This paper was presented at the 1995 Oxford Energy Seminar. The views expressed are those of the author and not necessarily those of the International Monetary Fund. The author is grateful to Paul Chabrier and Sena Eken for their helpful comments. For the purpose of the analysis in this paper, the Middle East is defined to cover the Arab economies, Iran and Israel.
Like other developing countries, Middle Eastern economies are facing a rapidly changing external environment. In their case, the challenges arising from the process of globalization and integration of the world economy are compounded by changes in the regional context. The manner in which Middle Eastern economies react to these challenges will be a critical determinant of their process of economic growth and development including, most importantly, their ability to raise living standards and provide employment to a growing number of entrants into the labor force.
The purpose of this paper is to set out the main challenges facing Middle Eastern countries as a result of developments in the international and regional economies. To this end, it reviews the main external developments and their policy implications (section 2). The discussion addresses both major structural changes and the outlook for the more established channels through which international demand and supply conditions affect countries in the region. This analysis sets the stage for a general discussion of recent policy initiatives in several countries in the region (section 3).
Three principal messages emerge from this analysis: First, despite a more favorable regional context, countries cannot and should not look to their external environment to provide major stimuli to economic growth and development. Second, the external outlook accentuates the challenges facing the region because of internal economic and financial factors. Third, several countries have in place the right economic policy response to these challenges. The issue is to sustain implementation. The potential payoff is substantial since country-specific gains can be supplemented by region-wide benefits resulting from the linkages among countries.
THE CHANGING STRUCTURE OF THE INTERNATIONAL ENVIRONMENT
The economic performance of a country is the result of a complex interaction of a range of economic, political and social factors. On the economic front, two inter related elements stand out: the country's own implementation of measures and the influence of its external environment. This section addresses the second of these elements. In doing so, it distinguishes between (1) the impact of structural changes in the world economy; and (2) the evolution of the main price and quantity variables through which international demand and supply conditions influence the economies of the Middle East region. Given the ongoing changes in the regional economy, it also looks at the potential impact of the evolving peace process and the European Union's (EU's) new initiative for the region.
The international economy in which developing countries operate is undergoing a fundamental process of change. Two developments are particularly relevant in this regard:
• The conclusion of the Uruguay Round has given an important stimulus to the process of multilateral trade liberalization.
• Cross-border financial transactions have grown remarkably as evidenced by surges in capital flows to certain countries, developing country international placement of bonds and equities, and increased institutional linkages between firms in developing and industrial countries.
These changes entail both benefits and risks. On the positive side, the globalization and integration process provides for important efficiency gains, albeit with transitional costs as a result of associated resource reallocations. Of particular importance are the opening of industrial country markets and the greater availability of private capital to finance investment in developing countries.
Recent progress in multilateral trade liberalization provides for three important elements: (1) reductions in tariff and non-tariff barriers, (2) the extension of multilateral rules to new areas such as trade in services and intellectual property rights, and (3) the strengthening of rules and institutional structures, in\\eluding the establishment of the World Trade Organization. By reducing trade barriers in a credible and transparent manner and strengthening the underlying structure of multilateral trade, these changes provide the world economy with significant scope for greater welfare-enhancing trade interactions.1
At the same time, the internationalization of capital markets offers developing countries a larger pool of resources to supplement domestic savings in financing productive investments. Thus, private capital is now significantly more mobile in terms of its responsiveness to changes in expected rates of return. The importance of this is accentuated by the prospects for contraction pressures on industrial country aid budgets. There are also a number of positive externalities associated with this process, including greater access to market-based risk-management instruments that can reduce countries' vulnerability to unfavorable external price developments.
For these potential benefits to materialize, the domestic economic and financial environment must be appropriate. At the most basic level, this involves a stable macroeconomic framework and a sound structural base. Two aspects are of particular importance with regard to the latter: first, a responsive traded-goods sector that is able to exploit the dynamic opportunities arising from the changes in the international trade environment; second, a solid financial sector that is adequately supervised and regulated and has relatively deep and wide primary and secondary markets.
