Middle East: Innocent as charged

The major cloud hanging over the world economic outlook is the size of global imbalances. Latest data notwithstanding, the US current account deficit continues to widen and absent a slowdown in the US economy, the possibility of a USD 1 trillion deficit in 2007 cannot be ruled out. In terms of net external liabilities, the international investment community owns around 30% more of the US assets (as a percentage of US GDP) than US investors hold of overseas assets. Only one developed country that we have found is in a worse net external position - the more open and commodity-related Australian economy. This has led the IMF to conclude:

'As a matter of simple arithmetic, the global imbalances remain on an unsustainable trend over the long run, as - unless returns on U.S.-issued financial instruments continue to substantially underperform those issued in other countries, thus generating large further capital gains for the United States - they would lead to an ever-accumulating stock of emerging Asian and oil exporters' assets and U.S. external liabilities. Therefore, the issue is not whether but how and when they adjust.'
Source: IMF World Economic Outlook, April 2006

It is clear that it is everybody's interest to correct these external imbalances in a gradual manner. And the longer their expansion continues, the more likely it is that the ultimate correction will be damaging to the global economy in a way that everybody fears, but nobody appears to expect - although risk appetite has wavered a little in recent weeks. In this region, we cannot ignore developments in this area as a failure to proactively address global imbalances increases the risks to the global economy. For a market predicting oil prices to stay above USD 60pb through the rest of the decade, any such destructive correction could be catastrophic for these projections and could seriously undermine economic activity in the region were low oil prices to be sustained for a long period of time. This is especially the case were oil prices to settle significantly below USD 30 per barrel where the GCC is estimated to break-even on their fiscal accounts.

Unfortunately, thus far, the discussion of global imbalances in international policy circles has been a blame, name and shame game rather than focusing on a multilateral solution to the problem. The US has been blamed for cutting taxes and interest rates so aggressively even as the economy recovered in 2002, thus giving a further push to domestic demand, increasing the demand for US imports and putting upward pressure on its current account deficit.

Meanwhile, the US has been keen to blame virtually everybody else. Japan was blamed for failing to push through with structural reforms and for intervening to keep the yen artificially weak. However, the rebound in the economy to above-trend growth rates, and the fact that the Bank of Japan has physically left FX markets to find their own level - although the US is still upset at the verbal intervention that we see on a weekly, if not daily, basis - has reduced the focus of attention on Japan.

Europe is similarly criticised for failing to push through with economic reforms to boost trend economic growth. In the US's opinion, Europe's failure to recognise that it has a role to play in correcting global imbalances means that the US has to pursue expansionary policies because, absent an alternative growth driver of sufficient size, the alternative is a global recession.
Then, of course, there is the G7's attack on China and its failure to change its exchange rate policy rapidly enough for the West, despite the huge competitive advantage possessed by the economy. Ironically, with evidence of rising Chinese export prices, any significant acceleration in the currency appreciation trend could help correct imbalances by forcing tighter monetary policy in the US and thus restricting US domestic demand. That said, were increasing import prices to become an issue, it is quite possible that the inflation hawks at the European Central Bank would also accelerate the single currency areas hiking cycle, largely irrespective of the consequences for growth. Thus the rebalancing would likely come between the West and Asia (and the Middle East should oil prices fall markedly).

The problem appears to be that when the G8 meetings convene, many of the participants arrive as if they have two mouths and one ear, rather than the more common one mouth and two ears. Everybody is keen to have their say rather than listen to what other people have to say and try to find a mutually agreeable solution.

In recent times, there has been a positive development on this front. The IMF has recently set up a multilateral consultation process to discuss global imbalances, including the US, Europe, Japan, China and Saudi Arabia. This is a step in the right direction, although it remains to be seen whether this remains a forum for discussing views rather than agreeing on a coordinated
plan for deficit reduction, and then more importantly following through on it.

Of course, Saudi Arabia's inclusion in this forum is a sign of the times, just as China's involvement in the G8 signaled a greater attention to its behaviour. While China remains very much a focus in the western world, the focus has also shifted somewhat to the oil producing countries, including those in the Middle East. It is believed that oil producing nations are not doing enough to correct global imbalances. We believe this is largely unjustified.

There are two aspects of the policy recommendations: 1) to boost demand for foreign goods and services; and 2) to allow greater exchange rate flexibility. On the issue of boosting demand, the focus has been on the surge in both current account and fiscal surpluses (see pages 8-9). These are clearly sizeable and in Kuwait's case are expected to exceed 40% of GDP this year.

