Draft 09 The Secret Of Dubai's Long-run Economic Success Counter Intuition

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The Secret of Dubai’s Long-Run Economic Success:

COUNTERINTUITION

Ohan S. Balian, Ph.D.

Dubai June 2009

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To my mother

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Acknowledgments

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Preface

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Table of Contents Acknowledgments...................................................................................3 Preface.....................................................................................................4 Introduction.............................................................................................6 Counterintuition and Super-Competitiveness.......................................16 Dutch Disease...................................................................................16 Super-Competitiveness and Productivity..........................................21 Capital Inflows and Investment............................................................33 Real Estate.........................................................................................33 Tourism.............................................................................................43 Finance..............................................................................................53 Economic Policy vs. Commercial Policy .............................................58 Economic Policy Effectiveness.........................................................58 Commercial Policy and Market Structure.........................................66 Governance and First-Best Solutions....................................................72 Governance Indicators......................................................................72 The ‘Luxury’ of Choosing First-Best Solutions................................79 Dubai Strategic Plan (2015) and Sustainability....................................83 Building-Blocks of DSP (2015) .......................................................83 The Rising Cost-of-Living................................................................89 Some Labor Issues ...........................................................................94 Bibliography..........................................................................................98

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Introduction A ski resort in the desert, a ‘palm tree’ on the sea, a hotel under the sea, the tallest building in the world, and the list goes on and on, all examples of counterintuition defined as intuition that is counter to common expectations. When Stephen Hawking, a world renowned physicist disabled by a crippling disease was asked why he was so famous even in the eyes of the general public, he replied: “People simply did not expect to see me on a wheelchair”. But to achieve these counterintuitive outcomes, one has to be super-competitive because these achievements must be beyond expectations. This book reveals the secret of Dubai’s remarkable economic success by showing that its governance structure, institutional setting, market structure, and economic policies have all been highly supportive of powerful market forces, beyond the control of any government, which have channeled investments into the most profitable sectors. Although the emirate of Dubai, one of the seven emirates of the United Arab Emirates (UAE), does not contain much oil, it has experienced large inflows of capital. The book is written in simple non-technical language and is not an exposition of the latest theories and practices in public policy making. It also does not contain extensive descriptive data on the performance of the Dubai economy which can be easily found in hundreds of newspaper articles and from the recently launched portal of the Dubai Statistics Center (www.dsc.gov.ae). The book simply places what Dubai has achieved so far in the ‘right’ perspective in the sense that all of its actions and policies are based on fundamental

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economic principles. It also argues that counterintuitive ideas, in both industry and government, are key to the economic success of Dubai with scarce natural resources and a small native population. Although there is a huge literature on the competitive advantage of nations in the form of resource abundance, low labor costs, and good governance, very little has been said on the ability of nations to create this competitive advantage; what is termed as super-competitiveness in the form of achieving improvements in the many factors that affect overall economic performance. The secret of Dubai’s economic success has been the government’s ability to recognize and identify the flow of resources into specific sectors and devise original and innovative policies to take maximum advantage of these flows. Perhaps one of the best examples of a counterintuitive outcome is the so-called Dutch Disease. When Netherlands in the early 1970’s discovered natural gas, the common expectation was that the resulting export earnings would lead to rapid economic growth. But contrary to this expectation, Netherlands experienced high rates of unemployment and inflation. The explanation of this counterintuitive outcome was that large inflows of capital, which are unrelated to the productive capacity of the economy, caused an increase in wages. As wages (a cost) began to increase, producers increased their prices (a revenue) to maintain their pre-existing levels of profit. Producers in the non-tradable sector (services such as banking, tourism, and real estate) were able to increase prices but they could not do so in the tradable sector (mainly manufacturing) because prices of manufactured goods are determined in international markets. Since profits in the non-

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tradable service sector were greater than profits in the tradable manufacturing sector, resources (both labor and capital) began moving from the tradable manufacturing sector to the non-tradable service sector. This process of Dutch Disease, also known as de-industrialization, caused unemployment - because labor was moving out of the manufacturing sector and it takes time to train these workers to work in the nontradable service sector - and inflation - because the prices of non-tradable services increased. A similar process has been happening in Dubai with one major difference – no unemployment. As capital inflows in Dubai have increased, the returns on resources (labor and capital) have increased in the non-tradable service sector which is evidenced by the booming real estate and tourism sectors. There has been no surge in unemployment because Dubai has started from a relatively low manufacturing base and all the labor and capital that has moved into the non-tradable service sector is new and did not come from the tradable manufacturing sector. This phenomenon is reflected in higher prices in the real estate sector, and many other non-tradable services, as evidenced by the rising cost-of-living in Dubai. The secret of Dubai’s economic success is its ability to reinforce the flow of resources into the non-tradable service sector such as real estate, tourism, and financial services. Most Dubai government policies, initiatives, and investments can be traced to the higher returns in these non-tradable service sectors, the biggest sector being the real estate sector. But just as capital inflows have increased the profitability of non-tradable sectors such as real estate and banking, the current global

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financial crisis has considerably reduced capital inflows into Dubai, in turn lowering the profitability of these sectors as reflected in falling property and stock prices. The more interesting question is where has all the money gone? The answer is that it is ‘trapped’ in banks because of their unwillingness to lend at current low rates of interest; and, ‘trapped’ with the public because of their unwillingness to invest since they expect property and stock prices to fall further. This situation, known as a ‘liquidity trap’, has severe policy implications since the rate of interest is so low that no one is willing to lend and everyone is holding money in idle balances earning very low interest. In such a situation, even if the government injects liquidity into the financial system, banks are not willing to lend because of very low interest rates. In other words, the traditional policy prescription of using an expansionary monetary policy to increase the availability of loanable funds does not work in a ‘liquidity trap’ situation. A more effective solution to escape this trap is for the government to bypass banks and, among other actions, lend directly to the public. This direct policy intervention is currently being adopted by the US government. For this reason, the recent liquidity injection of about $30 billion by the UAE Central Bank may not immediately ease the credit shortage faced by consumers if banks are not somehow ‘forced’ to lend at low interest rates, and if the government does not find alternative channels of lending directly to consumers. The ultimate cost of a ‘liquidity trap’ is that weak banks will fail unless they merge with stronger banks because weak banks will not be able to make profits at low interest rates.

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To be counterintuitive, one has to be highly competitive and productive. ‘Normal’ competitiveness will enable one to achieve normal outcomes. To achieve outcomes counter to common expectations, one has to be super-competitive which is defined as being productive in the ‘other’ factors that affect economic growth. To better understand this definition, when economic commentators speak of productivity they do not specify the productivity of which input. Usually, productivity implies labor productivity – or output per-man hour – and higher labor productivity generates higher rates of growth. But there are many ‘other’ factors which affect economic growth such as physical capital (machinery and equipment), human capital (education), knowledge transfer (especially the embedded technology in imported goods), institutions, and much more. A more accurate description of the productivity of an economy would be total factor productivity which takes into account the ‘mix’, with labor, of all these ‘other’ factors which affect economic growth. In other words, how much a worker produces depends on how much capital he or she has, on his level of education, on his health, on the available technology, on institutions, on governance, and on much more – what Robert Solow appropriately called a measure of our ignorance. Super-competitiveness, in addition to the normal competitive factors, takes into account these ‘other’ factors to improve our measure of ignorance. The secret of Dubai’s economic success, to a large extent, is explained by the strengthening of these ‘other’ factors through strong leadership, improved governance, knowledge transfer, and much more, and in the achievement of successful, yet counterintuitive outcomes.

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Economic success also depends on the effectiveness of economic policies. However, in most emerging economies, there is some misunderstanding of economic policy as developed countries know it. When economists talk about economic policy, they usually mean fiscal, monetary, trade, and labor policies at the country level which are conducted through changes in taxes, the money supply, import tariffs, and the like. In most emerging economies, economic policy is regarded more as ‘commercial’ policy which can be conducted through rules and regulations. This interpretation of economic policy is especially blurred in the United Arab Emirates primarily because each emirate can formulate its own rules and regulations at the emirate level. Economic policy deals with macroeconomic issues such as unemployment, inflation, budget and trade deficits, and is not directly concerned with influencing market structures. The indirect effects on industry are more of a byproduct of these policies. Commercial policy, on the other hand, affects market structure directly through rules and regulations on free zones, establishment of enterprises, and competitive practices which are normally enacted by local specialized government agencies. One of Dubai’s biggest successes has been the recognition of this difference between economic policy and commercial policy in the design of policies to attract foreign investment and increase domestic competition. The secret of Dubai’s economic success is its ability to achieve a more accurate measure of our ignorance through the use of indicators for improvements in government performance – the ‘other’ super-competitive factors which affect overall economic performance. As Albert

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Einstein famously noted, “Not everything that can be counted counts, and not everything that counts can be counted”, Dubai has been highly successful in choosing indicators that measure government performance more accurately. These indicators have sometimes been adopted by looking at best practices in other countries, especially in the emerging economies of Asia, and have been modified to capture the specific characteristics of local government agencies. Dubai has also been successful in avoiding the ‘moral hazard’ problem - a situation in which firms and institutions perceive that the government will bail them out if they fail or under-perform - by rewarding successful enterprises and demoting unsuccessful ones through its various excellence programs. Dubai has also been able to achieve remarkable economic success because of its governance structure which has enabled the choice of first-best or optimum solutions to pressing problems. In most developed countries, policy decisions and the enactment of laws and regulations require considerable time and debate prior to implementation. Although these policies are usually based on intuitive research and policy debates, the relationship between policy research and policy making in the real world is very weak. Several studies have shown that the relationship between policy analysis and policy making is not very strong because of the influence of special interest groups, and because of differences in the objectives of policy researchers and policy makers. These differences have been very often responsible for choosing second-best solutions to urgent economic problems in developed countries. This is another example of a counterintuitive outcome in the sense that although common sense tells us to base our decisions on ‘scientif-

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ic’ research for optimum outcomes, there are so many complexities in the real world that we cannot measure policy variables accurately, especially those ‘other’ factors of a productive economy which explain a sizable portion of overall economic productivity. For this reason, initially counterintuitive policies may yield first-best optimum outcomes. To sustain this rapid economic growth, the Dubai government in 2005 began to formulate a 10 year strategic plan known as the Dubai Strategic Plan DSP(2015). Although the DSP(2015) covered economic, social, infrastructure, and security issues, the economic development component was based on 6 building blocks to generate an annual average rate of growth of 11% with the help of 880,000 additional workers over this 10 year period. DSP(2015) contains hundreds of action plans and initiatives which are currently being implemented by the government. Unlike standard 5 or 10 year development plans formulated by many developing countries, the DSP(2015) is a ‘live’ document taking into account changing regional and global economic conditions. The DSP(2015) also makes sure that its recommendations and many initiatives are based on fundamental economic principles tested in developed economies, and has been modified to take into account the specificities of the Dubai economy such as market structure, immigration, labor issues, and the expected rise in the cost-of-living. The rising cost-of-living in Dubai is an expected outcome because it is caused by the high rate of government spending (as it builds the infrastructure of a rapidly growing economy), and a high rate of capital inflows (as it attracts foreign direct investment). The increase in the general level of prices is also fuelled by the increase in the prices of

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non-tradable services as the demand for such services has increased due to Dutch Disease effects noted earlier. The rising cost-of-living is also due to the fixed-exchange rate regime with the US currency which has fallen considerably in recent years causing an increase in the relative price of Dubai imports, especially imports from euro zone countries. This has been reflected in the high price of intermediate inputs such as cement and steel which are heavily used in the real estate sector. But the recent increase in the value of the US dollar has somewhat reduced inflationary pressures, and the slowdown in capital inflows caused by the global financial crisis has also lowered prices of non-tradables as evidenced by the decline in property and stock prices. However, regardless of the underlying causes of inflation in Dubai, the government has not been able to adopt ‘standard’ economic policy tools, such as increasing the rate of interest or decreasing the money supply, because its fixed exchange rate regime with the US dollar has tied the movement of its domestic interest rate with movements in the US rate. Moreover, even if Dubai desires to control its rate of inflation through contractionary monetary policies, it has few degrees of freedom because the money supply is controlled by the UAE Central Bank at the federal level. Alternatively, the Dubai government has adopted counterintuitive policies in controlling inflation using various price and rent controls. The rising cost-of-living has also eroded the purchasing power of unskilled workers. Although it is becoming increasingly more difficult to retain skilled workers due to the rising cost-of-living in Dubai, nominal wages of skilled workers have actually increased due to Dutch Disease effects. There is no doubt that wages of unskilled workers have

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eroded in recent years but that is primarily due to the fall in the US dollar. This erosion of purchasing power has been somewhat rectified due to the recent appreciation of the US dollar. Moreover, both the Dubai local government and the UAE federal government have achieved considerable progress in improving labor conditions of unskilled workers, much more than the improvements achieved by the governments of their home countries. This book illustrates the many examples in which Dubai has adopted counterintuitive policies to generate rapid rates of growth. But the adoption of counterintuitive policies requires supercompetitiveness to identify and measure the ‘other’ factors that affect overall productivity such as leadership, innovation, technological change, and institutional performance. The secret of Dubai’s economic success has been its ability to identify, in Einstein’s words, ‘what counts’, and formulate appropriate policies, very often counterintuitive, to achieve first-best optimum outcomes.

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Counterintuition and Super-Competitiveness Dutch Disease Perhaps the best example of a counterintuitive outcome is the so-called Dutch Disease or de-industrialization caused by a large inflow of capital which is unrelated to the domestic productive capacity of the economy. Although the original model by Corden and Neary (1982) looks at the effects of a natural resource discovery (natural gas), they were well aware that the same effects could be generated by large capital inflows caused by Foreign Direct Investment (FDI), remittances, foreign aid, or the discovery of precious metals such as gold. Corden and Neary group the goods and services produced by an economy into three groups: natural resources (oil), tradable goods (manufacturing), and non-tradable goods (services)1. By definition, tradable goods are subject to international competition; hence, their prices are determined by international demand and supply, and it is assumed that the country is small enough so as not to be able to influence these prices. Services, since they are non-tradable, are not subject to international competition and therefore their prices are determined by domestic demand and supply2. 1

The building & construction sector is also regarded as a non-tradable sector because you cannot physically ‘import’ or ‘export’ a building. Perhaps the earliest example of this awareness was when foreigners in the early 70’s were purchasing buildings in the UAE and residents became very worried and complained to His Highness Sheikh Zayed Al Nahyan, the late President and founding father of the UAE. His wise reply was that as long as they were not tying ropes around buildings and pulling them to their home countries, he was not really worried. 2 Tradable sectors are defined as sectors that produce goods for both domestic consumption and exports (imports). Non-tradables are sectors that produce goods and

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The Dutch Disease model distinguishes between a resource movement effect and a spending effect. A rise in the price of oil increases the demand for labor and capital in the oil sector which leads to higher wages and a higher return on capital in that sector. If factors are mobile and can move between different sectors, then this will induce labor and capital to move from the manufacturing and services sectors, to the oil sector. Output and employment in the oil sector will thus increase while output and employment in manufacturing and services will decline. While the price of manufactured goods does not change (because it is determined internationally), the decline in services output leads to excess demand for services and therefore to an increase in the price of services3. Resources (both labor and capital) would move into the production of services to meet the excess demand. This is known as the resource movement effect. The spending effect occurs when some fraction of the increase in income generated by the booming oil sector is spent on both the tradable and non-tradable sectors. This higher income would push-up the price of non-tradables. But since prices of tradables are fixed (since they are determined in international markets), then an excess demand for tradables can only be eliminated by an increase in imports. At the same time, the price of services relative to the price of manufactured goods also increases causing an appreciation of the real exchange rate – i.e. a unit of foreign currency now buys fewer services only for domestic consumption. 3 It is explicitly assumed that the market for non-tradable goods (domestically produced) always clears through the price system – i.e. an excess demand causes domestic prices to increase and an excess supply causes domestic prices to decrease. In the tradable sector, excess demand and excess supply are eliminated through increases in imports and exports respectively.

