Economic Co-Operation in the Arab Gulf: Issues in the Economies of the Arab Gulf Co-Operation Council States (Routledge Studies in Middle Eastern Economies)

Economic Co-operation in the Arab Gulf

This book examines the major issues facing the economies of the Arab Gulf today, covering all six of the Arab Gulf Co-operation Council (AGCC) states: Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates. These countries enjoy global economic significance on account of their huge oil reserves, and are likely to remain at the forefront of the global economic agenda for many years to come. This book analyses the critical questions facing these economies today, outlines the key trends and likely prospects for the future, and goes on to formulate policy recommendations. Important topics covered include the AGCC monetary union, intra-AGCC national labour movement, Islamic banking and programmes to finance small and medium enterprises (SMEs). It examines the costs and benefits of the proposed monetary union, assessing whether AGCC economic structures have sufficiently converged and whether these economies have the internal flexibility necessary to make the union work effectively. It investigates intra-national labour mobility in the context of the forthcoming monetary union and identifies the most crucial features in a successful common AGCC employment strategy. It considers the fortunes of the prominent Islamic banks in the region, and examines the impact on liquidity of financial and regulatory policy. Finally, it contrasts and compares some of the major SME financing schemes, focusing in particular on SME financing in Oman. Overall, this book provides a detailed account of the central features of the economies of the Arab Gulf, drawing out the critical trends that will shape the region in future years. Badr El Din A. Ibrahim currently serves as an Economic Expert at the Ministry of Finance, Oman. He was previously Assistant Professor and Head of the Department of Economics at Khartoum University, and thereafter Professor of Economics at the Modern College of Business and Science, Oman. He has written on SMEs, Islamic banking, adjustment programmes, and AGCC economies. He is the author of Banking and Finance to Small and Micro-enterprises in Sudan – Some lessons from the Islamic financing system (Institute of Islamic Banking and Insurance, London, 2004).

Routledge studies in Middle Eastern economies

The Egyptian Economy Performance policies and issues Khalid Ikram Economic Co-operation in the Arab Gulf Issues in the economies of the Arab Gulf Co-operation Council states Badr El Din A. Ibrahim

Economic Co-operation in the Arab Gulf Issues in the economies of the Arab Gulf Co-operation Council states Badr El Din A. Ibrahim

First published 2007 by Routledge 2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN Simultaneously published in the USA and Canada by Routledge 270 Madison Ave, New York, NY 10016 Routledge is an imprint of the Taylor & Francis Group, an informa business This edition published in the Taylor & Francis e-Library, 2007. “To purchase your own copy of this or any of Taylor & Francis or Routledge’s collection of thousands of eBooks please go to www.eBookstore.tandf.co.uk.” © 2007 Badr El Din A. Ibrahim All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging in Publication Data Badr el din, A. Ibrahim. Economic co-operation in the Arab Gulf : issues in the economies of the Arab Gulf co-operation council states / Badr el din A. Ibrahim. p.cm. – (Routledge studies in Middle Eastern economies) Includes bibliographical references and index. 1. Persian Gulf States–Economic policy. 2. Gulf Cooperation Council. I. Title. HC415.3.B33 2007 337.1'536–dc22 ISBN 0-203-96179-X Master e-book ISBN

ISBN10: 0–415–42883–1 (hbk) ISBN10: 0–203–96179–X (ebk) ISBN13: 978–0–415–42883–5 (hbk) ISBN13: 978–0–203–96179–7 (ebk)

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Contents

List of tables Foreword Acknowledgements List of abbreviations

vii ix xi xiii

Introduction

1

1

The AGCC Monetary Union

7

2

Intra-AGCC national labour mobility

33

3

Some aspects of liquidity of Islamic banks in two AGCC states

59

Financing small and medium-sized enterprises in the AGCC states: the case of Oman

91

4 5

Conclusion

135

Notes Bibliography Index

139 142 149

Tables

1.1 1.2 1.3 1.4 1.5 2.1 2.2 2.3 2.4 2.5 3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 3.9 3.10 3.11 3.12 3.13 4.1 4.2 4.3 4.4 4.5 4.6 4.7

GDP by economic activities AGCC: expenditure components of GDP, 2003 AGCC endowments and economic size Trade openness, trade integration and geographical breakdown of trade accounts Testing for procyclicality in AGCC countries Growth account in AGCC states, 1980–1990 and 1980–2000 Employment elasticity of output growth in AGCC states, 2000–2001, and other estimates of employment elasticity AGCC average annual growth rates of labour force and population Employment indicators in AGCC states and other groups of countries Omani labour force in Qatar – major characteristics Islamic and conventional types of deposits Financial statements of ISBs and CBs Macroeconomic indicators – UAE, 1998–2002 Macroeconomic performance – Qatar, 1998–2002 Banking performance – UAE, 1998–2002 Banking performance – Qatar, 1998–2002 Cash to current liabilities Cash to customer deposits Current assets to current liabilities Leverage ratio Customer deposits to current assets Current assets to total assets Net profit to customer deposits General characteristics of SME financing programmes Definition, types and target groups Methods and amount of finance Interest rates, charges, exemptions, grace and repayment periods Conditions and guarantees Objectives and priorities of finance Indicators of success, obstacles and future vision

16 16 17 19 24 41 42 43 46 54 61 62 72 73 75 76 82 82 84 84 86 86 86 104 107 110 112 114 117 119

Foreword

The issue of economic integration in the Arab Gulf Co-operation Council (AGCC) states has been much written about in the media and debated both in the region and internationally. However, there is little academic or professional literature on the subject and much of the popular debate has been at a rather general level. Dr Badr El Din Ibrahim’s study aims to rectify this situation, as it provides a detailed evaluation of the challenges facing AGCC policy makers as they attempt to integrate their economies to create a regional economic power that has a more significant market and resource base than any of the individual countries participating. The focus appropriately is on AGCC monetary union, which could bring substantial benefits to the six countries through its positive impact on investment, the development of financial services and employment. However, as Badr El Din Ibrahim points out there are constraints given the limited degree of convergence in both structural and cyclical terms, as well as the inflexibilities in labour and capital markets and the rigidity of fiscal policy. Labour issues are investigated in detail, notably the extent of market segmentation, the dependency on migrant contract workers in all six economies and the paradoxical unemployment faced by some local nationals that policy makers have struggled to address. Strengths of the work include how hypotheses are properly formulated and objectively tested, with the findings clearly presented. Two particular issues are explored in considerable detail, the liquidity of Islamic banks in the UAE and Qatar and the finance of small and medium-sized enterprises (SMEs) in Oman. At first sight these would appear disconnected from the issue of AGCC economic integration, yet they are actually intertwined, as Badr El Din Ibrahim demonstrates. The AGCC has become the major global centre for Islamic banking, and there has been much discourse between Islamic bankers through conferences and other gatherings. Common regulatory rules are evolving thanks to the efforts of the Islamic Financial Services Board and co-operation amongst central banks in the region. In addition there is widespread respect for and adherence to the standards on financial reporting developed by the Bahrain-based Accounting and Auditing Organization for Islamic Financial Institutions. Shariah-compliant financial products have become standardized across the AGCC, with cross-border demonstration

x

Foreword

effects as concepts and structures are disseminated. There are lessons from the Islamic banking experiences for the adoption of common monetary policies that will become necessary if AGCC monetary union is to succeed, and for this Badr El Din Ibrahim’s liquidity analysis is highly relevant, as all the economies face similar issues with respect to the structure of bank deposits. The issue of the finance of SMEs in the AGCC is also important, and the Omani experience outlined by Badr El Din Ibrahim has potential implications for the other five economies. Although oil and gas account for much of the GDP of the AGCC, this sector employs relatively few. In contrast SMEs employ much of the workforce, but practices of rigid fiscal discipline following the stringent financial convergence criteria of the Monetary Union require minimization of subsidized credit to the SMEs. Government-backed equity and venture capital financing can help SMEs develop and prosper in the longer term, while leasing, possibly under sharia-compliant contracts, can help with the building and equipment provision that is so crucial for enterprise success. Overall there is much of value in this book, which is an important contribution to the literature on the economies of the AGCC. Badr El Din Ibrahim’s recommendations deserve to be studied by policy makers in the region, and hopefully acted upon. Professor Rodney Wilson Durham University, UK

Acknowledgements

The author is greatly indebted to the Economic Research Forum for the Arab Countries, Iran and Turkey for giving him opportunities to publish the materials from the first and the second chapters. These chapters were originally presented to the Economic Research Forum for the Arab Countries, Iran and Turkey 11th and 12th annual conferences in Beirut and Cairo, in 2004 and 2005 respectively. Thanks also go to Dr Izak Atiyas, Sabanci University, Turkey, and other participants for their helpful comments on the papers. I also appreciate the financial help from the Forum to pursue a study on liquidity of Islamic banks in the MENA region, from which some materials are drawn for Chapter 3. I also thank Dr K.C. Vijayakumar, the co-author of this study, for his consent to use some material in this book. I express my gratitude to my colleagues Dr Arbab Ismail Babikir, Dr Muneef Abdel Bagi, and the experts at the Ministry of National Economy, Muscat, for their helpful ideas and insight on the earlier drafts. I extend my special thanks to Mr Ammar Mahgoub Zaki, Ministry of Finance, Muscat, for his efforts in computation of correlation coefficients. I should not forget to thank Ms Jaya Ramesh Shettigar for her encouragement and valuable assistance in the editing. Finally, I am indebted to my wife Manal for her moral support and patience and my young twin sons Mohammed and Mohanad and my daughters Razan, Rowa and Rayan for their sacrifice and understanding while I have been working on this book.

Abbreviations

ADIB AED AFESD AGCC AMF CB CBO CBQ CFI CRC DEI DFI DHI DIB E ECES ESCWA EU FB FDI FDYP FLC GDP GMU GOIC HRD IBQ IMF ISB IT KFH

Abu Dhabi Islamic Bank UAE Dinar Arab Fund for Economic and Social Development Arab Gulf Co-operation Council Arab Monetary Fund Conventional Bank Central Bank of Oman Central Bank of Qatar Cost of Firing Index Center for Research and Consultancy (Modern College of Business and Science, Oman) Difficulty of Employment Index Difficulty of Firing Index Difficulty of Hiring Index Dubai Islamic Bank Expenditure (relevant to tables only) Egyptian Center for Economic Studies Economic and Social Commission for Western Asia (United Nations) European Union Fiscal Balance (relevant to tables only) Foreign Direct Investment Fund for Development of Youth Projects (Oman) (Youth Fund) Finance and Leasing Company Gross Domestic Product Gulf Monetary Union Gulf Organization for Industrial Consultancy Human Resources Development Islamic Bank of Qatar International Monetary Fund Islamic Bank Information Technology Kuwait Finance House

xiv Abbreviations KSA LIL LLC LLR LNG MCI MENA MOLF MOMP MONE MU NBFI NGO NOFB NOGDP OCA OCCI OCIPED ODB OECD OER OGR OP OPEC PIN PLS QIB QR R&D REI RHI RO ROA ROE ROP SANAD SMEs TFP UAE UK UN

Kingdom of Saudi Arabia Liquidity Instability of Liability Limited Liability Company Lender of Last Resort Liquid Natural Gas Company (Oman) Ministry of Commerce and Industry (Oman) Middle East and North Africa (region) Ministry of Labour Force (Oman) Ministry of Manpower (Oman) Ministry of National Economy (Oman) Monetary Union Non-Banking Financial Institution Non-Governmental Organization Non-Oil Fiscal Balance (relevant to tables only) Non-Oil Gross Domestic Product (relevant to tables only) Optimum Currency Area Oman Chamber of Commerce and Industry Omani Center for Investment Promotion and Export Development (Oman) Oman Development Bank Organization for Economic Co-operation and Development Oman Economic Review (Magazine, Oman) Oil and Gas Revenue (relevant to tables only) Oil Price (relevant to tables only) Organization of Petroleum Exporting Countries Public Information News Profit and Loss Sharing Qatar Islamic Bank Qatari Riyal Research and Development Rigidity of Employment Index Rigidity of Hours Index Rial Oman Rate of Returns on Assets Rate of Returns on Equity Royal Oman Police Self-Employment and National Autonomous Development, Oman Small and Medium-Sized Enterprises Total Factor Productivity United Arab Emirates United Kingdom United Nations

Abbreviations xv UNCTAD UNDP US$ USA WTO

United Nations Conference on Trade and Development United Nations Development Programme United States Dollar United States of America World Trade Organization

Introduction

The six states constituting the Arab Gulf Co-operation Council (AGCC) – Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates (UAE) – are located in the south-western region of the Asian continent, covering 2,285,844 km2, with a population of around 36 million. While there are some variations in output volumes and population sizes, current collective Gross Domestic Product (GDP) is around 536 billion US dollars (US$), and average per capita income is a little less than US$ 15,000. The AGCC is a regional organization founded on 26 May 1981. Its main objectives are to effect co-ordination, integration and inter-connection between member states in all fields, strengthening ties between their peoples, formulating similar regulations in various fields such as economy, finance, trade, customs, tourism, legislation, and administration, as well as fostering scientific and technical progress in industry, mining, agriculture, water and animal resources, establishing scientific research centres, setting up joint ventures and encouraging co-operation in the private sector (GCC Secretariat General; web: www.gcc-sg.org). The AGCC states are mainly oil economies, sharing around 20% of global crude oil production, and 45% and 17% of the world’s known oil and natural gas reserves respectively. Oil revenues contribute over 40% of GDP for all states, except Bahrain, in which the share is in the range of 25%. The oil share in export proceeds is not less than 70%. Oil is also the leading driver of governments’ activities and provider of support to private-sector spending. Moreover, the AGCC’s historical economic advancement cannot be isolated from oil resources and the role of the market and the governments. Historically AGCC economies are government-dominated and mainly trading-based economies. Oil has changed the economies of AGCC states since the late 1960s and resulted in significant structural transformation. Unfortunately, the past development of the oil sector creates very few linkages to the rest of the economy. Emphasis on privatization and economic liberalization starting in the 1990s was attempted to change this unequal pattern of sectoral development, but has not made much difference so far to diversify these economies, and oil still dominates economic activities. The history of economic development of AGCC states is amazing. Huge efforts were made to modernize AGCC economies via heavy investment in infrastructure and communications which was facilitated by the quadrupling of the oil prices in the early 1970s. Since then the market for oil has been irregular with some sudden

2

Introduction

sharp declines in prices within short intervals. During the period after 1973, prices declined, and then increased in the first half of the 1980s, and again slightly declined afterwards. This decline led to accumulated budget deficits, but did not hinder the expansion of socio-economic infrastructure after the 1980s. Moreover, AGCC states did not resort to restrictive austerity measures to improve their internal balances in the face of oil price decline during the second half of the 1970s. By the second half of the 1980s, the rate of decline in oil prices accelerated, investment expenditure declined and the exchange rate depreciated. For the first time, the AGCC countries resorted to medium-term measures to promote the private sector and to diversify their economies, including privatization of public enterprises. The political development and the increase in military expenditures following the Gulf War escalated the internal and external imbalances. By the year 1994, more imbalances were created. Consequently, there was a concern to mitigate the crisis in the short run by balancing revenues and expenditure, diversifying the economies and facilitating self-development to address the young and rapidly growing population of around 3.5%. Late 1997 was characterized by a relatively low decline in prices, but huge negative economic repercussions compared to the former ones. The decline of AGCC international investment, the increase of military expenditures and the difficulties of borrowing from both internal and external sources complicated the crisis and necessitated new strategies to face it. Short- and medium-term strategies via market-oriented policies were declared. The encouragement of the private sector with measures aiming to enhance the market through abolishing of subsidies, reducing government economic activities, setting reasonable prices for services, encouraging foreign investment and mobilizing financial resources to the private sector (through activating financial markets, enhancing savings and investment opportunities) is a policy pursued until now. The most important current international development of significance to AGCC economies is the strong oil price prevailing since 2001. Unlike previous episodes of oil price peaks, global demand for oil has increased; at the same time global growth remains stronger and the inflation environment has continued to be benign and growth-supportive globally. These developments supported growth of GDP, and improved fiscal and balance of payments positions in AGCC states. Moreover, benefiting from higher international oil prices, robust global growth and depreciation of the US dollar, AGCC (oil and non-oil) exports expanded, foreign exchange reserves accelerated and the banking system indicators, especially net profit after taxes, showed sound health. The major purpose of this book is to provide an overview of some major issues concerning economies of the AGCC states that are under scrutiny nowadays, and will remain so for many years to come. These issues, which are critical to the future prospects of AGCC economies, are often raised without rigorous analysis, and in most cases, unintentionally, are neglected in the debate pertaining to the future of the AGCC economies. Unlike other analyses of the AGCC’s future economic outlook, this book is not intended to pose questions without answers. Rather, it is intended to analyse and answer some critical questions about the future AGCC economic outlook, to formulate some policy recommendations and to raise some

Introduction 3 neglected issues to the level of debate and discussion, among practitioners and academics, relevant to the AGCC’s future economic scene. Topics under investigation in this book are: AGCC monetary union (MU), intra-AGCC national labour movement, Islamic banking liquidity and programmes to finance small and medium-sized enterprises (SMEs). The AGCC MU, under formation at present, envisages a single currency to be introduced by the year 2010. Although the MU has been officially declared, still the following questions arise: Do AGCC states really need a single currency, what costs and benefits can these economies accrue from a single currency, and what should they do to fully utilize the benefits of the upcoming single currency. Furthermore, with the on-going AGCC nationalization of the labour force, the upcoming MU requires labour market flexibility that can partly be ensured through intra-AGCC national labour mobility in the future. Towards the two goals of activating AGCC economic integration through a single currency and optimizing AGCC national human resource exploitation, the question that arises is what these economies need to do to enhance intra-AGCC national labour movement, which we find to be weak at the moment. Another issue under scrutiny is the advent of Islamic financing institutions, which has resulted in the appearance of new and different financial arrangements. The changes brought about in the financial and regulatory framework of Islamic banks (ISBs) in AGCC state could affect their liquidity. Analysis of this issue covers some aspects of liquidity of some ISBs in two AGCC states (Qatar and UAE). In this regard, we argue that the future progress of ISBs in a mixed banking system such as in AGCC states (and elsewhere) depends critically on whether these banks will be able to survive competition with conventional banks (CBs). Specifically, we try to give answers to the question: Can these banks secure enough liquidity in the future, given the change in the structure of their balance sheets from the conventional to Islamic, and their current relations with the central banks? Finally, job creation together with an on-going AGCC diversification drive and private enterprise development require the development of the other, non-oil sectors, in which SMEs can play a major role. Chapter 4 reviews one major ingredient in SMEs’ development, the financing programme in one AGCC state (Oman). The issue we are concerned with, therefore, in this chapter is access to SME financing programmes and the significance of government-subsidized loans as a vehicle of job creation. Financing of SMEs after the formulation of the MU, we argue, must be reorganized through the market away from government financial support. The AGCC MU is a central issue of the book. The labour movement across national boundaries of AGCC states will enhance labour market flexibility and so will absorb unnecessary exogenous shocks after the establishment of the Union. The process of encouragement of SMEs following the AGCC states’ diversification and self-employment drive requires deep restructuring of government SME financing policies and institutions. The Union fiscal convergence criteria require curtailing unnecessary government spending on soft loans and providing finance through improved market-oriented financing institutions. In this respect the small-enterprises-oriented ISBs in the region need to take significant responsibility.

4

Introduction

The significance of and the link between these topics for the AGCC’s future economic outlook can be elaborated here: 1

2

3

The MU amongst AGCC states, following the mandate to strive towards greater integration from the inception of the AGCC, is expected to constitute a qualitative step to achieve a peak of economic integration, and is considered as one way to bring increased prosperity to the region. Among other things, the Union will support trade exchanges between AGCC states, enhance their negotiating power as well as their domestic products internationally, encourage foreign direct investment (FDI) and motivate local banks to stick to international performance standards. Nevertheless, AGCC states face common shocks emanating from oil volatility and the planned MU should strengthen their ability to address these shocks. Policies to promote flexibility in the labour market, we argue, will assume greater importance in this respect. Here we identified the limited intra-AGCC labour mobility across national frontiers, despite the constitutional permission, as the basic weakness that needs to be addressed for the MU to be able to absorb and neutralize the inevitable exogenous shocks that will put the common currency under pressure during the early years subsequent to its introduction. AGCC fiscal positions have not been convergent, reflecting differences in oil dependency and level of expenditures. Given the AGCC’s heavy dependence on volatile oil export receipts and high level of oil reserves, depletion rates and government financial wealth, fiscal convergence criteria would be a challenge. More specifically, practices of rigid fiscal discipline and restriction of inefficient government spending following the stringent financial convergence criteria of the MU will free AGCC governments from providing soft loans to the SME sectors, and SME financing will be left to the market. Unlike other forms of development challenges, however, small enterprise financing is intrinsically a function of individual entrepreneurial zeal rather than excessive external support. Government should therefore resist the temptation of doing too much to help SMEs, especially in terms of direct support such as financing support, whenever the returns on investments are expected to be negative. Therefore, loans provided to SME must be considered as loans supported by the real incentive to pay them back. SME entrepreneurs must know the facilities they want from banks before requesting financing, and they must be discouraged from borrowing or must not be pushed to borrow if it is not genuinely required. Studies of the small and medium establishments in Oman (and probably other AGCC states) have shown that they are the major contributors to Oman’s industrial establishments, and they need less fixed capital to create a new job. The major objective of SME development in AGCC states is job creation, and the major SME development instrument is the soft loan. The experience of SME financing in Oman (as one case of AGCC state) shows that government soft loan financing is unsustainable, inefficient, not commercially based and lacks deposits and savings components. Moreover, commercial lending is limited, uncompetitive, collateral- and not enterprise-based, and

Introduction 5

4

lacks credit information and incentives to innovate. Moreover, despite the fact that AGCC financial markets contain many of the institutions and features of a modern financial sector, the SME sector in AGCC states receives inadequate capital finance due to structural inefficiencies, including a highly concentrated commercial and Islamic banking sector, low personal savings rates and regulatory barriers. AGCC economies will operate well below their long-term potential growth rate and will be unable to solve their growing youth unemployment problem, resulting mainly from natural population growth and increasing education and female participation, until they address these inefficiencies and significantly increase the flow of investment capital to SMEs. Given the free market requirement, the AGCC governments’ role in supporting the finance of the SME sector should now shift away from soft lending to restructuring current programmes, improving overall financial market competition and diversification of financing modes and encouraging SMEs’ business environment and projects. In this regard, the expansion of ISBs in the region as a result of increased oil revenues coupled with the trust in religious beliefs requires more attention regarding indicators of banking soundness if these institutions are required to enhance their support to SMEs. More specifically, the effects on ISBs’ liquidity and lending for development of the changes of the asset and liability sides of the structure of financial statements from standard norms to the Islamic form warrant attention.

Given the current oil price boom and predicted high levels of oil prices and production volumes in the near future, with implementation of the right policy reform agenda and stable macroeconomic policies, AGCC economies are expected to perform well in the foreseeable future. The implications of the current oil price boom and reform agenda for the issues covered in this book cannot be overlooked. High oil prices strengthen the ability of AGCC states to develop their financial markets, enhance investment, stability, growth and employment, and therefore facilitate the smooth adoption of the MU. Moreover, liquidity of banking (including ISBs) will be enhanced and more finance will be provided to SMEs by private-sector institutions. Furthermore, with the ongoing AGCC nationalization of the labour force and more internal investment after the formulation of the Union, market flexibility through labour mobility will be enhanced to overcome any constraint adjustment after issuance of the currency. This book is the outcome of many events. It is basically a collection of materials that the author has written earlier for different occasions. It also draws on the author’s nearly 10-year experience as a researcher/lecturer in AGCC economies, and as an economic expert at the Ministry of Finance, Oman. The organization of the book is as follows: Chapter 1 assesses the costs and benefits of the upcoming AGCC MU. It applies the five tests guiding the United Kingdom’s policy decision on the European Monetary Union (EMU) to a Gulf Monetary Union (GMU). It will attempt to find answers as to whether the AGCC economic structures have reasonably comparable

6

Introduction

convergence so that they can live comfortably with the interest rate imposed by the Gulf Central Bank. It will also ascertain whether these economies have sufficient flexibility to deal with problems that may emerge after the formulation of the Union. In addition, the test will identify the benefits and costs of strengthening the ability of AGCC states to develop their financial markets, investment, stability, growth and employment. Chapter 2 investigates the national labour mobility in the AGCC states, and examines its importance in the context of the forthcoming GMU. The investigation will focus on identifying and/or analysing the main features that are crucial in enhancing a common AGCC employment strategy (labour market flexibility, output growth employment generation, labour market policies and legislation, employment information and so on). This chapter also studies major characteristics of the AGCC unemployed and investigates reasons for weak intra-AGCC employment of nationals. Chapter 3 covers some aspects of liquidity of some ISBs in two AGCC states (Qatar and the UAE). The chapter uses macroeconomic and banking data to analyse the economic set-up and banking regulations and policies and their likely effects on the liquidity of the selected ISBs. The financial statements of these banks are also analysed over the period 1990–2002, and some relevant indicators derived from the data of individual banks’ balance sheets are calculated and analysed. Chapter 4 attempts to analyse and compare the major features of SME financing schemes in Oman (as a case study of AGCC SME financing). In order to establish commercially based financing institutions, the synchronization of these financing programmes with international experience is one of our concerns. Chapter 5 summarizes the four themes, methodology, conclusions and policy recommendations.

1

1

The AGCC Monetary Union

Introduction

From the early 1980s, the AGCC states – Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the UAE – took some steps towards economic integration. Barriers to free movement of capital, goods, labour and nationals were eliminated. Corporations and individuals were granted national preferential treatment. In early 2003, common external tariffs were imposed under the umbrella of a Custom Union. Since 2000, a significant step has been taken towards the creation of an advanced stage of economic integration – the MU. At its meeting in Bahrain in 2000, the Supreme Council of the AGCC agreed to make a working plan and a timetable to establish a single AGCC currency.1 By the end of 2002 AGCC national currencies were pegged to the US dollar. The AGCC monetary authorities have finalized the agreement on the economic convergence criteria (which are not considered as prerequisites for joining the single MU but as a tool to assess policies before and after the establishment of the Union), methods of calculation and the levels of these criteria. Economic (monetary and financial) convergence indicators of inflation, budget deficit–GDP ratio, public debt–GDP ratio, sufficient foreign reserves, and inflation and interest-rate ceilings were agreed upon in the Riyadh Summit in December 2006. The budget deficit–GDP ratio should not exceed 3% and should be flexible in accordance with oil prices. Other criteria include a ceiling of 3% for a member state budgetary deficit–GDP ratio in any year; public debt should not surpass 60% of GDP; foreign exchange should stay at four-months’ import value; the prevailing inflation in any member state should not be more than
2% above the average of the lowest three inflation rates of the members states; inflation in any member state should be no more than
2% above the weighted inflation rate of the remaining members; and the interest rate in any member state should not exceed by more than 2% the average best interest rate in three states. These criteria will have to be fulfilled between 2007 and 2010 (instead of the original schedule of 2005–2010), the year in which a single currency will be introduced. The economic convergence criteria, which, for the GMU, are tools to assess policies of the member countries after the establishment, are not sufficient to assess the case of its formulation. According to the remaining time schedule, the establishment of the common monetary authority in accordance with the degree of national

8

The AGCC Monetary Union

central banks’ independence and the name and the characteristics of the common currency are still under investigation and will be completed during 2007. The most crucial issue, therefore, is assessing long-term costs and benefits of the Union, especially in the absence of entry criteria. Because of the delays in various processes including the activation of the Custom Union, which was due in 2005, there is some likelihood of non-adherence to the 2010 common currency target date. Oman and Kuwait cast doubts on the sufficiency over the time framework of the Union and asked for more time to transfer the authority over reserves management, monitoring of their banking system and relinquishing sovereignty over their currencies to the Gulf Central Bank. An Omani chief official declared in November 2006 that in the light of the current and future scene of the Omani economy, Oman will not be able to meet the deadline scheduled earlier to achieve the Union by January 2010 (CBO, 2006). The difference of opinion regarding the deadline is technical or circumstantial more than political. It is too early now to decide whether the time till 2010 is sufficient to achieve the working plan, despite the current constraints to stick to the time framework. The ambitious timetable might lead to delay in formation of the Union. Nevertheless, despite these constraints, all other AGCC states are keen, as on date, to achieve the Union by 2010. There are two alternatives: either to hurry up the application or to extend the 2010 timetable; that is, the decision to delay the Union critically depends on how much can be achieved in the programme during the coming years (Ibrahim Badr El Din, 2007, p. 13). The current policies for integration and harmonization of AGCC economies have been discussed in the AGCC Charter, the Unified Economic Agreement and at the Heads of States Summit held in Muscat in 2001. The AGCC Charter emphasizes co-ordination and strengthening relations, similar regulations in economic, commercial, and financial affairs, tourism, education, and cultural, social and administrative affairs and establishment of joint ventures. These objectives are further re-emphasized in the 1981 Unified Economic Agreement as it calls for free trade, freedom of movement, work and residence and better treatment for AGCC nationals in ownership, inheritance, and exercise of economic activities and co-ordination of monetary policies. The outcome of the Muscat AGCC Summit in 2001, in its statement ‘Economic Agreement between the States of the Co-operation Council’, went further to include some measures of common external tariffs, a single entry point principle, implementation of the Customs Union by January 2003, harmonization of all product standards, national treatment of AGCC capital/investment/employment/ ownership of real estate and equity, and complete integration/harmonization of regulation of financial markets. In the Unified Economic Agreement of 1981, monetary integration and commitment to co-ordinate monetary policy were envisaged. In addition, the prospect of MU was also mentioned therein. Later, the AGCC Economic Agreement of 2002 set up a timetable for implementation of the MU (AGCC Secretariat General; web: www.gcc-sg.org). All these developments reflect that the GMU is not isolated from the process of economic and monetary integration, and the political leadership of the AGCC member states has an economic faith in the GMU. Hence, the GMU is not a purely political decision.

The AGCC Monetary Union 9 This chapter will analyse some potential costs and benefits of the forthcoming GMU in the six AGCC member states. The chapter will start with a background theoretical analysis to outline the requirements and the theoretical benefits of the Optimum Currency Area (OCA) and review literature on the AGCC OCA. The testing section will highlight the macroeconomic costs and benefits of introducing a single AGCC currency in terms of surrendering autonomous monetary and exchange rate policies. This section will take up the same five tests that were used to determine the UK’s membership of the European Monetary Union (EMU). It will attempt to find answers as to whether the AGCC economic structures have reasonably comparable convergence so that they can live comfortably with the interest rate imposed by the Gulf Central Bank. It will also ascertain whether these economies have sufficient flexibility to deal with problems that may emerge after the formulation of the GMU. In addition, the test will identify the benefits and costs of strengthening the ability of AGCC states to develop their financial markets, investment, stability, growth and employment. Key economic challenges such as privatization and diversification from oil and their likely effects on the GMU will also be referred to. The results and the policy implications are evaluated in the final section.

2

Literature review – the theory of an OCA

Robert Mundell first elaborated the theory of an OCA in the 1960s (Mundell, 1961, pp. 657–665). A single currency, it was argued, eliminates the need to adjust prices between different economic regions during fluctuations in the exchange rate. Consequently, there are three options to make an economic adjustment: (1) labour must be mobile so that workers can move from an area suffering from recession to one that is enjoying an economic boom, (2) wages and prices must be flexible so that the economy can respond to any fluctuation of supply and demand and (3) there must be some way of transferring resources to the country or region suffering from recession to help it recover from the same. An OCA is an economic unit composed of countries or regions across which external shocks are sufficiently symmetrical, factor mobility is sufficiently high, real wages are sufficiently flexible and fiscal transfers are sufficiently robust to eliminate the need for nominal exchange rate changes within the unit and justify a common monetary policy (Mundell, 1961). The literature has identified four different modes of monetary co-operation according to the extent and the degree of co-operation and whether institutions and legal commitments need to be rearranged. The first three arrangements require a lesser degree of co-operation, lesser obligations and are partial compared to the advanced arrangement of an OCA. The first arrangement occurs when currencies of the member countries are freely exchanged at a constant rate (called a Currency Area). The second arrangement is an MU in which there is one currency and exchange rate vis-à-vis the outside world. The third is an arrangement where monetary markets are unified, and currencies and deposits freely move at constant rates. The fourth, advanced arrangement is the OCA, which is also called Monetary or Currency Union. The MU involves not only a unified currency among member states, but also common

10

The AGCC Monetary Union

monetary and banking policies, a pool of foreign exchange reserves dealt with by one central bank, fixed exchange rates, complete currency convertibility, financial market integration (liberal capital transactions, harmonization of national financial regulations, structures and institutions) and reasonable economic convergence (see, for example, Laabas and Limam, 2002; Majeed et al., undated). Traditional theories have attempted to find some imperative indicators necessary to form an advanced MU (Mundell, 1961; Mckinnon, 1963; Ishiyama, 1974). The free movement of factors of production is a vital adjustment mechanism in case of a shock. Then, there will be no need to use an exchange rate as a corrective mechanism. When foreign demand increases for a member (or members) of an MU this automatically leads to common currency appreciation and inflationary shocks. Adjustments to systematic shocks facing all member countries require common responses, which also entail flexibility in prices and wages. Moreover, when the economy is diversified, it will protect against terms of trade shocks. Hence, since it is unlikely to use an exchange rate mechanism for adjustment, the country’s chances of being a member of an MU are increased. Likewise, countries with similar economic structures, which are more likely to experience symmetric shocks from common factors, are also less likely to use exchange rates for adjustment. In addition, similar economic structures are followed by similar inflation and unemployment rates and more or less similar economic policies that trade off between inflation and unemployment (McKinnon, 1963). Hence, similar economic fates and indicators do not require a change in the exchange rates of member countries, thereby facilitating policy co-ordination for full monetary integration.2 Moreover, the greater the dependence of the economy on international trade, the less will be the effects of exchange rate adjustments on the balance of payments, reducing the negative effects of exchange rate adjustment on inflation and the cost of living (McKinnon, 1963, pp. 721–724). This suggests that there are strong reasons for open economies to fix their exchange rate via a form of MU arrangement. Finally, the political will and resolution to achieve an MU are prerequisites to its success. The literature also identifies some benefits and costs of an OCA to member countries (Ishiyama, 1974; Laabas and Limam, 2002). A single currency increases the transparency of prices and reduces the transaction costs of buying and selling goods as it does not require the conversion of money from one currency to another. It also eliminates the exchange rate risk among countries that share the currency. When a Currency Union exists, countries can no longer use devaluations as a part of their economic policy to gain an advantage over other countries. Moreover, it is easier for the Central Bank, which oversees the Currency Union, to focus on its primary objective, to control prices and fight inflation, because a single government does not control it. Joining an OCA benefits the high-inflation member country with a fixed exchange rate regime and a high-ceiling, regulated and credible OCA monetary policy. An OCA also reduces the exchange rate uncertainty that hampers trade and investment among member countries by reducing transaction costs of multiple exchange rates (cost of monitoring and predicting exchange rate fluctuations and money conversion). Moreover, bilateral trade between member countries increases, although there is some disagreement between

The AGCC Monetary Union 11 writers on the volume of the increase (see, for example, Rose, 2000). Another benefit of introducing a single currency is that individuals and corporations will have greater economic choices. The single currency will encourage trade that may in turn force governments to reduce structural barriers to trade. The market reforms that inevitably result from the introduction of a single currency should also be included in the list of benefits. Although there are many economic benefits from a single currency, several costs too should be considered. The major costs of implementing a single currency are macroeconomic and political. The most outstanding cost of an OCA is the loss of national control over monetary and exchange rate policies. This is why the theory of an OCA emphasizes the importance of flexible prices, labour mobility and fiscal transfers. After the formulation of an MU, member countries will adopt one currency and the nominal exchange rate between AGCC currencies will be fixed irrevocably at the entry rate. The interest rate will also be set by the Joint Central Bank on the basis of economic conditions of the member countries as a whole. In addition, member countries will be required to comply with the terms of an MU’s macroeconomic and financial policies.3 Another effect of the Currency Union will be less regional economic differentiation. The macroeconomic costs of giving up national monetary control in the context of an MU depend on the frequency and severity of asymmetric shocks that member countries are exposed to and the available adjustment mechanism to mitigate the impact of those shocks, given that the national monetary and exchange rate adjustment mechanisms are not in the hands of any individual member country (Mongelli, 2002). Another cost is imposing penalties on violators (sanctions or otherwise). It should be mentioned that the costs and benefits of an OCA in the Gulf might not resemble the outcome of the theoretical costs and benefits mentioned earlier, as these countries have special economic conditions.

3

The AGCC OCA – literature review

Literature commenting on the OCA (MU) in the AGCC raised conflicting opinions about the benefits and costs of the AGCC MU (see Jadresic, 2002; Laabas and Limam, 2002; OER, 2002; Fasano and Iqbal, 2003b). Those who question the need for a common AGCC currency argue that the robust regional trade and volatile currency fluctuations among trading partners which are the usual reasons for joining a Currency Union do not exist in the case of AGCC economies. Others argue that the AGCC economies, at least at this stage, lack basic factors in terms of comparative advantages in factors of production and intra-AGCC trade leading to a common MU. Moreover, some argue that although the structural convergence is high at the moment, it will diminish during the present diversification in the AGCC economies. Perhaps one of the most comprehensive studies of the AGCC MU was made by Laabas Belkacem and Limam Imad (2002). With the application of traditional criteria, such as openness, factor mobility, similarity of production structures and inflation rates, degree of policy integration and political will, they tested

12

The AGCC Monetary Union

whether the AGCC is an OCA and whether AGCC countries are ready to establish an MU. According to them the Gulf states are yet to fulfil some necessary pre-conditions. AGCC economies are still oil-dominated. Regional trade is limited and there is no evidence of economic convergence and business cycle synchronization. Nevertheless, a test based on Generalized Purchasing Power Parity shows that real exchange rates are closely related and share the same stochastic trend. The authors argue that the major factors in favour of an MU are the commitment to fix exchange rates and a strong political will. They also argue that once it is established it could expand intra-industry trade despite the present lack of diversification. An MU may result in more synchronized business cycles, provided the AGCC countries achieve convergence in economic structures and economic policies. Finally, they argue that in order to get full benefit from an MU, the AGCC countries should lift all restrictions on the free movement of goods and factors of production. Supporters of a single AGCC currency argue that although it is achievable, its benefits are minimal. The AGCC states, in many respects, already have a single currency – the US$. The six AGCC states’ currencies (except Kuwait, which is basketbased but has remained steady against the US$) have been fixed against the US$ for many years. Hence, the US Federal Reserve rather than local central banks fixes the AGCC interest rates. Others (e.g., Finigan, 2004, p. 20) added a new dimension to establishing a single AGCC currency: the benefit of facilitating the integration of Yemen, which is not a member of the AGCC. Some stress the negative aspects of an AGCC currency. As was the case when the euro was initiated, inflation is likely to occur when a single currency is introduced because the purchasing power will be less initially. Others mention the difficulties of giving up control of fiscal policy by some AGCC states as a means of enhancing growth and reducing the risk of low oil prices. Others raise the issue of the frequency and severity with which member states (such as AGCC states) are exposed to asymmetric shocks and the lack of adjustment mechanisms given the impossibility of adjustment in national monetary policies and nominal exchange rates (Mongelli, 2002). The location of the common central bank (the Gulf Central Bank) – to make the monetary policy decisions, supervising payments systems and co-ordinating financial integration – and the name of the single currency are also mentioned as potential constraints. However, others consider common factors and the weak relative strength of AGCC monetary policy as encouraging factors for the formation of an MU. They argue that the common historical, cultural, social and political union and the relative unimportance of a monetary policy in the AGCC economies, as well as the possibility of administering the excess oil financial resources jointly by AGCC states after the establishment of an MU, will not make the loss of power argument a decisive factor to hinder the upcoming GMU (Majeed et al., undated). Others argue that the degree of AGCC monetary convergence over the past two decades exceeds the convergence achieved in this field by the euro countries prior to the introduction of the euro in 1999 (Ibrahim Badr El Din, 2004c). To sum it all up, the opinions and findings show a considerable agreement on the possibility of establishing an AGCC MU during the time framework specified,

The AGCC Monetary Union 13 but they raise considerable doubts about the potential benefits when compared to the EMU. Our negative observations about the AGCC single currency have raised issues without providing analytical answers. Most of these writings represent individual opinions rather than research findings; hence, they markedly differ in their results. Nevertheless, those arguments will remain controversial until they are subject to solid analysis or solved when an MU is in operation. This also applies to constraints or the negative effects facing the establishment of the AGCC MU.

