Why Dubai can't afford to fail

The announcement of a planned international financial centre in dubai was met with mixed reaction, but officials involved in the project say this is a much needed venture that will bring liquidity to the region.

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By  Massoud Derhally Published  April 8, 2002

|~||~||~|“Size does not matter,” is the message that tiny Dubai is sending out again, with the recent announcement of establishing a Dubai International Financial Centre (DIFC). The announcement has certainly raised more than a few eyebrows, but this small emirate, which functions much like a conglomerate, Dubai Inc., has constantly adapted to meet demands brought on by a continuously changing business environment. Boundaries are no longer part of the equation and the goal of transforming Dubai into a commercial hub, a centre for trade by investing heavily in infrastructure and services, has just grown bigger.

It did not happen over night, but started with the Jebel Ali Seaport, the largest man-made harbour in the world, followed by the Jebel Ali Free Zone, the largest commercial and industrial free zone in the Middle East, that plays host to some 2000 companies today. In addition to creating the Dubai Airport Free Zone, the emirate also focused on investing in the development of its national carrier—Emirates Airlines, the fastest growing air carrier at the moment.
As the global playing field of business changes, so has Dubai’s strategy to position itself. In response to the proliferation of technology, telecommunications and the internet, Dubai Internet City was created to make the emirate a regional hub for e-business and technology, to encourage innovation and entrepreneurship. This was followed by Dubai Media City, in order to attract global and regional media players and promote freedom of the press.

Across the board, the success factor of the Dubai matrix and what differentiates the emirate from the rest of the region is its business climate and it should only be natural for it to build on its existing infrastructure. Recognising that Dubai Inc. needed to prepare itself for a wave of competition following its accession to the World Trade Organisation (WTO), Crown Prince Sheikh Mohammed bin Rashid Al Maktoum, issued a decree to establish DIFC in Dubai with a board of directors and an independent regulatory authority. “DIFC is financial evolutionary leap that will bring value to companies in the region,” said Anis Al Jallaf, chairman of DIFC, over lunch to journalists.

So what exactly is DIFC and what are the reasons behind its creation? “This project is about preparing our region to play the global game. There are no investment bankers, asset managers, merchant bankers, no critical mass is available and these are the types of companies that we want to attract in order to raise capital, and to bring liquidity to the market,” said Hussain Al Qemzi, chief operating officer of DIFC. “DIFC is about creating a new game that is not present in this region We can’t continue to finance growth through local direct bank finance, we need big major players here,” added Al Qemzi.
But what is DIFC and what does Dubai hope to achieve in the grand scheme of things from this project? Does it want to compete with London and New York? The goal is not to compete with regional financial centres around the world, but rather to complement them according to Essa Kazim, director general of Dubai Financial Markets and board member of DIFC. “We can be at the same level definitely and we would be in a position to provide financial services that would bridge the time zone between financial centres in the west and the east. Our goal is to provide high-class financial services that are internationally acceptable,” added Kazim.

The new venture will be for wholesale and institutional participants—meaning major international securities operators, mostly US and UK investment banks. Anis Al Jallaf, said that DIFC hopes to secure investment from its advisers which include: Goldman Sachs, HSBC Holdings, Deutsche Bank, Zurich Financial Services, Citibank, the Japan Centre for International Finance, as well as other blue chip companies like Merrill Lynch and Salomon Smith Barney. “We hope to provide a wholesale banking centre for interbank trading with clearing in dollars for banks in the region that wish to do deals with other banks,” Ian Hay Davison, acting commissioner of DIFC told Arabian Business.

In addition to wholesale banking, DIFC will include a stock exchange with the listing of securities but only with wholesale participants. Fund managers will be licensed to develop and manage Islamic finance funds, and DIFC will operate a reinsurance market. In addition, the new entity will license back office operations and e-banking activities. “We hope that the major international players, and it is expected that the first people licensed will be major players from London and New York, will operate on the stock market, will trade securities and wish to participate in our wholesale banking activities, and wish to launch funds which they can sell to Middle Eastern investors,” said Davison.

