Bahrains Financial Markets: Market Access and National Treatment - Essay Example

Financial Market Assessment In this paper, we are going to assess the degree of openness of Bahrain's financial markets seen from three different angles: market access, national treatment/reciprocity, and equality of competitive opportunity. Before we zero in on the financial sector, we will first take a general look at Bahrain's economy, using as our starting point the Washington, D.C. think-tank Heritage Foundation/Wall Street Journal's Index of Economic Freedom, an annual ranking of 155 countries. The index is a systematic empirical measurement of economic freedom, the result of careful analysis of the factors that most influence the institutional setting of economic growth ("Index of Economic Freedom"). The Index of Economic Freedom measures countries against a list of 50 independent variables divided into 10 broad factors of economic freedom. Low scores are more desirable. The higher the score, the greater the level of government interference in the economy and the less economic freedom a country enjoys. These 50 variables are grouped into ten categories: Trade policy, Fiscal burden of government, Government intervention in the economy, Monetary policy, Capital flows and foreign investment, Banking and finance, Wages and prices, Property rights, Regulation, and Informal market activity. As shown in Table 1, Bahrain ranked 20th of 155 countries (North Korea is 155th). Using the table, we can make a quick comparison of Bahrain and Hong Kong (HKG), the country with the highest economic freedom, and the United Arab Emirates (UAE), Bahrain's closest competitor for the title of the Middle East's financial capital. As Table 1 shows, Bahrain had the same scores as HKG in five out of ten categories, but in one of these (Fiscal burden), it scored higher (meaning, it performed worse) than the UAE, which is developing Dubai to compete with Bahrain. Since our paper is a study of Bahrain's competitive weaknesses in financial markets, we have a tool we can use to know what it should fix if it wants to win the competition with Dubai. The comparison with the United States gives us a better idea of how Bahrain fares in economic freedom. The U.S. is ahead only by a margin of two: better in three categories: Trade policy, Government intervention, and Informal market; worse in one: Fiscal burden; and tied in the rest. We now look briefly at where Bahrain did well. Then, by focusing on those where it scored badly, we can come out with the basic tools to analyze the degree of openness of Bahrain's financial sector. Bahrain's Good Points1 Bahrain scored well in four areas: monetary policy, banking and finance, wages and prices, and property rights. The main reasons for these are: Monetary Policy. Measured on the basis of the weighted average annual inflation rate of 0.04 percent, Bahrain is stable. Banking and Finance. Bahrain's banking and finance sector has very few restrictions. It is relatively easy to establish a bank; there are few, if any, restrictions or requirements on new banks; and foreign banks are welcome. At the end of 2003, there were 25 commercial banks, mostly foreign, and foreigners and Bahrainis alike have ready access to credit on market terms. The banking system is sound and undergoes examination and supervision by the Bahrain Monetary Agency (BMA), which has a solid international reputation. Efforts are being made to increase the liquidity of the Bahrain Stock Exchange (BSE), which opened in 1989. The government allows Gulf Co-operation Council (GCC) nationals to own 100% stakes in firms listed on the BSE and increased the proportion that could be owned by other foreigners to 49%. The Minister of Commerce has announced that ownership for non-GCC nationals will be increased to 100% by end-2005. Wages and Prices. Bahrain, despite issuing a minimum wage law, improved its wages and prices regimes in the past year, reducing its influence over setting of domestic prices. It liberalized its telecommunications sector, where it had monopoly power, and reduced state power over telecommunications services prices. Other than its monopoly in the water provision and petrol retailing sectors that effectively allows it to set prices in these sectors, the market is free in setting wages and prices. Property Rights. It has a very high level of legal protection available, not only in terms of security of asset and property ownership but also against expropriation. Foreign firms resolve disputes satisfactorily through local courts and there are