2 The Role of Financial Institutions in Facilitating Investment and Capital Flows
Author: Mr. Saíd El-Naggar1
  • 1 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund
Language:
English
Keywords:
BOOK; liberalization; developing country; investment; FDI flow; portfolio equity investment; venture capital; bond issue; investment regime; Commercial banks
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Abstract

This paper examines the flow of foreign capital into Arab countries, the nature and pattern of these flows in the last two decades, and the role played by financial institutions in promoting capital flows. The main aim of the discussion is to highlight the significance of foreign investment in the economic development of the Arab region and the crucial role that can be played by well-developed financial markets in mobilizing long-term foreign capital for economic growth. Two major sources of long-term capital are emphasized in the analysis: foreign direct investment (FDI) and portfolio investment. These two sources of private capital are rapidly replacing the more traditional sources of financing to developing countries, such as official grants and loans as well as commercial bank borrowing.

Introduction

This paper examines the flow of foreign capital into Arab countries, the nature and pattern of these flows in the last two decades, and the role played by financial institutions in promoting capital flows. The main aim of the discussion is to highlight the significance of foreign investment in the economic development of the Arab region and the crucial role that can be played by well-developed financial markets in mobilizing long-term foreign capital for economic growth. Two major sources of long-term capital are emphasized in the analysis: foreign direct investment (FDI) and portfolio investment. These two sources of private capital are rapidly replacing the more traditional sources of financing to developing countries, such as official grants and loans as well as commercial bank borrowing.

FDI (excluding oil) and portfolio investment flows to the Arab region are among the lowest in the world, however, as both sources of financing remain constrained by restrictive investment regimes and the absence of well-developed institutional arrangements—the intermediaries, instruments, and markets—that channel these funds for investment. If the Arab countries are to succeed in improving resource mobilization, recent efforts to liberalize the financial system must be accompanied by policy reforms and institution-building efforts to introduce proper financial intermediation and new financial instruments. The role played by the International Finance Corporation (IFC) in assisting Arab countries to mobilize foreign capital flows is also discussed.

The Changing Nature of Capital Flows

The structure of financial flows to developing countries has changed several times. After World War II, official flows (mainly concessional) were the main source of capital. The largest portion was bilateral aid, but some of it was channeled through the new multilateral agencies such as the World Bank and the International Development Association (IDA). Along with private direct investment and supplier credits, official finance provided the bulk of capital to developing countries until the late 1960s, when commercial banks started to play a prominent role.

Following the first oil shocks of 1973—74, international commercial bank lending rose dramatically as large OPEC surpluses placed in bank deposits were deployed to finance the growing current account deficits of developing countries. Many well-established Arab banks became involved in international lending, some linking up with foreign partners to form consortium banks. Further impetus came from wholly owned Arab banks set up in Bahrain, Dubai, Kuwait, and abroad. Arab countries were the main recipients of Arab bank lending until 1979-80, but others then took an increasing share. FDI declined as considerable commercial bank credit was available. However, the debt crisis caused an abrupt slowdown in commercial bank lending (including lending by Arab banks). To avoid the threat of default, official creditors and commercial banks maintained their flow of lending, and borrowers changed their policies (i.e., reduced their budget and current account deficits) to improve their debt-servicing capacity. Although big defaults were avoided temporarily, debts grew far larger and the threat of default still persisted. A series of debt reschedulings followed but did not resolve earlier problems of debt servicing. Eventually it was decided to reduce the debt burden of borrowing countries in the context of strong, effective adjustment programs.

Developing countries, which had earlier borrowed to postpone adjustment, now began to receive official assistance to undertake, maintain, and extend their adjustment programs. As official financing became increasingly tied to balance of payments financing, and commercial banks began to reduce their exposure in developing countries, many countries had to look to alternative forms of external capital to finance investment in the absence of higher domestic savings. These had been systematically eroded to finance growing debt-service payments in the 1980s. Foreign direct investment and portfolio investment have since been growing in importance, particularly as they are risk-sharing, non-debt-creating flows of capital.

Foreign Direct Investment

FDI is the biggest single component of the renewed flow of capital to developing countries. According to recent World Bank statistics (see Table 1), FDI to developing countries has more than tripled from $11 billion in 1986 to nearly $37 billion in 1992, with the share of FDI in total net resource flows having risen from 16 percent to 27 percent.1 FDI to developing countries has grown rapidly in response to economic reforms that have encouraged private sector growth and made a significant contribution to industrial development and export diversification via transfer of technology and management.

Table 1.

Foreign Direct Investment in Developing Countries1

(Millions of U.S. dollars)

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Sources: International Monetary Fund, International Financial Statistics, November 1993; World Bank, Financial Flows to Developing Countries, July 1993.

Figures in parentheses are negative.

Projected.