None of the banks that will be licensed by DIFC will be allowed to take deposits or deal with retail customers, as that is a matter for the UAE Central Bank. However, banks that are already licensed for retail banking in the region, for example like Citibank are an exception. Despite being mentioned as possible members, neither Goldman Sachs nor Merrill Lynch has officially applied to join DIFC. However, the formation committee includes Hong Kong’s HSBC, Citibank, and Emirates Bank.
The purpose of a DIFC regional stock exchange is to bridge the liquidity gap, a chief concern of many in the business community who cite flat market activity and little deal flow as impediments to raising finance and unlocking the potential of regional businesses. Bringing liquidity to the Middle East, argued DIFC officials, would allow local companies to achieve the scale needed to compete globally. The argument is that there is a lot of wealth in the Middle East, but that there is no world developed capital market to channel that wealth into important investments in the region.

DIFC intends to be such a capital market, by using international intermediaries who will be operating in Dubai, managing funds and investing on behalf of institutions in companies to be listed in the region. This would be a positive move, as most international firms that come to the Middle East, are set up to take money out of the region. “It will contribute tremendously to the growth of the region and will be a key enabler acting as the interface with banks,” said Al Qemzi.

But what kind of companies can come and list on the exchange? According to Davison, only major companies in the region, who are of considerable size, will be able to list. In addition, entities that wish to list on the exchange should already be public in its home country for at least two years, according to DIFC officials. “We estimate that 150 companies have been identified as being of size which would qualify them for listing in New York or London and I think that they would prefer to be listed in the local market and still meet the same standards as in London and New York,” says Davison. “We want to make it possible for Arab investors, through intermediaries to invest in Arab securities of Arab companies listed in the region. This is in addition to investing Indian, Iranian and Egyptian companies,” adds Davison.

While these are good intentions, Arab markets have failed to attract Arab investors to date and at the same time local markets were not able to cope with the sudden wealth of the 1970s petro dollars and had to go overseas. “Because of transparency and the comfort factor of overseas asset classes it became easy to keep assets overseas,” explains Blair. “You then had a number of crises in the region like the al manakh crisis in Kuwait, which led some to the belief that markets should not be developed and liquidity was pretty poor,” adds Blair. At the same time, companies from the Middle East have shown little interest to list on exchanges outside of the region, and only one, Aramex went public on the NASDAQ.

DIFC officials say the fact that only one Arab company is listed on a western exchange, serves as another reason to create an international financial centre for the region. A hypothetical example of this is that if Emirates Airlines wanted to raise additional capital, it could float its bonds on the DIFC. DIFC officials point out that as a result there will be international participation in these bonds from regional and international sources.
An encouraging sign for DIFC is that some exchanges have demonstrated that it is possible to attract outside interest despite certain shortcomings. The Egyptian market at its peak, in 1996-97, had nearly US$1billion of foreign portfolio capital according to Angus Blair. Egypt at that stage, was looked as an attractive market, and the government and companies were able to access through international institutions international capital.

Drawing parallel, Blair says, “DIFC could work if it is put together in a way where it can get over the hurdle of having two local markets, get over the hurdle of trying to encourage local and regional capital to look to the stock markets, as a longer term investment asset class, and encourage a number of companies local and regional to come to the stock market.”

One thing is for sure, the larger the market, the more liquid it will be, and the chances of attracting money will increase. The current problem of the Arab world is you have many small markets with low liquidity in trading and thus cannot attract investments. The 12 bourses amount to US$170 billion of which the GCC contributes two thirds. Turkey alone comes to US$170 billion, as does Malaysia. “Daily trading volume in all our markets is around $180 million,” says Iyad Duwaji, CEO of Dubai based Shuaa Capital. “It sounds high, but Microsoft daily trading volume is over $1,000 million,” explains Duwaji.

