Professional Documents
Culture Documents
COUNTERINTUITION
Dubai
June 2009
Tuesday, August 04, 2009 DRAFT 09
To my mother
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Acknowledgments
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Preface
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Table of Contents
Acknowledgments...................................................................................3
Preface.....................................................................................................4
Introduction.............................................................................................6
Counterintuition and Super-Competitiveness.......................................16
Dutch Disease...................................................................................16
Super-Competitiveness and Productivity..........................................21
Capital Inflows and Investment............................................................33
Real Estate.........................................................................................33
Tourism.............................................................................................43
Finance..............................................................................................53
Economic Policy vs. Commercial Policy .............................................58
Economic Policy Effectiveness.........................................................58
Commercial Policy and Market Structure.........................................66
Governance and First-Best Solutions....................................................72
Governance Indicators......................................................................72
The ‘Luxury’ of Choosing First-Best Solutions................................79
Dubai Strategic Plan (2015) and Sustainability....................................83
Building-Blocks of DSP (2015) .......................................................83
The Rising Cost-of-Living................................................................89
Some Labor Issues ...........................................................................94
Bibliography..........................................................................................98
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Introduction
A ski resort in the desert, a ‘palm tree’ on the sea, a hotel under
the sea, the tallest building in the world, and the list goes on and on, all
examples of counterintuition defined as intuition that is counter to
common expectations. When Stephen Hawking, a world renowned
physicist disabled by a crippling disease was asked why he was so fam-
ous even in the eyes of the general public, he replied: “People simply
did not expect to see me on a wheelchair”. But to achieve these coun-
terintuitive outcomes, one has to be super-competitive because these
achievements must be beyond expectations.
This book reveals the secret of Dubai’s remarkable economic
success by showing that its governance structure, institutional setting,
market structure, and economic policies have all been highly supportive
of powerful market forces, beyond the control of any government,
which have channeled investments into the most profitable sectors. Al-
though the emirate of Dubai, one of the seven emirates of the United
Arab Emirates (UAE), does not contain much oil, it has experienced
large inflows of capital. The book is written in simple non-technical
language and is not an exposition of the latest theories and practices in
public policy making. It also does not contain extensive descriptive
data on the performance of the Dubai economy which can be easily
found in hundreds of newspaper articles and from the recently launched
portal of the Dubai Statistics Center (www.dsc.gov.ae). The book
simply places what Dubai has achieved so far in the ‘right’ perspective
in the sense that all of its actions and policies are based on fundamental
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tradable service sector were greater than profits in the tradable manu-
facturing sector, resources (both labor and capital) began moving from
the tradable manufacturing sector to the non-tradable service sector.
This process of Dutch Disease, also known as de-industrialization,
caused unemployment - because labor was moving out of the manufac-
turing sector and it takes time to train these workers to work in the non-
tradable service sector - and inflation - because the prices of non-trad-
able services increased.
A similar process has been happening in Dubai with one major
difference – no unemployment. As capital inflows in Dubai have in-
creased, the returns on resources (labor and capital) have increased in
the non-tradable service sector which is evidenced by the booming real
estate and tourism sectors. There has been no surge in unemployment
because Dubai has started from a relatively low manufacturing base
and all the labor and capital that has moved into the non-tradable ser-
vice sector is new and did not come from the tradable manufacturing
sector. This phenomenon is reflected in higher prices in the real estate
sector, and many other non-tradable services, as evidenced by the rising
cost-of-living in Dubai. The secret of Dubai’s economic success is its
ability to reinforce the flow of resources into the non-tradable service
sector such as real estate, tourism, and financial services. Most Dubai
government policies, initiatives, and investments can be traced to the
higher returns in these non-tradable service sectors, the biggest sector
being the real estate sector.
But just as capital inflows have increased the profitability of
non-tradable sectors such as real estate and banking, the current global
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non-tradable services as the demand for such services has increased due
to Dutch Disease effects noted earlier. The rising cost-of-living is also
due to the fixed-exchange rate regime with the US currency which has
fallen considerably in recent years causing an increase in the relative
price of Dubai imports, especially imports from euro zone countries.
This has been reflected in the high price of intermediate inputs such as
cement and steel which are heavily used in the real estate sector. But
the recent increase in the value of the US dollar has somewhat reduced
inflationary pressures, and the slowdown in capital inflows caused by
the global financial crisis has also lowered prices of non-tradables as
evidenced by the decline in property and stock prices. However, regard-
less of the underlying causes of inflation in Dubai, the government has
not been able to adopt ‘standard’ economic policy tools, such as in-
creasing the rate of interest or decreasing the money supply, because its
fixed exchange rate regime with the US dollar has tied the movement
of its domestic interest rate with movements in the US rate. Moreover,
even if Dubai desires to control its rate of inflation through contraction-
ary monetary policies, it has few degrees of freedom because the
money supply is controlled by the UAE Central Bank at the federal
level. Alternatively, the Dubai government has adopted counterintuitive
policies in controlling inflation using various price and rent controls.
The rising cost-of-living has also eroded the purchasing power
of unskilled workers. Although it is becoming increasingly more diffi-
cult to retain skilled workers due to the rising cost-of-living in Dubai,
nominal wages of skilled workers have actually increased due to Dutch
Disease effects. There is no doubt that wages of unskilled workers have
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eroded in recent years but that is primarily due to the fall in the US dol-
lar. This erosion of purchasing power has been somewhat rectified due
to the recent appreciation of the US dollar. Moreover, both the Dubai
local government and the UAE federal government have achieved con-
siderable progress in improving labor conditions of unskilled workers,
much more than the improvements achieved by the governments of
their home countries. This book illustrates the many examples in which
Dubai has adopted counterintuitive policies to generate rapid rates of
growth. But the adoption of counterintuitive policies requires super-
competitiveness to identify and measure the ‘other’ factors that affect
overall productivity such as leadership, innovation, technological
change, and institutional performance. The secret of Dubai’s economic
success has been its ability to identify, in Einstein’s words, ‘what
counts’, and formulate appropriate policies, very often counterintuitive,
to achieve first-best optimum outcomes.
