Getting labor policy to work in the Gulf

For GCC states, liberalizing the labor market and developing the local workforce
are the keys to moving beyond a reliance on foreign workers.

Gassan Al-Kibsi, Claus Benkert, and Jörg Schubert

Web exclusive, February 2007

Bahrain’s economy is growing at more than 5 percent a year, and per capita income
averages about $15,000. However, such statistics make little difference to Jafar Ahmed
Ali, a 30-year-old Bahraini citizen who works more than 12 hours a day, seven days a
week, for a construction company. Like many Bahraini nationals, Jafar faces stiff
competition from foreigners willing to work for less than half the minimum—$500 a
month—that he needs to support his family. Even after four years with the same
employer, Jafar can’t beat the system.

In Bahrain and the five other states that make up the Gulf Cooperation Council (GCC)—
Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates (UAE)—foreign workers
hold the majority of private-sector jobs. At the extreme, in the UAE, foreigners account
for 99 percent of the private-sector workforce (Exhibit 1). This situation has led to high
unemployment among GCC nationals, declining productivity, and a growing social malaise
(caused in part by weak job prospects and poor working conditions) that could threaten
the region’s economic prospects.

About the artwork: An estimated 42 percent of the GCC’s local population is currently under the age of 15
Paul Guiragossian 1987 and will soon be in search of work. Yet the public sector—where GCC governments have
traditionally employed up to 90 percent of the national workforce—is now too bloated to
accommodate large numbers of new entrants. Meanwhile, the private sector, which would need to double both the
number of jobs and the salaries of individual jobs by 2015 to meet this increase, does not currently offer the sort of
high-salary employment that would attract nationals. Clearly, the policies that served a purpose 30 years ago have
reached the end of their usefulness.

The preponderance of
foreign workers dates
back to the oil boom of
the 1970s, which
helped finance the
establishment of the
GCC’s modern
industrial
infrastructure. This
massive undertaking
required a larger labor
force than was
available locally, not
only because nationals
were few in number
and short of skills, but
also because they
shunned the kind of
physical labor
associated with building
infrastructure. To solve
the problem, GCC
governments
introduced immigration
policies designed to
attract foreign workers.
This dependence on cheap foreign labor has delayed the formation of a skilled national workforce and prevented the
development of a diversified and productive private sector that could help absorb new entrants into the workforce.
Addressing these challenges is vital to the further expansion and diversification of the GCC economies in order to
shield them from the effects of volatile oil prices.

A workable solution will require comprehensive—and painful—reversals of the GCC’s immigration and national labor
market policies. Instead of promoting loose immigration and rigid labor markets, GCC governments should tighten
immigration controls to raise the cost of employing foreign workers while also liberalizing national labor markets to
promote competition among nationals and expatriates for jobs. At the same time, GCC governments must take
measures to promote vocational-skills training for nationals to help them compete more effectively for those jobs.

The high cost of cheap labor

The labor problem persists in part because the GCC states’ policies allow foreign workers from countries such as
Egypt, India, and the Philippines to fill private-sector jobs at wage levels much lower than GCC nationals would
accept and in sectors they traditionally have shunned, such as construction and manufacturing. But as increasing
numbers of women and new graduates have entered the national workforces, public-sector employment costs have
ballooned. For the GCC as a whole, the central governments’ bill for wages exceeds 11 percent of GDP, on average—
and 17 percent in Saudi Arabia.1 By comparison, among the G8 nations2 the wages of central-government employees
account for 4 percent of GDP, on average, while total wages for the public sector (including regional governments
and municipalities) average approximately 9.5 percent of GDP.

GCC governments pay additional costs for foreign workers in the form of subsidized health care, infrastructure,
electricity, gas, and water. Neither employers nor expatriates pay taxes that would allow governments to recover
these costs, and current immigration and health fees are insignificant. Our analysis shows that every expatriate in
the GCC generates social costs of approximately $1,300 a year. Meanwhile, foreign workers in the GCC remit about
$35 billion a year to their home countries—approximately 10 percent of each host state’s GDP.

Even if current oil revenues could sustain the existing labor system, they are no match for demographic trends in the
GCC. Expanding populations, along with increasing numbers of women entering the job market, have already pushed
up unemployment rates among the national populations of Bahrain, Oman, and Saudi Arabia to 10 or even 15
percent; unofficial sources report unemployment among 16- to 24-year-olds of more than 35 percent in these states.

