Oman - Sustainable growth and economic diversification

Report No. 12199-OM Sultanate otC Oman Sustainable Growth and Economic Diversification May 31, 1994 Technical Cooperation Unit Country Department IV Middle East and North Africa Region FOR OFFICIAL USE ONLY MICROGRAPHICS Report No: 12199 Om Document of the World Bank Type: ECO This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization  ABBREVIATIONS AND ACRONYMS Ministries and Government Agencies GTO General Telecommunication Organization MOAF Ministry of Agriculture and Fisheries MOEW Ministry of Electricity and Water MOCI Ministry of Commerce and Industry MOF Ministry of Finance and Economy OBAF Oman Bank for Agriculture and Fisheries ODB Oman Development Bank PDO Petroleum Development Oman VTA Vocational Training Authority Other CEM Country Economic Memorandum CPI Consumer Price Index GAMS General Algebraic Modeling Systems GCC Gulf Cooperation Council GDP Gross Domestic Product GNP Gross National Product ICOR Incremental Capital/Output Ratio IMF International Monetary Fund LIBOR London Interbank Borrowing Rate LNG Liquefied Natural Gas MUV Manufacturing Unit Value OPEC Organization of Petroleum Exporting Countries PAC Planning Assumption Committee (World Bank) RER Real Exchange Rate RMSM Revised Minimum Standard Model (World Bank) RO Omani Rials SGRF State General Reserve Fund SIPRI Stockholm International Peace Research Institute Measures bcf billion cubic feet b/d barrels a day tcf trillion cubic feet Exchange Rate US dollars ($) = .3845 Omani Rials (RO) (since 1986)  FOR OFFICIAL USE ONLY PREFACE This report was prepared at the :equest of the Government of Oman, which asked in late 1991 that the Bank exaniine Oman's longer-tern economic prospects, provide a frank assessment of the Government's economic policies, and suggest changes where they appeared desirable. The Government helped greatly in the preparation of the report. With the support of the Deputy Prime Minister for Financial and Economic Affairs and the Secretary General of the Development Council, Bank mission members were afforded generous access to goverment ministers, who provided a frank and comprehensive overview of prospects, problems, constraints and public policies, and facilitated access to officials. The General Secretariat of the~ Development Council provided the mission with infornation, logistical and other sup,port, and general guidance. Development Council Secretariat staff counterparts worked with, and provided infornation to, Bank staff members. The Bank acknowledges with gratitude this exceptional level of assistance. However, it wishes to make clear that no Omani official is to be held responsible for, or associated with, particular conclusions that it has reached, nor with any of the recommendations of the report. The report was prepared by a Bank mission that visited Oman in January-February 1993, following a preparatory mission in April 1992. The mission members comprised Ibrahim Elbadawi (Mission Leader, Macroeconomic Modeling and Economic Diversification); Hideo Hashimoto (Petroleum and Gas Developments and Optimum Savings); Nader Majd (Macroeconomic Modeling and Projections); Abdelaleem Sharshar (Private Sector Performance, Subsidization and Privatization); and Derek White (Recent Economic Developments, The Role of Government, Eliminating Deficits, Financial Institutions and Omanization). William Tyler participated in pre-mission discussions of the issues with the Government, led the discussions of an earlier draft with the Government, and provided general support throughout the development of this report. Overall coordination and integration of the various parts of the report were carried out by Derek White. The fial revisions were incorporated by Abdelaleem Sharshar. Professor Hossein Askari (George Washington University), contributed valuable clarifications to an early draft. Professor John Cuddington (Georgetown University) suggested a number of further clarifications and proposed useful expositional imiiprovements. The task of the mission was facilitated by access to preliminary versions of two Bank reports being prepared in parallel with this report, viz.: Oman: Review of Recurrent Public Expenditure, June 1993, and Report to the Sultanate of Oman on Legal Reform to Encourage Private Sector Investment, April 1993. A draft of the report served as the basis for further intensive discussions with the Omani authorities over the period October 23-28, 1993. These exchanges resulted in mutually sharpened awareness of the key economic policy issues and choices confronting Oman. A chapter-by- chapter review of the report with the Secretary General and staff of the Development Council led to the identification and correction of a number of errors of fact and interpretation, to a fuller presentation of the Government's fiscal position, to improved analysis of the Government's strategic investment choices, and to improved presentation of the Government's Omanization policies. This document has a restricted distnbution and ma) be used by recipients only in the performance Of their official duties. Its contents may not othemwise be disclosed without World Bank authorizaion.  CONTENTS ABBREVIATIONS AND ACRONYMS PREFACE 13XECUTIVE SUMJI1MARY AND CONCLUSIONS ......................... i I INTRODUCTION AND BACKGROUND ....I..................... I Central Themes ............1............................... I Ecoisomic, Social and Political Background ........................... 2 2 RECENT ECONOMIC DEVELOPMENTS ............................ 8 Oil and Gas .............................................. 8 Public Finance ............................................. 11 Domestic Production .......... ......................... 22 Saving and Investment ........................................ .6 Balance of Payments and the Exchange Rate .......................... 27 Prices ............................................... 30 3 TIHE NONRENEWABLE RESOURCE BASE AND THE CASE FOR HIGHER NATIONAL SAVING .......... ............................. 32 Conceptual Issues . ........................................... 32 The Savings Model . ......................................... 33 Policy Implications . ......................................... 36 4 THE MACROECONOMIC FRAMEWORK AND MEDIUM-TERM PROJECTIONS . ........................................... 38 The Structure and Solution of the Macroeconomic Model .................. 38 Medium-Term Projections ..................................... 39 5 ECONCMIC DIVERSIFICATION: ISSUES AND OPTIONS ................ 50 The Real Exchange Rate and Sectoral Diversification .................... 50 Quantitative Implications for Industrial Diversification of an Optimum National Saving/Higher External Investment Strategy ...................... 54 6 THE ROLE OF THE PUBLIC SECTOR .............................. 56 The Traditional Responsibilities of Government ........................ 56 The Role of the Omani Govemment ............................... 56 Analysis of the Govemrnment's Role ................................ 58 The Optimum Role for Oman's Public Sector ......................... 63  7 ELIMINATING DEFICITS, GENERATING SURPLUSES ANID RAISING PUBLIC SAVING ............... .......................... 65 General Considerations ............................ 65 Cutting Public Expenditures ........... ................. 65 Introducing User Fees, Unit Costing and Cost Recovery .69 Raising Non-Oil Taxation .70 Improving the Efficiency of the Public Sector ..... ........... ........ 70 An Initial List of Cost-Cutting and Revenue-Raising Measures ... .... 71 8 STRENGTHENING THE PRIVATE SECTOR ................ ......... 75 Private Sector Development ....... 75 The Incentive (Subsidy) Framework .... . ......................... 80 Reforming the Legal Framework ................................. 82 Privatizing Public Enterprises and Authorilies ......................... 83 Strengthening Private Sector Financing . ........................... 89 Channeling More Oil Revenue Through Private Hands .95 Attracting Foreign Capital ........................... ........ 95 An Overall Strategy ....... 95 9 OMANIZATION, LABOR MARKET EFFICIENCY, AND THE MAXIMIZATION OF SOCIAL WELFARE ....... 101 Definition and Context of Omanization ............................. 101 Goovernment Omanization Policies ....... 102 Complementary Labor Market Policies ....... 103 Key Omanization Issues ....... 104 Optimizing the Employment of Expatriates ....................19 ...... 1 Conclusions and Recommendations ....... 110 10 A LONG-TERM DEVELOPMENT STRATEGY FOR OMAN ... .... 113 Future Prospects ................... r ....................... 113 Development Constraints ...................................... 115 A Comprehensive Reform Strategy ....................... 116 Annexes A Optimum Saving Model - Theoretical Underpinning B Optimum Saving Model - Numerical Presentation C The Macroeconomic Framework D A Descriptive Model of the Real Exchange Rate E Oman's Incentive System F Government Policies Giving Preferences to Omanis G Government Fourth Plan Follow-up Omanization Measures H Omanization - Supplementary Analysis and Data  Tables In Text Table 1 1: Oman - Social Indicators ......................3 .............. 3 Table 1.2: Omani and Non-Omani Employment, Public and Private Sectors. 4 Table 2.1: Breakdown of Non-Oil and Gas Current Revenues .16 Table 2.2: Financing of Government Deficit/Surplus .... . ................... 17 Table 2.3: Public Finance (1991-1993) ..................... 19 Table 2.4: Non-Oil Exports Percentage of Total Non-Oil Exports Excluding Reexports .... 30 Table 4.1: Oman - Major Assumptions of the Model ..................... ... 41 Table 4.2: Key Variables - Base Case and Reform Scenario Projections for the Year 2005 .................... 47 Table 5. 1: Oman - Major Economic Indicators ......... ............ 53 Table 6.1: Regional/Sectoral Distribution of Investments in the Fourth Five-Yeai Plan .... 60 Table 7.1: Structure of Government Expenditure, 1991 ..................... .. 66 Table 7.2: Structure of Civilian Recurrent Expenditures, 1991 ................. .. 67 Table 8.1: Sectoral Distribution of Non-Oil Private Investment ................... 77 Table 8.2: Private Investment ..................... 78 Table 8.3: Indicators of Industrial Growth ..................... 79 Table 8.4: Nuumbers of Cases Approved for Various Types of Public Support to the Private Sector ......... ............ 80 Tab;e 8.5: Cost of Industrial Subsidies, 1991 .................... 81 Table 8.6; Budgetary Costs of Public Support to the Private Sector .81 Table 8.7: State-Owned Enterprises As of End 1991 ......................... 85 Table 8.8: Assets of Banking Institutions, 1991 .................. .......... 90 Table 8.9: Distribution of Commeruial Bank Credit, 1991 ...................... 91 Table 8. 10: ODB Financing by Economic Subsector, 1979-4991. ...... . ............ 92 Table 8.11: Loan Approvals of Specialized Long-Term Lenders, 1991 ..... ......... 93 In Annexes Chapter Annex Table I .A1: Government Revenues and Expenditures (1976-1992) ... .... 7 Chapter Annex Table 4.A1: Oman - Key Indicators' Base Case Scenario .... ......... 48 Chapter Annex Table 4.A2: Oman - Key Indicators' Reform Base Scenario .... ....... 49 Chapter Annex Table 7.A1: Country Rankings of Military Expenditures Based on Proportion of GDP, 1972-1988 .................................. 73 Chapter Annex Table 8.A 1: Numbers of New Industrial Firms, 1975-1991 .... ....... 97 Chapter Annex Table 8.A2: Industrial Investment, 1975-1991 .................... 97 Chapter Annex Table 8.A3: Gross Value of Industrial Output, 1975-1991 .... ........ 98 Chapter Annex Table 8.A4: Industrial Employment, 1975-1991 .................. 98 Chapter Annex Table 8.A5: Position of State-Owned Enterprises As of End 1991 .... ... 99 Chapter Annex Table 8.A6: MOF Investment Department Shareholding Information Statement (Foreign Organizations) ............ .. .................. 