VOL. XLIII
No. 41
9 OCTOBER 2000

GCC

The Middle East And Private Capital Inflows: Muscling In Or Missing Out

According to the latest International Monetary Fund (IMF) report on international capital markets, total net private capital inflows into emerging markets in 1999 amounted to $80.5bn, or 7% higher than the previous year. Both the IMF and the World Bank confirm that private capital flows have replaced official flows as the largest external source of capital for developing countries and now account for 80% of net flows to all developing countries. In the Middle East and North Africa, the World Bank estimates that net resources flows nearly doubled in 1999 to an estimated $20bn. This compares with a net resource flow of only $3bn in 1995 and an average of $8.7bn for the period 1990-1997 (see Table 1 below). Most of the increase in 1999 consisted of an $8bn rise in private flows which, according to the Bank, “is a reversal from the situation in the early 1990s, when official development assistance made up the bulk of net resource flows.”

But some analysts question whether the region can generate sufficient inflows to achieve critical mass, given its track record in attracting private investment funds and reluctance to fully open up to international markets. They project a “now or never” scenario, saying that if reform and global integration do not occur during the current period of high oil prices, the region risks being relegated to a marginalized global position. Others argue that recent increases in investment are simply the product of a flight to safe havens – or low correlation assets – rather than the result of pro-active efforts to improve economic fundamentals. On the sidelines of the recent IMF/World Bank meeting, Mohamed A. El-Erian, Managing Director of US-based investment firm PIMCO, said that he remains more optimistic about the future of the region. In an interview with MEES Banking and Finance Editor, Clare Woodcraft, he explained how current enabling factors bode well for pushing the liberalization process forward, but cautioned that the region’s history of missed opportunities should not be overlooked. (Prior to joining PIMCO, Mr El-Erian was associated with Salomon Smith Barney/Citibank in London as Managing Director and, head of the emerging markets economic research team. He previously spent 15 years with the IMF.)

“If you look at the region as a whole, two enabling factors are occurring right now. One is the positive trade shock of the oil price, which results in a huge transfer of income from the rest of the world to the region,” said Mr El-Erian. The other is the improvement in the region’s institutional framework through reform and a certain momentum in the process of liberalization. In the past two years, all of the GCC countries have made some progress towards opening up their capital markets in one form or another to the rest of the world. And, according to Mr El-Erian, many countries have “increased the robustness of the financial infrastructure such as the payments and settlements system – the plumbing.”

He also points out that more of the region’s countries, including most notably Algeria and Lebanon, have entered global aggregates and are now “on the radar screen for people who follow indices.” The region is also undoubtedly better positioned now than it was one or two years ago – a fact perhaps reflected by Qatar’s ability to place $2.4bn in international bond market with tenors of up to 30 years. Many analysts say this was at a high price, but Mr El-Erian believes this was due to an “entrance fee” being paid to establish Qatar as a familiar name. Since then, he argues, the issue has gained ground. “The first one came in at 395bps over US treasuries, it tightened to as much as 210bps and then it widened again as a new issue came on, but the new 30-year issue came at a slightly better spread than the 10-year one at 385bps.”

In the Gulf, the pace of reform – a key influence on investors’ perceptions – has accelerated. It is still too early to predict whether the latest round of high oil prices can truly galvanize the region into reforms, but Mr El-Erian thinks there are some positive signs. “It is clear, that unlike in the past, governments are saving the surplus,” he says. “Their first priority is seemingly to rebuild reserves that have been depleted and there is no talk of expanding budgets to the same amount as the positive terms of trade shock. They are rebuilding a portion of what was used – and used effectively – in 1998.”

Source: International Monetary Fund, International Capital Markets, Developments, Prospects and Key Policy Issues (September 2000).

Mr El-Erian believes that there is a growing feeling in the market that certain countries are embarking on a positive economic course. “In the non-oil countries of Jordan and Tunisia, which are considered as having the right sort of policies in place,” he argues, “you can see positive results in terms of foreign exchange reserves, inflation and in terms of growth picking up.” And there is also a growing awareness among investors of the region’s diversity. “There was concern after S&P’s decision to put Egypt’s investment grade on negative watch,” says Mr El Erian, and similar concerns remain about the Lebanese economy. But this reflects that “in terms of non-oil you have a very clear distinction in investors’ minds between countries with improving fundamentals and those with deteriorating ones.”

There are those who argue that fiscal austerity and reform commitment may fade as the memory of the era of low oil prices fades. But Mr El-Erian contests that the severity of the crisis was sufficient to secure long-term commitment. “Some of the region’s currencies came under speculative pressure of an unprecedented nature in the past two years. I believe there is a strong incentive to build up the reserve cushion,” he says.

According to Mr El-Erian, further liberalization, and notably a more aggressive foray into international capital markets, is more contingent on external factors than the need for direct funding. “This is not a region that is dependent on capital markets, so there is no need to refinance maturing bonds,” he said. “Also this is a region that has access to other choices of funding, bank loans, official funding, so whether they developed a relationship with the capital markets or not is a question of vision. It is whether the externalities justify it. Or put another way, do governments have sufficient public support for sovereign bond issues?”

