The country went through capital flight, devaluation, and large debt repayment in the early 1980s. The number of SOEs increased to about 400 in 1985, and state employment increased significantly. At the same time, public investment plummeted as personnel expenditures and interest payments on external debt in SOEs went up substantially. The subsidies proliferated, and the number of large manufacturing firms under protection more than doubled in the 1970s–1980s, receiving the most state credits. With the liberalization of the late 1980s, many firms could not survive. Heavy-industry firms witnessed the lowest number of exits because the political costs of closing them down were high, but existing firms were running much below capacity. Policies were misguided, but in large part they were driven by the fragmented political system, which was unable to exclude firms and business interests from state support or discipline them, or coordinate investments and subsidies across the economy (Di John 2009).

By the early 2000s, the third phase of the diversification, as oil prices started rising, oil exporters pursued another investment strategy. Increasing oil revenues led oil exporters to increase spending on investment in infrastructure to compensate for underinvestment during the bust years. After the liberalization policies implemented earlier, international markets were open to them and countries pursued further improvements in business environment to attract foreign capital. Oil exporters invested in general-purpose investment, in particular infrastructure and real estate, and focused further on comparative-advantage sectors to promote export diversification: oil-related and energy-intensive industries such as aluminum and petrochemicals. Algeria, the GCC, and Venezuela’s non-oil exports were still mostly chemicals and metals. In addition, the GCC countries focused on developing services, especially in tourism, logistics, and finance.

Diversification Successes

Indonesia, Malaysia, and Mexico have succeeded in diversifying their exports, but more needs to be done.

Malaysia

Malaysia successfully expanded its exports base as well as the sophistication of its manufacturing. The country has promoted specific strategic industries to achieve the maximum technological transfer possible. It relied on both horizontal and vertical development of industries as well as natural-resource-related industries (Yusof 2012; Jomo and others 1997; and Jomo 2001). Above all, Malaysia used active state intervention to spur growth in sectors it deemed important.

Malaysia is richly endowed with diverse natural resources such as palm oil and oil, considered its comparative-advantage sectors. The country pursued vertical policies toward higher-value-added activities related to natural resource industries. Active state intervention produced mixed results. The petroleum industry got going around the time of the spike in oil prices in the early 1970s, when oil was discovered. Petronas, the state oil company, became a very efficient and globalized firm operating in more than 30 countries, involved in exploration, exploitation, refining, and numerous oil-related complex activities. It is ranked among the most profitable firms in the world. Countering oil depletion and exploiting offshore oil fields must have contributed to its active technological upgrade. Palm oil refining could also be considered a success: Malaysia has retained a dominant position in the sector and succeeded in diversifying away from relying exclusively on raw palm oil exports. Investment in refining capabilities followed the imposition of export duties on raw palm oil. However, a similar approach in moving up the value-added chain in the rubber industry to produce tires and in the logging industry to build furniture did not yield the same results. A common thread in all the resource-related manufacturing in Malaysia, in contrast to most other oil exporters, is its emphasis on technology transfers and upgrading and the drive to compete internationally.

In the 1960s, Malaysia followed an import substitution strategy, in heavy industries in particular: steel, cement, and automotive (the Proton car). To protect new industries, state intervention with tariff barriers and subsidies started with public enterprises, although most of them were privatized at least partially at a later stage. This strategy was similar to Korea’s a decade earlier, but with much less emphasis on exports and much less performance assessment (Jomo and others 1997; Jomo 2001). So far, these companies have not been as successful as their Korean counterparts in international markets and have relied mostly on domestic markets. Yet it should be pointed out that in other countries successes in these industries was preceded by several decades of losses (such as Toyota and Nokia—Chang 2007).

