The surge in investment and strong productivity gains from broad-based structural reforms are expected to sustain growth above the 6 percent level (see table). However, against the background of persistently high fuel and food prices, strong domestic demand, and supply bottlenecks, inflationary pressures are unlikely to abate. Inflation in the region is forecast to climb to 10.7 percent in 2008, up from 9.2 percent last year.

The IMF’s Regional Economic Outlook for the Middle East and Central Asia, released in Dubai on May 12, said that with high oil prices boosting oil revenues, fiscal and current account surpluses in oil-producing countries are projected to remain large despite stronger imports and further fiscal expansion. [see separate story on oil outlook.

Aim to reduce vulnerabilities

In most non-oil-producing countries, the policy stance will likely aim to rein in fiscal and external deficits, thereby reducing further vulnerabilities.

Risks to the outlook are broadly neutral, with some upside risks from domestic demand likely to be balanced by downside risks from the external sector. High oil prices and further cuts in U.S. interest rates could lead to a stronger-than-expected increase in domestic demand in the GCC countries, comprising Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates (U.A.E.).

Furthermore, the growing surplus in oil producers, combined with concerns about asset quality in advanced economies, may well lead to increased inflows to the other countries in the region, fueling stronger credit and domestic demand.

However, a protracted slowdown in advanced economies would hurt growth in most MCD countries, depressing exports and commodity prices. Tighter credit in advanced economies and lower risk appetite, as evidenced by widening sovereign spreads, could also curtail the capital inflows that have supported growth in many countries in the region.

"All countries in the region have been largely unscathed by the recent financial turmoil in developed countries, except Kazakhstan, where the banking sector relied heavily on foreign borrowing," Mohsin Khan, Director of the IMF’s Middle East and Central Asia Department, told the Dubai press briefing. "As in most other emerging markets and developing countries, this resilience owes much to the region’s strengthened macroeconomic position and progress with structural reforms."

Notwithstanding continued strength in import growth (20 percent in U.S. dollar terms), high oil prices will keep the region’s current account surplus above 18 percent of GDP in 2008, leading to a further accumulation of international reserves, now close to the $1 trillion mark, the report said.

Key policy challenges

The key macroeconomic policy challenge in the short run for most countries in the region is to contain rising inflationary pressures, and for countries with large external debts and current account deficits to protect their external stability in the context of high oil prices and slowing world growth.

The appropriate policy mix will depend on each country’s particular circumstances but would most likely call for fiscal and monetary tightening, and greater exchange rate flexibility when feasible. In oil-exporting countries with currencies pegged to the U.S. dollar, demand management policies will face challenges in controlling inflation, given the continuing bias toward monetary easing in the United States. The burden of the adjustment may well have to fall on fiscal policy, particularly in the GCC countries, where a change in the exchange rate regime would be disruptive in the run-up to the planned monetary union.

Beyond this immediate challenge, the report said that policymakers need to remain focused on strengthening policy frameworks, promoting sound financial deepening, and supporting the growth potential of the private sector.

In particular, countries need to continue strengthening their fiscal policy frameworks tailored to address specific issues in their fiscal outlook, most notably the efficient and sustainable use of oil revenues in oil exporting countries, and high public debt in some low-income and emerging market economies. Phasing out fuel and food subsidies while establishing a more targeted safety net would help some countries in the region preserve long-term fiscal sustainability, enhance efficiency of spending, and improve equity.

For countries where greater exchange rate flexibility is desirable over the medium term, it is important to continue to lay the foundation of an independent monetary policy. Despite the difficult challenges ahead, GCC countries are encouraged to keep the agenda of the proposed monetary union on track, including reaching consensus on the appropriate exchange rate regime, the report added.

Successful integration

Continued development of banking systems will be critical for achieving high growth and for the region’s successful integration into the world economy. In particular, dealing with the large stock of nonperforming loans and restructuring state banks in some countries will be crucial for enhancing the efficiency of the banking sector and lowering the cost of borrowing. Strong supervisory vigilance is also important, particularly in countries experiencing rapid credit growth.

The report noted that the private sector is essential for the expansion and diversification of the production and export base of the region’s economies, and for the creation of jobs for the rapidly growing labor force—a pressing problem for many countries in the region.

Among the key policies in this regard are those to improve the investment climate and lower the cost of doing business (including by reducing barriers to trade and removing excessive government controls and regulations), to enhance the transparency of the legal and administrative systems, and to overhaul national education systems to meet the demand for skills by an increasingly competitive world economy.