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goods in the domestic economy as it did before. This real appreciation weakens the competitiveness of a country’s manufacturing exports, and causes de-industrialization. Both of these changes take place because of the spending effect.4 Combining the spending and resource movement effects, the Dutch Disease hypothesis generates four predictions. First, since the relative price of services increases, the real exchange rate appreciates. Second, there is an unambiguous decline in manufacturing output and employment. Third, the combined effects on output and employment in the oil sector and the service sector are ambiguous because the spending and resource movement effects pull in opposite directions. However, if the oil sector employs relatively few workers or if labor mobility is low, then it is expected that the spending effect will dominate the resource movement effect in which case we would also expect to see an increase in service sector output and employment. Fourth, if

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Appreciation of the real exchange rate will occur regardless of whether the nominal exchange rate is fixed or flexible. Under a fixed nominal exchange rate, such as in the UAE and in all the GCC countries except in Kuwait, the conversion of the foreign currency into local currency would increase the country’s money supply, and pressure from domestic demand would push up domestic prices. This is why under a fixed exchange rate system this real appreciation will lead to higher inflation, the case in most GCC countries. This would amount to an appreciation of the real exchange rate because a unit of a foreign currency now buys fewer ‘real’ goods and services in the domestic economy than it did before. If the exchange rate is flexible, the increased supply of foreign currency would drive up the value of the domestic currency which also implies an appreciation of the real exchange rate, in this case through a rise in the nominal exchange rate rather in domestic prices. In both cases, real exchange rate appreciation weakens the competitiveness of the country’s manufactured exports and causes deindustrialization.

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labor is mobile, then the overall economy-wide wage level will increase.5 The above analysis is more relevant for resource rich countries with an abundance of oil or other natural resources. For an emirate such as Dubai with scarce endowments of natural resources and a small native population, the source of Dutch Disease has been the large inflow of Foreign Direct Investment (FDI)6 caused by the creation of a business friendly environment, especially after 2001. We thus look at FDI, as opposed to oil revenues, as the major source of capital inflows which, again, is not related to the internal productive capacity of the Dubai economy. This approach leaves us with two sectors: a tradable manufacturing sector and a non-tradable service sector. The increase in FDI causes similarly an appreciation of the real exchange rate which reduces the competitiveness of the tradable manufacturing sector and leads to deindustrialization7. As the return on capital and wages begin to increase because of the spending effect, resources begin to move from the tradable manufacturing sector into the non-tradable service sector since producers in the tradable sector cannot increase their prices because prices of manufactured goods are set internationally especially in a small open economy such as Dubai which is a price taker and cannot influence world prices. This resource movement effect in Dubai has 5

For an excellent discussion of Dutch Disease and its practical applications to the real world, see Migara, K. and O. De Silva (1994). 6 A survey conducted by the Dubai Statistics Center in 2007 showed that FDI was $11.6 billion in 2006, or an increase of 13.4% compared to 2005. 7 One explanation for why deindustrialization is perceived to be ‘bad’ is because there is more scope for technological progress in manufacturing than in services except in information technology and financial services, areas in which Dubai has achieved substantial progress.

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been evidenced by the dramatic growth of the real estate, tourism, and financial sectors. Moreover, since Dubai has started from a low industrial manufacturing base, most of the labor and capital in the non-tradable service sector is coming from abroad as evidenced by the increase in the expatriate population. The Dubai government, recognizing this phenomenon, has formulated appropriate policies to reinforce these resource movement effects into the highly profitable service sectors such as tourism, finance, and real estate. The recent global financial crisis has considerably reduced capital inflows into Dubai with ‘reverse’ Dutch Disease effects. In other words, as the inflow of capital has slowed down, the upward pressure on wages has somewhat subsided. This slower rate of growth of the wage rate has caused a reversal of resource movements out of the nontradable service sector as evidenced by layoffs in the real estate and financial sectors in recent months. Profitability, especially in the real estate sector, has also been reduced to ‘normal’ levels with lower expectations. This is a good sign since property prices were getting out of control and it was becoming increasingly difficult to attract and retain skilled workers. The slowdown in the rate of growth of wages has also been helpful in controlling inflation caused by the increase in aggregate demand through the spending effect. As capital inflows have decreased due to the global financial crisis, these reverse Dutch Disease effects have been very helpful to slow the rate of growth of the economy, especially in non-tradable service sectors. This lower spending by consumers has been to some extent offset by increased government spending as Dubai builds its modern infrastructure.

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Super-Competitiveness and Productivity The competitiveness of a country is a highly ambiguous concept since it incorporates many variables and indicators on the performance of the economy. Strictly speaking, there are two meanings of competitiveness: ‘business’ competitiveness as elaborated in various competitiveness reports, and ‘economic’ competitiveness which depends on factor endowments and productivity. Business competitiveness is best illustrated by the annual reports published by the World Economic Forum (WEF) and the International Institute for Management Development (IMD)8. Neither IMD’s nor WEF’s rankings are comparable through time due to changes in data, methodology, and countries covered. IMD’s World Competitiveness Index (WCI) has continued in the spirit of the original indices and has been mostly moderate in its revisions, and its methodology was considerably revised in 2001. WEF introduced a completely new measure, the Current Competitiveness Index (CCI), and relabeled the World Competitiveness Index (WCI) as the Growth Competitiveness Index (GCI).9 8

WEF is an independent non-profit organization based in Geneva, Switzerland. It promotes economic growth and social progress worldwide and has NGO consultative status with the United Nation’s Economic and Social Council. Its activities are funded by multinational corporations. IMD is an independent non-profit foundation and a premier business education institution located in Lausanne, Switzerland. It educates business executives at every stage of their careers. 9 WCI measures and compares how countries are doing in providing firms with an environment that sustains the domestic and global competitiveness of the firms operating within their borders. Similarly, CCI evaluates the underlying conditions defining the current level of productivity. GCI is considerably different from the two and it aims to measure the capacity of the national economy to achieve sustained economic growth over the medium term, controlling for the current level of economic development.

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There is no readily available economic theory that could be applied to the construction of these indices. Growth literature provides some guidance in selecting the appropriate variables and their relative weights but, beyond that, index crafters must rely on expert judgments and ad hoc empirical analysis10. All the indices combine ‘hard’ data (statistical indicators such as wage rates, inflation rates, interest rates, etc) and ‘soft’ data (indicators based on survey responses such as intensity of research collaboration, implementation of new technology, ease of doing business, etc)11. According to both IMD and WEF, current competitiveness is the same as having an attractive environment for a firm’s business activities. This is somewhat different from typical definitions of competitiveness which emphasizes a country’s ability to offer a high and rising standard of living to its citizens or the ability of a nation state to continuously attract high value-added activities in such a way that all factors of production are employed and earn high returns. Economic competitiveness, on the other hand, looks at resource endowments and how these resources are used most efficiently in the production process at both the micro and macro levels. Some countries are competitive in the production of certain products simply because they are abundantly endowed with natural resources. For example, Saudi Arabia is economically competitive in the production of oil

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Porter’s (1990) work on competitiveness has influenced WCI and his diamond model is highly visible in CCI. GCI is influenced by Barro (1991) and subsequent works. 11 The indices have several shortcomings, the most serious critique relating to the Executive Opinion Surveys, namely, that opinions of fewer than 20 business managers do not provide solid foundations for economic analysis.

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simply because its vast oil deposits are very cost effective to extract. Economic competitiveness at the macro level has to do with the economy-wide production function which is a technical relationship between output (GDP) and the various inputs that go into the production of that output. The functional relationship between total output and the various inputs is always positive but the degree of the effect on output depends on factor intensities and on the ‘mix’ of the different inputs. At the micro level, economic competitiveness has to do with market structures at the industry level such as perfect competition, monopoly, duopoly, or monopolistic competition. Countries usually have little control over economy-wide competitiveness in the short-run, but can affect market structures through various competition rules and regulations. Nonetheless, competitiveness, whether ‘business’ or ‘economic’, is important because it lowers costs and forces the factors of production to be more productive – that is, the same unit of input produces more output than before. But when economic commentators talk about productivity, they normally do not specify the productivity of which input. The common measure of productivity, at least in the US, is labor productivity – output per man-hour. But the productivity of an economy depends on much more than the productivity of its labor 12. It also depends on the ‘mix’ or efficiency with which the ‘other’ inputs in the production process are combined with labor – what is known as Total Factor Productivity (TFP)13. In other words, the amount of output 12

Productivity is important because it affects per capita GDP which in turn determines the rate of growth of the economy. 13 Also known as Multi Factor Productivity (MFP).

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that a unit of labor can produce depends on the amount of capital that the worker has, on his level of education, on his health, on his training, on institutions, on governance, and so on – what Robert Solow called a measure of our ignorance14. In effect, we are saying that an increase in TFP means that more output is obtained without increasing the quantity of inputs. This distinction between labor productivity and TFP is important because labor productivity might be increasing not because workers are working harder, but simply because they have more capital to work with. Since this capital is costly, it will ultimately reduce overall economic productivity. The same argument can also be made for all the ‘other’ inputs that affect overall economic productivity such as human capital, technology transfer, institutions, and so on. The important point for policy purposes is that overall economic productivity will be overstated if the measure is labor productivity because we are not taking into account the costs of capital, education, healthcare, technology, institutions, and so on15. TFP takes into account these costs and will therefore exhibit lower rates of overall productivity growth. Intuition tells us that interest rates will be low during periods of economic slowdown as governments push down rates to generate economic growth. The interest rate can be looked upon as the cost of capital since investors need to borrow to make investments. But given that the economy is in a ‘liquidity trap’, banks are not willing to lend at low levels of interest and will only be willing to do so at higher rates, thus 14

This does not imply that we do not know what these ‘other’ inputs are. It simply means that they are difficult to measure. 15 For this reason, the Organization for Economic Cooperation and Development (OECD) looks at Total Factor Productivity especially for cross-country comparisons of productivity growth. See OECD (2001).

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pushing up the cost of capital. In other words, although market rates are very low, actual rates - rates at which banks would be willing to lend are much higher. This higher cost of capital will be reflected in lower productivity growth which will eventually lead to slower economic growth. The current economic reality in Dubai is very similar to this situation which is evidenced by the fact that if one goes to the bank to borrow money, banks are only willing to lend at about 7-8%, even to their high net-worth customers. Again, a highly counterintuitive outcome in the sense that higher investment will lead to lower productivity growth, in turn, leading to lower economic growth. These ‘other’ inputs that affect productivity growth can be grouped under three main headings: knowledge; factor supplies; and institutions16. By knowledge we mean the creation, transmission, and absorption of knowledge. Since knowledge cannot be directly measured, it is often proxied by R&D and by the number of patents. There is very strong evidence to suggest that increases in knowledge positively affect productivity growth, and increases in the stock of knowledge are caused by investments in education and R&D. Knowledge can also be imported in the form of FDI (where technologically advanced foreign firms invest in the domestic economy) and/or in the form of technically advanced imported products (such as computers, advanced machinery, high-tech equipment, etc). Generally, more open economies tend to be better positioned to import knowledge from abroad although the effectiveness of this advanced knowledge may be limited by the absorptive capacity of the economy. For example, an educated and healthy popula16

For a comprehensive literature survey of these ‘other’ inputs, their determinants, and effects, see Isaksson (2007).

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tion will be in a better position to absorb and learn from imported knowledge. The creation of knowledge through innovations has also been shown to be an important determinant of productivity growth where innovation can be defined as a network of institutions (universities, public and private research centers and think-tanks), rules, and procedures that influence the way by which a country acquires, creates, disseminates, and uses knowledge. Factor supplies mean the supply of human capital17 (healthcare and education), infrastructure, and the supply of savings (financial system). A better educated and healthier workforce is much better positioned to absorb and use the latest techniques in both the manufacturing and service sectors, the latter in the form of better managerial techniques and processes. A good infrastructure reduces transaction costs of doing business as the transportation of both goods and people becomes more efficient, and an efficient financial system allocates savings to investments in such a way that returns on capital are maximized. With respect to institutions, there are generally 3 main issues that policy makers need to consider to increase productivity: enforcement of property rights (encourages investment); constraints on the actions of powerful groups (reduces the risk of expropriation); and equal opportunity for all (ensures equitable distribution of income). Better and stronger institutions result in higher savings and investment which in turn cause faster productivity growth rates. Institutions are also import-

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It is implicitly assumed that capital (machinery, plant and equipment) can be measured and is always used by labor. For this reason, it is not usually included in the ‘other’ factors which influence productivity growth.

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ant in improving the process of innovation because it is regarded as a public good and cannot be left to the market alone18. The term institution can be interpreted either as a political entity or an economic one. In the former context, institution means the system of political structure such as democracy or autocracy. As an economic entity, institution implies the rule of law and property rights. There is very strong evidence that institutions play an important role in generating higher rates of productivity growth19. But the more interesting question is whether there are certain institutions that secure, for example, property rights better than others, and hence, generate faster productivity and growth rates. In a democracy, factors of production are allocated according to market forces given that citizens are well informed and that the state establishes a sound set of laws, rules, and rights20. But for these rules and rights to be effective, the state must be highly committed which is not always possible in an autocratic system because citizens cannot force autocrats to do so. But this does not mean that democracy works better than autocracy because threats to property rights in a democracy can originate from powerful groups such as organized labor or special interest groups. An ideal political system would be “a system where the state is effective in what it does while being insulated from what it does not want to do”. (Rodrik 1992).

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Innovations cannot be totally left to markets because the market outcome might be sub-optimal. 19 See Acemoglu, D. (2003). 20 Are citizens really well informed? Do they have access to accurate sources of information? These are highly restrictive assumptions, and once dropped, the whole concept of ‘the market’ as an efficient allocator of resources becomes ambiguous.

