Lifting the veil from Mideast finance

For decades, corporate Arabia has been cloaked in secrecy. The culture of ownership and control among many major companies has shielded business and accounting practices from the public eye.

Weak government regulation - and little enforcement - has allowed bad habits to flourish. Even publicly listed companies have gotten away with minimal disclosure.

Some regional banks are known for 'name lending' on the basis of personal relationships rather than financial fundamentals - not to mention laundering money. The fact that many governments in the region are defiantly opaque when it comes to money has done little to encourage transparency and openness.

This lack of transparency carries a heavy price. Investors - both foreign and local - have had little faith that what they see is what they get when it comes to Mideast companies. As a result, capital has flooded out of the region and into the US and Europe, robbing the region of the investment it so badly needs to fuel economic growth, job creation and prosperity.

'It would be lame to claim there is not a problem in the Middle East,' says Qais al Maskati, manager of the Strategic Business Consulting Division at BDO Jawad Habib, one of the largest professional services consultancies in Bahrain. 'It is an emerging region, and it is not uncommon to have a transparency problem in an emerging market.'

He is not alone in confirming that transparency - or the lack of it - is a real problem in parts of the Middle East. 'Definitely there is a problem with transparency,' says Naser Nabulsi, chief executive officer of Dubai International Financial Center (DIFC).

The situation begs a number of searching questions. Just how bad is the problem? How much damage is it doing to the regional economy? And what must be done to repair that damage?

The consensus among the Middle East's business community is that the problem is real - but that it does not amount to the crisis some suggest.

'It is not fair to say bluntly that there is a lack of transparency in all countries on all levels,' says Maskati. 'We have to dissect what lack of transparency really means. A lack of transparency takes place on a number of levels: legal, monetary, data.'

Maskati cites the example of Qatar's recent closure of a $700 million Ijara Sukuk Islamic bond issue as an example of a high level of transparency in the region. The bond was rated by international ratings agency Standard & Poor's (S&P), and Qatar itself has a rating from S&P, among others.

'If you look at the major projects, there is a high level of transparency,' says Maskati. 'Take the recent Sukuk issue in Qatar. You are getting people investing from outside the region.'

Nabulsi at DIFC agrees. 'It is not just a Middle East problem,' he insists. Nabulsi spent 11 years working for US investment Bank Merrill Lynch. Based in the Middle East but answerable to regulatory authorities on Wall Street, he had an unparalleled international perspective on corporate Arabia.

'Lack of transparency is a worldwide problem. Even in the US, you see problems within the SEC [Securities and Exchange Commission] itself. It is human nature for us to hide things and not to show things.'

The lack of transparency can be broken down into two main areas - corporate and government. Some companies are better than others at financial disclosure, just as some Middle East governments are more open than others.

On a corporate level, the issue can present major problems - but the situation is improving. 'Yes, there is a lack of transparency,' says Walid Shihabi, head of research at Shuaa Capital. 'But I think it is overstated. If you want to get the basic information, you are able to. The present situation is an improvement over previous years. I'm talking about transparency in reporting standards, reporting mechanisms, tools to get information.'

As with most issues of transparency in the Middle East, the situation regarding disclosure among listed companies varies dramatically across borders. 'Are they there yet?' asks Shihabi.

'Probably not. It depends on the market. It depends on the laws and regulations - and to what extent they are implemented. If you let companies get away with not reporting on time, not reporting up to standards, placing misinformation in the market, even if there are laws against it, what's the use if they are not enforced?'

More mature markets such as Kuwait tend to be fairly well regulated. Newer markets such as the UAE - where formal stock exchanges were first launched as recently as 2000 - are some way behind. 'Domestic securities markets are small and undeveloped, and have been plagued by problems, such as insider trading,' wrote the International Monetary Fund (IMF) in its Financial System Stability Assessment report on the UAE, published earlier this year.

The conclusion is that poor transparency in Middle East capital markets is not universal - but when it occurs, it wreaks havoc with the efficient functioning of financial markets. And, by extension, the economy as a whole.

'It is a problem,' confirms Shihabi. 'The market sets the value [of a company that is listing] based on available information. But if it is not complete or there is misinformation, your valuation of these companies is off the mark. In that case, the market tends to use other sources, such as rumors, to price a stock. That is when you have inefficiency and false pricing. That is just one example.'

He adds: 'A second example is when information is not shared equally between all parties. Some investors have privileged information and an unfair advantage. In that case, market manipulation becomes easier. There has to be something to fill the void. And when there is a void, anyone can come up with something to fill it.'

Daniel Hanna, international economist with Standard Chartered bank based in Dubai, argues that there is a strong link between poor macroeconomic data in the Middle East and the weakness of regional financial markets. 'Good, timely, quality data gives confidence to investors,' says Hanna.

'I don't think it's a coincidence that the United States has the strongest macroeconomic data in the world and the world's most efficient and dynamic capital markets. If you get just one important macroeconomic data announcement every quarter or every six months, people react to it. You get over-shooting and under-shooting. If you have data on a regular basis, people build up an idea in their head of where the economy is going. That provides a solid foundation for markets. Otherwise you get a knee-jerk reaction.'

