Sunday, June 05, 2011

What will replace the property bubble in the GCC?

One of the trends in Islamic finance outside of the GCC (and excluding Malaysia, which has a thriving local Islamic finance industry) is that countries, fund managers and companies are eager to tap the financial resources of the GCC countries, particularly when oil prices are high and funds are entering the GCC seemingly faster than they can be deployed. Another factor in the flow of funds from the GCC to the rest of the world is the need to diversify (both geographically, but also the relative scarcity of investment opportunities locally. There is also some movement of funds internationally to take advantage of non-real estate based private equity and venture capital (look for an article in this coming week's Islamic Globe on a development in the U.S.).

This theme of funds flowing out from the GCC and being sought out by countries, companies and fund managers internationally is not solely the domain for Shari'ah-compliant investments; it is probably larger on the conventional side. On the Islamic side, two recent countries vying for a piece of the GCC investment pie were Indonesia, which is trying to attract both money and expertise in Islamic finance, and Russia, whose region Tatarstan is considering issuing a sukuk focused on attracting foreign capital from the GCC.

With the sheer amount of capital flowing into the GCC (and mostly into the hands of a few wealthy individuals and sovereign wealth funds), there are probably good reasons why international investments are likely to be able to attract this capital (and benefits for the GCC from this occuring). However, the more that international investment opportunities are able to attract GCC capital, the slower the region will be to developing a domestic financial sector as well as capturing the spillover in other areas from regionally-focused investment firms.

The main impediment to the deployment of capital in the region is that there is still too much dependence on oil for a big chunk of the GDP in many of the GCC countries. Because of the large oil wealth (and relatively under-developed public goods like a proven legal system), there has not been as much progress on creating a private sector outside of the energy sector. Even within the energy industry, there has been a significant reliance on expatriate workers, which is fine on its own, but when combined with the underdeveloped private sector outside of energy, you see the levels of unemployment (particularly youth unemployment) which hurts future prospects for non-energy-related sectors.

Some countries have found industries in which they can grow; Bahrain (at least until the recent protests and martial law) had developed a large financial sector while Dubai developed itself as a real estate/tourism capital with a significant role in international trade through ifs port. However, each has its own limitations and does not on its own create a sustainable, diverse economy that would generate a diverse enough set of investment opportunities to keep more of the money generated from natural resources locally.

Then there is the financial sector locally, which does not have a stellar track record post-crisis (not alone in that regard in the financial industry). Too much of the money invested locally went into real estate, which created a bubble at least as significant as the subprime-fuelled bubble in the US (all real estate is local, so there were some exceptions). The key point for Islamic finance with this is that the real estate bubble did not have nearly the same conventional focus as it did in the U.S. The blow up in real estate (e.g. in Dubai) was due much more to sky high prices than it was to derivative products magnifying the extent of the growth in prices.
For this reason, Islamic banks--particularly investment banks--had a much greater exposure to this real estate bubble than they did to the U.S. bubble. Like conventional banks, they had extended credit to real estate developments (either directly or through "private equity" transactions) with the expectation that prices could keep risisng. When they stopped rising and began their precipitous fall, the investment banks shrivelled. With the real estate bubble gone, many of these investment banks and particularly the ones with a focus mostly on real-estate driven "private equity" have struggled to find a way to generate revenue.

Now, without a property bubble to generate investment activity locally and with the spigots opening anew with rising oil and natural gas prices, the capital is accumulating and it needs a home. The Islamic financial institutions (like conventional banks) are returning to growth slower than the flow of funds, so there is a greater and greater share that will need to be invested internationally. Thus, the countries, companies and fund managers internationally have returned to make a 'pitch' to the GCC to invest the funds in banks in Indonesia, regional governments in Russia and private equity funds in the United States (among others).

The downside to the GCC if this persists and nothing more sustainable is developed post-real estate bubble is that the funds will not benefit the local economies as much as they could if found a home developing non-energy-related industries locally. So, while much of the capital from the energy resources is being invested internationally, there should be a continued focus on greating local industries--particularly new small businesses--that will be able to absorb some of the capital and create a relatively larger impact in terms of employment than large, capital-intensive businesses like downstream energy business or financial services.

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