Earlier this month, I spoke at two events – one at the Harvard Law School (HLS) and the other at the Harvard Business School (HBS) – regarding the relevance of Islamic finance principles to the global financial crisis. The topic has been raised by observers in the Muslim world and beyond – including regulators in a number of G20 countries and even commentators at the Vatican.

At the Law School event, organized by Harvard’s Islamic Finance Program, I presented a discussion paper on the theme, followed by comments from three discussants: Prof. Samuel Hayes (Jacob Schiff Professor Emeritus of Investment Banking at HBS), Prof. Roger Owen (A.J. Meyer Professor of Middle Eastern History at Harvard University), and Prof. Baber Johansen (Director of the Islamic Legal Studies Program at HLS).

The paper noted that there are a number of ethical maxims from Islamic finance which address key causes of the crisis. In theory, Islam’s focus on asset-based financing puts natural limits on the level of debt, preventing excessive leverage. The prohibition of the sale of debt (per the majority of Islamic scholars) fosters a more conservative approach to lending in which the party that originates a debt also takes the credit risk therein. Rules requiring financial transparency and disclosure act to prevent opaque securities like the mis-rated “toxic paper” that exacerbated the crisis. Further, Islamic finance offers practical models of ethical supervisory boards with real authority – a potential model for “corporate social responsibility with teeth.”

At the same time, Islamic finance as currently practiced does not offer a fully-developed alternative model to the conventional system. Further – due largely to competitive pressures, regulatory constraints, and customer expectations – Islamic financial practices today often seek to replicate conventional ones as closely as possible. In doing so, they lose several of the benefits and strengths which would come from following the spirit of Shariah maxims more closely. The crisis should, therefore, encourage the Islamic finance industry to re-commit to the spirit of the ethics it was created to serve.

The event was enriched by a lively, interdisciplinary discussion touching on a wide range of topics including ethics vs. regulation, the role of debt in Islam, the standardization of Shariah guidelines, and more.

An excerpt from the discussion paper (which we are currently finalizing to incorporate feedback from the event) is below. A final version should be available on the website of the Islamic Finance Program later this year. If you would like a copy of the final paper when ready, please email islamicfinance@rehmaninstitute.com

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(Excerpt from the discussion paper:

The current global financial crisis is causing a fundamental rethinking of the global financial system. Basic assumptions regarding the role of banks, the responsibilities of regulators, the treatment of customers, and the rules of financial innovation are being examined and revisited. Commentators are deeming the U.S. subprime mortgage crisis as a catalyst for exposing frailties in the current financial system that presented bundles of bad credit as creditworthy investments. Observers expect a “new financial order” to emerge from the crisis, redesigned based on the lessons now being learned.

The Islamic finance sector – itself a new global player – has not been immune from the current crisis. While several aspects of the Islamic banking model inherently provide insulation from the crisis, the financial markets and real economies of the Muslim world are clearly impacted by the global recession. At the same time, many, including the Vatican, see the crisis as reinforcing the relevance and merits of Islamic financial principles – principles worthy of examination by both the global financial community and Islamic bankers themselves. To quote an official Vatican publication, the “ethical principles on which Islamic finance is based may bring banks closer to their clients and to the true spirit which should mark every financial service.”

The pace of global economic decline is the greatest in decades, and will lead to a fundamentally different economic landscape. Governments are actively engaging in interventionist policies in an effort to stimulate aggregate demand. Emerging and newly industrialized economies with fiscal surplus and cash reserves will increasingly be partaking in international collaboration efforts and steering groups. The crisis has the potential to stimulate what many see as a much-needed shift from the Bretton-Woods era of international policy setting, to a forum reflective of the rise of the emerging markets.

Endeavoring to outline key themes on the interplay between the current crisis and Islamic finance principles, this paper is organized in four main sections:

I. Ethical perspectives on the current crisis;

II. Shariah maxims and the causes of the crisis;

III. Practices of Islamic financial institutions in light of Shariah maxims; and

IV. Practices from the Islamic finance sector relevant to addressing the crisis.

The paper seeks to provide a framework for – and help generate – robust discussion among seminar participants. It identifies themes for exploration, each of which can be explored more deeply in the ensuing discussion.

end of excerpt)

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In late 2007, I lauded the announced JV between Kuwait Petroleum and Dow Chemicals (dubbed “K-Dow”) in a letter to the Financial Times. I cited the planned venture as an example of a sound partnership “enabling Dow and KPC to build a stronger business than either could do on its own.” A year later, Kuwait pulled out of the transaction unilaterally. The reason cited in reports was that the Kuwaiti press and certain parliamentarians had voiced concerns about the deal, and were intent on probing the transaction with an eye to potentially blocking it.

The K-Dow breakup is, in a number of ways, unfortunate. The journal Middle East Economic Survey perhaps summed it up best when it noted “it is hard to find anyone at all connected with Kuwait’s oil industry who thinks the K-Dow deal was bad for the country.” The deal had been carefully assessed, reviewed, and approved by the prime minister. Nonetheless, the public controversy was sufficient to stop the partnership.

The breakup is strikingly reminiscent of the Dubai Ports World (DPW) controversy in the US – except in reverse. Questioned by US media outlets and members of Congress, the DPW transaction was ultimately re-structured (despite having the support of the Bush administration) to avoid a confrontation with Congress. A Harvard Business School case study later dubbed the affair a “debacle.” In the case of K-Dow, we see a similar phenomenon – except that this time the questioning regulator is from the Gulf.

