Since the mid-1980s, the global financial community has witnessed an unprecedented explosion of cross-border capital flows, as new financial instruments have been created and competition among borrowers, lenders and financial intermediaries has increased. Over the last decade, private-equity investing has changed from being a rather marginal source of foreign capital in the developing world to becoming one of the most important sources of capital available, replacing official (i.e., government, World Bank, IMF) grants and loans as well as commercial bank borrowing.
In the three years ending in June 1993, bank lending to developing countries amounted to only $3.5 billion, compared to $46 billion in bond and equity flows.1 It is however estimated that Middle Eastern countries accounted for only 2 percent of total flows of foreign portfolio and direct investment to developing countries in roughly the same period (from 1989 to 1992).2 Furthermore, indications are that a significant part originated from Arab sources and not from the Western world.
It looks as though Arab countries have remained impervious to the rising tide of international private-equity investment inflows primarily because of the existence of restrictions in practically all of these countries on the acquisition of real assets by foreigners and secondly because of general nationalistic resistance. Furthermore, in spite of recent steps by most of these countries to adopt outward-looking investment policies, administrative bottlenecks and red tape remain.
As Arab markets remain underdeveloped and generally restrictive, both developed and other developing markets will continue to offer more attractive investment opportunities to savers from the Arab surplus countries, thereby reducing intra-Arab capital flows and even further worsening the problem of domestic capital flight faced by the Arab deficit economies.3
This paper discusses the challenges of international private-equity investing in the emerging markets of the Middle East, and then finds that perhaps the most urgent task that lies ahead for both government and private-sector Arab institutions is to propose an agenda for capital-market development in the region throughout the remainder of the 1990s.
The major causes limiting both intra-Arab and foreign capital inflows seem mainly to be government policies that maintain various obstacles, uncertainties and restrictions on foreign private-equity investment and favor financial intermediation in banking over the securities markets.
The policy challenge is therefore to promote capital inflows, change the investment strategy and develop the securities markets.
1. PROMOTION OF CAPITAL FLOWS
Some key prerequisites are necessary for the promotion of capital flows in the region. First, hostilities or the threat of hostilities constitute a deterrent to private-equity investment, foreign or domestic. Likewise, political instability is an obstacle. Hence, the recent initiatives by the PLO and Jordan in signing peace treaties with Israel are a sign of potential political and economic stability in the region. No rational outside saver can be expected to invest in a given country without having reasonable confidence in the long-term stability and economic health of that country.
Second, peace and political stability alone are not sufficient conditions to attract private-equity investment, especially from foreign sources. Private investors, regardless of nationality, seek a maximum rate of return consistent with a minimum risk, conditions that obtain far less in the Middle East than in the advanced industrialized countries or those countries of East Asia or Latin America that have adopted and implemented wise economic policies. Hence, Arab policy makers would attract more international private-equity investment to the region by providing greater tax breaks on capital gains, rejuvenating industry, developing secondary market activities and nurturing of a first-class group of market makers and underwriters. There is no reason why the best and brightest Arab university graduates should not compete for securities jobs at Arab investment firms, just as "Ivy League" students compete for positions on Wall Street.
Israel has in recent years been more successful at attracting foreign private investment than any country in the Middle East, mainly because Israelis have been particularly good at building high-technology industries and tapping into the placement power of Wall Street underwriters to raise money for these companies both in Israel and in the U.S. capital markets. The buyers of shares in the 60 Israeli companies listed on American stock exchanges are motivated not by philanthropy but by profit. Foreigners have also invested in banks and some other profitable sectors of the economy.
Third, there should be incentives for the development of local investment and merchant-banking firms that would identify, structure and package investment opportunities for the international private-equity investors looking to commit capital in these countries. The dearth of international private-equity investment in, for example, Saudi Arabia, outside of oil refineries and petrochemicals, results more from the fact that Western investors find few profitable areas for investment in Saudi industry than any other reason. The same applies to Saudis and other Arabs who invest much or most of their funds in the West.
