By Roula Khalaf

in London

Gulf states’ fiscal surpluses will narrow substantially next year as oil prices average $56 a barrel, but the region will escape a recession, the Institute of International Finance has forecast.

In a report published yesterday, the association of leading financial services firms said that although the ripple effects of the global financial crisis had hit the oil-rich Gulf, the region would confront the turmoil from a position of strength. The institute expects real economic growth to slow to 3.6 percent from this year’s 5.7 percent. Based on the $56 oil price forecast, the IIF estimates that the budget surplus of the Gulf Co-operation Council countries - Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and United Arab Emirates - will decline to between 3 percent and 5 percent of gross domestic product, down from more than 20 percent of GDP this year.

Saudi Arabia, the world’s largest oil exporter, needs a $51 per barrel price to balance its budget, it says, while the UAE’s break-even oil price is just $36.

“The GCC region is facing the current situation from a far stronger position than in the past,” said George Abed, director of the IIF’s Africa and Middle East department. “Nevertheless, the GCC authorities need to take policy measures to address the expected growth slowdown, financial stress in certain segments of the banking sector and the sharp correction in the property market.” After years of high growth and big budget surpluses, GCC investors’ confidence has soured as oil prices have tumbled (they stood at $47 a barrel yesterday), stock markets have crashed and the property boom has turned into a sharp correction.

But the IIF insisted that the region’s diversification drive and the cushion built up in official reserves and foreign assets would help it to weather the storm with “scratches” rather than “permanent scars”. Even if half of the planned property and infrastructure projects were cancelled or postponed due to the credit crunch, there would still be $1,000bn (€791bn, £679bn) of projects over the next five years, said the IIF. Accumulated wealth - foreign assets of governments and banking institutions are at about $1,500bn - provide governments with enormous resources to fund projects. Since taxes are low and public sector spending high, the countries are essentially living what Abed called “a fiscal stimulus on a continuous basis”.

In a sign of growing constraints on sovereign wealth funds’ international appetites, the IIF said the reduction in value of funds’ investments in western equities and property had increased pressure to redirect their investments to local markets.

The institute said sovereign wealth funds in the region held 40-50 percent of their assets in fixed-income securities, which have held up well during this crisis; about 35 percent in public equities, which have suffered losses; and the rest in alternative investments and private equity.