Instead of the post-Ramadan surge which many of the region’s financial analysts and traders had augured during the slow days of summer, important Middle Eastern stock markets converged to a measly November diet in the bear’s kitchen. Over the coming months, these markets will have to deal with the poor investor confidence of which the selling mood speaks volumes—all the more so since corporate results and macro indicators may be much friendlier than the share price performance toward the end of 2006.

Downturns across the region
The Cairo and Alexandria Exchanges retained their ground with continued sideways trading, but the Tadawul Index of the Saudi Stock Exchange moved south by about 2,000 points, or 20%, between Eid Al Fitr and November 26. The Dubai Financial Market was not far behind with a drop of 17%, the Doha Securities Market lost 15%, and the Abu Dhabi Securities Market retreated by about 12% over the period.
The Bahrain Stock Exchange shed the gains it had made between mid-August and late-September and dropped back to levels in the 2,100 points range. The Kuwait bourse similarly weakened more than 5% and receded below 10,000 points in late November.
In Amman, the market gave up over 8% and in Beirut, the BLOM Index fell 7%—but that was its closing before the country received another blow through the assassination of Industry Minister Pierre Gemayel, after which the Beirut Stock Exchange shut its doors for several days, along with most of the country’s businesses.
This means that with exception of the smallish North African bourses in Tunisia and Morocco, Arab stock markets had nothing to boast of in the period immediately following the fasting month of Ramadan, a period which many experts had assumed would lead the markets to new consolidation or signal growth impulses after the correction phase that hit GCC and Levant capital markets in the first half of 2006, with some variations in terms of exact timing and severity of the respective share price drops.
While the danger of a crash in regional stock markets was thought distant by a substantial share of market protagonists in 2005, by the spring of 2006, capital market experts had noted that the downturn could no longer be considered a brief interlude. Many still expected the second half of the year to bring new promise, however.
With the year-end in sight, that optimism seemed increasingly premature, even as analysts said that the valuations of GCC equities are reasonable and offer good new potential—also given that the burst of the bubble in 2006 was fairly predictable because the region’s capital markets rally was driven by the oil boom and toward the peak of the rally, the ratios between oil prices and GCC equity market valuations had become excessive.
“At the market peaks, a significant disconnect developed between oil and regional equity pricing,” said Dubai-based investment firm Gulf Capital Group in a recent report, while concluding nonetheless that the markets are poised for future growth.

Harvest of oil revenues will continue
The broad consensus of international and regional financial institutions and banks is that oil will be the major force behind Arab economic and capital market trends for years to come, which also means that the region’s influence in the current account triangle of Western consumers, Asian manufacturers/new consumers and Middle Eastern oil suppliers is likely to increase.
In long-term perspectives, the global thirst for oil will not relent and oil-producing economies are bound to harvest the benefits. Within this outlook, the region’s economies and sectors will have further development opportunities, and various methods of share price modeling show that there are plenty of Middle Eastern companies with attractive upsides to their current share prices.
This is true even as 2006 results of listed companies suffered on the whole, due to shortfalls in their investment-related income and because some companies incurred losses that depressed the picture. As the National Bank of Kuwait pointed out in an analysis of earnings by UAE companies in the first nine months of 2006, one group of 14 companies with sound core earnings and accounting for over 60% of market capitalization achieved 27% growth in their net profit to a total of over $5 billion.
That was a much better performance than suggested by the modest 5% profit growth for 66 listed companies with published results, due to the fact that 23 companies reported declines in earnings and 11 incurred losses.
Thus, by global and local reasoning, investors will be well-advised to review the performance of Middle Eastern equities in the first nine months of 2006 and the entire year neither in search of short-term profit nor obsessing over the year-on-year slowing of earnings growth by many companies—which already a year ago seemed hardly avoidable for the 2006 earnings season, when corporation after corporation in the third and fourth quarters of 2005 had announced stellar growth rates in profits.
However, quick and speculative gains may not be easy to come by in the coming months and analysts now tend to see the consolidation phase of Arab stock markets as bound to take more time than expected earlier in 2006, which implies that rallies and bull runs in the near term will be the exception rather than the rule. But by measuring price to earnings as well as price to earnings to growth ratios, researchers such as Gulf Capital say that Middle East equity markets—with the exception of Saudi Arabia—are priced attractively in the long run.
Another matter of importance for the development of Arab equities is the regulatory environment and market culture. In this regard, several GCC countries moved to implement strict regulations and standards in order to purge violators of corporate disclosures and transparency issues.
UAE, Kuwait and Saudi Arabia tried hard to implement these rules and presented several companies to trials for lack of transparency and insider trading.
Additionally, the GCC countries realized that trading awareness and diversification are key aspects of sound capital markets. Governments encouraged education of market participants and supported the creation of increased awareness in the minds of inexperienced investors who were following the market trends and buying stocks without conducting fundamental analysis.
IPOs
The stock market correction did not prevent GCC investors from looking for quick profits through subscription in initial public offerings by Gulf companies in 2006.
IPOs of large companies such as Emaar the Economic City in Saudi Arabia, Al Babtain Power and Telecommunications, Advanced Polypropylene Co., Saudi Research and Marketing Group, Qatar’s Al Rayyan Bank, Bahrain’s Al Baraka Banking Group, the UAE’s Emirates Integrated Telecommunications (DU) and Kingdom Hotels Investment were oversubscribed several times.
The IPO trend is expected to continue in 2007, with 65 planned or rumored IPOs currently included in the IPO Monitor of regional business information provider, Zawya.
More than half of these IPOs are scheduled for Saudi Arabia and another 20% for the UAE, clearly indicating that the GCC markets will again dominate the regional IPO scene in 2007 as they did in 2005 and 2006. In Egypt, privatization and sales of already listed but state-owned companies will continue to appeal to investors.
Some of the high profile companies planning to go public or be privatized in the GCC are Saudi Development Bank (Inmaa) with $2.8 billion IPO, Saudi Arabian Mining Company ($1.06 billion), Saudi Aramco with $1.01 billion, Bahraini United International Bank ($800 million) and the privatization of UAE’s International Petroleum Investment Co. for between $540 million and $810 million.
Syria, where plans to launch the Damascus Stock Exchange are more likely to be implemented in the latter portion of 2007 than early on, could bring a boon to local investors through public offerings of new joint venture banks even ahead of the formation of the bourse. Later on, when the bourse’s rules have been tested and the playing field is open, the country has strong potential for its own IPO wave.
In Lebanon, where a number of IPOs scheduled for 2006 have been postponed until 2007 because of the summer conflict, the new year’s IPO prospects may have become open questions as long as the country’s political struggles preclude a clear investment picture.
To secure the interest of investors in future IPOs where political risk is not the problem, observers say that markets need to free themselves from overpricing issues through excessive issue premiums. One such example was the August 2006 IPO of Red Sea Housing Services in Saudi Arabia. The company’s asking price of 58 Saudi riyals ($15.5) per share represented a premium of SAR48 added to the share’s par value of SAR10. Analysts said that the SAR48 premium was 35% above the stock’s fair value.

