GCC faces challenge to diversify economy

Cultural homogeneity, determined political will and fixed exchange rates against the American dollar are the assets enjoyed by the Gulf countries in their endeavour to form a monetary union and a fully integrated political and economic bloc.

In essence forming an economic bloc is imperative in today's world so as to maintain economic strength especially with the growing regional blocs. This is one of the goals that the Gulf Cooperative Council (GCC) looked at when it endorsed the 1981 Economic Agreement.

But the other main factor that encouraged such an economic integrity is the similarity in the political and economic systems of the Gulf countries.

To realise economic integration, the GCC member states have taken many steps including those related to the creation of common market. In this respect they agreed to form a Customs Union by 2003 and a Monetary Union by 2010, thereby applying the 1981 Economic Agreement.

Hypothetically, the concept of monetary union is based on the 'Optimum Currency Area' (OCA) theory. In practice this means having a single currency and a common central bank to control the fiscal policy.

An examination of the GCC countries and the degree to which the OCA criteria apply to their economies shows they have open economies. They have taken many steps towards fiscal policy's integration. For instance in a summit held in Bahrain in 2000, the GCC leaders agreed to adopt a common peg for the different currencies of the Gulf countries as an introductory step towards a single currency.

They also agreed to fix their currencies against the American dollar before the end of 2002.

Fixing exchange rates is an important intermediate step towards the common currency or monetary union. By doing that, countries eliminate the transaction costs and uncertainties resulting from having more than one currency and their fluctuating exchange rates.

In fact during the past 20 years the GCC currencies have fluctuated moderately against the American dollar, which is a positive sign with consideration to the currency's union goal.

Because of reliance mainly on oil, the GCC countries have similar production structures and similar inflation trends. The inflation rates in these countries increase when oil prices increase and decrease when they drop.

On the other hand these countries do not have diversified economies. They still heavily rely on oil exports with the non-oil sector also dependent on the performance of the oil sector. Consequently these economies encounter frequent trade shocks because of the fluctuation of the oil prices.

Moreover, prices and wages do not adjust systematically to such shocks. Although the economic agreement stipulates factor mobility, the Gulf countries still impose restrictions on ownership and type of activities their nationals can carry out. Also the labour laws and markets are not similar and as such labour cannot move within these countries freely.

Despite the similarities between the GCC economies, dominance of the oil sector, they don't have synchronised business cycles. It is important to have similar business cycles because when recession hits one member state, it cannot form its own fiscal policy to correct the effects of recession. Thus a common fiscal policy will be implemented in all the countries.

In fact in many cases the response to the oil price fluctuations varied from country to country. This is because some countries have more domestic constraints than others and as such have to adjust to this shock differently.

While most of the criteria required to establish a monetary union apply to the GCC countries, there are drawbacks which should be rectified, namely those related to the mobility of labour, diversification of the economy and flexibility in prices and wages.

If prices and wages are flexible, the economy can be balanced after the recession. If not, devaluation of currency becomes necessary. But this option is not feasible because these countries have agreed to a fixed exchange rate.

The alternative solution then would be the mobility of labour. By moving labour to the high labour cost areas after a shock, wages decrease and the economy will return to equilibrium. Yet as seen there are many restrictions that hinder labour mobility.

However, the challenges of labour mobility and flexibility in prices and wages within the GCC countries can be managed because the Gulf governments have adopted a policy in which the exchange rate is not considered a mechanism to adjust to shocks.

Also the problem can be solved by budget relocation. Actually whenever the GCC countries encountered adverse oil price shocks, they used the government expenditure as an adjustment instrument to bring the economy back to equilibrium.

The real challenge for the GCC countries is to diversify their economy since a unilateral economy is not favourable for a currency union. Also trade between the Gulf countries compared to their foreign trade figures is weak.

For instance, 1989-1999 figures show that the average of inter-GCC exports to overall exports were 21.3 per cent for Bahrain, 1.6 per cent for Kuwait, 17.1 per cent for Oman, 6.3 per cent for Qatar, 6.6 per cent for Saudi Arabia and 4.6 per cent for the UAE.

These are weak averages especially when compared with the other economic blocs. In essence, the incomplete diversification of the GCC countries has limited the inter-GCC trade.

A good solution is that these countries collaborate and increase industrial specialisation so that their economies become more diversified and their inter-trade increases.

Moreover, the success of the currency union in the Gulf requires them to undertake more policy coordination, remove all restrictions which hinder the movement of goods and factors of production so as to create a common market. By doing that these countries will have similar business cycles and absorb economic shocks symmetrically.

Further, the Gulf countries should have similar terms of trade because external trade is correlated with exchange rates, which is the main source of concern. In addition, political integration by creating supranational institutions which focuses on regional interest is imperative for the success of the monetary union.