What explains limited diversification in the Arab world?
The data presented in the previous section show a current relatively low level of diversification in the Arab world. They also underline that slow improvements are occurring, although the situation differs widely across countries and sectors. A key reason for these results is the persistent reliance on oil and gas exports in many of these countries. On average, over 2005–15 oil and gas exports accounted for more than 70 percent of exports of merchandise in nine Arab world countries. 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 poorly governed ones, such as Libya and Yemen. Reliance on these exports exposes these countries to macroeconomic volatility resulting from changes in global prices for these commodities and can undermine the competitiveness of the tradeable sector. However, this is far from the only cause of the current situation.
Determinants of diversification have received significant attention. As shown below, recent research suggests that competitive exchange rates, higher-quality institutions, high levels of human capital, and policies that encourage trade and investment are associated with higher levels of economic diversity (see Table 1 for findings and coverage of key studies).14 In the Arab world, historical legacies of state-led development, institutions and the investment climate, the quality of education and innovation systems, trade policies, and financial sector performance are the key factors that impact the level of diversification.
A legacy of large state involvement
A key reason that many countries in the Arab world have struggled to diversify is that previous policies to encourage it have been poorly designed and/or implemented.15 Many countries in the region have developed policies to promote diversification, typically with a strong state-led component. However, most countries did not effectively adjust these programs when they did not yield their intended economic results (see Box 2). One consequence is a public sector that remains large to this day. Over the 2010–12 period,16 the central government wage bill expressed as a percentage of GDP was on average close to 8.1 percent in the Arab world, compared with 7.1 percent in Europe and Central Asia and 5.9 percent in Organisation for Economic Co-operation and Development (OECD) countries.
Box 2: State-Led Development and Economic Reform in the Arab World: A Long-Term Perspective
In the 1950s and 1960s, many countries in the region (like numerous others) adopted state-led economic development strategies, such as import substitution, to diversify their economies. State-led development was also seen as a mechanism that could ensure political support from the private sector. This allowed select key firms in the private sector to receive preferential treatment, such as restrictions on competition and subsidies from the state. Many governments also created expansive public sectors, in part to further secure their political base and to control the economy. As in Latin America, sub-Saharan Africa, and some parts of Asia, a growing global economy combined with external assistance led to rapid rates of growth in the 1960s and 1970s, even in countries with expansive public sectors and inefficient industries. Average per capita real GDP growth rates in the Arab world in the 1960s and 1970s were almost 5 percent, higher than in any other region during that period.1
The oil price spikes of the 1970s and recession in Organisation for Economic Co-operation and Development (OECD) countries in the early 1980s led to economic crises and structural adjustment in large parts of Latin America and sub-Saharan Africa. These reforms tended to include reducing government expenditure, privatizing state-owned enterprises, and implementing policies to create more dynamic and politically independent private sectors. Most countries in the Arab world were initially able to avoid these types of reforms because their economies benefited from the rise in oil prices.2 Thus governments continued to maintain their large command over the economies throughout the 1970s and early 1980s, unlike their peers in most other regions.3
The reprieve was temporary. Real oil prices declined, dropping by 80 percent from their high in 1980 to their low in 1998. Levels of aid fell as well. In addition, Gulf Cooperation Council countries began to turn to South Asia instead of the Arab world as their main source of foreign labor. The result was stagnation and rising levels of unemployment in large parts of the region.4Per capita GDP growth rates plummeted from 5 percent in the 1960s and 1970s to contractions of about 1 percent per year in the 1980s before rebounding to a growth of about 2 percent per year, a rate that has remained steady since the early 1990s. By the early 1990s, youth unemployment rates were around 30 percent and have remained at that level since.
