Strong and dynamic modern financial institutions and systems are important prerequisites for MENA countries to compete in the global economy and achieve full integration into world financial markets. While most MENA countries have undertaken financial sector reforms over the past two decades and have made progress in financial deepening, financial sectors remain generally underdeveloped compared with the fast-growing developing countries. As a broad measure, M2 in MENA has remained on average around 60 percent of GDP, significantly lower than the high-performing Asian economies, but somewhat better than countries in Latin America and the Caribbean. Furthermore, the regional indicator is biased upward by the high level of financial deepening in the Mashreq (particularly in Israel, Jordan, and Lebanon; see Chart 1).1 Progress in financial sector reform now is more urgent than ever if the region is to reap the full benefit of reforms undertaken in other areas, raise significantly the levels of domestic saving and investment, and promote higher economic growth and employment creation.
Financial Deepening
(M2 in percent of GDP)
Source: International Monetary Fund, World Economic Outlook.Financial Deepening
(M2 in percent of GDP)
Source: International Monetary Fund, World Economic Outlook.Financial Deepening
(M2 in percent of GDP)
Source: International Monetary Fund, World Economic Outlook.Successful financial sector reforms have been aimed at mobilizing domestic savings and enhancing their efficient use, promoting the role of market forces in the pricing and allocation of financial resources, and strengthening domestic bank institutions and improving their supervision. To be most effective, such reforms need to be part of a broader agenda of economic and structural change through trade liberalization, fiscal reform, privatization of public enterprises, and reform of prices and the incentive system.
The MENA Financial System Prior to Reforms
The financial sector in the MENA countries tended historically to be relatively narrow, heavily regulated, and somewhat isolated from global developments. The buffeting of the international financial system by the oil shock of the early 1970s provided an important impulse to change (although reform did not take hold in the region until the early 1980s) and underscored differences between oil exporters (mainly in the GCC) and oil importers. The main developments underlying the financial systems characteristic of these two groups, together with a short description of the special cases of Israel and Lebanon, are outlined below.
GCC countries. Between the early 1970s and late 1980s, most of the GCC countries ran large current account surpluses and exported significant amounts of official and private capital. During this period, these countries were, in effect, major providers of funds to global markets, whereas other MENA countries were absorbing funds in the context of rising fiscal and external imbalances. In the GCC countries, banks strove to capture larger shares of the intermediation business that was flowing to industrial country institutions through the promotion of offshore centers, such as in Bahrain, and by forming alliances with Western financial institutions. This, together with the prevailing open economic environment in these countries (currency convertibility and free capital movements), helped domestic financial institutions acquire technological know-how and managerial skills.
Differences in financial systems of oil and non-oil countries
Other MENA countries. In most other MENA countries, bank intermediation and financial markets were to a large extent shaped by the public-sector-driven development strategy that was pursued during the 1970s and much of the 1980s. In the framework of such a strategy, the role of financial institutions—most of which were in the hands of the public sector—was to help achieve development objectives set by the government, primarily by financing the public sector and priority activities such as export activity, tourism, and small and medium-sized enterprises. In many countries, domestic deposits were subject to interest rate ceilings, which in turn allowed the government and public enterprises to borrow at below-market interest rates. Until the mid-1980s, interest rates were administratively set and often were negative in real terms, credit was allocated on a bank-by-bank basis, financial institutions and markets were underdeveloped and tightly controlled by the government, and effective competition was lacking. In contrast to the more open economies of the GCC, the private sector and financial institutions were generally insulated from the international financial markets by tight restrictions on current account transactions and capital movements.
The financial structures in Lebanon and Israel stand out as special cases in the MENA region. Both countries have well-developed financial systems. Israel has well-established stock and bond markets, a variety of institutional intermediaries such as mutual funds and pension companies, a monetary policy conducted through indirect instruments, and a developed, albeit oligopolistic, banking system. However, until the mid-1980s, the Israeli financial sector was characterized by a high degree of government involvement. Lebanon has a long tradition of a highly liberalized and developed financial system. Unlike Israel, Lebanon’s banking system was characterized by a large number of small banks and a relatively competitive banking sector that served primarily to intermediate petrodollar revenue. The Lebanese financial system, however, has suffered greatly from the instability associated with years of war and has just begun the process of reconstruction and redevelopment.