This turn of events signals that – at least for transactions related to Kuwait and Bahrain (the Gulf states with the most activist parliaments) – consideration of legislators’ concerns is becoming more of a two-way street. Whereas Gulf investors have long been accustomed to the sensitivities of US and EU legislators and media, multinationals dealing with the Gulf have not had a similar challenge. Foreign companies have been able to rely on their Gulf counterparties to fully manage the local politics. Almost none would have imagined that a deal approved by Gulf prime minister would subsequently face hurdles.

Going forward, global firms sourcing capital from certain Gulf states will be well-served to consider potential legislative and media controversy as a potential risk factor. This capability is not alien to multinationals, as legal and corporate affairs divisions are increasingly accustomed to such analysis in the US and EU. What’s new will be the application of this toolkit to the Gulf.

For Gulf investors, the key implication is that they will need to assure global partners that post-agreement controversies will not force deals to fall apart. After the K-Dow affair, international partners may insist on stronger breakup penalties and other measures of assurance. This may mean outreach and consultation with a broader set of local stakeholders.

Tough economic times often breed protectionism legislator activism. The K-Dow affair shows that even Gulf-related transactions may be subject to these pressures, and parties involved will need to add such considerations to their analysis.

Earlier this month, the Hajj (pilgrimage to Makkah) was performed  by around 3 million pilgrims. The Hajj — an Abrahamic tradition dating back to the pre-Islamic era– has been a cornerstone of the Gulf economy since ancient times.  The “Hajj economy” has shaped the development of the Gulf throughout history.

While the direct economic impact of the Hajj is easily observable, the strategic implications for GCC — and particualrly Saudi — competitiveness are more subtle. If fostered and applied more deeply, capabilities and skills linked to the Hajj can be pivotal in developing and expanding world-class initiatives and companies. The skill set of the Hajj economy can, if viewed strategically, be a significant source of competitive advantage.

Infrastructure and logistics management

The infrastructure demands linked to the Hajj are enormous. From investment in airport facilities (e.g. an additional terminal for the Hajj season) to the need for roads and tunnels to procuring fleets of buses transporting pilgrims, facilitating the Hajj requires significant infrastructure. On top of this physical infrastructure, the logistics of managing the flow of people, water, food, electricity, and other utilities are daunting.

Institutions involved in Hajj infrastructure and logistics have developed a set of skills and competencies that are immensely valuable. Creatively leveraging, replicating, and applying those skills in a broader range of ventures represents a unique opportunity for such institutions and for the Saudi economy at large.

Public health and safety management

Managing the public health and safety aspects of the Hajj is another unique challenge. No other venue brings together millions of travelers  — mainly from the developing world — in close quarters where infectious  diseases can spread rapidly. The techniques used to mitigate risks and prevent outbreaks are immensely applicable in other contexts.

With investment in research and improvement, one can envision Hajj-related policies becoming a reference and a source of best practices for health and safety professionals worldwide.  Firms with expertise in this area could compete for projects worldwide.

Connectivity with the Muslim world

In bringing together Muslims from around the world, the Hajj naturally fosters trade and commerce across borders. In fact, the famous “Silk Road” of regional trade in the Middle East and Asia was paved largely by pilgrims and by merchants seeking to serve them.

As host of the Hajj, Saudi Arabia enjoys a natural advantage as a potential trade hub for the Muslim world.  Taking on this role, however, would require significant economic reform in the Kingdom as well as fundamental enhancements to the Saudi business environment.

Shariah-compliant savings and financial services

In saving for the Hajj, Muslims worldwide are particularly mindful of the need for complying with the Shariah. A Muslim who may otherwise not always invest Islamically will be highly inclined to invest his or her Hajj savings according to Shariah guidelines, since the Hajj is an inherently religious journey.

Malaysia’s Tabung Haji — an institution created to facilitate saving for the Hajj — is a prime example of the link between the pilgrimage and Islamic finance. The need to save for Hajj naturally channels funds towards Shariah-compliant vehicles, and Hajj-related entities are advantaged in attracting Islamic capital.

Throughout history, the  “Hajj economy” has been a source of prosperity. In today’s global economy, the skills associated with the Hajj — if strategically leveraged — could also  become a source of competitive advantage.

As the global financial crisis continues, markets across the world struggle to interpret and adapt to the wave of bank collapses, unprecedented government intervention, and wild volatility in equity and commodity markets. Markets everywhere are gripped with uncertainty as the saga unfolds. One fact, however, which is quite certain is that the Gulf — despite its fundamental economic health — is not immune to the crisis.

The Gulf’s vulnerability to the global financial crisis is evident in a number of ways. GCC equity markets have lost significant value in 2008, and investor confidence has weakened. Whereas just months ago, GCC entities were keen to increase their stakes in Western banks (e.g. ADIA’s investment in Citigroup), today they shy away from the ailing financial sector. The global trend of “de-leveraging” (a forced reduction of the debt-to-equity ratios of financial institutions, corporations, and households) will almost certainly manifest itself in the Gulf as well.

