Selected papers from a conference in Kuwait, October 22-23, 1994, sponsored by the General Secretariat of the Gulf Cooperation Council and the National Bank of Kuwait.
GULF BANKING DURING THE NINETIES: REALITY AND AMBITIONS
Sheikh Salem Abdul Aziz Al-Sabah, Governor of the Central Bank of Kuwait
This conference, to discuss the challenges facing GCC banks and review strategies that could be adopted during the nineties to face up to them, covers many issues that reflect the significance of banking in our economies. It also shows the concern of the banking sector's executives and officials to strengthen that sector, particularly at a time when we are witnessing rapid and frequent changes in the international banking and financial markets. These changes will have a profound effect at both local and regional levels.
It goes without saying how important the banking and financial sector is; it represents the sinew of the economy. It has a crucial and fundamental role in encouraging economic development with other economic sectors, thus coordinating the performance of the banking and financial sector with that of the economy as a whole. Within the framework of the efforts pursued by the GCC to effect comprehensive economic reform, and the part expected to be played by the banking sector in these efforts, the need to convene this conference became evident in 1990, but then had to be postponed to 1991. However, due to the unfavorable circumstances following the Iraqi invasion of Kuwait, the conference was again postponed.
This conference is being held today, more than three years since the liberation of the state of Kuwait, a period in which the GCC economies shouldered heavy responsibilities. This is a direct result of the damaging effects that the brutal Iraqi invasion of the state of Kuwait had on most economic sectors, but particularly on the banking and financial sector. This brutal invasion created a very severe challenge to the GCC economies and their banking and financial sector, indeed the most dangerous challenge to confront the Gulf banking sector since its advent.
The invasion increased the perceived risks in the region, which had an adverse effect on banking business both with regard to the cost of funds and to a decline of confidence in the banking sector. This has affected Gulf monetary stability. Now again, the Iraqi regime is repeating its attempts to undermine the security of the state of Kuwait and the stability of this region. But, God willing, the aggressive plans of this regime shall fail, and peace and stability shall return to our region.
The challenges confronting Gulf banks are comprehensive. Some of them are related to the general economic climate, the others are related particularly to the banking business. They are not restricted to this region, as they also involve the international community.
The future challenges of this decade, arising from regional and international economic developments and events, are likely to come from the international trend toward the creation of economic and regional blocs and consolidation of the concept of the regional state in international economic relations. This movement toward globalization of trade and free capital movement is such that it makes the world one vast highly competitive market. The competition will include financial services; there will be no place for weak or small economic entities or those functioning in isolation. It will be necessary to move toward consolidating ties with existing economic blocs or cooperating with other countries to create a large economic bloc.
An important part of the economic challenge that we face in the Gulf region has been caused by structural imbalances produced by certain macro-economic policies adopted under more favorable economic and financial conditions. The most prominent of these challenges is the public-sector dominance over economic activity in the GCC countries. Public expenditure has played the main role in motivating economic activities and generating growth in various non-oil economic sectors.
Undoubtedly, the dominant role of the public sector in economic activity in the GCC countries has sometimes become so large that it deprived the private sector of the most profitable and promising investment opportunities that would have enabled it to participate more effectively in economic activities. Too often this has restricted a large number of private investments to marginal available areas and has led, on occasion, to its recourse to speculation on financial and real assets in order to make quick returns. The limited available investment opportunities have weakened the demand for banking services, including bank financing, which has adversely affected loan portfolios of banks as well as bank performance in general. On the other hand, the expanded public-sector role has placed increasing obligations on public finance, thus reducing the ability of general budgets in the GCC countries to cope with decreasing oil revenues in the wake of falling prices since the early eighties.
During the nineties our countries have to face the challenges, among other things, of restructuring the economy, diversifying sources of income, and adjusting expenditure to conform with developments in public revenues. We need to give the private sector a larger role in economic activities and adopt privatization programs that will reduce the public-sector role and stimulate economic activities and development by increasing the contribution from the private sector. Here again I emphasize the importance of the banking sector, which is needed to participate in economic reforms by mobilizing national savings to finance these reforms. It has to provide the necessary funding, and increase the efficiency and effectiveness of its financial services, to ensure the success of privatization programs. In order that Gulf banks can successfully face up to these challenges, the right conditions and a favorable investment climate must be created to facilitate the flow of new resources to banking units, so that they can provide proper funding for economic sectors that address existing imbalances and adjust the current economic course.
The problems that will confront Gulf banks during this decade do not differ much from those facing banks in most industrial countries, as they are not confined to the region where they occur. Gulf banks are neither immune to them nor isolated from them. It can be said that the biggest challenge we should first face is to acknowledge that they exist and lay down appropriate strategies to confront them.
It may be useful at this point to shed some light on the most obvious global issues and propose some basic ideas and strategies that could be adopted to overcome them. These main issues can be summarized as follows: overbanking, technology advancement, increasing customer sophistication.
Overbanking is a phenomenon in the GCC, where we currently have more than 160 banking units, of which 41 are national banks, whose number has only fallen by one bank since 1987. Conversely, in other countries they have moved to create new larger banking units via mergers. This has helped these large units increase and improve the quality of their assets and strengthen their financial positions, thus becoming more able to compete regionally and internationally. In this regard, we see that although the number of banks is declining in many countries, they are nevertheless experiencing a significant increase in the value of their assets and a continuous improvement in their performance. For example, in the United States, the number of U.S. banks listed in the "World's Top 500 Banks" dropped from 104 banks in 1987 to 84 banks in 1993; but the value of their total assets increased from $1.909 trillion to $2.642 trillion. Similarly, the number of banks in the United Kingdom declined at a rate of 15 banks a year during the same period.
The second challenge is represented by the rapid advances in technology in all fields, but especially in the banking industry. Particularly relevant is the rapid progress that has taken place since 1980 in the settlement and payment systems. For the customer, technology provides a modern means for carrying out transactions through telephone or computer terminals, giving him the freedom to easily affect capital movements. In my opinion, unless our banks keep pace with technological advancements, they stand to lose their major clients. This would translate into capital flight to external markets.
Although our Gulf banks are aware of this challenge and are trying to introduce modern technology to their operations, investment in the area of technology is still painfully low in too many Gulf banks.
The third challenge, increased customer sophistication as a result of increased banking awareness, is linked with the second. For the Gulf banks to succeed in satisfying customers' increasing banking awareness and needs, they must improve their ability to keep pace with advances in technology.
Gulf banks' tendency to focus on the traditional products of their home markets has meant that they have not always developed the necessary experience to offer nontraditional products. Therefore, customers continue to place their funds with those foreign banks better able to provide the services and instruments customers require.
It can be said that this lagging behind in technological progress and modern customer services, in addition to the limited nature of the Gulf markets and their inability to absorb promising investment opportunities, has greatly contributed to the widening gap between internal and external Arab investments. Recent statistics from the Inter-Arab Investment Guarantee Corporation show that while internal Arab investments amounted to $11.9 billion, external Arab investments ranged between $650 and $700 billion.
Gulf banks have to invest in advanced technology to be able to offer non-traditional services, otherwise they will lose a large number of their customers.
Among the most serious challenges facing banks is that of cutting their total cost, especially in the area of wages and salaries, a too-great proportion of their revenues. Many international banks have realized this and embarked upon downsizing their workforce in certain areas of customer services as these banks adopted modern technology. This policy has brought a considerable decline in labor costs. For example, British banks were able to cut their wages and salaries from 48.5 percent of total revenues in 1987 to 35.1 percent in 1993. Certain Gulf banks lack a clear strategy to substantially reduce the ratios of wages to total revenues. To confront this challenge, these banks will have to take serious and practical measures to cut their labor costs to a lower proportion of total earnings in order to reduce their expenditure and raise efficiency and profitability.
Having set out certain international challenges that confront our banks in the Gulf area, we need to consider what we can do about them. The answer can be found from the approaches adopted in the rest of the world, namely: rationalization, merger, specialization and diversification.
Rationalization means not only reducing expenditure or investing in advanced technology; in some cases, it also extends to considering the rationale of banks themselves. This phenomenon explains why many banks disappeared in certain industrial countries during the eighties.
In this context, bank mergers are seen as an important instrument of rationalization. Besides the economies of scale and other economic benefits that merged units may reap, mergers, especially among Gulf banking units, will help expand the range of banking services and allow the merged units to provide financial services throughout the Gulf region. Therefore, the merged units can provide a lead in developing the efficiency of financial intermediation within the GCC and, in addition, help ward off international competition.
I believe that mergers should not be merely an issue for endless debate; we have to implement studied procedures and make them a reality.
Gulf banks will need to continue to specialize in those areas where they have a niche, but not at the expense of the diversification of the banking services offered to retain a customer base and increase earnings. Gulf banks need to strike a balance between specialization in certain fields and diversification of banking services, but based on professional and objective criteria, particularly efficiency and profitability.
Having discussed some of the international banking challenges facing us in the GCC and some possible solutions, I should point out that the challenges faced are not exclusive to the Gulf area; they extend beyond our borders. One of these involves bank confidentiality, which means non-disclosure of customers' banking, financial or economic information either by banks themselves, through their systems or staff, or by those who receive such information by virtue of their profession. There are some who carry out suspicious money-laundering operations in the Gulf area by exploiting bank confidentiality, a problem that we need to face and overcome.
However, the need for cooperation regarding the exchange of information between supervisory authorities in the home country and the host country, according to international supervisory standards as determined by the Basel Committee, raises a question about the breaching of bank confidentiality that may result from such an exchange of information with respect to either bank customers or the positions of banks themselves.
I believe that bank confidentiality is fundamental for building confidence in the banking business and for creating a stable banking environment. It leads to neutrality and objectivity of banks in any dispute. Therefore, such confidentiality must be maintained. At the same time, Gulf banks should abstain from performing any suspicious operation on behalf of their clients. The supervisory authorities, taking into account the 40 recommendations declared by the International Financial Committee for fighting money laundering, should issue necessary instructions to banks to help them counter it. Undoubtedly, this will maintain the good international reputation of Gulf banks.
Concerning any breaches of ·bank confidentiality arising from cooperation between supervisory authorities of the GCC and other countries, I believe that this subject requires more study. We need to accurately define the aspects of such cooperation and the means of exchange of information with other supervisory authorities, to ensure that this will not involve any unjustifiable amendments to banking legislation or breaches of bank confidentiality.
In closing, I would like to stress the need for Gulf banks to realize the gravity of the challenges before them and identify their own weaknesses and strengths in order to meet them. With the help of efficient management at all levels, banks can draw up strategies for this decade and go beyond the stage of identifying challenges to assessing the real benefits of confronting them, recognizing their reality and dealing with them objectively by taking decisive and timely decisions. Since Gulf banks are not isolated from the world and operate in a vast and highly competitive banking market where only strong banks survive, there is no room for slackness or reluctance in taking appropriate decisions or for boasting of past achievements. Once again, I emphasize that the more we understand the challenges and confront them bravely, the better we will maintain strong Gulf banking institutions.