Fourth, the presence of the competitive State of Israel is not the main reason for Arab economic woes and for not attracting the needed international private-equity capital into Arab economies. Jordan, for example, has been enjoying a de facto peace with Israel for the last 20 years, but Jordanian efforts at attracting international private equity investors have had minuscule results. On the other hand, although Egypt and Israel have been at peace since 1979, this has won Egypt little foreign private investment, especially in manufacturing. To the contrary, Egypt's economy has stagnated, at least on a per capita basis, since the end of the oil boom almost 10 years ago. Furthermore, of the 314 or so public-sector manufacturing and service companies covered by Egypt's privatization program, less than three dozen have been brought to the point of sale, and only four have been sold, according to a 1994 report by the U.S. and Foreign Commercial Service in Cairo. It seems that both countries' problems, and the economic problems of the Arab countries at large, stem more from internal policies than from the conflict with Israel or any external reason.
Fifth, a securities market, with a range of financial institutions and competent intermediaries as well as a properly structured regulatory and accounting framework needs to be developed to the fullest extent in order to avoid crises such as the Souq al-Manakh scandal (the $40 billion Kuwaiti bubble that burst in 1982), provide an exit strategy for the investors, improve their access to information and ensure their protection. The Souq al-Manakh crisis shook the confidence of both Arab and Western investors for at least five years (until the Wall Street crash of 1987). However, this process is unlikely to occur today due to the breadth and depth of the Arab capital markets compared to 13 years ago.
Sixth, the attitude toward foreign, and more specifically Western investments, needs to be revised. In fact, most Arab countries, including even the most liberal ones such as Lebanon, have foreign-investment laws that result from a fear of Western domination and a desire to protect domestic and other Arab entrepreneurs. Unfortunately, the discrimination affects both direct and portfolio investment by foreigners, even though portfolio investment is aimed at an attractive economic return rather than at control.
This applies further to countries that have archaic investment laws such as most of the GCC countries, which strictly forbid foreigners to take an equity position in any publicly traded Arab company. These laws exist mainly because the Middle East nurtures a great number of conspiracy theories, some genuine, others manufactured for external purposes. The time has come to put these aside and realize that economic progress is not a zero-sum game. The world today is aptly called a global village. If the "macro" game plan of the twenty-first century is economic growth and integration, Arabs have to accept the fact that this cannot be achieved effectively without implementing fundamental changes in the way they transact business.
2. CHANGE OF INVESTMENT STRATEGY
An increasing number of Arab countries have become aware of the significant role that foreign portfolio investment can play in the developing of local capital markets, either directly or through mutual funds.
In fact, recent capital-raising efforts to establish country funds that invest in a large number of companies in a specific country or group of countries have found a warm welcome in the Western financial community. Foreign & Colonial Emerging Markets' launching of their $60 million "Middle East Emerging Market Fund" in September 1994, with the help of the Washington-based International Finance Corporation (IFC), was a breakthrough that opened the floodgates for a number of other Western-sponsored investors. Furthermore, the Oryx Fund (a joint U.K.-Omani investment fund) of $52 million that was recently opened to investors from outside the GCC was a tremendous success. This is a short list of some of the Western sponsors looking to invest in the capital markets of the Middle East. A number of Arab-sponsored funds are successfully raising millions of dollars to capitalize on the "peace dividends" in the area and establish themselves as recognized players in the "new" Middle East.
This seems to be a logical first step, as the task of selecting companies in which investments are made is left to the local professional fund managers, whereas both Western and Arab investors do not need to be concerned about the detailed knowledge of the various companies in each country. Most of these funds are betting on the outcome of the Arab-Israeli peace process and believe that, in due time, many privately owned Arab companies will use the public route to raise money.