These conditions are also key to minimizing the risks associated with the process of globalization and integration, risks that are accentuated by the potential for "herd behavior" in international capital markets. Indeed, with a more open balance of payments, an economy becomes more vulnerable to shifts in sentiment. As a result, policy slippages translate more quickly into capital outflows, currency substitution, and disruptions to trade patterns. The economy also becomes more sensitive to developments in financial markets in other countries, the so called "contagion effect." These factors were vividly demonstrated not only by the international repercussions of the December 1994 Mexico crisis, but also by the impact of the February 1994 increase in U.S. short-term interest rates.
Relevance for the Middle East
The importance of these factors for Middle Eastern countries varies from country to country. This variation is not surprising given differences in countries' resource endowments, openness, depth of financial markets and development strategies. Nevertheless, two general points may be made:
• The changes in the multilateral trade environment will involve short-term costs as well as long-term opportunities. Offsetting these costs in a sustainable manner requires more adaptable trade regimes.
• Since the process of integration with international financial markets is less advanced in most Middle Eastern countries, especially when compared with economies in Latin America and Asia, these countries are less exposed to international transmissions of shocks through financial markets; at the same time, they are yet to exploit sufficiently a significant channel for the mobilization of investable resources.
(1) Trade in goods
Certain Middle Eastern economies may be expected to be adversely affected by two particular aspects of the Uruguay Round agreements: the gradual reduction in preferential arrangements, and reduced subsidization of food production in industrial countries (albeit to a lesser extent than initially envisaged).
Most Middle Eastern countries have enjoyed various trade preferences from their major industrial country trading partners;2 the notable exceptions are members of the Cooperation Council for the Arab States of the Gulf (GCC). Existing trade preferences for the region include specific agreements with the European Union, GSP treatment by Japan and the United States and, for a smaller set of countries, Least Developing Country treatment by the European Union, Japan and the United States. As a result of such agreements, the region faces a high incidence of zero-duty lines for a range of its non-oil-product exports. Consequently, the region's relative position will be eroded as the overall level of protection is reduced.
Food items account for almost 15 percent of the region's non-fuel import bill, with significantly higher shares for the GCC and non-Maghreb (North African) countries. The region's self-sufficiency ratios are lowest in the case of dairy products, rice, grains and sugar. With the expected reduction in subsidization of food production in industrial countries, many observers anticipate an increase in the prices of certain food items in the short run. This increase is expected to be offset over the longer run as hitherto adversely affected production in other parts of the world comes on stream.
The ability of Middle Eastern countries to offset these negative influences depends on their exploitation of the dynamic advantages of multilateral trade liberalization. The latter relate essentially to the potential for faster and more sustained trade-led economic growth. Several Middle Eastern economies' potential in this regard is constrained by a key factor: the lack of dynamism of the external sector at the individual country level. This comes out starkly when comparing the characteristics of the region as a whole with those of its constituent economies.
As a region, the Middle East appears to have an economy that is quite diversified and integrated into the world economy. It produces a range of primary products, has both an agricultural and manufacturing export base, and supplies labor services to the rest of the world. Its export markets are relatively diversified, as are the sources of its imports. The degree of interaction with the outside world appears quite high when measured by the traditional "trade openness index."3 For the region as a whole, this indicator averaged 66 percent in 1989-94. Not only is this the highest among developing-country regions but it is also greater than the average for industrial countries.
At first sight, this extent of diversification and trade openness would tend to place the Middle Eastern economies among those that are most likely to benefit from the multilateral trade liberalization process. However, this is not borne out by the studies on the matter. This apparent contradiction is explained when one looks at the circumstances of the individual economies in the region. Two aspects stand out in particular: First, the lack of product diversification at the individual economy level; and second, the nature of the trade openness, especially when one accounts for trade in oil and oil-related products.
