Exploiting strengths

Published in The Gulf, 1 February 2016

Bahrain is searching for ways to re-invent its banking hub credentials.

The latest data from the Central Bank of Bahrain (CBB), released in January, showed a further decline in the value of assets held by the country’s banks. The consolidated balance sheet of the banking system was $190.5 billion at the end of the third quarter of last year according to the CBB, compared to $191.8 billion at the same point in 2014. It might only be a small drop, but it highlights the fact that the authorities in Manama have yet to find a way to revive a sector that has been struggling for the best part of a decade.

Since 2008, the overall size of the Bahraini banking system has fallen by around 25 per cent, according to ratings agency Standard & Poor’s (S&P). That fall has not been across the board, but concentrated in one particular part of the market.

Local retail banks have actually been steadily expanding since 2008, with assets growing from $63.5 billion in 2008 to $81 billion by the end of September 2015, while Islamic banking institutions have been stable, with their balance sheet barely changing from $24.7 billion in 2008 to $25.5 billion last year. Instead, the main problem has been with the position of wholesale banks, which have been gradually reducing the value of their balance sheets in Bahrain. Given the worsening regional economic environment and the country’s uncertain political climate, there are few reasons to suppose that trend will change soon.

The decision by Fitch Ratings to revise its outlook on Bahrain from stable to negative in early December won’t have helped things either. The change to the sovereign outlook prompted Fitch to make similar changes to its outlook on two of the country’s big banks, National Bank of Bahrain (NBB) and Bank of Bahrain & Kuwait.

S&P’s outlook on Bahrain is also classified as ‘negative’. Both it and Fitch have said that they could lower their BBB- ratings this year if the Bahrain economy or the government’s financial position worsens more than expected. Such a move would push the country’s debt into junk bond territory.

Nor will Bahrain’s position be helped by predictions that its economy may contract in 2016. The low oil price means that government budgets are under pressure across the region, but weaker economies like Bahrain are in the most vulnerable position.

“Some smaller, more vulnerable economies, such as Bahrain and Oman, could even be tipped into outright recessions [in 2016],” warns Jason Tuvey, Middle East economist at London-based research firm Capital Economics.

But while there are reasons for pessimism, Bahrain does have a few strengths that it can exploit.

Chief among those advantages is a decent pool of local talent. According to the CBB, locals represent around 77 per cent of the work force in the banking sector and 68 per cent in the wider financial services industry. That is far ahead of many other regional centres.

“Local human resources is our main resource, our main wealth,” says Abdulrahman al Baker, executive director of financial institutions supervision at the CBB.

Manama is also a relatively cheap place to do business, compared to other Gulf commercial centres. Renting office space in the capital currently costs around BD7-9 per square metre per month for the best quality developments, according to real estate consultancy CBRE. The figure has been stable since late 2012 and remains below where it was in 2009. At a time of low oil prices and stretched budgets, there is much to be said for being a low-cost business centre.

“The Bahraini value proposition is suited for all types of financial services, because of the experience and the diversity [of the sector in Bahrain], but I think it is particularly suited for areas where what matters above all is skill and reasonable cost of operation,” says Jarmo Kotilaine, chief economist of the Economic Development Board (EDB). “I think that is in particular the case with mid-office and ancillary services.”

One other advantage that Bahrain has over the likes of Qatar, Dubai or Abu Dhabi is its proximity to the Saudi market, which is by far the largest economy in the region. However, Saudi Arabia has been building up its own financial hub, the King Abdullah Financial District in Riyadh. Last year it also took measures to make it easier for international investors to put money into its stock market, the Tadawul.

Such factors could undermine the position of Bahrain as a base from which to target the Saudi market. As one international executive based in Dubai puts it, half-jokingly, “Bahrain might well be close to the Saudi market but Riyadh is even closer.”

All this is reflected in research that ranks the relative strength of financial hubs in the region and beyond. In the most recent Global Financial Centres Index, published by research group Y-Zen in September, Dubai was the best-placed hub in the Gulf and 16th best globally. You had to scroll all the way down to 50th place before Bahrain appeared, some four places lower than the previous year’s index.

In some market niches, Bahrain is better placed, however. The brightest spot remains Islamic finance, where the country has managed to sustain its regional leadership position. That in part stems from the fact that Bahrain is the home base of standard-setting bodies such as the Accounting & Auditing Organisation for Islamic Financial Institutions (AAOIFI) and the International Islamic Financial Market (IIFM), but there are also 25 Islamic banks in the country, including six retail banks and 19 wholesale banks.

Globally, the Islamic finance industry has been growing healthily in recent years, which is to Bahrain’s advantage. However, even here it is not all good news as some parts of the market appear to be struggling, not least the sukuk market where activity has been coming under pressure. The number and value of Islamic bonds issued has been falling steadily in recent years and that trend is likely to continue.

In a report issued in January, S&P said that a combination of the rise in interest rates by the US Federal Reserve in mid-December, along with the continuing low oil price and the complexities involved in issuing sukuk, means that activity in this area of the market is likely to remain subdued this year. The ratings agency predicts that the total value of sukuk issuance is likely to be in the range of $50 to $55 billion for 2016, compared to $63.5 billion in 2015 and $116.4 billion in 2014.

Going forward, Islamic banks, like their conventional counterparts, are also bound to be affected by the weaker levels of economic growth in the region as a result of falling oil revenues and reduced government spending. In its review of the Bahraini economy in December, S&P noted that competition between retail banks is likely to put some strain on their profitability, something which ought to encourage further consolidation among them. It also pointed out that Bahraini banks are still heavily exposed to the real estate and construction sector, which is still in a correction phase.

All this means that Bahrain’s credentials as a financial hub are looking rather stretched.

For the foreseeable future, when international financiers think of the Gulf they are likely to continue to think of the opportunities in places like Dubai, Riyadh, Abu Dhabi or Doha before they turn their attention to Bahrain.

Maintaining standards

Published in The Gulf, 1 January 2016

New regulations could help Bahrain maintain its strong position in the Islamic banking market, but there are plenty of headwinds for the industry.

The Central Bank of Bahrain (CBB) says it will launch a central sharia board for Islamic banks early in 2016. Previous reports had suggested that the board would be in place before the turn of the year and it is not clear what has caused the delays.

Nonetheless, the move could provide a useful fillip to the local Islamic banking sector at a time when the economy is having to face up to a tougher regional environment, with low oil prices and reduced state spending.

The new board will oversee product development and compliance by Islamic financial institutions in the country, provide guidance to the CBB when it is setting new regulations, and to the courts in legal cases involving Islamic finance. This should help to ensure there is greater clarity in the way that sharia principles are applied - an important issue given that a lack of standardisation is often blamed for holding back the growth of the Islamic finance industry. But there are many other issues that are hobbling the industry and Bahrain will have to continue to innovate if it is to maintain its position as a regional Islamic finance hub.

The central sharia board initiative is being supported by the Accounting & Auditing Organisation for Islamic Financial Institutions (AAOIFI), which is based in Bahrain and which is one of several organisations around the world that sets standards for the industry.

