by Richard Shediac [email protected] Rabih Abouchakra [email protected] Chadi N. Moujaes [email protected] Mazen Ramsay Najjar [email protected]

Economic Diversification The Road to Sustainable Development Booz & Company is a leading global management consulting firm, helping the world’s top businesses, governments, and organizations.

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Abu Dhabi Beirut Richard Shediac Rabih Abouchakra Chadi N. Moujaes Mazen Ramsay Najjar Partner Principal Principal Associate +971-2-699-2400 +971-2-699-2400 +961-1-336433 +961-1-336433 [email protected] [email protected] [email protected] [email protected]

Carla Khoury also contributed to this article. ECONOMIC A strong, growing, sustainable Studying Sustainable economy is the goal of every Development: Can diversifi- nation in the world. A sustainable Diversification Drive cation economy enhances a nation’s Sustainability? standard of living by creating This study grew out of The Road to Sustainable wealth and jobs, encouraging the Booz & Company’s work helping Development development of new knowledge Middle Eastern governments, and technology, and helping to particularly those in the Gulf ensure a stable political climate. Cooperation Council (GCC), Having a diverse economy—that formulate their economic is, one based on a wide range development strategies and of profitable sectors, not just a transformation agendas—that few—has long been thought to is, their “transfor-mations” from play a key role in a sustainable economies based on a single economy. Recent research by commodity to robust, well- Booz & Company confirms that diversified ones. These countries, is indeed the case. There is a rich in hydrocarbons and with link between economic diversity economies heavily invested in and sustainability, and economic oil and gas, face a particularly diversification can reduce a nation’s daunting challenge in diversifying; economic volatility and increase consequently, it was important its real activity performance. to determine just how critical Furthermore, there are metrics that economic diversity was to their policymakers can use to measure creation of sustainable economies. these key economic dimensions and ways that they can promote their To answer that question, we broad- nation’s long-term economic health ened our focus beyond the Middle and stability. East region and scrutinized 19 dif- ferent countries around the world with varying levels of economic maturity to assess their economic

Booz & Company 1 diversification, volatility, and Gross Domestic Product (GDP) for example, was 16 percent; for health.1 We studied the following: Should Be Distributed Across the GCC countries, 26 percent. The • GCC economies, consisting of Sectors. To begin, we assessed diversification quotient for the G7 Bahrain, Kuwait, Oman, Qatar, the the economic concentration and countries was 6.07; for the GCC Kingdom of Saudi Arabia (KSA), diversification of the GCC, G7, countries, 3.87. and transformation economies in and the United Arab Emirates These findings were not necessarily the study. We wanted to find out (UAE) surprising. Historically, the whether their GDPs were evenly • Group of Seven (G7) economies, economies of GCC countries have distributed across a wide variety consisting of Canada, France, been dominated by the oil and gas of economic sectors—or whether Germany, Italy, Japan, the United sector, and although the relative they relied heavily on just one or Kingdom, and the United States contributions of the GCC countries’ two sectors. • Transformation economies, various economic sectors to GDP consisting of Hong Kong, Ireland, We measured diversification have shifted noticeably over the New Zealand, Norway, Singapore, by evaluating the distribution years, the oil and gas sector has and South Korea (these economies of a nation’s GDP across its consistently represented the largest initiated or completed transforma- various economic sectors, such as share in these nations’ GDPs tion to an industrialized nation agriculture or manufacturing, to (Exhibit 2, see page 4). Moreover, sometime in the second half of the determine a “concentration ratio” registered growth in non-oil 20th century). and a “diversification quotient.” sectors, such as manufacturing Our analysis identified a clear link The concentration ratio measures and hospitality, generally has between economic diversification a nation’s concentration in a given reflected not organic growth and sustainable growth. It also sector by taking the sum of squares in those industries but, rather, showed how diversification of percent contribution to GDP. spillover effects from increased oil can reduce a nation’s economic The diversification quotient is the receipts and subsequent record-high volatility and increase its real inverse of the concentration ratio; inflows of capital. Needless to say, activity performance. These findings it provides a metric that such types of growth cannot be provide a firm reminder to policymakers can use to gauge considered inherently sustainable, policymakers worldwide that one their nation’s economic diversity. because they depend heavily on the key to building a strong, sustainable Essentially, the lower the dominant sector’s fortunes in the economy is building a diversified concentration ratio and the higher marketplace—a paradigm that most economy—one that is not overly the diversification quotient, the nations would want to avoid. more diversified a nation’s economy. dependent on a single commodity A key conclusion that can be drawn and that has a strong external as The results of our analysis showed from this ongoing trend toward well as internal focus. that the level of diversification concentration is that the GCC varied widely across the three countries’ non-oil sectors have Evaluating Economic studied categories, with the GCC not fully matured and still have Diversification countries having the highest pervasive structural gaps, such Our initial analysis of economic concentrations in terms of sector as inefficiencies in labor, capital, diversification across the GCC, contribution to GDP and thus the and knowledge and technology. In G7, and transformation economies lowest diversification quotients addition, this trend suggests that produced three key findings. (see Exhibit 1). The level of revenues from oil and gas are not concentration for the G7 countries, being reinvested effectively in GCC

