III. Main Challenges Facing the GCC Financial Markets

International Monetary Fund
Published Date:
November 1997
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A key challenge facing the financial sector in the GCC countries is to respond to the new demands arising from the strengthening of the role of the private sector and the governments’ gradual disengagement from economic activity. Fiscal retrenchment is likely to continue for the foreseeable future, and the private sector is expected to be the main engine of growth. Under this scenario, large investment projects in the petrochemical industry, in ports, power generation, airline transportation, utilities, and health care will have to be carried out with private sector participation and financing. External borrowing may be an option, as is currently the case for a number of large gas-related projects in Qatar, but there are obvious limitations to this policy, including mainly the reluctance of governments in the region to accumulate external liabilities. Therefore, there will be strong incentives to mobilize resources from the domestic market (including through the issuance of long-term financial and corporate paper) and to encourage foreign direct investment. In any case, domestic financial intermediaries will be under pressure to compete for this large and lucrative business, or run the risk of being marginalized.

It is clear that for GCC financial institutions to play an important role in this changing environment, they would have to strengthen further their deposit base and increase their capital to absorb the risk emanating from financing megaprojects. This, in turn, may lead to mergers among banks or associations with regional or international banks. More important, financial markets would have to gain depth and sophistication both at the national and regional levels to allow for the mobilization of large financing packages at competitive conditions. This can be achieved through concerted efforts to increase the volume and attractiveness of corporate bonds and government paper, encourage equity investment by pension funds and by small savers through mutual funds, and make further headway in reforming stock markets. In all these areas, efforts should focus on establishing a regional financial market in which saving and investment flows can be pulled together under homogenous and market-determined conditions.

Another challenge facing the GCC financial systems is to further open up to foreign participation and competition. While the recent good performance of the region’s banks was largely due to improved overall economic conditions and enhanced efficiency in the provision of financial services, it is clear that the prevalence of quasi-monopolistic situations and insufficient competition from foreign banks had also been an important factor. Opening up the financial sector to foreign investment, be it in banks, in mutual funds, or in investment advisory services, would add depth to the GCC markets, help strengthen management practices and the provision of financial services, foster the transfer of technology and know-how, and through increased competition, help raise productivity and lower the cost of financial services.

A related issue is the need for GCC financial institutions to respond to the demand for new financial services by domestic clients. GCC nationals are increasingly taking a more active interest in innovative financial instruments that can help them manage their savings or provide them with appropriate investment tools. Wealthy individuals and corporations have had access to these services either locally or through international banks; however, in the next few years, strong demand for these services is likely to emanate from a wider segment of the population as evidenced by the public’s enthusiastic response to initial public offerings of shares at GCC stock markets. To a certain degree, the GCC financial intermediaries have been already developing fee-based services, including mutual fund investments, but they would need to strengthen their ability to meet the demands of a larger segment of the population at competitive conditions.

Increased diversification of instruments, of market participants, and intensified competition among financial intermediaries will be beneficial to the region’s economies by enhancing efficiency and lowering the cost of financial services. Diversification, however, will also involve added risks that should be minimized through adequate prudential regulation and bank supervision, supported by more stringent international standards of dissemination of information and transparency.

Finally, financial sector reform can play a key role in meeting the challenge of maintaining macroeconomic stability in a changing economic environment. Reforms aimed at deepening domestic capital markets could provide the authorities with added instruments of monetary management and more room for maneuver in enhancing the effectiveness of monetary policy. Obviously, fiscal policy will continue to be key in maintaining financial stability and preserving the credibility of the exchange rate arrangements. In recent years, fiscal deficits in all GCC countries have been reduced and government spending has been brought under control (Chart 5). Inflation rates have been maintained below those in industrial countries, and exchange rate variability has been virtually nonexistent. While the region’s economies are likely to remain dependent on volatile oil revenue for many years to come, government spending will need to be brought under control, and ongoing privatization and deregulation efforts must be enhanced to help decouple non-oil activity from government stimulus and accelerate economic growth. In this respect, privatization and the development of domestic capital markets are closely interrelated and must be carried out in a coordinated manner.

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