SyriaEconomicReport AN UNTAPPED OUTPUT POTENTIAL WITH LARGE GROWTH RESERVES

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1 SyriaEconomicReport AN UNTAPPED OUTPUT POTENTIAL WITH LARGE GROWTH RESERVES The Syrian economy is currently characterized by output growth irregularities within the context of overall environment uncertainties. On the one hand, the Syrian economy is benefiting from rising oil prices and a regional post-iraq War boom translating into larger inflows of workers remittances and tourist receipts. On the other hand, the widening political uncertainties and the relatively slow reform process, despite the progress recently reported, continue to dampen growth performance. Within this context, real GDP growth was estimated at 2% based on statistics provided by the Syrian Central Bureau of Statistics for the year 2004 and the IMF recently forecasted it at 3.5% for 2005, as per its September 2005 World Economic Outlook. While the real growth figure this year represents above average growth trends for Syria, it remains far below the potential of the Syrian economy to grow within the context of significant needs for structural adjustment reforms. It is worth recalling that the Syrian economy had reported an average real GDP growth of 2.8% per annum over the previous five-year period extending from 1999 to It looks like despite the favorable regional economic performance, Syria s private demand continues to suffer from the lack of adequate financing, restricting its leverage effect on growth, but also from a generally sluggish private consumption and investment component in view of prevailing uncertainties. In parallel, the public sector picture looks more positive following debt repayments and forgiveness and stronger official reserves. Probably the most important development at this level is the write off of almost US$ 10 billion of debt to Russia, the equivalent of 73% of total Syrian liabilities to Russia as of the beginning of 2005, with the remaining US$ 3.6 billion restructured over a 10-year period. Such a move led to a drop in foreign debt to GDP from 88% to an estimated 48% post-agreement. However, Syrian authorities look fully aware that the key to enhanced economic performance is to give incentives to the private sector and this has to be led by growth in private demand. Bearing in mind the persisting economic growth impediments, the Syrian government has been embarking on few reforms targeting a stimulation of private sector value added. Syria looks increasingly keen at addressing the needed hundreds of thousands of jobs annually within the context of a rapidly expanding workforce, and attempting to generate sustainable growth in output and income per capita. Among the reforms that started to see the light, the financial sector reforms are so far the most important. Within this context, we mention the legislation for private banks, the relative easing of the repatriation of foreign exchange and more recently serious moves to allow private insurance companies. Still, serious hurdles are facing banking activity, calling for the implementation of further reforms. These include the need for providing liquid placement vehicles for banks, the need to upgrade clearing and settlement procedures, the need for improved corporate transparency and disclosure, and the need to establish a Credit Bureau or, at an earlier stage, a Central Office for Credit Risk... Such reforms are some among many others that need to figure on any reform agenda for Syria s economy. The basis for Syria s economic policy over the coming period is the recently disclosed five-year plan covering the years 2006 to Although the plan did not devote a great deal of attention to the detail of economic policy, the underlying direction of the plan, calling for a gradual reduction in the state s involvement in the economy, displays serious commitment to reforms. The new challenge for Syria is to decide on such specific measures and to implement them, within the context of a number of local and regional political challenges at the horizon. A detailed analysis of the recent conditions in the real, monetary, government and foreign sectors of the Syrian economy follows. The concluding part of the report looks at an analysis of strengths, weaknesses, opportunities and threats in an economy long characterized by large growth reserves as a result of the wide gap between actual and potential output. October 2005 The Syria Economic Report can be accessed via internet at the following web address: CONTENTS Real Sector Foreign Sector Public Sector Financial Sector Conclusion p2 p4 p5 p6 p8 Bank Audi sal - Audi Saradar Group Research Department Banque Audi Plaza, Bab Idriss Riad El Solh - Beirut - Lebanon P.O.Box : Tel : (01) Telefax : (01) research@banqueaudi.com Bank Audi Syria s.a Headquarters: Youssef Azmeh Square Mouhafaza Building - Damascus Temporary address: Pakistan Street Malas Building - No.75 - Damascus P.O.Box : 6228, Damascus - Syria Tel : Fax : audibank@scs-net.org