1 Data for this study were obtained from the UAE Ministry of Economy, Central Bank of the UAE, Saudi Arabia Ministry of Economy and Planning, Saudi Arabian Monetary Agency (SAMA), Central Bank of Kuwait, Oman Ministry of National Economy, Central Bank of Bahrain, Qatar Planning Council, International Monetary Fund (IMF) World Economic Outlook 2006, Organisation for Economic Co-operation and Development (OECD), World Development Indicators (WDI), Economist Intelligence Unit (EIU), International Labour Organization, Abu Dhabi and Dubai statistical yearbooks, official statistics bureaus of the sampled economies, and Booz Allen Hamilton analysis. Some countries are excluded from one or more exhibits due to the lack of available data.

2 Booz & Company Exhibit 1 Economic Concentration and Diversification in the GCC, G7, and Transformation Economies, 2005

Economic Concentration Economic Diversification (Percentage of Real 2005 GDP) (Diversification Quotient) Methodology 16% Canada 6.25 • The concepts of economic concentration and diversification can be captured with the 16% Japan 6.12 computation of the respective point estimators 16% G7 6.07 of concentration ratio and diversification 17% U.K. 6.06 quotient for the sample of studied economies. G7 Economies 18% U.S. 5.55 • The concentration ratio measures how 19% France 5.37 concentrated the particular economy is in any

Diversification by Category of Economie s given sector by taking the sum of squares of 20% Italy 5.01 percent contribution to GDP. 23% Germany 4.32 • Equal to the inverse of concentration ratio, the 15% Norway 6.79 diversification quotient provides a numerical perspective with which countries can baseline 16% South Korea 6.20 and target future economic development. 16% Ireland 6.19 Transformation • The lower the concentration ratio and the 19% 5.29 Economies Transformation higher the diversification quotient, the more 19% Hong Kong 5.27 diversified the economy. 19% Singapore* 5.14

14% Dubai 6.85 Comments 16% Bahrain 6.12 • Results show that GCC countries have the 19% UAE 5.18 highest concentrations in terms of sector contribution to GDP and thus exhibit the lowest 23% Oman 4.35 GCC diversification scores. 26% GCC 3.87 Economies • Nevertheless, the high reliance of economic 28% KSA 3.63 activity in the GCC on the oil and gas sector 33% Kuwait 3.00 does not preclude the region from effective 37% Abu Dhabi 2.69 economic diversification. 39% Qatar 2.59 • Norway is a paragon of a hydrocarbon-rich nation that has successfully diversified into Abu Dhabi and Dubai show the disparity of levels of diversification within a single country productive non-oil sectors.

Note: The aggregate scores for the G7, transformation, and GCC economies were calculated based on the total GDP breakdown for those economies, not on the average or median score for the individual constituents. *As a result of Singapore’s focused economic development strategies, the economy has become somewhat concentrated in two sectors: trade and manufacturing. Sources: UAE Ministry of Economy; SAMA; Central Bank of Kuwait; Oman Ministry of National Economy; Central Bank of Bahrain; Qatar Planning Council; IMF World Economic Outlook 2006; OECD; Abu Dhabi and Dubai statistical yearbooks; official statistics bureaus of sampled economies; Booz & Company

countries. Instead, excess liquidity is territories beyond Moscow and St. Concentration Is Not Inevitable being used to fund nations’ internal Petersburg and that can enable de- in Hydrocarbon-Rich Economies. (i.e., local) economies, rather than velopment of outbound industries. Historically, the bulk of the GCC external economies—that is, those region’s economy has been very Although some investment in sectors that contribute significantly susceptible to such changes in oil internal economies is necessary, to a nation’s net export of goods prices, especially so in the larger having an economy with a strong and services. This is a difficult pat- economies of KSA, Kuwait, Qatar, foundation in export helps to tern to break; Russia, for example, and the UAE. For example: despite being consumption-geared, insulate a country against the recently announced that it would vagaries of its domestic economy. • Since 1975, KSA’s overall GDP begin investing more of its oil and In the case of hydrocarbon-rich growth has been driven mainly gas revenues in infrastructure proj- countries, it also insulates them by growth in the oil and gas ects such as power and transpor- from the volatility of oil and gas sector—and that growth has varied tation, hoping to create an infra- prices and that volatility’s trickle- dramatically over the years, from structure that can better support down effect on the economy. negative 22 percent in the early growing businesses across all of its 1980s to 10 percent in 2005, largely

