4 Arab Capital Flows: Recent Trends and Policy Implications
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English
Keywords:
BOOK; country; GCC country; Arab country; worker; deficit country; capital-deficit economy; market rumor; capital deficit country; unattractive financial market intermediation; Securities markets; Stock markets; Foreign direct investment; Capital inflows; Global
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Abstract

International financial intermediation since the mid-eighties has made an enormous leap in apparent efficiency going hand in hand with the unprecedented explosion of cross-border capital flows, as new financial instruments have been created and competition among borrowers, lenders, and financial intermediaries has strengthened markedly.

International financial intermediation since the mid-eighties has made an enormous leap in apparent efficiency going hand in hand with the unprecedented explosion of cross-border capital flows, as new financial instruments have been created and competition among borrowers, lenders, and financial intermediaries has strengthened markedly.

This process was facilitated by the equally unprecedented emergence of persistent current account imbalances. From an average of less than $50 billion for most of the century, the sum of the 14 larger industrial countries’ imbalances (surpluses and deficits together) climbed to $100 billion in 1982 and reached $350 billion by 1987. But even though the imbalances stabilized at that level for the rest of the decade, international gross capital flows were double their size. By 1989, foreign exchange trading grew at a much faster rate than did international trade in goods and services: the comparative ratio of daily transactions reached almost 40 to 1 by the end of the decade.

Private capital movements tend to be driven largely by expectations of exchange rate realignments, which in turn are driven by current account developments. Typically, economies in deficit have to confront pressures of private capital outflows, which in turn exacerbate downward exchange rate pressure, whereas surplus countries are usually confronted with sizable ex ante capital inflows that further compound the initial external disequilibrium. Hence, private flows during much of the eighties tended to compound, rather than offset, current account imbalances.

The gradual erosion of controls on international capital flows that started in the seventies resulted in an explosion of capital movements during the eighties. Deregulation, internationalization, and liberalization paved the way for a growing range of innovative financial instruments being traded within and across borders at increasing speed and with dramatically reduced costs. Gross capital inflows to industrial countries were enormous both in nominal and real terms.

In contrast, and unlike the earlier period, in the eighties public sector capital inflows to developing countries remained virtually stagnant, private sector inflows were somewhat weaker, and developing countries were confronted with a massive decline in commercial bank financing.

The failure of the international financial system, with all the sophistication it had acquired, to channel much-needed finance from industrial to developing economies reflects a multitude of shortcomings and imperfections in the system, which cannot be discussed here, given the scope of the subject. Nevertheless, inappropriate macroeconomic policies, extensive controls, and uncertainties in government policies in many developing countries contributed to the creation of a business environment conducive to domestic capital flight and hostile to foreign investment in domestic assets.

Another important consideration that may account for the relative decline in capital inflows to developing economies is that industrial countries’ financial markets tend to act as a powerful magnet to foreign investors who are naturally attracted to a deep and liquid financial environment that offers a diversified array of financial instruments. U.S. assets, for instance, at the end of the decade attracted one-fourth of the rest of the world’s private assets.

Arab countries share most, if not all, of the problems and obstacles faced by the developing world, sometimes with more intensity, sometimes with less. But the Arab region has one clearly distinguishable feature: it comprises both capital-surplus and capital-deficit economies, a feature that presents as many challenges for integration as it offers opportunities for the region’s medium-term development strategy to enhance financial coordination.

This paper discusses these challenges and their policy implications, and then argues that perhaps the most urgent task that lies ahead for both national and regional specialized development institutions is to propose an agenda for capital market development in the region through the remainder of the decade of the 1990s to help establish the necessary infrastructure for intra-Arab financial cooperation and economic growth.

Arab Capital Flows

A brief analysis of recent developments in Arab capital flows,2 against the backdrop of international financial developments, reveals the weakness of Arab financial intermediation and the structural imbalance in the nature of Arab capital flows, as well as their size, composition, direction, and geographic distribution. Four major capital account categories are discussed here: foreign direct investment, portfolio investment, and long-term and short-term capital flows.

Foreign Direct Investment (FDI)

International FDI flows rose almost fourfold during the 1980s, to reach $192 billion by 1989, and although they declined slightly, to $180 billion in 1990, they represent well over 1 percent of the combined GNP of major industrial countries. The reasons for this sharp increase are mainly the desire of particular industries to relocate production abroad because of fear of protectionism, lower labor costs, and/or trends in effective exchange rates.

The underlying structure of international FDI flows during the second half of the 1980s, however, took a drastically different turn from the earlier period. Aggregate inflows into the developing world fell from one-half of the size of flows into developed countries experienced early in the decade to less than one-fifth by 1990. At the same time, the global distribution of flows into developing countries shifted in favor of the dynamic economies of Asia at the expense of indebted countries elsewhere, making their financial adjustment efforts even more painful.

The share of Arab countries in global FDI inflows, as Table 1 shows, remains small and erratic. Balance of payments statistics show an average inflow of over $1 billion yearly for Egypt; about $150 million for Bahrain, the Libyan Arab Jamahiriya, Morocco, and Oman; less than $100 million for Tunisia; and insignificant amounts for the other countries. Saudi Arabia, where FDI inflows amounted to almost $5 billion annually during the early part of the 1980s but declined since then and shifted to a net disinvestment of about $300 million a year in 1988–89, is a striking example.

