The Arab world is undergoing an uncertain transition. In the past, most states in the region offered a social contract where citizens received stability and security in return for limits on individual economic opportunity. This system, largely financed by exports of natural resources and foreign assistance, permitted expansive employment in the public sector, widespread subsidies, and government control over large parts of the economy. Unfortunately this approach is proving increasingly unable to provide the number of jobs needed for the region’s growing populations and has resulted in very high rates of youth unemployment, low rates of female labor force participation, and widespread social frustration. Addressing these challenges will require implementing a new social contract that focuses on offering opportunities for the region’s youth and future generations.
The region’s growing young, educated, and technologically connected population presents an unprecedented opportunity to foster development. Yet challenges to achieving it remain. Most economies in the region still need to implement a range of reforms to encourage the development of a more dynamic and sophisticated private sector. Moreover, they do not enjoy the luxury of a long timeframe to develop plans for addressing these challenges. The increasing size of the youth population and the low rate of labor force participation in the Arab world are already causing significant economic and social stresses. In addition, job creation in the context of high global economic integration and rapid technological change requires both governments and the private sector to make continued investments in education, innovation, and connectivity.
The development of a new social contract in the Arab world through reforms leading to better institutional frameworks, including appropriate macroeconomic, trade, and investment policies and more enabling business environments, would allow key productive investments in technology, education, and financial sector development to take place, offering the prospect of transforming the region’s economies. The analyses in the Arab World Competitiveness Report 2018 aim to shed light on these opportunities and to identify the changes needed to create more competitive, open, diverse, and entrepreneurial private sectors in the region.
Key global and regional trends
Rising income and wealth disparities and increasing polarization of societies are contributing to profound changes in the political and economic environments of many countries and are affecting the Arab world as well. For example, 56 percent of respondents to the World Economic Forum’s Executive Opinion Survey in Jordan are worried about persistent unemployment or underemployment, and about 40 percent of Tunisian and Algerian respondents place profound social instability and failure of national governance, respectively, among their top concerns. Cyber-dependency is also rising as a concern for some Arab countries. In the United Arab Emirates (UAE), for example, half of the respondents to the Executive Opinion Survey are worried about cyberattacks (up from 30 percent only one year ago) and one in five (twice the figure of last year) is concerned about data fraud. Finally, although adaptation to a difficult natural environment has always been a necessity for the entire Arab world, climate change might render this challenge significantly more difficult. Already today about 40 percent of Executive Opinion Survey respondents in Jordan and Qatar are worried about water crises.
In addition to these global trends, the region faces specific risks—separate from those generated by conflicts in some parts of the region—that are a direct consequence of its current economic structure. In resource-rich countries, excessive dependence on raw materials and lack of economic diversification have increased concern about fiscal sustainability and potential asset bubbles in the face of energy price shocks. These concerns have forced many Arab countries to pursue policies that aim at fiscal consolidation and allow a greater role for the private sector, including in infrastructure financing.
Increasing the competitiveness of the Arab world’s economies, diversifying their structures, and developing more entrepreneurial private sectors are vital to addressing the above risks. They are also essential for creating greater shared prosperity in the region. These are the key themes of the 2018 Arab World Competitiveness Report.
Competitiveness in the Arab world: Achievements and the way ahead
Even though a handful of countries have made intense efforts to reform and increase investments to improve their level of competitiveness, the region still lags in many areas. Overall, the aggregate competitiveness of the Arab world economies has not significantly changed over the past decade as measured by the World Economic Forum’s Global Competitiveness Index (GCI). It is, overall, less competitive than East Asia and Europe and more than Latin America and the Caribbean, South Asia, and sub-Saharan Africa.