no prohibitions on the use of international arbitration to safeguard contracts. Bahrain scored high in these areas. We now look at where it scored low before we focus on the financial sector. Areas for Improvement We now analyze Bahrain's weaknesses in the six categories of the index where it scored lower. Admittedly, compared to nineteen other countries in the world, Bahrain despite its best intentions to open its economy to the world still has some hard barriers, mostly regulations and laws, but also a few soft ones, mainly the size of the capital markets, liquidity, culture, and the relative inexperience and inefficiency of professional manpower. Bahrain is, however, one of the freest economies in the world, ahead even of Japan and South Korea, and ahead of the UAE, the next highest ranked country in the region. This is why the United States hopes to finalize its Free Trade Agreement (FTA) with Bahrain, its third FTA in the region2 by the end of 2005 (Zoellick). Table 2 summarizes the main problems of Bahrain's as regards economic freedom. Trade Policy. A moderate level of trade protectionism characterizes the country. Although Bahrain is one of the first members of the World Trade Organization (WTO), it has been predominantly silent on its obligations and commitments (Ali and Partners). Under the WTO's requirements of equal treatment and open sectors, such restrictions must ultimately be abandoned. Its FTA with the U.S. is a positive move in the right direction, guaranteeing the right of foreign companies to invest in most sectors on terms no less favorable than those given to domestic investors and third-country investors. Nevertheless, for effective implementation of the right, Bahrain will need to establish the necessary legal and administrative mechanisms and ensure complete transparency. On November 18, 2005, the FTA with the U.S. was approved by the U.S. Senate, paving the way for an approval by Congress by the end of the year. The agreement requires Bahrain to immediately eliminate its already-low tariffs on consumer and industrial goods and most agricultural products. The Gulf financial services hub also agreed to further open its market to U.S. banks and other service industry firms and to strengthen copyright and patent protection (Palmer). Fiscal Burden of Government. Government expenditures are an indirect tax on the economy. Although Bahrain is not yet deficitary3, its growing level of expenses means that it is using capital that may possibly be put to better uses. If the government lets expenditures go out of control, it starts crowding out the private sector in the capital markets. In fact, a big portion of the Bahrain Dinar (BD4) 1.1bn of Islamic bond issues (called Sukuks) at the BSE is for local government expenditures. Thus Bahrain, although scoring high in two of three sub-categories - income taxation and corporate taxation - with its zero personal and corporate income tax regime, had the worst possible score in the third sub-category: Change in government expenditures. The reasons for the high increase in government expenditures to GDP are the wage increases the government declared, extensive health education and other social benefits for its people, and other expenses under attack in the press (conferences that lost money, cars for government officials, etc.) (Al Sha'er 1). Although Bahrain did better in this category than the U.S. and did the same as HKG, it did worse than the UAE that had a more fiscally disciplined state. Government Intervention in the Economy. This category measures state intervention in the economy, indicated by the proportion of revenues and expenditures that are due to the state: 59.3% of revenues come from state-owned enterprises and government ownership of property, while its expenses are 20.1% of GDP, deemed too high for the small kingdom. Capital Flows and Foreign Investment. Although attracting foreign investment is one of Bahrain's top priorities, the government still maintains some barriers. As Table 2 shows, Bahrain has some problems related to market access, national treatment/reciprocity, and equality of competitive opportunity, details of which we discuss below. Regulation. Bahrain's process for establishing a business is relatively straightforward, but inefficiencies due to lack of experience and petty corruption, though rare in Bahrain, add friction to the work of investors in the country. Informal Market. There is a moderate level of activity in Bahrain's informal markets, due to the inexperience of some businesses in complying with regulations