Malaysia was one of the earliest oil exporters to scale down its import substitution strategy in the 1970s and started relying on an export promotion policy (Jomo and others 1997). As a result, Malaysian manufacturing grew tremendously over the past three decades as it was forced to compete internationally and grow beyond its small domestic market. Today, manufacturing represents more than a third of all exports (and three-quarters if refining and other natural-resource-related manufacturing are included). It is one of the major exporters of electric and electronic manufacturing goods in the world. To achieve this goal, Malaysia used a multifaceted approach: (1) it selectively encouraged foreign direct investment in exports, especially in electronics; (2) it relied on free trade zones; (3) it offered lower taxes; and (4) it provided a stable business environment as well as an educated workforce with competitive wages. However, Jomo and others (1997) note the low number of linkages of these industries with the rest of the economy and the absence of export “champions” in high-value-added goods, as in the other successful East Asian economies, partly explaining why Malaysia did not join Korea’s rank as an exporter.

A standard explanation of the success of Asian economies, including Malaysia, is the high rate of saving and investment, which led to a rapid accumulation of physical capital. Jomo (2001) shows that for most of these economies, saving was mainly comprised of corporate saving, while household saving was low. The only countries in this group where households’ saving rates were high were Singapore and Malaysia. In Malaysia, high household savings were due to a mandatory, publicly managed retirement fund for employees in the private sector. All employees were required to contribute 10 percent of their income, to which the employer added 12 percent of the employee’s salary (on average since 1980). Most of the savings were invested in government securities by law. This forced savings scheme amounted to financial repression and helped the government to finance its investment plans.

In parallel with rapid physical accumulation, one cannot ignore human capital accumulation as another important factor in Malaysia’s success. The Malaysian state used public agencies to enforce a continuous retraining and skills upgrading of employees. The Human Resources Development Fund was set up in 1993 and has been financed by a levy on employers (about 1 percent of each employee’s salary).21 Its main target is the manufacturing sector, although many service sectors are included. The firms in the program are eligible to use their contribution for retraining and skills upgrading within the fund’s guidelines. At the peak of their scholarship program in 1995, 20 percent of all students were studying abroad, costing the government an estimated $800 million annually, or 12 percent of the current account deficit in 1995.22 Finally, several agencies were tasked with helping firms, especially SMEs, to upgrade technology and boost quality control to reach international standards. These agencies contributed to helping firms export on international markets by providing consulting services at different levels.

Indonesia

Like other oil exporters, Indonesia experimented with an import substitution strategy in the 1970s during the spike in oil prices. It created SOEs involved in heavy industries such as cement and steel to support investment in infrastructure, and fertilizers and agricultural machinery to support agriculture. The growth of manufacturing during the 1970s reached about 15 percent a year (Poot and others 1990). However, the SOEs that operated in isolation from international markets and with little performance control were characterized by inefficiencies and relied on public support (Hill 1988).

With the collapse of oil prices in the 1980s, and contrary to most other oil exporters and, in particular, to other members of the Organization of the Petroleum Exporting Countries (OPEC), Indonesia managed a spectacular turnaround. It adopted a set of new policies meant to attract foreign capital into export-oriented manufacturing. The main instruments of this policy were the creation of free trade zones, tax incentives, the easing of tariff restrictions and nontariff barriers as well as the largest exchange rate devaluation among developing nations in the 1980s (Jomo and others 1997). The result was a substantial growth in labor-intensive manufacturing (textile, footwear, electronics, and others) due to attractive wage levels. Gelb and others (1988) argued that Indonesia was the only OPEC member that used a significant share of its oil revenues to develop its productive capacity, especially in agriculture. However, the low wages may have played a more prominent role, along with Japanese yen appreciation in the mid-1980s and the subsequent offshoring by Japanese firms in Southeast Asia.

More important, oil revenues were already declining rapidly in the 1990s to the extent that Indonesia became a net importer of oil by 2003 (Energy Information Administration 2014). In other words, the intensity of Dutch disease was fading in this period. Between 1985 and 1997, the growth of the manufacturing sector was about 10 percent a year (Dhanani 2000). However, growth in the manufacturing sector has stalled since the Asian financial crisis in 1997–98 to the extent that observers started fearing early deindustrialization (Aswicahyono and Manning 2011). Indonesia remained a good performer in overall growth during the 2000s, but manufacturing was not the engine of growth that it was in the 1990s (Aswicahyono and Narjok 2011).