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The secret of Dubai’s economic success can be explained by its ability to be super-competitive by focusing on these ‘other’ factors which affect total factor productivity21. In terms of the creation, absorption, and transmission of knowledge, Dubai has been creating various ‘knowledge centers’ such as Dubai Knowledge Village, Dubai Academic City, Dubai Internet City, and Dubai Silicon Oasis. Dubai Knowledge Village (DKV), launched in 2003, places the Middle East on the map as a destination for learning excellence and provides a ready environment for a variety of knowledge-based entities including training centres and learning support entities. This thriving knowledge community was founded as part of a long-term economic strategy to develop the region’s talent pool and accelerate its move into a knowledgebased economy. Benefits for DKV partners include 100% foreign ownership, 100% freedom from taxes, 100% repatriation of assets and profits, and effortless visa issuance procedures. DKV also offers firstrate facilities for the use of its knowledge partners and their students including serene landscapes, food courts, and sports grounds. Its partners include diverse nationalities such as Australians, Indians, Pakistanis, Iranians, Russians, Belgians, English and Irish. DKV has over 350 partners which include training centres, professional centres and HR companies. DKV also enjoys the distinction of being the world’s only free zone totally focused on professional training and learning support services.

21

This may be one explanation for the relatively low levels of productivity figures in Dubai because these ‘other’ factors which affect total productivity are costly and reduce overall economic efficiency in the short-run.

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Dubai Academic City (DAC) is the world’s only free zone dedicated to higher education. A regional base for premier international higher educational institutions, DAC is the world’s first dedicated tertiary cluster development. Spread across an area of 25 million square feet, the DAC campus provides an intellectually inspiring environment for students and faculty. Benefits for DAC partners include 100% foreign ownership, 100% tax free, and 100% repatriation of profits. There are currently 32 international universities of higher learning from diverse regions including USA, Australia, India, Pakistan, Iran, Russia, Belgium, UK, and France, operating out of DAC and catering to the needs of over 12,000 students. These include Michigan State University, The University of Wollongong in Dubai, Middlesex University Dubai, and S.P Jain Centre of Management Dubai, among many others. These institutions offer programs that range in duration from one year to four years. Major academic programs on offer include engineering, computer science, media studies, environmental studies, child development, quality management, and business management programs. Dubai Internet City (DIC) provides a strategic and cost effective platform for ICT companies targeting emerging markets in a vast region extending from the Middle East to the Indian subcontinent, and from Africa to Central Asia. Launched in the year 2000, DIC now features a dynamic international community of ICT companies including global giants like Microsoft, Cisco Systems, IBM, HP, Dell, Siemens, Sun Microsystems, Computer Associates, PeopleSoft and Sony Ericsson. Many small and medium businesses and promising entrepreneurial ventures are also part of the community. The cluster comprises com-

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panies from a variety of sectors - software development, business services, web based and e-Commerce, consultancy, sales and marketing, and back offices. DIC provides an environment that attracts all the elements of the ICT value chain, and has developed several programs that can be leveraged by the community to explore and expand development opportunities. Companies are privy to an advanced Ethernet broadband infrastructure and a range of business-enabling services including government transactions. DIC also has the world’s largest commercial IP telephony network and offers both 100% tax exemption and 100% business ownership. Dubai Silicon Oasis (DSO) was established by the Government of Dubai in 2005 with the objective of developing an integrated technology park highlighting industries built around the production of information and communications technologies using semiconductors. Its vision is to make DSO one of the world’s leading centers of advanced electronic innovation design and development, and to create a universally recognized state-of-the-art ‘technology oasis’ by facilitating and promoting technology-based industries, research and development within a fully integrated community. It is spread over a 7.2 square kilometer area providing a highly conducive environment for manufacturing companies, warehousing, and regional offices. It is rapidly becoming a thriving urban community with a core technology zone surrounded by a master-planned residential environment consisting of villas, technologically advanced commercial and residential buildings, and offering 100% foreign ownership, zero

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personal taxation, zero corporate taxation, and a state-of-the-art IT infrastructure. Dubai has benefited immensely from its openness by acquiring knowledge through its imported intermediate and final goods and services, especially modern managerial techniques and construction technology. Dubai is also paying very close attention to upgrade its healthcare and education systems by establishing Healthcare City and conducting a comprehensive reform of its education system to be more compatible with the needs and requirements of a knowledge-based economy. The Dubai Health Authority (DHA) was created in 2007 with a clear mandate to upgrade health standards and improve the health of everyone living and working in Dubai. Since then, DHA has been responsible for promoting international accreditation of all healthcare services, and has actively promoted numerous partnerships between public and private healthcare providers. The Knowledge and Human Development Authority (KHDA), established in 2006, has the task of developing all knowledge and human resource sectors in the emirate of Dubai. KHDA aims to develop the education and human resource sectors and bring them on par with international standards and prevalent best practices while keeping in mind the requirements of the job market. Keeping in line with the economic and social growth in Dubai, the KHDA was established to ensure the continuous development of the education sector and to improve the quality and outcomes of education on all fronts and at all stages22. Moreover, huge infrastructure projects 22

The first ever official study into local education conducted by the Dubai School Inspection Bureau found that 9 out of ten schools in Dubai were found to be providing education that was ‘acceptable’. See Annual Report 2009, Dubai School Inspection

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from the Dubai Metro to the construction of new roads and bridges will ultimately lead to reductions in transaction costs and increase total factor productivity. Dubai has also established a modern financial center such as the Dubai International Financial Center (DIFC), encouraged Islamic finance, and developed various financial markets which will ultimately maximize the returns on capital. But perhaps the biggest advantage that Dubai has over other emerging economies is its focus on institutional performance23 by honoring property rights and a zero tolerance against corruption, especially in the booming real estate sector. In the political dimension, Dubai’s governance is very close to the ‘ideal’, as envisaged by Rodrik (1992) – “a system where the state is effective in what it does while being insulated from what it does not want to do” - a highly counterintuitive approach compared to most governance structures in emerging economies.

Bureau. 23 Institutional performance is discussed in detail in the section on Governance Indicators.

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Capital Inflows and Investment Real Estate The fastest growing sector in Dubai has undoubtedly been the real estate sector where the booming domestic economy has caused a large increase in the demand for both commercial and residential space. The surge in tourism has also increased the demand for hotels, hotel apartments, and various types of resorts to cater for the needs of different types of tourists. Moreover, the expansion of existing industrial areas in duty free zones and the construction of new ones have substantially increased the demand for housing for different income groups. This dramatic growth in the real estate sector has posed three related questions: What are the main causes of this growth? What are the underlying economic fundamentals of the Dubai real estate market? And, are there any signs of bubble trouble? The current boom in real estate traces its roots back to 1997 with the creation of the publicly quoted Emaar and Nakheel properties which have spawned developments such as Dubai Marina, Burj Dubai, The Palm Jumeirah, The Palm Jebel Ali, The World, and The Universe24. Until 2002, only Gulf Cooperation Council (GCC) nationals were allowed to hold property in Dubai while non-GCC expatriates living in the UAE were only permitted to rent or own property on a federally approved 99-year leasehold basis. In 2002, the Dubai government allowed the ownership of freehold property to all foreigners triggering 24

This list is by no means exhaustive. Many projects and developments are in the pipeline which will be completed during the 2008-2015 period, and beyond.

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a chain of events which quickly began changing the face of the real estate sector. The 2002 announcement coincided with another decree allowing foreigners to purchase and own freehold property in selected areas of the city known as ‘New Dubai’. It then took until March 2006 for the publication of the new law legalizing foreign ownership of properties in designated areas. As a further move to boost investor confidence in the real estate market, the Real Estate Regulatory Authority (RERA) was established in July 2007. The main responsibility of RERA is to formulate, regulate, and manage various real estate activities in Dubai. In 2009, RERA was affiliated with six global real estate associations and organizations to improve property laws and protect the rights of both developers and consumers according to global best practices. The second major cause of the growth in the real estate sector is the movement of resources into this sector because of its higher profitability compared to the profitability in other sectors. As capital inflows into Dubai have increased, especially after 2001, the economy-wide wage rate has also increased25. Producers, to make-up for the loss in their profits, have been forced to increase their prices. They were able to increase their prices in the non-tradable service sectors (the most prominent being real estate) but they were not able to do so in the tradable manufacturing sector because prices of manufactured goods are determined in world markets. This difference between the higher profitability in the real estate sector and the lower profitability in the manufacturing sector has attracted developers into the real estate sector as 25

Wages have increased because of greater spending caused by the increase in the money supply as a result of large capital inflows.

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evidenced by the increase in construction and related activities. The Dubai government has been able to reinforce these resource movement effects into the real estate sector by improving property laws and creating a highly conducive business environment for real estate developers. At the same time, the Dubai government has not neglected the lagging manufacturing sector which is evidenced by the establishment of various industrial parks such as Dubai Investment Park and Dubai Industrial City, to name just two. Whenever the word ‘market’ comes across, one tends to think of the concepts of ‘demand’, ‘supply’ and ‘price’. The real estate market is no different in the determination of the ‘price’ of real estate which is ultimately determined by economic fundamentals such as demand and supply. However, the standard analysis of this market is based on static instantaneous changes in market forces such as an overnight increase in the supply of housing. But as we know very well, an increase in the supply of housing does not happen instantaneously and one needs time to build new houses, structures, and buildings. Hence, in the real world, a more dynamic approach is required for real estate price determination. A second caveat is that the simplistic view of demand and supply is based on the assumption of perfect information (for both buyers and sellers of property) and does not take into account speculative motives which more than often have driven property prices, and which tend to be influenced by expectations rather than by pure economic fundamentals. For these two reasons, the analysis of the real estate market is not as straightforward as the analysis of other markets. For a more accurate determination of the price of real estate, and for more effective policy

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intervention, one has to take into consideration these shortcomings and be able to isolate the speculative factors from pure demand and supply fundamentals. Most economic commentators on the real estate market in Dubai have attributed the increase in the price of property, housing, and rents, to a supply shortage caused by the high rates of economic growth. Some have argued that this surge will be eliminated as new units are completed and released to the general public by 2010 26 thus dampening the upward pressure on prices, while others have predicted that the increase in population and tourism will result in further increases in the demand for residential and commercial space and will more than make-up for the increase in supply, thus sustaining the high prices in the real estate market27. Another factor which has been putting upward pressure on prices is explained by the actions of both individual and institutional speculators who purchase and hold property for short periods of time, and thus create an ‘artificial shortage’, eventually selling their properties at higher prices28. Having realized this rapid pace of price increases in the real estate market, the Dubai government has adopted various policies, with varying degrees of success, to control this price increase. Perhaps the most counterintuitive policy has been the use of rent controls for both 26

By some estimates, about 180,000 new units will be delivered by 500 registered developers in 2010. However, due to the recent slowdown in the real estate market, only about 60% of these units are expected to be delivered on schedule. 27 The population of Dubai is expected to increase from 1.4 million in 2007 to 1.7 million in 2010, and tourism is planned to increase to 15 million by 2015. 28 This practice is commonly known as ‘flipping’. Some speculators also purchase property ‘off-plan’ (on the map) by paying 5-10% of its value and sell them at higher prices after a few months.

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residential and commercial properties. The government in 2006 imposed a 15% cap on rental price increases which have been progressively lowered to 7% in 2007, and most recently to 5% in 2008 for tenants who have occupied their apartments for 2 years. This policy has been counterintuitive since no country has been successful in holding prices down using such controls29. The main argument against such controls is that they discourage developers and divert investment to more profitable sectors30. Rent controls also create black markets and are difficult to administer since they need to be enforced on a case-bycase basis and have many loopholes. Moreover, country experiences have shown that once these controls are lifted, prices tend to overshoot as landlords attempt to make-up for their ‘losses’. To control speculation, the Dubai government has recently enacted new rules and regulations administered by RERA to prevent property flipping by forcing property buyers to hold their properties for relatively longer periods of time, and by making it more difficult to purchase off-plan. Recent highprofile corruption scandals by well known property developers have also strengthened the government’s resolve against corruption by declaring a zero tolerance policy. All of these policies have been designed to maintain the traditionally high levels of confidence in the Dubai real estate market. As capital inflows into Dubai have decreased because of the global financial crisis, the rate of growth of wages has also decreased. 29

Except Canada which also simultaneously controlled wages and incomes. This is the reason for the transformation of the South Bronx area in New York City into a slum in the early 1970s as landlords began to cut down on maintenance, landscaping, and other expenses. 30

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However, profitability in the non-tradable sector, especially in real estate, is still greater than profitability in tradable sectors such as in manufacturing because producers in the manufacturing sector cannot increase their prices to make-up for their ‘losses’ 31. Developers in the real estate sector will still be able to raise their prices but not by as much as before the decrease in capital inflows. Given this relatively lower profitability in the real estate sector, investors will be inclined to move their capital to more profitable sectors but since real estate investments entail ‘sunk-costs’, capital is not as mobile as one would expect32. Hence, the rate of return on capital will be lower as evidenced by the fall in property prices in recent months. Some analysts have recently predicted property prices to fall by as much as 80% in the coming few months but such a large drop is highly unlikely because the Dubai government has considerably increased its expenditure to transform the Dubai economy from a supply-driven economy (where the government builds a business friendly environment to attract producers and suppliers of goods and services) into a demand-driven economy (where economic activity will be determined by aggregate demand). The real estate market has also been affected by lower spending as a result of reductions in capital inflows. This lower spending by consumers and investors has pushed down property prices further to more ‘normal’ levels. This ‘reverse’ Dutch Disease effect has not been as 31

Producers in the manufacturing sector cannot increase their prices because prices of manufactured goods are set in international markets. This is why they are also known as ‘tradables’ – i.e. manufactured goods can be exported and imported. 32 ‘Sunk-costs’ are investments that cannot be easily relocated elsewhere because of the physical nature of the investments. In other words, once a building is built, the capital (cement, steel, etc) used-up in the process cannot be ‘taken-out’.

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powerful as standard Dutch Disease effects demonstrated earlier because capital in the real estate market is less mobile than in other sectors such as in the financial service sector where one can easily withdraw capital. For this reason, the adverse direct effects of reductions in capital inflows on the real estate market will not be as severe as the adverse effects on banking, tourism, finance, and other non-tradable service sectors33. Nevertheless, both the general public and various analysts are deeply concerned about the effects of a real estate market ‘correction’. So are there any signs of bubble trouble in the Dubai real estate market? A simplistic view would be to say that if we can somehow separate the increase in the price of real estate into its fundamental (demand and supply) and speculative components, then if, say, 70% of the increase in prices is caused by fundamentals and 30% is caused by speculation, it automatically follows that the ‘correction’ would result in at least a 30% price fall. But just like a stock, a house has also a price-earning ratio, where earning is interpreted as rent34. When we buy a stock (an asset) we are effectively buying an earning stream. The price we pay for the stock should reflect current earnings and reasonable expectations about future earnings. A bubble is created when these get disconnected. The price of a house follows a similar logic – namely, 33

However, there may be indirect effects on the real estate sector because of liquidity shortages in the financial sector caused by ‘capital flight’. For example, as currency traders (primarily from GCC countries) were expecting a re-valuation of the UAE Dirham against the US dollar, they amassed large Dirham deposits at UAE banks. But as the de-pegging with the US dollar did not materialize, there was a huge ‘capital flight’ which reinforced the adverse effects of resource movements out of the real estate sector. 34 This section follows closely Leamer (2002).