4

Hypothesis and methodology

This section focuses on testing some major criteria in relation to the costs and benefits of the upcoming GMU. The methods of investigation will follow the same pattern of five tests guiding the UK policy decision on an MU – convergence, flexibility, investment, financial services and growth, stability and employment (www.official-documents.co.uk/cgi-bin/htm). The five-test approach was the outcome of the UK debate over the EMU, and was announced by the Chancellor of the Exchequer to the House of Commons on 27 June 1997. The UK assessment concluded that the economy is not convergent with the economies of the euro area, and there was insufficient flexibility. It was argued that the lack of sustainable and durable convergence will hinder the UK in enjoying benefits from EMU in terms of high investment, growth and jobs. By mid-June 2003, the Chancellor, therefore, directed the UK not to forgo fiscal and monetary independence to secure long-term benefits from the membership of EMU on the basis of results of these tests. The five tests are stated as follows: 1 Convergence test. Membership of an MU entails having a permanent fixed nominal exchange rate with the member countries and a common monetary policy (a single interest rate across all members of the MU). The convergence test addresses the issue of whether a single interest rate will be suitable for all Gulf area members over a period of time. The test assesses, with reference to past performances and current conditions, the likelihood of the GMU to be prone to different shocks or different responses to common shocks, including shocks through economic policies. 2 Flexibility test. Is there sufficient flexibility to deal with emerging problems? Flexibility means minimizing the costs of adjustment. 3 Investment test. Would joining the GMU create better conditions for firms making long-term decisions to invest in each member country by limiting uncertainty, reducing the cost of capital and encouraging cross-border investment? 4 Financial services test. How will joining the Union impact the competitive position of each member state’s financial services industry? 5 Growth, stability and employment test. Will joining the GMU stimulate trade (with higher investment, currency stability, high level of competition and economic stability through Union policies), promote growth and stability and increase job opportunities?

14 The AGCC Monetary Union The five tests serve two purposes. First, they investigate the long-term and sustainable case for GMU (convergence and flexibility tests). Second, they will ascertain whether there are some benefits (and probably costs) that can be realized (through the investment test, financial services test and growth, stability and employment test). It ought to be mentioned that these two purposes are related, as sustainable and long-term prospects are prerequisite conditions for benefits from GMU. These tests are superior to the commonly used test of convergence criteria, which is not a sufficient basis for assessing the long-term benefits and costs from entry. The latter is carried out as a necessary condition to join the Union only. Moreover, testing of factors (such as openness, factor mobility, price and wage flexibility, production structure, etc.) identified in the literature for determining whether a country is ready to join the OCA will assess only current economic characteristics. The five tests differ as they reflect a long-term approach to assessing the benefits and costs, as they take into account the irreversible nature of the decision to form an MU. Theoretical criteria such as intra-trade, factor mobility and similarity of economic structures to decide whether a group of countries would benefit from a single currency are taken into account. Most of these tests (investment, competitiveness of financial services, high growth, economic stability and work promotion) form the foundation of the economic policy objectives of the AGCC states. All AGCC economies declared diversification from oil and gas, attraction of FDI, decrease in the size of the government sector and labour market reform to cope with population growth as their objectives. In addition, the economic theory underlying these tests originated from theoretical work on MU, especially that of Robert Mundell (Mundell, 1961). Although these five tests have been originally used from the exclusive standpoint of the UK, they can be used as determinants to ascertain whether a group of countries will jointly benefit from an MU or not. It would not be surprising for a similar outcome or result to be observed with the implementation of the five tests for a group of countries.

5 5.1

Testing Convergence

An MU entails having a permanently fixed nominal exchange rate and a common monetary policy (a single interest rate across all members of the MU). The convergence test addresses the issue of whether a single interest rate will be suitable for all GMU members over a period of time; that is, if AGCC states display similar structures, then there is every likelihood of a rise in their ability to jointly respond to these shocks through a common monetary policy. Convergence is best understood by its implications for membership of an MU. As described in the UK study that was conducted in order to see the feasibility of UK membership in the single currency of the EMU (www.official-documents. co.uk/cgi-bin/htm), prospective candidates for an MU are convergent if they have similar economic structures, so they will respond to the same shocks in a similar

The AGCC Monetary Union 15 way, and are unlikely to be hit by a large number of country-specific shocks. They are non-convergent if they have different structures which imply differing responses to common shocks, greater vulnerability to asymmetric shocks, or that the monetary policy stance suited to one country or region does not suit the others. 5.1.1

Structural convergence

The structure of the AGCC economies could mean that there will be countryspecific developments causing divergence within the Gulf region in future. This is because differences in structures could make one country more vulnerable to shocks that do not affect the rest of the members of an MU, and consequently it would react differently to changes in economic circumstances, which would then affect the entire MU. Compatibility of structures will limit the extent of divergences in either country-specific shocks or responses to such shocks. Sectoral specialization indicates how specialized an economy is in certain sectors in relation to other countries. Structural features of the economy like sectoral composition and trade patterns condition its shocks and responses. The sectoral share of output and specialization in the Gulf area determine how shocks affecting particular sectors might affect one country more than others and whether this could imply divergent behaviour in future. Table 1.1 shows the present high dominance of oil and gas in the economic structures of AGCC economies, while contributions of the other sectors are more or less comparable. Convergence can also be seen from the expenditure components of GDP. The outcome of Table 1.2 is clear: expenditure components of GDP exhibit a similar pattern among the AGCC countries. With the exception of Qatar, private consumption is a less dominant expenditure component of GDP, while capital formation and export–import have more share in Qatar compared to the same components in other AGCC states. The issue is the convergence not in the current structures but among the dynamic structures. Diversification as well as exhaustion of oil and gas in some AGCC countries in the future may reduce structural similarities. After several years, AGCC factor endowment may change as can be seen from Table 1.3. Among the AGCC countries, Saudi Arabia has relatively huge natural resources, while Bahrain has limited natural resources. However, three AGCC countries – Saudi Arabia, Bahrain and Oman – are projected to run out of oil sooner when compared to other countries. Gas reserves are also relatively smaller in Oman, Bahrain and Saudi Arabia, and higher in Qatar and Kuwait. These future developments in oil and gas resources might have some bearing on structural convergence. The distinct differences in gas and oil reserves can also be seen if we compare the AGCC countries with Organization of Petroleum Exporting Countries (OPEC) and world reserves. Table 1.3 shows a sharp contrast between AGCC countries and world and OPEC gas and oil reserves. These sharp differences will have some repercussions for future developments in oil and gas resources in the region and so for structural convergence. AGCC current figures also show that output is not

16 The AGCC Monetary Union Table 1.1 GDP by economic activities (at current prices, 2003) (%)

Agriculture Petroleum and mining Manufacturing Electricity, gas and water Construction Wholesale and retail, hotels and restaurants Transport, communications and storage Finance and insurance services Real estate services Government services Other service Total

Bahrain

Kuwait

Oman

Qatar

KSA

UAE

Average

0.60 24.32

0.51 44.90

1.88 39.08

0.27 57.38

3.33 26.85

2.80 29.00

1.50 36.90

10.78 1.32

6.96 2.33

11.39 1.22

6.84 1.31

7.87 0.90

13.00 1.80

9.47 1.40

3.71 9.87

2.21 6.14

2.20 11.94

4.82 5.40

4.29 4.92

8.00 13.00

6.00 8.50

7.01

4.91

6.53

3.40

30.33

7.00

9.80

19.00

5.89

3.85

4.50

3.64

4.00

6.80

8.56

5.31

5.07

3.20

4.20

7.80

5.60

14.83

20.82

15.39

13.35

12.77

9.00

14.00

— 100.00

— 100.00

1.45 100.00

— 100.00

0.90 100.00

5.60 100.00

1.00 100.00

Source: Own calculations from figures obtained from AGCC, 2006. Note — Negligible.

Table 1.2 AGCC: expenditure components of GDP, 2003

Private consumption Government consumption Capital formation Exports–imports (goods and services)

Bahrain

Kuwait

Oman

Qatar

KSA

UAE

Average

42.97 18.44

43.29 23.83

43.99 22.30

17.07 16.90

33.55 24.63

48.60 14.16

38.25 20.04

21.52 17.07

14.61 18.27

15.72 18.77

35.58 30.45

18.41 22.00

23.39 13.84

21.54 20.07

Source: Own calculations from figures obtained from AGCC, 2006.

evenly distributed among countries and between AGCC countries’ populations, with Saudi Arabia coming first with more than 50% of AGCC value of output, but coming third (after Qatar and UAE) in per capita income. The sharp differences in population mean that the lower GDP countries are not necessarily the lower per capita income AGCC countries.

78.00

131.00

38.00

89.00

89.00

103.00

43.90

2.40

7.80

12.00

29.70

Est. oil reserve lifetime

0.20

Per capita oil reserves (thousand barrels of oil)

376.70

1,090.50

349.80

624.20

1.80 904.00 0.50 1.00 632.50 14.80 29.20 7,699.60 3.70 7.30 2,060.00 3.50 6.90

855.90

50.70

Proven gas reserves per capita (millions cu. ft/day)

— 1,882.90 0.90

38.00 —

Proven gas reserves (millions cu. ft/day)

Note — Negligible.

Sources: AGCC Statistical Bulletin, 2001 and Arab Joint Economic Report, 2003.

Bahrain 0.15 % of world — reserves (2002) % of OPEC — Kuwait 96.50 % of reserves 9.00 world % of OPEC 13.40 Oman 5.70 % of reserves 0.60 world % of OPEC 0.70 Qatar 4.50 % of reserves 1.40 world % of OPEC 2.00 KSA 263.50 % of reserves 24.60 world % of OPEC 31.00 UAE 98.10 % of reserves 7.50 world % of OPEC 11.50

Proven oil reserves (billion barrels of oil)

Table 1.3 AGCC endowments and economic size

2.60

1.50

12.00

6.00

1.70

3.00

Oil extraction cost

70.50

188.40

16.40

19.80

37.80

7.90

GDP (billion US$, 2002)

66.30

62.90

41.60

51.20

51.80

72.00

Non-oil GDP (%)

3.30

22.01

0.58

2.40

2.20

0.75

Population (millions)

21.40

8.60

28.30

8.30

17.20

10.50

Per capita GDP (thousand US$)

18

The AGCC Monetary Union

In general, structural convergence does not seem to be an impediment to creating, sustaining and benefiting from an AGCC MU. Nevertheless, the future structural development may be an obstacle to achieving structural convergence. Hence, the prime issue is convergence not of current structures but of dynamic structures. Diversification as well as exhaustion of oil and gas in some AGCC countries in the future may reduce structural similarities and might have some bearing on the current structural convergence. The current structure exhibits a similar pattern among AGCC countries, as seen from the expenditure components of GDP. Private consumption is a dominant expenditure component of GDP, while other components share similar patterns. 5.1.2

Degree of openness and trade pattern

Trade exposes relative patterns, and the degree of openness to trade has an important role in determining how global shocks might affect one AGCC member country in relation to others. AGCC trade openness, trade integration and the geographical breakdown of trade accounts are investigated in Table 1.4. Overall, AGCC economies are open, although the degree of openness varies widely between individual countries. Trade openness as a percentage of GDP shows that the UAE and Bahrain are far ahead of the AGCC average, while the rest are more or less average. There are also sizable variations in the pattern of trade. The geographical breakdown of current account trade (goods and services) shows a relatively homogeneous pattern, with some exceptions. The direction of trade is also relatively homogeneous, with Asia as a major export destination and Europe and the USA as the major sources of imports. Japan is the major export trade partner (with the exception of Bahrain), while the EU and the USA are the major import trade partners (with the exception of Oman). The EU accounts for approximately one-third of imports, while the USA records a 13% share. AGCC trade integration on the other hand is limited, with some exceptions. The most outstanding limitation is in exports, due to the limited volume of intraAGCC oil exports and the dominance of oil exports among AGCC exports. Bahrain and Oman receive a considerable percentage of their imports from the other AGCC countries, while the others receive less than 15% from AGCC countries. No AGCC country exports more than 10% of its total exports to AGCC countries. However, although it is not clear from the table that non-oil intraAGCC trade is more than 30%, this is less than intra-EMU trade, for example, which is almost double. In summary, even if we look at non-oil trade integration between AGCC countries, intra-trade is far from being high, and this will limit the benefits from one currency. Moreover, trade shocks that may result from these differences in trade exposures could generate some cyclical divergences. On the other hand, the relatively homogeneous pattern of trade with the outside world may transmit asymmetric shocks. Nevertheless, in the light of an MU, non-oil intra-AGCC trade could be enhanced, coupled with diversification of the economies.

The AGCC Monetary Union 19 Table 1.4 Trade openness, trade integration and geographical breakdown of trade accounts (%)

Trade openness (trade as % of GDP, average 1996–2001) Exports GCC countries Other Arab countries Other Islamic countries EU USA Japan Other countries Total Imports GCC countries Other Arab countries Other Islamic countries EU USA Japan Other countries Total

Bahrain

Kuwait

Oman

Qatar

KSA

UAE

129.00

75.50

80.50

77.50

60.20

121.70

8.40 1.60

1.00 1.70

10.10 2.50

5.70 1.70

5.60 4.60

5.80 1.10

4.90

8.00

4.30

2.10

5.10

3.90

5.10 4.80 4.00 71.30 100.00

11.40 11.50 22.80 43.50 100.00

1.50 1.20 22.70 57.60 100.00

3.10 3.60 43.10 40.70 100.00

15.60 16.00 15.30 37.80 100.00

4.30 1.70 20.30 63.00 100.00

24.50 3.40

11.10 11.10

39.10 6.10

14.90 8.60

4.70 5.40

8.40 1.20

3.10

6.40

4.60

3.40

4.00

9.20

29.30 10.10 3.80 25.80 100.00

29.90 13.10 13.60 14.80 100.00

20.70 6.80 16.20 6.40 100.00

43.60 6.00 8.70 14.80 100.00

29.50 18.90 9.20 28.20 100.00

33.20 9.70 9.10 29.20 100.00

Source: Own calculations from figures obtained from Alkhaleej Economic Report, 2002–2003.

5.1.3

Cyclical convergence

The two key indicators of cyclical convergence used widely are short-term interest rates (main monetary variable) and GDP growth (a simple measure of the business cycle). In the past decade the highest and the lowest short-term (3-month) deposit rates have been 4 and 0.8 percentage points. The absolute range of the interest rate has narrowed to 1.8 percentage points in the course of the past three years (Finigan, 2004, p. 14). Interest rates in AGCC countries are affected by changes in US interest rates and, to a lesser extent, by the development of oil prices. An oil price increase widens the spread between AGCC interest rates. Moreover, AGCC interest rates are known to move in line with US interest rates, and the spread between the two rates is generally low. This is a reflection of the credibility of the exchange rate when AGCC national currencies are linked to the US$.

20

The AGCC Monetary Union

GDP growth rates in the AGCC countries on the other hand show some correlations over the past few decades, as they critically depend on oil price movements, which tend to be similar in all cases. Our calculations of the annual average growth rates between 1995 and 2000 are more or less similar, being 0.07% in Bahrain, 0.08% in Kuwait, 0.09% in Oman, 0.20% in Qatar, 0.27% in Saudi Arabia and 0.13% in the UAE. The co-movement of GDP growth rates exists despite the difference in growth cycles in some AGCC countries due to factors such as the development of the natural gas sector in Qatar during the mid-1990s and the Iraqi invasion of Kuwait in the early 1990s. The co-movement of non-oil GDP growth cycles is less correlated. Table 1.5 on page 24 shows the non-oil GDP growth rate (NOGDP) for the six AGGC states over the period 1996–2003. The non-oil growth differentials (the differences between the higher and lower annual non-oil GDP growth rates) tend to be higher and in the range of 0.006 in Qatar (between 2001 and 2002) and 0.622 in UAE (1996–1997). The results of cyclical correlation tests are of a mixed nature. Over a decade, the short-term interest rates differential is more than 3 percentage points. This shows the structural differences in AGCC monetary conditions. The aggregate GDP growth rate showed some cyclical convergence, while the NOGDP differential showed no sign of cyclical convergence. 5.1.4

Endogenous convergence

The act of joining an MU may lead to changes in economic structures and business cycles. This concept is known as endogenous convergence. If the economic structures and business cycles of the countries in an MU converge over time, the potential costs of membership to the MU are reduced. However, while convergence of structures can help reduce the incidence of future shocks after entering the MU, it cannot alleviate the potential shock of entry to an MU itself. Different drivers of endogenous convergence potentially operate over different time periods. The immediate effects of the entry may change the macroeconomic policy environment, through creation of a common monetary policy and a permanently fixed nominal exchange rate. Over the short to medium term, firms and households would gradually adapt their behaviour to the new economic environment – for example, the removal of barriers such as exchange rate transaction costs is likely to promote trade and investment within the Currency Union. Over the longer term, an increase in cross-border trade and investment will lead to greater integration of economic structures. This might induce a change in the industrial landscape with more specialization in production (House of Commons, 2003). The economic structures of AGCC countries, as we have identified, are mostly similar, and energy is a leading sector that drives government expenditure. As these economies depend on the oil sector, where oil price fluctuation is considered a symmetric shock to these economies, the growth rates tend to be volatile but correlated. Finigan (2004, pp. 14–15) showed high correlations between AGCC

The AGCC Monetary Union 21 economic growth rates. The coefficients of correlations of economic growth rates between various pairs of AGCC countries are positive, except in the case of Bahrain and Kuwait. Moreover, the coefficients of determinants of economic growth are greater than 65%, except for Kuwait. These results support the convergence of the current AGCC business cycles. Greater trade and investment within an MU, combined with higher levels of competition as a result of price transparency and more integrated markets, may result in increased industrial specialization, where regions specialize in certain types of economic activity. With the permanent elimination of exchange rate risk, firms will have greater certainty about relative costs. In these circumstances, they may concentrate on production where they have a comparative advantage and can best exploit the economies of scale. Another source of potential medium- and long-term convergence is through financial structures. Greater financial-market integration and greater similarity of financial structures could promote convergence of business cycles. 5.2

Flexibility

Flexibility ensures durable convergence. It relates to the resilience of the economy and its ability to adjust rapidly while minimizing disruption. Sustainable and durable convergence is a pre-condition for realizing the potential benefits of membership. The assessment of the flexibility test considers the following key issues and questions: 1

2 3

Flexibility and adjustment mechanisms in the Gulf answer the questions: How do flexibility and adjustment work in AGCC countries? What are the adjustment differences among the Gulf member countries? Is the non-exchange rate flexibility of AGCC economies sufficient? How would the formation of the GMU affect overall flexibility? Market flexibility answers the question: How flexible are Gulf labour, product and capital markets? The potential for fiscal flexibility answers the question: What role does fiscal policy play in adjusting to shocks? Can it be enhanced in the Gulf member states?

5.2.1

Labour market flexibility

AGCC countries are characterized by high population growth averaging 3.5% per year in the last decade. The result is a very young population, as around 40% of the population are below 15 years of age. The economies of AGCC countries rely heavily on an expatriate labour force, mainly because they are highly skilled and qualified. The number of nationals in the total population differs widely in AGCC countries (24% in Kuwait, 26% in the UAE, 38% in Qatar, 60% in Bahrain and over 70% in Oman and Saudi Arabia) while the average is around 70%

22 The AGCC Monetary Union (United Nations Development Programme, 2002). The share of the national population in the workforce is lower. Figures for the number of unemployed nationals are not readily available. The United Nations (2002) estimated unemployment figures in the AGCC countries to be 17.2% in Oman, 15.0% in Saudi Arabia, 7.1% in Kuwait, 5.1% in Qatar, 3.1% in Bahrain, 2.6% in the UAE. The Arab Human Development Report (UNDP, 2002) estimated a rapid growth rate of population to reach 44 million by 2020. The problem of unemployment of nationals represents a real challenge. To tackle it, the AGCC governments restrict public-sector employment to nationals by creating quotas. Work permits for the employment of expatriates are imposed in the private sector more strictly. Market regulation policies also rely on the education and training of nationals. It is observed that education levels differ widely in the AGCC countries. While education and enrolment is relatively advanced in Bahrain and Qatar, it lags behind in other countries. The labour market in the AGCC is divided between nationals and expatriates. The high share of the expatriate labour force adds a great deal to its flexibility, as the number of expatriates can be adjusted in response to shocks. Nevertheless, the public and private sector vary in flexibility. While nationals are the bulk of the public-sector employees, expatriates are mainly employed in the private sector. Dominance of nationals in the public sector in all AGCC economies hinders flexibility of labour and capital markets. The nationalization process will reduce the flexibility of the labour market, as a national labour force will increase wage rigidity and job protection. While international labour mobility is freely permitted, in practice it is not significantly carried out, because most AGCC unemployed nationals have education below average, and so cannot be assured of job mobility. The current labour mobility of the expatriate workforce is restricted by the absence of free migration of expatriates between AGCC member states. There are no common visas or residence permits for expatriate workers. Cross-border mobility is most likely to become an important adjustment mechanism after the formation of an MU. The high degree of linguistic homogeneity will facilitate international labour movement provided legal obstacles are removed. Labour flexibility necessitates ending the policy of automatic employment of nationals, increasing the spread of job information and creating a proper database for matching and replacement of nationals in the private sector. It is also essential to reduce domestic market segmentation of expatriates and the national labour force and to ensure wage flexibility. There must be a transition to a market-based system, where wages reflect labour productivity and skills. 5.2.2

Capital market flexibility

The capital market in the AGCC is limited in size and is inflexible. Participation in local capital markets is largely restricted to nationals. Rules in all AGCC countries require a majority of national ownership in all corporations. Investment in low and secondary bond markets has not developed. Stock market capitalization

The AGCC Monetary Union 23 ranges from 12% of GDP in Oman to 106% in Kuwait and between 40 and 80% in other countries. In all AGCC countries, bank assets (which are more than 100% of GDP in all AGCC countries and in Bahrain exceed 1,000%) exceed stock market capitalization (AMF, www.amf.org.ae). The same applies to non-banking financial institutions (insurance, capital markets, pension funds and finance companies), which are also limited in size and inflexible. Success of an MU requires deepening of the financial market by permitting foreigners to invest in trade shares of joint stock companies listed on the stock exchange, development of bond and equity markets and harmonization of stock market legislation.

5.2.3

Fiscal policy flexibility

AGCC countries differ sharply in their fiscal performance and fiscal adjustments in the context of large oil price changes. In 1998 there was a large drop in oil prices. Some AGCC countries resorted to financing from official assets, while others mobilized non-oil revenues. In a high oil price era, since 2000, responses have differed markedly between high total spending (out of non-oil GDP) and accumulation of net financial assets. Moreover, fiscal policies (despite the creation of the Custom Union on 1 January 2003) remain the least co-ordinated policies of the AGCC countries. The major characteristics of fiscal performance in AGCC countries that limit fiscal flexibility can be summarized as follows: 1 Variations of fiscal deficits. AGCC countries have registered fiscal deficits on their overall balance sheets and for non-oil deficit to non-oil GDP without stability in these ratios. Table 1.5 shows the annual percentage changes in total expenditures (E), oil price (OP), oil and gas revenues (OGR), non-oil revenues (NOR), fiscal balance (FB), non-oil fiscal balance (NOFB) and non-oil GDP (NOGDP). The main conclusion is that there is substantial variation not only in the degree of annual percentage change in FB and NOFB in all AGCC countries, but also between AGCC countries. 2 Variation in the degree of procyclical fiscal policy. Procyclical fiscal policy is a positive co-movement of government expenditure and various fiscal balances on the one hand and different measures of revenues and oil price on the other hand. The association of total expenditures and oil revenue or of oil price and fiscal balance, for example, shows indirect evidence of procyclical fiscal policy, except when there is an automatic stabilizer (such as drawing from reserves that accumulate when oil prices are rising to allow spending during harsh periods to delink from oil revenue). Procyclical fiscal policy is an indication of lack of flexibility because spending commitments increase expenditure rigidity, which often cannot change when oil prices decline. One way to test for procyclicality is by estimating the correlation coefficient between changes in expenditures and various measures of budget deficits on the

Table 1.5 Testing for procyclicality in AGCC countries (% annual change) E Bahrain 1996–1997 1997–1998 1998–1999 1999–2000 2000–2001 2001–2002 2002–2003 Kuwait 1996–1997 1997–1998 1998–1999 1999–2000 2000–2001 2001–2002 2002–2003 Oman 1996–1997 1997–1998 1998–1999 1999–2000 2000–2001 2001–2002 2002–2003 Qatar 1996–1997 1997–1998 1998–1999 1999–2000 2000–2001 2001–2002 2002–2003 KSA 1996–1997 1997–1998 1998–1999 1999–2000 2000–2001 2001–2002 2002–2003 UAE 1996–1997 1997–1998 1998–1999 1999–2000 2000–2001 2001–2002 2002–2003

OP

OGR

NOR

FB

NOFB

NOGDP

0.121 0.100 0.027 0.087 0.069 0.238 0

0.045 0.376 0.517 0.566 0.149 0.085 0

0.075 0.393 0.432 1.059 0.121 0.029 0

0.181 0.029 0.019 0.022 0.092 0.087 0

1.333 66.00 0.090 0.023 0.002 0.002 0

0.085 0.470 0.208 0.431 0.039 0.328 0

0.034 0.195 0.122 0.059 0.041 0.068 0

0.023 0.016 0.008 0.205 0.489 0.379 1.051

0.011 0.347 0.423 0.527 0.150 0.070 0.136

0.185 0.297 1.127 0.056 0.001 0.016 0.46

0.122 0.360 0.148 0.055 0.856 0.112 0.188

0.095 0.121 0.301 0.018 0.101 0.090 0.338

0.042 0.023 0.014 1.334 4.328 0.434 3.405

0.049 0.024 0.050 0.048 0.016 0.073 0.064

0.024 0.037 0.019 0.137 0.077 0.027 0.166

0.041 0.360 0.456 0.484 0.139 0.056 0.145

0.181 0.278 0.034 0.425 0.086 0.169 0.017

0.001 0.176 0.007 0.081 0.193 0.235 0.352

0.038 0.062 0.009 0.030 0.007 0.050 0.005

2.030 0.097 0.037 0.247 0.052 0.030 0.049

0.069 0.034 0.022 0.063 0.123 0.030 0.065

0.192 0.044 0.107 0.055 0.121 0.144 0.006

0.057 0.364 0.446 0.563 0.116 0.037 0.047

0.281 0.232 0.226 0.636 0.162 0.225 0.033

0.003 0.232 0.263 0.295 0.481 0.444 0.088

0.000 0.080 0.043 0.125 0.075 0.088 0.009

0.002 0.481 1.101 0.000 0.010 0.019 0.060

0.025 0.174 0.006 0.046 0.086 0.006 0.032

0.117 0.141 0.033 0.280 0.084 0.085 0

0.037 0.356 0.430 0.565 0.150 0.062 0

0.177 0.500 0.306 1.053 0.142 0.097 0

0.056 0.354 0.302 0.015 0.014 0.060 0

0.006 0.063 0.029 0.092 0.071 0.010 0

0.134 0.269 0.096 0.361 0.10 0.115 0

0.069 0.011 0.027 0.032 0.032 0.030 0

0.111 0.124 0.008 0.327 0.001 0.092 0.037

0.072 0.334 0.434 0.534 0.131 0.035 0.136

0.111 0.380 0.100 1.138 0.139 0.208 0.382

0.073 0.109 0.088 0.599 2.475 0.040 0.158

0.071 0.128 0.018 0.176 0.134 0.007 0.057

0.122 0.129 0.045 0.599 2.478 0.107 1.999

0.653 0.222 0.034 0.820 0.305 0.053 0.058 (Continued)

The AGCC Monetary Union 25 Table 1.5 Continued Correlation

Bahrain

Kuwait

Oman

Qatar

KSA

UAE

Average

E/OP E/OGR E/NOFB E/FB NOFB/OP NOFB/OGR FB/OP NOR/NOGDP NOFB/NOGDP

0.42 0.03 0.12 0.55 0.23 0.42 0.59 0.21 0.88

0.19 0.35 0.86 0.35 0.37 0.24 0.49 0.71 0.10

0.50 0.57 0.11 0.40 0.08 0.32 0.42 0.24 0.21

0.18 0.36 0.18 0.29 0.23 0.13 0.82 0.49 0.05

0.57 0.84 0.94 0.58 0.76 0.91 0.91 0.13 0.44

0.44 0.68 0.19 0.35 0.37 0.45 0.78 0.64 0.43

0.32 0.35 0.24 0.24 0.01 0.14 0.67 0.25 0.17

Source: Own calculations from data obtained from AGCC national banks’ annual reports, different issues. See text for abbervations used.

one hand and percentage change in oil price on the other hand. Procyclicality can be measured by the following three sets of correlations: a

b

c

Correlation coefficients between percentage change in expenditures (E), percentage change in fiscal balance (in % GDP) (denoted by FB) percentage change in non-oil fiscal balance (denoted by NOFB), percentage change in oil prices (denoted by OP) and percentage change in oil and gas revenues (denoted by OGR). Correlations between percentage change in non-oil fiscal balance (denoted by NOFB), percentage change in oil and gas revenues (denoted by OGR) and percentage change in oil prices (denoted by OP). Correlations between percentage change in fiscal balance (in % GDP) (denoted by FB) and percentage change in oil prices (denoted by OP).

These correlations should be positive for budget procyclicality. Table 1.5 tests these correlations for fiscal procyclicality in the six AGCC countries during the period 1996–2003. The following matrix summarizes the average fiscal procyclical correlations. Average fiscal procyclical correlations matrix Variable

E

FB

NOFB

OP

OGR

E

1

0.24 (0.58, KSA) 1

0.24 (0.19, UAE) —

0.32 (0.57, KSA) 0.67 (0.91, KSA) 0.01 (0.37, UAE) 1

0.35 (0.84, KSA) —

FB NOFB OP OGR

1

(0.45, UAE) — 1

Note Figures within parentheses are the highest correlation coefficients between the six AGCC countries and the respective countries.

26

The AGCC Monetary Union

The first set of correlations, although not very high, is nevertheless positive, except the correlation between E and NOFB. They are in the range of (0.24), (0.24), (0.32) and (0.35) respectively. This result can be interpreted to mean fiscal procyclicality. Results of the second set of correlations show that the coefficient of correlation for NOFB and OP is, as expected, positive (0.01), but very weak. The second test of correlation between NOFB and OGR shows small (but negative) correlations for three AGCC countries out of six, while in three countries it is positive. The overall average result is a small negative (0.14). The correlation of FB (in % GDP) and OP is positive, as expected. This correlation is high, reaching (0.67) on average. This indicates that oil price is the major influential factor on the fiscal balance in AGCC countries, notably in the Kingdom of Saudi Arabia (KSA), Qatar and the UAE. The current fiscal flexibility is weak. The process and the results are markedly different among individual countries. Table 1.5 also clearly shows sharp variations in procyclicality correlations among AGCC countries. One distinct characteristic that can be seen from Table 1.5 is that Kuwait and Oman have a remarkably lesser degree of fiscal procyclicality compared with Saudi Arabia and the UAE (especially when we look at the correlation between oil prices and fiscal balance). This may partly be caused by the short-run counter-cyclical oil stabilization and saving funds established in these countries that managed to delink fiscal policies from oil price movement. Some fiscal stance characteristics show that the oil-dependent AGCC countries exhibit weak fiscal flexibility and different responses to fiscal shocks. AGCC economies are strongly oriented towards oil and gas. This can be seen from the share of the oil and gas sectors in GDP, the share of oil exports in total exports and the share of oil revenue in government revenue. The oil and gas sectors contributed over 40% of AGCC output, while oil income contributed around 80% of government revenues. Oil exports account for over two-thirds of total AGCC exports (see, for example, Fasano and Iqbal, 2003a, p. 2). The high contribution of oil and gas to total government revenues severely affects budget balances through oil price volatility. Fiscal flexibility is constrained by a high dependence on oil as well as oil price movements; that is, fiscal outcomes are affected by common factors and convergence is less marked. Besides low shares of non-oil revenues in total revenues, procyclical fiscal policies are also related to the governmental role in employment, social benefits and subsidies and the lack of a medium-term budgetary framework that spreads out fiscal risks over a period of time. 3 Negative relationship between non-oil revenue (NOR) and non-oil GDP (NOGDP). This negative relationship can be seen from Table 1.5, which shows that the correlation between NOR and NOGDP is negative in four AGCC countries and on average. The registered average correlation between NOR and NOGDP is (0.25) over the period 1996–2003. 4 No use of fiscal policy rules. No AGCC country uses fiscal rules based on any fiscal aggregate such as non-oil fiscal balance in its budget documents. They all depend on the absolute fiscal stance. Fiscal rules are important to achieve targeted indicators of fiscal performance, to overcome the procyclical nature of fiscal policies and to enhance their flexibility and sustainability.

The AGCC Monetary Union 27 5 Variations between AGCC countries in medium-term budget target expenditure frameworks. Some AGCC countries have initiated a medium-term budget target expenditure framework and some have established stabilization and fund saving to bridge the gap in financing any shortfalls in oil revenues. In Oman and Bahrain budget plans are made for five and four years respectively. Kuwait is planning to start the same process, and Saudi Arabia and the UAE have initiated it recently. Since the lack of a medium-term budget framework will not allow AGCC countries to phase or spread fiscal responses to shocks over time it will restrict fiscal flexibility. 6 Variations in stabilization and saving funds. Oman has established a stabilization saving fund (the State General Reserve Fund) to which revenues above the budgeted oil price are transferred. Kuwait established a General Reserve Fund to smooth the impact of fluctuating oil prices on government spending. It also established a Fund for Future Generations to which 10% of the government revenue is transferred. The Emirate of Abu Dhabi has a stabilization fund known as the Abu Dhabi Investment Authority. Bahrain planned to establish a stabilization fund. Qatar and Saudi Arabia, however, have none. 7 Deviations between the approved estimates and actual budget. Deviations between approved estimates and actual budget are caused by many factors such as unrealistic revenue projections due to oil price fluctuations, underestimation of expenditures, extra-budgetary activities and lack of a medium-term budget framework. These deviations complicate fiscal flexibility, especially when oil prices are low. 5.3

Investment

The assessment of the investment test will be confined to showing the impact of the exchange rate on FDI. A recent classification of AGCC states in terms of the inflow of FDI was given in the World Investment Report, 2006 (UNCTAD, 2006). In this report the AGCC countries are classified into the group of high FDI potential and high FDI performance, or front-runners (Bahrain, UAE, Qatar), and the group of high FDI potential and low FDI performance, or below potential (Kuwait, Oman, KSA). AGCC overall FDI inflow in 2005 reached US$9,311 million, and the FDI outflow reached US$14,072 million. This indicates that the inflow of FDI equals only 66% of FDI outflow. The ratio of AGCC inflow of FDI to the total world inflow of FDI is only 1%, while the ratio of FDI outflow to the world FDI outflow is 1.8%. The classification of FDI outflows worldwide ranked Bahrain at No. 6, followed by the UAE at Nos. 63, KSA at No. 85, and then Oman, Qatar and Kuwait (Nos. 115, 120 and 133 respectively). UNCTAD data for 2005 (UNCTAD, 2006) identified a sharp difference in the inflow of FDI to GDP ratio among AGCC countries. In Bahrain, the ratio is 64%, followed by the UAE (21.1%), Qatar (16.2%), Oman (13.3%), the KSA (8.5%) and Kuwait (0.9%). The ratio of inflow of FDI to fixed capital formation also shows strong contrasts, but with higher percentages. In the UAE, the ratio is 51.8%, followed by Bahrain (42%),

28 The AGCC Monetary Union Qatar (21.2%), Oman (14.6%), the KSA (9.4%) and Kuwait (3%). FDI in the AGCC countries is concentrated in the hydro-carbon sector, and (to a lesser extent) the manufacturing and services sector of tourism, telecommunication and banking. The low share of AGCC states in FDI is not different from the whole Arab world’s low share of FDI. The Arab world not only received a tiny proportion of global FDI without any visible spillovers, but also experienced steady fluctuation in the share of net inflow of FDI, from 2.6% of the total net flow of global FDI in the mid-1970s to 1980 to only 0.7% during 1990–1998, and to 3% in 2005 (UNCTAD, 2006). More than half of FDI comes from the region (intra-Arab investment) (UNDP, 2002). Moreover, the Arab overseas investment is far more than the intra-Arab investment. According to UNCTAD figures (2001), the cumulative stock of intra-Arab investment between 1985 and 2001 was US$17 billion, whereas overseas Arab investment was estimated to be over US$1.3 trillion. More than 80% of FDI in the Arab world is concentrated in five countries, two of which are AGCC countries (Saudi Arabia and Bahrain). Out of 16 Arab countries for which data on average annual net FDI flows are used, between 1996 and 2000, Saudi Arabia comes first, Bahrain third, Qatar sixth, the UAE eighth, Kuwait tenth, and Oman thirteenth. AGCC countries collectively shared 50% of Arab FDI in 2000, and 66% in 2005 (UNCTAD, 2006). The share of foreign investors in AGCC countries is subject to some limitations. Although the rule of 51% foreign investment is applied in Kuwait, Qatar, the UAE and Oman, foreigners can hold a share of more than 51% and even up to 100% in special circumstances and projects. With the exception of Saudi Arabia, there are no government regulations to impose national management. Moreover, value added should not be less than 40% to enjoy full tax exemption, as profit remittance abroad is allowed in all AGCC countries (GOIC, 2001). After the establishment of an MU capital market reform is likely to give some push to FDI in the AGCC countries. The stock markets in the AGCC at the moment are not active. There is an urgent need for transparency of the regulatory processes, protection of property rights and an effective resolution of disputes. The impact of exchange-rate stability on FDI is unlikely to be enormous, as FDI depends on multiple factors besides the exchange rate. Moreover, limitations to the share of foreign investors in AGCC countries are also related to capital restriction and inactivity of the stock markets. An MU will probably have some limited effects on the share of FDI provided some other FDI incentive factors are brought in. By removing exchange-rate volatility and transaction costs within the Gulf area and by boosting price transparency, an MU can have some positive impact on returns on investment and size of FDI. AGCC countries have similar exchange-rate arrangements in which all currencies are pegged to the US$. Nevertheless there are more FDI-enhancing factors than exchange rate invariability. A fixed exchange rate is not likely to make much difference to FDI in AGCC countries. AGCC countries already have an exchange-rate union, because their currencies are pegged to the US$. Perhaps the GMU can enhance the credibility of monetary policy and can reduce inflation to comparable and manageable levels in some relatively high-inflation AGCC countries. Though the overall result seems positive, it is likely to be minimal. Further assessment of the investment

The AGCC Monetary Union 29 test needs to identify the position of exchange-rate stability as a determinant of investment for firms in each country separately. 5.4

Financial services

The assessment of the financial services test takes up two issues. The first is regarding the future drivers of Gulf financial services. It assesses how the drivers are shaping the development of the Gulf financial services sector. The second is about the costs and benefits of an MU for the Gulf’s financial markets. The driving factors of financial sector development are macroeconomic stability, financial sector competition, transparency and a well-developed institutional and legal framework (Creane et al., 2003, p. 1). An International Monetary Fund (IMF) study of the Middle East and North Africa (MENA) region identified six major financial development themes: (1) the development of the monetary sector and policy; (2) banking sector size, structure and efficiency; (3) quality of banking regulations and supervision; (4) development of non-banking financial institutions (NBFI); (5) financial openness and (6) institutional environment (Creane et al., 2003, p. 2). Based on quantitative and qualitative data for 2000–2001, a comprehensive weighted index was computed from these themes. All AGCC countries’ financial development was ranked high, scoring above 6 (out of 10) on average. Their strength was in financial openness, regulation and supervision (all scored 8.9). Other themes score over 7, except institutional environment and non-banking financial sector, which score 5.9 and 6.7 respectively. The policy outcome of the above result is that the provision of an attractive climate for the AGCC financial sector is one of the most important requirements for an MU. The inter-regional competition and open-market policy for foreign banks (in accordance with World Trade Organization (WTO) requirements) will most likely consolidate national banking in the AGCC. Mergers between Gulf commercial banks would make them more efficient and competitive and therefore strengthen their ability to compete with international banks and support privatization and diversification of the structures of AGCC economies. The MU is also required to develop both the non-banking financial institutions (insurance, capital markets, pension funds and finance companies) and an institutional banking environment. Moreover, the future drivers shaping the development of the AGCC financial system under globalization are most likely to be openness and integration of world capital markets. These benefits are most likely to come through on condition that the trading barriers for financial assets and currencies are removed and given an assurance that the currency exchange rate system operates freely. It is most likely that the GMU will persuade policy makers to formulate additional reforms to create a more favourable environment regarding financial services. Among these are the adoption of common legal and judicial banking regulations, development of capital and investment laws, diversification of the non-banking financial institutions, integration of AGCC capital markets, enhancement of financial competition and spreading innovation and technological change across the single currency area. Moreover the GMU is also expected

30 The AGCC Monetary Union to encourage AGCC commercial banks’ mergers to strengthen competition with foreign banks in the region. 5.5

Growth, stability and employment

Macroeconomic stability (fiscal policy stability, sustainable public debt and so forth) cannot be isolated from the credit/monetary policy framework. There is a strong consensus that credibility is best achieved by delegating the operation of monetary policy to an independent central bank, which is less vulnerable than the government to the suspicion that it would sacrifice its long-term monetary stability goals by making a short-term dash for growth at the expense of future inflation. There will, no doubt, be a potential impact of the GMU on trade, competition, productivity and growth. This includes (1) enhancing competition to improve flexibility in product and capital markets and promote greater business efficiency and consumer choice, (2) promoting enterprise by removing the market barriers that deter entrepreneurship and prevent new firms from developing and growing, (3) supporting science and innovation to harness the potential of new technologies and to provide more efficient ways of working, (4) improving skills among young people and the adult workforce to generate a flexible and dynamic labour market and (5) encouraging investment and better investment decision-making through stronger local and national capital markets. Membership could affect all these drivers of productivity either directly or indirectly. Joining an MU would remove any barriers to trade between AGCC countries, enhance competition and stimulate investment by aiding the integration of capital markets. It could also help to spread innovation and technological change across the single currency area. The increase in investment and growth following the Union will create more jobs for the increasing number of national job seekers, but investment in human capital and a sustained increase in non-oil growth rates seem to be a more crucial factor than a single currency for job creation. It is not possible for the employment rates within an MU to diverge because the rate of employment is largely dependent upon the fiscal stance, as governments in AGCC countries are major employers. Nevertheless, empirical research confirms that sharing a common currency does not imply sharing the same unemployment rate. Indeed, unemployment rates can vary more between regions of the same currency area than they would across different currency areas. However, as a result of growing unemployment, creating employment opportunities for nationals in the AGCC economies forms an integral part of the policy objectives of these countries and it cannot be overlooked.

