The Nexus between governance and human Capital Details research PROPOSAL investigate the relation between spending on higher

Innovation and Diversification Policies

for Natural Resource Rich Countries

Mueid Al Raee

UNU MERIT, UM MGSoG

Supervisors

Professor Jo Ritzen

Dr. Denis de Crombrugghe

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Contents

1. Introduction …………………………………………………………………………………………………….. 7

Appendix 1-A ……………………………………………………………………………………………………. 16

2. Productivity and Innovation Policy …………………………………………………………………… 19

2.1. Introduction …………………………………………………………………………………………….. 20

2.2. Innovation policies and the path towards successful innovation ………………………. 24

2.3. Identification Strategy ………………………………………………………………………………. 29

2.4. Data ………………………………………………………………………………………………………. 32

2.5. Results ……………………………………………………………………………………………………. 36

2.5.1. Global ………………………………………………………………………………………………. 36

2.5.2. Arabian Gulf countries – A special case? ……………………………………………….. 42

2.6. Conclusions and Discussion ……………………………………………………………………….. 45

Appendix 2-A ……………………………………………………………………………………………………. 49

Appendix 2-B ……………………………………………………………………………………………………. 50

3. Policy and Economy in the GCC ………………………………………………………………………. 53

3.1. Introduction …………………………………………………………………………………………….. 55

3.2. Perspectives on innovation ………………………………………………………………………… 59

3.2.1. General …………………………………………………………………………………………….. 59

3.2.2. The literature on GCC countries ………………………………………………………….. 61

3.3. The Case of GCC – Policies and Enablers …………………………………………………… 68

3.3.1. Section Summary ……………………………………………………………………………….. 68

3.3.2. Development of education systems ……………………………………………………….. 71

3.3.3. Literacy, primary education, secondary education, reforms and performance 72

3.3.4. Tertiary education and vocational education …………………………………………. 77

3.3.5. R&D ………………………………………………………………………………………………… 80

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3.3.6. Business and Entrepreneurship…………………………………………………………….. 85

3.3.7. Governance and Infrastructure …………………………………………………………….. 87

3.4. The Outputs of GCC – Indicators of Innovation and Diversification ……………….. 89

3.4.1. Section Summary ……………………………………………………………………………….. 89

3.4.2. Patents, Trademarks and Industrial designs ………………………………………….. 91

3.4.3. Non-traditional sector – share in the economy and labour productivity ……… 94

3.5. Connecting Policies, Enablers and Outcomes ……………………………………………….. 96

3.6. Summary, Discussion and Conclusion ………………………………………………………….. 98

Appendix 3-A ………………………………………………………………………………………………….. 103

4. Natural Resource Abundance: No Evidence of an Oil Curse ……………………………….. 107

4.1. Introduction …………………………………………………………………………………………… 109

4.2. Literature Review …………………………………………………………………………………… 110

4.3. Modelling the natural resource extraction and capital investment relationship … 113

4.4. Empirical Model …………………………………………………………………………………….. 113

4.5. Data …………………………………………………………………………………………………….. 121

4.6. Data Reliability ……………………………………………………………………………………… 124

4.7. Results ………………………………………………………………………………………………….. 127

4.8. Postestimation tests and robustness ………………………………………………………….. 133

4.9. Discussion and Conclusion ……………………………………………………………………….. 134

5. “Stars in their Eyes?” …………………………………………………………………………………….. 137

5.1. Introduction …………………………………………………………………………………………… 138

5.2. Background and Literature ………………………………………………………………………. 140

5.2.1. Diversification …………………………………………………………………………………. 140

5.2.2. Evaluation of Diversification Strategies ……………………………………………….. 140

5.2.3. Methodologies for Evaluation …………………………………………………………….. 143

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5.2.4. Oman and Saudi Arabia Evaluations ………………………………………………….. 144

