ECONOMICS AND SECURITY 172 ESCEW 05 E Original: English NAT O   Pa rl i a me n t a ry  As s e mb l y SUB-COMMITTEE ON EAST-WEST ECONOMIC CO-OPERATION AND CONVERGENCE ECONOMIC TRANSITION IN THE MIDDLE EAST AND NORTH AFRICA DRAFT REPORT KURT BODEWIG (GERMANY) RAPPORTEUR* International Secretariat 14 October 2005 * Until  this  document  has  been  approved  by  the  Economics  and  Security  Committee,  it represents only the views of the Rapporteur. Assembly documents are available on its website, http://www.nato-pa.int

172 ESCEW 05 E i TABLE OF CONTENTS I. INTRODUCTION..........................................................................................................1 II. A REGION FALLING BEHIND.......................................................................................2 III. THE CURSE OF THE OIL ENDOWMENT......................................................................8 IV. TRADE........................................................................................................................9 V. FOREIGN  INVESTMENT,  THE  BUSINESS  CLIMATE,  GOVERNANCE  AND  POLITICAL REFORM..................................................................................................................10 VI. POLITICAL REFORM.................................................................................................11 VII. CONCLUSIONS.........................................................................................................15 BIBLIOGRAPHY ..................................................................................................................19

172 ESCEW 05 E 1 I. INTRODUCTION 1. The  Middle  East  and  North  Africa  (MENA)  is  a  politically  and  economically  heterogeneous region that is nonetheless frequently characterized as a collection of relatively similar states. The reason why this flawed view has taken hold might be explained by the common if hardly identical religious,  cultural  and  ethnic  profiles  of  the  region's  nations,  elements  of  a  common  historical narrative,  and  a  range  of  shared  political,  security,  diplomatic,  and  economic  challenges.  This report will deal largely with these economic challenges, but it will begin from the assumption that the region is indeed heterogeneous. The MENA countries of the region vary in size, natural and energy  endowments,  income  levels,  human  capital  and  skills,  social  and  political  structures, institutions, and religion. (Nabli) 2. The end of the Cold War has dramatically altered Middle East and North Africa's strategic landscape as well as that of NATO. The salience of the terrorist menace after the September 11 attacks coupled with political and military instability in the Middle East are now fully recognized as major threats to international stability.  This has inevitably shifted NATO's attention to the region. Yet, hammering out a common strategy to contend with the broad array of challenges to security and stability throughout MENA has proven exceedingly difficult. The transatlantic fallout over Iraq perfectly  illustrated  the  difficulties  involved  in  cobbling  together  a  common  Western  approach  to the region. 3. There  are  nonetheless  numerous  areas  of  obvious  common  transatlantic  interests  with regard  to  the  Middle  East  and  North  Africa.    The  economic  development  of  the  region  certainly ranks among the most important of these. More rapid growth in the region would confer benefits well  beyond  the  borders  of  these  countries  –  to  the  region's  neighbours  and  trade  partners  to begin with, but also to the broader international community.  Certainly, economic liberalization and the   expansion   of   human   liberties   are   mutually   reinforcing,   if   hardly   identical,   phenomena.   Advances on one front frequently trigger progress on the other, and improvement in both arenas is now widely understood as fundamental to building a more stable regional and international order.   4. The  problem  throughout  the  MENA  region has not only been the cautious and very partial manner in which economic reforms have been undertaken, but also the widespread failure to open the  political  process  to  broader  participation,  a  democratic  leap  that  would  deepen  the  public's sense  of  ownership  of  the  reform  process.    The  lack  of  openness,  public  engagement  and institutional  development  are  perhaps  the  central  explanations  for  why  the  region  has  failed  to keep  pace  in  broad  developmental  terms  with  a  number  of  other  developing  regions.    Tellingly, over  the  course  of  the  1990s  the  average  growth  rate  in  the  MENA  region  was  only  1.3%  as opposed to 2% for all developing countries.  (Abed and Davoodi)   5. The  Atlantic  Community  is  certainly  positioned  to  support  reform  in  the  MENA  region provided  the  approach  taken  is  responsive  to  the  region's  unique  needs,  sensitivities,  and concerns - many of which are marked by centuries of foreign intervention in the region. It can do so by according MENA greater market access, providing training and development assistance and sharing  knowledge  about  transition  experiences  which  have  had  a  profound  effect  in  expanding the zone of peace and security in Europe itself. Many MENA countries urgently need to embark on economic  and  political  transition  not  dissimilar  to  the  transition  that  Central  and  Eastern  Europe have undergone. The process of change could well provide the foundation for a new partnership with the West.

172 ESCEW 05 E 2 II. A REGION FALLING BEHIND 6. The  MENA  region's  economic  fortunes  have  shifted  dramatically  over  the  past  50  years. From  a  very  low  level  of  socio-economic  development  in  the  early  1950s,  the  region  embarked upon a startling level of economic expansion.  Per capita GDP growth in the 1960s outpaced that of Latin America, while the countries of the region embraced a range of social policies that began to transform their societies in important ways. 7. In  the  1980s,  however,  the  pace  of  expansion  declined  substantially.    This  slow  down, according to the Georgetown economist Tarik Yousef, was due to: - Structural and economic imbalances; - The curse of natural resource (oil and gas) abundance and the fall of oil prices; - Weak political systems and instability; - Several  cultural  factors,  such  as  the  place  of  women  in  society,  that  tended  to  undermine development efforts; - The entrenchment of a statist-interventionist-redistributive model that blunted market signals; - Excessive   state   planning,   import   substitution,   nationalization   of   domestic   and   foreign economic assets and highly centralized and hierarchical trade unions. 8. The  highly  complex  process  of  nation  building  in  the  Middle  East  after  the  end  of  colonial occupation  provides  perhaps  the  most  important  explanation  of  the  central  role  the  state  has played in the economic life of the MENA countries.  In the post-colonial era, governments, keen on bolstering  their  legitimacy  by  providing  public  welfare,  placed  the  state  at  the  centre  of  national economic life. The notion that states had an important role to play in generating and redistributing wealth  was  also  pervasive  in  the  West,  but  the  West  also  enjoyed  large  and  dynamic  private sectors – something that was notably absent in the MENA region. 9. There  was  a  basic  bargain  implied  in  these  policies.    The  region's  states  provided  a modicum  of  economic  security  to  their  people  in  exchange  for  political  loyalty.  But  that  bargain ultimately   resulted   in   a   fundamental   lack   of   transparency,   accountability   and   efficiency. Authoritarian  governments  in  the  region  simply  wanted  to  purchase  social  peace  and  had  little regard for bolstering productivity. This had important financial consequence as the region's states extended  themselves  into  an  ever-broader  expanse  of  national  economic  life  and  did  so  without exercising significant budgetary controls and without heed to the micro-economic consequences. At the same time, security tensions in the region were stoking major military outlays that weighed heavily on the region's economies.   10. The states' expanding financial burdens invariably undermined productive investment.  This problem  became  apparent  over  the  course  of  the  1980s  and  1990s,  a  period  characterized  by declining  oil  prices,  mounting  public  debt,  a  demographic  explosion,  the  emergence  of  highly competitive emerging economies in East Asia and the rise of a more genuinely global economy. Because  of  a  series  of  policy  choices,  the  MENA  region,  with  the  exception  of  a  few industries, was increasingly operating on the margins of the global economy.   Physical capital accumulation declined by 75% on a per worker basis over the course of the 1980s, while over the 1990s there was virtually no productivity growth at all. 11.     MENA today confronts grave economic, social and political challenges.  Many of the region's countries  have  failed  to  take  advantage  of  new  development  opportunities  brought  on  by  the opening  of  the  global  trading  system.  MENA  countries  have  slipped  below  the  level  of  human development that one would have anticipated for the region given its adjusted per-capita income. Accordingly,  the  gap  between  it  and  regions  like  Latin  American  and  South  East  Asia  began  to widen inexorably.