Quick and speculative gains
may not be easy to come by
in the coming months

On the other hand, investors are also likely to stay alert to the unfulfilled promises that marred some IPOs such as the flotation for 20% of the Hariri family’s Oger Telecom on the London Stock Exchange and the Dubai International Financial Exchange, which was called off in the last minute in November because of “adverse market conditions.”
Integration of markets or expansion of corporate networks?

Other than tunisia and morocco, Arab stock markets had nothing to boast of
following Ramadan

One aspiration of Arab capital markets is convergence into larger trading realms. As a herald of greater integration of Arab capital markets into globalized trade, the DIFX was overall off to a slower start than its promoters had announced at its launch in September 2005. Similarly, rapid integration and eventual mergers of other Middle Eastern stock markets are not to be counted on with certainty for 2007.

However, on the level of corporate expansion and investments, the region’s equity markets are set for further enhancements. Some of the strategic privatization investments in Egyptian companies are prone to originate from investment firms and other corporations in the Gulf, and there is a strong likelihood of expanded equity participation by Gulf companies in firms in Jordan, Syria, and, provided that political fundamentals improve, Lebanon.
In one example for infusing capital into regional firms, Dubai International Capital invested $272 million in the Amman-based Jordan Dubai Capital Investment Company.
Such involvements are less prominent but for regional economies no less meaningful than high profile international investments by the likes of Dubai International Capital, which in 2006 included the purchase of UK engineering firm Doncasters and assumption of a $1 billion stake in DaimlerChrysler.
A recent report by International Institute of Finance (IF) and Dubai-based Hawkama, a corporate governance institute, said that GCC companies acquired close to $26 billion worth of assets in UK, Europe and North America in the first eight months of 2006.
Despite the scrutiny of Arab investments in US-linked companies and the problems that marred Dubai Port World’s acquisition of P&O over the group’s US operations, the 2006 trend of international investments by regional corporations is bound to continue in 2007, while the importance of Arab investment firms grows in regional and global capital markets.

The race to host a central bank for the western Gulf region sees Bahrain and the UAE emerging as the top two candidate nations and, barring any more fanciers, one or the other is likely to be the location of a central financial institution for the Gulf Cooperation Council (GCC). If the organization achieves its 2010 target of monetary union, the choice will probably be either Abu Dhabi or Manama. The two cities are bidding hard.
Late entries, however, cannot be ruled out, with Saudi Arabia also tipped to enter the lists. News of this came at a routine meeting of the region’s central bankers in Abu Dhabi at the end of October 2006. During a break at this event, GCC Secretary General Abdulrahman bin Hamad al-Attiyah said that Saudi Arabia had not yet submitted a bid to host the institution, but elsewhere Hamad al-Sayari, the governor of the Saudi Arabian Monetary Agency (SAMA), said that this should not be taken as confirmation that his country would not throw its hat into the ring.