Characteristics of Monetary and Financial Systems in MENA
While characteristics of the financial sector differ among the countries in the region, some general conclusions can be drawn about the operation of the monetary and financial systems prior to the period of reform, beginning in the early 1980s.
MENA financial systems: narrow and overly regulated
Monetary policy was conducted through direct allocation of credit and refinancing, legislated interest rates, the manipulation of reserve requirements, and a rationing of excess demand for credit through bank-specific credit ceilings. Banks often had a mandated portfolio and were forced to hold treasury and other public sector bonds at below-market rates. Other financial intermediaries (such as insurance companies and pension funds) also were required to hold a large portion of their portfolios in government debt (Egypt, Israel, Jordan, and Morocco). Financial institutions were frequently compelled to lend at preferential rates to designated priority sectors, such as agriculture (for example, in Israel, Morocco, and Tunisia), tourism, or the export sector (for example, in Morocco and Tunisia). In some countries, credit was tightly controlled, with the central bank directly approving individual loans. In others, such as Algeria, it was the treasury, not the central bank, that played the role of controlling liquidity and interest rates.
Banking systems in the region were often highly oligopolistic, with limited competition among the banks, which in many cases were owned by the state or by a small number of prominent families. Many of the banks were forced to make loans to state enterprises with little prospect that these loans would ever be repaid (for example, Algeria, Egypt, Jordan, and Tunisia). In others, such as Kuwait, the banks were associated with speculative loans, followed by a massive collapse of their portfolios as with the Souk Al Manakh crisis. As a result, many of the banks in the region carried substantial nonperforming loans on their balance sheets and required continual government support to remain solvent. This problem was generally compounded by a lack of rigor in supervision and regulation of banks and other financial institutions.
The range of financial instruments available to the banks and the public tended to be narrow, with maturity structures and yields unrelated to risk and liquidity. Although most countries in the MENA region have had stock markets for some time, many of these markets—with the notable exception of Jordan and Israel—were dormant through the 1980s and not used as an important channel of capital from savers to borrowers. In the GCC countries, in particular, the ability of nonresidents to participate in the stock market was severely restrained by rules reserving these markets for national residents.
Wide-ranging economic distortions led to slow growth
The economic effects of such an underdeveloped and tightly regulated financial system are difficult to disentangle from those arising from other distortions and economic mismanagement. In this respect, MENA’s experience was similar to that of other regions in the world. In the early 1980s, many non-oil countries in MENA experienced rising fiscal deficits that led to excessive credit creation, a surge in imports, a fall in international reserves, and a substantial buildup of external debt; in others, inflation rates were high, and negative real interest rates strongly discouraged private saving and distorted resource allocation. These were compounded by weaknesses in the regulatory framework and in the enforcement of existing laws. Thus, it can reasonably be concluded that the relatively unsophisticated and tightly controlled financial systems contributed to the region’s sluggish growth performance during the second half of the 1970s and mid-1980s.
Features of the Reform Experience
Since the mid-1980s, many MENA countries have moved toward a financial system that operates in a more competitive environment under market-determined prices and interest rates, and away from mandatory allocation of capital. The extent of reform has varied in both focus and depth, but in all cases, the objectives of the reforms have been to strengthen the role of market forces in bank intermediation, improve the capacity of institutions to mobilize domestic savings, enhance competition among banks, encourage new entrants into the market, and reinforce the soundness of the financial sector.
Positive response of savings and investment is evident
In a number of countries, financial liberalization has often been accompanied by, or has followed, broader macroeconomic reforms (such as trade liberalization and fiscal reform), sometimes in the framework of IMF-supported programs (Algeria, Egypt, Jordan, Morocco, and Tunisia). In the GCC countries, steps toward reform were generally motivated by adverse developments in oil markets and rising financial constraints, which exposed the rigid and undersupervised structure of the financial system. However, in a third group of countries (Iraq, Libya, and the Syrian Arab Republic), the reform process has yet to take hold. In those MENA countries that embarked on a wide range of structural reforms, the reforms in the financial sector have led to an improvement in the overall health of the banking sector, a repatriation of capital attracted by stability and higher rates of return, and an expansion of private sector deposits in domestic financial entities. In a number of countries, the ratio of credit to the private sector in total domestic credit increased significantly during the postreform period (Egypt, Israel, Morocco, and Tunisia), although, broadly speaking, the ratio declined significantly in the GCC (Chart 2). Bearing in mind the impact of other factors and difficulties of measurement, there is some evidence that national saving and investment have responded favorably in cases where reforms have been implemented. For example, private saving in Tunisia rose from 13 percent of GDP on average in 1981—87 to 18 percent in 1992—95; in Jordan total saving rose during the same period from 17 percent to 21 percent of GDP.