6

Conclusion and policy recommendations

The AGCC states will incur some costs for having a joint MU. The impact of the loss of monetary policy independence and exchange-rate flexibility is likely to be low as AGCC countries currently do not rely heavily on these tools under the

The AGCC Monetary Union 31 pegged exchange-rate regime. Moreover, external shocks, given heavy dependence on oil, induce comparable effects across AGCC states, despite the absence of fiscal flexibility to deal with these shocks. Though an MU is one of the necessary conditions to achieve the national economic objectives of the AGCC states, such as increase of GDP, stabilization and provision of employment opportunities for the indigenous labour force, it is not adequate. We believe that the overall potential economic benefits of the AGCC MU at the moment seem to be less significant, as the present exchange-rate risk in AGCC economies is minimal. Nevertheless, some benefits are expected to evolve, but they will take time and a lot of efforts are needed in line with the following policy recommendations: 1

2

3

Diversification and privatization have been declared as key policies. Diversification efforts in banking, tourism and transport in Bahrain are under way, while similar efforts are being made in tourism, petrochemicals, construction, trade, financial and communications centres and transport in the UAE. Oman has succeeded to a certain extent in diversifying into gas-related industries and tourism and Saudi Arabia into petrochemical manufacturing, minerals, power, infrastructure, industry and services. Qatar is focused on natural gas, commerce, information technology (IT) and financial centres. Diversification and privatization may lead to future changes in the economic structures of AGCC economies, and might reduce the structural similarities enjoyed by them today. If a diversification drive leads to different economic structures, this may result in giving increasing importance to tools apart from nominal exchange-rate adjustments. It may also lead to the establishment of an intra-AGCC fiscal transfer to smooth the adjustment mechanism under a single monetary policy, and/or support AGCC efforts of ensuring flexibility of labour and product markets as an alternative adjustment tool, after the establishment of an MU. In our view, price flexibility in product and factor markets will become an important adjustment tool after its establishment. Nevertheless, removing barriers to the movement of goods, services, labour and capital to enhance their flexibility may not completely substitute the absence of budget flexibility in AGCC economies. Intra-AGCC intra is a weak factor, which minimizes the benefits of one currency. However, if low intra-trade is partly a result of trade barriers, this may be eliminated by an MU or by new policies to remove trade barriers. Provided that the low intra-AGCC trade is partly a result of trade barriers (not a result of similarity of factor endowment), non-oil intra-AGCC trade can be enhanced in an MU if AGCC economies are diversified. Here we may add that the drive towards diversification by AGCC countries, as identified, will create different economic structures and hence weaken the exchange rate as an important adjustment tool of the MU. Further work remains to be done to answer the question whether low intra-trade is a result of trade barriers or similar factor endowment before any result is ascertained. Procyclicality of fiscal polices in AGCC states is related to the low share of non-oil revenues in total revenues, the governmental role in employment,

32

4

5

The AGCC Monetary Union social benefits and subsidies, and the lack of a medium-term budgetary framework that spreads the fiscal risks of AGCC economies over a number of years. Nevertheless, to remove procyclicality of budget policy and to insulate their budget against oil price volatility, AGCC countries need to work with fiscal rules such as budget deficit rules (specification of non-oil deficit to GDP ratio), debt rules (ceilings on net or gross debts), and spending rules (overall or on components of spending), or establish a joint stabilization and saving funds or both. It ought to be mentioned that removing barriers to the movement of goods, services, labour and capital to enhance their flexibility is a prerequisite, but may not completely mitigate the negative effects of the absence of AGCC economies’ budget flexibility on the working of the upcoming GMU. By removing exchange-rate volatility and transaction costs within the Gulf area and by boosting price transparency, an MU can have some positive impact on returns, investment and the size of FDI. Perhaps the AGCC MU can also have some effects on investment by enhancing the credibility of monetary policy and by reducing inflation to comparable and manageable levels in some AGCC countries with relatively high inflation. The AGCC MU will probably have some limited effects on the share of FDI provided that some other FDI incentive factors are brought in. Before we can judge the effect of the MU on investment and provide some policy recommendations, we need to identify the magnitude of exchange-rate stability as a determinant of investment for firms in the economy of each AGCC country separately. Nevertheless, we can recommend enhancing other investment-incentive factors to achieve the benefits of the MU on investment. Significant gains from AGCC MU could be achieved by deepening the financial markets. The GMU can (following the globalization drive) integrate capital markets, enhance financial competition, spread innovation and technological change across the single currency area, encourage AGCC commercial banks’ merger, strengthen competition with foreign banks in the region and create common and effective legal and judicial regulations for AGCC banking and credit policies. These measures require first the removal of trade barriers on financial assets and currencies and then an assurance that the currency exchange-rate system operates freely.

2

1

Intra-AGCC national labour mobility

Introduction

Since the early 1980s, the AGCC states have undertaken many steps towards economic integration. In the year 2000, they marched on a significant stride, that is, towards an advanced stage of economic integration – the AGCC MU. A working plan and a timetable to establish a single AGCC currency have been devised and drawn up. The AGCC monetary authorities have finalized the agreement conclusively on the economic convergence criteria, methods of their calculation and the levels of these criteria. The fulfilment of the criteria is planned to be effected between 2007 and 2010, the period in which a single currency will be introduced. After the establishment of the Union, the ability of the AGCC economies to withstand cyclical disturbances can be improved by (among other factors) permitting free movement of the labour force among AGCC states. This movement constitutes one element of the required labour market flexibility. Furthermore, the intra-AGCC labour movement can be visualized as a response to the effects of globalization and global labour movement in the coming years, which will pressurize countries to adopt international labour laws, thereby changing laws in AGCC states and permitting more flexible, market-oriented, labour regulation and easier international AGCC labour movement and employment. This chapter examines labour mobility among AGCC states as one important adjustment element in the forthcoming GMU. The chapter will begin with a background literature review of AGCC labour market studies, and will also scrutinize the link between MU and labour market flexibility. The testing section analyses statistics and characteristics of the AGCC labour market, unemployment and reasons for weak labour movement. The investigation will focus on identifying and/or analysing the main features that are crucial to enhancing a common AGCC employment strategy (labour market flexibility, output growth, employment generation, labour market policies and legislation, employment information and so on). This section also aims to study major characteristics of the AGCC unemployed and investigate reasons for weak intra-AGCC employment of nationals. Results and policy implications are outlined in the final section.

34 Intra-AGCC national labour mobility

2 2.1

Literature review AGCC labour market studies

The approach of economic thinking to the sources and remedy of unemployment has undergone many changes since the era of the classical economists. The classical economists believed that unemployment is temporary and result from wage and market rigidities in some sectors, whereas Keynesian analysis relates it to the lack of ‘effective demand’. Subsequent analysis of labour markets incorporated institutional factors such as trade unions, market rigidity, social insurance, labour mobility, employment burden (the difference between the growth of the labour force and that of jobs in the market) and access to labour market information. More recently, following the opening up of world economies, liberalization, competition, productivity, trade, exchange-rate policies and FDI are becoming the most important factors in the analysis of unemployment and labour markets. Moreover, as unemployment issues are not unrelated to output growth, the issue of sources of growth performance to create enough new jobs to absorb the rapid expansion of the labour force is now becoming one major factor of analysis (see, for example, Jennifer and Nabil, 2002; IMF, 2003b and Fasano and Goyal, 2004). Recent literature has identified and investigated different factors that have repercussions for the labour market such as economic growth, macroeconomic adjustment, openness, liberalization, labour market flexibility, policies and institutional arrangements. Studies of labour market trends and outcomes in AGCC states stress the factors that have contributed to unemployment of national job seekers and the low contribution of the national labour force in the non-oil private sectors. Moreover, issues of enhancing employment, strengthening investment in human capital, adopting institutional reforms, promoting the non-oil economy, and the role of diversification in creating more job opportunities for nationals are also stressed (see, for example, Fasano and Goyal, 2004). Other studies trace back migration of expatriates to the Gulf since the 1940s, and examine the changes of expatriate nationalities and their distribution among AGCC economies and sectors (Briks and Sinclair, 1979; Girgis, 2000 and Al-Khaleej Daily Newspaper, 2004–2005). Others tackle turnover of employment of the national workforce in the private sector, the deficient labour force and population structures resulting from migrant labour, and income losses from increased employment of expatriates (see, for example, different contributions in Abdelkarim, 2001; Beblawi, 2002; UNDP/ AFESD, 2002 and Al-Kawari, 2004). These studies are imperative to understand the characteristics, structure, trends, dynamics and implications of the expatriate and national labour forces. While these studies seem to touch almost every corner of AGCC labour market issues, they clearly detach themselves from AGCC economic integration issues (activation of the labour force policies that were approved in the context of the AGCC integration process) and the need to have flexible AGCC labour markets to achieve other unified macroeconomic objectives in the context of the forthcoming MU. Moreover, these studies do not take into consideration issues pertaining to the large

Intra-AGCC national labour mobility 35 AGCC labour market. Therefore, policy recommendations given to AGCC labour market policy makers by the authors of these studies have neglected national labour mobility among AGCC states as one way to secure job opportunities and consolidate macroeconomic co-operation. 2.2

Monetary Union and labour market flexibility – the link

Traditional MU theories have attempted to find some imperative indicators necessary to form an advanced MU. Indeed, the macroeconomic costs of an MU depend on the frequency and severity of asymmetric shocks the member countries are exposed to and the available adjustment mechanisms to mitigate the impact of those shocks, given that the national monetary and exchange-rate adjustment mechanisms are not in the hands of any individual member country. The exchange rate between currencies of the participating states will be irrevocably fixed in relation to the new single currency. Moreover, the country-specific monetary conditions can no longer cushion differences in cyclical position among the Union member states, or help them to adjust to asymmetric shock (IMF, 1999, p. 96). Fiscal policy can be used, and along with it sound public finance is also required. But fiscal policy alone is not an adequate method of dealing with economic disturbances, especially those caused by oil price fluctuations. In the case of AGCC economies, since revenues are not generated from taxes, wage-cutting following external shocks would not add to economic difficulties by cutting tax revenues. But employment could be affected. Therefore, labour market flexibility is a good adjustment mechanism for AGCC economies. The question is what labour market flexibility AGCC MU will demand. That is, to what extent can labour flexibility be used as a ‘shock absorber’? A single-currency theory suggests that the macroeconomic costs of forgoing exchange-rate flexibility will be relatively small if there is a low frequency of asymmetric shocks, a high degree of labour mobility across member countries and a transfer of resources from member countries hit by positive shocks to those hit by negative shocks. A common currency will have implications in the labour market. This was made clear already in Robert Mundell’s (1961) theoretical analysis of OCAs. Countries with rigid price and wage structures need their exchange rates to be flexible. Thus, in an OCA, prices and nominal wages must be flexible and/or the workforce must be mobile (SAK, 1998, http://netti.sak.fi/sak/english/emulabor. html). The price for the monetary stability and predictability offered by a Currency Union would thus, according to many economists, be instability, especially in the labour market. On the other hand, the economic theory stipulates that the right thing to do when confronted with an external, asymmetrical shock is to devalue the currency. As this is not possible within the MU because the exchange rate is fixed, then employment and nominal wages must fluctuate in response to external shocks in a group of countries forming an MU. The desirability of strengthening labour markets to adjust more rapidly in the countries of the Union stems from the point that even in the absence of asymmetric shocks, differences in the sensitivity of national economies to a unified monetary policy can cause

36

Intra-AGCC national labour mobility

problems owing to differences in the transmission mechanism among member states. Consequently, one way to react to external shocks is to accept a fall in nominal wages or a rise in unemployment. To make this possible, labour markets should be deregulated. And hence the free movement of factors of production and wage and price flexibility are viewed as vital adjustment mechanisms in case of a shock (Laabas and Limam, 2002; Ibrahim Badr El Din, 2004b, p. 14 and Ibrahim Badr El Din, 2005a). Ibrahim Badr El Din (2004b, p. 21) identified that, as an alternative adjustment mechanism to the exchange rate, AGCC member states may be required to establish intra-AGCC fiscal transfer to smooth the adjustment mechanism and/or ensure flexibility of labour and product markets. One major prerequisite of a successful GMU is the creation of a flexible AGCC labour market as an alternative adjustment tool, supported by improvement of national skills and qualifications of job seekers.4 The ability of the AGCC economies to withstand cyclical disturbances can be improved by, beside other factors, free movement of the labour force amongst AGCC states. This movement constitutes one element of the required labour market flexibility, and is ‘most likely to become an important factor of adjustment mechanism after the formulation of the Monetary Union’ (Ibrahim Badr El Din, 2004b, p. 14). Moreover, there are some potential shock risks in the face of structural non-convergence that might occur following the current AGCC diversification drive. Monetary policy affects different sectors of the economy differently, and so the impact of it will depend on the pattern of regional specialization. This can possibly be mitigated by (among other measures) ensuring flexible labour markets, which can be brought about by collective labour market actions, in addition to country-specific action (Ibrahim Badr El Din, 2004b, p. 14). The AGCC states need to explore the practical solutions required to tackle possible problems arising from the forthcoming MU. Many authors have argued that the implementation of the MU provides a stimulus to accelerate structural reforms to combat the unemployment problems or to induce countries to improve their policies (IMF, 1999, p. 97; Masson and Pattillo, 2004, p. 15). Moreover, the increase in competitive pressures generated by a single market and globalization will mean enterprises need more flexible markets (IMF, 1999, p. 97). For AGCC states, special focus should be on the possible mitigating mechanisms needed to deal with external shocks. Labour market solutions to stabilize the economy and protect the social security system could be one solution. In this regard, national labour mobility is freely permitted, but in practice it is not yet significant across borders.5 One way to ensure labour market flexibility in AGCC states is by enhancing employment of AGCC nationals in all AGCC states, a target that is possible to achieve under the AGCC’s linguistic, cultural and labour law homogeneity. Moreover, cross-border mobility is most likely to become an important adjustment mechanism after the establishment of the AGCC MU, and structural policies that would promote flexibility in the labour market will assume greater importance in the planned MU (Ibrahim Badr El Din, 2004b, p. 14). To sum up, intra-AGCC labour movement, we argue, stems more from the macroeconomic side than from the labour market side. Moreover, intra-AGCC national labour adjustment, following the GMU, can be viewed as a response to future economic shocks, and

Intra-AGCC national labour mobility 37 as a means to enhance future AGCC labour market flexibility within the purview of achieving some nationalization of the labour force. However, some authors are not optimistic about relying upon factor mobility across AGCC states as an alternative adjustment mechanism to the exchange rate following the MU for ‘regulatory’ and ‘institutional’ reasons. For example, Laabas and Limam (2002) argued that ‘[AGCC] labour market regulations and institutions are not very similar. This, in addition to factors related to welfare state, precludes labour from moving across AGCC states’ (Laabas and Limam, 2002, p. 9). Moreover, they added that prices and wages in all AGCC states do not adjust systematically to accommodate frequent oil shocks, because governments’ expenditures act as the main stabilizer of economic activities during oil-market recessions. This means that prices and wages and government expenditures, following the MU, will not qualify to be alternative mechanisms to the exchange rate. Therefore, in our view, a proactive approach to see the mobility factor as an alternative adjustment mechanism is required. That is to say, reliance on factor mobility as an adjustment mechanism is possible, but necessitates a course of action. AGCC states need to strengthen regulations and institutions, to ensure labour market flexibility and, among other measures, to enhance labour movement. These structural and policy factors are discussed in this chapter.

3

Hypothesis, analysis and methodology

Compiled from the Gulf Economic Report (2004–2005, p. 100) and Beblawi (2002, p. 167), the following AGCC labour market structure can be displayed. Labour market structure in the AGCC Nationals employed

Expatriates employed

Total AGCC employment

Unemployed nationals

4.7 million (40% of total AGCC employment)

7 million (60% of total6 AGCC employment)

11.7 million

Around 400,000 (equivalent to 6% of total expatriates and 8.5% of AGCC employed nationals) AGCC unemployment rates in recent (but different) years: 5.6% (Bahrain) 2.5% (Qatar) 9.0% (Kuwait) 15.0% (Oman and UAE) 15.0% (Saudi Arabia)

AGCC unemployment rates rose to a level of more than 15%, while expatriate labour increased to about 60% of the total labour employed. Although the unemployment scenario among AGCC nationals does not depict a serious picture compared to many other countries, AGCC states are still currently facing both structural unemployment (mismatch of skills and job requirements) and cyclical

38

Intra-AGCC national labour mobility

unemployment (resulting from economic slowdown caused by oil price fluctuations). This situation has occurred despite their governments’ efforts to reduce employment of expatriates in the last decade. Against this backdrop, at the very outset it may seem that the analysis of intra-AGCC employment among nationals as an adjustment mechanism following the MU is an irrelevant issue, especially in the light of an expatriate average employment ratio of around 60% of the total labour employed in these countries. However, if we look at intra-AGCC employment among nationals from the forthcoming MU perspective, the result might be different. Hence the options for economic adjustment in the face of economic shocks following the establishment of an MU are open. One option is that labour must be made mobile between countries of the Union so that workers can move from an area suffering from recession to one that is enjoying an economic boom. This option necessitates intra-AGCC employment among nationals. Moreover, intra-AGCC labour movement can be visualized as a response to the effects of globalization and global labour movement in recent years. Globalization pressurizes countries to adopt international labour laws in wages, social insurance, and so on, thereby changing laws in AGCC states and permitting more flexible, market-oriented, labour regulation and easier intra-AGCC national labour movement and employment. The significance of this study also stems from the fact that on one hand there is a lack of research and a dearth of studies on intra-AGCC national labour mobility,7 and on the other hand since the 1980s no joint practical measures have been adopted to improve employment of AGCC nationals in other AGCC states. Therefore, this chapter will tackle some of the structural factors that are supposed to hinder labour movement such as labour market segmentation and rigidity, unavailability of labour market information, and so on. The study hypothesizes that despite the abolition of intra-AGCC employment policy barriers for AGCC nationals, intra-AGCC employment for nationals is still limited due to segmentation and unavailability of supply and demand information, lack of enthusiasm among both parties (AGCC employers and employees) and the limited qualifications of most AGCC job seekers. Moreover, the study also hypothesizes that enlarging the AGCC labour market for AGCC member states would create some employment prospects (although limited compared to nationalization), if policies agreed upon in the context of the AGCC Supreme Council are activated. Hence some crucial policy recommendations to enhance intra-AGCC national labour movement will be furnished. The methodology adopted in this chapter involves descriptive analysis of AGCC labour market issues pertaining to intra-AGCC national employment such as labour market policies, outcomes and flexibility. The study will analyse the AGCC labour market in terms of employment, national and collective policies and measures adopted, as well as intra-AGCC labour participation. As a matter of fact, this topic is new and under-researched. The very small number of AGCC state nationals employed in other AGCC states (compared to other labour market participants in each AGCC country – nationals or expatriates) does not help any compiled and unified data available (from official or unofficial

Intra-AGCC national labour mobility 39 sources) to serve any major and immediate local labour market objective. Moreover, the lack of data as well as the lack of official AGCC consideration of the importance of application of measures to enhance intra-AGCC labour movement has not made this area of research a vital one. These two reasons reveal why there are no previous studies in this particular area. Nevertheless, the topic will be crucial for macroeconomic objectives more than for specific labour market ones. That is why AGCC states are now starting to search for information about nationals working in all other AGCC states. Until the time these data are completed and compiled and open for public use, any analysis of the issue at hand must be fragmentary. But for the sake of analysis here, we will make use of the existing available scanty and unpublished information to make some judgements. The analysis is meant to touch on questions related to the labour market that are fundamental to the upcoming MU. It is also an attempt to contribute to our understanding of the issue at hand, and to formulate some policies crucial to enhancing AGCC national labour movement in the context of the upcoming AGCC MU. The following are the major areas of analysis: 1 2 3

4

4 4.1

Assessment of the current AGCC labour market flexibilities/dynamism using internationally calculated indicators. AGCC growth and labour market dynamism. The unified AGCC labour market policies and measures pertaining to labour movement among AGCC states, the actual applications and reasons for the strengths and weaknesses of intra-AGCC labour movement. Analysis of the AGCC national labour working in other AGCC states (with the help of some scattered and unpublished information, and experiences of some AGCC states), and reasons for weak intra-AGCC national employment.

Testing AGCC output growth and labour market outcomes

The analysis of growth of labour market outcome is crucial here. In an attempt to understand why AGCC states’ growth rates cannot meet their labour market requirements, it is important to break down growth per worker into separate contributions, and to measure employment elasticity of growth. Employment elasticity provides a signal for the ability of AGCC economies to ‘collectively’ and ‘individually’ absorb the forthcoming labour force growth and facilitate intraAGCC national labour movement. Moreover, increasing total factor productivity (TFP) will possibly lower total labour costs, thereby giving all AGCC economies the same advantage of devaluation. This advantage can be considered as ‘internal devaluation’, without inflationary pressures. This ‘internal devaluation’ can possibly further facilitate intra-AGCC national labour movement by creating more job opportunities and replacing exchange-rate adjustment as an alternative mechanism to mitigate external shocks. TFP can also be considered from the

40

Intra-AGCC national labour mobility

point of view of total labour cost and hence can replace socially undesirable nominal wage cuts as an alternative mechanism to exchange-rate adjustment. Growth-accounting, originally suggested by Robert Solow (1957), was used by the IMF (2003b) during 1980–2000 and by Jennifer and Nabil (2002) between 1980 and 1990 in the MENA region. Growth-accounting uses the aggregate production function to estimate the contribution of aggregate output stemming from increases in factor inputs and TFP. In basic growth-accounting, growth in output per worker can originate from growth in the capital stock per worker or from growth in TFP, which includes, among other things, labour utilization and schooling quality (Jennifer and Nabil, 2002, p. 11). Jennifer and Nabil (2002) showed that the TFP growth in the region (as well as in AGCC states) had improved during the 1980s and the 1990s, but due to a large decline in accumulation of physical capital the improvement in factor allocation and efficiency have not been translated into significant improvement of GDP growth rates. Moreover, TFP declined sharply in the 1960s, 1970s and 1980s, from 2.4 to –1.4 and to –1.3, respectively, but improved to reach zero during the 1990s (Jennifer and Nabil, 2002, p. 13). The IMF (2003b) concluded that the benefits of high education attainment were offset by a steady and substantial decline in TFP, as average output/worker decreased by 0.2% during the period 1980–2000 (IMF, 2003b, p. 77). Jennifer and Nabil (2002), on the other hand, concluded that the changes in TFP during the 1980s and 1990s in the KSA and Kuwait were positive and in the order of 3.77 and 2.17 respectively, while in Oman the decline was in the order of –3.08. For AGCC states the result is mixed. The IMF study (IMF, 2003b) identified that in all AGCC states in which data were available (Kuwait, KSA and UAE) TFP during 1980–2000 declined by 3.5, 1.6 and –0.5 respectively. AGCC results showed that output/worker fell, while human capital improved steadily, but this was more than offset by a sharp decline in physical capital per worker and TFP (see Table 2.1). Although TFP in AGCC states increased between 1980 and 1990, during the decade after 1990, it showed a sharp decline. It is clear from the two estimates that the rate of change of TFP during the decade 1990–2000 was negative. This result led the IMF to conclude that GDP growth had fallen short of absorbing the growing labour force (IMF, 2003b, p. 77). Jennifer and Nabil speculated that the failure to improve the labour market outcome of AGCC states is related to the failure to raise the employment-creation capacity of growth (the employment elasticity of growth) or to lower economic growth itself (Jennifer and Nabil, 2002, p. 18). In Table 2.2, we calculate the employment elasticity in AGCC states. Apparently, at the first glance, the elasticity of employment with respect to growth in AGCC states, with no exception, indicates that AGCC states’ growth has a reasonable employment capacity.8 The relatively high employment elasticity compared to international standards is likely to be consistent with expansion in employment of good-quality and high-wage-earning nationals, rather than lowskilled and lower-wage earners. Although most of the new jobs have been primarily created in lower-skill and lower-wage sectors in the non-oil economy (Fasano and Goyal, 2004, p. 11), the national labour force (who are the subject

9.11 (4.10) 5.69 na 1.29

Notes a Jennifer and Nabil, 2002, p. 17. b IMF, 2003b, p. 78. c Average for 10 MENA countries. — Negligible. na, Not available.

Kuwait Oman KSA UAE MENA (Avg.)c

Total factor productivity (TFP)

7.64 (3.33) 5.2 na (1.26)

6.47 0.52 (0.27) na 0.45

2.17 (0.08) 3.77 na 1.52

(2.1) na (3.1) (1.9) (0.2)

0.8 na (1.5) (1.4) (0.1)

Physical capital/ worker

0.6 na — — 0.6

Human capital/ worker

Output/ worker

Human capital/ worker

Output/ worker

Physical capital/ worker

Average annual rate of change (1980–2000)b

Average annual rate of change (1980–1990) a

Table 2.1 Growth account in AGCC states, 1980–1990 and 1980–2000

(3.5) na (1.6) (0.5) (0.7)

Total factor productivity (TFP)

79 235 138 29 35 na 103

84 244 147 31 37 na 109

6.3 3.8 6.5 6.9 5.7 na 5.8

4.8 1.1 9.3 7.2 1.3 na 4.3

4 0.9 12.4 8.5 2.7 na 5.7

Non-oil output growth rate, 2000–2001 (%) 1.31 3.5 0.7 0.96 4.38 na 0.77

Employment elasticity of real output growth, 2000–2001 1.6 4.2 0.5 0.8 2.1 na 1.84

1b 0.5b 0.5b na 1b 1b Range: 0.5(1)b

Notes a Jennifer and Nabil, 2002, p. 7. b Fasano and Goyal, 2002, p. 14; 1997–2000 period average. Fasano and Goyal measured employment elasticity by taking the ratio of growth in employment to growth in non-oil output, p. 11. na, Not available.

Range: 0.70–1.1a

0.70a (1987–1994) 1.10a (1992–1997) 1.10a (1991–1997) na na

Employment Other estimates of employment elasticity of elasticity non-oil output growth, 2000–2001

Sources: Own calculation from data obtained from IMF, 2003b, pp. 1980–1981; Gulf Investment Corporation, 2004.

Bahrain Kuwait Oman Qatar KSA UAE Average

National National Employment Real output labour, labour, growth (%) growth rate, 2000 2001 2000–2001 (%)

Table 2.2 Employment elasticity of output growth in AGCC states, 2000–2001, and other estimates of employment elasticity

Intra-AGCC national labour mobility 43 matter of the national employment elasticity measured here) are more likely to work in administrative and skilled jobs. Moreover, despite the discrepancy between AGCC states, the average AGCC employment elasticity does not seem to be out of line during the early 2000s (0.77) compared with the 1990s (0.7–1.1), as measured by other estimates in Table 2.2. It is worth comparing employment elasticity defined as growth in employment in response to total output growth and employment elasticity defined as growth in employment in response to non-oil output growth, as shown in Table 2.2. The average of the latter (1.84) is higher than the average of the former (0.77), a good sign of a relatively high capacity of the non-oil sectors to generate job opportunities.9 This result has an implication for intra-AGCC national labour employment, as job seekers, the AGCC nationals across the AGCC states, are most likely to find jobs in the private sector. Here a thought-provoking question arises: Can this employment creation capacity of economic growth be sustained in the future? Can it cope with the growing number of graduates and other AGCC national job seekers? The average national labour force growth of 5.8% in 2000–2001, as can be seen from Table 2.3, is too high to be maintained in the future. The evidence is that up to 2000 the largest AGCC employment-creating economies (UAE and KSA) were creating 130,000 and 100,000 jobs a year on average respectively (Fasano and Goyal, 2004, p. 10), while the annual labour growth rate of 5.8% indicates the need to create around 272,600 jobs for AGCC nationals per year (based on estimates of a national employment figure of 4.7 million mentioned in section 3). As mentioned in section 3 the present average national unemployment is 6% of the total expatriate labour force and the number of job seekers will further increase in the coming years. In fact, Table 2.3 indicates that the expected average annual employment growth up to 2015 of 3.1% (coinciding with the annual average rate of growth of population during the same period), is far below the expected rapid growth of national job seekers, estimated to be 4–5% annually over the medium Table 2.3 AGCC average annual growth rates of labour force and population (%)

Bahrain Kuwait Oman Qatar KSA UAE Average MENA

Average annual rate of growth of labour force

Average annual rate of growth of population

2001

2015

2015

6.3 6.6 7.6 5.8 3.5 4.8 5.8 na

na 4.2 2.8 na 3.5 2 3.1 3.1

na 3.1 2.9 na 3.9 2.4 3.1 na

Source: World Bank, 1999, pp. 51–52, table 2. Note na, Not available.

44

Intra-AGCC national labour mobility

term (Fasano and Goyal, 2004, p. 3). The point to mention here is that the average annual growth rate of the labour force of 3.1% for all AGCC economies during the period up to 2015 requires a high average output growth of 4.0% to maintain the same level of moderate, inadequate and sluggish average employment elasticity of 0.77.10 Given that the growth of AGCC economies is highly dependent on fluctuating oil and gas revenues, which account for over 40% of GDP, it is unlikely that this growth rate will be maintained over a medium- to long-term period. Overall, the average as well as individual states’ employment elasticities of growth in the AGCC are not high enough to create the needed AGCC job opportunities at a time when the projected increase in AGCC nationals will continue to be strong in the future. A large proportion of the AGCC national labour force are below 30 years of age. Given the continued efforts in education and female participation, AGCC labour force growth will be even higher in the near future. The UN projection foresees a gradual decline in the average relative share of people under 15 years of age in the AGCC population. It follows that the share of the labour force in total population will increase and so will the supply of nationals searching for jobs (UN, 1992; World Bank, 1995). Given this situation, it is not easy for AGCC growth to keep pace with labour requirements. Moreover, from some basic facts gathered, the problem of job creation for nationals in the AGCC states seems amazing. The total number of new national job seekers in all AGCC states exceeds 210,000 annually, while the number of expatriates with intermediate and secondary-level education is about one-third of total expatriates. Given the total estimated number of expatriates of 7.5 million, Girgis (2000) concluded that around 2.1 million jobs requiring intermediate and secondary levels of education (equivalent to the general skill levels of the new entrants) could be held by AGCC nationals. This could provide jobs to AGCC nationals at these educational levels for around 10 years. The question arises why the AGCC labour market cannot provide employment opportunities to those secondary and intermediate-level education groups. One possible reason could be related to labour market segmentation and rigidity. 4.2

Labour market segmentation and rigidity

In all AGCC states, while employment in the public sector is saturated, and governments are no longer able to act as first and last resort employers, the privatesector jobs are not capable of filling the employment gap. This could be partly attributed to the rigidity of the labour markets. According to the IMF (2003a), the correlation between unemployment and labour market rigidity is evident worldwide. Pierre-Richard Agénor (2004) argued that MENA countries exhibit rigidities in educational systems, wage setting and regulatory regimes due to the dominance of the public sector in labour markets. Because of such factors and although rates of human capital accumulation have remained steady, he argued that MENA countries have reaped less than their potential in terms of economic growth and job creation. Hence the dominance of structural unemployment demands a closer look at labour market institutional flexibility/rigidity. This was also emphasized

Intra-AGCC national labour mobility 45 by the IMF when it stated that the structural explanation of AGCC unemployment requires, among other things, an investigation of labour market institutional structure, including flexibility/rigidity of labour markets and wages, flexibility/rigidity of labour movement, labour relations and availability of information (IMF, 2003b). In the context of free movement of labour among AGCC states, this analysis is, indeed, crucial as removals of market barriers are fundamental to enhancing intra-AGCC national labour employment. In the following, we will review different outcomes of AGCC labour market rigidity in an attempt to arrive at some conclusions. Studies of the AGCC labour market refer to rigidity factors such as the high level of public employment and wage-related benefits as well as low participation rates of women in AGCC states11 in labour market flexibility and growth performance (see, for example, IMF, 2003b, pp. 73–75). Indeed, the AGCC’s high oil revenue has been used to finance wage-related benefits (subsidies and transfers) and high public employment, thus hampering labour market flexibility (IMF, 2003b, p. 73). While the civil service and private-sector pay scales have not changed for quite a long period of time, the labour market is characterized by wage rigidity. Moreover, public-sector wages are higher than the private-sector ones, and governments are not taking steps to align the former with the latter. As a result, AGCC nationals are discouraged from seeking employment in the private sector. Segmented wage markets between men and women in favour of the former also distort the AGCC wage structure. Although statistical data on pay scales are not readily available, it is believed that male/female wage differentials are quite large in many cases. The AGCC wage structure is also segmented between nationals and expatriates who are doing the same jobs. Apart from skills and sector of employment, the AGCC labour markets are wage-segmented. Workers with similar qualifications receive different wages depending on whether they are nationals or expatriates. The basic indicator of labour market rigidity in the region – the correlation between academic background and income earned – is identified by the United Nations Economic and Social Commission for Western Asia (ESCWA, 2002, p. 37). The income gap between secondary school and university graduates is not significant and not sharply different from that between secondary school graduates and below. In Oman, for example, our calculation of the difference between publicsector average gross income/month of men educated to secondary and primary level (or less) in 1996 is 127 Rial Oman (RO), whereas the difference between secondary and university level gross income is 239 RO. For female gross incomes the differences are 144 RO and 197 RO respectively (MONE, 1996). This means that the percentage difference in male gross income/month between secondary and primary levels (or less) is 50.4%, while the percentage difference between university and secondary levels is only 60.1%. The result is reversed in the case of females. The rate of change of income/month between secondary and primary or less (80.9%) is higher than the rate of change of income/month between university and secondary levels (61.2%). Related to this issue is the outstanding characteristic of higher education in AGCC states, which is social science domination. In 1999, 60% of AGCC university graduates were education, arts, Islamic and social

46 Intra-AGCC national labour mobility studies. Engineering graduates were only 14.4% and science graduates were only 10.3% of the total graduates (ESCWA, 2002, p. 60). More or less similar results are given in the UN Arab Human Development Report (UN, 2002). The report estimated that 38% of AGCC university graduates were in social and Islamic studies, 34% in education, 11% in business studies and only 18% studied technical subjects. This social science domination of university education (not unrelated to the role of governments as major employers of graduates) obliged graduates to accept jobs at still lower wages in the private sector, which might constitute one major reason for the lower income gaps between secondary and university levels. This means that the high school is not a step from which higher education is rewarding. The study by the UN ESCWA refers to the structural rigidity of the labour markets in AGCC states arising out of difficulties of replacing expatriates, labour markets regulations, high wage expectations by nationals, high social and economic costs of empolying expatriates, concentration of nationals in the public sector and high demand for public-sector employment as a result of education, demographic factors and the increasing share of female employment (ESCWA, 2002, p. 55). The AGCC share of nationals working in the public sector is more than 70% of total employment of nationals, compared to developing countries, wherein it is about 15%, and almost half of that in industrial countries (ESCWA, 2002, p. 31).12 The wage, skills and sector of employment segmentation characterizing the AGCC labour market constitutes an implicit guarantee to nationals that they will be employed in the public-sector (Fasano and Goyal, 2004, p. 7). This public-sector flexibility explained the ability of labour market to withstand shocks up to the mid-1980s. Nevertheless, recently it has led to distortions and reduction of competitive capabilities and inefficiency, as public-sector employment is becoming restricted. The World Bank (2001) chose two major employment regulation indicators as part of its assessment of conducting business all over the world: (1) The Rigidity of Employment Index (REI) (average of three indicators: Difficulty of Hiring Index (DHI); Rigidity of Hours Index (RHI) – night work, number of working days, overtime and so on; and Difficulty of Firing Index (DFI)) and (2) The Cost of Firing Index (CFI) (the cost of advance notice requirements and penalties expressed in terms of weekly wages). Each index assigns values between 0 and 100, with higher values representing more rigid regulations (World Bank, 2005). Table 2.4 shows the outcome of the two indices in AGCC states in comparison with other regions. Table 2.4 Employment indicators in AGCC states and other groups of countries

Rigidity of Employment Index (REI) Cost of Firing Index (CFI) Source: World Bank, 2005.

