MIDDLE EAST governments are waking up to the need to achieve higher rates of economic growth. Populations are rising rapidly and the income generated from oil is no longer enough to cover every investment need. The region no longer has surplus funds to offer to others and now finds that it needs to attract funds itself.

The Middle East finds itself in the unfamiliar position of having to compete for capital in the international market. In 1993, the flow of funds to developing countries reached a peak of some $200,000 million, before dropping back to $170,000 million in 1994. Only a fraction less than 3 per cent of total flows in 1994 - found its way into the Middle East. Despite their need for new investment, Middle East states are not proving a great attraction for the foreign investor.

The Mexican experience at the end of 1994 and early 1995 exposed the risks of relying on short-term foreign capital flows to finance development and helps to explain why many Middle East states remain wary.

When the Mexican economy faltered, foreigners pulled out their funds, the currency collapsed and the country was plunged into a crisis from which it is only slowly emerging. There are fewer pitfalls with direct foreign investment, which is harder to attract precisely because it is less liquid.

Direct investors cannot withdraw so easily if the political or economic climate turns against them.

The southeast Asian economies provide an alternative model for developing countries which other states are keen to emulate.

Foreign capital has played a key role in their advance, but a high rate of domestic capital accumulation has been another essential ingredient. Savings rates in these countries range from 30-35 per cent of gross domestic product (GDP). Singapore achieved an exceptional savings rate of almost 50 per cent of GDP in 1994.

The principle is simple. 'If you can tap the local market then there is no need to amass foreign debt,' says an economist at one London-based bank. 'If the domestic savings ratio is pretty low, a country has to look overseas if it is to achieve rapid rates of growth.' With a high domestic savings rate, developing economies can be more selective about the kind of foreign investment they welcome.

Domestic savings rates in the Middle East vary widely. In the Gulf, there were huge domestic savings during the oil boom of the last two decades but mostly of public funds, while citizens developed a culture of consumption. As oil prices have fallen, so too have public savings rates. Saudi Arabia, for example, had foreign assets of some $150,000 million in the early 1980s, but they have since fallen to about a third of that figure.

The need to increase savings rates is particularly pressing for the oil-dependent economies that rely on mining a non-renewable natural resource. The World Bank highlighted the issue in a 1994 report on Oman. 'Oman, like most neighbouring oil and gas producers, is currently spending an excessive proportion of the proceeds of extraction on current consumption,' the report said. Oman's savings rate is far below the optimum rate of 39 per cent of gross national product (GNP) recommended by the bank. The report said foreign investment was essential to ensure long-term prosperity;

it also urged the government to take action to improve savings levels. Without such action, Oman faces falling living standards as its natural resources are depleted.

The countries of the Mashreq and Maghreb, where savings rates fall close to single figures as a percentage of GDP, face an even greater challenge. 'The problem of savings is a problem of wealth. Only wealthy countries save,' says David McWilliams, a senior economist at the London-based United Bank of Switzerland.

Government action to boost individual savings can begin with freeing up interest rates and devising fiscal policies to make it more attractive. The banking system has a crucial role to play in attracting and mobilising funds. 'No country can develop in this day and age without a healthy national banking network,' says Adel el-Labban, managing director of Egypt's Commercial International Bank.

Banks also have a role to play in lending on those funds, or setting up suitable investment vehicles. By international standards most Middle East banks have a low ratio of loans to assets and have plenty of scope to increase their lending levels. In Egypt in the early 1990s, many banks found it more profitable to invest in treasury bills that were offering 20 per cent on six-month paper, rather than lend to local customers.

Such high interest rates brought back capital that was previously held abroad and has given the Egyptian financial system the capacity to seek new commercial opportunities.

Open market Many Middle East states face particular difficulties as they try to mobilise national capital resources. 'There is a more complicated problem for Middle East economies because it is as if their capital market is completely open,' says World Bank economist John Page. A high proportion of the national savings of countries such as Syria, Jordan, Egypt and Lebanon, which export labour, are effectively held abroad.

To build up their domestic pool of funds, these governments must woo back this capital, encountering many of the same problems presented by the effort to attract foreign investment. Lebanon is a rare success story, having managed to attract some $4,000 million in 1995, much of it from Lebanese expatriates.

Domestic savings can aid national development effort but there is still a need for foreign investment, economists say. 'The bottom line is if savings are imperative for growth then it undermines the entire emerging market principle,' says McWilliams. 'Absence of domestic savings demands that companies go outside, which imposes a market discipline itself... Savings deficits are almost a necessary imbalance to set up a flow of funds.'