The export performance of several countries in the region is dependent on developments in one or two sectors. This is particularly the case for the oil-exporting countries. Agriculture is particularly important for countries such as Somalia and Sudan. Indeed, diversification centered on the manufacturing sector is significant in only a few countries-essentially, Israel, Morocco and Tunisia. This lack of diversification at the country level translates into significant fluctuations in terms of trade. Using GDP weights, Middle Eastern countries were subject to fluctuations in their terms of trade in 1989-94 that were 15 times higher than for developing countries as a group and 30 times higher than for industrial countries.
The extent of trade integration with the world economy also varies sharply among economies in the region. Economies with particularly high openness-indicator ratios are the GCC economies and those with important oil and reexport activities. Sharp variations are also apparent when looking at per capita export measures. The per capita exports of GCC countries and Israel are near or above the industrial country average (of $4,300 for 1989-94). At the other end of the spectrum, several countries have exports that are equivalent to less than $315 per capita.
(2) Capital flows
In contrast to changes in the international trade environment, the region is being less affected by the ongoing process of globalization and integration of financial markets with the exception of a few countries. This is brought out starkly by two quantitative indicators relating to the Arab economies:
• The region has attracted a disproportionately small share of recent international equity flows to developing countries-less than 1 percent according to certain estimates.4
• The total flow of private capital (i.e., equity, bond and foreign direct investment) to the region has only been about 2 percent of that going to developing countries.5
Not surprisingly, effective equity market capitalization in most countries in the region is low-albeit growing. This has reflected the dominant role of the public sector, as well as the closed, family-owned nature of many private sector companies in the region.6 The financial sector in many of these countries has been almost exclusively bank-based with, until recently, significant controls on rates of return and sectoral allocation of credit. Finally, some of the existing equity markets, including those in the GCC, retain barriers to direct foreign investor participation.
The relatively limited inward flow of portfolio capital has been accompanied by significant capital being held outside the region by residents of the region. Moreover, there have been almost no direct placements of Middle Eastern financial instruments in international equity and bond markets (the major exceptions being Israel and, more recently, Jordan, Lebanon and Tunisia). This is in sharp contrast to other developing countries, especially in Asia and Latin America. These countries have found two major advantages to such placements. The direct benefit comes from the mobilization of funds in large markets (e.g., through Euro-bond issues). The indirect effect comes from the benefits of increased name "recognition" which can translate into favorable effects on markets and direct investment flows.
Superimposed on these structural factors is the more traditional set of influences emanating from developments in international demand and supply conditions. Of particular relevance in this regard are prospects for the region's exports of oil and oil products, exports of non-oil products and receipts of remittances from nationals working abroad. Variations in oil prices translate into important repercussions for the export receipts of a number of countries in the region. Thus, at current export levels, a $1 variation in prices translates, other things being equal, into a $6 billion change in receipts for the eight major oil exporters.7 As regards future prospects, there appears to be some convergence of expectations on the outlook for the oil market in the medium-term. Thus, while demand is expected to rise, the anticipated evolution of non-OPEC supplies is such as to result in only a marginal increase in OPEC output/international prices. Moreover, even this scenario of moderate demand growth for existing OPEC oil exporters is subject to an important downside risk-that emanating from the potential return of Iraq to the market.
The prospects for the region's non-oil exports appear more favorable. Projections undertaken in the context of the IMF's World Economic Outlook exercise point to a growth in real demand in partner countries of some 5 percent per annum in 1996-2000.8 Accordingly, non-oil exports can provide a contribution to growth in some countries. The limitation in this regard relates to the lack of export diversification discussed earlier. Turning to labor flows, the outlook for relatively buoyant economic activity in industrial countries may not translate into growing employment opportunities for nationals of the Middle Eastern countries. First, although growth in these countries as a group is projected to remain at about 2.5-3 percent a year through the remainder of the decade, unemployment levels are expected to remain high, reflecting the structural rigidities in the labor market.9 Second, large unemployment levels in several European countries, related sociopolitical factors, and the flows of workers to the EU from central and eastern Europe will likely constrain the demand for migrant labor from the Middle East region.
