Economic Research Forum (ERF)

The United Arab Emirates’ dilemma

As energy-producing economies strive to reduce their reliance on oil revenues, they must strike a balance between the competing demands of fiscal sustainability and steady growth of the non-energy sector. This column outlines how the United Arab Emirates is addressing this challenge.

In a nutshell

The UAE is the most diversified economy of the Gulf Cooperation Council countries, yet oil revenues remain an integral part of its fiscal budget.

The country has adopted long-range strategies to promote sustainable development of non-energy sectors and to reduce oil’s share in GDP.

Managing fiscal resources is pivotal to striking the necessary balance between non-energy growth and fiscal sustainability objectives.

After a four-year period of stability at around $105 per barrel, the collapse in oil prices since the second half of 2014 and the new ‘low for long’ oil price present big challenges for the world economy. The challenges of adjustment to the new norm are most formidable for the major oil exporters, such as the Gulf Cooperation Council (GCC) countries in which GDP, fiscal revenues and exports are heavily dominated by oil.

Even though the United Arab Emirates (UAE) is the most diversified oil-producing country in the GCC region, oil revenues remain an integral part of the fiscal budget. Accordingly, price volatility is crucial for setting policies to stabilise and promote economic growth, particularly in the non-energy sectors.

The UAE’s oil sector continues to account for over a third of real economic output, nearly half of export earnings and around 80% of total budget revenues. Even with strong growth in non-oil output, the non-oil sector still depends on oil revenues, which support government spending as well as liquidity in the banking system. Thus, changes in oil prices have forced initially massive fiscal consolidation and squeezed liquidity.

Long-range development strategies

As the adjustment has taken its toll in slowing non-energy growth, policies have focused on safeguarding non-energy growth and continuing on the path of further diversification of economic activity while laying the foundations for reforms to ensure fiscal sustainability and intergenerational equity.

To that end, the UAE has adopted long-range development strategies, such as Vision 2021, to promote sustainable development of non-energy sectors (targeted at 5% by 2021) and to reduce oil’s share in GDP to around 20% by 2021.

The UAE’s first response to the fall in the oil price was to undertake a comprehensive fiscal adjustment in 2015, reducing spending and raising non-energy revenues, amounting to 8.5% of non-oil GDP, to contain the fiscal deficit.

On the revenue side, the government raised electricity and water tariffs and removed fuel subsidies by moving to market-based pricing of gasoline and diesel. It also announced plans for mergers and consolidation in the public sector to cut costs and raise efficiency.

Fiscal adjustment is also underway through mobilisation of additional non-oil revenues. Plans for a value-added tax in the context of a GCC-wide initiative at a rate of 5% are underway, to be introduced in 2018, as well as an increase in excise taxes on tobacco and alcohol and a tax on soft drinks. While the reform strategy has paid off in terms of containing the fiscal deficit, spending cuts have included capital spending.

Together with a decline in investment sentiment, non-energy growth in the UAE has moderated since 2014. More recently, non-energy growth has shown signs of recovery, as the government has moderated the pace of fiscal consolidation and prioritised spending with a growth-conducive strategy. While non-oil GDP grew by only 2.7% in 2016, following an increase of 3.2% in 2015 and 4.6% in 2014, it is projected to recover to 3.1% in 2017.

The continued projected decline in government revenues

Against this backdrop, the UAE is facing a new challenge, given the continued projected decline in government revenues. On the one hand, sustaining the momentum of growth in the non-energy sector requires preserving priority government spending on infrastructure and development projects.

On the other hand, keeping the same level of spending that prevailed prior to the oil price drop would raise the need for financing with the ‘low for long’ oil revenues, which would produce a significant budget deficit. Hence the need to prioritise spending to restructure the fiscal budget, increase efficiency and mobilise the scope for generating non-energy revenues.

Simulation results illustrate that the reduction in government spending, to ensure fiscal sustainability and accommodate lower oil revenues, could reduce the momentum of growth in the non-energy sector, through different channels:

  • First, the reduction in financing infrastructure and capital projects would slow down investment that is necessary for private sector growth.
  • Second, public financing requirement through the domestic banking sector could shrink available financing to support private sector activity.
  • Third, in the context of the persistent low oil prices, decreasing public investments could discourage foreign direct investment, which could further slow non-energy growth.

Fiscal policy as an anchor for stabilisation

Empirical analysis using historical time-series data shows that UAE fiscal policy has mostly been pro-cyclical. More specifically, a rise in oil prices increases revenues and stimulates both government expenditures and non-energy growth, while a drop in oil prices decreases government spending and affects non-energy growth negatively.

Establishing a fiscal rule would help to decouple fiscal spending from volatility in the oil price. A non-energy growth target would set priorities for fiscal spending, such that the government does not react discretionally to volatility in the oil price.

Instead, savings would increase during an oil price boom, which could be tapped during episodes of low oil prices to ensure a steady stream of spending and attain the non-energy growth objective in line with Vision 2021 priorities.

Moreover, as oil prices could continue to be volatile, scenario analysis illustrates the role of discretionary fiscal policy, underpinned by fiscal rules, to mitigate the impact of volatility and sustain the growth momentum to attain the objective of 5% non-energy growth by 2021.

By establishing these fiscal rules and priorities for spending and sources of financing, fiscal policy would be an anchor for stabilisation in the face of continued oil price volatility. During episodes of higher oil prices, the speed of spending should not accelerate beyond what is necessary to attain the growth target, allowing for a build-up of fiscal surpluses that could support existing financial buffers.

The converse, however, requires tapping into these resources to sustain the growth momentum and avert a slowdown during episodes of low oil prices. This contrasts with an accommodating pro-cyclical fiscal stance that forces a massive reduction in spending in response to lower oil revenues at the expense of slowing non-energy growth.

On the contrary, the reduction in oil revenues would necessitate a countercyclical fiscal stance that requires a faster increase in government spending, capitalising on existing financial buffers, to hedge against the risk of slowdown and sustain the growth momentum despite lower energy price that could slow non-energy growth.

But a faster pace of government spending risks a wider fiscal deficit, which could be easily financed by tapping existing financial buffers that have been accumulated during the energy price boom.

The long-term vision

Fiscal priorities should target a long-term vision to insulate cyclicality in government spending from continued oil price volatility and tie spending to targeted growth objectives.

Over time, the support of government spending will decrease gradually as the economy continues on the path of increasing non-energy growth and contributions from private sector activity. In the near term, this amounts to a need to finance a small fiscal deficit given the persistent low oil price.

But the UAE will have options to diversify financing of the fiscal deficit, including by drawing down existing financial buffers and tapping international markets towards establishing the optimal pace of fiscal consolidation.

As energy-producing economies strive to reduce reliance on oil resources, managing fiscal resources remains pivotal to striking the necessary balance and paving the way for a bigger fiscal withdrawal as the economy sustains momentum to lay the foundations for bigger and sustainable contributions by private non-energy sectors.

Having achieved this balance, the need for fiscal stimulus will be gradually reduced over time regardless of the continued volatility of the oil price.

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