2 Gross Domestic Product 1,400 SP million 1,200 1, % % 1. REAL SECTOR 1.1. Agriculture 5.1% Nominal GDP Real GDP growth rates Agriculture plays a significant role in the Syrian economy. It is traditionally one of the largest contributors to GDP and employs nearly one third of the Syrian workforce. The output of the sector was SP 423 billion in 2004, equivalent to one fifth of the economy s total output for the year. Agricultural output grew at a CAGR of 5.6% over the past four years, of which value added rose by nearly 5.5%. Vegetable and animal production have been growing annually, showing a CAGR of 5.9% and 4.8%, respectively, over the period. Vegetable production totaled SP 271 billion and animal production SP 147 billion in 2004, growing at 4% and 7.6% year-on-year, respectively, while agricultural exports have stagnated at SP 37.1 billion in 2004 and progressed by 16% during the period. Agricultural price increases have been modest both at the wholesale and retail levels, as retail price inflation was at 5.6% and wholesale inflation was nil last year. But the recent price trends signal a potential resumption of inflation. The sector remains heavily reliant on government subsidies, protections, marketing controls, and trade barriers. As such, it is likely to be shielded in the foreseeable future from the reforms that are reaching other sectors. The sector also suffers from old and insufficient irrigation infrastructure that is in need of upgrading and expansion. But despite its importance for the government, the sector has also faced the challenge of scarcity of funds. The Investment Higher Council announced it has licensed 30 agricultural projects for a value of SP 9.52 billion in It has licensed a total of 93 projects since 2000 for an aggregate value of SP 21.6 billion, with the average commitment per project rising from SP 50 million in 2000 to SP 317 million in % 1,017 1, % 1, % 7% 5% 3% 1% -1% -3% -5% 1.2. Construction The output of the construction sector was SP 98.5 billion in 2004, equivalent to 5% of the Syrian economy s total output for the year. Construction output grew at a CAGR of 6.4% over the period, of which value-added was estimated to have risen by 3.8% during the covered period. The real estate sector is witnessing substantial activity, as licensed construction areas grew by 72.7% to 11.4 million square meters last year. The growth is evident in both residential and non-residential buildings, as residential activity accounts for more than 80 percent of total licensed areas. Permits for residential construction rose by 80.2% to 9.2 million sqm, while those for non-residential buildings showed a healthy 50% growth to 2.2 million sqm. The ongoing demand resulted in a significant increase in real estate prices over the past four years as the retail price index rose by 1% in 2001, 4% in 2002, 18% in 2003 and by another 8% in A combination of factors such as declining interest rates, new legislation that has shifted demand towards legally-built housing, a rise in the cost of building materials, and a jump in foreign demand from the arrival of hundreds of thousands Iraqis into the country contributed to the rise in prices. Further, the Syrian authorities gave the go ahead for the construction of 50,000 new flats in the coming five years, which is expected to inject SYP 45 billion in the real estate market. The apartments consist of affordable housing for young people. In parallel, the government is preparing a draft law to attract domestic and foreign capital into the real estate market and the law is expected to include incentives for local and foreign investors Energy Oil plays an important role in the Syrian economy. Syria has been an exporter of oil and such exports have accounted for about two thirds of the country s foreign currency earnings, particularly with the ongoing rise in global oil prices. But Syria is facing the prospect that a decline in production, along with a rise in domestic consumption, would lead to a reduction in net oil exports. In turn, this trend could result in the country becoming a net oil importer over the long term. Indeed, oil output and production have regressed due to technological problems and a decline of oil reserves, as older fields have reached maturity. According to the US Energy Information Administration, Syria produced 460,000 barrels per day (bbl/d) in 2004, compared to a peak of 590,000 bbl/d in Further, output of crude petroleum has declined steadily from 31.7 million cubic meters in 2000 to 25.7 million cubic meters in In parallel, and reflecting this trend, exports of Agriculture SP million Var Var Var Var CAGR Gross agricultural output 340, , , , , % 4.1% 2.4% 4.5% 5.6% Agricultural imports 35,652 34,331 39,646 41,899 52, % 15.5% 5.7% 24.5% 10.0% Agricultural exports 20,491 22,208 44,240 37,117 37, % 99.2% -16.1% 0.0% 16.0% Retail price inflation (foodstuff) -5.7% 5.0% -1.9% 3.9% 5.6% 10.7% -6.9% 5.8% 1.7% 3.1% Wholesale price inflation (foodstuff) -8.3% -5.0% 6.3% 4.0% -1.0% 3.3% 11.3% -2.4% -4.9% 1.0% Number of inv. projects approved % -22.2% 107.1% 3.4% 96.8% Investment commitments (SP billion) % 0.0% 200.0% 31.9% 212.2% Avg. Inv. commitments per project % 28.6% 44.8% 27.5% 58.6% 2