AGCC

MENA

OECD

Europe and Central Asia

Sub-Saharan Africa

25.3

38.7

34.4

41

42

57.5

73.3

40.4

42

50

Intra-AGCC national labour mobility 47 The overall REI for AGCC states is 25.3, compared with the regional average of 38.7, Organization for Economic Co-operation and Development (OECD) average of 34.4, Europe and Central Asia average of 41, and Sub-Saharan Africa average of 42. Moreover, the CFI of AGCC states is 57.5, compared to the regional average of 73.3, OECD average of 40.4, Europe and Central Asian average of 42 and Sub-Saharan average of 50. Although not depicted in Table 2.4, there are some variations among the AGCC states in both indicators. For example, the REI in Oman is 35, UAE 33, Kuwait 20 and KSA 13. The CFI in Oman is only 13, while in UAE it is 96, in KSA 79 and 42 in Kuwait. The AGCC states are better than other groups in terms of REI, even in comparison with the OECD. Moreover, the differences in REI between AGCC states and other groups are not major. On the other hand, the CFI is greater in AGCC states than in OECD states, but less than in other MENA countries, which indicates the rigidity of regulations preventing the firing of workers without proper compensation. We also observe that the AGCC labour market, despite being fragmented, has some flexibility due to the high share of the expatriate labour force working in the private sector, as the number of expatriates can be adjusted in response to shocks. Nevertheless, the dominance of the public sector in all AGCC economies hinders flexibility of labour markets, and the ongoing nationalization process is most likely to reduce the flexibility of the labour market, because a national domination of the labour force will increase wage rigidity and job protection. In their attempt to evaluate whether the rigidity of the labour market matters for the success of economic reforms, Forteza and Rama (2001) combined an average of four pairs of labour market rigidity indicators13 over the period 1970–1999 (or less in the case of data unavailability) in a single indicator by taking a simple arithmetic average for 93 countries to capture aggregate labour market rigidity in practice. Only in two AGCC states for which data are available was the market evaluated (Bahrain and Kuwait). The aggregate rigidity indicators (ranging from 0 to 1) are (0.30) and (0.27) respectively, and the labour market rigidity ranked medium (49 and 35 out of 93).14 The AGCC individual country estimates of labour market rigidity are more or less equivalent to the average of the MENA region of (0.32) and the world average of (0.32), while they are better than East Europe (0.49), and slightly better than industrialized countries (0.39). A group of other countries (South Asia, 0.27 and Sub-Saharan Africa, 0.23) are, nevertheless, performing better. Forteza and Rama (2001) in their analysis concluded that the size of government employment and the strength of labour unions are most likely to be the major factors that cause deeper recession before adjustment and weaker recoveries (or continued recessions) afterwards, and so employment generation will tend to be disappointing. Perhaps the size of government employment factor is likely to be the major factor in AGCC states that needs to be looked at if we seek to improve labour market flexibility. Likewise, the IMF diagnosis of growth performance of oil-exporting countries of the MENA region – especially the AGCC oil exporters – revealed a significant decline in the real per capita GDP during the 1980s, and a very slow growth during

48

Intra-AGCC national labour mobility

the 1990s. This growth performance, the IMF argued, is not fast enough to absorb the growing increase in the labour force and reduce the level of unemployment (IMF, 2003b, p. 66). Likewise, Pierre-Richard Agénor et al. concluded that following the oil bust in the late 1980s, the MENA region experienced a weak recovery in the 1990s due to the delays of policy reforms. Therefore, rigidity of unemployment, caused by structural factors that were not addressed by policy makers in the past decade, has now been highlighted (Agénor et al., 2004, p. 2). Recapitulating, we can conclude that there is some evidence that AGCC states are ranked somewhere in the middle of all estimates of labour market rigidity. As a result of multiple factors, AGCC states show evidence of some rigidity in their labour markets that has interfered with the efficient functioning of the labour market. Rigidity of AGCC labour markets stems from different factors. Among these factors are the lack of correlation between academic background and wage levels, gender-based and national/expatriate wage differentials, high wage expectations by nationals, rigidities of firing without proper compensation, the rigidity of wage setting and regulatory regimes, the dominance of the public sector and employment guarantees for nationals in labour markets, and the high cost of employing expatriates. The labour market in the AGCC is divided between nationals and expatriates. The high share of the expatriate labour force adds a great deal to its flexibility in the short run, as the number of expatriates can be adjusted in response to shocks. Therefore, labour adjustment in response to short-run shocks in the AGCC states following the MU, achieved by replacing the expatriate labour force, would reduce not only market segmentation between nationals and expatriates but also AGCC labour market flexibility as well. The public and private sectors also vary in flexibility. While nationals form the bulk of the public-sector employees, expatriates are mainly employed in the private sector. Moreover, dominance of the public sector in all AGCC economies hinders the flexibility of labour movement. 4.3

Labour market policies

The AGCC states follow more or less similar labour market policies, as they all face similar labour market conditions and constraints (nationalization of the labour force and human resource development (HRD)). Policy instruments to nationalize the workforce in all AGCC states have relied heavily on restrictive administrative and mandatory measures such as stricter work permits for the employment of expatriates, unemployment compensation, restriction of job transfer, residential permits to families of highly paid expatriates, sponsorship permits, public-sector nationalization, private-sector expatriate quotas, bans on hiring expatriates in selected sectors, tightening immigration legislation and levying/increasing fee/taxes for employing expatiate workers (see, for example, ERF, 2000, p. 120; UNDP/AFESD, 2002, p. 92 and Fasano and Goyal, 2004, p. 17). Moreover, some market-based measures are used (reduction of implicit subsidies on low-price and long-term lower-cost loans, enhanced benefits, education and training programmes in line with the private-sector requirements). The number of measures used, reflecting national labour mobility, is limited. Amongst these measures are

Intra-AGCC national labour mobility 49 removing legislative mobility barriers for nationals and supporting job search and information dissemination. Apart from individual states’ labour market regulations and policies, AGCC states have set out joint labour market policies manifested in the Unified Economic Agreement of 1981 and the Economic Agreement of 2002 (AGCC Secretariat General, 1981, 2002). The 1981 Unified Economic Agreement between AGCC states, for example, stipulated similar AGCC market regulations that guarantee equal treatment of movement, work, residence and inheritance (AGCC Secretariat General, 1981). Moreover, the AGCC Economic Agreement of 2002 re-emphasized the same principles of national treatment of AGCC nationals in movement, residence and employment in both private and public sectors. It also stressed removal of barriers that hinder the mobility of the national labour force between AGCC states, and considered AGCC nationals in any AGCC state as part of the nationalization target in that state.15 The citizens of AGCC states have been permitted to pursue their professions in any member state without discrimination and distinction. In technical co-operation, the agreement also called for all AGCC states to co-ordinate their manpower policies to achieve HRD and full and optimal employment of human resources. It also called for the formulation of uniform and standard criteria and classifications for the various categories of occupations (AGCC Secretariat General, 2002). In its 14th Summit Meeting in Riyadh in December 1993, the Supreme Council established that each state must extend equal treatment to AGCC nationals working in the private sector regarding their rights and responsibility in accordance with legal labour rules and measures prevailing in each state. The equal treatment does not include benefits related to nationality such as provision of land or building loans or marriage subsidies. In 1995 the AGCC Supreme Council issued a statute to facilitate free movement of national employees among the member states. More measures were emphasized in the 18th Supreme Council summit in Kuwait in December 1997, including priorities in employment of AGCC nationals (subsequent to each state’s nationals) in the private and public sectors, as well as tying employment of a certain ratio of state nationals or AGCC nationals to company tenders or to any long-term commitment of both local and foreign companies with AGCC governments. Moreover, other measures approved include benefits to private-sector enterprises conditional on training and employment of nationals as well as AGCC nationals, and concentration of orientation campaigns on the benefits of free movement and employment of AGCC nationals between AGCC states. The Supreme Council summit in Bahrain, December 2000, decided to extend equal treatment to the AGCC nationals working in the public sector in member states (AGCC Secretariat General, 2004, web: http://www.gcc-sg.org/ yearlydec2k4.html). In August 2004, the AGCC states announced measures to increase the employment and movement of their nationals among member states, including plans to ease travel restrictions for the large expatriate workforce currently living in the AGCC states. Bahrain and Saudi Arabia have now agreed to ease border restrictions and have approved regulations. Saudi Arabia is considering approving the use of civil ID cards to replace passports for Gulf nationals entering

50 Intra-AGCC national labour mobility the country. Moreover, the Consultative Authority of the AGCC Council, established in 1997, studied ways and means to ensure employment and easy movement of national labour among AGCC states in 2003. It ought to be noted here that, so far, these policies have had very little effect on intra-AGCC labour movement, as we are going to see in section 4.4. Although intra-AGCC labour movement is restricted, the signs appear to be good now. A step in the right direction is now coming from the Supreme Council, in its 25th ‘Zayed Summit’ in December 2004 (Ibrahim Badr El Din, 2005b, p. 19). The Council reviewed the recommendations and follow-up reports forwarded by the Ministerial Council (council of AGCC foreign ministers) and approved recommendations to ensure insurance protection for the AGCC citizens who work in other AGCC states by January 2006. The final outcome of the 25th ‘Zayed Summit’ stated that: towards achieving the objectives of integration between AGCC states and facilitating the movement of the national labour force between AGCC states, in particular the social security of AGCC nationals in other AGCC states through a comprehensive and a suitable system for social insurance and civil service retirement in each AGCC state covering AGCC nationals the same way as it covers its own nationals, the Supreme Council decided to extend the umbrella of insurance protection to those AGCC nationals working in other AGCC states in both the private and the public sectors through the civil retirement and insurance systems as from first of January 2005, optionally, and from the first of January 2006 obligatorily. Moreover, the final statement set up the next stage, which includes: the study of a suitable mechanism to achieve equality in respect of service civil retirement and social insurance in a more comprehensive way through a unified system that guarantee the whole AGCC workforce in both the private and public sectors in any member state the benefits of retirement and social insurance, i.e. the same as the national labour force. This system is expected to be completed by early 2010 to coincide with the unification of the currency. (Own translation from AGCC Secretariat General, 2005; web: www.gcc-sg.org/aldowra25.html, emphasis added) This final statement, as well as the outcomes of both the Unified Economic Agreement of 1981 and the Economic Agreement of 2002 regarding treatment of AGCC nationals in employment in both the private and public sectors, in addition to the AGCC employment-supporting outcomes of the Supreme Council summits, supports our hypothesis that joint AGCC legislation is not a hindrance to labour movement among AGCC states. Moreover, the statement of the final outcome shows that the Supreme Council is fully responsive to the macroeconomic benefits of removing restrictions on labour mobility among AGCC states, as the programme of facilitation of labour movement among AGCC states matches with the deadline to issue the Gulf single currency.

Intra-AGCC national labour mobility 51 4.4

Unemployment and intra-AGCC national employment

The AGCC states are characterized by high population growth rates averaging 4–5% per year in the last decade. The Arab Human Development Report (UNDP, 2002) has estimated a rapid growth rate of population, to reach 44 million by 2020. The net result is a very young population, as more than one-third of the population is below 15 years of age (Fasano and Goyal, 2004, p. 3). The economies of AGCC states rely heavily on an expatriate labour force, chiefly as they are highly skilled and qualified. The number of nationals in the total population differs widely in AGCC states (24% in Kuwait, 26% in UAE, 38% in Qatar, 60% in Bahrain and over 70% in Oman and Saudi Arabia) while the average is around 70% (UNDP, 2002). The share of the national population in the workforce is lower. Figures for the number of unemployed nationals are not readily available. The UN (2002) estimated unemployment in the AGCC states to be 17.2% in Oman, 15.0% in Saudi Arabia, 7.1% in Kuwait, 5.1% in Qatar, 3.1% in Bahrain, 2.6% in UAE.16 The unemployment of AGCC nationals poses a real challenge. AGCC states are not an exceptional case prior to the introduction of the single currency. The IMF (1999) argued that the high structural unemployment in the euro area and the high regional concentrations of unemployment within these countries strongly suggested that ‘labour market flexibility in the area is not currently up to the requirement’. Likewise, the IMF added that the low geographical mobility of the labour force among and within member countries reduced the likely role of migration as a labour market adjustment mechanism. Labour market regulations, language and cultural barriers and high transaction costs in the housing market contribute to low labour mobility in the euro area. This, according to the IMF, implies a risk that symmetric shocks will entail prolonged depressed employment in the countries or the regions most affected (IMF, 1999, p. 96). The question with which we are concerned here is: To what extent have AGCC states contributed to securing jobs for AGCC job seekers in both the private and public sectors via labour movement among these states? We now turn our attention to this core issue. To our knowledge, there are no regular, complete, up-to-date and reliable published data on intra-AGCC labour mobility from either AGCC states or international organizations. The reason could be that it is a small number compared to the number of expatriates or the national workforce in each state or that the data available may not serve any major labour market objective, or even that the cost of collection may be higher than the value that could be generated from these data. Nevertheless, because AGCC states are now planning to extend social insurance and civil service retirement schemes, the AGCC public social insurance authorities have now started collecting information about nationals working in all AGCC states. The relevant national legislation in this regard and the mechanism of registration, premiums and public insurance pensions in all AGCC states are now under way. And since 1 January 2006, an agreement is in place, signed by the AGCC member states, that AGCC nationals working in the public

52

Intra-AGCC national labour mobility

sector in other AGCC states are allowed to join an AGCC country’s pension fund and social insurance. This allows AGCC nationals to work for the governments and private sectors of other member countries and still contribute to their pensions back home. The scattered and meagre statistics reveal some weaknesses in the employment structure for AGCC nationals in AGCC states. In the UAE, for example, there are only 648 public (central and federal) companies and private-sector institutions employing AGCC nationals (Al-Khaleej Daily Newspaper, 25 May 2005, p. 9). For the sake of analysis if we assume that each institution employs 10 AGCC nationals on average, the total employment of AGCC nationals will be only 6,480. Given that the total number of UAE employees is more than 2.5 million, the share of AGCC nationals is only 0.3% of total estimated UAE employment. The AGCC nationals in Qatar surveyed in 2006 numbered 852. Out of which 556 were Omanis, 144 Bahrainis, 98 Saudis, 44 from Emirates and only 10 Kuwaitis (Al-Khaleej Daily Newspaper, 2 February 2006, p. 23). According to the statistics of one official in 1997, there are about 3,500 Bahrainis working in the UAE. This is equivalent to only 0.2% of the total labour force in the UAE in 1997 (estimated to be 1,595,000), and only 3% of the Bahraini labour force (estimated to 115,000 in 1997). In its attempt to extend social insurance and the civil service retirement scheme to AGCC nationals working in the Sultanate of Oman, the public authority of social insurance had also circulated notices to enumerate AGCC nationals working in both the private and public sectors. According to the data received from Oman’s public authority of social insurance, so far only 4 AGCC nationals working in the private sector have registered from Bahrain, Kuwait and UAE (2 in IT, and one each in sales and administration). One major characteristic of intra-AGCC national labour mobility is that it does not constitute a major component of employment in AGCC states compared to expatriates. The disappointing, weak intra-AGCC labour movement is not at all the result of legislation, as there are joint market policies set to encourage labour movement amongst states (see section 4.3). Moreover, while national labour mobility is freely permitted, in practice it is not significant. We discern many reasons for this. One reason is that most of the AGCC unemployed nationals have education levels below the international or AGCC average, and so job mobility cannot be assured. The family and social links at home forbid some AGCC nationals to move for better job opportunities within the AGCC states. In this regard family groups in close proximity, such as the Al Ain/Buraimi conurbation, which is on both sides of the UAE/Oman border, may give rise to some labour mobility across national boundaries. Moreover, some AGCC citizens lack either incentives or enthusiasm to seek job opportunities in another AGCC state. Some AGCC nationals think seriously about losing certain benefits and incentives at home when they move abroad (such as social insurance, free land and lower-interest, long-repayment-period housing loans and so on). Another major characteristic of intra-AGCC national labour mobility is the observable differences between AGCC states. National labour movement between Oman, the UAE and Qatar; Bahrain and Saudi Arabia; Bahrain and the UAE; and Kuwait and Saudi Arabia is

Intra-AGCC national labour mobility 53 relatively sizeable, whereas between Oman, Kuwait and Saudi Arabia; Qatar and Saudi Arabia; and Bahrain and Qatar it is meagre. It is worth mentioning that there are some intra-AGCC employment experiences that deserve attention. Bahrain established two AGCC employment units in the Ministry of Civil Services and the Ministry of Labour and Social Affairs to secure employment opportunities for Bahrainis seeking jobs in the AGCC states. Moreover, the Ministry of Manpower of the Sultanate of Oman established a labour office in Qatar, as a body to organize recruitment of Omanis in Qatar. A memorandum of understanding was signed in January 2003 between the Ministry of Manpower of Oman and the Ministry of Civil Services Affairs and Housing of Qatar establishing a joint labour office in Doha. The office is meant to provide employment opportunities for Omanis by receiving details of available employment opportunities from Qatari companies and public institutions and by seeking information about job vacancies in Qatar that can be filled by Omanis (MOMP, 2005a). The characteristics of the Omani labour force employed in Qatar can be seen from Table 2.5. According to our analysis of figures obtained from the Ministry of Manpower (MOMP, 2005a), up to January 2005, 3,507 Omanis were registered, 1,655 were nominated, 1,004 were employed (91% are males) and only 49 had resigned. About 29% of the registered were employed and about 91% of those employed were men. Employed women numbered 89 (equivalent to 8.9%), whereas registered women numbered 460 (i.e. 13.1% of the total). Nominated women numbered 82 (equivalent to 4.4% of the total). These figures indicate male dominance due to social and mobility reasons. Moreover, about 46% of the total registered Omanis seeking jobs in Qatar are in the age group 23–27 years. Almost 75% of the employed have qualifications less than secondary level, 16% have secondary qualifications, and only 8.7% have qualifications higher than a high diploma. Moreover, job satisfaction is considered to be high, especially in the military, oil and financial sectors. The percentage of those who have resigned out of those employed is only 4.9% (mainly for low wages or lack of housing). The financial rewards for technicians and specialists (in health, oil and finance) are excellent. The Omani case study can be considered as a pilot project towards establishing a full-fledged intra-AGCC systematic employment system. This experience, although limited in scale, acts as a centre for labour market information in Qatar, by giving out available employment information to Omanis and equipping them with it. It is also a sign of successful co-operation in labour market employment and information among AGCC states. The successes of this experience are directly reflected in the limited number of resignations of those employed in Qatar, a relatively higher ratio of employed candidates to the number nominated for jobs and the success of lower-level qualification holders in acquiring jobs outside their home country. Chances for higher-level qualified AGCC nationals are brighter as they can find jobs at the AGCC level if such an experience is extended to include all other AGCC states. To summarize, the meagre available statistics (given insignificant differences between AGCC states) clearly indicate that intra-AGCC national labour mobility

57.30 21.90 20.80

3,507 87 13 63.50 24.00 12.50

1,655 95.60 4.40

Nominated (N)

75.30 16.00 8.70

1,004 91 9

Employed (E) 49

Resigned (RS) 47.20%

N/R

60.60%

E/N

Note a 61.5% of the registered labour force stated that low wages are the reason for resignation, while 38.5% maintained that housing is the reason.

Source: Ministry of Manpower (MOMP), 2005c, Sultanate of Oman.

Academic qualifications Less than secondary (%) Secondary (%) Higher than high diploma (%)

Total Male (%) Female (%)

Registered (R)

Table 2.5 Omani labour force in Qatar – major characteristics

28.60%

E/R

4.9%a

RS/R

Intra-AGCC national labour mobility 55 so far constitutes only a tiny fraction of employment, despite the encouraging government legislations. The low educational standards of most AGCC nationals, lack of enthusiasm and serious concern regarding forgoing benefits in their home state coupled with strong social and family links at home might be the major outstanding barriers to intra-AGCC labour movement. Nevertheless, the established Oman/Qatar joint labour office is not without visible signs of success in both labour market employment and information. Similar offices for higher-level qualified AGCC nationals can achieve further successes.

5

Conclusion and policy recommendations

This section investigates national labour mobility among the AGCC states, and examines its importance in the context of the forthcoming GMU. In the case of an economic shock and after the formation of an MU a country affected by the shock may not need to use the exchange rate as a corrective tool if (among other factors) labour can freely move between member states’ labour markets. The key message is that job creation via intra-AGCC national labour mobility, despite the fact that it may not provide the required solution to nationalization in the AGCC states, must not be viewed in isolation, but rather in conjunction with the upcoming single currency. The opening up of AGCC labour markets is, simply, a prerequisite for labour market flexibility and, in turn, the Gulf single currency. Perhaps the establishment of a common currency will help to advance the economic integration process, especially with regard to forcing member states to eliminate any barriers that limit labour flexibility and freedom. Although AGCC labour market flexibility and national labour mobility at present seem very limited and somewhat mixed, they can probably be enhanced through the following set of recommendations: 1

2

AGCC states first need to establish a kind of a central data assembly and data exchange centre within the Council of Labour Ministers to build a solid and comprehensive database of all AGCC nationals working in other AGCC states. These data must be integrated with the published AGCC labour market statistics. Moreover, issuing a weekly AGCC employment bulletin meant only for AGCC nationals will also be a step in the direction of assembling AGCC labour market data and will enable the usage of excess AGCC national labour in case of a labour shortage in other AGCC states. At present the lack of data prevents any concrete and meaningful quantitative analysis of intra-AGCC labour market issues, and also hinders employment generation at the wider AGCC level. Therefore, AGCC states need effective job search assistance programmes to help the job searching of nationals at both national and regional levels. We recommend the establishment of a joint AGCC job search support and information website as one way to shorten periods for national labour searching for jobs at the AGCC level. AGCC states require policies and measures to increase and arouse interest among AGCC national workers to seek jobs in other AGCC states. One such

56

3

4

Intra-AGCC national labour mobility measure is maintaining a uniform standard in job health and safety legislation. In this context, it is not recommended to introduce a uniform minimum wage as AGCC states differ in their levels of productivity and costs of living. Moreover, AGCC states would enhance labour mobility by removing barriers via ‘comprehensive’, ‘unified’ and ‘just’ social insurance and social benefits systems. The effort to extend the umbrella of insurance protection to those AGCC nationals working in other AGCC states (in both the private and the public sectors) by early 2006 through the civil service retirement and insurance systems was a step in the right direction. Supporting job search and information dissemination is a prerequisite to help as well as to encourage AGCC nationals to seek employment opportunities at the regional level. Additional measures to be undertaken include adoption of legal rules of stay and employment, creation of more transparent labour markets, improvement of knowledge and visibility of the right to free movement, including the right to social, economic and cultural involvement of the workers in the recipient states, the feasibility of AGCC nationals being employed in the public sector of each state, developing innovative and joint AGCC employment projects to absorb AGCC unemployed nationals and publishing a joint social insurance and social benefits booklet. We do not perceive any need to impose a ratio of employment of AGCC nationals in large companies dealing in oil and gas, insurance, telecommunications, investment and finance, which is a measure now applicable to nationals in almost all AGCC states. These types of measures preclude the uncontrolled working of labour market flexibility and freedom. Finally, the AGCC labour market recruitment mechanism is weak, especially the segmentation and unavailability of supply and demand information. Analysis here shows that the negative TFP as well as the moderate employment elasticity of growth indicates that output growth has fallen short of absorbing the growing AGCC labour force. The failure to improve the outcome of the AGCC labour market, in particular, is largely related to the failure to increase the employment-creation capacity of growth (the employment elasticity of growth). Given this situation, it is not easy for AGCC economic growth to keep pace with labour requirements. This is so even though the elasticity of employment with respect to growth in AGCC states (with no exception and despite the discrepancy) indicates that AGCC states’ economic growth has a reasonable employment capacity, especially after the year 2000. Therefore, further strengthening of employment elasticity of economic growth to absorb the forthcoming job seekers at both national and regional levels is required. Moreover, enhancing TFP will generate more employment opportunities and will possibly lower total labour costs; hence it gives the same advantage as devaluation (which cannot be undertaken after the formation of the Union), without creating inflationary pressures. The Gulf MU is likely to affect not only national and regional labour market policies but also the structure of AGCC labour markets, following

Intra-AGCC national labour mobility 57

5

6

7

the diversification of the economies currently under way. To fill AGCC employment gaps, education and training should be geared towards AGCC labour market needs, apart from national market needs; that is, AGCC states are required to review their HRD programmes and policies in accordance with the wider AGCC labour market requirements. This recommendation arises because the diversification and privatization drive in AGCC states may lead to possible future changes in the economic structures of AGCC economies. So the type of demand for labour may require different specialization and training programmes. Diversification efforts among the AGCC states do differ. For example, diversification efforts in banking, tourism and transport in Bahrain are ongoing, while efforts have been made in the spheres of tourism, petrochemicals, construction, trade, finance, telecommunication and transport in the UAE. Oman is moving into gas-related industries and tourism, while Saudi Arabia is into petrochemicals, manufacturing, minerals, power, infrastructure, industry and services. Qatar is focusing on natural gas, IT and finance. Institutional reforms must be adopted in each national labour market to ensure more elasticity and dynamism and to reduce market segmentation. In particular, analysis in this chapter points to the need to correlate academic background and wage levels, reduce wage differentials (mainly gender wage differentials), relax wage regulatory regimes, reduce the cost of employing expatriates and relax regulations on hiring and firing workers in the private sector. Enhancing intra-AGCC private-sector employment also requires retrenchment of public-sector employment. This, in turn, provides a false signal to national labour seeking higher education just to secure jobs in the public sector at the cost of these workers being unemployed or, if employed, characterized by lower productivity, as education is social-science-oriented. The analysis here indicates that the weak intra-AGCC national labour movement is unlikely to be caused by lack of joint AGCC legislation regarding the labour market but – among other major factors – by the lack of measures to put this legislation into practice. As we have seen, the issue of facilitating intra-AGCC labour mobility is almost a fixed subject on the agenda of AGCC institutions and policy outcomes, including the outcomes of the Supreme Council summits. As a result, enlarging intra-AGCC employment of AGCC nationals and greeting the new era of AGCC economic co-operation require that policies agreed upon by the AGCC Supreme Council since 1981 are activated, and due consideration be given by AGCC job seekers to the large AGCC labour market. Apart from policies recommended in (2) above, AGCC states are required to establish AGCC employment-facilitating public-sector units within their Ministries of Labour or their counterparts and must seek suitable additional educational specializations not only in line with national labour markets, but also in line with the regional labour market. Finally, to enhance intra-AGCC employment, AGCC states are required to find an answer to unattractive questions such as priorities of application

58

Intra-AGCC national labour mobility of approved policies of AGCC national employment within each state, their corresponding binding legislative policies, application obstacles and costs of application that might be incurred, and the degree of coverage of employment of AGCC nationals among AGCC states that they would like to achieve. AGCC states are also required to avoid thinking that this specific indispensable goal is not economically valuable or cannot be achieved.

3

1

Some aspects of liquidity of Islamic banks in two AGCC states

Introduction

In the international scene, there is greater focus on financial stability. Various research organizations and financial institutions like the IMF, Basel Committee, European Bank and Asian Development Bank as well as researchers have compiled and attempted to measure indicators for financial soundness (see, for example, Chai and Barry, 2000; Dziobek et al., 2000 and Evans et al., 2000). In this regard, research has been conducted substantially to identify and measure them. The advent of Islamic financing institutions almost four decades ago has resulted in the appearance of new and different financial arrangements. These elements and the changes brought about in the financial and regulatory framework could affect liquidity. Hence more research work is essential to understand and analyse the vulnerability thereby caused in the financial sector. This chapter covers some aspects of liquidity of some ISBs in two AGCC states (Qatar and UAE). The entire analysis and related issues are divided into eight sections. Following this introduction, section 2 reviews liquidity-related features of ISBs and also some theoretical arguments related to liquidity risk. Section 3 provides analysis of research problems and methodology. The macroeconomic performance in the two countries that might affect the health of the ISBs is enumerated in section 4. The salient features of the structure of ISBs in the UAE and Qatar are provided in section 5. This section also investigates some qualitative (institutional and regulatory) frameworks and measures governing the financial systems in the countries selected. Banking regulations and their supervision along with monetary policy have been highlighted in the next section. In section 7 the study will then go on to analyse liquidity-related issues of selected ISBs in the MENA region. Section 7 calculates some relevant indicators derived from data of individual banks’ balance sheets in selected countries and banks in the AGCC states over the period 1990–2002. Conclusions and policy recommendations are provided in section 8.

2 2.1

ISBs: fundamental liquidity-related features Introduction

This section is a review of the fundamental features of liquidity of ISBs. Theoretical arguments related to liquidity risks are under the purview of this section.

60

Liquidity of Islamic banks in two states

ISBs are mainly characterized by the prohibition of interest and any receipt of fixed (or predetermined) rewards. Their system is based on profit and loss sharing (PLS) arrangements in which the rate of return is not predetermined but depends on the actual profit accrued from the investment operations. Moreover, on the investment side, ISBs operate through a variety of modes of finance; the most common among them are PLS modes (Musharaka, Mudaraba, Muzaraa and Musaqat) and sales-based modes (mainly Murabaha, Ijara, Salam and Istisna)17 (see, for example, Iqbal and Mirakhor, 1987; Ibrahim Badr El Din, 2004b). 2.2

ISBs: deposits

ISBs are differentiated from CBs on the contracts and liability side of the balance sheet. On this side of the balance sheet of an ISB, there are three classes of accounts for deposits. Current account deposits, similar to demand deposits, are guaranteed in terms of capital value. For current account deposits the bank provides safe custody, amanat (or safekeeping), cheques and other services such as drawing money on demand. Demand deposits are not entitled to any of the bank’s profit; the bank uses demand deposits at its own risk, but it keeps a legal reserve at the central bank. Savings deposits can be withdrawn on demand. Some savings deposits may share profits on the basis of a minimum balance maintained during a specific period of time, and the provisions of maintaining legal reserves are sometimes applied to savings deposits. An investment deposit is based on an unrestricted Mudaraba contract between the depositor and the bank, in which the bank is authorized to use the deposit for any investment project not prohibited by Islamic principles. An investment deposit is not guaranteed in terms of capital value, and does not yield a fixed rate of return. Instead, profit or loss from the bank’s operations is distributed according to negotiated proportions. Profits are distributed at maturity or sometimes advances are paid to depositors at regular intervals and adjustments are made at maturity. Legal reserves are not kept against investment deposits since the bank cannot guarantee them. Sometimes special purpose investment deposits, which operate on restricted Mudaraba (on specific investment operation), are managed by the bank. Profits and losses are distributed according to the agreed formula. Before embarking on the liquidity-related literature on ISBs, we elaborate on deposits and the structure of ISBs’ financial statements to the extent that they are likely to have a relationship with the potential liquidity risk. Table 3.1 gives more details about the differences in the types of deposits between a typical ISB and a conventional bank. 2.3

ISBs: the structure of financial statements

The differences between ISBs and CBs are much more than the differences in the types and nature of deposits. The differences in both the assets and liability sides of

Liquidity of Islamic banks in two states 61 Table 3.1 Islamic and conventional types of deposits Characteristics

ISBs

CBs

Profit and loss principle is applied

Yes, equity-like contract between the bank and the shareholder who share in profit and loss

No

Yes (except in the event of insolvency), pure debts contract with no returns Yes No Some saving deposits share some returns. All other deposits do not share in the bank’s profit Yes

Yes

Nominal value guarantee of a. Demand deposits b. Saving deposits c. Investment deposits Return on deposits Linking the rate of return of deposits to bank’s profit Share in the bank’s profit and loss Mandated specific reserve requirement on demand and investment deposits How returns on deposits are generated

Equity-based system where capital is at risk Depositors’ influence in the bank investment decision Banks’ pooling of deposits’ fund to provide depositors with professional investment management Ability to reduce capital value of investment deposits in the case of a loss

Yes, according to ratios stipulated in the contract Not available Depends on the bank’s performance and profit from investment Yes

Yes Yes Certain and guaranteed for all deposits No No Yes Irrespective of the bank’s performance and profit from investment No

No, since the relationship is regulated according to restricted Mudaraba Yes

No No

Yes

No

Source: Modified and augmented from Erricro and Farahbaksh, 1998, p. 10.

the balance sheets of the two sets of banks can give a wider view about differences between ISBs and CBs. These differences have some bearings on ISBs’ liquidity. Table 3.2 summarizes the assets and liability components of a financial statement of a typical ISB and a CB. Although there are differences in the operations of CBs and ISBs, the financial statements exhibit similarities in many aspects. The following two sub-sections identify the similarities and differences of the assets and liability sides of both types of banks.

62

Liquidity of Islamic banks in two states

Table 3.2 Financial statements of ISBs and CBs Assets

Liabilities

Description

CB

ISB

1. Current cash balances Cash Balances with the central bank Balances with banks

x x x

x x x

x x

na na

2. Portfolio of securities Government bonds Loans, advances and discounted commercial papers Investment in securities Real estate investment Repaid amount (expenses) and other assets Financing and investment activities

x na x

na x x

na

x

Description

CB ISB

1. Shareholders equity Shareholders equity Paid-up capital Legal reserve Regular reserve General reserve Undistributed profits

x x x x x x

x x x x x x

2. Liabilities Call (current) deposits Time deposits Saving deposits Mudaraba Balances due to banks

x x x na x

x na x x x

Source: Zuair, Mohammed, 2002. Note na, Not available.

2.3.1 1 2

3 4 5

6 7

Cash or reserves are common in the two sets of banking, and so are balances with the central bank. In both cases reserves are part of deposits, but the concept of deposits is different, as ISBs have to obtain permission of the depositors to use these funds for financial investment. Moreover, deposits are guaranteed, but not the return on them. Both types of banks engage in exchanges in the form of cheques, money transfers and export documents. ISBs’ credit balances with CBs (positive or negative balances) do not carry interest (balances are kept to the minimum and usually covered before maturity). Investment items which do not appear in the ISBs’ financial statements: government bond, discounted treasury bill, bonds and (sometimes) companies’ shares. ISBs dealings with shares should conform to the Shariaa’ (form of profit and loss arrangements and activities of the companies should be halal). Financing and investment activities in ISBs are different from CBs (includes Musharaka, Murabaha and Mudarabah modes). Items such as fixed assets, overhead capital and depreciation are valued/ calculated the same way in both types of banks.

2.3.2 1 2

Assets

Liabilities

The CBs’ deposits carry a contractual agreement different from the ISBs. The deposits of CBs carry interest, whereas ISBs’ deposits are liable for profit or loss (return on deposit is related to profit and the volume of deposits).

Liquidity of Islamic banks in two states 63 3 4 5

Investment deposits in ISBs are invested by the bank and share profit or loss. Investment deposits in ISBs can be for a specific investment operation or they may be open. Savings deposits in ISBs exhibit the same conditions but withdrawal is made according to different sets of conditions.

To generalize, ISBs lack government bonds, loans, advances or discounted commercial papers on the assets side, and in the liability side time deposits with notification are not characteristics of ISBs. Moreover, balances with the central bank should conform to Shariaa’ rules. Other assets and liability items are the same. It is noteworthy that these changes from standard norms may have repercussions on ISBs’ liquidity as we will investigate in this study. The following section elaborates on risks and liquidity risk of ISBs and the role of the central bank. 2.4

Risks facing ISBs

The available literature on the subject of ISBs discusses various kinds of risks faced by islamic financial institutions (see, for example, Chapra, 2001, p. 16; Fiennes and Plowden, 2001, pp. 3, 4–5). They all agree that ISBs need good management practice, as this process is not confined only to CBs. Dissatisfaction with the way ISBs have managed their risks let Fiennes and Plowden, for example, point out that operating, credit and regulatory risks of ISBs ‘have frequently been ill understood and worse managed’ (Fiennes and Plowden, 2001, p. 3). The major risks identified by the ISB literature are 1 2

3 4 5

6 7

operational risk (the breakdown of internal controls and corporate governance); credit risk (the possibility of defaults arising from the lack of complete agreement on the liability of Murabaha contracts – that is, the risk of ISBs’ ownership of the assets being financed); foreign exchange risk (a loss due to exchange-rate fluctuations); market risk (arises from a change in commodity prices, in the mark-up price of deferred sales and lease-based transactions); risk arising from non-standardized nature of some ISBs’ products (Ijara – in some Islamic rules – is not allowed to be ended with ownership. Moreover, some financial instruments could not be used simultaneously as risk management instruments); Fiqh-related risks (e.g. Murabaha contract, which according to fiqh rules is not binding on the buyer); liquidity risk (arises from a decline of the bank’s cash flow or inability to raise resources).

Most of these risks are common to all types of banking systems. The risk characteristics of ISBs are slightly different from those of CBs. However, Llewellyn (2001) has shown that ISBs have solvency risk merits compared to CBs because of the presence of investment deposits on the liability side of their balance sheet. Investment deposits are not required to guarantee their nominal values, and the

64

Liquidity of Islamic banks in two states

quasi-equity nature of investment deposits implies that some deposits share in the risk of the bank. This is in addition to the PLS arrangements (Musharaka and Mudaraba) on the asset side. Llewellyn (2001, p. 16) argued that in this system ‘The problem [in CBs] of having money-uncertain assets being funded by moneycertain liability has been avoided [by ISBs]. This amounts to a pure ISB being less susceptible to insolvency risk.’ Moreover, most ISBs attract demand deposits with no returns and favour the Murabaha mode of finance that, unlike the Musharaka mode of finance, shifts most of the risk to clients. On the other side, Al-Harran (1993, p. 155) argued that ISBs do not charge interest on delays in due payments, as the Shariaa’ rules do not permit a penalty on defaulters.18 This may cause a liquidity risk element to ISBs. 2.4.1

Liquidity risk in ISBs

Liquidity risk is the major risk that influences the ability of the banking system to resist shocks, and the importance of liquidity for sound banking practice is beyond doubt. Although ISBs are prone to all kinds of risks, they, according to their nature, are mostly exposed to the last three types of risks mentioned in the previous section (i.e. non-standard nature of ISBs’ products, fiqh-related risk and liquidity risk). In this context, although it is potentially a risk factor, liquidity risk (unlike other kinds of risks) is not high on the agenda of the studies of ISBs. Some studies which have tackled many challenges facing ISBs in Muslim countries do not identify liquidity as a present or future constraint (see, for example, Khan, 2000; Al-Hamoud, 2002). Other groups of studies identified some theoretical reasons for potential liquidity problems in ISBs. We, however, think that liquidity risk is an important aspect of risk facing ISBs which deserves further investigation. The liquidity risk is created by the mismatch of deposits and financing tenures, which generates either an idle cash position19 or a shortage of cash position. Although the former needs only find new profitable and Shariaa’-compatible investment avenues, the latter requires some sort of balance sheet arrangements to raise funds or bridge the gap between assets and liabilities. Many factors are identified in the literature as causing liquidity risk: the lack of confidence in the bank (or the banking system as a whole) due to malpractice or mismanagement; concentration of investment in a specific sector, investment project or country; reliance on a few large depositors; the use of short-term deposits in long-term investment or the mismatch of assets and liabilities (Al-Sadah, 2001, pp. 4–5). This study is mainly concerned with the last factor, the mismatch of assets and liability. There are two types of liquidity: liquidity of assets and liabilities, which refers to the ability to sell assets at current market prices, and the liquidity instability of liability (LIL), which refers to the inability to access sufficient funds to meet payment obligations in a timely manner (instability of deposit base over a long period of time). LIL is the degree to which the bank is not able to meet its payment obligations to depositors when deposits are declining or fluctuating for reasons related to the change in the structure of assets and liabilities of ISBs away from

Liquidity of Islamic banks in two states 65 the normal practice of the conventional banking system. LIL needs to be distinguished from the ‘funding volatility’ concept, which refers to ‘the likelihood that bank depositors or creditors will, in the short period of time, withdraw their funds (or fail to roll them over at maturity) in response to a perceived weakness in the individual bank or banking system’ (Dziobek et al., 2000). Studies dealing with liquidity of ISBs make some observations about shortages of long-term funds in ISBs and consider these as signs of future liquidity risk (e.g. Ibrahim Badr El Din, 1992; Al-Harran, 1997). The liquidity risk of ISBs, which mainly takes the form of a mismatch between assets and liabilities, is, however, partly due to the shortage on long-term funds. There are some references in the literature on ISBs which point to the shortage of long-term deposits in ISBs, but without rigorous analysis. More than 10 years ago Ibrahim Badr El Din (1992), for example, noted that during the period 1988–1992 Faisal Islamic Bank of Sudan (FIB) had shortages of medium- and long-term funds. He concluded that the introduction of FIB has not improved the deposit situation in the Sudanese banking system at the time. A shortage in deposits of ISBs has also been noted by Al-Harran (1993). Al-Harran, although arguing in favour of ISBs’ methods to mitigate risks to depositors through direct and indirect control over the behaviour of entrepreneurs (via contracts and a reward–punishment system of refusal of further credit or blacklisting the name), concluded that ‘if they [the ISBs] do not devise tools of raising deposits, then these banks are likely to face problems in their growth particularly when they are working side by side with the modern banks’ (Al-Harran, 1993, pp. 107–109). Some of the studies noted some theoretical rationale behind the likelihood of liquidity risk and/or warned against the potential liquidity risk in the future (e.g. Khan, 1999, 2000; Fiennes and Plowden, 2001). Some other studies criticized the tendency of most ISBs to utilize risky demand deposits to finance investment, as capital and reserves cannot cover all depositors’ losses in case of a bankruptcy. They argued that demand deposits need to be fully safeguarded, as they do not get any returns to deposits. They disapprove the use of demand deposits which are kept as amanat at the time when their capital and reserves cannot cover the deposits. They suggest either restricting the use of demand deposits to no more than capital and reserves, or accepting unlimited liability for demand deposits (e.g. Chapra, 2001, p. 11). Moreover, the tendency to use investment deposits in investable projects and to participate in the risk involved is also seen as a potential source of liquidity problems (see Chapra, 2001, p. 10). Khan (1999, 2001) did not rule out liquidity risk in the ISBs in the future because of the following reasons: 1 2 3 4 5

Most of the ISBs rely largely on current accounts, which are withdrawn on demand. There is a restriction on ISBs’ sales of debt, which must be held until the maturity date. ISBs are not able to raise funds quickly from the market. There is a lack of an Islamic inter-bank money market. The lender of last resort (LLR) facility is not available, except on the basis of interest.