As a result, nationals
seeking work in the
private sector have had to
lower their wage and
status expectations. Over
the past decade the
abundance of cheap
foreign labor has
contributed to a decline in
the private sector’s
average real wages of 16
percent in Bahrain to 24
percent in Saudi Arabia
(Exhibit 2). The low-skill
segment of the labor
market has taken the
brunt of the fall. Today
private companies in
Bahrain, Oman, and Saudi
Arabia pay nationals an
average monthly wage of
$460 for manual labor. But
most GCC households
require at least $900 a
month to meet their
current living standards.
Meanwhile, with private companies finding it cheaper to employ expatriates than to invest in more capital-intensive
production methods, productivity rates throughout the GCC are also on a downward spiral, dropping by as much as
20 to 35 percent over the past decade. In the construction sector, the GCC states’ 2005 productivity figures were
only a quarter of the US ones.

Consequently, private companies offer few jobs that appeal to well-educated nationals. In Bahrain during the past
decade, for example, for every ten college graduates, the private sector created only one job that paid more than
$500 a month. We estimate that over the next decade, the private sector in the GCC states will need to increase the
number of medium- to high-wage jobs fivefold to soak up the 280,000 new national workers expected to graduate
each year with at least a secondary-school education. By 2015, to achieve full employment across the GCC, the
private sector will need to create 4.2 million new jobs for nationals—almost double the number of jobs that exist
today (Exhibit 3).

While all GCC states face

the same structural
challenges, the incentives
and internal pressures to
reform differ from state
to state. The situation is
especially acute in
Bahrain and Oman, since
their oil reserves are
nearing depletion and
government revenues will
be unable to prop up
public employment. Saudi
Arabia also faces a
demographic challenge,
as its national workforce
is outgrowing oil
revenues. In the
wealthier states of
Kuwait, Qatar, and the
UAE, the crowding out of
national job seekers by
foreign workers is less
acute.

In all GCC states, labor

market reforms will be
politically painful but
ultimately inescapable. Young citizens are likely to press for change, and the GCC states will need to take action to
build sustainable economies.

Labor’s loopholes

To date, GCC governments have addressed labor market imbalances by trying to minimize immigration through strict
sponsorship rules for foreign workers and limiting contracts for such workers to two years. Governments have also
set quotas to increase the number of nationals in private companies and have limited the circumstances in which
they can fire national workers (a policy that, in effect, makes expatriate labor even more attractive).

The GCC’s education system fails to prepare Initially, private companies complied with these measures,
students for work: basic training is treating the quotas for nationals as a kind of tax. But GCC
inadequate, and the region lacks systematic governments have gone on raising the quotas, to increase the
vocational training number of nationals employed in the private sector. Since 2000
Oman’s government, for example, has allowed only nationals
to fill low-skilled jobs in categories such as driving taxis and trucks and operating grocery shops. Recently, Oman
added 24 categories to the nationals-only jobs list. In 2005 Saudi Arabia passed a labor law requiring that nationals
make up 75 percent of a company’s workforce.
Companies routinely resist these measures, complaining that they cannot find sufficiently qualified nationals to fill
open positions. A key problem is that the GCC’s education system fails to prepare students for work: the basic
education is inadequate, and the region lacks any kind of systematic vocational training. Few nationals achieve the
level of skill that would allow them to land jobs in the higher-paying segments of the workforce. In a ranking that
measures achievement in math among eighth-grade students, Saudi Arabia, for example, is near the bottom,
between Botswana and Ghana. About 90 percent of first-year students at UAE University require one year or more of
courses in basic math and literacy.

Furthermore, by mandating the employment of nationals, the quota system gives them less incentive to compete
effectively for jobs. According to interviews conducted with private-sector employers in Bahrain, Saudi Arabia, and
the UAE, a quarter of national employees fail to show up for work regularly, while many leave jobs just six or nine
months after taking them, citing boredom or a lack of interest. Some companies even choose to pay low-performing
employees simply to meet the quota but ask them to stay home.

