Economic Research Forum (ERF)

Contagion vulnerability of MENA economies

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The weak economic performance of MENA countries in recent years would deteriorate further in the event of fresh negative shocks to the world economy. This column highlights the key vulnerabilities of the region to various external events as an essential step in the formulation of appropriate macroeconomic policies.

In a nutshell

When formulating macroeconomic policies, policy-makers in MENA countries should consider the excess vulnerability of the economies of the region to external shocks.

Shocks to the oil-producing GCC countries come mainly from fluctuations in the world oil price, global output and the value of the US dollar.

The remaining MENA countries are affected not only by those shocks, but also by fluctuations in world interest rates and the terms of trade.

Over the last two decades, the economic performance of the countries of the Middle East and North Africa (MENA) has been disappointing. Weak policies characterised by highly volatile exchange and inflation rates, and high levels of external debt and fiscal deficits – coupled with a deteriorating external environment featuring significant declines in global output, high volatility in oil prices and revenues, a sharp rise in interest rates in international credit markets, and appreciation of real effective exchange rates – have all put additional strains on the region’s macroeconomic performance (Neaime, 2000, 2005; Mansoorian and Neaime, 2003).

After the 2008 financial crisis, it became essential for the region to assess the impact of external shocks on its domestic economies. Further shocks to the world economy now are likely to undermine macroeconomic performance in the region even further – and could lead to a fully-fledged economic and/or financial crisis.

Currency and financial crises tend to spread along the lines of financial and trade linkages (Neaime, 2012, 2015a, 2015b, 2016; Michelis and Neaime, 2004; Mora et al, 2013). The extensive openness of MENA’s financial and trade relationships with the rest of the world make the transmission of shocks to the region a matter of great concern. Policy-makers need to consider how to pre-empt an impending crisis, thereby making it less likely that they will have to resort to painful economic measures after the fact.

While developed countries with relatively large economies are typically able to absorb and neutralise the effects of external shocks, it is more difficult for developing economies, which are usually smaller in size and dependent, as in the oil-producing MENA countries, on the export of just one commodity.

It is well known that MENA countries rely heavily on trade and enjoy a relatively high degree of economic and trade openness. This is due to the particular factor endowments of the region (rich in oil, poor in water), which results in considerable oil exports and food imports rather than regular trade.

This fact has made most of the economies of the region vulnerable to external shocks. The more open an economy, the more it is vulnerable to external shocks; and the smaller the economy, the greater the domestic impact (Neaime and Gaysset, 2017, 2018; Neaime et al, 2018; Guyot et al, 2014).

Within the region, the oil-producing countries of the Gulf Cooperation Council (GCC) tend to be the most vulnerable to external shocks because of their high degree of openness. These shocks come mainly from fluctuations in the world oil price, global output and the value of the US dollar. The remaining MENA countries are affected not only by those shocks, but also by fluctuations in world interest rates and the terms of trade.

The impact of external shocks on the macroeconomic dynamics of both the oil and non-oil-producing MENA countries is significant. But it differs across countries and depends on their individual macroeconomic asymmetries, economic policies, factor endowments and the time horizon under consideration (Neaime, 2004, 2008, 2010). Moreover, external shocks are likely to have high propagation power within the economies of the region, which is a clear signal that their macroeconomic policies need to be reformed.

For the GCC countries, the effect of oil price volatility on the fiscal balance has a relatively high magnitude, reflecting the high share of oil revenues in their budgetary structure and the de facto institutional currency peg to the dollar. The same is true of the trade balance, where the oil price and world interest rates capture most of the volatility.

In the non-oil-producing MENA countries, the oil price has less direct influence on the their macroeconomic dynamics. Variability in the trade balance of these countries is mostly captured by world demand, which directly affects demand for their exports.

For the GCC countries, a positive shock to the oil price has a significantly positive impact on per capita GDP growth, and on the fiscal and trade balances. These dynamics are in line with economic intuition, reflecting the high share of oil revenues in the budgetary structures of these countries, and the high contribution of oil exports to the trade balance.

But while an oil price rise constitutes a positive shock for oil-producing MENA countries, it constitutes a negative supply-side shock for non-oil-producing MENA countries in the short run. A positive shock to the world real interest rate also has a negative impact on the fiscal balance of non-oil-producing countries, because these highly indebted countries will have to service higher external debt, leading to more budget deficits.

