Effect of Economic Diversification on the Future Macroeconomic Performance of UAE - Example

Macroeconomics project Name: Tutor: Course: Date: UAE Economic Background United Arab Emirates (UAE) has the second largest economy after Saudi Arabia in the Arab world. In 2014, its Gross Domestic Product (GDP) was AED 2.1 trillion ($570 billion) with increasing diversity to non-oil sectors. The GDP expanded in 2014 by 4.6 percent and the growth rate since 2000 stands at 4.82 percent (Trading economics, 2015). Over 85 percent of the country’s economy is reliant on oil revenues. The country also prides on a thriving services sector, expanding manufacturing base and massive construction boom. Manufacturing accounted for 42 percent of outputs, while restaurants (15 percent), wholesale and retail (16.5 percent) and transport and communication (23 percent) accounted for the total output. Unemployment rate ad inflation rate stood at 4.2 percent and 4.3 percent respectively while interest rates were at all time low at 1 percent in 2014. Exports decreased in 2014 to AED 1.3 trillion while imports increased to AED 880 million due to increase demand for stones, metals and pearls. Consumer spending reduced to AED 492 million while corporate tax rate stood at 55 percent in the same year. The country attracts investors by creating free trade zones with zero taxes and 100 percent foreign ownership (CIA, 2015). The long-term economic challenges in the country are growing inflation pressures and overreliance on expatriate workforce. Economic Indicators Forecast Overview The following data provides forecasts for various economic indicators of UAE for the year 2016. The figures are as shown in the table below. Table 1: Economic Indicators Forecast Indicators Actual Q4/15 Q1/16 Q2/16 Q3/16 GDP ($Billions)/ GDP per capita ($) 402/25,773 425/26,160 431/26,256 437/26,352 443/26,448 Labor force (millions)/Labor force by occupation (Agriculture%, Industry%, Services%)/ Labor force by participation 6.2/(7, 15, 78)/ 80 6.3/(7.1, 15.2, 80)/ 81 6.3//(7.1, 15.2, 80)/ 81 6.3//(7.1, 15.2, 80)/ 81 6.3//(7.1, 15.2, 80)/ 81 Unemployment rate (%) 4.2 4.24 4.25 4.2 4.3 Consumer Price Index 127.58 128 129 130 130 Gross investment (Billions)/Budget (% of GDP)/Public Debt (to GDP)/Income distribution (Gini Index-not provided) 28.5/5/15.68/ 32.5/-0.8/17.84 32.9/-0.5/19.65 33.4/0.8/19.47 33.8/1/19.28 Industrial production (PMI)/ Electricity Production (kWh-trillion)/ Consumption (kWh/person) 54/99.1/15.1 55/100/15.3 54.8/100/15.3 56/100/15.3 54.88/100/15.3 Export(AED trillions)/Import value (AED Billions)/Exchange rate (Against $US) 1.36/880/3.62 1.35/895/3.5 1.34/891/3.5 1.32/888/3.5 1.41/885/ 3.5 From the table above, UAE experiences a steady growth in its GDP and its per capita income in 2016. Labor force participation is also expected to increase with more involvement in the services sector compared to industry and agriculture. Unemployment rate is anticipated to stabilize at 4.2 percent in 2016 while consumer prices of commodities are expected to go up. Gross investment is expected to rise at $28 billion to $33 billion in 2016. Although income distribution figures are not provided, the distribution of income is normal with large segment of the population accessible to basic amenities. Industrial production is stable especially in mining, heavy manufacturing and processing. Electricity production is high and its consumption per individual is stable at 15,000 kWh. UAE exports are at AED 1.36 trillion while its imports stand at AED 885 billion. However, the exchange rate against the US dollar will be expected to fluctuate at AED3.5 to AED 3.6 depending on the performance of US economy. Economic Challenges facing UAE Economic diversification UAE has a long-term strategy to diversify to non-oil sectors through innovation. Despite reducing oil prices, the country is posting a 3.1 percent rise in the GDP in 2015 mainly due to new dependence on non-oil sector development. Compared to advanced and emerging economies, UAE has one of the highest economic growth rates even when forecasted for 2016. Kane (2015) argues that UAE and others in the Gulf Cooperation Council (GCC) have learned that overdependence on hydrocarbons such as oil and gas will be detrimental to the economy during economic crises and falling global prices of oil. Economic diversification model is geared to upset macroeconomic imbalance, stabilize price volatilities and reduce dependence on hydrocarbons. Shediac et al (2013) argues that despite economic diversification is the road to sustainable development, non-oil sectors of the UAE economy still has pervasive structural gaps and is not fully matured. For example, the country still experience gaps in technology, knowledge, capital and inefficiencies in labor. This implies that the revenue from oil are still be used to fund local economies instead of external economies that contribute to net export of services and goods. The economic diversification is as shown in the figure below. (Source: Shediac et al. 2013, p. 3) Figure 1: Economic diversification of UAE However, the relative improvement in the non-oil sectors in the UAE confirms that efforts to diversify into part and harbors, real estate, travel and tourism, and hospitality sectors. Unlike Norway and Canada with oil and gas reserves and productive economic sectors, UAE lacks Foreign Direct Investments in various countries which would have eased economic concentration in the hydrocarbon sector. Despite being economically diverse in the GCC, UAE faces a challenge of dominating other sectors of the economy. Effects of falling oil prices Falling oil prices could predict a major disaster for UAE as it