The main elements of the reforms that have been undertaken by MENA countries over the past decade include interest rate liberalization, monetary policy reform, supervision and regulatory reform, diversification of financial instruments, and stock market reform.
Interest Rate Liberalization
An important component of financial reform is to allow the cost of money—the interest rate (or, in a system working on Islamic principles, the rate of return)—to be responsive to market conditions. (A brief overview of Islamic financial systems is provided in Box 1.) When rates are too low or negative in real terms, savers will avoid placing funds with the financial system and seek alternatives, such as investing in real estate, higher consumption, or otherwise fleeing the domestic currency. The same conditions can cause excessive and inefficient borrowing by the government or the business sectors, resulting in distortions of credit allocation and higher inflation. As these problems have become evident, a number of MENA countries have moved to liberalize interest rates in recent years—Algeria, Egypt, Israel, Jordan, Kuwait, Morocco, Tunisia, and the Republic of Yemen—although progress has not been uniform.
Allowing the cost of money to respond to the market
Islamic Financial Systems: The Islamic Republic of Iran and Sudan
Islamic banking has grown rapidly in Muslim countries, with total deposits now in excess of US$25 billion. Although about 45 countries have some form of Islamic financial institutions, within MENA, the Islamic Republic of Iran and Sudan have carried out the most advanced experiments in the adoption of Sharia banking principles, which forbid the payment of interest or returns that are fixed ex ante.
Islamic banks in these two countries offer two forms of deposits: (1) transaction deposits, which do not pay returns and for which the bank guarantees the nominal value, and (2) investment deposits, which are similar to shares in investment firms and on which the bank does not pay fixed returns or offer any guarantee. On the lending side, operations take place with various kinds of purchase or sale or profit-sharing agreements where rates of return also are determined ex post.
Since the mid-1970s the Islamic financial system has evolved along two lines. In the first, Islamic financial institutions were established in parallel with conventional banking and were successful at attracting depositors who rejected the notion of ex ante returns. The second form—illustrated by the Islamic Republic of Iran—has involved restructuring the economy as a whole, starting with the financial sector, to be consistent with Islamic principles. During this process, Iranian banks converted smoothly to Islamic modes on the deposit side, while progress on the lending side has been slow. Moreover, the authorities have encouraged the Teheran Stock Exchange as a means of promoting private sector finance that is consistent with Islamic principles.
While Islamic banking has expanded notably in the last 15 years, it faces a number of challenges in its further development, including the expansion of instruments and markets. Another issue relates to the consolidation of regulation and supervision. Expertise in this area is currently being developed. The collapse of several Islamic investment houses in Egypt in the late 1980s prompted the authorities to supervise these institutions more closely. Experiences elsewhere show that Islamic institutions can be sound, well-run institutions. Indeed, the recent establishment of an Islamic branch of Citibank in Bahrain attests to the potential development of this type of intermediation. While mechanisms have not yet been developed fully, nothing in the theory or practice of Islamic banking suggests that it is incompatible with a viable and well-supervised financial system.
The early impact of interest rate liberalization is difficult to assess. Where interest liberalization was not accompanied by strong fiscal adjustment, increased competition among banks, and free capital movements (Jordan, Morocco, Tunisia), real interest rates remained relatively high during the postreform period, thus tending to crowd out the private sector and inhibit investment. A related development was the phasing out of mandated lending and increased government recourse to borrowing at market interest rates with the accompanying fiscal costs. In Jordan, the preferential credit facilities to the public sector have been eliminated and the related subsidies have been entered explicitly into the budget; in Morocco and Tunisia, the authorities eliminated or reduced considerably the scope of mandated bank borrowing; instead, the governments increasingly relied on auctions of treasury bonds at market-determined interest rates to finance fiscal deficits.