The impact on the fiscal balance of oil-producing MENA countries is exactly the opposite. The improvement in their fiscal balance is due to the fact that most oil-producing MENA countries invest the proceeds of their oil revenues in US Treasury bills and bonds. Therefore, any increase in world interest rates translates into more fiscal revenues and an improvement in their fiscal position.

In short, when formulating future macroeconomic policies, policy-makers in MENA countries should consider the excess vulnerability of the economies of the region to external shocks. The GCC economies still rely heavily on oil price increases and high oil revenues to counterbalance their rising macroeconomic imbalances. Oil revenues and government spending are the main factors that enhance their GDP growth rates.

To avert any future deterioration in their economies, Kuwait, Saudi Arabia and the United Arab Emirates will have to reduce their reliance on the oil sector and diversify their economies towards the industrial and services sectors.

In the non-oil-producing MENA countries, recurrent current account deficits since the early 1990s have been mainly financed by external borrowing. Future servicing of the accumulated foreign debt may aggravate their deteriorating current account deficits, and put more pressure on these countries’ exchange rates.

Many economists have argued that the way to reduce chronic current account deficits is to raise national savings by reducing the budget deficit and increasing the rate of private saving. Under the current deteriorating world macroeconomic outlook, relying on curtailing MENA’s public budget deficits alone in an attempt to trim down current account deficits may not be a viable solution. Thus, one cannot treat the public budget as a fully controlled policy variable.

Further reading

Guyot, Alexis, Thomas Lagoarde-Segot and Simon Neaime (2014) ‘Foreign Shocks and International Cost of Equity Destabilization: Evidence from the MENA region’, Emerging Markets Review 18: 101-22.

Mansoorian, Arman, and Simon Neaime (2003) ‘Durable Goods, Habits, Time Preference, and Exchange Rates’, North American Journal of Economics and Finance 14(1): 115-30.

Michelis, Leo, and Simon Neaime (2004) ‘Income Convergence in the Asia-Pacific Region’, Journal of Economic Integration 19(3): 470-98.

Mora, Nada, Simon Neaime and Sebouh Aintablian (2013) ‘Foreign Currency Borrowing by Small Firms in Emerging Markets: When Domestic Banks Intermediate Dollars’, Journal of Banking and Finance 37(3): 1093-1107.

Neaime, Simon (2000) The Macroeconomics of Exchange Rate Policies, Tariff Protection and the Current Account: A Dynamic Framework, AFP Press.

Neaime, Simon (2004) ‘Sustainability of Budget Deficits and Public Debt in Lebanon: A Stationarity and Cointegration Analysis’, Review of Middle East Economics and Finance 2(1): 43-61.

Neaime, Simon (2005) ‘Portfolio Diversification and Financial Integration of MENA Stock Markets’, in Money and Finance in the Middle East: Missed Opportunities or Future Prospects? Vol. 6: 3-20.

Neaime, Simon (2008) ‘Twin Deficits in Lebanon: A Time Series Analysis’, Lecture and Working Paper Series No. 2, Institute of Financial Economics, American University of Beirut.

Neaime, Simon (2010) ‘Sustainability of MENA Public Debt and the Macroeconomic Implications of the US Financial Crisis’, Middle East Development Journal 2: 177-201.

Neaime, Simon (2012) ‘The Global Financial Crisis, Financial Linkages and Correlations in Returns and Volatilities in Emerging MENA Stock Markets’, Emerging Markets Review 13(2): 268-82.

Neaime, Simon (2015a) ‘Sustainability of Budget Deficits and Public Debts in Selected European Union Countries’, Journal of Economic Asymmetries 12: 1-21.

Neaime, Simon (2015b) ‘Twin Deficits and the Sustainability of Public Debt and Exchange Rate Policies in Lebanon’, Research in International Business and Finance 33: 127-43.

Neaime, Simon (2016) ‘Financial Crises and Contagion Vulnerability of MENA Stock Markets’, Emerging Markets Review 27: 14-35.

Neaime, Simon, and Isabelle Gaysset (2017) ‘Sustainability of Macroeconomic Policies in Selected MENA Countries: Post Financial and Debt Crises’, Research in International Business and Finance 40: 129-40.

Neaime Simon, and Isabelle Gaysset (2018) ‘Financial Inclusion and Stability in MENA: Evidence from Poverty and Inequality’, Finance Research Letters 24: 230-37.

Neaime, Simon, Isabelle Gaysset and Nasser Badra (2018) ‘The Eurozone Debt Crisis: A Structural VAR Approach’, Research in International Business and Finance 43: 22-33.

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