impacts on its sovereign wealth fund holdings and erodes domestic energy consumption subsidies. Al-Khateeb (2015) observes that future generations and current youth will suffer mass employment as the economy shrinks from dependence on oil revenues. With increasing fiscal budget deficits and reduction of sovereign wealth funds, UAE may experience a rapid collapse due to falling strength of the AED against the dollar. Ordinarily, it is expected that fall in oil prices sparks economic growth, but to oil exporters the fiscal and external balances are weakened. This will cause the current account surpluses to disappear and short term cuts in government spending. Despite these reductions, the government still has substantial built up in foreign reserves and sovereign wealth funds that makes it profitable for a number of years. Unlike GCC countries like Egypt, Morocco and Tunisia, UAE can increase its budgetary spending by reducing foreign reserves or liquidating its assets. For example, UAE has about 7 sovereign wealth funds and has options of investing in the private sector and Treasury bond markets. Moreover, the country is able to avoid budget deficits by deregulating transport fuel prices and economic diversification to limit dependence on oil prices (Shayah, 2015). Other measures taken are increased traffic fines, local government administration and increase indirect taxes on expatriate visas. Not only has a falling oil price affected sovereign wealth funds and budgetary but also caused a dip in Foreign Direct Investments (FDIs) abroad. This has been affected by growth of ISIS, terror attack on tourists and Mosque bombings. Fall in oil prices in the UAE has eroded investor confidence and affected property prices. Financing Budget Deficit in times of falling oil prices Financing budget deficits from fall in oil prices is a tall order for UAE especially when the country’s Abu Dhabi Commercial Bank failed to close a bond in 2015. While oil importers signal relief on reduced oil prices, UAE is suffering a liquidity squeeze forcing it to lean on local lenders through raising new debt and withdrawal of deposits. Kerr (2015) intimates that UAE’s government deposits have declined by $13.6 billion and have had to borrow from local banks or raid savings to sustain its spending programs. The trend in oil prices of UAE and other GCC countries is as shown in the graph below. (Source: Haque, 2014, p. 4) Figure 2: Break-even oil prices in the GCC This means that the country will create budget deficits from debt capital markets as a result, the interest rates will rise and liquidity will tighten. For example, in 2015, the UAE banks have issued $7.5 billion to the government to finance public spending. Consequently, the UAE government will cut spending on subsidies and salaries due to deep cuts on capital expenditure; hence placing undue pressure on social contracts with its citizens. Fiscal reforms will be necessary such as subsidy reform and introduction of taxes in the wake of curtailing debt and reducing budget deficits. Dokoupil (2014) observes that with economic slump in Europe, external deficits from cheaper oil will likely benefit weak Arab economies and other poor countries from lowered prices than from grants and loans. As budget deficits increase, sale of assets will be necessary in short and medium term. Falling prices of oil makes the country vulnerable because more debt is used in state spending as a way of easing social tensions. Population, Local skilled labor, Emiratization UAE has a population of 4.7 million people (2009 estimates) with an annual population growth rate of 4.1 percent (CIA, 2009). However, there is an increased concern over the rising number of expatriate families which currently account for 80 percent of the population with Emiratis comprising 20 percent of the population (Mustafa & Mansour, 2013). Despite the Emiratis outnumbering the expatriates in the retirement age group (65+), the population is still skewed to the youth. (Source: Gallacher, 2010, p. 13) Figure 3: UAE population distribution The country expects a rise in population to 20,000 Emiratis accessing employment annually. The demand for jobs is skewed towards the youth, the population growth in expected more in Sharjah, Dubai and Abu Dhabi. Currently, 50 percent of the workforce is from India, followed Pakistan and Indonesia. In 1999, Sheikh Sayeed decreed that creation of job opportunities for UAE nationals through federal and human resource policies that favor Emiratization (Kantaria, 2012). These policies were aimed at reducing dependence on expatriate labor and seize opportunity of participation of its citizens in labor market especially in Commercial companies and financial sector. For example, all banks were prevailed to employ Emiratis as managers in all banks through a quota system. Although the government preferred UAE nationals for most of the jobs in public and financial sector, Al-Ali (2012) agrees that private companies continued to hire unskilled and skilled expatriates. Emiratis are not only expensive and less productive but also under-skilled and less motivated. While the law required employment of Emiratis only in the secretarial and Human Resources department, the Levy payroll and Emiratization fees were imposed on illegal hiring of expatriates (Kantaria, 2012). The government realized that continued dependence on expatriate labor leads to cultural loss, security and national identity as the country diversifies from oil dependence. Unemployment Trading Economics (2015) shows that UAE unemployment rate is 4.2 percent and is expected to stabilize at 4.3 percent in 2016. Human resource policies that foster Emiratization and