August 8, 2008

Economic Diversification

A strong, sustainable economy enhances a nation’s standard of living, creates wealth and jobs, encourages the development of new knowledge and technology, and helps ensure a stable political climate. Economic diversity across a wide range of profitable sectors and sustainability are intrinsically linked, and are key to a sustainable economy – found a new study by Booz & Company. Economic diversification can also reduce a nation’s economic volatility and increase its real activity performance.

Studying Sustainable Development: Can Diversification Drive Sustainability?
Many Gulf Cooperation Council (GCC) countries are “transforming” their economies from being based on a single commodity to being robust, diversified ones. “Hydrocarbon rich GCC countries, with economies heavily dependent on oil and gas, face sizeable challenges in diversifying. It is therefore very important to highlight the need to create sustainable economies,” explained Rabih Abouchakra, a Principal with Booz & Company.
In evaluating economic diversification and subsequent sustainability, the study compared GCC economies, G7 economies, and transformation economies (Hong Kong, Ireland, New Zealand, Norway, Singapore, and South Korea).
Evaluating Economic Diversification
Three key findings were established during the analysis of economic diversification.
1.      Gross Domestic Product (GDP) should be distributed across sectors
Economic concentration and diversification was assessed by analyzing whether GDP was distributed across a wide variety of economic sectors – or across a few. This evaluation determines a “concentration ratio” and a “diversification quotient.” Concentration ratio measures a nation’s concentration in a given sector, while the diversification quotient is the inverse of the concentration ratio, providing an innovative metric that policymakers can use to gauge economic diversity. The lower the concentration ratio and the higher the diversification quotient,  the more diversified a nation’s economy.
“GCC countries have the high­est concentrations in terms of sector contribution to GDP and thus the lowest diversification quotients due to the historic dominance by the oil and gas sector,” Abouchakra said. 
Growth in non-oil sectors reflects spillover effects from increased oil receipts and subsequent record-high inflows of capital. These cannot be considered inherently sustainable because of dependency on the dominant sector’s fortunes in the marketplace.
“GCC countries’ non-oil sectors have not fully matured and still have pervasive structural gaps,” commented Richard Shediac, a Vice President with Booz & Company. This suggests revenues from oil and gas are not being reinvested effectively in GCC countries, but instead are being used to fund nations’ internal (i.e. local) economies, rather than external ones.
An economy therefore with a strong foundation in export helps insulate against unexpected changes in the domestic economy and insulates against volatility of oil and gas prices and the subsequent knock-on effects.
2.      Concentration is not inevitable in hydrocarbon-rich economies
Many GCC economies, especially larger ones, have been susceptible to such changes in oil prices. In KSA, GDP growth has been driven by the oil and gas sector, but has varied over the years due to oil price changes and shocks. Growth in non-oil sectors has also varied due to fluctuations in oil prices. This suggests “contagion effects” – the tendency of failure in one economic or financial arena to spill over into other arenas.
The UAE’s GDP growth has been driven mainly by the oil and gas sector. “The UAE however, has recently experienced relative improvement in non-oil sectors as a result of Dubai’s efforts toward economic diversification,” said Chadi N. Moujaes, a Principal with Booz & Company. Only 5 percent of Dubai’s GDP came from the oil and gas sector in 2005. In neighboring Abu Dhabi, the Emirate drew 59 percent of its 2005 GDP from oil and gas, and growth in non-oil sectors continues to lag.
Being hydrocarbon-rich does not predestine economic concentration. Sustained, robust policies focused on diversification can make large differences in an economy, and nations rich in any single commodity must be particularly attentive to the issue of diversification to avoid a natural tendency toward economic concentration. “Beyond the need of building a solid economic base that would endure after natural resources expire, economic diversification is key to shielding domestic economies from underpinning and relatively uncontrollable risk factors related to global demand and supply shocks” said Dr. Mazen Ramsay Najjar, an associate with Booz & Company.
3.      Labor distribution should support growth
Employment distribution generally reflects and shapes GDP distribution across sectors. In the GCC, employment is distributed unevenly, compared to G7 and transformation economies with employment balanced across a variety of profitable sectors. The oil and gas sector, producing 47 percent of GCC countries’ GDP, provides work for only 1 percent of the employed population, with the majority of the workforce employed in sectors relatively less economically productive and of secondary strategic importance.
“Government services constitute around 20 percent of total GCC employment, while a majority of workers are laboring for the support of other economic sectors, rather than driving growth themselves, which can lead to economic difficulties,” explained Abouchakra.
Evaluating Economic Sustainability
Measuring the relationship between economic diversification and sustainability highlighted a statistically significant relationship between the two. A collection of analyses measuring productivity and competitiveness and the relation of economic volatility to concentration, employment, and economic performance, resulted in a number of key findings:
Poor economic diversity is linked to low productivity and competitiveness
Productivity is directly related to competitiveness; the more people and/or capital it takes to do a job or create a product, the lower productivity is, which in turn raises the product’s price and lowers its potential for competition in the marketplace. GDP labor productivity in GCC countries in 2005 was US$1.6 million per employee for the oil and gas sector but only US$9,300 per employee for construction. GDP-to-credit capital productivity was US$121 million per unit of credit for the oil and gas sector but only US$1.2 million for construction.
Labor and capital productivity are key measures of sustainable economic development. “Poor economic diversification – the over reliance on a single dominant economic sector – has an unfavorable effect on the productivity and competitiveness of other lagging sectors,” commented Moujaes.
Underperformance is persistent across GCC economies and productive sectors. Even in the oil and gas sector, GCC output per employee remains low, suggesting inefficiencies, or less-than-ideal production processes. The achieved gains in labor and capital productivities have mostly been visible in the oil and gas sectors and limited in others.
