The International Monetary Fund has watched the Arab Spring play out, and now seeks a role for those Arab countries in transition. In late May, the IMF called on developed countries, including the G-8, to provide assistance to the Arab world, estimating the external financing needs of oil-importing countries in the Middle East and North Africa (MENA) region would be more than US$160 billion over the next three years.

Like many international entities, the IMF has cautiously provided advice, seeing the unrest as an opportunity to introduce reform to a region that has largely stagnated under authoritarian rule. It is backing its words up with generous funds — recently offering billions in aid packages for Tunisia and Egypt, and potentially for Yemen.

Masood Ahmed is director of the International Monetary Fund’s Middle East and Central Asia Department. In discussion with Arabic Knowledge at Wharton, Ahmed speaks about the role economic liberalization has played in the rise of the Arab Spring, and the economic and governance challenges facing countries that have deposed regimes. There is also the balance between wanting to encourage growth, and needing to provide subsidies and civil jobs, he says. Ahmed argues a country should not just focus on growth, but also ensure economic benefits reach a wider portion of its population.

An edited transcript of the conversation follows.

Arabic Knowledge at Wharton: After regime change, how can a government strike a balance of revoking or cancelling illegal deals, while and at the same time not scare away foreign investors who had signed contracts under the previous regimes?

Masood Ahmed: The events in the region are a timely reminder of the importance of transparency and good governance. Uncertainty and uneven application of regulatory policies that benefit a minority of privileged or connected individuals are major constraints to private sector activity. Business-friendly policy reforms-including the revocation or cancellation of illegal deals-would help boost confidence and attract foreign investment. Building a strong institutional framework to promote competition is important in this respect, including for example, an independent auditing mechanism for public finances, procurement rules, and transparency of fiscal accounts.

Arabic Knowledge at Wharton: Governments are raising subsidies and increasing handouts in countries, including several Gulf States. Do you foresee these policies will be in place for an extended period of time, halting reforms that were aimed at lowering dependence on Gulf governments and diversifying the economy away from oil?

Ahmed: The key subsidy in GCC (Gulf Cooperation Council) countries is for domestic petroleum prices, which are set at a low level and adjusted rarely-in some countries, prices have not been adjusted since the 1980s. In addition, most countries in the Middle East have announced new measures that attempt to dampen pressures from higher food prices, provide support to the unemployed, and alleviate housing constraints. The cost of these measures ranges between 0.3% of GDP (for Algeria) and about 22% of GDP (for Saudi Arabia, spread over a number of years).

While most of the oil-exporting countries in the region can easily afford this extra expenditure, some of the measures are not well-targeted for the neediest, can be difficult to reverse, and will impact fiscal outcomes over the medium-term. Therefore, as part of a plan to strengthen public finances over the medium term, it will be important to develop a more cost-effective system of social protection, focused on assisting low-income households, possibly including conditional cash transfers. While setting up such transfers will take time in many countries, in the near term one way of targeting poorer households could be to subsidize those products and services that are consumed mainly by the poor, rather than providing universal price subsidies that benefit the entire population. Reforming universal fuel price subsidies would also help contain rapidly rising domestic energy consumption.

Arabic Knowledge at Wharton: Do you foresee greater government spending aimed at fostering economic growth limiting private sector growth and crowding it?

Ahmed: Higher government spending is occurring in the context of increased oil revenues, so GCC countries are likely to see higher-than-expected fiscal surpluses, despite the higher spending. Higher fiscal surpluses translate into less need for domestic financing for government and high levels of liquidity in banking systems. The absence of an increase in credit growth over the past two years is explained by the weak demand in the wake of the global crisis as well as banks’ reluctance to lend in an uncertain environment. To stimulate private sector productive activity and increase demand for credit, government spending should focus on investment rather than current spending, and enabling a business-friendly environment.

Arabic Knowledge at Wharton: In the wake of the Arab Srping, Gulf governments are entrenching temporary public sector employees and raising overall public sector wages. How will these new policies help lower the unemployment rate and improve economic conditions, if they create little incentive for citizens to seek private sector jobs, while a greater public sector exacerbates bureaucracy?

