When money gets too sweet

With the price of oil at its record highs, it can be hard to imagine that key exporters thereof, six countries of the Gulf Cooperation Council (Bahrain, Kuwait, Qatar, Oman, Saudi Arabia, and United Arab Emirates) may currently be facing economic problems of any kind. The signs of prosperity seems to be all around as gleaming towers rise in the middle of the desert and guests arrive by helicopter at the world’s only seven-star hotel, Dubai’s sail-shaped Burj al-Arab. And yet not all is well.

A somewhat unexpected addition to the region’s stunning architecture is a… diabetes center in Abu Dhabi. Nearly one-fifth of the UAE’s native population now suffers from diabetes and the statistics are not much better in the rest of the GCC. A result of more sedentary lifestyle and unhealthy diet? Certainly. But, as the Economist points out, the diabetes problem can also be a useful metaphor for how…

The region’s economies are struggling to absorb petrodollars, accumulating like glucose in the bloodstream. The risk they face is the economic equivalent of renal failure: inflation, a hollowing-out of the non-oil sector, and a young, growing workforce in chronic need of outside labor to supplement it.

Last year the GCC countries earned a total of $381 billion from oil exports, plus another $26 billion from gas. This accounts for over a half of their economies with the combined GDP of $800 billion. But at the same time inflation sped up, which – coupled with the global boom in commodity prices – is making construction materials, real estate, and food more and more expensive. The mechanism works like this:

When an energy exporter converts its petrodollars at the central bank, domestic spending rises. But unless the local economy has a lot of slack, it cannot magically produce more goods and services to meet this fresh demand. Their price instead rises, relative to the price of things that can come in from overseas. According to a study by three IMF economists, a doubling of the oil price results eventually in a 50% rise in the price of non-tradable goods (such as housing), relative to tradables.

Inflation is causing more problems. Migrant workers, who constitute the majorities (often vast) of the GCC populations, are demanding higher wages. They challenging the decades-old policies that suppressed their wages compared to the privileged public sector jobs reserves for nationals. Swollen government payrolls have long been financed by petrodollars. But given the demographic transition currently happening in the region, even in Saudi Arabia, which holds a quarter of the world’s proven oil reserves, the demand for government jobs is rising faster than the oil output. Simply put,

The [Gulf] states cannot afford to employ every citizen who wants a job. But the “petrodollar wage” still casts a long shadow, setting expectations and raising living costs. Elsewhere in the world the private sector would compete with the government for labor, offering comparable pay. But in the Gulf private employers hire immigrants instead. This leaves many Saudis and Bahrainis in limbo. They cannot count on a government job; nor will they settle for a low private-sector wage.

The government response across the region has been workforce nationalization, or mandatory hiring quota for private companies to employ the native-born. But far from solving the unemployment crisis, this measure further skews job incentives, imposes extra costs, and lowers productivity. McKinsey estimates that a quarter (!) of native employees in Bahrain, Saudi Arabia, and the UAE do not even show up for work! Nationalization only reinforces such “work ethics.”

Building another gleaming tower – or even an entire set of gleaming cities, as is the case of Saudi Arabia – will not do much to diversify the region’s economies unless the underlying institutional problems in the GCC and other MENA countries are addressed. Meaningful reforms require moving away from entrenched state monopolies on economic and political power so that economic policies can be formed in a more transparent and accountable fashion that provides an enabling environment for the broader private sector to lead sustainable growth and job creation. The region badly needs an insulin supply of better institutions capable of inducing a healthier blood flow of productive enterprises in its economies that are clearly nearing a diabetic coma.