Yet the Arab world is composed of a set of very diverse economies, which include some of the richest countries in the world, middle-income countries with varied economic structures, and conflict-affected countries where it is difficult to satisfy even basic needs. As a result, the region contains some of the world’s most competitive economies, such as the UAE, Qatar, and Saudi Arabia, ranked 17, 25, and 30 out of 137 countries on the GCI (Figure 1); as well as a number of states—such as Iraq, Libya, and Syria—where fragility, conflict, and violence (FCV) precluded the collection of the data necessary for the calculation of the index. There are also large differences in changes in competitiveness by country over the past decade (Figure 2). While Bahrain, Oman, and the UAE have made notable gains, competitiveness has eroded the most in Morocco, Algeria, and Lebanon. It also declined in Libya and Syria before conflict made the calculation of the GCI impossible.
In general, resource-rich countries not affected by conflict rank much higher on the GCI than resource-poor ones do. The competitiveness gap between resource-rich and resource-poor countries reached its maximum with the peak in oil prices in 2013 and has slowly decreased since. The region as a whole has generally suffered from declines in oil prices over the past few years and the region’s overall competitiveness gap vis-à-vis Organisation for Economic Co-operation and Development (OECD) countries has widened over the past two years.
Of the 12 pillars of the GCI, infrastructure and technological readiness are the areas where the Arab world has made the most significant progress over the past decade relative to OECD countries, a result of heavy investments in transport and information and communication technologies (ICT) connectivity. However, these improvements have not led to gains—relative to OECD countries—in innovation.1 The gap between the OECD and the Arab world has widened on two pillars, the macroeconomic environment and labor market efficiency (Figure 3). While financial market development was negatively impacted by the global financial crises, the region suffered fewer consequences from it than OECD countries.
Resource-rich countries have increased their competitiveness the most over the past 10 years. Investments in infrastructure and connectivity were particularly notable in the Gulf Cooperation Council (GCC) countries where, in 2017, the total value of infrastructure projects in the planning or delivery stage amounted to US$2.7 trillion. The macroeconomic environment of these countries was hit heavily by the decrease in oil prices, but most have implemented effective countercyclical policies to shield their economies from adverse consequences. Similarly, the impact of investment booms and busts has been largely limited to the financial sector. In addition, perceptions of public institutions among businesses improved, while the perceived ethics of private boards and managers has deteriorated according to the World Economic Forum’s Executive Opinion Survey. The functioning of the labor markets and extent of training remain key areas of reform for resource-rich countries. Lack of adequate talent and private-sector competition, along with low labor force participation, weigh down their capacity to innovate, by far their biggest weakness.
The performance of resource-poor economies stagnated, with signs of improvement evident only in the past two years. Infrastructure, especially seaport connectivity, improved rapidly and has become one of these countries’ relative strengths. ICT use and technological readiness also advanced significantly, recovering ground compared with OECD countries, but these improvements have not turned into increased innovation or business sophistication. Although low oil prices have recently eased macroeconomic pressures on oil-importing countries, most of them have nonetheless experienced a stark deterioration in this area over the past decade. Finally, these countries continue to suffer from very low rates of labor force participation and high skill mismatches, leading to especially high rates of youth unemployment.
Overall, the analysis of the competitiveness strengths and weaknesses of the region compared with OECD countries shows today that innovation, technological readiness, higher education and training, and labor market efficiency are the four areas where the region is lagging furthest behind advanced economies (Figure 4). The region will need to invest in its people.
Key challenges to increase competitiveness
Attaining a new social contract for the Arab world fundamentally requires countries to increase the competitiveness of their economies. It requires far-reaching changes in the way societies produce economic resources and distribute them, and in the way incentives for both citizens and businesses are structured.
A new social contract will be based on different roles and interactions for governments, citizens, and the private sector and will require addressing the following four challenges.
Transitioning away from natural resources and diversifying the economy. Oil and gas remain the largest export from the Arab world, accounting for close to half the region’s merchandise exports. Changes needed to encourage more rapid diversification in the Arab world include regulatory frameworks that ensure competition and support private-sector investment; improvements in the quality of education; openness to trade and foreign investment; and a financial sector that better meets the needs of micro, small, and medium enterprises (MSMEs). Some of the Arab world’s resource-poor countries—especially Jordan, Lebanon, Morocco, and Tunisia—have managed to diversify better by making advances in these areas.
