Speech

Enabling Economic Transformation in the Middle East and North Africa by David Lipton, IMF First Deputy Managing Director

November 13, 2012

As prepared for delivery

Introduction

I am delighted to be here at the London School of Economics, with its vibrant tradition of marrying up the study of economics and other social sciences, including politics, law, and sociology. LSE was set up to improve society and to “understand the causes of things,” something we at the IMF strive to do every day in our work with our 188 member countries.

Today, I would like to talk to you about a topic close to my heart and to our work right now at the IMF: the future of the Middle East and North Africa (which I will refer to as MENA). Your institution has a long history of study and engagement with the region, and I look forward to sharing my thoughts with you on the prospects for stability and prosperity in that part of the world.

You may be excused for thinking that you don't hear much from us at the IMF about this subject amidst all the attention paid to the global financial crisis and the risks to the economic recovery. It is true that at the IMF and World Bank Annual Meetings in Tokyo last month, the Fund offered a somewhat gloomy picture of the global economy, projecting only a modest 3.3 percent this year, and a still sluggish 3.6 percent in 2013. We warned of the risks to recovery from the fiscal cliff in the United States and the eurozone crisis and we called for action on both counts.

So, you would be right to assume that we spend a lot of our waking hours working on the problems of the advanced economies.

But I can assure you that we are also keenly focused on the historic opportunities offered up by the changes going on in the MENA region. We are hard at work with mission teams deployed and engaging.

I want to speak to you about what is at stake right now for the people of the region and for the world. No doubt that in the end, the people of the region will make their own decisions about their future and choose their own destiny. But we too have a huge stake in successful transformation and I believe there is much we should do to try to help.

I will speak about what the IMF is doing. And I will also argue that the international community as a whole must resist the understandable preoccupation with its own difficulties, at this important moment when we all need to provide concrete support for the aspirations of the people of the Middle East and North Africa for a brighter future.

Historic opportunity

The Arab Awakening started as a revolution, with a single self-immolation by a street vendor in a rural town in Tunisia in December 2010. The next month, the call in Egypt for “bread, freedom, and social justice” echoed across much of the Arab world and excited observers everywhere. The mandate for change was not just political―it extended deep into the economic sphere. The people were calling for a say in how their countries would be governed and for greater opportunities for prosperity and human fulfillment.

Now, almost two years later, MENA's future is unclear. In their recent article entitled “This is Not a Revolution,” two prominent Middle Eastern scholars, Hussein Agha and Robert Malley, begin with the assertion that in the Middle East “history does not move forward. It slips sideways.” They say aloud what many recent observers have been thinking, that newly elected governments lack a clear direction in terms of political and economic reform and that religious factionalism is reinforcing inaction. They warn darkly that the fight for political power will block progress on political and economic reform. One could add that some have doubts about the pace and direction of reforms in countries where leadership has not changed.

To me a useful way to think about the present situation is that the revolution in the region could take any one of three alternative paths, as far as the economic consequences are concerned, paths which one could call deterioration, restoration, and transformation.

We could see economic deterioration, if squabbling over political power prevents stabilization let alone reform;

We could see stabilization achieved through a reassertion of vested business interests offering a respite from eroding economic conditions but condemning the region to a return to economic stagnation or at best tepid growth;

Or we could see a new economy emerge, as newly elected and inexperienced governments gradually find a way to end lingering economic disruptions and begin reforms to open the way to greater economic opportunity for their people.

While the first two paths would be undesirable, they could come to pass. Needless to say, the third path, transformation, would be best. How should we assess these prospects? What if anything can we do to affect the outcome? Let me try to address those key questions.

Region in transition

We need to recognize upfront that MENA is a huge and economically varied region. We are talking about 20 countries with a population of more than 400 million people and $3 trillion in GDP. That accounts for about 6 percent of the global population, and for 4 percent of global GDP. Of course, country circumstances vary widely. As you well know, some countries in the region possess vast oil and gas reserves, while others have less significant natural resource endowments. If there is one fact I would like you to remember from my talk here today, it is that the non-oil exports of the region, the whole region, are $365 billion, about the same as the exports of Belgium, a country of eleven, not 400, million people.

