Taking care of future generationsOctober 28, 2010
The six countries of the Gulf Co-operation Council (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates) weathered the Lehman Brothers tsunami and the great recession better than the advanced economies. Overall, the GDP of the GCC countries grew by about 1% in 2009, lower than emerging markets at 2.5% but in sharp contrast to the decline in GDP in ‘advanced’ economies of 3.2%.
Despite their efforts at economic diversification, the GCC countries were exposed to real shocks that were difficult to escape: the global recession led to lower energy prices, lower energy production and lower energy revenues; the collapse of world trade in goods and services, including tourism, had a direct impact on the budding non-energy sector; foreign capital inflows stopped or reversed while sub-prime contagion effects devastated the real estate market.
Across the GCC, the policy reaction of Governments and monetary authorities was the major factor cushioning the effects of the international tsunami. High levels of accumulated international and fiscal reserves from large current account and Government budget surpluses allowed Governments to maintain expenditure on infrastructure and development projects , while central banks– given strong US dollar exchange rate peg policies – followed US policies in monetary easing and lowering interest rates into negative real rate territory.
Indeed, 2009 was the first time the GCC discovered and implemented active counter-cyclical fiscal and monetary policies! Historically, fiscal policy has been perverse: largely pro-cyclical and therefore aggravating the boom-bust cycle resulting from oil price fluctuations.
But the crisis uncovered the vulnerability of GCC economies, public finances and regional Government revenues to energy shocks (both price and output). Governments woke up to the gaping hole in their economic policy toolbox. The lessons are that the GCC countries need to develop an independent monetary policy not subservient to the policy requirements of the US Federal Reserve, create the tools of fiscal policy and define their industrial policy, all too often subsumed under the ‘diversification’ label.
These necessary policy innovations and reforms are interrelated. As the GCC countries move towards greater economic and financial integration, they will need to evolve modern fiscal and tax regimes that provide resources for regional public goods and infrastructure projects, support sustainable economic growth, sound management of their non-renewable energy resources and allow for counter-cyclical policies. Public finance development and reform is required to reduce fiscal vulnerability, allow greater latitude for counter-cyclical fiscal policy and greater fiscal activism. In particular, Governments have to undertake a major fiscal transformation and acquire the policy tools enabling a separation between infrastructure and public works investment and spending and oil revenues.
Over the coming decade(s) the imperative policy transformations need to encompass the following areas:
- 1. Separation of energy wealth from Government revenues. There is a critical need for Governments across the region to diversify sources of revenue away from dependence on oil and gas ‘revenues’. Extracting oil and gas and selling it in world markets does not generate ‘income’ or ‘revenue’ and should not be counted as ‘Government revenue’: it is a transformation of natural resource wealth into financial wealth. Energy resource wealth – however plentiful it may appear – is exhaustible. Inter-generational equity requires that the financial wealth generated from energy resources be wisely and prudently invested – within a well-defined governance framework – for future generations.Applying sound public finance principles would dictate that Future Generation Funds (FGFs, otherwise labeled as SWFs) should be independently governed, held accountable for their investment performance and only transfer an agreed fraction of the income and returns generated from investment to the Government. Clearly, this would imply a revolution in public finances and would require a phasing in over a generation or more.
- 2. Diversification of Government revenues. The GCC countries should establish a broad-based taxation system in the form of a Value Added Tax (VAT): a tax on the final consumption of goods and services as a major source of Government revenue. Introducing a GCC-wide VAT would provide Governments with a more stable, buoyant source of revenue, growing with their economies and not subject to energy price volatility. Introducing VAT at a relatively low level of 5% would replace external tariffs (thereby strengthening the international competitiveness of the GCC) and the inefficient multitude of distortionary fees, stamp duties and other excises which raise the cost of doing business, increase transactions costs and reduce economic efficiency. The introduction of VAT should not only be seen as a revenue diversification measure but also as part of achieving greater fiscal equity. The GCC countries have large non-resident and largely untaxed expatriate populations that place a growing burden on public utilities and services and that should make a greater contribution to the provision and financing of public goods and infrastructure investment.
- 3. Phasing out oil subsidies. The GCC countries heavily subsidize gasoline, diesel, water and power. It has been estimated that the subsidy amounts to some 8% of GDP in Saudi Arabia and the UAE in 2008! These subsidies have led to surging domestic energy demand, affect the availability and product mix of oil exports, distort consumption and production patterns towards energy-intensive technologies (e.g. aluminum) and lead to environmental deterioration.Instead, the GCC countries, blessed with the enormous potential of harnessing solar power, should be phasing out oil subsidies and imposing a carbon tax to subsidize clean technologies and alternative energy sources. Removing the subsidies would lead to a large reduction in the non-oil fiscal deficit and free up resources needed for investing in human capital and core infrastructure in the GCC.
- 4. Develop public debt markets and management. The final policy priority is the imperative of developing local currency debt and Sukuk (Islamic bond) markets. Developing a Government securities market (including Treasury Bills) would allow Governments to smooth volatile energy revenues, enable the conduct of counter-cyclical policies, including deficit financing, and allow central banks improved control of domestic liquidity. Importantly, the debt and Sukuk markets would be used for the financing of the vast infrastructure and public works projects planned in the Gulf, estimated at some US$2 trillion. This will break the link between energy revenues and Government investment, which historically led to boom-bust economic performance as Governments tended to increase investment spending when energy prices were high and cut spending when prices were low.
The road map for fiscal development outlined above is ambitious and challenging. If implemented it would enable the GCC countries to enter a path of sustained economic development and sound diversification, to develop and implement fiscal policy in line with the specific requirements of the natural resource rich GCC and most important, help protect the interests of future generations.
By Dr Nasser Al Saidi, Chief Economist of the Dubai International Financial Centre Authority. The views expressed are personal and should not be interpreted to represent official views.Download full pdf version of T Magazine issue 02 3,2 MB