Economic Diversification (Booz Allen Hamilton)

Economic Diversification


The Road to Sustainable Development



A strong, growing, sustainable economy is the goal of every nation in the world. A sustainable economy enhances a nation’s standard of living by creating wealth and jobs, encouraging the development of new knowledge and technology, and helping to ensure a stable political climate. A diverse economy—that is, one based on a wide range of profitable sectors, not just a few—has long been thought to play a key role in sustainability.

Our recent research study confirms that this is indeed the case. There is a demonstrable link between economic diversity and sustainability, and diversification can reduce a nation’s economic volatility and increase its real activity performance.

This study grew out of our work helping Middle East governments, particularly those in the Gulf Cooperation Council (GCC), formulate their economic development strategies and agendas for transformation—their transitions from economies based on a single commodity to robust, well-diversified economies. These countries, rich in hydrocarbons and heavily invested in oil and gas, face a particularly daunting challenge in diversifying. It was important to determine just how critical economic diversity was to the creation of their sustainable economies.

Evaluating economic diversification

To make that determination, we broadened our focus beyond the Middle East region and scrutinized 19 countries with varying levels of economic maturity to assess their economic diversification, volatility, and health.

Our initial analysis of economic diversification involved the GCC; the Group of Seven (G7) nations (Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States); and what we termed transformation economies, those that became industrialized nations in the latter half of the 20th century (Hong Kong, Ireland, New Zealand, Norway, Singapore, and South Korea). Three key findings emerged:

GDP should be distributed across economic sectors. We determined a “concentration ratio” and a “diversification quotient.” Concentration ratio measures a nation’s concentration in a given sector. The diversification quotient is the inverse of the concentration ratio, providing a metric that policymakers can use to gauge economic diversity. The lower the concentration ratio and the higher the diversification quotient, the more diversified a nation’s economy.

Concentration is not inevitable in hydrocarbon-rich economies. Abu Dhabi has a high concentration ratio: It drew 59 percent of its 2005 GDP from oil and gas, and growth in non-oil sectors continued to lag. However, other oil-rich countries have deliberately lowered their concentration ratio: Only 5 percent of Dubai’s GDP, for example, came from the oil and gas sector in 2005, and Canada’s oil and gas trade represents just 4 percent of its GDP.

Labor distribution should support growth. Employment distribution generally reflects and shapes GDP distribution across sectors. In the GCC, employment is distributed unevenly, compared to G7 and transformation economies. The oil and gas sector, producing 47 percent of GCC countries’ GDP, provides work for only 1 percent of the employed population. Government services constitute around 20 percent of total GCC employment. A majority of workers are laboring in sectors that support other economic sectors, rather than driving growth.
Evaluating economic sustainability

Through further analysis of productivity; competitiveness; and the relationship of economic volatility to concentration, employment, and economic performance, we determined that there was a statistically significant relationship between economic diversification and sustainability. Specifically, we found that:

Poor economic diversity is linked to low productivity and competitiveness.
High economic concentration leads to volatile growth and fluctuating economic cycles.
Volatility in concentrated economies may spawn structural unemployment issues and engender systemic risks.
External trade (exports of goods and services) helps reduce economic volatility.
Recommendations for policymakers

Economic diversification is measurable, monitorable, and now known to be a critical component of a sustainable economy. But policymakers who decide to increase diversification have their work cut out for them. They must keep economic diversification front and center when creating development agendas, and must rigorously measure and monitor economic diversity in evaluating the success of their policies. Policymakers should:

Diversify economic bases’ output and input distributions. Stakeholders should encourage the movement of labor and capital into productive economic sectors, as well as the development of new knowledge and technology.

Foster the growth of the external sector by exporting a wide range of high-value-added goods and services internationally.

Enhance the productivity and competitive levels of the economic base through resources and strategic investments, including enhancing human and financial capital, technology, and knowledge to entrench innovation. Innovation allows economies to create economic value from scratch.

Use the metrics of economic concentration and diversification, as well as economic sustainability and uncertainty, as targets when determining policy.

Create clear diversification strategies and mechanisms to mitigate economic volatility and spillover effects, uncertainty, and perturbed business cycle transitions.
Our findings provide a firm reminder to policymakers worldwide that a key to building a strong, sustainable economy is building a diversified economy—one that is not overly dependent on a single commodity and that has a strong external as well as internal focus.

Taking the steps outlined in this study will help policymakers create long-term, sustainable growth. In so doing, they will ensure stability and a high standard of living for their nations.


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