The United Arab Emirates has done the unthinkable among many rentier economies by reducing petrol subsidies and tying the price of fuel to international markets.

Market Watch Blog AGSIW | Karen E. Young | Jul 23, 2015

The United Arab Emirates has done the unthinkable among many rentier economies by reducing petrol subsidies and tying the price of fuel to international markets. The exact mechanism for pricing, still to be controlled by the state, is not entirely clear. A new government committee has formed, the Gasoline and Diesel Prices Committee, to meet monthly to set prices. The UAE is bridging state planning with growing fiscal pressures and long standing advice from the International Monetary Fund (IMF) and regional economists that fuel subsidies are limiting economic diversification. In choosing to reduce the subsidy now, when oil markets are in a year of decline, the UAE is seizing a political moment when the public accepts that fiscal budgets are tighter and some changes are necessary. Interestingly, the government has couched its reform decision in the rhetoric of environmental conservation, rather than fiscal prudence.

Currently, a gallon of gasoline costs about $1.78 in the UAE. A reduction of the subsidy will affect the entire population, of which nationals are a small minority, roughly 10 percent. The policy shift represents a smart way to pass a budget reduction on to non-nationals, as they will be the largest group affected by the increase in gasoline prices. The government’s estimate of the cost of gasoline represents between 3 and 4 percent of average income in the UAE, causing little impact to most family budgets. Likewise, the continuation of the subsidy would help few poor families and disproportionately advantage the wealthy.

The subsidy reduction also seizes a moment when global fuel prices are low, lessening the impact on core sectors of the UAE economy – transport and logistics. Lower oil prices present a challenge, especially to the Abu Dhabi budget of which more than 90 percent of income is based on oil exports, other parts of the UAE economy continue to grow and even benefit. Standard Chartered has recently further lowered its average Brent forecast for 2015 and 2016 to $64 per barrel and $83 per barrel, respectively. While overall growth forecasts for the UAE remain relatively strong, projected at 3.8 percent for 2015, the decline in oil has already downgraded any budget surplus projected for 2016 by nearly half.

A recent IMF report estimated that the Gulf Cooperation Council states spend more than 3 percent of gross domestic product (GDP) on fuel subsidies, while advanced economies, as categorized by the IMF, spend less than 0.1 percent. In the UAE, fuel subsidies comprised more than 10 percent of the total federal budget, according to IMF estimates. While it is difficult to gage public opinion among nationals for the subsidy reduction, there is evidence from public sector and state-related entity leaders that fiscal responsibility is a concern, but perhaps even more important is transparency in budget deliberations. Creating a monthly cycle of price volatility could complicate the ability of private sector and state-related entity firms to forecast their own budget needs.

Across the GCC states, fiscal restraint is becoming the new normal. Kuwait cut diesel subsidies in 2014, creating a potential savings of 0.5 percent of GDP that year. The Ministry of Finance in Oman reported a 47.9 percent reduction in subsidies on rice, flour, sugar, and some fuel in the first three months of 2015, compared with the same quarter in 2014. Bahrain has pledged and initiated reforms, and perhaps needs them most, as roughly 50 percent of government spending in 2013 went toward subsidies and welfare. Bahrain announced an 11 percent increase in natural gas products for industrial users, and a system to pass medical insurance costs to employers in early 2015. Abu Dhabi, as a sub-federal unit, increased electricity and water tariffs in January.

Reforming a culture of subsidies will not be easy, but the extended period of oil price decline creates a reality check for Gulf governments and among Gulf nationals. The governments have more leverage and justification for reform, and citizens have a common issue to attempt to engage decision-making on budget outlays.

This article was originally published by the Arab Gulf States Institute in Washington (AGSIW)

Dr Karen E Young is a former senior resident scholar at the AGSIW. She is a resident scholar at the American Enterprise Institute in Washington and a senior advisor at Castlereagh Associates.