Introduction
Like other developing countries, the Arab states of Egypt, Tunisia, and Lebanon have faced a series of major negative external shocks since 2019. The first was the COVID-19 pandemic of 2020–2021, during which fiscal deficits rose. More recently, the ongoing Russia-Ukraine war has resulted in rising international prices of fuel and food. In Egypt, Tunisia, and Lebanon, subsidies were raised to alleviate the war’s impact on households, a development that increased internal and external deficits. After the global credit market tightened in 2022, following rich countries’ attempts to curb inflation by hiking interest rates, Egypt and Tunisia were cut off from global capital markets, and both are now in a state of debt distress. (Lebanon had defaulted on its debts earlier, in 2020.)
In all three countries, long-standing structural economic weaknesses, which led to a series of social uprisings that began in 2011—the Arab Spring—have given rise to increasing financial tensions that are threatening stability and creating acute policy dilemmas. Not adjusting to the rising strain will exacerbate the countries’ financial crises. Adjusting to it with austerity alone risks a social crisis.
Reforming the economy so that it emerges from the current difficulties in better shape is the wisest route, but this would prove politically challenging. In Lebanon, Egypt, and Tunisia, the precrisis debt-financed profligacy benefited very different groups: bankers in Lebanon, the army in Egypt, and the largest labor union in Tunisia. To enlarge the economic pie in each of these countries, reform-minded politicians must be able to neutralize opposition to reform and build a coalition for change.
Austerity Only: A Myopic Strategy
In times past, the governments of Egypt, Tunisia, and Lebanon might have simply tightened their belts when faced with a financial crisis. But the imbalances are now so large that thoroughgoing austerity would lead to a deep recession, which in turn could trigger social turmoil. The time has come to launch a credible national revival effort, as opposed to the austerity-only adjustments of the kind implemented in the 1980s.
In Lebanon, the debt crisis has brought about an economic, social, and political collapse. Egypt and Tunisia are not in substantially better shape; with capital no longer flowing in, incomes in both countries are falling drastically, much as happened in Lebanon. In all three, income and consumption were boosted and reforms delayed thanks to unsustainably high levels of external borrowing, with the countries having taken advantage of a decade of easy global credit and serial bailouts by the West and the Gulf Cooperation Council (GCC).
To ease political tensions in the wake of the Arab Spring uprisings, the governments of all three countries adopted expansionary fiscal policies. Yet even though fiscal deficits expanded, economic growth declined. Together, these two factors led to a spike in the public-debt-to-GDP ratio. In Tunisia, public debt rose from 40 percent of GDP in 2010 to 85 percent in 2020; from 70 percent to 95 percent in Egypt; and from 130 percent to 180 percent in Lebanon. These debt ratios, extremely high by global standards, left the three countries vulnerable to the series of shocks (COVID-19, the Russia-Ukraine war, and the tightening of the global credit market) that rocked the global economy.
Relying solely on deep fiscal cuts and tax increases to stabilize debt would cost enormous political capital, all the more so following a decade of poor economic performance. In Egypt, Tunisia, and Lebanon, most public expenditures now pay for the wages of civil servants, subsidies, support for state-owned enterprises, and interest payments on debt—all of which benefit powerful political constituencies, but some of which are of questionable economic merit. The social and political impact of austerity can be expected to lead to more instability, especially if there is no hope of future economic growth to compensate for short-term sacrifices.
In the three countries, much of the current adjustment focuses on shifting from subsidies to safety nets. The rise in oil and food prices was a major shock for the poor. Universal subsidies are not the best way to help—they are fiscally expensive, inefficient economically, and unfair socially. Targeted social safety nets, which are directed at ameliorating the conditions of the poor, resolve some of these problems. But removing subsidies is politically challenging, as it also harms the middle class.
Restructuring external debt would not meaningfully alleviate the debt burden of any of the three countries. A large share of external debt is owed to multilateral creditors, who do not renegotiate debt. Additionally, external public debt makes up only a small share of total public debt. Indeed, a large portion of public debt is domestic. Reducing debt thus involves distributing large losses among domestic agents, a very difficult political process. This is demonstrated vividly in Lebanon. Though the country is faced with losses several times higher than its GDP, no attempt has been made to reform the financial system in the three years since it collapsed.
International Monetary Fund (IMF) programs are needed—one has already been introduced in Egypt—but they should be adapted to the reality of the Middle East and North Africa (MENA). These programs play several roles during financial crises: providing liquidity, determining the extent of debt restructuring, enforcing policy conditionality, and giving the necessary stamp of approval to any reforms that are undertaken.
Yet by the IMF’s own admission, even though its programs helped to stabilize financial situations in the past, they did not lead to higher growth. To achieve the desired growth this time around, the programs in question would need to go beyond short-term fixes. The crises afflicting the three countries have exposed as major weaknesses the scarcity of good jobs and the poor quality of state services. Addressing these weaknesses requires developing credible national renewal strategies and not just belt-tightening.