During liberalization in the 1980s, the government performed a “strategic retreat,” but retained several of its strategic projects, in particular in steel and the aircraft industry. The national steel company is considered to be lagging behind other Association of Southeast Asian Nations producers (OECD 2013). The attempt to set up an aircraft industry was viewed negatively and taken as an example of why Indonesia failed to catch up (McKendrick 1992). While agreeing with the inefficiencies and other political economy problems, Jomo and others (1997) note that the experience of Indonesia also shows that, with government commitment, a complex technology industry can be started from scratch in a poor nation (as Indonesia was at the time). Indonesia today is part of a select group of developing economies with clusters of aircraft maintenance and aircraft parts manufacturing. The creation of the national champion, albeit at a large cost, did facilitate the establishment of this cluster.

Mexico

Indonesia and Mexico share several similarities. Both have large populations and followed broadly the same export-led strategy. Both relied heavily on free trade zones focused mainly on labor-intensive industries that were mostly foreign owned. This policy, coupled with attractive wages and business environment, built the export successes of both countries. However, the firms operating in these zones did not climb very far up the value-added ladder and linkages between them and the rest of the economy remained weak (Jomo and others 1997; Verhoogen 2012).

Mexico’s experience in the automobile industry in the last 15 years is notable. Most of the industry is located in the center of the country, far from its borders, the traditional land of the maquiladoras. Today employment in the sector in Mexico surpasses that of the U.S. Midwest (40 percent of North American employment in Mexico versus 30 percent in the U.S. Midwest in 2012) and is expected to continue its fast growth. Obviously, the North American Free Trade Agreement and exchange rate depreciation in the 2000s helped make the country an attractive place for FDI by automotive companies planning to export to the United States. However, the policies adopted by different states in Mexico in pursuit of building manufacturing clusters, and their performance in terms of productivity and quality upgrading, are of interest. In particular, the State of Guanajuato followed what can be described as a purpose-specific investment strategy in parallel with strong incentives to attract firms. In infrastructure, the state built a 2,600-acre interior port, customs facilities, a railroad depot, and a link to the local airport (Cave 2013). Nearby, there is also a polytechnic university to supply engineers, and the state gives incentives to firms to send workers for training abroad. The state has attracted foreign firms by providing tax incentives, but, more interestingly, by acting “as an overall consultant in terms of support.”23

More recently, Mexico saw the rapid growth of aerospace clusters reaching total exports of $12.2 billion in 2012 (Araujo 2012). The aerospace industry requires an even higher level of technical skills and is subjected to very high levels of international standards on quality control. So the establishment of more than 300 firms in the aerospace industry is a sign of an improvement in productivity. However, Romero (2010) observes that research and development activity in the sector is almost nonexistent. In his study based on surveys of aerospace firms in several clusters, he shows that the major factors in the location decision of these firms are industrial infrastructure, skilled labor force, and low operational costs. He concludes that as long as the government does not follow a more active policy to encourage research and development and innovation—in particular the creation of domestic “system integrators,” that is, a firm constructing and commercializing whole aircraft instead of components—the productivity gains and innovation in the sector will remain limited.

