Sheikhs and Souks: capital market formation in the Middle East.

• Position: Continuity and Transformation: The Modern Middle East

Introduction

Since the beginning of Western civilization, the markets of the Middle East have buzzed with activity. Yet the countries of the region that brought us currency, trade and law - the bases of modern commerce - have been relative latecomers to the global financial markets. Where the Middle East is concerned, political and religious issues continue to dominate the headlines. However, in the wake of the Cold War and declining oil prices, the countries of the Middle East are quietly returning to world markets. As befits a region of historic diversity, the roads to the market and each country's place on those roads, vary widely. We shall examine some of these paths and attempt to place them in the context of the recent history of this ancient region.

What distinguishes the Middle East from other emerging markets is the region's heterogeneity. Whereas countries in other regions have, to some degree, had similar experiences with economic development, there is no single regional pattern in the Middle East that describes the development of markets across countries. In Latin America, for instance, capital markets have similar arcs of development, largely the result of a shared history of indebtedness, subsequent restructurings and the recent wave of privatizations. The markets of Eastern Europe are emerging from an era of centralized state planning, most of which unraveled at approximately the same time. Export-led growth in East Asian markets occurred with little or no indebtedness (except in the case of the Philippines), and equity markets in the region reflect calculated strategies to attract foreign capital. The countries of the Middle East share few common experiences. The case studies selected below illustrate this diversity.

One common thread noticeable to the casual observer is that many Middle Eastern capital markets are relatively underdeveloped. They also tend to be lopsided, with a significant state presence, limited foreign involvement and often a dominant role for ruling families. As we shall see, the direction of a country's capital market development has been largely a function of one or a combination of the following: its oil endowments, the geopolitics of the Cold War and regional conflict.

Several factors explain the ability, or inability, of Middle Eastern countries to develop capital markets. First, a country's reliance on petroleum-export income is relevant to its vulnerability to oil price fluctuations and, consequently, to its need to diversify its economy or find alternative sources of financing when oil prices fall. In addition, most of the region was involved in the Cold War as a playing field for bipolar politics between the United States and the Soviet Union. Countries found themselves on different teams, and some, such as Egypt, moved from one camp to the other over time, but they all enjoyed financial or other support for their allegiance. Regional politics have also played an important role in determining the direction of capital flows in the form of military aid, development aid and expatriate remittances. Each country has been affected by a particular combination of these factors, and its response to them has affected the depth of its respective capital market development.

Oil Countries

The oil-producing countries of the Middle East thrived in the 1970s when the price of oil skyrocketed from $4 per barrel in 1973 to a high of $40 per barrel in 1979. However, oil prices since the mid-1980s have been low, and generally unpredictable. The bust of 1981, and that of 1986, when prices fell below $10 per barrel, were particularly salient events in the national accounts of Middle Eastern countries. By the last week of December 1992, the price of oil was $17.53 per barrel; a year later it was less than $13, at least 20 percent lower than what forecasters had predicted.(2)

For many of the countries whose income is derived primarily from oil, falling prices mean that they can no longer rely on the rents from petroleum extraction, or at least that the level of their annual oil income cannot be guaranteed. Faced with this reality, many of these countries have been forced to look elsewhere for capital. In order to access international capital markets, Middle Eastern countries have had to begin to radically reform their economies, both diversifying them away from oil and restructuring them to earn favorable credit ratings in the markets that they are trying to tap.

The Cold War and Regional Politics

Until 1989, the superpowers, seeking to protect their perceived geopolitical interests in the region, supported the military-industrial complexes of several Middle Eastern countries. The Middle East was one of many gameboards upon which the bipolar competition was carried out. At different times, Iraq benefitted from the military and financial assistance of both the Soviet Union and the United States, whereas Israel was solely the client of the United States. For a long time, Israel has enjoyed U.S. loan guarantees, and so has not needed to issue sovereign bonds until recently. In addition, possibly because of the Arab boycott, Israeli corporate bonds were issued offshore in order to attract foreign investors.(3) Thus, if we look at a cross-section of Israeli financial instruments, we see that there is little sovereign debt, and that equities are largely to be found on the New York Stock Exchange, where there has traditionally been greater interest in Israeli instruments than in other offshore markets.(4) During the Gulf War, some countries, such as Egypt, were rewarded for their role, whereas others, such as Kuwait, emptied their coffers to pay for their defense. As we will see, both Cold War politics and regional politics help shape the arc of capital market development in the region.