5.3. The Predictive Model ……………………………………………………………………………… 146

5.4. Review of the Economic Plans of Oman and Saudi Arabia …………………………… 147

5.4.1. Oman …………………………………………………………………………………………….. 150

5.4.2. Saudi Arabia …………………………………………………………………………………… 151

5.4.3. Reference Condition and Scenarios ……………………………………………………… 152

5.5. Results and Discussion ……………………………………………………………………………. 154

5.6. Summary and Conclusion ………………………………………………………………………… 162

6. Conclusion …………………………………………………………………………………………………… 165

6.1. Background of the dissertation …………………………………………………………………. 165

6.2. Summary ………………………………………………………………………………………………. 166

6.3. Limitations and Suggestions for Future Research ………………………………………… 171

6.4. Integrated insights from the dissertation and policy implications …………………… 174

6.4.1. Institutional Effectiveness, Productive Efficiency, Human Capital, Education

and R&D …………………………………………………………………………………………………….. 174

6.4.2. Natural Resources, Oil, Productivity and Investment ……………………………. 176

6.4.3. Regional Infrastructure, International Trade and Peace ………………………… 178

7. References ……………………………………………………………………………………………………. 181

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1. Introduction

A challenge that many countries face today is the sustenance of their economic growth in the

face of increasing reliance on natural resources. The number of natural resource-driven

economies has increased from 58 in 1995 to 82 in 2017. 1 Among these countries, 57% were

low- and lower-middle-income countries, while only 13% were high-income countries. The

natural resource-driven countries were home to more than two-thirds of all people living in

extreme poverty. If low-income natural resource-driven economies engaged in sound policy

for effective and efficient utilisation of natural resources, aimed at broad economic

development, it is expected that almost half of the world’s poor could be lifted out of poverty

by 2030. 2 This number is more than the number of poor people lifted out of poverty due to

China’s rapid economic development from 1996 to 2015. In the face of the fast-evolving global

demand for natural resources, diversification of the economy offers a path for economic

development in low- and middle-income natural resource-driven economies and for sustaining

economic growth in the high-income ones.

The central aim of this dissertation is to examine the challenge faced by natural resource-

driven countries, in particular, the countries in the Arabian Peninsula, to diversify their

economies. We investigate what policies can help stimulate innovation and diversification in

natural resource-driven economies to ensure sustained development. The research carried out

in this dissertation draws upon the evidence of the policies for development in the global

context. This part of the dissertation is complemented by research on the state of

1 Natural resource-driven economies are defined as those that qualify under at least one of the criteria:

1. Natural resource rents are higher than 10% of the economic output of the country, and/or, 2. Natural resource rents amount to more than 20% of the fiscal revenue of the country, and/or, 3. Natural resource rents represent more than 20% of the total exports of the country.

The natural resource-driven classification is used by various sources (IMF, 2012; Dobbs, et al., 2013; Addison & Roe, 2018). The 2017 classification of natural resource-driven countries is based on the author’s calculations. More details are presented in Appendix 1-A, Table 1.1. 2 See Dobbs, et al. (2013, pp. 5, 135-136) for the methodology used in determining the estimated reduction of poverty due to the effective and efficient utilisation of natural resource rents. The poverty line of 1.90 USD 2011 PPP a day is used to determine the number of people living under extreme poverty.

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diversification and its relation to the policy measures undertaken in the Gulf Cooperation

Council (GCC) 3 and its member countries.

The complexity of the problem at hand can be understood by bringing together multiple

strands of academic literature. Some of the distinct yet interconnected areas that this

dissertation relies upon include economics and policy of innovation, growth economics, studies

of natural resource-driven economies and economic diversification.

A review of the innovation policy literature at the outset of the research for this dissertation

identified a need for more empirical and theoretical research in the area. 4 Addressing this

need is expected to push the field further in its current transition from pre-paradigmatic phase

towards a defined set of theories of innovation policy. It was observed that research from the

broad innovation policy perspective was limited, and more attention was needed for the

interaction of policy instruments with systemic conditions and institutional settings.5 Lastly

and most importantly, discussions of suitable methodologies were necessary to advance the

field and facilitate research that can close the gaps in the innovation policy literature

mentioned earlier. One of the propositions has been to understand the policy realm as having

two parallel spaces. The first space covers macro-level, systemic and institutional enablers

and determinants of innovation, such as governance, education, research and development

investment, business environment, fiscal policies, and infrastructure. The second space

encompasses the dynamics of the innovation process itself such as knowledge and skills

required, the creation of products and services, intellectual property protection, incentives for

innovation, production factors, value chains and feedback. The enablers and determinants in