To judge how stimulatory policy is, the non-oil fiscal balances can be more instructive. The first thing to note is that these are negative across the board and, in most cases, markedly so. Assuming some sort of inter-generational equity consideration, then any extraction of the country's hydrocarbon reserves should be viewed as a depletion of the country's wealth. Therefore, over the long-run this should be offset by an increase in the country's financial assets, which will bear investment income over the longer-term. This consideration is very clearly being implemented in the UAE and Kuwait, and to a lesser extent Saudi Arabia, via the existence of the government's investment agencies which are given some of the oil revenues to manage. In Qatar, where the development of its gas reserves are accelerating at a dramatic pace, the government has also set up its own investment agency, which is likely to garner increased attention going forward.

Clearly, the above analysis suggests that there is the concept of an appropriate level of the non-hydrocarbon fiscal deficit. The appropriate level of the non-hydrocarbon fiscal deficit is too detailed for this article as it depends on many assumptions including anticipated investment returns, average oil prices, forecasts of the actual level of reserves, population growth and the overall objective of policy. However, in Qatar's case, we calculated that if the government wanted to maintain the hydrocarbon wealth per capita, then the appropriate deficit is 4% of GDP if you assume that oil prices will average USD 22pb (the 1980-2003 average) and 9% if you assume a USD 50pb average. Only Qatar was under this level in 2005, with the UAE expected to join them in 2006. But elsewhere the deficit is much higher, perhaps explaining why governments are considering introducing a value-added tax - Kuwait is even talking about introducing an income tax. This may suggest that fiscal policy is already a little on the lax side in the region as whole, contrary to the view held in the West that fiscal surpluses are excessive.

Meanwhile, the region is keen to learn the lessons of the past. In the 1970/80s oil price boom, the region experienced a boom-to-bust cycle. As noted in last month's Middle East Focus, this resulted in the GCC economies contracting over 45% between 1981 and 1986. While much of this was down to the pure fact that economies were so reliant on oil which lost a large amount of its value on international markets, the situation was exacerbated by a pro-cyclical fiscal policy and one that felt obliged to share a significant proportion of the windfall directly with its people. This fueled a consumption boom and failed to create a legacy in terms of investment in either financial assets, that will provide the country with an income stream in leaner times, or in physical investments, that would boost growth in the future.

The temptation to do likewise this time around must be great. In recent times the increase in oil revenues as a percentage of GDP has sometimes exceeded 20% of GDP. It must be acknowledged that it is very difficult to spend such a large windfall efficiently. Indeed, some governments are already being criticised for planning investments that some believe will not create significant value for the economy. Getting the balance between being ambitious enough in one's plans and rigourous enough to ensure the economic viability of the different projects is incredibly difficult and getting harder with each year of high oil prices.

Meanwhile, current investment plans in the region are impressive. The GCC, Iran and Iraq is already planning over USD 1.2 trillion in projects in the next 10 years. At a whopping 143% of 2005 GDP, with over 40% of this (around 60% of GDP) planned in the next two years, this clearly shows the intent of the countries to invest heavily in their economies, which should, over time, reduce the level of current account surpluses in the region, especially as oil prices come down to more sustainable levels.

These efforts are already reflected in strong import growth with all countries seeing growth in double-digits in 2004 and 2005 and only Kuwait expected, according to the IMF, to see growth slow below this threshold in 2006. Therefore, it is much easier to point to concerns of excessive investment spending than it is to suggest that the oil producing nations in the region should be more extravagant.

The second prong of criticism is the lack of exchange rate flexibility. While in the context of local requirements (seizing control of monetary policy and thus protecting the economies from excessive swings in the economy), we believe this criticism could be valid, in the context of global imbalances greater exchange rate flexibility would have a marginal impact.

As is well known, the huge current account surpluses are caused by the surge in international oil prices. As these are priced in USDs, a local currency appreciation would have no impact on oil revenues. There are two transmission mechanisms via which such a currency appreciation could, in theory, help address global imbalances. First, a currency appreciation would increase the international purchasing power of local currency revenues, which could boost imports. Second, the non-oil sector would suddenly become less competitive, reducing non-oil exports to the further benefit of imports.

However, for these to have a sizeable impact on global imbalances, the currency shifts would have to be dramatic and this would 1) reduce the value of the region's foreign asset holdings (which are largely denominated in USDs) and 2) undermine crucial diversification efforts. Therefore, our advice to the region, and to Saudi Arabia as its representative in the IMF's consultative process, is to follow China's lead and liberalise exchange rate regimes in accordance with domestic fundamentals rather than based on international pressure. While we would prefer this reform to start sooner rather than later in some countries, given the fact that real interest rates are still negative in the UAE and Qatar, the reality is that the single currency project is
likely to mean that a shift in policy ahead of 2010 is unlikely.