Monetary Policy Reform
In line with the general trend toward deregulation and liberalization, many countries moved gradually toward adopting indirect instruments of monetary control, establishing secondary markets in tradable instruments, and removing distortions such as credit ceilings and portfolio restrictions. In Jordan, a weekly auction for certificates of deposit (CDs) was introduced in 1993, and by 1994 the Central Bank of Jordan began to guide liquidity through intervention in the CD market to regulate reserve money. In Egypt, a weekly treasury bill auction was introduced in 1991 and credit ceilings were removed in 1993. In Morocco, the money market was strengthened and the range of participants was widened after treasury bill auctions were introduced; direct credit controls and ceilings were abolished, and in 1995 regular repurchase auctions became the primary instrument for liquidity management. In Tunisia, the main instruments of liquidity management since the early 1990s have been credit auctions and a central bank repurchase facility; there is an interbank money market, although the latter remains little used. The Kuwaiti authorities have since the mid-1980s increasingly relied on a wide range of instruments—discounts, repurchase agreements, foreign exchange swaps, and open market operations—to influence liquidity in their market. In Algeria, an interbank market was established in 1989, and a repurchase mechanism introduced.
Moving toward indirect monetary control
While such examples attest to the relatively widespread use of indirect instruments of monetary policy in the MENA region, in many cases market mechanisms have not operated fully in the allocation of liquidity or the determination of interest rates. Central banks have in some cases tended to rely on moral suasion and implicit direct control in order to affect bank liquidity and credit allocation. In other cases, the commercial banks themselves have contributed to limiting the scope of competition on the basis of interest rates.
Supervision and Regulatory Reform
The safety and soundness of financial intermediaries has become an important issue worldwide and in the MENA region in the wake of financial liberalization and heightened competition. As banking crises within the region and outside have shown, “regulatory failure” can be severe and can have adverse effects on financial stability (Box 2). Thus, it is not surprising that reforms of bank regulations in a number of MENA countries have been in response to financial crisis. For example, banking regulation in Jordan was tightened mainly after the Petra Bank failure; in Israel after the bank rescue package of 1983; in Djibouti after the 1991—92 failure of two major banks; in the United Arab Emirates after the collapse of the Bank of Credit and Commerce International; and in Kuwait after the Souk Al Manakh crash of 1982. In Algeria, banking regulation was strengthened in 1995, after the government was forced to take over large amounts of nonperforming claims on public enterprises. In Morocco and Tunisia, however, bank regulations were tightened in the framework of structural adjustment programs supported by the World Bank and in line with international trend.
Improving prudential supervision is an essential aspect of the reform process
In most of the MENA countries, as elsewhere, primary responsibility for regulation of the financial sector has been entrusted to the central monetary authority, and here too, progress has been made. Bank supervision has been improved, with many countries having taken steps to conform to international norms, such as the Basle capital adequacy standards.
In parallel with the strengthening of prudential regulations, efforts have been made in many countries to recapitalize banks, clean up their balance sheets, and allow them more freedom in determining the composition of their portfolios. Several MENA countries have gradually moved away from administrative restrictions and demands on the banks and other financial institutions to lend to the government or to public enterprises at below-market interest rates (Algeria, Jordan, Morocco, Tunisia, and Egypt). In others, the sectoral specialization of commercial banks was considerably reduced (Tunisia) or abolished, while restrictions on the portfolios of investment companies, mutual funds, and pension companies have been considerably loosened (Israel). In the same vein, efforts have been made to resolve the problems of nonperforming loans to government entities and enterprises.
In many countries, the improvement in formal prudential requirements has been complemented by intensified monitoring of depository institutions (Bahrain, Egypt, Jordan, Kuwait, Morocco, Tunisia, and the United Arab Emirates). Banks in several countries have been limited in their exposure to single borrowers and in their foreign exchange exposure. While of course it cannot be concluded here or anywhere else that all possible crises are past, the breadth of progress in central bank oversight in the MENA countries is encouraging.