Although no breakdown is available for the sources of FDI flows into the Arab countries, indications are that a significant part originated from Arab sources, mainly the United Arab Emirates and Kuwait. On outflows (as shown in the appendix tables), Kuwaiti direct investment abroad has progressively increased over the decade, to reach an annual amount of $0.5 billion in 1989. Saudi statistics do not record any of its sizable capital outflows under FDI abroad.

Arab countries may have remained impervious to the rising tide of FDI inflows because of the existence of restrictions in practically all capital surplus countries and, until recently, in most capital deficit countries, on the acquisition of real assets by foreigners and because of a general nationalistic resistance to FDI. In spite of recent steps by some countries to adopt outward-looking investment policies (Egypt, Jordan, Morocco, and Tunisia), administrative bottlenecks and red tape remain.

Table 1.

Direct Investment Inflows

(Millions of U.S. dollars)

Sources: IMF, Balance of Payments Statistics, and Arab Monetary Fund (AMF) calculations.

Also, takeover bids by foreigners of domestic corporate shares have been frowned upon, often with the absence of well-developed equity markets that would allow foreign participation in existing companies. This factor is critical when takeover bids through securities markets have been the major form of FDI in developed countries.

Portfolio Investment

On the international scene, portfolio investment rose markedly during the 1980s mainly owing to the huge expansion in assets of nonbank financial intermediaries (investment trusts, insurance companies, and pension funds) and the radical diversification from domestic to foreign assets. The increase in transactions took place, of course, almost entirely among the developed countries. International bond issues by developing countries, and by international institutions on their behalf, remained broadly unchanged. Moreover, half of developing countries’ issues during the second half of the eighties was accounted for by the seven dynamic Asian economies. Portfolio flows into equities remained weak throughout the period, a direct reflection of the limited development of securities markets in developing countries. As for Arab countries, only Saudi Arabia and Kuwait were active in portfolio investment abroad, whereas investment flows into the Arab region remained insignificant.

Equity Investment. Global international holdings of equities increased tenfold over the 1980s, to reach $10.9 trillion. Although nonresident holdings represent only 7 percent of that amount, the value of their aggregate transactions rose twentyfold during the same period, to $1.5 trillion annually, an even faster increase than that registered by domestic transactions. In volume terms, the increase was fivefold. For developing countries, foreign portfolio flows into equity markets remain limited, a direct reflection of their small level of capitalization which is estimated at only 6 percent of that of markets in developed countries (Table 2).

The status of Arab securities markets is even more drastic. Too small and virtually closed to outside investors, they have no share of the fast-growing market for international equities, as Table 3 shows.

Table 2.

Equities Markets

(Billions of U.S. dollars)

Source: Bank for International Settlements (1991).

On outflows, although balance of payments statistics on portfolio investment of developing countries are incomplete, available data (Table 3) show that Libya is the only Arab country registering significant transactions in corporate equity investment, amounting since 1986 to a net sale of domestically owned foreign assets of about $100 million annually, with an exceptionally high figure of $3 billion in 1987. The structural imbalance of Arab equity investment flows compared with other categories of capital flows is in clear contrast with the recent trend in international equity investment, which traditionally amounts to between one-fifth and one-fourth of the size of gross flows into bonds; the proportion is higher in times of stress and heightened volatility than in relatively quiet periods, because the correlation between returns on different international stock markets increases when the markets’ interaction becomes more intense.

Investment in Bonds. During the 1980s, global international holdings of bonds tripled, to reach $10.6 trillion in 1989, of which nonresident holdings amounted to 12.8 percent. This development explains the general belief that securitization of international capital flows is progressively replacing traditional bank lending. Available figures show, however, that the share of bond financing, which became just as important as bank financing at the onset of the debt crisis, lost ground as the latter rebounded to about three-fourths of international financing by 1989.

Table 3.

Total Portfolio Investment Flows1

(Millions of U.S. dollars)

Sources: International Monetary Fund, Balance of Payments Statistics, and AMF calculations.

Includes net investment in corporate equities, public sector bonds, and other bonds.

A minus sign under outflows indicates a net sale of domestically owned foreign assets; under inflows, it indicates a net sale of foreign-owned domestic assets.

All public sector bonds; equity investment is zero.

All equities.

Another important development is that private capital investment in bonds has increasingly been taking the form of the issue of overseas bonds by domestic enterprises rather than of nonresident purchases of domestically issued bonds. About one-half of bonds outstanding are denominated in U.S. dollars, which offer more liquidity, a wider variety of instruments, and extensive hedging opportunities.

With respect to Arab countries, as clearly shown in Table 3, two countries—Saudi Arabia and Kuwait—have been the largest investors in internationally issued government bonds. Kuwait has been a net seller of domestically owned foreign bonds since 1984, while recording net capital inflows from foreign-owned domestic assets. Saudi Arabia, on the other hand, recorded the highest investment in foreign government bonds of $13.4 billion in 1984, and another $21 billion during 1985–88, before it became a net seller in 1989. Saudi figures are believed also to include some of the loans extended abroad, to be discussed in more detail below.

