Economic diversification is the degree to which an economy moves away from a single source of income and towards multiple sources. It is essentially an economic strategy to reduce reliance on vulnerable economic sectors that are usually exposed to economic shocks.
Countries that are geographically landlocked, small, and heavily dependent on minerals, for instance, tend to have concentrated economic structures and remain highly exposed to revenues shortfalls. They have no other sectors from which to derive additional revenues.
Bad weather hits the harvest of a nation reliant on agriculture, and climate policies or pandemics deeply affect the price of oil as the global economy slows and oil demand falls. With revenues dwindling, cash-strapped countries, scramble to keep their fiscal deficits sustainable and their economies stable. They eventually adopt a range of policies, such as drawing down on their savings or borrowing money from international markets. Neither policy, however, is as good and sustainable as having diversified economic structures.
The GCC
Economists use a range of indicators to measure economic diversification. “Export product concentration index” and “government oil and gas revenues as a percentage of total government revenues” are two of the most accurate tools. The first measures the degree of concentration of goods exported and gives an idea of when “a large share of a country’s exports is accounted for by a small number of commodities”. For instance, Bahrain and Oman, are the most diversified with ratios less than 0.4. In contrast, Oman’s oil revenues account for around 76% of the total government revenues, making it the most vulnerable among the GCC countries to reduced oil demand. Qatar is the less dependent with oil and gas revenues equaling 34% of total government revenues.
Oil & Gas Revenues, Export Product Concentration
Country | Gov Oil and Gas Revenues | Export Product Concentration Index (2020) |
Kuwait | 69 | 0.61 |
Qatar | 34 | 0.43 |
UAE | 52 | 0.22 |
Saudi Arabia | 69 | 0.55 |
Bahrain | 72 | 0.34 |
Oman | 76 | 0.39 |
Source: WB, IMF, UNCTAD, Fitch Ratings
To understand the real impact of economic diversification, consider the different strategies the GCC could adopt in the event of unfavorable economic conditions. If oil demand falls and prices end up well below their fiscal breakeven price levels, the GCC could either cut oil supply, draw down on accumulated savings, or borrow from international markets. All three of these strategies have been used and proven relatively helpful in compensating for the shortfall in oil revenues. For example, between 2014 and 2017, Saudi Arabia used $240bn of its foreign reserves to balance its budget and defend the riyal.
But none of these strategies is sustainable. In fact, using foreign reserves might not be sufficient to cover large budget deficits, particularly on the long run. Cutting production is not always feasible given OPEC+’s failure to always agree on policy, and borrowing from international markets bears huge cost that increase their fiscal deficit and the sovereign debt levels.
A winning strategy, especially on the long term, is to move towards more economic diversification, where the shortage in oil revenues can be bolstered by revenues from other sources. More particularly, tapping on non-oil sectors to derive additional income and keep the economy afloat, balanced, and healthy, is a wiser strategy. Even in the presence of fiscal deficits due oil prices falling, diversified economies ensure resilience and help GCC governments plan for their future with more certainty and less instability.
How to do it?
There has been no scarcity of policy advice advanced by consultants and think tanks about the need for the GCC to prepare for a low-carbon future, in which the dependence on oil and gas is reduced through building the capacity of the private sector, setting a business conducive climate, attracting foreign direct investments, and replacing government revenues derived from oil and gas with revenues from other sources, such as taxes.
An outline of these and other policy recommendations consist of the following:
(i) Instituting an adequate business and investment climate, with clear, predictable, and transparent regulations that attract foreign investments and protect foreign investors.
(ii) Making sure business regulations are efficient and help investors and the domestic private sector to start businesses and enforce contracts without red tape.
(iii) Developing the financial sector to allow SMEs and larger companies to access credit easily and with lower cost. This entails a well-regulated, competitive banking system, along with a capital market that is well integrated into the global markets.
(iv) Ensuring competition in key service sectors such as transportation, finance, energy, and communications.
In brief, economic diversification requires increasing non-oil exports and creating non-oil jobs. Such a complex task starts with bold policy moves, supported by the political will to move steadily towards different economic structures with exports of either services or manufactured goods gaining primacy over exports of commodities.