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the price paid for a house should reflect the present value of future rents that the buyer expects to receive. The buyer must ask how much the house could currently be rented for on an annual basis, and then divide the seller’s asking price by this rental number. That’s the pricerent ratio. If a $200,000 house generates $10,000 rent annually, then the price-rent ratio is 20. A high price-rent ratio can be justified if the house is in an area that can be expected to experience high growth rates and thus rapid appreciation in rents, just like a technology stock can have a higher price-rent ratio than a car manufacturer. But one is completely mistaken if he or she thinks that there can be a long-run disconnect between a house price and its potential rental stream. If such a disconnect exists, then there is definitely bubble trouble. Going back to the analogy with the price of a stock, when a corporation experiences a rise in earnings, stockholders may bid up the price of the stock by a percentage that is higher than the increase in earnings, and thus increase the price-earning ratio. This new higher price-earning ratio could be based on the idea that these higher earnings are a permanent event. Similarly, if people think that there is a ‘momentum’ in rents with high appreciation supporting further increases in rents caused by expectations of population growth, increased tourism, and ‘shortages’, then the price-rent ratio of housing might also be set at a higher level. In other words, this higher price-rent ratio is based on the expectation of home buyers that rents will continue to rise, thus justifying higher prices for houses. A lot depends on the validity of these higher expectations which are in turn justified by so-called ‘shortages’ in housing. But a freely functioning market cannot have ‘short-

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ages’. A market system has high prices for some goods and low prices for others. A ‘shortage’ is created when the price mechanism is not allowed to work. There can be a ‘shortage’ of umbrellas in a storm because sellers choose not to increase the price to equate supply and demand. Then the sellers run out of umbrellas and people go without one even though they would have been willing to pay a higher price. A shortage can cause a rise in price if the fundamental demand and supply conditions that caused the price increase in the first place persist, and if the market is allowed to clear. But both the market for rentals and the market for houses are highly evolved and do not suffer from the fixed price pathologies that cause shortages. There are high rents, or low rents, but no ‘shortages’. There is no ‘shortage’ of houses anymore than there is a ‘shortage’ of cars, or diamonds, or shirts. Limitations on new housing can cause rents to increase at an abnormally high rate for a period of time but the higher rate of growth of rents should be quickly ‘capitalized’ in the price of a house once the market realizes the impact of supply restrictions on future rents. That means a one-time jump in price, and, thereafter, price changes like every other product – up sometimes, and down sometimes. In other words, since higher rents have been capitalized in the price of houses, then there is no guarantee that prices will always move higher. The global financial crisis and the concomitant fall in Dubai real estate prices have considerably reduced the willingness of banks to lend, especially for housing loans. Some banks have recently doubled the minimum salary requirement to qualify for a loan to consumers below a certain threshold, putting extra pressure on consumers’ ability to

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make timely mortgage payments. The recent fall in real estate prices has also reduced the ‘perceived wealth’ of many homeowners in various segments of the market. This wealth effect has reduced consumer expenditure, one of the largest components of aggregate demand35, putting added downward pressure on property prices. Property developers in Dubai have also announced ‘delays’ and some cancelations of real estate projects which will reduce future supplies. The ‘net’ effect on property prices will depend on the magnitude of these two market forces. If the fall in demand caused by the unwillingness of banks to lend is much larger than the fall in supply, then property prices will surely fall. On the other hand, if the fall in demand is less than the fall in supply, then the fall in prices will be moderate. Given that the UAE Central Bank has injected more than $30 billion into the banking system in recent months, and given that banks are currently more willing to lend, albeit at more stringent terms and conditions, the fall in Dubai property prices should not be very severe36.

35

Aggregate demand is the total demand for goods and services in the economy which is composed of 4 components: Consumer expenditure (C); Investment expenditure (I); Government expenditure (G); and net exports (exports – imports). In most developed countries, consumer expenditure accounts for up to 80% of aggregate demand. 36 The ‘net’ effect is beyond the scope of this book. For a more rigorous analysis, one needs to identify and measure the many factors that determine both demand and supply such as population growth, income, tastes, and many other factors.

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Tourism Another unexpected outcome has been the dramatic growth in the tourism sector. This outcome has been unexpected because Dubai had to compete with established tourist destinations in other parts of the world, especially under the political instability of the Middle East. Dubai has long been considered as the connecting link between Europe and Asia with a long history of acting as the ‘middleman’ in the facilitation of trade. Oil does not play a major role in its economy (about 3% of GDP) and tourism has contributed over 20% to its GDP attracting 6 million tourists in 2007 alone. The growth of the tourism sector can be explained by the higher profitability in this non-tradable service sector caused by Dutch Disease effects noted earlier. This higher profitability has encouraged both public and private foreign investment in the development of shopping malls, hotels, restaurants, entertainment and leisure activities, and many other related services. The driving force behind the development of the tourism sector has been the Department of Tourism and Commerce Marketing (DTCM) with the specific objective of transforming Dubai into a regional tourism hub. The current global financial crisis will undoubtedly have an adverse effect on the Dubai tourism sector. Tourism, by definition, is very sensitive to changes in income. For a more accurate assessment of this adverse effect, one has to distinguish between different types of tourism such as ‘business’ and ‘leisure’ tourism. Over the last few years, Dubai has been very successful in attracting a large number of ‘business’ tourists through its many international meetings, conventions, and exhibi-

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tions. Whereas ‘leisure’ tourism is regarded as non-essential expenditure and can be easily cancelled or postponed during economic hardships, business type tourism is not as sensitive to economic downturns. Unlike in most other emerging economies, the Dubai tourism sector is highly diversified catering to the needs of different types of tourists. In other words, the adverse effects of the financial crisis on the tourism sector in Dubai will be less severe than in other cities because the fall in tourism will be somewhat cushioned by the smaller fall in ‘business’ tourism due to the highly diversified nature of the Dubai tourism sector. The indirect effect of the financial crisis on tourism is that as tourism income falls, the profitability of this sector will also fall, forcing hospitality ‘guest’ workers to move out of this sector. To the extent that these ‘guest’ workers are willing and able to return back to their home countries, there will not be a large pool of unemployed workers that the government has to provide for through social and other programs. Having realized the movement of resources into this non-tradable service sector, the Dubai government has initiated many projects to reinforce these resource movement effects. The Dubai Shopping Festival (DSF) and the Dubai Summer Surprises (DSS) are only two notable examples in catering to the needs of international shoppers and vacationing families. DSF was first started in February 1996 by the Dubai government aimed at promoting trade in Dubai. Since then, it has become an annual shopping, entertainment, and cultural extravaganza that continues to promote tourism in Dubai and draws people from around the world each year. On February 15, 1996, the travel industry in the Middle East heralded the beginning of a new dawn - the birth of

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the most impressive shopping cum entertainment mega event. An entirely new concept, it succeeded brilliantly in showcasing what cooperation between private sector and public sector could do to create a mind-boggling achievement. Initially, the DSF was conceived as a pure retail event, the primary aim of which was to revitalize the retail trade in Dubai. It was later developed into a comprehensive tourism product in line with Dubai's far-sighted vision to set global standards in every field. DSF is basically a shopper’s paradise. Although Dubai is known around the world as such a paradise throughout the year, the red carpet is really laid out during shopping festival month with over 2,300 participating retail outlets that offer everything imaginable from gold, perfume, haute couture, cars, and electronics, to handicrafts and textiles. As months of preparations went into creating DSF, the shopping festival matured into a major retailing cum entertainment extravaganza. Today, one of the biggest beneficiaries of the event is the tourism sector. Hotels, travel agents and tour operators contribute to the selling of the event worldwide and run at peak levels of operation during the event. Every year, DSF lives up to its promise of staging the most exciting activities for the whole family inspired by the theme “One World, One Family, One Festival”. As universal brotherhood, happiness, excitement, joy and adventure became the signature trademarks of DSF, the Festival itself became a tribute to the inherent ambition and strength of the people of Dubai. Local and multinational brands acknowledged their faith in the event, and brands like Visa, Pepsi, and Emirates Airlines became partners to DSF's growth. Most hotels and apartments also get involved offering special discounts and offers

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during the period. Even the world famous Burj Al Arab is included in the hotels. With all these special discounts available, many would feel that would suffice. But Dubai goes quite a few steps further. There are scores of raffles that offer very attractive prices, and Emirates Airlines and most other airlines flying out of Dubai offer discounted airfares and much needed excess baggage allowances during the festival. There are other events as well including international fashion shows, children's events, street-side performances, nightly fireworks, film festivals, and many other cultural events that reflect the emirate's cosmopolitan character. One of the biggest events of them all, the Dubai World Cup, also takes place during the festival with a staggering US$ 12 million purse that makes it the richest horse race in the world. The Department of Tourism and Commerce Marketing (DTCM) has also focused on the worldwide promotion of Dubai as an ideal tourist destination and a thriving commercial and business centre, very attractive for Dubai property investors. This has involved setting up DTCM representative offices in many countries as well as participation in numerous international tourism fairs. In addition, DTCM has launched highly successful campaigns worldwide and has organised tourism related exhibitions. Dubai is also developing its medical tourism industry by establishing Healthcare City in partnership with Harvard Medical School to create a ‘centre of excellence’ for clinical and wellness services, and medical education and research aimed at competing with low-cost healthcare providing countries in Asia, especially Singapore and Thailand. This is another example of super-competitive-

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ness because Dubai is successfully competing with countries which have a well-established history of offering medical tourism37. In the leisure and entertainment sector, Dubailand 38 is the world’s most ambitious project catering to the needs of the entire family. This unique 3 billion square feet development has been designed to catapult Dubai onto the global map, reinforcing its ambition of emerging as an international hub of family tourism appealing to tourist segments across genders, age groups, world regions, and activity preferences. Dubailand is projected to attract millions of tourists annually from around the world once fully operational. A number of Dubailand projects are currently up and running including Al Sahara Resort, Dubai Sports City, and Dubai Autodrome, with a host of other projects currently in their final stages to be completed by 2010. The diverse projects under Dubailand include theme parks, eco-tourism projects, shopping malls, restaurants, and residential units. The project is estimated at $85 billion with a total of 45 mega projects and expects 40,000 daily visitors which will significantly contribute towards attracting 15 million tourists by 2015 as outlined in the Dubai Strategic Plan. It will also have a minimum of 55 hotels within its geographical location and pro37

Thailand, which received 1.2 million medical tourists in 2006, has gained an international reputation for offering the best of both worlds – inexpensive surgery combined with a 5 star beach holiday. Singapore, whose healthcare system has been ranked 6th in the world by the World Health Organization in 2006, consistently earns high marks in international surveys of medical tourists. It is aiming to attract one million foreign patients a year by 2012. 38 For a detailed description of Dubailand and its many theme parks and projects, see www.dubailand.ae

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jects a population of 2.5 million people which includes workers, residents, and different types of tourists once it is fully operational. Dubai's exciting new tourism destination started off as a huge cultural entertainment center to cater to the need for a central meeting point where different countries could showcase myriad cultures. Over the years it has grown into a star attraction among UAE nationals, resident expatriates from over 160 different countries, and visitors from across the world. Today, this major crowd-puller has been transformed into a unique international destination for tourism, entertainment, leisure and culture. As a world-class tourism destination, Global Village brings together diverse customs and cultures covering a broad spectrum of activities including music, dance, art, handicrafts, theatre, costumes, and cuisines of different countries. In addition to hosting the colorful activities that are organised by countries from the different continents of the world, Global Village also offers a range of top quality facilities and services including restaurants, shuttle transport services, and a huge parking area that can accommodate thousands of vehicles. Dubai has also developed numerous other touristic attractions over a relatively short period of time. The Burj Al Arab hotel has become an iconic symbol of Dubai. It is one of the region’s most famous tourist landmarks, and as a hotel it has set new standards for excellence in Arabian hospitality. The hotel, which was inaugurated in 1999, established its presence with its futuristic and magnificent exterior. The World, an archipelago of 300 man-made islands off the coast of Dubai, has been created from sand dredged from the sea. The World is a land-

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mark for future eco-tourism projects worldwide and is one of several tourist and commerce related projects off the coast of Dubai which can be seen from space. Dubai Marina, set to be the world’s largest manmade marina, located close to the heart of ‘New Dubai’ and linked with Jebel Ali Port, Dubai Internet City, and Dubai Media City. Mall of Arabia, set to be the largest shopping mall in the world, will have a final gross leasable area of 10 million square feet. Dubai Sports City, an entire sports city currently under construction in the entertainment complex of Dubailand, featuring apartment buildings as well as state-ofthe-art stadiums and facilities. Dubai Sports City will be the envy of venues around the world. Its centre-piece, a 60,000 seat, multi-purpose outdoor stadium, will play host to football, rugby, and athletic matches. Business Bay, a central business district located in Downtown Dubai, is designed primarily for international trade purposes and will have upwards of 230 buildings for both commercial and residential purposes. Burj Dubai, opening in 2009, is a super-tall skyscraper set to be the tallest building in the world. In a breathtaking design, which encompasses the makings of a small city in its interior, Burj Dubai will be the centerpiece of Dubai’s new Dubaitown District. Palm Trilogy, consisting of three man-made islands in the shape of palm trees, has been created to help solve Dubai's beach shortage. Atlantis is a 1,539 room, ocean-themed destination resort located at the centre of the crescent of the man-made Palm Jumeirah in Dubai. This US$1.5 billion joint venture project was developed with the Dubai government and was opened in September 2008. The resort utilizes a 46 hectare site with 17 hectares of water park amusement, further marine and entertainment attractions

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and a collection of some of the most renowned world-class chefs including Nobu, Giorgio Locatelli, Santi Santamaria and Michel Rostang. Atlantis offers an unprecedented entertainment centre, an impressive collection of luxury boutiques and shops, and extensive meeting and convention facilities. It is home to one of the largest open-air marine habitats in the world with some 65,000 marine animals in lagoons, and displays including The Lost Chambers, a maze of underwater corridors and passageways providing a journey through ancient Atlantis. Culture Village, situated on the Dubai creek, will offer a platform where all the components of a higher lifestyle can take place, satisfying the intellectual as well as the practical needs of residents and visitors. Visual arts, performing arts, and literary facilities will contribute to the higher standard style of living. Culture Village proposes a wide variety in styles and in content of art galleries, museums, theatres, public exhibition spaces, fashion activities, institutes specializing in different disciplines, gardens, and many other activities pertaining to the promotion of the arts in society and in the community in general. Restaurants and specialty stores will offer a mix that contributes to the eclectic and creative mood of the location. Bawadi will be the world's largest hospitality and entertainment development boasting from endto-end a spectrum of amusement centres, shopping malls, theatres, restaurants, convention centres, and hotels. Occupants at any of Bawadi’s 60,000 rooms in over 51 hotels will have their own incredible experience to bring back home. From the fabulous Desert Gate Hotels and Towers that mark the entrance and exit to Bawadi to the 6,500-room centerpiece Asia-Asia hotel, an 1,800-seat theatre, family and extreme

