ICAEW Economic Insight: Middle East

ICAEW Economic Insight: Middle East Quarterly briefing Q2 214 Welcome to this edition of ICAEW s Economic Insight: Middle East, the quarterly economic forecast prepared directly for the finance profession. Produced by Cebr, ICAEW s partner, and acknowledged expert in global economic forecasting, it provides a unique perspective on the prospects for the Middle East as a whole and for individual countries against the international economic background. We focus on the Middle East as being the Gulf Cooperation Council (GCC) member countries (United Arab Emirates [],,,, and ), plus,, Iraq, and, abbreviated to GCC+5. 1 Global recovery begins to take off, with advanced economies taking the lead After several years of lacklustre global economic growth, 214 is shaping up to be a turning point. World GDP growth is expected to reach 3.2 this year, the fastest pace of expansion since 211, and further acceleration is anticipated in 215 and beyond. Stabilisation in advanced economies is providing a boost to global growth prospects as the emerging markets, which have powered the world economy over the past half-decade, enter a cyclical slump and China negotiates the challenges of a structural shift in its economy. Slower growth in emerging markets and stronger demand from advanced economies leave global oil prices relatively flat Contravening pressures are likely to leave oil prices relatively flat over the short term, as stronger demand from advanced economies largely compensates for slower demand growth in emerging markets. Over the medium term however, increases in supply particularly rising production in the US, a resurgence among producers recently disrupted by violence including Libya and Iraq, and an incremental expansion in exports from are likely to lead to a gradual reduction in average oil prices from $12 in 214 to around $95 a barrel by 22. 2 The medium-term outlook of falling prices poses a challenge to the Middle East s hydrocarbon exporters, who have expanded production in response to raised prices in recent years and used the resulting revenues to boost public spending. Despite the prominence of the diversification agenda in regional media and political discourse, many of the economies in the region have a long way to go before exports of other goods are more important than commodities, as shown in Figure 1. BUSINESS WITH CONFIDENCE icaew.com/economicinsight

Figure 1: Many Middle East economies remain highly dependent on commodity exports Commodities, high-skill manufactured goods and medium-skill manufactured goods as of goods exports, 212 1 9 8 7 6 5 4 3 2 1 US Brazil Indonesia GCC High-skill manufactured goods Medium-skill manufactured goods Low-skill manufactured goods Labour and resource intensive manufactured goods Commodities Source: United Nations Conference on Trade and Development, Cebr analysis Middle East economies are highly exposed to commodity markets For the vast majority of countries in the Middle East, commodities make up more than half of their total goods exports by value. The sum is as high as 99.2 in Iraq, where many other export industries have been disrupted by conflict and ongoing violence. Commodity exports also account for more than 9 of the total value of goods exported from and much more stable economies. Even those economies which have made substantial efforts towards diversification have some way to go: commodities still account for 86.8 of s total goods exports by value and nearly two-thirds of the s. Even, with the fewest hydrocarbon resources of any GCC economy, still relies on commodity exports for nearly three-quarters of goods export revenues. While these economies remain so dependent on commodities markets, they are vulnerable to variations in global prices. Expanding capacity and competitiveness across a broader range of export industries would provide some protection against these fluctuations, reducing exposure to any single market. Developing a range of export industries remains a challenge for most countries in the Middle East Plentiful, cheap energy should provide the Middle East with a competitive edge when it comes to manufacturing. However, modern manufacturing also relies upon skilled workers and high-tech equipment. Middle Eastern economies have, so far, struggled to boost the proportion of their goods export revenues accrued from these activities, as shown in Figure 1. In 212, manufacturing activities accounted for less than a quarter of goods export revenues in all GCC states except. Where GCC economies have established overseas markets for manufactured exports to date, these have tended to be for technology and skill-intensive products. In 212, these accounted for just over a tenth of s goods export Iraq income, and 8.2 of the s goods exports. That being said, there has been little change in how important these export markets are to the GCC over the past decade. The proportion of goods export revenues earned through high-tech manufacturing across the group fell very slightly from 8.6 in 22 to 8.5 in 212, as