3 The Gulf Cooperation Council (GCC) is the colloquial term used to refer to the Cooperation Council of the Arab States of the Gulf (GCC). We use the abbreviation GCC to refer to the member countries as of 2017 – Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates. These are synonymously referred to as the countries of the Arabian Gulf, countries of the Arabian Peninsula, countries of the Persian Gulf and Arab countries of the Gulf. Other countries on the Arabian/Persian Gulf such as Iran and Iraq, and countries in accession talks such as Yemen, Jordan and Morocco are not included. 4 For more information on the evolution of the innovation policy literature landscape refer to Radosevic (2012), Fagerberg (2016) and Borras and Edquist (2019). 5 According to Lundvall (2007) systems of innovation in a narrow sense “leave significant elements of innovation- based economic performance unexplained”. In the “broad” sense the core knowledge-producing and disseminating institutions (such as educational institutes and research units) are embedded in a wider socio-economic system and the relative success of innovation policies is a function of influences and linkages beyond these core institutions (Freeman, 2002).

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both these spaces form the focus of the innovation policy studies. Therefore, it is frequently

recommended to carry out more research that considers the collective effect of these

determinants of innovation (Freeman, 2002; Lundvall, 2007; Fagerberg, 2016).

The literature of systems of innovation from a growth theory perspective has been criticised

for having a narrow conceptual scope. 6 Additionally, the policy relevance of the results in this

line of research varies depending on the measures of growth and innovation used.7 The

research for innovation policy through the growth theory lens has been carried out using

various productivity measures, most prominently Multi-Factor Productivity (MFP).

However, its use is challenged because of the imperfect imputation for developing countries

and a lack of direct policy implications that can be derived from research using MFP. Other

measures also face challenges and their use is context and target-driven. Given this, the use

of labour productivity-based measures (such as labour productivity in the modern sector) 8

generally increases the policy relevance of the results and widens the geographical and

conceptual scope of the innovation policy studies. In addition to this, innovation studies have

also been criticized as being too centred on rich countries. This critique is made plain in the

question, “whether innovation systems and policies are only for the rich” (Perez, 2013, p. 90) 9.

The substantial focus of innovation studies on innovation in the developed or rich countries

has partially contributed to the lack of understanding about the determinants of innovation

in a broader country income level context.

6 For more details on the literature of systems of innovation from growth theory perspective see Fagerberg, et al. (2013) and (Soete, et al., 2010). 7 The relationship between productivity and innovation, and a detailed discussion on the pros and cons of the alternative measures of innovation are presented in Mohnen and Hall (2013). 8 In this dissertation the terms non-traditional sector and modern sector exclude the natural resource and agricultural sectors, unless otherwise mentioned. The sectors where the productive efficiency is a function of the knowledge and skills of the labour force is often called the productive sector or modern sector. In the empirical literature, the modern sector has varyingly been defined to exclude either the natural resource sector, or the agricultural sector, or both sectors. This usage is derived from the assumption that the natural resource and agricultural sectors are predominantly non-productive sectors. 9 The question is posed by the editors of “Innovation Studies: Evolution and Future Challenges” Jan Fagerberg, Ben R. Martin and Esben Sloth Andersen to Carlota Perez as a discussion point for her contribution in the book (Fagerberg, et al., 2013).

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One of the main limitations of the growth literature, in general, is to ignore the importance

of natural resources in the economy (Sachs & Warner, 1995; Auty, 2007). The same limitation

is also observed in the literature on innovation policy from the growth perspective.

Additionally, the innovation policy mix for countries that are close to the technological

frontier and for those that are far behind in the catching-up process is likely to be different

(Szirmai, et al., 2011; Aghion, et al., 2014). Countries with natural resources form a unique

subset of world economies. Among other reasons, the uniqueness originates in the use of

natural resource revenues as a facilitator of broader economic growth. Thus, investigations

that focus on the policy mix that has been used and can be used in these countries for catch-

up, diversification and stimulation of innovation are warranted. The natural resource

economics and policy literature for a long time has been focussed on the so-called natural

resource curse and the search for its determinants. However, some argue that the outcome of

the mismanagement of national revenues for a natural resource-driven economy does not differ

from the consequence of the mismanagement of revenues in countries that are not dependent

on natural resource revenues (Maloney, 2002). Even without the precise assignment of blame

for the economic woes of the countries rich in natural resources, the literature appears to lead

towards a probable solution. 10 The general inference is that the diversification of natural

resource-driven economies is key for ensuring their long-term economic development. This

concept is not dissimilar from the more generalised perspective that countries that provide

more diverse products and services are more likely to have higher output growth stability

(Krishnaa & Levchenko, 2013; Content & Frenken, 2016).