While there are many reasons why the Gulf is not immune to the current crisis, three salient linkages are particularly noteworthy:

1. The jitters felt worldwide are shared by Gulf investors

Immediately following the collapse of Lehman Brothers, an FT piece cited a UAE Central Bank official commenting that as much as 90% of “speculative” foreign money may have left UAE markets due to concerns regarding the crisis and its potential impact on local currencies. Over the course of the year, the Saudi (TASI) equity index was down about one-third year-to-date, as was the the Dubai stock market. Even the highly buoyant Qatar market was down 14% year-to-date following the Lehman collapse. Gulf investors, like their counterparts elsewhere, seek safer havens for their capital and are shifting away from volatile equity markets.

2. GCC institutions and investors hold securities affected by the subprime crisis

It’s important to remember that the Gulf’s leading investors generally hold a bulk of their assets outside the region. Gulf institutions and investors — long-time holders of US debt instruments, commercial paper, and financial stocks — have felt the pinch of collapsing asset values in their international portfolios. This pinch constrains institutions’ appetite and ability to invest, thereby dampening the local investment environment.

3. Volatile commodity prices increase the Gulf’s uncertainty

In the midst of the current crisis, the prices of oil and other commodities have been highly volatile — with the barrel dropping about $30 in a single day, then recovering most of its value in a see-saw pricing environment. This volatility makes Gulf institutions particularly nervous, as sustained energy prices are the backbone of the region’s wealth and the driver of increased liquidity.

Fundamental economic indicators remain positive in the Gulf, with substantial surpluses and savings, strong corporate profits, attractive demographic shifts, and ongoing de-regulation. In the current environment, however, the underlying strength of Gulf economies is obscured by turbulent financial markets. In yet another reflection of the interdependency of capital markets today, the Gulf is far from immune from the current financial crisis.

With the Beijing Games fresh on their minds, aspiring cities across the globe feel increased enthusiasm to play host one day to the Olympic Games. A natural question on the minds of Gulf leaders and observers will be if – and when – a Gulf city will host the Olympics and capture the world’s attention as raptly as Beijing has. While GCC cities certainly have some of the elements needed to host the Games, Gulf leaders will need to reflect carefully on whether hosting the Olympics truly fits with their overall development strategies.

One key element required to host the Games – capital for investment in infrastructure – is available in the Gulf today more than almost anywhere else in the world. Several Gulf economies – and in particular the UAE, Qatar, and Kuwait – enjoy unprecedented surpluses and are engaging in large-scale infrastructure projects (e.g. airports, roads, and utilities) like never before. Gulf cities are better equipped than many of their counterparts around the world to build the stadiums, housing, and other facilities needed to host the Games.

Gulf cities also have a “location advantage”: at the crossroads of Europe and Asia, the GCC is easy to reach and its timezones are compatible with a large chunk of the global Olympic viewer base. For the most part, Europeans struggled to watch the Beijing Games live and in the US the time difference was a full 12-15 hours. The GCC, by contrast, is only 1-2 hours ahead of Western European time and a manageable difference from much of Asia.

Further, several Gulf cities have clear and demonstrated aspirations to raise their profiles on the world stage and might therefore see hosting the Olympic Games as helpful. This is particularly true of Doha, Dubai, and Abu Dhabi. As host of a watershed 2001 WTO summit and the 2006 Asian Games, Doha raised its profile significantly and signaled to the world – especially through the Asian Games – its rapid growth and development.

Despite these strengths, there are a number of reasons why Gulf cities may not find the role of Olympic host consistent with their development strategies. One is the question of how sporting facilities would be utilized after the Olympics: the total Gulf population is about 40 million, and the most likely host counties (the UAE, Qatar, and Kuwait) have populations below 5 million. For countries with populations less than half of New York City’s, the long-term need for massive stadiums is not immediately evident.

A second issue is that Gulf countries have a limited Olympic tradition. Despite Bahrain’s one gold medal in the 2008 Games, GCC countries have not been at the forefront of Olympic competition as larger nations of the world have been. Some might argue that Gulf states would need to build a deeper Olympic presence before seeking to host the event.

Third, the full scrutiny that comes with Olympic attention may not be desirable for GCC states. As evident surrounding the Beijing Games, hosting the Olympics exposes a country to both wanted and unwanted publicity from a wide range of perspectives. In pursuing the Games, potential host counties need to weigh whether this scrutiny is indeed worth inviting.

In some respects, Gulf cities could potentially mount impressive bids for hosting the Olympics in future decades. What’s less clear, however, is whether hosting the Games truly fits with GCC cities’ long-term aspirations.

In a time when the global airline industry faces significant challenges, a number of airlines — especially Gulf-based carriers — are enjoying extraordinary success. As noted in today’s Wall Street Journal, Etihad Airways — the national carrier of the UAE — enjoyed an astonishing 64% rise in passenger volume last year. The airline industry is one in which the Gulf States enjoy some substantial competitive advantages in the global marketplace, as well as a set of challenges particular to their unique circumstances.

The sources of Gulf carriers’ advantage lie in the key inputs and enablers required for an airline industry. One key input is capital — both for investment in the airline (e.g. new planes) and for investment in the infrastructure supporting the airline (e.g. airports). In a time of unprecedented surpluses, Gulf states are uniquely positioned to invest in both. Other carriers, meanwhile, struggle for both the capital to invest in their fleets and to lobby their governments for improvements in infrastructure.

