MENASource|News, Analysis, Perspectives

January 21, 2016
The US Federal Reserve (FED) announced its most anticipated policy change in December 2015: the long-awaited modest increase in short-term interest rates, which formally marked the beginning of a “Strong Dollar” period in the global economy. Coupled with the upcoming rate hikes in 2016, this policy will not only impact the US economy, but will also affect the economic, financial, social, and political structures of emerging market economies—including the already-fragile and stagnant economies of the Middle East and North Africa (MENA). The fundamental effect of this normalization period is its potential to increase the flow of economic activity towards the informal economy—the black market. In an already challenging economic environment, an active Middle East black market could provide a stop-gap for lagging employment and trade, but the long-term costs could be far more destructive.

Increasing interest rates directly and indirectly impose higher borrowing costs for Middle Eastern governments, as the global rates for lending money gradually increase. Project financing becomes more expensive, causing delays in national projects that require international partnerships. Currency depreciation takes a toll not only on the purchasing power parity (PPP) on a comparative basis, but also on inflation and capital flows in these MENA economies. The dollarization of debt in the region already makes Middle Eastern economies vulnerable. When combined with plunging oil prices, the result includes increased public sector budget deficits and a weaker banking sector. Recent examples from the banking sector include moves by Egypt, Iran, and Turkey.

Egypt’s central bank injected foreign currency liquidity into the banking system in a surprise move on December 13, just before the FED’s meeting on December 16. Central Bank Governor Tarek Amer has also taken measures to supply Egyptian banks with dollar-liquidity against the foreign currency shortage in the Egyptian markets. Iran and Russia also announced that the two countries aim to strengthen their banking ties. The Central Bank of Iran announced on December 23 that the two countries will operationalize credit lines and handle their transactions in Iranian rials and Russian rubles. The banking sector in Turkey increasingly faces profit pressures and has almost fully hedged its foreign exchange lending. But as markets normalize with the FED’s actions and the slowdown in the Chinese economy (another major factor as profound as the FED’s policy change), Turkey will have to pursue a growth-oriented economic policy again, which causes the banking sector to await for the easing of the macro-prudential measures and banking regulation on domestic banks adopted five years ago to cool the lending, thus putting the brakes on growth. International financial institutions estimate the overall GDP growth rate for Middle East and Africa at the 2.4-2.8 percent range for 2015, marking the third consecutive year of growth running below 3 percent.

Many MENA central banks have already started increasing their interest rates in parallel with the FED. For example, the United Arab Emirates (UAE) raised its rate on certificates of deposits; Kuwait raised its interest rate a quarter point to 2.25 percent; Bahrain increased its overnight deposit rate from 0.25 to 0.5 percent; Saudi Arabia introduced the first rate hike raise since 2009; Egypt raised its benchmark interest rates by 50 basis points a week after it shocked markets by postponing its decision. The Israeli Central Bank and the Turkish Central Bank have not introduced any reactionary interest rate hikes yet, keeping them on hold in their December meetings. But in Israel, the consumer price index fell over the past fifteen months, whereas in Turkey the annual inflation rate spiked to 8.1 percent in November, with the core inflation over 9 percent.

These increases in the interest rates throughout the region, combined with capital outflows, depreciating exchange rates, inflationary pressures, and stagnant growth pressurizing budgets, has the potential to steer Middle Eastern economic systems more towards a less regulated and tax-free informal economy. This black market already exists in all Middle East economies, with different depths and characteristics. According to the International Labor Organization (ILO), informal employment already accounts for a substantial proportion of employment in the Middle East, ranging from 30 percent to 70 percent depending on the country. Any undersupplied goods and services in an economy could potentially fall under this informal economy. It ranges anywhere from food supplies, medicine, gas, and oil transactions to arms and human or material trafficking. Since the revenue generated from these transactions is unaccounted revenue, it disrupts the economic and financial balances of the nation’s economy, causing further instabilities and social implications.

In Egypt, the so called “black dollar market,” which refers to the excessive US dollar currency market, is already a troubling factor for the Egyptian economy, valued worth $35 billion dollars per year. The Egyptian government’s months-long curfews between 2011 and 2013 and periodic unrest have also pushed people towards this informal economy. It is estimated that the curfews had cost the economy between $200 million and $350 million in one month on average during 2013. Underground market revenues increased as the demand for simple goods such as food supplies, medicine, gas, and shelter became scarce.

Curfews adopted by the Turkish government in the southeastern regions of Turkey have had similar effects. Setting aside the humanitarian and legal aspects, local economic dynamics in the region have eroded, creating a push towards the illegal trade, black market activities, and informal employment in and around the region. On top of these currently existing conditions, deteriorating economic dynamics caused by the FED’s “Strong Dollar” period as it raises the interest rates, has the potential to further ignite these black market dynamics—especially in the economies surrounding the ISIS territory. This shift imposes economic challenges and instability risks for most of the region’s economies including Syria, Turkey, Iraq, Iran, Lebanon, Israel, Jordan, and Saudi Arabia.

Given the current market dynamics and the global decline in oil prices, the Kurdistan Regional Government (KRG) in Iraq has seen a boost in its informal economy and struggles to raise funds through international borrowing. The informal economy in the KRG is intertwined with the ISIS-related regional conflict and the internal displacement of 2.1 million Iraqis, 60 percent of whom are hosted in KRG areas. KRG-Iraqi central government tensions since February 2014 have also limited the KRG’s access to its share of the national budget. Revenue from crude oil exports through the pipeline from Kirkuk to Ceyhan is one of KRG’s few official means of economic survival, exporting up to 18 million barrels of crude oil in November through the pipeline network to the port of Ceyhan in Turkey. Although the KRG has tried to raise funds by issuing international bonds, neither the KRG nor the Iraqi central government succeeded in these efforts due to high interest rates. Credit rating agencies Fitch and S&P both have “junk” ratings on Iraqi debt, which show that establishing a federal entity does not guarantee the flow of funds, revenue streams, or economic stability. On the contrary, it places additional black market pressures, making it easier to be exploited by regional criminal entities like ISIS.

Saudi Arabia recently announced a budget deficit of $98 billion (367 billion riyals) dollars for 2015, as declining oil prices cut into the government's revenue. This figure corresponds to 15 percent of the country’s GDP. Saudi Arabia has also announced its plan to cut spending, and raise domestic fuel prices by 50 percent from 0.60 riyals to 0.90 riyals ($0.24) a liter, among other price increases on utilities, to ease the financial burden on the government. According to Riyadh based Jadwa Investments, Saudi Arabia’s new budget for 2016 is based on likely crude prices of about $29 dollars a barrel.

The FED’s federal funds rate is not just any interest rate. It has the capacity to reverse the capital inflows that have been a major financier of growth in the Middle East economies into capital outflows, ramp down the economic activity that had grown in the post-2008 period and reverse the decreasing trend in the general cost of borrowing for these economies. Until now, these dynamics have kept Middle Eastern economies in a favorable position and scored points for the ruling political actors in these nations. With the new FED policy increasing the cost of borrowing, reducing foreign direct investment, curtailing growth, and increasing the allure of informal economies, MENA countries will now have to add this economic pressure to the list of concerns that could potentially contribute to volatility, both from a financial and social perspective.

M. Hande Akmehmet is an independent economist with a focus on Turkey, the Middle East, and emerging markets.