Booz & Company 3 Exhibit 2 region’s stalwart effort to diversify 1 GDP Breakdown by Economic Sector in the GCC, 1975–2005 its economy. Contrast this with the UAE’s Abu Dhabi, which drew 59 GCC GDP in Real 2000 US$ Billions percent of its 2005 GDP from oil $163.2 $199.6 $289.1 $444.8 100% 1% 3% 5% 2% and gas, and whose growth in non- oil sectors continues to lag. 28% 80% 32% 47% A common explanation for the per- 60% 8% 60% vasive lack of economic diversity 10% 8% seen in areas such as Abu Dhabi 8% 8% 9% % of GD P 40% 5% 8% is that economic concentration is 5% 6% 5% 7% 18% 7% inevitable in regions that are rich 3% 11% 4% 2% in a particular natural resource— 20% 8% 16% 17% 17% 12% such as Brunei, whose economy is 5% 0% 2% 5% 4% 3% entirely dependent on its reserves 1975 1985 1995 2005 of petroleum and natural gas; Decade-on-Decade Zambia, whose economy is entirely Change in Diversification dependent on its reserves of copper; Agriculture, Forestry & Construction, Electricity, Banking, Insurance, Finance, or Botswana, whose economy is Fisheries Water & Gas Real Estate & Business Services Mining, Quarrying & Trade, Restaurants & Government Services tied tightly to the diamond- Energy Hotels Manufacturing Transport & Communication Other Services2 mining industry. However, our findings indicate that 1 GCC figures are based on a constructed sample of GCC GDP series, subject to data availability. 2 Other Services include community, social, and personal services; activities of private households as employers; and being hydrocarbon-rich does not undifferentiated activities of private households, as well as extraterritorial organizations and bodies. predestine economic concentration. Sources: UAE Ministry of Economy; SAMA; Central Bank of Kuwait; Oman Ministry of National Economy; Central Bank of Bahrain; Qatar Planning Council; Booz & Company Norway, for example, produces approximately 3 million barrels of oil per day—an amount consistently exceeded only by KSA—yet it has as a result of oil price changes and negative to double-digit positive been able to adequately distribute shocks. The growth in non-oil growth rates; and growth of non- its GDP across a variety of pro- sectors has varied less noticeably oil sectors appears to have been ductive economic sectors, and its but nonetheless has fluctuated and affected by changes in oil prices. revenues from oil and gas make up has been influenced by changes in only approximately a quarter of its • However, the UAE has recently oil prices. This suggests possible domestic output. Canada has done experienced some relative “contagion effects”—that is, the much the same; despite its healthy improvement in its non-oil sectors, tendency of failure in one economic trade in oil and gas, it receives only largely as a result of Dubai’s efforts or financial arena to spill over into 4 percent of its GDP from that toward economic diversification, other, unrelated or tangentially industry. Exhibit 3 shows the break- such as the development of the related arenas. down of GDP by economic sector Jebel Ali port and harbor, various for the GCC, transformation, and • Kuwait, Qatar, and the UAE “free zones” (i.e., enterprise zones) G7 economies, as well as for Canada display sector distribution and throughout the city, and extensive and Norway specifically, in 2005. growth patterns comparable to real estate complexes catering to those of KSA over the same period. the travel and tourism industry. In The difference in diversity across The UAE’s GDP growth has been 2005, only 5 percent of Dubai’s categories is wide. Comparing the driven mainly by the oil and gas GDP came from the oil and gas diversification of the GCC countries sector; effective growth of that sector—a strong testament to with the diversification of Canada sector has varied from double-digit the results that can come from a and Norway, specifically, shows the

4 Booz & Company Exhibit 3 sectors generally reflects and shapes GDP Breakdown by Economic Sector in the GCC, G7, Transformation, Canadian, GDP distribution across sectors. and Norwegian Economies, 2005 In GCC countries, however, GDP in Real 2005 US$ Billions employment is distributed quite $600 $1,660 $39,019 $1,133 $296 unevenly. The oil and gas sector, 100% 1% 1% 2% 3% 2% 2% 6% 4% which produces 47 percent of GCC 20% 17% 24% countries’ GDP, provides work for 80% 46% 28% 7% 9% only 1 percent of the employed 9%

1 14% 6% population. The vast majority of the 60% 15% 10% 9% 7% workforce is employed in sectors 9% 9% 7% that are relatively less economically

% of GD P 21% 40% 6% 6% 25% 12% 7% 24% productive and of secondary 5% 5% 16% 19% strategic importance in sustainable 20% 9% 16% 18% development—such as construction 12% 17% 13% 8% 2% 2% and utilities, government, and other 0% GCC2 Transformation G7 Canada Norway services. Government services alone Least Most constitute around 20 percent of Diversified Diversified total GCC employment. This means Agriculture, Forestry & Construction, Electricity, Banking, Insurance, Finance, a majority of workers are laboring Fisheries Water & Gas Real Estate & Business Services Mining, Quarrying & Trade, Restaurants & Government Services in sectors that are supporting other Energy Hotels economic sectors, rather than Manufacturing Transport & Communication Other Services2 driving growth themselves.