Intra-Arab bond investment flows are nonexistent except for some past Kuwaiti bond issues. In contrast, foreign penetration of government bond markets in the industrial countries increased from 10 percent in 1983 to an average of 15 percent in 1989. The ratio exceeded one-third for Canada, Germany, and the Netherlands (Table 4).

Table 4.

Bond Markets’ Foreign Penetration Ratios

(In percent)

Source: J.P. Morgan, World Financial Markets (1989).

The increase in foreign penetration ratios of bond markets around the world is explained by two elements: first, is the significant shift of household savings from ordinary bank accounts to institutional investors generated by the rise in demand for insurance and pension schemes; and second, in the wake of liberalization and deregulation, the enormous increase in institutional investors’ funds has led to a massive drive for diversification of their portfolios into foreign assets. Institutional investors in Arab countries are not yet able to play a similar portfolio investment role within the region because of a lack of sufficient financial instruments and proper market mechanisms on the one hand, and because of the existence of legal restrictions on foreign penetration of domestic securities markets on the other.

Long-Term Lending

A clear distinction exists between two groups: the group of Arab donor countries that comprises Algeria, Iraq, Kuwait, Libya, Qatar, Saudi Arabia, and the United Arab Emirates; and the group of recipient countries with capital deficits, including Bahrain, Egypt, Jordan, Lebanon, Mauritania, Morocco, Oman, Somalia, Sudan, Syria, Tunisia, and the Republic of Yemen. Algeria and Iraq have at times also been recipients of Arab aid.

The general pattern of net disbursements of loans and grants by Arab donor countries has been closely correlated with their economic development and with oil price fluctuations. Disbursements of financial aid to developing countries increased from $2.6 billion in 1973 to about $8 billion annually during 1975–77. Disbursements rose again, in line with the major increase in oil revenues, to their highest level of $11 billion annually in 1980–81. Levels of financial assistance by Arab donor countries declined afterwards to reach very low levels in 1988–89, partly because of decreasing accumulated reserves over the years, and partly as a reflection of reflows coming due of payments of principal on loans extended in earlier years.

All in all, Arab donor countries contributed $99.7 billion to developing countries in development and balance of payments financing during 1973–89; this figure excludes military assistance and certain other transactions. Moreover, about 85 percent of Arab financial aid was extended on concessional terms, and as a share of the donors’ GNP represented on average 4.72 percent during most of the 1970s. The ratio declined to 0.84 percent in 1988, but remained more than double that of official development assistance and Development Assistance Committee countries, which fluctuated between 0.30 and 0.38 percent.

Kuwait, Qatar, Saudi Arabia, and the United Arab Emirates provided more than 90 percent of net Arab aid. Saudi Arabia’s share alone was 52 percent during the 1970s, and grew to 70 percent during the 1980s.

On the receiving end, Arab capital deficit countries received about $60 billion or 61 percent of total Arab financial assistance between 1973 and 1989.3

These flows from Arab sources represented 2.1 percent of the GNP of the Arab recipients, comprised nearly 7.1 percent of their cumulative imports, and fluctuated between 10.5 percent and 24.0 percent of their total investments. Looking at individual recipient countries, the highest ratios were recorded by Jordan, the Republic of Yemen, Egypt, the Syrian Arab Republic, Sudan, Mauritania, and Morocco.

Arab aid, by its very concessional nature, has undoubtedly accelerated economic development in the recipient countries beyond what would have been otherwise possible. But some countries were inclined to rely increasingly on foreign borrowing to finance their budget deficits and allowed their imports to grow nearly twice as fast as their exports, which resulted in an increasingly weakened balance of payments position.

Regarding the pattern of drawings and repayments of long-term loans for Arab countries (Table 5), first, it is practically all nonbank borrowing; second, public sector flows mainly reflect drawings and repayments of loans received by Algeria, Egypt, Jordan, Morocco, and most recently Syria and Tunisia; and third, Algeria accounts for more than three-fourths of “other sectors’” long-term capital flows. The remainder is mostly accounted for by Egypt, Morocco, and Tunisia.

Table 5.

Drawings and Repayments of Long-Term Loans by Arab Countries1

(Millions of U.S. dollars)

Sources: IMF, Balance of Payments Statistics and AMF calculations.

A minus sign under outflows indicates drawings on loans extended or repayment of loans received; under inflows it indicates payments of loans extended or drawings on loans received.

Short-Term Capital Flows

International capital account transactions are, wherever possible, classified under direct investment, portfolio investment, or official reserves. Since banks act only as agents (not principals) in virtually all those transactions, balance of payments statistics treat the category of short-term capital of the banking sector as a residual category. Nevertheless, figures compiled show that the total volume of capital transactions through the international banking system rose to huge dimensions during the 1980s. One indicator—foreign exchange transactions conducted by banks—was estimated by the BIS to have reached $650 billion daily in 1989. Most open positions, however, are closed within the same trading day and do not usually give rise to measurable capital flows. But aggregate net short-term bank flows for the major industrial countries averaged almost $80 billion annually during the second half of the 1980s.