Given the reservations of the neo-classical literature in considering the role of natural

resources as a contributor to economic growth, the theoretical contributions in this area have

been limited. Also, the determinants of economic growth in developed countries have

frequently been used to try to explain the same in low income economies without

contextualising the research. Diversification policy has long been a part of the national

discourse of natural resource-driven economies. However, policy instruments in some countries

10 For more information on the natural resource economics literature and the natural resource curse debate see Badeeb, et al. (2017) and Papyrakis (2017).

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have been limited to monetary and fiscal policy instruments, and ineptly chosen targets for

economic policy programs make it hard to evaluate the attainment of a positive net stimulus

or the lack thereof (World Bank Institue, 2010). Such complications in policy design,

evaluation and implementation are symptomatic of the absence of research-based innovation

and diversification policymaking. There is a lack of comprehensive theoretical background

that adequately applies to a broad set of economies including natural resource-driven and

developing economies. This limitation indicates that the complacency of the academics and

economic policy consultants is as likely to be blamed as that of the national governments and

policymakers for the failure of many countries to have an effective innovation policy. Among

the natural resource-driven economies, the GCC countries have attracted the general curiosity

of economists. However, the scientific publications aimed at trying to understand the

economic structure, systems of innovation and the state of diversification in the GCC

countries have been limited. The most frequently given reason is the lack of data. In view of

the academic context described in the preceding paragraphs, we have an opportunity to look

for the key where it is dark 11.

This dissertation presents a conceptual framework that can be used to analyse the interplay

of the determinants of innovation and diversification. As a first step, this is used in an

empirical exercise to discover the effective relationship between selected determinants and

labour productivity growth in the modern sector. A discrepancy among the regions is observed

and explored further by mapping the enablers and inputs of innovation and diversification

for three GCC countries. The relationship of these determinants is discussed in light of the

innovation and labour productivity outputs. These undertakings support theorising in the

area of innovation policy studies and ensure that such theorising covers the economic reality

and systemic conditions of all countries regardless of their income levels.

11. The streetlight effect, or the drunkard's search principle, is a type of observational bias that occurs when people only search for something where it is easiest to look. A parable featuring the Seljuk Sufi mystic Nasrudin Hodja is considered as the earliest form of the story (Shah, 1964, p. 70). The parable relates him as looking for his key outside his house because there was more light outside, while he knew that the key was lost inside the house. It was popularised in social sciences by Abraham Kaplan in his book “The Conduct of Inquiry: Methodology for Behavioural Science” (Kaplan, 1964).

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The introduction of the natural resource sector in this dissertation as an important

contributor to economic growth as well as to the development of the modern sector follows

the same logic as mentioned above. The aim is to ensure that the research contribution has

broad academic and policy applicability in terms of economic structure and country income

classification. The research places a special emphasis on the GCC countries to illustrate the

thesis that important economic questions can be addressed even in a state of data scarcity.

Economists should never be wary of research on a seldom studied region. Rather, the opposite

should be the norm, and, purposefully and promisingly, it has often been so for the last ten

years. The frameworks, tools and models developed in this dissertation can guide policymakers

to not only fix realistic targets for economic inputs and outputs but also embed an ex ante

and ex post evaluation of the achievements into their programs. Accordingly, the use of an

empirical model is presented to highlight the importance of research-based policymaking.

The findings in the various chapters of this dissertation illustrate that all the determinants

of the innovation system need to be working well in order to stimulate innovation and

productivity growth in the modern sector. The highlights, along with the structure of the

dissertation, are summarised in the following.

