Abstract

The ongoing process of deregulation and global financial integration is bringing about great changes in the international capital markets and unleashing a breathtaking expansion of cross-border portfolio investment flows. Many of the old controls that prevailed in the major capital markets are now gone. Analysts claim that we are only “two-thirds of the way” toward full deregulation and that many obstacles still prevail. Nevertheless, the segmented, heavily controlled, and often manipulated domestic capital markets in the major world economies have been replaced by an increasingly integrated global market. The Euromarkets, which began as an “add-on” to the domestic markets, have quickly grown to become one of the leading sources of all kinds of financing—from debt to equity—for governments and corporations of industrialized and developing countries alike.

Introduction

The ongoing process of deregulation and global financial integration is bringing about great changes in the international capital markets and unleashing a breathtaking expansion of cross-border portfolio investment flows. Many of the old controls that prevailed in the major capital markets are now gone. Analysts claim that we are only “two-thirds of the way” toward full deregulation and that many obstacles still prevail. Nevertheless, the segmented, heavily controlled, and often manipulated domestic capital markets in the major world economies have been replaced by an increasingly integrated global market. The Euromarkets, which began as an “add-on” to the domestic markets, have quickly grown to become one of the leading sources of all kinds of financing—from debt to equity—for governments and corporations of industrialized and developing countries alike.

A key factor behind the globalization of equity markets has been innovation—swaps, options, futures, and portfolio insurance have all increased substitutability of investment assets and mitigated risks, thereby enlarging the stock of acceptable investment instruments and adding depth to the international capital markets.

Another important factor is the drive toward securitization of various obligations, which has allowed financial institutions to shift risks to ultimate investors and has given them the ability to handle a much larger volume of transactions, to develop new products, and to secure economies of scale.

Finally, the blurring of demarcation lines, the growth of universal banking, the elimination of exchange controls, and the advance in communications technology have allowed the various players to operate simultaneously in different markets and transact in huge volumes at reduced cost, thus further increasing capital mobility.

At the outset, securities regulators and bank supervisors were caught by surprise by the new ways of raising funds, and the innovative instruments and speed of global clearing and settlement. Liberalization and deregulation coupled with competitive pressures allowed for speculative excesses and institutional mismanagement. Concerns still prevail about financial derivatives, and calls for self-discipline are on the increase. But in the end, the financial markets must cope with the enormous risks inherent in change in order to manage in a changing world.

In the process, some markets are likely to grow further, while others may remain excluded or may simply be eliminated. In the face of these developments, how are the emerging Arab capital markets performing?

Clearly, globalization has made Arab countries with open economies less insulated and has subjected them to disturbances and shocks that are not a result of domestic factors. Capital flight has become serious in the indebted countries, and speculative capital movements have at times caused abrupt disruptions in the normal functioning of financial markets in the capital-surplus economies.

Nevertheless, securities markets in many Arab countries have developed into increasingly important channels for savings mobilization and resource allocation. They have contributed toward financing both private and state enterprise investments in productive assets. Frequently, this may have taken the form of loan rather than risk finance, which normally contributes only a modest share to business finance, but thereby enlarges the capital base for further debt finance.

As a consequence, excessive corporate indebtedness rose with public sector deficits, even in countries that only a few years ago were generating surplus funds significantly beyond their domestic absorption capacity. This indebtedness has constrained economic activity and has increased the need to consolidate the financial structure of business enterprises in Arab countries. It has also prompted an awareness of structural imbalances within the domestic financial intermediation mechanisms.

Developing domestic securities markets in Arab countries thus represents a challenge in the face of both globalization of international capital markets and the domestic need for re-establishing financial balance.

The purpose of this paper is to discuss the experience of Arab securities markets, namely their current status and their perceived role. This discussion relies mostly on the normative questions to be addressed by Arab policymakers for the development and integration of Arab securities markets. The paper draws on the findings of extensive studies and field survey missions undertaken by the AMF within the framework of its program of technical assistance to its member countries, of which a brief description is included in the Appendix.

Finally, recommendations are given as to what might be desirable policies and practices to achieve effective securities markets as part of an efficient and balanced financial system, while operating within the framework of an ever-challenging global financial environment.

The Global Equity Environment

Overview

The impact of the above-mentioned deregulation and globalization process has been extensive, both on the financial industry itself and on the size of financial investment flows. As competition sharpened among banks and between bank and nonbank financial institutions, global portfolio investment rose markedly over the past decade.2 For example,

  • Global international holdings of equities increased tenfold in less than ten years, and exceeded the $10 trillion mark by the end of the decade, of which 7 percent were acquired by nonresidents (Table 1).

  • The total trading value of nonresident equity holdings rose twentyfold during the same period to $1.5 trillion in 1990; in volume terms, the increase was fivefold (Table 1).

  • Global international holdings of bonds also exceeded the $10 trillion mark, after tripling in total value during the 1980s.

  • The value of nonresident holdings of bonds followed a faster pace of increase and amounted to 12.8 percent of international holdings of bonds.

Table 1.

Portfolio Investment

(Billions of U.S. dollars)

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Source: BIS; IMF, Balance of Payments Statistics; and AMF calculations.

Negative inflows indicate a net sale of foreign-owned domestic assets.

Negative outflows indicate a net sale of domestically owned foreign assets.

With respect to the developing world, foreign portfolio flows into domestic equity markets remained small in view of their limited level of capitalization representing no more than 6 percent of the equivalent level in the industrial countries’ markets (Table 2). The situation varies greatly, however, as only a few developing countries account for the quasi-totality of emerging markets’ capitalization. Moreover, the burden of debt and the lack of economic and financial policy sophistication necessary to benefit from the global market mechanism are clearly reflected by the direction of capital flows, which during much of the decade has been almost a one-way street from most of the developing economies to the industrial countries.

Table 2.

