Kito de Boer: Beyond oil - Reappraising the Gulf States

Reform will be vital if the Gulf States want to take a broader role in the global economy, beyond gas and oil.

For most multinational executives, the Middle East conjures up images of high risk and low returns, of an area rife with instability, danger and opaque business practices. The states of the Gulf Cooperation Council "" Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates (UAE) "" fare little better. The reality is somewhat different.

We believe that the leaders of the Gulf Cooperation Council (GCC) states "" Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the UAE "" today have a unique opportunity to diversify their economies beyond hydrocarbons. If they succeed, it will have far reaching implications for not only their own populations but also the entire global economy.

Can they do the job? We think so. Oil revenues will help to sustain the reforms needed to break away from the boom-and-bust cycles that volatile energy prices create, while sharply rising levels of foreign direct investment will help to integrate their insular economies into a global one, providing an additional impetus for reform.

The stakes are high not only for the GCC states but also for the rest of the world. Beyond the obvious political importance of a stable GCC, economic development in the region could increasingly shape global investment flows. The combination of ever-stronger institutions, ambitious leaders, and sustained oil income has already prompted the GCC states to look eastward. If current trends continue, the GCC states will play a central role in channelling oil income generated in the West to investments in the East.

The region's governments will, of course, have to have the political will to cope with the latest oil windfall. Disciplined fiscal regimes and debt reduction policies suggest that they will. To illustrate, about $1 trillion worth of infrastructure improvements are already in the pipeline and this number could ultimately triple. Many GCC states have also initiated programmes to improve critical areas like education, healthcare and the financial markets.

Beyond political will, three powerful factors will push the need for reform even further forward.

Falling per capita oil and gas production: The pace of reform in the GCC has been uneven. States with relatively low ratios of oil and gas production to the number of citizens will find it increasingly difficult to sustain standards of living for their people.

Jobless youth: Unemployment and underemployment have been growing at alarming levels in the GCC states, particularly among the young, and the fastest-growing segment of their populations is under 25 years of age. To absorb GCC nationals with a secondary school degree or higher, the pace must rise fivefold, to almost 300,000 a year. To provide a livable wage, these jobs must pay at least twice as much as comparable jobs do now.

An inefficient financial system that allocates capital poorly: Part of the problem is underdeveloped bond markets, which remain small and illiquid. Another difficulty is the inability of local banks to assess credit risk accurately. In the absence of such an infrastructure, banks manage risk by channeling funds to safer borrowers, such as state-owned enterprises and large companies, depriving small and midsize businesses of funds.

Having said this, I do believe that to diversify beyond hydrocarbons, and thus tackle the monumental challenge of creating almost 300,000 high-paying private-sector jobs a year, the GCC states will also have to reform their labour markets, education, and financial markets.

Labour market reform
In the GCC, immigration policies are flexible, and labour markets rigid. Foreigners account for at least 40 per cent of the labour force and, in some countries, hold 90 per cent of all private-sector jobs. GCC businesses search the world for the cheapest labour to import rather than investing in skills and raising labour productivity.

The GCC states must undergo painful and fundamental labour reforms to unleash the private sector's job-creating power. A first step would be tightening immigration policies to wean employers from a dependence on foreign workers. Another would be to raise the cost of hiring expats which would help governments to manage the inflow of cheap foreign labour and encourage private companies to invest in labour-saving technologies and to create higher-value-added jobs.

Educational reform
Schools at all levels in the GCC states are failing to produce students with the skills and attitudes a modern productive economy requires. Part of the oil windfall should thus be spent on improving the quality of these schools "" from kindergarten through higher education, including vocational education. Both the quality of teaching and the salaries paid should be improved. Independent third parties should inspect the schools and develop examinations for students to help improve quality. School curriculums must also reflect the future demands of a modern private economy.

Financial-market reform
We estimate that by helping to allocate funds to the best opportunities and to nurture capital-starved small and midsize businesses, reforms to GCC financial systems could promote the creation of more than two million new jobs in the region over the next decade. Above all, it will be necessary to develop deeper and more efficient capital markets. The GCC's equity markets are reasonably well developed but could benefit if its governments provided more direct support. Both moves could create much-needed market liquidity. Greater transparency, better protection for investors, and the enforcement of corporate-governance standards would reduce the level of speculation and free investors to base their actions on market fundamentals.

Bond markets also need bolstering. Governments should issue bonds regularly to establish a yield curve and to help markets price debt adequately.

Although much remains to be done, most GCC states have taken the initial steps to address some of these issues. Saudi Arabia, for example, created an independent Capital Market Authority in 2004. This new body is redrafting the kingdom's capital market law to reflect international standards. Similar efforts are under way in the UAE and are planned for Qatar.

In conclusion, sustaining the pace of reform will be vital if the GCC wants to take a broader role in the global economy, beyond gas and oil. It is already one of the world's fastest-growing regions. It could become one of its leaders.

Kito de Boer is a Director based in McKinsey & Company's Dubai office