Mission Concluding Statement 

Oman-2011 Article IV Consultation Concluding Statement of the IMF Mission

December 19, 2011

I. Introduction

This statement contains the preliminary assessment of the 2011 Article IV mission to Oman. The mission met with H.E. Darwish Ismail Ali Al-Balushi, Minister Responsible for Financial Affairs, H.E. Dr. Ali Mohammed Moosa, Deputy Chairman of the Central Bank of Oman (CBO), H.E. Hamood Sangour Al-Zadjali, Executive President of the CBO, and other representatives from the public and private sectors. The mission thanks the Omani authorities for the excellent collaboration, productive discussions, and generous hospitality.

II. Current Economic Developments

1. Economic activity is accelerating. Driven by new oil extraction technologies and increasing government spending, overall real GDP growth is projected to reach 5.5 percent in 2011 with 6.4 percent growth in the non-hydrocarbon sector. Price pressures have remained contained and average annual CPI inflation is projected at 4.1 percent in 2011.

2. Despite strong economic growth, unemployment among nationals is high and a major social concern. In response, the government has raised the minimum wage for Omani workers in the private sector, established an unemployment benefit, increased the number of government jobs, and raised enrollment in higher education.

3. Fiscal and external balances have strengthened along with higher oil prices. Due to rapid growth in oil revenue and despite an expected 17 percent increase in government expenditure, the overall fiscal and external surpluses are projected to reach 8.2 and 12.7 percent of GDP in 2011, respectively. The rise in expenditure has mainly been driven by increased hiring in response to high unemployment.

4. The economy has been largely unaffected by recent turmoil in international financial markets. While regional unrest has created additional uncertainty, Omani banks have little exposure to the Eurozone. Credit to the private sector has continued to pick up and is projected to grow by over 11 percent in 2011. With about 80 percent of Oman’s oil-dominated exports going to Asia, the impact of the European crisis will be limited as long as it does not translate into significantly lower oil prices.

5. The domestic banking system appears sound. The system is well capitalized, with a capital adequacy ratio of 14.3 percent as of end of September 2011 (against the regulatory limit of 12 percent), and the NPL ratio of 2.6 percent is below the GCC average. Stress testing conducted by the CBO indicates that most banks are in a position to cope with significant macroeconomic shocks.

III. Outlook and Risks

6. The economy is set for continued expansion in 2012. Given a projected 10 percent increase in government expenditure and with some slowdown in hydrocarbon output, overall real GDP growth is projected to edge down to 5 percent in 2012. Inflation is expected to remain moderate at an annual rate of about 3½ percent, and the fiscal and external surpluses are projected to stay high at about 8 percent and 10 percent of GDP, respectively.

7. A large public investment program is underway and will help sustain growth over the medium term. Major projects in progress include a rail network and new air and sea ports. Government plans also reflect a strong emphasis on education and social infrastructure. With civil investment by the central government projected to average about 16 percent of non-hydrocarbon GDP over 2012–16, annual non-hydrocarbon GDP growth is expected to stay at about 5½ percent over the medium term. Oil production is expected to plateau and then slightly decline, leading to small contraction in real hydrocarbon GDP.

8. The main risk to the medium term outlook is a prolonged drop in oil prices. Higher government spending is raising the oil price that would be needed to balance the budget. The mission projects a breakeven price of $81 per barrel in 2012, rising to $105 by 2016. A drop in oil prices from the prevailing historically high levels could quickly lead to large fiscal deficits. If sustained, lower oil prices could force a pull back in spending and lead to sharply reduced growth in the non-oil economy.

9. The longer-term outlook hinges on economic diversification. Oman’s hydrocarbon reserves are relatively modest and cannot continue to support economic growth in the long-run. There has been progress towards diversification, with non-hydrocarbon exports—mainly petrochemicals, fertilizers, and metals—now accounting for over 20 percent of total exports. The non-hydrocarbon export industries, however, are highly energy intensive, have not generated many jobs, nor contributed much to government revenue.

10. The overarching policy challenge is to ensure strong and sustainable growth over the long run while addressing the urgent need for jobs. Achieving this calls for (i) strengthening public finances (ii) addressing the causes of high unemployment; and (iii) maintaining macroeconomic stability and supporting financial sector development.

IV. Strengthening Public Finances

11. Fiscal sustainability is a key challenge. Increased public sector hiring has for now helped address pressures stemming from high unemployment. But the step-up in spending since the original budget for 2011 has long-term implications and affordability is limited. To avoid a more severe adjustment later, there is an urgent need to start taking preventive measures.

