Middle East Intelligence Bulletin
Jointly published by the United States Committee for a Free Lebanon and the Middle East Forum
  Vol. 5   No. 5 Table of Contents
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May 2003 

Democratization of Capital in the Arab World
by Ziad K. Abdelnour

Kuwaiti stock market

As the Bush administration's efforts to revitalize the peace process shift into high gear, there is likely to be a lot of talk about "peace dividends" in the Middle East, much like there was after the signing of the Oslo Accords. For decades, it is said, the conflict with Israel has diverted Arab resources away from economic development and scared away international investment. However, while a comprehensive settlement of the Arab-Israeli dispute would no doubt bring many blessings to the region, it is a mistake to imagine that peace will inaugurate a new era of unbridled prosperity in the Arab world.

To be sure, the Arab world has stagnated. Per capita income in Arab countries grew at an annual rate of just 0.5% during the last quarter century - less than half the global average. Despite being blessed with massive quantities of "black gold," Arabs have seen their average standard of living decline relative to the rest of the world. The combined GDP of all Arab countries ($531.2 billion) is today less than that of Spain (a country that Arabs once ruled).[1]

It is also true that international investors have shown little interest in the Arab world. The region nets less than 1% of global foreign direct investment (FDI), and only about 4% of FDI flowing to the developing world. Most of this, moreover, is concentrated in the oil and gas industry, leaving non-energy sectors high and dry. But it is not the continuing Israeli-Palestinian conflict that scares away investment. Outside of a few hotspots, like the West Bank, Gaza, and south Lebanon, Arab-Israeli violence does not make companies go under. And, of course, suicide bombings have not made Israel inhospitable to investors. Investor confidence in the Arab world is also said to be deflated by the region's "delicate political climate," but in fact the region is more stable than most.

The main reason why the Arab world receives so little FDI is very simple - the returns are low. In April, the World Bank reported that the Middle East and North Africa (MENA) "had the lowest investment returns on FDI compared to other regions of the world."[2] Arab states have been rapidly outpaced by productivity growth in other regions of the world. According to a September 2002 report by the World Economic Forum (WEF), "with the exception of Egypt, Oman, Syria, and Tunisia, productivity growth in the Arab world has been negative."[3] In short, the Arab world is not a great place to do business - and it's not getting any better.

Low productivity in the Arab world does not stem from lack of natural resources or low domestic investment rates. There is plenty of skilled labor and plenty of capital. The problem is that financial markets in the Arab world do not channel capital into its most productive and efficient uses. Restrictions range from public sector monopolies and limitations on foreign majority equity ownership in particular sectors, to corruption and red tape throughout.

Arab Capital Markets

In the modern age, the prosperity of any people is directly related to the access to capital they enjoy. In the United States, control of capital has shifted from private financial institutions to public markets over the last half century. This transformation, accelerated by new financial technology, has fueled economic prosperity in several ways. First, it has offered the general public access to investment opportunities once reserved for the extremely wealthy. Until the early part of this century, the stock market was the exclusive preserve of financial elites. The rise of mutual funds made ownership of securities (stocks, bonds, etc.) affordable for working class Americans and provided a strong incentive to save and invest.[4]

This "democratization of capital" also fueled economic growth by giving startup companies and small businesses access to capital that didn't exist before. This shift to public capital markets, writes Michael Milken, "unleashed a tsunami of more than 50 million new jobs created by growing, entrepreneurial companies." [5]

In the Arab world, most capital is still controlled by a small number of financial institutions - mostly banks - that cater to a select, privileged clientele. In Egypt, supposedly a leader in economic liberalization, 50% of the banking sector is controlled by just four state-owned banks (Bank of Alexandria, Banque du Caire, Banque Misr, and the National Bank of Egypt), all of which are plagued by a conspicuously high percentage of poorly or non-performing loans. This means, in effect, that the banks do not provide financing to the most credit-worthy recipients they can find - most of their funds are loaned to the state and to elites who have political connections or pay bribes. In short, those who have capital are not competing vigorously to find productive projects, while credit-worthy entrepreneurs and small businesses that need capital cannot find it.

The Arab world's 12 stock markets are very small, with a total capitalization at the end of 2002 of around $200 billion - less than 1% of global stock market capitalization. Stock markets in the Arab world are also very illiquid - trading volume of most stocks is far lower than in Western exchanges. Of the 1,000+ companies listed on the Cairo and Alexandria stock exchanges, shares of at least 800 are not publicly traded at all. Arab stock markets are dominated by the financial sector, which comprises 50-60% of listed companies, offering investors a very narrow range of undiversified opportunities. There is also a lack of highly capitalized corporations, as the state often maintains a large stake in privatized companies.