Equally, strengthening existing coordination among monetary authorities and central banks in the GCC, especially in the fields of supervision, and removing existing legislation that hinders the movement of people, funds and trade, would be another positive factor in the convergence of performance and style of banking business in the region. It would also facilitate greater cooperation among Gulf banking units.
Finally, I believe our colleagues participating in this conference are well able to shed light on the various issues and aspects of Gulf banking and its strategies for the nineties.
ECONOMIC AND FINANCIAL CHALLENGES FACED BY THE GCC COUNTRIES IN THE 1990s
Hamad S. Al-Sayari, Governor of the Saudi Arabian Monetary Agency
The economic and financial challenges faced by the GCC countries in the 1990s reflect our aspirations for the future in the light of the circumstances we are going through and are likely to face. The aspirations that we have are not different from those of any other group of countries. Like the rest of the world, we aspire to develop our economies at a sufficiently high and continuous rate of growth so as to (a) raise the standard of living of our nationals and enable them to live comfortably without pecuniary and social problems, (b) provide increasing opportunities for gainful employment to the rising number of young people entering the labor market, (c) diversify our economies to reduce the dependence on a single commodity for all our export earnings and reduce our dependence on imports for a substantial part of our needs for consumer goods. Moreover, we would like to attain these goals without kindling domestic inflationary pressures and within a framework of internal and external financial balance.
Many of these aspirations have been realized. The momentum for their realization could have continued if the conditions that we faced in the 1970s and the early 1980s had not been interrupted. However, circumstances have now changed. This does not mean that our goals are unattainable. All it means it that we will have to be more cautious in the use of our available resources and work harder to realize our goals. We will have to review our policies continuously to modify them in the light of our changed circumstances and implement them with determination and steadfastness.
It may, therefore, be more appropriate to throw some light on the circumstances that we face. Some of these are negative and will tend to slow us down in the realization of our aspirations. However, some of the other circumstances are positive and should help us in accelerating our thrust upward. Such an exercise will enable us to evaluate realistically our circumstances and formulate suitable policies for facing them. I will start with the negative factors, the most important of which are the following:
1. The war for the liberation of Kuwait caused the weakening of the financial strength of all Arab states, and of the Gulf states in particular, which had to bear the brunt of the financial burden. This led to the loss of a substantial part of their savings and cast an adverse effect on the years that followed. The outbreak of the war after the weakness of petroleum markets in the mid-1980s accentuated the war burden and necessitated adjustment to conditions of low income.
2. The steep decline in oil prices since the middle of last year reminds us of the wide fluctuations experienced in the middle of the last decade. The enormous financial pressures resulting from the decline in nominal oil prices to their lowest level in many years affected the development programs of most of the oil-exporting countries. Nominal prices do not, however, reflect the true picture. If we were to look at the real price of oil, we would get a picture which is more revealing. If the nominal price is deflated by the G-7 Consumer Price Index, we will find that the real price of Arabian Light in 1993 was a little less than what it was more than 40 years ago in 1950 and less than one-fourth of what it was at its peak in 1981. Among the factors which have been most influential in this steep decline in the real price of oil are worldwide inflationary pressures, high taxes on oil in industrial countries, policies of industrial countries to reduce their dependence on oil as a source of energy and the one-sided policies against oil in the name of environment, when there are other sources of energy which are more harmful to the environment but not subjected to these policies. OPEC has no control over any of these factors. The prevailing facts do not encourage optimism and induce us to expect that a significant rise in the real value of oil may occur in the near future.
3. One of the characteristics of the states in this area is the limited availability of other natural resources. The GCC states face a harsh environment and depend to a great extent on one source of income. These states also depend on oil and gas for the operation of their desalination plants.
4. Accelerated and extensive development of our economies is a recent phenomenon as compared with other countries. It started only after the availability of abundant financial resources in the wake of the correction of oil prices since the first half of the 1970s, when we began from scratch to catch up with the development caravan. In an unbelievably short period of time, we have accomplished a great deal in laying down a highly developed infrastructure and providing utilities and services. We have to continue completing our accomplishments by further developing and improving our education system and training programs to raise the qualifications of our young men and enable them to take their natural place in the development process. This is particularly so because, as you know, our population is young; and it is necessary for us to respond to the future aspirations of the young people. It is also necessary to adopt methods which would enable us to utilize our financial resources more efficiently and effectively in responding to the increasing needs of both the public and private sectors.
5. There has been a delay in the formation of an integrated economic group to face increasing competition. I do not know if I should put this in the negative factors, because the Gulf states have not yet formed a unified market, or put it in the positive factors because we in the GCC states do have a suitable framework to realize this unified market. Even more important is the increasing competition we face around the world due to the formation of economic groups that provide a competitive edge to the members of each group in the world markets, which are being increasingly integrated and drawn closer because of the growth in transportation and communications facilities and in techniques of production.
Against this background of negative factors, let us also look at the positive factors which will help us in successfully meeting the challenges that face us:
1. The GCC countries hold about 36 percent of the world's proven oil reserves and enjoy an important advantage in the form of the lowest cost of production in the world. However, they produce only about 18 percent of world oil output. With the increase in the demand for oil and the limited ability of other parts of the world to raise production, it is expected that the share of the Gulf states in oil exports will increase in the future.
2. The extremely efficient infrastructure that has already been constructed by the GCC countries will make it possible for them to divert a greater proportion of their income to the productive sectors, enabling their diversification and expansion. This will make the prospects of growth in GCC countries relatively brighter.
3. The GCC states enjoy one of the highest rates of population growth in the world. While this has been one of the fruits of health and social-development programs, it represents a challenge with respect to meeting the increasing requirements of the population in relation to education, training and guidance. It should be possible to employ the trained manpower in raising productivity and economic expansion and to benefit from the large local market in the realization of uninterrupted economic growth. I wish to add in this connection that the goal of generating increased employment opportunities was not previously given high priority in our development plans because employment opportunities were abundantly available, and there was no threat of unemployment. Employment opportunities are still available to the extent to which the economies of GCC states depend on foreign manpower. However, the high rate of growth of the local manpower at a time when the rates of economic growth and employment opportunities are decreasing, makes it important to pay greater attention to the expansion of employment opportunities in different ways, including training, guidance and the replacement of expatriates by nationals. This should be given high priority in our economic programs.
4. The free-market approach, which the GCC states believe in and have adopted because of respect for private initiative and ownership and because of the full role it allows the private sector to play in the economy, is one of the fundamental principles of economic policy of these states. Although free-market policies are now becoming the distinguishing feature of economies around the world, these policies have been firmly rooted in the states of the area because of the principles of Islam, which respects the individual and his property and rights.
Therefore, the private sector in the GCC states enjoys dynamism and vitality, which enable it to play an increasing role in economic activity. For example, the private-sector share of national income in Saudi Arabia increased within 20 years from 25 percent in 1972 to 46 percent in 1992. The private sector enjoys a high level of savings that enables it to profitably utilize local investment opportunities. This enables it to support economic growth and offset the decrease in government spending. The continuation of government policies supporting the private sector, the availability of efficient infrastructure, the maintaining of the freedom of movement of capital, and the adoption of balanced economic policies will help the private sector in performing its positive role.
5. The strong banking system represents one of the prime assets in the economies of the GCC states. The banks in these states enjoy high levels of profit and have attained levels of capital adequacy, liquidity and profitability that are among the best in the world. Furthermore, the Gulf states are generally considered creditors to other parts of the world due to the savings of the private and public sectors, in spite of the additional financial burdens carried by them in the recent past and the weakness of oil prices. There is no doubt that the banks have played, and continue to play, a positive role in financing development programs in the private and public sectors. They thus constitute one of the sources of strength in the economic systems of the GCC states.
I wish to point out here that the authorities in the states of the area realize the vital role that can be played by the banking system in the economic development of the area. Therefore, there is continuous actual cooperation among the GCC authorities for strengthening the banking system and overcoming the obstacles that limit its development. The Banking Control and Supervision Committee of the Committee of Governors of Central Banks and Monetary Agencies of the GCC states is one of the most active joint committees. The monetary authorities are also studying the appropriate means for increasing the consolidation of the banking system and facilitating its operations because the existence of an efficient, safe and strong banking system is among the requisites for the realization of comprehensive economic development. This would tend to increase confidence in domestic investments and also assist in the growth of savings and direct them to more productive uses that promote economic growth and realize the objectives of development.
These factors help us visualize and evaluate the economic and financial challenges that are faced by the GCC states. These may be summarized as follows:
1. Realizing domestic and external financial balance.
2. Improving the utilization of available resources in the light of their scarcity and the increasing demand on them.
3. Meeting the needs of the increasing number of inhabitants for goods and services.
4. Employing the increasing domestic manpower.
5. Diversifying sources of income.
6. Maintaining a strong, developed and highly efficient banking system.
I wish to add here that one of the most important challenges is that during the period of abundant financial resources the people of the area became habituated to increasing levels of income, spending lavishly and living comfortably. The government is always expected to maintain those levels of welfare and income to the citizens and make services available at nominal rates and even provide assistance to private commercial activities in most cases. With the expansion of the economy, the growth of the population and the increase in claims on resources accompanied by the decrease in oil prices and revenues of the state, it has become indispensable to review many of our policies. These policies should be reviewed with an eye toward inducing our nationals to bring their spending into harmony with levels of income, stimulating them to the utmost for optimum utilization of our resources and to increase savings.
Finally, allow me to talk briefly about the Saudi economy. Irrespective of whether we undertake a simple or sophisticated analysis or look at its abundant oil reserves or other indicators, we realize its existing strength as well as its long-run potential. The Saudi economy has witnessed strong growth over the last three decades. This growth has raised its GDP to more than $123 billion in 1993. If this is evaluated in terms of the purchasing power, the real value is 37 percent higher in accordance with World Bank estimates. The volume of external trade exceeded $95 billion in 1993. Economic indicators also show continuation of diversification of the productive base and, as already referred to, the private sector represents about 46 percent of the GDP. Preliminary estimates indicate that value added by the industrial and agricultural sectors rose by 9 percent and 5 percent respectively in 1993. Non-oil exports have nearly quadrupled from a level of less than $1 billion 10 years ago to more than $3.7 billion in 1993. SABIC (Saudi Arabian Basic Industries Corporation) has successfully established a network of petrochemical industries which have boosted our non-oil exports substantially.
There has been a rise in recent years in direct investments for the expansion of existing factories or the establishment of new ones, both of which raise the country's productive base. It is noteworthy that this growth and expansion has been realized without inflationary pressures because the consumer price level remained stable. The average increase in prices for the last 10 years has been less than 1 percent annually. The Saudi currency has also maintained a stable value and exchange rate. This strength of the fundamentals has contributed to an increase in the confidence of the private sector. This has become reflected in increased direct investments and capital inflow which have helped offset a substantial part of the deficit in the current account during the last three years.
