Diversification in Gulf hydrocarbon economies and interactions with energy subsidy reform: lessons from Kuwait

After the recent oil price declines in mid-2014, Middle East and North Africa (MENA) oil exporters including Kuwait reduced energy subsidies and passed economic diversification-enhancing policies in an attempt to improve fiscal balance and economic sustainability. This paper argues that these economies already have a diversified base but this base has not contributed to export or fiscal diversification due to structural constraints and economic distortions.  Using illustrations from Kuwait, this argument is tested with simulations using an economy-wide general equilibrium model that embodies key features of the Kuwaiti economy—including subsidies, sovereign wealth funds, industrial oligopolistic structure with collusive pricing, and a labour market that depends heavily on a segregated expatriate labour force. Model simulations confirm that after an oil price decline, subsidy reform alone adds little impetus to diversification, but that relaxing some economic constraints, through mobility of Kuwaiti labour (which simulate Kuwaitization policies) and competition reform, would achieve large efficiency gains throughout the economy and could expand non-energy tradable sectors. This result supports the argument put forth in the paper that weak economic diversification in MENA oil exporters is not primarily due to Dutch disease, as is frequently argued in the relevant economics literature, but to economic and structural constraints and economic distortions. The results have two key policy implications.  In small MENA economies, pricing regulation has the potential role of moderating the economic impacts of oil price volatility. And in developing oil economies with pervasive oligopolies like those in the Gulf region, microeconomic reform can achieve efficiency and enhance the diversification effects resulting from energy and fiscal subsidy reforms.  Finally, implementing reforms that reduce distortions is a politically complex process, therefore, to achieve meaningful diversification and fiscal sustainability, these reforms ought to be implemented as part of a wider set of broader economic, social, energy, environmental, cultural, and institutional reforms.

By: Manal Shehabi

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