1 May not total 100% due to rounding. Countries with this type of labor 2 Total GDP regroups consolidated economic output from all six GCC economies. Sources: UAE Ministry of Economy; SAMA; Central Bank of Kuwait; Oman Ministry of National Economy; Central Bank distribution may suffer economically. of Bahrain; Qatar Planning Council; IMF; OECD; official statistics bureaus of sampled economies; Booz & Company Evaluating Economic Sustainability After assessing the overall difference that adopting sustained, attentive to the issue of diversifica- diversification of DG P and robust policies focused on diversi- tion to avoid a natural tendency employment across sectors in fication can make in an economy. toward economic concentration. our surveyed countries, we set Norway, for instance, has not only about measuring the relationship created a social pension or sovereign Labor Distribution Should of economic diversification to wealth fund from oil profits that Support Growth. In addition to economic sustainability. To do is invested abroad, both insulating examining the distribution of this, we conducted a collection the country from the shock of oil- GDP in the sampled GCC, G7, of time-series and cross-sectional price changes and removing excess and transformation economies, analyses measuring productivity liquidity from the economy. It has we also examined the distribution and competitiveness and the also invested labor and capital and of labor categories. In G7 and relation of economic volatility to explored knowledge and technology transformation economies, concentration, employment, and in industries—such as manufactur- employment tends to be balanced economic performance. Ultimately, ing—that were doing well but had across a variety of profitable we assessed diversification against some dependence on oil, so that they sectors, skewing slightly toward sustainability to demonstrate a could diversify. The success of Nor- service sectors such as trade, statistically significant relationship way and Canada also highlights the tourism, financial and business between the two. fact that nations rich in any single services, and real estate. Overall, commodity must be particularly employment distribution across

Booz & Company 5 Poor Economic Diversity Is gas sector but only US$1.2 million versus approximately US$2 Linked to Low Productivity and for construction. million/employee for Norway), Competitiveness. Productivity is suggesting pervasive, economy-wide These findings are important directly related to competitiveness: inefficiencies or the use of less- because labor and capital produc- The more people and/or capital than-ideal production processes. tivity are key measures of sus- it takes to do a job or create a Those gains in labor and capital tainable economic development. product, the lower productivity productivities that have been It appears that poor economic is. The lower productivity is, the achieved have mostly been visible diversification—reliance on a single more a product costs, and the less in the oil and gas sectors and absent economic sector—tends to have an competitive that product can be or negative in others. Evidence unfavorable effect on the produc- in the marketplace. Because the from the UAE, for example, tivity and competitiveness of the workforce in GCC countries is shows that gains in productivity other, lagging sectors. Indeed, labor so sparse in its largest economic have been offset by losses, thus and capital productivities across all sector (oil and gas) and so heavily leading to relative stagnation in GCC economic sectors fall consis- distributed in less economically terms of overall productivity and tently below benchmarks; specifi- important sectors (construction competitiveness (see Exhibit 5). cally those of comparable hydrocar- and government), labor and capital bon-rich economies (see Exhibit 4). Low productivity levels translate productivities in non-oil sectors lag into high costs to produce far behind those in oil and gas. For This underperformance is to a large goods and services. That in turn example, in 2005, the GDP labor extent persistent across the different has a direct, negative effect on productivity in GCC countries GCC economies and productive competitiveness, slowing economic was US$1.6 million per employee sectors, with hardly any exceptions. growth and threatening a nation’s for the oil and gas sector but Moreover, even for the oil and gas long-term and sustainable only US$9,300 per employee for sector, GCC output per employee economic development. construction. GDP-to-credit capital remains inferior to that of Norway productivity was US$121 million (approximately US$1.6 million/ per unit of credit for the oil and employee for the GCC countries,

Exhibit 4 GDP Labor Productivity in Comparable Hydrocarbon-Rich Economies, 2005

GDP Labor Productivity $1,992 $2,000 Lower labor productivity in Canada can be $1,500 $1,358 $1,237 mostly attributed to the existence of other non-oil mining elements. $1,000$300

$200 $167 $128 $144 $132 $113 $126 $125 $96 $98 $102 $98 $100 $88 $81 $73 $69 $60 $58 $61 $50 $50 $55 $39 $48 $54 US$ Thousands Per Employee $35 $33 $28 $21 $20 $36 $9 $6 $16 $0 Mining, ManufacturingFinancial & Transportation & Government Trade, Construction, Agriculture, Total Quarrying & Real Estate Communication Services Restaurants & Electricity, Water Forestry & Energy Services Hotels & Gas Fisheries

Norway Canada UAE KSA

Sources: Abu Dhabi Statistical Yearbook; Abu Dhabi Census; UAE Ministry of Economy; SAMA; Statistics Canada; Statistics Norway; Booz & Company

6 Booz & Company Exhibit 5 UAE Productivity Analysis by Economic Sector (Based on Recent, Reliable Data)

UAE Labor Productivity Analysis, 1995–2005 UAE Capital Productivity Analysis, 2001–05 (in %) (in %) 250% 120% Increasing Banking, Increasing Productivity Insurance, Productivity 100% Finance, Real 200% Mining, Estate & Decreasing Quarrying Business Decreasing & Energy Productivity 80% Services Productivity Manufacturing 36% 150% Manufacturing Mining, Trade, Restaurants 13% Quarrying & Transport & & Hotels 60% Trade, Restaurants Energy Communication 13% 13% & Hotels 100% 36% 13% Electricity, 7% 12% 40% Water & Gas Real GDP Growth 12% Transport & 7% 2% Government 2% Banking, Insurance, Finance, Communication 9% Real Estate & Business Services 7% 50% Services 2% Agriculture, 20% 2% Forestry & Other Agriculture, Nominal GDP Growth (2003–05) Construction* 2% Government 7% Fisheries 7% Forestry & Other Construction, Electricity, Services Services Fisheries Services Water & Gas* 0% 0% 0% 50% 100% 150% 200% 250% -50% -25% 0% 25% 50% 75% 100% 725% Employment Growth Sector Credit Growth (2001–03) Total GDPNon-Oil GDP