A second crucial input is oil. Gulf airlines’ proximity to oil production sources provides cost advantages not available elsewhere. More importantly, rises in the oil price act to strengthen Gulf economies overall (and therefore increase demand for air travel), offsetting the rise in input costs.

Third, airlines need attractive routes and fundamental passenger demand. In addition to flying locals and expatriates in and out of the country, Gulf airlines increasingly tap into long-haul passenger flows between the US / Europe and Asia. Located at the crossroads of these regions, the Gulf can conveniently play host to transit passengers and short-stay tourists. According to census data sourced in 2007, nearly 30 million passengers fly through Dubai each year. That’s more than 23 passengers per resident — twice the figure for London and four times the figure for New York.

Fourth, airlines need a flexible, skilled labor force to staff their operations. Many of the woes faced by US and European carriers are linked to labor costs (especially pensions) and the effects of rigid unionization. While the Gulf has a smaller local pool of talent to draw on, it is able to attract expatriates on lucrative — yet flexible — packages that keep labor costs manageable while also attracting strong talent.

Strength in these four areas naturally give Gulf airlines an edge in the global marketplace. At the same time, Gulf airlines do face some unique challenges. One such challenge is the risk of over-capacity. Dubai is building an airport in Jebel Ali which is the size of London Heathrow and Chicago O’Hare combined and will have the capacity for 120 million passengers per year. That’s about 30 times the population of the UAE. Up the road in Abu Dhabi, an airport with the capacity for 40 million passengers is being planned. Qatar also has ambitious airport plans, while Kuwait and Saudi Arabia are likely to upgrade key airports soon as well.

The capacity being built by Gulf airlines — both in terms of airport space and passenger seats — far exceeds their domestic demand. They are all seeking to capture the long-haul transit market, capitalizing on increased flows to China, India, and the Far East. Competition for these passengers may become fierce, and it is unlikely that all Gulf airlines will operate at their desired level of utilization.

Gulf airlines’ ownership models can also be both a benefit and a drawback — public-sector owners can be patient for financial return, but may miss some of the shareholder pressures which can lead to robust examination and frequent reviews of their strategies. This challenge is common across a large number of carriers around the world in which governments hold large stakes.

The airline sector is one in which Gulf businesses have the key ingredients for success. GCC-based carriers are therefore likely to remain key players in the global airline sector, taking a central role in the marketplace for years to come.

In recent weeks, commentators around the world have become increasingly concerned about the menace of inflation. As pointed out in an Economist cover story, “inflation’s back” and is particularly damaging in emerging markets most sensitive to commodity prices and the cost of foodstuffs. The Economist rightly points out that at least half the Gulf states are grappling with double-digit inflation. In the Gulf context, however, it’s worth noting that policy makers have a unique toolkit for managing inflation which differs significantly from the tools available elsewhere.

In general, two types of tools are used for managing inflation: monetary policy and fiscal policy. OECD observers are most familiar with the use of monetary measures — namely, the raising and lowering of interest rates — as the first line of defense against inflation or recession. Fiscal measures relate to government spending and resource allocation.

All GCC member states, with the exception of Kuwait, peg their currency to the dollar and therefore have limited flexibility in the realm of monetary policy. While many have blamed the peg for “importing inflation,” it is telling that even Kuwait — without a dollar peg — is facing double-digit inflation. Due to a number of trade-related concerns, it appears the dollar peg is here to stay for at least the short-term future.

It is in the realm of fiscal policy where GCC economies have more flexibility. On almost a daily basis, governments make choices about how much oil and gas to produce and — perhaps more importantly — how to allocate the revenue from energy exports. Much of the region’s growth has been spurred by investing more of the energy surpluses at home, as part of overall economic development and diversification strategies. Allocating the surplus is therefore a key instrument in the trade-off between growth and inflation.

The Gulf’s toolkit for managing inflation is thus a unique one. Monetary policy is relatively constrained, while the flexibility of fiscal policy — and particularly the allocation of energy surpluses — is substantial and potentially more potent than in states without such surpluses.

One key factor driving Gulf inflation is the rising prices of imports, upon which the GCC economies rely. Since many of these imports come from the EU and other non-dollar economies, their prices in relative terms have soared as the dollar has lost value. While policy makers are taking steps to reduce import-dependence, the economies and natural endowments of the Gulf are such that imports are simply indispensable.

In this environment of unprecedented energy prices, Gulf policy makers are choosing to stimulate their local economies as never before. Inflation is a natural consequence of this choice. The challenge will be for Gulf decision makers to grow household incomes at least as fast as inflation — and to do so using their unique toolkit.

This month, Dubai & Co. has been featured in two major media outlets: the Wall Street Journal (WSJ) and Fox Business. The articles touch on significant trends in global business in which the Gulf region is playing a central role: the increased commitment of multinationals into the Middle East and the role of sovereign wealth funds in international private equity.

The WSJ piece, entitled “Mideast Boom Lifts GE, Other Firms” notes that, last year, GE’s revenue from the Middle East region exceeded its China revenue by a 35% and was more that twice the revenue generated from India. The piece, which quotes both Jeffrey Immelt and GE regional head Nabil Hebayeb, discusses GE’s $50m research facility in Qatar (a case study of which is found in Dubai & Co.). Hebayeb notes that GE seeks to earn profits “in the country, not just from the country” — a spirit of collaboration which is refreshing and well-received (as well as often overlooked) in the region. The article, written by Kathryn Kranhold, is available here to WSJ subscribers.

