Jiang Yingmei

Research fellow of IWAAS

jiangym@cass.org.cn

Economic globalization, one of the dominant features of the current global economic development, includes the globalization of trade, production and finance. Its theoretical basis is Neo-liberalism. It is the global integration of market economies, a process in which the fittest survive. Countries which are part of this process are inevitably involved in the global competition. While financial globalization is the most dynamic factor behind economic globalization, it is the most risky, sensitive and vulnerable domain with the highest frequency of crises. Financial globalization and liberalization is closely linked to the deregulation of foreign exchange market, foreign direct investment and financial monetary systems. The financial depressions at the end of last century and at the dawn of this century have shown that trade liberalization can spur economic growth, but financial liberalization will lead to instability and financial risks. The financial risk is a functional complex composed of many inter-acting and inter-depending factors. The acceleration of financial globalization and frequent international financial crises has a profound impact on the healthy development of financial sectors and financial security. Causes for the existence of financial risk are as follows: 1. financial globalization boosts the global capital flow, 2. the modern financial system have inherent flaws, 3. people do not know how to react to globalization, and 4. financial globalization enhances the competition in the financial sector across the border.

Financial globalization is a double-edged sword for the Arab world, where the financial system is undergoing changes. The WTO requires financial market liberalization in its member states, covering the liberalization of banking, insurance and bond markets to allow the inflow of foreign investment. UAE, Kuwait, Qatar, Oman, Bahrain, Egypt, and Jordan are already the WTO members, and Saudi Arabia joined the WTO at the end of 2005. Some top-notch Arabic financial institutions such as Arab Banks Association, National Commercial Bank, and the Saudi American Bank are robust enough to deal with the challenges of globalization; however, some small-and medium-sized financial institutions are faring worse unless they can develop new financial products, especially those about consumer finance, mortgage service and payment channels on technical level. A rating agency of Cyprus holds that the Arabic financial institutions have been well protected; but there can be no financial preserve in a globalizing world. Arabic banks are usually small, with limited businesses. So their unity can help them better compete with international banks. Therefore, it is essential to improve the operation climate, promote the privitization, and strengthen the policies.          

Facing the financial globalization, the major challenges of the Arab states are:

1 whether they can fully understand and predict the course of financial globalization. Many core factors of profitability such as organization, management expertise and information are often ignored by them;

2 whether they are capable to build a sound environment so that the people can enjoy the fruits of the reform and to lead some changes;   

3 whether domestic market players can take the opportunity to innovate and shoulder social responsibilities.

1. Status quo of the financial system of the Arab states

Financial sectors in different Arab states develop to different stages. However, the banking sector does not play a sufficient role in boosting the economic development.[1] Although bank is the mainstay of the financial system, its impact on the economic development and financing is limited, and the capital market is underdeveloped. (Table 1) In some countries, governments are the biggest shareholder of banks. Even in countries where private banks are the bulk, rigorous market entry policies have dampened competition. Therefore, the financial system, though relatively stable, is inefficient and costly, unable to meet the demands of economic expansion. Most banks are lagging behind in financial product innovation and new service provision. According to the Global Financial Stability Report (IMF September 2005)[2], the banking sectors of the Maghreb countries have made huge headways, but the progress of the banking industry have been held back by the state-owned institutions, which are semiofficial with poor asset quality and a large market share. Petroleum exporters of the Gulf Cooperation Council (GCC) have witnessed economic prosperity and rising asset prices coming along with soaring oil prices. The financial index there maintains a sound momentum with better asset quality and higher capitalization. The GCC countries enjoy high liquidity, profitability and capitalization, but they face the potential risk of oil price vagaries. Due to the Islamic cultural norm, a large proportion of deposits are interest-free. In some GCC countries, non-interest income like brokerage commission is widely drawn. The Islamic banks play an important role in several Gulf countries. In some Arab countries, the soaring credit requires stricter regulations on banks. Private credits are on the rise. Part of it concentrates on consumer credit and other sectors, in which state owned banks are relatively inexperienced.

