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A.4. Capital Flows to the MENAP Region: Going Beyond Traditional Sources

International Monetary Fund. Middle East and Central Asia Dept.
Published Date:
May 2010
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Capital flows to the MENAP region fell sharply with the global financial crisis. So far, the recovery has been partial and generally weaker than in other emerging markets. Reviving inflows more broadly calls for efforts to make these countries more attractive to foreign capital and requires further diversification of the region’s bank-based financial systems.

Adjusting to a New Environment for External Financing

The uneven recovery of international capital flows presents a challenge for the MENAP countries. Flows to the region increased rapidly in the run-up to the global financial crisis, but then fell sharply in 2008 (Figure A.4.1). The region’s main sources of inflows in the past—bank financing for the oil exporters, and foreign direct investment (FDI) for the importers—remain subdued and are not set to recover quickly. Tapping into the rebound of inflows to emerging markets would help stimulate investment in the region at a time when local bank credit is tight. But doing so entails turning more to the areas where the rebound in global capital flows has been concentrated, in particular bond and equity markets, and transitioning away from the region’s traditional model of bank-based financing.

Inflows to the Gulf countries have rebounded strongly since early 2009, driven by bond issuance mainly by Qatar and the United Arab Emirates. This has been facilitated by a vibrant energy sector and a base of large corporations that are well positioned to switch from bank to bond financing. Sovereign bond issuance is helping these countries develop capital markets and open the door for private-sector participation. The region will also benefit from greater transparency and disclosure.

The region’s oil importers have largely been bypassed by the recent rebound in capital flows to emerging markets. Relying mainly on FDI, the oil importers have never been large recipients of international portfolio flows and stand out by the relatively small scale of their stock markets. Moreover, as a group, these countries have not seen much of a recovery of inflows since last year’s fall. Given a subdued outlook for non-oil FDI, and few large companies with the ability to access international capital markets, inflows to the oil importers are likely to remain muted for some time. Nevertheless, policies to make these countries more attractive to international investment could accelerate the recovery and, over time, contribute importantly to economic growth.

Figure A.4.1Spike in Capital Flows

(Change in FDI, portfolio, and other investments; billions of U.S. dollars)

Source: IMF, World Economic Outlook.

Policy Agenda for Reviving Inflows

  • Strengthening further international trade and finance links.
  • Improving the business environment by streamlining regulations and ensuring a responsive public administration to increase the attractiveness of local enterprise and facilitate investment.
  • Privatizing state-owned enterprises and promoting listing of stock. With bank credit lacking, equity markets are the main funding alternative for many firms. Governments can provide incentives for local family firms to list on the stock exchange.
  • Developing bond markets. Sovereign bond issuance can help develop the yield curve, provide a benchmark for the pricing of other debt instruments, and enhance market liquidity. The success of government efforts to develop financial markets is predicated on ensuring effective oversight and a culture of transparency.
  • Prioritizing strong macroeconomic fundamentals, especially in indebted countries, will help reduce risks, lower sovereign interest rate spreads, and raise demand for domestic assets. Sound fiscal stances would reduce credit risk associated with government paper and assist the development of other financial instruments.

From Boom to Bust

Prior to 2008, capital flows to the Middle East had risen particularly rapidly (Figure A.4.2). Coinciding with a period of rising oil prices and large current account surpluses, most of the inflows went to the region’s oil exporters, in particular Saudi Arabia and the United Arab Emirates, and were mainly in the form of financing from foreign banks. While governments accumulated large reserves, local banks and corporations were borrowing heavily abroad. Consequently, inflows to these countries rose alongside an even larger increase in their investments abroad. By 2007, signs of overheating emerged, with inflation rising toward double digits in several Gulf states, and speculation in currency appreciation adding to inflows.

Figure A.4.2Oil Exporters in the Midst of Capital Movements

(Percent of GDP)

Source: IMF, World Economic Outlook.

Compared to the oil exporters, investment into the oil importers increased only moderately. Supported by wide-ranging privatization programs, capital flows to this group of countries have mainly been in the form of FDI. Other types of inflows were smaller and did not rise as much as in other emerging markets, with the oil importers generally staying on the sidelines.