Capitalization of Equity Markets

(Billions of U.S. dollars)

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Source: BIS, Economic Paper No. 30, April 1991.

The level of capital flight from the Arab region is estimated by the World Bank to be the highest in comparison with other developing regions. Arab securities markets are still too small and virtually closed to outside investors, leaving little possibility of access for foreign portfolio investment inflows. The total capitalization level registered by existing Arab securities markets remains low at $50 billion in relation to the region’s private sector holdings of foreign assets, which exceeded $60 billion in 1990, 42 percent of which were in foreign bank deposits.3

Foreign penetration of government bond markets is practically nonexistent except for some past Kuwaiti bond issues, while, on the other hand, the region contains some of the developing world’s largest institutional investors in the international bond markets.

Securities Markets and Financial Strategy

One of the thorny issues often raised in any debate over financial strategy relates to the role that should be played by the banking sector vis-á-vis the securities markets. Both of them constitute important alternative channels of finance that can be either competitive, and therefore substituting for one another, or complementary. With appropriate government support and subsidization, banks in some countries have been able to provide long-term debt financing on less costly terms than would a bond market. This has contributed to a shift in favor of debt financing over equity financing, thereby resulting in a less secure pattern of corporate finance and a less efficient allocation of resources. Even in countries where most long-term finance is channeled through the securities markets, banks may act as securities market institutions providing broker-dealer, trust, and investment management services along with normal banking services.

The questions faced by most developing countries are, What role should banks play in the securities market, and which government policies and practices define or influence this role? In other words, should governments promote a global market mechanism where banks operate as securities market agents or fiduciaries in such a market, or would it be healthier for securities market institutions to remain independent and thus separate from banks?

Proponents of the universal system concept argue that the existing extensive banking branch network allows for economies of scale and more efficient securities distribution. Opponents point out that this leads to an unhealthy concentration of economic power, a lack of specialization and entrepreneurship, and conflicts of interest.4

Some argue that government policy toward securities markets development in this regard should depend largely upon how real the conflicts of interest are, and how significant the economies of scale are. Perhaps during the early stages of financial development, an active and dominant role of banks in the securities market is both desirable and unavoidable. As economies of developing countries become more efficient, however, specialization and competition among securities market firms and banks better serve the market by providing a wide variety of liquid instruments with more diverse risk and reward opportunities for savers, borrowers, and investors alike.

Objectives and Role

A greater reliance on equity finance, especially in developing economies, has several advantages.

Equity markets can promote financial innovation and expand the range of financial instruments offering investors different combinations of risk and reward, thus raising the total volume of domestic savings and investment. Moreover, the existence of equity markets makes venture capital operations more flexible and financing more accessible to small businesses, which in turn promotes the distribution of wealth and spreads the ownership of business and securities more widely among the public.

A securities market also increases economic efficiency by supervising new issues, introducing transparency in the establishment of fair prices for securities, minimizing intermediation costs, and requiring full disclosure of relevant financial information. This protects investors against unfair practices, enables them to adjust their portfolios quickly, and reduces the need for the business sector to hold large cash balances.

An efficient and liquid securities market makes access to international capital easier, and promotes the inflow of foreign direct investment (FDI) and portfolio investment that complements rather than replaces domestic savings.

Finally, the tapping of foreign savings to finance domestic investment in the form of equity participation is often associated with the benefits of acquiring market skills and better transfer of new technology. It is important to note, however, that success in achieving these objectives is conditional upon the assembly of a set of prerequisites and has some intrinsic costs.

Prerequisites and Costs

Establishing equity markets requires certain prerequisites. They include

  • political and macroeconomic stability as reflected in the size, quality, and growth prospects of local businesses;

  • a certain level of savings with a relatively large distribution;

  • an adequate legal framework and flexible regulatory environment; and

  • a sound and equitable tax system, and a price system determined by market forces with minimum distortions created by government interventions.

It is noteworthy, however, that what could be considered adequate for a certain country or in a particular time frame may not be so for another or in a different circumstance. Hence it might be reasonable to speak of minimum requirements regarding each of the various factors involved and to take a dynamic view by stressing the necessity for those factors to evolve in a harmonious and mutually supportive way so as to encourage the growth of the securities markets and to ensure their responsiveness to the actual needs and preferences of investors and savers alike.

Costs related to the establishment and functioning of equity markets vary from country to country and from one phase to another in the development and operation scale of each market. But the most important issues debated in this regard and for which no concrete empirical evidence or theoretical consensus can be reached relate to the impact on the overall financial development process and especially on the competitiveness and efficiency of companies. Those generally fall in three broad areas.5

  • The establishment of equity markets encourages the structural transformation of companies and the emergence of a healthier environment for private business. But this does not happen without costs due to the separation of management and ownership. The costs involved here stem from the fact that the interests of management and those of shareholders may not necessarily converge. Management may acquire enough power to be tempted to undertake risky or controversial investment decisions that might not be in the interest of the shareholders. The latter can, of course, always replace the former but, in practice, this operation is itself costly and may adversely affect the share price resulting in substantial capital losses for shareholders. In the case where management itself owns and controls the bulk of the shares of the listed company, the conflict of interest between ownership and decision making is minimized, but a higher cost to the society as a whole emerges in the form of oligopoly and concentration of economic power.

  • Another important cost associated with the operation of equity markets stems from the fact that it is difficult to safeguard against big losses when share prices tumble in the equity markets when subjected to frequent volatile and speculative fluctuations. The degree by which shareholders’ losses are minimized depends on the capabilities of management to evaluate and diversify the risk of investment.

  • A third major cost is directly related to the competitiveness and efficiency of companies—that is, the constant threat, whether potential or actual, resulting from takeover activities in the equity markets. This threat may at times distract management and induce it to concentrate on providing short-term dividends to the shareholders, thereby jeopardizing the corporation’s long-term success.