The major players in the markets for short-term capital have been, on the one hand, the United States and the United Kingdom with sizable current account deficits, and on the other, the surplus countries, Germany and Japan. The role of the latter has been particularly prominent because Japanese banks are subject to only an overall limit on foreign exchange exposure regardless of maturity. Furthermore, huge rises in the value of Japanese equities during the 1980s contributed to the capital base for much of the expansion in international lending. The dangers attached to this trend would quickly materialize if short-term interest rates rose unexpectedly and/or if equity prices fell substantially. If this happened, the consequences could be destabilizing for the banking sector in the surplus countries, would further enhance the inherent fragility of balance of payments financing in the deficit countries, as well as affect their nonbanking sectors, which financed much of the foreign investment in bonds by short-term borrowing in foreign currencies.

Arab countries have not, generally speaking, been active in the markets for short-term capital. But there are exceptions: almost 90 percent of short-term capital movements of the public sector in Arab countries is explained by the steady sale of foreign assets by the Kuwaiti Government of about $5–6 billion annually since 1984. The remainder relates to transactions by the public sector in Syria, whereas public sectors in other Arab countries did not effect any significant short-term capital transactions during the 1980s (Table 6 and relevant appendix tables). With regard to the banking sector, Saudi Arabia, Kuwait, Bahrain, and Egypt accounted for almost all of the recorded sales of foreign assets and increases in liabilities. As for other sectors’ short-term capital flows shown in Table 6, they are almost exclusively explained by an increase in Saudi Arabian private holdings of foreign assets and movements in the liabilities of Kuwait, Libya, Morocco, and Syria.

Table 6.

Short-Term Capital Transactions of Arab Countries

(Millions of U.S. dollars)

Sources: IMF, Balance of Payments Statistics and AMF calculations.

Conclusions

Perhaps the most important conclusions that can be derived from the analysis of Arab capital flow developments are as follows:

The three revolutions—deregulation, internationalization, and innovation—that the world financial system has been undergoing at the same time have not as yet had any significant positive impact on Arab capital markets. As these remain underdeveloped and generally restrictive, international financial markets will continue to act as a powerful magnet offering 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.

The notion of “reversibility,” which underlies international capital movements among developed countries and the dynamic developing countries, whereby capital withdrawn by certain temporary factors would soon flow back in once the outside attractions waned, does not relate to the Arab economies. With a business environment burdened by administrative restrictions and price distortions, and unattractive financial market intermediation, there is little room for channeling Arab or foreign capital into direct or portfolio investment opportunities in most Arab countries. Arab private capital, which sometimes flows back to the Arab region, is thought to be frequently driven by speculative motives in the financial and real estate markets.

By all accounts, as explained above, the past two decades have shown that Arab donor countries remain the most generous of all donors. Arab recipient countries have also benefited most from Arab official development assistance, bilaterally and multilaterally. By contrast, Arab private capital has not been able to flow as freely within the Arab region. Hence, the most logical proposition would be that the major challenge for the region during the 1990s is the development and integration of Arab financial markets with a clear strategic objective to foster and facilitate the free movement of Arab capital between Arab countries. This challenging task cannot be undertaken without policies conducive to a stable macroeconomic foundation, healthy financial structure, and improved investment environment.

Policy Implications

Policy Objectives

Whatever the development objectives of a country may be, it is essential to aim at achieving and maintaining financial balance. This balance requires that the demand for investment resources by the deficit sectors (which in most countries include the government and the corporate sector) be met by the supply of required resources from the surplus sectors, including primarily the household sector. The transfer of resources may take place either directly or through financial intermediaries. For the developing countries, the external sector may also be a major provider of financial resources in the form of official external assistance and private foreign investment.

Most of the success of economic planning in developing countries relies heavily on the ability to achieve a rapid and balanced growth of investment in both the government sector and the private corporate sector. This in turn would not be possible without an adequate transfer of household savings and foreign capital inflows to these sectors. The transfer can be facilitated only if, on the one hand, a major part of household sector saving is in the form of financial assets whereas, on the other, the inflow of private foreign capital requires the availability of diversified financial instruments and proper financial intermediation. Financial policies should therefore aim at quickening the development of financial institutions and instruments, which suit savers’ and foreign investors’ preferences, until saving in the form of financial assets and the flow of funds through financial institutions dominates the local financial scene.

A number of Arab countries have been and still are undergoing major economic structural adjustment, including the adoption of outward-oriented development policies, far-reaching trade and financial reforms based on “managed” economic liberalization, and attempts at regional policy coordination. Policy objectives include the structuring, or restructuring, of the financial sector, by relaxing the legal and regulatory framework, fostering financial institutions’ development, streamlining the administrative process, and opening up the capital account by reducing exchange rate distortions and restrictions on foreign capital mobility. The resulting free flow of funds, it is hoped, will increase the availability of financial resources, eliminate distortions in their allocation, increase competition, and encourage productivity to achieve higher and sustainable rates of growth.

