Outlook 2007: From Great to Good

In short, the region's performance is expected to go from Great in 2003-2006 to Good in 2007. This should not, however, bring on the doomsayers. The deceleration in growth is due to both much higher base effects and lower oil prices and production. Fiscal accounts will, in the main, remain deeply in positive territory for the oil producing nations, and this should allow investment to become an increasingly important driver of growth going forward. Finally, we expect inflation rates to ease somewhat in most countries, although remain high in Qatar and the UAE.

At a more structural level, and using the themes and terminology developed by Jim Collins in his book Good to Great, few countries are showing qualities that will lead their economies on the road from Good to Great, irrespective of what happens to oil prices. This does not rule out economies continuing to perform well as oil prices remain high. However, it does suggest that few will fully leverage the opportunity that huge oil revenues create. Indeed, high oil prices may get in the way of any such transition. In the words of Collins himself, 'Good is the enemy of Great'.

The recent economic performance of the Middle East region has been spectacular. Nominal growth is expected to have averaged 17.6% in the four years to 2006 (according to IMF data), compared to China's 15.1%. However, economic growth in the Middle East is likely to have peaked in the second quarter in 2006 as oil prices fell back in Q3, undermining GDP growth for the oil producers. Indeed, we continue to forecast oil prices to average USD 57pb in 2007 (West Texas Crude), down from an average USD 66pb in 2006. Add in the production cuts that OPEC has announced (1.2mbpd in October and a further 500kbpd from Feb 1) and it is clear that nominal and real growth will slow from the rapid pace of the past four years.

While the region is expected to decelerate, this is not a time for the doomsayers. Nominal growth is expected to post around 9.6% in 2007, based on the countries covered on pages 8 and 9. This compares to 16.9% in 2006.

For Gulf Cooperation Council (GCC) countries, the deceleration in growth notwithstanding, fiscal positions will remain extraordinarily healthy. Indeed, for the region as a whole, we expect the fiscal surplus to remain a healthy USD 155bn, still over 10% of GDP, with the GCC accounting for over 95% of this and averaging 19% of GDP. This should allow investment to become an even more important component of growth going forward. Outside of the GCC, Libya, Iran, and Algeria will face similar forces to the GCC countries in terms of lower oil prices and production and thus growth is expected to slow. For Algeria and Libya, with their strong fiscal positions remaining intact, investment will also remain strong and for the former, rising gas exports will likely offset declining oil revenues. For Iran, the focus is on social spending, and the country's weak fiscal position means that it may pay a price for this in the medium-term.

Outside of the major oil producers, Egypt is expected to slow only moderately as reform continues in 2007. Morocco is expected to see growth slow in 2007, but Tunisia is expected to see a modest improvement (to 6% from 5.8% in 2006). Finally, oil-importing Jordan's economy is expected to slow in both nominal and real terms, despite immediate benefits from lower oil prices as the base of comparison has risen dramatically and lower oil prices may slightly reduce the level of inward FDI.

Inflation is expected to moderate for most countries in 2007. This is most obviously the case in the UAE. We estimate that inflation will plummet to 7.3% in 2007 from 13.8% in 2006. This is based on an expectation that rent increases in Abu Dhabi will decelerate dramatically after the Emirate imposed a 7% cap on rent increases this year. A similar decision in Dubai has not changed our forecast, although it does reduce the uncertainty surrounding it. Qatar is also expected to see inflation ease somewhat, although not dramatically. The most notable exception to the declining inflation trend is Iran where very loose fiscal policy and negative real interest rates are expected to contribute to an acceleration.

As far as external balances are concerned, we expect the region to remain a strong source of liquidity on the global stage. Current account surpluses are expected to fall to a still extremely healthy level of USD 260bn - down from USD 290bn in 2006 - or over 18% of GDP. GCC countries are expected to account for over 80% of this surplus. These huge current account surpluses will ensure a continued build-up of foreign assets, both intra- and extra-regionally. This will help protect the outlook for long-term government revenues and thus boosts even further the ability to invest in the economies in times of economic weakness. As such, the longer the oil boom continues, the less likely it is to turn to bust. This is why we believe the economic prognosis is a move from Great to Good, not Bad.

Of course, such a deterioration in economic climate is only to be expected. Few economies can expect to grow at over 15% year in-year out. However, what is interesting is the foundation of the current strong economic performance, unlike in China, is extremely narrow and unless oil prices continue to go higher over the long-term, growth will be constrained by the increase in oil production. Few would doubt that it is theoretically possible to exceed this performance given the wealth that is being generated by the region as this creates the funds to invest in the economy. This begs the question, what would it take to broaden the base of the regional economy and thus go from Good to Great on a structural level?

Here, we use the concepts developed in Jim Collins' book, Good to Great, to see where different countries lie on the road to becoming truly Great. The aforementioned book relates to companies, not countries. However, the idea of the leader of a country being a CEO was first promulgated in East Asia, in Singapore and Malaysia. In the Middle East, the UAE, and Dubai in particular, is also seen in this light. Therefore, exploring these concepts could be useful in determining where different countries are on this journey and also for interpreting whether future actions are consistent with this direction.