100  EXECUTIVE SUMMARY AND CONCLUSIONS Background 1. Over the two decades since the Goverrnent began its drivc for economic, social and political development, Oman has made remarkable strides. Physical infrastructure has been brought up to advanced, modern standards over much of the country. Basic healtii indicators reveal dramatic improvements in life expectancy and sharp reductions in infant mortality. The coverage of primary education has become almost universal. Twenty percent of boys and girls now attend secondary schools and growing numbers of students in a widening range of fields are graduating from Sultan Qaboos UJniversity. Other students are being trained in teacher, nursing and technical institutions. Oman has also developed a complex structure of government and public institutions and an elaborate legal and regulatory framework governing private economic activity. The Government's Basic Objectives 2. The Government's basic objectives havc been: to develop Oman's human resources and distribute oil wealth equitably by providing free public education and largely free public health services; to foster an expansion of private sector agriculture, fishing, manufacturing and tourism through the provision of supporting infrastructure and subsidies; and to encourage growing and higher-level participation by Omanis in the economic life of the country by implementing an active program of "Omanization." A fundamental aim of the Government's efforts to strengthen the private sector has been to promote economic diversification into non-oil goods production so as to enable Oman to avoid a post-resource era collapse in exports and a consequent decline in Omani standards of consumption. Economic Performance 3. Rapid growth in oil reserves, rising rates of extraction and sharply rising oil prices were accompanied by an explosion in public oil revenues during the 1970s and up until 1981, triggering a massive expansion in public spending. However, since 1981, Oman's economic situation has undergone a fundamental change. Oil prices crested in 1981 at nearly $37 a barrel, declined slowly until 1985, and then collapsed in 1986 to $13.43 a barrel. While rising rates of extraction during the eighties offset the decline in prices, Oman's oil earnings remained virtually unchanged, overall, from 1981 to 1991. Oil reserves continued to rise rapidly until 1985, but an even sharper rise in the rate of extraction led to a decline in their expected life, from a maximum of nearly 26 years in 1984 to about 18 in 1991. Although oil prices have recovered from the lows of 1986 and 1988, they have remained, apart from a spike to $21 during the Gulf war, below US$i8 a barrel. 4. Even now, the Government has mnade only a partial expenditure adjustment to the stagnation in its oil revenues. In consequence, its financial position has seriously deteriorated and continues to do so. This is apparent in: an almost unbroken string of deficits since 1981; declining contributions to the State General Reserve Fund (SGRF); a substantial rise in external debt; increased recourse to borrowing from the domestic private sector; a massive, recent accumulation of negative changes in the Government's accounts; and the virtual disappearance of net government financial reserves. The deficits have been the result of an exceptionally high level of defense and national security expenditures, coupled with continued strong growth in civil  ii recurrent expenditures. The use of the SGRF as an oil revenue stabilization fund has preempted its potential as a vehicl . for long-term public savings and investment. The planned allocation of most of the money flowing into the State Emergency Reserve Fund to the financing of planned public sector deficits means that funds are not available to deal with genuine emergencies. 5. Particularly troubling features of Oman's economic performance have been the very pronounced overall decline in saving and investment - especially public saving and investment -- over the past decade and a half and the overall shift in the structure of output towards the production of services. The latter mainly reflects a decline in the value of oil production, a pronounced decline in construction, and the growth of government and public services. While manufacturing production has grown strongly -- from only 0.5 percent of GDP in 1976 to over 4 percent in 1991 -- and the share of agriculture and fisheries in GDP has also increased -- from 2.1 percent of GDP in 1976 to 3.7 percent in 1991 - these two key, non-oil goods-producing sectors remain relatively small. 6. Non-oil goods production remains dwarfed by oil, gas and services. Public and govemment services alone claimned 17 percent of GDP in 1991 -- more than twice the share of agriculture, fisheries and manufacturing combined. Non-oi] goods exports are only 4 to 5 percent of total exports. Private investment has declined appreciably as a share of total and non-oil GDP since 1986. Only about a fifth of this investment goes into manufacturing. Economic diversification into non-oil tradeable goods production thus remains limited and ihere is little sign of an immninent breakout. 7. Oman's economic performance raises the following basic questions: - Is the Government saving enough and prc.perly investing enough to prevent a post-oil and gas era letdown in overall consumption? - What will be the economic consequences if the Government continues its present financial policies? - Can the Government accelerate the process of industrial diversification; if so, how? - Is the Government trying to do too much and is it spending too much in some areas? - What is the best way, first to bring public expenditures and revenues into better balance, and then to increase the long-term rate of public saving? - What would be the most effective way to strengthen the private sector? - Are the Government's efforts to Omanize the economy compatible with the maximization of Omanis' economic welfare and Oman's long-term need for efficient labor and goods markets? These questions are addressed in Chapters 3-9 of this report.  tiii The Adequacy of National Saving 8. Oman's oil and gas wealth, being depletable, is analogous to a large inheritance. If too much is consumed and not enough invested, or if enough is saved but the proceeds are invested poorly, the inheritance will sooner or later be dissipated, leaving the country much poorer at some point in the future. To avoid this outcome, what should be consumed is the permanent income from oil, gas and invested capital -- not the transitory, realized oil and gas wealth itself. This means that, at each point in time, a substantial fraction of the proceeds of oil and gas extraction should be saved. The critical question is, "How much"? For the purposes of this report, optimum rates of consumption and saving have been calculated for Oman, using a formal, Bank- developed mathematical model (Chapter 3, Annexes A-B3). The model idenitifies the initial level and steady growth rate of consumption that can be sustained indefinitely from the proceeds of oil and gas extraction plus earnings on past and future investments, and, thus, for each point in time, optimum national saving. To arrive at these results, it was necessary to make reasonably realistic assumptions about: Oman's oil and gas reserves; the real rate of return on safe, long-term investments; and Oman's implicit social discount rate (i.e., the "interest" rate that is used by Omani society to discount future consumption versus present consumption. Present rates of extraction from existing fields were assumed to continue. World Bank projections of future real oil and gas prices were used to value future output. 9. The results shew that Oman. like most neighboring oil and gas producers, is currently spending an excessive proportion of the proceeds of extraction on current consumption. In other words, it is consuming its capital at a ,apid rate. The present rate of Omani national saving (17.6 percent of GNP in1 1991 on the basis of Development Council figures) is far below the current optimum rate of about 39 percent. Furthermore, the optimum rate is estimated to rise to a maximum of about 64 percent by around 2009, before dropping back towards the long-term desired rate. These results somewhat overstate required national saving because the model does not allow for the income and saving of labor. They are also subject to a margin of error because the eventual size of reserves of oil and gas and the real rate of return on capital can only be approximated. However, they strongly suggest that the Govcrnment would be prudent to cut the present level and future growth of consumption - particularly public consumption - very substantially if it wishes to forestall a gradual, but increasingly severe, decline in Omani standards of consumption when the economy moves into the post-resource era. 10. Moreover, it is critically important not merely for public saving to be substantially increased but for the funds to be invested in assets yielding the highest attainable risk-adjusted real rates of return. This means limiting domestic investment to those projects yielding risk- adjusted real (ex post) returns above, or equal to, those obtainable on external investment. This, in turn, calls for effective institutional mechanisms to ensure such an outcome through: (i) determination of an efficient allocation of public saving between foreign and domestic investment; (ii) an effective monitoAng of foreign and domestic investment performance; (iii) efficient implementation of Oman's foreign investment program; and (iv) upgrading the capability of institutions involved in establishing sectoral and programs' priorities and in the analysis of financial and economic returns on domestic investments. These roles could perhaps be performed within Oman's existing institutional framework by a high level authority whose membership includes the newly created Ministry of Development, the Ministry of Finance, the Central Bank of Oman, and the SGRF. The function of such authority would be to determine and manage Oman's investment portfolio in general and foreign investment in particular.  iv Public Financial Policies 11. Given the dominant role of public expenditure in Oman, the Government's financial performance has major ramifications for the entire economy. For this reason, a formal, macroeconomic modeling framework was used to examnine the implications of two contrasting, future-oriented scenarios (Chapter 4, Annex C). One scenario assumed the continuance of present public financial and other policies. The other assumed some highly iriportant changes: (1) a rise in the rate of public saving towards optimum levels; (2) the adoption of measures to raise the productivity of Omani labor and increased efficiency of capital; (3) the elimination of subsidies; and (4) the introduction of a modest general sales tax. 12. The results are striking. A continuance of recent expenditure trends would quickly lead to a huge public sector financial deficit, a massive deterioration in the current account of the balance of payments, a huge expansion of external public debt, and relatively low levels of private consumption. The Government's present financial policies ale clearly unsustainable and would lead to highly undesirable outccmes. 13. The "reform" scenario, on tie other hand, featuring rising public saving -- primarily the result of sharply reduced public expenditures - leads to a growing public financial surplus, rapidly expanding goods exports, reduced imports, a significant current account surplus, much higher GNP and private consumption, the elimination of external debt, and a massive buildup in external net reserves. The large rise in goods exports and the substantial decline in goods imports under the reform scenario reflects the impact of a relatively depreciated real exchange rate compared with the base case. This leads to sharply increased industrial diversification away from services into traded goods productiorn, thereby realizing one of the Government's most important objectives. The Real Exchange Rate and "Dutch Disese" 14. Increased diversification into tradeable goods production is the reverse of the so-called "Dutch disease." The latter occurs when a major increase in domestic spending takes place as a consequence of the large-scale development of a natural resource and an associated large-scale increase in public revenues and expenditires. This drives up the prices of domestic services relative to those of domestic tradeable goods, i.e., it produces an appreciation of the real exchange rate (Chapter 5, Annex D). (Domestic tradeable goods prices cannot rise because they are kept in check by international competition.) The result is that tradeable goods production becomes less profitable than the production of domestic services. Rising domestic demand also raises the cost of domestic labor and capital. This further reduces the profitability of domestic production of tradeables. Countries, such as Oman, experiencing a resource boom thus typically experience a gradual decline in tradeable goods vis-a-vis services production as factors of production are redeployed in response to the fimdamental changes in relative prices and costs. 15. Oman did, in fact, experience an appreciation of the real exchange rate from the late 1970s to the early 1980s. It was accompanied by a relative rise in services production and a relative decline in agriculture and fisheries production, a; expected. The depreciation of the real exchange rate after 1986 also, predictably, led to renewed relative expansion in agriculture and fisheries. However, manufacturing did not apparently respond to the appreciation and subsequent depreciation of the real exchange . -, Iartly because its response time is far slower, given the  v heavy fixed investmint in plant and equipment involved in manufactring and the sunken costs of an investment, once made. Moreover, continued high public spending on services meant that the demand for, and the prices of, factors of production, including urban labor, remained high, reducing the incentive for those factors to seek employment in goods production, Ncnetheless, the Bank's macroeconomic model projections show that, over time, the combination of a sustained reduction in the public s'Ctor's demand for domestic factors of production and the depreciation of the real exchange rate resulting from increased investment abroad leads to a pronounced shift in output away from the domestic production of services and into the production of goods (including manufactured goods) for export and the repiacement of imports. 