Oil is behind Middle East’s failure to develop, and diversify

Adeel Malik

Arab development and economies are running into the ground, and oil stands in the way of change. What’s keeping the Middle East from changing for the better?

The failure of Arab development is multifaceted in nature, and manifests itself at all levels — economic, political and geopolitical. Over the last three decades, three profound shifts have marked the landscape of global political economy. While these have opened new economic and political possibilities for the developing world, the Middle East has remained insulated from these winds of change and their transformative impact.

The first shift is political in nature — often dubbed ‘the third wave of democratisation’ — and defined by a gradual opening of the political system to more representative forms of government. The second shift represents successful economic diversification in several emerging economies of Asia, Africa and Latin America. A third trend is represented by the growing prominence of intra-regional trade in developing countries through their active participation in regional trade initiatives.

All of these shifts have bypassed the Middle East. Judged by any of the above metrics, the region has either stagnated, regressed or severely lagged behind. With the largest proportion of autocracies, it is one of the few regions in the world that remains an outlier to the third wave of democratisation.

On the economic front, the region continues to be mired in primary commodity dependence while many of its comparators have succeeded in diversifying their export structures. And, while the Middle East has hosted numerous platforms for regional trade promotion, mutual Arab trade remains hopelessly inadequate. Over the last four decades, for example, intra-regional trade (as a share of total trade) has hovered at around nine to 10 percent. This stands in sharp contrast to the dramatic growth and significance of regional trade in emerging economies.

The region’s failure in these three overlapping domains reveals the paradox of Arab underdevelopment, and deserves an explanation that combines the economic, political and geo-political aspects of development.

Consider the region’s failed attempts at economic diversification. Every resource-rich country in the region has faithfully adhered to tall promises of diversifying their economic structure away from an excessive dependence on oil and gas revenues. Yet, if anything, the region’s overall reliance on hydrocarbons has increased over time.

What explains this gap between intentions and outcomes? To understand this, one must first acknowledge that the core challenge of economic diversification is not technical, but political. Clearly, the challenge of diversification is deeper than simply learning the right lessons from successful experiences in Norway, Malaysia or Botswana. After all, if the recipes for diversification are so widely known, why have Arab countries not seriously pursued them?

To diversify their economies, resource-rich countries need to develop the non-oil sector, which entails, among other things, producing a greater number and variety of goods — including those at the higher end of the value chain that involve more complex forms of production. The problem is that the effects of doing so are rarely politically neutral. Political scientists have long recognised that structural change in the economy is usually accompanied by new forms of political contestation. New sources of income breed new constituencies, since economic power can easily translate into political power.

For this one needs to look no further than Turkey whose recent political transition is undergirded by fundamental economic changes on the ground. The appeal of Turkey’s Justice and Development Party (AKP) is based, not just on its populist narrative, but the material interests of a constituency empowered by Turkey’s vibrant economy. In the Arab milieu, where the overriding concern of rulers is to separate the economy from polity, a concerted drive towards economic diversification carries genuine political risks.

With a prolonged legacy of centralised rule, dating back to the Mamluk era, Arab regimes rest on two pillars: patronage and control. Such a political order runs counter to the logic of a dynamic economy that requires cultivating dense economic linkages among various parts of the supply chain. There is a clear danger that such vibrant linkages in the economy can serve as the basis for horizontal cooperation.

In this context, it is hardly surprising that resource-rich Arab economies have consistently failed to rise up to the challenge of diversification. These economies are doubly deprived in this regard, suffering both from the burden of history and oil. Whatever weak constituency of private production was inherited by these countries was further emaciated after the discovery of oil.

Even where rulers were more dependent on merchants prior to the discovery of oil — such as Kuwait — oil tied down the merchant class in state contracts and other forms of patronage. While the private sector has shown greater dynamism in Gulf countries, it still remains ‘structurally dependent’ on the state. Diversification is further hindered by macroeconomic challenges that oil-rich economies face by virtue of their exposure to commodity price cycles. The pro-cyclicality of fiscal policy, which is a universal feature of Arab resource-rich economies, means that oil cycles are accompanied by budgetary cycles that make planning for long-term investment more difficult. Counter-cyclical fiscal policies, which require that countries spend less in periods of higher oil prices, are politically difficult to implement. The underlying political settlement in these countries gives rise to extensive and sticky distributive claims in the form of salaries, subsidies and defence spending.