Why is that so telling? In answering, let me focus on the Arab countries in transition. I have in mind Egypt, Jordan, Libya, Morocco, Tunisia, and Yemen—all countries that have embarked on substantive political change, either through revolutions or from within.

Long before people took to the streets, the Arab countries in transition faced the challenge of employing rapidly growing, youthful populations. Despite several rounds of reforms, their economies were unable to generate enough jobs. There were three related problems.

First, there was a lack of openness to international trade, which might have generated more jobs than just producing for the home market.

Second, governments were unable to create the infrastructure needed to support a dynamic economy. In some countries, energy and other subsidies were repeatedly increased to placate restive populations and avoid challenges to political rule, leaving over-stretched budgets without room to modernize infrastructure.

And third, where meaningful structural reforms were attempted, there was a widely held perception that the control over investments in new sectors remained in the hands of a select elite and were not inclusive. In fact, research has now shown that in a number of countries, the stock prices of companies connected to the political leadership substantially outperformed the rest during periods of reform. The connected companies were able to get credit and gain market share, but they were not big job creators. And the evidence shows that once the political leadership changed, those same companies lost more in value than the rest.

The result of the three factors I have described was a lack of economic vitality and high and rising unemployment, including among well educated young people.

So, the statistic I cited earlier -- low non-oil exports – is a crucial indicator of the nature and size of the structural adjustment problem. But ironically, it also illuminates the way forward.

To achieve broad-based and sustainable growth, the countries of the Middle East need to move away from state-dominated to private investment and from protected industries and rent-seeking to export-led growth and value creation. That’s where the jobs will be. To unlock the region’s formidable growth potential, the private sector must become the main source of growth, which will only happen if they can access global markets, not just their home markets.

Key areas of reform

To achieve these goals, I see six areas where reforms are needed. But the list starts with and depends upon the very first item: stronger trade integration.

• Stronger emphasis on trade. The overarching strategy to deliver economic growth on a scale and timetable that would create enough jobs and prosperity for the rapidly growing populations in these countries is economic integration. More trade integration would not only create growth and jobs, but it would also act as a catalyst for reform: it would provide discipline and incentives to help get the reform strategy right. A country that opens up to international competition will inevitably find a greater logic in the rest of the list of reforms because those reformswill help them compete. Let me briefly run through that list.
• Improving the business environment. Complex and burdensome regulations hold back job creation and growth in the region. Take Egypt. No less than 36,000 regulations currently affect the private sector there. And Egypt is by no means the only country afflicted by burdensome regulation. Starting your own business also needs to become much easier. Many of the new political parties are grounded in support from people running small businesses and understood this is a priority. Equally important to the business climate is clarity and security about rules and their enforcement. And this ultimately is something that needs to be embedded at the highest level: in the constitution itself. For countries struggling to craft constitutions suitable to the societies they are trying to build, it is important to bear in mind that the rule of law is key to commerce, and that until constitutions are adopted, uncertainty will remain.
• Enhancing the labor market. Youth unemployment ranges from 18 to 30 percent in Egypt, Jordan, Morocco, and Tunisia. In Egypt, 650,000 people enter the labor force each year. Women face particular problems in securing employment, with only about a quarter holding jobs in Egypt, Jordan, Morocco, and Libya. The public sector dominates the job market, and labor laws are rigid. Governments should reform labor market regulation to reduce disincentives for hiring, while maintaining adequate worker protection.
• Improving education. The labor force needs more education, and greater technical skills in engineering and science. The education system has been unduly focused on training young people to fulfill the formal requirements for entry in the civil service. It now needs to be realigned to the needs of private employers.
• Facilitating access to finance. Another major constraint on economic growth in the Arab countries in transition is the lack of access to finance for companies. At present, private credit mainly benefits large established companies, and only 10 percent of firms use banks to finance investment. This is the lowest share of bank financing in the world.
• Replace untargeted subsidies with a modern social safety net. Finally, another key pillar on the reform agenda will be to reduce untargeted subsidies that accrue mainly to upper quintiles of the income spectrum, so that budget funds are freed up for needed infrastructure, health and education spending. That reform must be accompanied by the creation of modern and efficient systems to protect those most in need. Let me stress that it is crucial that reforms are preceded by a clear explanation that subsidy savings will be spent on valuable investments and that the poor will be protected.

