How the Middle East and North Africa can benefit from low oil prices

April 07, 2016 | Field Case Studies

By Shanta Devarajan | –

The Middle East and North Africa (MENA) is a region of extremes. It has the highest unemployment rate in the developing world, with the rate for women and young people double the average.  Its economies are among the least diversified, with the Herfindahl index—a measure of the concentration of exports in a few commodities—ranging between 0.6 and 1 for most countries. The region had the highest number of electricity cuts per month. The ratio of public- to private-sector workers is the highest in the world.  While, until recently, the region had been averaging 4-5 percent GDP growth, that average masked a highly volatile growth path.

These extreme outcomes are associated with policies in the region before 2014. MENA is home to 8 percent of the world’s population, 5 percent of its GDP—and 48 percent of the world’s energy subsidies.  These subsidies are an incentive to energy-intensive industries, which tend to have large, old firms.  These firms don’t create many jobs; small, young firms do. So the subsidy to energy acts as a tax on labor, contributing to the high unemployment rates. Energy subsidies also reduce the ability and incentive to maintain the grid, leading to chronic power cuts. Diesel subsidies give an incentive to farmers to pump water, contributing to MENA being the most water-scarce region in the world. Finally, fuel subsidies induce people to drive cars more often. Traffic congestion along eleven corridors in Cairo alone costs the Egyptian economy $2 billion a year in lost competitiveness.

In almost every MENA country, citizens working in the public sector are paid more than their private-sector counterparts. As a result, young people show a distinct preference for working in the public sector. In some of the Gulf Cooperation Council (GCC) countries, the government “tops up” the salary of citizens working in the private sector. Needless to say, with so many people working in the public sector at high wages, it is difficult to have a diversified private sector. Finally, growth is volatile because very few of these commodity-dependent countries have fiscal rules for managing price fluctuations. When the price of oil, say, rises, it is difficult for an oil exporter to resist the temptation to spend (and run fiscal deficits), which means that when the price falls, the countries have to tighten their belts and experience even slower growth.

Following the Arab Spring events of 2011, with oil prices high, governments of both oil-exporting and importing countries chose to increase subsidies and the public-sector wage bill, making the problems worse. Saudi Arabia’s welfare package included pay raises for government employees, new jobs, and loan forgiveness schemes worth $93 billion. Oil importers such as Tunisia and Egypt, buoyed by remittances and aid from oil-exporting countries, also raised subsidies and civil-service wages.  Among oil exporters, energy subsidies and high-wage public-sector employment are an extremely inefficient means of redistributing oil revenues to citizens. And oil importers, who rely on remittances and aid from oil exporting countries, have all the characteristics of a rentier state—without the resources.

The sharp drop in oil prices starting in mid-2014 is changing this picture. Almost every oil-exporting country is cutting subsidies in fuel, electricity, gas, and water. The United Arab Emirates has essentially eliminated fuel subsidies. Many are cutting public spending and some, like Algeria, are freezing public-sector hiring. Morocco and several GCC countries have introduced energy-efficiency improvements, lowering carbon emissions. Oil importers such as Morocco, Egypt, and Jordan, who started reforming subsidies in 2014, are shifting from a fixed domestic price of fuel to one that is tied to the world price.

In short, low oil prices are inducing substantial policy changes in MENA that will help the region overcome many of the problems it has been plagued with for a while. To be sure, these policy changes are only the beginning. To benefit even more from low oil prices, the countries in the region will need to move on at least three fronts: (i) substantial civil service reform, so the public sector is seen as accountable to citizens, which will in turn make citizens more comfortable with paying higher prices for public services; (ii) the adoption of fiscal rules that will permit smoothing of consumption through the inevitable price shocks; and (iii) for the oil exporters, consider more efficient ways of distributing oil revenues to citizens, possibly including the use of lump-sum transfers.

Shanta Devarajan is Chief Economist, Middle East and North Africa, at the World Bank.