Saudis an expected entrant
Many had been expecting the Saudis to make the contest a three-horse race, with some analysts wondering if their current reluctance is tactical, as they awaited more details to emerge on the other two offers.
Others have pointed out that there is still plenty of time for the Saudis. Not only is 2010 some way off, but there are many in Gulf capitals who wonder at the likelihood of that target being reached. Skeptics argue that the GCC has not had a good track-record in working together on economic issues, as spats over Free Trade Agreements have illustrated.
Nonetheless, the “race” does give observers a chance to study the form. Abu Dhabi is certainly a strong contender, known as the economic and political powerhouse of the UAE and a key global player in energy and investment markets. This gives it a substantial financial and banking community and the resources to match.
UAE Central Bank governor Sultan bin Nasser Al-Suwaidi confirmed in late 2006 that the UAE bid was submitted well in advance of Bahrain’s recent counter-offer, an indicator of Abu Dhabi’s confidence that it will be the eventual winner.
Al-Suweidi also took the opportunity to propose that any single currency in the GCC should, in the longer term, lose its dollar-pegging. He argued that it would not make sense to have a single currency linked to a hard currency and that the currency should be free floating. He also dismissed an idea that it could be linked to a basket of currencies, arguing that within such a basket there would always be one dominant currency.
According to Steve Brice, senior economist at Standard Chartered Bank, in an ideal world, the Gulf Central Bank would be in a better position to set interest rates than the US Federal Reserve. He further said that there seems to be some acknowledgement of this within the region as long as central bank’s intentions were flagged in advance, so businesses can protect themselves against the different currency and interest rate exposures they might face.

Problems ahead for the union
One particular concern regarding the proposed union is the differing inflation levels in the various participating countries. The UAE has a much higher rate of inflation, for example, than Saudi Arabia. Of all the convergence criteria including public debt, currency reserves and interest rates, inflation will be the most difficult to meet before the single currency. Without it, the union will not work.
However, Muhammad al-Mazrouei, assistant secretary general for economic affairs at the GCC, is not worried. At a meeting of GCC central bank governors in Abu Dhabi in October 2006, he said that inflation is transitory and limited to certain sectors such as real estate. He further dismissed concerns over frailing to meet all the criteria, recalling that even the Europeans violated the criteria, and still launched a single currency.
But what about Bahrain? The island emirate also scores highly. While the kingdom lacks Abu Dhabi’s hydrocarbon clout, it has long been known as the Gulf’s financial and banking capital, with its lack of oil and gas obliging it to specialize in such sectors such as this. It has also emerged as the hub for Islamic finance in the region, while also possessing good economic transparency and a lack of excessive bureaucratic regulation. At the same time, the central bank of Bahrain’s stringent laws governing the local financial sector have also won praise internationally.
According to a new study conducted in the region by Dubai-based Fusion Marketing and Management in conjunction with a US company, SurveyMonkey, the organizers of the Leaders in Dubai Business Forum 2006, Bahrain ranks second only to Dubai for ease of doing business.

Speaking at the MENA Economic Forum in Kuwait in November 2007, Ibrahim Dabdoub, CEO of the National Bank of Kuwait, declared that the “Arab banking landscape is being transformed” by the four horsemen of globalization, liberalization, technology and staggering regional growth. He noted that from now on, banks would have to prime themselves for competition and should seriously consider consolidation. “Success,” he said, would mean creating an ideal “economic, financial and institutional environment.” His words are as good a blueprint as any for the GCC banking sector in 2007.