Still, in many countries of the region, the transformation to more market-led economies has not gone very far. One reason some governments in the Arab world are reluctant to implement reforms that would allow for a more independent private sector is their fear that such reforms might lead to political challenges. The Arab Spring has reinforced these concerns in some countries as well.5
Partial implementation of economic reforms designed to reduce the scope of past state-led development strategies have also been impeding diversification in the Arab world. For example, state control over the financial sector in some countries hinders access to finance to the private sector, as discussed in greater detail later in the chapter. Moreover, energy subsidies in some resource-rich countries encourage continued reliance on energy-intensive sectors (see Appendix Table A.1). In addition, the capture of reforms designed to create more competitive and diverse economies have undermined these efforts and instead led to a high concentration of market power in many sectors.17 It is not unusual for a small number of companies to dominate the private sector in developing countries. The role of chaebols, or large industrial conglomerates, in the Republic of Korea’s economic development is a particularly notable example. Some have even argued that such concentration can be desirable under certain conditions because it assists in coordinating policy between the government and the private sector.18 Highly concentrated market power becomes problematic when firms are able to use their economic influence to advance their individual interests to the detriment of aggregate outcomes, such as restrictions on competition.19 The latter applies—to varying degrees—to each Arab world country type.
Most resource-rich countries in the Arab world have developed diversification strategies, but so far they have largely failed to implement them effectively.20 For GCC countries in particular, a key problem is a social contract that provides generous social welfare programs; easy access to well-paid public-sector employment; and a reliance on migrants for labor-intensive jobs in return for political loyalty, protected spaces in the private sector, and a very large state presence in key sectors such as hydrocarbons, transport, and communications. The result is that large parts of the private sector, independent of ruling elites, face considerable difficulties in creating competitive businesses.21
The current social contract inhibits greater diversification in GCC countries through three channels.22 First, energy subsidies discourage diversification from hydrocarbons. Resource-rich countries tend to have very low domestic energy prices. On average, energy subsidies amount to approximately 7 percent of GDP in GCC countries, for example. Such subsidies distort investment toward low-productivity, energy-intensive sectors and away from higher-value-added manufacturing and services. Second, public-sector employment discourages investment in human capital. GCC countries roughly have a 2 to 1 ratio of public- to private-sector employment, larger than other regions of the world. Furthermore, growth in public-sector job creation does not result from functional needs but is largely due to growth in the working-age population. Third, segmented labor markets discourage investments to improve productivity. GCC labor markets are segmented. On one side is a large public sector that employs nationals and provides them with generous salaries and benefits. On the other side is a foreign private sector, in which most of the workers have low-paid service sector positions. Two consequences are that firms face few incentives to invest in programs that would raise labor productivity and citizens do not demand these programs because they have relatively easy access to state employment.
One notable deviation from the aforementioned trends in resource-rich countries is the UAE’s successful implementation of its diversification strategies. Its current Vision 2021 focuses on encouraging trade and investment, especially in high-value-added sectors; enhancing the international competitiveness of UAE firms in foreign markets; investing in education, innovation, and technology; and strengthening commercial ties with foreign markets.23 Among the seven Emirates in the UAE, Dubai has implemented the most sophisticated diversification strategy, based on a large element of government coordination in development activities; large public investments; openness to trade and investment, including attracting needed talent from abroad; targeting high-value-added service sectors; and undertaking strong efforts to promote Dubai as a desirable location for trade and investment. Dubai’s effective execution of its diversification policy results from a competent government administration as well.24
States affected by fragility, conflict, and violence
Private-sector capture of policy reform in the Arab world’s FCV-affected states is an impediment to diversification. For example, according to the World Bank,25 a key constraint to diversification in Lebanon is that lack of regulation of conflicts of interest has concentrated market power into a handful of firms. Such conflicts of interest in the financial sector steer bank lending toward the public instead of the private sector and also distort government expenditures away from critical services and toward covering unnecessarily high levels of debt service payments.26 Similarly, capture of economic policy reform in Syria has led to declines in productive capacity, reduced economic opportunity, and contributed to its political instability.27
Yemen presents an extreme example of how elite capture can stifle economic diversification. According to Hill et al., “By the time of the 2011 uprising, ownership of the ‘commanding heights’ of Yemen’s economy were concentrated in the hands of a tiny elite. In early 2011, an estimated 10 families controlled more than 80 per cent of imports, manufacturing, processing, banking, the telecommunications and transport sectors.”28 For these reasons, it should not be surprising that only Haiti and Venezuela rate lower than Yemen on effectiveness of anti-monopoly policy and favoritism in decisions of government officials in the World Economic Forum’s Executive Opinion Survey.29
Private-sector capture of economic reform also is a barrier to diversification in the Arab world’s resource-poor economies. In Egypt, poorly implemented government interventions and barriers to entry and competition under previous governments led to high levels of ownership concentration in substantial parts of the economy.30 Recently the government has embarked on a significant program of business environment reforms that is lifting barriers to entry and competition and that is starting to improve the investment climate significantly. Saadi shows that politically connected firms in Morocco operate in numerous sectors and outperform their non-politically connected peers not because of higher levels of efficiency and productivity, but because of the privileges they enjoy as a result of their access, such as subsidies and barriers to competition.31 Tunisia has presented a similar pattern for many years. Prior to the country’s Revolution, the social network of President Ben Ali controlled about 250 companies, which accounted for about 20 percent of private-sector profits. These companies operated across a range of sectors, including telecommunications, air transport, real estate, and manufacturing, and they used their political influence to reduce competition in these sectors.32
Weaknesses in governance and the business environment
Institutional quality is a strong determinant of diversification. The previous section suggested that poorly designed state-led development policies and inadequate execution of market-oriented reforms have impeded diversification in the Arab world. This section undertakes a more thorough analysis of governance and the business environment in the region. Both affect firms’ investment decisions, operations, choice of markets, products produced, productivity, and levels of employment.