The banking sector has played a crucial role in the country's development. It commands even greater possibilities. The huge increase in the domestic and foreign assets of banks and the great improvement in the performance of banks has led to an increase in their profits which exceeded $1.4 billion in 1993. The ratio of capital adequacy exceeds 17 percent. Banks have also established and developed a network of automatic teller machines, banking payment and settlement systems, and points of sale and settlement of shares transactions in the financial market. This has become reflected in the diversification of their services in the field of financing, satisfying the financial needs of individuals and companies, and making consultancy services available in the field of finance.
As regards budgetary policy, the government has taken an important initiative for realizing fiscal balance by approving a reduction of 20 percent in expenditure appropriations for the current year 1994. This policy initiative, along with the country's domestic and foreign real resources, stable exchange rate, freedom of capital movements and the government's appropriate policies to stimulate the private sector, provides the basis for long-term continuous economic growth, barring short-term changes. As economic conditions in the GCC states are similar and interrelated, the same thing may be said with respect to the remaining GCC states.
INTERNATIONAL DEVELOPMENTS AND THEIR IMPACT ON GULF BANKS
Khaled M. Al-Fayez, Chief Executive Officer of the Gulf Investment Corporation
I will concentrate on the developments in the banking industry and factors that will be shaping the role of this industry for the foreseeable future. Obviously one must be mindful of other factors that impact on the role of banking and provide challenges and opportunities to the banking industry. These factors are political, economic and social developments, which by themselves may constitute a topic for another seminar.
Banking has traditionally been defined as the business of taking deposits and making loans. However, if one were to examine what most international banks are doing these days, one would have to conclude that either banking as we know it is dying. or a new and more encompassing definition has to be found for banking that is hardly related to deposit taking and loan making. Indeed, one is constantly reminded these days of the decline of banking. Recently, the chairman of Bankers Trust, Charles Sanford, voiced the view that "run-of-the-mill commercial banks are no more than inefficient mutual funds that do a poor job for their depositors." He expects conventional bank intermediation to have largely disappeared by the year 2020.
The decline of the intermediation role of banks has been brought about by a number of factors: (1) the relatively recent "bad" lending experience of banks, (2) the changes in the regulatory environment, (3) the competition from non-banking sources, and (4) financial innovation.
1. Recent Lending Experience
The LDC (lesser developed country) debt problem that arose during the early 1980s had a devastating effect on the financial position of most international banks. It also had a lasting effect on banks' attitude to lending in general and to cross-border lending in particular. The erosion of banks' capital has limited their ability to lend. The losses sustained have sparked new thinking with regard to risk management and control.
2. Regulatory Environment
In the area of risk control, there has been some serious tightening of the regulatory environment. This has to do with capital-adequacy requirements and the extent of information disclosure. In my judgment a number of the new requirements with regard to capital adequacy are related to the first factor, i.e., the losses sustained as a result of cross-border exposure and sectoral concentration of bank lending. Regulators have been much more concerned with the inherent risks the banks were running ·and the limited capitalization of banks to support such risks. They were also concerned with the disparity among the regulatory requirements of various supervisory authorities and the disparity among accounting standards and procedures. With the globalization of the banking industry, it became imperative that players in the same market play by the same rules. Risk assessment of various financial institutions had to be based on the same set of measurements, so as not to give any financial institution or market an undue advantage over the others.
On the other hand, there has been some significant relaxation in the regulatory environment with regard to banks' scope of operation. The Chinese wall between commercial banking and investment banking seems to be crumbling at a fast pace. This has led to "financial integration," where some of the international banks are becoming a one-stop place irrespective of what the customer needs.
3. Competition from Non-banking Sources
This refers to what is called in the profession "Disintermediation.'' Whether for borrowing needs or for their fund's management needs, customers are able to bypass commercial banks altogether and go directly to the capital market and/or specialized funds managers.
4. Financial Innovation
The last decade has witnessed the development of a number of risk-management tools, otherwise known as derivatives. These refer to options, futures and swaps. Although not normally included under derivatives, I should also mention another innovation, namely, securitization of debt. The development of these innovations has been to a large extent a result of the vast advance in technology. This has helped bankers by increasing their ability to manage risk and run their operations more efficiently. More important, the advance in technology has helped banks create a multitude of products and services which were not available until recently. While these products and services have opened up profitable opportunities for banks as well as for their customers and helped mitigate a number of risks that customers and banks were open to in the past, it has also created areas of risk that I am not sure many senior managers really understand. Even the supervisory authorities are still puzzling over all the bells and whistles that have been created by the computer whiz kids and scratching their heads to really understand the risks involved and how they can be controlled. In the words of a recent survey by the Economist, "[B]anking has become mathematical and computer wizardry."
I do not mean to give such an eminent audience a discourse on derivatives. One can hardly pick up a newspaper or a specialized magazine without finding an article or two on the subject. Some of this literature has been prompted by the bad experience of a number of users of derivatives during the past couple of years. The pendulum seems to be swinging from a sanguine approach to one of serious concern. In the past, the attitude of the practitioners seemed to be that derivatives were riskless. Central bankers, on the other hand, felt there was genuine risk but could not identify what it was and, as a result, fell on the catchall phrase of "systemic risk." However, recent losses due to derivative positions and threats of law suits are forcing both sides to go back to the drawing board. I am not an authority on the subject of derivatives, but it seems to me, as the name implies, their value to the end users derives from an underlying asset one is trying to protect or a liability the value of which one is trying to fix in the future. If one does not have the underlying asset or the liability, then one is betting on interest-rate movement and/or the foreign-exchange markets with the risks this bet entails.
IMPACT ON THE BANKING INDUSTRY
With a little exaggeration, international banks seem to be rediscovering Polonius' dictum in Hamlet, "[N]either a borrower nor a lender be." They have scaled down their lending as well as interbank money-market activities substantially. For example, in 1970, 65 percent of total short-term borrowing of non-financial companies in America was provided by commercial banks. At the end of 1992, these banks provided 36 percent of the short-term loans. At the end of 1993, only 17.3 percent of J.P. Morgan's total assets represented the bank's net-loan book. The bank's total balance sheet was $134 billion. Yet the notional amount of off-balance-sheet exposure was $1,700 billion. Another example is Bankers Trust, whose end-of-1993 total assets were $92.1 billion. However, the notional amount of instruments such as derivatives was $1.9 trillion. At the end of 1992, only 58 percent of American banking revenue came from lending while 42 percent came from fee income and trading. The comparable figures for 1981 were 76 percent and 24 percent respectively.
Bankers Trust revenue from own-account trading in 1993 was $1.6 billion, which was larger than the $1.3 billion earned in net-interest revenue. One can argue that 1993 was an exceptional year. However, figures over the past five decades for American corporate debt confirm the declining role of commercial banks as providers of corporate debt.
Some of the shrinkage of the intermediation role of banks is due to entrance of non-banking competitors. For example, the total assets of mutual funds in the United States at the end of 1993 was roughly $2 trillion compared to $2.7 trillion in bank deposits. Fidelity, the biggest mutual-fund company, has $200 billion under management. This figure is larger than deposits held by any American bank. General Electric Capital Services has total assets of $150 billion. It is the biggest issuer of commercial paper, the largest supplier of private-label credit cards for department stores and the largest issuer of home loans.
Banks have become more risk managers and traders than intermediaries between savers and investors. What does this all mean for the banking industry in the Gulf, and how does it relate to their strategies and activities? The globalization of the financial markets means that the Gulf financial institutions are not immune from the influence of the factors discussed above. If they are to play a role in the international financial markets, they must abide by the same rules.
Gulf commercial financial institutions as well as the central monetary authorities have had to make sure that the capital adequacy requirements are met by the Gulf banking industry. This has resulted in substantial increases of capital in many Gulf banks, particularly in Saudi Arabia. Some central banks, such as that in Oman, have instituted a minimum capitalization for banks to operate. This has led to a number of mergers. The trend will probably continue in a number of the Gulf countries. At present many Gulf banks not only meet the minimum capital adequacy requirements but exceed them by far.
At the same time, the central monetary authorities have instituted new disclosure requirements to ensure that Gulf banks meet international accounting standards. Many Gulf financial institutions already apply these standards, and the rest will have to follow. This is likely to bring the weakness of some banks into the open and force their management to act. Since the mid-eighties, great emphasis has been placed on the cleaning up of Gulf banks' balance sheets. Heavy provisioning by most local and regional banks has resulted in strong balance sheets in the case of the Gulf banks, some of which have ended up with probably some of the cleanest balance sheets worldwide. These developments are very positive for the Gulf banking industry. However, there are some negative implications of the risk weighting requirements in the calculation of capital adequacy. As many of you know, the GCC countries, excluding Saudi Arabia, have been given a non-OECD status for these requirements. This has resulted in a negative effect on the funding lines available to Gulf banks from abroad due to perceived risk in their portfolios and has made Gulf banks more reliant on local funding. It has also constrained their activities in their traditional markets due to the risk weighting of these markets.
Technology is expensive. Keeping up with the myriad advances in technology is probably beyond the means of many of the small banks in the Gulf region. While the major banks in the area have invested heavily in upgrading their computer systems, one suspects that the smaller banks are lagging behind. The heavy cost of technology has some major implications for strategy, as it means banks will have to be more selective in what they do.
I will turn now to market developments. I have already addressed the restructuring of international banks' balance sheets and the increasing emphasis on off-balance-sheet activities. With few exceptions, our smaller banks do not have the human skills or technical capabilities to participate in most of the off-balance-sheet activities. The economic slowdown in the industrialized world, and the relatively low returns obtainable from traditional banking activities there, have resulted in our banks refocusing their attention on their own domestic and regional markets. These markets have witnessed some major changes. On the positive side, the GCC economies have, until recently, witnessed a relatively high rate of growth compared to the rest of the world, with the exception of the Southeast Asian economies. This has increased the business opportunities for the GCC banks. Almost all the GCC governments are running a deficit, which gives the banks an opportunity to finance them. A change in the macro-economic policy of the GCC governments toward market-based economies and privatization is increasing the need for sophisticated corporate and advisory services in the region. At the same time, there is a growing confidence in the region which has been manifested by the return of substantial GCC capital into the domestic and regional economies.
However, given the volume of business activities available in our area, I would suggest that the market is over-banked. There are too many banks chasing relatively limited opportunities. This has led to declining lending margins.
STRATEGIC IMPLICATIONS FOR GULF BANKS
You can see from what I have outlined so far that the banking industry has been subjected to fundamental changes. These changes are so significant that most banks must rethink their strategies. It is obvious that there is no single right strategy applicable to all GCC banks. Each bank's strategic choice will need to be made in light of its competitive advantage or disadvantage. Such strategic choices will be determined by each bank's expectations with regard to growth, risk appetite, return expectations and any other objectives. These expectations are governed by what each bank thinks its role is, i.e., its vision, and in tum will dictate its geographical scope and business mix.
