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3. Reforms to Unlock Growth Potential in the Middle East and Central Asia

Author(s):
Pritha Mitra, Amr Hosny, Gohar Minasyan, Mark Fischer, and Gohar Abajyan
Published Date:
March 2016
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Raising growth potential requires combinations of reforms that can affect the factors discussed in Chapter 2 and, naturally, reform priorities vary across countries. Most reform areas are heavily discussed in the literature.10 However, the most effective combination of reforms for each subregion of the Middle East and Central Asia has not previously been systematically explored. Some reform areas will have a larger impact for countries in some subregions than others. This paper assesses the critical combination of reform areas for each subregion as the areas in which it performs poorly relative to its peers (based on empirical and survey data) and where improvement could lead to substantial gains in potential growth (based on regression analysis). Region-specific policies for advancing these critical reform areas are then explored.11

Yet there is one challenge that is common across the subregions of the Middle East and Central Asia: overcoming sociopolitical roadblocks in implementing reforms. These roadblocks are most often in the form of political instability or vested interests opposing reforms (World Bank 2009a). A strong communication strategy relying on outreach and buy-in from vested interests will be essential to forging ahead with reforms across the region.

The GCC

A more competitive business environment and financial market development would support higher growth in productivity and physical capital in the GCC. The GCC has generally achieved very high standards in almost all key reforms areas, having made marked improvements over the past few decades. It outperforms EMDCs in all reform areas. Nevertheless, the GCC still falls short of advanced economies in terms of evenhandedness of its business environment and the extent of financial market development (Figure 6), the most important reform areas for growth in productivity and physical capital, respectively. A number of specific measures can be taken to bridge this gap:

Figure 6.Areas for Reform

Sources: IMF, World Economic Outlook; ILO, Global Employment Trends; World Bank, Doing Business Report; World Economic Forum, Global Competitiveness Report (2014); and IMF staff estimates. Mitra, et al. (forthcoming) provides additional details.

  • Promoting a more competitive business environment, underlying productivity growth, will require streamlining business regulations and reducing bureaucratic red tape to significantly lower the cost of doing business, raise the efficiency of government services, and foster innovation. This would also be conducive to economic diversification and lowering the dependence of potential growth on oil-related activities, thereby raising the GCC’s economic resilience.
  • Advancing financial markets is especially important for fostering the accumulation of physical capital in the private sector—also critical for economic diversification. Financial market development hinges on both improving access to finance and legal rights.
    • Access to finance. In the GCC, and more broadly in the MENAP and CCA subregions, bank loans are heavily concentrated around large borrowers (Chapter 4, IMF 2014c; World Bank 2011b). As a result, the growth of small and medium enterprises (SMEs), an engine of economic activity and jobs (Syed and Lee 2010; Berthélemy and Söderling 1999), is constrained. Further progress in strengthening credit information systems—for example, by expanding the coverage of credit registries—will be important for enabling lenders to better assess the creditworthiness of borrowers. At the same time, further development of alternatives to traditional bank finance, such as Islamic finance, leasing and factoring, and less stringent disclosure requirements on capital markets, would ease some financing constraints.
    • Legal rights. Modern international best practices are lacking in the GCC and, again, more broadly in the MENAP and CCA subregions (Annex III, IMF 2014a). First, property transfer registration would facilitate collateral-based lending. Second, appropriate protection of minority shareholders would improve the ability of companies to raise capital. Third, strengthened insolvency and judiciary regimes would help enforce contracts and protect lenders in insolvency. In this context, decriminalizing bankruptcy is also important.