Financial Crises in Israel and Jordan
Israel: The 1983 Bank-Share Crisis
During the late 1970s and early 1980s Israel’s commercial banks actively traded their own stock in order to enhance their share prices in a high-inflation environment. The banks needed to meet prudential ratios and it was advantageous for them to have overvalued capitalizations. From 1977 to 1983 the share appreciation, along with new public offerings at inflated prices, contributed to a 700 percent rise in the banks’ market value. Banks were able to maintain such high prices because they had a dominant position on the Tel Aviv Stock Exchange. In addition, banks extended loans to purchase bank shares and relaxed the collateral requirements on such loans. Since the banks owned the mutual and provident funds, they were also able to persuade these intermediaries to purchase bank shares.
Banks’ purchases of their own shares eventually strained liquidity, and the undercollateralized loans raised concern about bank stability and threatened a run on deposits. The unchecked cartel behavior of banks, poor regulation, and the exemption of banks from insider-trading regulation all contributed to the ensuing bank-share crisis. In October 1983, the Tel Aviv Stock Exchange was shut down for 18 days following heavy selling of the shares of virtually all commercial banks in Israel. During the closure, the government devalued the currency and took over five of the banks. Bank shares were exchanged for zero-coupon government bonds yielding generous rates of return. After the Tel Aviv Stock Exchange reopened, share prices fell an additional 40 percent. Thirteen years after this state bailout, the government has not yet re-privatized the banks.
Jordan: The 1989 Bank Failures
After the second oil price shock, Jordan experienced large inflows of workers’ remittances, which in turn led to a rapid expansion of private sector construction. Banks provided large amounts of loans that were collateralized by real estate. By the late 1980s, when the real estate bubble burst and the market slumped, several banks were left with numerous nonperforming loans on their balance sheets. In addition, others had large foreign exchange exposure because of speculative positions they had taken between the official and parallel exchange rates. Petra Bank, the third largest commercial bank, collapsed in August 1989 and was merged with another institution.
In 1989, the Central Bank of Jordan was forced to inject massive amounts of funds—equivalent to 10 percent of GDP—to settle the foreign obligations and to meet the run on the insolvent banks. The blame for the crisis lay in inadequate banking regulation, overexposure to an overvalued real estate market, and imprudent speculation on foreign exchange. Since 1990, the Central Bank has implemented stronger measures governing loan loss provisions, capital adequacy, and rules on commercial bank portfolios.
Diversification of Financial Instruments
The development of new instruments that are attractive to savers and investors has been another aspect of reform. As noted earlier, some MENA countries have introduced marketable government debt instruments in the context of moves to indirect monetary control, whereas others have sought to mobilize domestic savings by offering savers a wide range of new instruments (certificates of deposit, mutual fund shares, and government and private corporate bonds). Work has also intensified on the development of a broader set of Islamic-based instruments covering both sides of the balance sheet.
In general, the institutional infrastructure of secondary and interbank markets have been set up, although the former are still lacking the necessary depth, and activity in the latter is limited, reflecting the oligopolistic nature of financial intermediaries. Moreover, the choice of instruments for both savers and borrowers still remains largely confined to short-term instruments, while longer-term instruments, if they exist, have been limited to government paper. In some MENA countries, there has been a move toward more innovative ways to finance fiscal deficits through domestic, tradable debt, which also provides instruments to the bank and nonbank public. Despite these innovations, many of the MENA markets remain relatively simple, with a general reluctance of private companies to issue longer-maturity paper.
Stock Markets
Equity markets have a long history in some MENA countries (Egypt, Jordan, Kuwait, Lebanon, and Morocco). However, not all markets have been able to effectively promote their role of mobilizing savings for productive investment. Several factors lie behind this shortcoming, including in some cases a lack of macroeconomic stability, investor concerns regarding the status of legal and institutional infrastructures, the lack of efficient financial intermediaries, the presence of tax distortions, restrictions on ownership that discourage investment in equities, barriers against foreign participation, and the limited number of financial instruments available.
The development of equity markets still faces many constraints…
In the aftermath of the Middle East crisis of 1990–91, many stock markets in the region boomed, reflecting the favorable impact of stabilization programs, the impact of debt relief, and greater optimism about the peace process. However, the activity of this period in large part has tapered off,2 and, in some cases, the markets have seen a substantial correction. While the infrastructure for equity issuance and trading is in place, administrative constraints and high transaction costs have tended to discourage firms from floating issues in the primary market, albeit to a declining extent. As a result, most of the market capitalization in the regions’ equity markets has been until now in financial institutions or in closed company shares held largely by the public sector. In many countries, the limited activity of the stock markets can also be attributed to the importance of public enterprises in the economy.