Ahmed: Governments throughout the Middle East are seeking ways to tackle unemployment. The most direct policy option available, when there is room in the budget, is to expand public sector employment, and several GCC countries have announced plans to do this. Higher public-sector employment will only be part of the solution and needs to be accompanied by private-sector growth. Reducing unemployment on a permanent basis will require a combination of higher economic growth and reforms to improve the responsiveness of the labor market. These could be achieved by implementing reforms aimed at creating a business climate more conducive to investment and competition, together with policies to improve labor market flexibility and reduce skills mismatches.

Arabic Knowledge at Wharton: How can the International Monetary Fund (IMF) encourage countries experiencing unrest to continue to pursue economic liberalization? Will there be opportunity to provide loans beyond the US$35 billion proposed to oil-importers?

Ahmed: When we recommend policies that help liberalize economic activity, we do so for a number of reasons: privatization, for example, can help fix loss-making and inefficient enterprises, thereby freeing public resources that can be redirected toward more productive spending, including, for example, on health and education, or on public investment. Privatization can also reenergize the economy by fostering competition, thereby creating jobs.

When we recommend such reforms, we also advise to set them in a framework that ensures good governance and provide appropriate safeguards to reap the full benefits of such programs. For instance, it is important that close attention is paid to the way privatization is carried out. For example, the right institutions, such as well-functioning regulators, need to be in place, and the privatization process needs to be designed in a fair and open way to ensure that the gains go to the government and the broader population rather than to a few insiders.

Trade liberalization plays a key role in supporting domestic production by providing the best inputs, and consumers are allowed more choice and better value. Liberalization also contributes to higher income, exports, and job creation. Outdated or weak regulations and institutions that encourage corruption and monopolies can undermine the benefits of trade liberalization. That is why it is important to modernize these regulations and strengthen institutions to ensure a level-playing field that allows average-income households to benefit from trade liberalization and other reforms. It is also important to complement trade liberalization with other reforms aimed at enhancing competitiveness.

As our managing director has said, the IMF could make around US$35 billion available to the region–by applying the average size of recent IMF-supported programs to the MENA oil importers–a rather large amount of resources. Of course, not all countries will request programs, and the size of programs will vary. But with or without direct financing, the IMF will be engaging with countries and offering advice on how to navigate these difficult times. Plus, we will continue to give countries technical assistance in our areas of expertise, including for example on fiscal and central bank issues.

Arabic Knowledge at Wharton: In countries such as Egypt, people often blame IMF-inspired policies for their social and economic grievances. How palatable will IMF assistance be in these countries, especially if financial assistance is provided?

Ahmed: Over time, we have found that the programs that are the most successful are the ones that are homegrown and owned not just by the authorities, but by the people. This means, among other things, creating an environment that boosts investment, jobs creation, and policies to protect the poor. Any comprehensive program would also include measures that help ensure macroeconomic stability, which is important for social stability.

In the case of Egypt, the first priority is for the authorities to define the economic policy framework that best suits the country in consultation with the various factions of the Egyptian society. The IMF will also engage with representatives of civil society and other segments of the population to get their feedback and understand what policies are broadly owned by the population.

In general, there are a number of benefits associated with a request for assistance from the IMF. First, the IMF can provide temporary financing to help the country transition to better times. Second, this solution is typically less costly than borrowing from the private sector, leaving room for other policy priorities. Third, when there is agreement on economic policies between the IMF and a member country government, it sends a signal of confidence to the markets as well as to other multilateral and bilateral lenders that a country’s economic policies are on the right track. This provides reassurance to investors and the official community, helping countries find additional financing from other sources.

Arabic Knowledge at Wharton: Will the raising of subsidies and wages only buy governments time, yet exacerbate the economic problems for countries adopting these measures?

Ahmed: Many governments in the region have responded to surging food and fuel prices by higher fiscal spending to provide relief to the population. Given the urgency, this policy response has relied on readily available instruments, including subsidies and wages. Universal price subsides have the disadvantage of not being targeted to those segments of the population most in need of government assistance, as such, they are costly. Therefore, over the medium-term, governments should consider replacing existing universal price subsidies with targeted subsidies, possibly in the context of moving toward a comprehensive and well-targeted social safety net.