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4
Appreciation of the real exchange rate will occur regardless of whether the nominal
exchange rate is fixed or flexible. Under a fixed nominal exchange rate, such as in the
UAE and in all the GCC countries except in Kuwait, the conversion of the foreign
currency into local currency would increase the country’s money supply, and pressure
from domestic demand would push up domestic prices. This is why under a fixed ex-
change rate system this real appreciation will lead to higher inflation, the case in most
GCC countries. This would amount to an appreciation of the real exchange rate be-
cause a unit of a foreign currency now buys fewer ‘real’ goods and services in the do-
mestic economy than it did before. If the exchange rate is flexible, the increased sup-
ply of foreign currency would drive up the value of the domestic currency which also
implies an appreciation of the real exchange rate, in this case through a rise in the
nominal exchange rate rather in domestic prices. In both cases, real exchange rate ap-
preciation weakens the competitiveness of the country’s manufactured exports and
causes deindustrialization.
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labor is mobile, then the overall economy-wide wage level will in-
crease.5
The above analysis is more relevant for resource rich countries
with an abundance of oil or other natural resources. For an emirate such
as Dubai with scarce endowments of natural resources and a small nat-
ive population, the source of Dutch Disease has been the large inflow
of Foreign Direct Investment (FDI)6 caused by the creation of a busi-
ness friendly environment, especially after 2001. We thus look at FDI,
as opposed to oil revenues, as the major source of capital inflows
which, again, is not related to the internal productive capacity of the
Dubai economy. This approach leaves us with two sectors: a tradable
manufacturing sector and a non-tradable service sector. The increase in
FDI causes similarly an appreciation of the real exchange rate which re-
duces the competitiveness of the tradable manufacturing sector and
leads to deindustrialization7. As the return on capital and wages begin
to increase because of the spending effect, resources begin to move
from the tradable manufacturing sector into the non-tradable service
sector since producers in the tradable sector cannot increase their prices
because prices of manufactured goods are set internationally especially
in a small open economy such as Dubai which is a price taker and can-
not influence world prices. This resource movement effect in Dubai has
5
For an excellent discussion of Dutch Disease and its practical applications to the real
world, see Migara, K. and O. De Silva (1994).
6
A survey conducted by the Dubai Statistics Center in 2007 showed that FDI was
$11.6 billion in 2006, or an increase of 13.4% compared to 2005.
7
One explanation for why deindustrialization is perceived to be ‘bad’ is because there
is more scope for technological progress in manufacturing than in services except in
information technology and financial services, areas in which Dubai has achieved
substantial progress.
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been evidenced by the dramatic growth of the real estate, tourism, and
financial sectors. Moreover, since Dubai has started from a low indus-
trial manufacturing base, most of the labor and capital in the non-trad-
able service sector is coming from abroad as evidenced by the increase
in the expatriate population. The Dubai government, recognizing this
phenomenon, has formulated appropriate policies to reinforce these re-
source movement effects into the highly profitable service sectors such
as tourism, finance, and real estate.
The recent global financial crisis has considerably reduced cap-
ital inflows into Dubai with ‘reverse’ Dutch Disease effects. In other
words, as the inflow of capital has slowed down, the upward pressure
on wages has somewhat subsided. This slower rate of growth of the
wage rate has caused a reversal of resource movements out of the non-
tradable service sector as evidenced by layoffs in the real estate and fin-
ancial sectors in recent months. Profitability, especially in the real es-
tate sector, has also been reduced to ‘normal’ levels with lower expecta-
tions. This is a good sign since property prices were getting out of con-
trol and it was becoming increasingly difficult to attract and retain
skilled workers. The slowdown in the rate of growth of wages has also
been helpful in controlling inflation caused by the increase in aggregate
demand through the spending effect. As capital inflows have decreased
due to the global financial crisis, these reverse Dutch Disease effects
have been very helpful to slow the rate of growth of the economy, espe-
cially in non-tradable service sectors. This lower spending by con-
sumers has been to some extent offset by increased government spend-
ing as Dubai builds its modern infrastructure.
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10
Porter’s (1990) work on competitiveness has influenced WCI and his diamond
model is highly visible in CCI. GCI is influenced by Barro (1991) and subsequent
works.
11
The indices have several shortcomings, the most serious critique relating to the Ex-
ecutive Opinion Surveys, namely, that opinions of fewer than 20 business managers
do not provide solid foundations for economic analysis.
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simply because its vast oil deposits are very cost effective to extract.
Economic competitiveness at the macro level has to do with the eco-
nomy-wide production function which is a technical relationship
between output (GDP) and the various inputs that go into the produc-
tion of that output. The functional relationship between total output and
the various inputs is always positive but the degree of the effect on out-
put depends on factor intensities and on the ‘mix’ of the different in-
puts. At the micro level, economic competitiveness has to do with mar-
ket structures at the industry level such as perfect competition, mono-
poly, duopoly, or monopolistic competition. Countries usually have
little control over economy-wide competitiveness in the short-run, but
can affect market structures through various competition rules and reg-
ulations.
Nonetheless, competitiveness, whether ‘business’ or
‘economic’, is important because it lowers costs and forces the factors
of production to be more productive – that is, the same unit of input
produces more output than before. But when economic commentators
talk about productivity, they normally do not specify the productivity of
which input. The common measure of productivity, at least in the US, is
labor productivity – output per man-hour. But the productivity of an
economy depends on much more than the productivity of its labor 12. It
also depends on the ‘mix’ or efficiency with which the ‘other’ inputs in
the production process are combined with labor – what is known as
Total Factor Productivity (TFP)13. In other words, the amount of output
12
Productivity is important because it affects per capita GDP which in turn determines
the rate of growth of the economy.
13
Also known as Multi Factor Productivity (MFP).
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that a unit of labor can produce depends on the amount of capital that
the worker has, on his level of education, on his health, on his training,
on institutions, on governance, and so on – what Robert Solow called a
measure of our ignorance14. In effect, we are saying that an increase in
TFP means that more output is obtained without increasing the quantity
of inputs. This distinction between labor productivity and TFP is im-
portant because labor productivity might be increasing not because
workers are working harder, but simply because they have more capital
to work with. Since this capital is costly, it will ultimately reduce over-
all economic productivity. The same argument can also be made for all
the ‘other’ inputs that affect overall economic productivity such as hu-
man capital, technology transfer, institutions, and so on. The important
point for policy purposes is that overall economic productivity will be
overstated if the measure is labor productivity because we are not tak-
ing into account the costs of capital, education, healthcare, technology,
institutions, and so on15. TFP takes into account these costs and will
therefore exhibit lower rates of overall productivity growth.
