Arab States Should Beware of Indexes Bearing Easy Money
(Bloomberg Opinion) -- The taps of foreign capital are about to open on some states in the Middle East, thanks to their inclusion in key emerging-market indexes. Over the next year, Saudi Arabia and Kuwait are expected to join Egypt, the United Arab Emirates and Qatar in the MSCI EM index. At the same time, Saudi Arabia, Qatar, the UAE, Bahrain and Kuwait are expected to join Oman in the J.P. Morgan Emerging Market government bond index. Kuwait was classified as “secondary emerging” status in 2018 in FTSE’s Russell index, and Saudi Arabia is expected to be included in March.
Inclusion in these indexes will send tens of billions of dollars pouring into their debt and equity markets, requiring little effort by their governments. But this easy money may hinder economic reform, making growth in 2019 less about liberalization, good governance and markets ruled by law, and more about capital simply going where indexes tell it to go—where the state is large, with large natural-resource revenues and risk-averse foreign policies, so long as equity and debt markets are integrated into global financial flows.
Access to this capital will encourage governments to continue to finance their deficits with international debt issuance, while doing little to spur more organic growth in local private companies. While governments have done some groundwork in order to achieve index inclusion, by regulating their capital markets and exchanges, the harder structural reforms of opening economies and creating a level-playing field for business are far from accomplished.
Among the losers will be young entrepreneurs trying to compete with state-owned or state-linked companies, and new firms seeking venture capital. This is bad news for a generation of young Arabs still seething over the grievances that motivated the 2011 Arab uprisings—the lack of economic mobility, the entrenchment of systems of elite privilege and access, and poor prospects for employment in the private sector.
Which countries will attract the largest share of the index-linked capital flows? Some regional favorites are already emerging, and they are not necessarily the states that are working towards real economic reform.
Instead of rewarding diversification efforts, index-inclusion may have the effect of leaving some behind. Inflows to Dubai, a beacon of economic openness in the region, are relatively flat, while neighbors seen as safe havens, or at least as low-hanging fruit, are receiving more. Kuwait and Egypt are seeing a greater inflow of foreign capital. Saudi Arabia has been subject to intense variability, the result of the 2017 corruption purge and the backlash over the murder of Jamal Khashoggi.
As of October last year, Kuwait had received more than $700 million in net foreign inflows in 2018, more than any previous year, according to research by EFG-Hermes SAE. This was led by passive inflows from FTSE trackers. Other reasons for increased investment were a low debt-to-GDP ratio, a national budget that breaks even at a low price for oil, a government program to increase infrastructure investment, and (compared to some of its neighbors) a problem-free foreign policy environment. The inflows into Egypt are also related to resource-revenues (specifically, the development of natural gas production for export), improved tourism, and the sheer size of the consumer market. Saudi Arabia’s inclusion is expected to drive $16 billion in passive inflows, starting in March.
For investors, the inclusion of resource-rich Arab states in emerging-market indexes will increase their vulnerability to fluctuations in energy prices. Sovereign debt from countries of the Gulf Cooperation Council now accounts for 30 percent of emerging-market issuance.
Will this vulnerability encourage investors to scrutinize, say, government reporting of budgets and state assets? Will they pay closer attention to financial disclosures by listed companies, and to efforts by governments to create a ladder for smaller firms to become publicly-listed?
Probably not. Rather than passive inflows, governments need to kick-start direct investment from both foreign and local sources by getting serious about reforms that support new business creation and provide jobs. In the meantime, foreign investors will be blindly-led by the indexes.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Karen E. Young is a resident scholar at the American Enterprise Institute.
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