16. If the Omani authorities do decide to increase public saving and external investment, with the objective of fostering economic diversification, substantially offsetting the adverse consequences for the balance of payments either by raising domestic interest rates and deflating the domestic economy or by depreciating the nominal exchange rate. Domestic deflation would entail significant transitional costs in terms of unemployment and reduced output. Such consequences would make it difficult to sustain. A nominal exchange rate d.preciation would produce an immediate depreciation of the real exchange rate, would be less economically and socially costly, and would be mote likely to gain social and political acceptance. ThI} kole of the Government 17. The role of government in Oman goes considerably beyond the traditional functions of providing public goods, developing public institutions, promoting efficient resource allocation, stabilizing the economy and promoting an equitable distribution of national income. At the same time, the Government's discharge of the traditional functions has been mixed (Chapter 6). There are serious deficiencies in the quality of basic health and educational services. The legal framework governing private investment and business activity is inadequate. Efficient resource allocation has been promoted by low tariffs and the absence of foreign exchange controls but hampered by public monopolies, legally sanctioned monopolistic private trading and production arangements, poor rnal allocative efficiency in the public sector, and distortion-creating subsidies. The stabilization of the economy has been only party effective and at the expense of a rundown in savings for the future. The promotion of a more equitable regional distribution of income has been attempted via an expansion of state investment in regional infrastructure but thwarted by limited productivity growth in agriculture and fishing. The promotion of a raore equitable interpersonal distribution of income has been fostered by the provision of free access to education but counteracted by the emergence of a privileged class of highly paid public employees, private entrepreneurs and upper-level private sector employees. 18. The Omani Government's extensive invol-ement in the economy includes: the direct provision of a range of commercial goods and services; guidance and subsidies to private sector activity; controls over the labor market and investment; targeted and subsidized Omanization; the provision of medium-term financing to the private sector; overinvestment (by normal developing country standards) in urban infrastructure and public buildings; and the supply of extensive municipal services. Most of this involvement appears unnecessary and counterproductive. The cost of government could be considerably reduced, and the efficiency of the economy greatly increased, by narrowing the Government's focus and concentrating its efforts on the effective fulfillment of the traditional public functions.  vi Cutting the Public Sector Deficit and Raising Public Saving 19. Cutting the public secto. deficit should bc achieved mainly by cutting public spending, which is exceptionally high by international standards (Chiapter 7). Public consumption accounts for almost a half of total consumption and public invest.nent, for over three fifths of total investment. The large element of rant in present public sector wages, salaries and allowances cannot be sustained indefinitely. Ways must sooner or later be found to bring public sector remuneration more into line with levels in the private sector. 20. The greatest potential for reducing public spending lies in the area of defense and national security outlays. These are among the highest in the world, equivalent to more than three- quarters of all civil recurrent expenditures combined, three times expenditures on education, and seven times expenditures on health. Recurrent expenditures on education and health (which account for 35 percent of civil recurrent expenditure) can only, by virtue of their relatively small size, make a modest contribution. 21. Nonetheless, the provision of mainly free medical goods and services and free education encourages waste that should be eliminated by the imposition of (initially nominal), selective user fees, notably on medicines, laboratory services, visits to doctors and clinics, school textbooks and higher t%;ucation. For low-income people, user fees could be a smaller percentage of the cost of supply (in the case of medical and textbook charges) or offset by loans (in the case of higher education). Savings in the health area could also be achieved through better use of hospitals, reductions in the cost of hospital construction, the elimination of redundant staff, and competitive procurement of drugs and medical supplies. In the area of education, there appears to be room for a reduction in administrative costs. More generally, there is considerable scope throughout the public service for a reduction in overstaffing, administrative reform, the simplification of procedures, and improvements in efficiency. 22. Civil development expenditures, although substantially reduced from earlier levels, could also be cut. They are still high by developing country standards and some are being inappropriately used as a primary instrument of job and income creation in economically deprived areas, instead of being confmed mainly to high-yield activities supporting private production. While socially attractive, the typically overlooked costs to Oman of such expenditures include: foregone higher earnings on external investments; foregone ir.dustrial diversification resulting from the maintenance of a more appreciated real exchange rate than would be the case if the public capital involved were allocated to external investments; a weaker private sector; and the future operation and maintenance costs of additional public infrastructure. 23. Increased public saving should be sought mainly from a reduction in excess demand for public services, frc ; expenditure cuts, and from improvements in efficiency; however, the introduction of some fees, cost recovery charges and taxes would be justified in its own right. In addition to user fees in education and health, cost recovery (which should be based on the accurate identification of unit costs) should be sought wherever public expenditures confer substantial benefits on limited groups of private individuals (as in higher education and certain aspects of Omanization). The introduction of income taxes on high-income earners, as well as taxes on cars, luxury consumer goods and expensive houses, could reduce labor market-distorting public/private sector salary differentials on an after-tax basis and thereby help moderate present income disparities and labor market distortions. Corporatz taxes on Omnani, as well as foreign,  vii corporations would encourage domestic firms to be as efficient as, and compete full)y with. foreign finns. Corporate taxes on state enterprises would be justified where these enterprises are in competition with private firms. Strengthening the Private Sector 24. The dominance of public spending has been the major factor inhibiting the development of an independent and dynarnic private sector (Chapter 8). Other factors include: a legal and regulatory framework that establishes serious barriers to investment and the entrv of new firms as well as sanctioning monopolistic practices; discrimination against, and failure to promowe or provide adequate protection to, foreign investment; and the preemptive role of the public sector in utilities, transport, conmmunications, development banking, hotels and some areas of manufacturing. The system of industrial subsidies is distortional, habit-forming and costly. The need for subsidies could be reduced if the Government were to pursue appropriate savings and other policies. Subsidies should not be the main instrument of industrial diversification. For social reasons, some temporary, countervailing subsidies may be unavoidable: for example, where neighboring states' subsidy policies are undermining the livelihood of Omani farmers. However, the preferred remedy is a GCC agreement on the downscaling and harmonization of such subsidies or, failing that, the imposition of countervailing duties, where practicable. 25. The Government's divestiture of its public enterprise holdings, if implemented in the right way and supported by other policies to strengthen the private sector, could quickly and effectively boost the private sector's role. The reservations that have been expressed concerning the desirability of such divestiture can and should be addressed but should not stop the process. The proceeds of divestiture should, of course, add to public saving - not facilitate further spending. The benefits of privatization would include: an improved private/public sector economic balance; higher and more rapidly rising private income; higher and more rapidly rising overall productivity and output; expanded outlets and strengthened motives for private saving; the revitalization of the stock market; the professionalization of management; and the provision of a wider range of opportunity for able and aspiring Omanis. 26. Successful privatization would call for a clear statement of the Government's objectives and the establishment of a fair and fully transparent process for carrying it out within a well- defined legal and regulatory framework. The Government, on its side, must be assured of a competitive price for its shares. The report proposes initial candidates for privatization and notes the need for special studies or continued public involvement in other cases. 27. The private sector could be further strengthened by channeling more oil money through private hands. Possibilities include the subsidization of private schools and medical facilities, either directly or through the issuance of vouchers to those electing to forego the use of public services, and an extension of subcontracting to include, e.g., medical laboratory services, the operation and maintenance of public infrastructure, ministerial transport services, etc. These measures could reduce public costs, lessen present public sector overloads and improve overall efficiency by subjecting the public sector to needed competition. 28. Private finpacial institutions could be strengthened by phasing out subsidized public medium-term lending and encouraging private institutions to move into medium- to long-term  viii lending. Efficiency 'n !he allocation of private financial resources could be improved by removing the ceiliig uvn bank lending rates. Oiianization, Labor Market Efficiency and the Maximization of Social Welfare 29. Present Omanization policies have four major components (Chapter 9): (a) Improving the education, training and skills of certain groups of Omanis to enable them to compete more effectively with expatriates for satisfactory jobs; (b) Subsidizing private employers (and in some sectors requiring them, through the establishment of sector Omanization targets) to hire and train Omanis; (c) Subsidizing the upgrading of Omanis to replace expatriates in the public sector; and (d) Pursuing economy-wide Omanization targets. 30. The first component, directed towards raising the productivity of Omani nationals, is consistent with the Govermnent's basic objective of maximizing Omani national welfare. The critical issues to be addressed are: the most effective ways to raise Omani productivity, and the priorities for action. Oman's entire education and training system rests on the quality of primary and secondary education, which is seriously deficient. At the same time, economic and social returns to public investment in improving these levels of education are typically very high. This suggests that high priority should be assigned to improving the quality of basic education. Public investment in training adults is, of necessity, selective. Most forms are typically costlier than basic education, have a shorter pay-out period and yield lower returns. It is important for the Goverrunent to bear this in mind in determining the allocation of public funds between basic education and Omanization-related adult education, training and skills enhancement. 31. The second component entails significant financial, and possibly significant economic, costs. The financial costs include the direct budgetary costs of the subsidies plus the overhead costs of administering Omanization. The economic costs are hidden. Where private sector Omanization means lower productivity for given wages, firms' unit costs are raised. This can lead to higher product prices, reduced consumer real incomes and lower output. It can also mean reduced exports and the displacement of domestic production by imports. Such measures tend to undermine the efficiency of the labor market, which should assure that wages tend towards equality with the marginal product of labor. Furthermore, the selective impact of these measures may tend to exacerbate Omani income disparities. It also tends to institutionalize rent-seeking behavior, to the detriment of long-term competitiveness. Since qualified expatriates can obtain equivalent positions elsewhere, the main effect of these measures is not, as superficially perceived, to give Omanis preference vis-a-vis expatriates but to give the individual Omanis involved preference at the expense of Omani society as a whole. 