Leaving aside fundamental differences in the level of economic growth and the development of financial intermediation and financial resource needs, the causes limiting intra-Arab capital and foreign capital inflows seem mainly to be governmental policies that either maintain various obstacles, uncertainties, and restrictions on foreign private investment and/or favor debt instruments over equities and financial intermediation in banking over the securities markets.

The policy challenge is therefore two dimensional: to increase capital inflows and to balance their direction. The solution for financial development and coordination in the region, therefore, requires that market-oriented countries adopt such outward-oriented financial policies by relaxing regulations and reducing restrictions on regional/international capital mobility, and that these countries seek to balance those policies better, and promote the proper institutional framework to ensure that an adequate proportion of financial savings flows into the equities markets.

A stable macroeconomic foundation and policy predictability obviously remain key ingredients in an action plan to promote private investment, spur inflows of foreign capital, and establish a healthy financial structure for economic growth.

Promotion of Capital Flows

Various studies have shown that capital flows take place in developing countries, both legally and by evading controls, with much greater frequency and ease than expected. Routine capital flight and evasion of controls through smuggling and overinvoicing of imports and underinvoicing of exports is common practice, which reflects the ineffectiveness of controls.

This finding has important implications for macroeconomic policy and financial reform: fiscal policy is more effective in directing domestic demand and influencing the trade balance, whereas the use of monetary policy is a better way of influencing the capital account flows. In fact, anticipated exchange rate adjustments can quickly be reflected in capital outflows, which to some degree helps explain the unsatisfactory performance of private investment in some Arab deficit economies.

On the other hand, when governments overspend, the results have often been large deficits, excessive taxation, borrowing and/ or monetary expansion, which ultimately lead to the crowding out of the private sector, higher interest rates, a lower expected real return on investment, and, consequently, reduced capital inflows. These have been quickly followed by higher rates of inflation, overvaluation of the currency, external debt problems, and lower economic growth.

In reappraising their spending priorities and reforming the financial sector, governments may be hard pressed to meet the goals of microeconomic efficiency and macroeconomic stability at the same time. But a coordinated regional policy that aims at fostering intraregional capital flows may prove to be the proper shortcut to reaching these goals with minimum sacrifice in terms of overall economic growth.

Some key prerequisites are necessary for the development of financial policy alternatives. First, Arab countries need to maintain political and economic stability. No rational outside saver can be expected to invest his savings in a given country without having reasonable confidence in the stability and economic health of that country over the long term. Second, government economic and financial policies should help create a healthy business environment that would make savers (domestic and foreign) feel that they can expect a reasonable return on their domestic investment. A fair and predictable fiscal policy would be instrumental in achieving this goal. Third, deficit countries should open up their capital account, eliminate exchange restrictions, and maintain a stable and predictable exchange rate policy. Fourth, a securities market, fairly complete with a range of financial institutions and competent intermediaries as well as a well-structured regulatory framework, needs to be developed. Fifth, it is necessary to establish appropriate accounting standards and financial disclosure rules to improve credibility in the information available from enterprises. Sixth, it is essential to ensure the protection of minority investors and promote a more balanced financial system, where the channeling of savings into equities is equal vis-à-vis the activity of banking and other institutions in the business of promoting savings of the deposit type from the public.

Seventh, the attitude toward foreign investment needs to be improved. In fact, most Arab countries had foreign investment laws that historically resulted from a fear of foreign domination and a desire to protect domestic entrepreneurs. Unfortunately, the discrimination affected both direct and portfolio investment by foreigners, even though portfolio investment is a minority investment and is aimed at an attractive economic return rather than at control.

An increasing number of Arab countries have become aware of the significant role that foreign portfolio investment can play in developing of local capital markets, either directly or through mutual funds. It not only adds to the demand for stocks, but also introduces a new group of sophisticated investors to the market who may be more inclined than local investors to require securities analysis, thereby indirectly increasing the level of the market’s sophistication.

Moreover, a step-by-step policy process, similar to that followed in parts of the developing world with assistance from the International Finance Corporation, could be adopted to help develop intra-Arab capital flows. Initially, attempts should be made to establish country funds that invest in a large number of companies in a specific country or group of countries. This seems to be a logical first step, as the task of selecting companies in which investments are made is left to the professional fund managers, whereas investors themselves do not need to be concerned about the detailed knowledge of the various companies in each country. Regional or multicountry funds could also prove instrumental in encouraging intra-Arab capital flows.

If a country is still hesitant to allow certain types of direct investment, it can use several methods to promote portfolio investment while maintaining control of the nature and size of foreign participation through:

  • a ceiling on foreign shareholdings in certain strategic industries;

  • a requirement for a minimum period of investment before proceeds (including capital gains) can be remitted; this could only be useful when the country is facing highly speculative foreign capital inflows, otherwise it would discourage outside investors;

  • limiting foreign investment through mutual funds controlled by local authorities. This is currently being adopted by some capital surplus countries of the Gulf Corporation Council (GCC), but it should be considered only as a first step in the financial development process;

  • separating the “economic” (dividends and capital gains) and “voting” aspects of ownership through a trustee arrangement whereby the trustee exercises voting rights.

