21 November 2005
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The Middle East has been experiencing a period of unparalleled growth driven by the high price of oil. The oil-producing countries in the region are awash with petrodollars looking for investment opportunities.
Increasingly, Middle Eastern investors are looking to invest their wealth regionally rather than in the Western markets. Some wealth has also been repatriated from the US to the region following the 11 September attacks in the US and the passing of the US Patriot Act. Another reason for the repatriation of wealth by Gulf investors has been the phenomenal performance of the Middle Eastern capital markets compared with the performance of Western stock markets since the bursting of the dotcom bubble. A 'virtuous circle' is now in place, with regional cash chasing limited investment opportunities, feeding the rise in share prices and encouraging further speculative investment in the region. Western investors, where permitted, are also investing in the region to take advantage of the high returns and to diversify their portfolios.
Will the bubble burst?
The main sectors of investment are real estate and equity, with local IPOs attracting huge interest throughout the region. In 2003, share prices rose by 70 per cent across the Middle East and North Africa region as a whole. The performance of certain Gulf state markets was even more spectacular in 2004: the Saudi stock market rose by more than 80 per cent while the United Arab Emirates stock markets rose by more than 95 per cent. Many commentators feel that such stock prices have entered the realm of irrational exuberance and that the price bubble will burst. Capital flows into real estate investments have been equally rapid and the view that real estate markets are now overvalued and due for a correction is even more widespread than in the case of the stock markets.
However, commentators point out that even if there is a speculative bubble in the region, the underlying fundamentals are strong - for example, investment in the region has not been funded by borrowing, but has been paid for in cash. The level of liquidity in the region has stimulated the local economies and the regional governments have embarked on ambitious capital investment programmes and infrastructure projects, such as the Palm Island Jumeirah and Dubailand projects in Dubai.
Growth in the Gulf region has also been stimulated by the lifting of various restrictions on foreign investment, particularly through the establishment of free zones in which foreign companies are encouraged to establish themselves through a series of financial and regulatory incentives. This has stimulated investment by western companies, but has also allowed Middle Eastern investors to invest in countries in the region other than their own.
A regional financial hub
Against this background, Gulf states are competing to develop the predominant regional financial hub. To this end they are developing not only the physical infrastructure, but also a regulatory framework to attract the international investment community. The Bahrain Monetary Harbour has been established as an offshore banking centre for many years and has issued more than 50 offshore banking licences. It has successfully adapted its regulatory system to cope with new Islamic finance practices and is seen by some as the world's Islamic finance capital.
But it is increasingly being challenged by the Dubai International Financial Centre (DIFC), which aims to be the pre-eminent international wholesale financial centre of a region extending far beyond the Middle East, with a status akin to Hong Kong, London or New York. The DIFC is a free zone created by detailed legislation that allows DIFC bodies to create civil and commercial laws. The DIFC aims to put in place a legal and regulatory regime that facilitates the development of a successful and well-respected financial centre.
The Dubai Financial Services Authority, the DIFC's financial regulator, is modelled on regulatory bodies in other major international financial centres. The DIFC has already received applications to set up offices in the free zone from more than 60 banks and other firms, so its future looks promising. One entity that has already been authorised is the Dubai International Financial Exchange. It launched in September and aims to be the key regional capital market, although it is yet to be seen whether it will be a success.
Qatar has also entered the fray, announcing that it too will be developing an international financial centre, to be known as the Qatar Financial Centre.
With all the voluble marketing from Bahrain, Dubai and Qatar, it is easy to forget that the regional financial giant remains Saudi Arabia. The breadth and depth of its existing debt and equity markets cannot be matched by those of the other Gulf states. Saudi Arabia has reformed its capital markets legislation and established the Capital Markets Authority as a regulatory body to make and enforce rules to ensure a fair and efficient market, with a strong focus on disclosure and penalties for proscribed activities, such as insider dealing.
Islamic financial products
The presence of so much wealth in the hands of Arab investors has spurred rapid innovation in the development of Islamic financial products. Sharia law prohibits a Muslim from engaging in certain types of common financial transactions, such as those that earn interest. Islamic banks have therefore been developing products for Muslim clients that reflect the economic substance of typical Western banking products, but which comply with Sharia law. The development of these products has traditionally focused on the retail and corporate markets, but Islamic finance techniques are increasingly being used in project financing, asset financing and capital markets issuances. Sukuk (Islamic bond) issuance in 2004 totalled $6.7bn (£3.85bn), an increase of more than 300 per cent compared with the previous year, when government and corporate issuance totalled $1.9bn (£1.09bn). The first $1bn (£574.8m) sukuk was issued by the Dubai Civil Aviation Authority in November 2004, signalling the potential depth of demand for this asset class. Although Islamic banking remains rooted in the Muslim world, Sharia-compliant products are increasingly being offered in Europe and North America. The International Swaps and Derivatives Association is also consulting on the feasibility of a Sharia-compliant master agreement.
In the past two years, Western investment banks and law firms have been rushing to expand their Islamic finance capabilities, while also expanding their presence in the Middle East, as the development of Islamic financial products is only one part of the region's current economic boom. The market is yet to see whether this is a short-term response to the opportunities offered by the region at present or whether it reflects a stronger commitment that will survive the correction to the equity and real estate markets that is likely to follow a significant drop in the price of oil.
Farmida Bi is a partner and Ravi Gupta a professional support lawyer in the Islamic Finance practice of Denton Wilde Sapte