Intuition tells us that interest rates will be low during periods of
economic slowdown as governments push down rates to generate eco-
nomic growth. The interest rate can be looked upon as the cost of capit-
al since investors need to borrow to make investments. But given that
the economy is in a ‘liquidity trap’, banks are not willing to lend at low
levels of interest and will only be willing to do so at higher rates, thus
14
This does not imply that we do not know what these ‘other’ inputs are. It simply
means that they are difficult to measure.
15
For this reason, the Organization for Economic Cooperation and Development
(OECD) looks at Total Factor Productivity especially for cross-country comparisons
of productivity growth. See OECD (2001).
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pushing up the cost of capital. In other words, although market rates are
very low, actual rates - rates at which banks would be willing to lend -
are much higher. This higher cost of capital will be reflected in lower
productivity growth which will eventually lead to slower economic
growth. The current economic reality in Dubai is very similar to this
situation which is evidenced by the fact that if one goes to the bank to
borrow money, banks are only willing to lend at about 7-8%, even to
their high net-worth customers. Again, a highly counterintuitive out-
come in the sense that higher investment will lead to lower productivity
growth, in turn, leading to lower economic growth.
These ‘other’ inputs that affect productivity growth can be
grouped under three main headings: knowledge; factor supplies; and in-
stitutions16. By knowledge we mean the creation, transmission, and ab-
sorption of knowledge. Since knowledge cannot be directly measured,
it is often proxied by R&D and by the number of patents. There is very
strong evidence to suggest that increases in knowledge positively affect
productivity growth, and increases in the stock of knowledge are
caused by investments in education and R&D. Knowledge can also be
imported in the form of FDI (where technologically advanced foreign
firms invest in the domestic economy) and/or in the form of technically
advanced imported products (such as computers, advanced machinery,
high-tech equipment, etc). Generally, more open economies tend to be
better positioned to import knowledge from abroad although the effect-
iveness of this advanced knowledge may be limited by the absorptive
capacity of the economy. For example, an educated and healthy popula-
16
For a comprehensive literature survey of these ‘other’ inputs, their determinants,
and effects, see Isaksson (2007).
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17
It is implicitly assumed that capital (machinery, plant and equipment) can be meas-
ured and is always used by labor. For this reason, it is not usually included in the ‘oth-
er’ factors which influence productivity growth.
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18
Innovations cannot be totally left to markets because the market outcome might be
sub-optimal.
19
See Acemoglu, D. (2003).
20
Are citizens really well informed? Do they have access to accurate sources of in-
formation? These are highly restrictive assumptions, and once dropped, the whole
concept of ‘the market’ as an efficient allocator of resources becomes ambiguous.
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21
This may be one explanation for the relatively low levels of productivity figures in
Dubai because these ‘other’ factors which affect total productivity are costly and re-
duce overall economic efficiency in the short-run.
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Dubai Academic City (DAC) is the world’s only free zone ded-
icated to higher education. A regional base for premier international
higher educational institutions, DAC is the world’s first dedicated ter-
tiary cluster development. Spread across an area of 25 million square
feet, the DAC campus provides an intellectually inspiring environment
for students and faculty. Benefits for DAC partners include 100% for-
eign ownership, 100% tax free, and 100% repatriation of profits. There
are currently 32 international universities of higher learning from di-
verse regions including USA, Australia, India, Pakistan, Iran, Russia,
Belgium, UK, and France, operating out of DAC and catering to the
needs of over 12,000 students. These include Michigan State Uni-
versity, The University of Wollongong in Dubai, Middlesex University
Dubai, and S.P Jain Centre of Management Dubai, among many others.
These institutions offer programs that range in duration from one year
to four years. Major academic programs on offer include engineering,
computer science, media studies, environmental studies, child develop-
ment, quality management, and business management programs.
Dubai Internet City (DIC) provides a strategic and cost effective
platform for ICT companies targeting emerging markets in a vast re-
gion extending from the Middle East to the Indian subcontinent, and
from Africa to Central Asia. Launched in the year 2000, DIC now fea-
tures a dynamic international community of ICT companies including
global giants like Microsoft, Cisco Systems, IBM, HP, Dell, Siemens,
Sun Microsystems, Computer Associates, PeopleSoft and Sony Eric-
sson. Many small and medium businesses and promising entrepreneuri-
al ventures are also part of the community. The cluster comprises com-
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from the Dubai Metro to the construction of new roads and bridges will
ultimately lead to reductions in transaction costs and increase total
factor productivity. Dubai has also established a modern financial cen-
ter such as the Dubai International Financial Center (DIFC), encour-
aged Islamic finance, and developed various financial markets which
will ultimately maximize the returns on capital. But perhaps the biggest
advantage that Dubai has over other emerging economies is its focus on
institutional performance23 by honoring property rights and a zero toler-
ance against corruption, especially in the booming real estate sector. In
the political dimension, Dubai’s governance is very close to the ‘ideal’,
as envisaged by Rodrik (1992) – “a system where the state is effective
in what it does while being insulated from what it does not want to do”
- a highly counterintuitive approach compared to most governance
structures in emerging economies.
Bureau.
23
Institutional performance is discussed in detail in the section on Governance Indic-
ators.
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24
This list is by no means exhaustive. Many projects and developments are in the
pipeline which will be completed during the 2008-2015 period, and beyond.
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a chain of events which quickly began changing the face of the real es-
tate sector. The 2002 announcement coincided with another decree al-
lowing foreigners to purchase and own freehold property in selected
areas of the city known as ‘New Dubai’. It then took until March 2006
for the publication of the new law legalizing foreign ownership of prop-
erties in designated areas. As a further move to boost investor confid-
ence in the real estate market, the Real Estate Regulatory Authority
(RERA) was established in July 2007. The main responsibility of
RERA is to formulate, regulate, and manage various real estate activit-
ies in Dubai. In 2009, RERA was affiliated with six global real estate
associations and organizations to improve property laws and protect the
rights of both developers and consumers according to global best prac-
tices.
