The report puts real GDP growth at 4 per cent in 2001 despite reduced oil revenues, as projects came on stream in the construction, power and water sectors. A large external current surplus was also recorded in defiance of oil price volatility, but the IMF warns that vulnerability is increasing through rising current account spending and the failure to institute a broad-based tax system - a move the report strongly recommends. To reduce current account outlays, subsidies on water, electricity and agriculture should be phased out, it says. The report finds that such spending had pushed the fiscal balance into a 5 per cent deficit in 2001.

The macroeconomic performance in 2002 is more mixed, as an increase in oil prices has been more than offset by quota-driven production cuts. With no compensatory cut in spending, the fiscal position has deteriorated over the course of the year, registering an estimated deficit of 9 per cent of GDP. On this basis, the public expenditure reform programme initiated by the government is welcomed.

Given this vulnerability to volatile hydrocarbon prices, the IMF urges the government to push ahead with economic diversification. To this end, the report advises focusing on improving the climate for foreign investment, strengthening financial services and increasing the participation of locals in the private sector.

The government has already embarked on a programme of Emiratisation. However, in common with business leaders, the IMF suggests that this should be achieved through better education and training rather than through the imposition of quotas. In order to encourage foreign investment, the report advises harmonising policies across the emirates and gradually lifting the restrictions on foreign ownership outside designated free zones. Recent reforms of the power and water sector - particularly in Abu Dhabi - are cited as positive developments.

In common with a study released in January, the banking sector was deemed 'sound and well-supervised' and measures to combat money laundering commended. The report concludes by encouraging greater transparency in economic reporting (see Special Report).