Over the long term, national worker talent needs to be developed. Less economic reliance on oil may adversely affect the GCC’s ability to hire talented foreign workers. Consequently, improving the quality of education of nationals today, where there is a substantial discrepancy between worker talent of foreign and domestic professionals, is critical for maintaining high levels of productivity into the future. In particular, better and more targeted education of nationals will support their participation in high value-added activities. To this end, the education system needs to be better aligned with the diversity of private sector needs. In addition, gradually raising female labor force participation rates (see Non-GCC MENAP section for policies) would not only raise labor force growth but also foster innovation, productivity, and, subsequently, jobs. Greater labor market efficiency—including reducing the wage gap between public and private sector jobs—and openness (in relation to the export of non-oil goods and services) can also play an important role in ensuring appropriate growth in employment of national labor.

Maintaining high quality public infrastructure and raising its efficiency can complement the reforms above. Public infrastructure supports the use and accumulation of physical capital both directly and indirectly through the provision of more affordable and reliable inputs into production. Indeed, high public infrastructure investment (as a percentage of GDP) bolstered physical capital accumulation in the GCC in recent years, reflecting the fruits of the past decade’s large oil-export earnings. But sustained lower oil prices and the accompanying fiscal consolidation they necessitate will constrain the resources available to build new infrastructure and maintain existing infrastructure. Consequently, raising the efficiency of public spending will be critical to make the most of any public investment. In addition, exploring other financing options—including issuing Sukuks, introducing taxes, and channeling savings from lowering energy subsidies—would help maintain adequate levels of public infrastructure investment. To this end, greater transparency of key investment projects over the entire project cycle (such as appraisal, procurement, and bidding stages) and the budget process would be helpful. Over the medium term, strategic alignment of projects with development priorities and revamping the management framework (including independent checks of project appraisal and selection) are both critical.

The GCC could add 1.5 percentage points to its growth potential by closing gaps with advanced economies in the reform areas discussed above (Figure 7). In doing so, GCC countries would advance the diversification of their economies away from oil and toward a more dynamic, private-sector driven, growth model. A little more than half the gains—adding to current potential growth of 6 percent—can come from boosting productivity growth through a more competitive business environment and developing the worker talent of nationals. The rest would depend on financial market development leading to the accumulation of higher physical capital in the private sector, complementing already high growth in public infrastructure.

Figure 7.How Much Can Potential Growth Rise?

Sources: Mitra and others (2014); World Economic Outlook; and IMF staff calculations.

1 Potential growth derived if each of the factors underlying potential productivity (for example, worker talent, modern production methods), capital (for example, business environment, financial development), and employment (for example, labor market efficiency, work environment) are increased to average benchmark levels. For simulation details see Mitra and others (2014, forthcoming).

Non-GCC MENAP

Multifaceted reforms are needed in the non-GCC MENAP region, for both oil exporters and oil importers alike. In contrast to the GCC, the rest of MENAP ranks below most EMDCs in almost all key structural reforms areas (Figure 6). But serious capacity constraints impede non-GCC policymakers from implementing such a wide spectrum of reforms all at once. Consequently, it would be better to initially focus on a handful of reforms—namely, those that can have the largest impact on the drivers of growth.