Another step (promoted by IFC) that could be adopted in the region is to assist individual companies in the capital deficit countries in particular in issuing securities regionally/internationally. Initial securities issues should generally be undertaken by large companies with significant project-related funding needs and able to issue a sufficient volume of securities to ensure some liquidity for investors in the financial markets.

This two-step process may further encourage institutional investors in the Arab region, such as pension funds and insurance companies, to widen their involvement across the Arab world and to diversify their assets further, and in so doing to increase capital mobility in the Arab region.

Development of Securities Markets

In a number of Arab countries, namely, those with a colonial past, stock markets developed many years ago; for example, the Alexandria and Cairo stock markets are nearly a century old. However, many of these securities markets have been forced by historical shifts in development strategy goals to be dormant until recently. During the past few years, other new securities markets were also established; some emerged more or less spontaneously (sometimes with disastrous consequences as in souk Al Manakh in Kuwait), while in most cases promotional efforts by government authorities induced the creation of stock exchanges and promoted active trading in securities (Bahrain, Jordan, and Oman).

Only 7 out of 20 Arab countries have established formal securities markets: Bahrain, Egypt, Jordan, Kuwait, Morocco, Oman, and Tunisia. Saudi Arabia has developed an electronic mechanism for securities trading managed by the Saudi Arabian Monetary Agency. Six other countries, the United Arab Emirates, Qatar, Syria, Sudan, Algeria, and Iraq are in different stages of preparing for the establishment of more formal securities markets in some form or another.

By the end of the 1980s, the number of listed companies in formally operating Arab securities markets had reached 1,063, with total capitalization equivalent to $40.2 billion including about $10 billion for Kuwaiti companies before the market closure in August 1990. Relative to GDP, the size of Arab equity markets is way behind compared with the rest of the world. Total capitalization amounted to less than 10 percent of GDP in 1990, compared with the 30 percent average reached by developing countries and the 60 percent for developed countries. Furthermore, a great discrepancy exists between Arab securities markets themselves, with the capitalization to GDP ratio reaching 48 percent in Jordan and 43 percent in Kuwait (before August 1990) whereas the ratios in Egypt and Morocco do not exceed 7 percent and 3 percent of their respective GDPs.

In absolute terms, Saudi Arabia has the largest market, with a total capitalization equivalent to $15 billion for 78 listed companies. Next is the United Arab Emirates’ informal market, with a $7 billion capitalization and 22 companies, representing an average capital of $320 million per company. In contrast, the Egyptian market has 627 listed companies with a total capitalization of $2.5 billion, which amounts to an average capital of no more than $4 million per company.

Currently, GCC companies represent about 85 percent of the total capitalization of Arab securities markets. The ratio may become better balanced if and when the proposed privatization programs in the capital deficit countries (such as Egypt, Morocco, and Tunisia) are implemented.

As far as trading volume is concerned, the Saudi Arabian market recorded the highest figure among Arab markets in 1991, with 29 million shares for a total value of $2.2 billion. The Amman financial market, on the other hand, traded 162 million shares for a total value of $445 million. In general, however, 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 time now that comprehensive macroeconomic adjustment is being implemented and financial policy reforms are under way more or less successfully in at least some of them. Moreover, the fluctuating prices of securities worldwide have prompted Arab investors to be more discriminating. This healthy attitude will progressively prompt the development of more sophisticated domestic markets with more transparency in trading practices, reliance upon timely disclosure of accurate corporate information, improved analytical capabilities of market intermediaries, and more efficient clearing and settlement arrangements in the market system.

Several basic prerequisites exist for the establishment and continued success of a stock exchange. As mentioned earlier, a stable political environment conducive to economic growth and an economic development strategy in which private enterprise plays a significant role as well as a favorable government attitude and policy environment are all necessary ingredients without which a healthy financial market may not take root, and the country may be confronted with pressures from domestic capital flight, while foreign capital would be even harder to obtain. Governments should therefore foster the role of securities commissions and ensure that appropriate institutional, fiscal, and monetary policies are devised and implemented to pave the way for capital market development.

Specifically, such an agenda should spell out the tasks and priorities and set an objective time frame for enhancing the status of local securities markets, reviewing present legal and regulatory frameworks in the various countries, improving the fiscal environment for both securities investors and issuers, streamlining the administrative process of existing financial institutions, and especially promoting the regionalization, if not internationalization, of securities markets, all within the context of growth-oriented policies needed to encourage and maintain capital inflows. Another essential ingredient for the development of Arab securities markets and the promotion of capital inflows is the protection of outside investors and small investors in general by establishing high standards for professional conduct by brokers and underwriters and by avoiding excessive speculation caused by market rumors and overly easy availability of margin loans. Such protection can be exercised by a securities commission or by another type of government body, usually the stock exchange itself, or through self-regulation by an association of stockbrokers and underwriters.

The policy measures should include development of:

Professional Standards for Brokers and Underwriters. These standards can be established by legislation or through self-regulation by brokers’ and underwriters’ associations. Regulations should include minimum capital for the incorporation of brokers and should also ensure that brokers and securities analysts are qualified to deal with the public or to analyze corporate statements.

