Middle East Economic Survey

VOL. LI

No 22

2-June-2008

GCC/REGIONAL

Financial Reform In The Middle East: Defining Objectives And Measuring Results

By Andrew Cunningham

Andrew Cunningham is Managing Director for Middle East and Balkan Programs at the Financial Services Volunteer Corps, a not-for-profit organization whose mission is to promote and facilitate the emergence of efficient financial systems in transitioning economies. He can be contacted at acunningham@fsvc.org.

When Queen Victoria of Britain suggested to her prime minister that the solution to Britain’s economic ills of the time might lie in reform, he is said to have recoiled in horror. “Reform, Ma’am?” he said, “But aren’t things bad enough already?”¹ Thankfully, there are no longer any Middle East leaders who would echo the prime minister’s words. All publicly espouse reform as the route to stronger economies, improved government finances, and the creation of new jobs.

But behind the rhetoric, different people mean different things when they speak about financial reform. For some, the aim is to create a privately-owned, market-driven financial system which replicates those seen in the US and Europe. For others, reform goes no further than improving the efficiency of financial transactions (reducing the time taken to clear checks, for example), and the creation of modern financial infrastructure (such as establishing a stock exchange). For this second group, financial reform does not extend to more fundamental and thorny questions of ownership and control – privatizing commercial banks, and ensuring that key institutions such as central banks enjoy independence.

Neither point of view is helpful to those tasked with designing and implementing a program of financial reform. A reform program which leaves ownership and control in the hands of the government is unlikely to achieve much more than a superficial and temporary improvement in financial sector efficiency. But to say that the objective of financial reform is to create systems which replicate those in the west is simplistic and unhelpful – it ignores the political and social factors which limit the ability of even the most committed reformers to execute fundamental policy changes; and it fails to recognize that reform will always be a halting, uneven and multi-dimensional process in which real benefits will occur well before the financial sector starts to resemble those in the west.

What is possible, however, is to identify the key components of a modern financial sector – for example, “central banking”, “capital markets” – and then ask two questions. First, “What do we expect these components to look like in a well-functioning financial system which is not only stable and robust, but also can act as a catalyst for strong economic performance?” Second, “How can we measure whether, and to what extent, the financial sector is moving in that right direction?”

Differing Priorities

We must accept that the priorities and sequencing of reform will differ from country to country. Although reform would logically begin with the central bank, then focus on commercial banks, before addressing the need for capital markets, political and social constraints, or the particular circumstances of individual countries, may force a different sequencing. Privatization of the largest state-owned banks is often highly sensitive, with the result that governments are often able to privatize only some of the banks, leaving a semi-state-owned system in place while they move on to other policy areas. Creating a stock market in an underdeveloped economy may appear pointless, but the process of creating one brings with it benefits such as improved corporate governance and disclosure, and a more robust accountancy profession, all of which are important underpinnings for financial markets. If governance, disclosure and accountancy are weak, moves to create a stock market may provide a much needed impetus for change.

We can categorize the key components of a financial sector as:

• Central banking, including monetary functions and banking supervision.

• Commercial banking.

• Capital markets, both equity and debt.

• Broader financial infrastructure, such as leasing, insurance, and pensions.

• The financial enabling environment, such as the legal and regulatory infrastructure, accounting, and professional associations.

In answer to our first question above – what should these sectors look like in a well-functioning financial system? – the table below identifies the key features of each financial market component.

*    It does not matter whether all financial sector regulation is consolidated under a single institution (as it is under the Financial Services Authority in the UK or the Central Bank of Bahrain) or whether the tasks are divided between several bodies. The important point is that all financial market activity falls under some sort of efficient regulator.

Answering the second question posed above – how to measure whether the financial system is moving the right direction – often appears easy. Central bank independence should be visible in the form of a law granting that independence. A collateral registry either exists or it does not.

Yet it is not enough simply to “tick the box”. A law granting independence to the central bank may not have much effect on the way banking is conducted if “old guard” officials with a civil service mentality are left in charge. A collateral registry will not increase the availability of bank credit if the process of registration is cumbersome or, worse, if banks know that the process of collateral enforcement will take years in the courts. What is needed is a range of measurable indicators which will show whether the financial system is becoming more capable of acting as a catalyst for strong economic performance.