The second major cause of the growth in the real estate sector is
the movement of resources into this sector because of its higher profit-
ability compared to the profitability in other sectors. As capital inflows
into Dubai have increased, especially after 2001, the economy-wide
wage rate has also increased25. Producers, to make-up for the loss in
their profits, have been forced to increase their prices. They were able
to increase their prices in the non-tradable service sectors (the most
prominent being real estate) but they were not able to do so in the trad-
able manufacturing sector because prices of manufactured goods are
determined in world markets. This difference between the higher profit-
ability in the real estate sector and the lower profitability in the manu-
facturing sector has attracted developers into the real estate sector as
25
Wages have increased because of greater spending caused by the increase in the
money supply as a result of large capital inflows.
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35
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29
Except Canada which also simultaneously controlled wages and incomes.
30
This is the reason for the transformation of the South Bronx area in New York City
into a slum in the early 1970s as landlords began to cut down on maintenance, land-
scaping, and other expenses.
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31
Producers in the manufacturing sector cannot increase their prices because prices of
manufactured goods are set in international markets. This is why they are also known
as ‘tradables’ – i.e. manufactured goods can be exported and imported.
32
‘Sunk-costs’ are investments that cannot be easily relocated elsewhere because of
the physical nature of the investments. In other words, once a building is built, the
capital (cement, steel, etc) used-up in the process cannot be ‘taken-out’.
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the price paid for a house should reflect the present value of future
rents that the buyer expects to receive. The buyer must ask how much
the house could currently be rented for on an annual basis, and then di-
vide the seller’s asking price by this rental number. That’s the price-
rent ratio. If a $200,000 house generates $10,000 rent annually, then the
price-rent ratio is 20. A high price-rent ratio can be justified if the
house is in an area that can be expected to experience high growth rates
and thus rapid appreciation in rents, just like a technology stock can
have a higher price-rent ratio than a car manufacturer. But one is com-
pletely mistaken if he or she thinks that there can be a long-run discon-
nect between a house price and its potential rental stream. If such a dis-
connect exists, then there is definitely bubble trouble.
Going back to the analogy with the price of a stock, when a cor-
poration experiences a rise in earnings, stockholders may bid up the
price of the stock by a percentage that is higher than the increase in
earnings, and thus increase the price-earning ratio. This new higher
price-earning ratio could be based on the idea that these higher earn-
ings are a permanent event. Similarly, if people think that there is a
‘momentum’ in rents with high appreciation supporting further in-
creases in rents caused by expectations of population growth, increased
tourism, and ‘shortages’, then the price-rent ratio of housing might also
be set at a higher level. In other words, this higher price-rent ratio is
based on the expectation of home buyers that rents will continue to rise,
thus justifying higher prices for houses. A lot depends on the validity of
these higher expectations which are in turn justified by so-called ‘short-
ages’ in housing. But a freely functioning market cannot have ‘short-
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ages’. A market system has high prices for some goods and low prices
for others. A ‘shortage’ is created when the price mechanism is not al-
lowed to work. There can be a ‘shortage’ of umbrellas in a storm be-
cause sellers choose not to increase the price to equate supply and de-
mand. Then the sellers run out of umbrellas and people go without one
even though they would have been willing to pay a higher price. A
shortage can cause a rise in price if the fundamental demand and supply
conditions that caused the price increase in the first place persist, and if
the market is allowed to clear. But both the market for rentals and the
market for houses are highly evolved and do not suffer from the fixed
price pathologies that cause shortages. There are high rents, or low
rents, but no ‘shortages’. There is no ‘shortage’ of houses anymore than
there is a ‘shortage’ of cars, or diamonds, or shirts. Limitations on new
housing can cause rents to increase at an abnormally high rate for a
period of time but the higher rate of growth of rents should be quickly
‘capitalized’ in the price of a house once the market realizes the impact
of supply restrictions on future rents. That means a one-time jump in
price, and, thereafter, price changes like every other product – up some-
times, and down sometimes. In other words, since higher rents have
been capitalized in the price of houses, then there is no guarantee that
prices will always move higher.
The global financial crisis and the concomitant fall in Dubai
real estate prices have considerably reduced the willingness of banks to
lend, especially for housing loans. Some banks have recently doubled
the minimum salary requirement to qualify for a loan to consumers be-
low a certain threshold, putting extra pressure on consumers’ ability to
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make timely mortgage payments. The recent fall in real estate prices
has also reduced the ‘perceived wealth’ of many homeowners in vari-
ous segments of the market. This wealth effect has reduced consumer
expenditure, one of the largest components of aggregate demand35, put-
ting added downward pressure on property prices. Property developers
in Dubai have also announced ‘delays’ and some cancelations of real
estate projects which will reduce future supplies. The ‘net’ effect on
property prices will depend on the magnitude of these two market
forces. If the fall in demand caused by the unwillingness of banks to
lend is much larger than the fall in supply, then property prices will
surely fall. On the other hand, if the fall in demand is less than the fall
in supply, then the fall in prices will be moderate. Given that the UAE
Central Bank has injected more than $30 billion into the banking sys-
tem in recent months, and given that banks are currently more willing
to lend, albeit at more stringent terms and conditions, the fall in Dubai
property prices should not be very severe36.
35
Aggregate demand is the total demand for goods and services in the economy which
is composed of 4 components: Consumer expenditure (C); Investment expenditure (I);
Government expenditure (G); and net exports (exports – imports). In most developed
countries, consumer expenditure accounts for up to 80% of aggregate demand.
36
The ‘net’ effect is beyond the scope of this book. For a more rigorous analysis, one
needs to identify and measure the many factors that determine both demand and sup-
ply such as population growth, income, tastes, and many other factors.
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Tourism
Another unexpected outcome has been the dramatic growth in
the tourism sector. This outcome has been unexpected because Dubai
had to compete with established tourist destinations in other parts of the
world, especially under the political instability of the Middle East.
Dubai has long been considered as the connecting link between Europe
and Asia with a long history of acting as the ‘middleman’ in the facilita-
tion of trade. Oil does not play a major role in its economy (about 3%
of GDP) and tourism has contributed over 20% to its GDP attracting 6
million tourists in 2007 alone. The growth of the tourism sector can be
explained by the higher profitability in this non-tradable service sector
caused by Dutch Disease effects noted earlier. This higher profitability
has encouraged both public and private foreign investment in the devel-
opment of shopping malls, hotels, restaurants, entertainment and leisure
activities, and many other related services. The driving force behind the
development of the tourism sector has been the Department of Tourism
and Commerce Marketing (DTCM) with the specific objective of trans-
forming Dubai into a regional tourism hub.