“We have had a lot of discussions with the Central Bank of Bahrain regarding the central sharia board,” says Khairul Nizam, deputy secretary general of AAOIFI. “It could help us in getting a stronger adoption of our standards. In Malaysia, for example, they have a central sharia board and that board uses our standards as the basis of their work. Having a central sharia board can definitely help to promote the adoption of standards.”

However, he notes that the initiative is not bound to succeed. “When it comes to central sharia boards, there’s no one size fits all model,” he adds. “It has worked in some jurisdictions and hopefully it will work in Bahrain, but it may not be a suitable model in some other jurisdictions.”

Bahrain is already home to 25 Islamic banks, including six retail banks and 19 wholesale banks. The most recent to be granted a licence was Sudan’s Bank of Khartoum, which officially launched its presence in the country in early December.
Some of the local banks appear to be doing very well. Recent research by consultancy firm Middle East Global Advisors (MEGA) named Bahrain Islamic Bank as the best performing Islamic institution globally in terms of return on average equity and return on average assets - both key indicators of a banks’ performance and its ability to create shareholder value.

Such metrics are not a reflection of size, however, and most sharia-complaint institutions remain very small. Speaking at the World Islamic Banking Conference (WIBC) in Manama in early December, CBB governor Rasheed al Maraj suggested this was a problem.

“The Central Bank of Bahrain continues to strongly encourage Islamic banks to merge or acquire other institutions,” he said. “Given a tougher regulatory environment, challenges to their business model and increased competition from Islamic as well as conventional competitors, the preferred path, particularly for Islamic investment banks, is to merge in order to create institutions of size. Not only will this increase their chances of survival by enabling them to participate in larger deals but also help them attract the right human resources.”

Overall, Bahrain punches well above its weight in Islamic finance. The country has the seventh largest Islamic finance market in the world, with assets of around $73 billion, according to Thomson Reuters. It is not far behind Qatar and Kuwait, which have Islamic finance assets of $87 billion and $98 billion respectively, despite having far larger economies. Bahrain also easily outpaces the likes of Turkey, Indonesia and Egypt in this regard.

However, the performance of the Islamic finance sector more generally has been rather muted of late. Sukuk issuance has been falling for the past few years, for example. According to a report published by Thomson Reuters in early December, the number of sukuk issuances fell from 834 in 2013 to 809 in 2014 and there were only 513 issues in the first nine months of 2015. The amount raised via these sharia-compliant bonds has been dropping at an even more alarming rate, from $137 billion in 2012 to $117 billion in 2013, $102 billion in 2014 and just $49 billion between January and September 2015.

In addition, the industry is struggling to break out from a narrow base. Around 74 per cent of all Islamic finance assets are held by banks, with a further 16 in the form of sukuk, according to Thomson Reuters. That leaves other areas like Islamic insurance and funds particularly small. In geographic terms, Islamic finance has also made little headway. As it stands, 65 per cent of the industry’s assets are in just three countries - Malaysia, Saudi Arabia and Iran. Such failings are widely recognised in the industry, not least in Bahrain.

“Islamic finance is full of good principles and fair practices. However, the industry has failed in publically communicating them,” said Khalid Hamad Abdul-Rahman Hamad, executive director of banking supervision at the CBB while speaking at the WIBC.
Local banking executives agree. “The potential of Islamic finance is more than what has happened already,” says Ahmed al Mutawa, chairman of the local Gulf Finance House (GFH). “There is a need to create greater awareness of Islamic finance, even in Islamic countries. A lack of awareness, a lack of understanding, limits the areas in which Islamic finance can operate and that’s why we see this [geographic] concentration. Once there is a better understanding I think it will reach broader areas and more economies around the world.”

Such comments suggest that the industry’s problems are principally down to a lack of decent marketing. Certainly that is a factor, but there are more technical issues at stake too. In his speech Hamad noted that the industry is weak in a number of important areas, citing the lack of an active and efficient capital market or well-developed money and credit markets. He also noted that there are skills shortages in many key areas of the industry, including sharia auditing and chief executives and chief finance officers who are well acquainted with Islamic finance.
As with standardisation, the need to develop skills and talent is an issue facing the industry around the world. Some claim that Bahrain is in a better position than most in terms of its skills base, at least within the Gulf region. The central bank says that Bahrainis account for 77 per cent of the workforce in banks and around 68 per cent of all staff in its wider financial sector.

“Although there are many centres of Islamic finance now in the GCC that might compete with Bahrain, at the level of human resources Bahrain is still the best,” says Al Mutawa of GFH. “It’s a more indigenous workforce in Islamic finance rather than an expatriate one. That’s their strength. This is not true in the other GCC countries.”
Another shortcoming of the global industry that is frequently noted is the lack of liquidity management tools, something which makes life harder than it otherwise would be for sharia-compliant banks.

“Liquidity management is quite limited and varies from country to country,” said Riaz Riazuddin, deputy governor of the State Bank of Pakistan, the country’s central bank. “Concerted efforts are required to address this issue. Limited liquidity management instruments have been among the key issues faced by Islamic banks in most jurisdictions.”

The Bahrain authorities have been making efforts to tackle this issue over the past year. In April 2015 the CBB launched a sharia-compliant liquidity management tool, called wakalah. This is aimed at absorbing the excess liquidity of local Islamic retail banks by allowing them to place their spare funds with the central bank. The instrument lasts a week at a time and is made available to the banks every Tuesday. Any money deposited with the central bank is invested on behalf of the retail banks in a sukuk portfolio.

The market would also be helped by the issue of more sukuk by the government. But although there is a clear need for states across the GCC to fund their growing budget deficits, there is an expectation that the Manama government favours conventional bond issues over sukuk these days.

Najla al Shirawi, chief executive of SICO, a Bahraini wholesale bank, says she expects Bahrain to concentrate on conventional issues in the short term. “For Bahrain we will see more conventional issues. For other countries it will mostly depend on the local appetite. Saudi will see just straightforward conventional issues. In the UAE it will be a combination.”

In the meantime, it is not clear at this stage how popular the wakalah facility has been with local banks. But such initiatives, along with the forthcoming central sharia board, do at least help the country to maintain a reputation within the Islamic finance industry as an important hub.

“Any jurisdiction that has thought of Islamic finance will always come to Bahrain to learn from their experience,” says Nizam.

“Bahrain as a jurisdiction has provided the top leadership for Islamic finance for a long time, and I’m not just saying that to be nice.”

Dimming outlook for Bahrain economy

Low oil prices present further challenges to the stuttering Bahraini economy. Published in The Gulf, March 2015

On 9 February, ratings agency Standard & Poor’s (S&P) downgraded the Bahraini economy, citing its widening fiscal deficit. It will not have come as much of a surprise. Another agency, Fitch Ratings, did something similar in December when it revised its outlook for Bahrain to negative.

The challenges facing Bahrain are varied. It has the smallest economy in the Gulf Co-operation Council (GCC) and the sharp drop in oil prices since last summer have only served to highlight weaknesses.