Including oil inflows.

During 1987-91, East Asia and Latin America accounted for almost two thirds of the FDI flows to developing countries, whereas FDI flows to the Arab world (excluding the investment by foreign oil companies) were much smaller. Net FDI flows to the Arab region in the same period were nominal and erratic. FDI flows to the Arab region between 1987 and 1992 averaged less than $1 billion annually (owing to higher outflows in some countries like Saudi Arabia, Libya, and Kuwait). There was also a disparity in inflows to individual countries, reflecting the differences in the investment climate of those countries. As indicated in Table 2, Egypt attracted high average annual inflows of about $1 billion until 1989, though these have since declined. FDI flows rose steadily in Morocco and Tunisia between 1989 and 1992; in 1992, FDI flows to both countries were almost twice their level in 1989. Saudi Arabia had FDI inflows of $5 billion annually during the early part of the 1980s, but this share declined to a net disinvestment of $1.2 billion in 1987, before gradually climbing back to $1.9 billion in 1990.

Table 2.

Foreign Direct Investment1

(Millions of U.S. dollars)

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Source: International Monetary Fund, International Financial Statistics, November 1993.

Figures in parentheses are negative.

Projected.

Excluding Saudi Arabia and Libya.

Appropriate macroeconomic policies have played a vital role in attracting FDI; that is, the existence of a favorable, stable, and predictable investment climate.2 The same economic reforms that have attracted renewed FDI flows in other developing countries—privatization, macroeconomic stability, liberal trade regimes, and private sector growth—have not always been present in Arab countries. Morocco and Tunisia successfully adopted a cautious and comprehensive approach of structural adjustment to stabilize their economies and liberalize their trade and investment regimes, which has resulted in increased investor confidence in their economies. The oil sector drew large FDI flows to Algeria in the 1970s, but increasing political instability and growing macroeconomic imbalances in the 1980s following the oil price collapse led to virtual stagnation in FDI flows. Egypt started attracting large FDI flows from 1975, the beginning of its open-door policy, until the first half of the 1980s. Difficult balance of payments and foreign debt problems, however, created foreign exchange shortages and restricted transfer of dividends abroad, resulting in declining FDI flows in the latter half of the 1980s. The oil-exporting countries (Saudi Arabia, Kuwait, and Bahrain) have supported foreign investment and export growth in the oil sector and have attracted large FDI inflows. However, all three countries have progressively increased FDI abroad, resulting in negative net FDI inflows in some years. The Gulf War of 1991 has affected recent FDI flows to the region, but countries that have pursued favorable and open economic policies have nevertheless succeeded in attracting larger FDI flows.

Portfolio Investment

Portfolio investment flows (including country funds investing in equity, investments via global or American depository receipts (GDRs and ADRs), and direct investment by external persons and entities in developing country stocks and bonds)3 to developing countries remained weak throughout much of the 1980s owing to the restrictive investment climate and inadequate development of securities markets in these countries. According to available data, there was a dramatic rise in portfolio investment in developing countries between 1989 and 1992 due to increased bond and equity issues by developing country entities in international capital markets.4 According to World Bank estimates, gross portfolio investment flow increased from $7.6 billion in 1989 to $20.8 billion at the end of 1991. Latin America, followed by Asia, accounted for the largest increase in resources raised in international capital markets. As for the Arab countries, their share in the gross portfolio investment in developing countries during 1989-92 remained negligible.

Equity Investment. Almost half the portfolio investment in developing countries is in the form of equity investments in the shares of companies. Equity flows, however, were limited in volume until 1989 and rose substantially thereafter. According to World Bank estimates, gross portfolio equity flows to developing countries rose from $3.5 billion in 1989 to $8 billion in 1992 (See Table 3). Latin America attracted over two thirds of the cumulative amount of portfolio equity investment in emerging markets, while almost all the remaining investment was absorbed by Asia.5 Arab countries, with their undercapitalized markets that are virtually closed to foreign investors, failed to secure a share of the growing market for portfolio equity.

Table 3.

Foreign Portfolio Investment in Developing Countries1

(Millions of U.S. dollars)

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Source: World Bank, World Debt Tables, 1992–93.

Figures in parentheses are negative.

Projected.

Global country funds that invest across emerging markets.

Equity investments in developing countries during the period 1989–92 were channeled largely through country funds. As of June 30, 1992, there were 234 closed-end investment funds with net assets of $22 billion, a threefold increase over its level three years earlier.6 Country funds are managed by professional fund managers and provide investors with an opportunity to invest in a diversified portfolio of securities across several industries, thereby avoiding the risk associated with direct investment in specific corporations. They provide institutional investors with an opportunity to enter newly emerging markets where poor corporate disclosure practices and domestic laws make it difficult or costly to invest in alternatives.7 A number of East Asian (Korea, Malaysia, and Thailand) and Latin American countries (Chile, Mexico, and Brazil) have raised resources via country funds en route to opening their markets to direct equity investment. Their success in mobilizing equity resources, coupled with the knowledge that portfolio equity investment is tied to economic return rather than ownership objectives, has encouraged many Arab countries to open their markets to portfolio equity investment through country and regional funds. The role of country funds in promoting capital inflows to Arab countries is discussed in the concluding section of the paper.