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1The GCC is comprised of Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates.
2Dutch disease here is broadly defined as the crowding-out of the non-oil tradable sector by the income generated from oil exports.
3Annex Tables 1.1.1 and 1.1.2 list the main economic characteristics of the GCC countries and other oil exporters.
4Although 1980 corresponds to the peak of the oil price boom that began in the 1970s, using it as a base year is valid as oil prices in real terms are about the same level in 2010 as in 1980–81. In addition, our results are still valid overall whether we use the 1970s or 1980 as a base year.
5The data on PPP GDP and employment come from the Penn World Tables 7.1 and could differ from other sources.
6IMF 2013a also finds declining TFP during 1990–2012 using national accounts data.
7See the seminal paper on creative destruction by Aghion and Howitt (1992).
8Export sophistication is measured according to Hausmann, Hwang, and Rodrik (2007). The measure, EXPY, is defined as the export-share weighted average of sophistication levels of the country’s export basket. The sophistication of each good is measured as the weighted average of real GDP per capita—a proxy for the level of sophistication—of all countries that export that good.
9When income increases as a result of oil revenues, and both tradable and nontradable goods are normal, the increased demand for nontradables is met by real exchange rate appreciation and a relocation of labor toward the nontradable sector (see, for example, Krugman 1987). Empirically, the real exchange rate in the GCC is unaffected by oil revenues, implying that traditional transmission of Dutch disease does not apply (Espinosa, Fayad, and Prasad 2013). However, as discussed in proposition five, the crowding-out of the tradable sector takes place in the GCC by the impact of oil revenues on incentives for exporting in these economies, given the distribution mechanisms of oil revenues to the rest of the economy.
10In the Cherif (2013) model, the relative wage depends on relative productivity in the tradable sector. The bigger the productivity gap, the bigger the relative wage, and thus an increase in oil revenues, when translated into domestic income, would have a bigger income effect than is the case with a lower productivity gap. This would result in greater crowding-out of the tradable sector. Empirical evidence supports this result.
11The data come from Feenstra and others (2005) (code 7 of the U.N. SITC classification). Jarreau and Poncet (2012) use a similar measure (share of high technology manufacture in total exports) as an alternative to EXPY, the export sophistication measure from Hausmann, Hwang, and Rodrik (2007). Both measures exclude services; however, it should not affect the results as the services share of exports is small for many countries.
12One could argue that instead of flows or revenues, the stock of oil reserves or oil wealth matters most through consumers’ expectations. However, consumers might not internalize the ownership of reserves, and even if they were to do so, either (1) credit constraints would prevent them from properly smoothing their consumption; or (2) the precautionary saving motive would be high as a result of the high level of uncertainty in the oil price (Cherif and Hasanov 2013). Empirically, most studies find evidence of Dutch disease based on flows to stocks (such as Cherif 2013 and Ismail 2010).
13The other main argument is that manufacturing expansion and technological upgrading of export sophistication are key to sustained productivity gains and development in general, as proposition two discusses.
14“Learning externality” refers to the positive effects the production activity has on other firms that are not taken into account by a firm performing this activity or paid for it.
15Standard Dutch disease theory would not fit the GCC picture, with its important assumption that labor is not internationally mobile. If it were, the increase in the revenues from oil exports would not lead to real exchange rate appreciation and crowding-out of the tradable sector. This assumption is fairly plausible for most oil exporters, especially those with large populations such as Nigeria or Venezuela. But the GCC economies have had open labor markets with huge inflows of expatriate workers in the past decades, especially from low-income countries.
16For evidence on the crowding-out effect of public sector employment, see Behar and Mok (2013).
17In the 1970s, for example, 43,000 kilometers of village roads, 61,700 kilometers of agricultural roads, and 79,000 small bridges were built, while 2.7 million households were supplied with electricity (Choe 2005, Table 1).
18As argued in Cherif and Hasanov (2013), with low productivity in the tradable sector, optimal investment should be relatively low.
19Note that if the same logic were applied to Korea in the 1960s, the conclusion would have been to focus on rice or wigs, the main export at the time.
20Government-linked companies in Singapore played a significant role in the economy since independence and are run efficiently on a competitive and commercial basis (Ramirez and Tan 2004).
21The Human Resources Development Fund website. Available: http://www.hrdf.com.my/wps/portal/PSMB/MainEN/Corporate-Profile/About-HRDF.
22Patrick Blessinger and Enakshi Sengupta, “Is Malaysia the Regional Leader in International Higher Education?” The Guardian, July 2, 2012. Available: http://www.theguardian.com/higher-educationnetwork/blog/2012/jul/02/higher-education-in-malaysia.
23Norbert Buechelmaier, Getrag’s executive vice president of manufacturing, in McCurry, John, “Center of Attention,” Site Selection magazine, January 2009. Available: http://www.siteselection.com/features/2009/jan/Mexico/

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