The Arab countries of the Gulf are navigating a historic transition as they strive to reduce their dependence on oil and natural gas and diversify their economies. The six Gulf countries—Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates (UAE)—are at different stages of this transition, largely depending on the amount of hydrocarbon reserves each has left. Leading the way is arguably the emirate of Dubai, one of seven emirates that form the UAE. Dubai has diversified successfully into logistics, finance, and tourism and serves as a regional hub for multinational corporations. In terms of national efforts, Bahrain and Oman, under pressure from low hydrocarbon reserves, are arguably furthest along, followed by Saudi Arabia, then Kuwait, Qatar and the rest of the UAE.

While the Gulf region as a whole still has decades of hydrocarbon reserves, the global demand is expected to decline within the near future as renewable energy becomes cheaper, energy efficiency increases, and the technology to store and transfer energy improves. As a result, the prices of, and revenues from, oil and natural gas are set to fall. Gulf states must diversify their economies and get their public finances in shape soon in order to successfully transition to a post-hydrocarbon future.

Time is not on their side. There is still a window of opportunity for Gulf states to act decisively, leveraging their hydrocarbon wealth and savings accumulated in sovereign wealth funds to implement a smooth transition. However, this window is closing fast. Unless substantive policy changes are made soon, the International Monetary Fund projects that Gulf countries could exhaust their wealth within a few years, beginning with Bahrain in five years, Oman in 10 years, and Saudi Arabia within 15 years. Even these alarming projections are generous, given that they were made before the coronavirus pandemic upended Gulf economies and finances. If Gulf states continue to delay necessary reforms, they risk having to make more painful choices later.

This is not to say that progress has not been made. Gulf countries have been trying to diversify and transform their economies for decades. Every iteration has moved the needle a bit further in a positive direction. However, as we discuss below, previous efforts to expand and diversify their economies also created institutions or introduced incentives that, over time, have become embedded in the state’s political economy, maintained through bureaucratic inertia, and defended by vested interests. Subsequent reform efforts have had to push further while pulling along the deadweight of legacy policies. For Gulf states to unlock the true potential of their economies, they must redouble their diversification efforts, while mitigating the adverse consequences of past policy decisions.

Initial conditions and the birth of the modern Gulf state

During the 1960s and 1970s, Gulf states used revenues from oil production (natural gas liquefaction began in the 1990s) to build state institutions and grow their economies. However, as we argue below, these investments also created institutions, vested interests, and cost centers that now stand in the way of further economic development. Large state bureaucracies and some large public enterprises continue to rely on revenues from oil and natural gas to sustain them. However, true economic diversification requires the development of firms and industries that are economically sustainable and independent of revenues from oil and natural gas. 

In the public sector, Gulf bureaucracies grew to become quite large, employing most of the national workforce. Citizens were attracted to better wages, benefits, and working conditions than they could find in the private sector. Over time, the large public sector wage bill became an albatross, siphoning resources away from other priorities. Gulf states are loath to fire citizens and thus must wait for them to leave or retire on their own to reduce their numbers. In the meantime, young Gulf citizens are seeking the education credentials needed to secure government jobs, instead of developing productive skills demanded in the private sector. Thus, many Gulf citizens are now unable to find good work in the private sector without the support of either government wage subsidies or quotas that require private firms to hire certain numbers of them.

Private sector development in the Gulf was also government-led, spearheaded through national public enterprises across sectors as diverse as energy, banking, insurance, construction, transportation, telecommunications, and health care. While these large public enterprises initially spurred innovation and growth, they eventually came to dominate their respective industries and even to serve as de facto regulators, preventing smaller private sector competitors from growing and disrupting the industry. Many public enterprises and state-led initiatives relied on revenues from oil and natural gas to sustain them. Such large state-led initiatives continue today, exemplified by flagship construction projects like Saudi Arabia’s new mega-project, Neom, and path-breaking education and research initiatives, such as those launched through the Qatar Foundation. 

