Ways to accelerate the needed diversification of the Arab world
The diversification process is happening slowly in the Arab world, and in only a few countries. As seen earlier, historical legacies, institutions and the investment climate, education and innovation, trade policies, and financial sector development all play a role in explaining the current situation.
Fostering the diversification of the region’s economies is critical for job creation and economic growth. To do so implies first recognizing that the old social contract based on public-sector jobs and widespread subsidies in exchange for limited opportunity needs to be replaced. A new paradigm needs to emerge with a focus less on public-sector involvement (either directly on markets or through laws and regulations) and more on private and financial sector development—including in the service sector—with emphasis on youth and women’s employment, two categories facing significant hurdles in the labor markets in the region. Policies to be implemented should be designed with this new orientation in mind.
Although such a transition is desirable, are there reasons to believe the region can overcome the obstacles that have hindered past efforts to diversify the Arab world’s economies? There are signs to support cautious optimism that this can occur. First, widespread social mobilization throughout the region over the past few years has made governments aware that they need to address public dissatisfaction with lack of economic opportunity. Second, declines in external assistance and falling oil reserves in some countries are forcing governments to prioritize spending, making generous subsidies, public employment, and support to state-owned enterprises increasingly less affordable. Third, some governments in the region are showing more concerted desires to develop their private sectors. For example, some GCC countries rate very well on competitiveness indicators, such as the World Bank’s Doing Business indicators and the World Economic Forum’s Global Competitiveness Index, because of concerted reform efforts. Likewise, governments in some resource-poor countries are making a considerable effort to design realistic strategies to improve the quality and quantity of their exports.
Combined, these trends suggest that opportunities to engage policymakers and the private sector on intensifying diversification efforts, with a focus on effective policy implementation, are growing. In addition, the examples of some countries that have successfully diversified over the past 50 years confirm diversification to be a realistic objective for the Arab world. In particular, countries such as Chile, India, Malaysia, and Mexico faced challenges similar to those in many Arab world countries today, including conflicts, weaknesses in the business environment, and high levels of social polarization, yet they still managed to diversify by applying specific policies, such as those shown in Box 5.
Box 5: Success Factors for Diversification Strategies in Various Countries
Successful diversification efforts often have been supported by policies built around the following:
- Fostering macro and institutional reform: Key areas include maintaining macroeconomic stability, creating a business environment conducive to developing export markets, and providing necessary education and infrastructure. In Mexico, for example, exchange rate devaluation and the North American Free Trade Agreement (NAFTA) were crucial for the development of its manufactured export sector. That sector required a range of reforms to open the economy to trade and foreign investment.
- Investing in high-productivity industrial clusters: The objective is to increase export sophistication by focusing on specific and more technologically sophisticated manufacturing clusters rather than labor-intensive manufacturing. The governments of Indonesia, Malaysia, and Mexico relied heavily on free trade zones to encourage investment in these areas. Some states in Mexico have developed investment strategies as well.
- Developing horizontal and vertical linkages from existing industrial clusters: The aim is to facilitate development of networks of local suppliers around existing export industries and undertake efforts to ensure efficiency of local suppliers. Malaysia has created these linkages from palm oil and rubber, while Mexico has created extensive linkages in automobiles.
- Using foreign capital to promote technological transfer: Examples include preferential trade agreements, economic integration, special economic zones, tax incentives, and reduction of non-tariff barriers. Free trade zones permitting high levels of foreign ownership have been crucial for technology transfer in Indonesia, Malaysia, and Mexico.
- Using performance-based export and tax incentives, and using access to finance to facilitate risk taking by entrepreneurs, especially micro, small, and medium enterprises: Moving into new sectors and markets requires firms to take new risks. These incentives help alleviate some of these risks. The efforts were particularly successful in Chile and Malaysia, in part because they employed robust systems of oversight and accountability.
- Making investments in training to ensure the availability of high-skilled workers: Creating new economic activities requires acquiring relevant skills as well as needed infrastructure and facilities. Malaysia and Mexico are good examples of such programs, especially the development of the aerospace industry in the latter. In addition, the Government of Morocco is attempting to reduce skills mismatch through pilot programs with the private sector, including public-private partnerships, to design or operate higher education and vocational programs at targeted educational institutions. Such training programs also emphasize soft skills such as communication, disseminate information on employment opportunities, and facilitate student internships.
