PDF Economic convergence in the Arab region: Where do we stand ...

[Pages:31]Distr. LIMITED E/ESCWA/EDID/2015/WP.1 21 April 2015 ORIGINAL: ENGLISH ECONOMIC AND SOCIAL COMMISSION FOR WESTERN ASIA (ESCWA)

Economic convergence in the Arab region: Where do we stand and how do we further it?

Jose Antonio Pedrosa-Garcia, Zara Ali1

United Nations New York, 2015

1 Economic Development and Integration Division (EDID), Economic and Social Commission for Western Asia (ESCWA). The authors would like to thank Mohamed Chemingui, Mohamed Hedi Bchir and Mohamed Hedi Lahouel for comments. Responsibility for any errors herein remains solely with the authors. Note: The views expressed are those of the authors and do not necessarily reflect the position of the United Nations. The designations employed and the presentation of the material do not imply the expression of any opinion whatsoever on the part of the Secretariat of the United Nations concerning the legal status of any country, territory, city or area or of its authorities, or concerning the delimitation of its frontiers or boundaries. Feedback or comments should be addressed to the authors. Corresponding email: pedrosagarcia@

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Abstract This paper explores convergence in Arab countries in regard to several economic dimensions. Overall there is little evidence of convergence in income per capita for the entire Arab region, although this result is not robust to different timeframes. The existence of natural resources by itself does not explain convergence, as resource-poor countries are not converging among themselves. The same applies to resource-rich countries. Disaggregating by sub-regions and regional integration agreements (RIA), it becomes clear that i) disparities in income per capita within the three Arab sub-regions have decreased in the last two decades, and ii) GCC countries have strongly converged since the GCC was created (non-GCC countries have not). As countries cannot change location, RIAs are proposed as the way to foster convergence. For RIAs to be successful, however, key imbalances have to be solved (notably in public finances), and Arab leaders will have to show stronger political coordination.

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1. Introduction

Economic theory explains convergence from different perspectives. Based on diminishing returns to scale, the neoclassical growth model predicts that poorer countries will grow faster than richer ones. This phenomenon is often referred to as unconditional, convergence or the `catch up' effect, and stipulates that over time, countries will converge in terms of absolute income.

From an international trade perspective, the Hecksher-Ohlin model postulates that different factor endowments favor specialization across countries, which leads to efficiency gains and resulting benefits from trade. When the factors of production are allowed to move freely, they will go where returns are higher, which will bring about the equalization of their prices and a fall in the differences of relative endowments.

In contrast, the new economic geography literature has shown that trade does not necessarily cause convergence of per capita incomes across countries. Most notably, the coreperiphery model explains how the existence of economies of scale generates self-reinforcing incentives for economic activity to concentrate in specific regions (Krugman 1991). As a result, certain industries would concentrate in some regions and leave others relatively undeveloped, leading to divergence rather than convergence.

Which phenomenon prevails empirically, convergence or divergence? Research in the 1980 and 1990s showed that often, countries do not converge in absolute terms. This finding led to another explanation that is consistent with the neoclassical growth theory: conditional or convergence (Sala-i-Martin 2002). According to this argument, poorer countries will grow faster than rich ones converging to their own steady state, which would explain why absolute convergence does not necessarily occur.2

Empirical evidence shows, e.g. that income disparity in Latin America increased during the 1990s (Blyde 2006), and that income per capita in the US diverged in the 19th century but converged in the 20th (Kim 1998). Kim's results illustrate the crucial role of the chosen time horizon; however, researchers sometimes fail to specify sensitivity to this parameter when stating their results.

In the Arab region, the results do not seem to be conclusive. Guetat and Serranito highlight the presence of strong income convergence in the MENA region (Guetat, Serranito

2 To converge with the wealthy nations in absolute terms, poor countries have to increase their steady state growth rate, which depends on growth determinants traditionally noted such as population growth rate, savings per capita, depreciation and capital stock and other factors that impact the productivity of the factors of production.

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2007). However, using a different methodology Erlat does not find similar evidence (Erlat 2007). Somewhat in between, P?ridy et al. find a lack of convergence for the MENA region as a whole, but they accept the -convergence hypothesis, especially for Tunisia, Egypt, Turkey and Morocco; the authors also find evidence of divergence for Jordan and Algeria (P?ridy, Bagoulla & Ghoneim 2012).