…but recent reforms have improved the legal and regulatory environment
A number of MENA countries have moved to reform their stock markets.
In Morocco a new stock market law was adopted in 1994, the stock exchange was privatized, and an independent commission entrusted with its oversight. The new law, combined with a strong privatization program, has caused capitalization to almost double in relation to GDP and turnover to surge since 1993 (Chart 3).
In Tunisia, the modernization of the legal and regulatory environment, which began in 1989, was significantly broadened in 1993. As a result, the stock market has boomed, with capitalization increasing ninefold during 1990-95.
In Egypt, the Capital Market Act (1993) revamped the legal framework for the securities market, allowing for foreign participation, increasing competition, prohibiting insider trading and other practices, and enforcing international accounting standards with more stringent regulation. The law helped revive the Cairo and Alexandria exchanges, which are among the oldest in the region and had languished for many years.
Market Capitalization
(In percent of GDP)
Sources: International Monetary Fund, International Financial Statistics, and International Finance Corporation,Market Capitalization
(In percent of GDP)
Sources: International Monetary Fund, International Financial Statistics, and International Finance Corporation,Market Capitalization
(In percent of GDP)
Sources: International Monetary Fund, International Financial Statistics, and International Finance Corporation,Except perhaps in the GCC area, foreign participation in MENA equity markets is being allowed incrementally. In some countries, restrictions on nonresident investment have been removed, but this process is not complete. On the Cairo Stock Exchange, foreign investors recently accounted for less than 2 percent of market capitalization, due in part to restrictions on capital mobility. These restrictions have been lifted recently, which resulted in foreign investors’ tripling their share of the Cairo Stock Exchange in the first half of 1996. Foreign participation is highest on the Amman Financial Market, where there are no restrictions or taxes. In the GCC, however, foreign participation is generally prohibited, although there are some reciprocal agreements allowing GCC residents to participate in the stock markets of other GCC countries.
Competition and market deepening are key issues
Outstanding Issues: An Agenda for Action
MENA countries have taken important steps toward reform of their financial sectors. However, the process has been gradual and is far from complete. Further concerted action is needed in several key areas such as strengthening market forces, reducing government ownership of financial intermediaries, strengthening the soundness of the banking system and improving the regulatory framework, deepening the financial sector, and opening up to foreign participation.
Strengthening Market Forces in the Financial Sector
Efficiency should be enhanced through greater reliance on market forces in the allocation of resources and the determination of interest rates. Liberalization of interest rates, promotion of competition among banks, and diversification of financial instruments are important policy measures for achieving this objective. In such an environment, monetary policy would be ideally conducted on the basis of indirect instruments of control.
To enhance competition among banks, the authorities should strengthen and enforce antitrust regulations, establish transparent rules for the entry of new banks and financial institutions, and eliminate market segmentation. Furthermore, the absence of active interbank and money markets has hindered the market determination of interest rates and the conduct of monetary policy through indirect instruments. The development of a deeper money market would allow a more market-based determination of interest rates. To this end, tradable and liquid government paper should be introduced or promoted, which in turn would facilitate the use of open-market operations by the central bank.
While instruments of indirect monetary control have been introduced in many MENA countries, their use has been undermined by efforts to direct credit toward preferred sectors. An important aspect of reform is to move away from direct controls over bank assets and liabilities, which generate costs and distortions, and ensure that overall liquidity and credit are controlled through indirect, that is, market-based, instruments. Indirect instruments have advantages of neutrality and flexibility that direct controls cannot achieve, and they rely on bona fide market incentives to produce the desired allocation of resources.
Reducing Government Ownership of Financial Intermediaries
Despite some progress in the privatization of banks and other financial institutions, in a number of MENA countries the state still exerts a strong hold over the financial sector through ownership of the main intermediaries. Throughout MENA, privatization would open up avenues for improvement in competitiveness and efficiency of capital allocation. Among other benefits it would
encourage new entrants and ensure a more level playing field among market participants;
help redirect bank lending operations away from the government and into private sector activity; and
as competitive pressures increase, promote financial innovation and help mobilize domestic savings.