Historically slow growth
Historically, conditions have stifled growth for Arab banks, but this is no longer the case. At the turn of 2007, the Arab banking sector finds itself, at last, in an environment conducive to sustained investment and strong economic activity that should persist until 2010. What has prompted this about-face? Among other factors are strong growth fundamentals, high liquidity and genuine moves to diversify and reform. And while oil prices remain high, there will be demand for lending as new and ambitious real estate developments are announced—and built—at a staggering rate. Both assets and revenues are set to increase, propelled by IPOs, bullish stock and property markets.
As profits boom, the new areas are emerging with strong growth potential. These break down into two categories: those that are already gaining momentum and those that show promise. In the former, there are new opportunities for corporate banking in an “energized” private sector and the financing of real estate projects, given the thriving commercial, office and residential markets. There’s also Islamic banking and brokerage and investment services as sectors to watch. In the “promising” category are on-shore private banking and wealth management services, as well as investment banking, which should accelerate as more family-owned businesses go public, new industries expand and private equity moves across borders. Finally, look for substantial prospects for financing oil, gas and infrastructure projects.
Nonetheless there are always challenges—maintaining bullish performance—and threats—bubbles and geopolitical risks in a region known for its turbulence. As local competition intensifies, weaker banks tend to move towards speculative lending without putting the necessary risk-reward structures in place. Capital markets are increasingly being used as alternative sources of financing; likewise, investment funds have begun to overtake low-cost deposits. Meanwhile, fiscal reforms and labor policies may actually have a negative impact on a low-cost sector that is already feeling the bite. Just as worrying is the threat that the technology sector, the WTO and market liberalization will open up profitable business segments to foreign banks that can, in turn, pick off local customers already looking for higher-quality service and better performance.
Attention should be paid to the underdeveloped regional operating environment, where the combined assets of all Arab banks are less than the total assets of Barclays Bank PLC. The environment is further limited by numerous structural weaknesses. A low spending capacity for development has held back innovation. Compared to their international counterparts, GCC banks invest relatively little in tech, and the regional human resources pool lacks real and sustainable talent. There is also an excessive dependence on interest income, while risk management and corporate governance remain weak.
Banks are employing a variety of strategies as they forge ahead, however. Some have sought out mergers with larger partners, while others have exploited niches such as Islamic and private banking to diversify revenue streams; as competitors seek to differentiate themselves, some banks have integrated strong IT platforms and process control. Furthermore, the culture and concept of corporate governance is slowly beginning to work its way into the banking consciousness.

New problems arise
However, these developments have spawned a new set of structural problems. They include speculative lending by smaller banks and an excessive number of new banks emerging that are liquidity-driven, rather than predicated on a real business plan or strategy. Meanwhile, effective asset and liability matching and large dividends in an era of rising capital requirements are also a concern. Also, in banking, at least, size does matter: smaller banks quite simply cannot compete with their larger, often foreign, counterparts. These competitors are financially stronger, better-equipped to absorb and diversify risk and technologically sophisticated, with a greater ability to innovate. They can also hire better bankers, often importing professionals from abroad—and raiding the best employees from local banks. In addition, several niches may prove vulnerable, such as private banking and wealth management, areas that offer new options to businesses that previously kept their wealth onshore.
With an ever-broader array of choices and products, customer loyalties in the Arab banking sector are set to be tested. Technological advances now offer customers greater options—and flexibility—in where they bank, and foreign banks tend to provide better access to capital markets, as well as strong experience in wealth management. These factors, especially in conjunction with generational transfers of wealth, could lead many customers to abandon longstanding family ties with local banks and move their business to more competitive foreign branches.
So what must Arab banks do to compete? First of all, they must recruit and train better-quality staff—from abroad if necessary—and improve their tech infrastructure. They also must be able to offer objective, comprehensive assessment of risks and rewards while coming in line with internationally accepted standards of corporate governance.

Banks must improve in order to compete
Success will also hinge upon improving core banking business, offering broader product lines, better advising services for clients, and strengthening their brands, in addition to improvements in the three most basic determinants for customer satisfaction: lower prices, better service and a higher level of convenience (both through wider branch networks and online banking services). Local banks should also play to their strengths, and highlight the value-added they can bring to the table, such as local market and customer knowledge and offering tailored services and products.
Much like the consolidation trend among Western banks in the 1990s, which saw the formation of “mega-banks,” Arab banks must also expand geographically, buying or merging with other banks in the region. To do this, governments and regulators should play an active role in ensuring the vitality of Arab banks by supporting the consolidation process across the region. However, they must be equally vigilant in preventing mergers that would create banks with too a large market share, threatening the stability of the sector, as well as those that could give foreign banks control over domestic sectors. They should introduce supervisory methods that suit new, larger banks, update local legislation on mergers and reform labor policies regarding layoffs as merged banks seek to maximize efficiency and productivity. Banks should also change their attitudes: acquisition targets have become limited due to the undervaluing of shareholders, paired with the tendency of controlling shareholders to overvalue their independence. Misplaced national pride and even tribalism present further challenges to expansion.

In addition, more basic issues also need to be addressed as banks eye the regional market. The Arab banking sector needs a degree of homogenity, especially in terms of labor, management, corporate governance, accounting standards and tax laws.
Yes, as Dabdoub said, the future competitiveness of Arab banks ultimately depends on the achieving the optimum economic, financial and institutional environment. This must be coupled with macroeconomic stability, bringing fiscal reform, privatization and market liberalization drives. In addition, more vigorous financial regulation and supervision must be implemented, to foster the kind of enabling institutional atmosphere banks need to operate effectively: a legal framework, a culture of corporate governance, genuine transparency and disclosure as well as greater emphasis on education and labor market reform.
Time will tell … but the clock is ticking.