32. With regard to the third component, while improving the productivity of Omanis through on-the-job, or closely job related, training is potentially one of the highest-return investments available to the Government and should be continued. However, public expenditures leading to increased Omanization of senior positions at current salary levels will tend to exacerbate income  ix disparities, could benefit private individuals at public cost, and could entail hidden cost borne by soc.ety if the efficiency of Omani incumbents was lower than that of the replaced expatriates. 33. The Government's purpose of the fourth component is to reduce the number of expatriates in low productivity services by raising the cost of rent seeking activities where unskilled expatriates dominate. Also, concerns about the threat to Omani cultural values posed by large numbers of expatriates, an important intangible consideration appear central. Also significant are concerns about the extra pressures placed by expatriates on Oman's scarce water and readily accessible land. However, the costs of arbitrarily restricting the inflow of expatriates when there is little domestic unemployment would be higher inflation, lower average productivity, reduced real incomes for Omanis, slower growth and impediments to economic diversification. These costs could possibly outweigh the benefits, resulting in a decrease in Omanis' overall social welfare. 34. Maximizing Oman's social welfare means employing additional expatriates only as long as the marginal benefits from doing so exceed the marginal costs. This means taxing expatriates or their employers to recover the external marginal costs they impose on Omanis; for example, by driving up the cost of scarce resources, such as water, and by adding to the need for public services. (Private employers may be relied upon to balance the direct wage and salary costs of expatriates against their marginal products.) At present, expatriate labor is directly subsidized through the provision of below-cost water and electricity to all residents. Subsidies to, and the undertaxation of, expatriates encourage excess demand for their services. If the full monetary (or monetary equivalent) external costs of employing expatriates were payable by them or their employers, there would be no need to establish aggregate Omanization objectives. The market place would automatically determine the socially optimum aggregate Omanization ratio. 35. An optimum Omanization strategy would be based on recognition of the fundamental need to raise Omani productivity and develop an efficient labor market. It would rest on the following six pillars: (1) raising the quality of basic education and improving, particularly through on-the- job training, the work skills of Omanis; (2) fostering realistic expectations and competitive attitudes among young Omanis; (3) eliminating present sources of Omani unearned income (rent); (4) eliminating present labor market imperfections and avoiding the creation of new ones; (5) unifying the labor market by working, over time, towards the elimination of public/private and Omani/expatriate remuneration differentials between people having comparable education, training, skills and experience; and (6) eliminating any implicit subsidization of expatriate employment by ensuring that the employer or the expatriate employee pay the full marginal external costs to Oman of the expatriate's residence in Oman. Sustainable Growth, Industrial Diversification, and Enhanced Efficiency 36. In summary, the Govermnent's development strategy for Oman should focus on the following: - Eliminating the public sector deficit, mainly by cutting public expenditures; - Generating and maintaining a high rate of public saving by substantily reducing public consumption and permanently restraining its future growth;  x - Allocating a very substantial fraction of total public saving to foreign investment and ensuring the ex post realization of internationally competitive risk-adjusted economic returns on both foreign and domestic public investment; - Establishing separate and effective long-term saving, stabilization and contingency funds; - Narrowing the scope of government and focusing on the more effective discharge of traditional public functions; - Strengthening the private sector by: reforming the legal framework; eliminating monopolies; attracting foreign capital; privatizing most domestic public enterprises and authorities; phasing out most subsidies; strengthening the role of the private banks in long-term financing; and - Pursuing Omanization simultaneously with the pursuit of efficiency in the labor market and the optimization of Omanis' social welfare by improving Omanis' education, skills, training and motivation; by appropriately taxing expatriates; by avoiding the imposition of quantitative Omanization requirements; by fostering more realistic, competitive and less rent-seeking attitudes among Omanis; and by gradually removing present labor market distortions. 37. This strategy would need to be executed as a whole -- not selectively -- since all its parts are interrelated. It could not be executed at once but would require three to five years. The particular steps to be taken at each stage would have to be carefully coordinated and closely monitored. The continued refinement of the national accounts and the carrying out of frequent surveys of employment, unemployment and the characteristics of the unemployed would be needed to track progress and identify problems. 38. The central and most critical concern would be to prevent the emergence of widespread unemployment among Omanis during the implementation phase, as public spending was cut, but at the same time to leave enough labor market slack to permit diversification into goods-producing activities to take place. It would be vital to avoid labor shortages as these might cause disruptions or generate inflationary pressures that could seriously impede or thwart the economic restructuring process. An effective job information system and close cooperation between business and the Government with respect to job training would be essential. It would also be critically important to ensure that measures to strengthen the private sector -- notably, the reform of the legal framework and the establishment of a vigorous and effective foreign investment promotion unit - were fully in place as public expenditures were scaled back, so that private investment and production could quickly take up any slack left by the Government's assumption of a less dominant role.  SULTANATE OF OMAN SUSTAINABLE GROWTH AND ECONOMIC DIVERSIFICATION I INTRODUCTION AND BACKGROUND A. Central Themes 1.1 Development in an economy such as Oman's, which is dominated by the extraction of a depletable natural resource that can be sold at a price considerably above its cost of production. has three special characteristics. First, the public sector typically dominates the development process as a consequence of public ownership of the resource and the accrual of the net proceeds of extraction to the public sector. Second, pervasive economic dependence on public spending out of resource revenues tends to foster a private economy dominated by rent-seeking behavior. Third, the government of the country confronts the problem of how to avert economic slowdown or decline when the resource is eventually exhausted. In analyzing such economies, it must be recognized that national income, as conventionally measure<', is not adjusted to allow for the depletion of the resource and thus heavily overstates the extent of gains in the country's material and social welfare. 1.2 The government of a country with these special characteristics must determine: - How rapidly to deplete the resource; - How much to save and invest out of the proceeds of depletion so as to avert a post- resource era slowdown or decline in consumption; - How to distribute the proceeds of depletion equitably over the indigenous population; - What balance to strike between external and domestic public investment; - What types of domestic public investment are likely to yield the best overall economic returns; - Whether, when, how, and to what extent, to foster economic diversification away from heavy dependence on the one depletable resource; - How to insulate the economy from the effects of significant fluctuations in the price of the resource; - What role should be played by the public sector and how its allocative and administrative efficiency can be assured;  - How to develop a vigorous, internationall)y competitive private sector, and - Hou to deflat. excessive public expectations. IFurthermiore, in the case of Olmlan and certain other Mliddle last oil prodtucers. wvhere the Government's desire to embarki on an ambitious program of social and economic development confrontled seveie domnestic absorptive capacity constraints and thius neccssitated large-scale recourse to expatriatc skills and labor, there was and remains the additional problem of wAhat limits, if any, to place on the emproyment of expatriates (e.g., ftor cu!tural and environmental reasons) and howv to deal with the inmnediate social and economic problems resulting from heavy dependenice on them. Coverage of this Report 1.3 This report addresses most of the central themes identified above. However, because the maini decisions have already largely been made, it takes rates of resource depletion as given. Given constraints on the resources available for this exercise, it has not been possible for the report to provide the following, despite their obvious importance: analyses of future prospects and public policy options in agriculture, fishing, tourism and manufacturing; an in-depth analysis and evaluation of the present development planning and investment selection process; an examination of external trade prospects, and the identification of critical issues relating to poverty and the environment. However, the Government's prevailing view that there are serious resource constraints on future development of agriculture is possibly correct. Opportunities for the development of an economically viable fishing, tourism, manufacturing industries are limited only by the Government's ability to provide the legal foundation and the targeted incentives necessary for a successful private sector development and private investment promotion, both domestic and foreign, as laid out in Chapter 8, below.. As for development planning, Oman is clearly in a process of transition, from a heavy emphasis on public investment to a more limited role of Government and dominance of the private sector. This transition would seemingly require more emphasis on policy formulation to guide the transition and on monitoring the impact of policies' implementation on the macroeconomic economic objectives of the Government. Finally, despite the absence of absolute poverty in Oman as a result of the rapid economic growth over the last twenty years and the free provision of public health and education services and subsidization of utility rates to low income users, relative poverty could exist and a strategy of poverty reduction may be called for. For that, an in-depth poverty assessment study is recommended. B. Economic, Social and Political Background 1.4 Oil production in Oman began in 1967. Following the accession of a new government in 1970, a process of modernization and economic and social development was embarked upon. This accelerated following the quadrupling of oil prices in 1973-74 and the settlement in 1975 of the civil war in the southern province of Dhofar. 1.5 Large-scale infrastructural development and a massive expansion of health, educational and other governmental services have taken place over the past two decades, financed by public revenues flowing from a rapid buildup of oil production to the current level of 250 million barrels a year. Today, the cities of Oman boast a standard of public infrastructure comparable (and not  3 infrequently superior to) that to be found in the advanced industrial countries. The development of efficient electricity, water and telephone services has permitted people living in the main urban and many rural communities to enjoy high, modern living standards. 