The current global financial crisis will undoubtedly have an ad-
verse effect on the Dubai tourism sector. Tourism, by definition, is very
sensitive to changes in income. For a more accurate assessment of this
adverse effect, one has to distinguish between different types of tourism
such as ‘business’ and ‘leisure’ tourism. Over the last few years, Dubai
has been very successful in attracting a large number of ‘business’ tour-
ists through its many international meetings, conventions, and exhibi-
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during the period. Even the world famous Burj Al Arab is included in
the hotels. With all these special discounts available, many would feel
that would suffice. But Dubai goes quite a few steps further. There are
scores of raffles that offer very attractive prices, and Emirates Airlines
and most other airlines flying out of Dubai offer discounted airfares and
much needed excess baggage allowances during the festival. There are
other events as well including international fashion shows, children's
events, street-side performances, nightly fireworks, film festivals, and
many other cultural events that reflect the emirate's cosmopolitan char-
acter. One of the biggest events of them all, the Dubai World Cup, also
takes place during the festival with a staggering US$ 12 million purse
that makes it the richest horse race in the world.
The Department of Tourism and Commerce Marketing (DTCM)
has also focused on the worldwide promotion of Dubai as an ideal tour-
ist destination and a thriving commercial and business centre, very at-
tractive for Dubai property investors. This has involved setting up
DTCM representative offices in many countries as well as participation
in numerous international tourism fairs. In addition, DTCM has
launched highly successful campaigns worldwide and has organised
tourism related exhibitions. Dubai is also developing its medical tour-
ism industry by establishing Healthcare City in partnership with Har-
vard Medical School to create a ‘centre of excellence’ for clinical and
wellness services, and medical education and research aimed at com-
peting with low-cost healthcare providing countries in Asia, especially
Singapore and Thailand. This is another example of super-competitive-
46
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37
Thailand, which received 1.2 million medical tourists in 2006, has gained an inter-
national reputation for offering the best of both worlds – inexpensive surgery com-
bined with a 5 star beach holiday. Singapore, whose healthcare system has been
ranked 6th in the world by the World Health Organization in 2006, consistently earns
high marks in international surveys of medical tourists. It is aiming to attract one mil-
lion foreign patients a year by 2012.
38
For a detailed description of Dubailand and its many theme parks and projects, see
www.dubailand.ae
47
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48
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49
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50
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51
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alone or flagship stores for the very first time in Dubai. The retail mix
includes two anchor department stores, Gallery Lafayette and Bloom-
ingdale’s (both opening their first stores in the Middle East), two hun-
dred and twenty gold and jewelry outlets, one hundred and sixty food
and beverage outlets including Dubai’s largest food court with 40 out-
lets, a super-supermarket, and an organic food mart.
A major challenge facing the tourism sector is the current slow-
down in the global economy, which would adversely affect the tourism
sector because of its income sensitivity. However, given the high rates
of growth in GCC countries and the difficulties associated with out-
bound travel to Europe and the US, especially after September 2001,
Dubai has been focusing on attracting high-income tourists from Arab
and GCC counties in both the leisure and business tourism sectors.
Dubai is the regional hub for meetings, incentives, conferences, and
events (MICE) with over 100 international exhibitions and countless
events held annually ranging from CityScape in real estate development
to GITEX in information technology. On the other hand, Dubai is facing
growing strains in its hotel capacity and infrastructure, and is working
round the clock to broaden the range of its tourist services and upgrade
its infrastructure to meet the shopping and travel needs of its visitors.
The ultimate objective is to position Dubai as a global travel industry
hub which is evidenced by building the largest airport in the world, a
state-of-the-art Metro system, and various leisure and entertainment
projects to attract 15 million tourists by 2015.
52
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Finance
Dubai has also reinforced the flow of capital into the financial
service sector through the establishment of ‘financial centers’ such as
the Dubai International Financial Center (DIFC). The future of these
centers as modern international financial centers will depend on main-
taining a strong and transparent regulatory framework, continuing in-
novation, and making improvements in human capital, the business en-
vironment, and market access. DIFC was established in 2004 to serve
as a gateway for the flow of capital to and from the region, and was
spurred by the sharp increase in economic activity and the subsequent
need for substantial financial intermediation.39 DIFC offers its parti-
cipants a highly attractive investment environment such as 100% for-
eign ownership, zero taxation, and no restrictions on profit repatriation.
It is regulated by the Dubai Financial Services Authority (DFSA), an
independent regulator staffed by an impressive list of international pro-
fessionals with a regulatory mandate covering asset management, bank-
ing and credit services, securities, collective investment funds, custody
and trust services, commodities futures trading, an international equit-
ies exchange, an international commodities derivatives exchange, insur-
ance, and Islamic finance. DIFC has registered over 320 companies,
and the Dubai International Financial Exchange (DIFX) located at
DIFC and regulated by DFSA, has a market capitalization of about $40
billion. It provides a dollar-denominated trading platform for interna-
39
See IMF (2008).
53
Tuesday, August 04, 2009 DRAFT 09
tional issuers to raise capital and debt through conventional and Islamic
instruments.
These financial centers have fostered a vibrant market for Is-
lamic financial products.40 DIFC has already established a strong pres-
ence in this market with about $16 billion listed in DIFX, and interna-
tional investors are flocking to Dubai’s first Sukuk issuances and initial
public offerings. Several Islamic finance learning centers have also
been launched in Dubai which offer a range of Islamic financial, bank-
ing, and training programs to help meet the significant demand for hu-
man capital development. These learning centers are also aiming to at-
tract practitioners from countries with large Moslem populations such
as the US, UK, Germany, and France. The rapid pace of economic
growth is also boosting the demand for insurance products with Dubai
commanding approximately 50% of the UAE share. Life insurance is
also increasing while the non-life segment of the market such as acci-
dent and liability insurance accounted for 60% of total premiums col-
lected, followed by the fire, marine, and aviation segments. The bank-
ing sector in Dubai is also positioning itself to become ‘the’ regional
banking hub driven by the very strong performance of the sector in re-
cent years. There are currently 52 local and foreign banks in Dubai and
the sector is seriously considering consolidating given the turmoil in
global financial markets.41 This would considerably strengthen the abil-
ity of the banking sector to face global challenges by pooling resources
40
Islamic finance refers to a system that is consistent with Fiqh al-Muamalat (Islamic
rules on monetary transactions). For example, since ‘interest’ is prohibited under Is-
lamic law, instead of giving the borrower a loan, the bank purchases the item and re-
sells it to the consumer at a mark-up. For an excellent discussion of Islamic finance,
see Rahali (2008).
