The main challenge facing Middle Eastern economies today is to grow at a high and sustained rate. This is needed to (1) improve living standards and basic social conditions, particularly in the poorer, non-oil-exporting countries of the region; (2) reduce existing levels of unemployment in some economies of the region; and (3) provide jobs for an increasing number of nationals entering the labor force.
The challenge facing Middle Eastern economies in not an easy one. Per capita income growth in the last few years has been disappointing, both in absolute terms and relative to other developing regions. The challenge has also been accentuated by pressures emanating from a young and rapidly growing population. Compounding all this is an international economic system that is changing structurally in such a way as to enhance benefits for the rapidly reforming countries and marginalize more quickly the countries lagging in policy reforms.
Not surprisingly, therefore, economic growth is at the top of the policy agenda for most, if not all, countries in the region. A critical input into their ability to meet this challenge is an improvement in the level and efficiency of investment in human and physical resources. Indeed, many economies in the region have now embarked on a significant strengthening of the economic-policy stance, allowing for enhanced investment and meeting, in a durable fashion, their growth challenge.
To provide an insight into the way in which the region's investment climate may be improved further, this paper focuses on two issues:
· The recent investment performance of the Middle East region in an absolute sense and relative to other developing countries; and
· The economic and financial policy implications, including the evolving economic relations with the European Union (EU).
As the analysis is conducted at the level of the region as a whole, it does not address differences among economies - including economies that vary significantly in terms of economic attributes and performance. Nevertheless, the findings of the paper are applicable to most, if not all, economies in the region.
The analysis in the paper indicates, as recognized by policy makers, that there is an important need to upgrade the region's investment performance. The policy requirements in this regard are the same as those needed if the region is to realize the large gains associated with changes in the regional and international economy, including for those economies participating in the Euro-Med Initiative. Fortunately, the availability of private financing is not a major problem. The strengthening of policies, supported by timely availability of official financing to certain of the poorer economies, may be expected to enhance national saving - a critical issue - and unleash inflows of foreign investment and repatriation of resident capital held abroad. Indeed, some countries, such as Egypt, are already experiencing a significant pick-up in private capital inflows.
WHY SHOULD WE CARE SO MUCH ABOUT INVESTMENT?
The large and expanding literature on the topic agrees on the importance of investment in the growth process. Thus, while investment spending is typically small in comparison to consumption and government outlays, it is viewed as the most important component of GNP. It holds the key to building human and physical capital, as well as transferring recent technological and managerial advances. As a result, investment can affect the transition to, and the nature of, the long-run, steady-state growth path of the economy.
From an empirical point of view, study after study has pointed to the fact that countries with high and efficient investment tend to grow faster. Specifically, the growth effects of investment depend on the size of the capital stock, its composition and its efficiency. Of course, there are important differences in the efficiency of investment across countries, as well as across different sectors in the same country.
The private component of investment expenditure, be it from domestic or foreign sources, depends on the expected return to the investment activity and the cost, actual and forgone. Variables include demand conditions, interest rates, and determinants of particular income streams (such as remittances or external terms of trade). These variables have been incorporated in different ways, with a suitable lag structure, in the various models of investment.
Private investment's contribution to economic growth is also linked to the role of public investment. There can be both positive and negative effects. The public sector can, and must, undertake critical investments in basic infrastructure, basic health and education that the private sector is either unable or unwilling to do, thereby "crowding in" private investment over time. This is particularly the case for investment in the basic social sectors. This is one of the lessons of the "East Asian miracle." Indeed, the experience of the "high-performing Asian economies" (Japan, Korea, Singapore, and the Taiwan Province of China) shows the importance of placing emphasis on primary education and basic health services early in the development process.
Public investment can also adversely affect private investment. If associated with high fiscal deficits, it can put pressures on interest rates and credit availability, thereby "crowding out" private investment. It can also contribute to macroeconomic imbalances, thereby reducing the risk-adjusted return to private sector activities.
INVESTMENT IN THE MIDDLE EAST
A number of significant observations emerge from the review of investment development in the Middle Eastern region.1 I would mention five in particular:
1. Investment has been low: Capital formation levels in the region have been below the average for developing countries as a whole and well below the average for the fast- growing Asian countries. The gap is not insignificant. In 1995-96, for example, the investment-to-GDP ratio in the Middle East was only two thirds that in Asia.