3 Energy and Manufacturing SP million Var Var Var Var CAGR Gross industrial output 611, , , , , % 4.0% 5.2% 10.6% 3.7% Industrial imports 151, , , , , % 5.2% -0.6% 41.0% 16.0% Industrial exports 195, , , , , % 16.4% -11.4% -7.0% 2.0% Crude petroleum production (m3 000s) 31,688 33,568 36,222 34,912 25, % 7.9% -3.6% -26.3% -5.1% Electricity production (KWH mn) 23,946 25,544 26,896 28,264 30, % 5.3% 5.1% 9.4% 6.6% Number of projects inv. approved % 12.5% 1.6% 50.0% 35.7% Investment commitments (SP billion) % -28.6% 72.4% 125.6% 39.2% Avg. Inv. commitments per project % -36.5% 69.7% 50.4% 2.6% mineral fuels and lubricants only slightly rose from SP billion in 2000 to SP billion in 2004, despite the significant increase in oil prices. Authorities plan to reverse the decline in oil exports by opening up new blocks for oil exploration and increasing natural gas production and exploration. The EIA estimates Syria s proven oil reserves at about 2,500 million barrels and its natural gas reserves at 8.5 trillion cubic feet as of January Authorities also intend to substitute natural gas for oil in power generation in order to free up as much oil as possible for export. However, it is still unclear how the U.S. sanctions imposed against Syria in 2004 under the Syria Accountability Act will affect the oil and gas sector in the long run. With demographic growth, urban expansion and economic development, Syria is also facing rising electricity demand. It hopes to add 3,000 MW of power generating capacity by 2010, at a cost of around US$ 2 billion, but progress on these projects has been slowed due to a lack of investment. Electricity production grew modestly to 31 billion KWH in Industry Industrial activity was significant last year, as the sector grew by 10.6%, with total output reaching SP 708 billion in Further, the Investment Higher Council licensed 288 industrial projects out of a total of 759 investment applications in The aggregate investment value of the projects is SP billion, of which industrial projects represent 87% of such investments. But industrial exports regressed by 7% year-on-year, and by an average of 9.3% over the past two years. Syria s Manufacturing Value Added (MVA) per capita is US$ 171, according to the latest figures from the United Nations Industrial Organization, ranking it as 9th in the Arab world. However, Syria s MVA as a percentage of GDP amounts to 21.5%, ranking it first in the Arab world and above the developing countries rate of 20.3%, revealing a strong contribution of manufacturing to the country s economic output. Authorities are trying to improve the sector s competitiveness. The Ministry of Industry announced a plan to overhaul state-owned industries through the merger of some state-owned companies and increasing decisionmaking authority of management. The ministry is also introducing new measures aimed at cutting losses in some of the companies, particularly in textile, such as market-driven pricing and the use of private distribution channels. More importantly, the ministry is trying to introduce private sector management to the public sector, but has avoided a transfer of ownership. For instance, the ministry tendered the management of four of its companies to the private sector, among which is the General Establishment of Iron and Steel in Hama, one of the largest stateowned industrial companies. The ministry also opened a number of companies from the food and beverages sector to private sector management. A total of 65,000 persons work in 96 state-owned industrial firms, which highlights the sensitivity of authorities to privatization issues. Another challenge to the industrial sector has been the lack of access to credit as a result of a state-controlled and outdated banking system. But this problem is likely to be eased with the authorization of private banks in Syria. But industry has historically accounted for the vast majority of projects licensed by the Investment Higher Council. The council has licensed a total of 922 projects since 2000 with aggregate investment commitments of SP 414 billion, and with the average commitment per project growing at a CAGR of 2.6% during the period and peaking at SP 617 million in Trade and services October 2005 The trade and services sector witnessed a relatively healthy performance over the past year, driven mainly by improved demand and rising tourism. The transport sector depicted a dynamic performance last year, exceeding the trend of previous years. Maritime activity improved, as the volume of merchandise at Syrian ports progressed by a CAGR of 13% over the period and jumped by 17% to nearly 14 million tons in Reflecting this trend, the number of ships using Syrian ports increased by 7% in the four years and by 22% in Tourism activity was positive last year, as tourism receipts increased by 57% to US$ 2.2 billion in 2004, compared to US$ 1.4 billion in the previous year. The number of tourists rose by 45% to 3 million tourists from 2.1 million in 2003, while the number of one-day visitors jumped by 36% to 3.13 million in Tourist activity continued its positive trend in 2005, as the number of tourists reached 1.41 million in the first half of 2005, up by 19.4% from the same period last year. Further, the number of Arab tourists increased by 15% to 1.02 million year-to-june. Tourists from Arab countries continue to constitute the bulk of visitors, as they accounted for 72% of tourists in the first half of However, the number of one-day visitors regressed by 19% to 1.16 million 3