Liquidity is key for the success of any electronic exchange. According to a consultant who has been involved in the creation of several worldwide electronic exchanges, “unless the proposed exchange has a very compelling value proposition and can lure participants by providing incentives, such as waiving transaction fees, giving away trading equipment and support, it will be very difficult for it to generate much interest.” “Other important success factors include the shareholder structure of the exchange itself, the proposed instruments to be traded, and the regulatory framework within which it will operate,” added the consultant.

“The success of DIFC is not bound to one area,” cautioned Essa Kazim, director general of Dubai Financial Markets and board member of DIFC. “Some areas may experience fast growth, other areas medium growth. It all depends on how financial institutions perceive it. You have several pillars which when linked together make a strong package and help develop one another. You also have other financial services that will revolve around these pillars.”

A lot hinges on the success of this project, and the move to create such a centre should be commended, but you cannot have a regional stock market unless you standardise the laws and the clearing and settlement systems. Transparency will be key, the legal background of the administration and the regulatory element, need to be addressed, as the success of the DIFC, will be the credibility of the regulatory authority.
The DIFC regulatory body will be two-tiered; a regulatory arm headed by Ian Davison, the current acting commissioner and a development arm that will encourage participants in the market headed by Hussain al Qemzi. According to one DIFC official, 12 months from now, the regulatory framework should be set up with about 25-40 people in regulatory staff, and up to 40 licensed intermediaries licensed. That, officials hope, will kick start trading on the regional exchange as well as the wholesale banking activity.

“We are talking about a new set of rules and regulations, in line with international accepted practices,” explained Essa Kazim. According to one DIFC official, regulation may be outsourced to someone like the NASD, in order to ensure strict compliance and have a credible statutory regime. Such a standard, say DIFC officials, will deal with investor concerns and market participants. “It’s a win-win situation, foreign institutions that want to invest in this long-ignored region will feel comfortable, because the system and local companies will be well regulated and transparent, while the local companies get access to the capital they need to grow,” said the source.

Duwaji of Shuaa Capital, welcomes the announcement of DIFC and believes there is a niche to be exploited by the centre. “As per my understanding, yes there is a niche that DIFC will try to fulfil. We in the investment community need a regional financial hub,” says Duwaji. “We also need a closer strong and well regulated jurisdiction, such as Ireland, with modern laws and regulations, where funds or holding companies can be incorporated for instance,” he added.

Some industry analysts say that Bahrain already provides such an infrastructure. “We have seen many banks and institutions that have focused on asset management front and Bahrain is also today a hub for Islamic finance. It is going to be difficult, there have to be a lot of inducements to attract companies,” said Daren Stubing, chief bank analyst of the Capital Intelligence rating agency.

Moreover, most of the financial products that people from this part of the world invest in, for instance Islamic funds are either created or managed by foreign companies. Many funds today are organised in Ireland and Luxembourg and that is another reason why an entity like DIFC is needed, say officials. Rather than develop products externally, the new financial centre will encourage local product development.

“Today if one wants to organise an investment fund, you need to go to an offshore jurisdictions such as Guernsey or the Cayman Islands, because of taxation issues among other things,” says Duwaji, and while “the UAE is a tax free country, but not a good jurisdiction due to existing restrictions on foreign ownership, weak corporate legal infrastrucure.”

According to Duwaji, DIFC can be a regional money centre and fill a regional gap. If you look at Europe, both Switzerland and Italy have exchanges, but they still go to London to raise financing. That does not negate the existence of a bourse in those countries.
“People were sceptical about Dubai as being a regional distribution center, or a tourist destination, yet it succeeded,” says Duwaji. “Admittedly, this is even more challenging, but past track record is good, as the government is both dynamic and responsive, so it will make adjustments as needed. At the end of the day, it will come down to execution.” Massoud Derhally||**||

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