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How the Middle East can recover from the oil crunch

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Richard T. Nowitz | Getty Images

It's been two years since a barrel of Brent crude cost more than $100. Since then, the Middle East has been fighting to survive a veritable oil industry bust. The approach has been to let prices slide, keep market share, tighten fiscal belts, defend local currency pegs to the U.S. dollar, and borrow or privatize to finance budget gaps. However, the Middle East is unlikely to maintain its current economic status without diversifying its economy more sharply away from oil and gas.

Admittedly, the combined wealth from oil and gas in the region is still staggering. Even assuming oil prices remain at around $45 a barrel, the value of proven oil and gas reserves amounts to $50 trillion, 25 times the region's GDP. The region's hold¬ings of foreign exchange reserves at $800 billion, or about 40 percent of GDP, give their central banks comfort in supporting their mostly pegged currency regimes. In addition to foreign exchange reserves at central banks, there is an estimated $2.9 trillion held by sovereign wealth funds.

Also, while budget deficits due to low oil prices this year are expected to average 10 percent of GDP, debt ratios are low by global standards, or less than 25 percent. Low leverage ratios give treasury ministries latitude to run fiscal deficits for several years.

Nevertheless, the Middle East's hydrocarbon wealth is finite and can only produce a limited annual income. And the region's economic needs are burgeoning. Given that 28 percent of the region's 210 million people are under 25 years old, policy makers have to worry about generating sufficient jobs to absorb new entrants to the labor force.

With foreign labor sometimes accounting for 60 percent or more of total employment in Saudi Arabia, the temptation is to restrict immigration severely. However, replacing typically cheaper and less well educated foreign workers with locals will likely increase wage costs and result in quali¬fication mismatches, adversely affecting the pro¬ductivity and profitability of local companies.

For the Middle East, diversifying beyond oil and gas is therefore critical. In some economies, greater diversification could lead to an eventual relaxation of exchange rate pegs with the U.S. dollar, boosting their long-term flexibility.

One particularly promising field is solar power. Without the prop of elevated oil and gas prices, UBS sees local energy subsidies as increasingly untenable amid growing domestic demand. With over 300 days of sunshine per year, the Middle East should use solar to help fill the gap. The Middle Eastern Solar Industry Association estimates that large-scale installations will stay competitive even with oil prices at $30 per barrel and gas prices at $5 per MMBtu.

A second potential focus is tourism. While Dubai has been at the forefront for many years, other countries in the region are following suit. Qatar is hosting the FIFA World Cup in 2022 and Abu Dhabi is planning to open Louvre and Guggenheim Museums. Saudi Arabia is targeting improvements in tourism and leisure in its Vision 2030 plan. Challenges include cultural differences between residents and visitors, as well as perceived security threats.

A third key area is finance. The oil and gas downturn has left the Middle East with growing financing needs, which is likely to boost interest from international investors. Bond issuance is rising, while the trend towards privatization and greater foreign ownership of companies will help open up Middle Eastern equity markets. With so much personal wealth still held locally, wealth management could also become an even more significant industry.

The good news is that the region has done this before. The United Arab Emirates are already a hub for tourism and finance, as well as retail, airline transportation and professional services such as corporate headquartering. Key development indicators in the region are advanced. Cell phone subscription rates are higher in the U.S.

According to the World Bank, education levels are well above the global average. Although entrenched interests are likely to oppose reform in some cases, and security concerns remain an issue, the Middle East may be at an inflection point. Investors and governments will need to act with courage and vision to realize its potential in the years ahead.

Commentary by Jorge Mariscal, the emerging markets chief investment officer at UBS Wealth Management, which oversees $1 trillion in invested assets. Follow UBS on Twitter @UBS.

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