After a brutal 2009, when growth in the GCC came to an abrupt halt, the recovery is now well and truly under way. Most indicators show growth is picking up and confidence in the recovery is improving.

So far though, that all hinges on government spending stepping into the gap left by private enterprise, and sustained high oil prices. The private sector is having a harder time shifting back into growth mode.

Government spending may be able to get the regional economies back on a growth path, but without the private sector, the recovery will lack the pace of the 2003-08 economic boom. It will also fall short of what is needed to solve the region’s longer term employment challenges and infrastructure deficit.

Gulf withdrawing financial stimulus

There are also mounting concerns that the GCC countries may need to start withdrawing stimulus spending as soon as 2011. Unless the private sector gets going soon, a withdrawal of government spending will lead to another slowdown in economic growth rates.

Breaking free of the two-speed recovery between the government and private sectors is a challenge. Managing the transition of the Gulf’s recovery from being public sector-led to the private sector should now be a key concern to regional policymakers, says Masood Ahmed, director of the Middle East and Central Asia department at the International Monetary Fund (IMF).

What is holding back the potential of the region is the demand side of the private sector

John Sfakianakis, Banque Saudi Fransi

The private sector is still grappling with indebtedness, oversupply, and inability to access credit. For a sustained recovery that lasts beyond the government stimulus, the private sector will have to overcome these problems quickly. The weakness in the private sector is in contrast to robust government finances buoyed principally by the turnaround in the oil price that has helped restore government finances after several, including Saudi Arabia, recorded a deficit in 2009.

“There is a clear dichotomy between the strong macro-economic conditions of the region and the weaker micro-economic conditions,” says Henry Azzam, chairman of the Middle East and North African arm of Germany’s Deutsche Bank. “We still have a very hesitant and risk averse private sector.”

That is reflected in the growth projections for the next few years. According to figures from the IMF, gross domestic product (GDP) growth has rebounded from a flat 0.4 per cent in 2009, to 4.5 per cent in 2010. Much of this is due to the recovery in the oil price and huge government stimulus measures. Next year, while the situation improves, growth will still fail to match the 5-10 per cent annual growth rates seen in the 2004-08 period.

A clear example of how the private sector has retreated is contract awards. In 2008, the private sector awarded $50bn of contracts and in 2009, it fell to $16bn. The public sector expanded from awarding $26bn in 2008 to $58bn in 2009.

UAE government support

“We agree with countercyclical policies, they acted as a buffer to the financial crisis,” say Philippe Dauba-Pantanacce, Dubai-based senior economist at the UK’s Standard Chartered. “But if you look at growth this year it is from oil, with lacklustre private demand. This has to change.”

Change may not be coming soon though. After several years of easy credit, a construction boom, and an influx of expatriate consumers, many private sector businesses now find themselves buoyed down by debt, fighting for customers, and unable to get cash from banks to help them finance themselves.

“It could take up to two years for the private sector to absorb losses and get used to a more normal operating environment,” says Simon Williams, economist at the UK’s HSBC in Dubai.

By that time, many regional governments will be thinking hard about whether they can sustain spending at current bloated levels. John Lipsky, first deputy managing director of the IMF said at a meeting with GCC finance minister in Kuwait in early November that rising inflation could force them to start withdrawing stimulus measures as early as next year.

That may be a bit too pessimistic, but clearly the level of state spending is unsustainable, and by 2012, many countries will have to reconsider their spending levels.

If government finances will be challenged by 2012, the problem is more immediate for the private sector, particularly because of a glut of supply. Real estate is not the only sector hit by overcapacity. Most sectors of the economy were busy building out for a rapidly growing market that has now done the reverse. Some sectors can slim down quickly through shedding their workforce, others, like retail, have already invested in expansion plans that are difficult to unwind.

This will put pressure on margins in the short term, only part of which will be able to be mitigated by cutting costs.

“What is holding back the potential of the region is the demand side of the private sector, which is still deleveraging and cautious,” says John Sfakianakis, chief economist at Banque Saudi Fransi. He adds that the potential for a further fall in asset prices could create further problems for the private sector.

Dealing with the legacy of the past few years is not the only problem facing the private sector. Perhaps a bigger hurdle the private sector has to overcome is the difficult credit environment. During 1998 to 2002, credit growth was around 7 per cent. That jumped to an average 30 per cent year-on-year during 2003-08. In the wake of the global economic slowdown and regional property bust, credit growth dropped to around zero.

“Credit is expensive and difficult to get access to,” says Fadhi Ghandour, chief executive of regional logistics business Aramex. “That is part of the reason that the economy is not growing faster, because SMEs (small and medium sized enterprises) do not have access to the funding they need, and outside of the government they are engines of growth for any economy.”

At the moment most banks are focusing on lending to government and government-owned companies. That is where most of the credit is being directed at the moment as banks also remain risk averse.

Despite the problems still to be dealt with, confidence is picking up to varying degrees around the region. According to HSBC’s Williams, business managers in Saudi Arabia are most optimistic about the recovery in the private sector, while in the UAE they are less so. Third quarter results for listed companies also indicate that profits are recovering.

They also take comfort that the government spending in the region is generally supportive of the private sector. The extent to which the public sphere crowds out private firms is expected to be limited because the two typically do not crossover that much in their activities.

Slow recovery for private firms in the Gulf

Recovery for private firms will still be a long hard slog. Most analysts see the government remaining the driving force for the Gulf economies over the next two years. That should give the private sector the time it needs to digest the problems it is currently facing.

The Gulf has the potential to go through an economic rebound that leaves other emerging markets behind, let alone developed countries, which are already facing constrained budgets limiting their ability to maintain stimulus spending.

The private sector will be necessary to provide the additional boost above what government spending can achieve. Already economists are predicting that overall growth rates in the GCC are expected to dip in 2012.

Unless the private sector can more quickly settle its debt and get back to investing for growth, then the recovery in the Middle East will continue to be lacklustre and the pace of diversification will be slow.