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sports parks, a themed shopping mall as well as a 20,000 seat multipurpose arena, Bawadi may stay unrivalled by any other development in the world for a long time. Bawadi will also be home to the world’s largest shopping area, literally promising a shop-till-you-drop experience, and providing over 40 million square feet of gross leasable area for retail outlets. Featuring malls, boutique malls, street shopping and an underground shopping area connecting all of Bawadi’s elements, the stage is set for Dubai to roll-out the longest shopping boulevard in the world. Besides its retail attractions including the Middle East debut of several global, high-profile brands such as Waitrose and Hamleys, The Dubai Mall has varied lifestyle and leisure offerings including a sprawling Gold Souk, an Olympic-sized Dubai Ice Rink, and the multimedia-rich Fashion Catwalk atrium. The Dubai Aquarium & Discovery Centre is already in the global spotlight having clinched the Guinness World Record for the ‘World’s Largest Acrylic Panel.’ The Dubai Mall will have a total of over 14,000 spaces for parking across three car parks, with valet services and a car locator ticketing system. Sprawling over 12 million square feet - equivalent in size to more than 50 soccer pitches – with an internal floor area of 5.9 million square feet and a gross leasable area of 3.77 million square feet, The Dubai Mall is the flagship development of Emaar Malls Group, the shopping malls subsidiary of global property developer Emaar Properties. When fully operational, The Dubai Mall will have over 1,200 stores of which nearly 165 retailers – equaling 1.1 million square feet or 30% of the total gross leasable area of the mall, are either new to the region or opening stand-

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alone or flagship stores for the very first time in Dubai. The retail mix includes two anchor department stores, Gallery Lafayette and Bloomingdale’s (both opening their first stores in the Middle East), two hundred and twenty gold and jewelry outlets, one hundred and sixty food and beverage outlets including Dubai’s largest food court with 40 outlets, a super-supermarket, and an organic food mart. A major challenge facing the tourism sector is the current slowdown in the global economy, which would adversely affect the tourism sector because of its income sensitivity. However, given the high rates of growth in GCC countries and the difficulties associated with outbound travel to Europe and the US, especially after September 2001, Dubai has been focusing on attracting high-income tourists from Arab and GCC counties in both the leisure and business tourism sectors. Dubai is the regional hub for meetings, incentives, conferences, and events (MICE) with over 100 international exhibitions and countless events held annually ranging from CityScape in real estate development to GITEX in information technology. On the other hand, Dubai is facing growing strains in its hotel capacity and infrastructure, and is working round the clock to broaden the range of its tourist services and upgrade its infrastructure to meet the shopping and travel needs of its visitors. The ultimate objective is to position Dubai as a global travel industry hub which is evidenced by building the largest airport in the world, a state-of-the-art Metro system, and various leisure and entertainment projects to attract 15 million tourists by 2015.

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Finance Dubai has also reinforced the flow of capital into the financial service sector through the establishment of ‘financial centers’ such as the Dubai International Financial Center (DIFC). The future of these centers as modern international financial centers will depend on maintaining a strong and transparent regulatory framework, continuing innovation, and making improvements in human capital, the business environment, and market access. DIFC was established in 2004 to serve as a gateway for the flow of capital to and from the region, and was spurred by the sharp increase in economic activity and the subsequent need for substantial financial intermediation.39 DIFC offers its participants a highly attractive investment environment such as 100% foreign ownership, zero taxation, and no restrictions on profit repatriation. It is regulated by the Dubai Financial Services Authority (DFSA), an independent regulator staffed by an impressive list of international professionals with a regulatory mandate covering asset management, banking and credit services, securities, collective investment funds, custody and trust services, commodities futures trading, an international equities exchange, an international commodities derivatives exchange, insurance, and Islamic finance. DIFC has registered over 320 companies, and the Dubai International Financial Exchange (DIFX) located at DIFC and regulated by DFSA, has a market capitalization of about $40 billion. It provides a dollar-denominated trading platform for interna-

39

See IMF (2008).

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tional issuers to raise capital and debt through conventional and Islamic instruments. These financial centers have fostered a vibrant market for Islamic financial products.40 DIFC has already established a strong presence in this market with about $16 billion listed in DIFX, and international investors are flocking to Dubai’s first Sukuk issuances and initial public offerings. Several Islamic finance learning centers have also been launched in Dubai which offer a range of Islamic financial, banking, and training programs to help meet the significant demand for human capital development. These learning centers are also aiming to attract practitioners from countries with large Moslem populations such as the US, UK, Germany, and France. The rapid pace of economic growth is also boosting the demand for insurance products with Dubai commanding approximately 50% of the UAE share. Life insurance is also increasing while the non-life segment of the market such as accident and liability insurance accounted for 60% of total premiums collected, followed by the fire, marine, and aviation segments. The banking sector in Dubai is also positioning itself to become ‘the’ regional banking hub driven by the very strong performance of the sector in recent years. There are currently 52 local and foreign banks in Dubai and the sector is seriously considering consolidating given the turmoil in global financial markets.41 This would considerably strengthen the ability of the banking sector to face global challenges by pooling resources 40

Islamic finance refers to a system that is consistent with Fiqh al-Muamalat (Islamic rules on monetary transactions). For example, since ‘interest’ is prohibited under Islamic law, instead of giving the borrower a loan, the bank purchases the item and resells it to the consumer at a mark-up. For an excellent discussion of Islamic finance, see Rahali (2008).

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and sharing risks. There is also very high potential in the retail banking sector with strong consumer spending and negative real interest rates. Dubai has also announced plans to establish a Financial Arbitration Center to quickly resolve disputes between businesses and different types of financial institutions. In its assessment of financial service sectors, the IMF and the World Bank jointly conducted a Financial System Stability Assessment (FSSA) in the summer of 2007 and concluded that the banking sector, which dominates financial intermediation, has enabled rapid credit expansion to households, corporations, and public and semi-public enterprises. Major construction projects for hotels, apartments, commercial and entertainment properties, and infrastructure have dominated the landscape in Dubai. Demand for credit has also been driven by rapid population growth and interest rates in the domestic currency that are negative in real terms. The assessment also demonstrated that the banking sector, as a whole, showed comfortable levels of profit having benefitted from the rapid expansion of the economy. In this favorable environment, the authorities have begun to open-up the banking sector to greater competition, and several stress tests conducted by the IMF and the World Bank joint team revealed that the banking system would adapt very well to a variety of shocks. Specifically, banks have absorbed the recent decline in stock prices with little effect on their balance sheets, and the rapid increase in overall lending has helped offset a drop in fees and commissions. The FSSA also concluded that the authorities 41

In 2007, Emirates Bank and National Bank of Dubai merged into a single entity, Emirates NBD. Such consolidations will ultimately create a few large banks with greater ability to withstand any external shocks caused by future crises.

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have made good progress in strengthening financial supervision by the approval of several key laws and the issuing of a new Code of Corporate Governance (May 2007) that is expected to enhance the governance and disclosure practices of listed financial companies. Nevertheless, the current global financial crisis has created a situation in which people do not expect high returns on physical and financial investments, preferring to keep their assets in short-term ‘safe’ bank deposits rather than make long-term investments – a ‘liquidity trap’ situation. In such a situation, banks are unwilling to lend at these low interest rates and consequently, any increase in liquidity by the Central Bank is ‘trapped’ with unwilling lenders. The current situation in global financial markets, and to some extent in Dubai, can be described as a ‘liquidity trap’ situation42 in which the nominal interest rate is so low that no one is willing to lend at the market rate of interest. Since banks base their lending decisions on real (taking into account the rate of inflation) rather than on nominal interest rates, they will not lend unless they can charge an interest rate which is at least equal to the rate of inflation during the period of the loan. In such a situation, the monetary authorities cannot stimulate the economy by lowering interest rates further. The alternative is to increase the money supply directly by injecting liquidity into the financial system as the UAE Central Bank has recently done. However, there is the real fear that most of this new liquidity, about $30 billion, will be ‘trapped’ with banks because of the low rate of interest. An alternative explanation of the recent economic slowdown is that the economy has suffered from the recession portion 42

This ‘liquidity trap’ situation was also prevalent during the Great Depression in 1929, and during the Japanese recession in the late 1990’s.

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of the business cycle brought on by high rates of inflation in Dubai which can only be ‘corrected’ by allowing the recession to liquidate the ‘wrong’ investments during the boom 43. In such a situation, government intervention of any kind will worsen the recession or even delay a much bigger one. The financial sector in Dubai has also attracted highly skilled professionals in the wake of the current global financial crisis. International branches of investment banks have set-up shop to cater for the needs of high net-worth customers in the Gulf region by providing specialized ‘boutique’ services and acting as suppliers of capital to other sectors, especially to the real estate sector. The current upgrading of the financial infrastructure of Dubai will considerably increase overall factor productivity as businesses will be able to raise capital and benefit from more diversified financial products. To reinforce the confidence in the financial sector and to reassure investors, the Dubai government recently injected $20 billion into the banking system to ease credit concerns and provide liquidity. The recent global financial crisis has also provided the opportunity for Dubai to boost its position as ‘the’ regional financial hub by providing a highly conducive business environment to enable the financial sector to innovate new products tailored to the specific needs of high net-worth Gulf investors.

43

This is also sometimes known as the Austrian explanation.

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Economic Policy vs. Commercial Policy Economic Policy Effectiveness When economic commentators speak of economic policy, they usually speak in very general terms such as the establishment of new companies, increases in investment, changes in consumer spending, increases in exports and imports, and the like. Even policies at the firm level are considered as economic policy. For an economist, economic policy tries to influence underlying macroeconomic variables using the tools of economic policy to steer the economy to desired growth paths. Given limited tools and instruments in a market economy, policy makers must usually choose between different macroeconomic priorities and do not have the luxury of choosing optimum policy tools due to trade-offs. For example, if policy makers target lower inflation, it will be at the expense of higher unemployment. If they wish to increase consumer spending, it will be at the expense of higher budget deficits, and so on. But all policy makers strive to achieve macroeconomic stability44 using ‘standard’ economic policy tools, knowingly and sometimes unknowingly, such as monetary policy, fiscal policy, trade policy, and labor policy. Monetary policy deals with controlling the money 44

Macroeconomic stability exists when key economic relationships are in balance— for example, between domestic demand and output, the balance of payments, fiscal revenues and expenditure, and savings and investment. These relationships, however, need not necessarily be in exact balance. Imbalances such as fiscal and current account deficits or surpluses are perfectly compatible with economic stability provided that they can be financed in a sustainable manner.

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supply through changes in the interest rate. Fiscal policy has to do with government expenditure and revenue. Trade policy tries to affect the terms-of-trade with its trading partners by changing (or fixing) exchange rates; and labor policy tries to affect underlying labor market forces to influence the wage rate (the price of labor). The effectiveness of economic policy, as demonstrated in many financial and economic crises, is not as certain as policy makers would like to perceive45. There are simply too many variables in the real world, and too many psychological reasons (‘expectations’) for policy tools to have a full impact on economic aggregates (such as on GDP, inflation, unemployment). But even under ‘ideal’ circumstances, the effectiveness of economic policy is based on behavioral assumptions. For example, if the responsiveness of consumers to changes in taxes is not very strong, then a given decrease in taxes will not have much effect on economic growth. Similarly, if a change in the money supply is not responsive to changes in the interest rate, then a decrease in the rate of interest will not increase liquidity. There are many such examples in economic policy where its effectiveness depends on the validity or ‘robustness’ of underlying assumptions. The effectiveness of economic policy in Dubai is further complicated by the fact that economic policy (monetary, fiscal, trade, and labor) is conducted by the federal ministries at the country level. The money supply is controlled by the Central Bank of the UAE; fiscal policy is determined by the federal government; trade policy is determined by trading relationships with the UAE; and 45

For an extensive discussion on the effectiveness of economic policies and the reasons as to why policy makers cannot always choose ‘optimum’ solutions, see the section on ‘The Luxury of Choosing First-Best Solutions’.

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labor policy is determined by the UAE Ministry of Labor. This unique situation has somewhat reduced Dubai’s degrees of freedom in conducting independent economic policies as we know it. Nevertheless, Dubai has been successful in conducting its own economic policies, sometimes in coordination with other emirates, to achieve desired outcomes46. The ineffectiveness of monetary policy, for example, is due to the fixed exchange rate with the US dollar which forces the UAE interest rate to move in the same direction of the US rate of interest. The increase in the money supply, on the other hand, is influenced more at the domestic level through changes in banking regulations, and by increasing the confidence in local banks, institutions, and financial markets. But even under these constraints, the Dubai government was recently successful in issuing government bonds to finance its economic growth47. Trade policies have focused on increasing trade through bilateral agreements, the expansion of existing ports and the construction of new ones, and by positioning Dubai as a trading hub for multinational companies. Fiscal policies have tended to be on the expansionary side given the rapid development of the Dubai economy and the continuous upgrading of its infrastructure. In June 2009, the government announced a further expansionary stimulus by announcing a 30 percent reduction in most of its fees to further boost economic activity. And finally, labor policy has been conducted by wage agreements with labor exporting countries (primarily with Southeast Asian 46

Note that ‘commercial policy’- those to do with rules and regulations to affect market structures at the industry and sectoral levels - is extensively discussed in the next section. 47 In early 2009, the Dubai government issued $20 billion worth of bonds which were subsequently purchased by the Abu Dhabi government with an annual yield of 4%.

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countries) and by enforcing labor substantially improving working conditions, especially for the unskilled segment of the labor force. But perhaps the two most important policy issues that have been the focus of much attention in recent months are the GCC currency unification and the introduction of a value added tax (VAT). The main argument for the introduction of a common currency in GCC countries is that it will reduce foreign exchange costs of intraregional transactions 48. A unified currency will eliminate foreign exchange commissions paid by firms and households when exchanging regional currencies. A unified currency will also eliminate uncertainty about bilateral exchange rates. The ultimate benefit of eliminating these costs and uncertainties is that it will increase intraregional trade and investment, and will contribute to advance the region’s economic integration. In addition, since trade between GCC countries is mostly in non-oil goods, the elimination of these costs will enhance non-oil sectors which are important strategic objectives of GCC countries. But the benefits of a currency union will be relatively small because of the relatively small size of intraregional trade between GCC countries49. Moreover, current exchange rates between GCC countries are already virtually fixed because of their fixed exchange rate systems with the US dollar (except in Kuwait). Nevertheless, when the benefits of a currency union are evaluated in terms of the contribution to the non-oil sector, the benefits are 48

In May 2009, the UAE exhibited ‘reservations’ in joining the currency union due to disagreements on the location of the GCC Central Bank. Although the UAE was the first country to propose the establishment of the GCC Central Bank on its soil, other GCC members chose Saudi Arabia (Riyadh) as its location. 49 The value of intraregional exports represented less than 10% of the total value of all GCC exports compared to over 50% in the European Union. See Jadresic (2002).