Diversification strategies in Dubai and Morocco share a number of similarities with those in Chile, Indonesia, Malaysia, and Mexico, including reforms to the business environment, investment incentives, economic integration, and infrastructure development. Creating a favorable business climate, increasing openness to trade and investment, and ensuring needed skills and infrastructure has been crucial for the rapid development of high-value-added service sectors in Dubai, such as finance, information and communication technologies, and logistics. Likewise, Morocco has been able to attract substantial investment in the automobile sector through tax incentives, free trade zones, and ensuring needed infrastructure and skills.
Callen et al. 2014; Cherif and Hasanov 2014; Haddach et al. 2017.
Over the years, a standard and familiar set of recommendations to encourage more rapid job creation, economic growth, and diversification has been developed. These recommendations typically include:
- Focus on increasing productivity through investment policy and incentives.
- Increase the quality of the labor force to foster productivity and raise labor force participation rates.
- Improve the business environment in key regulatory areas, improve access to finance and financial inclusion, and support competition and innovation.
These are sensible recommendations, supported by data, some of which have been presented before. However, they lack prioritization and do not apply very well to fragile countries or countries where the vast majority of labor market entrants face no realistic alternative to self-employment or employment in microenterprises, yet many countries in the region fit into either or even both these categories. In addition, resource-rich countries also tend to have challenges to job creation that standard prescriptions may overlook.
It is therefore useful to look at possible ways forward in two steps: (1) the definition of a set of core policies that should be applied to all countries, and (2) additional policies more specifically designed, relevant, and feasible for specific types of countries—as reflected in groupings such as FCV-affected states, resource-poor countries, and resource-rich countries. The core policies are medium- to long-term policies in their effects, but are nonetheless critical for any diversification endeavor; the latter often have short- to medium-term impacts.
The core policies
The building blocks of any diversification and growth efforts, the core policies, rely on elements present (to a varying degree) in any diversified economy: human capital, innovation, and macroeconomic policies.
The first set of key policies, adjusted to country circumstances, revolves around improving education and fostering innovation. The former typically involves promoting access to education, increasing literacy, reducing the gender gap, and ensuring sustained government financing at appropriate levels. The focus should be on the quality of the education provided and on how to reduce skills mismatch between the needs of the productive sectors and the knowledge and skills of the young. This typically implies significant involvement of the private sector in the design and implementation of such policies, especially at the professional and vocational level.
Fostering innovation typically involves creating an enabling environment that includes a modern information and communication technologies (ICT) infrastructure providing an appropriate basis for the development of a digital economy, support for R&D, and strengthening linkages to global knowledge. The objective is to help develop an appropriate ecosystem and support the adoption of productivity-enhancing technologies that help to foster export diversification. Performance-based tax incentives can also be useful to support innovation. Countries that have been successful at fostering innovation tend to build tax systems that include low taxes, a regime of R&D tax incentives, an intellectual property/royalty payments tax regime, and incentives for capital investment. In addition, tax breaks can also be considered.
Second, these core policies should include policies aimed at sound macroeconomic management—including appropriate countercyclical fiscal policies to contain commodity cycles that destabilize traded sectors and policies to establish competitive exchange rates. Sound macroeconomic management would help reduce volatility and encourage investment in new tradable sectors. Policy shifts should be avoided as much as possible to establish the credibility of such policies and help economic agents making sound decisions.
Targeted policies: States affected by fragility, conflict, and violence
Given that FCV-affected states in the Arab world tend to have weak institutions, damaged infrastructure, and poor investment climates, these countries face steep challenges to economic diversification and job creation. Moreover, the end of the active conflicts will not inevitably lead to conditions conducive to diversification. Rather, available evidence from other regions suggests that relapsing into conflict is likely if economic conditions are poor, a situation that currently exists in many of the region’s FCV-affected states. Ensuring these outcomes do not occur requires extensive and extended engagement with external actors to provide economic opportunities in conflict-affected areas and to rebuild damaged infrastructure needed to support productive economic activity. Yet private-sector development programs in these states often tend to be modest in scope and scale. As a result, they frequently fail to have a significant material impact since they often do not have a coherent focus on sustainability and/or applicability to local contexts.91
Furthermore, the usual recommendations to improve the business environment, increase the quality of education, or build government capacity alone are insufficient for these countries. First, FCV-affected states have weak capacity and policies may take a long time to be implemented. Yet they face immediate economic, political, and social challenges that need to be addressed right away to maintain stability in the short and medium term. Second, even if governments are serious about enacting reforms, the private sector may not respond until it is convinced the policies are effective and credible.92 Although institutional reforms and projects to rebuild infrastructure are necessary to support economic diversification, they will take time. There are parallel processes that governments, the private sector, and donors can undertake to facilitate private-sector investment in FCV-affected states while governments work on longer-term reforms. For these to succeed, they must possess the following characteristics:93
- sufficient funding to create a sustainable impact,
- partnerships with local business people and/or stakeholders,
- creative approaches using local knowledge to support vulnerable populations,
- small or pilot projects to start, and
- sufficient time for capacity building.