172 ESCEW 05 E 3 12. Recent World Bank studies suggest that the region has not been performing anywhere near its potential, particularly since 1985.  With only a few exceptions, this holds true for oil exporting as well as non-oil exporting countries.  This slippage is all the more alarming because MENA is failing to  build  a  foundation  for  future  economic  and  social  development.    One  World  Bank  study estimates that because of explosive demographic expansion, 47 million new jobs will have to be created in 16 MENA countries between 2002 and 2012 simply to keep unemployment at its current (official  and  likely  understated)  level  of  15%.  6.5  million  additional  jobs  would  bring  that  rate  to below 10%, and well over double the number of existing jobs would have to be created over the next decade to absorb the unemployed and new entrants into the labour force. (Nabli) To achieve this would, in turn, require growth rates that are at least 2% higher than today's.  Such a pace of job  creation  was  not even achieved in East Asia during the height of its most brisk employment growth.  (Keller and Nabli) 13. The state sector has typically assumed the burden of job creation in the MENA region. But today's  fiscal  realities  suggest  that  there  is  little  room  for  state  engineered  job  creation.  At  the same  time,  the  possibilities  for  labour  migration  are  growing  more  restricted.  As  a  result,  the region's  unemployment  rate  is  highest  today  among  young  first-time  job  seekers.    These  young people on average have three more years of education than did first time job seekers twenty years ago.  This  is  generating  enormous  frustration  in  the  region  and  is  having  political  as  well  as economic  consequences.  (Cassidy)  Declining  employment  prospects,  for  example,  has  been  a factor  in  the  surging  popularity  of  Islamist  movements  among  educated  young  people  in  the region's urban centres. Those movements are often deeply suspicious of the global market place, which in reality offers the only means for the region to pull itself out of its developmental malaise. 14.     Gender issues constitute another key element of the region's economic profile. Arab women have the lowest labour market participation in the world, although they are increasingly demanding the  opportunity  to  work.  These  demands  are  rising  just  as  the  opportunities  to  meet  them  are diminishing.  Throughout  MENA,  unemployment  for  women  is  30%  higher  than  for  men.  The problem is most acute in Bahrain, Syria, Egypt and Saudi Arabia, where women's unemployment is between 2 and 3 times higher than the region's average. (Nabli) 15.     Until  recently,  the   MENA  region  was  only  attracting  1%  of  the  world's  foreign  direct investment (FDI). (Ago and McCarthy) (OECD Briefing to the NATO PA Economics and Security Committee, Feb. 2005) Potential investors are discouraged by a business climate characterized by high transaction and service costs, heavy administrative interference and delays, imposing trade barriers,  excessive  freight  costs,  long  customs  clearance  times,  and  general  regional  insecurity. Yemen, Saudi Arabia, Lebanon and Egypt, for example, have erected some of the most daunting entry barriers for business in the world, according to a recent World Bank survey of 110 countries. (Iqbal)  Foreign investors are altogether discouraged by large, often unaccountable and coercive state  structures  that  tend  to  crush  economic  initiative.    Pervasive  suspicions  and  widespread reservations in the region about the phenomena of globalisation have also been a barrier to capital inflows. 16. Still, the investment picture has improved in recent years.  FDI into the Middle East rose 76% over  the  2003-2005  period.  (Ago  and  McCarthy)  This  could  point  to  growing  confidence  in  the region, although rising oil prices are certainly an important factor in attracting new investments to the region. 17. Another development challenge relates to climate. The MENA region's lack of water and its growing demand for it are increasingly seen as a source of regional tension as well as a barrier to development.    Water  scarcity  is  linked  to  other  environmental  problems  including  deforestation, desertification,  difficulties  in  preserving  and  protecting  seacoasts,  and  the  relative  scarcity  of arable  land.  MENA  governments'  capacity  to  monitor  environmental  trends  and  set  appropriate policies,  moreover,  is  very  low.  (Esty,  Levy  and  Winston)  "Hydropolitics"  has  also  proven  a

172 ESCEW 05 E 4 stumbling block in numerous negotiations between Israel and the Palestinian Authority and among neighbouring states. 18.     History too has imposed development-related burdens on the MENA region. For some two hundred years, much of the region has been an object of great power politics and rivalries.  This has left a telling mark both on its collective psychology and on its political and state structures. The colonial or semi-colonial experience in much of the region was protracted.  As suggested above, the  nationalist  elites  that  succeeded  colonial  administrations  adopted  import  substitution,  statist models   of   development   that   helped   concentrate   economic   authority   in   the   hands   of   state authorities or elites linked to the ruling class. Yet even this failed to curtail the role of outsiders, who  saw  in  some  elite  groups  proxies  through  which  they  might  compete  for  commercial  and strategic  influence.  This  dynamic  only  compounded  the  problems  of  building  coherent  national political and economic systems. Throughout much of the region, globalisation and liberal economic reform came to be seen as a new expression of old colonial forms. In this way, the economic logic of liberalization has frequently fallen victim to a myriad of deeply rooted apprehensions about the outside world. Economic hardship and mass unemployment have hardened these views. 19. This particular narrative, however, has not held uniformly across the region.  Several states initially  embraced  elements  of  the  standard  prescriptions  of  the  "Washington-based  Bretton Woods   Institutions"   and   thereby   accepted   a   more   liberal   approach   to   internal   economic development.  This  would  better  help  them  to  operate  in  a  global  setting.  (Page)  Importantly,  in these countries a commercial middle class had consolidated powerful social and political positions at critical moments in their respective histories and subsequently pursued development strategies at  least  partly  premised  on  integration  in  world  markets.  In  other  settings,  the  reform  agenda advanced by small liberal groups generated a powerful political backlash and, at best, were only adopted in a very partial manner or simply rejected as inappropriate. 20. Even among the region's opposition movements, the liberal economic impulse has remained quite  weak.    Islamic  movements,  for  example,  tend  to  demonstrate  greater  concern  with  social matters than with technical-economic ones as such, and rarely do they embrace the opportunities to participate more fully in the global economy.  Restrictions on political debate in some societies have  impaired  dialogue  between  economic  reformers  and  their  Islamic  critics  –  something  that might have made it possible for the two to achieve a kind of synthesis. Certainly there is no reason that the positions of the two groups need to be mutually exclusive, as Turkey's current government has so ably demonstrated. (Henry and Springboard, p.20) 21. During the post-colonial phase of development, trade policy was heavily protectionist.  MENA governments  tended  to  employ  an  import  substitution  model  of  development  that  accorded selected domestic firms a privileged and protected position in local markets while reinforcing the power and legitimacy of the political class.  The problem was that this model was highly inefficient. It   led   to   gross   resource   misallocation,   spawned   highly   concentrated,   vertically   integrated companies  and  nourished  huge  and  parasitic  bureaucracies.    It  also  prevented  MENA  societies from  accruing  the  natural  benefits  that  integration  in  the  global  economy  generally  confers, including:  comparative  advantage  specialization,  external  markets  for  locally  produced  goods, efficiency generating competition and lower prices for consumers and producers alike 22. At  the  same  time,  legitimacy  problems  for  certain  regimes  in  MENA  fed  the  habit  of patronage spending as a means essentially to purchase loyalty among the well-connected and the potentially  hostile  –  an  approach  that  made  governance  all  the  more  opaque,  while  further entrenching  powerful  groups  opposed  to  economic  reform.  Governments  throughout  the  region have historically played the role of employer of last resort – a practice that now imposes serious fiscal burdens on deficit-ridden states throughout the region, gravely hampers economic flexibility, and  has  opened  a  widening  gap  between  state-incurred  social  and  employment  obligations  and the capacity to deliver these services. State job creation has driven wage costs up at a faster rate