In addition to country funds, developing countries are raising capital through derivative instruments such as ADRs and GDRs, and through direct portfolio investment. So far, ADRs and GDRs have been used mostly by private entities in Latin American and Asian countries in an attempt to raise capital in international financial markets—these instruments have not yet penetrated the nascent capital markets of the Arab countries. Direct portfolio investment in the equity of companies is still small and confined to a few developing countries (not including the Arab countries) that have opened up their capital account.

Investment in Bonds. Following the debt crisis, developing countries were unable to raise financing through the international bond market. Bonds that were issued in the 1980s were primarily the result of debt conversions negotiated between borrowing countries and their commercial bank creditors to restructure existing debt.8 It was not until 1989 that developing countries were again able to access the international bond market. According to the World Bank’s estimates, developing countries nearly doubled the amount of external resources raised in the international bond market between 1990 and 1991 from $6.7 billion to $10.7 billion, mainly through issues of floating rate notes, convertible bonds, non-U.S. dollar foreign currency denominated bonds, certificates of deposit and commercial paper.9 This trend is reflective of the preference by private entities in developing countries to issue overseas bonds rather than organize nonresident purchases of domestically issued bonds, as the former offer greater liquidity, more variety, and greater hedging opportunities.10

Several Latin American countries, followed by Asian and Eastern European countries, have been active in the international bond market. Corporate entities in Arab countries have not yet explored the international bond market to raise capital due to legal restrictions on issue of overseas bonds by domestic enterprises. The surplus economies of Saudi Arabia and Kuwait have been investors in foreign bond markets. Saudi Arabia recorded the highest investment in foreign government bonds of $13.4 billion in 1984, followed by $21 billion investment in the next three years, before becoming a net seller in 1989. In contrast, intra-Arab bond investment flows have been insignificant primarily due to the dearth of proper financial intermediation and financial instruments, which has constrained capital-surplus Arab countries from playing a bigger portfolio role within the region.11

The Role of Financial Institutions

The institutional arrangements relevant for developing countries can be divided into two parts. In the first place, the official sector contains direct channels for capital flows, e.g, bilateral aid; and a number of intermediaries, such as the World Bank and other multilateral development banks. Second, the private sector also has direct mechanisms—direct foreign investment—as well as intermediaries, such as commercial banks, specialized credit institutions, and money and capital markets. Because intermediaries have become increasingly important in channeling finance to developing countries, the range of financial instruments has also grown. The economies of scale achieved by a range of financial intermediaries yield efficiencies that reduce costs and risks for borrowers and savers. The resulting improvement in financial efficiency implies increased flows to developing countries at lower costs.

The following paragraphs describe the institutional arrangements for channeling private capital flows and the growing importance of capital markets as a conduit for international equity investment and a source of long-term finance to maintain the solvency of the financial system in developing countries.

Banks

Commercial banks traditionally provide short-term and working-capital finance against short-term deposits. When developing countries sought the interventionist approach to promote financial development, they created new state-owned financial institutions or directed commercial banks to provide subsidized long-term credit to state enterprises and priority sectors in the economy. However, this led to unsatisfactory lending practices, excessive risk concentration, and mismatching assets and liabilities in terms of interest rates and maturities, resulting in a growing portfolio of bad debts and bank insolvency.

Bank failures have important macroeconomic consequences, disrupt the payment system, and lead to disintermediation (which decreases the mobilization of resources and the availability of finance for investment). To prevent such failure, many countries have implemented reforms to strengthen the banking system through improved prudential regulation and supervision. These include licensing to ensure adequate capitalization and sound management; capital adequacy stipulations to ensure that banks have enough capital to cover both assets and items not listed on the balance sheet; asset classification and provisioning for potential losses or problem assets; exposure limits on lending to prevent the concentration of risk in a single borrower, a group of related borrowers, or a particular industry; minimum audit standards to enable proper financial disclosures; and bank restructuring, which allows supervisors to plan effectively for recapitalization and transfer of ownership or to dispose of insolvent banks quickly. To be effective, prudential regulations must be backed by political commitment to supervision and enforcement. To promote a safer, more stable banking system, several Arab countries are strengthening prudential regulations and supervision (Egypt, Morocco, Jordan, Oman, Qatar, and Tunisia). Strict guidelines for portfolio concentration, loan classification, provisioning for potential loan losses and requirements for capital adequacy are expected to rationalize the activities of the banking sector (Tunisia, Morocco, Egypt, Jordan, Oman, Saudi Arabia, and Kuwait).