The country has relatively limited financial resources, with reserves estimated at just $16 billion, and it has been consistently running budget deficits in recent years. Although its oil reserves and output are far smaller than those of its neighbours, the government still relied on oil for almost 87 per cent of its revenues last year.

During the current period of low oil prices the government is bound to earn far less. US bank Citigroup says that, based on an average oil price of $63 this year, it expects Bahrain’s government revenues to fall from $7.6 billion in 2014 to $5.4 billion this year, a drop of 29 per cent.

Benjamin Young, an analyst at S&P, says lower revenues will lead to lower public sector consumption. He also predicts that local companies will make lower profits this year, which in turn is likely to translate into lower credit growth, reduced activity in the financial sector and lower private sector spending.

“We think that the prospects for Bahrain’s economy have weakened and could continue to weaken as a result of the lower oil price environment,” says Young. “Bahrain’s economy has posted robust growth over the past four years, which is a reflection of the economy’s relative diversification compared to regional peers. We think that growth will fall substantially in 2015.”

Just how the economy will be affected depends to a large extent on how oil prices perform over the course of this year and thus what happens to the government’s finances. But it seems inevitable that the government will be forced further into the red this year, even with some expected cuts in spending. S&P estimates that the general government deficit will widen to eight per cent of gross domestic product (GDP) in 2015, compared to 2.1 per cent in 2013 and 3.3 per cent last year.

The government is being helped to some extent by handouts from the richer GCC states. In 2011, $10 billion was pledged over the following decade to help the kingdom address its spending needs. That money is gradually coming through, at the rate of $1 billion a year, and is being directed towards infrastructure projects such as housing, schools and roads.

Even so, the government is expected to trim its spending plans this year to prevent the deficit getting too large. This year’s budget has yet to be published, but S&P says that it expects capital spending levels to be brought back from an average of around six per cent of GDP over the past few years to two per cent this year. Citigroup says it expects overall expenditure to be 11 per cent lower this year than last, dropping to $8.1 billion from $9.1 billion in 2014.

“There is no doubt that the upcoming budget will have to address the current economic climate, though I would not want to speculate ahead of time on possible measures,” says Jarmo Kotilaine, chief economist at the state-owned Economic Development Board (EDB). He adds that “there is also a recognition of the need to continue ongoing efforts to boost public sector efficiency and rationalise expenditure. The overall effect of any budget cuts would depend entirely on what spending was reduced and by how much. Clearly there are means of rationalising government spending that have comparatively less impact on the overall economy.”

Bahrain is, of course, not the only country to be struggling with the low oil price environment. The Washington-based Institute of International Finance estimates that the likes of Iraq, Algeria, Iran and Oman all need oil to be selling well above $100 per barrel to balance the books - known as the breakeven oil price. Even the likes of Abu Dhabi and Saudi Arabia are facing up to budget deficits this year. But that will be little comfort to the policy makers in Manama.

“The six Gulf monarchies are undergoing very profound change when it comes to the structure of their economies,” says Jane Kinninmont, deputy head of the Middle East and North Africa programme at the Chatham House think-tank in London. “The urgency and the timescale of these economic challenges varies from country to country. It’s most pronounced in Oman and in Bahrain, the least oil-rich of the Gulf countries. It’s really no coincidence that those were the countries that saw the greatest unrest at the time of the Arab uprisings.”

As is the case with other Gulf states, the authorities in Bahrain are likely to shy away from any significant cuts to public sector wages, given the risk of stoking further unrest on the island.

The political turmoil has inevitably had an impact on the economy, not least because as it serves to make Bahrain a less attractive place for international companies to do business. These days, executives tend to prefer Abu Dhabi, Doha or Dubai.

Bahrain was once the regional hub for banks and the financial sector remains the second largest part of the economy, accounting for around 17 per cent of GDP, according to the EDB’s most recent annual report. Yet there are fewer banks and insurance companies operating in Bahrain today than in 2009. By some estimates, the banking system has shrunk by as much as a quarter over the past few years.

The system of financial regulation in Bahrain is still well regarded and the country’s banking system also remains well capitalised, which in theory provide a solid foundation for a revival. Some executives in the region have even speculated that Bahrain could reposition itself as a low-cost alternative to Dubai, but it is likely to find that hard to achieve.

“We believe that there is growing momentum behind Dubai’s dominance in regional finance, which has been part of the reason behind the reduction in Bahrain’s banking system’s assets by some 25 per cent since 2008,” says Young. “We believe the already high level of competition in financial services - locally and regionally - will limit the scope for growth at Bahrain’s offshore and retail banks.”

Other areas of the Bahraini economy are also under pressure. Data on the hotel sector from consultancy firm EY show that occupancy rates were below 50 per cent in 2013 and most of 2014, compared to well above 70 per cent in the likes of Dubai and Abu Dhabi. That suggests that Bahrain is struggling to attract both business and holiday travellers.

That impression is further supported by data compiled by the World Travel & Tourism Council. It says the tourist industry directly contributed just $1.3 billion to the Bahrain economy in 2013, the same as in Yemen and well below the level of other Gulf countries.

Having said all that, the economy is still at least growing, even if it appears to be decelerating. The IMF is predicting that Bahrain’s GDP will expand by 3.3 per cent this year and 3.1 per cent next year. Others put the numbers slightly lower. S&P, for example, suggests that growth will average two per cent from 2015 to 2018, while London-based Capital Economics puts the figure at two per cent for this year and 1.5 per cent for next year.

The growth is being led by the non-oil economy, which is due to expand by 3.5 per cent this year and next, according to the IMF’s projections. Another positive element is the fact that inflation is also well under control, with prices rising by around 2.5 per cent a year.

Kotilaine is more optimistic about the country’s growth prospects than most observers. “Both the structural and cyclical growth drivers in the non-oil economy are robust and resilient, not significantly influenced by oil price variations,” he says. “We are projecting non-oil growth of around 4.5 per cent in 2015 and we expect this momentum to continue in the medium to longer term.”

Not everyone has such a sunny outlook, but even if it does struggle, Bahrain does at least have the comfort of knowing that its richer neighbours are likely to continue offering help.

“Bahrain may struggle, but we suspect that [its] larger Gulf neighbours would step in to provide financing if it was needed,” said Jason Tuvey, Middle East economist at Capital Economics, in a research note published in January.

Investcorp: The house that Kirdar built

Bahrain’s Investcorp has carved out a solid reputation over the past 30 years, but how is its founder preparing the firm for the future? Published in Euromoney, April 2013

High-profile Middle East investors picking up trophy assets are a mainstay of the market in such cities as London, Paris and New York these days. What is less often remarked on are the low-key Gulf buyers, content to undertake investment without making a song and dance about it. But for the past 30 years that is what Bahrain-based Investcorp has been doing, ever since it took a stake in the Manulife Plaza, an office building in Los Angeles in 1983.

The company, which calls itself a bank but is really more a combination of hedge fund and mid-market private equity house, also has offices in London and New York, and likes to think of itself as a bridge between the surplus wealth of the Gulf and the investment opportunities of the west.

