QFC head analyses regional capital markets

In order for a country to realise the potential of vast reserves of oil and gas, it must develop a climate of trust. This trust must be fostered - not just with international investors who will develop this potential - but with the governments (and their associated companies) that will be our trading partners for decades to come.

It is only by addressing these concerns that we are able to convert economic potential into economic reality. The success of countries such as Qatar, which will be supplying some 30% of the world's gas exports by 2010, has been in developing those bonds of trust throughout the global oil and gas community.

This is how Qatar has been able to commit $130 billion in investment across its economy over the next five to seven years. The ramifications of this ambitious investment programme will go well beyond reinforcing Qatar's energy infrastructure, and will extend into other sectors, e.g. utilities, ships and aircraft, tourism, and broader infrastructure projects covering everything from healthcare to education.

Put Qatar's national investment budget into a regional context, and it is immediately clear that the Middle East is emerging as the global destination for capital investment, just as much as it has emerged as a centre of capital creation. Both need managing with equal care and attention.

$50bn project finance

HSBC reports that the region has become the world's largest project finance market. It says that one in every three of the $99 billion raised in the first half of this year is directed at Middle East projects. The bank predicts that by the end of the year, project finance earmarked for the Middle East will total some $50 billion.

Meanwhile, Deutsche Bank this month put the value of identifiable projects across the region at some $1 trillion. However, it did so only to make a more pressing point. Corporate borrowing requirements have tested to breaking point the ability of banks to service demand through traditional lending arrangements.

Looking forward, some economists believe this is only the beginning of a regional boom - and a sustainable one at that - with oil prices stabilising at around $50/barrel.

Talking at a conference in Doha last month, Brad Bourland of SAMBA Bank projected capital flows for the GCC of some $24 trillion. This would turn the GCC into the world's most prominent force in investment both domestically, given the new inward bias to finance mega-projects, and overseas, where the value of official assets is growing by some $150 billion a year.

Nations such as Qatar have done well in translating resource-based potential into economic reality. But all the while the bar is being raised in terms of the levels of corporate governance, financial transparency and regulatory best practice.

A recent report from the Economist Intelligence Unit (sponsored by the Qatar Financial Centre) found three over-riding concerns of potential investors to the region. They were the rule of law; the quality of the regulatory and legal regime and government policies towards foreign investment.

Governance standards

To be sure, poor governance remains a real threat to the economies of the Middle East, and a real bar to development of the region's capital markets. It is a principal reason for the relatively low levels of Foreign Direct Investment in the region up to recent times. I doubt if any of us accept that regional governments don't need FDI.

Now, given the far greater willingness around the world to invest in the region, what was once a cautious approach has now changed to how best to channel these investments and put them to work effectively. Developing a balanced structure in the region's capital markets is then not an end in itself, but a by-product in creating the mechanisms necessary for investment to occur.

Just as the presence of oil or gas does not guarantee national wealth, so lots of liquidity with no structures through which to invest it do not build long term economic infrastructures.

QFC role

To extend this comparison, organisations such as the Qatar Financial Centre can be seen as performing the equivalent function for the financial community that our vast gas trains perform for our gas fields. Both provide the relevant mechanism for monetising an asset and creating value.

A brief survey of the region's volatile equity markets and its fledgling debt markets offer an interesting picture, shot through with ambition but still largely mired in bad habits.

Stock markets should be all about transparency. It is very difficult to use them to redistribute assets effectively to the investing population unless such markets are mature and reasonably stable. The bubble that so spectacularly burst at the beginning of the year across the region was as we all know a symptom of the immaturity of the region's markets.

Nevertheless, equity capital is here to stay. The harsh lessons learnt from the beginning of the year will I feel be used to introduce more acceptable rules and guidelines to avoid future damage to the market. In this, the Saudi market serves as something of a beacon in no longer pricing issues at a discount to underlying value - a sure sign of greater realism and maturity.

Risk management

But what is urgently required is the development of risk management tools - derivative products, the capacity for long and short equity trading and options trading that can only come from more depth and stability in the markets.

Too much liquidity on the buy side was a factor in creating the region's stock market bubble. But greater liquidity in the number of stocks, more accurate research, better disclosure, along with the ability to trade quickly and easily is what will take our equity markets to the next level. That and better investor education, of course.