Increasing the role of the private sector and diminishing the state’s intervention in the economy. Constraints to private-sector development remain substantial in many countries in the Arab world. States remain present as active market participants in a number of sectors, including construction, finance, transport, manufacturing, and infrastructure. Apart from state presence, a number of investment climate factors deter private-sector investment, including a complex regulatory environment, political instability in some countries, barriers to competition in markets such as finance and land, and skills mismatches.
Ensuring opportunities for the youth and the workforce of the future. In 2015, close to one person out of five in the region was aged between 15 and 24. The Arab world could reap significant benefits from its young, technologically connected, and increasingly educated workforce. However, the region is not making use of this opportunity, as this cohort suffers from low labor force participation and high unemployment. To realize youth potential in the region will require placing higher emphasis on the role of youth in society, using more merit-based systems for employment, making education systems more responsive to skills the markets demand, and fostering a culture of entrepreneurship and risk-taking.
Preparing for the Fourth Industrial Revolution and improving the innovation ecosystem. The Fourth Industrial Revolution is characterized by a fusion of technologies that is blurring the lines between the physical, digital, and biological spheres. The speed of technological development is increasing and eroding advantages of market proximity and low wages in the manufacturing and service sectors in favor of innovation and effective absorption of new technologies. The Arab world still needs to address some of the basic issues that will allow it to navigate through these developments. With half of the population not connected to the Internet, connectivity remains problematic for large parts of the region, especially in rural areas. In addition, the education systems need to train students to have a flexible, creative, and critical mindset, as well as the capacity to learn continuously and adapt to the challenges that the production and economic systems created by the Fourth Industrial Revolution will impose on them. Finally, it will be necessary for the financial sector to broaden beyond bank lending and provide financing opportunities to new investors with innovative and risky projects.
Solving the first two challenges, diversification and private-sector development, is essential for addressing the last two, job creation and mastering the rapidly advancing Fourth Industrial Revolution. The next sections analyze current barriers to diversification and more entrepreneurial private sectors in the Arab world as well as policies to address and overcome them.
Developing more diverse economies
For years, countries in the Arab world have faced difficulties in diversifying their economies away from areas of low productivity and exports of fossil fuels toward production and exports of higher-value-added goods and services. Although some countries in the region, such as Egypt, Jordan, Lebanon, and Tunisia, have levels of diversification that compare well to others at their level of income, most Arab world countries have levels of diversification that are well below it (Figures 5 and 6).
Diversification is a high priority for the Arab world for two principal reasons. First, diversification contributes to job creation as new sectors emerge. Creating a more dynamic private sector is especially important, as the region faces a large jobs challenge. Second, more diverse economies are less volatile. Economies dominated by a small number of sectors are highly vulnerable to fluctuations in global demand for those products. Prices of natural resources, in particular, can be especially sensitive to changes in global economic conditions. Such volatility can also can also discourage investment in new export sectors.
Barriers to diversification in the Arab world
A key reason for low diversification in resource-rich countries is that the persistent reliance on oil and gas exports exposes them to volatile macroeconomic conditions resulting from changes in the prices of these commodities and may reduce incentives for reforms to the business environment. Oil and gas exports accounted on average, over 2005–15, for more than 70 percent of exports of merchandise in nine countries in the region. Oil and gas are the main export for many comparatively stable countries, such as Qatar and the UAE, as well as some of its most unstable and weakly governed ones, such as Libya and Yemen.
Weaknesses in education and innovation are significant. Education and innovation promote diversification through multiple channels, including raising labor productivity, facilitating entrepreneurship, and enhancing a country’s capacity to produce higher-value-added goods and services. In addition, rapid technological change and intensifying global economic competition are making high levels of education and investments in innovation increasingly necessary for diversification. Although the Arab world ranks reasonably well in enrollment rates compared with other regions, the quality of education, as measured by scores on international tests, is low, especially in math and science (Figure 7). Likewise, most countries in the Arab world have low levels of innovation for their levels of income with the exception of Jordan, Qatar and, to a lesser extent, Morocco and the UAE.