The capital market of the Arab world is underdeveloped, featuring indirect financing, low market values and transactions (Table 2). With a short history, the Arabic stock market has grown with an amazing speed. Compared with Western countries, it is still at a low level in terms of stock values, transactions and listed companies; the financing and bond market is limited and monopolized by banks and telecommunication companies; the number of regular trading companies is small. In 1993, Alexander stock exchange in Cairo started business; the new capital market law eliminated restrictions on foreign investment; primary market and secondary market was established; mutual fund was introduced; listing rules were strengthened. The financial market in the GCC is sound with a strong liquidity. Nevertheless, these stock exchanges, which share the same features with listed companies, are semiofficial or official. Accordingly to a recent report by the HSBC, the GCC has become the latest “emerging market”. Since the Sept. 11^th of 2001, many investors from the Gulf region transferred most of their investments from the Western into the Arab states, hence a soar of the capitalization and transaction volume in the stock market there. The capitalization of the GCC stock market grew from $112 billion in 2000 to $1061 billion till end of October 2005 by 850%, even bigger than that of Hong Kong, and exceeding 1/3 of that of London[3]. The market index further testified the investors’ interests in investing in the Gulf region. The privatization of state-owned enterprises also boosted the prosperity of stock markets. But the financial liberalization failed to boost bond markets. The secondary market is immature; the treasury and company bond market is small; and monetary market relies heavily on the intervention of the central bank. The t-bond market is still in its infancy. The corporate market is lacking in long-term bond holders and big private enterprises, so the primary and secondary bond markets grow rather slow.

In the Arab world, contractual savings, whose mainstay is pension funds and life insurance companies, are backward. Besides the mutual fund (a form of investment company), the trust department of commercial banks, insurance companies, and life insurance companies are the biggest institutional investors. In the developed countries, their total assets usually equal or exceed GDP; while in developing countries, including the Middle East and Northern African countries (MENA), they account for only 50%. The pension system is the major part of contractual savings. In the Arab states, the system is pay-as-you-go with fixed-yield, with limited contribution to the long-term capital accumulation for investment. Even in countries with contractual saving systems, due to the younger population, the reserved assets are usually used to pay for the government debts, rather than for the long-term private equity. The return rate of pension insurance is lower than that of markets. In most Arab countreis, the pension system is fairly “generous”, accounting for 80% of wages with an annual interest rate of about 2%. These policy holders have to pay such a high income tax that it hurts the participation of the labour market into the pension and the flexibility and scope of the pension system itself. The percentage of work force that has joined the pension system is disproportionately low, in some countries even as low as 20%. The demographic composition of most Arab countries indicates that the current pension system can not last, because it will give rise to huge deficit in the coming decades. Most Arab countries have started reforming pension system and insurance market through analysis and lending. Compared with other parts of the world, the Arab countries haven’t fully realized the significance of the reform and are lagging behind in practice.

In the Arab world, the ratio of the housing finance, most of which are mortgage credits, to the GDP varies from 1% to 8%. It has always been a privilege for state-owned housing banks to operate in the formal housing finance. The operation of those banks exerts a heavy financial burden to the governmental fiscal expenditure and contingent liability.[4] The expansion of state-owned housing banks is hampered by the limited resources, the credit interests of the state-owned housing banks is lower than the market interest. That discourages market-based financial institutions to join the housing finance markets.

Micro-financial instruments are imperative for the Arab world. It is roughly estimated that 4 million people need micro-financial instruments worthy of $1.4 billion. But now only 700,000 people have access to loans of about $ 240 million.[5] Maybe in the Arab states, the effectiveness of micro-credit is as important as that of micro-saving and micro-insurance instruments. The money transfer service, although essential, does not exist there.

In addition to the conventional financial system, there is also an Islamic financial system consisting of 200 banks, mutual funds, mortgage companies and insurance companies. It operates differently from that of conventional banks: Islamic norms forbid an Islamic bank to charge interest rates. It grows fast, accounting for 10% of the market share. However, it is challenged by the financial globalization because of the following reasons. There is no financial authority to handle the contradictions between the Western and the Islamic financial systems. How to harmonize rules of the new financial market with the Islamic norms? The Islamic financial system, with less financial products and low liquidity, should accelerate financial innovation. There is no accounting system and auditing standards in the line with Islamic norms and economic rules. It is in need of a central religious authority to make economic and financial rules. It suffers the shortage of the financial expertise and professionals and the relatively backward IT technology.[6]

2. The major engines for the financial globalization and the Arab states

The financial liberalization, technology innovation and market participation are three major driving forces for financial intermediaries to change functions. Although they are enjoyed by the Arab world, governments and market players do not regard them as key rules.

