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1. Why Raise Long-Term Growth?

Pritha Mitra, Amr Hosny, Gohar Minasyan, Mark Fischer, and Gohar Abajyan
Published Date:
March 2016
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Underlying long-term growth is potential growth—the rate of growth of the level of output consistent with stable inflation,2 which is fundamental to job creation and living standards. Elevating potential growth rates translates into higher long-term growth through more production of goods and services, resulting in job creation, higher household incomes, and more money for the government to spend on education, healthcare, and social services (IMF 2014a). For oil exporters, this paper focuses on potential growth in the non-oil sector which carries fewer limits than those in the oil sector, which is constrained by finite oil reserves.

Potential growth has been declining across the globe in the aftermath of the global financial crisis (Cubeddu and others 2014; IMF 2013a). The crisis reduced potential growth rates in the Middle East and Central Asia (Figure 1) through its impact on the components of potential growth—long-term productivity, physical capital, and employment. Weaker investor confidence weighed on the physical capital, innovation, and productivity growth the world had become accustomed to in the years preceding the crisis (2003-07). High and persistent unemployment rates resulted in many discouraged workers leaving the labor force. In advanced economies and some EMDCs, this has added to the impact of aging populations. As a result, potential growth in advanced economies has fallen by more than half a percentage point and by almost three-quarters of a percentage point in EMDCs. In the years ahead, potential growth in advanced economies will largely rebound as investment and, subsequently, capital growth recover from the crisis. In contrast, EMDC potential growth is expected to decline further as a result of their aging populations, structural constraints affecting capital growth, and lower total factor productivity growth as these economies get closer to the technological frontier.

Figure 1.Falling Growth Rates

Sources: IMF, World Economic Outlook; Global Employment Trends, Mitra and others (2014); and IMF staff estimates.

Note: Potential GDP refers to potential non-oil GDP. Regional aggregates are weighted by GDP at purchasing power parity.

1 Difference in 2015-20 average potential growth rates from 2003-07 averages.

Strikingly, although not surprisingly, the added effects of low oil prices, geopolitics, and conflicts have amplified the slowdown in the Middle East and Central Asia’s growth potential (Figure 1). Over the next five years, MENAP and CCA declines are expected to exceed the EMDC average by 1.25 percentage points (Mitra and others 2014). This slowdown is especially pronounced in the CCA. It is experiencing a slowdown in export revenues owing to lower global commodity prices. Its strong economic links with Russia through trade, foreign direct investment (FDI), and banking have also slowed growth in capital and productivity, in part owing to the fact that Russia, a key economic partner of the CCA, had a substantial slowdown in potential growth owing to geopolitics, inadequate physical infrastructure, an overreliance on commodities, and a weak business climate (Box 1.2 IMF 2013a). Slower growth in China, with whom the CCA is enjoying rapidly growing economic ties, is placing further downward pressure on potential growth. In MENAP, weakened confidence in the aftermath of the Arab Spring and the global financial crisis, spillovers from intensifying regional conflicts (in Iraq, Libya, Syria, and Yemen), and, for oil exporters, the global oil price slump, have hurt public and private investment and capital accumulation. Sociopolitical tensions, strikes, and disheartened workers hamper productivity growth. The countries experiencing conflict face the additional challenge of massive destruction to their physical capital and the loss of talented and skilled workers, who have either lost their lives or left the country.

At this juncture in time, achieving higher growth is especially critical for the Middle East and Central Asia region:

  • GCC. In an environment of sustained low oil prices, the challenge for these countries is to achieve a level of economic diversification that allows for continued high non-oil growth. Oil revenues, through government spending, have driven activity in the GCC’s non-oil sector. In this setting, low oil prices, which are projected to persist over the medium term, necessitate a prolonged and substantial slowdown in government spending that will take a toll on economic opportunities and growth potential is anticipated to decline by more than 3 percentage points. At the same time, the number of new job market entrants is rising in these countries, a by-product of their young populations. Although growth rates in the GCC are still estimated at three times those of advanced economies and on par with EMDCs (Figure 1), the number of unemployed nationals is projected to exceed 1 million over the next five years (IMF 2013b). In a low oil price environment, absent higher growth (that is independent of oil), today’s high standards of living (measured as per capita income, Figure 2) are likely to decline.
  • Non-GCC MENAP. More jobs and higher living standards were the aspirations at the core of recent political transitions in the MENAP region. However, they are yet to be achieved, and this is only fueling sociopolitical tensions. Youth unemployment (more than 20 percent) remains one of the highest in the world. Against a backdrop of high population growth rates, non-GCC MENAP’s standards of living will drop from two-thirds to one-half of the EMDC average over the next five years (Mitra and others 2014). These pressures have accelerated in countries receiving large numbers of refugees (such as Jordan, Lebanon, and, to a lesser extent, Djibouti) from the conflicts in Iraq, Libya, Syria, and Yemen. Yet, current potential growth rates fall far short of other EMDCs (Figure 1), having declined by more than 3¼ percentage points in non-GCC MENAP oil exporters (more than double the decline in EMDCs). In the MENAP oil importers, potential growth is anticipated to decline (¾ percentage point) by less than that of EMDCs but nevertheless remain below other EMDCs (by almost 1 percentage point).
  • CCA. The prospects for improving standards of living in the CCA have been complicated by the sharp drop in commodity prices, coupled with the slowdown in Russia, especially through declining remittances. CCA oil exporters’ potential growth rates have dropped by more than 3 percentage points from being among the highest in the world to now only matching other EMDCs (Figure 1). Circumstances are even more difficult for CCA oil importers, with potential growth rates falling by 4 percentage points from just above EMDC rates to just two-thirds the rate of other EMDCs.