4 Trade and Services SP million Var Var Var Var CAGR Foreign trade 430, , , , , % 44.4% -18.4% 28.2% 15.7% Number of arrivals (000s) 3,015 3,389 4,273 4,388 6, % 26.1% 2.7% 40.2% 19.5% Merchandise at Syrian ports (tons 000s) 8,473 7,772 12,421 11,905 13, % 59.8% -4.2% 17.0% 13.2% Ships at Syrian ports 5,494 5,618 5,879 5,940 7, % 4.6% 1.0% 21.8% 7.1% Telephone main lines (000s) 1,674 1,817 2,099 2,414 2, % 15.5% 15.0% 10.2% 12.3% Mobile subscribers (000s) ,150 2, % 108.3% 187.5% 82.6% 197.0% Number of inv. projects approved % 123.0% -44.0% 27.1% 77.9% Investment commitments (SP billion) % 113.6% -24.2% 62.0% 74.7% Avg. Inv. commitments per project % -4.2% 35.4% 27.5% -1.8% due to a significant reduction of visitors from Lebanon during the covered period. Latest hotel figures show that occupancy rates at Damascus hotels was at 69% in 2004 against 65% in the previous year, while room yields have increased by 4.1% year-on-year. Also, the presence of a number of regional and international hotel operators such as the Sheraton, Four Seasons, Sofitel, and Rotana is likely to improve standards. Syrian authorities are also hoping that the sector will benefit from increased private sector participation. Syrian authorities consider tourism to be a sector of strategic importance, as it is a source of foreign currency and employment. As such, the government has decided to allow foreign participation and investment in some of the country s leading tourist sites through joint ventures with the Tourism Ministry and has offered a package of incentives in 37 projects. Syria continues to slowly open up its telecom sector to private players. The Ministry of Communication and Technology intends to launch a third mobile phone network at the end of Also, the first Syrian privately-owned satellite television channel is set to begin broadcasting shortly, while the first private radio station in the country was launched last March. Syria continues to lag behind regional standards in terms of internet penetration. A recent report forecast the number of Internet subscribers to grow at a CAGR of 24.9% during the period, with internet users exceeding the 1.7 million mark by It expected the penetration rate to reach 2.5% in 2009, up from less than 1% in The Investment Higher Council announced it has licensed 441 projects in trade and services for a total value of SP 16 billion in It has licensed a total of 1,730 projects since 2000 with aggregate investment commitments of SP 47 billion. Investment commitments in these projects have steadily increased, rising by a CAGR of 74.7% over the period and peaking at SP 16 billion in But the average commitment per project remains modest during the covered period and reached SP 37 million in Insurance The Syrian economy is considered to be one of the most underinsured economies in the Arab world and among emerging markets. Syria accounts for less than 2% of total premiums generated in the Arab world. The insurance penetration rate is about 0.6%, lowest in the Arab world, while the insurance density was SP 361, one of the lowest in the region. These indicators show that the Syrian insurance sector has a huge upside potential, as its GDP is estimated at US$ 25 billion and its population at about 18 million. Proper insurance legislation, clear rules and regulations, an independent supervisory body, the authorization of private players, along with the liberalization of other sectors will help the Syrian insurance sector realize its true potential. Indeed, Syrian President Bashar Assad has recently issued Decree no. 43 authorizing private insurance activity in the country. The law puts an end to 46 years of state monopoly, authorizes the establishment of private insurance and reinsurance companies, and welcomes foreign shareholding. Authorities have already granted preliminary approval to six private insurers to operate in Syria. Further, a previous decree set up the Insurance Supervisory Commission. Its goal is to reorganize the insurance and reinsurance sector, promote the role of the insurance industry and develop the awareness of the public, protect the rights of policy-holders, check the financial soundness of insurance companies, and supervise and develop the collection and investment of savings. 2. FOREIGN SECTOR Foreign trade witnessed a substantial rise in activity last year, as the volume of foreign trade progressed by 28% in 2004 compared to a contraction of -18.4% in the previous year and a 15.7% growth during the period. The improvement in 2004 was due to a significant 38% growth in imports year-on-year, against a 6% regression in exports. The rise in imports is partly attributed to price rather than quantity effect, as the continuing strength of the euro relative to the US dollar and higher all prices have increased the cost of imports from euro-zone and other markets. Imports increased for the second year in a row to SP 327 billion, while exports regressed for the second consecutive year to reach SP 249 billion, resulting in a trade deficit of SP 78 billion compared to a surplus of SP 28.3 billion in Ukraine was Syria s main source of imports, and accounted for 7.9% of aggregate imports in It was followed by China with 7%, Russia with 4.9%, Saudi Arabia with 4.7%, and Turkey with 4.3%. The resultant combined imports from these countries accounted for about 29% of total Syrian imports last year. Italy was Syria s main export destination, accounting for 24% of total exports in It was followed by France with 19.2%, Iraq with 9.6%, Turkey with 6.8%, and Saudi Arabia with 6.6%. Those markets represent two thirds of total Syrian 4