The Fox Business piece relates to an upcoming event in Dubai on sovereign wealth funds and global private equity. The piece includes an estimate, provided by the firm Private Equity Intelligence, that sovereign funds control $3 trillion in wealth, 40% of which is held by Middle East entities. The piece also quotes Abdul Aziz Yaqoob Al Serkal of M’Sharie, Dubai Investments’ private equity arm. My own quote relates to the increased market power of sovereign investors, and how their approach to PE investment — even when investing in the debt component of transactions — can be fundamentally different from the approach customarily taken by banks. The full piece is available here.

The current unrest in Lebanon, which has caught much of the outside world by surprise, raises meaningful humanitarian, political, and economic concerns. To many observers, the situation evokes memories of Lebanon’s protracted civil war, in which decades of economic progress were lost. What, one might ask, are the implications for firms doing business in the Gulf?

One factor to bear in mind is the impact of political unrest on energy prices. Conflict in the broader Middle East – even when the epicenter is not in an oil-exporting country – tends to lead to higher oil prices. It’s not surprising, therefore, that the barrel hit record highs (above $125) around the time the crisis in Lebanon hit the news. Higher oil prices mean, of course, even greater liquidity and wealth in the Gulf, and therefore a thriving local business environment.

As far as trade flows are concerned, the Gulf does have imports from Lebanon and from the broader Levant region. The GCC region benefits, however, from a broad and diverse set of trade partners such that commerce does not suffer greatly from crises like today’s. Certain sectors may feel higher import prices, but these should not have deep impact on Gulf economies overall.

More visible will be the impact of Lebanese unrest on tourism and vacation patterns this coming summer. Many Gulf families spend significant time – and money – in Lebanon during the summer as a temperate, nearby, and culturally familiar getaway destination. Like the summer of 2006 – when the Israeli-Hezbollah conflict disrupted tourist flows – we should expect the summer of 2008 to witness drastically reduced volumes of visitors to Lebanon. This will, almost certainly, exacerbate the economic loss associated with unrest and violence.

Unrest in Lebanon– at least under the current scenario – does not seriously threaten the economies and business environments of the Gulf. The Middle East is not a homogenous region, and the GCC economies remain quite safe. While the tragedy in Lebanon should surely spark concern amongst observers, the fundamentals of Gulf economies position the GCC markets to safely ride out the storm.

Earlier this month, I was cited in a Wall Street Journal (WSJ) article entitled “Time Runs Differently in the Emirates.” In the piece, WSJ writer Emily Flitter discusses experiences of global businesspeople who have noted that expectations regarding the timing of meetings and the exactness of appointments may vary in certain UAE settings.

My own perspective, which was faithfully conveyed in the article, is that UAE business norms — especially those of multinational companies — are deeply (and increasingly) reflective of global corporate practices. The bulk of professionals are expatriate, and these expats often bring to the Gulf their global corporate culture. I point out that the Dubai office of a German firm may be no less punctual than its offices in Berlin or Frankfurt, especially if most senior managers are on secondment from overseas locations.

In informal settings such as a majlis (private reception room) or social gathering, however, appointments are far less precise. As many important business decisions — especially those relating to family businesses — are made in a majlis — it is important for international businesspeople to be aware of and sensitive to these forums.

The WSJ piece affirms the growing level of interest amongst US and other global businesspeople in effectively engaging the Gulf region. That this week’s Economist features the cover story entitled “The Rise of the Gulf” is evidence enough of this booming interest.

While tactical matters (such as when to show up for a meeting) are certainly important, as firms get more serious about the Gulf they need to adapt to the region at much more strategic levels. That’s why Dubai & Co.: Global Strategies for Doing Business in the Gulf States takes a deeper, corporate strategy-level perspective on the key elements of the core functions of a company, including:

• Market entry strategies,
• Marketing to Gulf buyers,
• Human capital strategies,
• The Gulf as a source of capital,
• Operations strategies,
• Organization design strategies, and
• Raising awareness at the global head office.

In the long term, building a deeply successful presence in the Gulf requires a holistic and strategic outlook.

The full text of the WSJ article is available to WSJ subscribers here.

Earlier this week, I appeared on “Wealth Talk America,” a radio show hosted by Garrett Sutton (an author in the Rich Dad series). The interview reflects the level of widespread interest amongst US businesspeople in learning about the Gulf in general and Dubai in particular.

My discussion with Garrett was broad in scope, touching on the various reasons why the Gulf is a region “no one can afford to ignore if they’re interested in global strategy.”

Some of the topics covered include:

• how the Gulf is affecting global business today, both as a market for growth and as a source of capital,
• why the Gulf, despite its strategic importance, is so little understood in US business circles,
• what the natural “clusters” within the Middle East are, and how these clusters differ in business attractiveness, and
• how flexibility in entering joint ventures can be a key driver of success and market share when entering the Gulf.

The full 20-minute interview can be heard here.

In a major development for sovereign wealth funds (SWFs) – and capital markets more broadly – the Abu Dhabi Investment Authority (ADIA) issued a letter this week to finance ministers and international bodies (such as the World Bank / IMF) regarding its investment principles. The letter represents a major milestone for the historically guarded ADIA, and reflects the institution’s desire to accommodate demands for transparency – but on its own terms.

