Mario Draghi is set to act again to fight growing deflationary threats in the Eurozone and the ECB has set its December meeting as the place where it will decide whether to increase its current 60 billion euro asset purchase program. Draghi has not yet reached “Whatever it takes” mode with increased stimulus but is trying to push nonetheless with a statment that “the attitude [towards increased siimulus] is not wait and see but work and assess.” Turkey and North Africa would be primary beneficiaries of increased economic activity that stimulus would support if it were enacted in December and also are at most risk if the ECB fails to fight off deflation in the Euro area because of their trade ties with the EU.
Q&A with Dr. Hani Findakly on the implications of oil prices on commodity-dependent economies in the MENA region
Current Vice Chairman of Clinton Group, Dr. Hani Findakly speaks exclusively to Finance Forward on technology & commodity-driven growth ahead of flagship industry event WIBC. A Former Chief Investment Officer and Director of Investments for the World Bank Group, Dr. Hani Findakly has held senior financial positions in Wall Street, including, Group Head, International Capital Markets, Drexel Burnham Lambert; Managing Director, Global Risk Management, Paine Weber & Company; CEO, Potomac Babson; and Chairman, Dillon Read Capital.
Finance Forward (FF): The role of commodity markets has acted as a disruptive force in the Middle East in the past including during the period of sustained low oil prices throughout the 1980s and 1990s, are there any areas, like in technology development, where a prolonged disruption to the status quo from lower oil prices could be channeled into a positive direction?
Dr. Hani Findakly (HF): Unlike the 1980’s and 1990’s, where technology had an incremental impact on the methods of extraction and material sciences, the new technologies are disruptive in fundamental ways. Horizontal drilling, for example, enables the extraction of five times the volume of crude oil out of a well compared to the regular drilling. Hydraulic fracturing allows access to shale formations 1-1.5 miles deep, which could not have been accessible for economic, physical, or environmental reasons.
At the same time, new material technologies are giving users alternatives to raw commodities. Fiber optics cables, for example, have pretty much made copper obsolete. You need one kilo of silica, made from sand, with some engineering skills to produce the same capacity that a ton of copper would require. The groundbreaking Boeing 787, the Dreamliner, is remarkable in that it is built with no metals. This is bad news for aluminum producers, as the applications of composites instead of metals extend to other users as well. There are some areas where value-added technology using carbohydron products can give the region a niche. But that requires skills, R&D, and investment, three ingredients currently in short supply in the region.
FF: You have written that the good times in the Middle East reflect good world economic circumstances while bad times are deeply rooted in the economic and social fabric of the region. If the commodity super-cycle that began in 2000 is coming to an end, what needs to be done within the Middle East to manage the likely disruption caused by another prolonged period of low oil prices and the economic effects that this likely will entail?
HF: The commodity super-cycle has been in place for most of the 20th century, with real commodity prices declining throughout the period, with a few brief exceptions (in the 1970’s, 1980’s). The fundamental question that I have raised in the past few years is whether the commodity price behavior in the first decade of this century is an aberration or if the long secular decline of the past century is over. My guess has been that the past decade has been an aberration with technology value-added changing the relative values of the raw materials vs skills.
FF: Going way back to testimony you delivered to the U.S. Senate in 1991, you explained: “The most important and common thread that runs through the economies of the [Middle East] region is the dominance of the public sector over all aspects of economic life”. Governments have made an attempt to drive the private sector to reduce the reliance on the oil sector but in terms of employment opportunities, there is much less development, particularly for GCC nationals. With government resources for spending on public employment becoming more constrained in the years to come, how can governments provide the millions of jobs needed for youth in the region?
HF: This has been perennial concern of mine for more than 40 years. What you describe as a nascent private sector is predominantly driven by public sector support (spending, subsidies, price distortions, etc.). At this point, governments have limited choices in the near term.
The region’s governments need to make hard choices on spending priorities as well as reducing waste and corruption. They can support growth by making more resources available for venture capital and small business formation. Additionally, they need to privatize public businesses (telecom, airlines, banks, tourism, industry, tourism, etc.); better manage their sovereign wealth funds; offer generous incentives for foreign investments (as much for the management expertise as for the capital); and encourage export-oriented industries.
In the long-term, they will need an overhaul of the educational system to build the requisite skills for global competition. One potentially huge source of funding for investments in the region is in Islamic finance: liquefying the Awqaf system that according to my own estimates holds over $1 trillion that can be used to energize the region’s economies and create jobs. This will not be easy but require flexibility and imagination.
