GRM 2010 GRM 2011

Abstract Details

Family Name:
First Name:
Manal R.
Title of Paper:
The Hidden Face of Subsidies Reforms Following Petroleum Price Declines in Kuwait: An Economy-Wide Analysis
Paper Proposal Text :
Petroleum has been shown to be the most volatile of all traded commodities, leading to boom and bust cycles, real exchange rate volatility, and comparatively high investment risk in petrostates, defined as hydrocarbon exporting countries. Members of the Gulf Cooperation Council (GCC) face policy challenges stemming from this volatility and the exhaustibility of resources, especially due their high dependence on petroleum or petroleum- related (goods and services) industries. Challenges include fiscal sustainability and efficient allocation of rent and resources to harness oil rent windfalls during revenue booms and cushion downturns during busts, while simultaneously maintaining long-term growth and development. Despite GCC considerable advantages, petroleum price declines since mid-2014 presented additional long term challenges of GCC hydrocarbons exports and, consequently, their economies. Price declines foreshadowed exchange rate and current account instability, combined with significant fiscal pressures. The ensuing adverse macroeconomic effects challenge the effectiveness of various existing development plans and, therefore, threaten to impact the long-term sustainability of the GCC economies. These challenges are exacerbated due to expectations of recent trends in petroleum price declines to persist due to two main factors; first, the shale oil and gas revolution which decreased GCC countries’ market share and revenue sources; and second, anticipated increases in global supply from Iran following the 2015 Iran nuclear agreement, adding further downward pressures on oil prices. Further, the GCC countries’ fiscal positions are threatened by huge rigid government expenditures to fund welfare programs and increases in already-high domestic energy consumption of inexpensive energy products. Against this backdrop, discussions of subsidy reform (re)emerged as the solution for weakened fiscal positions. Kuwait represents an ideal state to examine this solution.

In this paper, I investigate and quantify the impact of proposed subsidies reform following petroleum price declines in Kuwait through economy-wide modeling. Kuwait’s economy is especially susceptible to volatility due to—(a) high dependence on petroleum exports (having generated 56% of its GDP and 92% of its government revenue in 2014); (b) high subsidies, especially in water, electricity and fuel (5% of GDP in 2014) with subsidization rates of 78-82%; and (c) the political difficulty of reducing subsidies as they anchor the welfare state as a mechanism for transferring petroleum rents to citizens as owners of the resource. In January 2016, following expectations of a 70% drop in its revenues when the average export petrol price hit $30/barrel (bl) (down from $103/bl in 2014), the Emir announced reducing electricity, water, and fuel subsidies by KWD700 million ($2.91 billion) by April 2016. The parliament is expected to acquiesce, yet public opinion has been very unfavorable, despite active attempts (from media outlets to mosques’ Friday sermons) to promote reform and consumption conservation.

Economic theory has widely accepted subsidies as distortionary (Plante, 2014), causing wasteful consumption and inefficient resource allocation. National oil companies are shown to be more inefficient than private oil companies, and their subsidies of domestic customers increased this inefficiency (Hartley and Medlock, 2008). In the context of Kuwait, existing studies show that the reduction of subsidies generates a net welfare gain (Fattouh & Mahadeva, 2014; BuShehri & Wohlgenant, 2012; Gelan, 2014). Nevertheless, these analyses focus on water or water and electricity subsidies only. More importantly, they ignore petroleum price volatility and they do not address specifics of the Kuwaiti economy. In an attempt to fill these gaps, this paper quantifies the impact of implementing subsidies reforms on the Kuwaiti economy in conjunction with petroleum price declines, while depicting subsidies across industries and labor-energy linkages. To that end, I employ a computable general equilibrium (CGE) model, which is an extension of economy-wide modeling approach of Asano & Tyers (2015). I extend it to embody: (a) dominance of the public sector in Kuwait; (b) industries’ oligopoly behavior; (c) labor market composition based on skills and nationality, as foreigner labor occupy 83% of and dominate the private (less subsidized) sector; (d) Kuwait’s economic structure; and (e) large subsidies and government transfers. I calibrate the model using a database in the format of a social accounting matrix (SAM) that I am currently constructing using data provided by the Kuwaiti government.

I first demonstrate that Kuwait has two very important stabilizers: sovereign welath fund (SWF) inflows and foreign labor exits. Moreover, I show that subsidies reform achieve are expected to achieve net welfare gains, drops in local energy demand, contribute to fiscal sustainability, and cause improvements in SWF positions. Nonetheless, they are not the wonder solution as presented by the government. In fact, their ability to achieve efficient reallocation of rent and resources will be difficult due to rigidity in employment contracts for Kuwaitis and their higher wages. Sectoral results are contrary to initial expectations. Removing subsidies negatively affects labor employed in the highly subsidized industries. Given guaranteed employment for citizens, employment levels will not be affected in industries dominated by Kuwaiti labor, like water. In other industries, foreign labor income and employment will be negatively impacted. Removal of energy subsidies will impact industries that use energy as an intermediate, and will reduce the GDP and production levels causing further deterioration in the private sector. Household consumption is impacted with real inflation as home energy consumption prices rise while foreign energy prices fall.

These results will impact Kuwait, the GCC, and the larger MENA region. Therefore, reform must focus on politically viable options. Successful implementation ought to accompany carefully designed mitigation measures and microeconomic reforms that address the ensuing sectoral losses and labor effects, especially for industries dominated by foreign labor. In the electricity sector, reform should also accompany investments in energy efficiency to meet increased demands. A critical implication is that subsidies reform can be part of a larger solution towards the tradeoff between local consumption and exports, and between withdrawals from and investments into the SWF as resources needed for future generations, infrastructure, and human capital development.