Inflows fell sharply in 2008 with the global financial crisis. Within the region, the oil exporters experienced by far the largest drop, in line with the sharper run-up of inflows to these countries. As investors reduced their positions, the stock of foreign non-FDI investment in the oil exporters contracted by almost 8 percent of GDP, compared to an increase of more than 20 percent of GDP in 2007—a larger reversal than for the world’s emerging and developing countries overall. FDI was much more resilient. It ultimately fell by just ½ of 1 percentage point of GDP compared to 2007, mainly on account of a 2 percentage-point drop for the oil importers, but remained at a higher share of GDP than the emerging and developing country average. On the whole, the impact on the economies of lower capital inflows was relatively modest for this region, with oil exporters able to buffer the shock by drawing down assets and providing large government stimulus that benefitted the oil importers as well.

Partial Rebound of Capital Flows

Financial flows started to revive in early 2009. Powered by low interest rates in advanced economies and improving growth prospects, portfolio flows to emerging markets started to recover strongly during the second quarter of 2009. Investment flows into MENAP as a group followed the renewed upward trend seen in emerging markets, although not to the point that inflows have become a widespread concern, and with inflows to most of the oil importers still subdued.

By end-2009, new issuance on international capital markets was back near earlier highs. Growing over the course of the year, the region’s total international issuance of bonds, loans, and equities reached US$54 billion in 2009, not far below the 2005–08 average (Figure A.4.3). Bonds took the lead in 2009, with the US$32 billion issued representing a record for the region and about 15 percent of emerging markets’ total bond issuance—more than the region’s approximate 11 percent share in emerging-market GDP.

The rebound has not been widespread. Syndicated loan issuance, previously a mainstay in the region, has been relatively low—at US$20 billion in 2009—and dominated by the United Arab Emirates. Equity issuance, although never of major significance in the MENAP countries, was even lower, at just US$2 billion. As such, equities represented less than 5 percent of the region’s total issuance in 2009, a sharp contrast to other emerging markets, where the share of equities in total issuance rose to about 30 percent over the course of the year. Equally striking is the fact that the rebound has largely sidestepped the oil-importing countries. Together, the oil importers placed less than US$5 billion of external bonds, loans, and equity in 2009—less than half of the average during 2005–08—and, of that amount, almost US$3 billion was Lebanese bonds purchased primarily by Lebanese banks.

Bond Issuance Centered in the Gulf States

Qatar and the United Arab Emirates alone accounted for some 85 percent of the region’s total bond placement in 2009. Moreover, as sovereign debt issuance increased to almost 45 percent of the total, financial sector bond issuance (at less than 25 percent of the total) was only half its 2005–08 level. The remainder was mainly energy related and supported by a switch from loan to bond financing.

The greater concentration of financially solid oil-exporting and public-sector borrowers has been reflected in favorable terms of the new external bond issues. At over six years, the average maturity of MENAP countries’ new bond issuance has held up at almost twice the emerging-market average (Figure A.4.4). In addition, the average spread relative to the interest rate on government debt in the currency of issuance (mainly U.S. dollars) declined to less than 3 percent in the third quarter of 2009, although individual issuers generally faced higher spreads than in early 2008.

Figure A.4.3Rebound in International Issuance

(MENAP, billions of U.S. dollars)

Source: Dealogic.

Figure A.4.4Strong Bond Placement

(MENAP countries’ external bond issuance)

Source: Dealogic.

The financial crisis has made capital markets more discerning, but conditions are normalizing. Bond financing, for a period, was essentially limited to the most creditworthy borrowers, and is still an option mainly for sovereigns or large corporations. At the same time, sovereigns in oil-importing countries, who previously had accessed international capital markets, have increasingly borrowed domestically for greater stability. This was made possible by ample liquidity in their home markets. Egypt’s external sovereign bond issue in April 2010, its first since late 2007, points to a more balanced approach in the future and may open the way for more corporate bond issuance in the region’s oil-importing countries.

The November 2009 announcement of a standstill on Dubai World’s debt repayment created uncertainty for borrowers and lenders. This was evidenced by the absence of new conventional bond issuance from the Gulf countries up to mid-March 2010. However, with a number of placements since then, and more underway, this lull appears to have been temporary.

