Karnes County in Texas, US, and the Al Ahsa governorate in Saudi Arabia’s eastern province have little in common. But these sparsely populated regions have, between them, transformed the global economy.
In recent decades, the massive Ghawar oil field that lies beneath the sands of Al Ahsa, along with similar reserves across the Arabian Peninsula, has helped to catapult Saudi Arabia and the other Gulf monarchies into economic powerhouses.
But easy access to oil fields such as Ghawar have produced economies almost totally reliant on energy receipts. As this economic model reached its zenith in 2008 – with the price of Brent crude nearly hitting $150 a barrel – rig drillers in oil-rich counties across the US were discovering new ways to reach vast reserves trapped in shale deposits such as the Eagle Ford in Texas. In doing so, they tipped the scales of the global energy order away from the Middle East to the US.
The outcomes of this shift have been profound. Gulf Co-operation Council (GCC) governments once used to swollen, double-digit fiscal surpluses are now contending with sizable deficits, while public debt issuance has ballooned. Populations that for years were showered with enviable public benefits are now grappling with biting changes to previously untouchable tax and subsidy regimes.
Race to reform
Economies across the GCC region are now in a race to reform as demographic pressures mount and the cost of their old operating models becomes prohibitively high. Today, glitzy economic reform programmes, drafted by consultants with mid-Atlantic accents, are pulsing through the conservative royal courts of the GCC region. Though each is distinct, they strive for the same endpoint: knowledge-based economies propelled by the private sector.
To reach this objective, the energy-exporting Gulf states are looking to the same ingredients that underpinned the shale revolution: innovation, competition and private investment. These components, together with the shake-up of regional labour markets and much-needed structural reforms, will be the main engines of regional change.
But since oil prices first collapsed in 2014, the GCC region’s reform story has yet to gain momentum. Despite some notable improvements taking place, the reform of Saudi Arabia’s capital markets and its stock exchange, the Tadawul’s inclusion in MSCI’s Emerging Markets Index being cases in point, many of these advances have occurred in niche or technical areas. Meanwhile, with some exceptions, the Gulf region’s most pressing reform challenges are yet to be touched.
“The temptation to return to the historical model of oil-funded, government-led growth and thus to move away from the challenging structural reform ambitions of recent years, is proving difficult to resist,” says Ehsan Khoman, head of Middle East and north Africa strategy at MUFG Bank in Dubai.
Rising oil prices have not helped the reform agenda. “Motivation for diversification is closely correlated with oil prices. As oil prices have been broadly rising in recent years, pressure for reforms dissolves, leading to spillage,” says Mr Khoman.
Backtracking on transformation
Examples of this abound. A quiet update to Saudi Arabia’s 2016-20 National Transformation Plan (NTP), a waypoint on the country’s broader Vision 2030 reform agenda, has seen a massive reduction in strategic objectives and key performance indicators, according to research from MUFG Bank. The original document included 178 strategic objectives and 346 key performance indicator targets, figures that have now been reduced to 38 objectives and 53 indicators, respectively.
“While markets may view these amendments as clearly highlighting that the initial goals were overly ambitious, we sense that the updated NTP strategy is more credible to achieve more realistic objectives for the next two years,” says Mr Khoman.
In the same NTP update, the Saudi authorities have amended their goal of attracting SR70bn ($18.7bn) in foreign direct investment (FDI) by 2020, instead targeting FDI inflows equal to 1.46% of gross domestic product (GDP), up from 1.3% in 2016. This comes as FDI into Saudi Arabia has collapsed. Figures from the UN Conference on Trade Development for 2017 indicate that total inflows dropped to $1.4bn in 2017 amounting to a 14-year low. To put this performance into perspective, FDI inflows into Jordan over the same period reached $2bn.
Given the importance of FDI to the regional reform agenda, a decline of this magnitude is startling. “If the Gulf states want to achieve their reform goals then they will need FDI. Without it, they’re never going to break the old model of the state being the key driver of the economy. FDI is required to provide new technologies and innovations, so to me it is really the cornerstone of the regional reform story,” says James Reeve, chief economist at Samba Financial Group.
Indeed, the GCC states have suffered a precipitous decline in FDI over the past decade, according to research from the International Monetary Fund (IMF), with the value of FDI inflows falling from more than $60bn in 2008 to less than $20bn in 2017. Meanwhile, between 2012 and 2016 about 60% of total regional FDI inflows were concentrated in just three sectors; petroleum, chemicals and real estate. While this data masks significant variations between markets and broader trends within the energy sector, for example, it points to the urgent need for Gulf states to attract higher levels of diversified foreign investment.