Enforcement of Generally Accepted Accounting and Auditing Standards. These are to ensure the accuracy of financial information and to make it comparable from company to company. A strong auditing profession should be developed that is adequately remunerated and plays an independent role.

Disclosure and Financial Reporting Requirements. These should include a prospectus at the time of a new issue, but also regular publication of financial information thereafter through annual reports, quarterly earnings reports to the stock market, etc. Outside investors and their intermediaries need to be able to make an informed judgment about the operations of a company, its profitability, financial health, growth, and prospects.

Listing Requirements. These may include minimum capital, minimum number of shareholders, minimum “float,” minimum history of profitability, and free transfer of shares, to ensure a company’s health before it can be listed for trading.

Trading Floor Procedures. Fraud by trading floor personnel and collusion between brokers to effect purchases for their own account before purchases are made for clients are common problems in the absence of regulations. All Arab operating stock exchanges set daily limits on price changes in order to control speculation in the short run.

Margin Loans. Without some general guidance, brokers (essentially banks in most Arab countries) tend to overextend margin loans to customers, thereby fueling speculation and endangering their own financial health. Desirable limitations include specific margin limits, margin calls, margin loan contracts between brokers and clients, and stringent collateral arrangements.

Insider Trading. Legislation in this area is usually difficult to enforce and should be formalized progressively while control is exercised informally during early development of the securities market. Insiders may be asked to disclose their sales and purchases of a company’s stock periodically.

While each of the above measures may be introduced in distinct stages, a balance in timing should be maintained, as an approach that is too gradual could lead to uncertainty and confusion in the market.

Promotion of Financial Balance: Equity Versus Debt

The main purpose of this paper is to make a case for greater attention to be paid by Arab policymakers to encouraging an increased intraregional flow of savings (especially private sector savings) into equities, both directly through the securities markets and indirectly through mutual funds, pension funds, and venture capital companies that invest principally in equities. The reason for making this point is that emphasis on encouraging financial flows into debt instruments through the banking system, and especially deposit-type short-term instruments, has often led in Arab countries, as elsewhere, to increasingly dangerous levels of financial instability.

In most Arab deficit economies, government intervention in the financial markets in the form of tax policies and banking support (for the latter also in the GCC surplus economies), tended to accelerate the trend away from equity toward debt, and thus contributed to the deterioration in corporate debt/equity ratios, thereby endangering the health of the financial system. In fact, significant differences occur in the tax treatment of equities on the one hand and bank deposits and other debt instruments on the other, which bias financial flows in favor of the latter. In some cases (Morocco and Tunisia) interest paid on bank deposits, government bonds, and other types of debt instruments, is free of income tax, whereas dividends on corporate shares are subject to tax. This different tax treatment, coupled with the treatment of corporate interest expense as a tax-deductible item and the double taxation of corporate dividends, provides banking institutions in these countries with a double advantage vis-à-vis the equity markets and disrupts the balance of savings and the allocation of foreign capital flows within the financial system.

Policymakers therefore need to consider alternative strategies in their individual countries to reduce the risks attached to policies leading to excessive borrowing and insufficient financial flows toward equity investments. The situation naturally differs from country to country as the degree to which savers, both domestic and foreign, are prepared to commit their resources to equity investments in a given country is a function of all of the historic circumstances and the accumulated measures that have brought the specific country to its present position.

Even for indebted countries, there are two major opportunities: the first relates to the benefits that may be derived from securitizing debt and the accompanying debt-to-equity conversion schemes; the second could only be reached, given a suitable policy environment, by joining the global equity market at a time when portfolio investment managers around the world are seeking greater geographic diversification, including investments in developing countries’ securities markets. A prudent securitization of debt into bond and equity issues amounts to treating it as an opportunity, rather than simply as a problem. In this sense, the conversion of nonper-forming loans into equity in otherwise viable companies would not only alleviate the debt problem, but would also contribute to the debtor countries’ efforts to achieve faster capital market development, encourage foreign portfolio investment, and realize a more balanced financial standing with more equity participation and less country debt exposure.

Finally, the building of an efficient regional mechanism for investment in equities will only happen if a clear-cut agenda is in place, and a significant amount of regional cooperation takes effect in working together to establish and strengthen domestic securities markets and to improve and standardize issuance regulations and trading procedures as well as investor protection standards.

The Role of Specialized Regional and International Organizations

Organizations such as the AMF, the IMF, the IFC, and the World Bank have different basic objectives and provide different services in various areas, including policy advice on developing financial systems for their member countries and technical assistance to implement specific measures of a financial development program. Their roles are to serve as catalysts in helping to focus government objectives and activities on the more important issues, for instance, financial system development.

Leaving aside the differences in the present basic strategies of the various international, regional, and national agencies, developing a more formalized system of cooperation among them in this sensitive area—so that a given country might receive the best advice and assistance available—would result in more effective utilization of available resources. Enhanced cooperation would also help to ensure that the recipient countries in the region are aware what types of assistance are available, which type might best suit their needs, and guarantee that the institutions directly involved in a specific country receive the full support from others not directly involved, but with the specific expertise that might be required. Each country in the region may be viewed as unique in its institutional details, which means that the techniques of financial market development have to be tailored accordingly.