54
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and sharing risks. There is also very high potential in the retail banking
sector with strong consumer spending and negative real interest rates.
Dubai has also announced plans to establish a Financial Arbitration
Center to quickly resolve disputes between businesses and different
types of financial institutions.
In its assessment of financial service sectors, the IMF and the
World Bank jointly conducted a Financial System Stability Assessment
(FSSA) in the summer of 2007 and concluded that the banking sector,
which dominates financial intermediation, has enabled rapid credit ex-
pansion to households, corporations, and public and semi-public enter-
prises. Major construction projects for hotels, apartments, commercial
and entertainment properties, and infrastructure have dominated the
landscape in Dubai. Demand for credit has also been driven by rapid
population growth and interest rates in the domestic currency that are
negative in real terms. The assessment also demonstrated that the bank-
ing sector, as a whole, showed comfortable levels of profit having be-
nefitted from the rapid expansion of the economy. In this favorable en-
vironment, the authorities have begun to open-up the banking sector to
greater competition, and several stress tests conducted by the IMF and
the World Bank joint team revealed that the banking system would ad-
apt very well to a variety of shocks. Specifically, banks have absorbed
the recent decline in stock prices with little effect on their balance
sheets, and the rapid increase in overall lending has helped offset a drop
in fees and commissions. The FSSA also concluded that the authorities
41
In 2007, Emirates Bank and National Bank of Dubai merged into a single entity,
Emirates NBD. Such consolidations will ultimately create a few large banks with
greater ability to withstand any external shocks caused by future crises.
55
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56
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43
This is also sometimes known as the Austrian explanation.
57
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44
Macroeconomic stability exists when key economic relationships are in balance—
for example, between domestic demand and output, the balance of payments, fiscal
revenues and expenditure, and savings and investment. These relationships, however,
need not necessarily be in exact balance. Imbalances such as fiscal and current ac-
count deficits or surpluses are perfectly compatible with economic stability provided
that they can be financed in a sustainable manner.
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supply through changes in the interest rate. Fiscal policy has to do with
government expenditure and revenue. Trade policy tries to affect the
terms-of-trade with its trading partners by changing (or fixing) ex-
change rates; and labor policy tries to affect underlying labor market
forces to influence the wage rate (the price of labor).
The effectiveness of economic policy, as demonstrated in many
financial and economic crises, is not as certain as policy makers would
like to perceive45. There are simply too many variables in the real
world, and too many psychological reasons (‘expectations’) for policy
tools to have a full impact on economic aggregates (such as on GDP,
inflation, unemployment). But even under ‘ideal’ circumstances, the ef-
fectiveness of economic policy is based on behavioral assumptions. For
example, if the responsiveness of consumers to changes in taxes is not
very strong, then a given decrease in taxes will not have much effect on
economic growth. Similarly, if a change in the money supply is not re-
sponsive to changes in the interest rate, then a decrease in the rate of in-
terest will not increase liquidity. There are many such examples in eco-
nomic policy where its effectiveness depends on the validity or ‘robust-
ness’ of underlying assumptions. The effectiveness of economic policy
in Dubai is further complicated by the fact that economic policy (mon-
etary, fiscal, trade, and labor) is conducted by the federal ministries at
the country level. The money supply is controlled by the Central Bank
of the UAE; fiscal policy is determined by the federal government;
trade policy is determined by trading relationships with the UAE; and
45
For an extensive discussion on the effectiveness of economic policies and the reas-
ons as to why policy makers cannot always choose ‘optimum’ solutions, see the sec-
tion on ‘The Luxury of Choosing First-Best Solutions’.
59
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60
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48
In May 2009, the UAE exhibited ‘reservations’ in joining the currency union due to
disagreements on the location of the GCC Central Bank. Although the UAE was the
first country to propose the establishment of the GCC Central Bank on its soil, other
GCC members chose Saudi Arabia (Riyadh) as its location.
49
The value of intraregional exports represented less than 10% of the total value of all
GCC exports compared to over 50% in the European Union. See Jadresic (2002).
61
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significant. When both crude and refined oil exports are excluded from
intraregional trade data, total exports among GCC countries increases
to over 40%, and for some countries such as Kuwait and Qatar, this fig-
ure is as high as 60%50.
One major disadvantage of a currency union is that countries
have to give up the option of unilaterally changing their exchange rates.
This is considered a disadvantage because there is always the possibil-
ity that a country might face a large current account deficit and will not
be willing to bear the full adjustment costs of lower nominal wages and
lower prices in a currency union. Another cost of a regional currency
union is that countries will lose the independence and control of their
domestic monetary policies. Although one could argue that the effect-
iveness of monetary policy is already very limited under the current
fixed exchange rate system with the US dollar, countries can still influ-
ence domestic liquidity by printing their individual currencies,
something that would not be possible in a currency union. But perhaps
one of the greatest fears of joining a currency union is that countries
that face no fundamental economic problems of their own may end-up
suffering negative monetary spillovers from macroeconomic imbal-
ances of other countries. In other words, the monetary union may be
forced to modify existing monetary and exchange rate arrangements for
the ‘common good’ despite the objections of an individual country
which may ultimately experience the adverse effects of the changes in
50
Rose (1999) has found that after controlling for variables such as geographic prox-
imity, existence of established trade agreements, language, common cultures and his-
tories, two countries that share the same currency trade 3 times as much as they would
with separate currencies.
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these arrangements. However, given that all GCC countries are oil
and/or gas exporters, an external shock will affect all countries such
that their interests will eventually converge. Moreover, they may al-
ways jointly decide on changing the peg for the common currency in
the face of common external shocks.