higher oil prices created incentives to expand hydrocarbon capacity. Despite the diversification agenda, commodity exports are now more important than they were a decade ago in the majority of Middle Eastern economies. However, with the price of oil set to slip in coming years, the need to broaden the industrial base becomes ever more pressing. Knowledge, technology and entrepreneurship are the keys to growth in the private sector In today s globalised world, manufacturing industries are often highly competitive, and the key to a country s export success is its ability to develop new processes and products, adapt technologies to new uses and diffuse this knowledge across the workforce. Innovation provides a competitive edge to companies which need to cut costs or find a way to differentiate their products in crowded markets. The World Bank s Knowledge Index combines several indicators of education, innovation and access to information and communications technologies (ICT) to provide a snapshot of how countries compare in creating the conditions to foster the development of modern competitive industries. The index is used to create international rankings which provide an insight into the opportunities and challenges economies (and their competitors) face in their transitions to knowledge-based economies, and their prospects for growth in industries reliant upon knowledge. As shown in Figure 2, this index suggests that Middle Eastern economies currently lack the tools to compete effectively in international markets for high-tech manufactured goods. Figure 2: Ability to generate, adopt and diffuse knowledge by country World Bank Knowledge Index, 212 1 9 8 7 6 5 4 3 2 1 US UK Japan Poland Brazil Mexico Source: World Bank. No data are available for Iraq In the global ranking, the highest scorer among GCC countries is the, coming 41 st out of 145 countries, followed by in 52 nd place, in 53 rd place and in 62 nd place. While five of the region s economies make it into the top half of the international ranking, the inclusion of other emerging markets in Figure 2 illustrates the strength of the competition. While the is comfortably in the top half of the international pecking-order, many other emerging markets, particularly those in Eastern Europe, score more highly. Brazil, scoring slightly below the, securely surpasses the scores of and, while Middle Eastern countries further down the list face tough competition from a Thailand China India icaew.com/economicinsight cebr.com ECONOMIC INSIGHT MIDDLE EAST Q2 214

range of other emerging markets including Mexico, Thailand and China. These are the markets that Middle Eastern economies must compete against if they are to successfully develop a range of industries. ICT provision in the GCC is world class, but other emerging markets have a competitive advantage in innovation and education Looking more closely at the underlying indicators in the World Bank s Knowledge Index, we find that performance varies significantly. In general, GCC countries score very highly on ICT. is the highest scoring country in the world on this component of the Knowledge Index, with a score of 9.4, while the and also feature in the top 15. Each of these countries ranks more highly than many advanced economies including Australia, Canada and France. When it comes to innovation, however, Middle Eastern economies are not keeping up with their competitors. In the education stakes, while GCC economies fare slightly better according to World Bank measures, their performance remains mid-table, with many other emerging markets performing more strongly. is once again the region s highest scorer, but it ranks below Russia, Kazakhstan, Cuba and Barbados. Education is a vital economic input, boosting the productivity of the workforce, reducing production costs and increasing profitability of enterprises. As such, its relative importance in determining the economic success of Middle Eastern economies will only rise in future. A relatively high proportion of students from GCC economies choose to study overseas, creating a new potential pathway for knowledge and skills development. While just.3 of students from the US and.7 of British students chose to complete at least some of their tertiary studies abroad in 211, 2.1 of students from took the opportunity to study in a foreign country, as did 4. of students from. 3 As these students return with experience of different cultures, they may introduce a greater entrepreneurial spirit and help to foster innovation in the future. These programmes will also help the GCC to tackle a shortage of workers qualified in science, technology, engineering and mathematics the STEM subjects. As GCC economies put additional efforts into building a range of industries beyond the hydrocarbons sector, increasing demand for these workers, these initiatives are likely to be increasingly important. Improving labour productivity is key to economic growth in a diversified economy Innovation, ICT and education will play a role in determining labour productivity. This is a crucial