By Nasser Saidi
The Arab world needs to undertake major structural transformations if it is to effectively address the challenges laid bare by the Arab Firestorm. Greater regional economic & financial integration, the development of local currency financial markets should be high on the agenda of policy makers’ priorities.
Not since the 1950s with its revolutions and coups d’état has the Middle East and North Africa (MENA) region experienced as much turmoil and portents of change and transformation. The turmoil has taken its toll with lower growth expected for the Arab region at 3.6% in 2012 and barely matching population growth. The average growth disguises vastly different outcomes between countries. The oil exporters –with growth expected of 4.4%- are benefiting from high oil prices (in part due to a risk premium resulting from the Arab Firestorm) and have the fiscal latitude to increase government spending in response to unrest or restiveness. By contrast, oil importers and countries in transition (optimistic growth forecast of 2%) are facing deteriorating economic conditions resulting from lower investment (both domestic & foreign), a decline in tourism and remittances and a growing budgetary burden from subsidies for food & fuel.
There are wide disparities in social, economic, governance and political conditions within and across economies of the Arab region. The Arab Firestorm (a term I prefer to the Arab Spring which elicits a rosy picture of rebirth) has uncovered poverty amidst riches and the fact that the benefits of economic growth over the past decade were not widely shared. Countries like Egypt and Tunisia were highly ranked by the World Bank for undertaking reforms to facilitate business and privatise. However, higher growth largely benefited elites symbiotically linked to political power, ‘crony capitalism’. There was no ‘trickle down’ or ‘pull up’ effect and the poor and disenfranchised of the Arab world stagnated. One fifth of the Arab region population, some 60 million people, live in poverty on less than $2 per day and the unemployment rate among youth is running at 25%.
Spreading across the region, the Arab Firestorm has ranged from Tunisia & Egypt, Libya and Yemen where longstanding leaders were overthrown and new regimes promised to near civil war conditions in Syria, to simmering unrest in Bahrain. Governments responded with a mixture of increased spending, reinforcing food & fuel subsidies and transfers to the population. While the visible factors that drove the protests in the Arab countries were political and governance related expressed in the term ‘Karama’ Arabic for dignity, the fundamental forces at work and grievances are demographic, social and economic. At a time when emerging markets are in the ascendant and rapidly catching up with advanced economies, the majority of Arab countries (with the notable exceptions of the UAE and Qatar) have underperformed, failing to create sufficient jobs opportunities to materially reduce chronically high unemployment, much less to absorb the flood of new job seekers entering the labour force.
Why MENA Needs a Financial Transformation
With the advent of the Arab Firestorm, the MENA landscape has become increasingly diverse: from the natural resource-rich GCC region and oil exporters, to countries in various stages of transition – Egypt, Libya, Syria, Tunisia, Yemen – to countries that have experienced years of war and destruction and require extensive reconstruction and development – Iraq, Sudan, Palestine, Lebanon – to vulnerable countries currently on the margins of transition, like Algeria, Bahrain, Jordan and Morocco.
However, one common factor characterises the region: the banking and financial sector remains underdeveloped and widespread access to finance is low1. It is well known that economic growth and financial development are directly linked. But the variance is large across MENA. In Egypt, the biggest country in the region by population, there are only 8 bank branches per 100,000 (Iran has 29.2), 439 deposit accounts per 1000 (UAE has 1751) and only 15% of households have bank accounts. But if you don’t have a bank account, you will not have access to financial services. You are not integrated into the market economy. Similarly, only 20% of SMEs have bank accounts in the region, though they represent more than 80% of businesses. The result is a lack of financial access and inclusiveness in MENA, mirroring the lack of economic inclusiveness.
The region’s financial sectors are largely dominated by banking systems that play a limited role in financial intermediation, while the non-bank financial sector has not evolved. To date, most financing remains in the form of bank lending. According to the IMF’s GFSR, the financial structure in the Middle East is unbalanced: the bulk of finance comes from the banking sector, at 60-65%, another 30% is derived from the equity markets while the debt markets are severely under-developed. Mortgage markets, which should be the mainstay of housing finance for countries with young & fast growing populations, are largely absent. The over-reliance on bank loans for financing led to core infrastructure and development projects being financed largely through short-term commercial bank loans. The predictable result was maturity mismatching, large risk exposures, and balance sheet constraints thereby limiting the ability of banks to refinance with the onset of the Great Financial Crisis. Dubai World and the Nakheel crisis are classical illustrations of the risks and dangers resulting from the use of short term funding for long-gestation projects.