When in Europe or the US, Investcorp likes to blend in rather than stand out. That much is obvious from the look and feel of its office on Grosvenor Street in London’s Mayfair. Designed to a template that is copied for all of its offices, it mimics the old-fashioned world of a traditional merchant bank, with thick carpets, wood-panelled walls and conservative art work. On the day we meet, Nemir Kirdar, the 76-year-old chairman, chief executive and heart and soul of the company, continues that theme with a three-piece pin-striped suit.

Euromoney first spoke to Kirdar 30 years ago, when the former Chase Manhattan banker was just setting up Investcorp, drawing in many of the most prominent political and business families in the Gulf as investors and clients. It was a novel venture for the region, subordinating the egos of wealthy individuals into a western-style investment house. In subsequent years, the Middle East has gone through several periods of boom and bust, and many individual fortunes have been made and lost. However, the basic model that Investcorp has pursued has not fundamentally changed.

"There are many companies in the industrial world that may have been started by the grandfather who then trained his son to run it after him," says Kirdar. "But two generations on, the founder’s grandchildren are less interested and may want to sell it. I said that if we could buy a promising company with good potential and present it to our investors in the Gulf, then we’d be rendering a service that was not previously available to them.

"That’s still the model today. The vision was to bring to a Gulf investor’s attention investments to which he would not otherwise have access. If he wants to invest in a publicly traded equity like British Airways, he knows how to go to his broker and acquire those shares, but if he wants to invest in a privately owned chocolate factory in Chicago, he won’t know about it; that’s where we can play a useful role."

Investcorp’s model is to look for deals and make an investment before offering its clients the opportunity to come in on the deal by taking a small percentage off its hands. The company itself tends to retain 10% to 20% of the investment in question.

"I don’t check with the clients what they want," says Kirdar. "I look at what is available for sale, and if we’re convinced that something is good enough for us, we should be able to present it to our clients as something that might be good for them too." He reckons Investcorp has placed $40 billion in investments over the past 30 years.

One of the earliest deals was the purchase in 1984 of Tiffany from Avon Corporation. Investcorp floated the luxury jeweller on the stock market three years later. That purchase is one that Kirdar and several of his colleagues cite as among the best transactions they have done.

"There have been some challenging deals that have caused me to lose even more of my hair," he says. "Tiffany, for example, was a very important deal. It was almost lost by the team that we sent to do the negotiating. When they told me we’d lost it, I thought I should go and see what I could do about it, and managed to revive it. In the end, it was probably the highest earner of all our deals. Back then, Tiffany did not have a single office outside the US. Today they’re everywhere. We helped them to come to the UK and Germany and other places."

Other transactions followed in the luxury sector, including Breguet and Chaumet in 1987, Gucci in 1989 and Saks Fifth Avenue in 1990. More prosaic companies have passed through the Investcorp portfolio too, such as convenience store chain Circle K, UK motorway service station group Welcome Break and Avecia, a speciality chemicals maker. The most recent came in February when Investcorp took a controlling stake in Aberdeen-based oil-services company Hydrasun via its Gulf Opportunity Fund for an undisclosed amount. Real estate investments have continued throughout the company’s history too and, since 1997, it has been active in the hedge fund market.

The nature of the investment game means that some deals have not come off, as Savio Tung, head of the corporate investment business in the US, acknowledges. "Sometimes we make the right assumptions, sometimes we make the wrong assumptions," he says. "We got into UK printing presses in 1998. We thought we could consolidate Watmoughs Holding and the British Printing Company, and drive efficiency and be a major printing company; that proved not to be right. We combined them and changed the name to Polestar. We were able to do some integration, but we didn’t see the industry trend of people reading fewer newspapers.

"We lost money there; it was a big transaction, so that was painful for us. For me the lesson was to avoid the assumption that we can take two giant companies and integrate them. The other lesson for me was do not try to do big deals."

The company’s track record of making a profit in all but one year of its 30-year history points to the fact that the successes have generally outweighed the mistakes. The one time that was not true was in the wake of the 2008 economic crash, when Investcorp had to write down the value of its assets by $1.1 billion and book a $780.6 million loss in its results for the year to June 30, 2009.

The episode was a timely wake-up call for the company, according to Hazem Ben-Gacem, who heads the corporate investment teams for Europe and for technology investments. Like many others, Investcorp had allowed itself to be sucked into an unhealthy position with debts in the boom years that had preceded the bust.

"If you remember back to the period from 2005 to 2007, it was a time of complete optimism and very liquid markets," he says. "We got tempted in a handful of situations to be very aggressive on the financial leverage for our portfolio companies. In certain situations we overleveraged some of our investments. The availability of debt maybe lured us to go down that path.

"It was definitely a bit of a wake-up call, but you see cycles that will throw your business plan off and you live through them and you appreciate it is not the end of the world. Since 2008 a significant amount of our time has been spent working with our portfolio companies. Many of our businesses have, with patience and support and in some cases additional capital, turned the corner."

Even since then, Fitch Ratings has raised concerns about Investcorp, including its volatile profitability, its level of debt, and the amount of co-investments. One of these issues was at least partly addressed with a deal to renegotiate some debt maturities last year. That led Fitch to change the outlook on its double-B rating for Investcorp from negative to stable. There has also been a reduction in co-investments as a proportion of total assets under management. This fell from 30% in June 2007 to 10% by December 2012, with the drop in hedge fund co-investments being particularly notable.

Some of the more recent deals by Investcorp have been done without taking on any debt, such as the December 2012 purchase of Swedish luxury goods maker Georg Jensen for $140 million from another private equity group, Axcel Capital Partners.

Senior executives at the company say that Investcorp is a tough working environment and while some mistakes and failures are inevitable, it is interesting that Kirdar says that one of the biggest failures has been making the wrong hiring decisions, recruiting people who do not fit in with the culture of the organization he has built.

"A lot of the mistakes we’ve made have been my mistakes," he says. "I’ve chosen people who appeared on paper to have excellent skills but who were unable to fit into our culture. We were never shy of correcting those mistakes."

Even so, the fact that there are numerous senior executives that have been with the firm for decades suggests that it can be a rewarding experience for some. Michael Merritt, for example, was Kirdar’s first hire and is still at Investcorp, these days as chief administrative officer. Tung joined in 1984 and Ben-Gacem signed up in June 1994.

Investcorp has avoided other potential pitfalls too. Although it has started to make investments in the wider Middle East in recent years, such as vehicle leasing company Automak Automotive Company in Kuwait and menswear retailer Orka Group in Turkey, it has not done any deals in the countries directly affected by the Arab Spring.

The events of the Arab Spring are a delicate issue for a company like Investcorp, which is based in Bahrain, a country where there has been more unrest than in any other Gulf state. Some big financial institutions left the island nation in the wake of the turmoil two years ago while others reduced their staffing levels. That is probably not an option for Investcorp, which has Sheikh Mohammed Bin Isa Al Khalifa as one of its board members. As well as being chief executive of Bahrain Telecommunications Company (Batelco), he is also a member of the country’s ruling family.

Kirdar, who lives in London, says of the unrest in Bahrain only that: "It had no effect on our business. We are dealing with people who have excess money, and they want to invest. We deal with international banks; we have not been deprived of any financing."

