The Arab Gulf’s winding road to financial stardom
The region's young population of savers and huge oil wealth are drivers of growth for asset managers
By Imran Ahmed*
Emerging economies benefit from 'leapfrogging' technologies in developing certain economic sectors. Any visitor to the Gulf is witness to this phenomenon. Physical infrastructure is brand new. For example, roads, airports and telecommunications facilities are all world class.
However, in the area of capital markets and investment management, the benefits of skipping older technologies and moving directly to cutting edge techniques does not work quite so well. It's hardly ever a problem making a cellular phone call in the remotest parts of the Arabian Desert but try buying a local investment product anywhere in the Gulf!
Given that the six nation Gulf Cooperation Council (GCC) comprising Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates (UAE) is among the world's largest exporters of capital, the state of the asset management industry is surprising.
Additionally, the GCC has one of the world's youngest populations; an important plus for investment managers. Young people are capital accumulators, or savers who create a natural demand for investment products as they prepare for retirement.
Savers and capital, two key ingredients for asset management, have helped to grow the GCC asset management industry during the last decade. According to a 2008 study, onshore assets under management in the region topped US$57 billion in 2007.
To be fair, US$57 billion is a pittance for an oil producing region whose sovereign wealth funds have been known to invest billions in individual high profile deals. Witness the capital Middle Eastern investors pumped into struggling banks, including Credit Suisse and Barclays, at the height of the global financial crisis.
According to the Sovereign Wealth Fund Institute, an organisation which monitors global sovereign wealth fund activity, of the US$4 trillion of investable assets in global sovereign wealth funds, 37% or approximately US$1.5 trillion belongs to Middle Eastern funds.
Despite the attractive demographics and availability of excess capital, the GCC states face many challenges in growing the asset management industry. There are multiple reasons why capital which plays such a significant role in the global investment arena has not induced a 'domestic playground' for itself. Some of the key factors are discussed below.
The development of stock and bond markets involves an iterative dynamic. There is a circular feedback loop between the market and the market's key participants, including asset managers. Neither the exchanges nor the major players mature in isolation of each other.
The capital markets require not only capital, an investor base but also listed businesses, enabling legal frameworks and the ancillary infrastructure so easily taken for granted in large financial centres such as London, New York and Hong Kong. Even less obvious though still successful financial centres like Toronto, Geneva and Luxembourg are amply supported by a diverse set of financial service providers ranging from custodians, administrators and registrars.
Yes, the Gulf has wealthy and sophisticated investors but, unfortunately, it is often easier for Gulf investors to send their capital overseas than to invest within their own region.
Certainly, the Gulf countries have many successful public and private sector businesses which investors would like to partially own, but few are listed. Those companies that are publicly traded have such limited free floats that absorptive capacity becomes an issue for large institutional investors.
Take the UAE. The UAE stock exchanges, possibly the most deregulated in the region, have a combined market capitalisation of approximately US$110 billion (relative to the country's GDP of US$230 billion). However, the true picture of the UAE stock market's influence in economic activity is only revealed by examining trading volumes.
In 2007, a reasonable but not stellar year for the exchanges, average daily trading value was north of US$500 million. More recently, the average daily trading value is nearer US$125 million. Daily liquidity measured in a couple of hundred million US dollars is simply not enough to encourage meaningful participation by large institutions.
Based on recent economic statistics, the UAE economy is diversified and not entirely reliant on oil revenues. Services account for over 50% of GDP. Nonetheless, GDP growth turned negative in 2009, about the same time that the impact of reduced oil prices filtered through into the broader economy.
Clearly, the dependency on oil wealth as a driver for the broader GCC economies remains high. Dubai's recent debt woes provide the most glaring example of this reliance on energy. Statistics may tell a different story, but the reality of oil's relationship with the GCC's economic prosperity is obvious.
Arguably, Saudi Arabia is somewhat different from its five GCC compatriots. The country has a relatively large domestic economy. The insulated nature of the Saudi market has resulted in some large private enterprises, both in the service and industrial sectors. However, as in the rest of the GCC, Saudi's critical energy sector and most allied downstream industries remain firmly in state hands.
GDP sizes
While the region's equity markets have stagnated recently, the fixed income markets have witnessed considerable activity. Record low interest rates are drawing out both shariah compliant and conventional bond issuers.
That private and public sector corporations can freely issue debt without compromising on their ownership structure has been an important factor in the market's growth. The rise in the popularity of the shariah compliant sukuk market is also playing an important part in the market's development. Sukuks are fixed income investment securities permissible under Islamic law.
In its own perverse way, the global financial crisis has proved a fillip for the GCC debt markets. Legal wrangling is testing jurisdictional frameworks and establishing precedents for the future. Market transparency is being nudged towards international standards, not least due to the participation of global fixed income 'vulture' hedge funds.
The regional fixed income market appears close to a tipping point beyond which the stock of debt certificates will satisfactorily support Middle Eastern fixed income investment products. Nevertheless, the dynamics of the Gulf's fixed income market also indicate why developing a robust home grown investment management business traverses a bumpy road.
Debt issuers have one primary motive: to obtain the lowest interest rate for the debt they are selling. Consequently, issuers naturally gravitate towards the widest potential investor base possible, a largely non-GCC investor base.
In reality, Gulf debt issuers do what they have always done: tap into the Eurodollar bond markets. Any interested GCC based investors must therefore access GCC paper through the international bond markets.