The changing environment leads me to think that Gulf banks must revisit their historically accepted vision of themselves. This may not happen in all cases. Many banks may continue to be content with their historical visions of being an Islamic bank, an investment manager, a retail bank, a wholesale commercial bank or a merchant bank. However, some may find that instead of a change in the geographical scope or business mix within their existing vision, the changing environment requires rethinking that vision if the bank is to achieve the growth and return expectations, as well as its other objectives.
In most cases, the banks will have to ask themselves whether the opportunities, risks and returns offered by the region and their competitive position to take advantage of the opportunities will allow them to achieve their ambitions in terms of growth and return without going beyond their zone of risk tolerance. Two seemingly similar banks may come to opposing answers to the same question. One may want to go the international diversification route to achieve its objectives because of one of the following reasons:
-It may feel itself in a competitively disadvantaged position in the regional markets, for example, offshore banking units (OBUs).
-It may consider the size and stability of returns offered by international diversification to be in excess of the risks introduced by such diversification.
The other may feel that the risks of international diversification are not worth the return and are beyond its risk tolerance. It may feel that its organization is not really capable of truly assessing the risk an international diversification brings into the question. It may decide to go for the regional business, the risk of which it can assess better than any other international player, even if that means curtailing its expansion ambitions and possibly accepting a somewhat lower, but less risky, return.
Some of those stressing the GCC region in their business-development efforts may find that their national focus is sufficient to meet their strategic objectives. Others may feel that the size of their capital and their expansion ambitions can only be met by developing into a pan-Gulf institution. For such a move to be truly effective, the central bankers of GCC countries will have to lift a number of explicit and implicit barriers against regional integration of the financial-services sector in the region.
Some of the banks may find the international diversification risks beyond their risk appetite while, at the same time, finding themselves competitively disadvantaged because of their lack of physical presence in all parts of the region or the high cost of funding due to heavy reliance on the inter-bank market. They may have to seriously examine their mix between (a) the asset-based business with a spread-based, credit-risk focus and (b) the off-balance-sheet, market-driven business with a market-movement-related risk focus that requires capital backing as a cushion against losses but does not require funding.
Despite the difference in strategies based on the given circumstances of each institution, there are some common themes that we must all be aware of and take into consideration in setting up our strategies:
1. The Gulf banks' competitive advantage beyond their region is very limited. It boils down in my judgment to our knowledge of our area and our access to business originating from our area. We are relatively small players. None of us counts in the top 200 banks of the world in terms of size or equity.
2. None of the Gulf banks can be everything for everyone. With limited skills, both human and technical, banks must identify their strength areas and concentrate on these. They must specialize in what they can do best.
3. As indicated earlier, there are too many small banks in our area. Their ability to carry the cost of expensive technology or, for that matter, expensive human skills is very limited. The merging of some of these banks has already taken place. This trend must be encouraged and promoted by the central monetary authorities. What I have already mentioned about over-banking in the area should be an added factor encouraging mergers in order to economize on expenses and maximize the utilization of limited national skills.
4. While over-banking in the traditional banking area is the case, the field is still wide open in the area of specialized banking services. These include corporate finance, mergers and acquisition, investment management, project finance and advisory services. The move toward privatization in the Gulf area opens up a great opportunity for our banks to create for themselves a regional niche.
5. The opportunities offered by the emerging capital market in our area referred to above is something for the offshore banks to capitalize on. Domestic banks have their domestic markets. Offshore banks have found themselves increasingly at a competitive disadvantage in relation to domestic banks. While the offshore banks continue to play an important role in financing regional projects and, of late, financing GCC governments' deficits, I believe the emerging capital market in our area creates a tremendous opportunity for the offshore banks to provide a genuinely needed service. To do this, however, they must always stay a step ahead of the local banks in terms of human and technical skills.
6. Gulf banks must continue to upgrade their human and technical skills. Banking, as I have indicated, has become a much more sophisticated business and needs sophisticated skills. At present, many of our banks suffer from lack of management depth, and in many cases there is too much centralization. In volatile and dynamic markets this must change. Banks must take a fresh look at how they are organized, how their decisions are made and how their overall risks are controlled.
7. Finally, I would like to tum to the role of the GCC governments in supporting the banking industry. Overall, the governments have been very supportive of the Gulf financial institutions. The role of the central banking authorities during the Gulf War was instrumental in maintaining confidence in our banking industry. At the same time, the measures which they have taken toward strengthening the capitalization base of our financial institutions and enforcing ever more stringent disclosure requirements have put many of our banks on a par with the best international banks.
However, the regional financial market is still fragmented. Increasing efforts must be made at integrating these markets. Freeing up cross-border banking within the GCC is a precondition for creating a genuine regional capital and money market. It is also a precondition for creating a really unified economic market.
Our banking legislation has not kept up with the globalization of the world of finance. There is a need for a great deal of new legislation governing a wide spectrum of new products and services.
The GCC governments and their agencies are still by far the largest users of banking products and services in our market. Yet that portion that goes to the local or regional banks is still very limited. These governments can give a big boost to the local banking industry by diverting more of their business to the local and regional banks.
PUBLIC-BUDGET AND DEFICIT FINANCING IN THE GCC COUNTRIES THROUGH THE NINETIES
Abdlatif Y. Al-Hamad, Director General and Chainnan of the Board of Directors of the Arab Fund for Economic and Social Development
The GCC countries today face a serious financial problem, expressed by the persistent large budget deficit in each and every state since the second half of the eighties, at a time when they should have a surplus. This is not only creating a fiscal problem but also affecting the performance, growth and stability of the national economies. They have failed to counteract the budget imbalances that their expenditure policies have led to. Since the mid-1980s, the deficit has remained in excess of $17 billion or about 9 percent of GDP through 1993. Thus a large public debt has accumulated in the last few years, and it is still increasing. The governments in these countries have continued to rely on the easy means of financing the deficit, such as withdrawal from their own general reserves or borrowing from the domestic financial markets, to maintain the levels of the welfare state created in the last three decades.
Our position on this matter is not traditional. We believe that the root of the deficit problem is not simply the shortage of revenue (oil and non-oil), it is more than that; it is caused by expenditure patterns. This may not be surprising, but it is not well-recognized in the inner circles of decision makers in the region. It is the inability of fiscal authorities to control their generosity; and whether the oil revenues increase or decrease, there will be a deficit at some point, given current conditions and practices.
The public-budget deficit, and hence the public-finance impasse in the GCC countries, is a mere reflection of the reality in fiscal practice. The deficit issue was not the product of the Gulf crisis only; rather it was an evolution of forces at work over many years. The paternalistic governments of the Gulf, overseeing oil revenues, have unintentionally created a welfare state that now seems very difficult to maintain. The income-redistribution steps taken after the oil boom have given rise to new rights and claims by many people on the budget beyond the principle of public benefits against the burden of cost. Since the governments monopolized all natural resources (i.e., oil), boundaries between the public goods and services and the private market and initiatives are determined by the state exclusively. Thus the relation between individuals and the state, as well as the role of the public budget, are blurred.
It could be stated that the first factor behind the deficit problem is the accounting and auditing methods used in GCC countries to prepare the budget. Most Gulf budgets exclude major items from revenue and include others as expenditure items. For example, the budget of Kuwait excludes the return on public investments as revenue and adds the allocation of 10 percent of total revenue for the Future Generations Fund as part of expenditures. Similarly, the federal budget of the UAE does not include all expenditures and revenues of some member emirates. This certainly does not give a comprehensive picture of the real fiscal position of the government.
The breakdown of the amount of deficit financing and the boundaries between external and internal borrowing, and between withdrawal from their own general reserves and outright borrowing, are not well-defined. Some countries, like the UAE, Bahrain, Oman and Qatar, report the net lending and financing "above the line," while Saudi Arabia records only foreign grants above the line; the rest of financing is reported below the line. These variations have led the governments to have misleading information about the size of the deficit and the actual size of their public debt as well.
The second factor worsening the deficit is the ever-increasing current expenditure in most GCC budgets. Although capital expenditures have fluctuated greatly, the current expenditures were consistently growing at high rates. Some of these increases are expected, due to population growth and technological changes in the society. Nevertheless, large portions of other increases are not economically justified, especially when many public services are still provided free of charge or below cost. Also, the events of the second Gulf crisis have pushed expenditures to a new high level by the "threshold effect," where it is very difficult for the government to reduce some expenditures to the previous level.
The third factor contributing to the deficit is the severe fluctuations of budget revenues, especially oil revenues, which represent the main source of funds. Since the record high of 1980, oil revenues have declined drastically-by more than 50 percent-and keep vacillating around that low level. None of the GCC governments have seriously tried to develop a policy of sterilization to mitigate the sources of instability in their revenues; in addition to that, the non-oil-revenue share in the budget is still far below the expected rate, given the adequate current level of economic development.
If our understanding of the problem is true, that the source of the deficit is expenditure rather than revenue, then we must take a fresh look at the components of expenditure to understand the underlying causes.
It is evident that one of the main causes of high expenditure is the public-services system and numerous direct and indirect subsidies and incentives provided by the government to consumers and producers in all GCC countries. Subsidies in these countries are given across the board and indiscriminately for all groups. For example, the rate of subsidy for (scarce) water and electricity is over 70 percent of the cost in most GCC countries. According to some estimates, the total cost of subsidy is around 20 percent of the total current expenditure in the GCC states' budgets. Therefore, it is fair to rationalize subsidies and restrict benefits to certain groups only. In addition to that, salaries and wages of public employees represent over 50 percent of the current budgets in all GCC countries.
On the other side, the GCC states have spent large amounts on purchases of arms and enhancements of their defense capabilities, especially after the Gulf crisis. These expenditures were financed, generally, outside the budget allocations and not correlated to the improvement of their oil revenues. This added an extra burden on the GCC countries' budgets.
The last component that contributed to the growth of the deficit is capital expenditure. This component is subject to reduction or increase faster and more easily than others. However, as the GCC countries have accomplished the basic infrastructure in their high-income societies, a high investment commitment is required to maintain these levels of lavish public services. Unless the private sector takes up part of these investments, the replacement needs alone would be tremendous in low-growth-rate economies, that is, if we ignore for a moment the needs of new investment.
How have the GCC governments financed their budget deficit? The most common method and the simplest has been the "withdrawal" from their general reserve accounts in Kuwait, Saudi Arabia, the UAE and Qatar. On the other hand, Bahrain and Oman have relied heavily, from the beginning, on internal and external borrowing. The two years following the oil-price crash of 1986 witnessed the emergence of a different phase of deficit financing in the GCC countries, but with wide variation among them. Almost all states employed a basket of financing tools including withdrawal from reserves, direct borrowing from the banking system, issuing of public-debt instruments such as bonds and treasury notes, syndicated loans, and external commercial and concessional borrowing. After the Gulf crisis, some GCC states, like Kuwait, went one further step by direct borrowing, on a large scale, from the external financial markets.