Note: Size of bubble equals relative share of 2005 GDP. *Construction is split from electricity, water, and gas for the purposes of the capital productivity analysis due to dramatic differences in their respective growth rates. Sources: Central Bank of the UAE; UAE Ministry of Economy; WDI; Booz & Company

High Economic Concentration trend, the health of GCC economies likely spillover of volatility from oil Leads to Volatile Growth and has remained more correlated to oil into non-oil sectors. Fluctuating Economic Cycles. prices than has the health of G7 and This sensitivity of GCC economies High economic concentration transformation economies—and to changes in oil prices is makes an economy vulnerable to the GCC economies are thus more manifested in growth volatilities external events, such as changes exposed to the effects of volatile across not just oil and gas, but all in the price of the dominant changes in price. Between 1999 and the different sectors that contribute commodity. The vulnerability of 2005, for example, the GDP of G7 to the bulk of economic output and the GCC economies to this factor countries shifted up and down only employment. Evidence from KSA, is shown in Exhibit 6 (see page 8), 2 percentage points per annum at for example, shows that volatility which reflects the high sensitivity most, although oil prices fluctuated is widespread in the kingdom’s of GCC real activity to oil-price dramatically. In contrast, the GDP economy, suggesting both shocks versus the relative stability of GCC countries from 1977 to inadequate economic diversification of the G7 and transformation 2005 moved between recessionary and significant spillover of volatility economies over the same period. periods when growth was less than from oil to non-oil sectors. Several 0 percent, to relatively normal peri- The exhibit shows that, with time, factors have contributed to this ods with growth of 2 to 3 percent, economies worldwide have some- spillover, including government to periods of explosive expansion, what adapted to better absorb sensitivity to non-oil spending when with growth jumping to 9 percent. oil-price shocks, as businesses, gov- oil prices are low; a dependence in ernments, and individuals have inte- Furthermore, exposure to oil-price the non-oil internal economy on grated changing oil prices into their shocks has resulted in oscillating oil output and prices; and limited decision making, expectations, con- business cycles, as economies non-oil exports. Those factors also sumption, savings, and investment expand and contract in response to suggest inadequate and relatively patterns. Despite this worldwide rises and dips in the price of oil, and ineffective economic diversification.

Booz & Company 7 Exhibit 6 Oil Price Change versus Real GDP Growth in the GCC, G7, and Transformation Economies, 1997–2005

20% 150% Although GCC economies have become relatively less sensitive and exposed to oil shocks with time, their overall GDP growth remains 15% 100% highly correlated with changes in oil prices. % Growth in Real GD P 10%

50% 5%

0% -0%

-5%

% Change in Oil Prices * -50% The overreliance of GCC economies on oil output led -10% them to witness a recessionary period during the 1980s. -100% -15% 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005

GCC GDP Growth Transformation GDP Growth G7 GDP Growth Oil Price Change*

*Average annual Brent Crude Oil spot price from 1977 until 2005 was tracked against discrete annual real GDP growth for the GCC, G7, and transformation economies. Sources: WDI; Booz & Company

Exhibit 7 shows that the highest pervasive across the economic as 18 percent in KSA and in excess growth volatility in KSA has been sectors of the other GCC countries, of 20 percent in the UAE. Although in the oil and gas sector, which particularly Kuwait, Qatar, and some volatility is to be expected in constitutes the bulk of the region’s the UAE. Growth volatility in oil all markets, a high level of volatility economic output. Similar growth and gas and a number of other hinders sustainable economic volatility is to a large extent economic sectors has been as high growth, mainly because periods of prosperity generally do not offset the negative structural effects of bad times. In other words, economic Exhibit 7 shocks tend to have a long-lasting KSA Employees and Growth Volatility by Economic Sector negative effect.

Increasing Employment Volatility in Concentrated Econo-

Construction, mies May Spawn Structural 40% Electricity, Unemployment Issues and Engen- Water & Gas 35% 6% High growth volatility is seen der Systemic Risks. Significantly, across KSA’s economic 30% sectors, namely those that the elevated volatility seen in GCC Trade, Restaurants constitute the bulk of the countries is highest in the economic 25% & Hotels employed labor force and 5% GDP output. sectors that employ most of those 20% G7 Overall Volatility = 1.3% Government nations’ populations. For example, KSA Overall Volatility = 5.3% GCC Overall Volatility = 5.1% Services 15% Manufacturing 15% volatility is prevalent in sectors that Agriculture, 3% Other Forestry & 10% 9% Services employ 85 percent of KSA’s work- (% of Total Employed ) Transformation Overall Volatility = 2.2% Fisheries Banking, Insurance, Transport & 3% Mining, force and in sectors that employ 80 5% Finance, Real Estate Communication Quarrying & Business Employees by Economic Sector, 2005 7% 3% 20% percent of the UAE’s workforce, & Energy Increasing 0% Services Volatility 0% 5% 10% 15% 20% 25% including government services; -5% Growth Volatility, 1975–2005* construction, electricity, water, and (% of Volatility Growth) gas; and trade, restaurants, and