and the presence of bureaucratic barriers that are biased towards locals. Implications on the Financial Sector The weaknesses summarized in Table 2 reflect hard and soft barriers that exist in Bahrain's business regime. We will now analyze their effects on the financial sector. Bahrain is currently the leading international financial center in the Gulf region. Its financial sector is the largest single employer in Bahrain; 90% of its employees are Bahraini. Commercial bank sector assets currently stand at around US$100bn, a GDP multiple of about fourteen. The BMA, the Kingdom's central bank and single regulator for the financial system, currently regulates a total of 362 institutions, of which 186 are banks and banking-related institutions, 163 insurance and insurance-related firms and 13 capital market brokers offering a diverse range of services, including money market and portfolio management, corporate and private banking, investment advisory as well as insurance products and services. The financial industry represents 17.5% of gross domestic product (GDP) in 2002 ("Financial Sector" 1). The BSE, set-up in 1989, has developed into a modern, fully automated bourse with a wide range of products on offer, including common and preference shares, bonds, warrants, mutual funds and floating rate notes, as well as Islamic Sukuk. It has a total market capitalization of approximately US$17.032 billion and currently has 47 companies listed, including 5 foreign companies (BSE 1). According to a recent OECD study (McCall): the region is characterized by varying degrees of financial market development and share common problems brought about by low market capitalization, low foreign ownership, low private vs. public investment, and insufficient economic diversification. Sovereign debt markets are small and consist mainly of short-term government maturities. Corporate bond markets are limited and lack liquidity. Low public savings, inadequately funded pension funds, and low levels of liquidity in the domestic and regional banking systems contribute to lower levels of economic growth (1). In addition, these countries have restrictive regulatory regimes, foreign investment regulations, import quotas, lack of WTO access, low levels of foreign direct investment (FDI), and lastly, relatively underdeveloped financial markets. Recent conflicts in the region tend to disrupt reform efforts and focus attention on defense spending as well as lessen the political will to enact reform (McCall 2). The study identified four barriers to investment in the region (McCall 4): 1. Lack of ownership diversity 2. Insufficient diversification of the economy 3. Inadequate transparency and regulation 4. Underdeveloped capital markets Analyzing Bahrain's situation based on Table 2, we can see that the country has significantly overcome many of the problems McCall identified and associated with the region. Johnson (2005) mentions some problems regarding the development of a futures market, including Bahrain (1), which is ironic because derivatives trading is said to have started in 2000 B.C. in the island kingdom (Dodd 1).5 Therefore, we can narrow down the existing barriers to capital market development and foreign direct investments to the following: 1. Market Access a. Lack of liquidity discourages the development of financial instruments like derivatives b. Insufficient diversification of the economy c. Import quotas d. Improvement of electronic commerce infrastructure 2. National Treatment/Reciprocity a. Sharia-compliant financial instruments b. Inexperience with regulations c. Employment quota on foreign workers 3. Equality of Competitive Opportunity a. Foreign (non-GCC national) ownership of land limited to 49% b. Import licenses limited to majority Bahraini-owned enterprises c. Government-owned companies and parastatals d. Export-oriented enterprises should not compete with local businesses We now briefly analyze those with implications on the financial sector. Barriers to Financial Investments Liquidity. As Johnson (2005) stated, liquidity is one of the region's problems, because investors are not only looking for an entry strategy, but also for an exit strategy as well. If liquidity stays low, investors who find it hard to exit will not even think of getting in, despite the fact that Bahrain already conducts trades in exotic financial instruments.6 Diversification. Bahrain is still highly dependent on oil-related income for its revenues (60% of government revenues and 30% of GDP). By encouraging the growth of its financial sector, Bahrain