MENA: No Reforms, No Growth

Middle East and North Africa (MENA): hard choices needed, but unlikely. For political transitions to be successful, economic fundamentals need to be solid. Yet, MENA countries are facing political change and pressing social demands while enduring economic strains. The sluggish global outlook, the Eurozone (EZ) recession, and China’s deceleration hamper exports, remittances and capital inflows. Prolonged policy uncertainty constrains investment and hinders tourism. Monopolistic practices keep hampering job creation. Without bold structural changes, economic stagnation and persistent unemployment are likely. Between 2012 and 2013, growth will slow from 3.3 to 3.2 percent. The Gulf Cooperation Council (GCC) will grow the fastest, led by Qatar, Saudi Arabia and a diversified Oman. Given population growth, 50-75 million jobs are needed over the next decade. Neither the public nor the private sectors are likely to create them.

Government spending supports consumption … While most “Arab Spring” demands remain unanswered, the most affected countries – Tunisia, Egypt, Libya, and Bahrain – are recovering. Syria remains in turmoil. Given political concerns, social tensions and rising global commodity prices, governments increased spending, particularly on wages, and energy and food subsidies. In 2011, about $212 billion (over 7 percent of regional GDP) was spent in subsidies, of which 80 percent in fuel – considered an entitlement, especially in resource-rich countries. Going forward, oil-exporting countries, helped by resilient oil prices global and fuel demand, will support growth in oil-importers, via trade and financial links. Fiscal policy will remain supportive across the region.

… but fiscal and foreign exchange cushions are eroding. Fiscal deficits increased (to about 8 percent of national GDP on average), debt levels rose and domestic government borrowing started crowding-out the private sector. External positions also weakened, with a drawdown of international reserves – most noticeably in Egypt – and a worsening of creditworthiness and other financial market indicators. Maintaining macroeconomic stability will be challenging.

Inflation is elevated, but monetary conditions remain easy. Via subsidies, food and fuel price-hikes were absorbed by public deficits, not by consumers.  As weaker global and domestic demand eased prices, inflation decelerated in most countries – except in Jordan, Tunisia, Iraq and Saudi Arabia – but is expected to gently pick up. Between 2012 and 2013, inflation will rise from 5.8 to 6.2 percent. Central banks are importing easy monetary conditions through USD-pegs or close-tracking, and are likely to remain on hold, hence providing liquidity to the economy. In countries where government deposits are supporting the banking sector (Kuwait, Qatar, and Saudi Arabia) liquidity might be mopped up. Tightening is likely in Tunisia, and possible in Iraq.

Oil-exporters (Algeria, GCC, Iraq and Libya) are performing better than oil-importers. Growth rates are declining below-potential, but – thanks to higher oil prices – the combined current account surplus almost doubled by end-2011, approaching $400 billion. Official reserves exceeded $1 trillion, and foreign assets rose. On average, in GCC countries current account surpluses rose to more than 20 percent of GDP. Mergers and acquisitions (M&A) are back on the agenda, although small in volumes and deal size. While natural gas exploration and infrastructure should stimulate the GCC economy, Qatar’s rapid hydrocarbon growth is likely to stabilize. Social demands fostered government spending, especially public-sector salaries. Going forward, higher expenditures will support growth and improve local liquidity, particularly in Libya, where economic output is bouncing back, and Iraq, Oman, Qatar and Saudi Arabia. Yet, fiscal breakeven prices – the price of oil needed to balance the fiscal accounts at current oil-outputs and spending levels – are rising. In 2013, oil-output might decline in Saudi Arabia, UAE, and Kuwait, possibly depressing local consumption and asset markets. Saudi Arabia will keep playing the role of swing producer, able to balance global energy demand and supply.

Oil-importers (Egypt, Jordan, Lebanon, Syria, and Tunisia) are likely to grow below-trend. Lower global growth, negative spillovers from the EZ crisis and Syria’s conflict kept growth well below-potential. Economic activity deteriorated because of declining investments, meager tourist arrivals, capital outflow, stock markets underperformance, widening sovereign-spreads, credit-rating downgrades, rising non-performing loans and high commodity prices. While remittances and exports helped stabilize income, governments increased spending on wages and subsidies to cushion food and fuel price-increases. Subsequent attempts to reduce subsidies, in particular fuel, struggled because of public pressures. Unemployment rose, and tax revenues decreased as a result of automatic stabilizers and – in some countries – tax breaks. Capital expenditures were reduced to avoid deterioration in fiscal balances. Yet, fiscal and trade deficits deepened, debt service increased, and international reserves declined. Economic reforms to support growth are needed, but the political transition is slow. Gross external and fiscal financing needs are projected at about $90-100 billion in 2013. As capital markets are unlikely to provide funds, in order to avoid sharp adjustments external-aid is expected, but not guaranteed. Except in countries where subsidies are cut, inflation should decline, driven by weak aggregate demand and lower food prices. To maintain competitiveness, looser monetary policy and greater real exchange-rate flexibility are needed.

