As the initial shock of 11 September starts to wear off, and the war in Afghanistan draws to a close, the main political preoccupations in the Middle East are the familiar questions of Palestine and Iraq. In neither case is there much reason for optimism. The new year starts with Palestinian leader Yasser Arafat once more locked in a battle for survival. In the nine months since Ariel Sharon assumed power, it has become plain that the Israeli prime minister's agenda has changed little since his 1982 campaign to eliminate Arafat and sink the cause of Palestinian nationalism. What has changed, however, is that Arafat is present on Palestinian territory and enjoys a measure of protection from the international legitimacy of his Palestinian Authority. This means that the elimination Sharon appears now to be seeking is political rather than physical.

Arafat is in a position where he is drawing on his last shreds of international support in a bid to outmanoeuvre Sharon. The main gain secured by Arafat and the Arab world since 11 September was the explicit endorsement by the US of 'a viable Palestinian state' as a central element in any peace settlement. However, the pendulum swung back again in Israel's favour following the December suicide bomb attacks by Islamist groups. Arafat is now faced with the task of enforcing a ceasefire on Hamas, Islamic Jihad and the semi-autonomous West Bank wing of his own Fatah movement, while ensuring that resentment at his acting effectively as Israel's policeman does not escalate into open conflict within Palestinian ranks.

If the ceasefire can be made to stick, Sharon's government would be drawn into negotiations with Arafat. Sharon has said that he is in favour of the creation of a Palestinian state, but it remains doubtful whether he is prepared to make the concessions on issues such as settlements, Jerusalem and refugees that would be necessary for a final peace settlement to be reached. With the US now pulling back from active engagement in the issue, Palestinians and Israelis seem doomed to endure more conflict and instability until the Israelis elect a leader with the vision and statesmanship to enable peace to be achieved. On the Palestinian side, the time is approaching for a new political leadership to come through. But Israel and the US would be deluding themselves if they thought they could find a Palestinian leader more prepared than Arafat to offer concessions.

The waning of Washington's interest in tackling the Palestinian problem has coincided with the surge in American military confidence as the Afghan war has unfolded. The success of the campaign has led some senior figures in the Bush administration to conclude that a similar outcome can be achieved in Iraq. Opposition to such a move is much broader than was the case with the Afghan campaign, but it is not clear whether this will stop the US from pressing ahead with an operation seeking to engineer the downfall of the regime of President Saddam Hussein.

Washington has maintained that the Iraqi leader's refusal to allow inspectors in to monitor the destruction of weapons of mass destruction poses a security threat to the US, and therefore military action against Baghdad is justified. Plans said to be under consideration entail a bombing campaign supported by the seizure of a southern enclave to be used as a base of operations for Iraqi opposition forces.

The UN, Russia, China and - in a muted way - the UK have expressed reservations about the legality of any such campaign. It also appears from the debates being conducted in the US press that some senior figures in the administration have doubts about its feasibility. The issue is likely to be one of the dominant themes of the first half of 2002.

What happens on the Iraq front will have a direct bearing on the economies of the Middle East. The slump in oil prices in the final quarter of 2001 has produced a more sober outlook for the Gulf economies than had seemed likely earlier in the year, and the rise in regional political tensions has had a devastating effect on those economies dependent on tourism for their foreign exchange income. A major US military operation against Iraq would tighten oil supplies for a period, and lead to a spike in oil prices until alternative supplies could be secured. That should not pose a problem, given the abundant spare capacity following the successive OPEC production cuts of the past 12 months. However, it would once more bring uncertainty to the market, frustrating the producers' efforts to achieve price stability.

Military strikes on Iraq would also revive uncertainty about the stability of some other Arab regimes and raise fresh questions about long-term investment prospects.

However, the region's economies have shown great resilience over the turbulent period since 11 September. Lower oil prices have taken the shine off the budgets of Gulf states, and some project finance deals have priced in an extra element of political risk. However, the underlying economic themes of reform and diversification have endured.

