What Lessons Are We Sending?

Yesterday I came across a surprisingly upbeat article on Lebanon in the Wall Street Journal. I say surprising since I have not been actively following Lebanon recently. The article recaps an interview with the country's central bank governor who is now forecasting a possible 6 percent growth rate in 2009 based largely on an anticipated strong growth in consumption in the second half of the year after the parliamentary elections next month. Continuing in this happy vein, Moodys upgraded the country's sovereign credit rating last month (around the same time it was issuing a warning for a downgrade in Kuwait), and according to a report in the Daily Star, the Lebanese benchmark outperformed the MSCI Arab market index, making it the best performing index in the Arab world second only to Qatar.

With all of this optimism, I had to stop myself and think- this is Lebanon, people. Political instability is only a stone throw (or an election) away. Debt to GDP ratios still exceed 150 percent and finance continues to be the one thriving industry in a country that has witnessed enough destruction of its infrastructure to last a lifetime. Coupled with that a decline in remittance payments from the Gulf as those economies slow and almost sure decline in tourism receipts on the back of the global slowdown, I still have a hard time seeing the sunshine.

But more troubling is the general message that this crisis might be sending to countries in the region. A colleague of mine asked several months ago whether or not I thought the global economic crisis would create a general distrust of capitalism in the Middle East as countries that were at best reluctant to accept Washington consensus style reforms watched as Anglo-Saxon capitalism collapsed in a big ugly heap. I thought at the time (and said as much) that I didn't think it would make that much of a difference since most regimes in the region saw their fortunes tied to a limited but specific plan of reform- privatization and some liberalization in order to create jobs. Most Arab governments were not, in fact, modeling their efforts on western models but on a hybrid Arab-Asian model- that is, some economic reform with continued authoritarian control over governments.

But here's the thing- the crisis is teaching the countries in the region a potentially scary lesson- the more integrated your banking and financial system is with the global system, the more you will suffer. Look at the two countries that so far have taken the biggest hit- UAE and Kuwait. It was precisely their reliance on, links to the global financial system that have lead to their current weakness. They are essentially getting it at both ends- seeing their export markets shrink (in both cases, export earnings have declined with the price of oil) and their credit markets, which in the case of the UAE, was perhaps the most robust in the region, have dried up. North Africa, specifically Egypt, Morocco, and Tunisia, have proven remarkably resilient in the face of the crisis. Why? Well, their export markets have shrunk, for sure, but their closed banking systems have prevented any contagion effect. So what's the lesson? Don't lend and don't invest internationally.

I would argue, though, that the single biggest issue holding these economies back is their closed financial systems. Credit is largely unavailable to both individual consumers as well as private businesses. Financial systems in these countries, despite the limited reform being carried out, remain largely patronage systems. If you have ties to elite families, you get the loan. One of the most important "innovations" in the Gulf in recent years was to break the back of this system and open credit markets to the masses. Huge windfall oil profits somewhat masked the fact that the private sector in many of the Gulf countries was growing at an even faster rate than oil receipts.

Opening credit markets does have long term beneficial consequences for growth and diversification, even if that's hard to see now. My biggest fear is that this is a lesson that might get lost in the hullabaloo of the current crisis. In the meantime, all other ridiculous bad behavior ala Lebanon will be tolerated.