As is widely recognised, resource-rich economies also find it particularly difficult to build a productive regime for competitive diversification since the dominance of the oil sector is likely to lead to exchange rate appreciation, which prices their non-oil exports out of global markets. But the absence of a competitive exchange rate regime is not just the consequence of a dominant oil sector. An overvalued exchange is also favoured by lobbies representing the non-tradeable sector, which are strong and pervasive throughout the region. Historically, economic exchange in the Middle East has stayed in the hands of importers and distributors, who depend on simple arbitrage opportunities and prefer a fixed and overvalued exchange rate.

This adverse politics of diversification is difficult to bypass in the midst of multiple development traps. While the region’s resource-rich economies are exposed to global price shocks there are few institutional shock-absorbers to mitigate the effect of such events. Herein lies the problem for oil rich countries: The same factors that are needed to cope with oil price volatility are also needed for diversification. This does not mean that diversification is impossible to achieve in these economies. It is simply that diversification attempts are selective, and often take forms that are politically more acceptable to local elites. In the UAE, Bahrain, Oman and parts of North Africa, liberalisation of the financial sector has provided such a politically safe avenue for diversification. Financial sector liberalisation has offered lucrative brokerage opportunities for state elites who, through carefully brokered partnership opportunities with foreign banks, have derived additional rents.

Two additional factors make financial liberalisation a politically palatable form of diversification. First, the bulk of private sector credit extended by the financial sector is earmarked for real-estate projects. Second, land is principally owned by the state. Together, this means that even when the financial sector enhances its lending to the private sector it is unlikely to give rise to independent forms of accumulation that might threaten the political order.

But the political challenges of diversification are by no means limited to the region’s oil-exporting nations. Even resource-scarce countries are afflicted with similar constraints at varying levels of intensity. Consider Morocco and Tunisia, the two countries that have had some success in developing the private sector. Although export structures in both countries are less concentrated than their other MENA counterparts, exports have expanded mostly along the intensive, rather than extensive, margin. Effectively, this means that these countries have mostly relied on existing export relationships rather than establishing new products and trading partners.

Additionally, in Tunisia, policy regimes have traditionally segmented the offshore sector, which is mainly export-oriented, from the onshore sector, oriented towards the domestic markets. Furthermore, economic activity remains confined to a closed circle that protects its privilege by virtue of its proximity to state elites. Such systematic undermining of market competition serves a larger political purpose, since it provides much-needed rents in countries where oil rents are either absent or scarce but where rents are nevertheless needed to solidify elite coalitions.

But while these market-generated rents support the prevailing authoritarian order, the resulting crony capitalism undermines productive capacity. It militates genuine economic diversification, which requires a level playing field that reduces barriers to entry and mobility.

This pattern of economic control is shared by other states in the region, including Lebanon, where concessions to monopolies have long been used as a principal means of distributing privilege.

When pressed for reform, MENA countries have been reluctant to take the leap, resulting in the ‘partial reform syndrome’ where trade liberalisation is selectively pursued to protect elite interests.

In Egypt, for example, average tariffs have fallen since the mid-1990s, but their dispersion has increased at the same time. This is because, despite the general reduction in tariff barriers, sectors dominated by connected actors continue to benefit from relatively higher protectionism.

Thus, a sector is more likely to benefit from higher trade protection if a political or army crony is active in the sector. Similar patterns are revealed through an analysis of non-tariff barriers. In Tunisia, the greater presence of political cronies in a sector increases the likelihood of that sector bring protected through non-tariff measures (which are more discretionary and non-transparent).

In spite of the plethora of excuses used to justify flagging economies, if Middle Eastern countries have difficulty diversifying their economies despite their tall promises and grandiose plans it is probably more to do with politics than the mere absence of good policy, informed strategy or weak implementation.