Risk after an Arab Spring
Investing in the Middle East
Risk is a key factor in determining investment and business strategy. Too much risk deters investors whilst too little risk likely means little to no yield on invested funds. Yet in the Arab World, where investment risk and potential returns have always been high compared to the West, political instability continues to deter backers. This presents a substantial obstacle to countries and firms in the region; particularly those who desperately need new funds to drive the economic growth and development expected by those supporting regime change.
While most developing countries, such as Russia, India, and China, have benefited from internal and external sources of funding, the Arab World has had to rely predominantly on growth funded from within. This is mostly thanks to constant political upheaval and instability in the region.
The Arab World can be split into two groups: nations with abundant natural resources (oil and gas), and those with very little. The gulf between the two could not be vaster. Most investment in the Arab World has traditionally come from within the Arab World. After the discovery of oil, poorer Arab countries became reliant on newly wealthy neighbouring Arab governments to fund their development and growth. However, as wealthier Arab nations such as the UAE and Qatar began investing in their domestic large-scale infrastructure projects, they became increasingly reluctant to invest in poorer countries in the region.
Regional governments with
large sovereign wealth
funds continue to pour
money into the West to
diversify, but in reality for
no other reason than to
preserve wealth by avoiding
the perceived increased risk
of investing at home
With less support from neighbouring governments, some Arab governments tried to attract non-Arab foreign direct investment (FDI) yet very few non-Arab countries or firms were willing to gamble on resource-poor, volatile countries, unless strong government and financial guarantees were in place for the investing firm. Without much sovereign wealth, guarantees were difficult to provide: financial institutions were hesitant to lend to Arab countries with no oil. Any substantial business in the region was normally conducted through joint ventures with local businesses, where the local partner took a disproportionate amount of the risk. The level of corruption in many of the Arab countries also played a large part in effectively alienating non-regional foreign investment. With a large and growing youth population and few jobs, this lack of investment and misuse of funds presented a major problem.
That was the scenario before 2011. This past year the Arab World has seen a sweeping wave of change, termed by many as the Arab Spring. People in the Arab region have been marching to demand reforms to what they view as corrupt regimes that offered little hope of work or economic prosperity. In Egypt and Tunisia, protestors and reformers have succeeded in removing the previous governments. In contrast, protests in Syria, Libya, and Yemen have led to varying degrees of violent conflict. Many regimes, especially in the oil-rich Gulf, have suppressed uprisings through the announcement of generous welfare systems for their citizens or by using force.
All of this has had very real and inevitable consequences on local investment and FDI in the region. In particular, regional governments with large sovereign wealth funds continue to pour money into the West to diversify, but in reality for no other reason than to preserve wealth by avoiding the perceived increased risk of investing at home. However, investing abroad often brings its own, often unapparent, exposure and risk.
The effects of the Arab Spring can be understood by considering its affects on risk levels. There are two broad categories of risk: systematic and unsystematic. Systematic risk is a risk that affects most asset classes, such as political risk, while unsystematic risk is asset or firm specific risk. Systematic risk is almost impossible to protect against while diversification can help offset unsystematic risk. However, diversification in the form of investment of large portions of funds outside the Arab World leads to a wide array of associated risks, from commodity and currency risk to equity and interest rate risk.
Currency and commodity risk is incurred as most sovereign wealth funds and government investment firms in the Arab World have exposure to international currencies, predominantly US Dollar, the Euro and the British Pound. Some countries have tried to address this issue by pegging their respective currencies to these Western currencies. Inevitably, this means that they import US and European inflation or deflation through both negative growth and currency devaluation. In particular oil is traded in dollars, which automatically puts most Gulf countries in the precarious position where they have to help absorb any perturbation in the US economy and market.
Removing a corrupt government
does not ensure that another will
not replace it. These countries
will have to move forward
quickly and present plans to
convince investors to help
reinvigorate the region and
Hence, when the uprisings started to impact local economies and drive up the price of oil, many Arab countries moved their excess cash into perceived safe-havens such as US Treasury Bonds, yet negative fundamentals and interest rate risks that currently exist in the US meant they inherited substantial risk. Although it may soon be more practical to move the funds back into local projects and businesses that will yield much higher returns compared to US bonds, there is no sign of this yet. In addition, Western firms that were only recently starting to look at the Arab World as a potential area of investment have pulled out substantially, or opted in favour of other developing nations in Asia.
Planning for Prosperity
The real question is timing. In the short-term, funding will be difficult to attain due to both the perceived and real risk in the region. This will affect businesses and poorer countries the most, as funding becomes much more expensive to obtain, if at all. The long-term view is less clear as the potential positive outcomes of the unrest seem so uncertain.
When the dust finally settles, social, economic, and political rebuilding will be necessary. Removing a corrupt government does not ensure that another will not replace it. These countries will have to move forward quickly and present plans to convince investors of the opportunities to help reinvigorate the region and spur development. Without this support, these movements for change will have had little positive outcome for the region and will only drive up the costs of business in an already expensive region.
Tariq Bin Hendi is a PhD student at the Imperial College Business School. His thesis focuses on the impact of labour nationalisation on wages and unemployment in the United Arab Emirates.