Is the Gulf construction boom economically sound?

The Gulf countries have announced $125 billion of new projects during the first half of 2019. While spending has been rising and falling quarter-to-quarter over the past few years, the long-term trend is upward since 2014. Around half of the latest spending increase is on construction contracts - a 33 percent increase compared to last year – including within the oil and gas sector, which was allocated $29 billion this year (an increase of over 200 percent on the same period in 2018). Although investment in construction supports or spawns a range of economic sectors in line with diversification plans, this investment does not fall directly under the Gulf countries’ long-term economic plans, outlined in a variety of “Vision” strategies. Is this volume of spending a good idea, and to what extent is it consistent with the Gulf countries’ economic strategies?

Let’s start with the positives. The 2019 boost to government spending is focused on investment, rather than public sector salary increases, which provides long-term benefits.

Increases in government spending in the Gulf countries have previously often taken the form of increased public sector salaries, which are politically popular but generally ineffective, and resulted in a rise in consumption and a concomitant increase in imports. In the long-term, increased spending through investment is more beneficial, as it builds the economy’s productive capacity and creates a stream of returns, such as the benefits that Saudi Arabia is now earning from its past investments in industrial cities like Jubail.

This latest investment will reap similarly long-term rewards. Recent investments help cement the Gulf countries’ reputations for high-quality infrastructure: The UAE is ranked 10th in the World Bank’s infrastructure index, and five of the six Gulf countries are in the top 50. All the Gulf countries’ economic strategies, including Saudi Arabia’s Vision 2030, stress the importance of infrastructure to the economic development plans.

A second positive is the timing of the investment. The Gulf countries are boosting spending both because they are trying to compensate for falling oil prices, and because they are trying to fundamentally transform the underlying structures of their economies in line with their economic strategies. While other governments are sometimes hindered by bureaucratic delays, causing spending to arrive too late or leading to inflation in a post-recession economy, the Gulf countries appear to have avoided that pitfall, aided by government structures that permit rapid decision-making when the need arises. Rather than increasing spending only as a temporary reaction to a recession, the Gulf countries are boosting spending also in line with their own transformative plans.

Despite these positives, there are some important question marks surrounding the infrastructure investment boom.

The most obvious cause for concern is that oil and gas investments account for a quarter of the investments. As a comparison, in the US in 2017, mining (which includes oil and gas extraction) accounted for only 3.7 percent of total investment. It is difficult to reconcile the high share of oil and gas in Gulf investments with the goal of diversifying the economy away from oil and gas.

It is true that some of the oil and gas investments are on new revenues, not existing oil revenue streams: Bahrain has just discovered a new shale oil field, while Saudi Arabia is trying to increase its natural gas exports. But given the huge scale of transformation that these economies are trying to achieve – Saudi Arabia’s Vision 2030 seeks to “raise the share of non-oil exports in non-oil GDP from 16 percent to 50 percent” – current levels of government spending on the oil and gas sector should be temporary. The Gulf economies need a plan for shifting the balance of investment toward new, vibrant, non-oil sectors, to genuinely diversify the economy. Realizing these ambitious goals requires raising large amounts of capital and investing it in sectors such as tourism to dilute fossil fuel’s contribution to the economy.

The second issue is uncertainty from Gulf countries not making their long-term fiscal plans publicly available, which leaves domestic and foreign investors uncertain regarding two matters. Firstly, investors are unclear how long is the current investment boost going to last. Secondly, there is uncertainty over what future fiscal adjustment – if any – is required to fund this current rise in spending, given the fact that all of the Gulf countries (except Kuwait) are running fiscal deficits and are facing fiscal challenges for the foreseeable future due to the oil price decline.

This kind of uncertainty undermines the effectiveness of deficit-funded fiscal stimuli. According to the phenomenon known as Ricardian equivalence, forward-looking investors and consumers dampen the effect of increased government spending by scaling back their own activity – in other words, if people anticipate future tax rises or spending cuts to balance the budget after government spending, they may start saving now to reduce the impact. In Saudi Arabia and the UAE, the growth rate of consumer spending has declined in the same period that the government has been boosting spending, possibly as a result of this mechanism.

Fiscal policy must therefore aim to counter this phenomenon, ideally by disseminating future fiscal plans to the greatest extent possible, especially if there is a possibility that current spending will improve the long-run rate of economic growth and will therefore diminish the need for future tax increases or spending cuts.

This is the goal of the current fiscal stimulus: Rather than simply providing temporary relief from a transient economic downturn, as occurs in traditional economies, the Gulf countries are ramping up investment in an effort to transform the economy. While it is too early to evaluate the likelihood of success of these long-term projects, sharing as much data as possible with investors and consumers can fortify the effects of the fiscal stimulus, and counteract the adverse effects of Ricardian equivalence. But in general, it is the right time to spend heavily and judiciously – and this data suggests that the Gulf countries are heading in the right direction.

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Omar Al-Ubaydli (@omareconomics) is a researcher at Derasat, Bahrain.

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Last Update: Wednesday, 14 August 2019 KSA 15:47 - GMT 12:47
Disclaimer: Views expressed by writers in this section are their own and do not reflect Al Arabiya English's point-of-view.
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