A second policy issue which has gained much attention in re-
cent months is the introduction of a value added tax (VAT). The general
concern is that this tax will ultimately lead to higher prices and add ex-
tra pressure to already rising rates of inflation. A VAT is a tax on all
sales of goods and services at every stage of the production process. Its
defining feature is that it credits taxes paid by firms on their inputs
against taxes they charge on their sales – i.e. the government collects
revenue on “value added” throughout the production process. Its distin-
guishing feature is that it does not affect the prices firms pay for inputs
because the tax is ultimately passed-on to the final consumer. Since it
does not affect input prices, it does not cause any production distortions
and does not create “cascading”51.
Perhaps the biggest advantage of the VAT is that it is very prac-
tical to implement since it is collected at every stage of the production
process. As a simple example, suppose firm X sells its output to firm Y
for a price of $100, which in turn sells its output to the final consumer
for $300. Assume now that there is 10% VAT. Firm X will now charge
firm Y $110, remitting $10 to the government in tax. Firm Y will
charge consumers $330, remitting tax of only $20 (output tax of 30$
minus a credit for the $10 of tax charged on its inputs purchased from
51
Cascading is a “tax on tax” when a tax is levied on both the output and on the final
inputs used in the production of that output.
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firm X). The total revenue of the government is therefore $30. Al-
though this is equivalent to a 10% tax on final sales of $300, this meth-
od of collection secures the revenue more effectively. In other words, if
firm X, for some reason, were to omit charging tax to firm Y, the gov-
ernment would still collect $30 from firm Y. If firm Y were to omit
charging the tax, the government would at least collect the $10 from
firm X. The advantage of VAT over a standard sales tax on final con-
sumption is that if the final retailer (firm Y) somehow were able to
avoid paying tax, then the government would still collect $10 from firm
X. With a sales tax, the government would receive nothing52.
Despite the problems faced by economic policy makers in gen-
eral, and problems associated with the definition of economic policy as
economists understand it, Dubai has been highly successful in formu-
lating effective economic policies53. This is primarily because policy
implementation in Dubai is taken very seriously with strict timelines
and monitoring mechanisms. The effectiveness of economic policies in
most emerging economies is hampered by poor enforcement and
‘loose’ implementation due to bureaucratic red-tape and the lack of
qualified professionals. Even in developed economies, the effectiveness
of economic policy is hampered by special interest groups with their
52
The ultimate payer of the tax is the consumer. Thus, there is some justification
about the concern on rising costs-of-living. For a detailed yet very simple discussion
on VAT, see Liam E. et al (2002).
53
The effectiveness of economic policy can be measured either in a partial equilibri-
um model or a general equilibrium model. In the former, the modeler looks at the ef-
fect of the policy on a single market in isolation from the rest of the economy. Such
models are common in the analysis of the impact of a policy on a specific industry. In
a general equilibrium model, the analyst looks at the effect of the policy on the whole
economy by modeling inter-industry transactions and linkages between different eco-
nomic agents such as firms, households, the government, and the rest of the world.
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own objectives, and by the fact that governments may be ‘voted out’
and will not have the required time to implement a given policy.
Moreover, any economic policy will have ex-post undesirable outcomes
affecting economic groups disproportionately and which cannot be de-
termined until the policy is fully implemented ‘on the ground’. The
secret of Dubai’s success in increasing its economic policy effective-
ness is that these undesirable outcomes are quickly rectified through the
establishment of specialized task-forces, working-groups, committees,
and other specialized agencies. Perhaps a good example of the effect-
iveness of economic policies in Dubai is the current implementation of
the Dubai Strategic Plan (2015) which contains hundreds of initiatives
and action plans to triple Dubai’s GDP to over $100 billion by 2015.
The DSP(2015) is having some undesirable, yet expected impacts such
as a rising cost-of-living and falling real wages which are being recti-
fied by a special task-force on inflation and the signing of agreements
with labor exporting countries to increase wages.
65
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54
For a comprehensive list of all free zones in Dubai see eyeofdubai.com
66
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55
See UAE Federal eGovernment Portal http://www.government.ae/gov/en/biz/start/incorp.jsp
56
See World Trade Organization (2006).
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68
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69
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70
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71
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72
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or we determine if there are rules ‘on the book’ on, say, compulsory
education, and we ‘map’ this rule to outcomes ‘on the ground’ by ask-
ing the public through opinion surveys if it perceives the country to
have a good education system 63.
Dubai has been very innovative in the use of governance indic-
ators to measure and evaluate government performance through various
programs and initiatives64 such as the Dubai Government Excellence
Program (DGEP), the Dubai Government Performance Measurement
System, the Mohammed bin Rashid Program for Leadership Develop-
ment (MBRPLD), and many innovations in e-Government to improve
performance and delivery of public services. Most of these programs
and initiatives are outcome-based governance indicators. The most not-
able of these programs is the Dubai Government Excellence Program
(DGEP) which was initiated at the Department of Economic Develop-
ment (DED) in 199965. Its main objective, among many others, is to es-
tablish a guiding reference and benchmarks to measure the progress in
effecting change and evaluate the performance of public agencies ac-
cording to established criteria in different categories divided into ad-
63
The most frequent criticism of such indicators is that it is impossible to trace back a
specific outcome ‘on the ground’ to a specific rule ‘on the books’ because there are
many other variables that can influence the outcome. Moreover, there is no clear de-
marcation line between rules-based and outcome-based indicators, and both types of
indicators are highly subjective and are based on value-judgments.
64
For an excellent discussion on the Dubai experience in governance, see Al Yousuf
(2005).
65
The original name of the program was the Sheikh Mohammed bin Rashid Govern-
ment Excellence Award which was conceived as an innovative impetus to speed up
the pace of change and drive all administrations towards improvements, increased ef-
ficiency and effectiveness.
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75
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like. The program was launched in 2003 and has produced over 150
graduates who are employed in government and semi-government or-
ganizations. Some graduates have also been employed in the private
sector and a number of them are currently leading new projects and es-
tablishments. The distinguishing feature of MBRPLD is that it tries to
achieve balanced growth in various fields of leadership by providing
the opportunity to all UAE nationals to develop their ‘hidden’ leader-
ship abilities in their specific areas of interest. In this way, each future
leader is given a chance to distinguish himself or herself in their chosen
field of expertise. The program is regularly updated to take into account
regional and international developments such as the recent launching of
a training program on Business and Finance Fundamentals in response
to the current global financial crisis.