Current Status of Arab Capital Markets

Various Arab countries have acted in recent years to develop their domestic capital markets. Policies have aimed at improving the business environment, correcting the legal and regulatory framework of the securities markets, and producing comprehensive securities laws with a unified set of objectives that are similar to those of many market-oriented economies, namely,

  • To mobilize savings through equity and long-term debt investment opportunities in both the public and the private sectors. Deficit economies also aim at curtailing capital flight by providing competitive financial instruments and attracting foreign portfolio capital.

  • To facilitate access to capital funds by newer businesses and spread the risks of long-term investment projects in order to contribute to a lower cost of equity capital and help stimulate private sector investment and production growth.

  • To broaden the ownership base of enterprises through wide distribution of equity shares.

In practice, however, not all Arab countries have been successful in meeting those objectives. The determining factors relate to the type of development strategy being followed and ensuing business and regulatory environments.

Business Environments

Historically, Arab business environments and the size of securities markets activity have been shaped by the role of government and the institutional structure of financial intermediation.

Preponderance of the Public Sector Role. The public sector role has been prominent in determining the level of economic activity in all Arab countries, as is the case in developing countries in general. This situation has been dictated, depending on the country concerned, by either the requirements of transition after independence or the level of government control of economic resources and activities, and the abrupt accumulation of huge financial reserves by the public sector. The need to implement ambitious economic and social development projects has further strengthened the role of the public sector in those countries.

This has resulted in two major sets of opposing implications for savings, investments and resource allocation and, hence, capital accumulation and economic development structures. On the one hand, state involvement in economic activity has helped develop infrastructure that otherwise could not have been developed and paved the way for more rapid growth in the private sector.

On the other hand, the state monopoly of economic activity adversely affects the aggregate volume of national savings for a number of reasons.6 Increased public expenditure outlays on government services, which are mostly underpriced and subsidized, raises aggregate demand, and hence consumption of these services, which in turn leads to a lower rate of national saving. This also creates certain distortions in the price system that make resource allocation less than optimal, and thereby rekindle inflationary pressures adversely affecting the level of aggregate savings.

Predominance of the Banking Sector. The financial structure in the Arab countries is dominated by commercial banks. Traditionally, these confine their lending to short-term trade financing. The issuance of securities instead of bank loans as a principal financing vehicle has become more urgent in recent years. The change in attitude is caused by the drive for privatization that is gaining momentum in many Arab countries, because of the decline in foreign sources of funding, coupled with the acute problem of limited availability of domestic finance as manifested by the low level of savings.

As a result, the overall Arab business environment has improved significantly in recent years, although not to the fullest extent possible in view of the often incomplete institutional and regulatory structures.

Legal and Regulatory Frameworks (LRFs)

If the economic and sociopolitical conditions necessary for securities markets to emerge and to grow are not in place, it would be unrealistic to expect that laws or regulations could create and guarantee successful development of such markets. However, at a given level of market potential, the introduction of a legal and regulatory framework can have a catalytic effect.

Another side of the argument is that without the existence of an adequate legal and regulatory framework, markets in general tend to remain shallow, uninformed, frequently informal, lacking transparence, and more exposed to the undesirable consequences of unchecked speculation.

Some of the existing Arab company laws date back quite a few years and thus do not necessarily take into full account more advanced provisions necessary for the dynamics of modern business structures. They may even contain, as often pointed out by AMF technical assistance surveys, provisions that affect such markets negatively.

In a number of cases, limited liability companies offer such an extent of facilities and are not sufficiently restricted in terms of size or number of participants that they discourage entrepreneurs from opting for a corporate form of business. In many other aspects, outside shareholder protection remains equally inadequate, thus reducing investor confidence and consequently reducing long-term demand for securities. The various aspects may encompass such issues as rights and obligations regarding capital contributions, conflicts of interest, privileged information, and accounting audit and reporting requirements.

Moreover, the widespread lack of comprehensive securities market laws and regulations has impaired the emergence of some Arab markets and even caused some to develop in an undesirable manner, calling for costly corrective measures.

Though the situation differs greatly from country to country, for analytical purposes, we may divide Arab countries into four distinct groups with respect to the stage of development of their LRFs and securities markets:7

  • In four countries—Algeria, Iraq, Libya, and Syria—policymakers have opted for the state monopoly of economic resources and activities during the past two decades. This has ruled out an eminent private sector corporate business activity, which is necessary to justify and support the development of securities markets. In recent years, however, policymakers in the countries concerned have shown an active interest, to varying degrees, in the promotion of private enterprise. During the current transition period, these countries need to establish the appropriate LRF necessary for the promotion of a healthy business environment and an optimal allocation of resources.

  • Five countries—Djibouti, Mauritania, Somalia, Sudan, and Yemen—still lack strong macroeconomic foundations in terms of size and diversification of production, completeness of the institutional framework, and policy sophistication, which are regarded as prerequisites for capital market development. Nevertheless, some of these countries are progressively enacting better economic and financial legislation, and adopting appropriate adjustment policies to mobilize domestic savings, improve the business environment, and remove distortions in the pricing system. In time, such policies are bound to lay down the necessary foundations for capital market development.

  • The six countries of the Gulf Cooperation Council—Bahrain, Oman, Kuwait, Saudi Arabia, and to a lesser extent Qatar and the United Arab Emirates—have made significant strides in less than twenty years toward the development of proper LRFs. They are open economies with a capital surplus, in the sense that there are no exchange restrictions or other controls on capital flows. Three countries—Kuwait, Oman, and Bahrain—have already set up domestic stock exchanges. Saudi Arabia has developed an electronic mechanism for securities trading managed by the Saudi Arabian Monetary Agency. Qatar and the United Arab Emirates have only informal markets at this stage.