Labor movements within the region are unlikely to offset the lack of increased demand from the EU. The major regional market (the GCC) is facing the challenge of absorbing a large number of its own nationals entering the labor market at a time of some retrenchment in public expenditure-an important contributor to aggregate demand and employment in these economies. At the same time, the market for Palestinian labor in Israel (particularly from Gaza) has been adversely affected by Israel's closure of border crossings and its substitution of Asian labor for Palestinian workers.
THE REGIONAL CONTEXT
In order to obtain a complete picture of the Middle Eastern countries' external environment, it is necessary to supplement the analysis of the international outlook with a brief discussion of the regional context. Two issues stand out in this regard:
• The potential impact of the ongoing peace process and
• The evolving relationship with the EU under the auspices of the latter's "Mediterranean Basin Initiative."
The region has made significant progress, albeit uneven, in resolving the longstanding Arab-Israeli conflict. Egypt and Jordan have signed peace treaties with Israel, while progress has been achieved between the Palestinian Authority and Israel. Syria and Israel are holding their own set of peace negotiations. Regional economic conferences have been organized, the latest in Amman in October 1995.
The economic arguments for a potentially beneficial impact of a regional peace are based on the analysis of the costs of the conflict. It is generally agreed that the conflict has adversely affected the region through three channels:10
• First, it has provided an impetus to what are the largest military outlays among developing country regions.11 Such outlays have contributed to macroeconomic imbalances and/or diverted resources away from more productive uses, including investments in human resources and in the social sector.
• Second, the resulting negative impact on sociopolitical risk assessments has acted as a disincentive for investments by lowering the expected rates of return.
• Third, opportunities for welfare enhancing regional projects have not been exploited.
The establishment of peace can serve to counter these factors provided the peace is a comprehensive, just and durable one, and that it is accompanied by appropriate economic policies. Given the history of the conflict, the establishment of region-wide economic and financial ties may well take time to flourish, notwithstanding the prospects for more rapid advances for certain bilateral relations.
The second major development relates to the region's evolving economic relations with the European Union. The EU has recently launched a new initiative targeted at the progressive establishment of a "Euro-Mediterranean Economic Area." In the economic area, the emphasis is on (1) the private sector as the engine of investment and growth and (2) the establishment of free-trade zones between the EU and Mediterranean countries.12
To facilitate the transition process, the EU Council decided to provide ECU 4.7 billion of grant assistance to the region in 1996-99. This amount is to be matched by loans from the European Investment Bank. Accordingly, over $12 billion will be available. At this time, there are no a priori country allocations. Disbursements are to be made on the basis of each recipient country's progress in implementing economic reforms.
PUTTING IT ALL TOGETHER
Putting these various factors together leads to a simple but important conclusion. While there are positive regional developments, the region as a whole is facing-at best-the prospects of a broadly neutral international environment, with important downside risks.
The region, with the exception of some countries, is not in a position to look to its external markets as a means to stimulate economic growth and reduce internal and external financial imbalances. Most countries' trade regimes are not diversified enough to exploit significantly the opportunities emanating from the multilateral trade liberalization process-this when the outlook for non-oil export prices is relatively favorable. At the same time, several countries in the region are likely to experience an erosion in their preferential access to certain markets. Finally, most countries in the region are not as yet in a position to exploit the opportunities arising from the process of capital-market globalization and integration.
The policy implications of these findings are accentuated by the possibility of a significant downside risk: the potential for a marked fall in oil prices should Iraq's return to the oil market not be undertaken in an orderly fashion. Such a fall would further dampen demand for intra-regional labor flows, thereby compounding the impact of relatively sluggish demand from outside the region.