Governance affects diversification through multiple direct and indirect channels. According to the International Monetary Fund (IMF), “institutional quality is found to be positively associated with the product quality, likely because sound institutional frameworks encourage investments needed for process and product upgrading.”33 Institutional frameworks can affect a broad range of factors that influence a country’s level of diversification. The World Economic Forum’s Global Competitiveness Index’s measure of institutional quality, for example, correlates strongly with numerous factors that support diversification discussed in subsequent sections of this chapter, such as innovation, higher education and training, technological readiness, and financial market development.
Disaggregating institutions into their constituent parts can help clarify the links between governance and diversification. The Worldwide Governance Indicators, for example, divide governance into six dimensions: government capacity, regulatory quality, extent of corruption, degree of adherence to the rule of law, political stability, and extent of citizen participation in government. Political instability and weak adherence to the rule of law are deterrents to diversification, and especially to innovation, because they adversely affect investment.34 For example, businesses are unlikely to invest in developing new products or production processes if they are uncertain they will be able to benefit from them. Likewise, a poorly functioning legal system impedes technology transfer.35 Regulatory quality also impacts investment.36 For example, weak regulatory environments may limit the degree of competition between firms, lead to a risk-averse financial sector, and permit lax enforcement of product standards. Along the same lines, weak government capacity is likely to lead to poor quality infrastructure and education.37 Where relevant, subsequent subsections of this chapter draw attention to these linkages.
The Arab world governance scores, as measured by the Worldwide Governance Indicators, are fair at best compared to other regions and show particular weaknesses in political stability and voice and accountability (Appendix Figure A.3).38 Regulatory quality and control of corruption are below average as well, but to a lesser extent.39 Government effectiveness and rule of law are relative strengths,40 although they are at levels lower than in many other regions.
There is, however, a substantial amount of variation in institutional quality within the Arab world (Figure 15). Besides significant weakness in voice and accountability, governance is slightly better in resource-rich countries along the other five dimensions of the indicators. For example, countries such as Qatar and the UAE have relatively high scores in government effectiveness, political stability, and regulatory quality, respectively.
Among resource-poor countries, Jordan rates highest overall, especially in control of corruption and enforcing the rule of law. Egypt performs the worst of the four resource-poor countries. Unsurprisingly, FCV-affected states rate very poorly in institutional quality, having some of the lowest ratings on all six dimensions of the indicator.
Data from the Doing Business reports allow a narrower focus on specific regulatory constraints to private-sector development and diversification. The World Bank’s Doing Business reports present quantitative indicators on business regulations. At the aggregate level, the Arab world does not rate very well in a regional comparison, since only South Asia and sub-Saharan Africa have worse average distance-to-the-frontier (DTF) performance (Figure 16).41 This result is primarily determined by the DTF of FCV-affected states because, on average, resource-poor countries and resource-rich ones have relatively good DTF scores (Figure 17).