While Gulf countries like to point to these projects as signs of the advances they have achieved, such initiatives are more likely to draw on increasingly scarce hydrocarbon revenues than to promote true economic diversification or sustainable development. Despite genuine intentions to diversify their economies, most state-led diversification efforts in the Gulf have been illusory.      

In particular, Gulf states tend to invest in construction projects, whose economic returns are temporary. Long-term economic development comes from the human activity and innovation that takes place within these offices, business parks, and commercial structures after construction is completed. Real economic diversification requires Gulf states to establish sectors, industries, firms, and initiatives that can survive and thrive on their own, without relying directly or indirectly on revenues from oil and natural gas. Gulf states must nurture firms and industries that can generate enough profits to support public finances and enough export revenues to replace hydrocarbon exports. 

Incremental improvements, but new problems too

Thus, while revenues from oil and natural gas have allowed Gulf states to build public institutions and to galvanize economic development, their large public bureaucracies and national public enterprises have introduced cost centers, vested interests, and incentive structures into each state’s political economy that are not easily reversed. However, rather than reforming these institutions, Gulf countries have largely tried to work around them, but reform efforts have resulted in their own problems and have further hindered diversification. 

As a first step, Gulf states attempted to limit the size of their bureaucracies. Rather than laying off citizens or reducing their wages, they chose to reduce the numbers of foreign workers in the public sector and limit the hiring of nationals. This decision not only failed to address the issue at hand—the presence of highly paid bureaucracies—but also increased unemployment among young nationals wanting to access government jobs. Unemployed rates reached 27% among young Kuwaitis in 2017, for example, and 35% among young Saudis in 2019, as compared to a global average of 13% in 2018.

As a second step, Gulf states tried to compensate by introducing mandates and incentives for private sector firms to hire nationals. Mandates, in the form of nationalization policies (Emiratization, Saudization, etc.) added to the financial burdens of private firms, limiting their ability to grow, create jobs, and support long-term diversification objectives. For example, in Saudi Arabia, Saudization programs resulted in firms hiring ghost workers on the books to meet their quotas. More recently, financial incentives, such as wage subsidies and subsidized on-the-job training, have been tried in Bahrain and Saudi Arabia. These have added to the budget obligations of countries, without a clear indication that the jobs will persist after the subsidies end. 

As a third step, Gulf states tried to support private sector development. However, rather than limiting the scope and influence of public enterprises, they supported small and medium enterprises (SMEs) directly through financing, subsidies, and government contracts. While these policies may help, it is not clear that they will lead to the development and growth of competitive, sustainable businesses that can compete internationally on their own. The cost of subsidies (financial, energy, etc,) provided to these firms can outweigh the government fiscal revenues they generate. Gulf states have also made impressive progress in reducing unnecessary regulations, at least on paper. However, many regulations have persisted in an informal manner and large public enterprises often continue to regulate industries behind the scenes, creating delays and uncertainties for new businesses. 

Most recently, Gulf states have attempted to jumpstart economic diversification by creating free zones and special economic zones that aim to bypass burdensome local regulations and attract local and foreign investors. Examples include the Dubai International Financial Centre, Qatar Financial Center, and Bahrain International Investment Park, among others. While these zones have contributed to improved private sector economic activity, they have also led to the creation of segmented markets and delayed needed reforms in the primary economy. Still, the hope is that these efforts will provide a necessary space for local administrators to experiment and learn, thereby paving the way for countrywide expansion. 

Addressing mistakes of past reforms

While creating space for economic activity to take place in free zones and special economic zones is a promising first step toward real economic diversification, Gulf governments must ultimately address the problems created by past diversification efforts in order to forge a new path forward. 

First, governments need to limit the ability of their large public enterprises to regulate business activity and restrict competition in their sectors. Instead, one of the performance criteria for public enterprises should be the extent to which they provide an enabling environment for SME development, growth, and innovation in their respective industries. This is the opposite of what currently takes place. For this shift to happen, how public enterprises see themselves must change from national champions that dominate their space to national enablers that nurture and develop their space. Regulatory authority must also fully reside with relevant government agencies and a firewall should exist between public enterprises and the government authorities that regulate them. 