66

Liquidity of Islamic banks in two states

Other authors who have raised the issue of fragile liquidity management in ISBs include Yousef (2001), who identified four liquidity management challenges facing ISBs as follows: 1 2 3

4

The lack of a proper and conducive jurisdiction that recognizes Islamic banking’s nature and the critical need for effective management of liquidity. The central banks’ regulatory support in a mixed banking system20 that creates asset rigidities in ISBs. The liquidity challenge, which comes within the ISBs themselves, being related to the lack of risk management tools and expertise as a result of poor product innovation, and research and development (R&D). The limited liquidity management tools and inactive secondary market; ISBs depend on debt-based tools, which cannot be transformed into negotiable financial instruments, except at par value.

Fiennes and Plowden (2001), summarized the sources of ISBs’ potential liquidity risk as follows: 1 2

3 4

ISBs’ funds come from customers’ accounts, the vast majority of which are on call or very short notice. The conventional means of risk combating are not in compliance with Shariaa’ laws, and there is no central receiver and provider of liquidity to and from the Islamic banking market. Therefore, ISBs need to match their shortterm customers’ deposits with short-term low-risk assets. Many of the ISBs’ assets have come from Murabaha markets because they offer attractively priced funding. The ISBs’ debts are (largely) not tradable.

Despite these theoretically likely reasons for liquidity problems in ISBs, many scholars argue that this issue is not a serious one at the moment. Khan, for example, explained that despite significant deficiencies in the existing infrastructure of ISBs to manage liquidity, liquidity risk at present is low because of ‘the excess liquidity syndrome that these banks face as a result of the non-availability of adequate Shariaa’-compatible investment opportunities’ (Khan, 2000). Chapra (2001), also relates what he calls ‘the good liquidity of ISBs’ to the concentration of these banks on self-liquidating, predetermined returns, short-term Murabaha financing’. Others (Khan, 2000; Llewellyn, 2001) relate the non-existence of liquidity syndrome to the demand deposits, which resemble interest-free loans and do not share profit, and to the use of Salam and Murabaha modes, which shift most of the risk to clients.21 Nevertheless, there are serious concerns among scholars regarding liquidity to generate funds from other banks (inter-bank market) due to the non-payment of interest. The Bahrain Monetary Agency, the central bank of Bahrain, has been at the forefront of developing Islamic financial instruments and products and is the first central bank to issue Islamic bonds.22 Financial institutions holding Ijara Sukuk

Liquidity of Islamic banks in two states 67 will be able to engage in contracts involving sales and repurchase of Sukuk. The Sukuk market is still primarily a market in which holders keep bonds to maturity, and there is little secondary-market trading. Scholars argued that to diversify their reduced activities, ISBs should raise capital through the issuance of Shariaa’-friendly bonds and find other ways of lending. At the moment liquidity is still inadequate, but such new tools (if made on a large scale) could help in solving the problem of liquidity affecting ISBs by providing banks with greater flexibility in meeting unforeseen liquidity requirements. Nevertheless, times have changed. The need to enhance liquidity, and hence to move towards greater securitization of assets, should be recognized by ISBs. Another serious problem is related to the liquidity management system of ISBs. Khan describes the absence of liquidity risk in ISBs at the present time as a ‘doubleedged weapon’. He argues that, even though this absence of liquidity risk protects the bank from liquidity crises at present, it has also led to the lack of development of formal liquidity management instruments. In sum, although the topic is raised in the literature, studies have only mentioned and identified types of liquidity risk faced by ISBs and commented on (and warned against) its likely occurrence. No rigorous analysis of liquidity risk has been made so far. Moreover, liquidity risk has not been at the top of the agenda of Islamic banking research to date because it has not been apparent so far. This absence of concern about potential liquidity risk can be considered as one common major limitation of these studies. As a result, it is argued that even after almost three decades since the establishment of most of the ISBs in the MENA region, a potential liquidity crisis cannot be ruled out and has not been researched yet. Many factors identified here might cause this crisis, including the change in the structure of equity and liability from one based on interest to one based on a share in profit. A comprehensive study of ISBs in the MENA region will reveal whether a liquidity crisis is likely. 2.5

Liquidity risk and the central bank role in an Islamic framework

Many scholars have raised the issue of ISBs’ deposits required by central banks. Such deposits, which pay interest, are not in line with Shariaa’ requirements, and hence ISBs are in a disadvantaged position vis-à-vis commercial banks, which earn interest from those deposits. Likewise the function of the central bank as a LLR in a mixed banking system cannot help ISBs, as these banks do not accept borrowing with interest. ISBs are also not able to participate in open-market operations because of the interest-based nature of securities (see Al-Harran, 1993, p. 146). Scholars have argued that problems of liquidity shortage or surplus in a mixed banking system23 would have to be handled differently in ISBs, since the ban on interest rules out resort to the money market and the central bank. Chapra (2001) suggested alternatives such as reciprocal accommodation among banks without interest payments and creation of a common fund at the central bank into which surpluses would flow and from which shortages could be met without any interest charges.

68

Liquidity of Islamic banks in two states

Others have suggested a financial assistance provision by the central bank through Mudaraba deposits with the ISB, or opening a current account at the central bank with occasional drawing facilities free of charge, or lowering (or abolishing)24 liquidity requirements on deposits (see, for example, Sarker, 2002). The discussion of central banking in an Islamic context and its role to provide liquidity in the face of a shortage is somewhat meagre, presumably because Islamic central banking is viewed as too farfetched an idea, except in Iran, Pakistan and Sudan, where the banking systems are fully Islamized. Nevertheless, some literature discusses the question of central banking in an Islamic framework. The general opinion seems to be that the basic functions of a modern central bank are relevant also for an Islamic monetary system, although the mechanisms may have to be different. Thus, for example, the bank-rate instrument cannot be used as it entails interest. Uzair (1982) has suggested adjustments in profit-sharing ratios as a substitute for bank-rate manipulations by the central bank. Thus, credit can be tightened by reducing the share accruing to business and eased by increasing it. Siddiqi (1982) has suggested that variations in the so-called refinance ratio (which refers to the central bank refinancing of a part of the interest-free loans provided by the commercial banks) would influence the quantum of short-term credit extended. Siddiqi has also proposed a prescribed ‘lending ratio’ (i.e. the proportion of demand deposits that commercial banks are obliged to lend out as interest-free loans) that can be adjusted by the central bank according to changing circumstances. In this context, reference may also be made to a proposal by Uzair (1982) that the central bank should acquire an equity stake in commercial banking by holding a certain percentage of the capital stock of the commercial banks. The rationale behind this proposal was that it would give the central bank access to a permanent source of income so that it could effectively act as LLR. Although no separate regulations of ISBs by central banks were adopted in most cases, in some other cases preferential provisions were granted when ISBs were operating side by side with CBs. In Bangladesh, for example, ISBs have been allowed to maintain the liquidity requirement at a lower percentage to total liabilities compared with CBs. Therefore, they are allowed to hold more liquid funds. Moreover, ISBs were also allowed to fix their profit-sharing ratios and mark-ups independently (Sarker, 2002). Nevertheless, there is no separate department to control and guide ISBs, and staffs of the Central Bank of Bangladesh are not familiar with the technicalities and operational methodologies of ISBs. Moreover, inspection and supervision of ISBs’ operations are conducted as per the general guidelines framed for CBs. It may be noted that the Islamic system of banking, which shares risk and returns, exposes depositors to risk which they might not be exposed to under the conventional banking system, especially when there is a high share of demand deposits, which get no returns. Deposits should not be exposed to any kind of risk if ISBs have to comply with liquidity standards. ISBs do not receive interest on compulsory reserves which they have to keep at the central banks. Moreover, the interest charged by traditional banks to their customers and the profit taken by ISBs from their partners are not usually treated equally. While the former is considered a deductible cost, the latter is not. These reasons alone are enough to justify a separate and different

Liquidity of Islamic banks in two states 69 set of rules and regulations for ISBs’ supervision by central banks in a mixed banking system. It is argued that the variable that should be regulated in the monetary policy of an Islamic setting is the stock of money rather than the interest rate (Al-Harran, 1993, p. 127), and that the central bank monetary policy should be geared towards generation of the growth of the money supply, which is adequate to finance growth in output over the medium and long term within a framework of stable prices and other socio-economic goals of Islam.

3 3.1

Research problem and methodology Statement of the problem

The vital question to be raised is how the CBs’ financial statements, including resource mobilization, have been affected by the replacement of interest-based transactions by profit-margin-based transactions. ISBs’ concept of equity capital and demand deposits have not changed compared to CBs. The term deposits are removed and replaced by a pool of funds and investment accounts which carry profit margin rather than interest rate. It might be argued that following the change in the structure of the bank, ISBs mainly use low-cost demand deposits (interest free with some fixed administrative costs) to finance investment and therefore tend to be more profitable,25 and hence are expanding rapidly. Demand deposits have high rates of turnover and if they are used for long-duration projects/activities, the possibility of a liquidity crisis cannot be ruled out. In short the high turnover of deposits coupled with problems of deposit mobilization poses a threat to the growth of ISBs. In sum, the hypothesis is that the change in the structure of assets and liabilities from interest-based to profitshare-based and the high turnover of deposits will cause a liquidity crisis in the future, and ISBs can improve their liquidity position by changing the structure of equity and liabilities. Moreover, the macroeconomic environment and the central banks’ regulatory conditions and policies influence the mobilization of deposits. 3.2

Research methodology

This chapter will use macroeconomic and banking data to analyse the economic set-up and banking regulations and policies and their likely effects on liquidity in selected banks of the MENA countries. The financial statements of selected ISBs will be analysed over the period 1990–2002 in three MENA countries. Moreover, the study will use primary and secondary data, published materials, reports and financial statements of the selected banks. The analysis will be made through statistical and accounting analytical methods such as ratio analysis. Methods of assessing liquidity can be identified here: 1 2

The ‘sources and uses of funds’ approach measures a liquidity gap between the sources and uses of funds; when the uses exceed sources, a deficit occurs. The ‘structure of funds’ approach is directed at the structure of the sources and uses of funds. Here the forecast of liquidity is made by dividing bank

70 Liquidity of Islamic banks in two states

3

deposits and other sources of funds into categories according to their probability of being withdrawn. The concern is the maturity of the assets portfolio and the maturity match of assets and liabilities. A common measure of potential LIL is the ratio of liquid assets to short-term liabilities, or loans to assets, or even loans to deposits (excluding inter-bank deposits).

Dziobek et al. (2000) refer to two models to assess liquidity, namely the cash-flow model and the balance-sheet model. The cash-flow model allows for dynamic analysis of liquidity, whereas the balance-sheet model is static. However, in the absence of sufficient data, it becomes necessary to use the balance-sheet model, in which data are published annually. One weakness of the available balance-sheet data is their focus on the values of the assets and liabilities rather than liquidity. That is why it is sometimes difficult to classify instruments as liquid or illiquid. In this chapter, and subject to the availability of data, the analysis of liquidity will be undertaken through the calculation of some ratios from financial statements and also through analysis of some published material related to the banking system. The methods are: 1 2 3 4 5

6

distribution of liquid assets or near-liquid assets to meet liabilities on due dates, and distribution of investment assets to gain adequate returns; the matching of maturity of assets to maturity of liabilities; the realization of investment into liquid assets on maturity (i.e. prompt repayment of finance; minimization of doubtful and bad debts); ratios: for example, equity capital/total assets; term deposits and borrowings/ total assets; call borrowings and deposits/total assets; analysis of the maturity profile of deposits and the way these funds are deployed on a time-to-time base, subject to the availability of data from banks; analysis of the factors that can affect liquidity of ISBs (dependence on current accounts, restriction on ISBs’ sales of debt, current use of LLR facility and so on).

The choice of banks is made from two countries of the AGCC region. Two banks are selected from the UAE: Abu Dhabi Islamic Bank (ADIB) and Dubai Islamic Bank (DIB), and one bank from Qatar: Qatar Islamic Bank (QIB).

4 4.1

Macroeconomic performance Introduction

Economic conditions and other bank-regulatory conditions and policies prevailing in the country can influence the mobilization of deposits. That is why any

Liquidity of Islamic banks in two states 71 assessment of the financial soundness of ISBs must be based on a comprehensive set of indicators, taking into account the overall structure and economic situations of the country and the financial sector regulatory arrangements. The safety of banks and the absence of liquidity risk are related to not only the macroeconomic set-up but also the micro-management of banks under the umbrella of sound and efficient banking regulations and supervision. It is proposed to study the macroeconomic variables and relate them to the growth in deposits. Macroeconomic sources of financial fragility and vulnerability can come from instability of inflation, monetary aggregates, current account balance (current account deficit to GDP), external debt, fiscal performance, exchange rate and credit boom. A large external current account deficit, for example, is a signal of vulnerability to a currency crisis, with a negative implication for the liquidity of the financial system. Lower or declining aggregate economic growth and sectoral slumps can have an immediate impact on export performance, deterioration in terms of trade, assets and liabilities portfolios and profit margins. Moreover, the banking sources of financial fragility can be caused by deficient supervision and regulation, weak supervisory capabilities of the central banks, inadequate instruments of monetary control, incompatible trends in loans and deposits, and the degree of competition of the banking system. These factors will be dealt with in section 6.

4.2

The UAE

Overall the economic performance of the UAE appears to be good. Being highly liberal, business-friendly and market-oriented, it is resilient to oil price fluctuations and external shocks. Since the contribution of the oil sector to GDP is about 20%, the economy depends on the non-oil sector to achieve growth rates. Compared to other countries of the AGCC, the inflation rate upto 2002 is stagnant but relatively higher in the UAE. The difference between real and nominal GDP is almost zero. The balance of trade is favourable and is steadily improving as imports are increasing at a lesser rate than exports. The increased rate in exports is attributed to the increase in re-export and oil export. Investment has a slightly fluctuating ratio to GDP. The current account balance has shifted from a negative balance in 1998 to a positive balance throughout the years after that. The fiscal balance registered a continuous deficit during the period 1998–2002, as a result of increased government spending, especially current expenditure on subsidies on agriculture, water and electricity. Except for the budget balance, the output growth rates, inflation, investment and balance of payments showed more or less stable behaviour. The UAE’s open market-oriented economy and sound management of the economy have sustained robust economic growth, low inflation and a comfortable external position, despite oil price fluctuations (IMF, 2003c, p. 3). The following table of macroeconomic indicators, Table 3.3, exemplifies this.

2 3.6725/US$ 27.7 131.62 45.4 119.2 12.42 6.42

2 3.6725/US$ 30.1

114.11

34.6 112.1 2.01 4.09

37.5

33.6

43,761 72,009 28,248

192,894

na

42,713 71,469 28,756

190,455 26

173,147 20

1999

Note na, Not available.

Sources: Central Bank of UAE, Annual Reports, different issues; IMF, 2003c.

Nominal GDP Oil sector (mining and quarries %) Real GDP (1995 prices) CPI Exchange rate Investment/ GDP (%) Exports and re-exports Oil exports Imports Trade balance Current account balance Total revenue Total expenditure Surplus (deficit) budget External debt/ GDP (%)

1998

26.0

74,386 84,066 9,680

79.46 128.57 54.44 50.5

183.02

1.4 3.6725/US$ 26.8

214,327

214,327 24

2000

Table 3.3 Macroeconomic indicators – UAE, 1998–2002 (million AEDs, unless otherwise indicated)

20.3

68,633 95,459 2,6826

65.2 136.96 42.16 36.54

179.12

2.2 3.6725/US$ 36.7

221,751

254,236 23.8

2001

na

57,209 86,374 29,165

62.24 143.73 38.41 31

191.57

2.9 3.6725/US$ 23.6

226,011

261,370 21.6

2002

Liquidity of Islamic banks in two states 73 4.3

Qatar

The overall economic performance of Qatar is good. The inflation rate up to 2002 is low; the balance of trade is favourable and is steadily improving as imports are increasing at a lesser rate than exports. The increase in total exports is attributed to the increase in non-oil exports. The investment to GDP ratio is rising. The current account balance has shifted from a negative balance in 1998 to a positive balance throughout the following years. The fiscal balance has registered a positive, but small, surplus since 1999 as a result of the increase in revenues against expenditure. The following table of macroeconomic indicators, Table 3.4, illustrates this performance.

4.4

Conclusion

The performance of the economies of the two countries is similar. On the one hand, these are strong economies with stable behaviour of fiscal performance, exchange rate, growth rates, inflation, balance of payments, exports, trade balance and so on. This stability might have an impact on assets and liabilities of the banking system, especially the mobilization of deposits. An external current account surplus is not a signal of vulnerability to currency crisis and cannot, in principle, have negative implications for the liquidity of the financial system. Table 3.4 Macroeconomic performance – Qatar, 1998–2002 (millions QRs, unless otherwise indicated)

Nominal GDP Oil sector (%) Real GDP CPI (base year 1988) Exchange rate Investment/GDP Exports Oil exports Imports Trade balance Current account balance Total revenue Total expenditure Surplus (deficit) budget External debt/GDP

1998

1999

2000

2001

37,330 34.9 — 134.1

44,397 44.9 — 137.0

64,646 60.4 — 139.3

62,341 58.7 61,480 141.3

— — 18,311 — 11,177 7,134 1,658

—

—

—

3.1 42,202 23,979 10,664 31,538 16,655

5 39,567 20,422 12,324 27,243 15,113

7 39,959 20,488 13,287 26,672 13,918

15,200 16,968 1,768

15,256 17,336 2,080

23,428 18,294 5,134

22,755 20,504 2,251

26,636a 22,516 4,120

—

—

—

—

—

4.4 26,258 14,612 8,196 18,062 7,903

2002 63,578 59 63,425 141.6 —

Sources: Central Bank of Qatar, Department of Economic Policies, Quarterly Statistical Bulletin, different issues. Note a Fiscal years.

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Liquidity of Islamic banks in two states

5

Banking structure and performance

5.1

Introduction

Prudential indicators comprise three sets of indicators: (1) macro prudential indicators of the health of the whole banking system, (2) micro prudential indicators of the health of individual financial institution and (3) the institutional and regulatory framework governing the financial system as a whole. In this section we focus on the first set. The next section will examine the institutional and regulatory framework, leaving indicators of the liquidity of individual ISBs to be scrutinized in section 7. 5.2

The UAE

The banking structure in the UAE is heterogeneous in nature. It has a large number of local and foreign players and enjoys a high level of government ownership and support, participation in large government-sponsored projects and a strong and stable macroeconomic environment. It comprised 21 banks in 2003 (and 340 branches), two ISBs, one specialized bank and 26 foreign banks, although no new foreign licenses have been granted since 1989 (Gulf Investment Corporation, 2004). The top ten local banks command around 71% market share of the assets. The foreign banks had only a 24% share in 2003. The banking sector in the UAE is strong, well-supervised and capitalized, fairly rated and has well-diversified assets, leading to a weighted average capital adequacy of 19% in 2003 (significantly above the international standard). It is proving profitable due to varied factors like high levels of government support, a strong and stable macroeconomic environment, participation in large government-sponsored projects in infrastructure, trade, finance and BOT projects, lower operating costs and widening margins between deposits and lending interest rates.26 The average rate of returns on equity (ROE) of 15% in 2003 also suggests that the UAE’s banking system is profitable (see Table 3.5). Islamic banks have been in the spotlight in the UAE recently. There are three ISBs currently in operation; two of them, DIB and ADIB, were established in 1975 and 1997 respectively. DIB and ADIB have 16 and 13 branches and estimated asset market shares of 7% and 3% respectively, deposit market shares of 8.4% and 2.6% respectively, and loan market shares of 6.9% and 3.3% respectively.27 The high level of growth of ISBs in the UAE over the last decade or so led commentators to anticipate a change in the banking landscape in the UAE, and a decline in the share of CBs (Gulf Investment Corporation, 2004, p. 13). The overall performance of the banking system in the UAE can be seen in Table 3.5. 1

2

The reasonably high growth of demand deposits volume (related in part to the high nominal GDP growth rate) and the growth of the ratio of total deposits to GDP signal confidence in the banking system of UAE. The high ratio of broad money currency to GDP (50–60%) reflects the size of the financial sector, strong financial liquidity and financial depth.

Liquidity of Islamic banks in two states 75 3 4

5

The high ratio of credit to GDP (over 70%) denotes a relative ease in providing funds. A high loans-to-deposit ratio (over 100%) indicates no risk taking when resources are extended, no pressure on the banking system, and a high level of liquidity to respond to shocks. This indicates the overall risk is low despite the banking system in the UAE operating in an emerging market with no optimal regulatory supervision. The high ratio of total assets to GDP and liquid assets to total assets reflects a strong financial base.

Table 3.5 Banking performance – UAE, 1998–2002

Public expenditure/ GDP GDP growth rate (%) Demand deposits (millions of AEDs) Total deposits/ GDP (%) M2 currency/ GDP (%) Credit/GDP (%) Non-performing loans/total loans Velocity (GDP/M2) Total assets/ GDP (%) Liquid assets/ total depositsb (%) Credit/total assets (%) Total deposits/ total liabilities (%) Loans-to-deposits ratio (%)

1998

1999

2000

2001

2002

45.45

39.05

28.3

32.89

35.42

1.8 10.0 12.5 18.6 2.8 (1997/1998) (1998/1999) (1999/2000) (2000/2001) (2001/2002) 21,530 22,343 30,357 153,674 170,046

54.3

54.8

64.3

60.5

65.1

57.1

57.8

66

61.6

66.4

78 na

77.3 na

72.4 na

64.3 na

73 na

1.8

1.7

1.5

1.6

1.5

135.8

131.8

129.3

117.9

127.5

21.3

33.5

26.4

27.5

19.6

57.5

58.6

56

54.5

57.3

40

41.6

49.7

51.3

46.4

127

125.2

112.7

106.3

77a

Sources: Calculated from figures obtained from the Central Bank of the UAE, Annual Reports, various issues; Gulf Investment Corporation, 2004. Notes a In 2003. b Liquid assets are defined to include cash and deposits with the central bank, and due from resident banks. na, Not available.

76

Liquidity of Islamic banks in two states

It is further noted that the performance of ISBs in the UAE is mixed. The average ROE and rate of returns on assets (ROA) of all banks are 15% and 1.9% respectively (annual average of 2000–2003). The average ROE and ROA for DIB are 12.6% and 0.95% respectively, while those for ADIB are 14.4% and 2.05% respectively. Both rates of returns are slightly lower than the national average. The loan-to-deposits ratio (a measure of risk) varies markedly among the UAE’s ISBs. The average loanto-deposit ratio of DIB over the period 2000–2003 is 60.9%, while the ADIB ratio is 97.0% (Gulf Investment Corporation, 2004, pp. 17, 19). This, compared with an overall loans-to-deposit ratio of 77% in 2003, shows that ISBs have somewhat high risk compared with the national average. Current non-performing loans as a percentage of loans for the UAE banking system are quite high, reaching a maximum of 18% in 2003, with the exception of ADIB, which reported non-performing loansto-gross loans of just 0.28 in 2003 (Gulf Investment Corporation, 2004, p. 10). 5.3

Qatar

Qatar has the same structure of banking as the UAE. The Qatari banking system comprises 15 commercial banks: seven branches of foreign banks, five domestic commercial banks, two ISBs and the government-owned Qatar Industrial development bank (QCB, 2002). Table 3.6 illustrates the performance of the Qatari banking system. Table 3.6 Banking performance – Qatar, 1998–2002

Public expenditure/GDP (millions of QR) GDP growth rate (%) Demand deposits (millions of QR) Total deposits/GDP (%) M2 currency/GDP (%) Credit/GDP (%) Non-performing loans/ GDP (%) Velocity (GDP/M2) (%) Inflation rate (%) Total assets/GDP (%) Liquid assets/total deposits (%) Loans/total assets (%) Total deposits/total liabilities (%) Loans-to-deposits ratio (%)

1998

1999

2000

2001

2002

—

—

—

31.8

31.8

9.2 2,717

18.9 2,465

45.6 2,776

3.6 3,479

2 4,368

75.55 62.51 76.61 na

69.39 58.52 64.29 na

56.22 44.48 43.18 na

68.2 46.12 54.56 na

71.99 50.56 56.57 na

1.6 2.9 113.84 —

1.7 2.2 107.33 26.5

2.3 1.7 77.72 29.5

2.2 1.4 91.97 23.4

2 0.24 98.53 60.9

— —

62 64.7

77.8 72.3

61.9 74.2

57.8 73.1

105.30

92.40

76.50

na

78.60

Sources: Central Bank of Qatar, Department of Economic Policies, Quarterly Statistical Bulletin, various issues. Note na, Not available.

Liquidity of Islamic banks in two states 77 1

2 3

4 5 6

5.4

An increase in demand deposits (except for the period 1998–2000, which showed some fluctuations) and the stagnation in deposit-to-GDP ratio signal stable confidence and do not give a sign of liquidity problems in the banking system in Qatar. The ratio of loans to deposits shows a decreasing pattern, but the average of 88.7% reflects a low risk. The relatively high ratio of broad money currency to GDP (average 52.4% over the period 1998–2002) reflects the relatively strong size of the financial sector, strong financial liquidity and financial depth. The high ratio of credit to GDP (average 59%) reflects a relative ease of providing funds. A relatively high loans-to-deposit ratio indicates no pressure on the banking system, and a high level of liquidity to respond to shocks. The high ratio of total assets to GDP and liquid assets to total assets reflects the strong financial base of the Qatari banking system. Conclusion

The banking systems in the UAE and Qatar are mixed and heterogeneous in nature. Banks in the UAE and Qatar are highly competitive, as they have a large number of local and foreign players. They enjoy a high level of government ownership and support, participate in large government-sponsorsed projects and take advantage of a strong and stable macroeconomic environment. The effect of the macroeconomic performance on banking performance is evident. The high growth of demand deposits, high credit/GDP and loan/GDP ratios signal absence of risk and confidence in the banking systems of the UAE and Qatar. Moreover, the assets/GDP ratio and money supply/GDP ratio reflect the strong size of the financial sector, strong financial liquidity and financial depth. Furthermore, the available information indicates that the performance of ISBs in the UAE is mixed.

6 6.1

Monetary policy, banking regulations and supervision Introduction

It may be argued that an assessment of financial development can be made through ratios such as the M2-to-GDP, loans-to-GDP and assets-to-GDP ratios. Nevertheless, these quantitative measures, taken individually, do not necessarily prove financial development in a broader sense. To ensure the better and efficient management and operations of financial institutions, proper regulations and supervision are considered essential and crucial. This will enable confidence to be instilled and ensure healthy liquidity indicators. Effective supervision and prudential regulations will have repercussions on risk, thereby affecting the liquidity of banks. Liquidity crises usually occur when the regulatory framework is inefficient or malfunctioning. The main objective of regulations (setting common minimum standards) is to sustain stability, maintain the soundness and safety of financial institutions and finally protect the consumer.

78

Liquidity of Islamic banks in two states

In this section we choose to review the monetary policies and banking regulations in two countries, namely, the UAE and Qatar. 6.2

The UAE

The main aim of credit and monetary policy in the UAE is to achieve economic policy objectives, including balanced economic growth and relatively stable prices, and maintain the stability of the real value of the national currency and its free convertibility into other currencies. Credit and monetary policy has sought to maintain adequate levels of domestic liquidity to provide the appropriate financing to economic activity, albeit taking into account strengthening the banking and the monetary system. UAE monetary and credit policy normally seeks to achieve its objectives by affecting the level of overall domestic liquidity, which, in turn, is mainly influenced by the country’s net transactions with the external world (net foreign assets) and levels of domestic credit. The central bank in the UAE uses most of the conventional quantitative tools, such as interest rates, discount and rediscount (loans, advances and deposits), reserve requirements, issuance of certificates of deposit, in addition to several other measures, namely, inter alia, liquidity ratios to be maintained by all commercial banks to ensure their liquidity and solvency, limits for the total discount operations and the loans and advances extended to commercial banks and interest rates and fees charged by the bank to their customers. It ought to be mentioned that despite the existence of both ISBs and CBs, the monetary policy has no specific regulations for ISBs in UAE. 6.3

Qatar

The Central Bank of Qatar (CBQ) defines the bank’s monetary and credit policy, the investment policy for foreign assets and supervision of the bank’s proper performance of its functions. The bank decides on all the matters pertaining to the issuance of the currency and its withdrawal from circulation, and lays down the internal regulations of the bank and formulates the administrative and financial regulations necessary to enable the bank to conduct its business and exercise its functions. The CBQ also decides the rules for discounting commercial papers, and fixes the rates of discount, interest and commission to be charged by the bank. It also decides on issues relating to supervision of banking business and the rules governing the granting of loans and advances to the banks operating in the state. It defines the upper limits of such loans and advances, and specifies the securities required. It finalizes the advances to be made to the government in accordance with the provisions of this law. It establishes clearing houses and had set up a credit risks bureau. Above all it approves the bank’s annual budget, and the bank’s final balance, profit and loss account. It lays down the rules pertaining to the affairs of the bank’s personnel. This includes appointment, promotion and termination of the services of senior officials of the bank in accordance with the bank’s staff affairs regulations. The CBQ makes the monetary and banking policies in conformity with economic policies. Since its inception the target has been to maintain the value of Qatari

Liquidity of Islamic banks in two states 79 Riyal (QR) and to stabilize prices, the banking system and the economy as a whole. The bank started to fix the exchange rate vis-à-vis the US$, control the interest rate and determine the minimum reserve requirement. Since 1995, in this context, more freedom was gradually granted regarding the interest rate on loans and deposits. Complete freedom was granted to deposits with maturities of more than one year in 1999. In 2002, rates on all deposits were made completely free. Deposits with less than one-year maturity are subject to a maximum interest rate determined by the CBQ. In 1995 the CBQ determined the required reserve ratio as 19% for all deposits. In 2000, the ratio was 2.75% for all types of deposits. Beside the required reserve ratio to manage liquidity, the CBQ depends on government securities repurchasing operations. The CBQ permits commercial banks to sell part of the government securities held by them to the CBQ, with the assurance to repurchase within two weeks or less at the prevailing CBQ interest rates (called repo rate). Unlike the Central Bank of the UAE, the banking regulations of the CBQ include the financing policies of ISBs, which set regulations on local and international finances. Moreover, ISBs are also required to adhere to specific banking ratios measured in a different way from CBs (which comprise ratios like the capital adequacy ratio, loans-to-deposits ratio, international finance-todeposit ratio, capital and reserve-to-total assets ratio). ISBs are required to maintain a level of foreign financing to total deposits which must not exceed 70% investment in real estate, funds and other assets. 6.4

Conclusion

Central banks in the two countries mostly use conventional quantitative monetary policy tools to achieve stated economic targets. Qatar Islamic Bank (QIB) (which requires ISBs to adhere to specific banking ratios measured in a different way from CBs) has some other instruments to control ISBs, while the Central Bank of the UAE has no specific instruments for ISBs. Central banks in the two countries use similar rules relating to supervision of banking business. One common characteristic is that a uniform regulatory and legal framework supportive of an Islamic financial system has not yet been developed. Existing banking regulations in the two countries are based on the Western banking model. In addition, ISBs establish Shariaa’ advisory boards to ensure that their contracts are consistent with Shariaa’ rules. Finally, interviews with officials of ISBs reveal that Islamic financial institutions face difficulties operating in the mixed banking systems of the UAE and Qatar owing to the absence of a regulatory body operating in accordance with Islamic principles, which means they face a high degree of competition with CBs compared with a full-fledged Islamic banking system.

7 7.1

Liquidity analysis Methodology

Both primary and secondary data serve as tools for the purpose of analysis. Primary data are collected by interviewing officials of various ISBs. Secondary

80 Liquidity of Islamic banks in two states data are collected from financial statements for different years for different banks. In addition, published materials relating to ISBs are also made use of. Clarifications regarding classification of assets as short term and long term, the nature of investment deposits and so on have been discussed with the various authorities. This section covers ISBs from AGCC economies (two from the UAE and one from Qatar). In addition, data relating to a few more banks from the UAE have also been considered for analysis. Data for 10 years have been collected from four banks. For the UAE bank, data were available only for four years from their annual reports. For other banks from the UAE annual reports were not available and hence data in US$ were downloaded from internet sources. Since the analysis is based on ratios the currency difference will not pose a problem. The study focuses on the liquidity aspects of ISBs. Liquidity may be interpreted to mean the ability to meet obligations. Here the focus is on short-term liquidity since ISBs accept mostly short-term demand deposits. The following are the ratios that enable the analysis of financial statements and liquidity: 1 2 3 4 5 6 7 8 7.2

Cash to Customer Deposits. Customer Deposit to Current Assets. Cash to Current Liabilities. Current Assets to Current Liabilities. Customer Deposits to Shareholders’ Equity. Return on Equity. Return on Assets. Cash Flow from Operations to Customer Deposits. Data limitations

At the outset it may be pointed out that the published financial statements of ISBs do not deliver the data in the required form for analysis. For the first few years, starting from 1991, cash flow statements were not prepared by these banks. Again, the available cash flow figures are not in conformity with proper cash flow statements prepared as per accounting methods. Further, proper classification of items like cash and equivalents, customer deposits, short-term liabilities and so on varies among the banks. Restated figures after certain years are seen in certain statements. Care has been taken in this analysis to overcome these problems and shape the account to a uniform pattern by authenticating the details with the officers of the company. Still, some shortcomings may be found. In addition, there are some blank cells because of one bank, ADIB, which started operation late in 1997. Moreover, in some financial statements of other banks, some ratios cannot be properly calculated due to the lack of some information, or the way information is classified, because it is not in conformity with the standard methods.

Liquidity of Islamic banks in two states 81 7.3 7.3.1

Liquidity Introduction

The liquidity aspect of ISBs is to be viewed from the angle of ability to meet the demand for withdrawals of deposits. In general, all deposits are short term, with a maximum period of one year or less. Even in the case of investment accounts, the depositors have an option to withdraw the money before its maturity. It may be noted here that deposits are made not with an objective of getting regular income but for capital appreciation with a profit/loss-sharing arrangement. There is a possibility of premature withdrawal by account holders when there is a mismatch between an investor’s expectation of return and the actual return. Thus the ISBs are required to keep adequate cash or cash equivalents to meet the demand. But in practice, the majority of these depositors generally renew their deposits after the expiry period. For all practical purposes, these deposits are, thus, in effect, medium or long term. In a perfect liquidity management system, it may be theoretically possible to estimate the likely demand for withdrawal. If this estimation is nearly perfect, these banks need keep only that estimated portion as liquid cash or near cash items. However, we have observed (based on interviews and the data available from the published statements) that most of the ISBs do not follow this and keep a lot of excess money in liquid assets. An instance can be cited here: in certain years some banks have kept up to 90% of the customer deposits in cash or cash equivalents. During discussions with officials, some stated that this particular situation is due to uncertainty relating to withdrawals as the percentage of withdrawals cannot be estimated. There can, thus, arise a situation of excess liquidity in certain cases. The analysis in the following pages is based on the ratios calculated from the published financial statements.

7.3.2

Cash to current liabilities

This ratio measures the ability of the bank to meet the short-term liabilities. For the ISBs, short-term liabilities include customer deposits (unless otherwise specially provided), since deposits are for a short period with a right to withdraw at any time. Other current liabilities, as a proportion of the total, are relatively small. Thus these banks should maintain cash/cash equivalents to meet the demand for withdrawals. Table 3.7 shows the ratio of cash to current liabilities. As is evident from the table, for ISBs in the UAE and Qatar, the ratio is lower and in the range of 5–12.9. This may be due to Islamic banking practices and commercial banks existing side-by-side. How far the ISBs are in a position to meet the customer demands for withdrawal can be ascertained by looking to the cash/customer deposit ratio, which can be seen from Table 3.8.

— —

— 10

1991

— 24

1992 — 14

1993 — 15

1994 — 15

1995 — 15

1996 — 14

1997

— —

— 11

1991

— 26

1992 — 14

1993 — 15

1994 — 15

1995

Sources: Own calculations from each bank’s financial statements, 1990–2002.

ADIB DIB

1990

Table 3.8 Cash to customer deposits

— 16

1996 — 14

1997

Note Curent liability  Total liability  equity (deferred income if known separately is also included).

Sources: Own calculations from each bank’s financial statements, 1990–2002.

ADIB DIB

1990

Table 3.7 Cash to current liabilities

1999 8 8

4 13

8 8

3 12

1998

1999

1998

5 10

2000

5 9

2000

6 11

2001

4 11

2001

— 8

2002

— 8

2002

6 20

Avg.

5 12.9

Avg.

Liquidity of Islamic banks in two states 83 7.3.3

Cash to customer deposits

In fact, relying on past experience, one can estimate the percentage of withdrawals or renewals of deposits and can effectively apply the same to derive a minimum cash balance required to be kept over a period of time. This will release a considerable amount of funds for other investments if opportunities exist. For example, assume that from experience, the banker estimates that on one-year deposits the probability of renewal works out to be 0.8. Then the cash requirements with respect to one-year deposits will be approximately 1  d ( pr)
m where d is the amount of deposits, pr is the probability of withdrawal, m is the maximum to meet any contingency or any statutory reserve required. Probability ( pr) depends on the nature of customers, their needs and so on, which only the banker can estimate. Again m is to be adjusted for possible inflows of cash from different sources. The model gives only a guideline for the minimum cash balance to be maintained. From the analysis we found that DIB and ADIB keep relatively low percentages (6–20%). The same reason as seen in the previous analysis can be attributed to this finding. Strictly from the point of view of financial analysis, these banks are not better off when compared to others. For ISBs, no standard for this ratio is available for comparison. Hence judgement regarding adequacy or otherwise can be subjective. If all depositors opt for withdrawal, there is possibility of a liquidity crisis. The analysis above reveals that ADIB and DIB may have a problem of liquidity in the event of customers withdrawing their deposits. But this can be considered as a remote possibility. Throughout the history of ISBs, one can cite only a few examples of ISBs facing liquidity problems. This again may be an exception and not a general rule. Deposits in ISBs are made because of religious sentiments against interest and at the same time for deriving reward by way of profit sharing. The short-term deposits are often renewed. The increase in the amount of customer deposits for a period of time in all these banks shows the confidence of the people in the system. 7.3.4

Current assets to current liabilities

As a rule, current assets must exceed current liabilities. Current assets are those which can be converted to cash within a year or during the operating cycle of a company, which include cash and receivables. For a manufacturing firm the ratio may be 2 : 1. This provides an adequate cushion to liquidity. For an ISB, the ratio is only a guideline indicating the bank’s ability to meet its liabilities. As we have seen, customer deposits account for a major share of total current liabilities and other liabilities are less significant. Table 3.9 shows the results. Almost all the banks maintain a ratio around one. For ADIB it is more than one. It may be noted that the cash-to-current-liabilities ratio of this bank is very low but the ratio of current assets to current liability is high. This may be due to its

— 100

— 99

1991

— 99

1992 — 99

1993 — 100

1994 — 100

1995 — 88

1996 — 102

1997

1999 154 101

1998 367 102

126 101

2000 111 99

2001

— —

2002

189 99

Avg.

— —

— 1,381

1991

— 1,586

1992 — 1,771

1993 — 1,636

1994 — 1,302

1995

Sources: Own calculations from each bank’s financial statements, 1990–2002.

ADIB DIB

1990

Table 3.10 Leverage ratio (customer deposits to shareholders’ equity)

— 1,128

1996

— 2,839

1997

31 664

1998

134 767

1999

250 95

2000

335 1,218

2001

— 1,121

2002

255 886

Avg.

Notes Current assets  Total assets  (Non-trading instruments
other assets
premises
equipment), or cash and balances with banks and other financial institutions, receivables, Ijara receivables. Curent liability  Total liability  equity (deferred income if known separately is also included).

Sources: Own calculations from each bank’s financial statements, 1990–2002.