Private Banks’ Financial Strength

The importance of privatization lies in the belief that private banks are generally financially stronger than government owned banks (and so do not burden the state budget with the need for constant capital injections) and more effective at directing credit to productive industries, as opposed to those which are deemed by the government to be strategically important (for which read “politically” important). So while the relative size of state-owned and privately-owned banks is a common and not unreasonable way to measure the progress of financial reform, measuring the share of loans extended by privately owned banks is a far more sensitive indicator of the power of the financial system to drive economic growth. Better still, is an analysis of whether such banks are using their resources to extend credit to the private sector – to judge that we calculate the proportion of private sector credit re-distributed by banks in the form of private sector loans.

In Yemen, where ownership of the banking system is mixed between the government and the private sector, only about 30% of bank deposits are deployed as loans, while large amounts are placed in government bonds or abroad with foreign banks – a clear indication that the banking system is not discharging its role as an engine of economic growth.

In the case of capital markets, sound regulation, strong standards of disclosure and accounting, and the availability of a wide range of equity and debt products are the prerequisites for a market which can be used to raise capital and attract investors. The result should be seen in the number of local companies raising money on the stock exchange, and the number of local and foreign investors willing to buy their shares. So, for example, the fact that in 2006, 18 newly established Jordanian companies made offerings on the Amman Stock Exchange, compared to only seven in 2005, is a clear indication that the exchange was playing a greater role in the mobilization of capital. And the fact that in 2007 non-Jordanians made net investments of JD466mn on the Exchange – higher than any previous year – shows that Jordanian companies are increasingly able to attract funding from regional and international investors.²

A mortgage finance law, a land registry, publicly-licensed professionals trained in appraising the value of real estate, and a legal system which will enforce mortgage contracts are prerequisites for the emergence of a residential mortgage market which will enable citizens to buy their own homes and pass them on as assets to the next generation. But the only measure of whether these prerequisites are effective, as opposed to just being “in place,” is the size and growth of mortgage loans actually extended by banks.³

In practice, indicators that financial reform is taking hold can be distilled into a small number of metrics. The table below gives examples of such key metrics, and explains their significance.

Clearly the list given in the table is an oversimplification, and omits many significant elements of a financial reform process, such as the use of International Financial Reporting Standards in corporate reporting. But its value lies in the measurability of the indicators which it uses and in the close relationship which those indicators have to economic activity. A further advantage is that most of the metrics cited are based on information which is generally in the public domain.

Ultimately, financial reform must contribute to an increase in economic prosperity. Yet economic growth, higher personal income, and more jobs are dependent on many factors which lie outside the areas influenced by financial reform. Higher oil revenues, rather than the effects of any financial reform, are driving an increase in per capita gross domestic product in Libya. Demographic growth in a country such as Egypt may dilute the effect of strong economic performance and job creation. As a result, it is difficult to attribute short term improvements in macro-economic indicators to the effects of financial reform – or indeed to any other single area of policy, such as increased literacy or improved sanitation.

But over the long term, it should be possible to make a connection between broader, deeper and more efficient financial markets and increasing economic prosperity. More efficient financial markets in Libya would enable higher oil revenues to feed through into the mass of the population more quickly, fueling a stronger and broader economic base. More sophisticated monetary policy in the Gulf States might be able to prevent them importing inflation via currencies pegged to the dollar.

An efficient, market-based financial system will never be able to shoulder the burden of creating a prosperous economy alone. External factors, such as natural disasters or falling commodity prices, can have an impact on prosperity which is far more dramatic in the short term than the well-paced march of economic reform. Internal factors, such as low levels of literacy and poor sanitation will hold back an economy no matter how dynamic its financial policy making may be. But over the long term, steady progress on financial reform leads to an economy which directs resources more efficiently to those who can use them effectively.

Notes:

1.  The remark is attributed to Lord Palmerston in various contexts. Palmerston was Prime Minister from 1855-58 and from 1859-65.

2.  Statistics are taken from Annual Reports of the Jordan Securities Commission and the Amman Stock Exchange.

3.  In view of the current difficulties in western mortgage markets, we should perhaps add “repayment rates” as another indicator.