Bank Lending and Non-Oil FDI Remain Subdued

Bank credit remains tight. Borrowing from foreign banks, traditionally the main source of external financing for MENAP countries, has yet to recover from the downturn in 2008. The decline in the region’s stock of foreign loans was smaller than for emerging and developing economies as a whole (Figure A.4.5), in part reflecting the larger buffer in foreign assets. However, as elsewhere, the increase in foreign bank lending in the region in 2009 has been limited and is contributing to the slowdown in domestic credit extension. This tightness is of particular concern for the largely bank-based financial systems in the MENAP region, especially among the oil importers, where few companies issue bonds.

Direct investment has diverged between sectors, with FDI in the oil industry holding up, but elsewhere falling below precrisis levels. During the past decade, oil-importing countries benefited from particularly strong increases in FDI, which had reached an average of more than 5 percent of GDP in 2008 (Figure A.4.6). By then, privatization programs had largely tailed off and given way to greenfield investments. In line with other emerging markets, the subsequent drop in FDI was consequently a significant factor underlying the oil importers’ drop in capital formation. FDI has held up better for the oil exporters, but with significant variation across countries. FDI flows to the United Arab Emirates fell from US$14 billion in 2008 to US$4 billion in 2009, as the country’s construction and real estate boom came to an end. In contrast, Saudi Arabia’s economy—less reliant on those sectors—witnessed a small increase in FDI inflows to US$43 billion, mainly into the downstream petroleum industry.

Figure A.4.5International Bank Lending Still Subdued

(Liabilities to foreign banks; billions of U.S. dollars)

Source: Bank for International Settlements.

Figure A.4.6Diverging Patterns in FDI

(Inward foreign direct investment; percent of GDP)

Source: IMF, World Economic Outlook.

Intraregional investment has fallen sharply. A good part of the MENAP countries’ outward FDI—increasing from negligible amounts before 2004 to about US$45 billion in 2007—was directed to other countries in the region. For example, intraregional mergers and acquisitions reached more than US$7 billion in 2007; almost all involved GCC countries, and sovereign wealth funds (SWFs) and state-owned enterprises played a leading role. That trend reversed in 2009, as outward FDI dropped to less than US$20 billion and intraregional mergers and acquisitions came to a near standstill during the first half of the year. This partly reflects growing home bias: the global financial crisis and resulting losses made SWFs more risk-averse and led countries to prioritize support for their own economies.

Gradual Normalization Ahead

For the period ahead, the ongoing global economic recovery suggests that capital flows will continue to expand. Lower interest rates in advanced economies than in other parts of the world are likely to support continued flows to emerging markets. Indeed, driven by interest rate differentials, a few countries within the region are beginning to see increasing bank deposits from abroad or foreign purchases of treasury bills. In addition, high oil prices and widening current account surpluses in oil-exporting economies may lead to new momentum in intraregional investment. As their economies pick up, sovereigns in the oil-importing countries also will be more likely to reenter international markets.

Some core areas, such as bank lending and non-oil FDI, are likely to remain relatively slow. With banks still under pressure worldwide, the recovery in bank lending is likely to be protracted. Moreover, in line with the outlook for other emerging and developing economies, FDI in the oil importers is expected to remain below precrisis levels for at least another year. In general, given the fragile global recovery, investors are likely to continue to primarily target low-risk assets and to show a preference for bonds over other less liquid instruments.

Policy to Cautiously Attract Inflows

Higher capital flows are aiding the MENAP economies, and policymakers should aim to support the process. Recent inflows, although concentrated in the Gulf region, have helped provide much-needed stimulus in a period of low output growth. Continued reforms to strengthen and open the region’s economies will make them more attractive to foreign capital and can thereby support the recovery. But adjusting to international investors’ heightened preference for portfolio over other instruments also points to the benefits of developing local bond and equity markets.

Close monitoring of capital inflows is called for, alongside efforts to attract investment. In the current environment of surging capital flows to fast-growing economies, there is a risk of overheating and asset-price bubbles. At present, with bank credit still subdued, there is little to suggest that valuations in the region have become overstretched. However, the burst of Dubai’s real estate bubble in 2008 highlights the danger associated with excessive capital inflows. Avoiding such downside risks requires strong financial sector regulation and careful monitoring.

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