172 ESCEW 05 E 5 than productivity gains – a labour policy that has effectively prevented the region from exploiting a potential  comparative  advantage  in  labour  costs  that  would  certainly  enhance  its  international competitiveness and help it cope with mounting unemployment. 23. Unfortunately, regional and internal insecurity have also been part of the economic picture.   War, endemic regime vulnerabilities and terrorism have fuelled abnormally high levels of defence spending, which stands at 20% of GDP as opposed to a developing country average of 12%. This has  diverted  scarce  budgetary  resources  from  targeted  public  investment  projects  that  would provide  a  more  stable  foundation  for  sustainable  and  broadly  based  economic  development.   Concerns about the region's stability have added an enormous risk premium to the cost of doing business  there,  although  arms  sellers  have  flourished.  This  is  yet  another  illustration  of  the importance of creating a peaceful environment to sustain development in the region. 24. Macro-economic  policies  in  the  MENA  region  have  also  posed  problems.  Loose  spending policies pursued throughout the 1980s were premised on high oil prices that the cartelisation of oil production wrought after 1973. But that cartel power eroded substantially over the course of the 1990s with the rise of non-OPEC production – a development that helped precipitate significant oil price  falls.    The  region's  states,  however,  lacked  sufficient  fiscal  flexibility  to  adjust  to  oil  price fluctuations.   Top-heavy   states   scrambled   to   survive   financially   but   did   so   by   cannibalising resources that might otherwise have been invested in projects conducive to long-term investment.   Fiscal rectitude as well as real investment were the casualties.   25. Of  course,  oil  prices  today  are  approaching  historic  highs.    Ineluctably  rising  Chinese  and Indian energy demand suggests that over the long term, the central point around which oil prices fluctuate  will  rise  substantially.  (OECD  Briefing)  Major  oil  exporters  are  already  generating  huge windfalls from the price increases. In Saudi Arabia where oil sales account for 70% to 80% of state revenue, sharply rising oil revenues have turned an $8 billion deficit in government revenue into a $26 billion surplus.  In 2005, revenue is expected to be $74.77 billion, pushing overall economic growth to 6.2%. In Oman, growth was 43% higher than expected. (Kahwaji) 26. But  given  demographic  trends  in  the  MENA  region,  even  higher  oil  prices  will  not  be sufficient  to  cushion  the  region's  governments  from  the  need  to  generate  new  sources  of investment and finance.  There is a down side to rising oil prices even for major oil producers. It tends to blunt the sense that reform is essential and can lead to decisions aimed at underwriting consumption   rather   than   boosting   productivity.   It   tends   to   penalize   other   industries,   the development of which is essential to more broadly based development.  Finally, the revenues from rising  oil  prices  have  often  spawned  armaments  spending  sprees.  Oil  revenue  for  the  Gulf Co-operation  Council  states  increased  by  35%  while  gross  domestic  product  is  up  9.4%  from 2003, according to official reports. (Kahwaji) 27. It  is  important  to  consider  the  mounting  fiscal  problems  in  the  region  before  the  recent  oil price rises. Saudi Arabia, for example, has run a budget deficit over 21 of the past 22 years. The share  of  its  budget  spent  on  education  and  health  has  been  steadily  falling.  Unemployment  for those  under  30  has  reached  25%,  while  –  perhaps  not  unrelated  –  political  support  for  radical fundamentalism seems to be on the rise. (Posner) Economic development clearly needs to be put on  a  more  sustainable  basis  there  and  must  be  combined  with  significant  rather  than  cosmetic political, social and economic reform. 28. Clearly, demands for a broad-based structural and political reform are on the rise throughout the  region.    The  2002  UN  Arab  Human  Development  Report,  authored  by  an  eminent  group  of Arab experts, for example, pointed to a range of problems that are pushing the region ever lower in global human development rankings.  The report's call for action was startling in its clarity and in its warning of what failure to reform might portend.

172 ESCEW 05 E 6 29. That  report  laid  out  a  range  of  human  development  indexes  in  which  the  MENA  region  is clearly falling behind.  The problems are particularly worrisome, not the least because the global economy  is  increasingly  premised  on  the  cultivation  of  knowledge  workers  and  information infrastructure. In this emerging economy, lower wages and high-skill societies will obviously fare better  in  attracting  investment  than  high  wage  low-skill  societies,  other  things  being  equal.  Only the   former   will   provide   the   foundation   for   longer-term   job   creation   based   on   productivity improvements. Greater and more efficient investment represents the best way to drive productivity and  wages  upward.  The  bad  news  for  MENA  is  that  over  the  last  fifteen  years,  prevailing development,  social  and  commercial  policies  have  increasingly  combined  to  wed  low  skills  to relatively higher wage costs, a deadly combination that in tandem with low levels of innovation, has helped dissuade both domestic and international investors from operating in local markets.   30. Today the MENA region is ill structured to derive commercial benefit from its human capital. It  suffers  from  relatively  low  literacy  rates;  poor test scores; inadequate schools and universities that are structured to create statist elites; a consequent dearth of opportunities for those emerging from  the  university;  underdeveloped  telecommunication  infrastructure;  and  a  lack  of  access  to computers.  The  fact  that  women  are  oftentimes  prevented  from  fully  exploiting  opportunities  in school and in the work place effectively slashes the region's potential work force and talent base.   (Arab  Human  Development  Report  2002,  2004)  When  heavily  interventionist  states,  corruption, military tensions and authoritarian political practice are thrown into the mix, the situation begins to look dire and unsustainable. 31.     Education systems throughout MENA are lagging behind other developing regions.  Illiteracy is high, particularly among women, some children still do not have access to basic education, the number of students enrolled in higher education is declining, as is public spending on education, which,  despite  the  large  increase  in  the  number  of  young  people,  is  actually  less  than  in  1985.   Access to the Internet is very low, and there are only 18 computers per 1000 people in the Arab region,  compared  to  a  global  average  of  78.3.    A  mere  4.4  translated  books  per  million  people were  published  in  the first five years of the 1980s, or less than one book per million people per year.  The rates in Hungary and Spain for the same period were respectively 519 and 920. (Arab Human Development Report 2003) Some in the West contend that the educational systems and universities are increasingly dominated by Islamists. But this view should be taken with a grain of salt.  It is certainly true that in Pakistan and Saudi Arabia, for example, sectors of the educational system  are  so  thoroughly  dominated  by  religious  teaching  as  to  leave  students  functionally illiterate  in  many  of  the  areas  that  might  galvanize  national  development. Several Gulf countries need  to  import  skilled  workers  because  they  are  failing to create their own technocracy, despite the  fact  that  they  possess  the  financial  means  to  do  so.    Islamic  pressures  are  also  sometimes exerted on the scientific community to restrict research in certain culturally sensitive areas. But it is also the case that problems of education in the MENA region are more due to a lack of resources, bureaucratisation and overly rote pedagogic methodologies than "Islamization" as such. 32.     Research  and  development  spending  is  very  low  throughout  the  MENA  region.    Scientific research  centres  in  the  Arab  world  suffer  from  inadequate  funding,  inadequate  institutional structures  and  a  political  environment  that  restricts  scientific  dialogue.    Poor  working  conditions perpetuate  the  problem.  It  is  particularly  difficult  to  attract  new  generations  of  research  workers when  the  sector  is  capital-starved  and  politically  neglected.  This  weakness  has,  in  turn,  harmed the region's capacity to adapt and integrate foreign developed technology and to develop its own.   It  is  not  surprising,  therefore,  that  many  of  the  region's  top  scientists  have  emigrated.  Indeed, some 25,000 of the 300,000 first degree graduates from Arab universities emigrated in 1995/1996 while more than 15,000 Arab doctors left the region between 1998 and 2000. (Arab Development Report  2003.)  Only  training  sufficient  cadres  of  knowledge  workers  and  providing  them  the opportunity to conduct their work will help the region's societies stem the brain drain and tap into technology in ways that might trigger their own development.  

172 ESCEW 05 E 7 33.     Despite  these  real  problems,  some  improvements  have  also  been  registered.  In  a  recent study of 12 MENA countries, the segment of the population over 25 years of age with no schooling declined from 80% in 1970 to 46% in 2000.  Average years of schooling increased in that same period  from  1.3  years  to  4.5  years  (Abed  and  Davoodi).  These  gains  reflected  the  strong  social component  of  state  spending  in  the  MENA  region.    The  challenge  today  lies  in  finding  gainful employment for graduates who are finding it increasingly difficult to put their skills to work. 34. There are a number of factors shaping MENA's rather unique economic profile. Perhaps the most  salient  of  these  is  that  many  of  the  region's  countries  have  depended  on  oil  exports  or transfers from oil exporting countries to underwrite consumption and development.  But there are important   structural   differences   as   a   result   of   varying   energy   endowments   in   the   regions.   Countries  like  Egypt,  Jordan,  Lebanon,  Morocco  and  Tunisia  are  resource  poor  and  labour abundant. Others are resource rich with abundant labour including Algeria, Iran, Syria and Yemen, while the Gulf countries are rich in oil and have long imported labour. Yet all have fallen behind other  developing  countries  in  human  development terms. (Iqbal) (UN Arab Human Development Reports 2002, 2003) 35. Secondly,  central  planning,  nationalization,  consumption  subsidies  and  import  substitution policies  were  pillars  of  the  region's  national  development  strategies.  In  some  respects,  these approaches  assured  a  minimum  level  of  development  and  helped  broadly  raise  consumption  in this impoverished region, particularly after the enormous oil price hikes of the 1970s when OPEC all  but  cornered  the  international  oil  market.    Oil  exports  generated  funding  for  infrastructure, public  health,  and  education  spending;  since  the  1960s  illiteracy  has  fallen  markedly  and  health care and longevity registered sharp improvements. 36. Yet,  once  oil  prices  began  to  slump,  the  vulnerabilities  of  the  region's  economies  became more  evident.  Income  flowing  to  the  public  sector declined, and investment in infrastructure and social spending fell along with it.  This has led to a 60% reduction in the physical capital stock per worker   since   the   late   1970s,   attendant   productivity   decreases,   mounting   macroeconomic imbalances, an ever poorer investment climate, rising unemployment and very low growth.   37. This  extended  downturn  led  Morocco,  Tunisia,  and  Jordan  to  undertake  a  range  of  critical reforms:   the   introduction   of   value   added   taxes   (VAT),   reduced   subsidies,   improved   public management, tighter monetary policies and more liberalized trade regimes.  Morocco and Tunisia joined the GATT and embarked upon exchange rate liberalization, fiscal modernization, trade and financial  reform  as  well  as  privatisation.  The  three  countries  also  signed  agreements  with  the European Union in the 1990s that provided access to new markets and EU project support.  These countries have subsequently enjoyed higher factor productivity gains and relatively stronger per- capita growth than many oil-producing countries. (Abed and Davoodi) 38. Yet,  the  reform  impulse  in  other  countries  proved  weaker  and  faded  over  time.  Egypt,  for example,  reversed  its  reform  programmes  through  excessive  administrative  controls.  Lebanon also  embarked  on  reforms,  but  these  too  were  watered  down,  in  part  because  of  the  difficult legacy  of  a  catastrophic  civil  war  and  continued  Syrian  occupation.    Algeria,  Syria,  and  Yemen were more partial in their reform efforts. Algeria suffered from serious macro economic imbalances after the oil price collapse and as a result adopted spending discipline to contain the deficit. But it was  slow  to  adopt  structural  reforms  and  subsequently  abandoned  several  trade  liberalization measures it had earlier embraced. Likewise, Syrian reforms were not sustained, while Yemen has simply  failed  to  diversify  its  economy,  although  it  has  managed  to  adopt  a  more  open  trading system. 39. The Gulf countries of Saudi Arabia, the United Arab Emirates, Bahrain, Kuwait, Qatar, and Oman have long enjoyed relatively open trade and capital movement policies, but all were afflicted by  the  downturn  in  oil  prices.    This  inspired  the  smaller  Gulf  countries  to  pursue  a  degree  of