measure of a country s ability to prosper in the cut and thrust of international markets. Labour productivity growth has stagnated across many advanced economies over the past five years, as a result of the 28 financial crisis and subsequent recession. This contrasts with emerging markets, where productivity improvements are relatively easy to achieve and have remained fairly robust in recent years, as shown in Figure 3. Although average annual labour productivity growth was slower in emerging markets including China and India over the five years to 212 than between 22 and 27, the rate of progress remained strong. Chinese labour productivity increased by approximately 9 each year between 28 and 212, equivalent to a 52.9 increase in the amount of output produced by each worker over the five-year period. Despite strong GDP growth and high oil prices, improvements in output per worker have been sluggish across the Middle East For some Middle Eastern economies, the pace of labour productivity growth slowed between 28 and 212. As Figure 3 illustrates, Iraq and both saw a reduction in the pace of labour productivity growth over the past five years, as both countries were affected by violence either at home or in neighbouring states. also experienced a substantial reduction in the average annual increase in labour productivity, from 6.9 over the five years to 27 to. over the five years to 212. In this case, productivity fell sharply in 29 as the economy entered a sharp recession, but has begun to recover in recent years. and the have both seen falling productivity for some time meaning that each year, a typical worker is producing less than in the previous year. Promisingly, however, labour productivity in the returned to marginal positive growth in 211 and 212. In, meanwhile, labour productivity continued to fall, albeit more slowly, with the amount of output produced per worker declining by 1. in 212 compared to the previous year. Figure 3:,, and have seen productivity rise since 28, while productivity has fallen in and the China India Nigeria Iraq Poland OECD -6-4 -2 2 4 6 8 1 12 23 27 28 212 Source: World Bank, International Monetary Fund, Cebr analysis. No data are available for Other GCC economies experienced improvements in productivity over the five years to 212. In, where labour productivity fell by an average of 1. a year between 23 and 27, output per worker rose by an average of 1.8 each year between 28 and 212. and also benefited from a reversal in labour productivity trends over the same period. Public sector employment stifles productivity In many GCC countries, the dominance of public sector employment among nationals is responsible for some of the stagnation in labour productivity. Across the GCC, more than two-thirds of nationals were employed in the public sector in 211, while the vast majority of private sector workers were expatriates. 4 During years of high oil prices and correspondingly high government revenues, maximising the productivity of public sector workers is icaew.com/economicinsight cebr.com ECONOMIC INSIGHT MIDDLE EAST Q2 214

Index of economic freedom, 214 unlikely to be a priority. This is in direct contrast to companies in the private sector for which the profit motive and need to maximise efficiency cannot be avoided. Encouraging the development of private sector employment for nationals across the GCC is thus likely to raise labour productivity and, ultimately, economic output. Foreign direct investment can provide a welcome boost to labour productivity Investment by foreign companies (foreign direct investment or FDI) can accelerate productivity growth by introducing the domestic workforce to new technologies, production techniques and management procedures. Companies seeking investment opportunities abroad will look for opportunities with relatively high returns and relatively low risk. This means that the legal and regulatory system of an economy is paramount in its ability to attract FDI, and the broader benefits this investment can bring. The Heritage Foundation s Index of Economic Freedom, illustrated in Figure 4, considers a range of variables which are likely to influence a company s decision over where to invest abroad, including: rule of law including property rights, corruption and legal enforcement; freedom to invest for example, limits on foreign ownership of companies or access to foreign exchange; freedom to trade with other countries (including the level of tariff barriers); freedom in business (management structure and regulation); and freedom of labour, including regulation of working hours, redundancy payments, barriers to hiring and firing workers and minimum wage legislation. Countries are scored out of 1 where higher scores indicate greater economic freedom. Figure 4:, the and are among the world s most attractive destinations for foreign direct investment 6 5 4 3 2 1 China Nigeria India Source: Heritage Foundation, 214. No data are available for Iraq This index suggests that several countries in the Middle East are already relatively attractive