This is something that needs to be driven by institutional investors, who for the moment are still reticent to get involved as a result of these unanswered questions of governance and transparency.

The homogeneity of excellence being cultivated by the region's new financial centres needs to spread throughout the region's financial institutions. The same message applies equally, if not more so to the region's debt market.

Debt market

As Deutsche Bank has already highlighted, traditional bank lending is simply not going to be able to satisfy the enormous appetite for finance being shown by GCC Governments and businesses.

What market makers have long been calling for is the flexibility and innovation that comes with a fully functioning debt market - and this means the development of a long term bond market.

In the bow wave of the Basel II requirements, it is increasingly important for banks to be able to manage their balance sheets more effectively.

This will mean a greater reliance on securitised products and bonds - products that are currently in scant supply in the region. In conversation with one banker the other day, I was told that there are no more than 50 Middle Eastern issues of bonds currently traded and these came from as few as just two dozen names.

This reflects a serious lack of depth for a region that is in such need for debt. Pressing his point, my source complained that only 20% of the financing he had undertaken recently was going to the bond market, with 80% being made through bank loans. Shouldn't these proportions really be the other way round?

Systemic risk

Such distortions have not gone unnoticed by the credit rating agencies. In May this year, Moody's warned of a build-up of systemic risk in banks operating in the Gulf as a result of rapid loan growth and what the Financial Times called: "possible asset bubbles".

Central to the evolution of a long-term bond market, say our banking colleagues, is the creation of a sovereign yield curve as a bench mark. They need this to be able to confidently price other securities, and they feel governments have been slow to act upon this either to avoid harming their otherwise healthy credit ratings, or have simply relied upon local liquidity for their funding.

This is changing, however, and the realisation that such structures are required for the healthy functioning of our capital markets - rather than for the creation of government debt for its own sake - is being noted at governmental level across the region.

This was evidenced in September this year when Standard Chartered reported that the Central Bank in the UAE has been in negotiations earlier in the year with several institutions in order to create an active debt market.

Private liquidity

A report, published last month by Global Research and based upon UN figures, claimed that private liquidity in the Gulf has leapt to $1.5 trillion - accounting for 60% of the $2.3 trillion of Arab capital available for investment.

Moreover, the report went on to suggest that by 2015, 60% of this will be retained in the region as opposed to the 20-25% currently invested here now. But while these instruments such as private equity funds act as effective locators of value, there remain few domestic or cross-border opportunities to be had regionally, and the growth of the industry in the region is dependent on the evolution of the equity and debt markets.

What we are seeing is the growing fire-power of Gulf capital being deployed overseas and investing in industries in developed markets across the globe.

Private equity funds

Private equity funds raised in the GCC have grown at a compound rate of 41% per year over the past five years and are set to continue at around 25% for the next three. This would explain the estimated $50 billion in overseas acquisitions made by Gulf investors in the course of this year.

So are we nearing some sort of tipping point in the development of capital markets? Well, the answer is yes and no. Undoubtedly, the region has the world's attention purely by virtue of the enormous potential that exists here. But the remaining obstacles to development range from the structural to the cultural and political.

Structurally, we have surveyed the barriers to development that exist in the equity and debt markets - ranging from the relative shortage of foreign capital, to the need for greater transparency and liquidity in the stock markets and a reliable index in the bond markets.

But there are also indirect structural issues that organisations such as the QFC can address directly. Primary among these is the looming problem of finding a financially skilled labour force with which to facilitate the growth of the capital markets.

As for the cultural and political obstacles to market development, it is my belief that these are disappearing. While pessimists might point to the continued pursuit of national interests rather than regional or international engagement amid the GCC countries, change is definitely afoot.

Over the past year or so, market authorities and legal authorities in Qatar, Dubai and Saudi Arabia have all demonstrated a refreshing diligence to investigate and prosecute recent incidents of malpractice.

Justice is therefore increasingly being seen to be done and this can only erode the current imbalance in regulatory practice between the region's new financial centres and the broader capital markets of the Middle East. Moreover, if the commitment is made at a national level, then a regional change in attitude will certainly not be far behind.