The region’s bias and dependence on bank financing raises multiple risks. MENA banks are facing an increasingly restrictive regulatory environment under Basel III requiring an increase in capital availability and adequacy along with the introduction of liquidity requirements, while facing a more challenging lending environment. Though they are better capitalised and with less leverage than their Western counterparts, their ability to meet the financing requirements of governments and the private sector will be constrained. Second, they are reliant on the European MTN market for medium term funding. But European credit markets are in crisis as investors and creditors are increasingly risk averse to invest in bank debt. Third, there are contagion and spill over effects from Europe’s sovereign debt crisis. European banks have the largest exposure of international banks to the region: they provide international trade finance and some 50% of cross-border loan syndication. European banks face the four R’s of recapitalisation, retrenchment, restructuring and recession that undermines their ability to continue providing finance to the region. Faced with weaker balance sheets as a result of recession and the on-going sovereign debt crisis in Europe, EU (and Western) banks will continue a process of deleveraging. For the MENA region the implication is a loss of bank financing and increasingly difficult and more expensive access to European credit and financial markets.
Meanwhile, financing needs are growing in the region. One, the region’s has ambitious investment plans and infrastructure projects, driven by demographic factors (60% of the population is below 29), growing incomes and aspirations, and the need to create jobs for a rapidly growing labour force, with some 70 million new jobs to be created by the end of the decade. The MENA region needs to invest some $100 billion annually for core infrastructure and faces a $40 to $50 billion funding gap2. Two, countries in transition and those destroyed by war and violence require massive infrastructure & public works investments for reconstruction and development in addition to the need to fund growing budget deficits in the aftermath of the Arab Firestorm.
Moving to a New MENA Financial Architecture
So, how do we address the financing needs of the MENA region? The challenges are growing given the dire straits of the Western banking system. We need a new banking & financial architecture, a major financial transformation. There are three building blocks: (a) Re-orient our banking relations toward Asia and China; (b) Developing local currency financial markets and a capital market for SMEs and FOEs; and (c) we need a region-wide institution in the form of an MENA Bank for Reconstruction and Development, a MEBRD.
Re-orient Banking & Financial Relations to the East
Given the shift in global economic geography towards emerging market economies and Asia/China and the accompanying shift in trade patterns, the Arab countries need to restructure and re-orient their banking, trade & investment strategies and policies accordingly. The Arab banking sector should develop new relations with the emerging banks from Asia, with a focus on China. The Renminbi will be emerging as the world’s third global currency alongside the US dollar and the Euro.3 We need to take the steps to integrate the Renminbi into our trade and investment transactions and payment systems.
It is in the strategic interest of the Arab countries to move towards greater economic & financial integration with China, to be part of the New Silk Road supply chain. This should include developing and facilitating trade finance and move towards using the Renminbi for the settlement of trade with China, which is rapidly becoming the largest trade partner of the GCC and other Arab countries. Using the USD or the Euro to finance trade with China is incongruous, raises transactions costs, and generates exchange rate and counterparty risks at a time in which the US and European banking systems continue to suffer the aftershocks of the Great Financial Crisis, limiting their ability to finance the trade of emerging markets. To mitigate these risks requires developing direct banking relationships between Arab banks and their Chinese counterparts as well as between the region’s central banks and the PBoC, including through the establishment of currency swap agreements.4
A Capital Market for SMEs
The majority of companies in the MENA region are Small and Medium Enterprises (SMEs) and Family Owned Enterprises (FOEs). SMEs and FOEs underpin the economies of the MENA region, accounting for roughly 71% of all employment and 28% of GDP. The percentages increase substantially if the oil, gas and telecom sector are excluded. SMEs & FOEs play a critical role in economic diversification, reducing the reliance on traditional sectors, moving away from a state-dominated development model and dependence on natural resource based activities. However, SMEs & FOEs tend to rely on self-financing and have highly constrained access to bank financing. MENA governments have launched a variety of programmes to incubate, nurture and promote SMEs given that they can be a major source of job creation for young people and encourage innovation. These initiatives are useful and promising. However, they do not provide for sustainable financing mechanisms and lack an ‘exit’ strategy: SMEs may remain ‘infants’, dependent on external assistance and support.
A vibrant, innovating, job creating SME/FOE sector requires access to long-term sources of capital. Stock markets in the region have adopted a model best tailored for large, well-established companies with long track records and operating in mature sectors. Accordingly, the regional stock markets are dominated by banks, real estate, hotels, utilities and petrochemical conglomerates, often with a dominant public sector presence among the shareholders. Growth companies, dynamic businesses and FOEs find the regulatory framework and listing requirements of established exchanges costly, burdensome and a disincentive to list. Owners of growth companies and FOEs are reluctant to lose control over their companies by being forced to list a substantial part of their equity on existing exchanges.
To cater for their needs, I have proposed the development of a capital market dedicated for SMEs and FOEs in the MENA region, to be called Nexpand. The market would target promising companies that are not ready or suitable for listing in the main equity market – typically, large family enterprises, smaller or mid-sized enterprises or companies backed by private equity and venture capital (or, collectively “growth companies”). This would mean that private equity, venture capital and other investors or creditors (including governments) would be provided with an exit strategy for their investments/ funding.