The financial sector does not meet the needs of productive sectors. A competitive and well-regulated financial sector facilitates economic diversification by encouraging efficient capital allocation, competition, and new firm creation. In general, banks in the Arab world are not serving these functions well. Rather they tend to lend to large, sometimes state-owned or well-connected firms, and have few incentives to serve MSMEs. Loans to MSMEs account for a smaller share of bank loans in the Arab world than in any other region. This results in less competition, does not encourage the development of new firms and new sectors, and eventually impedes the diversification process.
A legacy of large state involvement is another key reason why many countries in the Arab world have struggled to diversify. State-owned enterprises stifle competition, often have privileged access to factors of production (land and finance, particularly), and are frequently inefficient and protected. State ownership was dominant in the early years of industrial policies that aim to spur diversification. These policies have mostly failed in Arab countries, but state-owned firms remained, keeping their competitive advantage, privileged access to resources, and soft budget constraints.
Weaknesses in governance and the business environment act as a major impediment to diversification. Institutional quality is a strong determinant of diversification. The Arab world fares poorly compared with other regions on most measures of governance quality, with the partial exception of some GCC countries. Political stability remains a serious concern, and not only in conflict-affected countries. Frequent changes of governments and recurrent policy reversals hurt government credibility in a number of countries. In terms of the business environment, the Arab world does not fare very well in regional comparisons of the World Bank’s Doing Business rankings: only South Asia and sub-Saharan Africa have worse average Doing Business rankings when using the distance-to-the-frontier measure (see Figure 8).2
Trade policy impediments exist. The Arab world is the least integrated region in the world, despite its attractive geographical positioning at the crossroads of Europe, Africa, and Asia’s trade routes. Trade policy in many countries is impeding diversification. The Arab world has high average effective tariff rates, mainly resulting from non-tariff barriers. In addition, the region is not well integrated in global value chains, has relatively protected service sectors, and has low levels of regional trade and investment.
Policies to promote diversification
There are broadly two large sets of policies that countries in the Arab world would need to implement to encourage diversification and the transformation of their economies. These will apply to various degrees depending on specific country situations and priorities. Some of these policies are core and apply to most countries, while others are more targeted to country-specific circumstances.
Core policies should first and foremost focus on education and innovation. The former includes promoting access to education, improving education outcomes, reducing the gender gap, and alleviating skills mismatches between the needs of the productive sectors and the skills students learn. Encouraging innovation involves creating an enabling environment that includes a modern ICT infrastructure, support for research and development as well as human capital development, and policies to promote technology transfer. Such policies foster the productivity of the labor force and firms themselves, both being key drivers of growth, employment, and diversification. Second, sound macroeconomic management, including countercyclical fiscal policies and competitive exchange rates, can reduce volatility and encourage investment in new tradable sectors. Sound macroeconomic management is essential for creating positive incentives for investment and business development. Third, firm-level interventions and microeconomic reforms, in particular firm-level support policies, should target firms to help them improve their productivity, export potential, and capabilities, in particular in technology adoption. In some cases, this could involve providing targeted support to exporters through services to improve export capabilities, developing appropriate export financing schemes, or improving trade logistics.
Tailored policies would cater to the specific circumstances and needs of certain country groups—countries affected by fragility, conflict, and violence; resource-poor countries; and resource-rich countries.
In countries affected by fragility, conflict, and violence (FCV), implementing programs addressing the basics in terms of infrastructure (including special industrial zones), limited mobility to connect people to jobs, access to finance (including restoring payment systems), and skills development should be prioritized. Supporting local economic development and increasing the job content of investments in sectors that are at the forefront of reconstruction and post-conflict situations (such as construction or retail and trade) are also crucial for promoting stability. In addition, targeted policies such as those that provide programs for vulnerable populations, investments in specific value chains, focus on isolated and lagging regions, and/or increase the quality of jobs are likely to be needed. Finally, there is a need to attract private-sector investment in addition to donor funds. Reducing risk, promoting realistic investment opportunities, and linking foreign and domestic investors are possibilities for FCV-affected countries.