  • Fostering a competitive business environment could substantially boost productivity. Promoting the rule of law would help to discourage corruption. The privatization of large state-owned enterprises involved in sectors critical for businesses (electricity, transport, services, telecommunications, and banking) would lower their costs and improve the quality of services, while reducing the government’s liabilities and fraud. Lastly, systematic streamlining of business regulations, tax codes, and bureaucratic red tape can both reduce the cost of doing business and promote inclusiveness by discouraging favoritism.
  • Worker talent, also critical for productivity, can be nurtured with policies that improve the education system and leverage diaspora networks:
    • Education. Across non-GCC MENAP, the quality of education underperforms other EMDCs (Figure 8). Returns from schooling are among the lowest in the world (Montenegro and Patrinos 2013) and workers lack the skills needed for private sector jobs. Public–private sector partnerships in curriculum design, apprenticeships, and internships can address this challenge by better aligning education with private sector needs. In the MENAP oil importers, the number of years a student spends in school also falls short of other EMDCs and can be raised through programs that provide incentives for parents to send children to school. IMF (2014c) elaborates on policies to raise both the quality and quantity of education.
    • Leveraging diasporas. Large and successful MENAP diasporas can be tapped by governments through policy initiatives that facilitate communication networks where emigrants abroad can share their knowledge and expertise with businesses at home. A strong communication strategy on the benefits of diaspora networks—especially for the elite, who may view them as competition—is very important. Some examples of successful leveraging of diaspora networks are Globalscot (Box 1), Foundation Chile, South African Network of Skills Abroad, and Thailand’s Reverse Brain Drain project.
  • Financial market development is critical for raising physical capital growth. By supporting SME growth, financial markets not only build physical capital but also support a shift from state-dominated to private sector–driven growth models. The first step toward developing these markets is to boost the soundness of banks, raise access to finance, and ensure the legal rights of investors. The intricacies of reforms in these last two areas are similar to those that apply to the GCC (discussed above).
  • More and better quality public infrastructure (especially for electricity) also underlies physical capital growth and its effectiveness in raising growth. The MENAP oil importers and the non-GCC oil exporters invest considerably less in public infrastructure than is warranted by their income levels (Annex II, IMF 2014a; Albino-War and others 2014). The challenge of limited fiscal space can be largely overcome by streamlining and reallocating spending from untargeted subsidies and the public sector wage bill toward infrastructure spending,12 mobilizing additional public revenues (Jewell and others 2015), developing a platform to mobilize equity investment or donor grants, and blending concessional and nonconcessional financing. Public–private partnerships are also attractive but their risks (including to cost overruns and debt sustainability) need to be managed through better public investment management, appropriate legal and institutional frameworks, and transparent fiscal accounting and reporting. In addition, better public investment management can raise both the quality and efficiency of public infrastructure (specific recommendations in GCC section above).
  • Greater labor market efficiency is the main factor supporting higher employment growth in non-GCC MENAP and encouraging productivity growth as it facilitates higher wages and salaries, mobility, and promotions, reducing incentives for the most talented workers to emigrate. But labor market efficiency is lacking in the non-GCC MENAP countries (Figure 6) due to rigidities that stifle labor markets and fuel large informal sectors. Worker supply and demand can be increased when wages are set according to a less centralized collective bargaining processes. And more flexible hiring and firing policies (with unemployment benefits and protection against discrimination and arbitrary employer decisions) reduce firms’ costs and provide incentives for investment in firm-specific training (policy measures are described in IMF 2014c).

Figure 8.Educational Quality and Quantity

Sources: World Economic Forum, Global Competitiveness Report; and IMF staff calculations.

Over the longer term, using more modern production methods can further bolster productivity. Once momentum has been gained in improving the business environment and worker talent—both of which have a stronger impact on productivity growth—freed-up resources can then be channeled toward raising non-commodity foreign direct investment. This spurs the widespread use of modern production methods (ranking among the lowest in the world for many non-GCC MENA countries), particularly when it is in multinational global manufacturing chains (Box 2 elaborates on the channels).13 How can the non-GCC MENAP attract more investment of this kind?

  • Increased openness (see the CCA section below for specific policies). Non-commodity trade with fast-growing economies fosters vertically integrated global manufacturing chains.14 In open East Asian economies, these interactions (such as imports of intermediate and capital goods) led to twice the amount of technology transfers than in MENAP (Pack 2008).
  • Investment promotion cost-effectively reduces investors’ transaction costs through public services that provide information on business opportunities, laws, regulations, and factor costs. The diaspora (see above) can also assist. Investment promotion is particularly relevant where there have been recent political transitions. Harding and Javorick (2007) find investment promotion to be more effective than tax incentives and subsidized infrastructure such as energy.
  • Worker talent (see above), especially technical and language skills, also attract multinationals (Noorbakhsh and others 2001).