Financial sector reforms also include measures to make banks more competitive and efficient because they hold a major portion of the assets of all financial intermediaries in most developing countries and will continue to remain an integral part of their financial markets in the near future. In many Arab countries, financial markets are dominated by large commercial banks that face growing financial difficulties. Therefore, banks are increasingly being allowed greater freedom to respond to market signals, to choose their own customers, and to set interest rates. Competition will also permit failed banks to go out of business, be privatized, or be merged with sounder institutions and open the way for foreign banks to establish branches or start joint ventures with local banks.

Nonbank Financial Institutions

Development Finance Institutions (DFIs). The most common type of nonbank intermediary in developing countries is the DFI. Most are public or quasi-public institutions that are primarily funded by the government or from official foreign assistance. They were originally intended to address the scarcity of risk capital for small- and medium-sized enterprises in developing countries that was not supplied by commercial banks. During the 1970s that mandate was broadened to include the promotion of priority sectors.12 DFIs extended subsidized credit to activities considered too risky or unprofitable by other lenders. They constituted an important intermediary for development financing and were actively encouraged and supported by bilateral and multilateral creditors. Consequently, almost all developing countries, Arab as well as others (see Table 4), had at least one DFI, and many had a special DFI for each priority sector.

Table 4.

Institutional Framework in Arab Countries

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State development banks.

Six specialized credit institutions and five nonbank Fls.

In practice, many DFIs found it difficult to finance projects with high economic but low financial rates of return and remain financially viable at the same time.13 The use of inappropriate lending criteria resulted in a marked deterioration in portfolio quality and the financial performance of DFIs; many of them are insolvent and need to be restructured. Many DFIs have continued to depend on governments and foreign official creditors for funding because weak performance left them unable to pay market rates of interest for long-term resources. Moreover, term structure of interest rates often did not permit the higher rates necessary to mobilize longer-term resources, and markets for longer-term domestic instruments were poorly developed. Also, in many instances, the foreign exchange risk associated with foreign resources was passed on to clients catering to the domestic market who were unable to bear the risk or hedge it; sharp currency devaluations thus badly affected both the clients of DFIs and, in turn, the institutions themselves.14

The difficulties experienced by DFIs in other developing countries were also present in Arab countries. The ability to borrow cheaply encouraged less productive investment. Many directed credits financed high-risk investments that could not be repaid. Consequently, the distorted allocation of resources and the erosion of financial discipline have left intermediaries, especially DFIs, unprofitable or insolvent. The growing insolvency of DFIs is being addressed through financial sector reforms. Morocco and Tunisia have removed interest subsidies to DFIs and have almost phased out credit allocation to increase the efficiency of financial intermediation through competition. Several countries have chosen to strengthen or restructure existing DFIs in the same ways outlined for commercial banks. DFIs have also been encouraged to diversify their risks by expanding their range of services. However, in the absence of adequately developed financial markets, DFIs continue to depend on foreign sources of term financing.

Leasing Companies. Leasing is closely associated with productive sectors, and with small and medium-sized enterprises, in particular. By providing such entities with an alternative source of equipment finance, the leasing industry facilitates growth in investment and capital formation. Moreover, because leasing companies have to compete for resources and clients with other institutions, usually without benefiting from access to subsidized credit, they are generally more efficient in mobilizing and allocating capital as compared, for instance, to DFIs.

The segmented nature of financial markets in most developing countries generally ensures that there is a market for leasing. This is often overlooked by operators accustomed to highly developed financial markets, where fiscal factors are often crucial to the success of leasing. In emerging countries, banks tend to be inefficient, and the resulting high intermediation spreads provide opportunities for leasing companies, particularly if they can source funds outside the banking sector. However, in the absence of liquid financial markets, obtaining term funding can be a problem for many leasing companies. In such cases, joint-venture leasing companies, with strong foreign shareholders, are able to mobilize resources from abroad, although they usually hedge this currency exposure by passing it on to their clients by writing foreign currency-linked leases. Given that lessees—unless they are exporters—are often reluctant to take foreign exchange risk, this type of funding can at best supplement, but not substitute for, local resources. Their need for local sources of term funding often makes leasing companies the catalysts for accelerating stock market activity.