A possible limitation is that the available studies on Arab convergence tend to concentrate on income per capita. This ignores the marked structural differences between the region's countries' economies (e.g. the presence of natural resources). Furthermore, in the available studies time horizons, and even sampled countries, differ. For instance, some studies focusing on MENA include Israel, Iran or Turkey and very few Arab countries.

More importantly, convergence is usually seen as exogenous because the policy options to achieve such convergence are not discussed. Some of the exceptions emphasize two determinants: public investment and governance. With regards to the first, it has been noted that the convergence process strongly depends on education, R&D, transport, infrastructure and public investment, while trade specialization and firm agglomeration have been detrimental to convergence in MENA countries (P?ridy, Bagoulla & Ghoneim 2012).

Governance has also been stressed: the current institutional and governance framework of Arab countries favors rent-seeking by economic and political elites, which inhibits convergence of their GDP per capita (Souissi 2014).

This study suggests a third option: regional integration, which has received little attention as a mechanism to promote convergence in the region despite research suggesting it may be crucial, e.g. regional industrial specialization in the US explains the convergence in income per capita in the 20th century (Kim 1998).

The rationale behind regional integration as a means to promote convergence is linked to international trade: understanding integration as "the process by which different countries agree to remove trade barriers between them" (McCormick 2004), resources move where returns are higher, promoting specialization and higher efficiency in the productive process.

One of the best examples of integration and convergence is the European experience. Europe has long recognized that for regional integration to succeed, it has to occur between members of similar developmental levels (ESCWA 2014). To ensure this, convergence remains a priority today: from 2007 to 2013 the EU allocated funds with the following objectives: 82% of the funds were allocated for convergence, 16% for competitiveness, and the remaining (2%) for territorial cooperation (European Commission 2014).

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Regional integration agreements (RIAs) are the most important policy tools available to influence economic regional integration (Schiff, Winters 2003). RIAs can been defined as "the process by which two or more nation-states agree to cooperate and work closely together, following some established rules, to achieve such objectives as peace, stability or wealth" (McCormick 2004). RIAs are usually categorized as Free Trade Areas (FTAs), Customs Unions, Common Markets or Economic Unions, although in practice the boundaries between the different RIAs are not always clear and some ad hoc components may be added.

RIAs involve different levels of economic policy coordination across countries, which can be understood by looking at the RIAs in place. For instance, in a monetary union the degree of coordination is so high that countries actually share a common currency, thereby sharing interest rates, which makes them more likely to follow the same investment patterns and business cycles.

Despite the importance of RIAs, the Arab region has made little progress developing regional trade agreements (Mohamadieh, Shaw & De France 2007), which is evident when comparing it with other regions (Table 6.1 in the Annex). There is only one largely inclusive agreement, in terms of number of countries, in the Arab region: the Greater Arab Free Trade Area (GAFTA)." The most advanced RIA, however, is the Common Market of the Gulf Cooperation Countries (GCC), though it includes very few countries and has not been fully implemented.3 There is no RIA between Arab countries and other countries of the region such as Iran, Israel and Turkey.

This paper addresses the caveats noted by focusing on convergence and economic policy coordination in Arab countries. First, the objective is to assess convergence in the region and present RIAs as an alternative to promote such convergence. Second, the type of convergence emphasized is absolute (), because from the viewpoint of international relations (and particularly RIAs) the relative position of countries' income among themselves is more relevant than that of conditional () convergence. Third, to emphasize the importance of the time horizon, several timeframes are considered. Finally, the analysis shows the structural economic differences in addition to income per capita: the current situation of each dimension and its evolution over time is described.

It should be noted that it is not a goal of this paper to make a comparison to other regions but when benchmarks to better assess convergence and integration are found necessary, insightful comparisons with other regions are provided.

3 For specific details see e.g. Kingdom of Bahrain, Ministry of Finance

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The structure of the paper is as follows. Section two describes income per capita and its evolution, the weight of Arab countries' productive structures and specialization, and the synchronization between their business cycles. Section three describes the key elements of monetary policy; the main features of fiscal policy are presented in section four. Section five concludes.

2. Economic Structure

Income Table 6.2 in the Annex shows key income and population indicators for the countries considered. The largest economy in 2012 was that of Saudi Arabia, followed by the United Arab Emirates (UAE) and Egypt, which was the most populated with 80.7 million people. At the other extreme, the Palestinian economy accounted for some 4 billion USD in 2005, followed by Bahrain (30.4 billion USD), which had the lowest population at 1.3 million people.

