In a nutshell
All the GCC countries have undertaken significant fiscal reforms to adjust to the ‘new normal’ of oil prices, to reduce their dependence on oil revenues and to sustain the momentum of growth of the non-energy sectors of their economies.
Fiscal sustainability requires careful management of public finances and diversifying sources of financing, in coordination with monetary policy, to ensure debt sustainability and continue the course of economic diversification and higher non-energy growth.
Fiscal management should be budgeted on the basis of a realistic breakeven oil price, with clear contingency plans to safeguard priority spending in the face of oil price volatility and to diversify sources of financing to ensure higher growth and fiscal sustainability.
Over the past decade, the countries of the Gulf Cooperation Council (GCC) have enjoyed large external and fiscal surpluses as well as rapid economic expansion on the back of booming oil prices. But with oil prices plunging in recent years, external and fiscal surpluses have turned into deficits and growth has slowed, raising concerns about fiscal sustainability and its implications for macroeconomic stability.
Despite the long-range economic and social development strategies adopted by all GCC countries to promote sustainable development in the non-hydrocarbon sector, oil prices remain the main driver of economic growth in the region. The hydrocarbon sector continues to account for over a half of real economic output, and over 70% of budget revenues and export earnings in most of those countries.
The oil price shock propagates into the macroeconomy through a decline in government spending and slower growth of monetary aggregates, liquidity, deposits and credit, adding further challenges to the diversification strategies of oil-dependent economies.
Adjusting to the ‘new normal’ of oil prices
In an effort to sustain the move of economic activity away from oil, all GCC countries have undertaken significant fiscal reforms since 2015. These include subsidy cuts and lower public spending.
The GCC countries are also continuing fiscal adjustments through mobilisation of additional non-oil revenues, especially the implementation of a value-added tax (VAT) at a rate of 5% in the United Arab Emirates and Saudi Arabia since January 2018, to support government budgets. The pace of fiscal consolidation has been too fast in some cases, at the cost of slowing down non-energy growth and plans for further economic diversification.
Nevertheless, as the medium-term horizon looks more challenging for the oil market, GCC governments need to strike the right balance between the short-term priorities of containing the budget deficit and ensuring fiscal sustainability, and medium-term objectives of ensuring adequate government spending on priorities to support non-energy growth towards achieving further diversification of the economy.
Sustaining diversification efforts requires that GCC governments continue to play a leading role in fostering confidence and prioritising spending in support of further development and private non-energy growth. To that end, priorities for fiscal reforms should be established to increase the efficiency of government spending and safeguard valuable resources for priority spending on development and infrastructure.
In parallel, and to avoid potential crowding out of private activity, diversification of sources of financing is necessary to reduce dependence on domestic financing, particularly from the banking sector, and drawing down government deposits with negative effects on available liquidity for private sector lending.
Diversifying sources of financing
To achieve their visions, the GCC countries could mobilise other sources of financing, such as using existing financial buffers accumulated during periods of high oil prices, and issuing more domestic and foreign debt.
But even if government debt stocks remain low by international standards, a persistent fiscal deficit, coupled with a shrinking surplus or a larger deficit of the external current account as a percentage of GDP, could cause a rapid rise in debt stocks in the short run. This might jeopardise fiscal sustainability and macroeconomic stability.
Hence, debt financing should be supporting spending that maximises the impact on growth and helps to ensure debt sustainability in the near term as the economies continue on a path of further diversification to reduce dependence on oil resources and the need for continued large government spending to support growth.
Diversification of sources of financing requires careful macroeconomic management. Rising public debt could have adverse effects on economic growth if it crowds out private activity and shakes investors’ confidence.
Moreover, managing external debt is a high priority in the region since most countries, except for Kuwait, peg their domestic currencies to the US dollar. Sustaining the stability of the peg requires adequate international reserves to meet external liabilities and stem speculative attacks on the peg.
But maintaining the stability of the peg has proven to be costly for economies that seek to diversify and reduce their continued dependence on oil revenues. Specifically, the direction of US monetary policy has been going against the economic cycle that has slowed down with the oil price in the GCC countries.
Hence, fiscal policies should continue to play a bigger countercyclical role, while safeguarding fiscal sustainability. The GCC countries cannot afford continued pro-cyclicality of fiscal policy – that is, a sharp fiscal consolidation – in line with the decline in oil revenues, which has exacerbated the economic cycle and prolonged economic slowdown.
Therefore, fiscal reforms and diversifying sources of financing are necessary to increase the space for countercyclical fiscal policy to respond to unforeseen shocks from the global economy and continued volatility of oil prices. In parallel, coordination between fiscal and monetary policies is necessary for domestic liquidity management and issuance of debt towards sustaining the course of economic diversification and higher non-energy growth.
The ultimate goal is to safeguard priority spending and ensure adequate liquidity in support of private sector activity and non-energy growth.
Ensuring fiscal sustainability
As higher oil prices have historically helped to sustain higher fiscal primary balances in the GCC countries, the ‘new normal’ of a ‘low for long’ oil price coupled with high oil price volatility does not bode well for sustained improvement in the primary fiscal balances. This warrants additional efforts to prioritise and diversify revenues towards more fiscal consolidation, without compromising non-energy growth objectives.
To that end, low oil prices provide an opportunity to press ahead with energy subsidy reforms, to increase efficiency and to reduce unproductive spending, in order to increase the fiscal primary balance and ensure debt sustainability despite the need to issue more debt to finance the deficit and safeguard priority spending.
Enduring fiscal deficits in the near term are not a problem, but managing and financing those deficits without compromising non-energy growth and debt sustainability objectives are the key challenge.
Our empirical research has focused on evaluating the long-run sustainability of GCC public finances by estimating a ‘reaction function’ of the government’s primary balance to determine whether the authorities are pursuing appropriate policies to avert excessive debt accumulation, rein in the deficit and reform public finances.
The main finding reveals that the primary balance is not affected only by the oil price but also by oil price volatility. High volatility makes it difficult to sustain a stable stream of revenues in the budget in support of a higher primary balance as well as to adjust spending plans to oil revenues, particularly for oil-exporting countries with a high share of oil revenues in the budget.
Moreover, our results show that GCC countries are still running a sustainable fiscal policy and that public finances have improved in response to recent fiscal adjustments and reforms. The evidence illustrates that the issuance of debt, which has been accelerated in the wake of the ‘low for long’ oil price to diversify sources of financing, has been coupled with a higher drive for fiscal consolidation to increase the primary balance and render the public debt sustainable over time.
But national experiences differ considerably, especially given variation in the fiscal breakeven prices against the ‘new normal’ of low oil prices.
Overall, by diversifying the sources of funding their budgets, sustaining growth momentum and pressing ahead with necessary reforms to increase the primary fiscal balance, GCC countries can reduce the risks of entering a vicious cycle of low non-energy growth and unsustainable debt.
To that end, by enforcing better management and prioritisation of expenditure outlays, as well as diversifying sources of non-energy revenues in the budget, GCC governments stand a good chance of overcoming the near-term challenges of adjusting to ‘low for long’ oil prices while building their capacities to afford more investments and diversify their economies.
Sustaining the momentum of non-energy growth would reduce the dependence of GCC countries on oil revenues and fiscal spending in the medium term, create greater scope for private sector participation in economic activity, and increase the prospects of further diversification away from long dependence on oil price volatility and its adverse implications for the fiscal budget and economic cycles.