When Investcorp was being set up in the early 1980s, Bahrain was the pre-eminent financial services hub in the Gulf and the obvious place to establish the business. Since then, however, a number of other financial centres have emerged, most notably Dubai but also to a lesser extent Doha and Riyadh. Kirdar says he might be tempted to opt for another location were he setting up the business today. "

At the time Bahrain was the only viable place," he says. "It was sophisticated, with a very competent central bank with high levels of scrutiny. We wanted to be regulated. We were building an institution and wanted to be completely transparent. Today, if we were to do it again, we might consider other locations. We might still choose Bahrain, but now there are other places that offer similar advantages. That was not the case at the time."

The company is at least hedging its bets a bit, by opening offices in several other regional cities. The first of these has already opened, in the Al Faisaliyah Tower in Riyadh. Abu Dhabi has also granted a licence to Investcorp, and the company is looking for an office location there. It has applied for a licence in Qatar. If the expansion continues, the next place will probably be Kuwait.

These moves make sense given that the company’s base of around 1,500 Gulf investors is heavily skewed towards the Saudi market. Around half of its investors are from there, with a further 20% from the UAE, 15% from Kuwait and the rest divided between Bahrain, Qatar and Oman. The new office network should give Investcorp the kind of on-the-ground contacts that will be useful as it looks to expand and potentially look for deals in the region.

"Being in the market will link us with the deal pipeline and we’ll see what’s going on in the market. Staying away from it works some of the time, but some of the time you miss some of the deals and transactions," says Mohammed Al-Shroogi, president of Gulf business at Investcorp. "The Gulf is the backbone for Investcorp. This is where the money is. There are deeply rooted relationships between Investcorp and its clients, especially in Saudi Arabia, and you need to be close to your clients. We have more than 1,500 individuals and institutions as clients in the Gulf. They have trusted us for the last 30 years, and we need to keep this relationship going forward with them so it requires a lot of visits and a lot of calls."

The new offices could also form the basis for a new line of business for Investcorp: offering advisory services for family businesses. It is an area that Kirdar is keen on exploring, although the nature of the business world in the Gulf means that is not something that is likely to happen quickly.

"The region has a lot of family conglomerates that are involved in manufacturing, travel, insurance and so on," Kirdar says. "Some day, when these assets are transferred to a younger generation, those businesses will require rationalization, so the region will need merchant banking services like those offered by the investment banks and merchant banks that played a similar role in the US and UK. I’m hoping Investcorp will evolve accordingly.

"If we see that the needs of family businesses are evolving, we should be evolving too in response to those needs. The Middle East is not an industrialized society. As yet, there are no grandchildren selling the businesses set up by their grandfathers. But some day there will be."

In the meantime, the focus for revenue generation and deal-making remains the US and Europe, with the US in the stronger position these days.

"In the last year we’ve been a lot more cautious about doing investments in Europe compared with the US," says Tung. "That will change with time and I’m sure Europe will rebound, but right now the US presents the best opportunity from a private equity and a real estate investment standpoint and even in terms of our hedge funds business. In the US it is a wonderful time for private equity. It’s certainly better than a few years ago and even better than before the crisis. Interest rates are low, US corporations are more efficient and the government is keen to support key sectors like construction and automotive."

It is not just as a source of deals that the US is important for Investcorp. It is also its favoured recruiting ground for new staff. The CVs of Investcorp staff are awash with references to time spent at such banks as Citigroup, Goldman Sachs, JPMorgan and other bulge-bracket firms.

"As the most successful economy in the world, the US has set the standards," explains Kirdar. "I would like to see people who’ve been educated there and who’ve succeeded there helping us to achieve our objectives. It’s not nationality that’s important – we have people from 37 nationalities in Investcorp – it’s exposure to US business and business standards."

It was its effort to bring western business practices to the world of Gulf investment that marked out Investcorp from the crowd when it was first set up and arguably helped to convince investors to entrust their money to Kirdar and his colleagues.

Having one foot in the west and one in the Gulf has paid off for the firm in more ways than one. In particular, at a time when many investment houses in the west have struggled since 2008, Investcorp has been able to rely on an investor base that has been buoyed up by high oil revenues.

"We are fortunate enough that our investor base has continued to have a strong liquidity position throughout the crisis and we have had a steady and very strong momentum of investment from our investors and our corporate investments. So we are trying to take advantage of that," says Ben-Gacem.

The company’s experience in recent years also offers an insight into the different dynamics across all three regions of the US, Europe and the Gulf.

"In north America, the timeframe for deals has shortened, driven by very robust debt markets and a quite active private equity market," adds Ben-Gacem. "Getting a deal signed from beginning to end in five weeks is not unheard of. In Europe it is taking a bit longer. The process is definitely longer than before the crisis. Investors are taking more time and there is more thorough scrutiny of business plans, particularly if they are based on assumptions to do with sales in Europe.

"In the Middle East it continues to take a long time to get transactions done, less because of the process itself but more because it takes longer for shareholders to get comfortable and make a final decision to go ahead with a sale or not. Many processes take six or 12 months, and even then the owning family may just decide to sell the shares between themselves and not involve an institutional investor. That is probably going to be one of the largest hindrances to the growth of private equity businesses in the Middle East."

Those dynamics mean that Investcorp is likely to remain an unusual case in the Middle East, where private equity has not developed in the same way as in other markets. The closely held nature of many family-owned businesses and the dominant role played by state-owned enterprises in other sectors of the economy mean that the opportunity to do deals will remain limited. On the other hand, the likelihood is that the region will continue to be a viable and valuable source of clients for Investcorp in the future, keen to diversify their investments beyond the region.

As such, Kirdar’s dreams of developing its advisory business in the region might take longer to be realized than he would like. And despite its strong track record, not everything that Investcorp had hoped to achieve when it set out has been realized. In Euromoney’s original profile of the company in September 1983, Investcorp’s Bahrain general manager, Yusef Abu Khadra, said that the company aimed to underwrite new equity issues, help companies go public and promote the region’s stock markets.

"We have not done that yet," says Kirdar. "Some of the forecasts made by Yusef at the time may still materialize in due course. So far we’ve concentrated on investment products in the western world for which there is demand from our investors."

Perhaps the biggest challenge the company will face in the coming years is not the vagaries of international markets or the details of specific deals or even trying to expand into corporate advisory work in the Middle East, but learning to live without its founder.

Senior executives talk in glowing terms about the role Nemir Kirdar has played in the company and describe him as a visionary while also saying that he has built an institution, not a personal empire. This seeming contradiction may not be easily fixed, but Kirdar himself already seems to have at least half an eye on a time when he will no longer be at the helm.

"Building an institution definitely implies there’s a time for people to move on and be replaced," he says. "My mission is to see that we have the right machine. I have high confidence that that machine is now in place. There will come a time when the company needs leadership at the top to replace me. My mission will not be complete until I’ve achieved that last part and let someone else take my place. I’d like to see a leadership change at the top in the next 10 years."