Companies have developed a variety of schemes to avoid quotas. The most straightforward is to negotiate with
government authorities, on a case-by-case basis, for additional expatriate labor. As a result of this approach,
companies within a given sector are treated unequally, which opens the door to corruption and favoritism. It also
encourages civil servants to micromanage private businesses.

Some businesses bypass the bureaucracy altogether and list “ghost workers” on their payrolls. Ghost workers are
nationals whom companies employ only on paper to meet their quota requirements; once they fulfill the quotas, they
can obtain more expatriate work permits. Other businesses get foreign workers through a system of “ghost
companies”—shells registered in sectors (especially construction) with low quotas for national employees. The only
business these companies do is importing foreign workers and releasing them illegally into sectors with more
restrictive quotas, often by selling sponsorship rights to other employers. Our analysis suggests that 25 to 30
percent of the GCC’s expat workforce falls into this category.

Since most private companies view the circumvention of quotas as a necessary part of doing business, such practices
have become so widespread that governments accept them tacitly.

Narrowing the local-expatriate cost gap

The GCC could eliminate this brew of corrupt practices by reversing current labor policies. All developed economies,
for example, manage their labor markets through a system of controlled immigration, achieved by placing quotas on
immigrants, establishing a system of fees, or both. Once foreign workers enter a developed country, however, they
typically enjoy the same rights—such as job mobility, transparent termination rules, and limits to the number of
hours they can be required to work—as their national coworkers. These policies serve both to equalize the cost of
employing foreign workers and nationals and to make the labor market more flexible. Research shows that flexible
labor markets help raise employment levels.3

GCC states need to clamp down on immigration by adopting the comprehensive approach found in developed
economies. Doing so will raise the cost of foreign workers compared with the cost of nationals and forestall further
increases in expatriate populations. Taxes on immigrant labor should be particularly effective in the GCC, since they
enable governments to recover some of the costs associated with foreign workers. Quotas, on the other hand, drain
money out of the economy, since most foreign workers repatriate their earnings.

Critics argue that fees on foreign labor could increase inflation and drive private companies to other low-cost
destinations. But while an increase in labor costs of $250 per month per worker (which would raise the cost of
employing expatriates to about $570 and close the cost gap between expatriate and local workers) would boost
consumer prices 4 to 8 percent over five years in Bahrain, for example, that additional cost would be unlikely to
drive away private companies. Surveys show that investors place a higher value on other factors, such as access to
markets, incentive systems, and the availability of skilled labor.

Since most private companies view
the circumvention of quotas as a
necessary part of doing business,
such practices have become so
widespread that governments
accept them tacitly
Our analysis suggests that gains in productivity could exceed the additional
costs associated with fees on expatriate labor. Moreover, these gains will
end the cycle of decreasing wages. The fees would give businesses
incentives to increase their productivity, since more capital-intensive
production methods reduce overall labor costs. At the same time, such
methods create higher-paying jobs that appeal to national workers. Our
analysis suggests, for example, that if the GCC’s construction companies
raised their labor productivity by 60 percent, to match that of Turkey, they would more than offset the cost of labor
fees or expatriates.

GCC governments must take additional measures to let all participants in the labor market, regardless of national
origin, compete for opportunities on their own merits, under the same termination rules and with equal job mobility.
As the cost of importing workers rises, the governments should boost the appeal of employing nationals by gradually
eliminating quota laws and onerous termination processes. Similarly, the governments should eliminate current
sponsorship requirements that tie foreign workers to a single employer for two years. Instead, these workers should
be able to transfer their work permits to other employers if and when they choose to find new jobs. This policy
change will enable expatriates to compete freely for jobs and release them from what now resembles a system of
indentured employment. Moreover, foreign workers will be likely to flock to the best-paying, most desired jobs,
thereby pushing up overall wage rates and helping to level the playing field for nationals and expatriates.

Emerging markets can win in the Other GCC governments should consider some combination of the reforms
global war for talent by leveraging that Bahrain recently pioneered, notably the introduction of a tax on foreign
the skills of their expats. See workers and the use of the resulting revenue to improve the quality of the
“Brains abroad.” domestic workforce. The current tax level is about $690 per worker per two-
year employment contract, and the government plans to increase the tax
annually for the next few years, until the cost gap between expatriates and locals closes. As labor fees increase
Bahrain will gradually relax quota regulations. The government will discontinue quotas altogether once the fees reach
a level that eliminates the cost gap between expats and nationals.