Average performance on DTF scores varies by country and country type in the Arab world. FCV-affected states have low rankings; all except the West Bank and Gaza and Lebanon, (respectively ranked 114th and 133th out of 190 countries) rank between the 168th and 186th positions. Although country weaknesses vary, common ones for FCV-affected states include regulations related to getting credit, minority investor protection, and insolvency regimes.42 Resource-poor countries show significant variation as well, but possess common shortcomings in the legal framework for getting credit, minority investor protection, contract enforcement, and insolvency regimes. Resource-rich countries are slightly more homogeneous as a group (with the exception of Algeria and Mauritania) and have better overall DTF scores than other countries in the region, but still face obstacles in getting credit, minority investor protection, and insolvency regimes. A brighter regulatory spot is the region’s relatively good performance on regulations to start a business. Yet, while most countries of the region, irrespective of their category, score reasonably well in this area, formal entrepreneurship remains low. For example, weaknesses in contract enforcement and difficulties in getting credit often deter business creation and expansion, which are common sources of diversification into new products. These issues are addressed in detail in the next chapter.
Weaknesses in education and innovation
Education and innovation are crucial inputs into diversification. This section describes these links and assesses trends in education and innovation in the Arab world.
Studies of diversification consistently find a strong link between levels of education and the extent of diversification.43 Education promotes diversification through multiple channels, including by raising labor productivity, facilitating innovation, and enhancing a country’s capacity to produce higher-value-added goods and services. Rapid technological change and intensifying global economic competition are making high levels of education increasingly necessary for diversification.44
The Higher education and training component of the Global Competitiveness Index,45 which combines elements of access to education and quality of education, shows that countries in the Arab world on average rate one-half a standard deviation below the global average for their levels of income. As a result, their levels of education are usually lower than would be predicted based on their income levels (Figure 18). Deeper analysis shows that this discrepancy mainly reflects education outcomes, not access to education. The Arab world’s school enrollment rates are close to the world average. More specifically, the region’s gross tertiary enrollment rates are lower than those of Europe and Central Asia, Latin America and the Caribbean, and East Asia and Pacific, but higher than those of South Asia and sub-Saharan Africa (Figure 19). Country situations vary starkly, however. Saudi Arabia, Jordan, Syria (pre-conflict), and Bahrain exceed East Asia’s average enrollment rates, while Yemen’s is closer to sub-Saharan Africa’s, the region with the lowest gross tertiary enrollment rates.
As opposed to its often comparatively favorable enrollment rates, the Arab world’s performance on educational outcomes is rather low. For example, among the 70 countries that are involved in the OECD’s Program for International Student Assessment (PISA) study, the highest-ranked country for mathematics is the UAE at 47, while five of the twelve lowest-ranked countries are in the region (Algeria, Jordan, Lebanon, Qatar, and Tunisia).46 Trends in International Mathematics and Science Study (TIMSS) results, which has a broader coverage for the region, show a similar pattern (Figure 20).47 In 2015, countries in the Arab world scored on average 81 points, or 1.37 standard deviations, lower than other countries at similar levels of income in eighth grade math and science. Kuwait, Qatar, and Saudi Arabia scored particularly low given their level of income. In addition, the six lowest-ranked countries in the study are in the region.
Skills mismatches are also a problem.48 World Bank Enterprise Surveys find that more firms in the Arab world contend that inadequate skills hinder firm growth and capacity to hire talent than in any other region, with only about one-third of new graduates possessing relevant skills for the employment they seek. Along the same lines, access to technology in schools is problematic. According to the World Economic Forum’s Global Competitiveness Index, apart from Bahrain, Jordan, Qatar, and the UAE, countries in the Arab world rate well below average for access to the Internet in schools compared with others at their level of income.