  • The remaining five countries—Jordan, Tunisia, Lebanon, Egypt, and Morocco—have developed relatively complete LRFs. The Alexandria and Cairo stock exchanges are nearly a century old, although they have been forced by shifts in development strategy goals to lead a dormant existence until recently. Similarly, the frameworks of Morocco and Tunisia have now been adapted to allow their respective stock exchanges a major role in the privatization process and in efforts to attract foreign portfolio investment. The Amman Financial Market in Jordan is considered by many (along with the Kuwaiti market) to be one of the pioneers of modern LRF in the Arab region. The Lebanese market, on the other hand, which had shown signs of maturity in the past, is now inoperative.

In the 11 countries that either operate securities markets or at least appear to have reasonable potential for such markets to emerge, there exist, however, wide differences among their respective legal and regulatory frameworks. Company laws exist in all the countries except the United Arab Emirates, where application of Law 8/84 continues to be suspended; but some of these laws don’t offer adequate protection to outside shareholders. In contrast, only in eight countries do markets operate under comprehensive securities market laws, most of which are of recent vintage. Neither Qatar, Saudi Arabia, nor the United Arab Emirates has adopted comprehensive legislation so far.

In other words, the current LRF status in the Arab countries can be summed up as follows:

  • Primary markets are organized in nine countries: Jordan, Bahrain, Tunisia, Saudi Arabia, Oman, Kuwait, Lebanon, Egypt, and Morocco. They are partially organized in two other countries: Qatar and the United Arab Emirates.

  • Secondary markets are organized in eight of these nine countries, Saudi Arabia having opted for a more discrete mechanism. Internal consultations have been under way for some time among the various parties concerned within both Qatar and the United Arab Emirates to pave the way for the establishment of an organized secondary market.

  • The other likely candidates for capital market development are Algeria, Iraq, Syria and Sudan.

All Arab stock exchanges operating at present have taken the form of legally and financially independent bodies with an authority, board, or committee, appointed at a high level of authority. The task assigned encompasses both functions of promoting and regulating the activities of the capital market, including the setup of companies, listing requirements, trading procedures, and clearing and settlement mechanisms.

The laws and regulations governing the various markets may differ in approach, but they all aim to mobilize savings, provide finance for corporations of the private and public sectors, and safeguard the interests of both shareholders and traders.

The problem areas generally relate, to varying degrees, to the enforcement of accounting standards, the quality of information disclosure, and the protection of small investors from insider trading and other malpractices.

Before addressing those issues, we briefly compare market activity to highlight its general weakness and relatively embryonic state.

Comparing the Markets

Operational Aspects. Although a number of Arab countries (Egypt, Morocco, Tunisia) have had securities markets since the colonial era, these markets have really only recently emerged, or are emerging, from the periphery into the mainstream of the respective financial systems.

Awareness of investment opportunities becoming available in the securities markets is growing steadily in all the Arab countries. Only in a few countries, however, has this awareness and interest crystallized into a committed, discerning, and growing pool of investors.

Some of the main constraining factors, especially in the capital surplus economies, have been high volatility in market prices, undesirable practices, and structural inadequacies that frequently have led to a severe erosion of investor confidence and occasionally hampered sustained growth in the markets.

Not surprisingly, supply and demand factors are unbalanced in a region as diverse as the Arab region, but the classical limiting factors can be identified in most cases. Qualitative aspects of the nature of supply and demand, such as the quality and price of company issues and excessive speculation for short-term capital gain, are cause for some concern. Some countries have dealt with these problems more effectively than others. Securities finance represents a further challenge for carefully coordinated development strategy. Supervision and promotion of market activity mostly falls under the responsibility of ministerial departments rather than constituting the specific objective of a separate, autonomous agency as in the case of the Egyptian Capital Market Authority.

Both the primary and the secondary markets vary greatly in their institutional aspects. Intermediated primary issue activity is largely identified with the banking systems and frequently lacks an approach that is specifically oriented toward the securities market. Only in a few cases (Kuwait, Jordan, and Oman) has the emergence of specialized institutions been encouraged in order to improve the quality of issues and professionalism in their placement.

Consequently, the supply of securities remains inadequate both in absolute terms and relative to the size of the countries’ respective gross domestic products (GDPs), owing largely to the closed nature of companies in Arab countries. Because many companies are family owned there is a strong reluctance to go public. The number of quoted companies is thus relatively small, and shares available for trading are limited. This encourages investors to take a “buy and hold” attitude. Many of these markets are as a result thin and illiquid.

Market Size.8 By 1992, the number of listed companies in Arab countries with formally operating securities markets reached 1,133 with total capitalization equivalent to $50 billion including around $10 billion for Kuwaiti companies before the market closed in August 1990 (Table 3).

Relative to GDP, Arab equity markets are way behind compared with the rest of the world. Total capitalization amounted to less than 13 percent of GDP in 1992, compared with an average of 30 percent in developing countries and 60 percent in developed countries.

Table 3.

Market Capitalization and Number of Listed Companies

(1986-1991)

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Source: AMF calculations based on information from Arab Stock Exchanges.

Furthermore, a great discrepancy exists among Arab securities markets themselves, with a capitalization-to-GDP ratio in 1992 of 8 percent in Jordan and 46 percent in Kuwait (prior to August 1990). The ratios in Egypt and Morocco do not exceed 6 percent and 7 percent of their respective GDPs.

In absolute terms, Saudi Arabia has the largest market with a total capitalization equivalent to $1 billion for eight listed companies. The United Arab Emirates’ informal market, with an $8 billion capitalization and 22 companies, represents an average capital of $30 million per company. In contrast, the Egyptian market has 656 listed companies with a total capitalization of $2.6 billion, which amounts to an average capital of no more than $4 million per company.

Currently, Gulf Cooperation Council companies represent about 83 percent of total capitalization of Arab securities markets. The ratio may change significantly downwards, however, when the privatization programs under way in the capital-deficit countries (Jordan, Egypt, Morocco, and Tunisia) are implemented.