There is limited incentive for Gulf based corporations to issue tradable debt solely to local investors. Indeed, given the long standing US$ – local currency fixed exchange rate regime in GCC countries (except Kuwait) corporations perceive little or no advantage in issuing local currency paper. The local currency debt markets lack both liquidity and a benchmark yield curve. For most corporations, the banking system is more than satisfactory to meet local currency long and short term financing.
Despite falling out of favour at the height of the global financial crisis, derivatives are now a part of the mainstream financial ecosystem. There is a implicit glass ceiling placed upon any financial centre which does not have an active derivatives trading market, exchange traded or over the counter.
There is hardly any indigenous derivative trading in the GCC financial markets. The little over the customised derivatives trading which exists is customised and generally prohibitively expensive. Any form of a GCC derivatives market is hindered by the lack of broad and deep equity and debt markets.
Moreover, it is also difficult to have an asset management industry of critical mass without dynamic underlying debt or equity markets. The key, therefore, is to create an environment to facilitate the growth of the two core constituents (equity and debt markets) and allow market innovation to spur subsidiary growth.
It must be remembered that debt and equity markets are necessary but not a sufficient condition for a vibrant asset management industry. They are only one piece of a larger puzzle. Associated supplementary infrastructure, including a credible legal framework, ancillary service providers and human talent is also necessary.
To be fair, the Gulf's leaders recognised these shortcomings some years ago. Attempts to address the gaps are at varying stages in different countries.
Bahrain had the early mover advantage through its attempts to transplant Beirut as the Arab financial hub following the onset of the Lebanese civil war in the 1980s. Bahrain's status as the Gulf's most developed and liberal society, resulting partially from housing a major US naval base, made the country an appealing option for foreign expatriates in the 1980s.
However, since the turn of the century ambitious efforts by Dubai and Doha to steal Bahrain's mantle have chipped away at Manama's lead. To some extent, Bahrain's main advantage no longer lies in its regulatory framework or quality of life but in the country's proximity to Saudi Arabia, the largest regional economy. Road and air links between the two nations make Bahrain a practical location for housing regional offices focused on the Saudi market.
Meanwhile, Dubai and Qatar's high profiled attempts at becoming the region's preeminent financial hubs are embodied in the Dubai International Financial Centre (DIFC) and the Qatar Financial Centre (QFC) respectively.
Both initiatives take a similar approach, start with a clean slate and create a regulatory regime running parallel to the historical framework operated by the central banks. By and large, the legacy frameworks are seen as being out of date and impractical to meet the needs of a modern financial centre.
The 'clean slate' approach has plus and minus points. For starters, it allows for reasonably rapid upgrading of the existing archaic frameworks. Additionally, it gives a relatively free hand to skilled regulators who may use a combination of discretion and rules based management over their jurisdictions; flexibility which is a virtual necessity in virgin financial centres.
On the other hand, the approach suffers due to a lack of clarity about the exact jurisdictional limits of the new regimes. This often leads to confusion over where the authority of the central bank and the Ministry of Finance ceases. The political risks and shortcomings associated with relying entirely on frameworks independent of mainstream national legal systems are real and potentially highly disruptive for businesses that opt into the new system.
Undoubtedly, both the QFC and DIFC are here to stay, if for no other reason than as a result of their comparatively relaxed immigration rules. Both centres adopt a more lenient approach towards quotas for locals and, in the case of Qatar, exit visa requirements. These flexibilities make the parallel regimes an attractive place to house businesses and bypass costly restrictions.
In the long term, having two dissimilar legal regimes regulating financial services seems like an unsustainable situation. Ultimately, fusing the two distinct financial frameworks may be required if Qatar and Dubai's ambitions as regional financial centres are to be realised.
The six Arab GCC nations have come a long way in developing their stock markets and allied industries during the last few years.
Most recently seen as the final frontier among already opaque frontier markets, the Gulf region is now knocking on the doors of mainstream emerging markets. The decision by FTSE to include several UAE counters in its broad emerging markets index is a nod in this direction.
Nonetheless, stock market depth and liquidity concerns linger, especially for the ex-Saudi Arabia GCC markets. These worries are likely to be around for some years.
Without adequate new equity supply, the equity markets can only develop so much. As long as no serious public sector asset divestment program is undertaken by the six states, the equity markets may continue to experience a paucity of free float.
On the contrary, issuance of fixed income paper, shariah compliant and conventional, is on a positive trajectory. However, not all the benefits are accruing to the GCC markets. Trading in regional debt securities continues to be dominated by Eurobond desks located in established European and Asian financial centres. This trend reflects the broad, diversified investor base, even for Islamic paper, which already exists outside of the Gulf region.
Ironically, the Gulf region and its many large wealth funds form an important part of the global institutional investor base. Yet, these same pools of capital have a very nominal impact on their own regional markets.
The same is true of private wealth in the Gulf region. Gulf private capital tends to look overseas for an investing home. For expatriates working in the region, their home markets are an obvious choice. Yet, even GCC citizens tend to view the Gulf's capital markets as temporary, speculative plays, not stable long term investments.
There are positive signs on the horizon. The two compelling yet simple reasons for the GCC asset management industry to stay the course are a young population of savers and the substantial flows of oil wealth into the region.
The test for Gulf based asset managers will be to transform a traditionally outward looking industry used to feeding capital towards international securities markets into a local industry capable of capturing an increasing portion of the region's growing wealth.
Not an easy task even in the best of times, but coming out of a global financial crisis it requires courage of conviction - and hefty capital outlays. Only time will tell if the region's authorities have the stamina to finish the financial centre marathon they so enthusiastically started at the turn of the century.
* Imran Ahmed is a principal at Deodar Advisors LLP. He can be reached at Imran@deodaradvisors.com.