North Africa (Maghreb): suffering the EZ recession, fragile growth ahead. Despite rising GCC investment, growth will be hampered by reduced demand from EU trading partners, lower remittances from the EZ-periphery, declining FDI, and higher import costs. Aid money is likely to be scarce, as the largest donors – the EU and the US – reduce fiscal deficits.

Algeria will maintain policy stimulus to avoid unrest. The government will draw on its reserves ($185 billion) to finance capital spending plans, so far delayed; indeed, only 40 percent of the 2012 $103 billion budget was implemented. As a result, growth will accelerate from 3.1 in 2012 to 3.4 in 2013.

Libya is in recovery, thanks to the resumption of oil production. The new government struggles to impose law and order, and to push economic diversification and job creation. Yet, growth is rebounding from -40.0 percent in 2011 up to 30.0 percent in 2012, and 10.0 in 2013.

Tunisia is still fragile, with manufacturing production hurt by EZ recession and strikes. The country’s institutional strength supported the recovery, but growth is slowing. The EU is the economy’s main market, accounting for 75 percent of exports and 72.5 of imports. Tourism employs 400,000 people and constitutes 7 percent of GDP. Drags on growth are the EZ recession and fewer touristic arrivals, put off by local protests and strikes. In Q2-2012, the economy grew by 2.1 percent, down from 4.6 in Q1-2012. In August, the central bank hiked interest rates by 0.25 percent because of inflation pressures. Planned subsidy-cutbacks will further increase consumer prices. Weaker tax revenues and rising welfare demands – total spending grew by 10.7 percent – will bring the 2012 budget deficit to about 9 percent of GDP. The current account deficit – at 8 percent of GDP and widening – hints at the need for IMF support. Still, growth is expected to accelerate from 2.2 in 2012 to 3.5 in 2013.

Levant (Mashrek): the Syrian civil war clouds the regional outlook. Russia and China’s veto on sanctions and foreign intervention, including the buffer zones proposed by Turkey, keep tensions brewing. The intensifying exodus of refugees (an estimated 100,000 fled in August alone), exacerbates sectarian divides in Lebanon, Iraq, Turkey and Jordan. A deterioration of fiscal and external balances will require foreign assistance.

Egypt is stagnating during the political transition. In 2011, subsidies accounted for more than 8 percent of GDP, but popular demands are rising and – despite foreign financial support – resources are getting scarce. The central bank keeps rates high to contain inflation pressures due to planned subsidy-cutbacks and to support the currency. The economy grew at about 1.5 percent in 2012, and is expected to grow at 1.9 in 2013. As tensions and social unrest are likely to reignite, IMF support is needed to stabilize the transition and improve investment prospects.

Lebanon suffers weak tourism and capital inflows. Sluggish demand weighs on banking and property activity. In H1-2012, asset growth eased to 3.6 percent year-on-year and transactions volume fell by -8 percent. Stricter visa requirements in the UAE might entail lower remittances. High government debt, at 135 percent of GDP, reduces the capacity to maneuver, but after months of stasis the ratification of the 2012 budget is a positive development. Despite Syria’s conflict, the economy should grow at 3.0 in 2012 and pick up to 3.8 in 2013.

Jordan faces weaker trade and rising commodity imports. In 2011, only 1.4 percent of GDP was budgeted for investment in health and education, but food and fuel subsidies accounted for more than 8 percent. As a result, fiscal and current account deficits are projected in double digits. Planned subsidy-cutbacks, if executed, will add to inflation pressures. As Egyptian fuel is getting costlier, more regional support, particularly from Saudi Arabia, and an IMF program are needed – and increasingly likely. The economy grew at 2.8 in 2012 and is expected to stabilize at about 3.0 in 2013. Political constraints are likely to hamper the economic reform program.

In the GCC, growth is supported by oil revenues and fiscal expansion. Between 2012 and 2013, GCC growth will decelerate from 4.6 to 3.8 percent; in Saudi Arabia, it will soften from 4.8 to 3.5; in Kuwait from 4.5 to 3.0. The Iran oil-embargo is lifting GCC production, especially in Saudi Arabia. As output volumes grow, revenues rise (at the expense of future income), reserves accumulate at central banks and sovereign funds, and civil-service wages and subsidies are rapidly increased to prevent social unrest, propping consumption. In 2011 Saudi Arabia increased government spending by 25 percent, mostly in entitlements. In Kuwait, where a political-deadlock hinders the implementation of the development plan, about 80 percent of the national labor force is employed in the public sector. In 2012, civil-service salaries were increased by 25 percent and 7 percent of GDP spent on fuel-subsidies. While GCC fiscal expenditures rose, higher oil prices and export volumes improved the fiscal balances. As current spending outpaced capital outlays, infrastructure investment and non-oil exports lag behind and competitiveness indicators deteriorate.