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significant. When both crude and refined oil exports are excluded from intraregional trade data, total exports among GCC countries increases to over 40%, and for some countries such as Kuwait and Qatar, this figure is as high as 60%50. One major disadvantage of a currency union is that countries have to give up the option of unilaterally changing their exchange rates. This is considered a disadvantage because there is always the possibility that a country might face a large current account deficit and will not be willing to bear the full adjustment costs of lower nominal wages and lower prices in a currency union. Another cost of a regional currency union is that countries will lose the independence and control of their domestic monetary policies. Although one could argue that the effectiveness of monetary policy is already very limited under the current fixed exchange rate system with the US dollar, countries can still influence domestic liquidity by printing their individual currencies, something that would not be possible in a currency union. But perhaps one of the greatest fears of joining a currency union is that countries that face no fundamental economic problems of their own may end-up suffering negative monetary spillovers from macroeconomic imbalances of other countries. In other words, the monetary union may be forced to modify existing monetary and exchange rate arrangements for the ‘common good’ despite the objections of an individual country which may ultimately experience the adverse effects of the changes in 50

Rose (1999) has found that after controlling for variables such as geographic proximity, existence of established trade agreements, language, common cultures and histories, two countries that share the same currency trade 3 times as much as they would with separate currencies.

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these arrangements. However, given that all GCC countries are oil and/or gas exporters, an external shock will affect all countries such that their interests will eventually converge. Moreover, they may always jointly decide on changing the peg for the common currency in the face of common external shocks. A second policy issue which has gained much attention in recent months is the introduction of a value added tax (VAT). The general concern is that this tax will ultimately lead to higher prices and add extra pressure to already rising rates of inflation. A VAT is a tax on all sales of goods and services at every stage of the production process. Its defining feature is that it credits taxes paid by firms on their inputs against taxes they charge on their sales – i.e. the government collects revenue on “value added” throughout the production process. Its distinguishing feature is that it does not affect the prices firms pay for inputs because the tax is ultimately passed-on to the final consumer. Since it does not affect input prices, it does not cause any production distortions and does not create “cascading”51. Perhaps the biggest advantage of the VAT is that it is very practical to implement since it is collected at every stage of the production process. As a simple example, suppose firm X sells its output to firm Y for a price of $100, which in turn sells its output to the final consumer for $300. Assume now that there is 10% VAT. Firm X will now charge firm Y $110, remitting $10 to the government in tax. Firm Y will charge consumers $330, remitting tax of only $20 (output tax of 30$ minus a credit for the $10 of tax charged on its inputs purchased from 51

Cascading is a “tax on tax” when a tax is levied on both the output and on the final inputs used in the production of that output.

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firm X). The total revenue of the government is therefore $30. Although this is equivalent to a 10% tax on final sales of $300, this method of collection secures the revenue more effectively. In other words, if firm X, for some reason, were to omit charging tax to firm Y, the government would still collect $30 from firm Y. If firm Y were to omit charging the tax, the government would at least collect the $10 from firm X. The advantage of VAT over a standard sales tax on final consumption is that if the final retailer (firm Y) somehow were able to avoid paying tax, then the government would still collect $10 from firm X. With a sales tax, the government would receive nothing52. Despite the problems faced by economic policy makers in general, and problems associated with the definition of economic policy as economists understand it, Dubai has been highly successful in formulating effective economic policies53. This is primarily because policy implementation in Dubai is taken very seriously with strict timelines and monitoring mechanisms. The effectiveness of economic policies in most emerging economies is hampered by poor enforcement and ‘loose’ implementation due to bureaucratic red-tape and the lack of qualified professionals. Even in developed economies, the effectiveness of economic policy is hampered by special interest groups with their 52

The ultimate payer of the tax is the consumer. Thus, there is some justification about the concern on rising costs-of-living. For a detailed yet very simple discussion on VAT, see Liam E. et al (2002). 53 The effectiveness of economic policy can be measured either in a partial equilibrium model or a general equilibrium model. In the former, the modeler looks at the effect of the policy on a single market in isolation from the rest of the economy. Such models are common in the analysis of the impact of a policy on a specific industry. In a general equilibrium model, the analyst looks at the effect of the policy on the whole economy by modeling inter-industry transactions and linkages between different economic agents such as firms, households, the government, and the rest of the world.

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own objectives, and by the fact that governments may be ‘voted out’ and will not have the required time to implement a given policy. Moreover, any economic policy will have ex-post undesirable outcomes affecting economic groups disproportionately and which cannot be determined until the policy is fully implemented ‘on the ground’. The secret of Dubai’s success in increasing its economic policy effectiveness is that these undesirable outcomes are quickly rectified through the establishment of specialized task-forces, working-groups, committees, and other specialized agencies. Perhaps a good example of the effectiveness of economic policies in Dubai is the current implementation of the Dubai Strategic Plan (2015) which contains hundreds of initiatives and action plans to triple Dubai’s GDP to over $100 billion by 2015. The DSP(2015) is having some undesirable, yet expected impacts such as a rising cost-of-living and falling real wages which are being rectified by a special task-force on inflation and the signing of agreements with labor exporting countries to increase wages.

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Commercial Policy and Market Structure Notwithstanding the limitations of economic policy in the traditional sense, Dubai has adopted commercial policies in the form of laws, rules, regulations, and projects to attract foreign investment and affect market structures. Perhaps the most important of these commercial policies has been the establishment of Free Zone Areas as international business hubs in a wide range of sectors and services such as Dubai Airport Free Zone, Dubai Healthcare City, Dubai Knowledge Village, Dubai Industrial Park, and much more54. Dubai is well placed midway between Europe, Asia, and Africa and provides its clients with a huge customer base of over 2 billion people. An outstanding logistics infrastructure is one of the free zones’ key strengths. Dubai has also the world’s 7th largest seaport and the upcoming Al Maktoum International Airport will be the world’s largest cargo airport. Free zones also provide a range of facilities which include pre-built modern warehouses ready for lease, office space in various sizes, and plots of land from small and large scale operations such as manufacturing and extensive warehousing. Free zones enjoy a wide range of commercial incentives, from a 100% foreign ownership, zero corporate and income taxes for a period of 50 years, to exemptions from local labor restrictions, full repatriation of profits and capital, and no foreign currency restrictions attributes seldom found in other parts of the world. The two commercial policies which have had the greatest impact on Dubai’s economic growth are the Trade Agency Law and the 54

For a comprehensive list of all free zones in Dubai see eyeofdubai.com

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Company Law55. The Trade Agency Law grants special privileges to UAE nationals to import specific goods. The law has been criticized on various grounds for restricting competition. Recently, the government has been considering the enactment of a Competition Law to limit the goods that UAE nationals can import, and some items, especially food items, have been exempted from this law to increase the availability and choice of these products due to the rising cost-of -living. The Company Law restricts foreign ownership of companies to 49% of total capital except in Free Zone Areas. Some sectors, especially the service sector such as education, healthcare, and technology, have been exempted from this requirement on the grounds that such restrictions have held back human capital development by discouraging highly skilled professionals to start their own businesses in areas other than in the free zones. Despite the many advantages that these laws provide to foreign companies, both the Trade Agency Law and the Company Law have been unfairly criticized by international organizations, especially the World Trade Organization, on the grounds that they discriminate against foreigners and distort resource allocation56. Many other commercial policies, initiatives, and projects are also formulated and implemented by the various Dubai government departments and agencies such as the Department of Economic Development (DED), Dubai Chamber of Commerce and Industry (DCCI), Dubai Ports, Customs and Free Zone Corporation, and Dubai Municip-

55

See UAE Federal eGovernment Portal http://www.government.ae/gov/en/biz/start/incorp.jsp

56

See World Trade Organization (2006).

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ality, to name just a few57. The Department of Economic Development was established with a mission to contribute to economic planning and business sector regulation by recommending policies and preparing development programs and projects. Its most important goal is to create a competitive investment environment to attract local and foreign investment, and to organize the business sector according to best practices. To achieve this goal, DED has been instrumental in conducting specialized studies on different economic sectors, recommending policies and processes to attract investments, performing regular reviews of its rules, regulations and procedures, and becoming close partners with the private sector. DED has also several projects to enhance competitiveness and human capital. ‘Intilaq’ (which means ‘take-off’ in Arabic) is a project initiated back in 1999 to encourage all UAE citizens residing in Dubai to start their own home-based businesses within the framework of certain regulations and professions to preserve the residential character of neighborhoods while permitting certain limited commercial activities such as fashion design, educational services, and brokerage services. DED has also launched a ‘Human Development Initiative’ which includes a number of projects and awards that aim at upgrading and developing human resources. The Dubai Chamber of Commerce and Industry (DCCI) started its activities in 1965 with only 450 members, and by the end of 2007 had over 100,000 registered members representing all economic sectors. DCCI has been continuously streamlining its processes to simplify 57

For a comprehensive list of all Dubai government departments and agencies and links to their respective websites, go to www.dubai.ae

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and expedite the setting-up of businesses in Dubai by acting as an information and research center by providing business documentation, offering legal services, facilitating business networking opportunities, and providing effective business solutions to the business community. The Dubai Ports, Customs and Free Zone Corporation encompasses Dubai Ports World (DP World), Dubai Customs (DC), Jebel Ali Free Zone Authority (JAFZA), and Dubai Multi Commodities Center (DMCC). Terminals in Dubai are among DP World’s flagship facilities and are ranked as the 7th top container port in the world handling 11 million TEU of cargo in 2007. Dubai Customs facilitates free trade and helps secure the integrity of Dubai’s borders. Its major duties are the collection of customs revenue and the administration of trade measures. It has also implemented information networks to minimize customer hassle and manage risk efficiently. Jebel Ali Free Zone Authority (JAFZA) is spread over an area of 50 square kilometers and ranks among the world’s largest and fastest growing free zones. Since 2000, JAFZA has grown by over 3 times its original size and is situated between Jebel Ali Port and the upcoming Al Maktoum International Airport. It is the only free zone in the world located between these two major logistic enablers, and with a six lane highway, JAFZA will facilitate the transportation of goods from sea to air in just 20 minutes. The Dubai Multi Commodities Center (DMCC) was created to establish a commodity marketplace in Dubai and provide a full range of facilities for gold, precious metals, diamonds, colored stones, energy, and other commodities. Its objective, among others, is to facilitate the integration of the entire value-chain of its key segments by providing a highly supportive busi-

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ness environment. DMCC is a Free Zone Area offering participants 100% ownership, a 50 year tax exemption, and a one stop shop facility for processing all documentation including immigration, registration, and licensing. The highly supportive role of the government through these commercial policies has attracted a large number of firms into the service sector58, especially in the retail, hospitality, finance, and real estate sectors, creating a very healthy competitive market structure59. These markets in Dubai are characterized by fierce competition, primarily through marketing and advertisement campaigns, to differentiate their products in terms of quality, taste, preferences, and other attributes resulting in the provision of a wide variety of goods and services catering to the distinct needs of various income groups especially in the retail and hospitality service sectors. On the other hand, the market structure in the telecommunications sector can be described as an oligopolistic structure in which there are only 2 service providers, Etisalat and du, which, unlike oligopolies in the traditional sense, do not collude but compete to improve their services. Some service sectors, such as utilities, are ‘natural’ monopolies because of strategic reasons but do not act 58

The relative growth of the manufacturing sector has been slow because of Dutch Disease effects through an appreciation of the real exchange rate – i.e. a unit of the foreign currency now buys less domestically manufactured goods. This has reduced the competitiveness of the manufacturing sector. 59 Market structure refers to ‘the degree of competition’ in a specific market which ranges from perfect competition to monopoly. In a perfectly competitive market, there are many buyers and sellers dealing with a single homogeneous product. In a monopoly, there is a single producer. In the real world, however, market structures fall somewhere between these two extremes such as monopolistic competition where there are many buyers and sellers but a differentiated product, and oligopoly in which few firms (2 to 10 depending on the size of the existing market) dominate the market.

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as typical monopolies in the sense that they do not restrict output to charge higher prices. This is especially true of the Dubai Electricity and Water Authority (DEWA) which has relatively low tariff rates, especially if one takes into account the scarcity of water resources in the region. Moreover, the price of gasoline is much lower than prices in other countries because these prices are heavily subsidized by the government. Most ‘outsiders’ incorrectly think that Dubai is rich in oil just because it is in the Gulf. On the contrary, Dubai has very limited oil resources and purchases most of its oil needs at international prices.

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Governance and First-Best Solutions Governance Indicators The secret of Dubai’s economic success is also explained by the intimate involvement of the Dubai government in the provision of goods and services to consumers and businesses alike. Governments, by definition, are inefficient because they do not allocate their resources using the price mechanism. In a market economy, the price system acts as a powerful signaling mechanism ‘telling’ producers what and how much to produce. In other words, in a market economy, demand creates supply. If a typical government wishes to supply a product or a service to the public, its ‘price’ is not determined by demand and supply factors. This misallocates resources by producing goods and services that are not demanded by the public, or by underproducing and creating shortages. For this reason, the Classical school of thought holds the view that the role of the government should only be a regulatory role such as policing and judiciary, and should not interfere in the market system. On the other hand, the Keynesian school of thought advocates government intervention in the market system through fiscal policies (taxes and government expenditure) to help achieve desired economic outcomes60. Although in the real world there 60

Prior to the start of the Great Depression in 1929, the Classical (or laisez faire) school of thought was the dominant school arguing that any market inequalities will be automatically corrected by the ‘invisible hand’ through the forces of demand and supply, and there is no need for government intervention. However, the high and persistent levels of unemployment during the Great Depression were not eliminated through automatic market corrections and the government had to interfere extensively through its use of Keynesian expansionary fiscal policies by reducing taxes and in-

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is always some form of government intervention, the recent collapse of the global financial system and the subsequent intervention of governments to bail-out these financial institutions demonstrate the dominance of Keynesian government intervention over the classical ‘hands-off’ approach. The secret of Dubai’s economic success has been the government’s deep involvement in the market and its genuine desire to improve its performance; again, a highly counterintuitive approach compared to the role of many other governments in emerging economies. Governance is defined as ‘the manner in which public officials and institutions acquire and exercise the authority to shape public policy and provide goods and services’. 61 The difficulty in measuring government performance is that unlike the output of commercial entities, the ‘output’ of the government is a highly subjective concept influenced by the views and opinions of individuals, firms, and experts. As Einstein’s quote reminds us, “not everything that can be counted counts, and not everything that counts can be counted”, Dubai has been highly successful in choosing those indicators that matter most. In principle, all governance indicators fall into two groups: rules-based and outcome- based indicators62. In the former, we determine the existence (or non-existence) of a rule, and in the latter we look at the implementation of the rule ‘on the ground’. For example, in a rules-based indicatcreasing government expenditure. 61 Although there are many definitions of governance depending on the level of development and the political structure of a country, most definitions agree on the importance of a capable state operating under the rule of law. For an extensive and practical discussion on governance and its many indicators, see World Bank (2007). 62 For a detailed discussion and list of rules-based and outcome-based indicators, see Kaufman and Kraay (2007).