Growth Opportunities Are More Promising Than in the Past
Growth opportunities arise in part from engaging in the very reforms that were avoided in the past—such as those that can inject dynamism into the private sector, improve resource mobilization, and boost the state’s financial capacity. Additionally, meeting new challenges connected to a changing world can improve growth prospects. These challenges include catching up with technological progress, taking advantage of de-globalization, and adapting to climate change.
The private sector is now dominant across the Arab world and has the potential to serve as a powerful growth engine. But from 2012 to 2022, private investment has declined to historically low levels, from around 20 percent of GDP in the three countries to below 5 percent in Egypt and below 10 percent in both Tunisia and precrisis Lebanon. There are multiple causes for this: the crowding out of private finance by large fiscal needs, a rise in monopoly power, and high levels of political risk. Because of poor business climates, firms want to be as far from or as close to the state as possible. The corporate landscapes lack medium-sized firms—those that tend to be the most dynamic job creators worldwide—due to unfair competition by a mass of informal small firms and a few dominant privileged ones. In Egypt, such firms are aligned with the military, whereas in Tunisia and Lebanon, they are connected to the ruling political class. A private-sector boom is possible in the three countries but would require improvements when it comes to the business climates, the rule of law, fair competition, and access to finance.
Also, low economic dynamism has led to the demobilization of society. Saving rates in the three countries are below 10 percent of GDP—less than a third of the global average. Tax revenues are low and taxes are regressive, in part because of the spread of informality. Labor force participation is also low, in large part because of the scarcity of good jobs. Not only is the female participation rate of 17.5 percent far below the global average of 50 percent, but the male participation rate is also below the global average. Reversing these trends requires more trust in institutions, and more confidence about the future. Only then will citizens believe that it is personal effort, and not rent-seeking, that leads to improved outcomes.
The success of digitalization in the region, as elsewhere, is dependent on the development of both “hard” and “soft” infrastructure. MENA countries have invested in hard infrastructure, with the robust growth of mobile and fixed broadband subscriptions, as well as mobile data consumption, to show for it. But the level of digital skills—the soft side—remains low and is hampering these countries. Also, although Arabic-speaking people represent about 5 percent of the global population, the Arabic content of the internet is only 1 percent. To keep pace with digitalization, the amount of Arabic content must increase significantly.
After decades of hyper-globalization, the world has reached a turning point for global trade, with an ongoing trend to relocalize production closer to consumers for the purpose of reducing carbon dioxide emissions and offsetting geostrategic risks. The new preference for near-shoring by Europe and the GCC provides MENA countries with valuable advantages compared to distant Asian producers. Also, in line with new green policies, the European Union (EU) will soon start to tax goods imported from countries with low environmental standards, increasing such countries’ incentives to adopt greener production techniques in manufacturing and agriculture.
The MENA region itself is highly vulnerable to climate change. The global average temperature has already risen and could rise a further 3.3 degrees Celsius by 2100 if greenhouse gas emissions continue to be produced at the same rate, which would spell disaster for the region. Precipitation volumes in the MENA region are already declining, water scarcity has reached critical levels, and climate hazards are becoming more frequent and intense. To reduce vulnerability, massive investment is needed. The region remains the most fossil fuel–dependent one in the world, though it has a lot of potential in the realm of renewable energy. For example, Egypt is piloting large solar farms. Egypt and other countries could conceivably export renewable energy to Europe, as well as convince European producers to move production closer to where renewable energy is produced.
The climate-change arena also presents opportunities for expanding regional cooperation. Climate adaptation projects to reduce the risks of flooding make for one such opportunity. Additionally, though the MENA region includes food-insecure countries, there are also those with vast but undeveloped agricultural capabilities, rendering possible a collective food security project that would make for a win-win scenario. The abundant capital of some countries could be combined with labor in labor-abundant countries, now that migration to the GCC—which previously absorbed such a labor surplus—has declined significantly.
To capitalize on these opportunities, a fundamental reorientation of the economy is needed. This is no easy task. Shifting from the current rentier model to a productive economic model entails enacting a host of reforms. This will prove difficult on the technical level and will be politically challenging.
Possibilities for Political Economy–Driven Solutions
The ongoing financial crises allow for the adoption of one of two strategies by the affected states: reduce public-sector deficits or increase growth rates. The first option would at best offer short-term reprieve, thereby raising the eventual threat of a vicious cycle of economic, social, and political decline. Because both the risks of inaction and the potential gains from taking action are higher than ever, the time is ripe for change. As regime survival comes into question, decisionmakers in Egypt, Tunisia, and Lebanon may finally prove willing to gamble on development. Yet to do so, they would have to break with old political allies that stand to lose from reform and build new alliances with social groups that stand to gain.