2. There has been a convergence in the investment performance of the oil and non-oil Middle Eastern economies: Both groups of countries now channel relatively equal amounts of resources to investment activities despite the differences in their endowments and income levels. Nevertheless, important differences exist among individual countries.
3. Changes in investment levels have been closely correlated with developments in international oil prices: Fluctuations in investment levels correlate, with some Jag, to international oil-price developments - not only for oil producers but also for the non-oil producers, reflecting the linkages through remittances and, to a lesser extent in recent years, capital flows.
4. The ratio of public to private investment is relatively high: The public sector accounts for a higher share of investment in the Middle East than in other developing-country regions, consistent with the dominant role that the government has tended to play historically in production and employment. Given the low level of overall investment, the region's private sector investment spending has been well below that of other countries - e.g., half the level of that in Asia (in terms of GDP).
5. The region has attracted little foreign direct investment and, until very recently, was largely bypassed in the surge of portfolio capital to developing countries: Foreign direct investment inflows have been low, with an important portion associated with the energy sector. As a result, the region has forgone not only the additional investment funds but also the associated transfer of know-how and technology. Moreover, until 1996, the region had attracted a disproportionately low share (less than 1 percent) of the portfolio capital that flowed from industrial to developing countries; this has started to change in response to the reforms being implemented by governments. Finally, residents continue to hold significant capital outside the region.
These five observations support the policy view that, first, there is an urgent need to increase the level of investment; and second, the process should be led by private-sector investment from domestic and foreign sources. This view is now held by most, if not all, countries in the region and, in many cases, is reflected in a marked strengthening of economic policies, as discussed below.
Regarding the efficiency of investment, the general impression is that this has been an issue in some countries, especially in the public sector. An illustration of this is contained in recent studies on the return from public investment in education and health - key factors impacting the long-term growth and development potential of the region. For example, the Arab countries have been shown to spend more public resources on education in terms of GDP than any other developing-country region; similarly for health. Yet the outcome in terms of human-resource development has been rather disappointing.
The explanation for this relates to,
· The composition of expenditure - for example, too large a share being devoted to higher education compared to primary education;
· Weak delivery systems; and
· Inadequate incentives to maximize the return from investments in human capital (particularly, labor-market distortions).
This leads to the third policy priority: improving the return from a given dollar of investment in the region while maintaining a high level of spending on the social sectors.
Having identified the policy priorities, the question now is how to meet them. Here, I can be brief. as there is very little new to say. Indeed, there is broad agreement on the three critical aspects for sustainable and efficient investment:
· A stable macroeconomic situation;
· Structural reforms to enhance the return from, and effectiveness of, private and public investments; and
· Strengthening institutional and informational mechanisms.
On the macroeconomic front, significant progress has been made in Middle Eastern economies in recent years. Inflation rates have fallen sharply, particularly in the non-oil countries. There has also been an increase in international reserves. The principal reason for the improved domestic and financial balances lies in the sharp reduction in fiscal deficits. This has allowed lower monetary growth and greater scope for credit financing of productive activities in the private sector.
Looking forward, continued emphasis needs to be placed on fiscal consolidation and reform. In particular, the free-trade component of the Association Agreements with the EU will entail a reduction in taxation of international trade with an increasing need for taxation of domestic activities.2 For most countries, this implies broadening consumption and income taxation and improving tax administration and collection.
The implementation of structural reforms is, in general, less advanced in the region, notwithstanding significant progress in some countries. Non-GCC countries still stand out internationally in terms of the public sector's dominance of the economy and a relatively high level of external tariffs.3 In the case of the GCC, an important issue is the still restrictive - albeit declining- limit on foreign participation in certain countries' banking and capital markets.
Recently, there has been a marked change in Middle Eastern governments' approach to structural reforms. Increasing emphasis is being placed on
· Deregulating domestic activity, including opening up segments previously reserved exclusively for the public sector;
· Increasing external trade liberalization;
· Broadening and deepening financial markets; and
· Strengthening social safety nets to protect the most vulnerable groups of the population, particularly during the reform period.
