Five years ago, the Gulf states of Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates shared a fiscal surplus of some $600 billion; by 2020, the International Monetary Fund predicts that they will have accumulated a combined deficit of $700 billion. Sustained low oil prices could make things even worse. This bad news is yet one more reminder of resource-rich Arab states’ need to build vibrant, diversified economies that can withstand the effects of oil price shocks.

Although Arab governments have long recognized the need to shift away from an excessive dependence on hydrocarbons, they have had little success in doing so. Iraq, for example, set economic diversification as a core policy objective in one of its first five-year development plans in 1965—yet the country has only become more dependent on oil over time. In Qatar, Kuwait, and Saudi Arabia, too, diversification has been a central, yet largely unrealized, development goal since the 1970s. Even the United Arab Emirates’ economy, one of the most diversified in the Gulf, is highly dependent on oil exports.

Kuwaiti Oil Minister Ali Al-Omair (C) at the second Kuwait Oil and Gas Show and Conference in Mishref, Kuwait, October 2015. Stephanie McGehee / REUTERS

Why have Arab governments consistently failed to diversify their economies despite tall promises and grand plans? The answer has more to do with politics than economics. Indeed, if diversification were as simple as importing technical blueprints from states that have already diversified their economies, such as Botswana, Malaysia, and Norway, it would already have been accomplished.

Economic diversification carries deep power implications for ruling elites.

The trouble is that in many Arab economies, good economic policies rarely constitute good politics, especially for ruling elites. This is because the structural changes demanded by economic diversification—specifically, the production of a greater number and variety of high-value goods—promise to empower business constituencies that, flush with new income, could potentially challenge the ruler. In Kuwait, for example, the rise of an independent merchant class could undercut the power of the monarchy. If rulers in the United Arab Emirates have accepted diversification, meanwhile, it is partly because the Emirati private sector poses little political threat, since it is overwhelmingly reliant on foreign labor.

For diversification to succeed, its political costs for elites must be offset: they need to know that they will gain more than they will lose from the reforms. Any serious discussion of economic diversification must therefore begin by recognizing that resource-dependent elites will have to be compensated for the losses they will risk.

THE DEMANDS OF DIVERSIFICATION

Countries that have successfully diversified have generally had political frameworks that could tolerate it and regional environments that encouraged it. Consider the example of Botswana, which at independence in 1966 was highly reliant on mineral extraction, particularly diamond mining, and since then has developed strong agriculture and tourism sectors. Botswana’s success can be attributed to a number of factors: the country inherited constituencies with diverse economic interests, among them farmers and herders; it also benefited from political competition and stable coalitions. And Botswana’s membership in the South African Customs Union served as an important external inducement for sensible macroeconomic reform, because it constrained Botswana from pursuing imprudent monetary and trade policy. Together, these ingredients encouraged the development of new and varied economic sectors.

A diamond cutting factory in Gaborone, Botswana, November 2006. Joan Sullivan / REUTERS

The case of Malaysia offers similar lessons. At the time of independence in 1957, the country’s ethnic Chinese minority controlled much of the Malaysian private sector, serving as a powerful counterbalance to the natural resource sector, which was dominated by rubber, palm oil, and tin interests. This state of affairs was reflected in Malaysian politics, where ethnic Chinese managed to protect their economic interests despite their demographic minority, aided by a consociational power-sharing agreement with the ethnic Malay community. Bad macroeconomic policy—especially an overvalued exchange rate, which typically results from a booming natural resource sector and limits the competitiveness of private manufacturing—was unacceptable to Chinese interests. At the same time, Malaysia’s proximity to major global trade routes allowed Malaysian firms to tap into regional trade, investment, and supply-chain networks, with powerful economic benefits. These factors combined to open the way for an economy that is thriving not only because of its primary commodities, but also as a result of export-oriented manufacturing.

Closer to the Arab neighborhood, the Iranian experience provides similar lessons. Like Botswana and Malaysia, Iran has long been home to diverse economic interests that have profoundly shaped its political economy, from the famed bazaar economy run by Iran’s urban commercial classes, to a strong automobile sector and a solid manufacturing base in consumer goods. Iran’s geopolitical situation also encouraged diversification, since its isolation following the 1979 revolution and the subsequent international sanctions left its elites with few options other than looking beyond oil, into such sectors as petro-chemicals and consumer goods. The result is an economy that is far more diversified than many of its Arab neighbors.

Low oil prices offer Gulf states an opportunity for creative institutional reform.

Arab states lack all three ingredients that facilitated economic diversification in these success stories: varied economic constituencies, strong political coalitions, and beneficial neighborhood effects. Indeed, at the time of independence, many Arab economies did not inherit economic constituencies that could have gained strong political roles; instead, economic activity remained confined to royal circles. The discovery of oil compounded the problem, since it enabled rulers to tie down the merchant class in state contracts and other forms of patronage. Pervasive conflict in the region further undermined the prospects of private production by disrupting market linkages among states.

A SPOONFUL OF SUGAR

To move away from their dependence on oil, then, Arab societies need to develop a new political settlement that forces elites to cede ground to the private sector. That, however, raises a difficult question: if a closed, resource-dependent economy benefits elites, what could possibly persuade those elites to allow for diversification?

The answer likely lies in policies that compensate elites for the losses they suffer from a leveling of the economic field. China provides an illustrative example of this process: by incorporating business leaders into the Communist Party structure, Beijing managed to align economic reform with the interests of political elites. Or consider the case of Ethiopia, now among the world’s ten fastest-growing economies, which has set up party-owned enterprises supported by specialized endowments to promote investment in underdeveloped regions. Such models of party capitalism raise tough questions about market competition. But they nonetheless demonstrate that elites tend to favor an expansion of the economic pie when they stand as its lead beneficiaries.

Low oil prices offer Gulf states an opportunity for similarly creative institutional reform. Many states in the region have looked to the financial sector as a principal avenue for diversification; so far, however, they have hesitated to implement the legal and regulatory policies that would put that sector onto a sound footing, and regional secondary markets for debt remain underdeveloped. As some Gulf states consider issuing bonds to offset the fiscal challenges presented by low oil prices, they should also consider pursuing these long-delayed financial reforms, among them the development of macro-prudential regulations. Oil-rich Arab states could also consider opening protected sectors, such as consumer goods, housing, and real estate markets to domestic and foreign competition. Yet for any such diversification to succeed, existing elites need to become stakeholders in reform through clever institutional design.

A worker at the Khurais oilfield, about 100 miles from Riyadh, Saudi Arabia, June 2008. ALI JAREKJI / REUTERS

Next, diversification is unlikely to succeed without closer linkages among Arab economies. Private enterprise thrives on the regional connections that support dense supply chains, afford larger markets for private producers, and incentivize governments to pursue trade reforms. In Asia and Latin America, for example, connected regional markets facilitated industrialization by allowing firms to participate in global supply chains. Talk of regional cooperation might sound impractical in the Middle East’s current security climate, but it will be hard to sidestep the regional question in the future. In fact, economic integration should be an essential component of any attempt to escape regional violence. And although an economically independent Middle East might be seen as a challenge to the interests of Western powers, it would have benefits as well: as the recent refugee crisis has shown, the spillover effects of regional conflict are difficult to contain, and a peaceful and prosperous social order would benefit regional and foreign powers alike.

Economic diversification in the Middle East is thus far from a technocratic affair. It carries deep power implications for ruling elites and for broader regional dynamics. If the Gulf states hope to reap the benefits promised by diversification, they should ameliorate the costs it might impose on ruling elites and exploit the benefits it offers the region at large.