5 exports. Petroleum and petroleum products continue to represent more than two-thirds of Syrian exports, the decline in exports suggests the potential difficulty of maintaining a rise in oil exports due to rising domestic demand and dwindling reserves. Syria s attempt at trade liberalization and integration in the global economic and trading system were slowed due to geopolitical developments. The government initiated the EU- Syria Association Accord as a preliminary step towards its implementation, becoming the last country in the Mediterranean basin to sign the agreement. Syrian officials were hoping the accord would allow the country to benefit from technical cooperation in its reform efforts and institutions building as well as export promotion. But the EU refrained from ratifying the accord due to political considerations, and there does not appear to be a timetable or tentative date for ratification. In addition, Syria remains under economic sanctions that were imposed by the United States in 2004 and that were extended indefinitely in May of this year. Syria posted a balance of payments surplus of SP 417 million in 2004, down from SP 695 million in the previous year. The decline in the balance of payments surplus was due to a 50% regression in the current account balance, as a result of a deficit in the trade balance. This deficit was counterbalanced by a rise in the services account due to improved tourism activity that helped generate higher tourist receipts. Syria managed to attract sizeable foreign direct investment in Foreign Sector Indicators 150% 100% 50% 1.1% 5.4% 5.8% 0% -5% Exports/Imports Current Account/GDP 2004 despite the various limitations and structural obstacles that currently exist in the system. Syria was the fourth biggest Arab recipient of foreign direct investment in 2004, as FDI flows totaled US$ 1.2 billion, up 11.3% from US$ 1.01 billion in The UNCTAD World Investment Report for 2005 placed Syria in the category of countries with low potential to attract FDI but with strong performance, raising the question of whether the country can sustain this rate of FDI flows without in-depth reforms. The Inward FDI Performance Index for 140 countries ranked Syria in 43rd place globally and third among 19 economies in the Middle East and North Africa region. The index ranks countries by the FDI they receive relative to their economic size. Further, the Inward FDI Potential Index for 140 countries, measuring the potential of countries in attracting FDI based on a set of 12 structural variables, ranked Syria in 95th place globally and 18th in the region. One way for Syria to sustain this significant FDI flow is to 6.6% 106.0% 115.3% 110.2% 127.9% 3.2% 111.9% 1.5% 76.1% 7% 5% 3% 1% -1% -3% implement structural reforms that could improve Syria s investment climate, which would help its rankings on the various global indices that institutional investors use as part of their decision-making process. Indeed, Syria ranks near the bottom of most investment climate indicators. For instance, it ranks in 14th place among 16 Arab countries on the Arab Economic Freedom Index, 13th among 17 Arab countries in Institutional Investor s country creditworthiness rankings, and 13th among 16 economies in the Euromoney Country Risk survey. 3. PUBLIC SECTOR The current state of public finances witnessed the continuation of the overall expansionary fiscal trend of recent years, as the Syrian government resorted to enhance spending with the aim of promoting growth and creating jobs, given the accelerating population growth rates. October 2005 Over the past few years, the Syrian government has implemented numerous structural reforms at the legislative and regulatory level, as part of its comprehensive economic reform and liberalization plans. The government paved the way for the modernization of the tax system by introducing a new Income Tax Law in 2003 and endorsing a new consumption tax law in The main purpose of the former is to improve transparency and simplify taxation procedures, while that of the latter is to simplify the way duties are levied on goods. Such laws should bolster collection and efficiency as well as contribute to the struggle against tax evasion. Accordingly, the government reduced income taxes in early 2004, imposed high penalties for evasion and adopted rigorous collection guidelines. Nevertheless, numerous problems such as corruption, red tape, the lack of qualified employees in the public sector and the weakness of the administrative structure could seriously jeopardize the success of such reforms. In 2004, budget figures indicated that public expenditures rose by a higher percentage than public revenues, leading to an increase in the budget deficit by almost two fold year-onyear to reach circa US$ 1.3 billion in 2004 according to IMF figures. The 12.9% annual increase in public expenditures has largely resulted from an important progression in public sector salaries, while the 3.3% yearly rise in public revenues was driven by the surge in international oil prices that boosted export revenues. The budget deficit accounted for 5.3% of GDP in 2004, compared to 2.7% in the previous year. At the level of public indebtedness, total foreign debt amounted to US$ 21.8 billion in 2004, representing 87.9% of Syria s GDP. In early 2005, Syria successfully managed to settle part of its outstanding foreign debt. Indeed, the most notable progress in alleviating the foreign debt came in January 2005, as the government obtained the write-off of 73% of the US$ 13.4 billion debt owed to Russia. While the Russian government arranged to cancel circa US$ 9.8 billion worth of debts, it agreed with its Syrian counterpart to restructure the remaining US$ 3.6 billion. As a result, Syria will repay US$ 1.5 billion over 10 years and retain US$ 2.1 billion in the form of a Syrian pound-denominated credit line to be used to fund Russian investments in the country. The country also fully 5