destinations for global investors. ranks as the 13th most free economy in the world beating the UK and only one place below the US. The also fares relatively well on this measurement, with a score of 71.4, equal to the average score across all OECD countries. and the both score particularly well on fiscal freedom taxes are particularly low by international standards Poland OECD despite less positive ratings on freedom from corruption and property rights. Other economies in the GCC are relatively less attractive destinations for FDI, according to this measure. Saudi Arabia and, for example, both have mid-table scores with rankings of 76 th and 77 th respectively out of 186 countries. This index suggests that at present, other emerging markets such as Ghana, Bulgaria and Botswana may be more attractive destinations for FDI. While Saudi Arabia scores nearly as well as the neighbouring and on fiscal freedom, its index score is reduced by a relatively poor investment freedom measure, while a relatively low labour freedom score holds back in the race to provide an attractive environment for international investors. Strong growth prospects and diversification efforts provide opportunities for growth in FDI The Middle East, and GCC in particular, is likely to remain a key destination for global FDI flows in coming years, as shown in Figure 5. Although FDI flows into the GCC economies slowed in the aftermath of protests in 211, the scale of inwards FDI jumped up in 213 amid a profusion of positive headlines about the region s prospects not least the resurgence of Dubai s property markets after the Emirate won the right to stage the 22 World Expo, s continued preparations for the 222 football World Cup and the dramatic infrastructure developments in progress, including the Etihad Railway across the. The region s position at the crossroads of global North-South and East-West trade routes makes it an almost irresistible proposition for international businesses. Given this, it is expected that FDI will continue to grow strongly in the coming years. However, some domestic regulations will make life difficult for international investors, and are expected to weigh on FDI prospects in the GCC, preventing its growth from surpassing the previous peak reached in 29. Limitations on foreign ownership of companies, for example, and regulations restricting the use of foreign labour will pose hurdles for firms hoping to invest in the area. Changes to regulatory structures to welcome the use of public-private partnerships, like those being introduced in, will help to overcome some of these issues. Despite this, as spending on mega-projects fades towards the end of the forecast period, the growth of FDI in the GCC will slow to around 3 of GDP per year. Figure 5: Foreign direct investment (FDI) in GCC economies has peaked, but investment across the rest of the region is likely to accelerate in coming years Net inflows of FDI as a of GDP (forecast from 213) 6 5 4 3 2 1-1 1992 1994 1996 1998 2 22 24 26 28 21 212 214 216 218 22 +5 GCC FORECAST Source: International Monetary Foundation, United National Conference on Trade and Development (UNCTAD), Cebr analysis icaew.com/economicinsight cebr.com ECONOMIC INSIGHT MIDDLE EAST Q2 214

Multinational businesses seek markets as well as a return Although economic freedoms and the likely returns are often major determinants of where multinational firms choose to invest, companies often decide to operate in countries despite relatively high risks. For example, many international companies, including banks and financial consultancies, have already begun to open or re-open offices in Iraq, despite the recent flare-up of sectarian violence. Equally, even considering s uncertain position in the international political sphere, several international firms have spoken of their willingness to produce inside the country. What makes these markets attractive to foreign investors, despite the substantial risks involved? The answer: the size of their domestic markets. This means that Iraq, and, despite being among the most volatile economies in the region, are attractive due to the sheer number of potential consumers they represent. The population of is expected to top 78m this year 5 more than twice the population of, and seven times larger than the population of the., the region s most populous country, is expected to have a population of 83m in 214 larger than Germany. As these countries are also relatively under-developed they represent a juicy prospect for international businesses. We expect FDI to the +5 region to accelerate significantly over the next six years, overtaking the growth of FDI in the GCC by 219 as the political situation settles down. Economic growth prospects remain strong across the region Figure 6: GCC countries expected to maintain relatively stable GDP growth, while +5 economies see some acceleration Annual GDP growth forecast 1 9 8 7 6 5 4 3 2 investment in infrastructure. In the the bounce from the announcement that Dubai will host the 22 World Expo continues, with indicators