Our expectations about the future of the budget deficit depend on some scenarios for expenditure and revenue alike. Given the magnitude of current and past deficits, the scenario for expenditure depicts its real growth rate would be low, not to exceed 3.5 percent annually. The low growth of the budget is a result of trimming and rationalizing expenditures on subsidies, defense and capital investment in the coming few years. By the year 2000, the total public expenditure will be around $110 billion, or above the current level by 18 percent, for all GCC countries.
On the other hand, the scenario for revenue depicts higher public revenues from both oil and non-oil sectors. According to some estimates, based on OPEC forecasting of the oil market, the oil revenues for the GCC countries are expected to be around $85 billion by the year 2000. If we added the non-oil revenue in the amount of $18 billion at least, the total revenue available for budgets will be around $103 billion.
This simply says that the deficit will be there, around 6 percent of GDP, but with a clear improvement, in the worst-case scenarios. It is still a big deficit, although not as bad as it seems, if we look at the future optimistically.
The process by which a government is able to reduce its budget deficit is a long one and warrants considerable effort, where the political, social and economic forces interact continuously in the fabric of life. What makes this process difficult in the GCC countries is the absence of stable and well-defined fiscal and monetary policies. However, thinking about joint solutions to the region's deficit problem is a little easier due to similarities in the economic structures and policies of the GCC states.
We may list several options in our arsenal of ways to cut the budget deficit. The first is reviewing priorities of public expenditure according to well-studied and applicable criteria, in accordance with clear and defined directions of fiscal policy that meet present requirements and future aspirations. In this respect, efforts should be focused on expanding the role of the private sector in the national economy. This option also includes restructuring public enterprises and transferring certain public-sector units to the private sector and strengthening the free-market mechanism. This requires that governments reconsider, objectively, the civil service and its pricing system, review subsidies for producers and consumers and priorities of capital investment, and finally address the coordination of purchases of arms and defense policies in order to reduce expenditures.
The second option is the call for an increase of non-oil revenues. This is a bundle of items that would include the increase in efficiency of public enterprises, better utilization of public services, and imposition of new taxes and fees. So far, the Gulf is considered to be a non-tax heaven, but the recent calls for the introduction of new taxes could be justified on economic and fiscal grounds, according to their advocates.
Of course, there is no illusion about the vitality of taxes as a source of budget revenue. Whenever the tax system is applied in any country, it is generally based on the social consensus; and the burden of taxes is measured against the benefits generated by public services, according to the political-equilibrium criteria of taxpayers and voters.
This requires that the constitutional statement "no taxation without representation" be preserved. The imposition of new taxes is technically feasible, but are the GCC countries ready to accept the political and social implications of such action and install a fair and comprehensive tax system that is applied equally to residents?
The third option calls for deepening of financial, monetary and fiscal tools. The economic management in the GCC countries ought to develop and nourish the economic forces at work and let the interaction between investment accelerator and government fiscal behavior be homogenized in one direction, to reduce economic fluctuations and, hence, budget deficits. The implementation of positive and comprehensive structural adjustment and systematic promotion of private initiatives and market forces certainly would mitigate the burden on the public budget.
The fourth option is to revise the present budget accounting system, where the discrepancies and variations of recording and auditing are widely observed in the GCC budgets. Once a uniform accounting system is addressed, the decision makers and specialists can undertake correct measures without fear of being misled by inaccurate information. These would help coordinate the efforts by each government in a regional system to finance its own deficit through the utilization of the regional financial institutions and markets.
The last option is the promotion of the offset economic program. As the GCC countries still award large contracts for supply and construction to foreign companies, it is beneficial for both the public budget and the economy to force these companies to reinvest part of their profits back in these countries. This would certainly reduce the burden on the capital budget in each state.
To conclude our review of public finance, and particularly the budget deficit impasse, we can state that the "declared deficit" of 9 percent of GDP in the GCC countries is high and may have negative fiscal and economic implications. Our analysis of the problem has suggested that the deficit is not a cause of the public-finance impasse, rather it is an effect. It is illogical to say that shortage of revenue has caused the deficit, when uncontrolled expenditure has persisted over three decades as the general practice of governments.
The present accounting systems of the budgets have sometimes contributed significantly in creating an artificial deficit (or even surplus) and hence led to misleading recommendations and actions. Therefore, unless the public expenditure itself and its components and priorities are readdressed in a rational manner, the deficit problem will persist no matter what the size of revenue, whether there is an oil boom or a recession.
It is in this context that the call for imposition of new taxes as an alternative source of revenues should be evaluated with great care. A fair and suitable tax system requires constitutional and legal changes to guarantee adequate supervision and control procedures, for which the Gulf societies may not yet be ready.
What makes the task of dealing with the deficit on the GCC level somehow easier is the countries' similarity in economic, political and financial systems. The development of a coordination mechanism among the GCC states regarding financial markets and monetary and fiscal policies is vital in order to facilitate a flow of regional resources that may help in resolving the budget crisis.
THE GLOBAL QUEST FOR CAPITAL IN THE 1990s
Robert D. Hormats, Vice-Chairman of Goldman Sachs (International)
In recent months financial and currency markets have been preoccupied with, and on occasion have reacted sharply to, a series of central-bank adjustments in short-term interest rates accompanied by continuing shifts in expectations about future levels of inflation. Now with most, although probably not all, of the major interest-rate modifications by central banks behind us, at least in the near term, and inflationary concerns largely factored into bond prices, a second broad set of considerations is beginning to receive greater attention. These considerations can be categorized under the broad heading, "The Escalating Global Competition for capital." I shall endeavor in this speech to shed some light on the subject by discussing recent shifts in the supply and demand for capital, changes in the degree and direction of international capital flows and the likely impact of increased competition for capital on the world's economies and financial markets. The central question is not whether there will be a "shortage" of capital, because in the final analysis the market equilibrates international supply and demand-that is, the global supply of savings always equals global investments ex post facto; both adjust to match one another. The central questions in this era of escalating competition for capital are: 1) how well the marketplace will mobilize savings, 2) how effectively it will facilitate the flow of funds to productive investments and 3) what the implications of shifts in the global allocation of capital will be for markets and growth in individual countries.
Private-sector credit demand is increasing as Japan and Europe start to recover; U.S. growth remains robust, and emerging economies in Asia, Latin America and formerly communist Europe attract large amounts of investment. Growing international demand for capital is beginning to collide with the more limited international supply of capital-exerting an upward bias on interest rates. At the same time, there is likely to be a downward bias on global prices at any given point in the business cycle due to the new surge in global competition in goods and services as emerging economies become more competitive by embracing market capitalism. The combined results are likely to be threefold:
-Real interest rates around the world are likely to remain relatively high by historic standards-although not necessarily at the very lofty current level.
-There will be an international reallocation of capital as investors pursue higher returns in emerging economies.
-With more and more nations and enterprises seeking capital, financial markets will be increasingly demanding; they will reward good economic performance by corporations, national governments and sub-national units such as states and provinces while penalizing poor performance-which will mean an ongoing series of significant new shifts in capital flows. The United States and the Gulf countries alike will need to compete actively for capital to sustain economic growth. And our investors will constantly evaluate and reevaluate the performance and policies of our governments, markets and companies as they decide where to place their funds.
CAPITAL SHORTAGES AND CAPITAL MARKETS
Is there a global shortage of capital? There are two correct answers. Yes and no! In one sense there is always a shortage of capital-like apples or cars. There is always someone who would like to buy an apple but does not have the change required or wants a new Mercedes but cannot afford the price. Likewise there are people, corporations or governments that would like to borrow money but cannot pay the interest asked by the lender. In another sense there is never a shortage, because at a given level of capital availability ex ante, the interest rate equilibrates supply and demand ex post.
Globally the equilibration process works through transborder capital flows. In any given nation, savings can exceed investment or investment can exceed savings. In the world economy, the two must be in balance. A country's savings come from its government's budget surplus, the savings of its families and the retained earnings of its corporations. Savings can be employed to buy bonds to finance a government's budget deficit (in economic jargon "government dissaving"), to buy stock to help a corporation to build a new factory or to enable a bank to finance a greengrocer's inventory of fruits and vegetables.
The United States has seen a reduction in its budget deficit, but its level of private savings is the lowest in the Western world. Its budget deficit gobbles up roughly one-half of America's private savings, so to meet the capital needs of the private sector it must import large amounts of savings from abroad.
A country in such a situation runs a current deficit, roughly the amount by which domestic savings fall short of domestic investment. It must import the shortfall from countries in current-account surplus, in which savings exceed investment. This surplus can occur because of a high savings rate, low capital requirements, which usually accompany recession, or some combination of the two. International capital markets are the primary vehicles through which countries with a surplus of savings provide financing-by purchases of stocks, bonds, real estate or direct corporate investment-to countries with savings shortfalls. ·
In the final analysis, global savings must equal global investment, and the sum of all current-account surpluses must equal the sum of all current-account deficits. (Statistical discrepancies in balance-of-payments accounting suggest that the sum of all the world's current-account balances adds up to a deficit of roughly $100 billion, which means that measurement methodologies need to be improved.) If the ex-ante demand for capital rises, putting added demand on the ex-ante availability of savings, the market allocates credit through increases in the cost of capital and tighter credit decisions within and among nations. Shifts in the purchases and sales of assets across borders, and in national interest rates and exchange rates, reflect shifts in the expected risks and rates of return.
THE RISING COST OF CAPITAL
Currently the cost of capital is rising; long-term real interest rates are exceptionally high in virtually every country. In the United States, real bond yields are roughly·5 percent compared to an average of 2.8 percent over the last 30 years; in the United Kingdom, comparable figures are 6 percent and 2.3 percent; in Japan, 4 percent and 2.5 percent. In Germany, real rates are close to the country's 4-percent historical average. The ratios of bond yields to short-term interest rates are now at historic post-war highs in all of the major industrialized countries; the sharp steepness of the yield curves in these countries is extremely abnormal by historic standards.
There are several sets of reasons (some of a general nature and some country-specific) for this twin phenomenon:
First, the factor that had the most impact on rates early in 1994 was the unwinding of enormous financial leverage. For most of 1993, many investors in the United States and Western Europe expected interest rates to continue to decline and borrowed heavily at low short-term interest rates to increase their bond positions. Many U.S. investors profited from borrowing short-term and investing in longer-dated bonds, as well as in other types of securities, in the United States and abroad. When the Fed (Federal Reserve Board) increased short-term rates in February, the bond market collapsed as investors-persuaded that the period of easy money was over-rushed for the door and unwound their heavily leveraged positions. American investors also sold German and British bonds, a significant portion of which (especially hedge funds) they had bought with cheap money, because they had to produce liquidity to cover their exposed positions at home. In February and March, panic sales pushed interest rates up in those countries even more sharply than in the United States.