Whilst not appropriate for the main market, these growth companies would benefit from listing rules and on-going reporting requirements specifically designed to meet their needs and cater for sophisticated investors, removing regulatory barriers to listing and instituting streamlined listing rules, while ensuring appropriate corporate governance standards are maintained. Light regulation does not mean lack of safeguards for investors; it means that rules and enforcement are designed to be efficient with a focus on substance rather than detailed formal requirements.
Nexpand would be a “stepping stone” for companies to the ‘big board’ market and could be a key driver in the development of a liquid capital market and assure long term sources of capital and funding for MENA SMEs & FOEs.
Developing Local Currency Financial Markets
MENA financial markets are underdeveloped, being small and fragmented, a lack of depth and liquidity, a small retail investor base and the absence of active regulators. There is an urgent need to develop the region’s nascent debt markets, both conventional and Sukuk. As noted above, Middle East debt markets are miniscule by global standards at less than 10% of GDP compared to a global average of 150%. Globally, debt markets represent the main source of liquidity and financing for governments, public companies, and financial institutions in modern economies; in the Middle East, they represent the smallest.
For the MENA Region, and in particular the GCC, the growing propensity to invest both in private and public infrastructure and long gestation projects make a compelling case for developing a sophisticated debt market. At present commercial bank channels are the primary source of funds, which heightens financial vulnerability due to maturity mismatching.
Developing local currency debt and Sukuk markets would bring multiple benefits: greater independence for the conduct of monetary policy through the diversification of monetary policy instruments, provide stable access to capital, creation of a yield or profit curve for pricing financial assets, and tailoring of risk management tools. Importantly, local currency markets can provide a buffer from the contagion risk and spill over from foreign shocks. Indeed Asian economies that focused on building local currency financial markets in the aftermath of the Asian Crisis fared better and were able to withstand the tsunami of the Great Financial Crisis.
GCC Markets & a New International Financial Architecture
The GCC and other oil exporting countries have a strategic reason to develop their financial markets. For more than 100 years, a “hub and spoke” model has dominated and defined global capital markets and flows. In this model, excess savings – including “petrodollars’ from the Gulf countries – would flow through international commercial and investment banks in London or New York to be deployed in investments across the globe.
However, global imbalances, unprecedented current account deficits, growing budget deficits and the transformation of the US into a massive importer of capital undermined the model. The hub-spoke model has failed, begetting financial centres that were ‘too big to fail’ (TBTF) and ‘too interconnected to fail’ (TITF). These centres had financial institutions that were mal-governed, inefficiently regulated and supervised and themselves TBTF and TITF, creating systemic financial market risk. The near meltdown in the hubs provoked heightened global risk aversion and led to contagion effects affecting emerging markets and their economies.
We must not allow this to happen again. We need to design and move to a more stable and sustainable “spider web” model, where regional international financial centres in the Middle East, Asia and Latin America have the capital market breadth, depth, liquidity and regulatory sophistication to absorb and redeploy capital from their own regions, as well as from elsewhere. A “spider web” financial architecture would reduce systemic international financial market risk.
Indeed, the Dubai International Financial Centre (www.difc.ae) and other Gulf financial centres have endowed the Gulf countries, for the first time in their history, with the ability to manage and control their own wealth. Given their rapidly growing financial wealth (we estimate that the present value of revenues to 2030 from the GCC’s oil and gas reserves is some US$ 37.7 trillion at oil price of $1005) the banking & financial industry will be second only to the energy sector as the major focus of investment of the Gulf countries.
The economic future of the Gulf countries is solidly grounded in the two foundations of natural resource and financial wealth. Governments and corporations wanting to tap the financial wealth and liquidity of the GCC countries could issue securities on their markets. Similarly securities issued by GCC countries could act as an anchor for the international financial system. GCC securities would be backed directly or indirectly by the region’s vast energy commodities reserves, accumulated private and public wealth and political stability. Furthermore the value of the GCC, equity, debt and Sukuk securities would be underpinned by a series of forward looking fundamentals such as endogenous growth capacity reinforced by the ongoing diversification process, the shift of the epicentre of the world economy and trade patterns towards Asia, closer South-South financial links and a talent pool which is increasingly attracted outside the mature economies. The more risk averse and unleveraged market participants such as pension funds could find a safe haven in the GCC securities to hedge against episodes of extreme risk aversion and uncertainty.