Arab markets are poorly regulated - laws governing insider trading and financial disclosures simply are not thoroughly enforced. As bizarre as it may seem to Western investors, there are still companies listed on Arab stock exchanges that do not issue quarterly financial figures. Some do not even publish audited annual reports in a timely manner. This scares away institutional investors. In most developed countries, the value of investments in mutual funds is at least 30% of overall market capitalization. In most Arab states, it is no more than 3 per cent. Rather than serving to pool the savings of small investors and allocate them efficiently, Arab stock markets benefit insiders at the expense of small investors.

Arab bond markets are also underdeveloped and illiquid. Although roughly $100 billion in government bonds was outstanding at the end of 2001, secondary markets for government debt are small, as most investors hold bonds to maturity. The corporate debt securities market is nascent, with around $6 billion in corporate bonds outstanding at the end of 2001. Venture capital is almost completely unavailable.

High net worth citizens of oil-rich Gulf Cooperation Council (GCC) states have invested roughly $1.2 trillion (about 85% of their wealth) abroad, mostly in the United States. Widespread expectations that this wealth would be repatriated after the September 11 attacks turned out to be unfounded. Despite their familiarity with economic conditions in the Middle East and willingness to take a fresh look at investment opportunities at home, these elites have diverted only a trickle of their wealth back into the Arab world because they cannot find ways to invest it productively at home.

Some progress is being made. In Jordan, where the government has pursued privatization aggressively, about 25% of the population now owns shares in publicly listed companies. In mid-2004, the Dubai International Financial Center (DIFC) will inaugurate a new stock exchange with solid regulatory foundations. Plans are underway in Saudi Arabia (which technically does not have a stock exchange, but an inter-bank bourse run by the central bank) to establish a formal stock exchange and an independent regulatory body to supervise it.

On the whole, however, Arab governments have been slow to develop open capital markets - mainly because authoritarian political systems thrive on restricting access to capital. The rise of properly functioning capital markets that channel capital directly to private firms would hurt the interests of elites who currently enjoy preferential access. Inefficient state-run companies and politically connected firms that monopolize certain sectors of the economy would face a rush of competition from new start-ups. Vibrant stock markets would divert national savings to higher yield equity investments, making it harder for governments to borrow money domestically.

However, maintaining restrictions on access to capital is no longer viable for Arab governments. Because of skyrocketing birth rates in recent decades, the Arab world's labor force is increasing by over 3% a year - the fastest rate of growth in the world. Most Arab governments - even in the oil-rich Gulf - have accumulated such high levels of public debt over the years that they can no longer keep a lid on unemployment by expanding the public sector. Instead, they must rely on entrepreneurs to build businesses that can employ millions of job seekers and pave the way for broad-based prosperity.

The challenge for Arab governments is not so much figuring out how to attract private sector investment - with the appropriate economic reforms in place, capital will find its way to productive projects in the region. Western companies and emerging market funds that invested early in post-communist Russia and eastern Europe were richly rewarded and are anxious to repeat this success in other areas with untapped potential (e.g. large pools of idle skilled labor). The American government should do its part to ensure that its Arab allies don't look a gift horse in the mouth.

The real challenge for Arab governments will be to adapt politically to the new economy - to mobilize beneficiaries of "democratic" capital markets into a new pro-government coalition, while marginilizing cronies who benefited from restricted capital markets and have the resources to obstruct change. Syria is the paradigmatic example of a country where the political leadership has had trouble doing this - entire sectors of the economy remain under the grip of powerful figures opposed to change.


  [1] Arab Human Development Report, United Nations Development Program, 2002.
  [2] Foreign Investment, Remittances Outpace Debt As Sources of Finance For Developing Countries, The World Bank, The World Bank, 2 April 2003. Note that MENA countries include three non-Arab states, two of which (Israel and Turkey) have comparatively high levels of FDI.
  [3] Klaus Schwab and Peter Cornelius, eds., The Arab World Competitiveness Report: 2002-2003 (World Economic Forum, 2002). See executive summary (pdf).
  [4] Garry Emmons, America and the Rise of the Mutual Fund: Where Main Street Meets Wall Street, Harvard Business Review, June 1999.
  [5] Michael Milken, The Helical Ride to Global Prosperity, Forbes, 4 October 1999.

2003 Middle East Intelligence Bulletin. All rights reserved.

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