Chapter 2, titled “Productivity and Innovation Policy” presents a conceptual framework of

innovation policy and its empirical application in developed and developing countries. The

condition of the GCC region in terms of labour productivity growth in the modern sector is

explored within the context of this model. The results of Chapter 2 underscore the importance

of investment into enablers of innovation such as tertiary education, and research and

development expenditures. It is observed that not only the level of investment matters but

also the effectiveness of the system in which the policy is executed. This observation highlights

the importance of improving governance and investing in the development of institutions.

Chapter 2 also reveals that the modern sector in the GCC region is performing relatively

poorly compared to other regions in terms of labour productivity growth in the modern sector.

This is followed by a comprehensive review and comparative analysis of the broad innovation

system in three of the six GCC countries in Chapter 3, titled “Policy and Economy in the

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GCC” in the form of an eclectic comparative case-study. We present a snapshot of the

development of enablers and policies for diversification and innovation in Oman, Saudi Arabia

and the United Arab Emirates and highlight the limitations of their systems. The low

innovation and diversification output in these countries is a consequence of the observed

limitations. This observation leads to the notion that the lowest-performing policy area limits

the system performance and that it is essential to ensure the robust performance of all the

determinants of the system.

Chapter 4 of the dissertation, “Natural Resource Abundance: No Evidence of an Oil Curse”,

outlines a theoretical model in order to examine the possibility of using natural resource

revenues to fund fixed capital investments and develop the modern sector. It also examines

empirically, to what extent oil wealth has been used for diversification by the six GCC

countries. Chapter 4 shows that the lower performance in the GCC region in terms of labour

productivity growth in the modern sector is not due to natural resource rents. The GCC

countries have been rather successful in investing their natural resource revenues into fixed

capital. The chapter highlights that natural resource rents can be used for the development

of the modern sector.

This is followed by an analysis of the stated economic diversification policies of Oman and

Saudi Arabia contrasted against the predicted outcomes in Chapter 5, titled “Stars in their

Eyes?”. It is an ex ante evaluation of national policy programmes based on the empirical

model developed in Chapter 2. The challenges and prospects for meeting the desired and

declared diversification targets are also discussed. The results of Chapter 5 project that Oman

and Saudi Arabia are not likely to meet their 2030 targets for diversification. A research-

backed discussion of the policy limitations and possible pathways to meet future targets is

thus presented. It is observed that the several enablers that may be improved through

investments must all be understood in the national and regional context in order to achieve

successful diversification and improvements in the innovation system of the country. In the

final Chapter 6, a short review of the background and results of the dissertation are presented.

It summarises the chapters of the dissertation, formulates academic research

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recommendations, acknowledges some of the limitations of this dissertation, proposes an

integrated view of the dissertation and outlines the policy implications of the research carried

out. The synopsis of this dissertation is that there is no natural resource curse and that there

is no one policy or area of investment that drives growth and productivity in the modern

sector. A broad and holistic approach to academic enquiry in innovation policy and

productivity growth in the modern sector is justified and recommended. The policy relevance

of this dissertation, already discussed in the subsection “Integrated insights from the

dissertation and policy implications,” is exposed a second time in the “Valorisation

Addendum”.

The successes and limitations in the policy actions of the GCC countries brought to light in

this dissertation support a broad approach to policymaking for diversification. The GCC

countries started using their oil revenues for economic and social development while in a

position of relative poverty in comparison to the rest of the world (Khalaf & Hammoud, 1987;

Pamuk, 2006). 12 They invested in human capital, fixed capital and the improvement of the

standards of living of their population. As a result, the GCC countries successfully eradicated

extreme poverty in their countries, and by 2017 all the six GCC countries were included in

the list of “very high human development countries” based on their Human Development

Index (HDI) (UNDP, 2018; GCC-STAT, 2019). Along with using their natural resources for

human development, the GCC countries have attempted to stimulate diversification of their

economies and ensure sustained economic development. They have been successful to varying

degrees and are undertaking policy actions to deepen diversification aimed at securing and

increasing the prosperity gains of the last fifty years. The policy lessons from the GCC

countries are critical for other natural resource-driven economies. The empirical evidence from

this dissertation, on innovation policy, diversification and natural resource-based

development, helps illustrate the importance of …

Innovation and Diversification Policies

for Natural Resource Rich Countries

Mueid Al Raee

UNU MERIT, UM MGSoG

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