1.6 Omani residents have experienced rapidly rising per capita incomes and have also enjoyed fair quality, free education and health care. Oman's main social indicators have recorded remarkable advances (Table 1.1). GNP per capita increased to 10 times its 1970 level by 1980 and more than doubled between 1980 and 1985 to reach US$7,550; however, it had dropped over 30 percent by 1989 as a consequence of the decline in international oil prices. Oman's basic education and health indicators also reveal dramatic improvement. Net enrollment is now 90 percent at the primary level, 50 percent at the preparatory level and 20 percent at the secondary level. Sultan Qaboos University, established in 1986, was expected to graduate 556 students in the 1991-92 academic year, with degrees in arts, education, agriculture, science and engineering. It is expected to begin graduating medical students in the 1992-93 academic year. Oman also has 5 technical and industrial colleges, 4 teacher training centers, and 4 technical secondary schools, spread across Oman. Present teacher training centers are to become colleges. In the area of health, expected age at birth climbed from 44 to 66 years over 1971-90, infant mortality dropped from 64 to 28 per 1,000 over 1980-1991, and crude death rates from 17 to 7.6 per 1,000 over the sarne period. Table 1.1: Oman - Social Indicators 1965 1970 1971 1975 1980 1984 1985 1988 1989 1990 1991 GNP Per Capita (US$) -- 360 -- 1280 3660 7 7550 - 5220 5583 - Crude Death Rate/1,000 - - 17 _ 7 6 - Life Expectancy at Birth (Years) _ 44 _ _ _ _ 66 - Children Immunization Coverage (%) -- 40 - _ _ _ 85 - Infant mortality per 1,000 live births 191 _ _ 64 36 _ _ _ - 28 Population per physician 23790 . - 1700 _ _ _ _ Population per nurse 6420 - 390 _ _ Primay school net enrollment - _ - 32 _ . 82 _ 90 1.7 While the proceeds of oil production made these truly impressive gains possible, they also inevitably produced a rather lopsided economy, with output dominated by oil production, the servicing of the oil industry's requirements, government spending out of oil revenues, and tertiary service activities ultimately dependent on oil. Petroleum accounted for 95 percent of exports of Omani origin and petroleum and gas output for 42 percent of GDP in 1991. Non-oil exports of Omani origin - mainly fish and other ocean products, copper cathodes, and textile, mineral and vegetable products -- represented only 5 percent of total exports excluding re-exports. Traditional activities - notably agriculture and fishing, which employ about 52 percent of the indigenous Omani labor force -- accounted for only 4.4 percent of GDP. 1.8 Rapid economic growth has brought its own problems. Many rural residents do not enjoy access to the modem amenities available to city dwellers and thus feel underprivileged. Within the cities and between the cities and the rural areas, there are very substantial and growing  4 disparities in the distribution of income and wealth. Not least, the development of human capital, while proceeding very rapidly, has not kept pace with that of physical infrastructure. Upgrading its stock of human capital is one of Oman's most critically important challenges. 1.9 Much of the country's progress in building up its infrastructure and expanding its coverage of social services of improving quality has hinged upon large-scale, unimpeded imports of goods and people. In the absence of major recourse to expatriate Akills and labor, Oman could not have realized the output increases it has achieved and could not have absorbed the enormous growth of public spending that has taken place witliout generating massive inflation. 1.10 Employed nationals were estimated by the Development Council at 244,390 in 1992. However, expatriate employment in the same year was estimated at 455,274. Expatriates thus accounted for about 65 percent of the employed labor force and were concentrated in trade, construction, community and personal services, manufacturing, and agriculture and fishing. Most were in lowly paid jobs, with nearly three quarters earning under RO 70 (US$182) per month in 1990. Foreign worker remittances abroad are a significant element in the balance of payments, amounting to RO 340 million (US$883 million) in 1991. This figure is equal to over a quarter of the value of Oman's goods imports. 1.11 Over time, the proportion of Omanis in public employment has risen slightly. Whereas 24.1 percent of employed Omanis held government jobs in 1975, the proportion had increased to 25.9 percent in 1990. With the enormous influx of expatriates since 1975 (their numbers are estimated to have increased from 74,500 in 1975 to the 455,000 level noted above in 1992), expatriates have come to dorninate the private sector, rising from 39 percent of private sector employment in 1975 to 70 percent in 1992. They have also i creased their proportion of public employment, rising from 22 to 35 percent of the total between 1975 and 1992 (Table 1.2). However, this still leaves the public service predominantly Omani. Table 1.2: Omani and Non-Omani Employment, Public and Private Sectors 1975 Public Private Total '000 % '000 % '000 % Omani 33.9 78.1 (25.1) 100.0 60.8 (74.9) 134.8 (100.0) Non-Omani 9.5 21.9 (12.8) 65.0 39.2 (87.2) 74.5 (100.0) 43.4 100.0 165.0 100.0 209.3 1992 Omani 63.2 64.9 (25.9) 181.2 30.1 (74.1) 244.4 (100.0) Non-Omani 34.1 35.0 (7.5) 421.1 69.9 (92.5) 455.3 (100.0) 97.4 100.0 602.3 100.0 699.7 Source: 1975 data, Oman: Development of Human Resources at Crossroads, World Bank, March 8, 1991 p. Al l. 1992 data, Development Council. Numbers may not add exactly because of rounding.  5 1.12 With 52 percent of employed Omanis following traditional pursuits in agriculture and fishing, and over 35 percent in government, only 13 percent were engaged in the remainder of the private sector in 1990. The labor market for native Omanis, like the overall labor market, is clearly highly distorted. Most young, urban Omanis entertain high expectations, regard free social services as a right, and look primarily to the government sector and the more highly paid and prestigious parts of the private sector for employment, refusing to do jobs that expatriate labor (95 percent from the Indian subcontinent and Sri Lanka) is willing to) do or being prepared to do so only for substantially higher wages. 1.13 There is thus a sharp divergence of economic interest between Omani employe rs seeking competent labor at the lowest cost and Omani job seekers expecting preferential status, as well as the potential for increasing unemployment among young, ambitious Oinanis The Government has attempted to avert realization of this potential by adopting measures to "Omanize" the work force, focusing particularly on the better-paying parts of the private sector currently dominated by expatriates. These efforts are described and evaluated in Chapt' r 9. 1.14 The unbalanced character of the Omani economy is further illustrated by the role played by public spending. In 1991, at 45.8 percent of GDP at market prices, public spending exceeded total private spending (44.6 percent of GDP). (Net exports, equal to 9.6 percent of GDP, constituted the balance of demand for GDP). Government consumption (35.4 percent of GDP) almost equalled private consumption (38.3 percent), while public investment (10.4 percent) substantially exceeded private (6.3 percent). This demonstrates the vastly larger role for government than in most economies, where private consumption normally dominates economic activity, typically accounting for close to two-thirds of total spending. 1.15 The growth of public employment over 1981-90, at 7.2 percent a year, was well in excess of the rate of labor force growth and has, as noted, absorbed a rising proportion of employed Omanis. A substantial fraction of Omanis are underqualified for the positions they hold. Furthermore, there is substantial overstaffing. Informed sources put it at least 10 percent, partly attributable to unnecessary directorates and sub-directorates in the various ministries. Government procedures are viewed by many in the private sector as cumbersome and slow. Public employees are deemed by some private se,.tor groups to be unequal to the tasks required of them. There is a clear and well-recognized need for reforms in the public sector to improve skills and eliminate redundancy. 1.16 Notwithstanding the emergence of such problems, several aspects of Oman's oil revenue use policies represented major steps in the right direetion. The decision in 1980 to place a significant portion of public oil revenues into a State General Reserve Furd (SGRF) was a prudent one that stood Oman in good stead when oil prices fell precipitously in 1986. The establishment, under the Fourth Five-Year Development Plan, of an additional, separate Contingency Fund was potentially an important additional improvement. This fund could constitute a first line of defense against unforeseen contingencies, reducing the need for frequent ad hoc recourse to the SGRF. The SGRF should help insulate the Omani economy from transitory fluctuations in oil prices and it (or, preferably, a separate fund) is potentially capable of mitigating to some extent the adverse impact on public revenues of the eventual exhaustion of oil  6 and gas reserves. ' Whether the two funds as presently constituted and operated are adequate for these tasks is taken up below (Chapter 2). 1.17 A difficult problem confronting the Omani authorities in initiating a large expansion of public spending was how to do so in such a manner as not to introduce major distortions into the structure of private incentives. A further (although largely unrecognized) problem was whether it was feasible to prevent a scale of public spending that was clearly far in excess of indigenous absorptive capacity from simultaneously preempting significant expansion of efflcient export- oriented and import-substituting activities. 1.18 In the event, the allocation of an important fraction of public revenues to building up Oman's public infrastructure and to providing free health and educational services to its people represented a use of public revenues that was relatively non-distorting in its impact on the allocation of private resources and constituted a way not only of building up future productive capacity but of spreading oil wealth reasonably equitably. The Government's avoidance of both large-scale, uneconomic publicly financed indus rial development and massive subsidies to support uneconomic private development was also commendable. However, it was not possible to prevent the effect on the real exchange rate of the domestic absorption of the bulk of the oil revenues, together with the sheer scale of public expenditure, from preventing substantial, simultaneous expansion of efficient private goods production. 1/ The SGRF was initially established with the intention of providing an inheritance to future generations but has been used largely as an oil revenue stabilization mechanism.  Chapter Annex Table I.AI: GOVERNMENT REVENUES AND EXPENDITURES (1976 - 1992) ITEMSMiYARS 1.976 1977 1978 1979 1980 1911 1982 1983 1984 198-5 11986 1987 1988 1989 1990 1991 1992 OHl Revenue 454.7 482.2 457.7 634.6 1095.5 1341.3 1215.7 1277.5 1304.6 1510.0 928.9 1194.9 993 6 1197 4 1701 6 1.515.7 15251I Transfers to SGRF 0.0 0.0 0.0 0.0 264.3 2115.9 158.4 169.9 172.5 203.2 33.9 51 9 (289 1.13) 213.6 193 0 195.2 Tradisfers to SERF 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 17 0 0i '0 0 82 0 54 1 t. Net off Revenue 454.7 482.2 457.7 634.6 831.2 1125.4 1057.3 1107.6 1132.1 1306.8 895.0 1143.0 95089 1084.4 1 ~38 .( 1240.7 1275.8 2. Non-Oil Revenu 32.6 38.3 44.6 57.6 92.4 136.8 118.1 146.3 208.6 266,2 291.9 427.2 2540o 2PI5 7 348 3 3444 4 4(74.4 A. TOTAL REVENUE 487.3 520.5 502.3 692.2 923.6 1262.2 1175.4 1253.9 1340.7 1573.0 1186.9 1400.2 1204.8 (477)7 I576 1585, 1 169(02 (1+2) I__ _ _ _ _ Goveronent Expenditures 3. Defense & Nat. Sec. 271.3 237.1 264.5 269.0 406.8 521.9 581.3 670.7 728.2 744.9 665.4 583.6 589. 2 6006 742 1 643 777.8 Capital Kip. 92.2 73.0 63.4 22.6 .59.! 71.9 83A4 140.3 159.4 136.0 86(1 42.4 649 1') I 16 I 2j '7 70 6 'All Other Items 179.1 164.1 201.1 246.4 347.7 450.0 497.9 530.4 568.8 608.9 579.4 541.2 525 3 ~81I 7151;6 (,.' 6 747 2 4. CivilIan 107.0 142.0 172.9 188.3 271.2 335.1 388.9 440.6 5047.2 588.8 648 2 @48.5 682 0 760 5 827 8 819 7 960) 5 S. Developmnent 195.1 145.9 122.7 193.1 246.7 317.4 395.2 377.1 464.7 55.0. 532.4 328.8 2802 270 2(75- 8 191 7 4'1 1 6. Support to Fri. Sec. N.A. N.A N.A N.A 25.1 49.4 47.5 58.6 60.2 43.8 40.8 48.2 1,,9 44.1 I ( I 114 49) 3 B. TOTAL 573.4 525.0 560.1 650.4 949.8 1223.8 2412.9 1547.0 1760( 3 1928.4 1886.8 1609.2 15f7 4 1665 8 I1887 -1 181,8 I 225R -7 EXPENDrMRES (3+4+5+6) C. GOVERNMENT -86.1 .4.5 -57.8 41.8 .26.2 38.4 .237,5 -293.1 . 1 419.6 -355.4 6999 .)-148.9 362 S 29)~ 7 1t21 230 578 SURPLUSI(DEFICIT(A-0) D. MEANS OF MEETING DEFICIT 60.5 124.5 3.35 48.9 300.5 353.7 310.6 368.5 278.4 24R.5 172.6 39 2 100i If I) 97 47') 2 210677 7. Grants (Net) I28.0 92.7 6.7 6L.9 35.? 50.0 14.7 50.7 72.8 88 fl(. 2.7 IS 8 . ' 60l 8. Loans (Net) 42.5 31.8 -10.2 .13.0 1.0 50.5 41.0 162.8 150.7 73.4 2159 52 2 72 I 7.'.' 211 9. Governmnent Bonds 0.0 0.0 0.0 03) 0.0 0.0 0.0 0.0 0.0 0 130 0 I) 7( (i( 70 4 4 I( 10. Short Loans 0.0 0.0 0.0 (0 1)(0 0.0 (1.) 00 (. (1 ( (1.7) fil 7 , 61 0 ,7 11. Net Movement on 0.0 0.0 0.0 0.0 264.3 253.2 254 9 255.0 54.9 183.9 43 0 88.7 98~ 2 it '4I7- 1 (t Reserve I__ __ I _ _ - 74 12. ResI Surplusi .25.6 220 0 -613 90.7 274.3 392.1 73.2 75.4 241.2 206)9 -527 3 09i.7 462' 2 ( , i', %. (dericli)(C + D) _ _ _ _ _ _ _ _ _ _ _ __ _ _ Movement on Reserve a. Transfers to SGRF 0.0 0 0 0.0 ((.0 264 3i 215.9 258 4 169.9 172.5 201 2 31 9 ~ ' 7 h. Trarslers to SERF 00 0.0. 