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or we determine if there are rules ‘on the book’ on, say, compulsory education, and we ‘map’ this rule to outcomes ‘on the ground’ by asking the public through opinion surveys if it perceives the country to have a good education system 63. Dubai has been very innovative in the use of governance indicators to measure and evaluate government performance through various programs and initiatives64 such as the Dubai Government Excellence Program (DGEP), the Dubai Government Performance Measurement System, the Mohammed bin Rashid Program for Leadership Development (MBRPLD), and many innovations in e-Government to improve performance and delivery of public services. Most of these programs and initiatives are outcome-based governance indicators. The most notable of these programs is the Dubai Government Excellence Program (DGEP) which was initiated at the Department of Economic Development (DED) in 199965. Its main objective, among many others, is to establish a guiding reference and benchmarks to measure the progress in effecting change and evaluate the performance of public agencies according to established criteria in different categories divided into ad-

63

The most frequent criticism of such indicators is that it is impossible to trace back a specific outcome ‘on the ground’ to a specific rule ‘on the books’ because there are many other variables that can influence the outcome. Moreover, there is no clear demarcation line between rules-based and outcome-based indicators, and both types of indicators are highly subjective and are based on value-judgments. 64 For an excellent discussion on the Dubai experience in governance, see Al Yousuf (2005). 65 The original name of the program was the Sheikh Mohammed bin Rashid Government Excellence Award which was conceived as an innovative impetus to speed up the pace of change and drive all administrations towards improvements, increased efficiency and effectiveness.

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ministrative excellence and employee excellence 66. In 2002, the ‘mystery shopper’ was introduced to the evaluation process, and in 2003 the concepts of employee satisfaction and departmental social responsibility for the community were added. Also in 2003, a category called ‘Excellence in Departmental e-Government’ was added with the aim of achieving a paperless public administration. In 2004, the original model67 was changed to the European Business Excellence model which enhances innovation, learning, and transparency. Today, in a highly publicized ceremony broadcasted nationwide, winners are granted promotions and substantial monetary rewards for their achievements. After seven years of its launching, DGEP commissioned the services of a team of experts from Cranfield School of Management in the UK to measure the impact of the excellence models on public administration and users of public services. Their study concluded that DGEP is credited as being the ‘key driving force’ behind the remarkable performance of the public sector. To ensure a more professional approach to the collection, analysis, assessment and monitoring of performance results, the government has recently installed a state-of-the-art performance management software to assist departments in the preparation and submission of their applications for evaluation. The government has also achieved remarkable progress in the application of electronic on-line tools in the provision of a wide range of services to the general public. The Dubai e-Government initiative was launched in 1999 and currently handles 90% of about 2000 public 66

For an in-depth discussion of the inception of this program and its subsequent modifications, see Makharita, R. (2005). 67 The original model was an adaptation of the US Malcolm Baldrige model.

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services provided by the government. For example, Government e-Services Statistics (GeSS) measures the levels of e-Enablement from overthe-counter services to e-Services by government departments; the eComplain service allows all customers to electronically record and track their complaints against government entities which are then forwarded to the respective departments to improve customer satisfaction; e-GovCards is a convenient, flexible, and highly secure alternative to carrying cash, and has all the advantages of a standard payment card in addition to unique government-related features; and mPay enables one to make payments using the mobile phone. All of these electronic services have considerably reduced transaction costs and increased competitiveness with the ultimate objective of increasing overall economic productivity. According to the United Nations international classification, Dubai has reached the fifth and final stage in the project lifecycle of e-Governance by offering fully integrated services through a single portal, namely, www.dubai.ae To sustain the development of the Dubai economy and further improve governance, the government has also been supportive of creating ‘future leaders’ to achieve the ambitious targets of the Dubai Strategic Plan (2015), and beyond. The Mohammed bin Rashid Program for Leadership Development (MBRPLD) is a highly innovative program comprising of four categories – Young Leaders, Promising Leaders, Government Leaders, and the Director-General Majlis. The overall aim of this program is to foster leadership skills in UAE nationals to ensure local sustainable development in partnership with leading institutes such as INSEAD, Harvard, Duke Corporate Education, and the

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like. The program was launched in 2003 and has produced over 150 graduates who are employed in government and semi-government organizations. Some graduates have also been employed in the private sector and a number of them are currently leading new projects and establishments. The distinguishing feature of MBRPLD is that it tries to achieve balanced growth in various fields of leadership by providing the opportunity to all UAE nationals to develop their ‘hidden’ leadership abilities in their specific areas of interest. In this way, each future leader is given a chance to distinguish himself or herself in their chosen field of expertise. The program is regularly updated to take into account regional and international developments such as the recent launching of a training program on Business and Finance Fundamentals in response to the current global financial crisis. It is also important to note that the deep involvement of the Dubai government in the economy does not imply that the government will always act as a lender of last resort to bail out under-performing establishments. The raison d’être of the government’s interference in the economy of Dubai is to increase competition by creating a healthy competitive environment for all, both private and public establishments, so that they can compete on a level playing field. The ‘moral hazard’ problem – a situation in which large establishments perceive that the government will always bail them out – was clearly demonstrated in the bail-out of US and other financial institutions.68 The risk 68

The argument for bailing-out large establishments is that their collapse will have ripple-effects throughout the rest of the economy and cause irreparable damage. This argument is misleading since the financing of the bail-out is harmful by itself since it is paid for by the public in higher taxes.

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of bailing out inefficient establishments, whether private or public, is that this would breed more inefficiency and ultimately decrease overall productivity. Perhaps the best example of the absence of the ‘moral hazard’ problem in Dubai is the recent fall in the price of Emaar stocks, a partially government owned real estate developer, in which the government has not interfered to boost its stock price. This has forced Emaar to cut labor costs by laying-off hundreds of workers and restructure to increase profitability. In other words, under-performing establishments, even public ones, do not get special treatment in the highly competitive Dubai market. Again, a highly counterintuitive approach compared to the support granted to inefficient ‘natural’ monopolies in most other emerging economies.

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The ‘Luxury’ of Choosing First-Best Solutions The secret of Dubai’s economic success can also be explained by the government’s ability to choose first-best optimum solutions to pressing economic problems. In most advanced economies, first-best solutions are determined by social science researchers using a wide range of sophisticated ‘models’ to replicate the effects of a specific policy which ‘theoretically’ enables them to choose the ‘optimum’ policy among many alternatives. But models are nothing but rough representations of the workings of a real complex economy with a countless number of unpredictable variables which can influence the outcome of a given policy69. Even if modelers were able to accurately capture these real world variables in their policy analyses, there are certain aspects of the real world policy making process that are incompatible with the utilization of research. For example, research requires a clear definition of the problem and the variables to be measured which is not always possible because governments tend to have loosely defined and multiple, even contradictory, objectives. Moreover, the need for research often becomes apparent too late because of other more urgent priorities. It is also important to realize that in the real world, especially in Western societies, policy decisions are arrived at through a bargaining process to satisfy the political needs of the ‘opposition’ or some special interest group. For all these reasons, accuracy and specificity are sacrificed at the expense of ‘broad statements of principles’ declared by 69

This does not mean that models are not important. On the contrary, models simplify the real world by focusing on variables that matter most, especially in determining the direction and magnitude of a specific policy change. In other words, just like travelling from one city to another, we do not need to know every single landmark on the way. The direction and distance of the route will get us there.

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governments that are not easily amenable to rigorous research and analysis. Another important aspect of the policy making process is that the objectives of researchers and government policy makers are not always the same70. Policy makers in government are more interested in distributional issues such as ‘winners’ and ‘losers’, whereas policy researchers are concerned with efficiency issues such as the efficient allocation of scarce resources. Moreover, most policy makers in government tend to have backgrounds in law and thus favor legislative instruments as opposed to using incentives to affect economic behavior. University research is also not very suitable for policy makers because it takes much longer to produce research results at academic institutions than a policy maker in government with a short deadline can tolerate71. Nevertheless, there are three conditions under which first-best solutions are most likely to be adopted by governments72. The first of these conditions is when research is concerned with critical future outcomes such as forecasting population growth rates or rates of growth of the economy. The second condition is when there are powerful competitive pressures and incentives to innovate. And the third condition is when government departments are highly accountable and must somehow justify the policy decisions they take. Bearing in mind that first-best solutions can be adopted by governments under these conditions, it is indeed encouraging to see that Dubai satisfies all three conditions. 70

See Glover, D. (1991). This does not mean that university research is not important. It simply implies that university research is ‘research for knowledge’ as opposed to ‘research for action’ which the policy maker in government requires in a relatively short period of time especially when the economy is in a recession. 72 See Faulhaber and Baumol (1988). 71

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With respect to the first condition, a big chunk of policy research in Dubai has been concerned with forecasting critical future outcomes for planning purposes. For example, the Dubai Strategic Plan (2015), currently being implemented by the government, is based on several assumptions on the rate of growth of population, on the number of incoming tourists, on the cost-of-living, on the supply of housing, and many other determinants of the successful implementation of the DSP(2015). We also need to bear in mind that the Dubai economy is currently a ‘supply-driven’ economy where the government is building both the soft and hard infrastructures of the economy to attract investors, tourists, and different types of labor. The objective of the DSP(2015) in the long-run is to transform Dubai into a ‘demand-driven’ economy in which production of both goods and services will be determined by tastes, preferences, consumer behavior, and expectations. For policy purposes, it is much easier to forecast future critical outcomes in a ‘supply-driven’ than in a ‘demand-driven’ economy because there are fewer uncertainties in a ‘supply-driven’ economy. For this reason, the Dubai government has been able to choose first-best optimum solutions from many alternatives. Moreover, critical future outcomes, especially in the short-run, are much more relevant in a rapidly changing economy because the DSP(2015) can be modified, especially during the initial stages of its implementation, to achieve its highly ambitious objectives73. The Dubai economy is also a highly competitive economy and there are numerous incentive structures in place to encourage innovation in both government and industry. The fulfillment of this second condition 73

In May 2009, the government announced that the targets and assumptions of the Dubai Strategic Plan (2015) were to be revised and adjusted to current global market conditions.

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is self-explanatory since the very definition of ‘competition’ necessitates the choice of first-best solutions to achieve optimum outcomes in a competitive environment. These powerful competitive forces have been repeatedly demonstrated throughout the book either in the form of market forces beyond the control of the government (Dutch Disease effects) or in the form of incentive structures such as the various excellence programs and awards to encourage innovation in governance and the establishment of ‘technology’ clusters to encourage innovation in industry. And finally, the third condition of accountability of government departments was extensively discussed in the previous section. The fulfillment of all three conditions, by no means an easy and ‘luxurious’ task, has enabled the Dubai government to choose first-best optimum solutions.

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Dubai Strategic Plan (2015) and Sustainability Building-Blocks of DSP (2015) 74 Dubai’s economic growth has been truly remarkable with doubledigit real GDP growth rates and a relatively high per capita income despite negligible dependence on oil. The driving force behind Dubai’s economic performance has been the government through investments and other initiatives supported by the private sector. Economic performance at the sectoral level has also been impressive and has been led by the trade, construction and real estate sectors with good signs of successful diversification. In particular, since 2000, real GDP has been growing at a compounded annual growth rate of 13%, by far exceeding that of its GCC counterparts. The Dubai economy has also been growing faster than the emerging economies of China and India, and the developed economies of Ireland, Singapore, and the US. Much of Dubai’s current success has been a result of its bold and visionary leadership and innovative human resources, mainly driven by government policies aimed at improving the business and investment environment, in addition to initiatives to establish specialized zones and megaprojects such as Internet City, Media City, Healthcare City, the Palm, Dubailand, and much more. These developments ensured a leading role for Dubai and help attract excess regional liquidity in the form of foreign direct investment. Economic growth has also been fueled by private sector participation in developing sectors for which the government has set the 74

This section follows closely The Executive Office (2006). Highlights: Dubai Strategic Plan (2015), Dubai… where the future begins. Dubai, United Arab Emirates.

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stage by establishing a conducive business environment, coupled in many instances with heavy initial investments to boost private sector confidence. Other supporting factors are supply-side factors such as availability of labor and land for major real estate projects, the existence of efficient government services, a solid institutional framework and good mechanisms for service delivery, strong laws and regulations, excellent infrastructure, a strategic location coinciding with the rapid rise in global trade especially in China and India, and openness to other cultures giving Dubai a reputation as a safe and comfortable place to live and do business. These factors have put Dubai’s real per capita GDP at $31,104 in 2005 with an annual average growth rate exceeding 6% over the 2000 - 2005 period75. Economic performance at the sectoral level has also been impressive. The non-oil sector has played a more prominent role since 2005 with a 95% contribution to GDP, as compared to 90% in 2000, and 46% in 1975. This was mainly the result of the reduced dependence on oil as well as a deliberate policy of diversifying the economy in favor of non-oil sectors in which both the overall business environment and sector-specific programs have played vital roles. The service sector has been the key driver of economic growth with an annual growth rate of 21% since 2000, constituting $27.6 billion or 74% of Dubai’s current GDP. In particular, the trade sector has experienced the highest increase in the share of GDP. Although the contribution of the manufacturing and oil & gas sectors has decreased, the manufacturing sector has grown by an average of 12% since 2000. The 75

Dubai’s per capita income today compares very favorably to that of many developed countries such as Singapore’s ($26,836) and Hong Kong’s ($25,493), countries which required a much longer period of time to reach their current high levels of GDP.

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construction and real estate sectors have also exhibited share gains primarily due to the availability of land, labor, domestic and foreign capital, and changes in regulations. Dubai’s current GDP mix is very favorable as its strongest sectors by international standards happen to be highly conducive to future global growth. These sectors are tourism, transportation, construction, and financial services, and are well-placed to constitute the focal point of Dubai’s future growth path within the economic development sector plan. Building on Dubai’s remarkable economic performance and future trends, economic targets for 2015 have been set and are classified into the following categories: (1) Economic growth: sustain a real GDP growth rate of 11% per annum for the next 10 years and increase real GDP per capita to $44,000 in 2015; and (2) Enhanced labor productivity and sector development: increase productivity by 4% per annum, move existing sectors of strength to new frontiers (both domestically and internationally), create new sectors of strength with sustainable competitive advantage, and promote innovation to develop new sectors and increase productivity. The recommended future strategic growth path is based on 6 combinations of sectors, or vertical building blocks, including, among others, sectors such as tourism, trade, transportation, and financial services76. These sectors were identified based on their current status, international competitiveness, Dubai’s capacity to develop them, and local availability of required factor conditions. However, targeting these building blocks will not yield rapid and sustainable growth unless 7 horizontal enablers for growth are addressed in parallel, namely, human capital, productivity, 76

These are strong sectors by international standards which are highly conducive to future growth.