Innovation and absorption of new technologies are crucial for diversification. The former involves creating new products and processes (technological innovation) and new organizational and marketing methods (non-technological innovation). Technology transfer needed to raise productivity and for firms to produce new goods and services is particularly important for middle-income countries to avoid falling into the middle-income trap where wages rise faster than productivity.49 Incentives for innovation and technology transfer are closely linked to the quality of a country’s institutions and human capital. For example, firms are unlikely to invest in innovative activities if they are unable to secure benefits from them or they lack access to needed talent. Likewise, in the absence of effective legal and regulatory systems, firms may not be able to acquire new technologies. For example, existing empirical evidence shows that developing countries offering stronger intellectual property rights protection have easier access to new products, attract more foreign direct investment (FDI), and receive more technology transfer than peers at the same level of development with less strong intellectual property rights protection.50
On average, most countries in the Arab world have low levels of innovation for their level of income (with the exception of Jordan, Qatar, and, to a lesser extent, Morocco and the UAE). Firm-level data show that, on average, 33 to 37 percent of surveyed firms in the region engaged in the development of new products or process innovation, respectively. Such activities are particularly important for encouraging diversification in emerging markets.51 Furthermore, very few firms export new products. In addition, around 13 percent of firms engage in R&D expenditures against a global average of 16 percent.52 The region also has low levels of intellectual property rights payments, a proxy for technology transfer.53
Greater levels of global integration and rates of technological change are raising the importance of innovation and technology transfer in supporting diversification. In this environment, firms are rewarded more for designing new products and methods of production than for having low costs of production. To thrive in this environment requires countries to have high levels of capability, connectedness, and competitiveness.54 As shown in Figure 21, countries in the Arab world, with the partial exceptions of Bahrain, Saudi Arabia, and the UAE, do not rate well along these three dimensions. Levels of connectedness are especially low.
An open trade policy is important for economic development and diversification. Existing studies document that improved access to imported inputs typically raises firm productivity,55 expands firms’ product scope,56 and leads to higher rates of economic growth.57 In turn, more productive firms are better able to compete on international markets and with imports. Similarly, Eaton and Kortum find that 25 percent of cross-country differences in productivity can be attributed to price differences for capital goods, and that about half of these price differences are caused by trade barriers.58 Improved access to imported capital equipment is also usually associated with higher economic growth.59
The Arab world’s trade structure is unique. Although its total exports as a share of GDP are the highest of any region in the world, fuel exports as a share of total exports are higher and manufactured exports are lower than any region other than sub-Saharan Africa (Table 2).
The region has also low levels of global value chain (GVC) participation.60 For example, the region’s GVC participation is below what is predicted by its level of income, proximity to markets, and volume of manufacturing.61 The extent of GVC integration varies by country and stage of processing. Jordan, Lebanon, and Tunisia have the highest shares of backward linkages (the use of imported inputs in exported products) at around 30 percent of exports, followed by Morocco with about 20 percent. Egypt, Saudi Arabia, and the UAE have the lowest participation in backward linkages, at around 15 percent.62 Apart from exports of natural resources, forward linkages (exports of products used for further processing) are low for the entire region.
The Arab world also has average effective tariffs rates (i.e., tariffs plus non-tariff barriers) that are higher than the average in East Asia, Europe and Central Asia, South Asia, and sub-Saharan Africa.63 These high effective tariffs result primarily from non-tariff barriers such as regulatory policies. Since the early 1990s, most favored nation weighted average tariff rates have largely declined, dropping from close to 20 percent in 1992 down to about 6.1 percent in 2016. The Arab world’s formal tariff rates are lower than those of Latin America, South Asia, and sub-Saharan Africa, but still higher than those of Europe and Central Asia or East Asia and Pacific (Appendix Figure A.7). Most of the reductions in formal tariff rates in the region are a result of countries ratifying multilateral trade agreements, such as World Trade Organization (WTO) membership, and preferential trade agreements with the European Union, the United States, and the Greater Arab Free Trade Area (GAFTA). Prior broader liberalization efforts, such as WTO membership, as well as high rates of growth and FDI inflows into the region, greatly facilitated enacting the latter. GAFTA, the most extensive regional integration agreement implemented to date, is broad in its coverage of products but shallow, since it has no enforcement or dispute resolution mechanism.64
Despite the fall in formal tariff rates, many non-tariff barriers remain in the Arab world. These include technical barriers to trade, such as phytosanitary regulations, complex rules of origin regulations, and import licenses. Non-tariff barriers are often justified to ensure consumer safety, food safety, and environmental safety. Yet evidence exists that countries also use non-tariff barriers as obstacles to trade in reaction to trade agreements that demand reductions in formal tariffs. Apart from the GCC countries, the region’s markets remain protected, largely because of non-tariff barriers such as technical barriers to trade, quotas and prohibitions, import and export licenses, anti-dumping, and other anti-competitive measures.65
Trade integration is also weak. Regional trade agreements, for example, “have especially failed to expand regional trade. . . . Attempts at economic integration have been frustrated by internal rivalries, dependence on external powers, and the absence of a strong domestic constituency for integration.”66 Challenges to integration within Maghreb countries provide a good illustration of the problem (Box 3). Trade within the region is lower than standard trade models predict.67
Box 3: Regional Integration in the Maghreb
The Maghreb Arab Union, comprised of Algeria, Libya, Morocco, Mauritania, and Tunisia, is a subregion of the Arab world with a variety of economic structures. Libya’s and Algeria’s economies largely depend on natural resources, while Morocco’s and Tunisia’s are more diversified and have a significant manufacturing base. Mauritania is a low-income country where agriculture, natural resources, and fisheries dominate the economic structure. Integration into the world economy has improved through increased exports of goods and services, but regional trade within the Maghreb is still lagging (Figure A).