172 ESCEW 05 E 8 economic diversification.  Oman, for example, embarked on a policy of privatisation and introduced more open foreign capital investment laws.  Saudi Arabia, however, has been much slower in its reform  process,  and  the  state  there  continues  to  play  a  dominant  role  in  an  economy,  which  is utterly   dependent   on   oil   revenues.   State   finances   in   the   monarchy  are  opaque,  while  the distribution   of   oil   wealth   is   highly   uneven   and   is   biased   toward   consumption   rather   than investment.  A  stunningly  high  concentration  of  wealth  restricts  domestic  demand,  limits  the potential for setting up local production, and reduces incentives to set-up small and medium-sized enterprises. Statist policies in several countries have even destroyed local Bazaar structures and the  commercial  class  that  once  flourished.  These  are  some  of  the  most  serious  impediments to self-reliant development in the region. III. THE CURSE OF THE OIL ENDOWMENT 40. The MENA region's huge oil endowment – 60% of global oil reserves, 25% of gas reserves and a 44% share in global oil trade; and very low oil and gas production costs (Tempest)  – has ironically lowered incentives to broaden the foundation for economic development. Oil wealth has provided  a  facile  means  to  meet  immediate  consumption  requirements;  yet  it  has  tended  to discourage   measures   that   might   prompt   more   sustainable   and   broadly   based   forms   of development.  Oil  earnings  certainly  provided  the  initial  impetus  for  rapid  economic  and  social development throughout the region both for oil-producing economies as well as for the resource- poor  neighbours  that  benefited  from  labour  remittances,  transit  fees  and  aid  flows  from  their  oil rich  partners.  All  used  oil  revenues  to  underwrite  important  social  programmes  that  helped redistribute this windfall. 41. Over thirty years, per capita income in oil producing countries declined at a rate of 1.3% per year, while non-oil producing countries in the region grew by an average of 2% per year.  These non-oil producers thus managed to keep pace with the rest of the developing world, at least, until the  1990s  when  their  per  capita  income  growth  also  slowed.    Yet  many  of  the  oil  exporters  fell behind. Although energy prices are now higher and could stay high for some time to come, given tightening  demand  conditions,  there  are  still  important  reasons  why  economic  diversification  is needed. First of all, several oil producing countries, including Egypt, Yemen and Algeria, will soon confront oil production declines. Several other countries are approaching peak production points in the life cycles of their oil supplies and will simply have ever less to export over time.  Few states in the   region   have   taken   measures   to   encourage   domestic   energy   conservation   and   so   are consuming  ever-higher  amounts  of  their  own  oil.    Commodity  dependant  economies  are  also subject to radical swings in income over time. This can have adverse effects on employment while complicating  development  and  investment  planning.  Meanwhile,  other  key  sources  of  income  to the  region  including  aid  and  labour  remittances  are  highly  unlikely  to  make  up  for  potentially declining long-term foreign exchange earnings generated by oil exports 42. Large  oil  exports  and  oil-related  capital  investments  have  also  sparked  real  currency appreciation  in  a  number  of  MENA  countries.  This  has  led  to  a  structural  bias  against  the manufacturing sector.  The high cost of local currencies has priced many domestically produced goods out of international markets and dissuaded potential market entrants from investing in non- oil  businesses.  One  recent  study  suggests  that  over-valued  currencies  reduced  the  ratio  of manufactured exports to GDP in the region by 18% a year between 1985 and 1999. (Iqbal) 43. Economic  reliance  on  oil  also  seems  to  have  diminished  incentives  to  engage  seriously  in broader  pro-development  reform.  Oil  revenues  have  long  provided  a  convenient  if  nevertheless volatile  means  of  sustaining  consumption  in  exporting  countries.  Reliance  on  one  commodity, however, has left some of the region's important economies susceptible to highly volatile shifts in their  terms  of  trade,  while  government  spending  patterns  tend  to  exacerbate  the  effects  of commodity price swings.  Kuwait, Oman and Iran have established Oil Stabilization Funds in which

172 ESCEW 05 E 9 portions of oil earnings are saved abroad in order to weaken the impact of oil price changes on the non-oil domestic economy.  Other countries in the region, however, have found themselves caught up  in  "sink  or  swim"  earnings  fluctuations  that  provide  a  poor  foundation  for  nurturing  long-term sustainable growth in which benefits can be more generally shared. IV. TRADE 44. As  mentioned  above,  a  related  problem  for  the  region  is  its  very  weak  integration  into  the international economy, its falling share of world export markets, and its low level of intra-regional trade. The MENA economies are among the most heavily protected in the developing world.  The problem  is  that  global  competition  is  growing  fiercer.  New  entrants  in  the  global  economy,  like Central Europe and the burgeoning commercial powers of Asia and Latin America, are far more globally linked than the MENA region. Without dramatic reform, the region will be hard pressed to compete even in those sectors like textiles where it has managed to carve out a niche for itself.   45. Most development economists recognize that poverty reducing economic growth cannot be achieved  without  some  degree  of  openness  to  the  global  economy.    Trade  is  now  widely understood  as  a  critical  counterpart  to  reform,  investment,  and  aid  in  fostering  sustainable development. The international economy not only offers export markets for locally manufactured goods, it also generates capital for investment, competition to ensure that firms are structured on competitive  foundations  and  a  means  to  contain  prices.  In  the  MENA  region,  where  import substitution was a critical feature of the old development model, the level of protectionism remains quite high. This has driven costs upwards and penalized the region's exporters. Protectionism has thus made diversification away from the oil sector all the more difficult. Not surprisingly, it is the oil- poor  countries  like  Tunisia,  Morocco,  Lebanon  and  Jordan  that  have  achieved  a  reasonable degree of diversification, while oil rich countries have fared far worse on this front. 46. Indeed the region boasts few exports beyond oil and gas, and its economies are among the most highly protected in the world. Beyond energy, the MENA countries tend to export low value finished  goods  while  importing  most  of  the  parts  for  their  very  inefficient,  vertically  integrated manufacturing  base.  (Iqbal).  High  tariff  walls,  overvalued  currencies,  high regional transport and service costs, poor, opaque and often corrupt border controls, and an array of administrative non- tariff  barriers  all  hinder  trade.    At  the  regional  level,  there  is  very  little  commercial  integration among  the  MENA  countries.    The  level  of  intra-regional  exports  among  Arab  countries  has hovered between 8-9% over the last two decades as compared to 22% in ASEAN (Association of Southeast  Asian  Nations)  (and  25%  for  MERCUSOR(South  American  Common  Market)  (Nabli).   Still the MENA countries do trade among themselves twice as much as they trade with the rest of the world. Excluding petroleum and its derivatives, the products that are most traded on an intra- regional  level  are  fresh  fruits  and  nuts,  fresh  vegetables,  live  animals,  plastic  materials and iron and  steel  -  products  that  have  very  low  value  added  in  domestic  processing.  (MENA  Trends Reports) 47. Although the similar manufacturing profiles of the region economies could suggest that the gains  from  more  open  interregional  trade  would  not  likely  be  of  overriding  consequence  initially, service trade liberation would have a far more immediate positive impact. Services in much of the MENA region are very highly priced and of low quality, and this has long penalized other sectors.   Opening up services to regional competition would benefit manufacturers by lowering input costs. Of  course,  intra-regional  service  integration  should  only  be  a  first  step  to  deeper  regional commercial  integration  and  the  region's  full  participation  in  a  liberal  multilateral  trading  system.   Indeed, the latter should remain the ultimate goal.  (Hoekman and Messerlin) 48. There   are   some   signs   of   improvement   on   this   front.   The   Tunisian   government   has progressively reduced import quotas in textiles, automobiles, and agriculture goods, while Morocco

