Middle East: This time it is different

This time it's different. Four words guaranteed to make the hairs on the back of investor's necks stand on end. You heard it around the peak of the Nasdaq bubble in late 1999 and early 2000. Last year, in the Middle East, stock market investors were uttering these words as markets soared to unsustainable levels even assuming the rosiest economic scenario possible. Indeed, we have continued to have an almost nirvana state of affairs in the past 18 months for the region's economy and yet stock markets have plummeted from their peak. Therefore, it is with huge trepidation that we use it with regards to the sustainability of the region's recent economic performance.

We are looking for the region's economy to grow a compounded average growth rate (CAGR) of 8.1% in nominal terms from 2005-2010. For the Gulf Cooperation Council (GCC) countries, the forecast is 7.0%. On the face of it, this does not sound too impressive, adding weight to those who believe we are too cautious in out GDP projections given the region's recent performance.

However, the comparison between the 1980s and what we expect going forward is stark and illustrates that we also believe a dramatic transformation is under way in the region and that this will lead to a significant improvement in the region's long term dynamics.

Between 1981 and 1986, the region's economy shrank by almost 18% in nominal USD terms. The GCC economies were much harder hit, given their reliance on the hydrocarbon sector, contracting by almost half. It took the region's economy 10 years to pass its 1984 peak and 14 years for the GCC economy to recover its 1981 high. Putting this into an international context, this is longer than the 8 years it took for the Indonesian economy to reach its pre-Asian crisis highs, after its 58% decline in two years from 1996-1998.

Therefore, forecasting for continued growth across the region over the course of the next five years warrants some explaining. There are five main prongs of the rationale for such an out-performance versus the previous oil price induced economic boom.

First, the region's demographics are much more favourable. The dependency ratio for the region has improved with 1.6 workers to each dependent in 2002, up from 1.1 in 1980. Interesting to note is the fact that the ratio is highest for those with the most abundant natural resources, namely the UAE, Qatar and Kuwait. This bolsters our view that, in a culture where multiple marriages are allowed, the birth rate can be positively related to wealth rather than negatively correlated as in many emerging markets.

Looking forward, on a slightly different basis, the World Bank also predicts a further improvement in this ratio, rising to 2.1 in 2020 from 1.8 in 2005. However, while the historic increase was broad-based, the future improvement is expected to be dominated by the poorer North Africa and Levant countries. This may especially prove to be the case if the latest oil boom leads to an increase in the birth rate in the oil-producing countries as the 1980s boom did.

Second, our Head of Commodity Research believes there has been a structural shift in the long-term oil price dynamics. From 1984-2002, the average West Texas Intermediate crude oil price was USD 21.4pb. However, we expect the long-term average oil price to be much higher than this due to strong demand and limited supply and will average around USD 40pb. While we only formally forecast oil prices out to 2007, we have assumed a gradual decline to this long-term average by 2010. Looking at the futures market, our oil price assumptions appear very conservative with the market implied forecast remaining above USD 60pb over the next six years.

Third, there has been a significant improvement in fiscal policy in the GCC countries. This includes the size of the accumulated fiscal surpluses and the composition of spending. On the former, we estimate that the GCC has accumulated over USD 330bn in fiscal reserves - equivalent to 50% as at 2006f GDP. Meanwhile, if rumours about the returns on Abu Dhabi Investment Authority's investment portfolio in 2005 are anything close to being correct and can be applied to other like agencies in the region, the risk is that this hugely understates the financial well-being of the GCC's financial position.

In terms of the composition of spending, it is clear governments are less willing to raise the level of recurrent spending than in previous economic booms. This has been achieved by providing budget numbers based on extremely cautious oil price forecasts (around USD 35pb for 2006 for those that publish such assumptions) or exclude some of the revenue from their budget numbers altogether. This vastly reduces the size of the planned fiscal surplus and thus justifies, at least to a casual observer, a less stimulatory fiscal stance.