For those familiar with ADIA, the letter itself holds no surprises. Signed by Yousef Al Otaiba, ADIA’s director of international affairs, it articulated nine principles such as the practice of generally being a “passive investor” and not seeking “involvement in the management or direction of firms.” These principles, which are borne out by ADIA’s three decade track record, are not legal commitments or guarantees.

(For more on ADIA and Gulf institutional investors, see Chapter 8 – Capable Capital: The GCC as a Source of Capital – of Dubai & Co. For more on the letter, see this article from the Wall Street Journal)

ADIA’s letter is an important chapter in a story that is far from over. In considering what will likely come next, a few market realities should be kept in mind.

The first of these is that ADIA’s letter may have some PR benefits, but will not — in all likelihood — assuage the most vocal critics of sovereign funds. These critics, in the media and in government, will almost certainly call for legally binding agreements rather than statements of intent.

The second is that ADIA and other sovereign funds (especially in the GCC) will almost certainly grow in importance as a rare source of liquidity in a time of global financial crises. The combination of high oil prices with lower-priced companies available for sale would only suggest even that greater overseas investment is on the horizon.

The third is that Gulf capital has choices. Markets that take a more nuanced stance – protecting their legitimate interests without repelling GCC investors with blanket prohibitions – will win out in the competition to attract investment.

The most practical approach moving forward seems to be greater transparency at the deal-level – not at the fund-level. As sovereigns like ADIA make equity investments in companies, appropriate covenants ensuring a focus on shareholder value can be articulated and publicized. This moderate approach both addresses political / security concerns while protecting the confidentiality of sovereign investors.

Another interesting method is to fund joint ventures like the Kuwait / Dow Chemical JV about which I wrote in December. While this strategy has many benefits, it does not always provide the level of liquidity multinationals may be seeking at the parent-company level.

In issuing its letter, ADIA has chosen a diplomatic and understated approach, rather than flexing its substantial muscles. Savvy observers will nonetheless appreciate that making sovereign funds feel unnecessarily unwelcome is hardly a recipe for attracting much-needed capital and enhancing shareholder value.

Earlier this month, Business Intelligence Middle East published a review of Dubai & Co.: Global Strategies for Doing Business in the Gulf States. The publication, widely read in Gulf business circles, offered a powerful endorsement: “if you read just one book this year, we recommend that you pick up this one.”

A passage from the review (which is followed by an interview) is pasted below and the full text is available here.

From Business Intelligence Middle East:

“A new business book by Aamir A Rehman shatters many myths about the Middle East. He offers an easy-to-read guide at a strategic level for firms seeking to do business in the six nations of the GCC. He explains why Dubai has become a major hub for the region as it experiences an unprecedented expansion in energy, financial services, consumer goods, hospitality, retail, real estate and countless other industries. Here he speaks with BI-ME about his inspirations and insights for tapping into Gulf capital and opportunities. If you read just one book this year, we recommend that you pick up this one.”

This past week, the Financial Times ran a front-page piece on the increased role of sovereign wealth funds (SWFs) in providing debt to support private equity firms’ acquisitions. As the global credit market copes with the subprime crisis and slowing economic growth, SWFs — particularly those in the Gulf — remain strong and are a crucial source of capital and liquidity.

The FT quoted a Terra Firma executive who asserted that the Abu Dhabi Investment Authority (ADIA) “will effectively replace Wall Street.” While sovereign funds do have the capacity to provide debt financing, it is crucial to remember that they approach debt as principal investors, not as financial agents. When engaged as genuine co-investors — rather than as a new flavor of “banker”– SWFs can make private equity firms more effective and enable higher levels of return for all.

Private equity firms have long tapped sovereigns, like other large institutional investors, as investors in their funds. SWFs have the core attributes that private equity funds seek in their investors: deep pockets, sophistication, risk tolerance, and the patience needed to accept the illiquid nature of PE investments. Now, PE firms are looking to SWFs for the debt financing of individual investments.

Typically, the debt component of private equity transactions has been provided by large banks. These banks have the ability to either syndicate the debt to clients or otherwise mitigate their own risk through client funds. Wealth funds providing debt in buyout situations, however, generally do not syndicate the debt. Instead, they hold on to it.

Holding the investment is consistent with sovereign funds’ mission of being principal investors but, at the same time, it does expose the sovereign to the full credit risk. In other words, SWFs lend their own money more than banks do.

Therefore, a more appropriate way for private equity firms and sovereign wealth funds to approach their collaboration is as co-investors. Not only does this reflect the reality of SWFs’ “principal risk,” but it also highlights the importance of collaborating in areas where the co-investors bring complementary capabilities and skill sets.

(For more on the increased sophistication of Gulf investors, see “Chapter 8 — Capable Capital: The GCC as a Source of Capital” of Dubai & Co.)

In today’s environment, sovereign wealth funds can insist on a genuine partnership with private equity firms by which they are more than merely providers of debt. At the same time, private equity firms can benefit from sovereigns’ increased investment savvy and their ability to help portfolio companies grow. Since SWFs share a principal investor mindset with private equity firms, seeing them as a “replacement” for bankers misses out on the benefits of a more holistic relationship.