0.0 12 0.0 .4 0.0 7 (1. (7471 0( 477 ) (7 c. Total Transfers (a+ b) 0.0 0 t) 10.0 0.0 264.3 215.9 184 1 64.9 (72.5 20142 39' I 9 42 .II 2 d. Reserve Fundts Incerwe 0.0 0.0 0.0 (.0 0.0 '7 3 Q76.5 65.1 27 4 280.7 449.4 71 2 .47'' e. Total (c +d) 0.0 0.1) 21.0 (7.) 264 I 253.2 254.9 2145.0 7*)499 483 '7 4817 , 7770 I .'' r. W.ithdrawals from 0.0 0 0 (A. .1.1) 0( 00 D ( 80.77 2154i 3()7 .7 ('75 I ~ ' 7 1 P. FundI g.Net (e-t 0. 10 0 0. 2644 254.2 2-5494 1 55(4 574 'I 7(7' 574 75 ____(__ ~ >7: 7 tf'o Source: Devetopment Council  8 2 RECENT ECONOMIC DEVELOPMENTSE A. Oil and Gaq Oil 2.1 Reserves and Extraction. The initial discovcries in the late sixties establisliedl proven oil reserves of about 1.8 billion barrels. These were maintained until 1972 and then began to decline as extraction rose to exceed 100 million barrels a year (Clart 2. 1). Reserves expanded rapidly to the 4 billion barrel level as new discoveries were made over 1979-84. Since theni. thev have grown more slowly than the annual rate of extraction, which rose very sharply over 1983-86 and reached over 240 million barrels in 1991. Consequently, the life of the reserves at the current rate of extraction had fallen to 17.9 years by 1991 from the 1984 peak of 25.8. Proven reserves are currently about 4.7 billion barrels. In the past, the proving ol new oil reserves has kept the life of the reserves from falling very much below the 1968 level. Some proving of new reserves will almost certainly also occur in the future, both from new discoveries and enhanced recovery from existing fields. However, it would be inprudent to count on it nor for government policy to make inadequate provision for savings based on expectation concerning ultimate recoverable reserves. CHART 2.1 OIL RESERVES, ANNUAL EXTRACTION AND LIFE OF RESERVES, 19a7 - .~~~~~~M m IR YG31 ANNUAL IWtIUAOllON ae a . . ... .. . ... ... ........ ..... .................... ....... ................... ........ .. . ... . ; .. . . . . . . . .' sW '' ' ' ' v~~~ ~~~~~~~~~~~~~~~~~~~ ... ... .. ..... _ s~~~~~~M. i . . ' ''' .. ' -.. ' '. . .''. .'. .. ... .'. .'. '. . ..'.. .. . ''..... . ... . ..... '' ''..''.'..'' .. .. . . . .. .. .... ...................................................................................... ............. .u re wii un ui ornua u un X uM SouJrce: Do.wopm.nt Council  9 2.2 Uses. Prior to 1982, virtually all of Oman's oil was exported. Since then, with thc coming out streamn of the domestic refinery, part of the oil, langing from 13 to 24 million barrels a year, has been consunied domestically (Chart 2.2). CHART 2.2: PRODUCTION AND EXPORTS CRUDE PgTROLEUM VIS Bioo 1070 1974 1076 1962 1968 190 ycdr 1I Producton 0 Erpi1 Souw0o: Statlottal Year Book, 1ee2 and Petroleum Developmenr Oman 2.3 Prices. The price at which Oman's oil output could be sold rose precipitously in 1973. It jumped again in the late 1970s, almost tripling between 1978 and 1981 and reaching US$36.92 a barrel in the latter year (Chart 2.3). Prices declined steadily over 1982-85 and then plummeted in 1986 to US$13.43 a barrel -- little more than a third of the 1981 peak price. Following some recovery in 1987, prices fell back to close to the 1986 level in 1988. They have held in the US$16 to US$18 range over 1989-92, except for 1990, when the Gulf War pushed the average price up to US$21.43 a barrel. CHART 2.3: AVERAGE CRUDE OIL EXPORT PRICES, 1978 -1992 40 s0 Jan. - Oct. 20 10 0 1976 19o0 192 1114 196l 1U11 1990 1992 Souro Potrofeum Development Oma  10 2.4 flTe rapid rise in the value of Oman's oil production over 1978-81 reflected primarily the strong increase in prices over that period. The overall effect of oil price declines on the value of output over the 1981-91 decade was offset by increased production, although the value of output was depressed over 198(-89 as a consequence of the particularly low oil prices over that period (Chart 2.4). CHART 2.4: VALUE OF OIL PRODUCTION, 1978 -1992 Jan. - Oct. 4= w 000 _ _ _ _ 0 1070 1080 106 1004 106 196 1900 1962 Yew Souros: Statiloal Yearbook, 1901 and Petroleum Deveopment Omnn Gas 2.5 Reserves. Oman has substantial proven reserves of natural gas, estimated in 1992 at 17 trillion cubic feet (tcf) -- equivalent to 2.9 billion barrels of crude oil (i.e., to about 60 percent of Oman's oil reserves). Estimated proven reserves were increased to 20 tcf in late 1993. Only 2.7 tcf are in the form of associated gas. Until 1989, reserves stood at 10 tef. New fields discovered by deep drilling in 1989 and since have added a further 7 tcf of non-associated gas, with highly valuable condensates. Expectations are for further significant discoveries. 2.6 Uses. It is intended that the pre-1989 fields serve domestic uses and the new discoveries, a proposed LNG project.2 The use of natural gas for domestic purposes averaged about 185 billion cubic feet (bcf) per annum in 1990-91, equivalent to about 88,000 b/d (about 10 percent of combined oil and gas equivalent extraction) of which about 130 bcf is associated and 55 bcf non- associated. Domestic consumption of the gas is approximately as follows: 2/ For further details, see Annex 2.  11 Billion cu ft Govermnent gas pipeline system serving power stations, copper and cement plants, industrial areas and defense facilities 60 Sales to gas companies converted into butane, etc., and distributed in cylinders to households for cooking purposes 15 Oil-field use for fuel and reinjection 85 Flared 25 Total 185 Domestic demand for gas is projected to increase at 5 percent a year. It is currently sold at half the reference price for crude oil. Consumption by the LNG plant is expected to be 775 million cubic feet (mcf) a day. Under the present plan, 5 million tons of LNG will be produced and exported, beginning in 1999. A decision on whether to proceed with the project, based on the results of ongoing exploration, will be taken at the end of 1994. B. Public Finance Allocation of Government Gross Oil Revenues 2.7 Establishment of State General Revenue Fund. Initially, following the beginning of oil production in 1967, all oil revenues accriing to the Government went directly into the government accounts. With the explosion in oil revenues resulting from the jump in oil prices over 1978-81, the Government decided in 1980 to put part of the additional revenues into a reserve, outside the budget, called the State General Reserve Fund (SGRF), established by Royal Decree 1/80. The fund was fed not only by its share of Government oil revenues but by its own earnings and capital appreciation. Although set up initially to provide a source of income for the future, it was also to be used to finance the state budget in "years when there was a need." 2.8 The proportion of gross public oil revenues flowing into the reserve fund was initially quite high, reaching 24.3 percent in 1981, but it declined during the early to mid-eighties and plunged to 3.6 percent in 1986 (Chart 2.5). The proportion remained low until 1990, when soaring oil prices gave rise to a 42 percent jump in gross oil revenues and additions to the SGRF climbed to 10.2 percent of the total. 2.9 Establishment of Contingency Fund. In formulating the Fourth Plan, beginning in 1991, the Government allowed for the establishnment of a Contingency or Emergency Fund, outside the budget, that would also receive a share of gross oil revenues. Its purpose was to provide an initial source of funding for the public sector deficit and thus obviate ad hoc recourse to the SGRF, which could revert to being a more strategic, long-term reserve. Chart 2.6 shows the overall structure of the Government's financial stocks and flows following the establishment of the Contingency Fund. Under the Fourth Plan, the share of the SGRF in gross government oil revenues was to be increased from 5 to 15 percent. It was, in addition, to receive all surplus oil receipts, defined as those resulting from an oil price above US$25 a barrel. The emergency  12 reserve fund was to receive 7.5 percent of oil revenues when the price was between US$18 and US$20 a barrel and 10 percent when the price was between US$20 and US$22 a barrel. The additional revenue accruing when the price of oil was between US$22 and US$25 a barrel was to be allocated to specified public expenditures. CHART 2.5:. PROPORTION OF GROSS OIL REVENUES FLOWING INTO THE STATE GENERAL RESERVE FUND so 25 20 JIs 10 5 M 0 1680 1962 1984 19s6 1ess 1960 Yeaw Soiuro: SORF Dafta, Ministry of Firnonc and Eoonormy; Government Gross Oil Revenue Dats, Development Council CHART 2.6: SIMPLIFIED STRUCTURE OF FINANCIAL STOCKS AND FLOWS *t1'PUOL3C~~~~~~~~~~MIU IqNANCIALIANIA RSmS  13 2.10 Changed SGRF and Contingency Fund Allocations. The rules governing the allocation of oil revenues to the reserve and contingency funds were altered in 1992 by Resolution 92/12 of the Council for Financial Affairs. This gave first priority to financing the public expenditure program set out in the Fourth Plan. The SGRF was to receive each month 15 percent of the oil proceeds remaining after deducting 1/12 of the year's public expenditure allocation under the Plan. The Contingency Fund was to receive at least 7.5 percent of the remainder when the price of oil was between US$18 to US$20 a barrel and about 10 percent when the price of oil was between US$20 to US$22 a barrel. Additional proceeds resulting from an oil price between US$20 and US$25 a barrel were to be allocated on the following basis: 40 percent to defense and security; 30 percent to second and third priority civilian economic development projects up to a total of RO 162.8 million; 15 percent to civilian recurrent expenditure; and 15 percent to cover the deficit. Any remaining excess oil proceeds were to be allocated to the SGRF. Government Revenues. Expenditures and Deficits 2.11 Oil Revenues and Expenditures. Reflecting the explosive run-up in oil prices, public revenues nearly tripled over 1979-81, temporarily outstripping a huge concomitant rise in public expenditures (Chart 2.7). From 1982 on, however, with oil revenues flattening and expenditures continuing to climb, a long string of deficits emerged. The collapse of oil prices in 1986, following a continuing decline from the peak reached in 1981, resulted in an enormous expansion of the deficit to the unsustainable level of RO 666 million. When government revenues are expressed net of transfers to the SGRF, this figure is increased to R.O. 699.9 mnillions (Annex Table 2.Al). This led to a sharp curtailment of government expenditure over 1986-88. With the recovery in oil prices in 1989 and a further jump in prices of over a third in 1990 as a consequence of the Gulf War, government revenues climbed rapidly, again temporarily exceeding a renewed expansion in government spending. However, with oil revenues declining again in 1991 and development spending surging, a small deficit reemerged. In 1992, with a major increase in public spending taking place, the deficit rose substantially. 2.12 The main overall cause of the growth in government spending and the emergence of semi- chronic deficits has been the inexorable rise in civilian recurrent expenditures, coupled with the maintenance of an extremely high level of defense and national security spending. Whereas government revenues grew at an average rate of 10.6 percent a year over 1978-91, civilian recurrent expenditures grew far more rapidly, averaging 12.7 percent a year. 2.13 Chart 2.7 shows that 1986 was a watershed year for the Government's finances. Following more than a decade of rapidly increasing revenues, the Government after 1985 was confronted with a situation both of major fluctuations in revenues and negligible overall growth. With a flattening profile of oil extraction and little prospect of any significant rise in the real price of oil, this situation is likely to persist as far as oil is concerned although gas development will provide substantial additional future revenues.  14 CHART 217: GOVERNMENT REVENUE, EXPENDITURE AND DEFICIT* 1976s1991 (Millions of Omanl Rials) GOVERNMENT REVENUE AND EXPENDITURE 2600 IE I I y 1976 low 1U. 1904 less169 1ow Year M Rw uw o E* E wedituro SURPLUS/DEFICIT 400 0 4340 Ism 107 1980 1902 1964 1989 1906 1900 Year * 1wDvpewt Counofl date umd In this chart kWuds groal .v renue bhem. alooanm tothe SORf an the Conngenoy Fund a a dffe*r dellnkim of expendlum hn repoted by th Cotrol BarJL Thus, th do%it sow hee dfe, fnt th 0Ofloala dd.t Sow D_op_Counol  15 2.14 The Government tried to meet the fundamental change in its revenue position after 1986 by substantially cutting public spending, particularly development spending until 1990. By 1991. total public expenditure was still 3 percent lower than in 1985. despite the significant recovery that had taken place in revenues. The deficit was accordingly very sharply reduced from its 1986 level. The renewed mnassive expansion of spending in 1992, leading to the re-emergence of aun unsustainably large deficit, reflects the fact that the Governmlent's policy of trying tO adjust recurrent expenditures to lower revenues mainly by squeezing initial departmental budigetary allocations has broken down. 2.15 Shifts in the Structure of Government Expenlditure. The decline in public spending after 1985 was borne, as noted, mainly by development spending and (to a much lesser extent) expenditures on defense and, national security. Development spending was slashed almost in half. from a peak of RO 534 million in 1985 to RO 270 million in 1989, while defense expenditures dropped from RO 745 million in 1985 to RO 589 in 1988. Civilian recurrent expenditures, on the other hand, merely flattened out between 1986 and 1987, before resuming their rise. One of the main causes was a continuing rise in government employment, which increased by almost a fifth over the four years 1986-90. Public service wages and salaries averaged 56 percent of the recurrent budget over 1987-91 and the overall wage and salary bill rose at an average rate of & percent a year over the same period. 