For resource-poor countries, the most pressing reforms are to improve the business environment, including encouraging the development of MSMEs, especially in the service sector; and removing constraints to competition, including by implementing effective competition policies and reducing skills mismatches. Enhancing access to finance for MSMEs is especially crucial for the development of new firms. Furthermore, developing infrastructure and reducing non-tariff barriers is necessary for expanding opportunities for trade and facilitating regional integration.
Finally, in resource-rich countries, lowering restrictions on trade in services and reducing energy subsidies to remove distortions toward energy-intensive activities are often crucial reforms to encourage diversification. In addition, many resource-rich countries still need to implement business environment reforms, even if a number of them have made great strides in this area in recent years, particularly in the GCC. Governments in these countries can also accelerate diversification by making private-sector employment more desirable by transforming benefits enjoyed by public-sector employees into more broad-based social welfare programs. Finally, targeted vertical/sector-level policies to develop linkages from the natural resources sectors to the rest of the economy could have strong impacts on the development of a domestic private sector, particularly MSMEs.
Encouraging more entrepreneurial private sectors
Global experience shows that entrepreneurship stimulates job creation in the economy, as most new jobs are created by young firms, typically those three to five years old. The degree of success, however, varies, since new firms build on the maturity of the underlying ecosystem. With traditional pathways for job creation and growth through industrialization and export expansion at risk of not bringing enough jobs in the future, the Arab world’s policymakers have been encouraging entrepreneurship to accelerate rates of job creation.
Time is of the essence to reap the benefits of the growing new (digital) economy as entrepreneurship is lagging in the Arab world. The region has low rates of firm entry. According to World Bank data, about 1.2 new limited liability companies (LLCs) per 1,000 working-age population were registered per year over the decade 2006–2016, compared with approximately 6.3 in the OECD countries, 6.0 in Europe and Central Asia, and 5.6 new companies in East Asia and Pacific (Figure 9)3. At the same time, there are signs of progress in many countries. The formation rate of firms increased significantly between 2006 and 2016, for example, in Oman (from 0.5 to 2.1) and Morocco (from 0.9 to 1.7).
Determinants of entrepreneurship
The level of entrepreneurship in an economy is largely a function of the quality of its entrepreneurship ecosystem. These systems tend to be hyper-local, are usually located in urban areas, are cultivated by stakeholders rather than designed by governments, and are self-sustaining. The key priority for nurturing an effective entrepreneurship ecosystem is to support entrepreneurs through the processes of designing, launching, and running a new business. It also requires supporting pre-entrepreneurship activities, such as raising awareness of the possibility of entrepreneurship as a career choice and improving the chances that individuals will choose it as a career by providing effective support systems.
The ecosystem approach recognizes that entrepreneurship is a complex activity and that the success or failure of individual entrepreneurs and their ventures is not dependent just on their own skills and aspirations, but also on the quality of the surrounding ecosystem in which they seek to grow. Although no single ecosystem can simply be copied, their growth can be assisted or hindered by government interventions in various domains. The ecosystem framework used in this report is composed of six mutually influencing components, ranging from macro-level policies to firm-level policies that build firm capabilities, management, and technical skills (Figure 10):
- quality human capital,
- the availability of funding and finance,
- venture-friendly markets for products,
- enabling policies and leadership,
- institutional and infrastructure supports, and
- conducive culture.
Results from a survey of leading Arab world entrepreneurs conducted jointly by the World Bank and the World Economic Forum in May 2017 suggest that, in the Arab world, the three domains critical for business success are access to markets (68 percent), access to finance (66 percent), and availability of talent (65 percent).