6 reimbursed some US$ 0.5 billion in debts owed to the World Bank and has cleared up debt arrears owed to Japan, in addition to negotiating debt agreements with Eastern European countries. Such reform measures come in line with the State Planning Commission s (SPC) new five-year plan adopted in June of the current year. The plan aims, in principle, to trigger a series of economic reforms expected to increase the private sector involvement in the economy so as it becomes the main growth driver, thus helping Syria shift from a Stateled economy to a market driven one. The new plan attempts to alleviate the government s dependence on oil revenues, and includes the introduction of the value-added tax (VAT) by In its Article IV Consultation Report published this October, the IMF recommends that the country adopt a comprehensive program of fiscal consolidation and accelerated reforms, focused on enhancing the non-oil budget balance. As such, comprehensive tax and expenditure reforms encompass the adoption of a broad-based VAT, overhauling the price subsidy system, and restructuring/privatizing public enterprises. The recently adopted measures to that effect are considered as a start but need to be developed into a more comprehensive fiscal reform package. The IMF points out that if such structural reforms and measures are not hastened, Syria could get locked in a cycle of financial volatility, fiscal deterioration, low growth and rising unemployment. Money Supply and Inflation 30% 20% 10% 0% -3.7% 13.4% % Money supply growth 3.0% 20.0% 24.6% 4. FINANCIAL SECTOR 4.1. Monetary situation 5% 3% 1% -1% -3% -5% -7% -9% -11% -13% -15% Consumer price inflation (avg.) A process of slow liberalization in monetary policy has been increasingly visible over the past year. Interest rates have been altered for the first time in 20 years and foreign currency rules have been somewhat relaxed. As a matter of fact, the 0.6% 18.5% 5.0% 8.1% % 13.2% 2004 Central Bank of Syria announced, on the 21st of September, that the bank s base rate had been raised from 6.5% to 7%, and that certificates of deposits were introduced, at a rate of 9%, with the specific aim of encouraging people to save in Syrian Pounds. The step followed the easing of foreign exchange controls implemented since the 1960s, with Syrians now able to open bank accounts in foreign currencies and to trade in foreign denominations. At the foreign exchange level, banks were allowed to set their exchange rate within a narrow band around the fixed Central Bank rate. More flexibility is definitely needed to establish a more effective monetary system. Flexibility in the movement of foreign exchange is likewise a must. The use of foreign exchange among residents should be eased and the move towards free float should be gradual. It can take two to three years or may be 10 to 15 years through a stepped approach. In due course, the currency should enjoy full convertibility to other currencies at market rates. A gradual move towards exchange rate flexibility is much safer than a direct, may be disorderly exit. It is important to mention that many countries adopted a gradual approach towards exchange rate flexibility. Only 39% of orderly exits to flexible regimes were one-step moves from hard, fixed or crawling pegs to free floats and 61% involved intermediate steps. For example, Chile and Poland shifted from crawling bands and gradually widened their crawling band regimes over 14 years and 5 years respectively prior to adopting a floating regime. Additionally, the full liberalization of capital transfers is very important for the development and outgrowth of market activity in Syria and for triggering economic growth and job creation. Capital flows from Syria or towards Syria should be freed in due time, with no barriers whatsoever on entry and outflow of capital. Such a relaxation is a prerequisite for non-resident funding to flow into the banking system. Last but not least, a market for Treasury bills is a prerequisite for the establishment of appropriate monetary conditions. At present, there is no securities market infrastructure. The government should allow banks to trade different types of Treasury bills and to undertake the operations of an open market and discount bills at the Central Bank at different rates. Besides opening up new opportunities for private banks to invest liquidity in interest bearing instruments, the increased banking sector liquidity could support the Finance Ministry in issuing Treasury bills and using their proceeds to finance development projects. Finally, such a market would expand the range of investment instruments available and would give the monetary authorities a valuable tool in tackling inflationary issues. Monetary Situation Flows in SP million Var Var Var Var CAGR Net foreign assets 138, ,196 84,881 25,870 47, % -28.2% -69.5% 84.9% -23.3% Claims to public sector -19,682 41,928-3,276 17,204 23, % % % 39.1% - Claims to private sector 1,266 2,126 5,198 25,468 38, % 144.5% 390.0% 50.6% 134.6% Total 119, ,250 86,803 68, , % -46.5% -21.0% 60.7% -2.0% Money supply (M2) 97, , ,969 70, , % -6.4% -47.9% 75.6% 6.1% Other items (net) 21,936 18,019-48,166-1,821-13, % -367% -96.2% 638.2% - 6