Note: Size of bubble equals relative share of 2005 GDP. hotels. Having such high volatility *Historical aggregate and sector volatilities are measured by the standard deviations of aggregate and sector real activity in such a large portion of eco- growth rates, respectively, over the sampled period. Sources: SAMA; KSA Ministry of Economy and Planning; WDI; Booz & Company nomic sectors presents a particular

8 Booz & Company problem. It causes frequent unem- issues as manufacturing moves note, it does seem that this ployment (unemployment in most offshore and former manufacturing pervasive volatility (and its GCC economies has been consis- employees struggle to find a new enduring spillover effects) can be tently at double-digit rates, and this place in the economy. mitigated with the development and employment challenge is expected diversification of high-value-added to worsen as a substantial segment Volatility in non-oil sectors in the exports of goods and services. In of the population reaches working GCC region has decreased over the G7, GCC, and transformation age in the near future and overflows time, ranging from 5 to 9 percent. economies studied here, when non- oil exports are mapped against the job markets) and often results This is a significant improve- real activity volatility, an inverse in high structural unemployment ment, given that the number in the relationship is revealed between rates—that is, in this context, UAE, for instance, used to range external trade diversification and unemployment that occurs because between 10 and 35 percent. How- ever, this reduction could be the economic uncertainty (see Exhibit the available laborers do not have 8). In a nutshell, the higher and the skills or knowledge needed to result of there being fewer aggre- gate shocks rather than the result the more diversified a country’s match the available jobs. Displaced exports, the lower its volatility. workers with particular knowledge of effective diversification. Despite and skill sets (or lack thereof) can- these reductions, growth volatility The evidence in Exhibit 8 shows not easily be moved into different in GCC economies remains high that oil-dependent economies sectors of the economy without an when compared with the volatility such as those of the GCC—and extensive expenditure of time and of analogous economies. any economies based on a training. Regions of the United single commodity—will become States, for example, have suffered External Trade Helps Reduce effectively diversified only when from structural unemployment Economic Volatility. On a positive they successfully create a robust

Exhibit 8 External Trade Diversification and Economic Stability in the GCC, G7, and Transformation Economies

Non-Oil Exports1, 2000–06 Average2 GDP Discrete Growth Volatility, 1974–2005 (% of Nominal GDP) (in %)

78.4% Singapore 3.7%

56.3% Ireland 3.1% External Trade Diversification by Category of Economie Transformation 42.4% Transformation 2.2% Economies 35.2% South Korea 3.8% 27.4% Norway 1.8% 10.2% Hong Kong 4.6% 38.5% Germany 1.7% 25.5% Canada 2.0% 22.4% Italy 1.7% G7 21.1% G7 1.3% Economies 18.3% U.K. 1.7% 16.7% France 1.2% 14.9% Japan 1.9% 7.3% U.S. 1.9% 18.7% Bahrain 4.8% 5.6% Qatar 6.2% 5.1% KSA 5.3% GCC 4.6% GCC 5.1% Economies 4.3% Oman 6.9% 3.3% UAE 9.4%

2.5% Kuwait 9.0% s 01020304050607080

1 Export data are net of reexports and include only exports of non-oil goods—and thus are not inclusive of export services. 2 Average data ranges vary for the different countries depending on data availability. Sources: UAE Ministry of Economy; SAMA; Central Bank of Kuwait; Oman Ministry of National Economy; Central Bank of Bahrain; Qatar Planning Council; EIU; Booz & Company

Booz & Company 9 quantity and variety of exports This unfortunate phenomenon is 1 percent with growth of 2.52 and worldwide purchasers for shown in Exhibit 9, which evaluates percent; in comparison, the GCC them. Norway and, to a certain the Sharpe ratio of the studied economies increase volatility by 1 extent, Canada provide examples G7, GCC, and transformation percent with growth of just 0.69 of nations that have done this economies. The Sharpe ratio percent. In other words, for the GCC successfully. For Norway, non-oil measures an economy’s risk- economies, any increase in growth exports make up 27.4 percent of its adjusted performance—that is, inherently increases economic GDP, but it has only a 1.8 percent the average economic return per risk—rather than economic reward. GDP growth volatility score. unit of volatility—by dividing the economy’s average GDP discrete Diversification Is a This evidence serves as a further growth premium by the historical Critical Component of a reminder that policymakers in growth premium volatility. Sustainable Economy hydrocarbon-rich nations must pay So what is the solution? How can Exhibit 9 shows that unlike G7 attention to the issue of economic economies that have historically and transformation economies, diversity—and in particular, to the relied on the export of a single GCC economies have high growth development of external trade. commodity reduce volatility, premiums that are outweighed by Otherwise, high but concentrated improve risk-adjusted real activity excessive volatility, leading to low economic growth is likely to be out- performance, and therefore risk-adjusted performance. weighed by excessive volatility and achieve sustainability? Is economic lead to low risk-adjusted performance. On average, the transformation diversification truly a key part of economies increase volatility by accomplishing this?