In the case of public investment, continued progress is required in assessing the efficiency of spending, reducing low productivity outlays, and increasing the resources devoted to essential infrastructure, basic education and health services. Progress will also need to be made in the areas of civil-service and labor market reforms.
Progress in the macroeconomic and structural reform will need to be accompanied by the further strengthening of institutions and institutional mechanisms, as well as improved information flows. Indeed, international experience clearly demonstrates that these factors, while tending to attract less attention and glamour, matter a great deal in the process of economic development.
Internationally, we are seeing an important trend encompassing better provision of timely economic and financial data to the markets, as many countries are finding it in their interest to do so. Such information can enhance international assessment of economic developments in the region, overcome market imperfections resulting from information failures, and prevent undue or excessive financial market disruptions.
The region has made progress in this regard with several countries having obtained sovereign risk ratings. Corporations have also moved in this regard, assisted by institutional strengthening (including a recent regional rating joint venture involving the Arab Monetary Fund). Nevertheless, there is scope for improving the provision of economic and financial information to the market in terms of both coverage and timeliness.
To complement this recent progress, steps are also needed to
· Improve coordination between the various economic and financial authorities;
· Strengthen central monitoring of developments in an overall macroeconomic framework; and
· Enhance regulatory structures including anti-trust legislation, clearer property rights, and strengthened prudential supervision.
Regional institutions, both existing and new ones, and regional initiatives will also play an important role. In this regard, much attention. is being devoted these days to the impact of the growing economic integration between the EU and the eastern and southern economies of the Mediterranean basin.
The Euro-Med initiative impacts the process through five major channels:
· It enhances public awareness and debate of the structural-reform challenges facing the economies of the region;
· It provides important economic roadmaps for domestic and foreign investors, particularly with respect to the underlying private-sector-led growth strategy and the timetable for external trade liberalization and harmonization of standards;
· It can enhance the credibility of the adjustment and reform efforts of Middle Eastern economies by effectively anchoring them to the EU;
· It will strengthen the incentives for greater welfare-enhancing economic integration among the countries of the Middle East; and
· Finally, the financial resources made available by the EU through grants and financing by the European Investment Bank can facilitate what promises to be a challenging transition.
It is important to stress that there are significant risks and that the benefits will not materialize automatically. Much will depend on the nature of the Association Agreements (the EU's treatment of the agricultural sector is an issue here) and the sustained implementation of adjustment and reform efforts by Middle Eastern economies. Also, the Euro-Med initiative currently excludes an important number of countries in the Middle East, thereby limiting the scope for exploiting the full range of welfare-enhancing opportunities within the region.
The Middle East is facing an important growth challenge. To meet this challenge, investment needs to be increased and its efficiency improved. The stakes are high, and the returns from reform considerable.
Policy makers recognize the challenges and opportunities facing their economies. They have stressed that their countries are now "open for business." For domestic and foreign investors to respond in a vigorous and sustained manner, recent improvements in countries' financial balances need to be accompanied by continued progress in structural reforms and strengthened institutional and information mechanisms - thereby strengthening the basis for high economic growth and significant employment creation.
* This paper was presented to the EuroMed Financial Focus Convention held in Italy June 5-7, 1996. The author thanks Amer Bisat, Christopher Browne and Nemat Shafik for their helpful comments and Peter Kunzel for efficient research assistance. The views expressed in the paper are those of the author and not necessarily those of the IMF.
1 An in-depth discussion of investment and growth in the region is contained in Bisat, El-Erian, El-Gamal and Mongelli (1996), "Investment and Growth in the Middle East and North Africa," IMF Working Paper, WP/96/124, November.
2 Association Agreements under the recently launched Euro-Med Initiative have been concluded as of March 1997 between the EU and each of Israel, Morocco and Tunisia. The EU is currently negotiating with other economies including Algeria, Egypt, Jordan, Lebanon and Syria as well as the Palestinian Authority.
3 The members of the GCC (Cooperation Council for the Arab States of the Gulf) are Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and United Arab Emirates.
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