High economic concentration leads to volatile growth and fluctuating economic cycles
High economic concentration makes an economy vulnerable to events like price changes in the dominant commodity. Price shocks have resulted in fluctuating business cycles, as economies respond to rises and dips in the price of oil and the spillover of volatility from oil to non-oil sectors. This sensitivity is manifest in all sectors that contribute to the bulk of economic output and employ­ment.
“A high level of volatility hinders sustainable economic growth, because periods of prosperity generally do not fully offset the negative structural effects of bad times. Economic shocks have a long-lasting negative effect,” stated Shediac.
Volatility in concentrated economies may spawn structural unemployment issues and engenders systemic risks
Elevated volatility in GCC countries is highest in economic sectors that employ most of those nations’ populations. High volatility causes frequent unemployment, resulting in high structural unemployment rates – i.e. unemployment because available laborers do not have the skills or knowledge for the available jobs. Workers with particular knowledge and skill sets cannot easily be moved to different sectors of the economy.
Volatility in non-oil sectors in the GCC region has decreased over time. “This reduction could be more the result of there being fewer total shocks, rather than the result of effective diversification,” commented Shediac. Growth volatility in the GCC however, remains high.
External trade helps reduce economic volatility
Pervasive volatility can be decreased with the development and diversification of high value-added exports of goods and services, especially for economies based on a single commodity. When non-oil exports are mapped against real activity volatility, an inverse relationship is revealed between external trade diversification and economic uncertainty - the higher and more diversified a country’s exports, the lower its volatility.
“High but concentrated economic growth will be outweighed by excessive volatility leading to low risk-adjusted performance if diversity is not effectively implemented,” said Najjar. This phenomenon can be captured by a revisited version of the Sharpe ratio,  which measures an economy’s risk-adjusted performance.
On average, transformation economies increase volatility by 1 percent with growth of 2.52 percent; in comparison, GCC economies increase volatility by 1 percent with growth of just 0.69 percent. For GCC economies,  any increase in growth inherently increases economic risk –rather than economic reward.
Diversification is a critical component of a sustainable economy
How can economies that have relied on the export of a single commodity reduce volatility and achieve sustainability? Is economic diversification a key part of accomplishing this?
The study compared GDP growth volatility against economic concentration and GDP reward-to-volatility ratio (i.e. the Sharpe ratio) against the diversification quotient. The results revealed a clear link between economic diversification and sustainable development.
Nations – like those in the GCC with a high concentration ratio – suffer from higher growth volatility than G7 or transformation nations. Nations with a high diversification quotient like Norway, South Korea, and Ireland enjoy a high Sharpe ratio – a high economic return per unit of volatility.
Regression estimators in the analysis are significant. About 30 percent of variation in GDP growth volatility and reward-to-volatility ratio is captured by single inde­pendent variables, economic concentration and diver­sification. The remaining 70 percent of the variation not explained by the regression can be explained by other factors – oil prices, inflation, exchange rates, investor and consumer confi­dence, general asset price shocks, and so forth. Many of these are difficult for policymakers to directly influence, while economic diversification is measurable, monitorable, and a critical component of a sustainable economy.
Effecting Sustainable Development: Summary of Key Findings and Recommendations for Policymakers
  • GCC economies are the most concentrated and inadequately diversified. Hydrocarbon-rich nations are not necessarily doomed to poor economic diversification – as shown by the paragon economies of Norway and to a certain extent Canada.
  • Employment distribution is balanced in G7 and transformation economies, but skewed toward low-value-added sectors in the GCC economies.
  • High economic concentration exposes economies to external or exogenous events like changes in oil prices, which creates economic volatility.
  • Overall volatility and subsequent spillover effects can be mitigated with the effective development and diversification of high-value-added exports.
  • Volatility minimization and risk-adjusted real activity performance improvement can be achieved with increased economic diversification.
  • Policymakers must focus on economic diversification when creating development agendas, and must rigorously measure and monitor economic diversity in evaluating the success of their policies. Specifically, policymakers should pursue the following courses:
  • Diversify economic bases in terms of output and input distributions. Stakeholders should incentivize injection of labor and capital into productive economic sectors, as well as the development of new knowledge and technology.
  • Foster the growth of the external sector by exporting a wide range of high value-added goods and services internationally.
  • Enhance productivity and competitive levels of the economic base, through resources and strategic investments, including enhancing human and financial capital, technology and knowledge to entrench innovation. Innovation allows economies to create high economic value from almost nothing as a starting point. This said, although preparing the ground and establishing the prerequisites and underpinnings of an innovation economy should be initiated at early transformation stages, the effective generation of economic output out of innovation sectors should come as a natural phase in an economy’s transformation path. “A premature reliance on innovation sectors is likely to minimize chances of success and expose a not-yet-immunized economy to harmful and disruptive competition” Moujaes commented.
  • Use the metrics of economic concentration and diversification, as well as economic sustainability and uncertainty, as targets when determining policy.
  • Monitor and devise clear diversification strategies and mechanisms to mitigate economic volatility and spillover effects, uncertainty, and perturbed business cycle transitions.

These steps will help policymakers create long-term, sustainable growth in their economies – to help ensure stability and a high standard of living for their nations.