As far as trading volume is concerned (Table 4), the Saudi market recorded the highest turnover among Arab markets in 1992, with 35 million shares for a total value of $3 billion.

Table 4.

Annual Value and Size of Trading

(1986-1991)

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Source: AMF calculations based on information from Arab Stock Exchanges.

Kuwaiti market trading resumed on 2/8/1992.

In general, capitalization and trading activity in most Arab markets are not representative of the potential size that may be reached by these markets. This is especially the case for those countries implementing comprehensive macroeconomic adjustment, financial policy reforms, and privatization of public sector companies.

Development Prospects of Arab Capital Markets

A number of Arab countries have introduced stimulation policies in recent years to develop corporate securities markets. The level of development in each market, however, varies significantly.

Policy objectives for restructuring the financial sector aim at fostering institutional development, removing obstacles and inconsistencies within the legal and regulatory framework, and streamlining the administrative process for more efficient capital mobility.

The results have sometimes been compromised because of inconsistency and poor timing, but above all through a lack of effective accompanying macroeconomic policies in general and proper fiscal and monetary stimulus in particular.

This section discusses some of the major issues and priorities that policymakers in Arab countries need to consider adopting to enhance the efficacy of local securities markets and to encourage inter-Arab investment capital flows. But before addressing these specific policy measures, a brief note on the overall macroeconomic framework is of interest to further highlight the importance of efficient securities markets to the promotion of national savings in Arab countries.

Macroeconomic Framework

Arab economies have experienced major macroeconomic imbalances during the past two decades. These have stemmed from three major sources.9

  • For the capital-deficit economies the most common source of imbalance has been over expansionary demand-side policies, that is, large budget deficits financed either through the banking system or by unsustainable levels of foreign borrowing. Domestic financing of deficits has often been inflationary while recourse to external financing resulted in unsustainable balance of payments deficits.

  • For the capital-surplus economies, the most common source of imbalance has been external shocks in the form of a deterioration in the terms of trade caused by an abrupt reduction in the price of exported commodities such as oil. Such shocks can also be experienced by the Arab capital-deficit economies due to the rise in import prices (oil and manufactured goods) and the fall in export prices (phosphates and foodstuffs).

  • A third source of imbalance is due to structural factors, for example, after a fall in productivity or a rise in real wages in excess of productivity growth. All Arab countries have had to face structural imbalances of this type, particularly in sectors such as manufacturing that were often protected through a combination of subsidies and import restrictions.

Owing partly to an unfavorable external environment and to poor policy implementation, the recommended policy responses for the above cases have not always produced successful results in the countries concerned; this has often resulted in the deepening of both internal and external financial imbalances and further complicated the required adjustment efforts. Needless to say, the adjustment process carries two economic difficulties. The cost of adjustment may be high and the need for synchronizing monetary fiscal and exchange rate policies may present technical difficulties.

On the one hand, the degree of success or failure of adjustment policies has a direct bearing on the level of efficiency and health of the capital markets. When the rate of inflation rises, the opportunity cost of holding non-interest-bearing financial assets becomes higher. This also prompts a shift away from domestic securities into financial assets denominated in foreign currency, causing the domestic capital market to shrink. The recent experiences of Morocco, Tunisia, Jordan, and Egypt show that the costs of adjustment can at times not only be quite heavy but may also lead to structural imbalances in the financial sector (more debt and less equity).

On the other hand, the level of development of the securities markets in turn affects the adjustment mechanism. One important common finding derived from Arab countries’ experiences with macroeconomic adjustment is that the correction of external imbalances has almost always taken the form of large cuts in investment due to reduced imports of capital goods rather than increases in domestic savings. This decline in investment, which mirrors the decline in both savings and external capital inflows, was especially sharp in the highly indebted countries and was accompanied by slower economic growth, which endangered the sustainability of the adjustment effort. Experiences of other developing countries, however, have shown that the availability of efficient domestic capital markets allowed those countries to implement adjustment less painfully without a major decline in domestic savings while maintaining a steady net external capital inflow.

It would be difficult to recommend a set of uniform policy measures that would suit all the Arab countries owing to differences in their economies other than reiterating the need for and urgency of taking the necessary policy measures to enhance capital market development.

The following summarizes the various policy measures discussed with authorities of the Arab countries that have benefited from the AMF technical assistance program (see Appendix). Such policy tools may be categorized according to their impact on the demand for and/or supply of equity investment instruments.

Supply of Securities

In addition to the existence of an adequate legal and regulatory framework, an efficient administration of its provisions, and adequate market facilities, capital market development will fundamentally depend upon sufficient supply of and demand for securities.

The supply of securities is clearly deficient in most operating Arab markets. Some of the securities exchanges may have several hundred companies listed but only a few issues with more than a sporadic presence on the trading floor. Listing for reasons of prestige does not provide securities to the market and should be discouraged, and proper policies need to be put in effect to encourage genuine market growth.

The supply of securities can be increased by encouraging the issuance of new securities by existing public companies, or through privatization of government-held equity, as well as by private companies seeking public status for the first time. Besides these, the introduction of new and varied financial instruments would also boost the supply of securities in the market and provide a number of investment options to existing and prospective investors.

The experience of the AMF in providing advisory assistance to Arab countries demonstrates the need to foster the supply of equities, remove legal and regulatory impediments to the development of corporate business, implement measures that facilitate access to the securities markets, and also take steps to enhance investor confidence in the intermediation mechanism. The following is a brief discussion of specific measures that were recommended to AMF member countries.

Review of Corporate Law. A thorough review of corporate law is required in some Arab countries to update its provisions and bring them more in line with recent developments in corporate business, eliminate cumbersome procedures, and modify requirements where needed to make it easier for private companies to go public without jeopardizing disclosure and accounting requirements. In this regard, the proposed new Kuwaiti company law could serve as a model for other countries in view of the thoroughness of its provisions.