172 ESCEW 05 E 10 has  eliminated  most  of  its  quotas.    Algeria  has  moved  somewhat  more  hesitantly,  while  Jordan and  Egypt  have  made  some  progress  in  reducing  quantitative  restrictions.  Syria  and  Lebanon, however, have kept trade barriers high.   49. The  Euro  Mediterranean  Partnership    (EMP)  is  helping  to  deepen  trade  co-operation between the European Union and 12 non-EU Mediterranean countries. It has extended duty free access  to  a  range  of  products  traded  in  both  directions,  although  several  crucial  but  sensitive sectors  are  left  out.      Moreover,  the  partnership  extends  beyond  mutual  trade  matters;  it  also includes  a  human  rights  clause  (article  2),  and  strongly  endorses  sub-regional  co-operation. Morocco,  Tunisia,  Jordan  and  Egypt,  for  example,  formed  the  "Agadir  Group"  in  May  2001  to establish a sub-regional free trade area as a first step in building a greater EU-Mediterranean free trade  zone.  The  European  Union  is  also  providing  funding  under  the  MEDA  programme,  the European  Union's  primary  vehicle  for  extending  technical  and  financial  assistance  to  the  region. The European Union spent some €5 billion between 1995 and 1999 and has allocated some €5.4 billion for the current programming period from 2000-2006.  The goal is to create a free trade area by 2010 of 600 to 800 million people engaging some 40 countries.   50. If one looks at export trends just in North Africa, it emerges that despite preferential access to EU markets, the market shares of the MENA countries have declined substantially since 1980. This is due both to competition from other developing countries and also to the many restrictions the European Union still attaches to states receiving preferential access.  For example, agriculture exports  face  a  range  of  non-tariff  barriers  when  entering  the  EU  market.  (Ghoneim,  von  Hagen and Wolf)   51. Finally,  there  are  signs  of  increased  Arab  economic  co-operation  with  Israel.  Both  Jordan and  Egypt,  for  example,  have  established  Qualified  Industrial  Zones  with  Israel.    In  this  case, production with joint input from Israel and the partner countries enjoy preferential access to the US economy.      Integrating   Israel,   a   highly   developed   economy,  into  a  system  of  intra-regional economic co-operation and trade would clearly generate enormous benefits for both Israel and the Arab countries.  Of course, this could be putting the cart before the horse; progress in the peace process is the key to facilitating deeper economic links between Israel and its neighbours. V. FOREIGN  INVESTMENT,  THE  BUSINESS  CLIMATE,  GOVERNANCE  AND  POLITICAL REFORM 52. The level of foreign direct investment in the MENA region is extraordinarily low, and this too is  undermining  the  region's  capacity  to  export  and  grow.    Poorly  structured  equity  markets,  the relatively  low  level  of  private  business  activity,  inadequate  worker  training,  political  uncertainty, regional insecurity, red tape and corruption continue to scare off potential investors. Recent World Bank  and  IMF  studies  point  to  serious  problems  in  public-private  sector  relations  (Iran,  Tunisia, Mauritania  and  Pakistan),  woeful  statistical  data  collection  (Algeria,  Tunisia,  the  United  Arab Emirates,  Morocco  and  Oman),  and  low  levels  of  fiscal  and  financial  transparency,  particularly related  to  money  laundering  and  terrorist  financing  (nearly  all  the  countries  of  the  region). Together these problems are discouraging trade-creating investment flows.  (Abed and Davoodi) Yet mounting international and domestic pressures are advancing change on all of these fronts.   53. Investment capital is very scarce in the MENA region, and firms there have few opportunities to  enhance  the  technical  or  physical  capacity  of  their  operations.    Even  worse,  many  of  the region's  companies  are  compelled to navigate through a daunting web of red tape that imposes enormous  costs  on  their  operations.  Poorly  developed,  opaque  and  sometimes  corrupt  judicial systems add further burdens by undermining the rule-of-law, transparency and predictability that markets need in order to thrive. One World Bank analyst suggests that it costs significantly more

172 ESCEW 05 E 11 to set up a business in the MENA region than in East Asia and Central Europe largely because of heavy-handed bureaucracy and other barriers to market entry. (Iqbal) 54. The  investment  environment  is  made  all  the  worse  by  woeful  governmental  accountability and  transparency.  According  to  one  World  Bank  study,  the  MENA  region  generates  very  little reliable empirical data on the quality of governance. None of the region's governments expressly recognize  their  citizens'  rights  to  government  information.  In  Egypt,  the  detailed  government budget is neither fully published nor discussed outside of parliament. Iran's record in this regard is far better. It fully publishes its budget and televises parliamentary debates. 55. Parliamentary powers are generally very low; and there are few checks and balances across governmental branches, both in the monarchies and in the more pluralist governments like Algeria, Egypt  and  Tunisia.  In  general,  power  is  excessively  concentrated,  and  this  simply  reduces  the scope  for  checks  on  executive  power.  These  shortcomings  have  conspired  to  place  MENA  very low  in  international  governance  rankings,  with  the  region's  oil  producers  fairing  worst  of  all.   According to one model, had MENA matched the average quality of public administration of South East Asian countries, its growth rates in recent years would have been 1% higher annually. (Better Governance  for  Development  in  the  Middle  East  and  North  Africa,  World  Bank)  Transparency International's  2004  Corruption  Perception  Index  places  a  number  of  MENA  countries  in  the bottom half of its global rankings. (www.transparency.org) 56. As suggested above, state owned businesses have long enjoyed a privileged position in the national  economies  of  the  region.    Large  vertically  integrated  state  monopolies  and  oligopolies, however,  have  constrained  competition,  jacked  up  prices  and  foisted  inferior  services  upon consumers and private firms, conditions that have had adverse knock-on effects to other sectors. Although  the  pace  of  privatisation  in  the  region  has  picked  up  in  recent  years,  MENA  countries have  moved  more  slowly  on  this  front  than  other  developing  regions.    Over  the  course  of  the 1990s only $8.2 billion of state-owned assets were sold to the private sector as opposed to $65 billion for Eastern Europe and Central Asia and $44 billion for East Asia and the Pacific.  (Abed and Davoodi)  Some successes, however, have been registered, particularly in Jordan, which has created  a  fairly  robust  regulatory  framework  for  transparent  privatisation.  Such  frameworks  are essential;  privatisation  without  a  robust  regulatory  structure  would  lead  very  quickly  to  asset stripping and corrupt sell-offs of no benefit to national economies. 57. Not  surprisingly,  there  are  also  problems  in  the  region's  economic  infrastructure,  although this varies by country. The Gulf countries, Lebanon, Jordan, Tunisia and Morocco enjoy relatively good  and,  in  some  cases,  even  excellent  infrastructure.  Several  cities  in  the  Gulf  are  perfectly modernized and enjoy cutting edge information networks. But they are very much the exception. Generally   road   systems   throughout   the   region   are   reasonably   well   developed.   Regional telecommunications networks, however, are less robust, in part because of the lack of competition in the sector.  For example, it can take four years to have a phone installed in Syria.  The growing use of mobile telephones, however, is at least helping to circumnavigate that particular problem, although  costs  remain  high.    The  electricity  sector  is  also  fairly  underdeveloped.  Electricity transmission losses in recent years have approached 16% of output compared to 7% in East Asia, and  this  reflects  a  generally  poor  record  in  energy  conservation  and  infrastructure  investment.   Again, many of the problems here can be traced to the existence of high cost, low service public monopolies  that  simply  operate  without  competition  and  thus  lack  the  impetus  to  perform  to  a higher standard. VI. POLITICAL REFORM   58. The 2002, 2003 and 2004 United Nations Arab Human Development Reports also assessed the   MENA   region   in   terms   of   relative   education   levels,   literacy,   gender   equality,   and   life

