This paper is part of an MEI scholar series, titled "Obama's Legacy in the Middle East: Passing the Baton in 2017." Click here to view the full project, or navigate using the table of contents to the right.

Introduction and Overview

Economic trends will provide a very important part of the context in which President Obama’s policies play out in the remainder of his term until January 2017. The Middle East’s economic recovery from the 2008-2010 global economic crisis has been mixed. While major oil exporting countries have made a solid recovery, most of the oil importing countries continue to struggle, which reflects, in large part, regional political and security issues, the inability of governments to implement difficult policy reforms, and continued slow global growth. The increased financial support from some major oil exporting countries has helped a number of oil importing countries to stave off economic challenges. However, underlying conditions remain highly vulnerable to domestic and external risks. The near and medium term economic outlook is fragile and, unless addressed vigorously, could heighten regional political and security instability.

A more activist U.S. involvement in addressing underlying factors will be crucial and is in the United States’ strategic interest. Such involvement should not only help facilitate the provision of adequate financial resources but also the political reforms that are needed for an orderly transition to sustained growth and employment. Read more importantly, U.S. support, in collaboration with multilateral lending agencies and regional players, will be crucial in encouraging oil importing countries to pursue appropriate economic policies that would allow a more efficient use of external assistance and the mobilization of domestic resources to phase out extraordinary dependence on external financing. This will require a delicate balancing of political and economic reforms in the oil importing countries so that they reinforce each other. Institutional reforms that help allocate oil exporting countries’ generous financial support more effectively and help in the mobilization and use of domestic resources in the oil importing countries will be highly beneficial.

Recent Economic Trends and Outlook

The anticipated economic recovery in 2014 of the oil importing Arab countries has turned out to be weaker than expected because of heightened regional security concerns, continued political uncertainty, weak economic policies, and slower global economic recovery. Most of these economies are now expected to grow by less than 3 percent in 2014, or at about the same rate as in 2013, well below their potential growth path and what is needed to make a dent in mounting unemployment.[1] Fiscal and external deficits are also estimated to remain large, especially in countries most adversely affected by political upheavals. On the other hand, major oil exporting economies (including members of the Gulf Cooperation Council, or GCC), have so far registered a solid recovery. Notwithstanding the recent softening of oil prices, they are (except Iraq) poised to grow at about 5 percent in 2014 with continued fiscal and external sures and a buildup of external reserves.[2] These sures have been the major source of financing external deficits of a number of oil importing countries.

The near and medium term outlook has become somber. Should ISIS-related regional conflict deepen, civil war in Syria continue, and civil/political discontent persist, with the associated market uncertainties, the next two years and the medium term will probably see more pronounced negative effects on the oil importing economies, especially those dependent on tourism and external financial support. If the negative effects of the ongoing Syrian and Libyan conflicts on neighboring countries—Egypt, Jordan, Lebanon, and Iraq—are an indicator of the broader ISIS-related conflict’s effects, and if policy reforms are further delayed, growth in most of these economies may not recover from the low levels in 2014. These countries will likely see capital flight, lower investment, pressures on the exchange rate, and—above all—diversion of government outlays away from productive activities with adverse effects on the governments’ ability to generate employment opportunities. In the absence of politically difficult domestic policy reforms, macroeconomic imbalances will deepen and external financing requirements will increase; these are presently projected to rise from over $50 billion in 2014 to $60-65 billion in 2015-16.2 Such gaps will be difficult to fill.

Over the next two years, external sures of major oil exporting countries will shrink. With the additional burden of regional conflict, rising domestic demand, and lower oil receipts, GCC countries’ ability to finance external imbalances of oil importing economies will also contract. In these circumstances, governments in many oil importing countries will have less room—financially and politically—for the needed tougher action to get the economies moving toward a faster pace of growth and the employment generation that are prerequisites for political sustainability.

The longer term outlook is difficult to project. On the regional level, loss of political cohesion, worsening economic conditions, and weakening cultural identity (including sectarian conflicts, radicalization, and deepening of conflicts between the rulers and the ruled) could exacerbate intraregional conflicts. Most of the oil exporting countries will likely run fiscal deficits as oil prices fall and expenditures increase. In the absence of drastic economic reforms in the oil importing economies, growth will remain below what is needed for political sustainability. Even if political cohesion is strengthened and domestic political discords are resolved, national and regional stability will call for substantially more resource transfers from abroad than is presently feasible.

Economic Policy Options in Oil Importing Countries

Governments in oil importing countries will continue to be confronted with contradictory economic objectives: reduction in fiscal and external deficits to stabilize macroeconomic positions versus acceleration of growth to address unemployment challenges. While sharply expanded external financial assistance to some of these economies, mainly from some GCC countries, has temporarily staved off crisis, underlying vulnerabilities to external and domestic shocks remain large. In the period ahead, external financial support will likely shrink, highlighting the policy dilemmas in some of these countries.

Challenges in oil importing countries are both political and economic, and both have to be addressed for durable economic progress with political stability. At the political level, consensus-building will be necessary to engender broad support for difficult economic reforms. While countries like Jordan, Morocco, and Tunisia have initiated important economic reforms under IMF-supported programs, in other countries a lack of progress on the political front has resulted in inadequate and halting economic reforms. In particular, there has been an excessive increase in dependence on potentially unsustainable external financing. Any measurable drop in such financing could further weaken efforts at employment generation and trigger political discontent derailing economic reforms.

