73759 October 2012 – Number 75 AN NATURAL RESOURCE ABUNDANCE, GROWTH & DIVERSIFICATION IN MENA: THE EFFECTS OF NATURAL RESOURCES & THE ROLE OF POLICIES Ndiame Diop, Daniela Marotta and Jaime de Melo 1 concentration of economic activities, in addition to the classical Dutch disease effect; and (iv) the impact Introduction: The Middle East and North Africa of macroeconomic factors on the drive for regional (MENA) region is one of the richest in the world in integration. The main findings are summarized in terms of natural resources. It holds more than 60 this Quick Note. percent of the world’s proven oil reserves, mostly located in the Gulf region, and nearly half of global Economic Performance in MENA: MENA countries gas reserves. Not surprisingly, oil represents close to set for themselves three interrelated policy shift 85 percent of the merchandise exports of the region, goals in the 1990s: a shift from economies dominated making it highly susceptible to fluctuations in by the public sector to economies led by the private international prices. A long strand of economic sector; a move from closed economies to more literature suggests that such dependence may hurt a globally integrated ones; and a transition from oil- country’s growth prospects and job creation by dominated to more diversified economies. reducing the scope for economic diversification. As a result, economic performance in MENA A forthcoming WB publication2 investigates how showed some progress starting from the late 2000s, MENA can overcome this challenge and encourage featuring higher growth rates, less growth volatility, greater economic diversification. The study and increased market shares for exports than in the examines the pattern of structural transformation in past, despite competition from fast growing MENA and explores the role of natural resources countries and exporters such as China and India. and macroeconomic policies in driving the current Nonetheless, with the exception of Oman, MENA (limited) diversification outcomes. The authors countries have failed to climb the economic ladder explore analytical questions, such as: (i) the impact and remain in either the lower-middle- or in the of the real exchange rate on manufacturing and upper-middle-income group. An analysis of the tradable services competitiveness in MENA; (ii) the correlates of this overall disappointing performance role of fiscal policy in supporting diversification; (iii) shows that at the macro level MENA countries have how “weak links� (input sectors with low been unable to maintain depreciated (undervalued) productivity) play a critical role in explaining the real exchange rates for long periods. Such undervaluation has proved important elsewhere to offset the market failures and poor institutional 1 Ndiame Diop and Daniela Marotta are Lead Economist and environment that severely hit the dynamic non- Country Economist in the MENA region of the World Bank. resource-intensive traded sectors. Jaime de Melo senior fellow at the FERDI (Fondation pour les Études et Recherches sur le Développement International) in Clermont-Ferrand, France. This Quick Note was cleared by In addition, the volatility of the real effective Bernard Funck, Sector Manager, Economic Policy, Poverty and exchange rate in MENA has been greater than in Gender Unit, The Middle East and North Africa Region comparable groups of countries, contributing to the (MNSED), The World Bank. lack of development of new activities outside the 2 Diop, Marotta and DeMelo: “Natural Resource Abundance, resource sectors and to short-lived export spells. Growth and Diversification in MENA: the effects of natural resources and the role of policies�, Direction s in Development Furthermore, despite some progress toward (2012) reducing tariffs on industry, MENA countries have fared poorly in most indicators describing the resource rich countries in reducing barriers to labor domestic microeconomic environment, underlining mobility within the region. the impression of an environment in which trade is MENA and Global Patterns of Diversification: not facilitated and of an unfinished reform agenda. There are systematic differences between the Improved domestic regulatory policies along with patterns of diversification in MENA and the rest of improved public sector governance reflected in the world. The relationship between economic better values for key indicators would help MENA diversification and income per capita is non- achieve greater integration into the world economy. monotonic: at early stages of development, countries typically diversify as income increases and new Services sectors in resource-rich MENA countries economic opportunities emerge, but at later stages are subject to a Dutch disease-type effect: The the production bundle becomes more concentrated traditional negative effect of Dutch disease on the as income rises. This empirical regularity does not fit development of tradable manufacturing sectors is the observed pattern of development and well documented. What this new study finds is diversification in MENA countries. At their early those Dutch disease related phenomenons also have stages of development, production becomes more an impact on the services sector, since the former has concentrated as income rises, and then less become increasingly tradable. concentrated after reaching a certain income-per- capita threshold. Services sectors in resource-rich MENA countries have been declining as a share of gross domestic The correlates of these different patterns of product (GDP) and of non-mining GDP as per capita diversification are varied, starting from the role of incomes increase. This negative relationship relative endowments in natural resources and then between the share of services in GDP and income investigating the role of Dutch disease associated per capita is contrary to global patterns and is linked with a strong appreciation of the real exchange rate to the large rents generated by natural resources in in contrast with the role of weak links in the these countries. A large number of services sectors economy. The weak link argument is recent—it can now be moved offshore or provided by shows that complementarities in production and temporary movement of service providers, implying linkages among sectors can lead to either multiplier that countries need to be competitive to maintain or weak link effects. When the links are weak, low domestic production. Rents from natural resources productivity in one sector can reduce productivity inflate wages and nontradable prices, thereby throughout the economy, depending on the degree appreciating the real exchange rate and of substitutability among inputs. discouraging domestic provision of tradable services. In a setup with low substitutability, weak links will result in a less diversified production bundle as The study highlights that the negative effect of rents downstream sectors are hurt by higher input prices is compounded by the negative impact of policy and and factor prices3. The study econometrically tests regulatory restrictions on entry, and of business the relevance of the Dutch disease versus weak links conduct on the development of services sectors. in explaining MENA’s peculiar pattern of These restrictions create rents captured by diversification. It was found that weak links “protected incumbents� or increase the real cost of contribute to a more concentrated production producing services—in both cases inflating the price bundle than Dutch disease. Moreover, after of services. Resource-rich