However, governments have been keen to spend money to help boost their economy's long-term potential. As one can see in Table 5, this is no longer focused purely on developing the region's oil and gas reserves, although this is still a significant focus in Qatar. Instead, much of the efforts are now aimed at introducing new sectors where the region may have a competitive advantage. In particular, many countries are now focusing on the tourism industry with increasing attention being paid to financial sector development in the UAE, Qatar, and Saudi Arabia in recent times.

Fourth, because of the above efforts, the oil-producing economies have diversified to a significant extent. More importantly, there has been a significant change in mindset in terms of the need to reform. If one looks at the relative positioning of the region in terms of the ease of conducting business, it still ranks relatively poorly in a global context. Clearly, there is much work to make the region an easier place to operate. Much effort has been placed in boosting the physical infrastructure, but we expect the focus to shift towards improving the region's administrative and legal infrastructure to boost the willingness of investors to invest in non-public sector dominated areas. This will boost the long-term growth potential of the private sector. Dubai has shown what can be achieved here under the right conditions where private sector growth has been in double-digits for many years. We expect other countries to try to replicate this performance going forward.

Finally, there has been an increased focus on intra-regional development this time around. Whereas in previous cycles, the focus had been on accumulating financial assets in the Western markets, in the current oil boom there has been increased interest in direct investments within the region. This not only helps spread the oil wealth through the region, but should also increase the portfolio returns as they are moving into largely untapped markets, albeit with higher risks than has traditionally been the case. Meanwhile, given the size of some of the suggested investments - for instance, the UAE's plans to invest up to USD 20bn in Morocco with a GDP of USD 52bn in 2005 - investors will have significant bargaining power which could lead to an improvement in business environment and thus long-term growth potential. Indeed, many of the countries in the region, particularly in North Africa, are already focusing on the need to increase foreign direct investment in order to create the number of jobs that will be needed in the coming years to keep unemployment under control.

The main risk to our view is oil prices fall below our implied forecast of USD 40pb average by 2010. Markets have got used to a strong growth/low inflation environment and, in our opinion, are not adequately pricing for the risks facing the global economy. In this environment, and with supply expected to increase only gradually in the coming few years, then many believe that the recent rise in oil prices are not an aberration, but indicative of things to come.

The biggest risk to this view, and possibly even ours, is the fact that global imbalances continue to balloon. Of course, if they are corrected by significant USD weakness without this feeding through into a dramatic slowdown in the global economy, then oil prices could actually go significantly higher. However, it is interesting to note that the US current account deficit actually widened from 2002-2004, despite a significant decline in the USD. Therefore, while the central scenario over the course of the next 12 months remains for a gradual slowdown in global economic activity, the risks increase the further forward we look. If demand were to fall sharply, this could lead to a slump in oil prices even more than we are assuming and this would have a detrimental impact on growth in two ways.

First, and most obvious, is that lower oil revenues would directly hit nominal GDP in the oil-producing region. Second, once oil prices start falling below USD 30-35pb then some GCC countries would start to experience budget deficits. This would undermine their ability to invest both locally and regionally, although as mentioned above the improved financial position of the economies this time around would mean that growth could be sustained for longer than in the 1980s. This suggests that the melting away of the economy seen in the 1980s can be avoided.

Another risk is that economies may be unable to fully absorb labour market entrants and that this leads to significant social instability and a resultant deterioration in the investment climate. This looks to be a low probability in the foreseeable future given the strength of public finances and the ability to alleviate any economic pain felt by the unemployed.

In conclusion, the region has a huge opportunity to move away from being seen as just a source of oil and gas to one that becomes increasingly integrated into the global economy in different areas, both services and industry. Reform has started, but clearly more needs to be done to ensure that growth is sustainable into the long-term. The good news is that there appears to have been a shift in mindset in recent times which should mean that this time is, indeed, different.