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Lessons in diversification There are only few examples of countries that successfully managed diversification away from primary dependence. The examples of Malaysia and Norway suggest that a sound institutional framework, robust fiscal framework, supportive public sector industrial policies, appropriate business climate and human capital are important factors in enabling successful diversification away from the oil sector. A backdrop of low oil prices exacerbates diversification challenges but also provides impetus for change. Saudi comprehensive reforms follow standard template to shift gears The Saudi NTP broadly follows the generally accepted template of comprehensive macro- and micro- reforms needed to diversify beyond the hydrocarbon sector, in our view. The literature suggests successful diversification entails ideally a combination of three types of innovations: processes, products and organizations. Enhancement in processes would enhance productivity, new products would support emergence of new sectoral growth drivers, and improved micro- and macro-governance would help sustain production gains. The key to furthering the development path would be to move from an initial labour- and capital-intensive phase towards a phase focused on increasing productivity growth through higher value-added sectors. This will require the retention of white-collar workers, steady progress on institution- building, an increase non-hydrocarbon FDI, horizontal and vertical integration, a broader manufacturing base including at first through sectors with competitive advantage (downstream or energy-intensive ones), greater integration into the global value chain through enhanced trade relations, as well as education and business climate reform to overcome structural rigidities, in our view. Medium-term diversification may require Fx reform As diversification progresses, the case for increased Fx flexibility and making space for autonomous monetary policy conduct is likely to gradually take shape. Presumably, such a move would require putting in place a supportive institutional structure which is currently broadly lacking. It would also await improvements in productivity growth and the development of competitive local industries to minimize a potential Dutch disease effect on infant or other sectors. A fairly valued real effective exchange rate (REER) would support efficient allocation of production factors across sectors and improve competitiveness of the tradable goods sector. Malaysia case study highlights the role of supportive public sector Malaysia’s diversification away from primary commodities relied on a series of National Industrial Policies and Industrial Master Plans to promote the manufacturing sector. Focus was given to sectors with high export potential, and efforts were taken to create linkages with other sectors and to deepen interconnection with other industries. Growth strategies also aimed to develop local technological capabilities and clusters of industrial development, similar to the localization and industrial strategies spearheaded by the Saudi National Transformation Plan. OS Merrill Lynch GEMs Paper #26 | 30 June 2016 31 HOUSE_OVERSIGHT_016141