Intra-regional merchandise exports and imports have increased since the late 1990s, but this is still below the level reached by other regional groupings. On standard measures of intra-regional trade performance, although some improvements appeared during the 2000s, the Maghreb is still far from being truly integrated. Trade complementarity across countries remains low and intra-industry trade is lower than for other regional trade groupings.1
Besides instability in some countries of the region and political disagreements among member countries, the regulatory framework in the Maghreb for trade and investment is not conducive to trade integration. Protection levels are still high on a comparative basis; non-tariff barriers are widespread; and although the web of existing intra-regional trade agreements is supposed to help in this matter, it has not yet met expectations. Country-specific restrictions remain in several areas, including repatriation and surrender requirements for exports, a domiciliation requirement for imports, and other non-tariff measures. The situation for foreign direct investment (FDI) is similar. Countries have put in place needed institutions and regulations to attract FDI, but non-negligible issues remain in areas such as sectoral entry regulations (including entry in the services sector) and restrictions on the transfer abroad of proceeds of liquidation and acquisition of real estate for FDI purposes.
The GCC is a notable exception to this weak record on regional integration. GCC countries have made significant progress in the past in regional integration, including creating a common market and common external tariff, sharing a common power grid, and increasing levels of trade and foreign investment.68 Trade within GCC countries grew quickly and quadrupled from 2003 to 2015. At about 19 percent of their total trade in 2014, intra-GCC trade was close to trade within the Association of Southeast Asian Nations (ASEAN) economic community.69 Several factors accounted for greater progress in regional integration in the GCC than the rest of the region. First, the geography of the Arabian Peninsula is favorable for integration. Saudi Arabia, by far the GCC’s largest economy and market, sits at the center of the GCC and borders all other GCC countries. This allows Saudi Arabia to serve as a natural focal point for efforts at GCC integration.70 Second, business environment reforms within some GCC countries, along with their shared history, language, and culture, makes these countries attractive candidates for FDI from the region’s large sovereign wealth funds.71 However, recent tensions between member countries demonstrate that significant barriers to further integration remain and further analysis is needed.
Trade logistics quality also affects diversification.72 Efficient trade logistics reduces trade costs, allows for more timely import of inputs, and lowers non-tariff barriers to exports. The Arab world’s aggregate performance on the World Bank’s Logistics Performance Index (LPI), a measure of the quality of trade logistics, is relatively good (Figure 22). The region performs better than Latin America and the Caribbean, South Asia, and sub-Saharan Africa, but less well than Europe and Central Asia or East Asia and Pacific. The relative weakness of the region is the efficiency of customs and border management (the Customs sub-indicator of the LPI). However, going beyond the regional aggregation, there is a huge divergence within the region. The UAE ranks the highest (and is 13th out of 160 countries). Bahrain, Oman, and Qatar also rank in the top third. By contrast, Syria was ranked last globally, while Iraq ranked 149th.
The Arab world’s service sector has remained relatively protected as well. It has the highest level of restrictions on service trade compared with any other region according to the World Bank’s Service Trade Restrictions Index (Figure 23).73 The index covers five service sectors: telecommunications, finance, transportation, retail, and professional services. There is, however, a large amount of variation in the degree of openness by country and subsector (Figure 24). Qatar has the most closed service sector, followed by Egypt, Kuwait, and Bahrain. Morocco, by contrast, has a relatively open service sector.