countries need to reduce these restrictions, build strong human capital, and 3 improve their institutions to create an enabling Examples of sectors that can be considered weak links are the energy production or oil refining industries whose products are environment for diversification in the long run. broadly used by others sectors as intermediate inputs, and which Meanwhile, they offer formidable export have a non-negligible, nontradable component. Energy is diversification opportunities to resource-poor required by almost every sector, and while oil is highly tradable, MENA, provided that these countries reduce their energy production can be highly nontradable. Low levels of own regulatory restrictions to investments in productivity in energy production will imply higher costs for users of energy and might constrain diversification into new exporting service industries, improve their backbone sectors as their expected profitability falls. Thus, the presence of services (such as telecom), and proactively engage weak links may lead to higher levels of concentration. October 2012 · Number 75 · 2 controlling for these two variables4, the differences management, although they have all neglected in development patterns between MENA and the infrastructure investments. rest of the world become smaller. This result has The long-term challenge for the MENA region is to some interesting policy implications, at least in ensure that fiscal policy is used to promote growth terms of the timing of industrial policy reforms. and diversification. The GCC countries will need to Policies aimed at diversifying the production implement policy reforms to accelerate non-oil process should first try to address the region’s weak growth and create employment opportunities for a links. Otherwise resources may be wasted in trying rapidly increasing labor force in a sustained fashion. to diversify into sectors that are not economically For oil importers in the Mashreq and Maghreb, fiscal viable. Although more research is needed in this management must ensure that the pressing area, this chapter suggests that if governments first demands on the state from the citizenry must be address the existing weak links in their economies, accommodated without jeopardizing longer-term diversification may naturally follow. If addressing macroeconomic stability. weak links may sometimes seem like a daunting task requiring large infrastructure investments with Reorientation of public expenditure away from a long term objective, it is important to note that one subsidies that do not go to the poor and towards characteristic of weak links is that they are non- both conditional cash transfers and effective public traded goods. If there is an easily imported investment programs must be encouraged. Through substitute, then the low productivity of the domestic fiscal policy targeted toward infrastructure, MENA input sector is no longer a drag on growth. Thus, countries can help lay the foundation for successful when restrictive trade policies limit the tradability of diversification. input sectors, liberalization may be sufficient to address those weak links. Incentives for Regional Integration among Resource-rich and Resource-poor MENA Fiscal Policy and Diversification in MENA: From a Countries: The authors of the study emphasize the historical perspective, fiscal policy has not different characteristics of regional partners in terms contributed significantly to diversification in of their resource endowments and consider wealth MENA, because it has been more oriented toward distribution effects within the region. A recent food and fuel subsidies (consumption) rather than theoretical model developed by Venables shows that toward public goods such as infrastructure the proximity of resource-rich and resource-poor (investment). Even at that, fiscal policy has not been countries creates an opportunity, through regional well targeted and has been particularly ineffective at integration to even up wealth distribution among promoting redistribution. Fiscal policy in resource- these countries. Preferential trade liberalization is rich countries of MENA has also suffered from a typically more beneficial than unilateral lack of transparency and accountability. The most nondiscriminatory most-favored-nation trade recent oil boom in the Gulf Cooperation Council liberalization for the resource poor country, because (GCC) countries has led to an impressive buildup of the country gains access to the rents in the resource- sovereign wealth funds, which have helped mitigate rich country. This would imply that integration deficits and cushion these countries through crises, between resource-rich labor-importing and but transparency on the governance of these funds resource-poor labor-abundant countries might be has been limited. Nevertheless, over a longer period, beneficial only for the resource-poor countries in the three regions in MENA—the GCC oil exporters, MENA. The study tests the extent to which the Maghreb countries in the northwest of Africa, economic diversification has been achieved at the and the Mashreq countries located in the Middle expense of trade diversion and, consequently, at the East—have all improved their overall fiscal expense of broader economic efficiency. Results suggest that significant trade creation is associated with regional integration within MENA, with no evidence of trade diversion in resource-poor 4 Dutch disease (proxied by percentage changes of the real countries. But there is evidence of trade diversion in exchange rate) and Weak Link (proxied by the probability of both labor-abundant and labor-importing resource- observing productivity in a sector lower than a certain rich countries. Hence, while further intraregional threshold-mean productivity minus 2xstandard deviation- in a given country and year) trade integration is an important avenue for October 2012 · Number 75 · 3 enhancing diversification of resource-poor MENA Contact MNA K&L: countries, resource-rich countries have no strong Laura Tuck, Director, Strategy and Operations. incentive for further preferential regional integration MENA Region, The World Bank from a purely economic standpoint, and this may explain their relative reluctance to engage in this Regional Quick Notes Team: type of scheme. Omer Karasapan, and Roby Fields Conclusions: Several policy recommendations Tel #: (202) 473 8177 emerge from the report. Policy makers should strive to avoid real exchange rate overvaluation through The MNA Quick Notes are intended to summarize consistent fiscal policies, flexible exchange rates, and lessons learned from MNA and other Bank Knowledge adequate product and factor market regulations. and Learning activities. The Notes do not necessarily reflect the views of the World Bank, its board or its Reforms to strengthen the competition and member countries. efficiency of upstream input activities are crucial for improving the performance of downstream activities and diversification. Consistent and transparent fiscal policy is essential to reduce instability, build the fiscal space needed to invest in core infrastructure and human capital, and create a favorable environment for diversification. Finally, it is worth considering that while regional trade integration leads to greater diversification and welfare gains for the resource-poor countries, the resource-rich countries need to go beyond trade to derive benefits from regional integration since trade preferences tend to generate net income losses for them. October 2012 · Number 75 · 4