FF: Another area where your Congressional testimony from the early 1990s remained extremely relevant was about the role of exchange rates and the financial system in helping the private sector grow. Your more recent writings have been more optimistic about the capabilities of the management in central banks and commercial banks in the region. Is their ability to support the private sector forever compromised by the exchange rate peg that limits the ability of the central bank to respond more closely to the economic needs of the local economy? Is there potential disruption coming in this regards and are there any silver linings that a shift away from fixed exchange rates would entail?
HF: I have indeed been increasingly positive about the improved capabilities of central banks in the region. I am not as sanguine, however, about commercial banks. This enhanced capability and markedly improved skills have not, however, been augmented by a wider scope for more independent decision on monetary policy and exchange rates, both of which making remained anchored to the U.S. Dollar and its associated policy decisions. I have argued a few years ago that, while the GCC’s peg to the US Dollar has served the region well as it was developing its economy and financial system, the window for such a peg was drawing near to a close.
The reasons are twofold:
(1) Pegging the GCC currencies to the US Dollar limits the flexibility of policy makers to adjust their monetary policy when the economic cycles for the oil producers move in the opposite direction of the US economy as we face today (Argentina and Mexico paid a heavy price in the past 30 years);
(2) Since there is practically no broad range of fiscal policy tools (Oil is a majority of government income–90% in Saudi Arabia) and there are no tax policies that can be adjusted to economic cycle. In the absence of independent monetary policy from the US Federal Reserve), foreign exchange may offer a short-term relief (as Japan and Europe find themselves today, along with China and many emerging economies). But exchange rate policy is a “Cath-22” situation: it offers short term relief but can only be effective if coupled with structural reform and repositioning of the economy on a more competitive footing.
Basel III rules to extend to Malaysia’s Financial Holding Companies (FHC)
The transition from Basel II to Basel III will be more complicated for Malaysian banking groups with guidance from Bank Negara, although it will not shake up the market too much as it had been largely expected. At issue are the forms of regulatory capital that are not Common Equity Tier 1 (CET1), namely additional Tier 1 capital (AT1) and Tier 2 capital.
Previously, the capital rules were only applicable for bank entities, not their holding companies which may also own non-bank subsidiaries. Following the financial crisis, it has become more of a regulatory priority to look at the risks to the financial system that emerge from non-banking entities (many of the worst hit companies in the financial crisis were broker-dealers like Bear Stearns and Lehman Brothers or insurers like AIG).
Fitch Ratings released a summary of the effect the rules will have on the Malaysian banking system and concluded that most big banks will be affected because Asian capital markets have seen few Basel III compliant bonds that have triggers for loss-absorbency at both the bank level and the financial holding company (FHC) levels. This creates discrepancies between the banking groups where the top-level entity is a bank (like Maybank and Public Bank) and those where the FHC is the top-level entity and its subsidiaries include banks with outstanding debt that does not include triggers that can recapitalize the parent FHC.
Of greatest interest in Malaysia is how this would affect Islamic banks which are required to be registered as separate subsidiaries. Whereas an Islamic window remains within a conventional bank, a subsidiary is a separate legal entity and would be required to account for its capital separate from either a parent bank or FHC. Under the rules, both the subsidiary Islamic bank and conventional bank (either as parent or other entity owned by a FHC) would have to meet capital adequacy rules.
This could create an issue for Islamic bank’s capital providers (those providing capital other than its CET1). How would the Shariah board view the inclusion of triggers in its Basel III compliant sukuk that would allow for the recapitalization of its (conventional) parent (for those banks like Maybank, Public Bank and soon to be RHB Capital), or if it is owned by a FHC, by an entity that has substantial activities within conventional banking.
There are two outcomes which could occur. On the one hand, the triggers may be viewed not to be problematic because although they could be used to recapitalize a conventional bank, that possibility does not affect the Shariah compliance of the sukuk because it is judged on the use of proceeds by investors and the SPV, not the regulatory treatment of it in the future.
Alternatively, if the contingent use of capital provided by a sukuk to recapitalize a conventional parent bank or FHC is viewed as problematic, the Islamic subsidiary model could become more burdensome under Basel III rules. This would set a challenging precedent in one of Islamic banking’s largest markets and have the effect of moving one step further towards encourage standalone Islamic banks.