A second and more sustaining set of factors has been tighter monetary policy in the United States, the market's expectations (as indicated by futures prices) that the Fed would continue to raise rates, and the belief that other central banks also will raise interest rates in the not-too-distant future. Expected increases in short-term rates are a source of upward pressure on long-term bond yields; they will remain so until these expectations are reversed or markets start to believe that lofty rates will cause an economic downturn.
A third factor is higher inflationary expectations. Strong economic growth in the United States, producing a sharp decline in unutilized capacity, coupled with rising international commodity prices, has caused inflationary concerns to rise. The prospect of higher prices has caused lenders to seek a greater return on their loans to compensate them for the risk that inflation will erode the purchasing power of the money they have lent. Investors demand an extra "inflation premium" in countries where the expected rate of inflation is likely to be above average; for example, from time to time in recent months the yield curve in the United States has steepened, with real long-term rates rising sharply, when markets believed the Fed was not acting aggressively enough to fight anticipated inflation.
A fourth factor raising interest rates still higher in a few countries is the "stability premium" that markets require when concerned about repayment prospects or special inflation risks. Countries with exceptionally large budget deficits such as Italy, Sweden and Belgium have seen extraordinary drops in the prices of their bonds because of assorted apprehensions about repayment prospects, the possibility that they will monetize their deficits and thereby pay off their debt in debased currency, or the future weakness of their exchange rates.
A fifth factor-the major focus of this speech-is that the international availability of investable funds is growing less rapidly than the current and prospective demand for it. The most dramatic change in global finance in recent years has been the rapid increase in the flow of capital to emerging economies and those in transition from communism to market systems. Many of these countries have implemented major structural reforms, trade liberalization, deregulation and policies to slash budget deficits. Privatization of state-owned companies from Mexico, to China, to India, to Singapore has provided attractive new investment opportunities for investors in industrialized nations. Recovering from the 1980s debt crisis, several of the larger countries in Latin America have regained creditworthiness, enabling them to issue bonds in Western markets.
According to a recent Institute of International Finance report, capital flows into emerging economies shot up from less that $30 billion in 1987 to roughly $180 billion in 1993; private flows accounted for 87 percent of this figure. The Bank for International Settlements (BIS) puts the 1993 figure at $165 billion; with $92 billion of that in the form of portfolio investment (up from an annual average of $8 billion during the 1986-90 period). Net industrialized-country purchases of equities of emerging countries grew at a 48-percent annual rate over that period. Although only a relatively small portion of that flowed to the Gulf, the amounts are increasing as well. Today the collective market capitalization of emerging economies is over $2 trillion, compared to only about $200 billion a decade ago. Direct investment in emerging markets reached $74 billion in 1993, according to BIS estimates, compared to an annual average of only $23.5 billion from 1986 through 1990.
A significant factor in the increased flow of investment to emerging markets has been the growth of the foreign holdings of institutional investors; mutual funds have significantly increased their holdings of emerging-country assets. Net annual aggregate investments in mutual funds by Americans doubled from $144 billion in 1986 to $298 billion in 1993; in the first quarter of 1994 holdings of mutual funds by Americans came to $1,525 billion, up from $427 billion in 1986. The holding by U.S. mutual funds of emerging-market securities has grown from less than $1 billion in 1986 to over $50 billion at the end of 1993. Another factor has been the progressive liberalization of capital transactions across borders. As recently as 1975, many industrialized countries were imposing limits on the ability of their citizens to buy and sell foreign financial assets. By the early 1990s, most such restrictions had been lifted. At the same time, emerging economies relaxed restrictions on the sale of domestic assets to foreign residents and improved clearance and settlement procedures.
One way of looking at the impact of these flows on the international pool of capital is to examine shifts in the current accounts of non-Japan Asia, Latin America, the Middle East, Africa and formerly communist Europe taken together. This combined figure represents the net amount of capital these countries obtained from the rest of the world. It indicates the reallocation of short- and long-term capital flows. In 1989 the combined current-account deficits of these countries was just over $20 billion; in 1993 it was over five times that amount. However, the size of the current-account deficits of the emerging economies underestimates the amount of investment capital inflows, because in some of these countries investment capital inflows (stocks, bonds, real estate, etc.) substantially exceed the size of their current-account deficits. The difference between the two is the export of short-term funds, for instance, by central-bank purchases of U.S. Treasury bills.
Flows to emerging nations have declined somewhat this year from the extraordinary levels of 1993. But the capital imports of these countries are, and are likely to remain, very large. Many of these countries' assets offer returns considerably higher than the assets of industrialized countries, and their governments are continuing to consolidate their structural and market reforms. Moreover, the demand for capital is enormous. The Asian Development Bank estimates that its 37 Asian and Pacific member countries (excluding Japan) will need to spend about $1 trillion on infrastructure alone between now and the year 2000.
Not all of the capital requirements of these countries will be financed by imported capital, of course. The lion's share of the funds for investment in these countries will be generated internally. Aggregate savings in the emerging countries is significantly higher as a percentage of GDP than in the industrialized countries. Nearly 25 percent of world savings comes from these countries today compared to only 15 percent in the early 1970s. Savings rates are 30 percent of GDP in East Asia and 20 percent in Latin America. Higher savings rates will be sustained by the liberalization of domestic financial sectors in these countries and, as in the case of Chile, the move towards private pension funds. However, their investment requirements are likely to exceed their internal savings rates for years to come. In China, for example, the rate of savings in 1993 was an extremely high 34 percent of GDP, but investment was an even higher 37 percent!
The large and growing capital flows from industrialized to the developing and transitional economies had little impact on global interest rates through 1993. World interest rates fell beginning in 1989 because demand for credit in much of the industrialized world was held down by slow growth or recession. Although America's current-account deficit rose from $101 billion in 1989 to $109 billion in 1993, the current-account positions of the industrialized nations as a whole shifted over this period from a deficit of $84 billion to a surplus of $12 billion, largely on the strength of a rapid growth in Japan's current-account surplus.
Japan's enormous capital exports contributed to the decline in interest rates in other nations and helped the financial system to accommodate the increasing current deficits and capital inflows of the emerging nations. Japan's surpluses occurred as recession led its corporate sector to sharply reduce its borrowing needs, enabling that country to increase its capital exports.
THE SAVINGS SHORTFALL
But the world economy is now in a different cycle. If flows to the emerging countries remain close to recent levels, Western Europe recovers, the Japanese economy emerges from its doldrums and the United States sustains high rates of growth, international demand for investment capital will increase substantially. These increases will focus growing attention on a problem that until early 1994 had been masked by the efforts of the Federal Reserve to stimulate the U.S. economy by creating relatively cheap credit, by efforts of other central banks in the industrialized world to do likewise, and by weak private-sector credit demand in Japan and much of Western Europe. That problem is the low level of savings in the industrialized world!
Low savings are the result of three major factors: 1) a decade-long decline in private savings in the industrialized democracies, largely caused by the fall of savings in the United States; 2) large government deficits in many of these same countries, although here the United States (now with the lowest deficit-to-GDP ratio among the major industrialized countries) deserves special positive mention; and 3) Germany's post-Cold-War tum from investing large sums abroad to drawing in foreign capital to rebuild its new eastern states.
Weak Private Savings
Private savings in the industrialized countries fell from 21.5 percent of GDP at the beginning of the 1980s to roughly 19.5 percent in 1993. In the United States, private savings declined from just under 18.8 percent of GDP to below 16 percent during this period, with further weakening anticipated when the figure is measured at the end of this year. Savings have remained at roughly 21.5 percent of GDP in Western Europe, but have dropped from 28 percent to roughly 24.5 percent in Japan (which is appropriate as that country seeks to reduce its current-account surplus).
There are numerous explanations for the decline in U.S. private savings over the last decade: revaluation of the stock of wealth as equity markets rose over the last decade, improvements in the relative income position of older groups in the population, certain tax-induced distortions that encourage borrowing, and the expectation (increasingly suspect) that in the future government pensions will be so generous that a large portion of current revenues can be consumed rather than saved.
Growing government deficits in the West (except, at least temporarily, in the United States) constitute "dissaving." They drain the private pool of savings. The collective budget deficits of industrialized countries were 2.3 percent of GDP at the turn of the last decade and 3.5 percent at the turn of this one. Western Europe's combined budget deficit rose from 3.5 percent to 5.3 percent over this period, and the U.S. deficit increased from 0.6 percent to 3.5 percent. Japan's budget deficit has been historically very low, but, under pressure from the rest of the world and its own citizens to boost growth, its budget deficit too is increasing. Excluding social security, it has risen from 3.5 percent of GDP in 1993 to an 5.7 percent of GDP this year.
The U.S. deficit has dropped sharply this year. As recently as January 1993, the Congressional Budget Office was projecting deficits of over $260 billion for FY1994 and 1995. Currently it is running at below $200 billion and is likely to fall below $160 billion next year. And although Japan's fiscal deficit is likely to increase, those of most Western European nations are projected to decline because of fiscal policies tilted toward restraint and increased revenues that result from economic recovery. Reflecting these improvements, new bond issuance in the United States in 1994 is expected to be $163 billion compared to $235 billion in 1993; sharp declines are also expected in Britain and France, with a lesser decline in Germany. Such factors should help in the near term to reduce pressures on capital markets.
But over the longer term, there is an underlying danger posed by the high ratio of government debt to GDP in the industrialized nations. Even with budget consolidation and higher growth in Europe, Japan and the United States, that ratio is expected to rise in 1995 to about 70 percent of GDP (compared to about 53 percent a decade ago); if growth and revenue expectations do not materialize or interest rates rise more sharply than anticipated, worsening the debt-service burdens of these countries, decreases in deficits would not be realized, debt-to-GDP ratios would increase and government demands for capital would be higher.
A further concern down the road is pensions. Unfunded pension plans will raise borrowing needs as baby boomers in Western societies retire and need to be supported by the declining percentage of the population in the active work force. The OECD estimates that the unfunded private and public pension liabilities of many industrialized countries are between 150 and 350 percent of GDP, which implies enormous pressure on savings in the early part of the twenty-first century. Public pension commitments will either be defaulted on, or taxes will need to rise sharply on a smaller group of workers to pay for a larger group of retirees as Western societies "gray." A potential financial and intergenerational crisis is brewing here.
The Reversal of German Capital Exports
West Germany, once a major exporter of investment capital, must now utilize enormous amounts of capital to rebuild the new eastern states. In 1989, West Germany exported about $60 billion of capital. By 1991, a united Germany was importing nearly $20 billion. Germany's current account, long in substantial surplus, was roughly $22 billion in deficit in 1993-drawing savings from the rest of the world rather than supplying them.