Privatization as a means of enhancing efficiency
Strengthening Bank Soundness and Enhancing the Regulatory Framework
Most MENA countries have taken steps to restore the soundness of their banking system through recapitalization, provisioning of bad loans, and the establishment of prudential norms and accounting standards in line with international rules. Nevertheless, the banking system in many countries still suffers from bad loans, and several banks, notably those owned by the government, do not yet meet internationally accepted capital adequacy norms. The focus of regulatory and banking system reform should be on the following three issues:
Strengthening loan provisioning and collection mechanisms, resolving the problem of nonperforming loans owed by government entities and public enterprises, and encouraging recapitalization and, in some cases, mergers of existing banks.
Further enhancing on-site supervision, improving accounting standards, and strengthening transparency. In addition, MENA countries might also benefit from harmonization of banking and financial regulation across the region. This could entail establishing common accounting standards, reciprocal information systems on banks that operate across borders, and similar regulatory environments and promoting a coordinated approach to credit ratings.
Introducing a simple and transparent deposit insurance mechanism in much of the region’s banking industry (while taking account of the inherent moral hazard issues involved). In some countries, although there is a tacit understanding that the state will stand behind deposits, no formal scheme exists; in other countries, an insurance scheme may exist, but funding may be in doubt.
Deepening the Financial Sector
In many MENA countries, the range of instruments available to savers and borrowers is still limited and consists primarily of bank-intermediated capital and debt. There is a need to develop broader capital markets and a more diverse set of financial instruments, including equity and marketable debt instruments.
The further development of country and possibly, regional, stock markets would be helpful. Reforms in other areas—more aggressive privatization, reform of pension funds, and elimination of tax distortions—hold the promise for the development of more dynamic stock markets. Establishment of mutual funds—which has already taken place in Kuwait, Morocco, and Tunisia, and is under active consideration in Bahrain and Saudi Arabia—is a welcome trend that will help to attract small savers to equity investment.
Developing equity markets and improving their liquidity is another challenge
Another challenge to these equity markets is to improve liquidity and strengthen supervision. In many markets, liquidity is undermined by the fact that transactions can take place outside the official stock market on a bilateral basis between investors, as well as by the dominant role of banks, which may limit intermediation in equities to their clients through own mutual funds. Thus, the lack of liquidity in stock markets may have contributed to a disproportionate relationship between supply and demand and exerted upward pressure on share prices. Bringing equity markets up to acceptable international standards and enforcing regulations by truly independent supervisory institutions are among the most promising steps that MENA could take to enhance confidence and complete the ongoing reforms of stock markets.
Finally, the reluctance of private owners to relinquish individual or family control by selling equity to the public is an important obstacle to the development of stock markets in many MENA countries. Increased confidence in stock market operations together with appropriate tax incentives (for example, the elimination of double taxation on dividends and capital gains) could help encourage private companies to raise equity capital through the stock market. In addition, the establishment of investment banks and investment advisory institutions will provide important logistical support to private corporations by offering a range of services that can help them become familiar with innovative instruments of long-term financing.
Greater scope for foreign participation
Opening Up the Financial Sector to Foreign Participation
Greater foreign participation in the financial sector can enhance competition, encourage acquisition of technology and know-how, and help facilitate the integration of MENA in world financial markets. Restrictions on foreign participation in financial intermediaries and in portfolio investment through the stock exchange have been reduced significantly in recent years in many MENA countries. However, further progress is clearly needed, particularly in those countries with more restrictive financial sectors. Greater opening up should be accompanied by the establishment of an adequate regulatory framework for both domestic and foreign investors.
Conclusions
MENA countries have made significant progress in establishing the instruments, institutions, and policies that can contribute to deepening financial markets, promoting more efficient allocation of resources, and establishing sound and healthy financial institutions. More important, the reforms have been guided by increased awareness that government intervention and administrative controls have exacerbated costs and distortions in financial intermediation and have undermined the broad objectives of economic reforms that were simultaneously pursued through other means. Thus, in MENA as elsewhere, pragmatism, not ideology, has been the driving force behind the general movement to market-based reforms in the financial sector.