In several Arab countries, leasing is beginning to develop as a new institutional source of long-term finance for small and medium-sized companies that cannot compete with larger firms or state-owned enterprises (SOEs) for subsidized credit from DFIs. Currently, leasing finances only a small portion of total investment in Arab countries, and thus has considerable potential for further growth. Arab countries are encouraging the formation of joint-venture leasing companies between domestic financial institutions (commercial banks and/or DFIs) and overseas leasing companies or banks with leasing affiliates. Tunisia has two leasing companies that were created as joint ventures with French institutions. Tunisie Leasing, Tunisia’s first leasing company, is now listed on the Tunis Stock Exchange. Morocco has six leasing companies that were established jointly with local commercial banks and French leasing groups and commercial banks. Oman National Leasing Company was established as Oman’s first joint-venture leasing company with Orix Leasing of Pakistan Ltd. In addition to receiving long-term funding from IFC, the sponsors have committed to arrange additional term funding through a privately placed bond issue. IFC has played an important institution-building role in establishing new leasing companies in Arab countries. IFC has identified strong technical partners and been responsible for structuring the first leasing companies in Jordan, Oman, and Tunisia. IFC and other multilateral institutions can also assist the growing leasing industry by extending lines of credit to finance leasing of productive equipment to private sector enterprises, encouraging syndicated leasing for large equipment items, and supporting the expansion of market-based leasing companies.

Venture Capital Companies. Venture capital is typically high-risk financing aimed at “converting enterprises out of entrepreneurs” and often takes the shape of start-up financing in the form of equity capital and loans, with returns linked to profits and some degree of managerial control. Venture capitalists expect losses on some ventures to be greater than traditional financing, but they invest with the notion that greater than normal returns on others will compensate for those losses. Venture capital is ideally suited to high-risk projects and is therefore an alternative to DFIs. It requires an entrepreneurial class and an environment conducive to private sector growth. A source of long-term investible resources is also necessary. And an active stock market is essential to divest portfolio investments of venture capital companies, although investments may be sold through private placements until secondary markets become more dynamic. Several Arab countries have potential for this type of finance (Morocco, Tunisia, Egypt), which has been limited so far due to small stock markets and fiscal incentives that have supported debt financing over equity.15

Contractual Savings Institutions. Life insurance companies, pension funds, and funded social security systems are sources of long-term finance for investment in corporate bonds and equities. They provide investors with the opportunity to diversify risk with the benefits of investing in a portfolio selected by professional investors. Pension funds have contributed significantly to the supply of long-term funds in Singapore and Chile. However, many governments have impeded the contribution of contractual savings as a source of long-term finance by requiring them to invest a part of their resources in government securities or programs with low returns in social sectors (Malaysia, Kenya, India, Morocco, Tunisia). This system is being phased out in most countries implementing financial sector reform. The lack of alternative investment opportunities has also confined the role of these institutions to investing in government securities. As capital markets grow in developing countries, the removal of investment controls will encourage the growth of these institutions as investors in corporate equities.16

Securities Markets

Securities markets basically consist of money markets and capital markets.

Money Markets. The development of securities markets usually starts with trading in a short-term money market instrument, often a government security. Other money market instruments are interbank deposits, bankers’ acceptances, certificates of deposit and commercial paper issued by nonfinancial corporations. Money markets provide a noninflationary way to finance government deficits. They are a source of funds for commercial banks and other institutions, including DFIs and leasing companies. By enabling large corporations to issue short-term securities in the form of commercial paper, money markets make the corporate loan market more competitive and reduce the control of large commercial banks. Investment banks are usually issuers and dealers in money market instruments; licensed dealers are often proxies for investment banks in developing countries with a dearth of such institutions.

One measure that promotes money market growth is issuing government securities at market rates. The reluctance of finance ministries to pay market rates on their debt is usually the biggest obstacle to the development of money markets. In Morocco, financial sector liberalization has attempted to remove barriers to the growth of money markets. The system of mandatory placements on banks and institutional investors, such as Caisse de Depot et Gestion and insurance companies, to place a percentage of their funds in treasury bonds is being phased out. Under the World Bank’s financial sector development loan, mandatory placements will be replaced by funding through the auction market, and banks will be allowed to underwrite treasury bond issues and place long-term bonds through public offerings. Deregulation of interest rates will allow government securities to become more competitive with other bond instruments. In Tunisia, mandatory placements have been abolished for banks and are being addressed in the case of insurance companies and social security funds. The Tunisian money market came into being in 1987 when certificates of deposit and commercial paper were introduced with maturities of up to five years and in 1989, treasury bills were introduced with attractive yields and are issued through an auction process on the money market. These developments are creating competition in the financial sector and making alternative forms of short-term finance available to private and public entities.

Capital Markets. Capital markets provide equity finance as well as long-term debt (through the issue of bonds) for both the government and corporate sector. By offering an array of financial instruments available to investors, capital markets increase competition and ensure the most effective mobilization and allocation of investible resources. This lowers financial intermediation costs and contributes to productive investment and growth. Capital markets also facilitate the dispersion of business ownership and the reallocation of financial resources among corporations and industries.