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Bahrain: Like Wall Street, but now with guns

The political unrest in Bahrain has adversely affected banks and their customers. Loss of business to other Gulf states might be hard to reverse, especially as the government crackdown continues, leaving popular resentment smouldering. Published in Euromoney, September 2011

In early 2010, TV ads featuring international corporations such as HSBC and KPMG began airing in Bahrain to promote the country’s position as a regional financial hub. In one of them, an executive from French bank BNP Paribas describes the small Gulf island nation as "like Wall Street with palm trees" and signs off by asking: "Wish you were here?"

A year later, in early 2011, many people were wishing they were almost anywhere else. As troops moved onto the streets of the capital to dispel pro-democracy protestors, Manama’s financial district was more like Wall Street with guns and tanks.

The EDB has confirmed that Crédit Agricole has pulled out of Bahrain, although they insist that no other big player has followed. For all their reassurances though, for that to remain the case in the longer term depends on the maintenance of peace and stability in the kingdom.

But others in the industry were still prepared to tell Euromoney about the mood among bankers in Bahrain and offer views about the short-term and long-term impact of this year’s unrest. Many in the country deny there are any serious problems but the views in other financial centres are important for Middle East trade. Bankers in such as Dubai, Beirut and London are often far more pessimistic.

The political unrest in the country began in mid-February when protestors camped out at the Pearl Roundabout calling for greater freedom and equality. It was a rare outbreak of political activism for the Gulf and was only briefly tolerated by the authorities. A brutal crackdown took place in mid-March with the aid of troops from Saudi Arabia and other Gulf Cooperation Council countries.

The events had some notable short-term effects on the banking sector. Institutions in the country put their contingency plans into action by moving staff and operations to other centres, money was withdrawn from the market and credit lines were frozen by international banks. With normal economic life disrupted, some business owners had difficulties servicing their bank loans.

After March the situation, on the surface at least, appeared to return to normal. But the question now is, how much long-term damage has been done to the country and its key financial sector and how quickly a recovery can take place. As Esam Fakhro, chairman of the Bahrain Chamber of Commerce & Industry and a prominent figure on the local business scene, acknowledges: "It takes you a very long time to build and a short period to destroy things."

If Bahrain does not manage to recover all of the ground it has lost, the effect on its economy might be severe. There are 411 banks and other financial institutions in the country, including 77 wholesale banks, 30 retail banks and 27 representative offices, as well as 27 Islamic banks. According to the Central Bank of Bahrain, the financial sector as a whole contributes some 27% of GDP and is a big source of jobs for locals and foreign nationals.

At the end of December 2010 the financial sector employed a little over 14,000 people in the country, according to the annual survey by the Central Bank of Bahrain, and two-thirds of those were Bahraini staff. The main driver of jobs growth in the past year has been the non-bank sector, including insurance firms and money brokers. In 2010 employment in the banking sector fell, from 8,946 at the start of the year to 8,782 by the end of December. Unless the economy recovers, the number could have dropped even more by the time the central bank comes to do its next annual survey.

Even before the political unrest, Bahrain’s position as a regional financial hub had been coming under steady pressure as a result of the growth of the Dubai International Financial Centre and, to a lesser extent, the Qatar Financial Centre. Both have proved themselves to be adept at luring large international banks and, just as important, both have remained peaceful this year. As a result, they are now viewed as safe havens and it is widely assumed in the Gulf that the money that left Bahrain at the height of the crisis largely went to those centres, even if this cannot be proved directly from the official sources.

"The data did show some outflow from Bahrain during the unrest," says Marios Maratheftis, the Dubai-based regional head of research at Standard Chartered Bank. "This was understandable and anticipated; it is something one would expect to see. That doesn’t mean the cash that left Bahrain went to Dubai and Qatar because we cannot really see that from the data. But there were large inflows into Dubai and Qatar. Dubai and Qatar emerged as relative winners out of the unrest."

The consolidated balance sheet of Bahrain’s banking system fell in value from $222.2 billion at the turn of the year to $201 billion by the end of March and then to $197.5 billion by the end of May – its lowest level since 2007. At the same time, more money was being moved into foreign currencies. The proportion of retail bank deposits held in Bahraini dinars fell from 66.3% at the end of January to 60.5% at the end of March, before recovering slightly over the following two months to reach 62.6% by the end of May.

Mixed picture

Not all banks were equally affected, according to the financial results released to date by local banks. For example, Bahrain Middle East Bank, National Bank of Bahrain and BMI Bank all suffered a fall in customer deposits in the first quarter of the year but the deposit levels of Ahli United, Arab Banking Corporation and Gulf International Bank rose. When it comes to the growth or decline in the value of assets, the picture has been equally mixed.

There are many stories of staff leaving Bahrain, too, although the evidence for that is mostly anecdotal as few, if any, banks have admitted to permanent transfers of staff to other countries.

“At the beginning there was some concern, definitely during the first month," says Fakhro. "Some of the offices here shifted their staff to neighbouring countries like Dubai and Qatar, but that was only on a temporary basis and things are back to normal. From what I know there hasn’t been any shift or migration of business to neighbouring countries."

Again, it is Qatar and the UAE that appear to have been the immediate beneficiaries, although most, if not all, staff who left are thought to have returned once the unrest died down.

Mazin Manna, chief executive of Citibank Bahrain, says that, in terms of the movement of staff and capital, the effects on his bank and the sector as a whole were limited. "Were there short-term concerns about Bahrain’s ability to maintain its position? Yes, at the peak of the events some people questioned it, but I don’t think any major banks have made a decision to leave," he says. "The expectation that there’d be large capital flight or departure of deposits never materialized. Even at the peak of the crisis there wasn’t the mass capital flight that people talked about. It’s had a very limited effect. We operated our contingency plans at the time, so some staff moved out temporarily but they all returned long ago."

Those who stayed in the country found that business activity was much weaker during the unrest. The clearing system remained operational throughout, ATM machines were regularly topped up and there were only very limited branch closures, but a lot of economic activity simply evaporated.

According to the Chamber of Commerce, business activity fell to as low as 30% of the normal levels expected at this time of year, with the SME and retail sectors particularly badly hit. Banks say they are hoping for an upturn in the second half of the year to compensate.

"Business levels were affected, particularly in terms of the volume of loans, because people were not too eager to commit to taking loans," says Karim Bucheery, chief executive of Bank of Bahrain & Kuwait. "With consumer loans especially, we have seen a decline in the growth level we have been used to in February and March. Consumer loans had been growing by anything between 5% and 10% last year. This year they are stagnant. On the corporate level there has been some growth and hopefully they will be growing more towards the end of the year."

The banks were put under further pressure by the attitude of their international peers to the crisis. According to a number of senior executives in the country, some local banks suddenly found their credit lines frozen. Although most are thought to have been restored fairly quickly, some might still be affected.

"Some banks put a freeze on our lines, but when we spoke to them and explained the situation they restored the lines without too many negative implications," says Bucheery. "There are only one or two that have continued to freeze or cut lines [with other banks], but the majority have restored their lines. It was mainly European banks that froze the lines; banks that did not have any presence in Bahrain."