The impact of poor transparency on multiple levels is to shatter investor confidence in Middle East financial markets - stifling investment in the regional economy and stimulating the outflow of funds to Western markets.

'You are damaging investors with practices such as market manipulation and insider trading,' says Shihabi. 'When your average investor suffers losses due to these factors, his faith in the market is reduced. So his contribution to the market is also reduced - therefore you are shrinking the investor base. So the market becomes less and less attractive for people to invest in and raise money through.'

He adds: 'You have removed one of the core tools for companies to raise capital and grow, and one of the main sources of investment income for the typical investor. The alternative is to send money elsewhere. Therefore the economy has lost an opportunity for this money to be used productively in the domestic economy.'

However, not everyone agrees that lack of transparency in the region is a serious barrier to economic development. Qais al Maskati at BDO Jawad Habib says that, in theory, there should be a strong link. But he argues that, in practice, that link may be much weaker. 'If you are looking at transparency and economic development, it is not a clear-cut relationship.

'It is debatable whether it has hurt it a lot,' he says. 'If you look at the textbooks and theoretical studies, it will tell you that a lack of transparency leads to lower foreign direct investment. And certainly, if you compare the emerging markets of the Middle East with other markets, you will find that Hong Kong and Singapore have greater foreign direct investment flows. But that is perhaps an unfair comparison. If you look at the Middle East, we have virtually all the world's major financial institutions represented here.'

Hania Farhan, regional director for the Middle East at the Economist Intelligence Unit (EIU) in London, believes that the link between transparency and investment is strong. 'Greater transparency can only do good. It will attract more investors.'

As such, what are the prospects for achieving greater transparency in the near future? Happily, most Middle East professionals whom Arabies Trends spoke to were upbeat. They cited significant improvements at both the corporate and government level in recent years - and voiced genuine optimism that those improvements will gather momentum in the years ahead.

Qais al Maskati at BDO Jawad Habib argues that capital markets will take center stage in this process. Market forces will oblige more companies to go public. And with regulatory authorities tightening up transparency requirements - and enforcement - greater openness is all but inevitable.

'Transparency is going to improve in the future. Transparency is linked to the number of publicly listed companies. Public companies open their books, they are more stringent on themselves; every investor has a copy of the financial report. That puts a lot of pressure on companies to work efficiently. I have reason to believe that the number of listed companies will increase in the near future.'

Nothing less than a change in the entire corporate culture of the Middle East will bring this about - and Maskati believes that this has already begun. 'In many countries tribal cultures still exist,' he explains.

'There is a culture of ownership and control of the business, of not allowing outside investors. But there is pressure to stop that practice. If the companies are looking at opportunities for growth and notice that the balance sheet is not strong enough, they will have to open up to raise capital. The lack of an opportunity to increase capital through IPOs has constrained expansion in this region.'

'You have the younger breed of managers coming through,' explains Maskati. 'The older breed who prospered in the boom years of the 1970s and 1980s are close to retirement, or already retired. Their sons and daughters are coming up. They will have an open mind about public listing, as opposed to their father or grandfather. They will recognize that if you want to grow, you have to tap into other people's money, not just your own.'

Shihabi at Shuaa Capital echoes the view that market pressures will force more companies to open their books more fully. 'I think the fact that capital is readily available in the Gulf has meant that companies were really not that interested in appeasing investors or potential investors. It is only when you really need the investment - and need investors to feel comfortable with corporate governance and transparency - that companies make the effort to retain this strong relation with investors. Then they give them as much information as they want. When your need for capital is reduced, your basic benefit from retaining strong relations with investors is diminished.'

With oil prices and, to a lesser extent, output forecast to dip sharply in 2004 and beyond, Gulf companies may feel this pressure sooner rather than later.

Shihabi points to countries such as Egypt and Lebanon as examples of what is likely to happen once Gulf companies feel the need to raise capital. 'That has been the case with Gulf markets, rather than with markets that are more cash-strapped. Look at Lebanon and Egypt. The companies that function and aim to raise capital regularly definitely have strong reporting standards. Corporate governance and investor relations are strong. These are things that are very much missing in some other parts of the region.'

'In the US, when someone hides information they can go to jail,' says Nabulsi of the DIFC. 'In this part of the world, this has not been looked at the way it should be looked at.' He cites the example of finance professionals swapping share tips around a dinner table as a good barometer of the culture of regulation and enforcement.

'In the Middle East, someone would say quite openly that they've got information that a certain company is undervalued and that people should buy it. In the US, people would be very, very quiet about that. They would be extremely cautious.'

Looking to the future, DIFC has recruited a law enforcement unit as part of its regulatory team in a bid to stamp out these practices once the Dubai Regional Exchange launches in 2004. 'The more transparency there is, the more investment there will be,' says Nabulsi. 'There is a problem, but we are recognizing that problem. And if you recognize a problem, you can address it. We are doing that.'