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

Listing requirements on some Arab securities markets are quite stringent, and rightly so. To increase the supply of securities in the capital market and to provide access to smaller companies that may be unable to meet the requirements for listing on these exchanges, the introduction of a two-tier market system with two distinct types of listing requirements would be particularly helpful. The first, or main market, lists larger companies that meet the more stringent requirements, while the second-tier market that generally has less stringent listing requirements is made accessible to smaller companies.

Jordan is a good example of a country with a successful second-tier market, as well as a well-regulated over-the-counter market.

Promoting Venture Capital. Another possible way to stimulate Arab securities markets is by encouraging the development of venture capital companies that will in time go public or seek quotation on the stock exchange. This type of activity is currently nonexistent or in an embryonic state in Arab countries.

Flotation of Issues. An important legal requirement in some countries is that new issues be floated at par with preference given to existing shareholders (rights issues). This policy inhibits the development of the market because prevailing demand and supply conditions, and other important criteria, are not taken into account in arriving at the issue price. In practice, however, the par value system has not been strictly implemented.

Cost of Raising Capital. The high cost of raising funds in the securities market vis-a-vis other options, such as the money market, can discourage companies from floating bonds or issuing stocks and have an adverse effect on the supply of securities in the market. It is essential therefore that Arab stock exchanges, in collaboration with other market operators, strive to maintain a minimal cost structure, competitive with the cost of funds in the money market and other external capital sources.

Markets in Bahrain, Oman, Kuwait, Jordan, Egypt, and Morocco have been relatively successful at reducing issue costs in recent years, but in some countries the policy of “cheap money” in the money markets encourages debt financing and serves as a disincentive to equity financing and securities market growth in general.

Fiscal Incentives. The introduction of a two-tier corporate tax system in favor of public companies listed on the market will induce some private companies to go public. If there is effective tax collection machinery in place, such a policy will yield significant results for both the budget and the supply of securities in the market. Such fiscal incentives, applied mainly in capital-deficit countries such as Egypt, Jordan, Tunisia, and Morocco, may take various forms. A tax break may be granted to newly quoted companies for a fixed period of time (one or two years).

  • All or a percentage of the cost of going public or seeking public quotation on the securities market could be made tax deductible. This has not been applied yet in Arab markets.

  • A given percentage of corporate profits distributed to shareholders as dividends could be made deductible from corporate tax (Tunisia).

  • Another alternative is to increase taxation on closed companies, which would amount to giving companies a comparative incentive to go public without reducing government revenue in the short term.

Credit Policies. Provision of subsidized credits to certain preferred sectors of the economy, a common practice in capital-deficit Arab countries (Morocco, Tunisia), also has adverse consequences for securities market development. It generates preference for bank credits rather than utilizing capital market funds by institutions in those sectors. Arab countries should minimize practices that misallocate financial resources, or at least counter their effect so as not to deter the development of the securities market.

Mandatory Measures. Although not always popular, mandatory measures are sometimes used to stimulate the securities market. In the absence of “nonmandatory” policies to stimulate the development of securities markets, mandatory policies may be applied effectively For instance, a law can be promulgated to mandate private companies to go public using certain specified criteria, based on, for example, the level of capitalization, the average turnover, or the average profit over a given period of time. These policy options should definitely be at the discretion of individual countries. It is noteworthy that regulatory measures of this type have been successfully applied in Jordan to help brake the concentration of ownership in private sector enterprises.

Demand for Securities

For securities markets to flourish, it is not enough to introduce supply-side measures without also adequately stimulating investors’ interest. It would not be reasonable to expect the supply of securities to increase while demand remains constant or only rises marginally. Undersubscription of issues in such a situation would ultimately dampen the interest of potential issuers in the market. Arab policymakers should therefore introduce an appropriate set of policies that would successfully stimulate demand for securities while increasing supply.

As conditions may differ from market to market and change from time to time, the policies should shift intermittently from the need to correct inadequate supply to that of giving a boost to slacking demand. Demand-side policies could take various forms as described below.

Public Enlightenment. In many Arab countries, particularly those with capital-deficit economies, the level of awareness about the securities market is relatively low. Without awareness, these markets are not likely to develop well. To improve knowledge about the market, therefore, stock exchanges and other market operators need to embark on public enlightenment programs about the benefits of investment in the capital market. Additionally, regular publications that disseminate accurate and up-to-date information on various aspects of the market are necessary. The development of financial journalism and financial newspapers, currently lacking in Arab countries, would disseminate information to the public and consequently enhance knowledge about the securities market. The results achieved by Kuwaiti and Jordanian markets are particularly impressive in this regard. Three other countries—Bahrain, Oman, and Saudi Arabia—are fast improving the mechanisms that disseminate information.

Financial Instruments. The gradual introduction of new instruments tailored to investors’ needs is essential for the growth of trading activity and the general development of the securities market. In Arab markets, the types of instruments are not varied and trading is limited to only traditional ordinary shares and bonds. Introducing variants of these might stimulate not only demand for but also the supply of securities in the market.

Transaction Costs. The high cost of transactions (brokerage fees, stamp duties, contract stamps) may discourage investors from participating in the market and vice versa. Arab markets should therefore ensure that transaction costs are kept at the barest minimum. Moreover, the GCC member countries may need to unify the structure of transaction costs to further pave the way for intra-GCC securities trading activity. The current structure differs widely among Bahrain, Oman, and Saudi Arabia. In Kuwait the costs are negotiable between the parties concerned.

Investment Funds. Investment funds such as unit trusts and mutual funds enhance capital market growth by mobilizing and investing the savings of small investors. Arab markets should encourage the development of investment schemes that are securities market oriented to attract more individual investors to participate indirectly in the market. This aspect of market development goes hand in hand with the above-mentioned public enlightenment policies. Saudi banks have in recent years been particularly active in promoting the establishment of different types of funds. Perhaps, these funds might better serve the promotion of securities ownership throughout the GCC by getting around the restrictions imposed on direct ownership of companies’ shares by nonnationals.