Professional services are the most restricted subsector, followed by transportation. The financial sector and retail are more open. There is also a substantial amount of within-country variation in service trade restrictions. For example, although the retail sectors are quite open in Algeria and Yemen, the transport sector in the former and the professional service sector in the latter are heavily protected. Along the same lines, while the telecommunications sector in Egypt and Lebanon is reasonably open, their professional services sectors are not. By contrast, the opposite exists in Qatar.
At the aggregate level, the Arab world does well in attracting FDI. Over the 2006–16 period, average net FDI inflows amounted to about 3.6 percent of GDP, below numbers observed in Europe and Central Asia (4.4 percent) but well above those observed for sub-Saharan Africa (2.7 percent), East Asia and Pacific (2.7 percent), and South Asia (1.9 percent). Resource-poor countries tend to attract investors in manufacturing and services while resource-rich ones tend to attract foreign capital in services and the extractive sector. FDI regulations vary greatly across countries, from a moderately closed regime such as Algeria’s, where there are rules granting de facto minority ownership to foreign investors and rules establishing selected barriers to entry, to largely open regimes like Jordan.
The financial sector
Levels of economic diversification correlate strongly with the degree of financial sector development. This section presents an overview of the financial sector in the Arab world and focuses specific attention on access to finance for micro, small, and medium enterprises (MSMEs) and the use of financial institutions and services.
Financial sector development in the Arab world
The financial sector is a key sector for economic growth and diversification. The relationship between efficient financial intermediation and a dynamic, diverse, growing economy is well established. A competitive and well-regulated financial sector facilitates economic diversification through numerous channels, including encouraging capital accumulation, product innovation, adoption of new technologies, competition, and new firm creation, as well as allocating finance to productive firms that need it.74 Wright, for example, demonstrates that the development of a comparatively sophisticated financial sector in the United States preceded and was necessary for its structural transformation from agriculture to industry.75 Two studies by Haber document similar trends in Brazil and Mexico.76 Figure 25 confirms a relatively strong correlation between financial sector development and economic diversification.77
Figure 25 suggests that many countries in the Arab world, especially its natural resources exporters, possess relatively developed financial sectors. Along the same lines, credit to the private sector as a percentage of GDP in the Arab world, a standard measure of financial sector development, compares favorably with other regions. Bank credit to GDP varies, averaging around 70 percent for resource-poor countries and 80 percent for resource-rich ones (Figure 26). Lending in Egypt, Algeria, and Saudi Arabia remains below subregional averages and is very low for the FCV-affected states that report this information, however.
Headline figures showing high levels of aggregate lending hide more problematic situations, however. First, in some countries the sector suffers from regulatory shortcomings, such as poor credit monitoring systems, weak contract enforcement mechanisms, and high collateral requirements.78 Second, the region’s banks have the highest rates of non-performing loans (NPLs) of any region in the world. Underdeveloped regulatory systems are one reason. State-owned banks continuing to fund unviable projects are another cause of high NPLs. High levels of NPLs limit access to credit.79 Third, the financial sector in most countries in the Arab world is not very competitive.80 In particular, high barriers to entry allow for a small number of banks to account for a large share of the sector. For example, in Kuwait, Oman, and Qatar, the two largest banks control more than 50 percent of the country’s total bank assets.81 The cumulative result is that banks in the region tend to lend far more to large, well-known, or politically connected firms than to smaller or newer ones. By contrast, loans to MSMEs, many of which are more innovative or productive than more established firms, account for a smaller share of bank loans than they do in other regions (see below for more detail).82 Such bifurcation results in less competition within the sector and impedes the development of new firms, products, and technologies.83 This is one reason why the Arab world has a low rate of new business formation.