2.1 Financial liberalization

The financial liberalization adopts market-driven interest rates, encourages competition, allows bankruptcy, ends the state’s ownership for financial institutions, removes restrictions on foreign financial institutions and trans-national credit, and abolishes the market-distorting foreign exchange system. The financial crises in Southeast Asia told many countries that the financial liberalization must be supported by rules and requires a sound macro-economy as a precondition. The opening up of the capital market should be more cautious and systematic infrastructure be buttressed in different ways.  

The financial liberalization in Arab states is slower and staggering. The industry was shielded from the globalization and international competition. Although many countries in this region have been perusing liberalization with a stable macro economy and pro-liberalization regulations, they still need more substantial reforms, such as the privatization of banks and the management mode and corporate governance, so as to develop an incentive mechanism for the sound growth of business operation to better integrate into the financial globalization.

The foreign shares in the foreign and domestic banks are different. Egypt allowed the foreign capital into its financial market in 1992; Jordan in 1997; and Algeria in 1999. Tunis gradually opened its financial sectors under the framework of the WTO. But foreign bank is still rare, and the only foreign capital controlled bank is the Citibank Algeria branch. In the UAE, foreign banks accounted for 1/4 of all banks by the end of 2000. Now all GCC members are the WTO members, and will improve the financial climate. In Oct. 2005, BNP Paribas launched a branch in Riyadh, the first European bank with 100% foreign capital in UAE financial market.[7]

2.2The technological innovation

The technological innovation, notably the Information Technology, has been a main drive for the reform in every sector. It changed the features of the industry and integrated it globally. Many sectors have adjusted strategies to adapt to the new economy, and decision-makers must create a better climate for new business models.

The global development of information and new economy technology is unbalanced. Many developing counties are trying very hard to improve their infrastructures to facilitate the advance of IT. The Arab states are lagging behind in this regard, which will hinder the financial reform and the potential for comprehensive development. Despite the skyrocketing of Internet usage there, the proportion of the internet users is relatively low compared with that of other countries, especially in the GCC region. The financial industry is even slower at investing in the IT equipment and adopting new technology. The slow telecommunication liberalization cripples the growth of the IT. But many Arab countries have seen the importance of the telecommunication privatization, and some have opened the telecommunication sector step by step. The Gulf States encourage the entry of foreign institutions and equipment suppliers through joint stocking holding.  

2.3 Markets players’ motivation to innovate

In many economies, market players, driven by profit and usually working independently, grab the opportunities brought by liberalization and technological progress and operate respecting the principle of honesty and transparency.

It seems that the Arabic population and market players have not unleashed their energy in such a free financial environment with high technology. The Arabic nations need diversified financial services such as micro-finance, small business finance, housing mortgage, sustainable pension plan, insurance, and other risk-averting products and project financing. Although there are such services available, they are not as effective as those in other countries, for instance, micro- and small business financing are far from enough, housing mortgage is hard to access in Algeria and Egypt, financial derivatives and other risk-management products almost do not exist, the capability of financial system to tailor products to satisfy different clients is low.

3. The global financial trend and Arab countries

Financial liberalization, the spread of technology, and creativity of market players are the major engines for profound changes in financial system so that diversified products will be provided. There are four developing trends for the global financial: non-intermediary[8], transition of system, modernization, and globalization. On the other hand, these four trends have affected the major engines, and have developed unevenly in the Arab world.

3.1 Non-intermediary

The development of the financial non-intermediary is still at its infancy. Although stock market has been established, its role as the financial non-intermediary is still marginal. The capitalization and bank assets accounts for 10% - 125% and 60% - 272% of GDP, respectively, lagging far behind the developed countries. (203% and 728% in Britain, 68% and 271% in Germany, respectively)[9]

The Arabic secondary market is still fledgling; even the primary market of company bonds and T-bonds. The secondary market in shortage of T-bonds lacks liquidity, which reduces the opportunity to issue new T-bonds, restrains banks from liquidity management through using T-bonds promotes investors to convert long-term bonds to short-term and more liquid one.  