Entrepreneurship ecosystems in the Arab world
The Arab world entrepreneurship ecosystems are underdeveloped and require a concerted effort on behalf of policymakers to address the significant gaps that are hindering existing and potential entrepreneurs. The annual Global Entrepreneurship Index (GEI) measures the quality of entrepreneurship as well as the extent and depth of the supporting entrepreneurial ecosystem across 14 components. Scores on the GEI range from 0 to 100 percent. The average score for the region’s countries in the 2018 GEI is 37 percent. Qatar, the UAE, and Oman are the top performers, while Algeria and Mauritania are at the bottom (Figure 11). Among the 14 components of the GEI, the region scores worst in risk acceptance, technology absorption, and competition (Figure 12). The 2017 survey of leading Arab world entrepreneurs conducted by the World Bank Group and the World Economic Forum noted earlier provides additional insights on the most acute impediments entrepreneurs in the region encounter. The three most severe obstacles faced by the leading entrepreneurs are lack of access to finance (42 percent), an inadequately educated workforce (28 percent), and business licensing and permits (27 percent). Furthermore, only 65 percent of those surveyed had received mentorship, and even fewer (about 42 percent and 44 percent respectively) had gone through incubation/acceleration and training.
Policies needed to develop entrepreneurship ecosystems
Although no single factor can aid the development of entrepreneurship in the Arab world, the region’s economies will not prosper unless businesses that aspire to take risks and grow can succeed within their communities, regardless of their social or economic privilege.
The most effective government policies for fostering entrepreneurial ecosystems in the region would employ a bottom-up and holistic approach. Most important, government policies need to change their focus from supporting broad-based entrepreneurship to more targeted policies aimed at innovation and growth-oriented firms. Furthermore, policies need to acknowledge the distinction between transformational and subsistence entrepreneurship and target their approaches accordingly. Governments also need to work with entrepreneurs to develop entrepreneurship ecosystems to give them space to create their own markets and sectors. Specifically, better business-enabling environments tend to have more favorable environments for promoting entrepreneurship.
More broadly, policies should include improvements in human capital, specific financing instruments for that segment
of new firms (start-ups, etc.), the development of market opportunities, and the fostering of an entrepreneurial culture.
Investment in education at all levels will continue to be a cornerstone in building the skill sets of tomorrow’s entrepreneurs. In particular, government policies on entrepreneurship education should ensure that entrepreneurship is embedded into the formal educational system, either public or private. For example, INJAZ Al-Arab, a Jordan-based non-profit organization, is a good example of the type of entrepreneurship education programs needed in the Arab world. It works in three areas: workforce readiness, financial literacy, and skills needed to start and run a business. About 3 million students in more than a dozen Arab world countries have participated in its entrepreneurship training programs.
Angel investment networks have been growing in a few countries of the Arab world, but are not widely accessible to young entrepreneurs. Governments should support the development of angel investment in the Arab world to include private investments, bridge equity gaps, and improve the pipeline of investment-ready start-ups for venture capital and private equity firms. Growth of the Arab world angels would provide access to early-stage financing to start-ups that can easily be combined with mentorship and market-access connections. Within the Arab world, GCC countries generally are undertaking the most intensive efforts to increase the amount of available seed capital to MSMEs, but other countries, such as Lebanon, Egypt, and Morocco, have been more active lately in this market.
Public procurement continues to dominate large parts of the Arab world economies and could be leveraged as part of the solution to give more opportunities for entrepreneurs. Policies to promote the growth of global value chains can also increase export opportunities for entrepreneurs. Each strategy comes with its own challenges and opportunities and countries need to gauge which is most to their benefit considering their own development interests.
Finally, developing the entrepreneurial culture in the region is key. Governments and the private sector can work to raise awareness about the benefits of entrepreneurship and to build an entrepreneurial culture. Furthermore, to foster female entrepreneurship, governments should support a cultural transformation process to encourage more women-owned businesses by eliminating gender-biased legal and regulatory restrictions, and should offer women-focused support programs for joining or start entrepreneurial initiatives.