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Diversification opportunity wasted

b66ca0aa25_soveSalim Al Aufi, Oman’s undersecretary for oil and gas, likens attempts to cut the reliance on oil during a price slump to acting “with a gun pointed at your head.”

If you have to make decisions under pressure, “you will probably make the wrong ones,” he said March 3 in Muscat during a panel discussion on the impact of the oil shock. Oman relied too much on revenue from crude exports when prices were high, he said.

Oman isn’t alone. Most Gulf Arab nations did little to create alternative sources of revenue during the decade-long spending spree that filled their cities with glittering towers and trophy projects such as man-made islands. They may have missed their best chance to break out of the dependency trap, as Malaysia and Mexico did.

 The region’s monarchies amassed trillions of dollars in reserves and sovereign wealth funds that acquired stakes in companies from Barclays Plc to General Electric Co. A prolonged drop in prices will erode their fiscal buffers and may force them to change spending strategies, according to Moody’s Investors Service and HSBC Holdings Plc. Rulers seeking to ward off any repeat of the unrest that toppled several Arab regimes in 2011 will have less revenue to distribute among fast-growing populations.

“At $60 a barrel, the old model of generating economic growth through ever higher levels of public expenditure just can’t be sustained,” Simon Williams, chief economist for central and eastern Europe and the Middle East at HSBC, said in a phone interview. “Deficits will rise, spending growth will fall and the economies will slow.” Brent crude prices have tumbled almost 50 percent since June to about $58 on Thursday.

The six-nation Gulf Cooperation Council will post a combined budget deficit of more than 6 percent of gross domestic product this year, compared with surpluses that regularly exceeded 10 percent in recent years, International Monetary Fund data show. Growth will slow to 3.4 percent from 3.7 percent in 2014.

Turbulence in the Middle East makes sweeping changes in economic policy harder. The GCC nations, key U.S. allies, are struggling to contain the influence of Iran and face new threats from the rise of Islamic State in Syria and Iraq.

“Regimes like this tend to be risk-averse, and the regional political environment is potentially too nerve-wracking for governments to take urgent action,” said Crispin Hawes, managing director of research firm Teneo Intelligence in London. “The environment is never quite stable enough to allow for deep structural reforms.”

Governments responded to the Arab Spring by boosting spending on public-sector wages, subsidies and defense. Investments focused on infrastructure, and mostly didn’t create alternative sources of foreign currency, according to an IMF study in December. Oil still accounts for almost 90 percent of revenue in Saudi Arabia, the world’s biggest exporter.

Reducing reliance on oil is “very difficult,” and typically depends on policies put in place before revenue is hit by a price shock, the IMF said. It cited Malaysia, Indonesia and Mexico among countries that have succeeded.

Exceptions include Dubai, home to the region’s biggest airline and financial center, though its model may be difficult for other Gulf nations to replicate.

Most GCC countries “have not diversified their economies significantly,” Hawes said. “You can pretend that private sector growth is an indication of real diversification, but in most cases it’s not. It’s a function of public sector spending, whether through salaries or infrastructure investment.”

For equity investors, the result is that Gulf markets have become more like a proxy for oil since the slump.

It’s a “noticeable shift,” said Simon Kitchen, a strategist at EFG-Hermes, a Cairo-based investment bank.

Investors are “much more conscious now of oil prices than before,” Kitchen said by phone. Before the decline gathered pace, “the correlation between these markets and oil prices was negative,” he said. “It almost felt like oil fell into the background.”

Now it’s in the foreground. In the last quarter of 2014, the Bloomberg GCC 200 Index fell 18 percent, the biggest quarterly drop since 2008, and almost four times the decline on the MSCI Emerging Market Index in the same period.

Standard & Poor’s last month cut the credit rating of Oman and Bahrain. It changed Saudi Arabia’s outlook to negative and said the kingdom could lose its AA- rating, the fourth-highest debt grade, in two years if there’s a decline in the country’s “liquid assets” or fiscal position.

The Gulf nations point to the expansion of their non-oil economies over the past decade. The IMF study acknowledged that growth and also drew attention to its limits.

“The share of non-hydrocarbons output in GDP has increased steadily, but is highly correlated with oil prices,” the Fund said. “Progress with export diversification, a key ingredient to sustainable growth, has been more limited.”

The main exception is the United Arab Emirates, where Dubai has bucked the trend by developing exports of services and manufacturing outside the chemicals industry, transforming itself into a modern economy, the IMF said.

Dubai’s success can’t be a direct model for Gulf peers, though, because there’s only room for one regional hub in the areas where it excels, according to Jim Krane, author of “Dubai: City of Gold” and a research fellow at Rice University’s Baker Institute for Public Policy in Houston.

“Dubai leveraged first-mover advantage in airlines, financial services and shipping, even light manufacturing,” Krane said. Other governments “have to find a sector that Dubai hasn’t already claimed.”

The IMF recommends steps to encourage exports and manufacturing, and cutting energy subsidies and government jobs that act as a deterrent to entrepreneurship.

That won’t be easy. Kuwait raised the cost of diesel and kerosene in January, only to roll back some of the increase a month later after domestic opposition. The backlash was expected, Finance Minister Anas Al-Saleh said.

“We are doing it in a prudent manner,” he said. Saudi Arabia has yet to take the plunge.

“Saudi companies can adapt to reasonable energy prices in the kingdom but they will have to reduce their operating costs, such as labor, and be more efficient,” Mutlaq Al Morished, chief executive office of National Industrialization Co., which has a market capitalization of 18 billion riyals ($4.8 billion), said in his office in Riyadh.

Oil Rebound?

An oil rebound could yet rescue Gulf economies from the dilemma. Some energy revenue also comes from long-term contracts, making countries such as Qatar, the world’s top exporter of liquefied natural gas, less vulnerable.

High oil prices have been “a blessing and a curse,” Hatem Al-Shanfari, a member of the board of governors of Oman’s central bank, said in an interview in Muscat.

“We have made a lot of progress on the social indicators because of oil spending,” Al-Shanfari said. The downside: “We became so addicted to it that we are not far away from where we started many decades ago.”-Bloomberg