172 ESCEW 05 E 12 expectancy  as  well  as  the  health,  vibrancy,  transparency  and  democratic  structure  of  public institutions.  They  linked  these  factors  to  development  in  broad  terms.  In  many  of  these  areas, MENA  has  done  very  poorly  indeed.    The  report  directly  associated  development  with  the problems  of  governance,  politics,  women's  rights,  health  care  and  education  matters  -  subjects that  are  often  considered  taboo  in  the  region.  The  authors  made  a  powerful  case  for  greater human rights protections, the empowerment of Arab women, and measures designed to help the region's  societies  make  better  use  of  knowledge  and  information.    The  report  systematically catalogued a broad array of shortcomings that undoubtedly have had much to do with the region's relatively  low  level  of  development.  But  it  also  noted  its  successes,  including  the  fact  that  life expectancy  has  increased  by  about  15  years,  adult  literacy  has  almost  doubled  and  women's literacy has tripled.  (Arab Human Development Report, 2002) 59. Economic reform is hardly a risk-free and apolitical process.  Those regimes with a tenuous claim   on   legitimacy   will   invariably   feel   threatened   by   introducing   policies   that   advance transparency,  the  free  exchange  of  information,  and  the  autonomous  activity  of  entrepreneurs. Privatisation schemes, for example, are often viewed by insecure elites as an unacceptable ceding of  a  convenient  lever  of  power.  That  these  industries  often  represent  an  important  source  of additional  income  either  for  the  political  class  or  for  their  clients  makes  sell-offs  all  the  more difficult.  Even the region's more open governments have used clientelist techniques to cultivate their own legitimacy, and thus worry about the political consequences of market reform. 60. Economic  reform  cannot  unfold  without  some  degree  of  political  change.  Markets  require transparency,  the  rule-of-law,  border  stability,  proper  judicial  oversight,  and  greater  latitude  for human freedom. All have been in short supply in the region.  Indeed, MENA countries confront a genuine challenge in managing economic and political change simultaneously; movement on one front will invariably spill over into the other, often in unpredictable ways.  Given the unique political and  economic  circumstances  in  each  of  the  countries  of  the  MENA  region,  reform  will  likely advance in very different ways and at varying speeds.  This is one reason why the future of the region today seems so uncertain. The generational change in leadership that is taking place since 2000 has seemingly quickened the pace of reform, but old concerns persist about regime stability and anachronistic state-society bargains. Whereas the Moroccan and Jordanian leadership have managed to adopt a modern image, Bashar al-Assad in Syria, among others, has conceded to the powerful old pillars of the regime he inherited from his father.   61. Pressures   from   civil   society   and   the   international   community   for   political   change   are undoubtedly on the rise, and MENA's governments are beginning to respond, albeit in an uneven fashion. Lebanon's population mobilized not only to push Syrian forces out of the country, but also to   demand   more   accountable   and   transparent   government.      Saudi   authorities,   like   other governments  in  the  Gulf,  increasingly  recognize  that  some  opening  up  of  public  life  may  be inevitable, although change in that society unfolds at a glacial pace. Moreover, the rhetoric about the  need  to  reform sometimes seems concocted for an international audience and obfuscates a more   entrenched   unwillingness   to   embrace   political,   economic   and   social   change.   Egypt's authoritarian President, Hosni Mubarak, under increasing pressure from Egyptian society and the United States – his country's principal source of foreign assistance – allowed competing political parties to participate in this September's elections for the first time in three decades of emergency rule. (El-Rashidi) But the arrest of one of the leading opposition figures on charges that seemed to lack substance at the outset of the campaign raised an immediate question about the democratic legitimacy of vote. This points to a pattern of rhetorical rather than real reform that is hardly unique to Egypt. 62. Although gaps between reformist rhetoric and political reality have been the norm, there is a sense today even among elements of the region's ruling elite that harsh authoritarian practices are pushing  their  own  societies  into  deeper  crisis,  providing  fodder  for  extremist  opposition  groups, damaging  relations  with  the  West,  and  ultimately  making  their  own  hold  on  power  ever  more

172 ESCEW 05 E 13 tenuous.    Events  since  11  September  2001  have  further  complicated  the  situation.  The  fight against terrorism has inspired some regimes to crack down further on civil liberties and democratic movements; yet this only seems to provoke greater alienation and instability. For its part, the West has  certainly  not  been  uniform  in  condemning  the  use  of  torture  throughout  the  region.  A United Kingdom  appeal,  for  example,  recently  ruled  that  evidence  extracted  through  torture  in another country can be entered into court proceedings in the United Kingdom. (Gillan) Censorship has,  in  several  instances,  increased.  The  struggle against terrorism has also recast the region's engagement  with  the  outside  world.    The  number  of  Arab  students  studying  in  America,  for example, dropped by 30% between 1999 and 2002. This has occurred precisely when more rather than  less  contacts  are  needed  to  foster  the  region's  openness  to  new  ideas.  (Arab  Human Development  Report  2003)  To  its  credit,  the  US  government  is  now  working  to  bring  more students  from  the  region  to  study  in  the  United  States.  It  should  be  noted  that  many  European universities have benefited from the tougher American controls on students, and some US officials have  had  second  thoughts  about  a  policy  that  can  put  them  at  a  competitive  disadvantage  in  a service  industry  that  generates  millions  of  dollars  a  year  while  increasing  the pool of knowledge workers. 63.     International media play an important role in fostering critical public debate. Whereas some means of communication, such as telephones and the Internet, are only accessible to a wealthy minority,  satellite  TV  is  widely  available.  People  today  learn  the  news  –  even  about  their  own country  –  from  the  Qatar  based  Arab  equivalent  of  CNN,  Al  Jazeera,  not  from  local  media.  Its reporting  is  free  from  intervention  by  national  censors,  who  cannot  operate  beyond  national boundaries.  The  people  of  the  region  have  begun  to  enjoy  comprehensive  political,  social  and economic  information.  That  often  contradicts  official  government  positions.  An  open  media  will have to play a central role in the reform process.   64. There are other factors that are likely to accelerate change over the coming years.  Certainly the  shock  of  the  Iraq  war  has  injected  enormous  uncertainty  and  fluidity  into  the  region.  The gradually improving dialogue between new and revitalized Palestinian leadership and the Sharon government could herald an important change in the region's strategic landscape. The closing of Israeli  settlements  in  Gaza  this  past  August  could  help  lay  the  foundations  for  a  broader  deal, which would have region-wide implications. The situation obviously remains highly fragile and the dialogue can be disrupted on any  given day by reports of suicide attacks on Israeli soldiers and civilians  or  retribution  by  Israeli  forces.  That  said,  progress  on  the  Middle  East  peace  process could over the medium- to long-term significantly ease the siege mentality that pervades parts of the  region.  It  would  also  undermine  one  of  the  primary  pretexts  behind  which  several  of  the region's governments hide in order to evade internal reform. 65. The Middle East is clearly in the midst of change. According to the French political analyst Oliver Roy, there is no question that the American intervention in Iraq is responsible for some of the  region's  current  fluidity  in  both  a  positive  and  in  a  negative  sense  (Roy).  The  international community   has   clearly   signalled   that   the   old   political   status   quo   is   no   longer   acceptable.   Palestinian  and  Iraqi  elections,  as  well  as  Syria's  withdrawal  from  Lebanon  and  elections  there, have shaken the long held assumptions about politics in the region. (Stephens) 66. Pressure and incentives from abroad will very much shape the sustainability of reforms in the region.  But  local  ownership  of  the  reform  process  will  be  vital  to  ultimate  success.  Outside pressure risks being perceived as neo-colonialism and could therefore backfire. Democracy, if not properly applied in whatever form it assumes, cannot work without the kind of political legitimacy generated  by  local  ownership.    Legitimacy  in  much  of  the  MENA  region  is rooted in nationalism and  in  Islam.  Any  process  of  democratisation  will  thus  have  to  achieve  some  kind  of settlement with both, and this is likely to endow it with features that are not necessarily familiar to the West. More  specifically,  in  Palestine  it  may  eventually  require  coming  to  some  agreement  with  groups like  Hamas  and  Hizbollah  that  the  West  has  tended  to  treat  as  well  beyond  the  pail.  Yet  such