can increase the proportion of income from services in its GDP beyond the present 58.4%. The share of industry, mainly aluminum and textiles, in GDP is 41% (CIA 1). Improved electronic commerce. This is one of the objectives of the FTA with the United States, aimed at increasing sales of telecommunications and computer equipment to Bahrain, which already has one of the most advanced telecom infrastructures in the world ("Capital Markets" 1). This improvement can speed up transactions in commodities and various financial instruments and eliminate market friction. Sharia-compliant financial instruments. Islamic law (Sharia) has certain provisions on charging of interest income and a ban on gambling, to which derivative trading is often compared. With the help of legal advisers knowledgeable in what is allowed by Sharia, Bahrain can develop a bigger market for trading in exotic financial instruments (Johnson 3). Inexperience and foreign workers quotas. Bahrain should encourage more experienced foreigners to work in its financial sector. Although Bahrain is proud that 90% of the workers in the sector are locals, their relative inexperience, and the high level of standards required7 add to inefficiencies that affect the implementation of financial regulations. Bahrain's regulation infrastructure is world-class, but the lack of experience of workers (although it will surely improve with time) is slowing it down, in the process allowing its competitors like the Dubai Financial Center and the Muscat (Oman) Securities Market to catch up very quickly (Johnson 2). Land ownership. Limiting the ownership of land to 49% for non-Bahrain/non-GCC nationals means that half of the value of real estate cannot be capitalized. As De Soto (6-9) showed, ownership restrictions result in undercapitalization of real estate assets and a failure to unlock the financial potential of property. Anyway, since an owner cannot bring land away with him, and the state remains the sole authority in determining what the owner can build on or do with the land through zoning restrictions, full 100% ownership like in other countries can help generate liquidity in the market if landowners are allowed to collateralize their property to the full. Import and export licenses liberalization. There are no restrictions on the inflow or outflow of currency, so offhand, bringing funds in and profits out is not a problem in the financial sector. However, the hard regulatory barriers related to the import and export of goods place restrictions on the trading of goods and commodities that can be covered by derivatives instruments that can be developed to minimize risk and maximize profits. Privatization. Selling public corporations to the private sector will raise funds for the government, cut down on government expenses, cut down on public debt, bring down interest rates (because the huge government bureaucracy will not borrow for its operations), and improve over-all government efficiency. All these improvements will help the financial markets by freeing up capital wasted on inefficiencies, thereby improving market liquidity. Privatization will help facilitate trade and investment in related sectors such as tourism and technology (McCall 6). Bahrain's Chance for a Place in History The development of the financial sector can play a critical role in economic growth, especially in the Gulf region, where economies are dependent on oil prices. Recent oil price surges are channeling billions of dollars to the region that can help improve liquidity and jumpstart the development of capital markets in the trade of exotic financial instruments. These instruments will help spread risks and prepare the region for the next economic downturn. In the 1970s and 1980s, most of these funds were loaned through Western banks to Europe, the U.S., Asia, and Latin America, which brought about the debt crises in the 1980s and 1990s. If the region turns into a financial powerhouse, the funds can be used properly and well for the good of the region and the rest of the world. Financial market development will also contribute to the development of a professional class of financial managers, improve the level of wealth, and minimize the region's propensity for violence and destabilization. By making the region a partner in economic growth, foreign investors can promote peace and greater global integration. In Bahrain's case, the infrastructure and the good intentions are there. What is needed is the daring to go forward. Table 1: Index of Economic Freedom Categories HK USA Bahrain