Clear as Oil
The future of the GCC economy
Clear as Oil
Can the flap of a butterfly wing in Southeast Europe cause a tornado in the Middle East? In light of the present frailty in Gulf Cooperation Council (GCC) market confidence, one could be tempted to answer this question in the affirmative. In effect, of late, markets in the region have weathered growing anxiety over signs that the Greek crisis may end up sapping the main pillars of the their economic recovery: namely, government investment and high oil prices.
On 25 May, the International Monetary Fund (IMF) announced that, according to its latest forecasts, oil-exporting countries in the Middle East and North Africa are expected to grow 4.3 percent in 2010. These numbers reflect rising oil prices (peaking at $89 on 3 May) and the injection of a substantial amount of stimulus money in the region’s economy, mainly via public investments. As oil prices now seem in a unambiguously downward trend, doubts arise about the sustainability of these policies.
These fears are not totally without foundation. According to a recent Moody’s report, if the sovereign debt crisis were to spread to other European countries, the resulting rise in investor risk-aversion could considerably hinder the ability of GCC government and corporations to issue debt. In such a (still likely) scenario, public and private investments would be severely weakened by widening credit spreads and rising capital costs, bringing to a halt much needed investment in infrastructure and corporate development.
However off-putting such dynamics may already seem, the crisis’ impact on oil prices may prove even more detrimental to the region. Despite the significant rise in the non-oil sector’s share of GDP in the last decade, the oil industry still remains the primary source of revenue and capital for governments and key investment funds. From this standpoint, fund managers in the region have stressed that falling oil prices would triply undermine the region’s economy: first, by a one off reduction in total economic output; second, by trimming down fiscal revenues; and third, by constricting the financing of public and private investment.
Within this context, the prospects for the region are, to say the least, not very encouraging. If oil prices still remain at comfortable levels ($70), oil futures—a good indication of future price levels—have already tumbled. Two main forces support this downward trend. The first and more obvious one is the uncertainty surrounding future European oil demand as a result of the ongoing sovereign debt fiasco. The second (and more ominous) one concerns the now observable overheating of the Chinese economy. Indeed, given China’s historic aversion to inflation, these growing inflationary pressures presage the tightening of monetary policy and, as a result, a drop in Chinese economic activity. Given China’s key role in the pre-crisis oil price boom, its structural economic adjustments are very likely to drag down oil prices.
If anything, specialists in the region argue, this vulnerability to international financial and economic fluctuations significantly heightens the necessity to accelerate the implementation of economic diversification policies. In the context of the region’s comparative advantage, they underline, diversification should primarily occur through the fostering of a dynamic services and financial sectors.
According to a recent Chatham House report, for instance, the region’s institutional shortcomings act as a severe drag on the development of the non-oil sector. The creation of reliable and independent legal institutions, according to the report, would work in reducing contractual risks and fostering trust within markets—the main staple of financial markets. Contrary to what critics say, this does not forcefully pass through the adoption of the Anglo Saxon common law system. Qatar, for instance, has implemented a hybrid legal system, applying Sharia law for matters of personal status (civil courts), and a western-style legal system within the jurisdiction of the Qatar Financial Centre. Similar arrangements also exist in the UAE and Bahrain.
Furthermore, if the GCC is to secure emerging market status for their financial sectors (they are currently classified under the “riskier” frontier markets status) and benefit from more stable capital inflows, the region must significantly fine-tune its financial regulatory framework. As with legal institutions, however, these countries need above all to focus on ensuring the impartial application of rules and regulations, without which stable and predictable rules of the game are impossible. This is so far not the case everywhere, according to a Toronto-based investment fund manager.
Another important barrier to the creation of a dynamic and stable financial system is the absence of sound government and corporate transparency standards. As David Senders from Invest AD highlights, the GCC is stuck in a Catch 22 situation where foreign investors demand more transparency in order to invest, while greater transparency depends de facto—even if not in principle—on higher levels of foreign involvement in GCC markets. In order to break this vicious cycle, governments should tackle foreign investor risk adversity by simply catering to their informational needs. This is mainly achieved with the adoption of efficient and credible government and corporate transparency standards throughout the economy.
Finally, observers such as Martin Wolf from the Financial Times and Deepak Lal from UCLA, highlight the impossibility of reducing the region’s dependence on oil revenues without first furthering the liberalization process of these countries’ financial systems. A case in point, by sustaining undervalued pegs, these observers argue, capital controls on currency convertibility currently create capital allocation distortions that overwhelmingly skew the allocation of resources in favor of the tradable sector (manufacturing and oil sectors). According to these authors, this has as a primary consequence the severe undermining of the untradeable sector.
Reforming this policy is not without mighty obstacles, not least because of its impact on the future plans of a GCC common monetary union. Nevertheless, given the comparative disadvantage of GCC countries in manufacturing, sustainable economic diversification must invariably pass through the development of the untradeable sector, and more specifically, the services and the financial sector. As things stand now, not only is regional economic diversification structurally hampered, but GCC economies also remain highly vulnerable to volatile oil prices and global business cycles.
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