To determine a logical program for contributing to financial development in each of its member countries, and to develop the necessary linkages to promote intra-Arab capital flows, the AMF began first by conducting domestic financial sector surveys to ascertain the current status, to identify prevailing problems, bottlenecks, and inconsistencies, and to define the prospects for future development. The surveys include specific recommendations for restructuring the legal and regulatory frameworks and suggest possible areas where performance may be improved by introducing new techniques and services and strengthening existing components.

Second, a process of fundamental data gathering is being initiated through the establishment of an Arab Markets Data Base (AMDB) with the cooperation of IFC and in conformity with its own Emerging Markets Data Base (EMDB). This would help to launch methodological analysis and make possible reasonable country comparisons, so that the maximum use can be made of countries’ earlier experience where similar problems arose or similar conditions were faced.

Third, the AMF aims to engage in further consultation with each willing member country to help develop an action program tailored to its specific needs and covering specific steps to be taken over a defined period to achieve the objectives as defined by survey findings and as indicated by future AMDB analysis.

The implementation stage in itself may include such matters as reform of the overall legislative structure as it pertains to capital market functioning, the establishment of relevant regulatory institutions to ensure healthy growth, and the implementation of effective fiscal and monetary policies as they relate to dividends from financial instruments and corporate profits. These policies have special significance for the pattern of financing flows, both domestic and foreign.

Fourth, the broad area of appropriate financial institutions, their proper mix of services, and the types of financial instruments issued by public and private sectors in which they would deal would have to be developed.

Finally, the business environment should be improved, appropriate standards of accounting practice and ethics developed, and standards of financial disclosure developed, all of fundamental importance to provide both reasonable information, protection, and the right signals to investors (national and foreign) as well as accurate information to policymakers concerned with financial planning and development. Obviously, the provision of training for individuals concerned with all these matters would also be an important part of future technical assistance activity.

This brief description of the steps taken so far to help define the major components of an action program to be jointly elaborated with the countries concerned barely touches on the complexities of the problem, especially for those countries that have to undo most of their restrictive regulatory apparatus, that has essentially evolved from a system of centralized planning with little room for private enterprise. It is also essential to emphasize that any action program can only endure for a limited period. Continuous updating and review is required to adjust both the ultimate objectives and the program details to the changing patterns of the financial environment, and, consequently, the various technical assistance activities deployed in its implementation.

Moreover, priority must be given to consolidating macroeconomic stabilization during the design of an action program for financial adjustment. Sustainable policies may prove to be better at promoting financial market development and at encouraging foreign capital inflows than are premature and inconsistent attempts at liberalization and deregulation, or establishment of a stock exchange, which may need to be reversed because solid macroeconomic and financial foundations are lacking.

Bibliography

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APPENDIX

Table A1.

Direct Investment

(Millions of U.S. dollars)

Sources: IMF, Balance of Payments Statistics, and AMF calculations.

Except Iraq, Lebanon, Qatar, and the United Arab Emirates, for which detailed balance of payments data are not available.

Table A2.

Portfolio Investment in Public Sector Bonds

(Millions of U.S. dollars)

Sources: IMF, Balance of Payments Statistics, and AMF calculations.

Except Iraq, Lebanon, Qatar, and the United Arab Emirates, for which detailed balance of payments data are not available.

Table A3.

Portfolio Investment in Other Bonds

(Millions of U.S. dollars)

Sources: IMF, Balance of Payments Statistics, and AMF calculations.

Except Iraq, Lebanon, Qatar, and the United Arab Emirates, for which detailed balance of payments data are not available.

Table A4.

Investment in Corporate Equities

(Millions of U.S. dollars)

Sources: IMF, Balance of Payments Statistics, and AMF calculations.

Except Iraq, Lebanon, Qatar, and the United Arab Emirates, for which detailed balance of payments data are not available.

Table A5.

Public Sector (Long-Term)

(Millions of U.S. dollars)

Sources: IMF, Balance of Payments Statistics, and AMF calculations.

Except Iraq, Lebanon, Qatar, and the United Arab Emirates, for which detailed balance of payments data are not available.

Table A6.

Long-Term Bank Lending

(Millions of U.S. dollars)

Sources: IMF, Balance of Payments Statistics.

Except Iraq, Lebanon, Qatar, and the United Arab Emirates, for which detailed balance of payments data are not available.

Table A7.

Other Sectors’ Long-Term Capital

(Millions of U.S. dollars)

Sources: IMF, Balance of Payments Statistics, and AMF calculations.

Except Iraq, Lebanon, Qatar, and the United Arab Emirates, for which detailed balance of payments data are not available.

Table A8.

Public Sector (Short-Term)

(Millions of U.S. dollars)

Sources: IMF, Balance of Payments Statistics, and AMF calculations.

Except Iraq, Lebanon, Qatar, and the United Arab Emirates, for which detailed balance of payments data are not available.