Since the publication of Dubai & Co.: Global Strategies for Doing Business in the Gulf States, a number of US companies have contacted me with a similar and compelling question. While the book provides a strategic guide for international firms seeking to integrate the region into their global strategies, is the Gulf opportunity available only to large multinationals? How, if at all, can smaller businesses enter the region?

For small firms, business development is typically a key challenge. When development plans include Gulf aspirations, the challenge takes on unique — and exciting — dynamics.

As a starting point, here are a handful of tips – specifically for small businesses – worth considering as they craft their GCC strategies. These are in addition to the overall frameworks and suggestions discussed in Dubai & Co.

Tip 1: Define and communicate the niche in which you are “best of breed”

Like buyers everywhere, Gulf consumers and businesses seek world-class products and services from international companies: that’s why they admire global brands. Smaller firms that define their space truthfully claim “best of breed” status – even if currently small – can find a niche in the Gulf market.

The cosmetics industry, for example, is one in which a niche product can be made compelling. Imagine a skin care product designed to withstand dry heat and tailored specifically for the complexions of the Gulf. Such a product – if communicated effectively – could succeed even in a highly competitive product category.

Tip 2: Tap into expatriate communities

One way for small international firms to learn more about the market and create awareness of their offerings is through the targeted engagement of expatriate communities. Small Australian companies, for example, can reach out to the vibrant and growing community of Australian expats in the region as a base for building contacts.

Formalized expatriate business associations and chambers of commerce have taken root in the Gulf and can be a useful resource. Some have even developed pro-active trade promotion strategies which give a heightened profile to smaller businesses. One striking example is International Business Wales’ trade promotion activities that have actively marketed Welsh businesses in the Gulf.

Tip 3: Pick up “excess” work from larger players

As the Gulf economies have boomed, global players have seen demand for their services expand tremendously. In private, leading companies – especially top-notch professional services firms – lament over the struggle to create capacity to meet client demand.

Less-known players can benefit from this phenomenon by picking up some of the “excess” workload. Market research companies, for example, can partner with consulting firms and advertising agencies to execute detailed research and analysis. In collaborating with larger firms, smaller ones develop track records that can help with client development of their own.

Tip 4: Manage your Web presence to promote and deliver

The Web is, of course, a great equalizer in which small firms can have a disproportionate presence. While overall broadband penetration in the Gulf is lower than some other markets, broadband adoption amongst the most attractive customer segments is very high.

In the book, I discuss an online women’s community called Hawaa World. One way in which women have used the site is to help each other shop for international products – such forums are ideal places to create “buzz” about your offering.

(For more on Hawaa World, see Chapter 2 – “Think Again: Addressing Misconceptions about the GCC” – of Dubai & Co.)

Tip 5: Explore free zones for building presence

The free zones developing around the Gulf, including several in the UAE and a growing number in Qatar, Bahrain, and Kuwait, are a magnet for small businesses. Dubai’s Media City is a prime example: while it has actively courted global leaders like CNN, it is also home to a great number of small, entrepreneurial ventures.

Companies typically start serving Gulf customers from a distance to develop traction in the market before opening in free zones. As a firm’s Gulf business grows, however, a free zone presence makes sense and can be a tremendous enabler.

Small businesses have long been the backbone of robust economies. As commerce becomes increasingly global, smaller firms no longer need confine themselves to their domestic markets. International expansion is a real option, and the Gulf is a bright spot of opportunity – for businesses large and small.

Last week, I was in Dubai to present at a conference on strategies for the investment of endowments (called awqaf in Arabic) in the Muslim world and beyond. The event, entitled the Dubai International Conference for Endowments Investment, was hosted by the emirate’s government.

Endowment investment is a prime example of an area with opportunity for transferring global business models and best practices into the Gulf – and the Islamic world more broadly. At the same time, it is an area in which authenticity and consistency with indigenous values are critically important.

Awqaf have a rich history, dating to the time of the Prophet Muhammad. Countless endowments have been established throughout centuries and around the Muslim world, for broad purposes as well as highly specific ones. Endowments have been used to fund public works such as wells and highways and to meet specific needs such as education and even wedding expenses.

Endowments in the region have traditionally taken the form real estate trusts. The properties are held in perpetuity and the proceeds are used for charitable purposes. In modern times, financial endowments – investing in financial securities in addition to real estate – have grown in popularity and are taking root more strongly than ever before. The migration from real estate to more balanced endowment portfolios was one of the key themes of last week’s conference.

My presentation was on the endowment sector in the US – both conventional and Shariah compliant – and key elements of the most sophisticated endowments’ business models. As a case study, I discussed salient elements of the Yale University Endowment model.

Four elements of Yale’s model stand out and hold particular relevance for international endowments:

1. The endowment practices robust strategy development, based on a rigorous analytical model developed by Nobel laureates affiliated with the University.
2. Yale invests in diverse asset classes, and has transformed its asset allocation dramatically in the past two decades. Private equity and “absolute return” (e.g. hedge fund) investments, for example, made up a larger part of the endowment than listed equities – domestic and international combined – by 2006.
3. The Yale endowment has developed strong internal capabilities, recruiting and retaining world-class investment professionals to oversee the portfolio. Its advisory Investment Committee, for example, includes senior leaders of top-notch investment and financial services firms such as Bain Capital and JP Morgan Chase.
4. The endowment is strongly marked by performance orientation – results are assessed using robust benchmarks and management is rewarded based on market practice.