Several developing countries, including India, Korea, Malaysia, Turkey, Mexico, and Chile, have active equity markets. Only a few countries have active bond markets; they include India and Korea. Of the Arab countries, only eight have established formal capital markets: Saudi Arabia, Bahrain, Egypt, Jordan, Kuwait, Morocco, Oman, and Tunisia. The United Arab Emirates, Qatar, and Algeria are planning to establish more formal capital markets. Currently only Egypt, Morocco, Tunisia, and Jordan have capital markets that are open to foreign investors. In absolute terms, Saudi Arabia has the largest market with 78 listed companies and a market capitalization of $15 billion. Currently, the capital-surplus countries represent about 85 percent of the total capitalization of Arab securities markets. This ratio is expected to become better balanced when the proposed privatization programs of the capital-deficit countries (Egypt, Morocco, and Tunisia) are implemented17 (Table 5).

Table 5.

Emerging Stock Markets in the Arab Region, 1992

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Source: International Finance Corporation, Emerging Stock Markets Factbook, 1993.

The supply of equities in many countries has been limited by the reluctance of owners of private companies to dilute their ownership and control by issuing stock to the public and to comply with requirements to disclose information about their operations. The availability of less expensive debt finance has also discouraged equity issues. The absence of an appropriate legal, regulatory and tax framework has further inhibited the development of capital markets. Double taxation on dividends and capital gains, and the tax-free status of government securities has lessened the appeal of private equity and bonds. Investor confidence has been further undermined by the lax enforcement of corporate income taxes as closely held corporations are able to avoid taxes by showing depressed profits. The lack of timely and accurate financial information has often resulted in speculative trading that has further hurt investor demand for securities in developing countries.

The efficient functioning of financial markets also depends on institutions that lend and borrow little on their own account; investment banks, securities brokers and credit rating agencies.

Investment Banks. Investment banks are important constituents of securities markets; they are intermediaries for locating and collecting funds for their clients so they can finance new investment products. They are major players in the development of securities offerings. In addition, they arrange private placements, provide funds management, and perform corporate advisory and portfolio management services. Investment banks have yet to play a major role in Arab countries, which are still in the process of developing their nascent capital markets.

Investment bankers bring new securities to the market by purchasing whole issues of securities from corporate issuers or from public bodies and distributing them to institutional and individual investors. By making a firm commitment to purchase the securities from the company, the investment banker insures any risk associated with a new issue. This service, known as underwriting, permits government and corporate entities to broaden their sources of long-term financing beyond the banking system. Underwriting is critical to the development of emerging markets where corporate or public entities are reluctant to raise equity capital without the guarantee provided by this service. Investment banks are also market makers in secondary markets.

Corporate advisory services are a growing business for investment banks in emerging markets. The private sector in many developing countries has been accustomed to functioning in heavily controlled and protected market environments that have provided inadequate preparation for businesses to respond to market signals. Investment banks can play an important part in advising businesses on how to compete in a more open and international economy. However, they also have a key advisory role in relation to project financing, i.e., identifying project risks, attracting technical partners, identifying and selecting sources of finance, and structuring the financial package. While banks, long-term financing institutions, and institutional investors provide financing, investment banks arrange financing and can play a useful role in organizing loan syndications for large amounts of financing.

Investment banks also provide portfolio management services by investing funds on behalf of institutional and individual investors. Their investment decisions are based on specialized research and analysis of securities. Consequently, they help to curb speculative tendencies—especially in emerging markets that are afflicted by poor corporate disclosure practices—by serving as conduits for dissemination of timely and accurate financial information.

Promoting Capital Flows in the Future: An Agenda for Reform

Successful economic planning in developing countries depends on the ability to achieve a rapid and balanced growth of investment in both the government sector and the corporate sector. This in turn hinges on an adequate transfer of household savings and foreign capital inflows to these sectors. This transfer requires the availability of diversified financial instruments and proper financial intermediation. Foreign capital flows to Arab countries have been limited by governmental policies restraining foreign private investment and favoring debt instruments over equities and financial intermediation in banking over the securities market. The policy challenge involves increasing capital flows by relaxing regulations, reducing restrictions on international capital mobility, and establishing an appropriate institutional framework to ensure that an adequate proportion of financial savings flows into the equity market.18

An increasing number of Arab countries are beginning to take steps to create the necessary infrastructure for securities market development. On the policy side, financial liberalization has to some extent already removed distortions that encourage financial flows into debt instruments through the banking system, and especially deposit type short-term instruments that have often led to financial instability.19 Fiscal incentives in the form of differential tax treatment of equities on the one hand, and bank deposits and other debt instruments on the other, are also being removed. Taxes on dividends and capital gains on sale of shares have been removed to put equity investment on par with other types of debt instruments (Morocco and Tunisia).