ADIB DIB

1990

Table 3.9 Current assets to current liabilities

Liquidity of Islamic banks in two states 85 classification of ‘cash and cash equivalents’ and ‘other cash assets’. On the whole the ratio cannot be considered as a danger signal from the point of view of Islamic banking business. 7.3.5

Fund volatility

Non-availability of accurate figures for loanable funds and investments (loans) prevents us from calculating the fund volatility. It was ascertained from the discussions that in general, they deploy short-term customer deposits on short-term trading loans only. Exceptions may be there where investment deposits of long duration have been used for long-term investments. 7.3.6

Leverage ratio (customer deposits to shareholders’ equity)

Table 3.10 shows the analysis. It can be seen that ISBs in general have customer deposits of 225–886% of shareholders’ equity. For any bank, customer deposits will be sufficiently higher than shareholders’ equity. Since there is no norm for capital adequacy for ISBs, we cannot say that it is a poor indication of the shareholders’ equity base. 7.3.7

Customer deposits to current assets

As can be seen from Table 3.11, the ratio of customer deposits to current assets ranges from 60.75% (Abu Dhabi) to 97% (Dubai). A ratio of 100% or more indicates that all customer deposits are deployed in short-term current assets. Some of the customer deposits may be trade investments, and hence a ratio of 100% or more is difficult. On an average this ratio seems to be reasonable for ISBs. 7.3.8

Current assets to total assets

A major part of the total assets are current assets, as indicated by the ratio shown in Table 3.12. It ranges from 90% to 91%. As expected, the fixed assets are comparatively lower except for some investments like buildings or furniture. 7.3.9

Net profit to customer deposits

This ratio measures the return on customer deposits. It is evident from Table 3.13 that all banks present a net profit before tax and Zakat of only around 0.9% to 5%, which cannot be considered satisfactory. It is true that this represents the share of the bank after meeting the customers’ share. Even then one doubts whether this rate is adequate for the sustainable growth of banks.

— —

— 90

1991

— 91

1992 — 99

1993 — 99

1994 — 99

1995 — 99

1996 — 111

1997

1999 63 96

1998 26 95

74 92

2000 80 97

2001 — 99

2002

60.75 97

Avg.

— —

— 94

1991

— 94

1992 — 93

1993 — 93

1994 — 93

1995 — 93

1996 — 92

1997

1999 89 89

1998 89 90

92 90

2000

88 91

2001

— 93

2002

89.5 90.6

Avg.

— —

— 1

1991

— 0

1992 — 0

1993 — 1

1994 — 1

1995

Sources: Own calculations from each bank’s financial statements, 1990–2002.

ADIB DIB

1990

Table 3.13 Net profit to customer deposits

— 1

1996

— 5

1997

10 1

1998

3 0

1999

5 6

2000

4 4

2001

— 3

2002

5 0.9

Avg.

Note Current assets  Total assets  (Non-trading instruments
other assets
premises
equipment), or cash and balances with banks and other financial institutions, receivables, Ijara receivables.

Sources: Own calculations from each bank’s financial statements, 1990–2002.

ADIB DIB

1990

Table 3.12 Current assets to total assets

Note Current assets  Total assets  (Non-trading instruments
other assets
premises
equipment), or cash and balances with banks and other financial institutions, receivables, Ijara receivables.

Sources: Own calculations from each bank’s financial statements, 1990–2002.

ADIB DIB

1990

Table 3.11 Customer deposits to current assets

Liquidity of Islamic banks in two states 87 7.4

QIB: some relevant ratios

Considering the case of QIB, it must be noted here that detailed and classified information relating to different headings for QIB was not available for all the 10 years, as the bank was established after that. Therefore, ratios calculated for the other banks could not be worked out. However, some ratios from 1997 to 2001, which are relevant, are shown below: Receivables to deposits and liabilities ratio 1997 81%

1998 88%

1999 84%

2000 91%

2001 87%

Of the total assets, around 80% are receivables. This indicates the poor solvency of the bank. Actually the correct position can be ascertained only when cash and cash equivalents are also considered. The bank may be keeping excess cash. Deposits to shareholders’ equity ratio 1997 14%

1998 11%

1999 12%

2000 11%

2001 11%

This ratio also is not impressive, as can be seen from the foregoing. Shareholders’ equity is above 10% of the deposits accepted in all the years. Since no standard capital adequacy norms are available one cannot suggest a poor capital adequacy for the bank. Return on equity and return on total assets 1997 ROE ROA

1998

1999

2000

2001

14% 22% 0.93% 1.7%

19% 1.4%

12% 18% 0.95% 1.5%

There is considerable fluctuation in both these ratios.

8

Conclusion and policy recommendations

The above analysis leads us to the following major conclusions and policy recommendations. In the case of Gulf countries, ISBs maintain a relatively small proportion of cash to meet current liabilities. Banks in the Gulf keep a relatively low percentage. Since no standard is available for ISBs, and the rule of thumb cannot be applied to these banks, the judgement regarding adequacy or otherwise is subjective. In case of a contingency, like the total withdrawal of deposits by depositors, these banks may face a problem of liquidity. Such a situation is only a remote possibility since

88

Liquidity of Islamic banks in two states

religious sentiments against interest earned guides the depositors. All the ratios calculated in the previous section (except the last one) lead to the same conclusion. The profitability (before tax and Zakat) is relatively low. This points to the fact that the deployment of short-term funds in short-term investments does not fetch a huge margin of profit. If their attention is focused on long-term projects, the probability of gaining more returns will be higher. Thus ISBs should think in terms of getting medium-term or long-term deposits so that more profitable opportunities can be explored. The existing equity base, when compared to the deposits accepted, seems to be relatively low. Here again no standard for capital adequacy is available. Hence it is futile to jump to the conclusion that these banks have a low equity base. However, measures to strengthen the equity base will definitely prove to be a step in the right direction. In general, the Islamic banking system has projected considerable growth over the past decade. This expansion is due to the ever increasing oil revenues coupled with religious beliefs. Hence the working of these banks must be made transparent. This can be achieved through proper control measures by apex banks and insisting on adequate disclosure of accounting and reporting practices. As reflected in the analysis, it is only the trust of the investors in the system that enabled these banks to grow. If not, theoretically the withdrawal of deposits (permitted at any time) may lead to liquidity problems. The analysis here confirms that the changes of the assets and liabilities sides of the structure of financial statements from standard norms to the Islamic form, shown in sections 2.2 and 2.3, have no apparent repercussions on ISBs’ liquidity, which means that worries about liquidity risk are not valid at present. This might be a result of non-availability of investment avenues and financing via Murabaha and Salam on the assets side, and the high share of demand deposits which look like interest-free loans on the liabilities side. Nevertheless, the future occurrence of liquidity risk cannot be ruled out due to reasons identified in the literature before and not thoroughly analysed here (lack of inter-bank money market, reliance on current accounts, restrictions on sales of debt and so on). In practice, the excess liquidity in ISBs may pose some problems. To cite an example, Kuwait Finance House (KFH) held an operating surplus in 1984 but did not declare a dividend, and stopped accepting fresh deposits. Rumours about a moratorium on withdrawals also spread. The actual cause was mainly because of the slowdown in economic activity, and lack of diversification of assets in times of crisis, which led to emergence of such problems. Under such circumstances, the investors’ interest is at risk. Thus these banks are susceptible. One must note that growth in these banks is directly related to the increase in the economic activities in the country. Otherwise they may experience some difficulty in deploying excess funds in profitable operations (which affects profitability). Therefore the above-mentioned problems of (1) how ISBs can deploy excess funds and (2) how to protect investors’ interest in terms of repayment of principal and returns need to be addressed properly by ISBs. One aspect that we have found in the analysis is that the majority of the short-term funds are used in financing trading activities. In fact ISBs can accept long-term or

Liquidity of Islamic banks in two states 89 medium-term funds with a provision to withdraw only after the stipulated period as a major source of funds. These long-term funds can be used for building social infrastructure projects benefiting the society in general. Some banks are doing so, but not all. For short-term funds, efforts should be made to increase the productivity by finding ways of using the same in conformity with Islamic principles. Thus different types of instruments for the short and long term may be made available to the investors. Like any other mutual fund, a part of these funds can be deployed in the securities market or money market or even commodities market. The second aspect is that of protecting investors’ interest in times of crisis. Regulatory bodies should specify the capital adequacy norms for these banks and insist on transferring a higher percentage of profits to the statutory reserve. Deposit insurance can also be introduced. We can also think in terms of guaranteeing a minimum return on deposits to compensate the loss in purchasing power. This can be done by fixing an index for the amount based on growth in the consumer price index. For example, if at the time of deposit the consumer price index was 120 and at the time of withdrawal it moved to 130, the amount of deposit can be indexed with an factor of 130/120 or 1.08. This leads us to deduce that any fund deployed should get a return above the index factor. Yet another important aspect which hinders analysis here relates to accounting practices. There are no uniform accounting practices followed by these banks. Prudent accounting standards relating to income/expense, depreciation, valuation of balance sheet items, declaration of dividend and so on should be formulated to enable transparency in banking. This must be followed by reliable auditing standards also. The regulatory bodies must compel these banks to follow uniform accounting standards. Regulatory authorities in each country should set up a standard multi-setting body for ISBs. This body with statutory powers should consist of experts in Islamic banking, professional accountants, lawyers and representatives from the public and should be responsible for issuing domestic/local standards. It may also co-operate with similar bodies in other countries. Initially, training should be given to the staff in preparing the accounts according to the prescribed standards. This step is of vital significance to enhance the measurement of liquidity and contribute to the credibility of Islamic banking. The major future developments related to the absence of liquidity risk should be emphasized here. Despite the absence of a liquidity constraint, ISBs are required to take cautions and develop liquidity-management instruments, create an Islamic bonds market to compensate for the lack of an inter-bank market, and explore long-term investment avenues to exploit current excess liquidity and to be able to raise profits. Moreover, ISBs in countries with a mixed banking system, owing to the absence of a regulatory body operating in accordance with Islamic principles, face a high degree of competition that might have implications for their liquidity status in the future. Therefore, future development also requires a separate regulatory and supervisory framework for ISBs in countries with a mixed banking system. This would address issues specific to Islamic institutions, including liquidity development and liquidity management.

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Finally, as identified in section 2.4.1, liquidity risk can be caused by different factors such as the lack of confidence in the banking system and reliance on a few large depositors. Moreover, liquidity risk in ISBs cannot be ruled out in the future as a result of the reliance of these banks on current accounts, restrictions on ISBs’ sales of debt and the absence of an LLR facility in practice. All these factors, which have not been dealt with separately and properly here, deserve attention in future research on the area.

4

Financing small and mediumsized enterprises in the AGCC states The case of Oman

1

Introduction

This chapter aims to identify and compare the basic characteristics of the financing which is advanced to SMEs in Oman, particularly in respect of the type of financing, volume, rate of interest, grace period, repayment period, guarantees, types of enterprises and non-financing programmes. The chapter also assesses the financing programmes for SMEs and how they should be rationalized in the future in the face of the necessity of meeting fiscal convergence criteria of the upcoming MU. The institutional programmes of financing SMEs, which include the Fund for Development of Youth Projects (Oman) (FDYP), Oman Development Bank (ODB), Scheme of Financial Support to the Enterprises in the Ministry of Commerce and Industry (Oman) (MCI), the National Fund for the Support and Development of Small Size Projects, Fund of Support of Small Projects, SelfEmployment and National Autonomous Development (SANAD), Fund for Financing the Means of Living and SANAD Nurseries, in addition to a general view on the SME financing programmes of the commercial banks and finance and leasing companies (FLCs), are discussed. Most of the institutional loans programmes for SMEs started their activities in the late 1990s. This span of time gives a reasonable ground for documentation and assessment of these programmes. In this context the chapter primarily highlights four basic aspects, namely: 1 2 3

4

Documentation and basic characteristics of the institutional financing programmes for SMEs and other accompanying programmes in Oman. Assessment of levels of performance of these programmes and studies of the causes of success and failure in the light of financing similar enterprises. Proposing appropriate objective methods for developing the institutional financing programmes for SMEs in the Sultanate in terms of quality and quantity. Studying the connecting and integrating link between these programmes so as to serve the national objectives.

92 Financing SMEs in Oman

2 2.1

Conceptual background Definition of SMEs

There is no unified universal definition of SMEs, as a result of the difference in fixed assets, type of establishment and the socio-economic characteristics of small producers. Terms such as small industries, small and micro-enterprises, crafts, income-generating activities and productive are used of them. There are more than 50 definitions that cover small and medium production in industrial, commercial and service sectors. The definition differs according to the differences in economic activities and the structure of the economies and the level of economic and social development and the aims of developing SMEs. The indicators usually used to define SMEs are labour employment, volume of investment, volume of production (output, sales or demand), type of technology and the value added (the difference between sales and purchases, or the price of final product compared with the price of raw materials). Despite the differences in the definitions of SMEs, the most commonly used definition takes into consideration the number of people employed. This means that the definition is a quantitative one, and it is used when we need to exclude large-scale enterprises from support activities (training, finance and consultancy services). The quantitative definitions (except that which takes the number of employees) are difficult to assess. The volume of investment is difficult to assess due to the difficulty of getting exact prices, especially when the enterprise depends on used machinery. The qualitative definition, on the other hand, is not accurate in identifying enterprises to grant incentives, but it is useful when we need to know the working differences between SMEs and large-scale enterprises. The quantitative definition determines that the small enterprise should be in the hands of one or two persons, who make the basic administrative decisions, or that the small enterprise is an activity to produce goods and services without the use of advanced machinery, or that small industries are those enterprises which are characterized by small capital and the use of unsophisticated technology and dependence on labour. It is clear that these definitions are free from quantitative limits, and they refer only to the basic characteristics of enterprises within the indicators shown earlier (Ibrahim Badr El Din, 2004a). The definition of small enterprises in Oman has not gone further than the number of employees and the volume of capital. Oman Chamber of Commerce and Industry (OCCI) identifies capital of RO 25,000 and labour employment of less than 10 in the trade service sector as criteria for small enterprises. Enterprises that have capital around 100,000 RO and labour employment of 100 were classified as medium enterprises. From the statistical outcome of the Industrial Survey of 1997, we calculated the average employment per small establishment (the ratio of total employment in small industries to the number of establishments) to be 4 workers, the mediumsized enterprise 20 workers and the large-scale enterprise 218 (Ibrahim Badr El Din, 2001). The small enterprise, according to the definition of The Industrial Survey, employs between one and nine workers (MCI, 1997). It ought to be

Financing SMEs in Oman 93 mentioned that the definition should specify the sector in which the establishment is working. The broad definition covers all enterprises in the industrial sector (conversion of raw materials to finished products), the service sector (repairs workshops and so on) and the trade sector (buying and selling of raw materials and finished goods). It is clear that not all SME financing programmes in Oman have used direct indicators for the definition, except through the volume of finance for each project and the types of projects to be financed by each financing programme. This seems to be quite sufficient for the purpose of selecting the types and the size of projects for each financing programme.

2.2

Importance of SMEs in Oman

For many reasons many countries have called for the promotion of SMEs. Reasons for promotion of SMEs are the following: (1) SMEs constitute the majority of industrial establishments and employ a sizeable number of workers, (2) they contribute to value added in the industrial sector and are a major source of incomes, (3) they use capital more productively and develop individual technical skills, (4) they develop the agricultural sector through backward and forward linkages and develop linkages among all economic sectors, (5) they preserve cultural heritage, (6) they are flexible and adaptable towards changes in the markets, (7) they constitute sources of innovations, (8) they are easy to administer, (9) they employ a local labour force, (10) they are not constrained by the lack of support services, (11) they specialize in products that cannot be made except by small enterprises, (12) they are attractive to local entrepreneurs, (13) they are scattered geographically and (14) SMEs are considered a mechanism for economic integration between countries. Small and medium industrial establishments in the Sultanate constitute 95% of the industrial establishments. Small industrial establishments have between one and nine employees and the medium industrial enterprises have between 10 and 99 employees. The large industrial enterprises with 100 employees and above constitute 4% of the total industrial enterprises according to the Industrial Survey (MCI, 1997). Most of the industrial establishments are single enterprises (80.7%) and are owned by single owners (95.1%). Omanization in the small and medium industrial enterprises is 19%, compared with Omanization in the large industrial enterprises of 22.9% (MCI, 1997). Our calculations from the figures of the Industrial Survey of the MCI, 1997, show that the large industrial establishments make a significant contribution to the national economy. Although they account for only 19.9% of the industrial fixed assets, large-scale industrial establishments share 72.9% of the total industrial output. Estimates of fixed capital–output ratio in the Omani manufacturing sector (average fixed capital required to produce a value of manufacturing output worth one RO) show that the large industrial establishments need less capital to produce output than SMEs. The ratio of fixed capital to output in the small, medium and large enterprises is 0.73, 0.11 and 0.1 respectively. The ratio of fixed capital to output for SMEs amounted to 0.19 compared to 0.01 for large

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Financing SMEs in Oman

enterprises. This means that the productivity of fixed capital is higher in large industrial enterprises compared to small and medium industrial enterprises. Regarding the ratio of fixed capital to labour (fixed capital required to employ one unit of labour), our calculation from figures from the Industrial Survey of 1997 shows that small industrial enterprises need an average of RO 4,100 to create a new job while medium enterprises need RO 1,900 to create a new job and the large enterprises need an average of RO 390. SMEs need a fixed capital of RO 2,600 to create a new job. In addition to this, the average employment figures (employees divided by the number of establishments) indicate that the large-scale industrial enterprises employ on average 218 employees while the medium and small enterprises employ an average of 30 and 4 employees, respectively. The figures which indicate the productivity of labour (total production divided by the number of workers) show that the average annual productivity of labour in the large, medium and small industrial enterprises amounts to RO 30,900, RO 17,200 and RO 5,700 respectively. Compared to medium and large enterprises, small enterprises need less capital as measured by average investment of fixed asset per firm. The capitalization per enterprise is such that the average small enterprise firm invested only RO 15,000 compared to RO 85,000 for a large-scale enterprise and RO 56,000 for a mediumscale enterprise. The SMEs together need a capital of RO 23,600 on average. Average production of a large enterprise compared with the medium and small enterprises is RO 6,745, 512 and 20.9 respectively. The ratio of foreign capital to total capital in the industrial sector of Oman is 4.6%, which indicates a weak attraction of foreign capital (Ibrahim Badr El Din, 1998). In sum, the small and medium-sized establishments in Oman have the following characteristics: 1 2 3 4

SMEs are numerous and constitute about 95% of the total number of industrial establishments. The current recruitment of indigenous labour in the SMEs is poor. Mobilization of foreign capital in industry is poor. There is a weak local market of industrial products.

Given the government’s diversification policy to enhance the role of the private sector and increase the share of the industrial sector in GDP to 15% in 2020, and given the high share of SMEs in the number of the total industrial establishments, industrial SMEs can effectively contribute in the Omani economy for the following reasons: ●

●

●

Despite the fact that industrial SMEs are not currently the major employers of Omanis, the capital–employment ratio of 7.9 and 13.4 for small and medium-sized industrial establishments compared with 23.4 for large enterprises is promising as far as job creation is concerned. SMEs create linkages with themselves and with other sectors through the use of local raw materials. The limited market for foodstuffs in Oman as a result of low population size gives another reason to promote SMEs.

Financing SMEs in Oman 95 The diversification and private sector strategy requires an equal attention to all sectors of the economy, but with different approaches. There is no disagreement that large-scale enterprises are suitable to enter the international markets. This sector is the major employer of the national labour force. But we have to take into consideration the unstable international markets to determine the national priorities. Due to their flexibilities, small enterprises have long been recognized as a good livelihood strategy during economic hardships. Moreover, during recessions SMEs not only provide livelihood opportunities, but push the performance of the economy as well. Looking closely at the industrial performance of the Omani economy based on empirical statistics can help us not to lose sight of these basic facts. 2.3

Growth constraints

The literature on SMEs has come up with different views about whether internal factors (weak administration) or external factors (difficulties in getting access to finance, appropriate technology and raw materials as well as the biased government policies against small producers) are the major constraints on SMEs’ development. The administration aspect as an internal constraint was widely emphasized during the 1960s. Many writers at that time believed that small entrepreneurs had the necessary ambitions and resources, but enterprises were not able to develop as a result of the lack of administrative skills and capabilities of entrepreneurs. They also saw that the best way to look at the administrative capabilities of an enterprise is to see its successes or failures, as success cannot be isolated from good management (see, for example, Schmitz, 1982; Ibrahim Badr El Din, 2004a). Since the 1970s, writers have not emphasized this factor, and some economists see the weak administrative capabilities of small entrepreneurs as a result not only of lack of training but also of socio-economic and cultural factors. The discussion about internal factors is followed by emphasis on external factors, which are perceived differently by two categories of opinions: those who see SMEs exploited by large-scale enterprises, and those who see that development of SMEs is constrained by the difficult access to raw materials, markets and finance (among others, see Anderson, 1982; Schmitz, 1982). The first group sees that SMEs were not able to expand labour productivity and income because they have been subject to exploitation from the modern sector. They buy from the organized sector at a high price and sell at a low price. Farmers sell agricultural products very cheap, and petty traders distribute output at low prices. As a result the linkages with the formal sector via the market mechanism are not going to be beneficial to small producers. This view is part of the discussion between the dualistic school and the exploitative school. The proponent of the dualistic school sees small enterprises as separate units but linked with the other parts of the economy that benefit the two parties. The proponents of the exploitative school see the linkages with the modern sector as negatively affecting small producers. The policy implication of the second approach is a prescription of subcontracting and policies to enhance incomes and provide more loans. On the other hand, the proponents of the exploitative approach rightly argue in favour of delinking from the large-scale sector.

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The difference between the two schools can be seen through subcontracting, the direct relationship between small- and large-scale enterprises. This relationship exists in many occasions following constraints in raw materials supplies and product marketing for small enterprises (i.e. external constraints). In this case the large-scale enterprise acts as the raw materials supplier to the small enterprise and the latter constitutes a production-selling centre for the large-scale enterprise. Some see these kinds of subcontracting as providing opportunities for growth of small enterprises, whereas others see them as exploitative and dependent relationships working against small producers. 2.4

Obstacles to financing SMEs

Easy access to credit is singled out to be one major problem of SMEs (Anderson, 1982). Most studies highlight the lack of credit facilities as the major obstacle to the extent that the existence and the continuation of these enterprises are critically dependent on financing. Capital scarcity of the small enterprise is sometimes seen as an illusion. When small entrepreneurs see their major problem in capital, they mean that they lack financing and not other internal constraints. Others see that although some SME entrepreneurs cited shortage of capital as one major problem, their present capital is not economically employed, or they have unsold output. In this case they might not need additional financing and the lack of financing might not be a constraint. Studies show that SMEs have little access to the resources of the organized financial sector, mainly due to the high risk of default and high administrative cost (costs of administering and delivering small credit). It is generally noted that small enterprise loans are relatively small, whereas the cost of administering credit is fairly constant, irrespective of the size of the loan. That is why bankers consider small enterprises as risky clients. They are not bankable, they do not keep proper records needed by the financial system, and hence they are not able to meet conventional security requirements. On the other hand many studies have shown that SMEs are characterized by a high rate of return on capital compared with large-scale enterprises. They are also characterized by economic efficiency or high factor productivity. This can be seen if we compare the ratio of output to capital for small- and large-scale enterprises. Studies have shown that there is a negative correlation between capital investment and the rate of return on capital; that is, at a low capital the rate of return is high. It is very perplexing, if not outright absurd, that the bankers’ reluctance to lend to small enterprises is based on the lack of suitable guarantees, at a time when the rate of return on capital of small enterprises is higher than that of large-scale enterprises (Ibrahim Badr El Din, 2004a). Some see SMEs are creditworthy as a result of these high returns on capital. Others consider the reason for the lack of access to be the shortage of funds, brought about by government imposition of credit controls that have tended to keep interest rates artificially low. At a low rate of interest, lenders are reluctant to take the risk of default and therefore prefer to lend to establishments, which have guarantees and good records of repayment. Subsidized credit programmes, it is also

Financing SMEs in Oman 97 argued, encourage small enterprises to use capital more intensively and less productively, and replace personal savings that are typically the source of investment of small enterprises (Harper, 1984; Liedholm and Mead, unpublished). Others, convincingly, showed that the benefit to the borrower of a reduction in interest rates would be relatively insignificant when compared with the lender’s reduction in income. This leads them to be reluctant to extend finance to SMEs.28 Having accepted the risk of default and high administrative costs, the literature goes on to encourage private banks to extend credit through various risk guarantee measures. Others argue that these measures may involve ‘moral hazards’ as a result of financial institutions passing on the losses to the government (through the credit insurance or guarantee scheme, in which the government takes over the risk in return for a premium from a small entrepreneur), rather than attempting to reduce the risk as intended in the programme. In addition some suggest a credit system that links the traditional lending institutions (credit and saving associations, non-governmental organization (NGO) programmes and associations that extend credit to their members) with the organized financial system such as banks or big financing companies. In this system the informal associations extend guarantees to banks to help in extending finance to small producers. However, such schemes as the ones highlighted have very rarely been successful. Like other suggested schemes this one has not been widely applied due to reluctance from banks and lack of trust. Others recommend setting aside a specific portion of a commercial bank’s loan portfolio for the exclusive use of small enterprises (Schmitz, 1982; Ibrahim Badr El Din, 2004a). The small enterprise reserved loan portfolio is slow in disbursement and has not reached the intended recipients. 2.5

Policies of financing SMEs

There is a wide belief that there is demand (or potential demand) for SME credits as a result of the widespread activities of the SMEs. Therefore ‘financing policies that follow demand for small credit’ were emphasized against ‘financing policies that create demand for small credits’ (Schmitz, 1982). As a result governments’ policies towards small credit usually start with the organization of the financial market. They see that the restricted market forces (existence of restrictive policies) create distortions in the financing system. These distortions forbid the system to automatically respond to the growth of different economic sectors. This means the rigidity of supply of credit services in response to demand for these services in some sectors of the economy, and also means an increase in the cost of credit. As a result experts argue for government interventions to control credit in favour of certain sectors, or determine the rate of interest or credit portfolio for some sectors at different interest rates to reflect reduction of interest rates to some sectors. In the literature on SME financing there are two contradictory schools: the school that favours government control and the school that favours market forces. The two schools agree that weak financing creates major constraints to SMEs, but they disagree on the reasons for this weakness and on policy prescriptions. The first school argues that when the market failure hinders financing to SMEs,

98 Financing SMEs in Oman government intervention in directing credit becomes necessary. The second school argues that government intervention will hinder the freedom of banks to extend credit and reduce their profits as a result of the imposition of low interest rates, given risks in financing this sector, among which is the high cost of lending and default payments. They also see that in this environment the chances for financing go to big enterprises within the sector. This leads enterprises at the lower end to depend on self-financing or non-institutional high-cost credit. This school sees the abolishing of credit and interest rate ceiling leads to a better distribution of credit and more incentives for banks to extend credit to SMEs, as the return from this credit will not be less than credit to large-scale enterprises. In sum, the proponents of the first school put much emphasis on the cost of credit, and the second school emphasizes the availability of credit not the cost of credit (Schmitz, 1982).

3

Mechanisms and institutions to finance SMEs in Oman

SME financing in Oman can be classified into three groups. The first group represents the government efforts at subsidized financing through the ODB, the Soft Loan Scheme for Financial Support to Enterprises in the MCI, and the recently established microfinance programme (SANAD Programme). The second group is equity finance made through the FDYP (Youth Fund), a fund financed by private and public shareholders, including RO 1 million from His Majesty Sultan Qaboos. The third group comprises 14 commercial banks and 6 FLCs, providing loans at the prevailing market rates. 3.1

Government initiatives

The Omani government has established a number of initiatives to increase financing to SMEs. These include the Soft Loan Scheme for Financial Support to Enterprises in the MCI, the ODB soft loan and the SANAD small loan programmes. Each programme addresses a different market segment. The MCI’s financial support to enterprises commenced in 1981. The major aim of the government soft loans programme is to develop the industrial sector and to increase its contribution to GDP from the current level of about 5% to 15% by the year 2020, and also to expand the production base, encourage investments by the private sector, realize the strategic objectives of development and create new employment opportunities for Omani nationals. A unit in the MCI (Directorate of Development Incentives) was established to supervise the programme. This Directorate is composed of five sections: Follow-up and Monitoring Section (accepts applications and follows them up), Industrial Incentives Section (studies applications for exemptions of import duties, taxes and other incentives), Technical Appraisal Section (appraisal of applications), Financial Analysis Section (analyses applications and budgets) and Restructuring Section (study of failed projects and design solutions).

Financing SMEs in Oman 99 The ODB was originally established in 1978 as a public–private initiative and in 1997 the Omani government gained 100% ownership of the bank. In addition to managing its own portfolio, ODB is also the apex organization to channel SANAD loans. ODB has a Board of Directors from the Ministry of Finance, MCI, Ministry of Agriculture and Fisheries, Ministry of Development (abolished), Ministry of Social Affairs and Labour (abolished), Ministry of National Heritage and Culture, Ministry of Guidance and Education, Ministry of Higher Education, Ministry of Health and OCCI. The bank provides subsidized loans to development projects. In addition the bank also acts on behalf of the government to disburse and collect government soft loans and SANAD fund loans. At present, the sole provider of microfinance in Oman is the SANAD programme. SANAD was established in 2001 and accommodated in the Ministry of Manpower (MOMP), to provide significant post-investment support to the microenterprises to which it provides long-term loans, as well as training of small-loan-seekers in local training institutes. Unlike other microfinance schemes, SANAD does not provide working capital, depository or savings products to its borrowers. The SANAD programme is composed of the following: ●

●

●

●

SANAD Fund for the Support and Development of the Small Size Projects (aims at backing and financing individuals who search for work as well as craftsmen so as to enable them to establish their own projects). SANAD Fund for Financing Means of Livelihood Projects (financing and supporting work seekers among beneficiaries of the Social Security Scheme, and those who have special needs, so as to establish their own projects and be able to meet their living requirements). SANAD Offices (to receive and follow up applications, give assistance to those who wish to establish small-size projects; also to supervise the financed projects and to train those who satisfy the conditions). SANAD Nurseries (to provide temporary care and guardianship to the projects in whose establishment the government, the private sector and the national societies had participated by way of providing the place and necessary supplies, fittings, subsidized raw materials and administrative and technical training) (MOMP, 2005b, pp. 85–87).

SANAD operates a modest RO 2 million revolving fund that offers small, subsidized loans of up to RO 5,000 to young school leavers and unemployed Omanis to foster self-employment, and contribute to the Omanization of trade and small businesses. The main purpose of SANAD is to respond to the demand for small loans arising out of the Intillaqah initiative, which is a free training programme financed by Shell, Liquid Natural Gas Company (Oman) (LNG) and local national banks to assist young unemployed Omanis to create their own businesses. It can be identified more as a job creation scheme rather than an SME development programme. It is also creating incubators for would-be entrepreneurs in grocery and tailoring. The SANAD programme is not currently regulated by the Central Bank of Oman

100 Financing SMEs in Oman (CBO), as the CBO does not have specific regulations governing microfinance institutions. SANAD’s organization structure is complex. The SANAD Board of Directors is composed of Ministers of Transport and Communications, Regional Municipalities, Environment and Water Resources, and Manpower, as well as undersecretaries of some ministries (Undersecretaries of Commerce and Industry in the MCI and Undersecretary for Economic Affairs in the Ministry of National Economy (MONE)), also the Secretary General of the Tender Board, and the President of the OCCI. The Board of Directors draws up plans, regulations, basic rules of the programme, and creates communications channels with bodies concerned with employment, training and financing. It also assesses the annual programmes and identifies the requirements for developing the experiment. The SANAD Executive Committee is chaired by HE Minister of Regional Municipalities, Environment and Water Resources and has a membership consisting of ODB’s general manager, the Intillaqah programme’s general manager, in addition to a full-time executive director seconded from the MOMP. The executive apparatus of the SANAD programme proposes policies and legislation relating to the establishment and running of the projects, identifies investment opportunities, prepares data, co-ordinates with the training and rehabilitation bodies, assesses the annual programmes and promotes the project. SANAD has eight offices in the governorates of Muscat, Dhofar, Al Dakhliya, Al Wusata, Al Sharqiya, Al Batinah and Al Dhahira. These offices receive and transfer applications to the main office. They also participate in the implementation of the projects, overcoming difficulties and supervising the financed projects in the Wilayats. The SANAD Committee for Individual Initiatives and Self-Employment is chaired by the Undersecretary of the MOMP and has a membership consisting of representatives from the concerned ministries, municipalities and governorates of Muscat and Dhofar, OCCI, Royal Oman Police (ROP), Council of Businessmen and some companies. The committee is responsible for the implementation of the Board of Directors’ resolutions in a way which is consistent with the recommendations of the first symposium on the employment of manpower held in October 2001, and the executive measures of the second symposium on national employment and objectives of the SANAD Programme, including identification of 19 commercial and professional sectors. It also works to propose plans to the Board of Directors of the SANAD Programme, set up implementation mechanisms, supervise work of SANAD Committees in the Wilayats, approve the mechanisms for carrying out the awareness and enlightening campaigns in the Wilayats, prepare quarterly assessment on the individual initiatives and Omanization accomplishments in the trading shops, businesses and vocations at the Wilayats’s level as well as any other development proposals. SANAD also has committees in the Wilayats. These committees are chaired by the Walis and have members representing Al Shura Council, directors of the Municipality in the Wilayats, directors general of manpower in the region, ROP’s officers in charge in the Wilayats, municipalities of Muscat and Dhofar,

Financing SMEs in Oman 101 representatives of OCCI and ODB, and some designated commercial companies. The functions of these committees are to support individual initiatives in the Wilayats and propose Omanization of the trading shops, individual businesses and vocations as appropriate for each Wilayat; to implement resolutions of the SANAD Committee for individual initiatives and self-employment at Wilayat level, and to facilitate the work of the field teams in respect of shop surveys and studies; to encourage participation of nationals in the Omanization programmes, register candidates with individual initiatives and co-operate with the designated commercial companies to select the appropriate ones; and to follow up assessment of the financed projects which belong to the individual initiatives at the Wilayat level (MOMP, 2005b, p. 55). 3.2

Equity/Venture capital

The FDYP (Youth Fund) is the sole provider of institutional private equity/venture capital in Oman. The Youth Fund was formed in 1998 with share capital of RO 6.36 million from 53 private and public shareholders, including RO 1 million from His Majesty Sultan Qaboos. Beside offering joint finance, the fund helps in the evaluation of project studies, obtaining government licenses and the best quotations from suppliers; it also helps enterprises qualify for obtaining grants and commercial loans and provides technical, administrative, marketing and organizational expertise. The organizational structure is composed of a Board of Directors to set up the general policies (composed of 10 members from the big shareholders), the Executive Committee (for actual supervision of the fund activities) and the Consultative Committee (composed of experienced individuals), in addition to Experts (volunteers and internal/external consultative firms). The fund is managed by a general manager (reports to the Executive Committee). He is assisted by a Director of Accounts, Project Analyst and administrative supporting staff. The Youth Fund began investing in 1999 and, by the end of 2002, it was managing a portfolio of RO 1.3 million invested in 20 companies. During 2003 and continuing into 2004, the fund ceased investing in new projects and instead focused on restructuring its existing portfolio and evaluating new strategies to better execute its mission. The fund had invested approximately 20% of its capital in 20 projects after five years of operation. Oman’s venture capital sector remains very small and is challenged by an absence of quality investment proposals, the low level of new business creation and a general reluctance by entrepreneurs to share ownership. This is reflected in the relatively modest deal flow that the Youth Fund has been able to generate to date. 3.3

Commercial banks

In 2004, Oman’s commercial banks stood at 14, of which five were locally incorporated and nine were branches of foreign banks, together having 330 branches all over Oman. Moreover there were three specialized banks operated within 26 branches, two of which were owned by the government (Oman Housing

102

Financing SMEs in Oman

Bank and ODB (CBO, 2004, p. 53)). Given the relative size of the economy and high minimum capital requirements, the Oman banking system experienced high entry barriers, and therefore it is highly concentrated, with three major banks accounting for around 70% of deposits. Commercial banks provide working capital loans, term loans for equipment financing, and trade finance. Banks provide credit facilities directly to SMEs and also via personal loans to entrepreneurs, where the latter represent a lower credit risk due to other sources of income. Lending to SMEs is not considered as one of the priorities of bank lending. Even though the definition and the small business lending out of the total loan portfolio cannot be determined precisely, estimates are around 2–5%. Credit decisions are mainly based on the strength of collateral provided, rather than the projected future cash flows of the enterprise. Most local banks rely on the personal guarantee of SME entrepreneurs, many of whom have other sources of income such as real estate rentals. However, given the unreliability of financial information provided by SMEs, banks have experienced difficulty in obtaining an accurate picture of their current financial condition on which to base a reliable set of projections. Most SMEs are organized as either sole proprietorships or limited liability companies (LLCs), and only those LLCs with share capital in excess of RO 50,000 are required to produce annual independently audited financial statements. Commercial banks in Oman are highly concentrated, non-competitive and depend mainly on collateral-based lending rather than cash-flow-based lending. Moreover, they do not have their own lending programme tailored to SMEs’ needs; instead they rely on lending methods used for large corporate enterprises. They suffer lack of a credit information system as well as weak collateral legislation; therefore they are not ready to enter relatively risky business such as SME lending, or when they enter they do it with high margins, and without incentives to invest in innovative lending schemes to address SMEs’ financing problems and to go for best practices in SME financing.

3.4

Finance and leasing companies (FLCs)

At present, Oman does not have a leasing industry. Instead, it has six specialized financial institutions, categorized as FLCs by the CBO. These FLCs have 24 branches within the country. Oman’s non-banking FLCs provide instalment finance credit to retail (automobile and electronic goods) and corporate borrowers. They provide finance for SMEs for expansion, modernization and replacement requirements, as well as for factoring and working capital (for cross-border or domestic trade or excursion of projects). Although not significant today, FLCs appear to be rapidly evolving into a potentially important new source of longterm finance for SMEs. According to the CBO, the percentage of these companies’ portfolios directed at the corporate sector appears to be increasing, with percentages in 2002 ranging between 19% and 59%. In 2003 these percentages increased to between 50% and 60% (CBO, 2002, 2003).

Financing SMEs in Oman 103 FLCs lend against assets as a primary source of repayment. FLCs typically work in the area of hire purchase and usually lend up to 70% of the value of a vehicle and 50% of the value of a house. FLCs look to salary as a secondary source of repayment and generally structure loans so that residual cash flow to a personal borrower, after all debt service to all creditors, is at least RO 120/month (the country’s minimum wage) or 25% of salary, whichever is greater. Omani FLCs provide secured term financing to SMEs for up to five years at interest rates that currently vary between 10% and 15%. Non-performing assets at one FLC range between 3% and 4%, with a significant portion of this total being attributable to delayed payments, rather than long-term borrower financial problems. Given their reliance on collateral as a primary source of repayment, FLCs are especially sensitive to the state of collateral legislation in Oman, including the post-judgement enforcement mechanisms. In the view of industry participants, the collateral enforcement procedure works reasonably well, with a time horizon of between 18 and 24 months being the typical time required to move from the initiation of a court case against a borrower to final enforcement and collateral liquidation.

