Monday, December 28, 2009

Gentlemen, this stock exchange thing is the best idea we've had yet! Someone get Sheikh Mo on the phone and see if he wants one.




In the fall of 2005 I attended a financial services conference in Dubai. The most relevant session I attended had to do with the future of the exchange architecture in Dubai. There were representatives from the DIFX and the DFM, the regulators and some local and international firms. Each participant gave a short and glowing talk about the future of GCC exchanges and those in Dubai in particular. Then there was an opportunity for those in the audience to ask questions.

One of the first questioners was a British man in his 50s or 60s. I remember thinking that he looked like an ageing hippie. In my memory he is wearing a flannel shirt and overalls, has a long white beard and a bandana but that is almost certainly not the case because you would have to be out of your mind to walk around Dubai in flannel. As much as his clothing may have stood out from the general audience of besuited bankers and Arabs in national dress, his mindset differed even more. He asked the assembled panellists how they thought any exchange could succeed when everyone knew that successful financial markets require a middle class and that in Dubai there was no middle class whatsoever.

The way he asked the question you might guess that he was one of those perpetual, and at the time frustrated, Dubai naysayers who had already decided the outcome but needed to ask the question out loud in order to print it. There were a lot of people who when they went to Dubai and saw the way the Emiratis lived and then spent time with the Indian community and noted the discrepancies felt strongly about issues of social justice within Dubai. It seemed to me that this was the journalist grandstanding and speaking truth to power at least that was how he saw it.

The men on the dais saw it differently. Who was this man with his bushy white beard and ridiculous outfit to question the Dubai dream that was in the making? It was a little embarrassing for someone to have sneaked into the Madinat Jumeriah and try to rain on the parade of the international financial system with this reference to the uncomfortable subject of income inequality in the Arab world. Luckily it was not hard for the men on the dais to figure out what the script was. This was 2005 when the prospect of doing business with a Dubai government entity made you reach for your wallet rather than your gun and everyone knew what the Dubai Inc. answer to this was: “of course there is a vibrant middle class in Dubai and the great project of making Dubai a financial center on par with London and Singapore is moving forward at full speed.”

Sitting in the audience I thought the whole exchange was preposterous. While they disagreed over whether there was a vibrant middle class in Dubai, and here I think the balance of the evidence would weigh in favour of the journalist, they both agreed a false premise. They both assumed that a thriving middle class was necessary for the Emirati capital markets to develop. In my opinion they had it backwards, without developing the capital markets in Dubai there could be no middle class. Why is that? I’ll get to that but first a little history:

OK folks, pop quiz question one: What was the first IPO in history?

Answer: the first IPO was for the Dutch East India Company (known by its Dutch acronym VOC) in 1604. Voyages were so expensive and so risky that the risk had to be shared. The Dutch took this one step further by scaling up the financing from individual voyages to an entire company organized for the purpose and by offering the shares generally the risk was spread as widely as possible. That share sale led to the organization in Amsterdam of the first regular stock exchange in history. Incidentally this was one of the best trades in the history of the world. The VOC paid 18% dividends on average for 200 years.

Pop quiz question two: which country in 2008 had a similar income distribution to that of the Netherlands in 1604, Dubai or the United Kingdom?

Answer: Dubai.

In order to understand how important capital market development is to Dubai and the Arab world generally it’s important to understand how their economies function today. Most people assume that the concentration of wealth in the Arab world is the result of the fact that there is not too much distinction between the royal families and the state and so in most countries the royal family effectively controls the oil wealth and this makes them fabulously wealthy. This is true but it is only part of the story.

The other part of the story is the extent to which the remaining economy is often controlled by a handful of merchant families. In Saudi Arabia ten merchant families control 24% of the non-oil economy between them, the top 25 probably control well over half. There are many reasons for this.

The most obvious is that some families receive royal patronage which gives them an advantage over other families. You have to remember that being an Arab monarch is not the same thing as being a dictator in the western sense. Their power comes much more from balancing various power centers against one another within the country rather than from the barrel of a gun. They generally follow a divide and rule strategy playing the religious establishment off against the business elite and the business elites against one another.