Short-term challenges

Unfortunately for the MENA region, not only will countries have to embark on these difficult reforms aimed at boosting growth over the medium term, they also have stabilize their economies in the short-term. That is because the process of change now underway has been disruptive and the new political and economic direction has created uncertainties for businesses and investors.

Policymakers face the immediate challenge of finding the right balance between satisfying peoples’ high expectations and carrying out tough decisions to bring public finances under control and secure the strength of weakened financial systems.

Worse yet, the state of the world makes stabilization even more difficult. A slowing world economy, the ongoing uncertainties in Europe, higher food and fuel prices, and the conflict in Syria, with its deplorable loss of life, all risk undermining the fragile gains that have been made in terms of stabilizing the economies in the region this past year and a half.

For newly elected leaders managing difficult and uncertain political transitions -- whether newly elected or newly mandated -- stabilization and transformation is a daunting challenge.

At the IMF, we are currently expecting a moderate recovery in 2013 for the ArB countries in transition, but growth will not be sufficient to begin making sizeable inroads in tackling high unemployment.

What is more, fiscal and external buffers have eroded, and these countries face projected external financing needs of $33 billion next year—a need so large it will not be fully met from private sources. It will require extensive support from bilateral partners, both from the region and beyond, and loans from international financial institutions, including the IMF.

This also means that difficult policy choices will have to be made on the budget. Fiscal deficits in the region have increased since the onset of the Arab Awakening, and now average 9 percent of GDP in the countries in transition (excluding Libya).

Consolidation cannot be achieved without shifting away from inefficient and expensive subsidies to targeted support for the most vulnerable. As I mentioned earlier, subsidies in the Middle East have proved a Faustian bargain―supporting social peace in the short run but siphoning resources away from investment in education, infrastructure, and other key areas.

Last year, price subsidies in the Middle East and North Africa cost around $210 billion, more than 7 percent of regional GDP. Besides being very costly, such subsidies do not do a good job at supporting the poor. For example, Hisham Kandil, prime Minister of Egypt has pointed out that one third of energy subsidies benefit the wealthiest one fifth of the population: people who can afford cars and air conditioners. And our research at the IMF suggests that the situation is similar in many other countries. Social safety nets, including cash transfers and targeted price subsidies, are better ways of supporting poor households and are much more cost-effective.

Role of the international community

So the bottom line is that the transformation now underway in MENA is taking place under adverse economic circumstances, and the endpoint is, for now, uncertain. Countries have understandably been focusing on political reform and securing macroeconomic stability. The progress that has been achieved in those areas is an achievement, especially in light of the difficult circumstances they face. There has not yet been a comprehensive effort to specify a new economic destination nor to lay out the transformation needed to get there.

When one considers the potential costs of the two undesirable paths I described earlier, and the benefits not only for the region, but for the global economy and security of the third path, it is clear that the international community should make a concerted effort to provide adequate financing, trade access, and policy advice.

At the IMF, for our part, we are trying to step up to the challenge. Throughout this difficult period, we have been deeply engaged with the countries in the region. We are advising countries on how to manage the shocks they have experienced and maintain economic stability, how to ensure that vulnerable households are protected during the transition, and how to lay the basis for job-creating growth.