2.16 The growth of civilian recurrent expenditures at a rate far in excess of the rate of growth of public revenues, coupled with cuts after 1986 in development spending, has resulted in major changes in the structure of governmnent spending, with the share of development expenditures dropping from 27 percent of the total over 1976-82 to 16.4 percent over 1988-90 (Chart 2.8). W1hile the share of defense and national security has fallen from 46 percent in 1976 to 34 percent in 1991, it remnains at a very high level by international standards. Civilian recurrent expenditures rose from only 15 percent of the total in 1976 to 44 percent in 1991. C HAiRT 2.8: ST R UCTU RE O F GBOVER NM EN T EXP>EN DITU RES Supportto Private Sector and Loans 20 Civilian Recurrent Expenditure 0 ., .- , 1976 197, 1962 1985 1986 1991 Year Sourco: Development Council  16 2.17 Government Non-Oil Revenues. Government non-oil revenues in 1976 represented only 7.1 percent of total government revenues. Their share has gradually expanded since to 9.3 percent in 1981, 15.0 percent in 1985 and 18.5 percent in 1991. However, most of the Government's non-oil and gas current revenue represents non-tax revenue (Table 2.1). Taxes and fees in 1991 were only 4.4 percent of total government revenues and of that amount, income and payroll taxes accounted for under 30 percent, with the remainder accounted for by customs duties and fees, licenses, etc. There are no sales or value added taxes. Table 2.1: Breakdown of Non-Oil and Gas Current Revenues (RO Million) 1987 1988 1989 1991 1991 A. Taxes and Fees Revenues 69.0 70.8 64.9 68.5 81.0 Income tax on companies and establishments 21.2 23.4 16.0 14.4 18.3 Payroll tax 7.? 6.0 6.5 5.8 5.6 Fees on licenses and others 13.6 11.8 13.0 15.4 17.6 Custom duties 29.6 29.6 29.4 32.9 39.5 B. Non-Tax Revenues 174.8 129.3 150.5 196.3 193.9 Electricity Revenues 59.3 47.2 51.3 57.1 59.6 Water Revenue 15.2 12.4 17.3 18.6 19.0 Postal Revenue 2.6 2.5 2.8 3.6 3.7 Airport Revenue 8.3 8.4 8.5 8.3 7.7 Surplus from Public Authorities 2.0 0.6 0.7 0.9 0.6 Rent trom Govt real estate 14.1 20.5 30.2 30.9 Income of Govt investment 1.7 1.9 1.7 1.9 1.6 Interest on Bank deposits and lending 16.8 9.9 14.0 18.8 17.8 13.7 8.5 8.8 7.5 9.3 Others 55.2 23.8 24.9 49.4 43.7 Total of Non-Oil and Gas Cunrent 243.8 200.1 215.4 264.8 274.9 Source: MOF 2.18 Financing the Public Sector Deficit. The public sector deficit has been financed from four sources: grants, loans, the SGRF/Contingency Fund, and changes in the Government's accounts (Table 2.2). Grants were important until 1984; since then their net contribution has been 3 The data included in Table 2.2 and in Chart 2.7 above are based on Development Council defmitions that differ from those used by the Ministry of Finance and Economy in defining the "official' deficit. Oil revenues are defined gross of contributions to the SGRF and expenditure definitions also vary slightea from those reported by the Central Bank, based on Ministry of Finance data. An updated ad reformulated table provided by the Development Council to the World Bank Octobe 1993 mission (Chapter Annex Table 2.A1) presentgovernment revenues on a net basis and shows the means used to finance the deficit.  17 negligible. Loans were important until 1986; since then, repayments have exceeded drawings. Up until 1984, large payments were made into the SGRF; however, large withdrawals were made over 1985-88 to finance the deficit. Changes in the Govertunent's accounts, while substantial from one year to the next, did not accumulate significantly over time until 1989-91, when the cumulative total reached the very large figure of RO 623.8 million (US$1.6 billion). A combination of loans and withdrawals from the SGRF fnanced the very large deficits in 1986 and 1988. The SGRF was rebuilt over 1989-91 but the improvement was more than offset by the cumulation of negative changes in the Government's accounts (Chart 2.9 below). Government's Net Financial Reserve Position 2.19 The SGRF. The emergence of the series of public sector budgetary d..ficits after 1981 occurred, as noted above, despite the Government's allocation of a rapidly shrinking proportion of gross oil revenues to the SGRF, particularly after 1985 (Chart 2.9), i.e. despite the allocation of a higher proportion of oil revenue to the budget. At the same time, from 1982 on, the Government was making increasingly large withdrawals from the SGRF to finance the deficit, peaking in 1986 at RO 380 million. Fortunately, strong earnings on fund assets over 1985-87 largely offset these withdrawals, so the balance in the SGRF continued to rise. Over 1987-89, net additions to the SGRF became negative and the level of the fund fell temporarily below the minimum level of RO 1200 million established by Council of Financial Affairs Resolution No. 4/87. During 1990-92, the Government rebuilt the SGRF to new highs but at the expense of large deficits in its own accounts. Table 2.2: Financing of Government Deficit/Surplus 1976 1977 1978 1979 1980 1981 1982 1983 Deficit/Surplus (98.4) (36.7) (82.8) 30.0 238.1 254.3 (79.1) (123.1) Grants 18.0 92.7 6.7 61.9 35.2 50.0 14.7 50.7 Loans 42.5 31.8 (10.2) (13.0) 1.0 50.5 41.0 162.8 SGRF 0.0 0.0 0.0 0.0 (274.3) (215.9) (98.4) (89.9) Change in Govt. Acct. 37.9 (87.8) 86.3 (78.9) 0.0 (138.9) 121.83 (0.5) Total Financing 98.4 36.7 82.8 (30.0) (238.1) (254.3) 79.1 123.1 1984 1985 1986 1987 1988 1989 1990 1991 Deficit/Surplus (247.1) (152.1) (666.0) (97.0) (319.7) (182.7) 152.5 (8.0) Grants 72.8 (8.8) (0.3) 2.7 15.8 6.2 (21.7) (1.3) Loans 150.7 73.4 215.9 (52.2) 72.1 34.6 (147.3 4.9 SGRF (27.5) 96.8 492.4 146.5 231.8 (113.0) (163.6 (184.4) Change in Govt. Acct. 51.1 (9.3) (42.0) 0.0 0.0 254.9 180.1 188.8 Total Financing 247.1 152.1 666.0 97.0 319.7 12.7 (152.5) 8.0 Source: Development Council  18 CHART 2.9: STATE RESERVE FUND AND STATE DEBT 1981-1991 (Millions of Omanl Rials) SGRF OIL REVENUE RECEIPTS DECEMBER 31 SGRF BALANCE 2 U.. s.c jgo, if",1ne.mW Pai MO.i,L 1 2 !- 1 go 100* o ~~~~~~~~~~~~~i0oI SGRF APREIAfHDNANDICOiGOENMN CUMULATIVE DHN ESTI gooJL jie.o 100 ioe iW 184 ee ilo wo lmIo iou iou ie iee iee im iee Year Veer SGRF IATH AN NRMENCUMIULANVGES DB MIU cIOnvERCHNMES INZOUTACOUT 1400 s 80 0- ~~~~~~~~~~~~~~~~~400' 8110: .s.,Il u d2 Fh00R toe Iou 1U4 iee toe ieo iouiu o 198 ie I=e I;o iou Year Year SGRP WITHDRAWAL~~~~~~INS CUMULATIVE CHANGES IN OTACUS U III~~I 200 ~~~~~~~~~~~~~~~~~~~400 100 ~ ~ ~ ~ ~ ~ ~~~~j0 .1000 2~~~~~~~~~040 0 19u i0 108 l4 iee ieee iees iou 19o0 iou2 ie4 19ee Iee IwM IOU Year Y" Source: Mins&y of Financ (SGRP)  19 2.20 Government External and Domestic Borrowing. At the same time that the Govermment was building up financial reserves after 1980, it continued to borrow. Outstanding debt grew quite rapidly during the 1980s, reaching a peak of RO 807 million in 1989. In 1991, it stood at RO 745 million. Beginning in 1991, the Government began borrowing domestically by issuing Development Bonds. These were seen as a means both of contributing to the financing of the deficit and of absorbing excess domestic liquidity. RO 40.6 million was raised from Development Bond sales to finance the deficit in 1991 and RO 138.3 million in 1992. 2.21 Chart 2.9 shows that the growth in the Government's debt has to a considerable extent offset the growth of the SGRF. In fact, after deducting cumulative debt and the cumulated negative public sector balances from the estimated balance in the SGRF account, the Gove-mient's net financial reserve position stood at RO 147 million in 1991 - less than 7 percent of 1990 gross oil revenues - down from a high of RO 714 million in 1982. It deteriorated substantially further n.j 1992. The decline in the Government's net reserve position is a further indication that it has failed to make an adequate adjustment to the basic change in its financial position beginning in 1982 and intensifying after 1986. Fourti Plan Intentions versus Outcome 2.22 Under the Fourth Plan, the Goverrunent proposed to reduce the size of the "official" deficit to 10 percent of total government revenues, discontinue borrowing from abroad, and eliminate recourse to withdrawals from the SGRF. The Plan projected the cumulative deficit over the five years 1991-1995 at RO 879 million, of which RO 450 million would be met from withdrawals from the Emergency Fund and RO 429 million from the issuance of domestic Development Bonds. 2.23 Actual public spending during the first two years of the Fourth Plan, i.e. 1991 and 1992, exceeded planned spending by a wide margin (Table 2.3). Actual government expenditures exceeded planned expenditures by 6 percent in 1991, 23.2 percent in 1992, and are expected to exceed planned expenditures by about 14 percent in 1993. The actual current deficit exceeded the planned deficit by 51 percent in 1991, 242 percent in 1992, and is expected to surpass it by 105 percent in 1993. These developments are causing a great deal of concem over maitaining fiscal stability. Table 2.3: Public Finance (1991-1993) Item 1991 1992 1993 Excess Rates Planned Actual Planned Actual Planned Estimated 1991 1992 1993 Revenue 1577 1585 1649 1660 1698 1698 Exeenditure 1764 1868 1818 2239 1881 2138 5.9 23.2 13.7 Current 187 283 169 579 183 375 51 243 105 Deficit _ % of 11.8 17.8 10.2 34.9 10.8 22.1 Revenue __ _ _ __ _ _ __ _ _ _ _ % of GDP 4.9 7.2 4.2 13.5 4.3 8.6 _ _ Source: Development Council  20 Conclusions 2.24 The following conclusions appear warranted concerning the financial performance of the public sector over the past two decades: (a) The growth of public recurrent expenditure has been clearly excessive, outstripping even the explosive rise in public oil proceeds; (b) The Government has made only a partial and incomplete expenditure adjustment to the post-1982 flattening of oil revenues; (c) The SGRF, which was initially established primarily to provide a source of income for the future and only secondly "to finance the public budget of the state in years when there is a need" has in fact been used mainly as a stabilization fund, although other means of financing the public sector deficit have also been employed; (d) The SGRF only partially offset public oil revenue fluctuations attributable to fluctuating oil prices; (e) The Government's development strategy has not encompassed the use of the SGRF (or any other fund) as a vehicle for the implementation of an explicit long- term saving strategy designed to yield a numerically defined flow of income during the post-resource era; and (f) Public civil development expenditures, which the Govermment has regarded as investments in the promotion of private sector production to replace oil and gas production, have declined markedly over the two decades as a percentage of total public expenditures. 2.25 The clear deterioration in the Government's finances over the past decade raises two highly important questions: (1) What is the appropriate role for the Govermnent and is it trying to do too much? and (2) What expenditure-cutting and revenue-raising measures should the Government adopt in order to restore its finances to a healthy state? (The latter involves not merely eliminating deficits but moving to significant surpluses in order to raise rates of public and national saving to appropriate levels (Chapters 3 and 4.) These questions are addressed in Chapters 6 and 7. 2.26 Significant questions arise concerning the intended and actual roles of the State General Reserve and Contingency fimds. The SGRF has not fulfilled its prime objective as a future generations fund that accumulates foreign reserves from oil savings and invest them to generate the highest possible recurrent investment income that can sustain economic growth in the post oil era. The SGRF had overplayed its secondary role of financing the budget deficit when needed. In fact, the record (Table 2.2 and Chart 2.9, above) shows that the secondary objective became the primary objective as the net additions to the fund had mostly decreased or became negative since 1981. For it to be a full saving and investment find, it would have to receive all net income from oil and gas resulting from oil prices in excess of given figure plus a small annual percentage increase to allow for the anticipated slow long-term rise in real oil and gas prices. In  21 light of the close connections between government oil and gas revenue, government spending and overall domestic demand shown below (para 2.28), it is clear that a stronger control of public spending would have put the SGRF closer to achieving its long term objective. 