4

Characteristics of the SME financing programmes

There are no compiled data or studies that show the most important features of SME financing programmes in Oman. In this section we attempt to put together some basic characteristics depending on internal sources of information as well as on other unpublished sources (e.g. MOMP, 2001, 2003; FDYP, 2002; SANAD, 2002 and ODB, 2003). 4.1

The programmes

Programmes of financing SMEs were started in Oman rather late. They clearly differed from each other in terms of size of the loans and the targeted groups. This means that there is no duplication in the financing programmes. The general characteristics of financing programmes in Oman are displayed in Table 4.1. It is clear from Table 4.1 that with the exception of the soft loans programme of the MCI, which commenced more than 20 years ago, the age of other programmes has not so far reached 10 years. Also with the exception of the commercial banks and FLCs, which rest upon the conventional banking and FLCs’ organizational structure, and the Soft Loans Scheme of the MCI, whose organizational structure depends upon a specialized unit (Directorate of Development Incentives), the remaining financing programmes depend upon boards of directors from the government and shareholders from the private sector in addition to an executive machinery for supervision of the actual daily work. The non-financing programmes focus upon direction, guidance, advice, feasibility studies, assistance in obtaining licenses and short-term courses. The relationships among these programmes are considered weak as they depend upon only co-ordination and participation in making the policies through membership

Composed of a board of SANAD’s organizational structure directors 10 members from the is composed of: (1) SANAD big shareholders; in addition Board of Directors, (2) The to the executive committee, Executive Committee, consultative committee and (3) SANAD Offices, (4) SANAD experts. The Fund is managed Committee for Individual by a general manager. He is Initiatives and Self-Employment assisted by three directors and (5) SANAD Committee in (accounts, project analyst and the Wilayats administrative supporting staff)

Marketing support, Guidance and advice, protection, recommendations to the banks, periodical field follow-up technical and administrative at the different phases of support and promotion of implementation and assessment, small projects short training courses in accounting and marketing, technical support, help

Organizational structure

Non-financing programmes and incentives (direction, marketing, training and

Established in October 2001 according to a Royal Directive. It is supervised by and housed at the Ministry of Manpower. The programme had an initial capital in the amount of RO one million, being a grant from HM the Sultan

Established per Royal Decree No. 76/98 as a closed joint stock company, subject to the provisions of the commercial law of Oman

SANAD

Commencement of the programme/ capital thereof

FDYP (Youth Fund)

Table 4.1 General characteristics of SME financing programmes MCI

CBs and FLCs

Commenced in Commenced with 1981 concurrently the start of the with an agreement banking and concluded with FLC operations the commercial in the late 1970s. banks Financing differs from one bank to another At the beginning The programme The conventional ODB had a Board is managed by banking and of Directors from the Directorate FLC 9 Ministries in of Development organizational Incentives of structure. Many addition to Oman Chamber of the MCI banks have Commerce and established a Industry. Recently small business a new board of unit within their directors corporate represented by banking five ministries departments was established Advise No clear nonAdvice on financing priority projects businessmen programme and feasibility direction in available studies, respect of protection financial through requirements and industrial assessment of

Established in 1997 per Royal Decree No. 18/97 as a public joint stock company with the amount of RO 20 million

ODB

Linkages with No written documentation for other co-operation with other programmes financing parties exists yet. and government There are some individual units initiatives in the form of joint finance with other programmes, co-ordination with the parties which are concerned with qualifying and training, recommending some projects to other financing institutions like the commercial banks or ODB or government soft loan scheme; in addition the General Manager of FDYP is a member of the executive committee of the SANAD programme

consultative services)

in feasibility study and registration of the project and legal protection, selection of areas, machinery and other project requirements, financial, project management and book-keeping advice and finding the best ways for marketing the products Co-operation and co-ordination between Ministry of Manpower (sponsor of the programme), Ministry of National Economy, Ministry of Regional Municipalities, Environment and Water Resources, ODB and private sector establishments General Manager of ODB is a member of the Executive Committee of the SANAD Programme

MCI, ODB, Ministry of Agriculture and Fisheries, Ministry of Finance and the commercial banks all participate in the soft loans programme

incentives, policies against dumping, surveys and feasibility studies for investors

The commercial banks represent one mechanism which effects financing of the soft loans approved by the MCI

working capital and support SMEs’ scientific activities

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Financing SMEs in Oman

in the boards of directors. It can also be observed that no co-operation exists between the financing bodies in the field of internal financing and non-financing work. In general, there is no central agency responsible for SME financing and promotion. Instead, there are many institutions already supporting SMEs, including the MCI, the ODB, the FDYP (Youth Fund) and the OCCI. Putting all these together, we strongly believe that there is a real need for a specialized SME development agency in the Sultanate. Decisions regarding form and functions, and the necessary public–private scope of activities, can be resolved at governmental levels in co-ordination with the major SME-supporting institutions and some larger-scale enterprises. Whether it should be through change in institutional mandates, or establishing a parastatal company through public–private mergers, or creating a new institution within the private sector for the purpose, or a combination, we believe that the proposed specialized agency should have deep roots within the private sector and be designed specifically for promoting SMEs to perform better. In other words, this specialized agency must be businesslike in its approach and more focused on energizing the private sector from within through SME subsectors. 4.2

The enterprises, the volume of finance and the target group

Table 4.2 shows different characteristics of financing in Oman: definition, types of enterprises and target groups. The financed enterprises are miscellaneous as they belong to many fields of production and services. FDYP financed enterprises, for example, are wide ranging. They are composed of the services sector (bakeries, photo shops, stationery stores, installation and maintenance of air conditioners, shoe and suitcase repair and so on), tourism sector (restaurants, entertainment and sport centres), industrial sector (office equipment, school supplies, furniture workshops, shoe and plastic industries and so on), crafts (silver and gold products and crafts workshops), commercial sector (distribution of commodities and brokerage activities) and transport projects (water, sewage, trucks and car rental). However, there exists some kind of invisible specialization; that is, while the SANAD Programme focused upon enterprises of the smallest size, ODB focused upon the sectors which do not fall under the scope of activities of the FDYP (Youth Fund) and the SANAD Programme, that is, the fields of agriculture, fisheries and tourism. On the other hand, the Soft Loans Scheme of the MCI mainly focuses upon the industrial sector. The commercial banks and FLCs finance projects of all sizes and all sectors, as far as financing these projects is feasible. Generally, enterprises under the financing programmes can be divided into three general divisions in respect of the financing volumes, that is, small-size enterprises (SANAD Programme), medium-size enterprises (FDYP) and relatively enterprises (ODB, MCI and the commercial banks and FLCs). Types and sizes of enterprises have been tied up with upper financing limits in all programmes and the type of the targeted groups. Until now, in the FDYP (Youth Fund) the financed projects have reached 16 in number, that is, seven industrial projects (mineral industries, paper, transport, power,

The small-size income-generating projects in the fields of services, tourism, industry, education and health. Minimum cost of the project (fixed and working capital) should not be less than RO 20,000 and the maximum should not exceed RO 250,000 Youth

Definition, characteristics and types of project

Targeted group/ categories

FDYP (Youth Fund)

Programmes/ Description

Table 4.2 Definition, types and target groups

Work seekers including graduates, craftsmen, professionals (who wish to start or expand their projects)

Small projects (e.g. distribution of foodstuffs, readymade clothes, fruits and vegetables, clearance of documents, internet cafés, beauty parlours etc.)

SANAD

Owners of SMEs, particularly in industrial sector

SMEs in the fields of commerce, tourism, health and industry

Projects in the fields of agriculture, animal resources, fisheries, conventional crafts, workshops, industry, exports, tourism, education, health and professional offices

Individual projects owned by natural Omanis, small crafts and professional entrepreneurs and registered Omani companies

MCI

ODB

All groups of entrepreneurs

Projects of all sizes in all sectors satisfying the usual terms of financing by banks and FLCs

CBs and FLCs

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Financing SMEs in Oman

plastic and so on), four commercial projects (printing, fish marketing, vending machines and so on), three service projects (engineering and car services), one tourism project (reptiles and birds) and one educational project (a private school). The SANAD Programme engages in small projects (e.g. distribution of foodstuffs, ready-made clothes, fruits and vegetables, clearance of documents, internet cafés, beauty parlours, oil change shops, small boat repairs, barber shops, photo studios, school cafeterias, sale/supply of electrical equipment, fishing boats, petrol filling stations and distribution vans/vehicles). Projects financed by ODB are in the fields of agriculture, animal resources, fisheries, conventional crafts, workshops, industry, exports, tourism, education, health and professional offices. Finance is advanced to new projects or to support existing projects (except projects which failed as a result of mismanagement or negligence). Soft loans from the Ministry finance SMEs in the fields of commerce, tourism, health and industry, existing projects (financing includes expansion in production capacity) and projects which are facing difficulties not as a result of inefficiency in the management of the project, and also new projects in which Omanis own not less than 51% of the capital. Commercial banks’ projects include all sectors yet must satisfy the usual terms of financing by banks. The target groups differ according to the type of the programme and the volume of finance. Although the FDYP (Youth Fund) targets the young, the SANAD Programme targets all categories of job-seekers who are willing to establish tiny projects. Moreover, ODB and MCI programmes target SME projects in all fields, and commercial banks and FLCs target all groups of entrepreneurs who are willing to pay the market rate. 4.3

Mechanism and amount of finance

It will be clear from Table 4.3 that there are two ways for granting finances, that is, financing against a rate of interest (subsidized or market rate) and participation in the equity capital. It can also be observed that no saving element is embodied into any of these financing programmes and no targeted group has participated in the capital of these programmes except the FDYP (Youth Fund) and at the level of the financed enterprise only. Moreover, ODB’s own fund, soft loans of MCI, SANAD loans, and the Youth Fund do not contain deposit elements. Also it can be observed (except in the FDYP (Youth Fund)) that all other programmes depend upon the existing banks as instruments for lending against terms fixed by the financing programmes. It can be seen from Table 4.3 – given the differences in the definition of SMEs and their financial needs – that there is a wide financing range, which depends upon the type of the financing programme needed to meet the financial requirements of SMEs. This range extends from RO 5,000 to not less than RO 500,000. The FDYP (Youth Fund) finance does not exceed RO 50,000 for individual projects or RO 100,000 for joint projects. The SANAD Programme has a limit of only RO 5,000. ODB limits finance up to a maximum of RO 165,000 as a soft loan.

Financing SMEs in Oman 109 A loan cannot exceed 150% of the paid-up capital of the project in the Governorate of Muscat (except Quriyat) nor 250% outside the Wilayat of Muscat. Moreover, up to RO 5,000 can be given free of interest for craftsmen. Soft loans from the MCI can go up to RO 500,000 (for individual projects not in the form of public joint stock companies and up to RO 5 million for projects in the form of public joint stock companies, which should have covered not less than 40% of their capital through public subscription. The maximum soft loan for all projects should not exceed 150% of the paid-up capital (in Muscat) or 250% outside Muscat and inside the Wilayat of Quriyat. In the commercial banks, no fixed limit exists. However, financing depends upon the size of the project and the required loan. Although there are no up-to-date data concerning the total volume of finance, especially for commercial banks, nevertheless, it is clear from Table 4.3 that the SANAD Programme, because of its volume of finance, is the smallest total financing programme, while the MCI total finance is the largest. 4.4

Rates of interest, grace period and repayment

A method of financing in the FDYP (Youth Fund) is in the form of participation or subscription in the capital (equity finance) for at most 50%. Other sources of finance, grants, self-subscription and other partners can be brought in. The SANAD Programme provides finance against the subscribed rate of interest. Moreover, disbursement is effected through ODB, which applies the terms of the fund in respect of repayments. The ODB and soft loans from the MCI are provided at the subsidized rate of interest. When financing of MCI soft loans is effected through the commercial banks they are made against government guarantees. However, the banks should take the necessary steps to ensure that the project satisfies their terms and conditions as well as the terms of repayment. Commercial banks charge the interest rate prevailing in the local market (see Table 4.4). Rates of interest differ according to the differences in the types of financing, their objectives and the targeted groups. The lowest rate of interest is charged by the SANAD Programme (2%), followed by ODB (3%), whereas the highest rate is charged by the commercial banks and FLCs, and the FDYP (Youth Fund) is not charging interest because it is venture capital financing. Interest rates vary widely between different programmes. The interest rate for subsidized lending is 2.5%, whereas market rates range between 9.33% and 15%. With the exception of the commercial banks (average rate is 9.33% per annum) all other financing programmes include some exemptions from the rate of interest, taxes and fees. It is observed that the grace periods increase with the increase in the volume of loans, except for the FDYP (Youth Fund) and the commercial banks and FLCs, where there are no grace periods, either because of the nature of financing upon which grace periods do not apply, or because banks and FLCs need the deposits for refinancing to make the highest possible profits. Though not big, differences between the grace periods exist, and most of the grace periods fall within a span of one to five years. As for the FDYP (Youth Fund) the repayment period depends upon the options for the sale of the shareholdings in the financed enterprises.

Total amount of finance

Amount of finance per project

Methods of advancing finance

RO 236,000 (1999) RO 493,585 (2000) In 2002 the FDYP was managing a portfolio of RO 1.3 million invested in 20 companies. During 2003 and continuing into 2004,

In the form of participation or subscription in the capital (equity finance) for 50% thereof at most Not exceeding RO 50,000 for individual projects or RO 100,000 for joint projects

FDYP (Youth Fund)

Table 4.3 Methods and amount of finance

Total loans agreed upto 2002 reached RO 300,000 (out of which RO 125,000 were in Muscat Municipality, RO 70,000 in Batinah, RO 35,000 in Al Dakhliya, RO 45,000 in Al Sharqiya,

RO 5,000

Against the subscribed rate of interest

SANAD

Up to RO 5,000 free of interest for craftsmen projects. Between 1997 and 2000 the total volume of finance reached RO 29.2 million. Out of this RO 6.4 million in Muscat.

Up to a maximum of RO 165,000

At the subsidized rate of interest

ODB

Up to RO 500,000 (for individual projects not in the form of public joint stock companies, and up to RO 5 million for projects in the form of public joint stock companies, which should have covered not less than 40% of their capital through public subscription Upto March 1997, 363 industrial projects obtained loans in the amount of RO 98 million. Also 58 industrial projects obtained grants in the amount of RO 1.899 million.

At the subsidized rate of interest

MCI

Not precisely known

No fixed limit exists. However, size of finance depends upon the size of the project and the required amount of loan

The rate of interest prevailing in the local market

CBs and FLCs

RO 15,000 in Al Dhahira, and RO 10,000 in Dhofar Municipality). Up to October 2004, 364 loans were granted with total amount of RO 1.6 million. Most projects financed were in Muscat and Batinah (28% each), Sharqiya (20%), Dakhliya (10%), others (14%)

Note a Information cited here obtained from Studies and Research Department – ODB.

the Fund ceased investing in new projects

Sectoral finances are as follows: Industry (RO 4.3 million) Fisheries (RO 5.8 million) Agriculture (RO 4.3 million) Tourism (RO 3.7 million) Animal resources (RO 2 million) Other sectors (RO 1 million)a

Up to the year 2000, loans amounted to more than RO 225 million advanced to 509 projects. The share of the industrial sector in that total amounted to 55.8% and 33.3% for tourism and 16.2% for agriculture and fisheries Between 1981 and 2005, RO 245 million was allocated under this programme for 552 projects in industry, tourism, health, education and agriculture; 424 projects (66.8%) in industry, followed by 74 project in the tourism sector and 35 projects in agricultural sector. 250 projects financed were located in Muscat Municipality, 110 in Batinah, 64 in Dhofar Municipality, 49 in Sharqiya, 32 in Al Dhahira, 29 in Al Dakhliya, and 12 in Al Wusta

SANAD

There are no charges except Rate of interest in rare cases where the Fund at 2% p.a. conducts the feasibility study for the project through a consulting firm, where the owner of the project bears 50% of the cost. Exemption from income tax on companies for 10 years (may be extended by the Council for Financial Affairs & Energy resources) Exemption from profit tax (for commercial and industrial establishments) for five years (renewable for another five years by the Council for Financial Affairs & Energy Resources) Exemption from subjection to the provisions of the law on Investment of Foreign Capital (Royal Decree No. 102/94 and its amendment)

Note a CBO, Annual Report, 2001.

Rate of interest, charges and exemptions

FDYP (Youth Fund) Rate of interest at 9.5% p.a. (3% payable by the borrower and 6.5% borne by the government). Owner of the projects bears the insurance premiums. As to loans exceeding RO 5,000, it may be covered by way of life assurance and the borrower bears the relevant premiums Some fees and fines are being charged

ODB

Table 4.4 Interest rates, charges, exemptions, grace and repayment periods

3% p.a. (for projects whose capital exceeds RO 250,000 in the field of tourism, general education, high education, health, agriculture, fisheries and conventional crafts). (1) Exemption from import duties on machinery and industrial raw materials all through the span of the project. (2) Provision of land and buildings against a nominal price. (3) Policies against dumping. (4) Reduction in the prices of electricity and water. (5) Surveys and feasibility studies for the investors. (6) Exemptions from custom duties on semifinished primary materials during the first five years from commencement of production. (7) Exemption from income tax during the first five years with the possibility of extending it provided that Omani employees in the project are not less than 25%

MCI

Average rate is 9.33% per annum (2001). Interest rates of FLCs range between 10% and 15%

CBs and FLCsa

Financing SMEs in Oman 113 4.5

Terms and guarantees

Table 4.5 displays conditions and guarantees required for financing by all financing programmes. As is clear from Table 4.5, with the exception of the SANAD Programme and the FDYP (Youth Fund) – which aims at encouraging the young and graduates’ enterprises – the rest of the financing programmes do not set age as a condition for granting loans. And with the exception of clothes designing and sewing in the SANAD Programme and workshops and professional offices for ODB, all other programmes do not require obtaining a training certificate as a condition for financing. Yet all financing programmes ask – whenever necessary – for personal guarantees, mortgages and so on, except the FDYP (Youth Fund), which does not require guarantees because financing is advanced in the form of participation in the equity capital. 4.6

Criteria for enterprise selection

Objectives and financing priorities are displayed in Table 4.6. Whereas the programmes have different criteria for the enterprise to be financed, proving the economic viability of the enterprise is the common basic condition among all of them, as we can see from Table 4.6. This does not mean that the Omanization condition does not exist, but it is not strongly required since the financing programmes are not concerned with following up Omanization ratios set out by the MOMP after granting the finance. And with the exception of the FDYP (Youth Fund) and the SANAD Programme, other financing programmes do not require Omanization as a basic condition for financing. They rather give preference to enterprises which belong to the sectors of priority (under each programme) despite the fact that their financing objectives include Omanization. Notwithstanding this, we find that objectives of financing have a relationship with the criteria which must be satisfied by the enterprises.

5 5.1

Evaluation and proposal Indicators of success and failure

Table 4.7 illustrates some indicators of success, obstacles and future vision as can be ascertained from either the managers of the programmes or their published materials. There are no indicators for the measurement of success or failure at the level of the financed programme. Analysis has focused upon the volume of finance and the concessions which have accompanied financing without assessing the financed enterprises or the impact of financing upon the targeted group. The period since the programmes of financing SMEs commenced operations in Oman has witnessed completion of the organizational frameworks and requirements in the SANAD Programme and the FDYP (Youth Fund). Other programmes which started before these two programmes completed their organizational

Conditions

SANAD Applicant should be an Omani citizen between 18 and 40 years old

Can read and write well

Not currently working and must devote full time to the project

FDYP (Youth Fund)

Full-time devotion to the project, which should be the main source of income

Reasonable level of education coupled with ambition (graduates of schools, universities, colleges and high institutes)

Age: at least 20 years old

Table 4.5 Conditions and guarantees

Three quotations for assets need to be submitted, plus audited accounts for at least two years (if the purpose of finance is expansion of the project) in addition to sufficient securities

The project shall be subject to the Omani Commercial Companies Law, registered and licensed accordingly There shall be a feasibility study and owners should be of good reputation There shall be a certificate from the Wali or Sheikh confirming the existence of a place for the project or partners in the project

ODB

Conventional guarantees usually required by the commercial banks

To satisfy the conditions in respect of licensing, registration, financial auditing and other legal procedures. The investment cost of the project is also a determinant

The project must belong FLCs lend against to an approved field; assets as a primary should be economically source of repayment viable; Omani ownership and salaries as a should not be less than secondary source of 51% and share in capital repayment payable by owners must have been paid in full before amount is disbursed

CBs and FLCs

MCI

ODB shall conduct feasibility studies for projects whose cost exceeds 100,000 RO within three weeks from the date of receipt of the application Disbursements of the loan payments are completed within one year only (an additional period of only three months may be granted) Financing of professional offices requires a university certificate and experience of not less than two years. Moreover, financing workshops also requires vocational training certificates and at least one year’s experience

Applicants should obtain a training certificate (for clothes sewing and designing)

Must complete application procedures (copies of the ID or passport, feasibility study, confirmation to employ nationals only, submit two quotations for machinery and equipment, insurance against fire and theft to be paid for by the Fund and then deducted from the loan)

ODB shall conduct feasibility studies for projects whose cost exceeds RO 100,000 within three weeks from the application

A place on which the project shall be established (either owned or rented)

(Table 4.5 continued)

Guarantees

SANAD Include all or some of the following: Personal guarantee from a very close relative (i.e. father, brother or sister) Mortgage of the project or post-dated cheques Mortgage of project asset

FDYP (Youth Fund)

No securities or mortgages are given

Table 4.5 Continued

These are determined according to requirements of the legal form of the project, circumstances and needs thereof. This includes mortgage of the assets (real estate or fixed assets covering 1.5 times the amount of the loan), shares and bonds (of good quality) or post-dated cheques: also bank and personal guarantees (assessed by the concerned approving parties) Total securities will not exceed 2.5 times the amount of the sanctioned loan. Additional guarantee may be taken in some cases Securities are documented and registered with the relevant government authorities for a period covering the duration of the loan

ODB

MCI

CBs and FLCs

Aims of advancing finance

To help in the evaluation of the project studies, obtaining the government licences and the best quotations from the suppliers; also to qualify for obtaining grants and commercial loans To provide financial, technical, administrative, marketing and organizational expertise, help change the business culture from government subsidy to self-reliance and risk taking, a change from exclusive reliance on bank debt to a mixture of debt and equity

FDYP (Youth Fund)

ODB

MCI

To achieve the highest possible profits

CBs and FLCs

(Table 4.6 continued)

To finance projects To develop the industrial To employ national manpower and contribute which are directly related sector and to increase its to Omanization of small to the services and contribution in the GDP projects economic fields from the current level of about 5% to 15% by the Encourage and sponsor (agriculture, animal individual initiatives resources, fisheries, year 2020. Also to expand To qualify for entering the industry, exports, education, the production base, labour market health, professional offices, encourage investments of To develop individual crafts and workshops) the private sector, realize projects and support To guarantee loans the strategic objectives of developmental efforts advanced by other banks development and create towards establishment of To manage the programmes new employment small-size production and of loans and grants opportunities for the services projects; to advanced by the Omani nationals establish nurseries government to the To eliminate disguised craftsmen trade by expatriates To enhance awareness of the importance of selfemployment, self-reliance and free business of whatever type for the Omani youth To eliminate the uneven competition with foreign labour To expand the base of the private sector

SANAD

Table 4.6 Objectives and priorities of finance

Project priority criteria

SANAD

ODB

Priority is given to Priority is given to the new Priority is given to projects which are vocations, crafts, projects which are proved proved to be distribution/production to be economically viable economically viable service projects Projects must be managed by owner themselves Project owners should have managerial and organizational skills Projects should offer jobs to Omani Youth, make use of local raw materials and cover the local market and export Short period for effecting repayment Observing diversity in the types of projects and geographical distribution of finance

FDYP (Youth Fund)

Table 4.6 Continued

Priority is given to projects which are proved to be economically viable, can achieve high additional value and should not be duplicates of other projects Priority is also given to industrial sector projects which export not less than 10% of their production and which produce foodstuff (edibles and soft drinks) that depend upon local raw materials for at least 20% of the total cost of raw materials used in production Preferences given to new tourist projects and health projects (private hospitals with specialized clinics, polyclinics, sports medicine clinics, physiotherapy centres, old age care homes, pharmaceutical industries and medical supplies)

MCI

Priority is given to projects which are proved to be economically viable and offer returns that cover the amount of finance and rate of interest. Financed projects may belong to all sectors

CBs and FLCs

Indicators of success in respect of objectives

SANAD

(1) All organizational (1) All organizational requirements have long requirements, work been completed. machinery, rules and (2) Compile information procedures have been and gain experiences of completed. (2) Upto the end practical value in respect of of 2004 SANAD managed to the issues faced by SMEs. offer 5,401 job opportunities (3) The Fund has financed through Omanization of 16 projects in all sectors 3,861 foodstuff shops in stated in its programme. 45 Willayats (95.9% are It is observed that the Fund self-financed and only follows the policy of 4.1% are financed through ensuring that all measures the SANAD programme) of success have been (3) Until October 2004, the completed before starting to SANAD Fund provided finance the operations finance to 522 self(qualitatively and not administered commercial quantitatively) and professional small projects with total finance of RO 23.6 million, and average finance of RO 4,600 and a repayment rate of 76.8%. (4) Up to 2005, 1,908 individuals were trained in IT, book keeping, administration of foodstuff shops, and fruits and vegetables shops, and tailoring. (5) Two nurseries in the field of tailoring of

FDYP (Youth Fund)

Table 4.7 Indicators of success, obstacles and future vision

By the end of 2001, total loans advanced by this programme amounted to RO 33.7 million

ODB

CBs and FLCs

(Table 4.7 continued)

Despite the success realized in terms of the the size of finance, which amounted to more than a quarter of a billion RO advanced to more than 500 projects, some of these projects are afflicted by some weaknesses and losses

MCI

Future vision

Obstacles

SANAD

ODB

MCI

CBs and FLCs

female clothes were established in Willayats of Ibri and Nizwa. Work is now under way to establish five other nurseries (1) Lack of technical skills (1) Weak understanding by the (1) Limited activities that the (1) Ways of assessing and Scarcity of in the proposed projects. young of the concept upon bank has to finance. following up the projects projects (2) Lack of awareness in which the SANAD Fund (2) Most financed are weak. (2) Concern is which are respect of management has been based. (2) Limited enterprises are small and mounting that the number highly concepts and the spirit of awareness of selfthe cost and the risk of of project failures will economically increase after expiry of the feasible entrepreneurship by owners employment among youth finance is high. of the projects. (3) Low and fear of business failure. (3) Saturation of the market five-year grace period. level of financing. (3) Spreading of disguised with the type of projects Overlapping in the (4) Absence of legislation trade and competition from financed by the bank. functions of the parties, which gives priority to expatriates. (4) Population (4) Weak government which are authorized to private projects (as can growth, increase educational support and short repayment approve the financing of be seen from our outcomes and limited period of services and the projects (3) Shortages correspondence with government jobs which educational projects (private in the cadres which are most of the youth are schools and individual qualified in the field of the Fund)a seeking. (5) Increase of medical clinics) project financing female participation in the labour market. (6) Limited adaptation of SMEs to changing market conditions. Lack of administrative, financial and technical expertise The Fund is currently (1) To expand the scope of (1) Extension of financing developing novel methods activities to include heavy base via financing new of financing so as to cope vehicles, electrical and activities. (2) Upgrading of

FDYP (Youth Fund)

Table 4.7 Continued

so on. (2) Ensure linkages of small- and large-scale enterprises, and amalgamation of small projects to form mediumsize or large projects. (3) Raise the profile of self-employment culture among youth (4) Enhance co-operation with other countries, regional and international organizations to provide finance, training, technical and marketing support. (5) Include university graduates and increase finance to RO 10,000. (6) Provision of a limited period incentive funding for starters according to criteria such as type of projects and location. (7) Encourage banks to provide additional equal finance to SMEs through the SANAD Fund as a guarantee and through a Fund Guarantee System to be established for this purpose

the volume of finance and extending repayment periods. (3) Need for the bank to perform other profitable activities to strengthen its financial base

Note a One of the outcomes of our communications with the Director General of the Fund for Development of Youth Projects.

with the financing problems it has faced

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frameworks a long time ago. Although programmes managed to create some jobs and accomplished some training plans in IT, bookkeeping and shop administration, these achievements are far from being satisfactory given the total loans advanced by these programmes. Moreover, the FDYP (Youth Fund) is the smallest programme in terms of the number of projects financed, and ODB’s and some of MCI’s projects have encountered losses. Obstacles at the target group level include lack of awareness and sprit of entrepreneurship and massive population growth. Spreading of disguised trade and scarcity of economically feasible projects are also noted to be impediments to these programmes. At the level of programmes shortages of cadre and weak assessment and follow-up of projects are the major weaknesses. The future vision is that at least three financing programmes should have in place extension plans, revisions and programmes with distinct features. 5.2

Financing procedures

The representation of the SANAD Programme and the financing scheme of the MCI by ODB was necessary because a financial institution is the most appropriate institution for lending to a small enterprise, as this represents an important part of the activities which are efficiently carried out by it. Moreover, it has now become necessary, and well known in the literature on financing SMEs, that governments and central bodies should not extend support to enterprises by themselves because their administrative structure differs from the administrative structures of small enterprises. The institutional arrangements for soft loans financing are inadequate. The SANAD Programme is managed directly by the MOMP; activities carried out by officials in this regard are not part of public administration activities. Moreover, there is limited private sector participation in decision-making and evaluation of applications for soft loans or SANAD small loans. Many of the evaluation studies on the effects of the programmes of the central bodies on the development of SMEs reached the conclusion that performance was rather weak compared with the related costs. Also such bodies were characterized by a concentration of power in the centre, lack of flexibility and focusing financing activities on urban areas. In view of the differences in the nature and fields of interest of the enterprises, many countries have established bodies to represent SMEs away from the groups or institutions which primarily take care of the big enterprises; that is, there is now a trend of diversion towards private institutions to render assistance to SMEs as such institutions are more acceptable by owners of small enterprises in view of their direct relationship with them as well as their knowledge of the basic problems of the owners of such enterprises. The government role should be the creation of the proper environment for the growth and development of SMEs through policies or giving support to the institutions which carry out the functions on its behalf, as it is not recommended for the government to assume an executive role. Indeed the government role should be the setting of the basis and policies for developing and lending to enterprises. This is what is prevailing now; however,

Financing SMEs in Oman 123 assessment of the applications for financing and recommendations for approval are matters which do not fall within the authority of the employees of the MCI. In this regard we suggest the establishment of a joint institution between the private and the public sectors whose function would be the development of SMEs, as such an institution would be more appropriate than the government or continuation of dependence upon a specialized institution like ODB. The form of the specialized joint institution for the development of small enterprises may be the subject of elaborate discussions since setting its functions, legal form and the activities or roles of each of the private sector and the public sector therein needs to be well studied. In any case we see the importance of the effective participation of the institutions which render support to SMEs (like ODB, commercial banks, financing and training programmes, OCCI and the Public Authority for Industrial Estate) in the creation and running of such joint institutions. In sum, it can be said that the central organizational function of rendering support to enterprises can be done by a national body in the form of a council or an institution specialized in the development of small enterprises. Such a body should be composed of representatives from the government and firms of the private sector. It should act as a central supervisory entity and director of policies with powers to be exercised by an executive committee. Limiting the financing rendered by the SANAD Programme to small new enterprises has an advantage which is seen in the fact that financing for the purpose of self-employment is more important for a new enterprise than for an already existing one. Many of the latter do not make full use of financing in creating job opportunities for national manpower. For the sake of financing new enterprises, we think it is appropriate to link the SANAD financing programme with the Intillaqah training programme. Experience of collective enterprises or the partnership of many individuals in one enterprise, which the SANAD Programme is looking at for the purpose of expanding production by means of increasing the capital of the enterprise, should be viewed cautiously because the probabilities of success of such experiences internationally have been very low, unless the objective is to bring the enterprises together so as to make use of the available services but to keep each enterprise independent (like the experience of the industrial estates for example). We see that the objective should be vertical expansion together with horizontal expansion and should aim at settlement of the people who take finance at this phase in the development of the programmes. This emphasizes the importance of the availability of more than one loan for an enterprise for the purpose of expanding the enterprise or realizing the settlement of workers or introduction of certain social programmes (such as housing loans in limits similar to those of the popular housing schemes or any other privileges) for enterprise owners who honour their repayment obligations. In section 2.5 we highlighted the difference between the financing policies that follow demand for small credit and the financing policies that create demand for small credit. In Oman (as well as other AGCC states) there is a strong belief that

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there is a rigidity of supply of credit services brought about by increased costs of credit. Therefore, policies strive to create demand for small credits by subsidizing credit. This policy is not based on solid foundations, as there has been no empirical research on the SME financing gap undertaken so far according to our knowledge. Moreover, soft loans encourage SME entrepreneurs to depend exclusively on cheap borrowed capital rather than on their own savings. Therefore, there is indeed a need for a comprehensive review of the soft loans programme for the sake of assessing the enterprises and following up their performance and also a review of the subsidized rate of interest on loans as well as a study on the feasibility of introducing refundable ‘seriousness’ fees to be payable by the loan applicant to ensure the success of the financed enterprises, guarantee the seriousness of the applicant for finance and ensure the continuity of the financing programme. In fact we see that the soft loans in the meantime should be targeting the existing enterprises more than start-up ones since it is known that the advancing of loans is more cost effective when loans are granted to existing enterprises. Also the test of the rise and success of an enterprise without assistance is in itself a test for the enterprise so that we can give support to it. In the long run, soft loans should be restructured and the government interest subsidy needs to be removed on ODB loans, or ODB should be abolished. In microfinance schemes shortening of the period between instalments in the schedule of repayments (depending on the cash flows of enterprises) has become quite necessary so that the borrower does not feel that he is losing a big portion of his money. Also repayment by big instalments over a long period of time constitutes a burden upon the borrower. Moreover, to increase the number of financed entities and encourage enterprises to realize quick returns before repayment, as a sign of success, we see that there is a need for shortening the period of loans. This proposal is in tune with the statement that if you try to assist enterprises more than necessary, you will then be weakening them because successful enterprises are the ones that have had not obtained any assistance. 5.3 5.3.1

Non-financing programmes Promotion

Our observations indicate that giving importance to promotion of the financing programmes among the targeted groups of most of the financing institutions in Oman has taken the form of promotion of the financing institutions themselves rather than for economically and technically viable businesses and enterprises and for how to apply for loans, satisfy conditions and make use of the services of such financing institutions. In view of the limited types of enterprises which can realize big economic returns in Oman because of the narrow investment opportunities in most of the non-oil sectors and limited local market, it is important that considerable efforts should be exerted by the SME-supporting institutions to promote some of the highly viable enterprises among the targeted groups.

Financing SMEs in Oman 125 5.3.2

Internal studies

It is observed that no attention is paid to measuring economic and social returns regularly in all financed enterprises in Oman, though there is now a tendency towards introducing monitoring by the SANAD Programme and the FDYP (Youth Fund). In this regard we see that it is very important to measure in figures the cost of financing of the enterprises. It is also necessary to compare the cost with the estimated economic and social returns. 5.3.3

Consultancies

Consultancies in the fields of financing and non-financing programmes are currently left to the financing institutions, which are always busy evaluating the feasibility studies, executing the procedures for granting finance, following up and doing other daily routine chores. If the institutions which give assistance to enterprises have to limit themselves to only one activity over which they exercise control and carry out the same more efficiently, the effect will be the following: 1

Establishment of a voluntary body (like, for example, a national society for the promotion of small enterprises and crafts) – or periodic meetings of concerned individuals, especially in the regions – which primarily assists and directs owners of enterprises (primarily small enterprises) in respect of the available financing opportunities and the most appropriate of them for the enterprise. It also helps in fulfilling the financing requirements through coordination with the financing programmes, provided that the activities of its members are consultative, directive and non-obligatory to the financing programmes. It can also provide individual consultations and conduct studies and seminars in all matters relating to the development of SMEs, particularly financing. We propose that membership of such a voluntary body should be composed of concerned parties, private consultancy offices, research institutes and centres, supporting establishments in the fields of training, administration and marketing, owners of enterprises, financing houses, university and college faculties and government employees in their personal capacities. We see that it will be most appropriate if such a voluntary society is established under the sponsorship of OCCI because it matches with the main objectives of the Chamber of Commerce and Industry, that is, encouraging SMEs, building up relationships between the private and public sectors, making proposals for the protection of the private sector, conducting studies and providing basic information, noting that the Chamber of Commerce and Industry is now active in fields like workshops and symposiums on how to establish and ensure continuity of small enterprises. It also tries to find investment opportunities for the owners of enterprises, provide legal and economic consultancy help the owners of enterprises to complete required government procedures and obtain soft loans and make proposals in respect

126 Financing SMEs in Oman

2

3

4

of industrial incentives and so on. Such functions tally with the functions of the proposed voluntary society. Establishment of a consultative, informative and directional unit for SMEs at the OCCI and at each financing institution to complement the role of the OCCI. The roles of the Chamber of Commerce and Industry and the national society for the promotion and development of small enterprises and crafts – as we see – are complementary or facilitative to the roles of the financing programmes as well as the governmental programmes and policies in respect of enterprise financing. Therefore the chance of success is high. We expect the government and the financing institutions to support the society and OCCI so that both can carry out consultative functions. To enhance skills and capabilities in the fields of consultancy, evaluation and follow-up of the enterprises through provision of high-quality courses on banking and development financing to employees of the financing institutions, particularly Omani graduates from universities and colleges. It is evident that there is shortage in the cadres who are qualified in the evaluation of enterprises as well as in developmental financing. Raising the skills of employees in the financing institutions is considered a long-term specialized activity which is necessary for providing consultancy, evaluating enterprise plans, following up and developing the enterprises. It is also considered one of the factors in the success of the lending programmes. To make use of the experience of the FDYP (Youth Fund) in the practical directives which are stated in its introductory brochure (FDYP, 2001) in terms of specific and practical guidance on preparing the working plan and its components (marketing, administrative, technical and financial study) and involving the applicant himself in the preparation in order to ensure his knowledge of enterprise affairs before financing is granted.

5.3.4

Training

Training programmes should be limited to essential and useful matters which will serve the interests of enterprise owners. They should be non-conventional and start well after the date the enterprise was established. Also, many training programmes have adverse results on the borrowers, particularly if training was made a condition for obtaining the loan, because an entrepreneur’s attention will be concentrated on how to obtain the certificate rather than making use of the training itself. Even if entrepreneurs hold training certificates pertaining to the enterprise, it does not mean at all that such certificates qualify for financing as well, because the terms and characteristics of financing differ from those of training. Also, undergoing training may help in the establishment of the enterprise yet will not guarantee the success of such enterprises and consequently the ability to repay loans. It is also important that training should be given to those who seek to get it as well as pay costs. Hence enterprises should pay for some of the services rendered to them. Obviously individuals appreciate services which are paid for. We see no good reason that the financing programmes should provide training to the

Financing SMEs in Oman 127 financed parties because the idea behind such programmes is to give assistance to the enterprise through serving one objective only (financing) against a rewarding return. Therefore, the financing programmes should not expand by way of carrying out other functions (though necessary) which do not fall within their specialization. 5.3.5 culture Success of financing small enterprises cannot be separated from the other optional services which are needed by entrepreneurs. Among these is to emphasize the culture of the enterprise in the form of enlightenment courses, symposiums, opinion forums, seminars and cultural publications aiming at imparting knowledge of the issues related to the enterprise like laws, health and environment matters and government policies. It is important that these services should be rendered free of charge and the same should be directly related to the lending institution. OCCI is considered to be the appropriate body for the provision of such optional services. 5.4

Participation in the project/partnership in the capital

The successful lending programmes have introduced the element of participation in the equity capital as a mandatory condition for financing. Among these experiences are the membership credit associations and the small enterprise financing banks. In Oman it is observed that there is no financing programme in whose capital borrowers participate. By this we mean an institutional programme or a bank owned jointly by the government and the borrowers, with the latter holding at least 70% of its capital. Among the advantages of participation in the capital of the lending institution is that such participation gives a chance to those who aspire to deal with an Islamic financing system because the rate of interest charged by such system (in which the borrower owns a shareholding in the capital of the lending institution) is being paid to the bank or lending institution yet in view of participation in the capital, as mentioned earlier, the borrower in fact pays the interest to himself. With the exception of the FDYP (Youth Fund), which is based upon participation in the capital of enterprises, other lending programmes primarily depend upon financing by loans instead of financing by subscription in the capital of enterprises. We see that it is important to consider expanding the base of financing programmes through joint capital (venture capital) in the short term or by way of any form of mixed capital to finance enterprises on a short-term basis and consequently participate in the profits and losses. However, such expansion should not be at the expense of the current trend which depends upon loans. But once more, diversification of the types of financing is an important matter, despite the difficulties that may be encountered in including the target groups as shareholders. The participation or partnership system actually confirms the

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seriousness of the borrower and reduces cases of default in addition to its higher returns and fulfilment of the objectives of financing which, is to make the financed enterprise, self-reliant in the future. The system also matches with the opinion that loans should not necessarily cover all costs of the enterprise, since if we try to finance enterprises with more than what is necessary, we will in fact be weakening them. We also believe that the commercial banks, with their rich long experiences particularly in financing the short-term working capital of SMEs, can employ part of the financing funds in equity participation, particularly in enterprises which have higher chances of success. Yet this requires practical experience, which currently is not available in the employees of the local banks. Hence, efforts should be exerted to establish such experience.

5.5

Links between programmes/the programmes and the relevant government units

The relationship which links the local financing programmes with each other can be summarized in the recommendation of some entrepreneurs to the various financing institutions and employment of the banks by some programmes as a financing vehicle. Also the relationship of the financing programmes with the government authorities can be summarized in some forms of non-organized co-operation between them in addition to the membership of the ministries in the boards of directors. Absence of memoranda of understanding as well as co-ordination between the various SME financing institutions in Oman can clearly be observed. However, this does not mean the absence of co-ordination at all, as it takes place in a partial, non-institutional and individual manner. We propose expansion of the connection and co-operative links between the local financing programmes in an institutional way through memoranda of understanding, trying to unite and co-ordinate the current efforts through joint promotional and encouragement plans in addition to establishment of a one-stop station. We also see the importance of co-operation for gaining experience and making use of the instruments of implementation and financing in the best enterprise-financing programmes in the world, particularly the Asian countries, which preceded Oman in the field of enterprise financing.