Comparison with the 1980s debt crisis is useful. Across the Middle East, adjustments in response to that crisis did not include structural reforms. State services were rolled back and markets were partly liberalized, but unlike in Latin America or Africa, the polity remained tightly controlled and repression rose. This led to runaway crony capitalism that did not deliver the good jobs needed to employ members of a more educated generation. The scarcity of such jobs ultimately led to social explosions in Egypt, Tunisia, and Lebanon in the decade beginning in 2011.
The aversion to reform, which persists to this day, can be attributed to three causes. First, an autonomous private sector has been perceived by ruling regimes as a threat to their power. Second, fear of political Islam pushed part of the middle classes to prefer autocracy to a competitive system that Islamists could end up dominating. And third, foreign backers also supported autocracy for fear of instability in a region with multiple geopolitical challenges.
All three factors have now shifted in important ways. Not only does the economic reform equation look more favorable, but the appeal of autocracy has lessened with the weakening of political Islam and the winding down of civil wars. Moreover, no external power seems willing to offer this or that regime a blank check for it to prop itself up; instead, there is a convergence of interest among outside powers—fearful of refugees flocking to Europe and conscious of the need to cooperate so as to arrest climate change—in helping the region become more sustainable, both politically and economically.
But it will not be easy to chart a path to growth, given the expected political opposition. The triple challenge is to open up the polity, build a coalition for change, and weaken the opposition. This last imperative will prove especially difficult, as the credit boom of the past decade has benefited and empowered particular groups that still hold much sway and stand to lose from reform.
In Egypt, the army was never properly financed but has been allowed since Anwar al-Sadat’s tenure as president to complement its meager allocations from the state budget with commercial activity. Moreover, the army has played a central political role since 2011, and its economic dominance parallels its political ascendency. The intentions of Egypt’s current president, Abdel-Fattah al-Sisi, remain elusive. To transition to a more productive and dynamic economy, he may pivot politically from a tight alliance with the army to a closer relationship with the country’s economic elite, as his predecessors Sadat and Hosni Mubarak did, but with a greater dependence on firms from the GCC. A truly new political and social deal, however, would involve a more dynamic parliament, a reform of state capacity, and a commitment to use the state budget to finance the army more generously.
In Tunisia, the political roadblocks are different. Faced with broad-based and resultantly weak coalition governments, the national labor union has managed to push the wage bill from 8 to 16 percent of GDP, in addition to overstaffing state-owned enterprises and prevailing upon the government to increase subsidies. The policy challenge is to lower public expenditures, regain business confidence, and engineer an investment boom. Tunisia has a great deal of potential for growth, given its large industrial base, and can expect strong EU support for reforms, including direct investment. But absent a credible government that can divide the burden of adjustment fairly and embark on a new phase of growth, the labor union will not accept to take losses alone. Politically, the only way out seems to reside in a successful presidential election, possibly an early one if the economy collapses before 2024, and the ushering in of a decisive economic reform package that would stabilize the economy and engineer a quick recovery.
Likewise, in Lebanon, the challenge is essentially political. If the country is to rise again, there is no choice but to adopt a new growth model, one in which there is more of a role for exporters than importers and for productive rather than speculative bankers. But adoption of such a model is not guaranteed because the leading bankers risk losing tens of billions of dollars and have the means to corrupt the political system to delay the day of reckoning. Nevertheless, external and internal conditions are conducive to the reformation of the system, even if—as with the end of the civil war—the price to be paid is a broad amnesty for those who brought about the disaster. Also, while a good financial system is essential for a dynamic economy, more will be needed to restore the rapidly degenerating state’s functionality. With state resources now down ten-fold, a big push by external donors is essential if Lebanon is to rebound. Again, however, this requires a modicum of political reformation.
Conclusion
Historically, the root cause of the MENA region’s mediocre economic performance has been a lack of political courage. Today, though courage is still needed to effect change, something greater is at play. There is a rare alignment of elements conducive to change: unattractive alternatives to reform, improved prospects for benefiting from reform, and constructive external pressure. While power politics have dominated economic outcomes since the countries of the region gained independence, perhaps the new economic equation will finally unleash incentives for progressive political change.
Political reforms are valuable for their own sake and have become unavoidable following the social mobilization set off by the Arab Spring. However, true economic progress requires liberty and justice. The protection of privileges, corruption, and monopolies, as well as the fear of change, need to be replaced with inclusion and fair competition, which would unleash individual creativity and effort. A gradual process of advancement is possible. Economic and political reforms would improve trust in institutions and confidence about the future, make it easier to mobilize collective action, and lay the groundwork for a coalition dedicated to bringing about more thoroughgoing change. This coalition would negotiate a social deal that neutralizes opposition by providing some measure of protection to those who expect to lose out from such change, while mobilizing active support by creating hope for a better future among those who expect to benefit from it.