Margin Loans. The provision of margin credit for loans would help induce demand for securities and enhance trading. Without some general guidance, brokers (essentially banks in most Arab countries) tend to overextend margin loans to customers, thereby fueling speculation and endangering the banks’ financial health. Desirable limitations include specific margin limits, margin calls, margin loan contracts between brokers and clients, and stringent collateral arrangements. No Arab country has yet adopted these measures.

Fiscal Incentives. Tax incentives to investors are perhaps one of the most effective methods of increasing the demand for securities. Specific measures can include

  • Elimination, or reduction if necessary, of withholding tax on dividends earned on equity investments to bring them significantly below the prevailing rates for competing investments.

  • Apart from exempting capital market investments from withholding tax, capital gains on such instruments should also be made tax free. In most Arab markets, capital gains are already exempted from taxation.

  • A tax policy that would allow investors to deduct some of the amount invested in capital market instruments or, at least in new issues, from income tax is another way of enhancing the demand for securities. In countries implementing privatization programs or where mutual funds are operational, special tax incentives could be introduced to promote participation in investment funds. Investment activities of some institutions, e.g., insurance companies and pension funds, are in fact vital to the securities market because some of their surplus funds are invested in market instruments.

Other Market Policies

Besides policies aimed specifically at influencing either demand or supply, Arab countries may introduce other policies that could improve the efficiency of intermediation, information, and market surveillance. In addition, governments could link current economic reform programs such as privatization and debt conversion to capital market development.

Intermediation Mechanisms. Financial intermediaries, including brokerage firms, issuing houses, investment banks, and underwriters are vital in the development of the securities market and the financial system as a whole. With a wide range of competitive institutions intermediating in the system, costs would also be reduced further, enhancing market activity.

Arab markets should therefore endeavor to improve the number, type, innovativeness, and activities of financial intermediaries. Standards for brokers and underwriters should be established by legislation or through self-regulation of brokers’ and underwriters’ associations. Policies should be aimed at providing a coordinated regulatory environment conducive to growth. Technical assistance reports of the AMF have noted that one of the major blocks to portfolio investment flows within the GCC is the fact that intermediaries cannot operate regionwide.

Quality of Information. Some Arab markets have been particularly active in trying to ensure that proper auditing and accounting standards and procedures are put in place while the disclosure of information is adequate and accurate enough to protect investors.

Most Arab countries, however, need to develop a strong and independent auditing profession that is adequately remunerated. Disclosure and financial reporting requirements should include not only include a prospectus at the time of a new issue but also regular publication of financial information through annual reports and quarterly earnings reports. To foster the growth of foreign portfolio investment in capital-deficit economies, outside investors and their intermediaries need to be able to form an informed judgment regarding their financial health and growth prospects.

Market Surveillance. Efficient and effective surveillance systems are vital to the development of securities markets and have been one of the priorities of the currently operating Arab stock exchanges. Because the level of economic, technological, and securities market development of countries differs considerably, systems should be further developed as appropriate for each case.

More Arab markets have developed adequate surveillance methods in recent years and often require insiders to disclose their sales and purchases of the company’s stock on a periodic basis. Legislation in the area of insider trading, however, has usually been difficult to enforce in Arab markets. It should perhaps be progressively formalized while control is exercised on an informal basis during the early period of securities market development.

Regional Integration Prospects

The Case for Transnational Securities Investment

The current lack of integration among Arab capital markets is a direct reflection of the unequal development of their respective legal and administrative restrictions, a lack of proper regional brokerage intermediation, and the limited access for nonresident investors to reliable, sufficient, and regular information.

Financial intermediation among Arab countries continues to be carried out mainly through the international capital markets. The major factor limiting inter-Arab financial intermediation is the prevailing imbalance between the demand for and supply of capital at varying maturity levels. Demand for capital in the Arab “deficit economies” is mostly for project investment needs of a long-term nature that produce low rates of return in the early stage of development. In contrast, supply of capital in the “surplus economies” of the region is attracted by the liquidity and high rates of return of short-term financial instruments provided by the international financial markets. Arab capital markets are not capable of bridging this maturity gap.

Limited economic integration among Arab economies is another factor constraining financial flows. While some progress has so far been made toward economic integration, especially within the GCC subgroup, more could be done to encourage brokerage intermediation across borders and coordinate financial policies overall.

Host Country Attitudes

Protectionist attitudes in the Arab countries have been dictated by two factors—a fear that nonnationals will gain control of the domestic economy and a fear that foreign portfolio investment will bring in hot money that could suddenly be withdrawn and create disruption in the domestic capital market.

Experience of the fast-growing developing economies has shown that these fears are to a large extent unfounded. To overcome these fears, corporate boards of directors may be required to be composed entirely of residents. A maximum could also be set on the number of votes by any individual shareholder.

As to the fear of “hot money,” these flows can be reduced by the issuance of different types of investment instruments by which foreign investors can be restricted to buying special shares or convertible debt issues that limit the portion of a company’s shares available to them. Alternatively, foreign portfolio investment may be limited to closed-end or partially closed-end investment trusts such as country funds. Closed-end funds cannot be liquidated; investors in the fund who wish to withdraw must sell their holdings to others on the secondary market.

Arab policymakers need to address these issues and remove other impediments to inter-Arab capital flows, as well as standardize and integrate policies and procedures on financial disclosure and rules governing “fair play” in new issues and equity market transactions.

Common standards and close cooperation are essential to prevent cross-border manipulation, which harms market efficiency and damages confidence of investors, especially foreign investors.