2.27 It is also clear that eliminating the instability in public oil and gas revenues attributable to variatiens in oil and gas prices would result in far stable economic growth in Oman, as well as much less price volatility. The role of the recently established Contingency Fund is, as described in the Fourth Plan is " to meet any international or national economic changes which may occur during the implementation of the Plan and affect . .. expected revenue. . . . " The creation of the fund is described elsewhere as required (together with the SGRF) "to deal with future changes and forestall the consequences of fluctuations in the price of oil, whereby a stable level of oil revenues will be maintained throughout the years of the Plan.5"' Table 2.3, above, clearly indicates that the Contingency Fund had succeeded in stabilizing revenue, both in absolute terms and as a percentage of GDP, at the planned levels during the first 3 years of the Fourth Plan. Of the total of RO 533 million projected to be allocated to the fund under the Fourth Plan, RO 450 million was to be used to finance the public sector deficit.6 However, the same Table 2.3, ove, shows that public spending and thus the budget deficit had exceeded their projected levels ruling out any significant use of the fund either to deal with unforeseen contingencies or to stabilize oil revenues in the face of price fluctuations. Again, the main cause of macroeconomic instability -s the lack of expenditure control. 2.28 It is apparent that, if it is more fully to achieve its diverse aims in establishing the SGRF and the Contingency Fund, and, in addition, to save, and invest externally, a much higher proportion of its oil revenues, as recommended later in this report, the govermnent will need to redefine objectives and uses of the two funds. First, SGRF, as a long-term saving fund, should be the recipient of all net government saving out of oil proceeds that might result from the Govemment's pursuit of an optimum strategy (Chapter 3) designed to provide Omanis with income from oil capital during the post-oil era. (Net government saving in this context are defined as govermnent revenues minus (substantially scaled down)7 public domestic recurrent and development spending). The SGRP would receive each month the proportion of total proceeds from oil that had been determined on the basis of the saving strategy for that point in time.8 The fund would invest, primarily abroad, in long-term assets. Second, the Contingency Fund, as a separate stabilization mechanism, would receive all oil proceeds, net of SGRF contributions, that might result from an oil price above a predetermined, conservative, and infrequently adjusted benchmark level or trend (e.g., US$17.25 a barrel or US$17.25 a barrel plus x percent p.a.). It would hold its balance primarily in shorter-term liquid assets. The Contingency Fund balance 4 The Fourth Five Year Development Plan, p. 122. A ikLd, p. 81. 6 Ibid pp. 89 and 107. 7 See Chapter 7, paras. 7.5-7.16 , which discuss the need to reduce both pubic recurrent expenditures and certain types of domestic development expenditure. I The way in which the savings rate might vary over time under different scenarios is illustrated in Annex n, Chapter 3, which presents the numerical results of the optimum savings model.  22 would hold its balance primarily in shorter-term liquid assets. The Contingency Fund balance would be drawi upotn to make up government revenue deficiencies whenever the price of oil fell below the fixed benclhtnarkl and to meet truly unforeseen emergencies. Government net oil revenues would thus he inmerrvws to oil price chfanges (as long as the fund retained a positive balance) but would 1e in responise to any increase in oil and gas production. C. Domestic Production Fluctuatiors inl (iverall Irodttuction 2.29 The level of public spending largely determines the level of spending for the entire domestic economy) (Clhart 2.10). Throughout the second half of the }970s and the first half of the 1980s, domestic de.mand, like government non-defense spending, enjoy.d an uninterrupted rise. As with public spending, the growth of total domestic demand fell sharply over 1985-91 (to 2.8 percent) compared with 1976-85 (16.9 percent). (This compares with nominal overall GDP growth of 2.2 percent over 1985-91 and 16.3 percent over 1976-85.) 2.30 The relationshlip between overall GDP and public non-defense spending is less close than that between public total domestic demand and non-defense spending because overall GDP is strongly affected by changes in the value of exports, in turn attributable to variations in oil pric^s (Chart 2.11). For exarnple. net exports were 26.5 percent of GDP 1981 but dropped to minus 1.7 percent in 1986. CHART 2,10: GOVERNMENT EXPENDITURE AND FINAL DOMESTIC DEMAND* 1976 - 1991 GOVERNMENT NON-DEFENSE EXPENDrURE Go~~~~~~~~~~o i ae _ 07 lo _ 0 lm _ __ Yeaw DOMESTIC DEMAND no OG 1970 $07tl 1971 lOU 1SU 11t IS i.el * Govommont and Privdo Consumpon and lbevwnt Soum. Dovolopnont Counil  23 CHART 2.11: COMPOSITION OF GROSS DOMESTIC EXPENDITURE 197681991 PUBUC CONSUMPTION PUBUC INVESTMENT *76 ~ ~ ~ l low tm im lo Is 1m 1 e " Zt Y"r ~~~~~~~~~~Y"r PRIVATE CONSUMPTION PRIVATE INVESTMENT tw 1 zot *0 40 40 J~ ~ ~ _ii i i i l l i __ _ _ _____ _ 10 ~~~~~~~~~~~~~~~~~~~10 0 ~~~~~~~0 . P P IPE E. 1974 IWO 1060 108 1064 1906 190* 1090 l 1976 1076 1960 10204 10s100 1000lo Year Year NET EXPORTS s0 40 J30 .10r - I 1907t 109 1 1982 1904 1908 108 1900 Year Some*: Drnolpm.ntCouncll  24 2.31 Chart 2. 10 made it clear that, even after eliminating the instability induced in the growth of GDP by sharp variations in the value of oil exports caused by fluctuations in international oil prices, there remains a great deal of instability attributable to variations in the level of public spending, again mainly in response to revenue fluctuations associated with variations in the price of oil. These variations in public spending caused the rate of change in overall domestic demand to swing sharply from one year to another, as shown in Chart 2.12. If the Government were able to reduce the level of public spending and restrain its future growth, thereby generating increasing surpluses (as recommended in Chapter 3) the problem of public revenue induced instability in financial domestic demand would be largely eliminated, since public revenues and expenditures would be far less closely related. CHART 2.12: CHANGES IN DOMESTIC DEMAND 1985- 1991 20 is 10 (15)t 1985 1980 1967 1986 1989 1log 1891 1992 Year Source: Development Council The Structure of Production 2.32 The structure of production has undergone major shifts in the past decade and a half (Chart 2.13). Mining, quarrying and oil wells, already dominant in 1976, accounting for 59 percent of GDP at factor cost, increased its share to 60 percent in 1981. However, reflecting the drop in oil prices, its share fell to 39 percent in 1986. It recovered to 43 percent in 1991 as a consequence of increased production and the recovery in oil prices. There was a major decline in the role of construction. In 1976, during the construction boom, its share of GDP was 10 percent. With the decline in public construction, its share fell to only 4 percent in 1991. On the other hand, mirroring the rise in public recurrent spending, public and government services rose from 8 percent of GDP in 1976 to 11 percent in 1981, 18 percent in 1986 and 17 percent in 1991. The decline in mining, quarrying and oil wells, together with the drop in construction, coupled with the strong rise in public and govermnent services, combined to increase the share of the overall services sector from 29 percent in 1976 to 32 percent in 1981, 47 percent in 1986 and 46 percent in 1991. Thus, since the early days of the oil boom, the Omani economy has evolved from one dominated by oil output and construction, with services accounting for less than three-  25 tenths of GDP to one in which services now account for a little under a half of total output. CHART 2.13: STRUCTURE OF INDUSTRY 120 > : : ::; :::.,.;: .::: :: -:,:: .: :,: ~~~~~~~~. . .. .. : ::.:. ... ;. , . . .. . . .U .: 100 -80 '|*I_t|i 20 0- 1976 1981 1986 1991 YEAR Agrioultur. & Fisheries Mining & Quaying L Manufacturing E[ Ejotuicty & Watew Construction Wholesale & Retail Trade Private servies ^ 2.33 In the non-oil goods-producing sector, manufacturing -- the most strongly growing of all the components of GDP over the decade and a half -- rose froiii only 0.5 percent of GDP in 1976 to over 4 percent in 1991. This appears attributable to a number of underlying factors. First, the income elasticity of demand for manufactured goods is typically high, i.e., as incomes rise, the demand for manufactured goods rises more than demand for basic foods and services, since these are already largely filled. Second, the Government has, over the past decade or so, initiated a number of activities, such as cement manufacturing, flour milling and copper cathode production, involving relatively large increments to an initially minuscule manufacturing base. Third, the Government has provided a range of significant subsidies to manufacturing activities (see Chapter 8) in the interests of diversifying the economy away from oil and gas. Despite its rapid growth, manufacturing remains relatively small at 4.3 percent of GDP. Its 1991 GDP share was still only equivalent to about a quarter of the share of public and government services. In relation to GDP excluding mining, quarrying and oil wells, its share was close to 8 percent in 1991. (However, on this basis, public and government services accounted for 30 percent of the total.) Agriculture also increased its share, from 2.1 percent of GDP in 1976 to 3.7 percent in 1991. This was not solely due to the decline in the share of mining, quarrying and oil wells. Even in relation to GDP excluding mimng, quarrying and oil wells, its share rose from 5.0 percent to 6.5 percent over 1976-91. 2.34 While the growth of manufacturing and agriculture has been encouraging, their role remains quite minor. Moreover, private investment in these industries remains quite low. If domestically preduced non-oil goods and services are eventually to replace oil exports, then manufacturing, agriculture, fishing and tourism must expand considerably in the future. The factors producing the present industrial distribution of production and those that would produce diversification away from the production of domestic services and towards externally competitive goods and services production are analyzed in Chapter 5.  26 D. Saving and Investment 2.35 Chart 2.11 showed that the GDP shares of both public and private investment have declined substantially since the seventies, while the shares of public and private consumption have risen. The lack of private investment appears in large part to reflect the dominance of public spending and the absence of export and efficient import-substituting opportunities in an oil- dominated economy with an appreciated real exchange rate. The share of net exports, while highly variable, as noted, has fallen slightly (its average GDP share was 16.9 percent over 1976- 85 and 12.6 over 1986-91). 2.36 The decline in gross domestic saving and gross investment is also shown graphically in Charts 2.14 and 2.15. Saving and investment were relatively high in the early days of the oil boom, averaging 46.7 percent of GDP over 1976-81. The average declined to 41.8 percent over 1982-85 and dropped to 31.3 percent over 1986-91. Although these rates of saving appear high by industrialized country standards, they are extremely low -- especially in recent years -- for an oil-dominated economy in which government gross oil receipts - essentially realized oil capital - repre ented 35 percent of GDP. Furthermore, national saving (Chart 3.1) are much lower than domestic saving, reflecting large external transfers by expatriate workers. Chart 2.15 shows that the decline in the GDP share of total domestic saving is primarily explained by the drastic decline in public saving. 2.37 The decline in the GDP shares of saving and investment -- particularly public saving and investment -- has serious implications for Oman's economic future. The Government has been relying on developing the non-oil economy as a means to sustain Omanis' real incomes when the proceeds from the extraction of oil and gas start to decline. The Government's strategy required that high levels of domestic saving be maintained and that this saving flow into highly productive private investment This has not been happening. How much Oman -- particularly the public sector - should be saving and how its saving should be invested are issues that are taken up in the next two chapters. CHART 2.14: GROSS DOMESTIC SAVING AND INVESTMENT 60 60 a .. .. 20 lao B. _10 |||| 0 -10 1C76 i 190 192 1064 16 6 Iwo Year * Publlo lm_tnnwi U Pdvaft Invebf l Net Fogn Inwment  27 CHART 2.15: GROSS DOMESTIC GOVERNMEFNT AND PRIVATE SAVING (PERCENT OF GOP) 4,,50 IL 210