GCC: Growth to peak in 2005

The Gulf is experiencing an unprecedented period of economic expansion. We expect growth to average 6.9% in real terms amongst the six members' of the Gulf Co-Operational Council (GCC) in 2005. This would make the last three years the fastest growing period in the organisation's history with an average real growth rate of 7.1%. With nominal growth rates (including the direct impact of higher oil prices) likely to average 25-30% in 2005, on the ground the boom feels even stronger.

External observers can get a feel for the current boom by looking at the performance of the local stock markets. The top eight performing stock markets in the world in the first half of 2005 were in the Middle East, four of them in the Gulf. The UAE led the charge with a 114% gain in US dollar terms, followed by Egypt 98% and Jordan 75%. Saudi Arabia's stock market rose by 65%.

The Gulf States currently suffer from a problem of plenty. Their economies are the fastest growing amongst countries with similar per capita income levels and momentum is strong. However, fast growth brings its own challenges: inflation, rising asset prices and shortages of goods and services. On a more fundamental level, past experience has shown that during periods of strong growth, resources can too easily become misallocated and inefficient investment takes place.

Oil economies have a particular problem of falling into a 'resource curse' where a booming oil sector squeezes out the non-oil sector to the detriment of the country's long-term outlook, something encouraged by a world hungry for increased oil supply and capacity. This is part of the reason why the Middle East boom of the 1970s and early 80s was followed by a decade of slow growth, rising government fiscal deficits and unemployment. The key lesson is to manage the boom now in order to avoid a painful bust later.

The summer correction in regional stock markets led many to conclude that a bust was already taking hold. This was premature. Equity valuations have since rebounded, but more importantly the fundamental causes of the boom are still in place; in particular oil prices broke record levels in August. That said expectations, and therefore valuations, now look over-optimistic.

The current boom in the Middle East is distinctive. While the rapid rise in oil prices has played a role, unlike previous periods of fast regional growth, it has been only one factor in a range of issues. Local interest rates are arguably too low for current economic conditions - due to the currency pegs against the US dollar, monetary policy is determined by the US Federal Reserve and not the local monetary authorities.

Meanwhile, there has been an increased desire to repatriate and retain oil revenues in the region following the 9/11 attacks in the US in 2001 and the increased attention being paid to anti-money laundering efforts. With so much money looking for a home in a region with relatively shallow asset markets, it is hardly surprising that asset price inflation has accelerated.

Boom will not last forever

The key question on everybody's lips now is when does this run into problems. Clearly, the current rate of equity and property price appreciation cannot go on forever. In the UAE, the central bank governor, just this week, indicated that property prices are likely to fall in 2006 as increased supply hits the market and rents decline.

The truth is that the fundamental drivers for strong asset gains are unlikely to change dramatically over the course of the next six months with oil prices expected to remain high, the Fed to retain its stance for measured interest rate hikes and the aversion to pouring money into developed market investments to remain intact.

That said, it is getting increasingly difficult to justify that the recent growth performance should be extrapolated into 2006/7. The good news is that governments have the ammunition to cushion any slowdown in the economy, while asset markets should not weaken too dramatically in the near term. However, the risks naturally increase over time, especially if high oil prices the global economy into the rebalancing of growth away from the US to the rest of the world and the resultant fall in oil prices undermines support for regional asset markets.