Trade integration with developed economies, in particular the EU, access to information and knowhow (including the acquisition of foreign-licensed technologies) through participation in GVCs could help firms in MENA catch-up with other regions and close the innovation gap of the region.<sup>3</sup> Digital capacity and connectivity to international markets are critical to cope and adapt better to the economic shocks such as the COVID-19 crisis. Policies should prioritize investment in digital infrastructure and pay special attention to improving workers’ digital skills. Moreover, improving customs and trade regulations, which will lower entry costs for firms to engage in trade, will increase access to international markets to a larger share of firms. But these measures should not give preference to certain groups of firms. Instead, the focus should be on creating better incentives to invest in innovation for all firms. Ultimately, this may also help increase the integration of domestic firms, especially smaller ones, into GVCs.

The remainder of this paper is organized as follows. Section II provides an overview of trade integration, economic development and barriers to trade and innovation for firms in MENA. Section III explores the interrelationships of trade participation and innovation. Section IV discusses the responses of traders and innovators and their performance during the COVID-19 crisis. The last section concludes with policy implications for fostering private sector development in MENA.

# **II. Trade, innovation and business environment barriers**

As a share of GDP, economies in the MENA region tend to import more goods than they export. As the trade balance is the major driver of the current account balance, large deficits might be a source of a macro risk.<sup>4</sup> However, the current account deficit also implies an excess of investment over domestic savings, which could reflect the catching-up process of less developed economies (Ghosh and Ramakrishnan, 2020; Carranza, 2002). In 2019, all six MENA countries had a negative trade balance (Figure 1). Imports represented more than 30% of GDP of these countries (with the exception of Egypt), which is above the average of UMI (upper middle income) and LMI (lower middle income) benchmark economies, which are around 20% of GDP. Exports accounted for about 18% of GDP, in line with the average of LMI and UMI countries.

According to Enterprise Surveys, most firms in these regions engage in trade. But the breakdown of firms’ trading profiles outlines the import dependence of most of the countries, in particular in Jordan, Lebanon and the West Bank and Gaza (Figure 1).<sup>5</sup> This may reflect the relatively small size of the economy in these countries. This may also indicate that firms are unable to find inputs in the domestic market or reflect policies overvaluing currencies for example, due to pegged exchange rate to hard currencies in Lebanon and Morocco (Jaud and Freund, 2015). The share of non-traders is particularly large in Egypt and Morocco. In these two economies, this needs to be interpreted in light of the size of the economy, as they are significantly larger than the other countries in the MENA region.

Most firms that export their goods or services also import at the same time, indicating that they participate in GVC by importing, transforming and adding value before re-exporting. The share of

> 3 Figure A1 in the Appendix highlights that real GDP growth and GVC integration are correlated. For the positive association between real GDP and both service and goods trade in MENA, see Karam and Zaki (2015). 4 A current account deficit is considered unsustainable when it may trigger a drastic policy shift or when it leads to a crisis, for example, an exchange rate collapse that prevents the country from servicing its external obligations.

> 5 Importers are defined as firms that purchase more than 10% of material inputs or supplies of foreign origin. Exporters are defined as firms exporting more than 10% of their sales directly.

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