Most countries need oil at $90/barrel to meet spending commitments. Past savings can shoulder a few years of budget deficit if the fiscal position were to deteriorate because of lower oil revenues or higher expenditures. However, entitlements are hard to cut and in the long run will undermine the sustainability of both fiscal trajectory and growth model. Bahrain, held back by political constraints, is already running a deficit. Kuwait might start running deficit by 2017. The implementation of GCC employment nationalization policies will add to private-sector costs and reduce remittances to other Arab countries. At the same time, high public sector salaries increase reservation wages and crowd out private sector employment.

Inflation is expected to remain stable, at 3.2 in 2012 and 3.0 in 2013. Poor credit growth will constrain economic activities and stock market performance, which in turn will induce a rise in non-performing loans in the banking sector. The value traded on regional stock markets peaked at $1.6 trillion in 2006, dropped to $296 billion in 2010 and slightly recovered to $354 billion in 2011. In 2012, market liquidity is higher but not sufficient to prevent banks’ provisions and retrenchment. In Saudi Arabia and Qatar, credit prospects are better than in UAE – where growth has stabilized, benefiting from stronger trade and logistics – and Bahrain, still recovering from excesses of the previous boom. Intra-GCC FDI flows reached 40 percent of the total, concentrating firms’ geographical risk.

Iraq is growing strongly, supported by rising oil output. Oil output is rising, likely to reach 3.5 million barrels per day (bpd) in 2014. The economy will grow at 9.8 percent in 2012, to slow to 6.5 in 2013. Growth is supported by higher investments and rising electricity supply, while an expanding agriculture output is reducing import requirements. Political polarization – and uncertainty over profit-sharing across regions – is deferring infrastructure spending and reducing exports. As oil prices trend down on weaker global demand, revenue growth will slow into 2013, but weaker public investments should facilitate a small fiscal surplus.

Iran’s economy is contracting. With oil production operating at only 2.8 million bpd, less than Iraq, and August exports at less than 1 million bpd, the lowest level since the Iran-Iraq war, growth contracted -2.0 in 2012, and is expected to stabilize at 1.3 in 2013. The sanctions-driven currency-collapse made inflation spike (the official rates of 21.3 percent in 2011 and 21.8 in 2012 understate the real increase) and weakened domestic demand. The nuclear program continues to weigh on regional stability, providing an upside risk to oil prices. As the regime is unlikely to compromise, the risk of conflict rises over time, but remains unlikely. An Israeli strike on Iran, and Iran’s closure of the Strait of Hormuz, would lead to a spike in oil prices and hamper the region’s economy.

Since the beginning of the “Arab Spring”, not much has changed. Political evolution and economic recovery need structural reforms and fiscal discipline. Yet, while vacuums of power are getting filled, economic development is still inhibited by conflicts, political stasis, and weak governance. Health and education outcomes are below world-averages. Two-thirds of citizens have no access to financial services. Technology needs to be imported.  Powerful alliances between ruling and business families keep blocking competition to favor rent-seeking. Rent-extraction and nepotism widen income inequality. Monopolistic practices and administrative red-tape hamper job creation. The results are poverty and unemployment. About 50 percent of the population is under the age of 25, and 25 percent of the youth is unemployed. Brain drain is extensive: more than 40 percent of skilled workers leave Lebanon, almost 20 Morocco. A paternalistic use of economic rents ‘buys peace’ by increasing wages and living standards. Alas, meeting the demands of various economic groups is leading to higher public spending, larger budget deficits, and lower tax revenues. As a result, sovereign spreads are rising, capital outflows accelerating, and currencies depreciating. If economic history is a guide, rising debt levels might lead to defaults or – when money is printed – rising inflation.

Reform to recover, or face a prolonged stagnation. Unless MENA governments accelerate the political transition by building participatory institutions, and pursue meaningful reforms to quickly spur a rapid job-creating recovery, the region risks a few years of structurally-anemic growth and financial instability. To avoid economic hardship and income volatility – which tend to bring about political and social unrest, and eventually strongman rule – it is essential to limit élite-capture by amending rent-capturing regulations and create a viable private sector, hence enabling job-creation. As the region sits on top of large shares – 60 percent of oil, 45 of natural gas – of the world’s proven reserves of fossil fuel, and controls over US$ 1.6 trillion in assets, more than a third of global sovereign wealth, the management of national resources with increased transparency and accountability is also crucial. Perhaps most important of all, though, is building a middle class with visionary supra-national interests. Integration is needed to attract capital, reduce unemployment and retain talent. Given the potential size of the market – MENA’s 300 million consumers could reach 460 million through trade agreements with the “Union for the Mediterranean”, and 600 million with Europe – the benefits of a free trade area, a common market and a currency union are to be considered.