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innovation, cost-of-living and doing business, quality of life, economic policy and institutional framework, and laws and regulations. The strategic thrusts supporting the achievement of economic development targets are described as: (1) Sector focus and development: moving Dubai to a new growth path, coupled with further diversification while maintaining focus on high-value added sectors that can boost overall economic growth. (2) Productivity growth: transforming Dubai into a hub of business excellence by raising the productivity of economic sectors and maintaining high production quality standards. (3) Human capital excellence: preparing Dubai’s workforce for the high-value, knowledge-driven economy, which requires attracting and retaining highly skilled employers, improving nationals’ qualifications, and increasing their motivation. (4) Science, technology, and innovation capacity building: turning Dubai into a vibrant science and technology hub in targeted sectors by supporting the development of existing sectors and establishing the right environment for nurturing the post 2015 economy. (5) Cost of living and doing business management: ensuring and maintaining Dubai’s competitiveness by managing the rising cost-of-living. (6) Quality of life improvement: establishing Dubai as a preferred home for current and future residents by improving the well-being of citizens and residents and helping them live healthier lives enriched with opportunities and choices. (7) Policy and institutional framework excellence: striving for excellence in economic policy-making and deployment through coordination with the federal government, provisioning of adequate data, and strengthening the institutional framework and capabilities. (8) Laws and regulations alignment: aligning Dubai’s economic laws and regulations with international best practices and stand-

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ards. The pursuit of the proposed strategic growth path will promote GDP growth to $108 billion by 2015. This approach would strengthen Dubai’s healthy sector mix by ensuring focus on key sectors while further promoting diversification and ensuring reduced vulnerability to external shocks, and a systematic integration into the regional and global economy. To achieve these economic growth targets, it is estimated that 882,000 additional workers are required to join the workforce by 2015, bringing total employment to 1.73 million with a significant move towards higher skilled employment. Perhaps one of the most important attributes of the DSP(2015) is that it is a ‘live’ document constantly being updated and modified to changing regional and international conditions. During its formulation in 2005, the major thrusts of its growth path were also based on current and expected developments in the rest of the world. Moreover, the DSP(2015) is based on macroeconomic principles to ensure that priorities do not clash and market forces are reinforced. The positive aspect of the DSP(2015) are double digit economic growth, a carefully thought out strategy of diversification, a substantial increase in the share of Arabs in the labor force, deeper integration of the economy both regionally and globally, and strengthening of the ability of the economy to absorb and cushion the effects of external shocks through improved policy making and institutional strengthening. On the other hand, the DSP(2015) faces many challenges such as a declining share of nationals in the labor force, major human capital development challenges, continued reliance on imported unskilled labor from South Asia, and the ability to attract and retain skilled workers

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given the expected rise in the cost-of-living which is primarily caused by a sharp increase in government spending to achieve its targets by 2015.

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The Rising Cost-of-Living The sustainability of the Dubai Strategic Plan (2015) depends on, among other things, maintaining a stable level of prices to prevent the erosion of purchasing power and attract high-skilled workers. The rising cost-of-living in Dubai is an expected outcome because it is primarily caused by the rapid pace of government spending as it builds both the hard and soft infrastructures of a rapidly growing economy. The rising cost-of-living is also fuelled by large capital inflows in the form of foreign direct investment which has contributed significantly towards the increase in the money supply which, in turn, has resulted in an increase in consumer spending on both durable and non-durable goods. The fixed-exchange rate system with the US dollar has also caused an increase in the relative price of imports, especially the price of imported products from euro zone countries, as the value of the US dollar has fallen in recent years. But apart from these standard traditional causes of increases in the cost-of-living, prices have also increased due to Dutch Disease effects noted earlier as resources have shifted from tradable manufacturing sectors to non-tradable service sectors which is evidenced by the dramatic boom in the real estate, tourism, and financial sectors. The standard policy prescription in most countries facing inflationary pressures is to adopt contractionary monetary and fiscal policies to decrease both the money supply and consumer spending. Contractionary monetary policies work by increasing the rate of interest to increase the cost of borrowing and thus reduce business investment and

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consumer spending. However, due to the fixed exchange rate system with the US dollar, domestic interest rates closely follow US rates which are currently at historically low levels. Moreover, monetary policy is conducted at the federal level by the Central Bank of the UAE which considerably reduces the degrees of freedom available to Dubai in controlling the money supply. Dubai has also limited instruments in its fiscal policy toolkit to reduce aggregate spending due to the absence of all forms of taxation. One of its few fiscal policy instruments is to reduce government spending but this would ultimately work against the achievement of the ambitious growth targets of the Dubai Strategic Plan (2015). Dubai has adopted price controls, a highly controversial yet counterintuitive policy, to control the rising cost-of-living especially in the control of rents and prices of basic food items and intermediate inputs. In 2006, the government imposed a 15% cap on rental price increases which has been progressively lowered to 7% in 2007, and more recently to 5% in 2008 for tenants who have occupied their premises for 2 years. The Ministry of Economy has also recently fixed the price of cement at $4.35 per 50kg sack and began monitoring the price of basic food items imposing penalties on producers who ‘unfairly’ increase prices. The biggest drawback of such price controls is that they discourage developers and producers to invest in these markets because of their lower profitability as a result of fixing the price below the market price. Price controls have been tried in many countries with disastrous outcomes such as in the South Bronx in New York where landlords could not afford to maintain their buildings which ultimately led to the

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creation of urban slums. Price controls also encourage the creation of ‘black markets’ since they create an artificial shortage at the lower controlled price77. Moreover, country experiences have shown that since price controls are perceived to be a temporary measure, once they are lifted, prices tend to ‘overshoot’ as landlords and producers try to make-up for their previous ‘losses’. Nevertheless, this highly controversial yet counterintuitive policy has been partially successful in Dubai because of strict enforcement, and because tenants are provided greater choices as the supply of housing expands in the medium term. Price controls have been only partially successful because of major loopholes such as the possibility of landlords evicting ‘old’ tenants on the pretext that they will be renovating their premises, and due to the large volume of complaints which cannot be always handled by the courts on a timely basis. Against this background on the rising cost-of-living in Dubai, the government has considered several other options to control prices. One option would be to fix the exchange rate to a basket of currencies with different weights according to its different trade volumes with the rest of the world. For example, given the relatively large share of imports from euro zone countries, a greater weight would be attached to the Euro compared to the US dollar. This would cushion the inflationary effects of a fall in the US dollar as the relative price of imports from euro zone countries will not be affected by as much as under the current fixed exchange rate system. For a more direct and policy oriented solution, the government could adopt inflation targeting which is character77

For example, after the imposition of the $4.35 cap on the price of cement, most producers began selling it at $6 on the black market.

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ized by an announced numerical inflation target, an implementation of monetary policy that gives a major role to an inflation forecast, and a high degree of transparency and accountability78. The recent global financial crisis has considerably reduced the cost-of-living in Dubai. A government report on month-by-month economic data shows the lowest rate of inflation in nearly a decade. Since the beginning of 2009, the rate of inflation has slowed to just 1.9% (from 7.2%) as reported by the UAE Ministry of Economy. This fall in the rate of inflation is explained by the fall in housing and utility costs (which make up 40% of the basket of goods an services used in the calculation of the Consumer Price Index), and decreases in the price of intermediate inputs such as steel and cement. The price of steel has fallen by almost 70%, and cement prices have fallen by an average of 22% in 2009. Moreover, the Ministry of Economy has signed several Memoranda of Understanding with large retailers and cooperative societies to fix the price of basic food items. Annual inflation in January of 2009 stood at 7.2%, slowing to 6.2% in February, 4.5% in March, and 1.9% in April according to the latest figures published by the Ministry of Economy. In 2008, the average rate of inflation was 12.3%, peaking at 13.5% in the second quarter of the same year. Due to this fall in the price level, some economists are predicting a deflation which could have severe negative repercussions on the domestic economy79. 78

See Blum and Durlauf (2007) for a more detailed definition of inflation targeting. The main problem with deflation is that people in debt (a large number of people during a recession) will be worse-off. When someone has borrowed $1,000 from a bank, a 10% annual deflation rate will increase the burden of the loan by 10% - i.e. the borrower has to pay back $1,100 in a year’s time. Conversely, when the rate of inflation is 10% annually, then the burden of the loan will be only $900 since the pur79

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However, given the expansionary fiscal policies in the form increased government expenditure to finance the rapid development of the Dubai economy, it is highly unlikely that the Dubai economy will fall in a deflationary trap.

chasing power of the dollar has decreased by 10%.

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Some Labor Issues As outlined in the Dubai Strategic Plan (2015), to achieve its ambitious targets of generating an annual average GDP growth rate of 11%, Dubai requires an additional 880,000 workers by 2015. The bulk of these workers, about 70%, will be in the construction and related service sectors which would add to existing labor problems especially in the unskilled segment of the labor force. Currently, there are approximately 500,000 unskilled workers in Dubai, mainly from Southeast Asian countries (India and Pakistan) which constitute close to 50% of the labor force80. These workers earn a net monthly income of between $150 and $250 and live in labor accommodations in designated areas. Recent labor unrests and disputes have increased the profile of these workers, and the government has taken serious steps to improve their working conditions. These labor protests have been primarily caused by the fall in workers’ real wages due to the fall in the US dollar and rising rates of inflation which have reduced their purchasing power and their ability to remit a large chunk of their incomes to their families in their home countries. Another source of tension has been caused by the illegal actions of labor recruiting agencies which charge unskilled workers for work visas and related costs, a practice illegal under UAE labor laws. Non-payment of wages on a timely basis by construction companies has also been a major source of tension in recent months. Having realized these problems, the government has begun to take serious steps to improve working conditions and act as an enforcer 80

Statistical Yearbook – Emirate of Dubai (2007). See Table 03-02, pp 91-92.

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of existing labor laws and regulations. Tens of thousands of unskilled workers have taken advantage of a summer-long amnesty in 2007 for illegal workers agreeing to either legalize their residence status or leave the country. In recent interviews, officials at the ministries of economy and labor have said that there is no sign of an impending labor shortage. Plenty of workers are eager to enter the country to take the place of leaving workers. In addition, regulators have enforced midday sun breaks, improved health benefits, upgraded living conditions, and cracked down on employers bold enough to stop paying workers at all. To this end, the Ministry of Labor has just launched a Salary Protection System to ensure that workers receive their wages on time by requiring all companies in to transfer worker salaries to personal bank accounts. In a break with past practices, the Ministry of Labor has been backing the demand of the workers. In cases where companies are not able to pay wages, the Ministry has tapped company bank guarantees to pay back wages. It has also barred some companies from hiring additional workers which has led them to close their Dubai operations, and has helped existing workers find new jobs. At the GITEX 2008 exhibition recently, a mobile-phone service was launched to meet the financial needs of low-income workers. The service, called “Alo”, is a pay-asyou-go mobile service which has been designed to suit the needs of unskilled workers. Workers will not have to pay subscription fees but only a monthly installment fee of less than $2. The service, apart from the normal mobile package, will inform workers about changes in labor laws, provide labor news and other labor related information, and will enable easy communication between workers and the government.

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Moreover, in a highly innovative initiative, Etisalat, the local telecommunications company, will soon enable laborers to send remittances to their home countries through their mobile phones using a system called mPay. This will greatly ease the burden of unskilled workers by avoiding the high transfer fees paid to traditional money remittance companies and exchanges. Other initiatives include the proposed establishment of an agency directly under government supervision to stop the practice of labor agencies to charge illegal work visa fees. Currently, most labor agencies recruiting workers from Southeast Asia openly charge the men and women they bring to the country the ‘cost’ of their visas which is illegal under UAE labor laws. Due to this practice, many workers have to take out loans of more than $2,000, often at high interest rates. As a consequence of this practice, a construction worker uses a chunk of his monthly wages towards the repayment of the loan, forcing him into a cycle of debt. Since this illegal practice emanates in the workers’ home countries prior to the worker’s arrival in Dubai, the government has signed several agreements with labor exporting countries to prevent such practices and set minimum wages and standards which has considerably improved working conditions and wages. Moreover, the relatively low wages that these unskilled workers receive in their home countries is still a big incentive for them to migrate to Dubai even under the assumption that Southeast Asian economies, especially India and Pakistan, have experienced recent economic boom. This is because most of the new jobs created in these countries are more suited for skilled and semi-skilled workers. The government has also been con-

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sidering shutting down the labor agencies that recruit construction workers and build ‘worker cities’ to replace about 170 labor agencies currently licensed by the Ministry of Labor. The government realizes the importance of labor issues and has taken many concrete steps, as outlined above, to improve their working conditions. In the words of one official, “a happy worker is a more productive worker”. This is especially true of unskilled workers in the construction sector who are building the infrastructure of a rapidly growing economy to meet the ambitious targets of the Dubai Strategic Plan (2015). However, the boom in the real estate market will gradually slow down in the coming few years as many projects have been delayed or put on-hold, in turn reducing the profitability of the real estate sector to ‘normal’ levels. Nevertheless, given the speed at which real estate projects are completed in Dubai and the slowdown in the global economy, there will always be labor disputes to tackle, just as in any other market type economy.

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IMF (2007). United Arab Emirates: Financial System Stability Assessment. International Monetary Fund, Washington, D.C. Isaksson, A. (2007). Determinants of Total Factor Productivity: A Literature Review. Research and Statistics Branch, United Nations Industrial Development Organization (UNIDO). Jadresic, E. (2002). On a Common Currency for the GCC Countries, IMF Policy Discussion Paper, International Monetary Fund, Washington D.C. Kaufman, D. and A. Kraay (2007). Governance Indicators: Where Are We, Where Should We Be Going? Policy Research Working Paper WPS4370, The World Bank, Washington D.C. Leamer, E. (2002). Bubble trouble? Your home has a P/E ratio too. University of California Los Angeles, Anderson Forecast. Liam, E., M. Keen, J.P. Bodin, and V. Summers (2002). The Allure of the Value-Added Tax. Finance and Development, Volume 39, Number 2, International Monetary Fund, Washington D.C. Makharita, R (2005). Innovations in Public Administration: The Case of The Dubai Government. Meeting on Sharing Best Practices in Governance and Public Administration Innovations in the Mediterranean Region. UNDP Program for Governance in the Region of Arab States (UNDP-POGAR). Migara, K. and O. De Silva (1994). The Political Economy of Windfalls: The ‘Dutch Disease’ – Theory and Evidence, BLE-95-02. OECD (2001). Measuring Productivity: OECD Manual – Measurement of Aggregate and Industry Level Productivity Growth. Organiz-

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ation for Economic Cooperation and Development (OECD), Paris, France. Porter, M. E. (1990). The Competitive Advantage of Nations. London: The MacMillan Press Ltd. Rahali, A. (2008). Islamic Finance: A Practical Guide. Publisher: Globe Business Publishing. Rodrik, D. (1992). Political Economy and Development Policy. European Economic Review, Vol. 36, pp. 329-36. Rose, A. (1999). One Money, One Market: Estimating the Effect of Common Currencies in Trade, NBER Working Paper 7432, National Bureau of Economic Research, Cambridge, Massachusetts. The Executive Office (2006). Highlights: Dubai Strategic Plan (2015), Dubai - where the future begins. Dubai, United Arab Emirates. World Bank (2007). Strengthening World Bank Group Engagement on Governance and Anticorruption”, Washington D.C. World Trade Organization (2006). Trade Policy Review Report by the Secretariat, United Arab Emirates.

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