Diversifying GCC Economies: The prospects and pitfalls of financial services
As other Trends contributions have observed, the slump in global oil prices has reignited the debate surrounding the need to diversify the economies of the Gulf Cooperation Council (GCC). Speaking at the Arab Fiscal Forum in February 2016 Christine Lagarde, the IMF Managing Director, revealed that oil exporters in the Middle East North Africa (MENA) region had haemorrhaged $340bn of revenue in 2015. With more than 80% of fiscal revenues deriving from hydrocarbons between 2011 and 2014, GCC countries have reined in public spending, drawn down reserves, and sought new income streams, for example introducing exit charges for airport passengers and considering the introduction of a Value Added Tax (VAT) from 2018. Increasingly, as Saudi Arabia’s Vision 2030 proposals unveiled on the April 25th demonstrates, these changes are crystallising into plans for longer term economic reform.
While the situation is unlikely to be permanent, most forecasters point to a protracted period of low oil prices prompting calls for more drastic reforms to wean GCC economies off their hydrocarbon dependence. Many look towards the UAE, especially Dubai, where less bountiful oil reserves long ago forced the government to foster the development of alternative industries including tourism, transportation, retailing, and construction. However, the sector perhaps most covetously eyed by Dubai’s regional partners is its development of financial services.
Since beginning operations in 2004 the Dubai International Financial Centre (DIFC) has, despite strong showings from competitors in Doha and Abu Dhabi, established itself as the Middle East’s leading regional financial hub. In addition to providing a growing array of financial services to individuals and companies from the GCC, the DIFC is an entrepot for corporations from outside the region looking to invest in Africa and Asia and has developed niche expertise in, for instance, Sharia compliant investment vehicles currently one of the fastest growing segments of financial services. Today the DIFC boasts 1445 registered companies, double-digit growth in the numbers of incorporated companies and a workforce just shy of 20,000. That Dubai’s financial centre has flourished reflects a confluence of good luck and good policy. The DIFC profits from being situated in a time-zone between the Asian and European financial centres and to inhabit a country that is economically and politically stable. Meanwhile deliberate policy choices have conferred the DIFC additional advantages. An increasingly sophisticated communications and transport infrastructure is complemented by the promise of predictable, efficient, fair and transparent institutions underpinned by a legal system grounded in English-style common law. Likewise, the UAE’s extensive network of 65 Double Tax Agreements (DTAs), with a further 25 signed but yet to become operational, helps to reduce taxes on profits remitted home by Dubai based corporations. Exemption from income and corporate taxes, no requirement to maintain a physical presence, rapid incorporation, the absence of a public register of directors, and various forms of financial secrecy are amongst the other inducements offered to foreign investors.
Presently financial services contribute approximately 12% of Dubai’s GDP and the its rulers view financial services as an integral part of the kingdom’s economic future. An ambitious strategy launched in 2015 aims to catapult the DIFC into the top ten financial centres worldwide, in the process more than doubling the size of the workforce and expanding twenty-five fold the value of assets under management. Whether these ambitions can be realised and whether the development and expansion of a financial services industry should be something the wider GCC should emulate is a more open question.
There is already evidence that GCC countries are seizing on financial services as a key strand of their own diversification strategies. For example, whereas in 2007 Dubai was the only GCC financial centre to appear in Z/Yen’s inaugural Global Financial Centres Index, no fewer than five (Dubai, Abu Dhabi, Doha, Bahrain and Riyadh) appeared in the survey’s latest iteration in March 2016. These centres share with Dubai the blessings of geographical location and policies designed to enhance their legal and physical infrastructure. Likewise, this is a sector that is poised to grow. PwC estimates that assets under management in the MENA region will grow by 12% per annum to $1.5tr in the decade to 2020. Much of this demand is likely to come from High Net Worth Individuals (HNWIs) who desire “world class services delivered locally”. The Boston Consulting Group reports that all GCC countries are amongst the top 15 in the world in terms of the proportion of millionaire households. Private financial wealth in the Middle East and Africa region is projected to rise by 8.4% per annum to reach $12.6tr by 2019. The deepening of financial markets may also assist the broader economy by making it easier and cheaper to finance both public and corporate investment and provide incentives to enhance the institutional and regulatory frameworks.