172 ESCEW 05 E 14 groups  are  increasingly  adopting  parliamentary  and  at  least  quasi-democratic  forms.  Oliver  Roy has noted that, by shifting from radical to conservative political agendas, many such movements are focusing on family law and personal status, at the expense of issues such as women's rights. By  contrast,  authoritarian  and  supposedly  secular  regimes  such  as  Tunisia  and  Syria  seem  to have  no  agenda  with  great  resonance  in  their  societies.  The  main  mistake  of  the  West,  and Europe in particular according to Roy, has been to favour authoritarian secularism over democracy in the name of curbing the "Islamic threat", thus de-linking secularism and democracy in the minds of many Muslims while still claiming the two were inseparable. (Oliver Roy, Financial Times, April 12, 2005) Yet Europe, like its American ally, is increasingly focused on the democracy issue. (Roy) 67. There is also the problem of Arab perceptions of American motives in the region.  A recent article   in   the   Economist   captured   this   dilemma   rather   well:   ”Opinion   polls   among   Arabs… conducted last year by Zogby International and the University of Maryland, show sky-high levels of cynicism,  especially  in  countries  such  as  Jordan  and  Saudi  Arabia,  whose  governments  are friendly to America, about American motives in the Middle East. By overwhelming margins, Arabs think "oil" and "Israel," not a desire to promote democracy, drive American policy in the region, so both Europe and America suffer serious problems with the Arab public. Building democracy in the MENA region will be a long-term even generational project. Elections are only a small part of the challenge, constructing functioning civil institutions and open legal systems, inculcating a culture of tolerance   and   debate,   finding   a   new   balance   between   clerical   and   secular   authority   and economically and politically empowering women are even more important and could take years to achieve.” (The Economist, July 30, 2005) 68. The Sanaa Declaration of January 2004 committing members of the Arab League to human rights protection, democracy, the rule-of-law and market economic systems was an important first step. Following this local initiative in June 2004 the G8 launched a "Partnership for Progress and a Common  Future"  with  the  Broader  MENA  region,  aimed  at  supporting  attempts  at  conflict resolution,  democratic  and  economic  reforms  in  the  region.  NATO  complemented  this  at  its Summit the same month with the Istanbul Co-operation Initiative designed to forge Partnership for Peace-type relationships with countries of the region and to forge enhanced practical collaboration beyond  the  Mediterranean  Dialogue.  In  parallel,  the  NATO  Parliamentary  Assembly  has  also upgraded  relations  with  many  parliaments  in  the  Mediterranean  region  by  granting  the  status  of mediterranean   associate   delegation.   All   of   this   suggests   that   there   is   room   for   renewed transatlantic co-operation in forging an approach to the region that will help create an international context  for  positive  change  and  which  according  to  Ron  Asmus,  of  the  German  Marshall  Fund, could even be the catalyst for rejuvenating the Atlantic Alliance. But this push should not simply focus  on  the  region's  problem  states;  several  so-called  friendly  governments  in  the  region  have appalling   human   rights   records  and,  not  surprisingly,  are  pursuing  policies  that  are  hardly conducive to economic and political transition. 69.     Indeed,  the  11  September  2001  attacks  have  helped  American  and  European  leaders  to recognize that underdevelopment and the weakness of democracy in the MENA region represent a perilous problem that renders the old status quo untenable. The challenge lies in devising a new approach to a region that views both Europe and America with some suspicion.  Along these lines, the European Union is set to propose a multi-million euro "governance facility" to "strengthen the fundamentals  of  democracy"  in  the  Middle  East  and  North  Africa.  On  this  issue,  the  European Union  and  the  United  States  increasingly  seem  to  be  singing  off  the  same  page.  (Beatty)  The proposal calls for all Mediterranean partners to ratify and implement all UN and regional charters on civil, political, social and economic rights by 2010.

172 ESCEW 05 E 15 VII.    CONCLUSIONS 70. For the MENA region to avoid a rapid rise in unemployment, it will have to achieve growth rates of nearly 6-7% a year for an extended period of time, or more than double its current growth rate. Given the broad range of policy deficiencies shaping the region's economies, this is not an impossible  goal  if  key  reforms  are  made.  There  are great gains to be had simply by adopting a range of policies including: - Reform  of  educational  systems  so  that  the  region  is  better  able  to  produce  knowledge workers, engineers and business leaders rather than civil servants; - Rationalization of regulations; - Support of economic diversification and reduced overall reliance on oil and gas exports; - Labour  market  reform,  including  to  initiatives  to  weaken  full  employment  guarantee  by  the state not only de facto but also de jure; - Higher levels of integration in the global trading and financial systems, significantly lower real tariff and quota rates and elimination or reduction of price distorting subsidies; - A  general  opening  up  of  national  political  systems  to  ensure  broader  participation  of  civil society in decision making, and the emergence of more democratic and pluralist cultures that fit into the region's unique historical and cultural setting; - Rationalization of state institutions and an improved legal and judicial climate; - Fiscal and monetary reform; - Privatisation of state industrial holdings with the participation of strategic investors, but only after proper oversight, laws and institutions are in place to ensure transparent and efficient privatisation processes; - The establishment of incentives for the development of small and medium-sized enterprises; - Greater transparency in economic and fiscal policy-making. 71. Unemployment  may  be  the  greatest  immediate  and  long-term  challenge  to  the  region. Failure  to  create  new  jobs  poses  serious  political  risks.  The  experience of other developing and transition  countries  suggests  that  labour  output  might  increase  by  2-3%  a  year  simply  through greater  international  integration.  Improving  institutional  accountability  and  public  administration could  add  from  0.8-1.3%  in  growth,  while  boosting  women's  participation  in  the  labour  market might  add  0.7%  to  GDP  growth  per  capita.  In  all,  policy  changes  such  as  these  could  add  an increase in output growth per labourer of 2.5-3.5% a year.  This would help attract long-term FDI to the region and begin the process of economic rationalization that is essential to long-term job growth. 72. The MENA region currently stands to gain from what could be a permanent rise in oil and gas  prices.  Changing  global  demand  conditions,  driven  by  explosive  growth  in  China  and  India, increasingly suggest that the region's oil exporters could well enjoy a sustained windfall. But this is not  going  to  be  sufficient  to  meet  the  region's  economic  requirements.  More  efficient  and transparent means are needed to manage, save, and invest this wealth in ways that will advance broader development goals. Oil endowments can be a curse in development terms if not properly administered;   enclave   economies   based   on   a   single   commodity   export   tend   to   have   little resonance and few linkages back into the broader societies around them. 73. Banking reform in the MENA region will be vital to the overall reform process.  The region's financial institutions need to be more responsive to real economic opportunity and less responsive to  demands  for  the  political  allocation  of  capital.  State  owned  banks  have  customarily  extended soft  loans  to  politically  connected  state  enterprises  –  a  practice  which  has  only  added  to  public liabilities   while   penalizing   more   entrepreneurial   businesses.      Investment   banking   capacity throughout the region is very weak. The banking sector needs to be far more stringently regulated and more transparent. It is also crying out for greater competition. Currently there are restrictions on cross-border mergers and serious constraints on foreign-owned banks. This is partly inspired

