Oil Economies and Dutch Disease - Is Abu Dhabi Handling it Right?

Abu Dhabi runs on oil revenue. The Emirate owns 8 percent of the world’s oil reserves which are approx. 98 billion barrels - and at the current drilling rate of 2.7 mbd, the reserves will last over 90 years. The economy is worth USD. 270 billion (AED 1 trillion, almost!) where approximately 58 percent of this money comes from the oil and gas sector. Little has been achieved in terms of diversifying away from oil and gas and diversification has largely occurred in sectors closely related to oil and gas, such as petrochemicals. The second largest contributor to GDP is the construction sector, which accounted for 10 percent of GDP in 2011, followed by the finance and real estate sectors, which made up approximately 8.5 percent of the GDP. These numbers paint a bleak picture for a state that wants to transition into a knowledge economy, diversifying away from oil and gas, by 2030.

This dependence on oil exposes Abu Dhabi to Dutch Disease. Dutch Disease is what happens when huge amounts of foreign currency (from oil reserves) flow into the economy and cause the local currency to appreciate, making other non-oil sectors less price competitive on the export market. It also allows cheap imports to enter the local market which negatively impact the industrialization of non-oil sectors as production moves to lower cost locations. So in a nutshell, oil rich countries are cursed in that they can never really diversify away from oil and gas!

However, to mitigate Dutch Disease, countries use a nominal exchange rate peg. In UAE, the dirham is pegged to the dollar at a fixed exchange rate. This is the case across the small oil-exporting states of the GCC, except Kuwait that uses a basket of currencies. A peg is used in order to contain an overvaluation of the local currency when oil money floods into the economy. However, the dollar peg is not without its drawbacks. When the price of oil rises, this creates or increases inflation in the local economy as wages and property prices go up (because the adjustment to the real exchange rate comes through adjustments in prices). A fall in oil prices causes deflation in the oil producing economies. Furthermore, the peg causes macroeconomic policies to be highly procyclical as the government’s spending decisions are dictated by oil prices; i.e. when the price of oil rises, government revenue increases, spending increases, inflation increases and interest rates fall, and the opposite happens with oil price falls.

A better defense against Dutch disease is adopting a conservative fiscal policy instead of a peg to control currency overvaluations. This is what Norway does, as well as what Abu Dhabi is doing right. Norway spends part of its oil money to build production sectors and invests the rest of it abroad through its ‘Pension Fund’ – the largest sovereign wealth fund in the world. Abu Dhabi Investment Authority, the second largest sovereign wealth fund has also invested heavily in assets abroad.

Abu Dhabi has also done several other things right. They have taken concrete steps to build capital in non-oil sectors; increased investments in social and physical infrastructure – with a conscious effort to overhaul the education system and encourage research and development in new sectors. The standard of living is pretty high with GDP per capita being among the highest in the world at above USD. 100,000; the physical infrastructure is consistently rated among the best in the world.  

See: Peterson Institute for International Economics, “The Case for Flexible Exchange Rates in Oil Exporting Economies”; Booz & Co, “Economic Diversification: The Road to Sustainable Development”; Economic Research Forum’s Working Paper Series, “Has the UAE escaped the Oil Curse?”