Against this backdrop, the erratic leadership decisions made by the likes of Saudi Arabia’s crown prince, Mohammed bin Salman, are puzzling and concerning many onlookers. The detention of leading business figures in Riyadh’s Ritz-Carlton Hotel in late 2017, for example, may have assisted the crown prince’s domestic agenda but has done little to gain favour with international investors. Likewise, allegations over the killing of journalist Jamal Khashoggi have not cast the country in an investor-friendly light.
A bar on FDI
Meanwhile, the GCC region as a whole needs to do more to lift restrictions to FDI, according to some industry watchers. “As the GCC states have woken up to the need to attract more FDI, there has been a growing push to abolish the kafala system, which is widely seen as an impediment to foreign investment,” says Christopher Davidson, a visiting fellow at Leiden University College in the Hague.
Under the kafala system (which operates to varying degrees across the Gulf states) foreign entities or investors engaging onshore must partner with a local citizen or business sponsor who retains a majority stake in the venture. Often acting as a silent partner, the Gulf national will extract fees in return for their participation.
“What’s been interesting over the past few years is that there have been quite a few cosmetic attempts to reform the old kafala sponsorship system. The kafala system has traditionally offered GCC nationals another benefit of being a citizen along with healthcare, education and housing. By removing or reforming it, you are thus also stripping citizens of one of their perks,” says Mr Davidson.
UAE example
In some jurisdictions, the introduction of new regulations designed to facilitate onshore foreign investments are pushing up against these perks. The United Arab Emirates, for instance, recently announced plans to permit foreign ownership of businesses of up to 100%, depending on the sector, outside of free zones. The move, while representing a positive and game-changing development for the economy, offers a glimpse of this friction.
“What has surprised me is the level of tension in the UAE. I always had the impression that the UAE was the most liberal of all [Gulf states]. But it has been a sticking point; many of the conservative elements of the citizenry are reluctant to see it go. [The new law won’t change things] overnight and the people who have been benefiting from the kafala system in the UAE will find a way to circumvent this,” says Mr Davidson.
Indeed, tensions between GCC nationals and their respective governments, though unlikely to escalate, could be energised in the coming years. Regional administrations are desperately pushing for more of their citizens to occupy private sector jobs, requiring longer and more difficult working hours, while simultaneously cutting benefits in terms of subsidies and tax reforms. Precisely how this will play out remains unclear, although urgent change is required to reduce bloated public sector wage bills.
Public sector spending
According to IMF research, real wage bill growth in the GCC rose by 8% a year between 2001 and 2007, before jumping to 10% a year from 2008 to 2016. That the wage bill expanded at this rate in the wake of the financial crisis and the collapse of global oil prices has not been helpful for government balance sheets.
Nevertheless, the same research points to important variations between markets. Saudi Arabia’s public sector wage bill stands at about 13% of GDP, for example, while that of Qatar and the UAE is less than half that figure. However, across all Gulf markets the public-private sector wage gap is vast. In Saudi Arabia it stands at more than 150% in favour of the public sector, while in Kuwait it is 245% – so attracting citizens into private sector jobs will not be easy.
In Saudi Arabia in particular this challenge is daunting. “What we have been seeing in Saudi Arabia is an almost overnight attempt to nationalise the labour force. That just can’t work politically or socially,” says Mr Davidson.
The Saudi government has in recent years applied levies on expats with dependents, as well as employers of expatriate workers. In general, these are flat fees that rise every year until 2020. These measures, in tandem with the introduction of value-added tax and the removal of other subsidies, have had a significant impact on the country’s labour market.
Research from MUFG Bank, citing Saudi government figures, points to the fact that close to 1 million foreign workers left the country between the first quarter of 2017 and the second quarter of 2018. This is equivalent to 7.6% of its total employed labour force. In the second quarter of 2018 alone the number of foreign workers leaving the country reached 290,381.
“Critically, while expatriates have left, Saudi nationals have not fully replaced them, with the number of Saudis employed in the private sector only rising by 63,946 during the same period, highlighting that effective Saudisation to date has been held back by skill and productivity gaps,” says MUFG Bank’s Mr Khoman.
According to Mr Davidson, limited signs of strain are already apparent. “Saudi Arabia does not have a knowledge economy yet. Most of these jobs are menial, low-end jobs that have been filled by African or South Asian labourers. As these workers have left, we have seen little hints that public services, along with some sectors of the economy, are struggling to adjust,” he says.
Kuwait's local drive
Kuwait is also taking steps to restructure its labour market. The government has been releasing greater numbers of foreign workers from the government payroll in recent times, while regional media sources were reporting a reduction in the hiring age limit of foreigners from 65 to 60. But the country has a long way to go to balance public and private sector employment. More than 90% of employed Kuwaiti nationals work in the public sector, while over the next five years fewer than 15% of nationals entering the workforce will be absorbed by the private sector, according to the IMF.