The following programs—provided they have the above characteristics—have a good chance of success and will address key drivers of fragility:
Active labor market programs might have an important role to play in FCV-affected states. Programs addressing inadequate skills, insufficient information about job opportunities, and mobility constraints can prove useful for quickly connecting people to jobs and restarting economic activity, leading to future diversification.
Targeted policies that promote diverse economic activity, create jobs, and increase the quality of jobs are likely to be appropriate. Programs helping to address obstacles facing vulnerable groups (such as women at risk of being cut out of the labor market, ex-combatants and youth at risk of engaging in violence, or the displaced) and targeted interventions promoting investments and growth in certain subsectors, value chains, or lagging regions are particularly worth considering.
Efforts to develop and/or revive the productive sectors of an economy in FCV-affected states need not rely on the efforts of donors alone. Rather, private-sector investment, including FDI, can occur in FCV-affected states, even during conflict. Lebanon is an excellent example. Despite very high levels of political instability, it has sustained private-sector investment of about 23 percent of GDP and FDI of approximately 8 percent of GDP over the past decade. FDI has taken place in several sectors, including consumer retail, financial services, and food and beverages. Successful private-sector investment in FCV-affected states requires finding promising business opportunities given existing constraints and uncertainties. “De-risking and retaining investment, targeting investment promotion toward realistic investment opportunities, and optimally formalizing the economy to promote linkages between foreign and domestic investment are key elements of such a strategy.”94
Targeted policies: Resource-poor countries
The region’s resource-poor countries, Egypt, Jordan, Morocco, and Tunisia, have implemented reforms that have increased the dynamism of their private sectors. Exports of labor-intensive manufactured exports alone are unlikely to be sufficient to further diversify their economies because of technological change and competition from low-wage economies in East Asia. For example, China’s level of income is similar to that of resource-poor countries in the Arab world, but China is much more competitive. Instead, opportunities for resource-poor countries to diversify will probably need to occur by increasing productivity and developing their service sectors.95 Besides the core policies underlined earlier, this approach would imply the need to address the following policy areas:
Reform the business environment in key areas. This should include encouraging the development of MSMEs and start-ups, notably in services, and ensuring through effective competition policy that dominant firms do not undermine market competition and do not derail changes. Policies aimed at reinforcing investor protection, enforcing contracts, and strengthening insolvency regimes should be implemented since these are three important weaknesses in their regulatory framework. Furthermore, policies that encourage risk-taking (such as tax incentives) and that facilitate technology transfer and FDI can be especially useful.
Enhance access to finance for MSMEs. Firms in resource-poor countries tend to be very small. According to the World Bank’s Enterprise Surveys, in the 2010s, the average firm in Egypt, Jordan, Morocco, and Tunisia had 14, 16, 20, and 20 employees respectively. MSMEs in these four countries experience much higher barriers to access to finance than the small number of large and well-connected firms (either public or private). Measures to increase bank competition, strengthen banks’ capacity to assess credit risk, improve contract enforcement, and reduce government reliance on banks for financing can help to make credit more easily available to MSMEs.
Reduce firm-level export barriers. Develop and use instruments—the depth and width of which depend on the fiscal position of each country and its governance abilities—aimed at improving firms’ abilities to become exporters and/or to export more, whether they are confirmed exporters or firms trying to enter export markets (Box 6). This would naturally lead to increased export diversification.96 A key constraint to access to export markets is often the lack of information, training,97 and export finance.98
Box 6. Some Firm-Level Support Policies for Export Diversification
Policies aimed at improving firm’s ability to become exporters and/or to export more include:
- Supporting new or first-time exporters, which would require training or retraining, on a demand-driven basis, on issues related to access to export markets (including regional markets) and alleviating constraints linked to export finance. To do so, in the short run, may entail developing guarantee schemes,1 matching grants,2 or business plan competitions with a focus on exports. In the longer run, this would entail improving (among other things) the working of the financial sector by improving collateral regulations, credit information systems, and lending technologies such as mobile banking.