7 4.2. Banking activity Despite the relative improvement in banking activity over the past year, the Syrian banking sector is currently characterized by a relatively weak mobilization of domestic and offshore savings and a bad channeling of savings towards private productive investment, the main engine for growth and job creation. The banking industry had US$ 13.8 billion in total deposits at end-2004, the equivalent of 54% of total bank assets and 56% of Syria s GDP. It has a network of 282 branches, equivalent to one branch per 64,000 inhabitants, against a regional average of one branch per 25,000 inhabitants and an emerging countries average of one branch per 15,000 inhabitants. Total bank loans to the private sector accounted for a mere 12.3% of GDP, against a regional average of 37.5% and an emerging countries average of 75.7% of GDP. Bank lending suffers from the weakness of institutional disclosure and the lack of a track record in the borrowing and settlement experiences of private enterprises and individuals. Banking Sector Comparative Aggregates (2004 estimates) 120% 100% 80% 60% 40% 20% 0% 12.3% 55.6% Syrian Arab republic Bank loans/gdp 37.5% 69.8% MENA countries 87.9% 75.7% Emerging countries 63.0% 57.6% Developed countries Customers' deposits/gdp The Central Bank of Syria has been exerting laudable efforts to create the appropriate environment for private banks. Over the past two years, a multitude of regulations have been put in effect to facilitate the work of banks in general. Repatriation of foreign exchange has been eased, transaction fees and stamp duties have been cut to acceptable levels, and banks have been permitted to open branches throughout the country. The performance of private banks has also enticed a wave of newcomers, all of which have been significantly over subscribed in their public offering subscriptions. A more complicated banking sector yet emerged. On one hand, the private banks outlook is very promising, driven by their significant potential for growth and diversification while, on the other hand, public banks need major backing and support to stay in business. In this environment, the constitution of an Association of Banks in Syria is a must to manage the upcoming and potentially growing gap between public and private banks. Aligning the development of both types of operating banks cannot but positively impact the system s overall credibility and its ultimate ability to attract off-shore resources at large. Such an Association could also provide valuable research, advise and training on significant operational and regulatory issues. Beyond the discrepancy between banks development perspectives, all banks face serious hurdles calling for the implementation of drastic reforms. These include the need for providing liquid placement vehicles for banks, the need to upgrade clearing and settlement procedures, the need for improved corporate transparency and disclosure, the need to establish a Credit Bureau or at an earlier stage a Central Office for Credit Risk, the need to encourage and promote micro financing operations, etc. Indeed, there is a strong need for providing credit information on borrowing and settlement behavior of private institutions and individuals as a prerequisite for private bank lending. Credit bureaus contain and provide information on the performance of borrowers in a financial system. The goal of credit information bureaus is to ease a problem that is fundamental to credit markets: asymmetric information between borrowers and lenders. Empirical experience has showed that credit bureau is good for the economy, financial institutions and consumers at large. Both Government and private sector involvement could be vital for credit bureau success. October 2005 While it could take a long time to get a credit bureau to start, the Central Office for Credit Risk is much easier to implement. The Central Office for Credit Risk, generally managed by the Central Bank, provides operating banks and financial institutions upon their request and under strict confidentiality with information on total credits extended to a debtor without specifying the lending sources. Core central credit office data include information on the identity of borrowers, the size of any loans or credit lines outstanding with reporting institutions and their status. Status implies whether a loan is in good standing, past due, in default, or other non-accrual status. In parallel, the clearing and settlement procedures in Syria should be re-engineered in an efficient and effective way. It would help boosting commercial activity and make a smooth transformation from a cash economy towards a paper money economy, with favorable impact on aggregate spending at large. The applied laws on payment systems should clearly provide for (1) developing and regulating payment systems, especially with regard to ATMs and payment cards; (2) developing and regulating transfer payments, including electronic transfers; and (3) developing and