diversification seeks to incorporate the UAE nationals in every sector of the economy. Mustafa and Mansour (2013) observe that population imbalance with presence of more expatriates than locals pose not only challenges of knowledge and skills but also security, political, social and economic challenges. Lack of local expertise on many development and infrastructural projects requires expatriate labor attracted to high standards of living and lucrative job offers. While expatriates were previously regard as a boiling pot of cultures, the move towards knowledge economy, intentions of government leaders to economic diversification, highly sophisticated globalized private sector and unemployment of UAE youths exacerbated the situation. The private sector is constrained on recruiting and paying the locals who expect lucrative fringe benefits and high salaries at the expense of cheap expatriate labor. Worse still, wealthy expatriates are now hiring cooks, drivers, house maids and house laborers creating more demand for expatriate expertise and labor. As the economy diversifies and lacking qualified local personnel, the UAE is seeking labor from Arab sister states to build infrastructure and build institutions. Increasing unemployment among locals is due to their deficiency in skills and knowledge base in areas such as sports, education, and medicine, management and administration. Mansour and Alshahin (2008) observe that in a meeting of GCC ministers of labor, the serious debacles facing the nations were manpower localization, unemployment and population imbalance. Slow economic growth Economic stability is slowly coming to the UAE due to recovery in transport and trade, resurgence in tourism, increased government spending and high oil prices. The policy of diversification is to increase the contribution of non-oil sectors to more than 70 percent of the GDP. The centrality of population imbalance has been seen as the reason behind security challenges, unemployment and slow growth in some economic sectors. Although the government is committed to employing nationals in the public sector, the private sector still rely on expatriates leading to structural unemployment. However, Forstenlechner and Rutledge (2011) warn that the ambitious plans of the government in ‘localizing labor or Emiratization’ away from unskilled and skilled expatriate labor will lead to collapse of tourism-oriented and knowledge-based economy. As the issues of national identity and security override labor efficiency questions, the ramifications will be felt in the growth and stability of the economically diversified sectors. The 2007-2010 economic crisis affected UAE with many firms being bailed out by oil wealth in Abu Dhabi. Despite the country reducing dependence on oil, building international finance and world class tourism takes time. The oil sector prices may take long to rise and stabilize even as the country depends more on food imports and machinery equipments due to limited of diversity of growth paths. Despite these challenges, the government is involved in short-run stabilization policies to spark aggregate demand and offset reductions in consumer expenditure. Income distribution/Education Income is evenly distributed among UAE citizens despite poor compensation of unskilled labor. On the contrary, skilled foreign workers are well remunerated and poor citizens depend on welfare state. UAE nationals (about 90 percent) have access to sanitation, health services and clean water. Compared to the other states, Emiratis in Dubai and Abu Dhabi enjoy higher incomes yet poor states receive subsidies. Although literacy rates are high at 90 percent with more for females (94 percent) than that of males (86 percent) gender parity remains high in the secondary and primary levels of learning (Euromonitor, 2015). The presence of expatriate families is inflating the ranks of UAE households who are enjoying high disposable income. This leads to skewness in income distribution away from the one shown in the chart below. Figure 4: Monthly Income distribution of UAE households (2012) Even though UAE nationals enjoy high disposable incomes, steeped housing costs and unequal access to medical services, communications and health goods among the poorest segment of the population remains a challenge (Euromonitor, 2015). Inflation and Exchange rate UAE’s inflation rate peaked in 2008 at 12.5 percent but gradually reduced to 4.3 percent in 2015 (Arabian, 2015). On the other hand, the exchange rate stood at AED3.6 against the US dollar. To fix inflation, the government of UAE can manage the exchange rate, interest rates or monetary policy of free capital flows. However, the government can use interest rate as it cannot set its own rates because appreciation in the rates affects foreign investors with stable exchange rates. This means that when the federal government raises interest rates, the Central Bank of UAE also does the same. Although the US and UK can use interest rates to reduce consumption and expenditure, Bouyamourn (2015) argues that UAE may not use it to stoke or reduce inflation. Moreover, consumer debt will be less attractive and more expensive with many projects in a high interest rate and positive net present value environment falling. The government reduces lending by demanding high-quality capital and high levels of cash on balance sheets of banks. Nonetheless, UAE is an open economy with less control on monetary policies to reduce inflation or increase subsidies. Foreign Direct Investment (FDI) Inflows of Foreign Direct Investment are facilitated by a closely integrated UAE economy into those of Arab world in terms of multilateral and bilateral cooperation