The banks’ customers also found themselves in difficulties, particularly those involved in tourism and related services sector activities such as hotels and car rental firms. As a result of the Formula 1 race being cancelled and many international conferences also being cancelled or moved to other countries, they found that business was down across the board and it became difficult for some to service their loans.

In all of this, the situation was slightly different for international investment banks based on the island that do the vast majority of their business in other markets. "It didn’t affect us at all as an international bank," says Nahed Taher, chief executive of Gulf One Investment Bank. "Our investments are global and we don’t have any branches. But it was a worry for some of our staff. We were ready to move staff to Dubai or elsewhere. No staff moved, but for three days they worked from home."

Pressure pays off

Rasheed Mohammed Al Maraj, the governor of the Central Bank of Bahrain, reacted to the problems in the local economy by encouraging banks to relax the terms of customer loans. At a meeting on March 28 with the chief executives of local retail banks, he urged them to ease the pressure on SMEs by rescheduling or restructuring their facilities. Indeed, the approach of Al Maraj and the central bank in general appears to have been very hands-on throughout the crisis and the pressure exerted on the banks appears to have paid off.

"They have been in touch with us on a daily basis and at the highest level," says Bucheery. "The governor himself was calling me on a daily basis to make sure banking operations were going fine and to offer support in terms of liquidity, cash movement and replenishing our ATM machines.

"We have kept the doors open for SMEs to help with restructuring of debts they have. We have not seen too much demand on that front. There are some clients who have approached us to reschedule, but it is nothing significant. All we have seen is that some major corporate clients or SMEs have some pressure on their liquidity and have asked for the postponement or rescheduling of their repayments. This is normal when a country goes through a crisis and we are not too concerned."

The extent of non-performing loans has yet to emerge but might lead to further problems for the banking sector. But banks might well be able to recover some of their lost ground in the second half of the year, given the expansionary economic policy adopted by the government, which passed its largest ever budget earlier this year, including spending of more than BHD3.1 billion ($8.3 billion). A further $10 billion in financial assistance from other Gulf Cooperation Council states is being made available to Manama over the coming decade.

"There’s optimism that the second half of the year will see a rebound in sectors affected in the first half such as tourism, although it remains to be seen if that will be sufficient to achieve previous growth targets," says Mazin Manna. "We expect [the government’s] expansionary fiscal policy will also help spur growth. While effects on the provisioning levels of banks have been very limited in the first two quarters, there may be more provisioning to come in the second half of the year. Having said that, Bahraini banks are liquid and well capitalized and therefore able to weather the potential fallout."

The country’s inward investment agency, the Economic Development Board, has also been actively trying to reassure investment companies. During the crisis, the organization’s chief executive, Sheikh Mohammed bin Isa Al Khalifa, met senior officials from at least 30 investment companies to assess the business environment they were facing and the extent of any support that they might need.

The activism of the authorities during this period appears to have achieved one of its main goals, in helping to reassure banks and others.

"The central bank was very proactive in dealing with the crisis," says Abdel Hamid Shoman, chairman of Arab Bank. "In terms of communication, the central bank and the Association of Banks proved to be efficient and practical in the way they handled the crisis. We have faith that Bahrain will maintain its position as the centre for wholesale banking in the Gulf and will remain an important financial centre. Bahrain should be able to demonstrate its resilience to put the crisis behind it and focus on its many strengths."

Indeed, the reputation of the central bank is one of the strengths of the Bahraini banking system most often cited by senior executives. But the country retains some other advantages that haven’t simply disappeared overnight and that should help it to maintain the position of its financial sector in the future.

Perhaps most important, Bahrain is widely seen as a good entry point into the lucrative Saudi market. There is also widespread recognition of its open economy, which allows for the easy repatriation of capital, a friendly tax regime, a skilled labour force and infrastructure that is good, if not quite as advanced as that in Dubai and Qatar.

Tarnished reputation

Such factors are likely to encourage banks that already have operations in Bahrain to feel that they have good reasons to stay. Nonetheless, Bahrain’s reputation today is rather different from the one it had at the turn of the year, when it was seen as a peaceful, stable country with a mature and well-established financial sector. Today many bankers view it with a far more wary eye and most acknowledge that for any banks coming to the Gulf for the first time, Manama is likely to be off the list of potential locations for now.

"New entrants to the region are less likely to look at Bahrain now than they were at the end of last year," says Simon Williams, chief economist for HSBC Middle East, who is based in Dubai. "There has been erosion to Bahrain’s position and the events of the last six months may have given that an additional push. I think Dubai’s position has been enhanced on a relative basis."

Another banker, based in Beirut, adds: "Bahrain has suffered long-term damage. Any company that’s eyeing a foothold in the Middle East and is choosing between Bahrain, Qatar and the UAE is definitely going to exclude Bahrain from any future plans. Unless they come to an amicable solution that pleases all the parties I really don’t see any multinationals or institutions setting up shop in Bahrain to tap Middle East wealth."

Another senior banking executive, based in London, says he doubts whether Bahrain will ever be able to recover its momentum. If he is to be proved wrong and Bahrain is to fully restore its reputation, the reconciliation process launched by King Hamad bin Isa Al Khalifa in early July will have to lead to a credible compromise between those loyal to the regime and its opponents.

However, while the streets of the capital have been cleared of protestors, the grievances they were voicing have not disappeared and indeed cannot be dealt with quite so easily. To date, the prospects for a credible, long-term solution do not appear strong. The way in which the authorities clamped down on demonstrators and the propaganda war that took place both during and after the protests is only likely to have cemented the enmities between the two sides. The National Dialogue itself got off to a poor start when the largest opposition party, Al Wefaq Islamic Society, withdrew from it within days.

If there is compromise, it is perhaps more likely to emerge from behind the scenes rather than via such a public process. Crown Prince Salman bin Hamad bin Isa Al Khalifa, the person who has been most closely associated with the economic reform process of recent years, kept his distance from the crackdown and so could provide a figurehead that both sides can gather around, although the more hard-line supporters of the regime are thought to be suspicious of him.

Right now no one is holding their breath expecting a breakthrough. According to political analysts, in the current environment, it appears more likely that the government will continue to try to suppress dissent rather than meet the demands of opponents to any extent. That, in turn, makes it likely there will be more protests in the months or years ahead, something that those involved in the banking industry are as aware of as anyone. And this will do nothing to reverse the gradual slide towards Dubai and Qatar that has been taking place in recent years.

"There is stability returning to Bahrain and there is a sense of business as usual and normality returning," says Marios Maratheftis. "But there is an element of risk still there and that could affect Bahrain going forward. There is a sense in the markets that Bahrain is riskier than it used to be and that could take away from growth dynamics later on. There doesn’t seem to be a panic; there is more of a wait-and-see stance."

Euro woes prompt pause for thought for GCC monetary union

The impact of Greece’s debt problems on the euro is good reason for GCC members to proceed with caution as they work towards monetary union. Published in MEED, Issue No 28, 9-15 July 2010

When European officials decided on the symbol for their new currency in the late 1990s, they probably thought the E character, based on the Greek letter epsilon and with two parallel lines to denote stability, was a good fit. But some 11 years after the euro was introduced, and with a flailing Greek economy causing its value to fall sharply on international markets, the choice looks less assured.

