In the three years since the Arab Awakening of late 2010, the Middle East and North Africa (MENA) has seen an increase in conflict and political instability, on the one hand, and a deteriorating economic situation on the other. Given the vicious cycle between economic hardship and conflict, it is natural to ask whether a return to political stability will restore prosperity in the region.
The recent MENA Economic Developments and Prospects Report, Investing in Turbulent Times, looks at one, important component of the economic decline—the drop in foreign direct investment (FDI)—and its link to the region’s political risk. There is no question that political turmoil has weighed down economic activity in developing MENA in 2013, with growth expected to drop to 2.8 percent, but it is also the major risk to the regional outlook for 2014. From a “two-speed MENA” in 2012 when the oil exporting countries were growing faster than the oil importing ones, we are down to one, slow speed in 2013, as unfavorable developments, especially in Libya, Iran, and Syria, have brought down their growth rates.
Pronounced economic weakness has exacerbated external and fiscal imbalances, especially in the oil importing economies. Fiscal imbalances grew due to slippage in government revenues, increases in current public spending, rising costs of heavily subsidized imports, and, in some cases, growing interest expenditures. External imbalances persisted as exports, especially tourism receipts, declined. Public investment also dropped, while domestic private investment remained relatively unaffected. Closing the current account gaps has become a problem in many countries as risk premiums increased and FDI plummeted.
The report finds a robust, negative effect of political instability on aggregate FDI flows to the region. The political shock interrupted the recovery in FDI flows after the 2008 global financial and economic crisis. However, a closer look reveals that, while FDI to the region increased in the 2000s relative to the 1990s, it remained below potential and was dominated by investments in the commercial service sectors as well as the resources and nontradable sectors. And while 60 percent of FDI went to oil importers in the 1990s, 70 percent went to oil exporters in the 2000s. FDI in the non-oil manufacturing sectors—the kind that generates jobs and knowledge spillovers—remained low.
Furthermore, we find that FDI in non-oil manufacturing is much more sensitive to political instability than is FDI in the extractives or nontradable sectors. So, one of the effects of the political turmoil in the region is that it is exacerbating this pattern of FDI.
The reasons for the lack of job-creating FDI in the region are many, but they clearly have to do with the weak business climate, which continues to be based on privilege rather than competition. For example, the protection of monopolistic providers in the telecommunications and transport industries in Tunisia raises the costs of these services for the off-shore export industries, undermining their competitiveness in world markets.
So how can developing MENA countries escape a vicious cycle of violence and economic hardship? Governments will have to boost job creation by improving the business environment, which has deteriorated during the past few years, as shown by the Doing Business 2014 Report. Special focus will be needed on reforming regulations that currently favor privilege over competition and strengthening incentives for innovation. Governments will also have to reform costly and regressive subsidies and improve public sector efficiency and service delivery. Progress in these areas, coupled with greater transparency, will build trust between citizens, government, and investors, enabling further reforms to create a virtuous cycle of peace and prosperity.