12. Committing to a gradual improvement of the non-oil fiscal balance would help ensure fiscal sustainability. Implementing a fiscal rule targeting long-term fiscal sustainability would help anchor fiscal policy. Based on a standard model of intergenerational equity, and assuming that new discoveries will be able to provide 60 years of the current level of oil production, the projected non-oil fiscal deficit for 2011 is about 9 percent of GDP above the level consistent with constant real per capita consumption out of the country’s petroleum wealth. To eliminate the gap, the mission recommends a fiscal adjustment of at least 1 percent of GDP a year over the medium term.

13. Curtailing growth in the wage bill will be critical. In order to allow for investments in infrastructure and human capital it is essential to contain wage expenditures. More generally, there is scope to achieve greater value for money, including by improving processes for ex ante project evaluation and instituting regular reviews of past spending. In addition, establishing a macro-fiscal unit, casting spending in a multiyear framework, and limiting the number of in-year revisions to the budget would provide greater stability.

14. There is also substantial scope to enhance revenues. Non-hydrocarbon revenue has been declining and currently amounts less than 11 percent of total revenue and only about 5 percent of GDP. A VAT and other steps to widen the tax base would help raise revenue as well as enhance the efficiency of the tax system. Implicit fuel subsidies could also be reduced. These subsidies, estimated at about 12 percent of GDP in 2011, have been increasing along with rapidly growing domestic consumption and higher opportunity costs. Steps to align domestic prices with those in international markets would provide for a more efficient allocation of resources and encourage the development of a less energy dependent production structure. While the bulk of fuel subsidies typically go to the better off, accompanying price increases with more targeted and cash-based forms of social protection would help offset the social impact.

V. Addressing the Causes of High Unemployment

15. Creating employment for the growing population is a pressing challenge. While overall job growth has been strong, most new jobs have gone to foreign workers. Strikingly, the recent census indicates that the unemployment rate among nationals reached 24.4 percent in 2010, although the high number may include many that are not truly looking for work. To absorb new labor force entrants and significantly reduce unemployment, some 45,000 new positions for Omanis each year will be needed, twice the number achieved in the five years to 2010. To be sustainable, these new jobs will have to be in the private sector.

16. Recent policy actions have led to large increase in public sector employment. From a base of 164,000 public sector jobs in 2010 (excluding security and defense personnel), 44,000 new government positions were created in 2011 and the draft budget for 2012 includes another 36,000. These measures have alleviated short term pressures stemming from high unemployment but do not address the underlying problems.

17. Addressing the root causes of joblessness calls for a multipronged approach. Removing labor market distortions underpinning high unemployment will require resolving the wage and benefits differentials between the public and private sectors and between Omanis and expatriates. Large-scale job creation will also require strong economic growth as well as transitioning from energy-related industries into areas with greater employment potential. Simultaneously, there is a need to enhance education and training to ensure that new graduates and job seekers have the needed skills. Raising fees for work visas or instituting temporary subsidies for hiring and training should be considered as ways of making employment of nationals more attractive.

VI. Maintaining Macroeconomic Stability

18. Maintaining macroeconomic stability is a prerequisite for sustained economic growth. Given the peg to the U.S. dollar, ensuring macroeconomic stability rests primarily on fiscal policy, but reducing excess liquidity in the banking system will also be important. The mission encourages the CBO to continue to proactively mop up excess liquidity and be ready to apply macroprudential measures if credit growth starts to feed into higher inflation. Direct attempts at controlling market prices should be avoided.

19. The peg to the U.S. dollar has served Oman well by providing a strong and credible monetary anchor. The mission finds that the exchange rate is broadly aligned with fundamentals and that the policy of pegging to the U.S. dollar remains appropriate. Nevertheless, in light of ongoing economic diversification and deepening trade ties with Asia, preparing for a more flexible regime in the long run would be prudent. Of particular importance will be to develop hedging instruments to enable the private sector to better manage exchange rate risk.

20. The financial system is relatively shallow and could play a larger and more dynamic role in supporting economic growth. Regular issuance of government debt in a range of maturities would be important to establish a yield curve and help spur market development. The CBO could also consider expanding the range of maturities for CDs. Finally, at only about 2 percent, the share of bank lending to SMEs is well below that in most other countries and new initiatives to encourage bank lending in this area can potentially play a positive role.

VII. Data and Statistics

21. The coverage and quality of Oman’s statistics compare favorably with other countries in the region, but there is scope for improvement. Priority areas include improving the general timeliness and dissemination of statistics, as well as compilation of International Investment Position, application of a budget classification consistent with GFSM2001, and enhancing labor market statistics