5.6

Periodic assessment of the operations and performance

Only the SANAD Programme has made one field study evaluation of the social and economic outcomes. The major results are that 92% of beneficiaries are school graduates, with income improved by more than 140%, and 87.6% of beneficiaries are making profits greater than their counterparts in other job; average jobs created per project is 1.4. SANAD also has periodic (monthly) visits using standard reports and personal files. Moreover, ODB submits and annual financial report showing the repayment position of the year.

Financing SMEs in Oman 129 Regular assessments should be conducted for each financed enterprise or at the end of each financing operation so as to measure the socio-economic outcomes.29 We need also to determine the type of social outcome required from each financing programme. In addition, we suggest not relying upon the results of the government statistics such as average sales, exports, value added and sectoral Omanization to measure the economic outcomes. For example, the results of the industrial surveys should not be looked at as a success for the government soft loans scheme. Performance of the financed companies is the real yardstick for the degree of success or failure, noting that it is possible for unsuccessful enterprises not to make full use of finance because of internal administrative and technical constraints and that the enterprises which contributed good performance reflected in the sectoral statistics are the enterprises which had not availed themselves of any assistance from the government or from the financing programmes. Results of the regular assessments can lead to proposing rehabilitation packages for the defaulting borrowers, like rehabilitation of the enterprises or conversion of the loans into equity or partnership between the borrower and the lender or selling the assets in case of failure of these proposals; if these proposals are not helpful then such enterprises should be liquidated. It is rather more useful that assessment should also include performance of the financing institution itself. Work plans and accomplishments should be revised as well and future plans and objectives should likewise be set up. 5.7

Studies on enterprises

From experience we see that no studies have been conducted in respect of identifying the financing gaps for all types of enterprises in Oman. Also studies and periodic statistical surveys relating to constraints and the investment environment for SMEs do not exist. We also call for studying the possibility of introducing some of the international social programmes applied by financing institutions towards fulfilment of the social side of the financing process, such as introduction of housing loans (within the limits of popular housing) in the SANAD Programme for owners of successful enterprises who honour their repayment obligations when they fall due. Such supplementation leads to stability and drives entrepreneurs towards creation of success.

6

Conclusion and policy recommendations

SME financing programmes, government soft loans schemes, financing programmes of voluntary organizations and other financing schemes SMEs should not look at giving finance to profit-seeking entrepreneurs as part of human rights such as education, clean water and so on. It is not required that such programmes should finance SMEs if such finances do not generate some benefits such as profits or the achievement of some economic objectives within a limited period of time. Moreover, SMEs were originally started without any need for financing, and financing took place a long time after the enterprises were

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established. The trend towards rendering assistance to enterprises commenced in India and the USA in the 1960s. However, it is now expanding more than the expansion of the enterprises. Nowadays there is an international trend in SME financing not to consider any newly established enterprise. There is also a general understanding that financing institutions which are profit-seeking and which aim at ensuring their continuity must avoid financing enterprises during the starting phases up until they prove their worthiness. Perhaps the usual period for that would not be less than two years. Also by reviewing the performance of the enterprise, the seriousness of the entrepreneurs – on one side – can be confirmed, and reasonable success of the enterprise – on the other hand – can be seen. The literature on SME financing established that enterprises which have been established a year or two years ago are the ones which are more able to utilize training and financing in an effective way, more than enterprises which ask for financial assistance but whose entrepreneurs do not know how to utilize it because they have not earlier entered into the field of enterprises. Despite such opinions the banks and other financing institutions can finance new enterprises against terms which are different than the currently applied ones. Such terms should naturally be stringent, motivating but not incapacitating. The aim of these conditions should be not only to ensure more guarantees for repayment, but also to give assistance and guidance to entrepreneurs regarding the best ways for utilizing the loans. Obviously, many of the existing banks have no qualified cadres to give assistance in those matters at the level we expect. Hence banks and financing programmes must create cadres who are qualified for giving guidance, direction, advice and follow-up. The government may also continue adoption of the objective of financing new enterprises, particularly when it falls within an integrated national plan to realize objectives like self-employment, increasing output, self-reliance or developing the small-scale industrial sector and so on. However, due to budgetaryrationing reasons, this type of financing must be applied against a strong basis, including identification of those who need financing more than others and establishing a mechanism to guarantee the return of capital as soon as possible for refinancing, thus ensuring continuity of the financing programme. Also one of the necessary conditions is that this type of lending should be selective and should depend upon the importance of the new enterprise and the seriousness of the entrepreneur. We also expect such financing to be decreasing and not continuous, because it is either a success or a failure, and hence in either case should be stopped. Despite all the amendments introduced for considering many of the problems of bank lending to newly established and already existing enterprises, some of these problems still exist, the most important of which is represented in the case when a project fails, and its owner loses his means of livelihood and enters into the difficulties of repaying the loan from sources outside the enterprise. Therefore, lending in the form of partnership in the capital (equity finance) or any other system based upon PLS between the financing institution and the entrepreneur can solve the repayment problem and put the entrepreneur in a better

Financing SMEs in Oman 131 position. In this regard, we add that the PLS arrangement can be utilized as a financing mechanism for the newly established enterprise. Here the partner has to share, and this may resolve the issue of the seriousness of the entrepreneur, but in itself does not guarantee the success of the enterprise. One of the advantages of this type of financing for newly established enterprises is that the two partners (the entrepreneur and the financing entity) have a keen interest in the success of the enterprise. In a system where an entrepreneur does not pay a predetermined fixed return for utilizing capital or bear the investment risk alone but shares some with the lending institution, new entrepreneurs will feel that they are in a better position if risks are being spread between them and the banks. Given the above analysis, the following set of recommendations seems essential: 1 The previous period in the life of the financing programmes witnessed the completion of the organizational frames and requirements, yet there does not exist any measurement of indicators of success and failure in the financed projects. 2 There is utmost importance for establishing a joint institution between the private and public sectors for promoting small enterprises. Such an institution would be more appropriate for helping small enterprises than the government or continuing to rely upon specialized institutions like the ODB. 3 The current trend in financing programmes towards financing small-size new enterprises has an advantage because financing for the purpose of selfemployment is more important for new enterprises than already existing ones. However, it is more successful in already existing enterprises. 4 We must be cautious in financing collective enterprises in which many individuals participate, unless the objective is to group the enterprises so as to make use of common services and each enterprise remains independent (like the experience of the industrial estates). 5 It is important to conduct a comprehensive review of the soft loans programme so as to assess the financed enterprises and follow up their performance. Also important is to review the subsidized rate of interest on loans or study the likelihood of introducing a system of refundable seriousness fees payable by the loan receiver to ensure the success of the financed enterprise, seriousness of the applicant and continuation of the financing programme. SMEs must be financed at market rate, with credit and loans granted by commercial banks or by a development bank operating on a commercial basis. Soft loans, if any, should be targeting existing enterprises more than new ones. 6 The repayment period between one instalment and the next in microfinance should be shortened, whenever the cash flows of enterprises permit, so that the borrower will not feel he is losing a big portion of his money. Moreover, repayments by large instalments which fall due after a lapse of long periods between each represent a burden to the borrower.

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7 In view of the limited types of high-returns enterprises, we see it is important to give more attention to the promotion of economically and technically viable enterprises and explain how to apply for loans, fulfil terms and make use of the services of the financing programmes than to conducting promotions for the financing programmes themselves. 8 No importance is attached to measuring the economic and social returns in a regular manner in all financed enterprises in Oman. We must propose measuring the costs against the economic and social returns, and determining the type of social benefits required from each financing programme. 9 If the institutions which assists the enterprises limit themselves to one activity where they exercise control and perform efficiently, there will then be the extremely important room for the establishment of a voluntary society to be primarily engaged in helping and directing owners of enterprises (particularly small enterprises) in respect of the available financing opportunities and the most appropriate of them for the enterprise, as well as helping in meeting the requirements of financing through co-ordination with the financing institutions, provided that the work of the members of such a society is consultative, directional and non-obligatory to the financing institutions. We also propose establishment of a consultative, informative and directional unit in the MCI for SMEs so as to complement the consultative role. 10 We recommend enhancing the skills and capabilities in the field of consultation, feasibility studies, evaluation and follow-up of the enterprises, by way of providing high-quality courses in banking and development finance to employees of the financing institutions, particularly Omani university and college graduates. In providing these training programmes we need to cater for the differences in the financing programmes (partnership-based, interestbased, economic-outcome type, social-outcome type and so on). 11 We should make use of the experience of the FDYP (Youth Fund) in the area of practical directives, that is, specific down-to-earth guidance to prepare work plans and components, in addition to involving the applicants themselves in the preparation of such plans so as to ensure knowledge of the enterprises before financing is granted. 12 Training programmes should be to the essential and useful matters for the entrepreneurs. Such programmes should be non-conventional and far from having the objective of establishing the enterprise. It is better that training – if necessary – should start after the date an enterprise is established. Such training should not be arranged by the financing institutions, nor should it be a condition for obtaining finance. It should also be given to those who seek to have it and will meet the cost. 13 The introduction of a financing system that allows the target group to participate in the capital of the financing institution as a condition for financing is highly desirable. Among the merits of such a system is the opening of the opportunity for those who wish to deal with an Islamic financing system, which will close the gaps in the financing of enterprises in Oman and other AGCC states.

Financing SMEs in Oman 133 14 To diversify methods of financing we suggest considering expanding the base of short-term joint financing of enterprises (venture capital) or any other form of mixed capital with the consequential participation in the profits and losses, particularly in the field of enterprises which have high chances of success. 15 To expand the co-operation between the local institutional financing programmes through memoranda of understanding, and unite and co-ordinate the current efforts through joint promotional campaigns and a one-stop station. We also see the importance of co-operation with international financing schemes to gain experience in instruments, implementation and financing, particularly with Asian countries, which entered into this field well before Oman. 16 To conduct periodic assessments all financed enterprises at the end of each financing operation to measure the economic and social returns. This should be carried out without relying upon the government statistics in this field. It is also more useful to assess the performance of the financing institution itself, revise work plans and achievements and set up future plans and specific targets. 17 To conduct studies to ascertain the financing gaps for all types of establishments in Oman. Also to conduct periodic studies and statistical surveys relating to SMEs’ constraints and investment environment. Indeed, it is possible for SMEs to become the leading subsectors in Oman and other AGCC states that provide local employment, as is traditionally the case worldwide. This can be done through a relentless and concerted approach to enterprise development spearheaded by the private sector itself. The government, on the other hand, must take critical note not only of those aspects of development policies and regulations that reinforce enterprise development but also of those that end up destroying enterprise culture and the entrepreneurial spirit. Trying to do too much to promote small-enterprise development from outside, usually with a social-welfare approach, is one damaging example. Moreover, this programme cannot fit with the upcoming MU requirement of stringent fiscal policy. The government of Oman and other AGCC states have continued to provide the necessary environment conducive for enterprise development,30 but the government itself should not act as the implementing agency promoting and financing small enterprise development. This role must be assigned to a specialized agency. The need for this specialized agency is also drawn from the fact that the best institution to help SMEs is another enterprise. As such, we believe that the proposed specialized agency should have deep roots within the private sector. In other words this specialized agency must be businesslike in its approach. Within the private sector institutions, large-scale enterprises, whether local or foreign, are often the best institutions to help small enterprises to develop. Large enterprises can profit by selling to and through SMEs, and by buying from them, so they have the motivation and understanding to promote them. Financing SMEs when properly done can stimulate and energize a strong enterprise culture in Oman.

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Loans must be considered as loans supported by the real incentive to pay them back. SMEs must know the facilities they want from banks before requesting financing, and they must be discouraged or must not be pushed to borrow if not genuinely required. Lastly, SME financing programmes in Oman and other AGCC states need to be liberalized to ensure corporate flexibility that will not depart from the concept of profit making. SME financing needs to be market-oriented to ensure maximum repayment, to realize its objectives and to establish institutional open creative thinking so as to help the targeted groups to create the spirit of initiation. Oman and other AGCC states need to separate their short-term objective of job creation and the long-term objective of SME development via two distinct programmes. SME support for the job-creation objective via financial incentives usually produces non-efficient and non-financially viable SME initiatives, as SMEs entrepreneurs in these cases do not value such financial support because they do not pay all of it or they do not pay it at all. In conclusion, assisting SMEs to provide employment by way of admitting them into the institutional financing system, but against a good return for the financing institution to secure sustainability of the latter, is the right approach.

5

Conclusion

This book is composed of four different but related topics. The key significance of the four studies included is that they all relate to the distinctive characteristics of oil-dependent AGCC economies and their future economic polices in some crucial areas. They, by themselves, cannot form an integral analysis but they can serve as a useful addition to other published materials on AGCC economies. These topics are timely and they are most likely to form an integral part of the future policy outcomes of AGCC states in areas such as the currency unification and the consequent required labour-market adjustment policies, Islamic banking liquidity challenges, and SME financing policies and programmes following the stringent fiscal adjustment required by the MU. The MU is a focal point and other related polices will come through. More specifically, the encouragement of labour movement across AGCC national boundaries is required to promote the Union-required labour-market flexibility in order to be able to absorb exogenous shocks that will endanger the common currency. Moreover, the fiscal convergence criteria of the Union necessitate cutting of inefficient government spending, including government soft loans, and encouragement of SME financing, along with implementing international standards and improving overall SME financial market efficiency, including the growing ISBs in the region. Chapter 1 attempts to relate the standard optimum currency literature to the context of the AGCC. It converts the five tests guiding the UK’s policy decision on the EMU to a GMU. The absence of any GMU entry criteria renders these tests vital. These five tests conform to the AGCC economic policy objectives and prove to be a long-term approach to assess potential costs and benefits of the GMU. Research confirms that though elements and types of convergence are broadly and readily present, future diversification, specialization and differences in factor endowment might wipe out current convergence. Fiscal-policy flexibility does not exist and labour-market flexibility is limited, but labour mobility is likely to bear some adjustment burdens. The financial market is most likely to benefit from a GMU. Though the volume of FDI is small, dispersed and oil-dominated, the GMU is unlikely to change this pattern. Its contribution to growth, stability and employment is subject to a credible monetary policy. Overall, the cost in terms of loss of monetary independence and exchange-rate flexibility is likely to be low, as these tools are not currently heavily used under

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the pegged exchange-rate regime. Moreover, benefits accrued from the GMU are conditional on timing and specific policy efforts in trade, diversification, development of NBFI, financial assets promotion, the labour market, fiscal rules and the budgetary framework. Chapter 2 investigates the international labour mobility in the AGCC states, and examines its importance in the context of the forthcoming GMU. The intraAGCC national labour mobility adjustment mechanism, following the formation of the GMU, will enable AGCC labour-market flexibility to respond to economic shocks in the absence of an exchange-rate mechanism. The analysis confirms that the weak intra-AGCC national labour mobility is likely to be caused not by the absence of joint AGCC legislation, but by factors such as the lack of practical measures, weak labour market information and enthusiasm and limited qualifications of AGCC nationals. The chapter concludes, evidently, that enlarging the AGCC labour market for AGCC member states would generate some employment prospects, if the following conditions pertain – activation of AGCC Supreme Council policies, enhancement of labour-market flexibility and AGCC-oriented HRD, removal of national labour movement barriers, and consideration by AGCC job seekers to the large AGCC labour market (motivated by an effective job-search programme). Chapter 3 covers some aspects of liquidity of some ISBs in two AGCC states (Qatar and the UAE). We hypothesized that the ISBs’ liquidity has been affected by the replacement of interest-based transactions by profit-margin-based transactions. The study uses macroeconomic and banking data to analyse the economic set-up and banking regulations and policies and their likely effects on liquidity in the selected ISBs. The financial statements of these banks are also analysed over the period 1990–2002 and some relevant indicators derived from data from individual banks’ balance sheets are calculated and analysed. The analysis confirms that the changes on the assets and liabilities sides of the structure of financial statements from standard norms to Islamic forms have no apparent repercussions for ISBs’ liquidity at present. The study mainly relates this to the non-availability of investment avenues and financing via sales modes on the assets side, and the high share of demand deposits which look like interest-free loan on the liabilities side. Despite this result, the study does not rule out future liquidity risk due to reasons such as the lack of an inter-bank money market, reliance on current accounts, and restrictions on sales of debt. Liquidity risk can also be caused by other factors such as the lack of confidence in the banking system and reliance on a few large depositors. All these factors, the study noted, deserve attention in future research on the area. Despite the absence of liquidity constraints, ISBs, the study warned, are required to take cautions and develop liquidity-management instruments, create an Islamic bonds market to compensate for the lack of an inter-bank market and explore longterm investment avenues to exploit current excess liquidity and to be able to raise profits. Moreover, ISBs in countries with a mixed banking system, such as states of the AGCC, owing to the absence of an Islamic regulatory body, face a high degree of competition that might have implications for their liquidity status in the future.

Conclusion 137 Therefore, future development also requires a separate regulatory and supervisory framework for ISBs. Regulations should also specify the capital-adequacy norms for these banks and insist on transferring a higher percentage of profits to the statutory reserve. Deposit insurance and guaranteeing a minimum return on deposits to compensate for the loss in purchasing power are also recommended. The latter can be done by indexing the growth in the consumer price index. One major aspect that hinders the analysis here is the lack of uniform accounting practices followed by ISBs. Prudent accounting standards relating to income/ expenses recognition, depreciation, valuation of stock and assets, off-balance sheet items, declaration of dividends and so on should be formulated to enable transparency in banking. This must be followed by reliable auditing standards also. Regulatory authorities in each country are also called upon to set up a standards-setting body for ISBs consisting of experts in Islamic banking, professional accountants, lawyers and representatives from the public which should be responsible for issuing domestic/local standards. Chapter 4 is about the SME financing programme in one AGCC state, Oman. In spite of their late start, these SME financing programmes have achieved some successes, among which is completion of organizational structure and programmes. Financing was done through different loan sizes and target groups in addition to specializations and diversification in project types and sizes. Non-financing programmes focused upon direction, guidance, advice, feasibility studies, assistance in obtaining licenses and short-term courses, as well as some financing privileges such as exemptions in interest rates, taxation, fees and relatively long grace periods. Soft finance was granted against differentiated interest rates using the existing banking instruments. Only one case performed financing via participation in the equity capital of the projects, and all programmes lack a savings component and sharing in the capital of the financing programme by the target group. All programmes use personal guarantees and mortgages to guarantee repayments, and do not set age as a condition for granting loans. Project feasibility and some preferences for certain sectors were put forward as conditions for financing. With one exception, training certificatation is not required as a condition for financing. Moreover, with the exception of one programme, all others have not specified Omanization as a condition for financing, despite the objectives of all financing programmes including Omanization. All financing programmes lack periodical evaluation of projects financed to measure their performance as well as the economic and social outcome of finance. Despite the limited number of projects with high returns in Oman and the weak awareness about financing procedures by the target groups, the promotion campaigns were directed mainly to the financing institutions themselves rather than to technically feasible projects. Programmes suffer from the lack of emphasis on enterprise culture in the form of enlightenment courses, symposiums, opinion forums, seminars and cultural publications. Moreover, weak co-ordination between the various SME financing institutions, as well as the lack of studies on financing gaps and periodical statistical surveys and studies of SME constraints, was also emphasized. The indispensable fiscal convergence of the upcoming MU requires that SME financing be left to the private sector through diversified, competitive,

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multiple-mode, market-oriented financing institutions. Meanwhile, it is important to conduct a comprehensive review of the soft-loans programmes so as to assess the financed enterprises and follow up their performance. After the establishment of the Union we recommend either abolishing soft loans or charging market interest rates. Meanwhile, the system needs to consider introduction of refundable seriousness fees payable by the loan receiver to ensure the success of the financed enterprise, seriousness of the applicant and continuation of the financing programme. Moreover, the soft loans, at this stage, should target the existing enterprises and reduce the repayment period. One of the major recommendations of this chapter is the utmost importance of establishing a joint institution between the private and public sectors for promoting small enterprises. More emphasis should be given to the already established enterprises, and we must be cautious in financing collective enterprises in which many individuals participate. In terms of the non-financing programmes we recommend advancing target-group awareness and advertising for high-returns enterprises, measuring the economic and social outcomes, and establishing a consultative unit at the OCCI to help financing programmes in the sphere of consultation, upgrading staff in providing consultancy services, project evaluation and development financing. We also recommend essential training which is currently not obligatory for obtaining loans. We recommend enhancing enterprise culture and introducing a financing system which allows the target group to participate in the capital of the financing institution. Finally, periodic evaluation, studies and statistical surveys to expand and promote SMEs’ financing experience in Oman are also recommended.

Notes

1 The AGCC Monetary Union 1 An MU does not always require the introduction of a single currency. The AGCC states have decided to have both the MU and a single currency; hence the two terms will be used synonymously here. 2 Ironically the OCA in the literature on MU requires two contradictions: a high degree of intra-regional trade and similarity in the member states’ economic structures. 3 With a fixed exchange rate, economic shocks will require common action. Individual countries will not be able, under the OCA, to use monetary policy alone to enhance output and employment. The fiscal position, which will be in the hands of member states, will be subject to the requirements of an MU to avoid excessive deficits. 2 Intra-AGCC national labour mobility 4 Free movement of labour is one requirement for a flexible labour market. 5 See sections 4.3 and 4.4. 6 This is compared with a figure for expatriate labour in the total AGCC labour force of 39.1% in 1975 (IMF, 1998). 7 The characteristic of limited national labour mobility at the regional level, despite the right of free mobility to work for AGCC nationals in other AGCC states, was noted (but not analysed) by Fasano and Goyal (2004, p. 7). 8 Jennifer and Mustapha Nabil identified that the international evidence suggests that employment elasticity is likely to be closer to 0.8 for a labour-intensive economy (Jennifer and Mustapha Nabil, 2002, p. 18). Moreover, Fasano and Goyal also identified that the international average for non-oil growth employment elasticity is 0.7 (Fasano and Goyal, 2004, p. 11). 9 Note that our estimate of the elasticity of employment of non-oil output growth (1.84) is higher than the other comparable estimates (0.5(1)). Nevertheless, estimates of employment capacity of non-oil sectors, in all cases, are still higher than estimates of employment capacity of all sectors of the economy. 10 The average growth rate of 4% is calculated by the division of the average annual AGCC growth rate of the labour force up to 2015 (3.1) by the average AGCC employment elasticity (0.77). 11 AGCC average female participation was only 15% in 2001. Female participation is the lowest in the UAE (13.7%), and the highest in Kuwait (25.2%) (Al-Khaleej Daily Newspaper, 2004–2005, p. 208). 12 Higher wages and social allowances, retirement benefits and job security are the main reasons for this high share of AGCC nationals working in the public sector.

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Notes

13 The ratio of minimum wages to average labour costs in large manufacturing firms, the ratio of minimum wages to income per capita, the percentage of salaries that employers and employees have to contribute to social security administration, membership of the labour movement measured as a percentage of the labour force and employment in the general government, including local administration, as a fraction of the labour force. 14 Zero represents maximum flexibility and one maximum rigidity, and the labour rigidity ranking increases with the labour rigidity indicator. 15 To our knowledge, this crucial recommendation that can help in facilitating movement of AGCC labour has not been applied by all AGCC states, so far. 16 Compared with unemployment ratios provided in section 3 there are some differences, especially for the UAE and Bahrain. This may be due to differences in dates, measurement and data sources (official and unofficial). 3 Some aspects of liquidity of Islamic banks in two AGCC states 17 Musharaka – joint partnership, credit/partnership, where two or more persons combine either their capital or labour together to share the profits. Mudaraba – agency joint venture/limited partnership which involves two parties – the bank (which owns the money) and the partner/entrepreneur (who uses his/her skills to use it). In Muzar’aa and Musaqat (Musharaka contracts in agriculture) the bank provides finance and/or land and share in investment. Sales-based Islamic formulae include Murabaha – markup/deferred payment sales of a working capital or means of production – after adding a specific profit margin (Murabaha margin). ISBs also resort to other sales-based modes of finance on a deferred payment basis: leasing/Ijara (lease or pre-paid purchase of goods for a specified sum at a specified period of time, including purchase as a portion towards the final purchase and transfer of ownership), Bai’muajjal (selling instalments or lump sum payments for an agreed fixed price), Bai’Salam (the buyer pays the full negotiated price of the product that the seller promises to deliver at a future date). 18 While it is possible for an ISB to seek compensation for damages based on the profit that it could otherwise have received, difficult pre-conditions would need to be satisfied for the bank to seek compensation. 19 Al-Harran (1993) identified that some ISBs, particularly those in the Gulf area, are not facing shortages of funds but rather a profitable disposal of surplus liquid assets (Al-Harran, 1993, p. 142). Likewise, O’Hare and Holmes (2001/2002) noted that ISBs across the Middle East have huge cash resources available, but few means of utilization in the long run. 20 In the UAE and Qatar the banking systems are dual. 21 The PLS arrangements (Musharaka and Mudaraba) constitute a small proportion of ISB financing today. The major reasons are that they involve risk and erosion of investment deposits. ISBs are hesitant to use PLS at initial stages, as they have no adequate experience in managing these modes of finance. Instead they resort to less-risky, easier-to-manage sales-based modes such as Murabaha, Salam and Istisna. 22 Sukuks (short-term, liquid, asset-backed, tradable treasury instruments) and longer-term ijara (Islamic leasing) Sukuk securities. 23 By mixed banking system we mean a system which is composed of both ISBs and CBs. 24 The argument in favour of abolishing liquidity requirements of ISBs is that any loss in the principal amount of deposits will be borne by depositors as per the rule of Mudaraba. 25 Another argument is that, beside being a low-cost liability to ISBs, demand deposits do not get returns and so they should not be exposed to risk. 26 The average lending rate in 2002 was 8.9%, while the deposit rate was only 1.1% (Gulf Investment Corporation, 2004, p. 1).

Notes 141 27 In addition to DIB and AIB, the National Bank of Sharjah is the first ISB in the UAE that was converted from a CB, in 2002, followed by Emirates Islamic Bank. Other banks which offer Islamic products through special Islamic windows or Islamic finance companies are RAK Bank (The National Bank of Ras Al Khaimah), Mashreq Bank, Union National Bank and First Gulf Bank (Augustine, 2005). Moreover, in January 2007, Al Noor Islamic Bank (ANIB) was launched, and Dubai Bank turned Islamic (Hussain, 2006). 4 Financing small and medium-sized enterprises in the AGCC states: the case of Oman 28 One of the major worldwide success stories of financing small enterprises that depends on the market rate of interest is the Grameen Bank of Bangladesh. The bank extends credit to the poor at a rate of interest of 20%. The arrangement is known to have a high rate of repayments and lower financing risks. This experience has also shown low administrative costs as it depends on information from the local communities and the pressure from the group of which the small entrepreneur is part (see Ibrahim Badr El Din, 2004a). 29 In our communications with the General Director of the FDYP (Youth Fund), he suggested the assessment of the economic outcome by taking indicators of investment in new assets, local sales, exports and the creation of new employment opportunities. We suggest that assessment should be made in line with the objectives of each programme separately, but this may include assessment of common indicators such as the creation of employment opportunities. 30 In early March 2007, for example, a Royal Decree was issued to establish a General Directorate at the MCI to promote SMEs in Oman.

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Index

Abdelkarim, A. 34 AFESD (Arab Fund for Economic and Social Development) 34, 48 AGCC (Arab Gulf Co-operation Council) 1; Charter 8; economic development history 1–2; see also individual entries Agénor, Pierre-Richard 44, 48 AMF (Arab Monetary Fund) 23 Anderson, A. 95, 96 Arab Human Development Report, UN 22, 46, 51 assets 23, 62, 66, 70, 74, 88, 103; see also individual entries Augustine, B. D. 141 n.27 Bahrain 1, 7, 15, 18, 21, 22, 27, 31, 49, 53, 57 Bahrain Monetary Agency 66 balance-sheet model 70 Bangladesh 68, 141 n.28 banking regulation 69, 71, 136; and monetary policy 77–79, Qatar 78–79, UAE 78 banking structure and performance Qatar 76–77; UAE 74–76 Barry, Johnston 59 Beblawi, Hazim 34, 37 Birks, J. S. 34 capital market 28, 29, 30, 32; flexibility 22–23 cash-flow model 70 cash to current liabilities 81–82 cash to customer deposits 83 CBO (Central Bank of Oman) 8, 100, 102, 112 central bank 10, 11, 12, 30, 60, 63; role and liquidity risk, in Islamic framework 67–69; see also individual entries

Central Bank of Qatar (CBQ) 78–79 Chai, Jingqing 59 Chapra, Umar 63, 65, 66, 67 commercial banks 67, 68, 78, 79, 98, 101–102, 103, 106, 108, 109, 128 Consultative Authority, of AGCC Council 50 conventional banks (CBs) 3; comparison, with ISBs 60–62, 63–64, 68, 69, 79 convergence test 13, 14–21; cyclical convergence 19–20; endogenous convergence 20–21; structural convergence 15–18; trade openness and pattern 18–19 Cost of Firing Index (CFI) 46, 47 Creane, Susan 28–29 cross-border mobility 22, 36 Currency Union see Monetary Union current account deposits 60 current assets to current liabilities 83–84, 85 current assets to total assets 84, 86 customer deposits to current assets 84, 86 Custom Union 7, 8 cyclical convergence 19–20 demand deposits 60, 64, 65, 66, 68, 69, 77, 80, 140 n.25 deposits 60, 89, 137; see also individual entries Difficulty of Firing Index (DFI) 28, 46, 47 diversification 2, 3, 10, 15, 18, 19, 29, 31, 32, 56–57, 67, 94, 95, 127, 133 Dziobek, Claudia 59, 65, 70 Economic Agreement (2002) 8, 49, 50 economic convergence criteria 7, 33; see also fiscal convergence criteria

150

Index

employment, in AGCC states 35, 36, 38, 49, 51–55, 57 employment elasticity 39, 40–41, 43, 44, 56 employment test 13, 30 EMU (European Monetary Union) 9, 13, 14, 18 endogenous convergence 20–21 equity/venture capital 101, 109, 127, 130 ERF (Economic Research Forum for the Arab Countries, Iran and Turkey) 48 Erricro, L. 61 ESCWA (Economic and Social Commission for Western Asia), UN 45–46 European Union (EU) 18, 20 Evans, O. 59 exchange rate 10, 11, 12, 13, 14, 28, 31, 32, 35, 139 n.3 Faisal Islamic Bank of Sudan (FIB) 65 Farahbaksh, M. 61 Fasano, Ugo 11, 26, 34, 42, 43–44, 46, 48, 51, 139 nn.7, 8 FDYP (Fund for Development of Youth Projects) 98, 101, 103, 106, 109, 113, 126, 127, 132, 141 n.29 Fiennes, Toby 63, 65, 66 finance and leasing companies (FLCs) 98, 102–103, 106, 108 financial services test 13, 29–30 Finigan, John P. 12, 19, 20 fiscal convergence criteria 3, 91, 135, 137–138; see also economic convergence criteria fiscal policy 35; flexibility 23–27 fiscal transfer, intra-AGCC 31, 36 flexibility test 13, 21–27; capital market 22–23; fiscal policy 23–27; labour market 21–22 foreign direct investment (FDI) 4, 27–28 Forteza, A. 47 fund volatility 65, 84 Gill, M. 59 Girgis, Maurice 34, 44 GOIC (Gulf Organization for Industrial Consultancy) 28 Goyal, Rishi 28–29, 34, 42, 43–44, 46, 48, 51, 139 nn.7, 8 Gross Domestic Product (GDP) 16, 18, 20 growth-accounting exercise 40 growth test 13, 30 Gulf Central Bank 6, 8, 9, 12

Gulf Investment Corporation 42, 74, 75, 76, 140 n.26 Gulf Monetary Union (GMU) 7, 8–9, 28–30, 32, 36, 135–136; see also Monetary Union Al-Hamoud, Turki 64 Harper, M. 97 Al-Harran, Abdul Sattar 64, 65, 67, 69, 140 n.19 Hayder, M. 10, 12 Hilbers, P. 59 Hobbs, Kin 59, 65, 70 Holmes, J. 140 n.19 Hussain, Shakir 141 n.27 Ibrahim Badr El Din 8, 12, 36, 50, 60, 65, 92, 94, 95, 96, 97, 141 n.28 IMF (International Monetary Fund) 29, 34, 35, 36, 40, 41, 42, 44, 45, 47–48, 51, 71, 72, 139 n.6 India 130 inflation 2, 7, 10, 12, 30 interest rates 7, 9, 12, 19–20, 79, 109 internal devaluation 39–40 intra-national labour mobility, between AGCC states 33; analysis 38, 39; hypothesis 37–38; literature review 34–35, labour market studies 34–35, MU and labour market flexibility 35–37; methodology 38; policy recommendations 55–58; testing: employment 51–55, labour market policies 48–50, labour market segmentation and rigidity 44–48, output growth and labour market outcomes 39–44, unemployment 51–55 investment deposits 60, 63–64, 84 investment test 13, 27–29 Iqbal, Zubair 11, 26, 60 Iran 68 Ishiyama, Y. 10 Islamic Banks, liquidity aspects 59; banking structure and performance: Qatar 76–77, UAE 74–76; central bank role and liquidity risk 67–69; deposits 60; financial statement structure 60–63, assets 62, liabilities 62–63; liquidity analysis 79–86, cash to current liability 81–82, cash to customer deposit 83, current assets to current liabilities 83–84, current assets to total assets 84, customer deposits to current assets 84, data limitations 80, fund volatility

Index 151 84, leverage ratio 84, methodology 79–80, net profit to customer deposits 84; macroeconomic performance 70–73, Qatar 73, UAE 71–72; monetary policy and banking regulations 77–79, UAE 78; Qatar 78–79, policy recommendations 87–90; QIB 87; research: methodology 69–70, problem 69; risks 63–67 Jadresic, E. 11 Japan 18 Jennifer, K. 34, 40, 41, 139 n.8 Jensen, Henning Tarp 48 Al-Kawari, A. 34 Al-Khaleej Daily Newspaper 34, 52, 139 n.11 Khan, Tariqullah 64, 65, 66, 67 Kuwait 1, 7, 8, 12, 15, 26, 27, 49 Kuwait Finance House (KFH) 88 Laabas, Belkacem 10, 11, 36, 37 labour market flexibility 3, 4, 21–22, 35–37, 135, 136, 139 n.4; see also intra-national labour mobility, between AGCC states lending ratio 68 Leone, A. 59 leverage ratio (customer deposits to shareholders’ equity) 84, 85 liabilities 62–63, 70, 88, 136; see also individual entries Liedholm, Carl 97 Limam, Imed 10, 11, 36, 37 liquidity, of Islamic banks see Islamic Banks, liquidity aspects Liquidity Instability of Liability (LIL) 64–65 Llewellyn, David 63, 64, 66 McKinnon, R. 10 macroeconomic performance 70–73; Qatar 73; UAE 71–72 Majeed, Abdul 10, 12 Marston, David 59, 65, 70 Masson, Paul 36 MCI (Ministry of Commerce and Industry), Oman 92, 93, 98, 103, 108, 109, 122 Mead, Donald 97 MENA (Middle East and North Africa) region 29, 40, 44, 47, 48, 67, 69 Mirakhor, A. 60

Mobarak, A. Mushfiq 29 MOMP (Ministry of Manpower), Oman 53, 54, 99, 100, 101, 103, 113, 122 MONE (Ministry of National Economy), Oman 45, 100 monetary policy 30, 36, 69; and banking regulations 77–79, Qatar 78–79, UAE 78 Monetary Union (MU) 3, 4, 7, 35, 38, 135; hypothesis and methodology 13–14; and labour market flexibility 35–37; OCA 9–13; policy recommendations 31–32; testing: convergence 14–21, employment 30, financial services 29–30, flexibility 21–27, growth 30, investment 27–29, stability 30 Mongelli, F. 11, 12 Mudaraba contract 60, 64, 68, 140 nn.17, 21, 24 Mundell, R. 9, 10, 14, 35 Murabaha contract 60, 63, 64, 66, 88, 140 n.17 Muscat AGCC Summit (2001) 8 Nabil, Mustapha K. 34, 40, 41, 48, 139 n.8 net profit to customer deposits 84, 86 non-financing programmes, in Oman 103, 137, 138; consultancies 125–126; enterprise culture 127; internal studies 125; promotion 124; training 126–127 OCA (Optimum Currency Area) 9–13, 35, 139 nn.2, 3; AGCC OCA, literature review 11–13 OCCI (Oman Chamber of Commerce and Industry) 92, 100, 125, 126, 127, 138 ODB (Oman Development Bank) 98, 99–101, 103, 108, 109, 111, 122 OECD (Organization for Economic Co-operation and Development) 47 OER (Oman Economic Review (Magazine, Oman)) 11 O’Hare, C. 140 n.19 Oman 1, 4, 8, 15, 18, 27, 45, 57, 93–95; small and medium enterprises (SMEs): financing, commercial banks 101–102, enterprise selection criteria 113, 117–118, equity/venture capital 101, financed enterprises 106–108, financing procedures 122–124, FLCs 102–103, government initiatives 98–101, grace period 109, interest rate 109, 112, mechanism and finance

152

Index

Oman (Continued) amount 108–109, 110–111, non-financing programmes 124–127, periodical assessment, of operations and performance 128–129, policy recommendations 129–134, programmes 103–106, programmes and government units, links between 128, project/partnership participation, in capital 127–128, repayment 109, studies, on enterprises 129, success and failure indicators 113–122, target group 108, terms and conditions 113, 114–116 Organization of Petroleum Exporting Countries (OPEC) 15 Pakistan 68 Pattillo, Catherine 36 Plowden, Charles 63, 65, 66 privatization 1, 2, 9, 29, 31 procyclicality, of fiscal policy 23–26, 32; measurement 25–26 Qatar 1, 3, 15, 53, 57; banking structure and performance 76–77; macroeconomic performance 73; monetary policy and banking regulations 78–79 QCB (Qatar Central Bank) 76 QIB (Qatar Islamic Bank) 79, 87 Rama, M. 47 refinance ratio 68 Rigidity of Employment Index (REI) 46, 47 Rigidity of Hours Index (RHI) 46 Riyadh 49 Riyadh Summit (2006) 7 Rose, A. 10–11 Sab, Randa 29 Al-Sadah, Anwar K. 64 Al Saddoun, J. 10, 12 SAK 35 SANAD (Self-Employment and National Autonomous Development), Oman 98, 99–101, 103, 108, 113, 122, 123, 128–129 Sarker, Abdul Awaal 68 Saudi Arabia 1, 15, 28, 49–50, 57 savings deposits 60

Schmitz, H. 95, 97, 98 Secretariat General, AGCC 8, 49, 50 Shariaa’ rule 62, 63, 64, 66, 67, 79 Siddiqi, M. N. 68 Sinclair, C. A. 34 single currency 3, 9, 10–11, 12, 29–30, 35, 50, 55 small and medium-sized enterprises (SMEs) 91, 130; definition 92–93; development 3, 4; financing, obstacles 96–97, policies 97–98, see also Oman; growth constraints 95–96; importance, in Oman 93–95 soft loans 98, 106, 108, 109, 124 Solow, Robert 40 stability test 13, 30 stock market capitalization 22–23 structural convergence 15–18 Sudan 68 Sukuk market 67 Supreme Council summit (1997) 49 Supreme Council summit (2000) 49 total factor productivity (TFP) 39, 40 trade openness and pattern 18–19 UAE (United Arab Emirates) 1, 3, 18, 52, 57, 80; banking structure and performance 74–76; macroeconomic performance 71–72; monetary policy and banking regulations 78 UN (United Nations) 22, 44, 46, 51 UNCTAD (United Nations Conference on Trade and Development) 27, 28 UNDP (United Nations Development Programme) 22, 28, 34, 48, 51 unemployment, in AGCC states 30, 34, 37, 44–45, 51–55 Unified Economic Agreement (1981) 8, 49, 50 USA 18, 130 Uzair, Mohammed 68 Wilayats 100–101 World Bank (WB) 43, 44, 46 Yousef, Shaheed, Y. 66 Yousef, Tarik 48 Zayed Summit (2004) 50 Zuair, Mohammed Abdul Karim 62