Sound, efficient financial systems mobilize savings and capital inflows
Despite this progress, reform in the region is far from complete. In many countries, financial sectors remain thin and tightly regulated, government ownership of intermediaries is still predominant, and with a few exceptions, market forces play a limited role in the determination of financial variables. Thus, the reform agenda, which can only be determined on a country-specific basis, should encompass measures to promote an efficient allocation of resources through increased reliance on competition and market forces; deepen the financial markets and diversify instruments; strengthen the financial situation of intermediaries; enhance prudential regulation and supervision; and open up the financial sector to foreign participation as a means of acquiring the necessary know-how and expertise.
The steps toward financial deregulation, promotion of stock markets, and reform of monetary policy will be crucial in bringing MENA financial sectors up to international standards. MENA countries are seeking to attract substantial flows of foreign private capital as well as to retain domestic capital for productive investment in support of their strategy of achieving high and sustained growth rates. A sound, efficient, and dynamic financial system can help mobilize domestic savings as well as intermediate higher foreign capital inflows without putting domestic financial stability at risk. However, to be successful, the reforms must be part of a more comprehensive and coherent strategy aimed at moving the economy toward a path of higher savings, investment, and growth.
Related Reading
Abdelnour, Ziad K., “International Private-Equity Investing in the Middle East: Trends and Objectives,” Middle East Policy, Vol.3 (April 1995), pp. 88–94.
Al-Sabah, Sheikh Salem A. Aziz, “Gulf Banking in the Nineties: Challenges and Strategies,” Middle East Policy, Vol. 3 (April 1995), pp. 95– 127.
Bisat, Amer, “Financial Reform in Middle Income Arab Countries: Lessons from the Experience of Other Developing Countries,” paper presented at the Arab Monetary Fund Financial Markets Workshop, April 1996.
Blass, A., and R. Grossman, “A Costly Guarantee? The 1983 Israel Bank Shares Crisis Revisited,” Working Paper 95.05, Maurice Falk Institute for Economic Research in Israel, August 1995.
Economic and Social Commission for Western Asia, Arab Banks: Current Situation and Future Prospects in the Light of the Fall in Oil Prices, World Debt Crisis, and Developments in the International Financial Markets (Baghdad: United Nations, 1987).
Economic and Social Commission for Western Asia Financial Markets and Investment Promotion in the ESCWA Region (Baghdad: United Nations, 1990).
Economic and Social Commission for Western Asia Review of Current Developments and Trends in the Monetary and Financial Sectors in the ESCWA Region, 1994 (New York: United Nations, 1995).
Eken, Sena, Paul Cashin, S. Nuri Erbas, Jose Martelino, and Adnan Mazarei, Economic Dislocation and Recovery in Lebanon, IMF Occasional Paper 120 (Washington: International Monetary Fund, February 1995).
El-Erian, Mohamed A., and Manmohan S. Kumar, “Emerging Equity Markets in Middle Eastern Countries,” Staff Papers, International Monetary Fund, Vol. 42 June 1995), pp. 313–43.
El-Erian, Mohamed A., Sena Eken, Susan Fennell, and Jean-Pierre Chauffour, Growth and Stability in the Middle East and North Africa (Washington: International Monetary Fund, 1996).
El-Naggar, Said, ed., Economic Development of the Arab Countries: Selected Issues (Washington: International Monetary Fund, 1993).
El-Naggar, Said, Financial Policies and Capital Markets in Arab Countries (Washington, International Monetary Fund, 1994).
Khan, Mohsin S., and Abbas Mirakhor, “Islamic Banking: Experiences in the Islamic Republic of Iran and Pakistan,” IMF Working Paper 89/12 (Washington: International Monetary Fund, January 1989).
Maciejewski, Edouard, and Ahsan Mansur, eds., Jordan: A Strategy for Adjustment and Growth” IMF Occasional Paper 136 (Washington: International Monetary Fund, May 1996).
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In this chapter, the financial sector is defined to include the central bank, bank intermediaries, specialized financial institutions (such as savings banks, investment banks, the stock exchange, and brokerage houses); however, insurance companies and pension funds are excluded from the definition, even though their activities may affect the financial sector.
Kuwait is an exception, where the market has flourished, partly because of the divestiture of government shareholdings in various enterprises.