The governments of Arab countries can also play a key role in developing capital markets. In addition to policy reforms removing barriers to equity financing, the process of privatization must be expedited to create incentives for foreign investment. Privatization through private placement or sale of shares on the still-emerging capital markets will encourage wider participation by domestic and foreign institutional investors and increase market capitalization substantially. Privatization has been one of the forces revitalizing equity markets in several developing countries, including Mexico and Chile. Several Arab countries are implementing large-scale privatization programs (Morocco, Tunisia, Egypt) to stimulate direct and portfolio investment.

Demand for securities can be raised by encouraging foreign portfolio investment. Regulations and restrictions that impede the entry of international investors into domestic equity markets are being lifted. Several countries remain concerned over foreign ownership of assets. But foreign portfolio investment is usually passive, and developing country concerns over volatile flows of money and increasing foreign control can be met by such means as the closed-end country fund, whose shares can be traded but not redeemed (Morocco, Egypt, and Tunisia).

Governments can help to put in place an appropriate regulatory framework to increase investor confidence in securities markets. Regulations are needed to provide for accurate and adequate disclosure of corporate information to curb speculation and allow investors to make informed decisions. There is a need to license securities intermediaries, establish minimum listing requirements, and curtail improper activities such as insider trading. Governments also have a crucial role to play in setting minimum capital requirements for securities firms. High minimum capital requirements relative to the size of the market will impede the formation of new securities firms (investment banks), but if they have insufficient capital they will not be able to take on the risks of underwriting new issues nor will they be able to work as market makers and thus provide liquidity for the secondary market. Another important aspect of regulation concerns concentration of ownership. Governments can take a variety of regulatory measures to encourage widespread ownership of equity through regulation of companies and securities markets.20

The Role of IFC

The development and deepening of capital markets in Arab countries will also require institution-building efforts as well as technical assistance from external sources and multilateral agencies. IFC can play a role in supporting the creation of the institutional and regulatory framework for capital markets as well as help in the establishment of stock exchanges and stock market institutions in Arab countries that do not have formal securities markets. In particular, IFC can assist in developing appropriate regulations to provide accurate and timely disclosure of financial information, ensure fair trading practices and listing requirements of companies, and prevent insider training. IFC can also help set up investment banks and securities houses to provide adequate financial intermediation services for equity markets in Arab countries. So far, brokerage services have been rendered by commercial banks as a courtesy to their clients with no incentive to accelerate stock market activity. Underwriting services are also absent in most Arab countries, which is a disincentive for companies to raise equity through public issues. Both brokerage and underwriting services are critical for the development of equity markets in Arab countries and should be addressed as a priority in institution-building efforts and in technical assistance programs.

IFC can also support the development of local markets by helping to establish investment funds for individual countries or a group of countries to encourage foreign portfolio investment in the Arab countries. These funds can best be established under a two-tier structure wherein the equity fund will be managed by a professional fund management company, to be set up with the participation of domestic financial institutions and suitable foreign technical partners. This structure achieves two objectives: it creates a new financial instrument to channel resources into equity investments and establishes financial institutions with strong technical skills to successfully engage in such investments. If properly structured, IFC may also invest in these funds and in their management companies. IFC’s presence is expected to enhance investor confidence among institutional investors and encourage them to invest in these funds. When capital markets in the Arab countries develop sufficient absorptive capacity, these funds will divest their investments by listing investee companies and selling their shares or through secondary public offerings to investors.

IFC is currently helping to establish a second investment fund ($30–40 million) in Morocco with Siparex of France and Wafabank, the country’s fourth largest commercial bank, to provide equity financing for small–and medium–scale export–oriented enterprises. IFC has already helped to launch INTERFINA ($23.6 million) in Morocco in 1992 to complement the government’s privatization program by mobilizing equity resources for its implementation, while simultaneously increasing the market capitalization of the Casablanca Stock Exchange. Clinvest (France) and Banco Exterieur de Espana (Spain) are the foreign technical partners for this fund. Banque Marocaine du Commerce Exterieur, Morocco’s second largest commercial bank, and Banque Nationale pour le Developpement Economique, a Moroccan DFI are the main local sponsors of INTERFINA. A fund of $30–35 million is expected to be launched in Tunisia to provide equity financing to public enterprises that are to be privatized and to provide mezzanine financing to small and medium–sized private companies. IFC is currently involved in putting together an equity investment fund for Egypt—International Egypt Investments Limited (IEIL) of about $25–50 million—with Schroeder Asseily & Co., a London–based merchant bank; and is also considering a second fund for Egypt with Kidder Peabody & Co., a U.S. investment bank.