- Supporting existing firms to access export markets, which would require first improving the working of existing export promotion institutions by streamlining them and increasing their focus on the service sector, ensuring that regional trade is part of their mandate, and making regular market research and information services available. Furthermore, to overcome asymmetries of information, registries could be developed (and existing ones updated) to include not only foreign suppliers but also, very importantly, regional suppliers. Support should also be provided to firms to help them comply with regulations in destination markets such as the testing and certification of products, consumer safety regulations, health regulations, and traceability of products.
Develop infrastructure, reduce non-tariff barriers, and seek better regional integration. Egypt and Jordan have relatively high effective tariff rates according to the World Bank’s Overall Trade Restrictiveness Index, while infrastructure in Morocco and Tunisia are below average for the region. Regional integration and better use of trade opportunities with the European Union are especially important for developing the service sector of resource-poor countries. Besides expanding firms’ capabilities (see the core policies described above), measures aimed at improving compliance with international regulations related to intellectual property rights, harmonizing and simplifying the taxation system, harmonizing and simplifying labor regulations, and improving government procurement regulations will help develop regional integration.99
Expand employment opportunities for women and youth. Governments can change regulations to increase employment among these populations. For example, the government of Jordan instituted maternity leave benefits—which was not an employer liability—that raised women’s employment by 31 percent.100 This type of initiative could be replicated elsewhere in the region. Similarly, private sector–led programs helping youths to develop the soft skills most required by the labor market and to become successful entrepreneurs are important tools to foster youth employment, new economic activity, and ultimately diversification.
Targeted policies: Resource-rich countries
Resource-rich countries face distinct and significant challenges to diversification and job creation. Volatility induced by commodity price swings, for example, can deter investments in tradable sectors. In addition, production linkages with the rest of the economy are relatively limited and direct creation of employment in the resource sector is often minimal. Some stable resource-rich countries in the Arab world, notably Kuwait, Qatar, and the UAE, also face limited pressure to undertake reforms that will diversify their economies because they possess sufficient resources to maintain the status quo.101 For these reasons, even in those resource-rich countries in the Arab world that rate well on the quality of their institutions and investment climate, such as Qatar and the UAE, obstacles to diversification remain. Although country specifics vary widely, existing research suggests particular types of policies that can be useful in supporting economic diversification.102 They should include policies that:
- Significantly reduce (as much as possible) restrictions on trade in services. Many resource-rich countries in the Arab world would like to follow the example of Dubai: to diversify by creating high-value-added service sectors in areas such as finance, ICT, and transport. Restrictions on trade in services undermine these objectives.
- Reduce energy subsidies to remove bias toward energy-intensive activities and noncompetitive legacy activities.
- Implement business environment reforms to produce a more competitive private sector. This includes encouraging the development of MSMEs and start-ups, notably in the service sector, and ensuring through effective competition policy that dominant firms (whether state-owned enterprises or large well-connected private firms) do not undermine the development of the private sector. Policies aimed at reinforcing investor protection and insolvency regimes should be implemented because these are two important weaknesses in resource-rich countries’ regulatory framework. Furthermore, policies that encourage risk taking, such as access to finance and tax incentives, and that attract FDI and facilitate technology transfer can be especially useful if they are properly designed and implemented.
- Lower firm-level barriers to export. Develop and use instruments aimed at improving firms’ ability to become exporters and/or to export more, whether they already are exporters or are trying to enter export markets (see Box 6).
- Improve access to finance for MSMEs. The financial sector is well-developed in many resource-rich countries in the region. Nevertheless, MSMEs continue to face considerable barriers in access to finance. Regulatory reforms, strengthening the financial infrastructure, and creating more competitive banking sectors can assist in facilitating access to finance for MSMEs.
- Make private-sector employment more desirable. Many resource-rich countries in the Arab world make private-sector employment less desirable than public-sector employment by providing compensation packages to government employees that are not widely available in the private sector. Transforming these benefits into more broad-based social welfare programs can make private-sector employment more attractive. Similarly, limiting salary increases in the public sector and state-owned enterprises can help—over the medium term—to reduce compensation differentials.
- Target vertical and/or sector-level policies to further develop linkages from the natural resources sectors to the rest of the economy. These policies can include specific infrastructure investments, tax measures and incentives, mechanisms to promote technology upgrading, and measures to facilitate access to related markets.