suggesting that activity in the non-oil sector was particularly strong through the first three months of 214. Economic growth of 4.5 is expected in 214, remaining steady at 4.4 over the subsequent two years. Sustained investment in infrastructure will support GDP growth in over the next few years. GDP is expected to rise by 6.3 in 214, accelerating to 7.4 by 216. GDP growth in, meanwhile, is expected to fall to 3.6 in 214 as growth in oil production slows, though the pace of expansion should accelerate in 216 as new gas capacity comes online. With no further expansion expected at s main oil field, growth is expected to dip in 214, although investment projects will ensure it remains relatively robust over the next few years with additional refinery capacity providing a boost from 216. Oil production in is expected to be relatively weaker in 214 than last year, reducing GDP growth to 2.5 from around 3. in 213. Strong domestic demand, however, will support an acceleration through to 216. s expected GDP growth for 214 has been revised up to 2.3, following significant donations by the and others to the country s coffers. Although the political situation remains relatively unstable, GDP growth is expected to rise to 3.1 in 215 and 3.8 the year after, as markets get to grips with new political norms. The modest loosening of economic sanctions against is expected to increase growth marginally this year, leading to an upward revision in our 214 forecast from 1.3 to 1.4. The longer-term outlook remains much less certain, however, with the country facing stagflation (stagnant economic growth and high inflation, a particularly difficult combination for economic policy to address). We do not expect GDP growth to exceed 1.9 in 215 and 2.1 in 216. Despite ongoing violence, growth in Iraq is expected to accelerate to 6.5 this year, and to rise to 8.6 by 216. GDP growth in and will continue to be limited by the impact of the Syrian crisis on trade flows, with neither country seeing any acceleration in GDP growth this year, although prospects should improve in coming years. 1 Iraq 214 215 216 Source: Cebr analysis Oil output is expected to rise slightly in Saudi Arabia this year, before falling back a little from 216 onwards in a bid to support prices. A recent law to limit the maximum private sector working week, together with continued efforts to reduce migrant employment, are likely to weigh on business growth. The pace of expansion will remain relatively strong, however, at 4.3 in 214 thanks to ongoing icaew.com/economicinsight cebr.com ECONOMIC INSIGHT MIDDLE EAST Q2 214

ENDNOTES 1 The phrase Middle East is often used to cover different parts of the region. Much of the internationally-available economic data relates to the Middle East and North Africa region which we call MENA (this covers the seaboard countries in North Africa from Somalia to Mauretania and all the states in the Arabian Peninsula including Israel, plus and Turkey in the north). Political discussions often treat the Middle East as synonymous with the Arab world. But if we refer to wider definitions of the region, we will try to point this out explicitly. 2 IMF measure, simple average of market prices of Brent crude, West Texas Intermediate and Dubai Fateh, Cebr forecasts. 3 United Nations Education, Scientific and Cultural Organisation data. 4 International Monetary Foundation, Regional Economic Outlook: Middle East and Central Asia, November 213 5 UN Population Department Cebr The Centre for Economics and Business Research is an independent consultancy with a reputation for sound business advice based on thorough and insightful analysis. Since 1993 Cebr has been at the forefront of business and public interest research. They provide analysis, forecasts and strategic advice to major multinational companies, financial institutions, government departments and trade bodies. ICAEW is a world leading professional membership organisation that promotes, develops and supports over 142, chartered accountants worldwide. We provide qualifications and professional development, share our knowledge, insight and technical expertise, and protect the quality and integrity of the accountancy and finance profession. As leaders in accountancy, finance and business our members have the knowledge, skills and commitment to maintain the highest professional standards and integrity. Together we contribute to the success of individuals, organisations, communities and economies around the world. Because of us, people can do business with confidence. ICAEW is a founder member of Chartered Accountants Worldwide and the Global Accounting Alliance. www.charteredaccountantsworldwide.com www.globalaccountingalliance.com For enquiries or additional information, please contact: Lara Khouri, Marketing Manager, Middle East T +971 ()4 48 E lara.khouri@icaew.com ICAEW Currency House Unit 4 Level 4 Dubai International Financial Centre PO Box 56836 United Arab Emirates icaew.ae ICAEW Chartered Accountants Hall Moorgate Place London EC2R 6EA UK icaew.com ICAEW 214 MKTPLN1362 5/14