Creation of a MENA Bank for Reconstruction and Development
If there is an important lesson to be learnt from the Arab Firestorm, it is that the region needs to own its transformation. Countries need to develop their own roadmap. There is no ‘one size fits all’ and there are no ready-made solutions. We need to develop institutions for collective action that are geared towards the betterment of this region. There is clearly a need for the effective mobilization of funds and the channeling of resources to meet the growing capital investment needs of the region. The countries of the region have been devastated by war, violence, waste, corruption and mal-governance. Iraq, Sudan, Lebanon, Libya and Palestine all need reconstruction and development investment on a vast scale. Algeria, Djibouti, Egypt, Jordan, Morocco, Syria, Tunisia, Yemen, as well as others need to address their own very pressing demographic, political and socioeconomic challenges. The region is also lagging in integrated regional infrastructure for water, transportation, telecommunications, power and energy. We need to build institutions to address these challenges.
This is the historic time to set-up a MENA Reconstruction & Development Bank (MEBRD). A pseudo-‘Marshall Plan’ for the Arab world will not be far-reaching enough to address all the region’s challenges. A regional financing institution is required. A MEBRD would focus on (1) financing and promoting private sector activity; (2) Financing and promoting private participation in infrastructure (PPI); (3) Development of financial markets in the region; and (4) Financing infrastructure, including regional and cross-border projects and investments that promote regional economic and integration.
As a regional entity, MEBRD would be able to tailor solutions to the needs of individual nations. Its scope and mandate should be similar to the post-1989 effort to rebuild eastern and central Europe. A MEBRD would be set-up as a multilateral institution, a joint undertaking by all the countries of the region. The GCC should play the prominent role using their sovereign wealth funds and other aid agencies, along with the EU. The EIB/EBRD should take a major stake given its expertise and substantial experience, along with the Islamic Development Bank and with other IFIs participating. The US, China, Japan, Korea and Turkey should also be stakeholders.
The GCC countries have a strategic interest in the growth and stability of the region and in enabling a successful transformation of countries in transition. They also have substantial financial resources that are being supplemented by the
increase in oil prices. This would enable them to subscribe the majority of the MEBRD’s capital. The region has the financial, human and natural resources for its medium and long-term development. It lacks the expertise and knowhow in
developing strategies, conceiving and implementing multi-year infrastructure and development projects to achieve sustainable and inclusive growth and development. That would be the role of MEBRD.
Regardless of how the political developments play out, all the regimes in the region have been challenged and the populations will not be content with business as usual. We are living through a defining moment for the Arab world. Humpty Dumpty had a great fall and it will not be possible to put Humpty together again! Mere promises of change without concrete action are no longer sufficient to curb the rage of protesters and the aspirations of youth who have had enough, “kifaya”. Quasi-new regimes, like those in Tunisia and Egypt, will need to show that they are departing from the old ways. The need of the hour is to reassure the people of the region and investors in the region that policies are in place for inclusive economic growth, productivity enhancing jobs, alongside political and governance reforms. The Arab world needs to undertake major structural transformations over the coming decade if it is to effectively address the multiple challenges and vulnerabilities laid bare by the Arab Firestorm. Financial transformation is required for economic & social development and as an enabler of structural change and policy reforms. Greater regional economic & financial integration, the development of local currency financial markets –including a capital market dedicated for SMEs and FOEs and a MENA Bank for Reconstruction and Development should be high on the agenda of policy makers’ priorities.
About the author
Dr. Nasser H. Saidi is the Chief Economist of the DIFC and Executive Director of the Hawkamah-Institute for Corporate Governance at the DIFC, since 2006. In 2011, he was named among the 50 most influential Arabs in the World by The Middle East magazine, for the third consecutive year. He was the Minister of Economy and Trade and Minister of Industry of Lebanon between 1998 and 2000, and was the First Vice-Governor of the Central Bank of Lebanon during 1993-1998 and 1998-2003. Prior to his public career, Dr. Saidi served as a Professor of Economics at the University of Chicago, the Institut Universitaire de Hautes Etudes Internationales (Geneva, CH), and the Université de Genève. He has written a number of books and publications addressing macroeconomic, capital market development and international economic issues in Lebanon and the region.
1.See the World Bank’s MENA Financial Sector Flagship Report (2011) for discussion and data. http://web.worldbank.org/WBSITE/EXTERNAL/COUNTRIES/MENAEXT/EXTMNAREGTOPPOVRED/0,,contentMDK:22734614~pagePK:34004173~piPK:34003707~theSitePK:497110,00.html
2.See Arab World Initiative on infrastructure requirements, http://arabworld.worldbank.org/content/awi/en/home/featured/infrastructure.html
3.See the discussion in “The Redback Cometh: Renminbi Internationalization & What to do about it” http://difc.com/difc/sites/default/files/economic-note-18.pdf
4.This has started: the UAE central bank and the PBoC signed an RMB 35 billion currency swap agreement on 17 January, 2012.
5.See N. Saidi, F. Scacciavillani and A. Prasad (2009): Wealth Effects in the GCC from Energy Commodity Prices, Economic Note 6, Dubai International Financial Centre, September