Micro, small, and medium enterprises
MSMEs,84 which account for 80 to 90 percent of total businesses in most countries in the region, face a challenging environment in gaining access to credit in the Arab world. MSMEs generate 10 to 40 percent of all formal employment and close to two-thirds of total employment, including the informal sector in non-GCC Arab world countries.85 MSMEs are a source of innovation and diversification. However, their potential is undermined by limited access to finance. For example, banks currently allocate only 2 percent of their loans to MSMEs in the GCC and 13 percent in the rest of the region.86 Although only a small percentage of MSMEs receive bank loans, almost 45 percent of the loans are provided by state banks or governmental agencies, higher than in any other region. The region also has the highest percentage of MSMEs that are underserved by the financial sector.87
Some governments in the Arab world, through their central banks, are attempting to increase access to finance for MSMEs. For example, starting in 2016, the central bank of Egypt pushed banks to gradually raise their MSME financing to 20 percent of their total credit portfolio by 2019. Likewise, Morocco’s central bank launched a new program in 2017 allowing it to provide advances to banks for up to one year in the amount equivalent to credit provided to MSMEs.88 Banks can also obtain additional refinancing equal to the credit granted to MSMEs that operate in the industrial sector or export at least 40 percent of their sales. In addition, the central bank of Jordan launched a new US$100 million fund in 2017 to invest in start-up MSMEs, and it will add another US$70 million to guarantee the loans of these firms. In Lebanon, the central bank allows banks to invest 4 percent of their own funds in start-ups. The program resulted in US$400 million in new investments in 2016. These policies suggest that governments are increasingly recognizing that they need to improve the capacity of MSMEs to gain access to credit. The donor community is also allocating important resources in this area, either financially or through technical assistance (Box 4).
Box 4: Examples of World Bank Group Efforts to Assist Micro, Small, and Medium Enterprises with Access to Finance in the Arab World
Development partner support for increasing access to finance for micro, small, and medium enterprises (MSMEs) covers the availability of funds as well as activities aimed at improving the financial systems. Some examples are listed below.
The International Finance Corporation (IFC) and the World Bank provide significant support in this area. They are now implementing the Cascade approach to investment decision-making to encourage private-sector participation, while leveraging and preserving scarce public resources for critical public investments. If commercial finance is absent, these institutions will try to address market failures and utilize risk instruments to try to encourage private investment. Finally, if necessary, public and concessional financing will then be used. This approach applies to the MSME finance space as well as other lending activities. This de facto screening mechanism for the use of public funds, combined with the IFC’s new creating markets approach, is expected to significantly improve access to finance for MSMEs in the Arab world.
The IFC is placing the power of markets at the center of its strategy for growth and impact. It works to create markets that give new opportunities to people in the region. For example, in Lebanon, the IFC successfully worked with the private sector to expand access to capital and provide training for women entrepreneurs in areas such as business management and leadership. In the same country, an IFC client bank, BLC Bank, supported the development of a producer of organic olive oil, tea, and spices. As a result of its successful development, the company recently acquired a French franchise of organic grocery stores to operate in and around Beirut in a major success financed by an IFC client bank.
Access to financial institutions and services
Firms and people in Arab world countries also have low financial access, limited account ownership, low use of credit and debit cards, and low utilization of financial services on mobile accounts (Figures 27 and 28). Data from Global Findex further show that access to finance varies by country type in the Arab world (Figure 27).89 For example, populations in resource-rich countries, resource-poor countries, and FCV-affected countries have rates of access to financial institutions of 74 percent, 30 percent, and 9 percent, respectively. Along the same lines, 22 percent, 5 percent, and 1 percent of people have credit cards and 61 percent, 19 percent, and 3 percent of people have debit cards respectively. In general, deposits and withdrawals are mainly made through bank tellers. The use of other channels such as automated teller machines (ATMs), bank agents, retail stores, and others is much less common. The use of alternative channels is highest for resource-rich countries and lowest in FCV-affected ones. Mobile banking also is not common. For example, Global Findex 2014 data show that only 0.5 to 1.1 percent of people had mobile accounts in Egypt, Jordan, Lebanon, and Tunisia, and 11 percent in the UAE. There were 24 live mobile money services in nine countries last year.90
• Ensuring competitiveness through lowering unit labor costs, adopting new technologies to reduce costs of production, and creating flexible business models that can adapt to changes in global economic conditions.
• Building capabilities to strengthen firms’ abilities to absorb new technologies.
• Strengthening connectedness through openness to trade in goods and services as well as adoption of new technologies.