And yet without such issues, the region’s ability to attract future capital flows may be constrained – growth in internationally traded sovereign debt goes a long way towards establishing a regional risk benchmark. “Whether you are an equity investor or a corporate looking for funding, you always look for a benchmark, and the best measure of market risk out there is the spread on government bonds,” says Mr El-Erian. “There is a direct beneficial impact from having a benchmark that allows other investors to price risk, especially for foreign direct investment. A market measure of sovereign risk feeds directly into the discounted cash flow of any investment project. If there isn’t one, people come up with one and it tends to be less favorable than a market wide concept.” (Mr El-Erian cautions that debt instruments have to be appropriate in this respect – Brady bonds, he points out, trade 100-200bps wider of global bonds because they are restructured instruments.) To date, only Oman, Qatar and Lebanon have launched such instruments, although Iran is planning to do so and Egypt is mooting an issue. (Jordan and Algeria both have Brady bonds.

But establishing a benchmark carries a downside. As Mr El-Erian explains, the success of launching a sovereign bond or other financial instruments depends largely on the ability of a country’s financial sector to cope with the increased level of risk. “Once you get linked up with the international financial markets, you get the benefits and you get the cost, there is no way of avoiding it. But it’s not an issue of whether your spreads tighten or widen day by day – that’s part of the market. It’s the extent to which this influences your future financing ability, which in turn is a function of how vulnerable you are to capital markets. If you don’t have a weak banking system, then you can absorb the day-to-day volatility.”

Oil producers are particularly well poised in this respect, as higher oil revenues allow them to raise their reserves, achieve surpluses, free up funds for the private sector and push through financial sector reform. But for all the region, timing is crucial. As Mr El-Erian points out, “Egypt is now talking about a eurobond issue, but the time to have done it would have been from a position of strength. You always liberalize the financial system and improve links with international capital markets from a position of strength rather than a position of weakness.” But this is a medium-term issue that aims to improve the long-term efficiency of an economy and therefore, by its very nature, requires a long-term strategic vision – not something for which Arab governments are often given credit. “The issue,” says Mr El-Erian, “is what you want your economy to look like in five years and to what extent integration with capital markets will hinder or help you. You have to have a vision – it’s about how to strike a balance between moving forward and at the same time explaining what you’re doing. It is not easy for a government in surplus to argue for such changes…it’s not easy for Mexico, that’s doing so well, to say we have to tax more.”

Ostensibly, the region’s long-term international debt stock is set to grow, since it has to if investor commitment to the region’s equity markets is to be secured. As Mr El-Erian points out, “investor confidence tends to evolve from short-term instruments, to tradable debt instruments. As investors become more familiar, they move into equity “where you have to make a physical commitment to the country.” Mr El-Erian believes that this is a process in which it is hard to jump the line. “Even if you don’t need the funding, having a benchmark allows you to get to the third part of the process more quickly.” (See Table 2 below for regional debt analysis.)

Mr El-Erian feels the region is moving in the right direction, collectively at least. “If you look at the list of achievements over the last year and a half, they’re all small, but if you look at them together, it’s a lot. I don’t remember seeing so many moves forward in 18 months, from the liberalization of certain systems to the strengthening of monetary policy regimes. There is a momentum.” But he acknowledges that more needs to be done and done soon. “These changes are all necessary but they’re insufficient. They should do other things as well, especially in education systems.” For the time being, the region – which is not highly dependent on international capital – can probably afford to stall the liberalization process. “The reason you want to run faster than another emerging market area is if you are competing for capital.” The positive terms of trade shock in the Middle East should allow it to “run faster than others,” says Mr El-Erian, “but nothing is automatic and our history is one of missed opportunities.”

Notwithstanding the financial crisis of 1998, which clearly demonstrated that “when things get bad they can get really bad,” to assume that fiscal austerity and the reform drive can be maintained indefinitely would be folly. “Deficits were completely out of control, foreign reserves were being depleted very quickly. That history is fresh in the mind of policy makers – this time around the windfall is not being spent.” But Mr El-Erian believes there has to be a process of creative destruction in the Middle East if the region is to become a truly global player. “There is going to have to be a form of dissent – in the banking system, in the industrial sector, in government, everything is going to be a process of creative destruction. Otherwise we are going to miss out on this new economy.”

Citing the US model, Mr El-Erian notes that there were three prerequisite factors for success: a positive technology shock; the ability of the private sector to fund itself; and the government moving into surplus, thereby freeing up private sector credit. “Technology shocks know no border,” says Mr El-Erian, “so that condition, in theory, is available to the Middle East. Governments are going into surplus, so they are no longer crowding out lending activities. But there are still only limited sources of private sector funding.” This is largely due to the lack of corporate bond markets and an underdeveloped IPO system. “That acts as a major constraint and that is where reform of the financial sector is so important,” says Mr El-Erian. “There is going to have to be a lot of good creation and a lot of destructive creation going on to allow the private sector to respond. If not, we are just simply not going to embark on this new economy.”