What drives the UAE's growth?

We estimate that the economy grew by 8% in real terms this year. Like the rest of the region the United Arab Emirates (UAE) has benefited from high oil prices, low interest rates and repatriated investment flows. However unlike many of its neighbours, these factors have been amplified by a booming private sector. Despite receiving a record USD 30bn in oil revenues this year, the oil sector is still likely to account for less than a third of the UAE's GDP. Indeed the UAE offers a useful example of how to develop a thriving and dynamic private sector alongside a large oil sector. Twenty years ago the oil sector accounted for 65% of the UAE's GDP.

We would identify three key factors that have enabled the Emirates to diversify and that will continue to provide an underlying economic resilience:

1. Political and economic devolution
2. Infrastructure investment
3. Liberal trade, business and labour laws

The UAE is a loose but supportive federation of seven emirates with each of the seven emirates retaining considerable autonomy over political, economic and financial affairs. This has enabled a variety of different economic policies to be pursued by individual states. Hence whilst Abu Dhabi has focused on developing its extensive energy resources - it holds over 90% of the UAE's oil reserves - the other emirates have sought other economic drivers as their own oil reserves have dwindled.

Trade has become Dubai's staple, with the Emirate reexporting over USD 10bn annually, while Sharjah has focused on light manufacturing. Successful strategies are copied in the other emirates and the resulting increase in competition deepens the market and allows the spread of best practice. There are three major airlines now operating from the UAE, which will increase competition, lower prices and also on a country level cement the UAE's position as an important transportation hub.

This process has been supported by the UAE's heavy investment in infrastructure, principally in Dubai. World class airports and naval ports have been built. Over twenty million people passed through the UAE's airports in 2003. Dubai's ports witnessed a throughput of 41m container tonnes last year. Investment has continued to improve and enlarge these facilities. Dubai is undergoing an AED 5.2bn airport expansion and Jebel Ali, the UAE's principal port, is expanding.

However heavy infrastructure investment can often be counter productive. Large unused state-led projects frequently are left empty and unused in the developing and developed world. Indeed many expected Jebel Ali to be an expensive failure when it was first built in 1979. What has been critical in the emirates' success has been the adoption of a liberal business environment alongside government investment that encourages private sector development.

For example an open skies policy has led to over a 100 airlines connecting through Dubai airport. But it has been the establishment of 'free zones' that has led to the UAE, and in particular Dubai, to be used increasingly as a business hub for the region. These zones grant 100% foreign ownership and exemption from taxes, tarrifs and local regulations. Jebel Ali free zone alone is home to over 2200 companies from over 100 countries, including many European and American blue chip companies. Dubai has been at the forefront of this policy and has moved into creating dedicated industrial or service zones in an effort to attract clusters of leading companies within targeted sectors. Dubai International Financial Centre is its latest and most ambitious project, which the emirate hopes will support the development of a regional capital market.

In a region that is amongst the most expensive and time consuming to start a business, the UAE's free zones are attractive propositions. As a result over the last twenty years the UAE has become the leading business and trading hub in the Middle East. This means that when the region booms, the UAE booms even more so. This process can be visibly seen in the country's real estate sector. Although construction and real estate investment have picked up across the Middle East over the last two years, its Dubai that has seen the most activity. Investment into Dubai's real estate sector is currently running at over 20% of the emirate's GDP. The recent IPO of Abu Dhabi based Addar properties, which was over 400 times oversubscribed, shows that this boom has further to go.

However the UAE's undoubted economic strengths do not mean that it can ignore economic reality. If oil prices fall, and the region slows, the UAE is likely to slow as well. The oil sector may account for less than a third of GDP, but it is still the largest sector and provides much of the momentum for the wider economy.

That said, the outlook for the UAE remains robust. Abu Dhabi's large stock of offshore assets gives it the flexibility to absorb even a large economic or financial shock. While we expect headline growth to moderate in 2005 and 2006, alongside a fall in oil prices, thanks to its liberal business environment the medium term prospects for the country remain extremely encouraging.