I believe, however, that most of these funds will soon realize that the vast majority of Arab companies are not yet ready or do not need to use the public venue to raise capital, for three major reasons:
1. The majority of Arab-owned companies are still not management-driven and the primary shareholder(s) still sits on the board. In fact, the general manager is restricted in his discretion and is perceived by the board as more of an adviser than a fully responsible manager. It is doubtful that these companies will ever be able to raise public monies and attract the "smart Western pools of capital" if they maintain this antiquated approach to doing business.
2. Most of the Arab-owned companies do not have access to medium- and long-term debt financing to leverage their balance sheets and grow. Debt in the Arab world is still viewed as risky. Neither Arab financiers nor entrepreneurs have yet realized that the optimal corporate financing structure has nothing to do with the use of debt versus equity. It has, however, a lot to do with the timing of the debt or equity financing under consideration and whether the funds will be used for growth, acquisition, restructuring or recapitalization. Furthermore, without access to long-term financing and cash-flow lending, it is doubtful how Arab companies can grow and compete internationally.
3. For a successful public offering to occur, or for a sophisticated investor to invest in a fast-growing Arab public company, management must be provided with the proper incentives to perform and be willing to change the company's corporate culture. This may entail cutting staff, challenging tradition and even opposing deeply embedded religious beliefs. In short, this may entail becoming a "maverick," and there is little room for mavericks in the Arab world, whether in business, politics or law.
As an alternative to raising capital for investments in the public securities of the emerging markets of the Middle East, I recommend Western sponsors put more emphasis on the private markets, raising "direct-investment funds" that put their proceeds in privately-held companies. Several factors suggest this approach:
1. To have better control over the credit situation;
2. To ensure discretion and professionalism during the initial period of change, when the Arab public investor may not know the true effects of a certain action of a company's balance sheet;
3. To institutionalize the business through the setting up of proper financial, accounting and other procedures before going public;
4. To better benefit from the arbitrage opportunity between the private and public markets. Private markets in U.S. manufacturing companies trade at a multiple of 5-6 times earnings versus a 12-14 times earnings for public markets. The arbitrage opportunity between the Arab private and public markets is vast considering the liquidity of the GCC private sector.
3. DEVELOPMENT OF SECURITIES MARKETS
Only seven out of twenty Arab countries have established formal securities markets: Bahrain, Egypt, Jordan, Kuwait, Morocco, Oman and Tunisia. Saudi Arabia, on the other hand, has developed an electronic mechanism for securities trading managed by the Saudi Arabian Monetary Agency (SAMA). Seven other countries-the United Arab Emirates, Qatar, Syria, Lebanon, Sudan, Algeria and Iraq-are in different stages of preparing for the establishment of some form of securities markets.
By early 1994, the number of listed companies in the 12 formally operating Arab stock markets had crossed the 1,000 mark with total capitalization around $50 billion, compared to the region's private sector foreign asset holdings of over $700 billion. 4 Their capitalization is expected to double by the year 2000, according to market experts. Relative to GDP however, the size of Arab equity markets is still way behind compared with the rest of the world. Total capitalization amounted to less than 10 percent of GDP, compared with the 30 percent average reached by developing countries and the 60 percent for developed countries. In absolute terms, GCC companies represent about 85 percent of the total capitalization of Arab securities markets. But now that the peace process in the Levant and North Africa is underway, those economies may outperform the Gulf economies over the next five years.
The Amman Financial Market is today the liveliest and one of the more diverse Arab stock markets. Its shares are widely held by the public; an estimated one in five adult Jordanians is a public shareholder. Trading volume has increased from $10 million in 1978 to over $1.5 billion in 1993, in a market whose total capitalization now stands at $4.5 billion, listing over 100 companies, evenly spread among industrials, real estate and financials. Despite these characteristics, the actual dollar value of foreign funds invested in the Amman Financial Market remains small.5 In early 1994, several Western institutional funds received the go-ahead to invest $200 million in the Amman Financial Market, but market sources say they have bought just under 5 percent of that amount so far.