Second, Gulf governments need to apply the concept of free zones and special economic zones to mainstream economic activity. This can be done at a sectoral level by identifying growth sectors that are not dependent, either directly or indirectly, on government subsidies or revenues from oil and natural gas. Gulf states should then allow these sectors to drive non-hydrocarbon economic growth. To an extent, this is what Dubai has done. The state identified growth sectors that were not dependent on oil revenues and then created the necessary regulatory and physical infrastructure to support them. Dubai then encouraged private sector development and foreign direct investment in these sectors.

Third, Gulf states need to reduce the size and scope of their public sectors. Large government wage bills drain resources away from private sector investment, and large bureaucracies naturally interfere with business activity. The difficulty here is the wage differential between citizens working in the public and private sectors. As we discussed above, subsidies are costly, while quotas create market inefficiencies and sabotage efforts to create a globally competitive private sector. An alternative would be for states to introduce either a universal basic income (UBI) scheme for their citizens or a supplementary social wage that applies to both the public and private sectors. Either policy would allow states to align public and private sector wages without financially harming citizens. 

Finally, it is important to note that regardless of the policies that Gulf states eventually pursue, financial constraints from lower hydrocarbon revenues and lower disbursements from sovereign wealth funds will eventually be reflected in lower wealth disbursements to citizens. Gulf states need to have an honest conversation with their citizens about financial constraints and the need to move away from lifelong high-wage public sector employment. As we discussed above, this has already led to  high rates of unemployment among young nationals. It will also be reflected in lower public sector wages and benefits or, if enacted, lower transfers through the UBI or social wage. 

Decisive action is needed now

Gulf economies face the prospect of lower global demand for hydrocarbons within the coming two decades. While some policymakers dismiss the warnings of peak oil demand as something they have heard before, the trends are real and Gulf countries will have to scramble to deal with the financial fallout when a tipping point is eventually reached. Yet, despite all the warning signs that a financial pinch is coming, real economic reforms have so far only taken place when Gulf countries have had no other choice. 

The poster child for diversification in the region is the Emirate of Dubai, where oil production peaked in 1991. Dubai developed its infrastructure and institutions and was able to establish itself as one of the most diverse and dynamic economies of the region. It has become a global hub for logistics, travel, finance, and tourism. Today, oil production accounts for only around 1 percent of its gross domestic product (GDP). 

It’s neighbor Bahrain has also nearly exhausted its oil reserves. Out of necessity, it has also made substantial progress, reforming its labor laws and opening up to foreign investment. Bahrain now allows full foreign ownership of businesses in several sectors including real estate, communication, and administrative services—sectors that had previously been restricted to investment by nationals.  

However, both Dubai and Bahrain continue to benefit indirectly from oil and natural gas revenues. A large share of their income comes from providing services to their neighbours. Dubai serves as a regional hub for global corporations and provides them with logistics, transportation, tourism, and financial services; Bahrain also provides tourism and financial services. In addition, both have been financially bailed out by their wealthier neighbours, Dubai in 2009 by Abu Dhabi during the global financial crisis and Bahrain in 2018 by Kuwait, Saudi Arabia and the UAE when oil production fell. This suggests that Oman, Saudi Arabia, Kuwait and the UAE need to undertake real economic reforms now in order to manage their own transitions. Within a decade, there might be no excess wealth left in the region to support their transitions or bail them out. Saudi Arabia appears to be taking this threat seriously and moving ahead with reforms at a rapid pace.

In the end, Gulf states must galvanize economic growth that is not dependent on government subsidies or revenues from oil and natural gas. In the past, reform efforts have been watered down by legacy policies and the vested interests that have emerged to protect them. There is early evidence to suggest that the most recent reform efforts are different. But these efforts continue to avoid undertaking major structural changes to deal with the influence of large public enterprises, expensive government bureaucracies, and an addiction to mega construction projects. Time is now of the essence. To move ahead, Gulf states will need to have open and honest discussions with their political bases and citizens about the constraints that they face in order to forge a new path forward.