Another aspect of non-intermediary is to transform illiquid financial assets into liquid capital market bonds, e. g. to mortgage real estates into bonds. The underdevelopment of the secondary markets has impeded the growth of long-term bonds benchmark interest rates and production curve, which are indispensable to price the long-term assets and to diversify the investment portfolio. It checks the growth of corporate bonds. Nevertheless, the growing interests of the international rating agency and vibrancy of bond companies are encouraging some Arabic companies to issue bonds as a form of long term financing.

3.2 Transition of system

Different systems play the roles of markets players. Pension funds, mutual funds, insurance companies, risky capital funds, micro-financial institutions, leasing companies, agents and other institutions form channels of funds flow. The proper adjustment and information disclosure of these fund help build a more transparent and efficient market.

The large pool of pension and social security system in the Arab world provides a key guidance in the growth of local capital markets. However, most of them are single pillar public pension system. Its operations are restricted because of the low return rate, the shortage of liquid financial assets, the prohibition or barrier on overseas investment, and inefficient fund management. The population covered by insurance in the Arab countries is the lowest worldwide, and the premium accounted for 1.1% of the GDP in 1999, about, less than 1/8 of that of North America and Western Europe and 1/3 of Sub-Saharan Africa.

Credit report and rating is most meaningful development for the credit, especially for small business loan. It reduces the costs of loan distribution, promotes the financial products into the market, calculates prices of different financial services, and improves the intermediary process. The basic theory for the existence of banks is the information asymmetry between borrowers and lenders. The development of credit registration institutions has dented the advantage of banks to collect and process the information. Some Arab countries are considering the establishment of credit report system by the model of internal risk rating. Some have already done so. But most of them fail to meet the requirement of Basel Accords II because there is not enough detailed and reliable data to estimate the probability of loss for each asset. The current system requires a bank set aside 8% of its total capital to support the corporate loans. For instance, the cost of a bank to lend to a company with AA credit rating is almost the same with that to a BBB credit company.[10] Another significant system reform is the development of micro-financial institutions. The gap between the supply and demand of micro-finance is still wide in the Arab world. 

3.3 Financial modernization

The modernization of financial system is reflected in two aspects. Firstly, financial intermediary is more effective thanks to such measures as paying channel, information procession and information disclosure. Secondly, financial stability brought by institutional overhaul, that is adopting cautious principles in the line with international practice.

3.3.1 Information technology

The IT in financial sector has cut costs and promoted competition. Emerging countries are exposed to international competition in their domestic market. Thanks to the IT and deregulation, international financial services have enjoyed easier access domestic market. The e-banking in the Arab world lags behind that of the rest of the world. Even in the Gulf States, the proportion of e-banking user is half of that in the emerging economies. Only 18 out of the top 100 Arabic banks provide e-banking services. Internet has been regarded more as a marketing and information exchanging instrument. The online transaction is in use in many stock markets there.

3.3.2 Modernization of management

The other aspect of modernization is modernization of financial system management, mainly through reforming the legal and regulation environment. Some Arab countries have joined the Financial Sector Assessment Program (FSAP) led by the World Bank and the IMF. The FSAP, being implemented in almost every Arab country, has laid a solid foundation for its financial sector. Some FSAP countries are looking forward to having their financial reform reviewed in order to map out the next step. Upon these requests, FSAP is being updated.

The Basel Committee on Banking Supervision has put forward Basel Accords II, which consists of three complimentary pillars to enhance the security and justice of the financial system. It was implemented in 2006 to adjust the capital adequacy supervision. To match the Basel II, banks have to improve the capability of data and remove the conflicts between the Basel II and the Islamic banking system.

3.4 Globalization

The financial globalization is an inevitable consequence of financial liberalization, technological innovation and creation of market players. The most outstanding character is the easier capital flow. Nevertheless, it is not unstable in emerging economies, coming with or leading to economic crisis or negative growth. Another feature is the larger financial intermediary, or, competition in the global financial market is determined by the scale effect brought by merging. Many banks in the emerging economies and industrialized countries are seeking for merging, and those in the Arab world, with relatively new investment banking business, is no exception. The merged banks would inevitably face competition from international counterparts.