Two others factors affecting the global supply of capital relate to the capital flows of Japan and the United States.
Shifts in Japan's Capital Flows
Japan, with its still enormous current-account surplus, has recently been a reluctant exporter of investment capital.
For most of the past decade, Japan was far and away the largest supplier of international capital to the American market. For years its investors made large acquisitions of bonds, stocks, real estate and whole companies in the United States-at times provoking exaggerated outcries that they were "buying the country." But times have changed. The prolonged recession in Japan has reduced profits of many Japanese corporations; its banks have suffered a sharp deterioration of their profits and balance sheets as the result of the collapse of domestic property values and the decline of the shares of Japanese corporations they hold. Many banks have had to increase their loss reserves to cover their nonperforming loans. To offset tighter liquidity at home, banks, mortgage-financing companies and corporations have had to sell large amounts of foreign, principally American, holdings of stocks, bonds and real estate.
This has led to significant periods of dollar sales and yen purchases. The weakening of America's real-estate prices and the decline of the U.S. dollar further eroded the value of Japanese investments in this country and further reduced the appetite of Japanese investors for American assets. Seeking to profit from the rising yen and increases in the price of Japanese stocks, they recently have increased their investments in Japan; and many Japanese companies have made substantial amounts of new investment in other parts of Asia.
The combination of a surfeit of dollars earned by Japanese exporters, the sale by Japanese investors of U.S. assets, and the increased purchases by Americans of Japanese assets pushed down the U.S. currency's foreign-exchange value vis-a-vis the yen through the first half of 1994. This necessitated intervention by the Bank of Japan to sop up excess dollars to prevent that currency's further drop.
All told, the increase in the quantity of dollars placed on the market in 1993 by the combination of America's current account deficit and its capital outflow amounted to $253, up sharply from $117 in 1992. This increase was accounted for by an increase in the purchase of foreign financial assets by U.S. investors and a widening of America's trade imbalance. These figures, which combined represent the country's "basic balance," constitute the sum of dollars foreign investors must recycle back to the United States. The basic-balance deficit in 1993 exceeded the appetite of foreign, particularly (for reasons noted above) Japanese, investors to hold dollars at a stable exchange rate. This caused the dollar to weaken and foreign central banks to intervene to attempt to stabilize the currency; it meant that the U.S. basic-balance deficit was financed in important part through foreign central-bank purchases of U.S. Treasury bills.
IMPLICATIONS OF THESE DEVELOPMENTS
There are several significant implications of the intensified competition for capital.
First, it will place increased demands on governments to ensure that their economic policies and performance are attractive to their own and foreign investors. This means controlling budget deficits, sustaining non-inflationary growth, and promoting regulatory and tax policies that are appealing to investors. The recent move by countries such as Mexico to make their central banks independent is an indication of their awareness of the need to demonstrate their credibility in ensuring price stability. Overall the new competition for capital should improve chances for price stability within and among nations by strengthening the role, and the anti-inflation zeal, of central banks.
Attracting direct investment in the late twentieth century also means placing emphasis on education-which will be increasingly important for drawing and holding new manufacturing and services enterprises-and providing a healthy social environment so that investors will want to send their best people and will have confidence in the country's long-term stability. For many workers in the West there will be a Catch-22, because for their companies to survive and keep them employed, wages will need to be restrained or lowered to provide attractive returns to investors, whose funds will be needed to finance new equipment and facilities.
Second, the role of sub-national units in the global economy is increasing as a result of their desire to attract investment to boost employment and wages. The Basque and Catalonian regions of Spain have been rewarded for sound economic policies by capital markets in Germany and, in the case of the former, the United States as well, where they have recently floated bonds-a step that would have been unlikely even five years ago.
American states, Canadian provinces, Russian regions, Chinese provinces and similar entities in Europe and Latin America are sending delegations around the world to attract investment. Delegations from North Carolina or Georgia don't say, "Come to the United States"; they say, "Come to our state-with its skilled workers, relatively low wages and taxes, pleasant life style and a government that supports business." Most states and provinces around the world now have their own international economic policies and will become more aggressive about pursuing their specific interests in the new global economy. The quest for capital means that such units must compete among themselves within and among nations by ensuring sound policies attractive to investors. In a global goods and capital market, such units have access to both and are rewarded for good policies.
Third, the downside of a more global capital market is the potential for periods of volatility and short-term exaggerations in price movements in financial and currency markets. Instant information flows, the application of new technologies to trading, the increased institutionalization of funds, and the desire of money managers not to be left behind in a market move are all partial factors. The danger is particularly great with some of the newer markets that are less liquid and are less understood by foreign investors (so investors tend to panic and move out quickly upon hearing bad news) than some of the older capital markets. As markets mature and learning curves flatten out, some of the problem will go away. More research on stocks and bonds and greater activity by rating agencies in these markets can improve the information flow and transparency that investors need.
A number of countries in the Gulf have taken steps to attract new foreign investment, and many investors in the United States, Europe and elsewhere are eager to pursue investment opportunities in this important region, as the reception given by investors to recently established regional funds clearly demonstrates. Progress in increasing the flow of economic information to investors, broadening the use of international accounting standards, further increases the efficiency and liquidity of local capital markets. Widening the range of assets that can be bought here will attract more investors to the region, as it has with East Asia and much of Latin America.
It is also worth bearing in mind a concern recently sounded by the Bank for International Settlements with respect to Latin America. It pointed out that a large proportion of Asian capital flows have been closely linked to increased domestic investment and imports of investment goods in Asia. This has contributed to stability in real exchange rates and helped to prevent excessive increases in domestic liquidity. In contrast, the influx of capital into many parts of Latin America has been dominated by portfolio and short-term capital flows (much of it repatriated flight capital, attracted by high real interest rates). These flows have been less directly associated with increased inflows of investment goods and have placed greater upward pressure on real exchange rates.
These large inflows of short-term or portfolio capital have increased the region's vulnerability to external shocks, such as higher interest rates in the United States. Latin American debt markets tumbled when the Fed began to raise short-term rates. Asian markets were also affected, but not to the same degree; their bond yields today show a lower risk premium.
Another risk to Latin America inherent in the type of capital flows it is receiving is that, as noted, capital inflows caused currencies to remain stable or even appreciate when they should have depreciated against the dollar, because the inflation rates in most of Latin America were higher than U.S. inflation. The impact of this appreciation in the real effective exchange rate is likely to be a deterioration in the competitiveness of the traded-goods sector of these economies and therefore a weakening of their trade balance.
Asian countries, many of which have been more successful at controlling inflation and holding down fiscal deficits than many Latin American countries, have generated higher domestic savings and produced higher rates of investment-and enjoyed lower rates of inflation; they are somewhat less vulnerable to the above-mentioned problems.
Fourth, mobilizing domestic savings and allocating them efficiently is a major challenge as the competition for capital heats up. In many industrialized countries, unfunded pay-as-you-go government retirement plans and private-sector pension funds are a financial Achilles heel. In Italy, France and Spain, governments over the years have incurred enormous obligations to pensioners which, if fulfilled, will place virtually impossible strains on budgets and the taxes of future workers. High expectations of large pensions also hold down savings rates in many nations.
A vital step toward better mobilizing domestic savings and avoiding large future liabilities for governments is the privatization of pension funds. It is no accident that capital markets work best and funds for new investment are most easily obtained in countries such as the United States and Britain, with large pools of private pension funds. Chile is an example of a country that has benefited dramatically from pension reform. Pension-fund privatization has raised Chile's domestic savings rate from the lowest in Latin America to one of the highest-20 percent of GDP. Argentina and Colombia subsequently undertook reforms modeled largely on those of Chile. That same model was recently recommended, after a study of pension plans around the world, for adoption by Poland.
Much work is needed in virtually all countries, industrialized and developing, to modernize pension plans to better mobilize domestic savings and prepare for the graying of their populations. They need to ensure that productive resources are invested today to support their retirees tomorrow so that the next generation of workers will not be faced with excessive tax burdens to finance the generous pensions that governments have promised their fathers and mothers. Unless this problem is addressed soon it will become the critical inter-generational and financial crisis for the industrialized nations in the next century.
Competition for capital will increase in coming years-in the Gulf, the United States, Western Europe and throughout the world. Capital markets, supplemented by bilateral and multilateral financial institutions, will be required to allocate world savings among an increasing number of potential claimants. A multitude of high-return projects in the emerging markets will likely attract investors and allow some of these countries to run large current-account surpluses. Others may find themselves more vulnerable if reliance on foreign capital is too great relative to domestic savings and investment.
Strong growth and credit demand in emerging and industrialized countries is likely to cause the price of capital to remain at unusually high levels in real terms at most points in the business cycle. That in turn will put more pressure on markets to efficiently mobilize and allocate capital. And it will mean that countries, subnational units and enterprises will more than ever have to promote policies and produce returns adequate to maintain the flow of investment. The alternative for governments is slower growth and higher unemployment and for enterprises, lower profits and ultimately extinction. For governments, the human element is also of vital importance; growth that does not provide benefits to lower income groups and cannot overcome social and environmental problems is neither sustainable nor convincing to long-term investors in this era. The pains of adjustment to more open markets, technological change (which can render jobs obsolete almost overnight), and fierce competition within and among countries require effective programs to train, retrain and support those who have been un- or under-employed and seek new jobs and careers. The supply side of the financial equation may well be the key to the ability of the world to cope with the investment requirements of the emerging economies and its own as well. For the United States, the most responsible course of action will be to further reduce the federal budget deficit, taking advantage of the current boom to cut back on entitlements, some of which current growth in any case renders less necessary. It must also provide new incentives to increase private savings and bolster private training programs; a thorough assessment of the options now is required.
In much of Western Europe, the major challenges are to continue to reduce structural budget deficits, also taking advantage of the opportunity provided by the current recovery to reduce entitlements and other expensive social programs. These countries must, in particular, begin to shift large government pension programs to the private sector in order to increase investment rather than government liabilities that will burden tax payers and siphon off savings well into the next century.
In the Gulf, each country will have its own blend of policies reflecting its history, culture, financial needs and market size to mobilize domestic and foreign capital. Governments in some cases will require a significant amount of finance in the period ahead. Banks, corporations and important projects will also need additional capital. Changes in global markets and the increasing international awareness of insurance companies, pension funds and mutual funds in the industrialized world offer new sources of foreign investment for this region if the underlying domestic conditions are favorable. And the expansion of global capital markets offers a wider range of opportunity for profitable investment by citizens in this region.
Finally, the international financial and trading systems must be kept open to ensure the most efficient allocation of resources. Controls on the movement of goods and investment distort resource allocation, which in tum reduces the efficient utilization of scarce capital. To the extent that global returns to, and opportunities for, investment can be enhanced, so can incentives for new saving.