Figure 2.Income per Capita, 2003-14 Average

Sources: IMF WEO; ILO; and IMF staff calculations.

Raising growth—avoiding the “new mediocre”—requires a better understanding of its drivers: productivity, physical capital, and employment. The long-term growth of each of these factors determines the overall growth of the economy’s potential.3 Long-term employment growth assumes a rate of growth where long-term labor demand matches long-term labor supply, net of a long-term unemployment rate. Long-term physical capital growth reflects growth in both public and private components. And how much output long-term employment and physical capital inputs create is referred to as long-term productivity. It depends on a wide array of factors, most importantly production technology.4

Productivity growth will be key to unlocking higher growth potential throughout the Middle East and Central Asia. Adding more employment or capital has diminishing returns in terms of output. By contrast, productivity growth, regardless of initial productivity levels, can boost growth potential for extended periods of time. But, in most of the region, productivity growth is low and declining (Figure 3). In non-GCC MENAP, this is partly due to resistance to productivity-enhancing reforms by vested interests, government administrations with little appetite for change, fragmented political parties, and large informal sectors. It also reflects an education system focused on government employment, leaving graduates unequipped with the necessary private sector skills. In the GCC, productivity growth is not only declining but negative, owing to a reliance on low-skilled foreign workers and cheap energy (IMF 2013b). Reversing this pattern will be critical to economic diversification, the urgency of which has increased in the low oil price environment. Productivity growth has declined the most in the CCA—dropping from just below the EMDC average to near zero in the CCA oil importers. This reflects the slowing of strong structural reform momentum following the global financial crisis, which has weakened productivity growth.

Figure 3.Productivity, Capital, and Employment Contribute to Slow Growth

Sources: IMF, World Economic Outlook; Global Employment Trends, Mitra and others (2014); and IMF staff estimates.

Greater physical capital accumulation will be equally important, though priorities regarding its appropriate composition—private or public—vary across the region. Higher accumulation of physical capital, from both private and public sources, is needed in oil importers in the non-GCC MENAP and CCA, and in non-GCC MENAP oil exporters, where both private and public stocks are inadequate. By contrast, in oil exporters in the GCC and CCA, private sector accumulation is expected to have a larger impact on growth potential than public capital accumulation. Public capital stock is already high in these countries and, moreover, stronger private capital growth would partly offset possible declines in public capital growth and support economic diversification.

  • The GCC has experienced some of the world’s highest public investment in physical capital. As large hydrocarbon exporters, these countries benefited greatly from decades of high oil prices. These oil receipts and, now in a lower oil price environment, savings from past oil booms, have financed massive physical infrastructure investment. Over the longer term, sustained low oil prices are likely to reduce the availability of financing needed to sustain this model, raising the urgency of increasing private capital growth.
  • Capital growth in non-GCC MENAP is one-half to two-thirds that of other EMDCs (Figure 3). In the aftermath of the Arab Spring, intensifying regional conflicts, strained public finances, and capacity constraints, low investor confidence reduced already weak private and public investment, stunting or lowering the growth of physical capital. In the current low oil price environment, non-GCC MENAP oil exporters with limited financial buffers may have to cut public spending further, taking a toll on physical capital accumulation, as well as employment.
  • CCA oil importers’ high capital growth has also suffered, though it still matches other EMDCs. The decline reflects the adverse effects on confidence of geopolitical tensions surrounding the conflict between Russia and Ukraine and an easing of conditions prior to the global financial crisis—namely Russia’s robust economic growth, which had provided the impetus both for governments to undertake large public infrastructure projects and for strong economic confidence that boosted private investment.
  • CCA oil exporters maintain public capital growth near EMDC rates but sustained low oil prices may slow these rates.

Finally, raising employment growth would particularly benefit the non-GCC MENAP oil exporters and CCA oil importers. Recall that, in the context of this paper, employment growth refers to a rate of growth where long-term labor demand matches long-term labor supply, net of a long-term unemployment rate. In non-GCC MENAP (both exporters and importers), fast-growing populations have resulted in a large, young workforce. But in some non-GCC MENAP oil exporters (as well as Syria), conflicts have caused massive economic destruction, loss of human lives, and large-scale emigration resulting in a substantial reduction of long-term labor demand and supply. As a result, growth in this subregion’s employment has declined, dropping by more than half (Figure 3). In non-GCC MENAP oil importers, long-term labor supply has also fallen but to a much lesser extent. Here, weak economic conditions have reduced near-term labor demand and raised near-term unemployment so high as to discourage worker participation (in the formal economy), including through the hysteresis effect, while expanding the informal workforce.5 At the other end of the spectrum, the GCC’s employment growth rates are five times the EMDC average and six times that of advanced countries. This reflects their relatively young populations and abundance of low-skilled foreign workers. In a world of sustained low oil prices, this could change quickly. A prolonged and substantial slowdown in government spending would substantially reduce employment of nationals in the public sector, leaving the majority of nationals to find jobs in the non-oil private sector—reducing the demand for foreign workers. In the CCA, low population growth has resulted in slow employment growth, with the CCA oil importers having the lowest growth rate across the region. The Caucasus, meanwhile, faces the additional challenge of aging populations.

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