Heterogeneous Development in the Region's

Financial Markets

The countries examined below illustrate the Middle East's range of experiences with capital market formation. Oil producers such as Saudi Arabia show the crippling effect of single-commodity economies, whereas strategic allies such as Egypt and Israel demonstrate two types of foreign patronage. Syria and Iran are examples of countries that are having a difficult time modernizing their economies and becoming integrated into international financial markets, whereas Morocco and Turkey have successfully attracted foreign investors, primarily through their respective privatization programs. Kuwait demonstrates a creative solution to a state's need for hard currency.

Egypt

In the past, Egypt has relied on three sources of revenue: oil exports, rents from the Suez Canal and international and regional aid. Although an oil producer, Egypt has only been a net oil exporter since 1976. Until 1981, oil revenues were partly responsible for the economy's growth. In fact, in 1980 they made up 58 percent of Egypt's export revenues, bringing in around $2.6 billion in foreign exchange.(5) However, when market prices fell in 1986, the government chose to fix prices at an artificially high level. Thus, no new contracts were signed. Since then, oil has been less important as a source of current revenue. Duties from the Suez Canal were also a significant source of revenue. But in 1967, when the war caused the canal to close down, Egypt suffered a financial loss that was remedied by large subsidies from Arab states. Today, neither of these two endowments contributes in any significant way to overall Egyptian revenues.

In fact, Egypt's most significant source of financing has been a combination of international and regional foreign aid. Between 1955 and 1973, Egypt relied on $4.22 billion in loans from the USSR for the development of its industrial base. In the mid-1970s, when relations between the two countries deteriorated, France, Italy, Spain and Yugoslavia provided it with financial assistance. In 1967, Kuwait, Saudi Arabia and Lybia agreed to provide Egypt with;e95 million each year, and increased their pledge to 1 billion [pound] for the period between 1973 and 1979. In addition, these and other Gulf countries supported the economy through state investments and various aid agencies. An example of such an investment is the Arab Organization for Industrialization (AOI), a $2 billion joint venture established in 1975 and jointly owned by Egypt, Saudi Arabia, the United Arab Emirates and Qatar. Originally intended to be a military workshop of sorts, the AOI employed 17,000 people at one point. Such aid and investments were cut, however, when Egypt made peace with Israel through the Camp David Accords in 1979.(6) This was the cue for the U.S. to step in.

[TABULAR DATA OMITTED]

Since 1980, U.S. aid to Egypt has exceeded $2 billion a year, and has been as high as $4 billion. In 1983, Egypt began to replace its mostly Soviet military equipment with U.S. equipment, thanks to $1.3 billion in annual military assistance from the U.S., making Egypt one of the top three recipients of U.S. foreign aid since 1979.(7)

In 1987, Egypt mended ties with its Arab neighbors, reactivating their former relationships. As a reward for Egypt's leadership role in forming the Arab coalition during the Gulf War, aid flows resumed. In 1990, Egypt enjoyed a $2-billion cash grant as well as a $7-billion debt write-off from its neighbors, resulting in an overall external-debt cancellation of about $10 billion. By 1990, Egypt had accrued over $7 billion in military debt to the U.S., but the U.S. wrote off the obligation, supposedly because of Egypt's strategic role against Iraqi aggression. By 1991, Egypt was the world's largest recipient of foreign aid, receiving a staggering $9.98 billion that year. Because of its continued strategic importance in the region, last year

[TABULAR DATA OMITTED] Egypt won $6 billion in aid pledges for the following two years, 60 percent of it in grant form.

Despite the generosity of its neighbors and the U.S., Egypt was the most indebted country of the Middle...