It is also important to note that the deep involvement of the
Dubai government in the economy does not imply that the government
will always act as a lender of last resort to bail out under-performing
establishments. The raison d’être of the government’s interference in
the economy of Dubai is to increase competition by creating a healthy
competitive environment for all, both private and public establish-
ments, so that they can compete on a level playing field. The ‘moral
hazard’ problem – a situation in which large establishments perceive
that the government will always bail them out – was clearly demon-
strated in the bail-out of US and other financial institutions.68 The risk
68
The argument for bailing-out large establishments is that their collapse will have
ripple-effects throughout the rest of the economy and cause irreparable damage. This
argument is misleading since the financing of the bail-out is harmful by itself since it
is paid for by the public in higher taxes.
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78
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79
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governments that are not easily amenable to rigorous research and analys-
is.
Another important aspect of the policy making process is that the
objectives of researchers and government policy makers are not always the
same70. Policy makers in government are more interested in distributional
issues such as ‘winners’ and ‘losers’, whereas policy researchers are con-
cerned with efficiency issues such as the efficient allocation of scarce re-
sources. Moreover, most policy makers in government tend to have back-
grounds in law and thus favor legislative instruments as opposed to using
incentives to affect economic behavior. University research is also not very
suitable for policy makers because it takes much longer to produce re-
search results at academic institutions than a policy maker in government
with a short deadline can tolerate71. Nevertheless, there are three condi-
tions under which first-best solutions are most likely to be adopted by gov-
ernments72. The first of these conditions is when research is concerned
with critical future outcomes such as forecasting population growth rates
or rates of growth of the economy. The second condition is when there are
powerful competitive pressures and incentives to innovate. And the third
condition is when government departments are highly accountable and
must somehow justify the policy decisions they take. Bearing in mind that
first-best solutions can be adopted by governments under these conditions,
it is indeed encouraging to see that Dubai satisfies all three conditions.
70
See Glover, D. (1991).
71
This does not mean that university research is not important. It simply implies that uni-
versity research is ‘research for knowledge’ as opposed to ‘research for action’ which the
policy maker in government requires in a relatively short period of time especially when
the economy is in a recession.
72
See Faulhaber and Baumol (1988).
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81
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82
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74
This section follows closely The Executive Office (2006). Highlights: Dubai Strategic
Plan (2015), Dubai… where the future begins. Dubai, United Arab Emirates.
83
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75
Dubai’s per capita income today compares very favorably to that of many developed
countries such as Singapore’s ($26,836) and Hong Kong’s ($25,493), countries which re-
quired a much longer period of time to reach their current high levels of GDP.
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construction and real estate sectors have also exhibited share gains primar-
ily due to the availability of land, labor, domestic and foreign capital, and
changes in regulations.
Dubai’s current GDP mix is very favorable as its strongest sectors
by international standards happen to be highly conducive to future global
growth. These sectors are tourism, transportation, construction, and finan-
cial services, and are well-placed to constitute the focal point of Dubai’s
future growth path within the economic development sector plan. Building
on Dubai’s remarkable economic performance and future trends, economic
targets for 2015 have been set and are classified into the following cat-
egories: (1) Economic growth: sustain a real GDP growth rate of 11% per
annum for the next 10 years and increase real GDP per capita to $44,000
in 2015; and (2) Enhanced labor productivity and sector development: in-
crease productivity by 4% per annum, move existing sectors of strength to
new frontiers (both domestically and internationally), create new sectors
of strength with sustainable competitive advantage, and promote innova-
tion to develop new sectors and increase productivity.
The recommended future strategic growth path is based on 6 com-
binations of sectors, or vertical building blocks, including, among others,
sectors such as tourism, trade, transportation, and financial services76.
These sectors were identified based on their current status, international
competitiveness, Dubai’s capacity to develop them, and local availability
of required factor conditions. However, targeting these building blocks
will not yield rapid and sustainable growth unless 7 horizontal enablers
for growth are addressed in parallel, namely, human capital, productivity,
76
These are strong sectors by international standards which are highly conducive to fu-
ture growth.
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86
Tuesday, August 04, 2009 DRAFT 09
ards. The pursuit of the proposed strategic growth path will promote GDP
growth to $108 billion by 2015. This approach would strengthen Dubai’s
healthy sector mix by ensuring focus on key sectors while further promot-
ing diversification and ensuring reduced vulnerability to external shocks,
and a systematic integration into the regional and global economy. To
achieve these economic growth targets, it is estimated that 882,000 addi-
tional workers are required to join the workforce by 2015, bringing total
employment to 1.73 million with a significant move towards higher skilled
employment.
Perhaps one of the most important attributes of the DSP(2015) is
that it is a ‘live’ document constantly being updated and modified to chan-
ging regional and international conditions. During its formulation in 2005,
the major thrusts of its growth path were also based on current and expec-
ted developments in the rest of the world. Moreover, the DSP(2015) is
based on macroeconomic principles to ensure that priorities do not clash
and market forces are reinforced. The positive aspect of the DSP(2015) are
double digit economic growth, a carefully thought out strategy of diversi-
fication, a substantial increase in the share of Arabs in the labor force,
deeper integration of the economy both regionally and globally, and
strengthening of the ability of the economy to absorb and cushion the ef-
fects of external shocks through improved policy making and institutional
strengthening. On the other hand, the DSP(2015) faces many challenges
such as a declining share of nationals in the labor force, major human cap-
ital development challenges, continued reliance on imported unskilled
labor from South Asia, and the ability to attract and retain skilled workers
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88
Tuesday, August 04, 2009 DRAFT 09
89
Tuesday, August 04, 2009 DRAFT 09
90
Tuesday, August 04, 2009 DRAFT 09
91
Tuesday, August 04, 2009 DRAFT 09
78
See Blum and Durlauf (2007) for a more detailed definition of inflation targeting.
79
The main problem with deflation is that people in debt (a large number of people
during a recession) will be worse-off. When someone has borrowed $1,000 from a
bank, a 10% annual deflation rate will increase the burden of the loan by 10% - i.e.
the borrower has to pay back $1,100 in a year’s time. Conversely, when the rate of in-
flation is 10% annually, then the burden of the loan will be only $900 since the pur-
92
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93
Tuesday, August 04, 2009 DRAFT 09
80
Statistical Yearbook – Emirate of Dubai (2007). See Table 03-02, pp 91-92.
94
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95
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96
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97
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