The financial system has different scales. From the perspective of the financial development, it has posed strategic questions for many regions including the Arab states. The first one is whether every stock market has high liquidity, whether they can operate independently and grow into effective financial intermediaries capable of raising enough capital for the development of regional economy. A deeper question is whether the merging of stock markets is a correct path. Practices in some regions have proved the integration of stock market boosts the economy and financial development. Enlarging scale and increased trade volume have beefed up investors’ confidence and cut down trading costs. So the institutional framework should be instituted according to international norms.

The financial development has a positive correlation with the economy. What the Arabic financial system needs is boldness and advanced management. The government and the public must adopt a new understanding on the rules of the government, which is indirect in finance. It conducts supervision on the operations and legal framework, issues consistent policies, and avoids suppressing innovation or misleading the market. It must not initiate financial activities on the stage and behind the scenes. Meanwhile, the public and businesses should not regard the government as a “kind father”, who hails the success and pays for the failure.

4. Financial reform in the Arab world: challenges and new agenda

The Arab world is faced with huge economic and social challenges. Is the financial market a problem or a solution? Can the financial market raise enough money for the steady development of energy facility and infrastructure? Can it promote the economic growth and prosperity? What changes have taken place in the agenda of financial reform in the Arab world?[11]

Although limited, the capability of the financial market in the Arabic states to raise funds for the development of energy facility and infrastructure is growing. The issuing of bonds in the GCC shows how popular the local financial institutions are. In Nov. 2004, the National Bank of Kuwait and the Kuwait Finance House announced they had raised $600 million for the Equate; Dubai-based Equity House Shu΄a estimated that $2.3 billion would be raised for local companies through the IPO in GCC in 2004; Emirates Airlines issued bonds worth $1billion in Oct. 2004, in which the Arabic banks played a notable role. The bonds were not rated by the international rating agencies, so it was exceptional to issue such a big amount of bonds without credit rating.

The size of Arabic banking is limited. By the end of 2003, the total assets of banks in the Gulf region was $ 44 billion, about 1/3 of the British bank the Barclays. Only three Arabic financial institutions have assets of over $2 billion. What’s restraining the development of bonds market are usually the borrowers’ inexperience rather than the banks’ discount capacity since borrowers need public information of financing and regular legitimate qualifications for borrowing.

The most significant functions of the Arabic financial market are to boost the economy, create jobs, improve living standard and abate the exodus of well-educated youth. Economic prosperity realizes on an effective financial sector and a sound legal system. Almost all the most severe challenges of the Arab world couple with financial system directly. Many problems impacting the ordinary mass, such as poverty, unemployment and inaffordability of houses for young couples, are inseparable from the financial market. Financial reforms matters not only to financiers but also to the general public, which could be illustrated by the following two cases.

4.1 Private Sector

In Arab world, SMEs employ most people in the private sector. For example, in Morocco, SMEs which account for 80% of the GDP are the biggest employer. But the lending of Morocco banks to the SMEs is minimal. It is the same in Jordan and Egypt. In Egypt, the private sector absorbs 2/3 of 700,000 new labors annually, with small businesses being the largest employer. But they almost don’t borrow from the banks. Because commercial banks are not only ill-equipped to SMEs but also in want of the ability to set prices acceptable to SMEs. Consequently, the biggest employer suffers from liquidity shortage.    

4.2 Mortgage Financing

Mortgage financing is limited in the Arab world. In some countries it is partly due to the lack of proper asset registration system. On many occasions, the legal system does not support mortgage institutions. Even if the long-term liability of a financial institution matches with the assets to be mortgaged, it would still be thorny for the financial institutions to acquire a long-term secure liability in a level. Therefore, it’s difficult for most young people to have their houses. Compared with such social problems as unemployment, poverty and the awakening, whether a new petrol-chemical company could raise enough fund is not longer a priority, because these social problems are time bombs. 

Is the financial market one of the problems or solutions?