The authorities in oil importing countries will have to prioritize their potentially conflicting economic objectives and appropriately sequence policy reforms in line with the projected shrinking external support. The short-term fiscal consolidation including expenditure restraints, reduction in subsidies, and increase in revenues—which should form the foundation of any meaningful reform in the near term—may have to be moderated so as not to lose political support and adversely affect growth and employment generation. Increased public sector spending on employment generation and infrastructural development to ease unemployment pressures should be an integral part of reform strategy. In this context, continuation of external financial support—but conditional on specific domestic reform measures—at about the current levels will be critical. Such a reform program should be integrated into a longer term strategy that progressively reduces dependence on external financing, improves market forces to more efficiently allocate resources through a regenerated private sector, and helps develop the financial sector for resource mobilization and investment.

U.S. Economic Policy toward the Middle East

The U.S. strategy in the Middle East has sought to establish overall political stability, to counter security threats emanating from the region, and to shore up orderly global oil prices and markets. In order to achieve these objectives, it has supported measures to stabilize economies of the selected oil importing countries that were most seriously affected by the so-called Arab Spring, and has cooperated with oil producers to stabilize the oil market. Primary instruments have been direct economic assistance to ease critical infrastructural shortages, defense-related support to ensure security, and trade preferences for selected countries. The United States has also encouraged countries to use its private sector financial resources, assistance from other countries, and multilateral financial institutions to help in easing external constraints and facilitating the needed changes in domestic economic policies. It has also encouraged countries to ease their regulations and domestic controls so as to facilitate foreign direct investment.

The last two to three years have seen important qualitative changes in the implementation of U.S. economic strategy. The recent political upheavals in the region have shifted the focus of U.S. policy primarily toward helping restore political stability and ensuring security, which has led to a reduced focus on pressing economic issues. In addition, reflecting the shift in the U.S. global focus to East Asia and Europe, transfers to the region have not kept pace with the mounting requirements in the wake of the political shifts. Increased self-sufficiency in energy may have also shifted priorities. Under the circumstances, the widening resource gap in the oil importing countries has been filled by oil exporting countries whose narrow strategic interests are primarily to preserve the political status quo. As such, economic reforms have been shelved, and the potential crisis has been postponed rather than resolved. This outcome is not necessarily beneficial for recipient countries, nor is it necessarily consistent with the perceived U.S. long-term interests of supporting sustainable long-term growth in the region that would nurture political stability and enhance security.

What Are the Options for U.S. Policy in the Next Two Years?

In an environment of rising intraregional tensions, the absence of a more activist U.S. policy to help correct the underlying economic distortions in these countries will not only be counterproductive in the short run, but could further weaken the glue that holds the region together and deepen political discord. The short term will likely be characterized by increased financing needs in the face of lower availability of external assistance, as well as reduced capacity to implement required policy reforms. Such a scenario will be inconsistent with regional stability, will hamper progress toward political resolution of underlying conflicts, and will increase the cost of meeting U.S. strategic interests.

Enhanced U.S. engagement will be required. It should encompass not only addressing the widening financial requirements of the region along with facilitating policy corrections, but also helping to establish an institutional framework that countries in the region can buy into to sustain growth, promote income equality, and cement regional economic interdependence. The latter is particularly relevant for the Middle East, where the probable decline in regional economic interdependence from an already low level relative to other regions in the world is heightening national and sectarian differences and increasing the cost of conflicts.

At the outset, steps could be considered to increase financial assistance to selected countries and improve the efficiency of its utilization by actions in both beneficiary and donor countries. The Deauville approach, initiated three years ago to muster and allocate economic assistance to oil importing countries, should be strengthened to not only increase allocations and disbursements, but also their effective use. In the same vein, the oil exporting countries’ assistance should be better targeted to enhance both economic and political conditions of beneficiary countries. It is critical that beneficiary countries be rigorous in reforming their policies so as to expeditiously eliminate the need for extraordinary financial support which is, at best, a double-edged sword. Multilateral financial institutions, especially the IMF, have been deeply involved in Jordan, Yemen, Tunisia, and Morocco to help refocus these countries’ macroeconomic policies, and they should continue to support the needed reforms. Active U.S. participation can go a long way in supporting these steps over the next two or so years.

Sustaining economic growth and stability over the longer term will call for building on the short-term measures. It is in the strategic interest of the United States and other friends of the region to make sure that the reform initiatives are nurtured through the establishment of self-sustaining institutions and political structures to support inclusive growth. In particular, development or strengthening of institutions that facilitate an efficient integration of sur and deficit countries, in part through the use of a part of oil exporting countries’ external sures in deficit economies, should be encouraged. Consideration should be given to the establishment of an autonomous regional development finance institution with capital and associated commitments from not only oil exporting countries but also major industrial countries; such an institution would supplement funding from national lending agencies of some oil exporting countries. Substantial U.S. participation in the proposed institution could further its development and effectiveness.

Concurrently, institutional and political capacity must be enhanced in the beneficiary countries to more effectively use additional resources and to become more self-reliant. This will entail not only help in establishing stakeholders for reform, but also mechanisms to mobilize domestic resources under broadly accepted rules.

The Obama administration has so far focused, among other things, on encouraging the oil-importing Middle East countries to liberalize their policies in order to facilitate inflows of direct foreign investment and to rationalize rules governing financial sectors to ease capital flows and improve domestic resource mobilization. These policies have reinforced recommendations of multilateral lending agencies and have had a positive effect. Over the next two years, the administration’s initiatives in the economic field will be constrained by the urgency to contain political turmoil and ensure security. The economic policy stance will, therefore, remain broadly unchanged. The U.S. private sector will continue to be encouraged to invest in line with policy/institutional reforms in the recipient countries. Recognizing the important role of concessional external assistance in the current context of the region, the administration will also likely encourage a larger and timelier distribution of such assistance under the Deauville process. Steps may also be mooted to make regional assistance more efficient.

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[1] IMF, Regional Economic Outlook: Middle East and Central Asia, October 2014.

[2] IMF, Regional Economic Outlook.