Exhibit 9 Real GDP Growth, Historical Volatility, and Risk-Adjusted Performance in the GCC, G7, and Transformation Economies, 1974–2005

Average GDP Discrete Growth Premium Discrete Growth Volatility Sharpe Ratio (% Growth) (% Volatility) (Reward-to-Volatility Value)

Transformation 5.5% 2.2% 2.52

Singapore 7.0% 3.7% 1.87 Risk-Adjusted Performance by Category of Economies Transformation South Korea 6.9% 3.8% 1.83 Economies Norway 3.3% 1.8% 1.82 Ireland 5.3% 3.1% 1.71 Hong Kong 6.2% 4.6% 1.34 G7 2.8% 1.3% 2.09 France 2.3% 1.2% 1.84 U.S. 3.1% 1.9% 1.63 G7 Canada 2.9% 2.0% 1.44 Economies Japan 2.7% / 1.9% = 1.44 U.K. 2.3% 1.7% 1.30 Germany 2.0% 1.7% 1.19 Italy 2.0% 1.7% 1.16 Qatar 6.8% 6.2% 1.10 Oman 6.8% 6.9% 0.99 Bahrain 4.1% 4.8% 0.85 GCC Kuwait 7.0% 9.0% 0.77 Economies GCC 3.5% 5.1% 0.69 UAE 5.5% 9.4% 0.59 KSA 2.7% 5.3% 0.51

Note: The average annual GDP discrete growth premium measures the adjusted real growth above a certain threshold that is equal to the risk-free real GDP growth rate of zero, which, in reality, is assumed to be a rate that matches year-on-year inflation. Sources: UAE Ministry of Economy; SAMA; Central Bank of Kuwait; Oman Ministry of National Economy; Central Bank of Bahrain; Qatar Planning Council; IMF World Economic Outlook 2006; OECD; official statistics bureaus of sampled economies;Booz & Company

10 Booz & Company

0246810246012 81010.02 0.5 1.0 1.5 2.0 2.5 3.03.5 4.0 To answer these questions, opposite perspective. It shows that would be difficult for policymakers we compared: nations with a high diversification to directly and actively influence quotient—such as Norway, South or shape. Economic diversification, • GDP growth volatility against Korea, and Ireland—enjoy a high in contrast, is measurable, moni- economic concentration for the Sharpe ratio; that is, a high eco- torable, and now known to be a studied countries nomic return per unit of volatility. critical component of a sustainable • GDP reward-to-volatility ratio economy. Policymakers who want It is important to note that the (i.e., the Sharpe ratio) against the to develop sustainable economies regression estimators in the analysis diversification quotient for the have a target in place—and have are statistically significant. About studied countries. their work cut out for them. 30 percent of the variation in GDP The results of our analysis are growth volatility and reward-to-vol- shown in Exhibit 10. Effecting Sustainable atility ratio is captured by the single Development: Summary independent variables of economic These analyses identify a clear link of Key Findings and concentration and diversification, between economic diversification Recommendations for respectively. The remaining 70 per- and sustainable development. The Policymakers left-hand side of the exhibit shows cent of the variation not explained This study has gone some way in that nations with a high concen- by the regression can potentially be empirically validating the links tration ratio—such as many of captured by other factors, such as between economic diversification the GCC countries—suffer from oil prices, inflation, exchange rates, and sustainable growth. Our main significantly higher growth volatil- investor and consumer confidence, findings are as follows: ity than do G7 or transformation asset price shocks, and so forth. nations. The right-hand side of the Many of these factors, despite hav- • Levels of economic concentration exhibit tells the same story, from the ing some bearing on the economy, and diversification are very

Exhibit 10 Relationship between Economic Diversification and Economic Sustainability

GDP Growth Volatility vs. Concentration GDP Reward-to-Volatility Ratio vs. Quotient in the GCC, G7, and Transformation Economies in the GCC, G7, and Transformation Economies

Increasing Increasing Risk-Adjusted 0.12 y = 0.2386*x – 0.0113* * 3.0 y = 0.2583*x + 0.0327** Growth Volatility R2 = 0.3492 Performance R2 = 0.3101 5

5 0.10 UAE 2.5 Transformation Kuwait

G7 2.0 0.08 Ireland Norway Oman Singapore France South Korea Qatar U.S. 0.06 1.5 Canada GCCKSA Hong Kong Bahrain Germany Japan U.K. Hong Kong Qatar Italy 1.0 0.04 South Korea Singapore Oman Bahrain Ireland U.S. Kuwait GCC UAE Canada Transformation 0.02 0.5 KSA GDP Growth Volatility, 1974–200 Norway Italy Germany U.K. G7 France Increasing Economic Increasing Economic Japan Concentration GDP Reward-to-Volatility Ratio, 1974–200 Diversification 0.00 0.0 0.10 0.15 0.20 0.25 0.30 0.35 0.40 2 345678 Concentration Ratio, 2005 Diversification Quotient, 2005