regulating clearing and settlement operations related to payment systems and financial instruments. In order to update existing laws and regulations related to the Syrian financial and payment systems, the Central Bank should create a Commission for Developing and Modernizing Financial and Banking Laws. This commission could result from the cooperation between the Central Bank and other private and public bodies. Additionally, the Central Bank can form a Committee on Modern Banking and Financial Techniques and Information Technology (such as the COBIT in Lebanon), with as main objectives setting out a comprehensive strategic plan for the payment and settlement systems in the banking sector including advanced electronic techniques. All such measures are crucial for Syrian banking activity today, although they are not claimed to be exhaustive. Others could figure on any priority reform agenda. The most important thing, after the preliminary achievements over the past few years, is to maintain the pace of reforms or even try to speed it. A dynamic banking sector liberalization policy, in 7

8 Banking Activity SP million Var Var Var Var CAGR Total assets 808, ,239 1,075,094 1,183,367 1,250, % 10.5% 10.1% 5.7% 11.5% % change in assets 21.4% 20.4% 10.5% 10.1% 5.7% -1.0% -10.0% -0.4% -4.4% - Total deposits 346, , , , , % 26.2% 8.1% 8.3% 17.9% % change in deposits 23.0% 30.8% 26.2% 8.1% 8.3% 7.8% -4.6% -18.1% 0.2% - Total loans to private sector 76,392 78,552 83, , , % 6.5% 30.6% 35.1% 17.9% % change in credits 1.7% 2.8% 6.5% 30.6% 35.1% 1.1% 3.7% 24.1% 4.5% - addition to the amendment of certain laws and regulations, cannot but ensure the needed stimulus to economic activity through the channeling of a greater share of domestic savings, estimated at circa US$ 15 billion, and foreign savings, estimated at more than four times domestic savings, towards more productive private placements and investment within Syria. Conclusion: A SWOT analysis Syria s economic and business environment for the years to come is largely dependent on its political outlook within rapidly changing regional geopolitics but also on the implementation of structural reforms that would contain public sector expansion in favor of a market-based economy. Within this context, Syria is increasingly addressing the need to modernizing its legal and fiscal environment, reforming its public administration, upgrading its customs regime, opening-up its domestic banking sector, supporting the deepening of its financial markets, and integrating further its economy into the global economy. Henceforth, if we have to put in perspective Syria s economy in terms of a SWOT analysis within the context of rapidly changing geopolitics, we would mention the following: The strong points are tied to the strong agricultural base, the low cost labor force, the steady support from solid workers remittances, the tourism potential, the continuing trade liberalization and tariff reforms, and a growing political determination to economic development at large. The strong oil prices definitely support the Syrian economy, although recently offset by dwindling reserves and higher domestic consumption. The weaknesses are obviously related to a sluggish private sector activity stifled by state dominance of the economy, inadequate financing for Syria s productive sectors, a weak IT infrastructure, high levels of bureaucracy and cumbersome public sector operations, elevated unemployment levels within a rapidly growing workforce, and persistent hurdles behind financial sector development despite opening-up efforts. Opportunities lie in a large economy with underutilized resources and significant growth reserves as a result of a wide cyclical output gap between actual output and potential output. With the Arab investment interest shifting back to the region in general, Syria is apt to be getting with time a growing share from such inter-regional investment, especially if its political environment proves to be supportive. In addition, the robust economic expansion in Syria s key export markets could ensure exports would grow at a favorable pace in the years ahead. Threats are related to a failure in the enhancement of structural reforms, a further rise in tensions with a wide range of international powers or a dramatic deterioration in security conditions in the region. Such threats might become increasingly serious and adversely impact Syria s outlook and impede its growth perspectives for years to come. The above strengths, weaknesses, opportunities and threats ought to be taken into consideration when assessing Syria s economic and financial prospects and their impact on the country s investment and business conditions. In a rapidly evolving domestic and regional environment, Syria is increasingly considered as a country of investment paradox. The issue is to ensure an overall confidence level in the country s structural adjustment prospects that would provide an appropriate channeling of domestic and off-shore resources to finance the economy s investment needs in the foreseeable horizon. While the challenges for the country are mostly short to medium term challenges, there is no doubt that Syria benefits today from a lot of underutilized potential and hidden reserves that would offer, in a long term perspective, interesting growth and return opportunities at large. 8