INTERNATIONAL BANKING IN THE 1990s
Andrew R.F. Buxton, Chairman of Barclays Bank
As the main industrialized countries of the world climb slowly out of recession, the banks are gaining strength. Banks are service industries, and they reflect the strengths of their customers and their economies. During recession, the withdrawal of some banks from the international market meant that margins rose as competition lessened, but once again, it is becoming quite clear that there is over-capacity in the international banking market as stronger balance sheets lead immediately to a greater capacity for lending at a time when lending assets are expanding quite slowly. This inevitably leads to greater competition and lower margins.
It is generally true that if a bank suffers large credit losses, its international portfolio gets cut back as it concentrates on its home market and on rebuilding its balance sheet. When recession hit the United States, for instance, we found U.S. banks withdrawing resources from Europe in order to concentrate on their home market. When recession hit Japan, the Japanese banks cut their international lending in order to be able to serve the home market. The position varies from country to country, but in the United States bank profitability has now risen substantially in the last two years, as it has in the United Kingdom. In Japan, however, the banks are still suffering from bad loans made in the past and are unlikely to get on top of the problem for another two years.
Barclays' profits reflect the change. In 1992, Barclays sustained a loss of £240 million; in 1993, that turned around into a profit of £650 million, and in the first half of 1994, Barclays made a profit of just over £1 billion, so you can see that there has been a dramatic turnaround.
Increasing profitability has brought strong balance sheets and high capital ratios but, at the same time, regulators are raising their sights and expecting large international banks to carry high ratios. In the United States, this has been encouraged by the Congress, which is concerned about the risk that banks are running, particularly in the derivative markets. I remember in London two years ago saying that I expected international banks to have a Tier I ratio of at least 6 percent. Some analysts expressed surprise and said that was too high, but Barclays now has a Tier I ratio of over 7 percent and a full ratio of over 11 percent. I do not look upon that as exceptional.
Capital is held as a reserve against risk, and by saying that international banks should keep relatively high capital ratios, I am really saying that the world is a risky place and the capital of a bank should reflect that. All bankers know that the gearing of a bank balance sheet is very high compared to that of the average industrial company, with an assets-to-capital ratio of about 12:1. This means banks cannot afford to make very many mistakes, and it also means that there may be a case for regulators to raise the minimum capital required for a bank's balance sheet. I think that the Basel regulators may have pitched the minimum capital slightly too low when they fixed the minimum risk-asset ratio at 8 percent and the minimum Tier I ratio at 4 percent. They did it in order to get uniformity because many banks had weaker ratios than that, but the time has now come to consider raising the minimum. There have been many examples in the last few years of banks that put their whole capital at risk through bad lending or bad dealing. You do not have to go far wrong in a lending portfolio to wipe out both profit and capital.
There have been several examples around the Gulf where central banks have bad to step in to rescue banks that simply did not have enough capital for the risk that they had taken on in their balance sheets. That experience is not limited to the Gulf. In Scandinavia, particularly in Norway and Sweden, substantial government help has been given to private-sector banks to enable them to survive. I realize there are substantial social issues and perhaps political issues if a bank goes into liquidation, but there is no economic justification for rescuing banks that have been badly managed and do not have the capital to support their business. The result of such a policy is continuing over-capacity, which, in the future, will result in more bank rescues.
For the moment, the regulators are concentrating on making sure that banks cover all their risks with a backing of capital. Banks should not have off-balance-sheet liabilities that are not covered by capital. There has been much talk about the risks incurred by banks in the derivative market, for instance, and the fact that some derivative business is still relatively capital-free. I support the need to find satisfactory measurements of risk that will result in capital being held against all risks. This is essential when the amount of capital is so small against the size of the business. However, we should remember that derivatives, essentially, are used to cut risk, and if used properly-which is, of course, an important condition-the market should be more stable, not less.
Most banks are trying to do two things as they learn from their mistakes of the past. First, they want to improve risk-management techniques, so they fully understand the risks that are being undertaken. That information can then be used to cut the risk in the portfolio. Second, the banks are trying to be selective in what business they do in order to raise the return on capital for their shareholders. The two aims are connected, because it would be easy to raise return by taking on more risk. What is difficult is to raise return by taking on less risk, or alternatively, to take on more risk in a disciplined way so that the bank understands exactly what risk is being undertaken.
What I can tell you is that most banks have found that lending large amounts of money at very low risk to very creditworthy companies or countries is not very profitable, because competition has driven the margins down to uneconomic levels. The banks are, therefore, being very selective and are cutting their portfolios, concentrating on customers who are willing to open up other sources of business besides just lending. It is not easy for a bank to sell the message to a major customer that the customer's credit is so good that the bank does not want to lend because the margin it commands is so low. Looked at from the customer's point of view, I believe that some borrowers should be more selective about the banks they deal with. If they decide that a particular bank holds a position in the world that is useful to them, it is worth developing a business relationship that is wider than just lending because the bank will be looking at total income, including products other than lending. That relationship might include fund management, stock-exchange trading, operational business or export-credit business. There is a wide range of options.
This has led many banks to place greater reliance on trading activity because the returns in the lending market are not high enough, while trading needs less capital. However, earnings derived from trading activity are volatile; and we have seen only too clearly the adverse impact that unsettled market conditions are having on trading revenues this year. This means that a greater strain is put on the capital employed in these activities.
It has also led banks to look at developing other parts of their business that can provide higher returns on capital and to put resources into countries which might provide them with growth for the future. Investment has been put into China, for instance, where a new power station is said to be required every week. There is great interest in India, where the government has been deregulating the economy and is encouraging inward investment. There is much talk of emerging markets elsewhere-in Asia, Africa or South America. All these markets are interesting, but the combination of strong capital ratios, weak lending assets and emerging markets that are hungry for capital is not one that benefited banks in the past, bearing in mind the history of lending to South America and some countries of Eastern Europe. International banks will have to be careful and judge their risk well if the margins they charge are, in the end, going to be sufficient to give them a profit over some of the bad debts that will undoubtedly result.
For many banks, the challenges in their domestic market are so great that all available resources are being devoted to meet them. Sixty-four percent of Barclays' pretax profit of £1,036 million for the first six months of 1994 was earned from the United Kingdom, so it is essential that Barclays protect and grow its key home franchise. Barclays in the United Kingdom has 8 million customers, 2,000 branches and will invest over £2.5 billion on information technology in that business alone over the next five years, with the dual aim of improving customer service and reducing costs. That is a very significant investment, and it is important that it be managed well.
Looking at these statistics, it is fortunate that Barclays is able to maintain a strong home franchise as well as a large international business. It does not surprise me that many banks have insufficient resources to look beyond the challenges facing them in their domestic markets and, as a consequence, have scaled down their international ambitions. A bank normally makes more money in its home market than it does in international markets, and many banks have come to grief over the years through having grandiose ideas of overseas expansion which are simply not justified by the amount of business they do. In the city of London now there are nearly 500 foreign banks, and I am quite sure that many of them do not make a profit but are there for prestige reasons. Of course, I want to encourage London as an international center; but, as a banker, I cannot encourage international banks to open loss-making businesses just for prestige. There has to be a flow of business to justify expansion.
One of the trends in international banking over the past few years has been a gradual realization that return on capital and a stable business are more important than international spread. In Barclays, we have cut the number of countries in which we operate as we followed that policy, but we still operate in over 70 countries, so we still have a long way to go.
The challenge for any bank or financial-services organization is to differentiate itself from its competitors because it is very difficult to differentiate pure cash except by price. Differentiation can only be achieved through the provision of a superior level of customer service, which means delivering skill or information to the customer so that it adds value. Any bank can provide an operational service, but can it also provide cash management? Any bank can provide foreign-exchange services, but can it provide the derivative products that add value? In other industries, the service providers that have added value are the businesses that have come out on top.
Technology offers huge opportunities to provide greater value to customers at lower costs. However, it also poses a significant threat as it enables new entrants to compete in the financial-services market by using more efficient and effective delivery and distribution channels than the traditional and costly branch networks.
Technology also has an important role to play in improving the quality of management information at our disposal, particularly in the area of risk management. Barclays is concentrating on giving customers more information and more convenient access to the information that we hold. Last year Barclays spent just over £800 million on technology round the world, and I doubt whether any international bank can face the future with any confidence at all unless its information-technology spending is relatively high. When Barclays' profits declined substantially between 1990 and 1992, we did not reduce our information-technology spending. We concentrated on getting good value out of it; and we changed much of the way in which we managed technology, but it was an important principle for us that we did not actually reduce that spending.
Through technology, we may find in the future that international banking takes on a greater significance for even the retail customer as a result of improvements in technology. Already in the world, multimedia delivery of products is coming directly into the home via fiber-optic delivery. I can see the day when a home-banking service could be delivered in Kuwait that would cover services in the United Kingdom or in the United States, and you might be able to sit with a hand-held unit in front of the television, which would enable you to scan bank rates across Europe and the United States for the best three months' deposit. Looked at from the bank's point of view, that is a challenging outlook because it may mean that banks' retail services become merely commodity services delivered through a service provided into the home. Many banks, including Barclays, are looking at the implications of that and wondering how they can add value to the customer so that their product becomes a premium product.
Just as technology can deliver information across the world to customers, it can also deliver operational ability for a bank. There is no technological reason why banks in Kuwait should have operational computer centers here. The work could just as easily be processed in Bombay or London. Swiss Air in Geneva is processing all their operational needs in Bombay; Barclays has closed its computer center in Lisbon and is processing from Madrid. That technology gives international banks greater ability to decide whether they need a physical presence to do business. London has proved to be an important center and appears to be gaining business at the expense of other European centers, as banks consolidate their European operations. New York is just as important. I suspect that Tokyo is losing business at the moment because of the authorities' unwillingness to deregulate at the pace that the market demands. Singapore is probably a beneficiary of some of that business.
Technology is bringing the world closer together, but it is also making competition easier to deliver to a wide range of markets, and that competition is coming not just from banks. That is a challenge, incidentally, not just for banks but for regulators who are not taking enough notice of the way in which non-banks are building up financial-services businesses.
G.E. Capital now has a very substantial lending business; General Motors is a large issuer of credit cards; telecommunication companies like AT&T are planning to bring financial services into the home. That will, inevitably, reduce bank profitability and should, in the end, result in fewer banks unless the regulators go on rescuing them.
For many banks the challenges will prove too great to meet single-handed, and I would not be surprised if there were an increasing number of mergers, joint ventures and alliances, particularly in the international field. More banks will concentrate on their regional business and look to forge an alliance for their international needs, either in a general form linking bank to bank, or in product form using banks with particular skills to deliver a particular product. There will be fewer banks operating global businesses across the world, and I hope we will see fewer rescues using state money to prop up weak banks. We will see stronger international banks with higher capital ratios using personal skill and technology to bring value to their customers. I can tell you that one of those banks will be Barclays.