The UAE has benefitted enormously from the commercialisation of its petroleum resources. Oil and gas export revenues have enabled this formerly disparate collection of nomadic clans to attain per capita income and wealth levels above those of many advanced economies. They have also provided the resources to diversify the economy and secure a future beyond hydrocarbons.

However, the global recession and financial crisis has exposed some flaws in the UAE’s approach to economic diversification, or at any rate Dubai’s. Its heavy borrowing for projects of untested commercial value in the days of easy credit has led to a large debt hangover that will exert a drag on growth for some years. Still, once the excesses have been worked off, the economy should still show competitive strength as a business, financial and transport hub, and energy supplier.

The UAE outranks advanced economies on two key dimensions of economic performance – GDP growth and income per head – but its business climate and creditworthiness are broadly on par (Chart 1).

Two key risks facing exporters and investors are difficulty enforcing contracts (very high) and business cycle risk (high). Enforcing contracts is both more time-consuming and costly than the OECD average. GDP growth has recently experienced a big bust and rebound (Chart 2).

Of the UAE’s seven emirates, only Abu Dhabi and Dubai are economically significant. Thanks to its large oil and gas reserves, Abu Dhabi is the richest, accounting for 60% of GDP.

Both Dubai and Abu Dhabi are pursuing a state-led, if still capitalistic, development strategy. A large network of public and quasi-public companies, with strong links to the UAE’s ruling families, have been investing heavily in infrastructure, real estate, tourism, manufacturing and financial services.

Thanks to strong oil and gas export revenues and overseas investor appetite, the economy prospered during 2002 08: GDP grew strongly; foreign reserves climbed; and sizeable current account surpluses were achieved (Chart 3 and Chart 4).

But this development model came under pressure during the recent crisis, and Dubai’s debt crisis has been a severe setback to the overall UAE economy and banking system. The construction sector, one of the main growth drivers, was hit particularly hard; in the wake of the downturn, builders delayed or cancelled projects worth about US$330 billion mostly in Dubai. As a result, the economy contracted by 3.2% in 2009 and the banking sector, which was heavily exposed to construction and real estate, required state capital injections of about US$16 billion as well as central bank liquidity support.

The crisis also exposed a large build up of public (and quasi-public) debt in Dubai equivalent to 140% of the emirate’s GDP, well above normally accepted sustainability thresholds.

Dubai has managed to stave off default thanks to support from Abu Dhabi. But many companies are having to renegotiate their debts with creditors and will probably have to grind through an extended repayment process. As a result, investment spending will be kept to a bare minimum. Thus it could be several years before projects completed at the height of the boom generate substantial positive cash flow.

The economy recovered through 2010, recording GDP growth of 3.2% and the IMF foresees growth of 3.3% in 2011. Dubai’s debt and property market problems will probably continue to constrain its pace of expansion, as they did in 2010, while Abu Dhabi should experience stronger growth on the back of oil exports and public investment spending.

Longer term uncertainties loom, notably the sustainability of the state led development and economic diversification initiatives. Significant oil and gas reserves means that Abu Dhabi is in a better position if the diversification strategy underperforms. In contrast, Dubai’s reliance on non petroleum economic activity and heavy debt load means it has less of a cushion and is more vulnerable to shifting risk perceptions.

The UAE is a confederation of seven emirates, each governed by a sheikh and a ruling family. Individual emirates have considerable powers, including control over mining rights and investment incentives.

At a federal level, power is typically shared between the rulers of Abu Dhabi and Dubai – since the UAE’s formation in 1971, the ruler of Abu Dhabi has occupied the presidency, while the ruler of Dubai has occupied the vice-presidency. In practice, Abu Dhabi’s economic weight means it plays a more dominant role in federal affairs, a role which has only been reinforced by its 2009 bailout of Dubai.

Freedom House, the political and civil rights monitor, rates the Emirates as ‘Not Free’. Unlike in some other Gulf states, high and rising living standards have so far restrained the demands of Emiratis for greater political representation.

Despite the presence of some intra ruling family and inter emirate rivalries, the UAE ranks fairly highly on World Bank measures of government effectiveness and political stability. However, its bottom quartile ranking on voice and accountability highlights some of the limitations of family based government (Chart 5).

The UAE is generally regarded as having a favourable commercial environment, which is reflected in its top quartile ranking on the World Bank’s ease of doing business metric and two sub metrics: hiring and firing workers and starting a business.

But the UAE also has a reputation for slow and lengthy commercial dispute resolution, which probably dovetails with the country’s relatively poor rankings on aspects such as enforcing contracts and protecting investors (Chart 6, left hand panel).

On factors that matter the most to foreign investors - controlling corruption, rule of law and regulatory quality - the UAE ranks in the first or second quartile of countries. It also outranks its regional peers on all three factors (Chart 6, right hand panel).

As a ‘high income’ country with a per capita GDP of US$46,900, the UAE has living standards on par with developed countries such as Australia, Austria and Finland (Chart 7). But this high level obscures large disparities between the economically weighty emirates of Abu Dhabi and Dubai and their less dynamic counterparts.

Rapid modernisation and a large influx of expatriate workers mean that the UAE is more heterogeneous than it was even a decade ago. Foreigners account for around 80% of the 4.8 million population and 99% of the private sector labour force. Apart from some highly-paid white-collar expatriates, the majority are lowly paid South Asians working in the construction and service sectors. This mix, coupled with the troubles in the Emirates’ property, construction and financial sectors, is fuelling tensions such as labour unrest and youth discontent.

Iran and the UAE have an unresolved territorial dispute over the Tunb and Abu Musa islands, but this is unlikely to lead to conflict.

Foreign embassies warn of a high terrorist threat. As a highly westernised Muslim society, with a large non-Muslim population and US partnership role in anti terrorist initiatives, the UAE makes a tempting target for jihadists. That said, the Emirates have not experienced a successful terrorist attack and the security services are ubiquitous and vigilant.

Occasional protests by foreign construction workers over pay and conditions have involved little bloodshed and property damage. The fact that foreigners can be deported at any time acts as a deterrent to labour militancy.

*All 2010 figures unless specified

**The HDI is composite measure of human development: long & healthy life (life expectancy), education (literacy & education enrolment) and income (GDP per capita)

***Expressed as % of GDP unless specified