Conclusion

The nature and pattern of private capital inflows to developing countries has been clearly influenced by the presence (or lack thereof) of well–established securities markets, proper financial intermediation, and a variety of financial instruments to channel financial savings into direct or portfolio investment. Nowhere has the importance of open and diversified financial markets been more visible than in several Latin American (Mexico, Chile, and Brazil) and East Asian economies (Korea, Malaysia, and Singapore). They have attracted the lion’s share of private capital inflows by complementing their economic liberalization efforts with the removal of stringent foreign investment controls and the deepening of their financial markets. Korea is a striking example of the successful transition from a heavily regulated financial structure to a more open, robust, and diversified financial system. Korea initiated stabilization, structural adjustment and financial reform in the 1980s. The government encouraged competition in the financial sector by relaxing barriers to entry, deregulating nonbank financial institutions, and allowing different institutions to offer a wide array of services. Foreign financial institutions, including banks and insurance companies, were permitted to open branches. Many government–owned commercial banks were privatized. Preferential credit lending rates were eliminated and no new directed credit programs were introduced. Controls on interest rates and capital flows were maintained until inflation was brought under control and exchange rates stabilized. By the mid–1980s Korea had established macroeconomic stability and laid the foundation for a rapidly expanding financial sector that included primarily nonbank institutions and securities markets.21

Between 1983 and 1992, Korea’s stock market capitalization increased from $4.4 billion to $108 billion, the number of listed companies went up from 328 to 688, and value traded soared from $2.2 billion to $116 billion.22

Several Arab countries (Morocco, Tunisia, Egypt) are beginning to redress their closed-door policies by dismantling rigid investment regimes; others had already opened their doors, at least partially, to foreign investment (Jordan and Oman), but investment flows are still constrained by the absence of diversified financial instruments and policies that have supported banks and DFIs over other forms of financial intermediation. The interventionist financial policies of strict control over interest rates and channeling of subsidized credit to certain sectors have resulted in investments in financially questionable projects and a growing portfolio of non–performing bank assets in developing countries.23 In several Arab countries, the banking system has been seriously undermined and the need for financial liberalization has become imperative. Financial sector liberalization in Arab countries should not be limited to the removal of credit allocation and interest rate controls and reform of the banking system, but seek to develop a more broadly based financial system that includes money and capital markets and nonbank intermediaries. Active securities markets would increase the supply of equity capital and long–term credit, which is vital to maintain the solvency of the financial system and effectively mobilize domestic savings and foreign capital for investment.24 A balanced and competitive financial system will also reinforce macroeconomic stability by making the system more sturdy in the face of external and internal shocks. Multilateral institutions such as IFC should play an increasing role in assisting Arab countries to build stable and competitive financial systems.

References

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  • El-Erian, Mohammed A., and Shamsuddin Tareq, “Economic Reform. in the Arab Countries: A Review of Structural Issues,” Economic Development of the Arab Countries: Selected Issues, ed. by Said El-Naggar (Washington: International Monetary Fund, 1993), pp. 26–50.

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  • El-Rifai, Ghassan,“Investment and Major Determinants of Capital Flows to Arab Countries,” Economic Development of the Arab Countries: Selected Issues, ed. by Said El-Naggar (Washington: International Monetary Fund, 1993), pp. 56–93.

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  • Gooptu, Sudarshan, “Portfolio Investment Flows to Emerging Markets,” Portfolio Investment in Developing Countries, ed. by Stijn Claessens and Sudarshan Gooptu (Washington: World Bank, 1993)

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  • International Finance Corporation, Emerging Stock Markets Facthook (Washington: International Finance Corporation, 1993).

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  • Park, Keith K.H., and Antoine W. van Agtmael, eds. The World’s Emerging Stock Markets: Structure, Developments, Regulations & Opportunities (Chicago: Probus Publishing Company, 1993).

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  • World Bank, World Development Report 1985: International Capital and Economic Development (Washington: Oxford University Press, 1985).

  • World Bank, World Development Report 1989: Financial Systems and Development (Washington: Oxford University Press, 1989).

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  • World Bank, (1993b), World Debt Tables 1992-93: External Finance for Developing Countries (Washington: World Bank, 1993).

4

Ibid., p. 9.

5

Ibid., p. 18 and World Bank (1993b).

6

Ibid. (1993), p. 20.

7

Ibid. (1993), p. 19.

8

Ibid., p. 13

9

Ibid, p. 14

13

lbid., p. 106.

14

lbid., p. 60.

15

Ibid., p. 107.

16

Ibid, pp. 106-107.

18

Abisourour (1993), pp. 107-108.

Within Same Series

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Cover Financial Policies and Capital Markets in Arab Countries
Financial Policies and Capital Markets in Arab Countries
Author: Mr. Saíd El-Naggar
ISBN:
9781557754189
Publication Date:
15 Sep 1994
Publisher:
International Monetary Fund
DOI:
https://doi.org/10.5089/9781557754189.071
Pages:
116