The nature of our involvement has shifted from mainly providing advice to helping with financing. In the past year alone, we have provided a total of $8½ billion in loans for Jordan, Morocco, and Yemen. We are also in active talks for a support package with the government of Egypt, and we hope to help Yemen with a follow-up arrangement to supplement the emergency assistance we provided last year.

In Tunisia, financing needs for 2012 have been met for now. As in the other countries, we are providing policy advice and technical assistance. Libya needs capacity building, not financing―so here we have stepped up our support to help the country rebuild its institutions and economy after the end of the conflict last year.

As we engage more closely in the region, we find that we have to explain the role of the IMF and how we work with governments today. We know from experience that programs are much more likely to succeed if they are designed and owned by the national authorities and enjoy broad support within the country. We are also focusing much more explicitly on policies that ensure that the benefits of economic growth are shared more broadly. And we now consult widely with civil society, labor, and parties across broad political spectrum.

But let me be candid: we can help countries stabilize and help create a climate conducive to reform, but we cannot shepherd MENA countries through transformation that lies ahead.

So, let me end with some thoughts about the role of the international community more broadly. MENA’s partners—including the United States, European Union and Gulf Cooperation Council countries—have already done a great deal to support transition countries in the region. But the task is so great that we must all do more.

It will be very important for the international community, including the G-8 countries, regional partners such as the Gulf Cooperation Council countries, and international and regional development banks to provide adequate support in financing stabilization and capacity building. The European Union and the United States will need to hold out the prospect of deep market access for trade in products and services for countries that are willing to undertake fundamental transformations.

Investment, including with support and enhancements from bilateral and regional partners, can help jumpstart growth. The invaluable expertise, coupled with investment in the private sector by the European Bank for Reconstruction and Development and other financial institutions can act as trailblazers, leading investors into new sectors and markets, as happened in Eastern and Central Europe. Those investments will not only catalyze economic transformation, but also serve the economic and security interests of the international community.

The Deauville Partnership has provided a useful coordinating framework but cannot by itself deliver on all that is needed. We look forward to working with the U.K. as it takes over G-8 presidency in 2013, and will help deliver on the theme of “Open Economies, Inclusive Growth” that will make the Deauville process a meaningful contribution during the U.K. presidency.

Conclusion

The Middle East and North Africa is unique and each country will need to chart its own path. But some insights can be gleaned from other transformations.

In Central and Eastern Europe after the fall of communism, the prospect of EU membership held out a powerful promise that served as a political and economic anchor and helped orient the transformation to market-based economies. Turkey also provides an inspiring example of a Muslim country that has chosen fundamental economic reform and has become a vibrant emerging market economy with a strong and growing middle class. There too, the prospect of EU membership provided an initial impetus to reforms.

In the Middle East and North Africa, a strong external economic anchor is currently missing. So now is the time for a dynamic dialogue with political and thought leaders in MENA countries about their economic future, a dialogue that might lead to a roadmap and transformation strategy to channel peoples’ energies toward a common goal.

The process of defining the reform agenda in each country must be truly participatory and draw on the perspectives of all stakeholders. Reform plans, no matter how technically sound, cannot be imposed without broad popular understanding and acceptance.

I believe one thing is clear: the Middle East stands at an historic crossroads and we would come to regret a failure to rise above our own preoccupations to engage with the people of that region.

During its golden age, which lasted five hundred years, the Middle East possessed enormous economic power, with commerce, communications and transport reaching across Europe, Africa, and Asia. Ibn Battuta, a fourteenth century explorer from Tangier whose travels across nearly the whole of the Muslim world may well have surpassed in scale even those of Marco Polo, acknowledged the power of openness and engagement when he wrote: “If you are a son of the land of the west and you seek success then head for the land of the east”.

Today, the west needs to reach out to the east, just as the east needs to reach out to the west. Only by traveling together will we see meaningful modernization and integration for the Middle East and North Africa. The region deserves our support. The time to act is now.