Middle East Overview: standing up to challenges

Negatively, there has been a marked escalation in violence in the Middle East, following Hezbollah's capture of two Israeli soldiers in a cross-border raid in mid-July. This triggered the first Israeli incursion into the Lebanon since 2000 and the heaviest air campaign against the country since 1982. Along with Hezbollah targets and areas, key infrastructure installations have been hit, including the country's only international airport, ports, bridges, roads, petrol station and fuel depots. In addition, Israel has imposed an air and sea blockade on Lebanon. Meanwhile, Hezbollah rockets have also struck deeper into Israel than ever before, reaching Haifa and Tiberias. Israel has also indicated that a navy ship blockading Beirut was hit.

The Lebanese economy will be hard hit by the outbreak in violence. For the rest of the region, with the conflict still contained, the implications for economic activity will be limited. Indeed, even if Syria is brought into the conflict, the contagion to the wider region will be limited. The main area of risk, globally and regionally, is if Iran enters the conflict as this will hit asset values and tourism in the wider region.

But for now, fundamentals in the rest of the Middle East will continue to be supported by the high oil price, strong investment levels and economic reforms. We have increased our oil price forecast for 2006 on the back of the high oil price in Q2 to USD 66 pb for WTI. Furthermore, in July, the oil price reached new record highs, driven partly by geopolitical fears. As a result, the GCC will realise another stellar year, with strong real GDP growth, strengthening external and fiscal positions, a build-up of FX reserves and falling debt levels.

Although the geopolitical deterioration resulted in fall in the regional stock markets, the continued buoyant oil price will support both the fundamentals and sentiment in the GCC. The robust fundamentals are central in mitigating the impact of the fall in the regional stock markets from end-February and many companies have reported robust profits for H1 2006. There was concern over the impact of the fall indexes on the banking sector given the practice of borrowing to invest in the booming markets.

Indeed, the profitability of some banks especially those with strong asset and brokerage businesses) has suffered in Q2 with the stock market falls and reduced IPO activity. National Bank of Abu Dhabi saw Q2 net profit fall by 40% y/y, bringing down H1 profit to AED 1.13bn, down 15% y/y. However, in some cases (as in National Commercial Bank and Abu Dhabi Commercial Bank), a strong performance in Q1 resulted in increased H1 profits, despite Q2 profits falling.

Importantly, the economic performances of the non-GCC countries are fairing relatively well despite the pressure of the high oil price, although admittedly the fiscal and external accounts of these countries will deteriorate in 2006. These countries have also had to adjust to the end of the Multi-Fibre Agreement (MFA) from 2005 - textiles and clothing amount to a large share of exports for these countries and are important employers in the economy. Nevertheless, real GDP growth in countries such as Jordan, Morocco and Egypt are forecast to remain robust in 2006.

Ironically, the sound performances of the non-GCC countries have been partly due to impact of the oil revenue being funnelled into the wider region. There are three main ways that these flows from the GCC states have been transmitted to the wider region: 1) higher remittances; 2) increased intraregional tourism; and 3) higher investment levels (both portfolio and FDI). These factors have resulted in FX reserves with central banks increasing, despite the widening trade deficits. These factors are forecast to remain buoyant, despite the upsurge in violence in Lebanon.

Remittances from the Gulf have steadily increased over the last few years with the increase in oil prices and supported private consumption in the recipient country. For example, remittance outflows from Oman have increased by 23.7% y/y in 2005 to USD 1.8bn. Expatriate remittances from the UAE totalled USD 14.0bn in 2005 and the Abu Dhabi Chamber of Commerce and Industry has estimated that remittance outflows could reach up to USD 15.8bn in 2006. Meanwhile, increased intra-regional tourism has made the sector more resilient to terrorist attacks. In the case of Jordan and Egypt, the industry rebounded strongly following recent terrorist bombings. In fact, the tourism industry outside Lebanon could benefit from the developments, as Gulf tourists reschedule their holidays, although those outside the region may decide to avoid travel in the immediate vicinity until the situation calms down.

The investment sentiment for the non-oil exporting countries has also been supported by reform, including privatisation and reducing oil subsidies. Egypt has witnessed strong inflows in the capital and financial account as a result of its privatisation program. This should remain strong in H2 2006, as the government makes progress with the postponed partial sale of the Bank of Alexandria, one of four Egyptian state banks slated for privatisation. Meanwhile, at end-June, the Jordanian cabinet approved the sale of a 41.5% stake in Jordan Telecom in a deal worth over JOD 515m. Additionally, a number of countries (Jordan, Tunisia and Morocco) have been reducing oil subsidies to reduce the government's oil bill. Although this will suppress growth and increase inflationary pressure in 2006, it has increased confidence over economic management and improved fiscal sustainability in these countries.

These reforms have supported the outlook for the non-GCC countries along with the increased flows from the GCC countries (and outside the region). It remains vital for the reforms to continue to maintain sentiment. In addition, it is critical to increase FDI to the region, especially sectors that are labour intensive, to provide employment opportunities. Educational reform is also key to increase the attractiveness of local labour, this is especially the case given the growing number of youths entering the job market.