*Indicates a statistical significance at a 99% confidence interval. **Panel-data regressions using the General Method of Moments (GMM) showed visible improvements to the overall adjusted goodness of fit. Additionally, diagnostic checks and a collection of regressions run with an extensive array of control variables asserted that the found relationships are both statistically valid and reliable. Sources: Official statistics bureaus of sampled economies; Booz & Company 0.12 3.0

0.10 2.5

0.08 2.0 Booz & Company 11 0.06 1.5

0.04 1.0

0.02 0.5

0.00 0.0 0.10 0.15 0.20 0.25 0.30 0.35 0.40 2 345678 different in the G7, GCC, and sustainable economy. This evidence the exploitation and use of transformation economies, with shows clearly that policymakers— natural resources; and enhancing the GCC economies appearing particularly those whose economies technology and knowledge with the to be the most concentrated and have historically relied on a single aim of entrenching innovation. inadequately diversified. export—must focus on economic • Innovation, in turn, allows econo- diversification when creating mies to create almost ex nihilo • Hydrocarbon-rich nations, development agendas, and must such as those in the GCC, are economic value by innovating a link rigorously measure and monitor not necessarily destined to suffer in the value chain, an industry, a economic diversity in evaluating poor economic diversification, as cluster, or even a whole sector. This the success of their policies. shown by the paragon economies said, it remains crucial to an econ- of Norway and, to a certain extent, Specifically, policymakers should omy’s success to carefully time the Canada and by the progress being pursue the following courses: transition toward innovation-based made in the UAE’s Dubai, which output generation. Although pre- • Actively seek to diversify their paring the ground and establishing going forward would still need to economic base in terms of economic further develop its external markets. the prerequisites and underpinnings output and input distributions. of an innovation economy should • Levels of employment distribu- Depending on the degree of be initiated at early transformation tion across economic sectors are interventionism appropriate in stages, the effective generation of also very different in the G7, GCC, each country, public and private economic output out of innovation and transformation economies. stakeholders should incentivize the sectors should come as a natural Employment distribution seems to injection of labor and capital into phase in an economy’s transforma- be balanced in G7 and transforma- productive economic sectors that tion path. A premature reliance on tion economies, but skewed toward can sustain real growth in the long- innovation sectors is likely to mini- low-value-added sectors, such as term, as well as the development of mize chances of success and expose construction and government, in new knowledge and technology. a not-yet-immunized economy to the GCC economies. • Specifically foster the growth of harmful and disruptive competition. • High economic concentration the external sector when promoting • Use the metrics of economic exposes economies to exogenous diversification; that is, the export of concentration and diversification, events such as changes in oil prices; a wide range of high-value-added as well as economic sustainability this exposure creates economic goods and services to a wide range and uncertainty, as targets when volatility, as verified by the high of destinations. determining policy—and aim to sensitivity of GCC real activity to further understand the dynamics oil-price shocks. • Continuously and consistently enhance the productivity and between them. • Overall volatility and its ensuing competitiveness levels of the • Monitor and devise clear spillover effects can be mitigated economic base by drawing on participatory and integrated with the effective development resources and making strategic diversification strategies and and diversification of high-value- investments in sectors, industries, mechanisms by which economic added exports. and value chains where there is a volatility and spillover effects, • Volatility minimization and risk- competitive advantage and where systemic uncertainty, and perturbed adjusted real activity performance there is market opportunity and business cycle transitions can be improvement can be largely growth potential. This effort can significantly mitigated. achieved with increased involve enhancing human capital, Taking these steps will help economic diversification. by increasing education levels and policymakers create long-term, These findings have important importing skilled talent, as needed; sustainable growth in their implications for policymakers enhancing financial capital by economies—and in so doing, help interested in ensuring that their developing new financing schemes ensure stability and a high standard nation enjoys a strong and and instruments; optimizing of living for their nations.

12 Booz & Company Richard Shediac is a partner with administration modernization, management. He can be reached Booz & Company based in Abu public policy, large-scale at +961-1-336433 or Dhabi. He specializes in financial transformation, and organizational [email protected]. services and public sector projects development and change Mazen Ramsay Najjar is an and has led and participated management. He can be reached associate with Booz & Company in various strategy, operations at +971-2-6992400 or based in Beirut. He focuses on improvement, and organization [email protected]. public policy, socioeconomic projects in the Middle East, Europe, Chadi N. Moujaes is a principal development plans, macroeconomic and Asia. He can be reached at with Booz & Company based policy and governance frameworks, +971-2-6992400 or in Beirut. He focuses on public and turnaround and transformation [email protected]. policy, socioeconomic development projects. He can be reached at Rabih Abouchakra is a principal plans, public administration +961-1-336433 or with Booz & Company based in modernization, large-scale [email protected]. Abu Dhabi. He focuses on public transformation, and performance

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