172 ESCEW 05 E 16 by a fear of western colonialism by financial means. Financial parochialism, however, has limited the   capacity   of   this   vital   sector   to   modernize.   (Wilson)      Ultimately,   some   combination   of privatisation and lowering financial protectionism, where it exists, would be helpful. 74. Indeed,  achieving  rapid  growth  in  the  region  will  only  be  possible  through  a  significant expansion  of  the  private  sector.  That  sector  cannot  play  a  leading  role  without  developing  the means to allocate capital to those firms that have the greatest potential to assume a competitive position locally and in the international division of labour.  The private sector in the MENA region is quite  small  compared  to  most  developing  countries.  It  is  hamstrung  by  a  lack  of  a  capital,  over regulation and high tariff and non-tariff barriers. Indeed, the entry costs for new firms is daunting; complying with regulations, high taxes, Byzantine and opaque legal systems and sometimes overt favouritism    for    national    champions    reduces    competitiveness   throughout   the   region   and discourages foreign investment, which normally would be an important catalyst for development. Rent  seeking  is  rampant  as  a  result,  and  private  firms  have  no  choice  but  to  hire  a  coterie  of experts and political insiders capable of navigating a regulatory and legal minefield.   75. The  region's  governments  thus  need  to  adopt  comprehensive  strategies  to  improve  the business  climate  by  easing  government  regulation,  privatising  state  holdings  particularly  in  the banking,  telecommunications  and  service  sectors,  lowering  tariff  and  non-tariff  barriers  to  trade, upgrading  judicial  and  legal  transparency  and  the  capacity  of  the  state  to  implement  law  with consistency and transparency. 76. In many MENA countries, two thirds of the population is under thirty years old while Europe is  ineluctably  ageing.  This  suggests  a  potential  complementary  structural  demographic;  yet  the politics of immigration suggest that any large increase of migration to Europe from MENA is not likely  to  be  politically  acceptable.    The  prime  challenge  for  receiving  countries  in  Europe  at  this point is the integration of migrants and the prevention of the emergence of parallel societies. Still, both  sides  need  to  look  at  how  this  demographic  reality  might  be  harnessed  to  better  meet  the future  employment  needs  of  both  sides.    Obviously  improved  trading  and  investment  relations might be one vehicle for doing so.  This should involve genuinely opening markets to the MENA region   even   in   so-called   sensitive   products   like   agricultural   produce.   Western   support   for governance,   financial,   educational,   and   environmental   capacity   building   also   needs   to   be intensified.    This  assistance  should  be  structured  so  as  to  encourage  deeper  regional  and international co-operation. Unfortunately, the outcomes of the referenda on the EU constitution in the Netherlands and to a lesser extent in France revealed widespread concerns that immigration will erode social standards in Europe. This does not bode well for an enlightened approach to the Mediterranean neighbours and beyond. 77. Over the last decade Central and Eastern Europe have derived numerous lessons on both economic and political transition.  The MENA region can learn a great deal from their experiences, even if there are important geographical, environmental and other differences. Of course, there is no single way to conduct a transition process; but there are nonetheless certain principals about what works and what does not. The West with its new Central and Eastern European adherents has a great deal of expertise in building internal and external accountability standards and control systems. Efforts to share these experiences with MENA governments, opposition groups and civil society in general should be deepened. 78. But none of this will work if political changes are not also introduced. These changes must include more democratically accountable political structures, more transparent legal and regulatory institutions,  free  and  independent  media,  broader  leeway  for  an  increasingly  articulated  civil society,  greater  gender  equality  and  improved  education  systems  capable  of  endowing  workers with skills appropriate for the global economy. Political repression has bred unaccountable and all- pervasive   state   and   para-state   institutions   that   have   all   but   strangled   economic   initiative. Repression and corruption have impeded broader social and economic development and left the

172 ESCEW 05 E 17 region highly vulnerable to potential social and political explosion.  Positive political change will be a critical complement to economic transition, and there is a growing push from civil society in the region  for  change.  If  the  region's  states  do  not  move  to  accommodate  these  demands,  the consequences could well be disastrous. 79. Genuine reform in the MENA region must spring from its own cultural and historical context, but  it  will  not  succeed  without  external  encouragement  and  support.  The  prospects  for  success would  improve  significantly  if  the  United  States  and  Europe  were  able  to  work  together  on  this front.  Too often the United States and Europe have worked at cross-purposes in the region, and there  is  ample  room  for  deeper  co-operation  among  allies.  (Reiss)  There  are  signs  of  growing transatlantic  unity  on  several  key  policies  including  the  need  to  promote  democratic  ideals throughout the region. 80. In this respect, aid to the region should focus on effecting this kind of transition rather than supporting  the  status  quo.  Western  policy  in  the  MENA  region  has  frequently  been  rhetorically dedicated to human rights promotion, yet it readily sacrificed these goals to pursue other interests: access  to  oil;  short-term  commercial  opportunities;  and  anti-terrorism,  among  others.  Pursuing these goals without balancing consideration for the need for regional political transition has helped entrench  authoritarian  governments  and  has  bred  widespread  cynicism  in  the  region  about Western motives. 81. Although  the  link  between  economic  development  and  a  reduction  of  terrorist  activity  is hardly   straightforward,   there   is   no   doubt   that   the   implementation   of   successful   economic development  strategies  in  the  MENA  region  will  undercut  the  pockets  of  support  for  terrorist activities  that  exist  among  today's  dispossessed  and  politically  alienated.    Economic  growth  and political reform are hardly going to solve the problem, but they are certainly part of the solution. 82. Western  governments  also  need  to  distinguish  between  constitutionalism  and  democratic practice.  The former is about process and rights while the latter is concerned more with political culture and outcomes (clientelism). Although democratic legal orders foster conditions conducive to  the  emergence  of  democratic  cultures,  this is not likely to happen immediately and uniformly. The content of democracy in the MENA region should not be expected simply to mimic Western political  mores.  Very  likely  it  will  not,  because  of  very  different  historical,  cultural  and  religious contexts.   Thus   the   West   would   be   better   off   focussing   its   regional   policies   on   advancing democratic processes and forms, while giving the region enough room to work out the content of its  own  democratic  existence  (e.g.  using  the  tribal  Loya  Jirgah  in  Afghanistan  to  generate legitimacy  and  resolve  conflict).  The  West,  however,  can  still  lend  support  to  the  emergence  of democratic  culture  by  helping  to  provide  an  economic  and  an  international  legal  and  security framework  conducive  to  democracy  building  while  actively  engaging  in  a  so-called  dialogue  of civilizations.  Resolving  the  Middle  East  conflict  will  provide  a  fundamental  boost  to  this  process and it must remain a key Western priority. (Aliboni and Guazzone) 83. A speech delivered in Cairo by the US Secretary of State Condoleezza Rice in June 2005 might  signal  a  new  direction  in  US  policy  towards  the  Middle  East.  Secretary  Rice  captured  the matter rather well: "For 60 years, the United States pursued stability at the expense of democracy in  this  region  here  in  the  Middle  East  and  we  achieved  neither.  Now  we  are  taking  a  different course…supporting  the  democratic  aspirations  of  people."  ( The  Economist,  30  July  2005)  This new  policy  will  undoubtedly  run  up  against  other American interests including its need for short- term  stability  to  ensure  the  continued  flow  of  oil.  But  one  has the sense that the Americans are increasingly  concerned  about  the  long-term  implications  of  political  and  economic  stasis  in  the region and particularly the absence of democratic rights, which has clearly fuelled alienation and political extremism.

172 ESCEW 05 E 18 84. The Americans have initiated the Broader Middle East and North Africa Initiative (BMENA) to engage MENA and Europe in a dialogue on economic and political reform. It has also established a  Middle  East  Partnership  Initiative  (MEPI)  to  support  economic  and  employment  growth  by encouraging private sector expansion and entrepreneurship, fostering greater democratic dialogue in the political process, and improving governance and respect for the rule-of-law.   85. The  European  Union's  recent  European  Neighbour  policy  allows  the  European  Union  to differentiate    among    its    Mediterranean    partners    to    reward    positive    reform    efforts    more systematically than it has in the past. Those that move quickly toward reform will be accorded a closer relationship with the European Union, gaining, by extension, greater access to its markets and   its   lending   facilities.   The   problem   here   is   that   some   EU   Mediterranean  countries  are somewhat leery of greater economic integration with a region that could directly compete in some areas, such as agriculture. There is thus a divide within the European Union between those who advocate aid before trade and others who see trade as the most important means of improving the relationship  with  Mediterranean  partners.  It  is  also  true  that  this  relationship  lacks  the  powerful incentives  that  the  European  Union  held  out  in  its  relationship  with  Central  Europe  during  the transition process. The European Union then was floating the possibility of accession to its Central Europe partners in the region.  This provided a very powerful incentive for change.  EU Accession, however,  is  not  part  of  the  picture  for  the  Mediterranean  dialogue  countries,  at  least,  not  at this juncture. If the European Union is able to hold out the possibility of a genuine free trade area with the Middle East, one not riddled with caveats to protect certain sectors, the incentives for transition would  accordingly  be  strengthened.  There  is  a  real  possibility  that  this  can  be  achieved.    The European    Union's    decision    to   launch   accession   negotiations   with   Turkey   this   October demonstrated  that  the  Union  is  by  no  means  a  "Christian  Club";  its  members  subscribe  to universal  humanistic  values  that  certainly  open  the  door  for  a  country  with  a  majority  Muslim population. The European Union's evolving relationship with Turkey will send a strong message to the MENA region that reforms can pay off over the long run, not just in domestic terms but also in terms of relations with Europe. 86. At the end of the day, however, it is the MENA countries that hold the greatest responsibility for  managing  transition  and  reform  processes.  Local  ownership  is  a  key  to  making  reforms sustainable, otherwise they may be washed away with the next change in government or the next fad  in  development  theory.  Western  governments  should  continue  to  advocate  and  support reform, but the burden of responsibility will fall on the people of the region and the governments that  they  must  hold  accountable.  We  can  only  help to empower them to make the right choices and do the right things.

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