“The Kuwaiti authorities are hoping to gain traction on their efforts of Kuwaitisation, as a means to address its demographic challenges. Examples of this have been in August 2018, wherein the Civil Service Commission formed a committee to dismiss more than 3000 expatriate workers from the public sector and open positions for almost 12,000 citizens who have registered to receive jobs,” says Mr Khoman.
Elsewhere in the GCC, some markets are doing better. The UAE, for example, boasts one of the lowest wage bills in the region while levels of public sector employment are less than 10%. Private sector employment of Emirati nationals is also buoyant. “You certainly see increasing numbers of Emiratis in the private sector. I meet a lot of Emirati entrepreneurs who are involved in some very interesting projects, including in the fintech space,” says Raza Mithani, parter, commercial dispute resolution, at law firm Bryan, Cave, Leighton, Paisner in Dubai.
Privatisation is the other common thread uniting the GCC’s regional reform agendas. Here, progress has been slow. Despite a few standout transactions, including the initial public offering (IPO) of a 10% stake in the Abu Dhabi National Oil Company’s fuel distribution unit, generating $851m, at a regional level the picture is less encouraging. While Kuwait, Oman, Qatar and the UAE have all made some inroads into public-private partnership markets, there is significant scope for an acceleration of the privatisation agenda across the region. This includes, among other things, the privatisation of non-strategic government-related entities.
Privatisation stalls
In Saudi Arabia, the postponement of the Saudi Aramco IPO has deflated much of the energy around the country's privatisation drive. “The Saudi authorities have continuously sought to privatise targeted entities as a response to the volatility in oil prices; however, little has been achieved thus far,” says Mr Khoman. “A central challenge lies in the complexity of the legal regulatory frameworks and the work required to disentangle the government from the targeted entity to be privatised. Saudi Aramco is no different, and a likely explanation for the IPO delay is the complexity of the transaction and the work required to separate it from the rest of the state.”
The failure to list a stake in Aramco mirrors the sluggish efforts to privatise far simpler entities, including Saudi Arabia’s football clubs as well as its 27 airports, the last of which was initially supposed to be completed by the end of 2018. “Clearly there has not been a lot of progress on the privatisation front in terms of sales. But there has been a lot of work taking place behind the scenes in order to get the plumbing right before any big sale is made. The introduction of the new bankruptcy law is a case in point,” says Mr Reeve.
Progress on the GCC’s aggregate reform picture is not encouraging. More than four years on from the collapse in global oil prices, meaningful achievements remain the exception. Important distinctions between markets do exist, however. By almost every indicator, the UAE stands apart from its peers in terms of diversification, as well as its ongoing commitment to reform.
“To my mind, [the UAE] has some quite promising initiatives in place to stimulate and advance the economy, which will continue to make the UAE the most attractive country in the GCC in which to live and work,” says Mr Mithani.
This view is mirrored by foreign investors, financial services professionals and academics. “The UAE has an abundance of savvy leaders who are innovators and disruptors, especially in Dubai. The concept of ‘high modernism’ applies well to the UAE. The leadership is willing to take a bet on new ideas and new technologies to advance the country’s wider prosperity,” says Mr Davidson.
Pivot eastwards
Nevertheless, the GCC region’s reform story is emerging at a time when the nodes of global political and economic power are also changing, and as political uncertainty across the Middle East is growing. These factors are reshaping the global outlook of regional administrations.
“We are now entering unknown territory in terms of the foreign policy of the Gulf states, and especially Saudi Arabia and the UAE. They distrust the West. They hated the Obama administration; they were so furious that Obama gave up on Mubarak in Egypt so quickly,” says Mr Davidson. “They increasingly have economic synergy with China, Japan and South Korea as major economic powers. So they are gravitating in that direction anyway.”
The long-term implications of these changes remain unclear. But a shift in foreign policy is being accompanied by changes on the domestic political front. Mr Davidson notes that Saudi Arabia is not alone in adopting a more authoritarian flavour.
“Something similar has occurred in the UAE, where Abu Dhabi’s crown prince is seen as being firmer in dealing with dissent. In both countries, there has been an effective and recent collapse of the old sheikh-based consultative system to something that more closely resembles one-man rule,” says Mr Davidson.
As the GCC countries move towards private sector-led economies, the intersection of politics and commerce is set to grow in importance. Nurturing outward-looking and innovative markets is likely to invite the presence of disruptive and free-thinking individuals, of the sort who transformed Karnes County and the US shale patch. Accommodating them may be the region’s next big challenge.