Regionalization of Trading

There are several alternative approaches that should be evaluated by Arab securities markets officials. The first alternative, previously tried in Kuwait, would allow securities issued by any company validly incorporated under laws and regulations of an Arab country to be listed and traded in the market of another Arab country, other than the one of incorporation. This would represent the most liberal but also the riskiest approach possible. It would allow companies incorporated under “liberal” legal provisions and not listed in the country of incorporation to seek listing elsewhere. The unfortunate experience of the Souk Al-Manakh in Kuwait comes to mind, where shares of companies incorporated but not listed in Bahrain and the United Arab Emirates were eligible for trading.

The second alternative would allow securities issued by a company validly incorporated under laws and regulations of any Arab country to be listed for trading in any formal market of another Arab country, provided that it meets all listing requirements. This would ensure that the more restrictive of the respective company laws, etc., would prevail. As no listing in the country of origin is required, the extent of risk depends upon the relative level of listing requirements in the market of trading. This alternative does provide access to formal markets for securities issued by companies in countries without formal markets. Still, it would not present a wholly satisfactory alternative, unless the requirements of the legal and regulatory framework of the country of trading were high.

The third alternative would allow securities issued by any company validly incorporated under laws and regulations of any Arab country and listed for trading in a formal market of the country to be listed for trading in the formal market of another Arab country, provided they meet the company and securities market law as well as listing requirements of the country where they intend to be listed. In the absence of a high level of harmonization among markets, this alternative may provide better protection for investors.

The fourth alternative would preserve the requirements of the third alternative but would establish additional conditions to be satisfied for intra-regional listing, such as higher levels of capitalization (or assets, sales, or similar indicators of size), minimum outside ownership distribution, corporate existence, profitability, and other criteria. This would limit access to regional trading to the more seasoned companies of the “home” countries. It represents the most conservative approach but also could impair incorporation of new enterprises through intra-regional public offer, unless specific rules were laid down for such purposes.

The fifth alternative would be to confer upon a regional intergovernmental agency or agencies the authority to establish, apply, and exact compliance with uniform requirements for intraregional trading of securities issued by companies incorporated in Arab countries. In this case, issuers would still have to satisfy the provisions of the local legal and regulatory framework of their country of incorporation; but, as far as intra-regional ownership distribution and trading is concerned, issuers would submit to the authority of a regional supervising agency. Intra-regional trading would not be confined to physically established local markets, but rather take the form of computerized trading on the basis of geographically dispersed input of bids and offers; the Saudi Arabian electronic trading system could serve as a model for this scheme.

This regional agency or agencies, should have the following authority:

  • To establish listing requirements for intra-regional trading and enforce compliance therewith at the penalty of delisting from intra-regional trading and sanctions for those responsible for such noncompliance;

  • To establish and enforce financial reporting standards and procedures, including timely disclosure of periodic or occasional financial information;

  • To establish uniform accounting and auditing norms and standards;

  • To require external auditing by independent auditors;

  • To license intermediaries to operate as brokers or, under investor protection conditions to be established by such agency, as dealers in the intra-regional market; and

  • To establish trading and settlement systems and procedures including those concerning the type of document showing ownership of the respective securities, such as share certificates, depository receipts, or current account systems for “paperless” securities.

Conclusion

A strong and healthy securities market plays a central role in fostering economic development. By encouraging savings and directing those savings into more productive channels, it allocates savings and investment allocation and enables the free market mechanism to achieve a better mobilization of internal resources, attract external resources, and secure a more equitable distribution of income and wealth.

Equity capital is important in that it helps provide the production sector with permanent finance with no contractual payments. By contrast, nonnegotiable bank-type debt finance, be it with fixed or floating rates of interest, carries contractual interest payments whose impact has traditionally been destabilizing in periods of business downturn, both for the borrowing enterprise sector and the lending financial institutions. Reliance on loan capital has resulted in an accumulation of debt within the Arab corporate sector that now constrains economic and financial management in a wide range of Arab countries.

Securities markets, rather than banks, have traditionally been the principal source of finance for long-term investment. Governments as well as private companies issued stocks and floated bonds to fund early industrial expansion in the industrialized economies. The preponderance of short-term bank debt finance during the past two decades was brought about mainly by the need to recycle the oil surpluses of the 1970s. This created unprecedented financial instability in the debtor countries and stunted their growth prospects as well as led to the disruption of capital flows from the industrial to the developing world.

The recent experience in both country and corporate overindebtedness in the Arab region as well as throughout the developing world has demonstrated the serious problems that can arise from the lack of efficient securities markets to match the highly integrated international banking market. Easy access to bank lending and difficult access to securities markets led inevitably to a sharp increase in floating rate debts relative to equity. In this context, commercial banks in Arab countries should concentrate more on their conventional role as providers of working capital and trade finance. Securities markets should be promoted to take the major responsibility for providing long-term development finance.

It is important to note that the deregulation movement taking shape in world financial markets has grown out of an institutional structure that has already reached a high degree of competitiveness both in terms of specialization and number of banks and securities firms. Arab capital markets have a long way to go to reach that stage.

The need to mobilize domestic savings to increase the level of investment outlays and attract foreign capital in non-debt-creating forms explains why Arab and developing countries should foster their emerging equity markets.

The task for the surplus economies is to reduce capital flight and develop alternative financial instruments to help channel excess liquidity toward the production sectors and away from speculative activities that disrupt the normal functioning of domestic securities markets.

It is equally important for the deficit economies to make better use of internal sources of financing and improve domestic financial intermediation structures necessary to attract foreign portfolio investment.

Market stimulation policies coupled with successful macroeconomic policy adjustment are vital to the development of securities markets and should therefore be implemented in a coordinated and mutually reinforcing way. Institution of stimulation policies for market development requires the involvement of regulatory authorities, market operators, and the government itself. In Arab markets, a strong political will may also be necessary to introduce such policies and to promote regional coordination and integration.

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The views expressed in this paper are the author’s and do not necessarily represent those of the Arab Monetary Fund (AMF).