The regional aspects discussed above provide some offset to these factors, particularly with regard to the EU Mediterranean Basin Initiative and positive aspects of the peace process. Here again, the translation of potential welfare gains into actual welfare gains will depend on having in place the right economic enabling environment.
THE POLICY FRAMEWORK
Recognition of the more difficult economic environment has been an important stimulus to the formulation and implementation of economic adjustment and reform efforts in the region. Countries vary in the extent to which they have already progressed in the process. This, together with differences in countries' starting positions, means that a country-by-country approach is best suited for assessing the remaining challenges, an approach that lies outside the scope of this paper. Nevertheless, some general comments may be made employing, for presentational purposes, two broad country groupings.
As regards the non-oil countries, several of them (including Egypt, Jordan, Morocco and Tunisia) have taken steps in recent years to strengthen their financial balances.13 These steps include (1) reducing fiscal deficits, (2) improving the structure of their budgets and (3) containing domestic liquidity growth while enhancing the process of financial intermediation. These efforts have contributed to reductions in inflation and an increase in official international reserves notwithstanding adverse exogenous developments, particularly unfavorable weather conditions.
The macroeconomic stabilization measures have been accompanied in some of these countries by reforms aimed at increasing private investment (from domestic and foreign sources) and enhancing the economy's growth and employment-creation potential. These reforms have sought to correct a relatively unresponsive economic structure that has prevailed as a result primarily of the pursuit of an inward-oriented strategy led by the public sector. The reforms have involved (1) expanding the range of activities available to the private sector through privatization and deregulation (2) liberalizing the external trade and payments regime through reductions in tariff and non-tariff barriers; (3) improving the regulatory and incentive environment by harmonizing procedures, removing controls, and leveling the playing field for private and public-sector activities; and (4) strengthening the provisions of the social safety net aimed, inter alia, at protecting the most vulnerable segments of the population.14 Notwithstanding recent progress, the policy agenda remains a challenging one, requiring continued determined implementation of macroeconomic adjustment and reform policies. Nevertheless, the progress to date made by some countries on these fronts-particularly Jordan and Tunisia-can provide important demonstration effects for other economies in the region.
The recent actions by countries in the GCC as well as Algeria provide significant insights into the adjustment and reform strategies of the oil-producing economies. Specifically, the medium-term plans adopted or under formulation in a number of these countries share three important and related elements on the economic front: (1) specified timetables to reduce fiscal deficits through revenue and expenditure measures that also strengthen the structure of the budget in a lasting manner, (2) emphasis on the private sector as the main source of investment and employment creation, and (3) priority on human-resource development as an essential factor for ensuring high and sustainable private sector growth.
These measures come at an important time in the process of economic development of these countries. In addition to the oil-market uncertainties discussed earlier, the drawdown in official foreign assets since the 1990-91 regional crisis-from very high levels has led to a decline in earnings from foreign investments, the second most important source of budgetary receipts for these economies. Also, in some countries, the budget deficits of recent years have resulted in a buildup of domestic public debt whose servicing imposes a burden on public resources.
The reduction in fiscal deficits is the main macroeconomic instrument available to policymakers in these economies to reverse the drawdown in foreign assets. Improvements in the budget will not only reduce financial pressures but will also ensure that the economies are better placed to deal with the vagaries of the oil markets. For example, Saudi Arabia's measures in its 1995 budget to enhance non-oil revenues and further reduce and rationalize spending serve both to lower the deficit and strengthen the structure of revenues and expenditures.
Given the structure of the economies, fiscal retrenchment will have a dampening effect on the non-oil sector in the short run. Thus, the emphasis is on structural reforms to stimulate efficient growth of the private sector. This would serve to minimize the short-term dampening effects of fiscal adjustment while providing a stronger basis for high and sustainable medium-term growth. Therefore, steps to privatize and deregulate will serve to broaden the range of activities available to the private sector; they will also enhance the scope for foreign investment. This will strengthen the foundation for self-sustaining employment growth over the medium term when a larger number of nationals will be entering the labor force.