Arabic Knowledge at Wharton: How can the international community, besides the World Bank and the IMF, help countries that need to appease popular demands and nurture their economies at the same time?

Ahmed: Countries in the region will find their own path for change and leadership. The way forward should come from the countries themselves. But it will be equally important for the international community to ease their short-term financial burden and support the longer-term political, social, and economic transformation, given the shared interest in a prosperous and stable region. Technical and financial assistance and further opening of markets will be key elements of such support. Partnership with the region, both to support the emergence of a transformation agenda and in providing financial assistance, could ensure strong domestic ownership.

Arabic Knowledge at Wharton: Many countries in the region are asking for debt relief and aid, but to foster growth they need greater access to international markets. How can countries, such as the ones in North Africa, increase trade to regions such as Europe when there are trade barriers and policies such as the Common Agricultural Policy that impede the free flow of goods?

Ahmed: With the EU as a main trading partner, North African countries would benefit largely from a further opening up of the European markets. In 1995, the Barcelona Conference paved the way for the creation of a free-trade zone between the EU and its Mediterranean partners. Hence, Tunisia, Morocco, Egypt, and Algeria signed bilateral free-trade agreements (FTA) with the EU in 1995, 1996, 2001, and 2002, respectively. These agreements constitute the basis for complete liberalization of trade and set out a framework for the relationship in other areas, such as foreign direct investment flows. Nevertheless, the process of integration has remained uneven since the signature of the agreements.

More recently, the EU granted Morocco preferential "advanced status" in 2008, and discussions are planned to grant Tunisia the same status in the near future. Providing such status would help countries in the region enhance the contribution of trade to growth. Furthermore, accelerating the completion of trade liberalization for agricultural products and services would support the development of those sectors, which employ a large share of the labor force.

Arabic Knowledge at Wharton: In countries where economic growth didn’t trickle down to the impoverished, how can future governments ensure that their policies achieve a trickle-down effect?

Ahmed: A key lesson from recent events in the region is that economic growth in itself is not enough. Attention needs to focus not only at achieving high and sustainable growth, but also on the question of who benefits from it. As is clear from events in the region, inequality and uneven access to economic opportunity stretch the social fabric and ultimately lead to social and, subsequently, economic instability.

For growth to help raise living standards, it must also create enough jobs for a growing labor force — and to that end, should be led by the private sector. In addition, growth needs to be more inclusive, which means that governments need to ensure that all segments of the population have access to economic opportunities through fair, transparent, and competitive processes. What is needed is an environment where people, especially young people, have opportunities to acquire a good education, to compete for high-quality jobs, to become entrepreneurs and to have access to credit. Moreover, growth should be accompanied by social policies to protect the most vulnerable.

Arabic Knowledge at Wharton: With a greater reliance on oil income due to low non-oil sector growth, how big is the danger of oil exporters falling hostage to oil price volatility?

Ahmed: The performance of the non-oil sector is not uniformly low across the region’s oil-exporting countries. As noted in our April 2011 Regional Economic Outlook, we project non-oil growth for these countries at 3.5% in 2011 — roughly the same as in 2010 (excluding Libya, of course, where conditions at present are very uncertain). While non-oil activity in some countries will contract as a result of unrest (in Bahrain, for example) or transitional effects of a widespread subsidy reform (Iran), in others, the non-oil sector may benefit from stepped-up government spending (in Saudi Arabia, for example).

These countries are currently benefiting from higher oil prices, which are allowing for greater expenditure but, in some cases, expanded government spending programs have raised the break-even prices for fiscal and external current account balances (the price at which the government would run an overall fiscal/current account balance, holding everything else constant). It is crucial that these spending programs do not lead to a permanent ratcheting-up of expenditures that rely on oil revenues for financing. In particular, governments should aim to diversify their revenue base precisely to reduce its vulnerability to oil price fluctuations. To that end, achieving greater economic diversification remains a key challenge.