Home to the Arab world's oldest stock exchanges, Egypt has failed to live up to the potential many saw there in the early 1990s. The government has vacillated over its announced privatization and economic liberalization policies, and its actual market conditions remain discouraging. Yet with over 600 companies listed, and the prospect of hundreds of privatizations coming onto the market, the Cairo and Alexandria exchanges are worth watching.6
The Casablanca Bourse is one of the oldest stock markets in the Arab world, founded in 1929. With a market capitalization of $4 billion in 1994, the Bourse's growth over the past two years, from $1.8 billion in 1992 and $2.6 billion in 1993, has been driven by domestic privatizations and an influx of expatriate Moroccan funds and investments by European and American institutional investors. Although share ownership is growing, it is still far below the per capita levels seen in Jordan. Although the Casablanca Bourse lists only 61 companies, its market capitalization is the second largest in Africa, after South Africa's Johannesburg Stock Exchange; and institutional investors have been arriving there in droves attracted by high returns, market transparency and the growing number of institutional investment vehicles. It is estimated that at least 30 funds now operate in Morocco and are responsible for almost 60 percent of all daily trades. Recent arrivals include Salomon Brothers, which created a $60 million fund in 1993, and Wafabank which created a $50 million fund in 1994. Furthermore, it is estimated that foreign institutional investors have put around $200 million into Moroccan equities over the past 12 months.7
Last but not least, a stock market where developments are worth watching is Beirut. Once the financial heart of the Levant, Beirut is now reemerging as a major regional banking center. The Bourse, closed at the height of the country's civil war is expected to reopen in May 1995. Many other Arab nations have publicly stated that the absence of Lebanese competition allowed them to develop their own financial and investment expertise. Most official Lebanese observers believe Beirut will soon reclaim a significant intermediary role, especially in bringing Western capital to Lebanon and the Levant.8 This prospect has been a key factor driving efforts to link other Arab exchanges in North Africa and the Gulf.
In general, however, the capitalization and trading activity in most Arab markets are not exactly representative of the potential size that these markets may reach in a fairly short period now that financial policy reforms are under way in at least some of them.
Encouraging financial flows into debt instruments, especially through deposit-type short-term instruments, has often led in Arab countries and others to increasingly dangerous levels of financial instability. Greater attention should be paid by Arab policy makers to encouraging the creation of local and regional investment and merchant banking firms in the Arab world at large. Furthermore, policy makers need to consider alternative strategies in their individual countries to reduce the risks of excessive borrowing and the insufficient flow of money into equity investments.9
An efficient regional mechanism for investment in equities will only be built if a clear-cut agenda is in place and that includes a significant amount of regional cooperation. Otherwise there is no way to establish and strengthen domestic securities markets and to improve and standardize issuance regulations and trading procedures as well as investor protection standards.
1 Charles Collyns, "Private Market Financing for Developing Countries," IMF World Economic and Financial Survey, December 1993.
2 Andre Hovaguimian, "The Role of Financial Institutions in Facilitating Investment and Capital Flows," IFC data, 1994.
3 Ahmed Abisourour, "Arab Capital Flows" in Economic Development of the Arab Countries, selected issues, IMF, Washington, DC, 1993.
4 Ahmed Abisourour, "The Emerging Arab Capital Markets: Status, Role and Development Prospects," in EI-Naggar, 1994.
5 International Monetary Fund (IMF), World Bank Economic Data and other World Bank reports.
7 Josh Martin, "Arab Stock Markets," Euromoney, October 1994.
8 Nasser Saidi, "The Renaissance of Beirut's Financial Markets," paper given at Economic Research Forum Workshop on Financial Market Development in Tunis, October 1994.
9 Mohamed El-Erian, "Mideast Financial Markets: Potential for Development and Internationalization," Middle East Executive Reports, June 1994.