Improving the national workforce

The success of immigration reform hinges on concomitant employment and education programs to assist the region’s
national workers. Instead of trying to protect them from low-cost foreign competitors, governments should invest in
building their skills so that they can become the employees of choice. To do so, governments should establish
multitiered employment programs that include training in skills for nationals, financial incentives for companies to
employ them, and job-matching services for employers and job seekers.

Bahrain’s recently established Labor Fund invests the taxes on foreign workers—which will eventually generate about
$500 million a year—both in skill-building programs for the national workforce and in measures to increase private-
sector productivity (such as subsidies for upgrading accounting and IT systems and for consulting support to identify
opportunities to improve productivity). The fund has also increased the level of loan financing for small private
companies by guaranteeing access to loans from commercial banks.

GCC governments should also consider establishing private-sector apprenticeships that enable their nationals to
acquire on-the-job training while earning a wage. Since companies are reluctant to employ nationals, governments
may need to entice them with subsidies to cover the cost of the apprenticeships. To be manageable and effective,
these subsidies should taper off gradually over the course of, say, two years, as a worker becomes more productive.
So that employees have an incentive to stay in their jobs, governments could work with the private sector to offer
bonus payments when they achieve milestones (for example, the successful completion of a probationary period or
of the full apprenticeship program).

Governments can further improve the employment prospects of nationals by offering job-matching services, such as
job databases and career counseling. Matchmaking programs work best when they segment job seekers along the
dimensions of skills and motivation. A successful matching effort would place low-skilled but motivated candidates in
training programs. Less-motivated candidates would be required to attend basic job-readiness programs focused on
work ethics before receiving specific technical training.

Such employment initiatives don’t come cheaply. Our initial estimate for matchmaking support and job training for
the entire GCC over the next decade ranges from $4 billion to $5 billion. Wage subsidies for noncompetitive nationals
will add a further $10 billion to $15 billion over the next ten years, depending on the duration of the subsidy and the
employee eligibility criteria. The total for the next decade represents approximately the entire annual spending on
education by GCC governments. Address-ing these structural issues now will be less of a burden for the wealthier,
smaller states of Kuwait and Qatar, since their national workforces are still small. In the case of Bahrain, however, a
more painful approach that relies on taxing employers of foreign workers is the only feasible solution to help finance
these costs.
In all GCC states, financing labor market reforms is likely to be easier than overcoming private-sector resistance.
Ultimately, however, labor market reform is inescapable. As GCC job seekers grow in numbers, they will find it
increasingly hard to accept the idea that their fast-moving economies do not offer well-paying jobs. Companies also
will find it necessary to move toward higher-paying, more-value-added jobs if they want to compete in the global
economy. On top of these internal drivers, Western countries will continue to use bilateral and multilateral trade
negotiations and other forums to pressure GCC governments into setting minimum standards for the work conditions
of expatriates. The GCC’s growing economic power, after all, will be considerably less welcome if accompanied by
excessive “social dumping.”

By addressing the demographic pressures now, GCC governments can stave off potential social unrest, avert
international criticism, and propel the economies of their countries toward a sustainable future.

About the Authors

Gassan Al-Kibsi is a principal and Jörg Schubert is an associate principal in McKinsey’s Dubai office; Claus
Benkert is a director in the Munich office.

Notes
1
Ugo Fasano and Rishi Goyal, “Emerging strains in GCC labor markets,” International Monetary Fund working paper,
number WP/04/71, April 2004; and Kingdom of Saudi Arabia, Public Administration Country Profile, Division for
Public Administration and Development Management (DPADM), Department of Economic and Social Affairs (DESA),
United Nations, September 2004, p. 4.

2
Canada, France, Germany, Italy, Japan, Russia, the United Kingdom, and the United States.

3
“Recent labour market developments and prospects,” OECD Employment Outlook 2004 Edition, pp. 23–72; and
David Kucera, “Unemployment and external and internal labor market flexibility: A comparative view of Europe,
Japan, and the United States,” Schwartz Center for Economic Policy Analysis working paper, number 1998–21,
October 1998.