agreements. In 2014, a new competition law came into effect as a means of updating legislations and updating reforms. According to UAEInteract (2015), the new law exploits intellectual property rights and regulates economic activities in a knowledge-based economy. UAE in 2013 benefited from inwards FDIs of $10.5 billion and pumped $2.95 billion in the global market. With assets to the tune of $733 billion and extensive sovereign wealth funds, UAE can maintain and secure the welfare and future of Emiratis. Infrastructure UAE has one of the most developed infrastructures in the world driven by Vision 2021 National Agenda and Vision 2030. The country is spending $8.2 billion to build infrastructure such as railways, ports, roads, airports and telecommunications (UAEInteract, 2015). This growth in infrastructure has enabled development business and economic growth by linking Etihad rail network of 1,200km. Moreover, the road network is linking population centers and major transportation centers. Although congestion and traffic jams have hampered trade and cross-border transaction in neighboring countries such as Saudi Arabia and Oman, more has been done on road network expansion. Not only is infrastructure about transportation but also on telecommunications which is contributing about 5.3 percent of the GDP (Prospect Group, 2015). As the country boasts of 7 international airports, the emirate of Dubai has leveraged Etihad and Emirates airlines to drive economic growth. The aviation industry provide more than 250,000 jobs (19% of all employment), and$22 billion to the GDP (Prospect Group, 2015). Besides, the fiber connectivity is a key enable and driver of economic growth due to faster broadband and infrastructural capabilities. Conversely, the timid investor sentiment and lack of liquidity has impacted on some of the infrastructural development projects in the UAE such as real estate and delayed infrastructural project development. Volume of trade UAE has been trading primarily with Asian countries (67% of trade) with India being the largest trading partner. The reason is that India has been in close contact with the Middle East for centuries. Although it trades with Germany, UK and US, the country’s trade is predominant in Asian markets. While most of the imports are from US, UK, France, Italy and South Korea, majority of the exports end up in Thailand, Kuwait, Saudi Arabia and Canada. The volume of trade of UAE with other countries is as shown in the table below. Table 2: UAE Volume of trade with Asian countries (Source: Kumar, 2013) In 2009-2011, the total imports from Asian countries were $140 billion while exports and re-exports were $26 billion and $ 38billion respectively. (Source: www.uaestatistics.gov.ae) Figure 5: UAE’s imports from other countries in 2009 Leading imports are plastics, base metals, machinery appliances and footwear and exports include base metals, textiles and articles as well as plastics and related articles. With progress in logistical operations and development of free trade zones with zero taxes, Kumar (2013) notes that UAE is now a hub of global and regional trade, and also a linchpin of economic interaction of Middle East and Asian economies. UAE is forecasted to import more electrical and telecommunications equipments in the next five years. Recommendations The following recommendations are made for UAE to consider in the wake of falling oil prices; a) Leverage on technology, knowledge, capital and inefficiencies in labor to venture into tourism, telecommunications and financial sectors to reduce dependence on oil revenues b) Increase the level of security to protect investments from attacks such as ISIS and terror attack on tourists c) Deregulate transport fuel prices and economic diversification by introducing fines and levies on imported goods d) Promote good workmanship and industriousness among local population to reduce dependence on expatriate labor e) Reduce lending by demanding high-quality capital and high levels of cash on balance sheets of banks f) Increase social program spending by raising government expenditures without affecting interest rates g) Inject more FDIs to Arabian nations and utilize sovereign wealth funds in developed countries to create and attract more capital inflows h) Spend more on infrastructure especially ports and airports to attract more tourists and visitors to the country i) Limit budget deficits and borrowing from commercial banks at 40 percent and instead raise money from sovereign bonds Conclusion This essay investigated the effect of structural transformation and economic diversification on the future macroeconomic performance of UAE. The study found that the country has diversified into tourism and real estate sectors but the economy is still reliant on the oil revenues. Although UAE takes pride in advanced infrastructure, free trade policies and high standard of living, the government is still concerned on security and cultural identity of the nation that is dominated by expatriate labor. The growth and stability of the population is paying off as the nationals are enjoying better incomes from public employment. The challenges of increasing budget deficits due to the economic crisis have been subdued by disposal of sovereign wealth funds and short-term borrowing from commercial banks. The UAE is capping on interest to control interest but to a limited extent. Even as the per capita income is rising, the country is benefiting from increased trade with major Asian partners that are likely to increase the country’s GDP, investment, and labor force participation. Reference list Al-Ali, J.A. (2012). 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