Collins highlighted seven key concepts in his analysis of corporate greatness:
1) Level 5 leadership
2) First who...then what
3) A culture of discipline
4) Confront the brutal facts (yet never lose faith)
5) The hedgehog concept
6) Technology accelerators
7) The flywheel and the doom loop

Let us explore each of these in turn.

Collins describes Level 5 leadership as 'builds enduring greatness through a paradoxical blend of personal humility and professional will'. It is clear that the region has some good leaders with the power and insight to drive the economy forward. Good examples of this are in the UAE and Qatar. Elsewhere in the region, it is harder to judge due to factors that constrain the ruler's effectiveness. Two good examples here are Kuwait, where the reform-unfriendly parliament is getting in the way of significant reforms, and Saudi Arabia, where the King wants to accelerate economic reform at a faster pace than he is able to. But the overall political machinery in most countries means that great leadership is difficult to find - some would argue this is the case the world over, of course.

The second concept is that of the need to get the right people on the bus first, before deciding what the optimal policies are. This is clearly an issue in the region. Even in countries that have strong leaders, there are concerns, rightly or wrongly, about the 'bench strength' of the leadership team, especially during a phase of dramatic growth.

Meanwhile, it is well acknowledged the educational systems in the region are failing to produce workers with the skills sets that match the opportunities in the workplace and a lot of work is required to change this to churn out the appropriate type of employees in sufficient quantities. In the Gulf countries, in particular, this gap is being filled by expatriates, which raises the question of who the growth is benefiting.

Finally, as far as the private sector is concerned, incentivisation may be an issue. Local workers can often easily find jobs in the public sector with shorter hours, better working conditions and better pay than the private sector can offer if it wishes to remain competitive. As such, the incentive to acquire the skills and maintain the discipline required in the private sector is diminished. Former Singapore Prime Minister Goh Chok Tong once described China as an 800-pound trading gorilla that is very hungry. Without this hunger, incentivising people to create value through education and innovation gets harder. This is the same problem the western world is increasingly facing.

On confronting the brutal facts, the region registers reasonably well. The December edition of the Middle East Focus highlighted the exposure of the GCC countries to oil prices. However, we get the sense that, while this is acknowledged, it is increasingly not seen as a problem. This can be seen by the significant expansion in government spending and thus increase in the break-even level of oil prices. Bahrain's investigation into the merits of unemployment insurance and the suggestion (later ruled out) in Kuwait that the government should pay off consumer loans indicates the perceived permanence of high oil prices that was not evident 18 months ago.

The Hedgehog concept is the most difficult to judge. Put simply, this concept states that you should try to focus on what you are passionate about, can be the best in the world at and what drives your economic engine. This actually suggests that you should not diversify into areas that you cannot be a true world leader. Clearly, much of the diversification we have seen, such as aluminium smelting and petrochemicals have been into areas where the countries should have a competitive advantage. Meanwhile, it is possible that Dubai will become a world leader in tourism and/or financial services while Bahrain could retain its status as the world leader in Islamic finance. However, what worries us the copycat nature of a lot of diversification, particularly in the areas of tourism and financial services. While it is theoretically possible that each country carves out a niche - for example, the more Arabian culture and eco-friendly tourism offering in Oman - it is a stretch to believe that all will be world leaders in these spaces.

What has also surprised us that countries have not really focused on being an energy-provider. This may sound strange given the reliance of the economies on oil and gas and in turn the world's reliance on the region's hydrocarbon reserves. But looking into other areas of presumed competitive advantage in the energy space - for example, solar power - to our knowledge has not been explored in any strategic manner.

Meanwhile, the above fits into the issue of technology accelerators. Clearly, one of the biggest risks facing this region is that the world wakes up one day to a technological breakthrough that means the world requires much less oil. Research into more ecologically-friendly sources of energy has been spurred by 1) much higher energy prices and 2) greater awareness of the damage being caused by increased hydrocarbon emissions.

While the consensus is that we are at least 15-20 years away from such a breakthrough, by their very nature such breakthroughs are very difficult to predict. Indeed, in 1994, arguably one of the greatest corporate leaders of our time, Bill Gates, commented that he saw 'little commercial potential for the Internet for at least ten years', three years before Amazon.com went public. We are clearly not experts as to when a significant, cost-effective alternative energy source will emerge. However, given the amount that is at stake (between 33-85% of GCC economies) then there are three strategies that make sense. First, make hay while the sun shines by maximising oil revenues. Second, diversify economies away from their reliance on the hydrocarbon sector - either in alternative energy or different sectors. Three, invest in alternative energy source research so that they can benefit from the value of the resultant patents and hedge against the Killer technology for the energy producers.

But there is hope. While many worry that the pace of reform is painstakingly slow, the flywheel and the doom loop concept suggests most successful reform takes time. Those launching a bold revolution 'almost certainly fail to make the leap from good to great', according to Collins. Thus, those who criticise the slow pace of reform, ourselves included, should realise that bringing everybody along with reform is crucial. Too rapid a transformation could create too wide a dispersion between winners and losers that could breed discontent.

Overall, the scorecard on the journey from Good to Great is mixed and there are many apparent holes that mean the road from Good to Great is far from assured. But the main constraint to making this journey may ironically be the thing that generally makes most analysts bullish about the region's prospects: high oil revenues. The words with which Collins opens Good to Great resonate deeply in this region: 'Good is the enemy of Great'.