This sort of thing went on in western Europe during the consolidation of monarchical power there as well. Remember Queen Elizabeth granted Sir Walter Raleigh a monopoly on the importation of wine, or vast tracts of land in the Americas. The same is true in the Arab world today. Arab monarchs often give gifts of land to favoured allies, this is why there are so few public parks in Arab cities, the kings tend to give the land away sometimes with disastrous consequences as in Jeddah recently. They can also grant or support monopolies on the importation of certain items. Awarding government contracts to favoured allies is also a source of wealth as is putting people in charge of government enterprises with opportunities for self enrichment. One need only look at the Byzantine structure of Dubai Inc. to see the hand of someone who wanted to reward many people with lucrative posts.

This is not to say that the only road to wealth is government favour. Ability is also a factor and the poor state of education in the Arab world means that a little education or a lot of ingenuity can go a long way because there is relatively little competition in local labor markets. The Bin Laden fortune was built on government contracts but the first contract was won with legitimate skill. The poor quality of general education in the Arab world perpetuates the concentration of wealth because it tends to stay in the hands of those who are wealthy and wise enough to send their children to school abroad or to the few quality international schools in the region.

The final reason for the concentration of wealth is access to capital. If you have a good idea for a business you need to have some way to fund it. Generally there are three ways to fund new business ventures: retained earnings, debt, and equity.

A great many of the businesses in the middle east are funded with retained earnings. This why you see so many family conglomerates. Aside from the fact that commercial ventures also serve to cement family bonds often a business produces more earnings that can profitably be reinvested in that business. Often when this happens the family will use those earnings to start another business venture sometimes in a similar line but often in a completely different field as a means of diversification. Of course who as access to retained earnings as a source of financing? Those who already own businesses! Thus this is another way in which the distribution of wealth is self reinforcing.

Another way in which one might fund a business is through debt, most commonly in the Arab world through bank loans. There are a few factors which conspire to make this not particularly effective. One is the nature of how decisions are made with bank loans, sure a lot of analysis is done to determine the creditworthiness of the borrower but at the end of the day the decision of whether to lend is made by one man or a at best a small committee. Those people can be influenced by the royal family or by long relationships with the potential borrowers so once again access to bank capital favors those who are already part of the system. There is another issue, peculiar to the Arab world, which makes it difficult to use bank capital to finance new ventures and that is that in Sharia courts it is not always so easy to take possession of collateral in the event of default. This means that a bank is unlikely to lend to someone that does not already have a reputation for paying back loans. Of course you can only have such a reputation if you are already in business so issues with recovery in insolvency also serve to sustain the concentration of wealth.

So that leaves equity markets as a source of capital for Arab entrepreneurs. In theory public and private equity markets together are an ideal source of capital especially in the Arab/Islamic world. Equity markets enable the investor to receive significant upside which gives a better return to the investor given the higher risks one faces in emerging markets that part of the world. Private equity is like a partnership and is therefore Sharia compliant in a way that many debt structures are not. As a result of these things the universe of private equity investors in the region is much greater than the number of potential bank lenders, not everyone can be a bank but anyone can invest in equity.

Thus you can think of equity markets as a sort of “democracy of capital.” At a bank a single loan officer can make a dictatorial decision as to whether to fund your idea o not and your connections and your collateral are as or more important to him than the viability of the idea. Additionally in most GCC countries you can count the number of banks on your fingers. The number of private equity investors number in the hundreds, or even thousands and the number of public equity investors in the millions. These investors become partners in the business and so are more concerned with the viability of the idea than the value of any collateral and they vote with their money. By aggregating up each individuals willingness to take risks and enabling them to share the risks equity markets should more efficiently channel money to the most productive enterprises. One can never completely eliminate the role of relationships and connections from the Arab world but equity markets, by their democratic nature minimize their influence and maximize the importance of the idea itself.

This is why effective equity markets are ABSOLUTELY ESSENTIAL to increasing productivity and employment and minimizing income inequality in the Arab and Muslim world. This is why I am so up in arms over the fraud at Damas. But the fraud at Damas is only one of many deep flaws in middle eastern equirty markets and I will illustrate more of them in subsequent posts. But I want to do more than simply curse the darkness, I want to look for what lights there are. There have been advances in recent years in Dubai, and in Saudi Arabia. Who knows what fruit the DIFX/DFM merger will bear. Perhaps the problems of debt and fraud in Dubai are beyond the powers of capital markets and reform to save them. But then again, perhaps not.

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