Qatar had the highest income per capita with a staggering 93,825 USD per person, followed by Kuwait and the UAE. On the other hand, Palestine had a meager 1,210 USD per person, followed closely by Yemen and Sudan.

Table 6.3 in the Annex shows income per capita growth rates from a long run perspective. Although the number of gaps in the data is considerable, Oman has seen the highest growth since 1960, followed by Egypt and Tunisia. On the other hand, the UAE, Palestine, Kuwait and Bahrain have seen their per capita income reduced, especially since 1960. Within a shorter time horizon, 1990-present, Lebanon has seen its income per capita double (a considerable benefit of the end of the country's long civil war), followed by Egypt and Sudan.

Figure 2.1 below shows convergence of Arab countries with linear trend lines for several timeframes, and includes the Eurozone and ASEAN countries as benchmarks. In the long run (1960-2012) there has been a significant growth of inequality in Arab income per capita (black linear trend); this trend is much steeper than that experienced in Europe (green linear trend) but flatter than that experience in ASEAN countries (blue linear trend).

The overall trend hides several periods, however. The oil crises of the 1970s yielded a structural break that led to a high increase in inequality (orange linear trend) but the trend's

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slope decreased and eventually became slightly negative for the periods 1980-present (grey trend line) and 1990-present (yellow trend line).

Figure 2.1 Sigma convergence of income per capita for selected regions and timeframes

2 1.8 1.6 1.4 1.2

1 0.8 0.6 0.4 0.2

0

Arab 1960 - 1979 ASEAN Linear (Arab 1960 - 1979) Linear (ASEAN)

* Different time horizons overlap for a same group

Arab 1980-present Euro Linear (Arab 1980-present) Linear (Euro)

Source: Own calculations based on data from the World Development Indicators

Arab 1990-present Linear (Arab Total) Linear (Arab 1990-present)

The fact that the oil crises of the 1970s caused a large divergence in income per capita, may lead to the interpretation that oil is the reason why Arab countries are not converging. To assess this idea, Figure 2.2 shows sigma convergence between those countries rich in natural resources (Algeria, Bahrain, Iraq, Kuwait, Libya, Oman, Qatar, Saudi Arabia, United Arab Emirates) and those not rich in natural resources (Egypt, Jordan, Lebanon, Morocco, Palestine, Sudan, Syria, Tunisia, Yemen).

As it turns out, resource-poor Arab countries have seen their income differentials grow since 1960 (orange line in Figure 2.2). The phenomenon is robust to the inclusion of the 1970s (i.e. the slope of the orange and yellow lines are similar), although the trend does decrease slightly from 1980 onwards. Hence, other factors beyond the availability of natural resources contribute to countries' converging or diverging.

From 1980 to the present, resource-rich countries also show a decrease in the pace at which their income per capita diverges (relative to including the decade of the 1970s). In fact, from 1980 onwards, resource-rich countries diverged less than resource-poor countries.

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Figure 2.2 Sigma convergence of income per capita for resource-rich and resource-poor countries 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0

Resource-rich 1960-today Resource-rich 1980-today Linear (Resource-rich 1960-today) Linear (Resource-rich 1980-today)

Resource-poor 1960-today Resource-poor 1980-today Linear (Resource-poor 1960-today) Linear (Resource-poor 1980-today)

* Different time horizons overlap for a same group

Source: Own calculation based on data from the World Development Indicators

1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

Besides natural resources it is reasonable that, to the extent that income per capita reflects countries' economic structures, countries that have become more similar over time should converge in income per capita. A possible force resulting in similarities may be countries' similar international economic contexts, e.g. their location. For instance, in the last two decades globalization has taken an unprecedented impulse and Europe has become one of the main global economic blocs, which has influenced North African Arab countries.

In this vein, Figure 2.3 shows convergence within sub-regions (North Africa, Mashreq and the Gulf). The trend is clear: countries are tending towards similar levels of income per capita inequality within their own sub-region, a pattern that is visible since the early 1980s. Furthermore, considering only the period from 1990 to the present, there is convergence within the three sub-regions (i.e. the slope of a linear combination between the three sub-regions would be negative).

Yemen and Libya are not included in Figure 2.3, because their data are missing for most years and the pattern is difficult to interpret: as those two countries have levels of income substantially different to those of their neighbors, their inclusion yields two breaks: in 1990 (due to the inclusion of Yemen) and another between 2000 and 2010 (due to the inclusion of Libya). Figure 6.1 the annex presents the same convergence by sub-regions including the two countries.

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