Saudi Arabia started 2001 flush with surplus oil revenues, but remained committed to the goal of broadening the economy's investment base through opening up new areas of activity to the private sector, and, in particular, to foreign companies. Saudi government spending rose by 8.5 per cent over the year, and the sharp dip in oil prices towards the end of 2001 left the budget back in deficit. This served to emphasise the point that the structural reforms which started to go into effect in the late 1990s need to keep up their momentum. In this respect, the first few months of 2002 will be crucial. The massive investment programme associated with the gas initiative should be spurred into action if the complex implementation agreements with international oil companies can be tied up by the revised deadline of mid March. The first part of the year is also expected to see the appointment of an electricity regulator and a minister dedicated to the water sector, and the ending of the exclusion of telecommunications from foreign investment.

Nominal gross domestic product (GDP) in Saudi Arabia is likely to fall in line with the reduction in oil prices and production, and the effort to keep government spending under control. However, there appears to be sufficient activity in the private sector to ensure modest growth in real GDP in 2002.

Similar patterns are expected in the other Gulf Arab oil exporters, although somewhat higher rates of growth are in prospect in the UAE and Bahrain where a larger proportion of economic activity is outside the oil sector. Dubai is pressing ahead relentlessly with new projects, including further expansions for the international airport, the Palm Island resort and a major new convention centre to be ready for the IMF/World Bank meetings in September 2003.

Doha put itself firmly on the map of global finance through hosting the World Trade Organisation meetings in November, and Qatar will remain in the spotlight in the coming year as one of the region's most active project markets. The close of 2001 saw the signing of the production-sharing agreements on the $3,500 million Dolphin project, entailing the supply of gas from Qatar to the UAE and Oman. Other major projects getting under way in Qatar include the third and fourth trains for Ras Laffan Liquefied Natural Gas Company (RasGas), a trailblazing gas-to-liquids (GTL) plant and an independent water and power plant (IWPP).

Bahrain is also gearing up for a surge in new project activity, notably the Hidd port and power projects and the long-awaited upgrades of the Aluminium Bahrain (Alba) smelter and the Bahrain Petroleum Company (Bapco) refinery.

A vibrant project market is not the only thing uniting the two small Gulf neighbours. Under their relatively youthful new leaders, Qatar and Bahrain have finally resolved their territorial dispute, and both states are now planning political reforms to allow more popular participation in decision making.

Making the transition to a younger generation of rulers is a challenge now facing Kuwait, as both the emir and the crown prince are becoming increasingly infirm. First Deputy Prime Minister Sheikh Sabah al-Ahmed al-Sabah has taken charge of much of the state's day-to-day business, but there are several younger members of the ruling family poised to take on more responsibility. They include minister of state for foreign affairs Sheikh Mohamed al-Sabah and Information Minister Sheikh Ahmed al-Fahd, diplomats say.

Among the Gulf oil exporters, Iran faces the most daunting challenge in terms of economic reform. President Khatami has set the agenda for the year ahead through applying a unified, market-based exchange rate for the new budget, and emphasising his support for privatisation and other measures designed to attract foreign investment. However, Khatami has been labouring against determined efforts by conservative forces to undermine his authority. His re-election by a landslide in mid 2001 has done little to deter the conservatives, and Khatami is starting to face mounting criticism from supporters who are frustrated with his inability to impose his will.

The kind of economic reforms on which Iran is now embarking share many features with those carried out in Egypt in the early 1990s. However, Egypt lost control of its fiscal policy towards the end of the decade, and a host of deep-seated structural problems have now started to re-emerge. Egypt carried out two substantial devaluations of the local currency in the second half of 2001, and the exchange rate faces a rocky ride in the year ahead, as the balance of payments will come under increasing pressure. A $1,500 million inaugural Eurobond has helped to tide the government over for now, but it is likely that further funds will be needed from donors or the international capital markets to keep the Egyptian economy afloat in 2002.

Egypt appears one of the most vulnerable of the region's economies both because of the short-term external shock resulting from the loss of tourism income, and because of the long-term issues that have still to be addressed satisfactorily. Most other countries in the region appear not to have been affected so severely, and will be able to look forward to a year of respectable economic growth, albeit with some retrenchment.