Equally the development of financial services in the GCC region faces some potentially strong headwinds. Firstly, not all GCC countries are blessed with the levels of economic and political stability found in the UAE. For example, while Dubai and Abu Dhabi have performed relatively consistently in the Z/Yen survey, Saudi Arabia’s deteriorating fiscal position and the uncertainty generated by political succession saw Riyadh plunge from 14th in 2015 to 57th in March 2016.. Similarly, other centres in the region are struggling to develop the legal, regulatory and physical infrastructure to replicate the DIFC’s success. Indeed, the capricious regional environment has prompted several companies to relocate their assets to the UAE’s financial centres.
Second, especially since the global financial crisis, financial services have been confronted with a more stringent and complicated international regulatory environment. The reformed international financial architecture includes inter alia the intensification of existing rules governing the capital, leverage and liquidity of banks under the rubric of the Basle Capital Accords, the development of new standards for over-the-counter derivatives, executive compensation, hedge funds and shadow banks, and strengthened efforts to boost the transparency of financial systems in order to clampdown on money laundering, terrorist financing, tax avoidance and evasion. Not only do these developments raise the costs of participation in the financial services industry the capacity of smaller emergent centres to comply with such initiatives is often hampered by a shortage of regulatory expertise. Irrespective of their cause, non-compliance with these international rules and norms can severely damage the reputation of a budding financial centre. For example, the Organisation for Economic Cooperation and Development (OECD) and the Financial Action Task Force (FATF) have resorted to the threat of ‘blacklisting’ jurisdictions that do not comply with their tax transparency and anti-money laundering initiatives. Blacklisting is likely to stimulate an outflow of business from economic agents unwilling to be stigmatised by association with a disreputable territory. To date, GCC financial centres have avoided censure. Indeed they have sought to bolster their standing by being in the vanguard of these initiatives, possibly calculating that the lustre of legitimacy would burnish their reputational credentials and attract extra business to offset additional compliance costs. For example, in 2013 the UAE became the first GCC country to have a seat on the International Steering Committee of the OECD Automatic Exchange of Information initiative. Nevertheless, good behaviour in the eyes of the international organisations does not inoculate financial centres against reputational damage. Parallel blacklists belonging to national governments and civil society organisations are being developed with the latter, as the recent leak of documents from Panamanian firm Mossack Fonseca demonstrates, ready to pounce on any perceived impropriety. These various blacklists are often inconsistent, obsolete or arbitrary, nevertheless as Jason Sharman has observed all too often “the bark is the bite” with financial centres being tarnished regardless of their guilt.
GCC states also need to be sensitive to the more general downsides of an outsize financial services sector. During the 1980s and 1990s, the promotion of financial services centres was widely advocated as a means of advancing economic development and diversification, especially in smaller states lacking plentiful human and natural resources. Nonetheless, many of the cheerleaders for this strategy have recently recanted or at least adopted more circumspect positions. Like the well renowned ‘Resource Curse’ some argue there is an analogous ‘Finance Curse’. This position holds that while the provision of financial services can be lucrative in terms of generating employment and government revenue these can be outweighed by exposing the economy to the pathologies of the global financial system, for example financial crime and crises. Moreover, in consolidating this sector states are often highly dependent on the expertise of the global financial services industry. This not only raises the danger that many of the benefits will accrue to the expatriate rather than the local community but also the spectre of financial interests ‘capturing’ the local political apparatus. Far from diversifying the economy, the financial services sector can act like a ‘cuckoo in the nest’ exploiting its privileged position to squeeze out or suffocate the emergence of competing industries and, paradoxically, narrow the range of economic activities upon which economic wellbeing depends.
Financial services look set to play an integral part in the GCC countries’ quest to lessen their reliance on oil. The region’s geographical position and concentration of wealth confer important advantages, nonetheless if other countries are to emulate the success of the DIFC this must be complemented by enlightened policy-making. GCC countries should be cognisant of the dangers of ‘capture’ and the necessity of applying the highest standards of international regulation and transparency.