The financial system of the GCC varies differently from that in other countries. The GCC boasts mature, effective and profitable banking system, but there are flaws such as underdeveloped capital market, low liquidity, and the lack of investment areas, forex investment, and information. But in other Arab countries, banking system is generally regarded as ineffective state-owned banks responsible for providing funding to state-owned enterprises. These banks have accumulated huge non-performing loans, or technically called internal budget or contingency debt. They have little interests in developing new financial instruments to keep up with the growth of private sector, let alone the development of capital market. There is, however, an exception: the efficient private banking system in Jordan and Lebanon, though the Lebanese government is heavily in debt.

What are the changes happening in financial reform agenda? Historically, financial reform was initiated from the Arab world, originally intended to tackle the macroeconomic problems such as budget deficit. Later, it was to resolve social problems, because the governments have realized that there was not enough funding to maintain economy growth and create jobs. So it was imperative to open financial market to private investors (from home and abroad). However, the agenda of financial reform was driven by the outside, e.g., the IMF and the World Bank. In Egypt in the late 1980s, domestic financial demands promoted the government to step up cooperation with the outside world, that is, if Egypt wanted to get capital from the international community, it must gain the recognition of the World Bank, which relied on domestic economic and financial reforms as a prerequisite.  

However, the last couple of years have witnessed the progress of the financial reform agenda. With old questions still relevant, new ones have emerged, such as following the international accounting rules, sound corporate governance, internationally accepted rules of risk management, anti- laundering management, the requirement to know your customer and more transparency. These new agenda stemmed from two major events. The first one is corporate scandals, for example, the bankruptcy of Enron and Parmalat and financial market turmoil following the bust of Internet bubble. The second one is Sept. 11^th terror attack, which have enabled the international community to see the possibility of terror groups raising funds through the international financial market. Financial market of the Arab states faces the potential risk of being dominated by US dollar. The share of foreign currency deposit in the total deposit is on the rise every year. Although it may strengthen macroeconomic stability, it can also make financial systems more vulnerable to liquidity and solvency crises.[12] Accordingly, the Arab states must make their own currencies more appealing while restricting use of US dollar.

So far, the impetus for the financial reform is the demands from the Arabic governments and private investors. However the new agenda are actually driven by international regulators. The current financial reforms are conducted in the ownership of banks, financial assets and the objective of financial operation. But the new agenda on how banks and financial institutions should operate are posing grave challenges, not only for countries with underdeveloped financial markets such as Algeria, Egypt and Syria, but also for more developed Gulf countries. For instance, a principle of sound corporate management is the establishment of a powerful, qualified and independent board which supervises the operation of the company. If investors the board supervision, crucial to boost the confidence of investors about the company, is very rare in the Arab and the Gulf countries. Financial transparency has not met the international standard. Financial reports are rudimentary if there are any. Some annual reports of banks don’t even match with the performance of the economy. The Arab world is facing huge challenges, and the financial system is one of them. In many cases, it is a stumbling block for the economic development, or at least it does not boost the economic growth.   

5. Summary

The financial globalization is irreversible, which means both challenges and opportunities for the Arab states. Financial system there is unsound; the impact of the financial sector on the economy is limited; the capital market is features with indirect funding. However, it is undergoing changes. It enjoys driving forces to spur financial intermediary to change functions, and shares the same trend with global financial system,namely, non-intermediary, transition of system, modernization, and globalization. But the Arabic governments and market players have not taken the financial driving forces as the major rule, and the financial development is unbalanced. Therefore, to achieve the optimal development, it is essential for the governments and market to switch functions and mindsets, transform the ownership of major financial institutions and reduce monopoly. These measures will maintain the healthy, sustainable and benign development of the financial market. To conclude, the past decades have witnessed sea changes in the Arabic financial market. We hope it will be more a solution to the problems in those countries than a problem, and it will avoid disadvantages and participate in globalization to achieve gradual advancement to meet with challenges of financial globalization and uphold the financial security of the Arabic states.

Appendix

Table 1

Composition of Financial Market Structure (%)

Resource: Global Financial Stability Report, IMF, November 2004.

Table 2

World Financial Market index in 2004 (billion dollars)

*: European emerging markets

Resource: page 171, Global Financial Stability Report, IMF, September 2005.