For the GCC countries, which missed a target of introducing their own single currency in January, the European currency’s difficulties offer a good excuse for further delays on their own scheme, and also a useful opportunity to reassess the policy.

Perhaps the simplest lesson of all for them to learn is that it pays to be prepared for the worst. “The euro’s problems have highlighted the fact that things can go wrong and that clear rules, monitoring and enforcement are needed to avoid crises,” says Jarmo Kotilaine, chief economist at NCB Capital, the investment subsidiary of Saudi Arabia’s National Commercial Bank. “This crisis is likely to prompt people to think twice and be more careful than they otherwise might have been.”

The euro crisis could not have come at a better time for the GCC, whose members are preparing the legislative framework for a Gulf central bank and monetary union. And even if it forces them to be more cautious, so far it has not deflected them from the task. The GCC Monetary Council, the precursor to a Gulf central bank, insisted after its meeting in Riyadh on 29 March that the project was one of the pillars of economic integration for its members.

The rationale for monetary union has not changed since the idea was first mooted in the early 1980s, when the GCC itself was formed. It offers the opportunity to boost intra-regional trade by eliminating exchange rate risks and simplifying cross-border acquisitions. It also promises to promote greater competitiveness between firms around the region and reduce the overall cost of doing business. But these advantages, while real, are all relatively limited for the four countries due to join in the first wave: Bahrain, Kuwait, Qatar and Saudi Arabia.

All of them have currencies that are either pegged to the dollar or, in the case of Kuwait, to a basket of currencies including the dollar. This means there is already very little exchange rate risk, unlike the situation among free-floating European currencies prior to the introduction of the euro.

Intra-regional trade may not be helped much either. “The structures of the economies are so similar that I don’t know how much you’re going to promote intra-regional trade by adopting the single currency,” says Randa Azar Khoury, chief economist at the National Bank of Kuwait. “Yes, there will be an improvement in trade, but most of these countries are oil-exporting countries [and] they’re not going to be exporting oil or petrochemicals products to each other.”

Given the rather limited nature of benefits on offer, the risks of joining a single currency also need to be low. In 2002, an IMF policy discussion paper, titled ‘On a Common Currency for the GCC Countries’, concluded that “the benefits [of a single currency] do not seem too large, but … neither do the costs”.

The crisis in the eurozone means the Gulf states cannot be quite so sanguine today – they now know what can go wrong and the scale of difficulties when it does.

The biggest downside of a unified currency is that governments lose their ability to use monetary and exchange rate policy to manage their economies. The fact that all the Gulf countries have strong pegs to the dollar means they have already given up much of their monetary independence, but what freedom remains will be further curtailed by the single currency.

For the stronger economies, there is an additional risk of becoming more exposed to the impact of macroeconomic problems in other, weaker member states. In the case of Europe, the weakest member so far has been Greece, which this year had to be bailed out to the tune of E110bn ($135bn) by other European governments and the IMF, after accumulating massive government debts beyond what are allowed in the eurozone’s Stability & Growth Pact.

The Gulf states are in a different situation to the European economies. High oil revenues mean there is little government borrowing, although some places have needed bailouts in recent years, notably Dubai. Even so, the travails of the Greek economy and its knock-on effect on the other members of the euro highlight the need to get the membership criteria right, but also of enforcing the rules after that.

“You need to create a central bank, define its powers and give it the mechanisms needed to exercise those powers,” says Kotlaine.

Although it is now the chief culprit for the euro’s woes, Greece is not alone in having contravened some of the key principles in the Stability & Growth Pact, of keeping government deficits under 3 per cent of gross domestic product (GDP) and overall public debt below 60 per cent of GDP.

“In terms of preparation for monetary union, the emphasis should be on the establishment of a strong institutional, operational and regulatory framework,” says Erwin Nierop, senior adviser at the European Central Bank, which has conducted two feasibility studies on a single currency for the GCC in the past seven years.

“You must also think critically about the necessary level of convergence and you need strong surveillance and enforcement of the convergence criteria. The difficulties we have now in the eurozone go back to how the Stability & Growth Pact was applied by the euro area countries in the past.

In 2007, the GCC agreed its own convergence criteria, encompassing inflation and interest rates, foreign cash reserves, the fiscal deficit and public debt. According to the US-based Institute of International Finance, most criteria have been met. But while the GCC states have been drawing closer together, they still lack the kind of intra-government coordination and transnational bodies seen in Europe for decades before the euro was introduced.

The GCC’s Monetary Council is the key body responsible for laying the foundations for monetary union. In its first two meetings this year, it has discussed issues such as the development of a common statistical framework across the member states and common payment and settlement systems. Such areas are vital to get right, but just as important is the powers that a GCC central bank will have to set or enforce rules and those have not yet been finalised.

The level of integration needs also to go far beyond a unified monetary approach and a powerful central bank. “You also need integration in other parts of your financial markets and fiscal policy,” says Khoury. “Single currencies don’t work if you don’t have fiscal integration. This is what we have seen happen [in Europe]. The fact that every country in the eurozone had its own fiscal policy and revenue pools created problems.”

Whether there is the political will in all the Gulf countries to accept such limits to national sovereignty remains to be seen. Two of the six GCC members have already withdrawn from the project, for the time being at least, and there can be little certainty that others may not follow. As it stands, it is likely to be years before the UAE or Oman decide to reverse their decisions and rejoin the project.

“The currency union will have to have been up and running successfully for several years before Oman would think about it joining again and that doesn’t look like happening anytime soon,” says a Dubai-based economist.

“Implementing the single currency impacts on issues of national sovereignty,” says Christian Koch of the Dubai-based Gulf Research Centre. “The EU stands for union, the GCC stands for cooperation. They are two very different concepts.”

Even if the remaining four countries can sustain the political momentum to continue with a single currency, it could still be many years before any Bahraini or Saudi withdraws such notes from their local bank, whether those notes are called khaleejis, dinars or something else. After the passing of the January deadline, few expect a currency to appear before 2015 at the earliest.

In the meantime there is much to do, including taking major steps like setting up a Gulf central bank and deepening financial market integration. There are also smaller but still important tasks like deciding what the currency should be called, what it will look like, and adapting automated teller machines in the Gulf to be able to accept it.

“You have to be cautious with your timetable, but also transparent,” says Nierop. “You need to have the markets on board and the public at large informed, since they need to prepare themselves in a timely fashion. There are always politically sensitive issues like the name of the currency and the location of the central bank. All these things are sensitive but can be solved. The establishment of the European Central Bank and the subsequent introduction of the euro prove it can be done.”

The euro crisis has certainly provided a useful opportunity to re-evaluate plans for a GCC currency union, but there is still a clear expectation that it is worth pursuing and will go ahead.

“The real issue is with integration,” says Khoury. “What is your objective with the currency union? Your objective is to create a stronger economic bloc. And that means you need to have the freedom of movement of people, goods and capital. A single currency is simply a means to facilitate that. It is a tool towards greater economic integration.”