International Monetary Fund. Middle East and Central Asia Dept.
Published Date:
October 2008
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The Middle East and Central Asia (MCD) region has continued to experience strong growth in 2008, outpacing global growth for the ninth year in a row. High commodity prices, strong domestic demand, and credibility of policy frameworks underpin an expected real GDP growth of 6½ percent this year. And while growth in MCD is lower than in developing countries and emerging Asia, the region has so far largely remained resilient to the ongoing international credit crisis and the downturn in developed economies.

The global credit crunch thus far has had a mixed impact on regional financial markets. Most equity markets are down from highs achieved in late 2007 and early 2008. Sovereign spreads have widened across MCD countries, but domestic bond markets have stayed broadly steady in most countries. Banking sectors in the region generally remain sound with continued improvements in prudential indicators and strengthened banking supervision, although liquidity pressures have emerged in a few countries.

Inflation has emerged as a key issue in MCD countries, and is well above the average of all developing and emerging market countries. The main sources of inflationary pressures range from the surge in food and fuel prices, which has notably affected low-income and emerging market countries, to strong domestic demand pressures and supply bottlenecks in the Gulf Cooperation Council (GCC) countries, to the weakening of the U.S. dollar (until July 2008), to which many MCD countries are pegged. To mitigate social tensions from declines in purchasing power, a number of countries have increased minimum wages and civil service salaries, which has risked further fueling inflation.

Driven by the oil exporters, external positions have continued to strengthen in 2008 despite the negative impact of higher food prices on imports, and emerging market countries have seen a surge in foreign direct investment. In this setting, gross official reserves of the region have increased substantially. Government savings are expected to rise considerably in 2008, with the total fiscal surplus rising to 8¾ percent of GDP in 2008. Monetary aggregates are expected to continue to grow strongly in 2008, in part reflecting the difficulty in tightening monetary policy—constrained by the relative inflexibility of many MCD currencies vis-à-vis the U.S. dollar—but also further financial deepening in some countries.

The short-term outlook for the MCD region is generally favorable. Real GDP growth is projected to slow to 6 percent in 2009. For the oil exporters, a pick-up in oil production should offset a moderation of activity in the non-oil sector in 2008–09. And while growth in low-income countries should rise as commodity prices soften, growth in emerging market countries will moderate in the face of headwinds from the global slowdown. Inflation should gradually ease in response to tighter macroeconomic policies, and as commodity prices soften. External and fiscal positions should remain strong, driven primarily by the continued large surpluses in oil-exporting countries.

Risks to the outlook in the MCD region are moderately to the downside. Growth could be lower than forecast in case of a sharper and more protracted slowdown in advanced economies than is envisaged. Inflation could be higher, if international food and oil prices surge once again, or if macroeconomic policy is not sufficiently tight. In particular, second-round effects—driven by wage increases in a number of countries—could take hold, leading to some entrenching of wage and price expectations if policies do not adjust appropriately. On the other hand, a continuation of the recent correction in commodity prices would lessen inflationary pressures, as would a further recovery of the U.S. dollar, for those countries that peg their currencies to the U.S. dollar. On risks to the financial sector, direct exposure of the MCD region to troubled financial institutions and credit markets in developed countries is relatively limited.

Thus, MCD financial institutions are unlikely to suffer significantly should financial conditions in developed country markets continue to deteriorate. However, growth in property prices in the region has been very strong in recent years, and could be vulnerable to a correction, impacting bank portfolios and overall growth of GDP.

The immediate macroeconomic policy challenges faced by the MCD region center on managing continued inflation pressures and addressing the growing risks from the global credit crisis. On inflation, many central banks have already raised policy interest rates, but policy responses so far have been modest and interest rates generally remain negative in real terms, particularly in countries where the exchange rate is heavily managed vis-à-vis the U.S. dollar. The appropriate policy mix will depend on the particular circumstance of each country, but would generally call for tighter macroeconomic policies and greater exchange rate flexibility. All countries should be particularly attentive to potential second-round inflation effects, and for this reason should avoid further broad-based wage increases.

To reduce effects from the global credit crisis, continued efforts are needed to boost the resilience and flexibility of the region’s financial sector. In particular, policymakers should aim to strengthen the banking system further and remain vigilant to any effects from the global credit crisis. They should also closely monitor developments in real estate prices and assess vulnerabilities of the financial system to property price corrections and liquidity pressures.

Countries should continue their fiscal consolidation efforts by phasing out petroleum and food subsidies. Despite the recent falls in commodity prices, oil prices are likely to remain at relatively high levels, and MCD countries should move gradually to market-based pricing of petroleum and food products combined with targeted measures to help the poor. In oil-exporting countries, continued investment in oil production is needed. In parallel, these countries should implement structural reforms that would contribute to building competitive non-oil sectors.

The depreciation of the dollar and the acceleration in commodity prices through the first half of 2008 have raised questions about the appropriateness of exchange rate pegs, notably for commodity exporters pegged to the U.S. dollar. While an exchange rate revaluation might have helped these countries manage inflation by lowering imported inflation, such a step would have a number of disadvantages. Moreover, the recent correction to commodity prices and the recovery in the U.S. dollar have weakened the case for revaluation. But if the currency and commodity price trends seen through the summer of 2008 were to resume, or if inflation were to accelerate, then the case for maintaining their exchange rate pegs would need to be reviewed. Countries with flexible exchange rate regimes should allow their currencies to respond more fully to market movements by reducing central bank intervention.

Finally, the recent macroeconomic performance provides an opportunity to address the long-standing problems of unemployment and poverty in the region. To this end, governments should take steps to improve the investment climate and lower the cost of doing business, reduce the size of the state in the economy, improve labor market flexibility, and reform the educational system to reduce the “skills gap” that is evident in many, if not most, MCD countries.

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