As illustrated by a number of countries, human-resource development provides the other necessary element of a sustainable strategy for growth and development. Accordingly, the renewed emphasis in these countries on training and other factors in human-resource enhancement seeks to ensure that the growing labor force has the appropriate skill mix to exploit employment opportunities, thereby strengthening the foundation for sustainable growth.
Middle Eastern countries will continue to be strongly influenced by developments in their external environment. The analysis of this paper suggests that most of these countries cannot and should not look to the international economy to provide an important stimulus to their growth and development process in the near future. Indeed, there is significant downside risk overall, notwithstanding improvements in the regional economy. This accentuates the challenges that the region faces as a result of a growing population, low living standards in certain countries, and vulnerability to adverse exogenous developments.
Concurrently, it puts a premium on the sustained implementation of sound economic and financial policies. The progress made by several countries in the region provides important and encouraging signals in this regard. The rewards of a more generalized process of economic reform in the Middle East are promising, as region-wide benefits can serve to supplement the gains of individual countries.
1 See I. Goldin, O. Knudsen and D. van der Mensbrugghe, Trade Liberalization: Global Economic Implications (OECD/World Bank, 1993).
2 Details are contained in P. Chabrier, M. El-Erian and R. Moalla-Fetinia, "The Implications of the Uruguay Round for the Arab Countries," in S. El-Nagger, ed., The Impact of the GAIT Agreements on Arab Countries, (Washington, DC: International Monetary Fund, 1995).
3 This is defined as the ratio of the sum of exports and the absolute value of imports to national income.
4 S. Bates, "Investments: A European View," paper presented at the London Conference on Financial Markets in the Middle East, April 28-29, 1994.
5 A. Hovaguimian, "The Role of Financial Institutions in Facilitating Investment and Capital Flows," in S. El-Naggar, ed., Financial Policies and Capital Markets in Arab Countries, (Washington, DC: International Monetary Fund, 1994).
6 M. El-Brian and M. Kumar, "Emerging Equity Markets in Middle Eastern Countries," Staff Papers, vol. 42, no. 2, 1995.
7 In order of importance they are Saudi Arabia, Iran, the United Arab Emirates, Kuwait, Libya, Oman, Qatar and Algeria.
8 World Economic Outlook, (Washington, DC: International Monetary Fund, 1995).
9 Unemployment in the EU currently averages almost 12 percent, with double-digit rates prevailing in several countries.
10 Details are contained in S. Fischer, D. Rodrik and E. Tuma, The Economics of Middle East Peace, (Cambridge, MA: MIT Press, 1993).
11 Based on data (GDP ratios) contained in D. Hewitt, "Military Expenditures Worldwide: Determinants and Trends, 1972-88," Journal of Public Policy, vol. 12, 1992; and M. Knight, N. Loayza and D. Villanueva, "The Peace Dividend: Military Spending and Economic Growth," IMF Working Paper, WP/95/53, 1995.
12 Agreements have been reached in the cases of Israel, Morocco and Tunisia. Negotiations were ongoing with Algeria, Egypt, Jordan and Lebanon.
13 For Tunisia, see Saleh Nsouli et al., The Path to Convertibility and Growth: The Tunisian Experience, Occasional Paper Number 109, (Washington, DC: International Monetary Fund, 1993); for Morocco, see Saleh Nsouli et.al., Resilience and Growth through Sustained Adjustment: The Moroccan Experience, Occasional Paper Number 117, (Washington, DC: International Monetary Fund, 1995).
14 For details, see M. El-Erian and S. Tareq, "Economic Reform in Arab Countries: A Review of Structured Issues for the Remainder of the 1990s" in S. El-Nagger, ed., Prospects for Arab Economic Development, (Washington, DC: International Monetary Fund, 1993).