Gradually raising female labor force participation can benefit employment and productivity growth over the long term. While undoubtedly a global issue, female labor force participation in MENAP is the lowest in the world. Raising it contributes directly to long-term employment growth—both by increasing the supply of labor and by creating jobs (including the numbers of female entrepreneurs who in turn create more jobs). By diversifying the labor force, female labor force participation also fosters innovation and productivity. Key policies include ensuring equality in wages and employment opportunities, the freedom of mobility, facilitating parental leave and child care, and improving access to—and quality of—education for young girls (Box 1.3, IMF 2013c).

These multifaceted reforms could more than double potential growth for non-GCC MENAP (Figure 7). Catching up to the average EMDC in the areas of a competitive business environment, developing worker talent, and eventually modern production methods can spur productivity—raising current potential growth rates (about 4 percent for both the non-GCC MENAP oil exporters and oil importers) by almost 2 percentage points. Physical capital accumulation, in both the public and private sectors, would rise by similar amounts if EMDC standards were to be achieved in financial market development, public infrastructure, and greater global trade integration (especially with fast-growing emerging markets). The latter, coupled with greater global investment integration and more flexible labor markets, would support labor growth, as well as contributing to potential growth—though to a lesser extent than productivity and physical capital growth.

CCA

In the CCA, improving the business environment, worker talent, and financial market development are essential. The CCA’s performance in these critical areas lags that of its peers in the rest of the world (Figure 6). Yet, these are the areas that bring the largest gains to productivity and physical capital growth. Against the backdrop of large spillovers from the recession in Russia, geopolitical tensions, and, in the case of oil exporters, lower oil prices, reform implementation should be accelerated, targeting reforms to the selected, most effective areas.

  • Developing a more competitive business environment supports productivity by facilitating private sector development. To this end, streamlining of business regulations, tax codes, and bureaucratic red tape would discourage corruption and level the playing field for businesses. Reducing the dominance of state-owned enterprises, in part through privatization, and raising their efficiency will also be critical for reducing the operating cost of businesses.
  • Cultivating worker talent, also underlying productivity, is especially important in the CCA oil importers where educational quality substantially lags other EMDCs. Re-orienting the education system toward the skills needed for private sector development would be an important step in this regard. Leveraging diaspora networks, as described in the non-GCC MENAP section above, can also be a strong tool for boosting CCA worker talent.
  • Financial market development, especially when geared toward SMEs, could elevate physical capital growth. Raising access to finance and ensuring the legal rights of investors (detailed policies discussed in the GCC section above), against the backdrop of a sound banking system, lay the foundations for such development.
  • Greater openness in trade and investment, lacking in CCA oil importers, is important for employment growth by expanding job opportunities and, to a lesser extent, supporting physical capital accumulation. But connectivity with large emerging markets has been limited in most of these countries with few benefits from the high growth in large emerging markets (Box 2.6, IMF 2013c; Annex V, IMF 2014a).
  • Greater trade integration. Key policies include lowering tariffs, and eliminating significant nontariff barriers and import barriers for exporting industries. Additionally, simplification of customs rules and procedures, upgrading logistical infrastructure, and export-promoting policies would also help.
  • Transitioning to higher value-added exports. Increased foreign direct investment can facilitate this process, particularly multinational investment that integrates these countries into international supply chains. Investment promotion is particularly relevant for this process in CCA economies, as they are nontraditional multinational destinations. As discussed in the non-GCC MENAP section above, these policies would also be conducive for modernizing production methods (where the CCA lags its peers, Figure 6), which in turn raises productivity.

Substantially higher potential growth can be achieved in the CCA through these policies (Figure 7). Current rates (4¼ percent) could be almost doubled in the CCA oil importers and raised from 7 to 8 percent in the CCA oil exporters. Productivity could account for almost half the gains by closing the gap with the average EMDC in the business environment and worker talent, and over the long term, modern production methods. Higher private sector physical capital accumulation, accounting for the rest of the pick-up in growth potential, could be catalyzed by elevating financial sector development. In the CCA oil importers, greater trade and investment integration with large emerging markets would support both growth in capital and employment15—with the latter adding further to potential growth.

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