UAE 2005 Ranking 1 12 20 48 Trade Policy 1.0 2.0 3.0 2.0 Fiscal Burden 2.0 4.0 2.0 1.3 Govt Intervention 2.0 2.0 4.5 4.0 Monetary policy 1.0 1.0 1.0 1.0 Capital flows & FDI 1.0 2.0 2.0 3.0 Banking & finance 1.0 1.0 1.0 4.0 Wages and prices 2.0 2.0 2.0 3.0 Property rights 1.0 1.0 1.0 3.0 Regulation 1.0 2.0 2.0 3.0 Informal market 1.5 1.5 2.5 2.5 Over-all 1.35 1.85 2.10 2.68 Source: http://www.heritage.org/research/features/index/countries.cfm Table 2: A Summary of Bahrain's Barriers to Investment (Trade, Capital, and FDI) Categories Hard Soft Trade Restrictions on foreign-owned businesses MFN tariff rates of 7.7% Import licenses for items to be sold in Bahrain are issued only to locally-established companies at least 51% owned by locals (cited by the US Commerce Department) Restrictions on agricultural imports Lack of familiarity with mechanisms Familiarity with WTO rules and willingness to negotiate Islamic teachings on clean (halal or kosher) food Fiscal burden Government consumption up 20.1% Health and other social benefits exert pressure on financial sector Wage increases Government Intervention 59.3% of revenues from state-owned enterprises and government ownership of property Need to diversify ownership of enterprises and property Culture of patronage by tribal heads Capital Flows and Foreign Direct Investments Bias for export-oriented sectors that do not compete with established local enterprises Does not license companies that compete with existing government-owned or parastatal companies, or that would be a danger to public health or other aspects of general welfare; prohibits imports and production for these items All significant investments, local or foreign, go through lengthy and complicated approval process Non-residents, except GCC* nationals, prohibited from buying land Foreign companies established in Bahrain and long-term residents may be allowed to buy property on a case-by-case basis Need to open the environment for electronic commerce (Zoellick) Small capital market size Low liquidity Underdeveloped financial markets in exotic instruments Sharia-compliant financial instruments Regulation New laws on transparency passed in 2002, but needs to be debugged, like malpractice ("Future Plans" 1) Bureaucratic procedures create significant stumbling blocks Labor laws restrict the hiring of foreign workers Occasional high-level corruption in contract bidding and the management of successful investments *GCC (Gulf Co-operation Countries) include Bahrain, the Kingdom of Saudi Arabia, Qatar, Oman, Kuwait, and the UAE. Works Cited Al Sha'er, Sawsan. "Government must not be so inflexible on wage increase." Local Issues 16 June 2005. Bahrain Tribune. 30 November 2005 Ali and Partners. "The Middle East and the World Trade Organization." Articles. 2004. Mideast Law. 30 November 2005 BSE. Monthly Trading Bulletin (October). 2005. Bahrain Stock Exchange. 30 November 2005 "Capital Markets." 2004. Bahrain Monetary Authority. 30 November 2005 http://www.bma.gov.bh/cmsrule/index.jspaction=article&ID=966 "Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2001: Turnover Data, Japan." 10 October 2001. Bank of Japan. 30 November 2005 CIA. The World Fact Book: Bahrain. 1 November 2005. CIA. 30 November 2005 De Soto, Hernando. Mystery of Capital: Why capitalism triumphs in the west and fails everywhere else. New York: Basic Books, 2000. 6-9. Dodd, Robert. Derivatives Markets: Sources of Vulnerability in U.S. Financial Markets (Draft). New York: Derivatives Study Center, 2001. "Financial Sector." 2004. Bahrain Monetary Authority. 30 November 2005 "Future Plans." 2004. Bahrain Stock Exchange. 30 November 2005 http://www.bahrainstock.com/bahrainstock/index.asp "Index of Economic Freedom: Bahrain." 2005. Heritage Foundation/Wall Street Journal. 29 November 2005 Johnson, Mark. "Futures Gazing." The Gate. 4 April 2005. IPT News. 30 November 2005 McCall, Patricia J. "Overcoming Barriers to Private Investment in the Middle East and North Africa Region." Arab Financial Forum, Bahrain, 22 November 2004. OECD. 30 November 2005 Palmer, Doug. 2005. "US House, Senate panels approve Bahrain trade deal." 18 November 2005. Reuters. 30 November 2005 "Triennial Report of Dealers Turnover." 31 March 2004. Bank for International Settlements. 30 November 2005 U.S. Commerce Department qtd. in Index of Economic Freedom: Bahrain. 2005. Heritage Foundation/Wall Street Journal. 29 November 2005 Zoellick, Robert. "Letter to Senator Stevens on Bahrain FTA." 4 August 2003. Office of the U.S. Trade Representative. 30 November 2005 Notes Read More