While these four elements are broadly applicable to the awqaf sector, the flow of “best practices” is by no means one-way. Awqaf must be invested in a Shariah-compliant fashion, and Shariah compliance demands rigorous ethical analysis of where investment funds are deployed. As discussed in my February 2008 Harvard Business Review piece, Islamic finance is rooted in the powerful notion that people should not profit from activities they consider immoral.

Mohammed Amin astutely commented (see relevant post on this blog) that this notion, if practiced universally, “would transform the world.” US endowments can apply this principle and adopt an ethical review of their investment portfolios, asking the tough – but important – question of how closely their investments match their values.

The endowment sector, like many others, is an area where the transfer of global best practices can bring great benefit to institutions and the people they seek to serve. A “cut and paste” approach, however, will not work – a thoughtful assessment is essential to developing models that fit.

The Harvard Business Review (HBR), in its annual list of “Breakthrough Ideas,” has included my article highlighting Islamic finance as “the new global player” in the world’s financial system. The article was co-authored by Dr. S. Nazim Ali, Director of the Islamic Finance Program at the Harvard Law School.

The HBR’s recognition of Islamic finance is yet another indication of the industry’s mainstream relevance and reflects the fact that no financial services institution can be truly global without expertise in Shariah-compliant products and services.

An except from the piece is as follows:

Islamic finance may even have a thing or two to teach regulators and conventional financial institutions. The sharia requirement that all parties to a contract must disclose both risks and rewards could have prevented companies from engaging in the kind of financial engineering that led to the subprime lending crisis. Similarly, the currency speculation that has historically destabilized some emerging markets would be prevented by sharia rules…. Opaque financial contracts laden with penalties and complex clauses would be more difficult to use because sharia requires that the risks of any product or service be clear to both buyer and seller.

Perhaps most interesting is the explicit link that Islamic law makes between financial decisions and values—the powerful notion that people should not profit from activities they consider immoral. Given the growing importance placed on values in the corporate world today, formal mechanisms whereby firms ensure compliance with sharia may serve as a model for all companies that take corporate social responsibility seriously.

The full text is available here and continues to the next page.

The Gulf states and the US have long-standing, highly interdependent relationships. Events of the past week, in the GCC and here in the US, have demonstrated both increased public acknowledgment of this interdependence and visible signs of growing connectivity between the GCC and the US economies. This trend is an important one for global business leaders to watch.

As President Bush toured the Gulf, he consistently conveyed messages of goodwill and alliance. Extremism and terror (and, to some degree, Iran) were identified as common enemies. The UAE was lauded as a model state. Bush was clearly out to “charm” his GCC hosts.

At the same time, according to a report in the Financial Times, the Abu Dhabi Investment Authority has engaged Burson-Marsteller (a member of the WPP Group) to support its public relations activities in the US. Good timing, as additional Gulf investments in troubled US financial institutions were announced during the week of sobering earnings reports and economic data. Anticipating backlash, ADIA is out to “charm” American stakeholders (presumably including regulators, opinion makers, and the general public).

Elites in both the Gulf and the US have long understood their interdependency. GCC-based institutional investors, and especially ADIA, have quietly been courted by US bankers for years as an increasingly important source of capital. Gulf states have quietly played host to US military bases (reflecting security dependence and general deference) and – except for Kuwait – maintain a currency peg to the dollar despite the imported inflation it brings.

(For more on capital interdependencies see Chapter 8 – Capable Capital: The Gulf as a Source of Capital – of Dubai & Co.)

What’s different now is not the nature of the relationships – it’s the level of awareness amongst the general public in both the US and the Gulf. For global businesses, this means at least two things.

First, expect so see more US companies taking the Gulf seriously and integrating it into their global strategies. Bush has brought both attention to the region and assurance that the Gulf states are friendly economies. Those who have long feared “political risk” will be more at ease. His enthusiasm for the region will be noticed in boardrooms nationwide.

Second, expect PR to become an increasingly important part of US-Gulf business activity. When taking capital from a Gulf investor, US firms should anticipate and prepare for scrutiny. When doing business in the Gulf, US firms – especially those working with governments – may consider actively positioning themselves as contributors to the collaboration for which public leaders in both parts of the world have called.

As business ties between the Gulf and the US deepen, the number of stakeholders involved inevitably increases. Recent events show growing recognition that the general public (with the media as a means of accessing them) is becoming a more important element in the process of strategy development.

——-

“Abu Dhabi fund hires media experts,” Financial Times, January 18, 2007 .
http://www.ft.com/cms/s/0/959c13e0-c5ef-11dc-8378-0000779fd2ac.html

The January edition of the Wharton Leadership Digest (WLD) features an interview with me on the topic of “Leading the Gulf: Making Sense of Business Leadership in Dubai and Beyond.” The interview touched on a wide range of interesting topics, including:

• how much of Dubai’s success is a “leadership story,”
• the degree to which business leaders need to adapt to thrive in the Gulf environment,
• women in the workforce,
• effects of the Dubai Ports World controversy, and more.

An excerpt from the interview is below and the full text is available here.

WLD: Is the story of Dubai’s success a leadership one? Has leadership been critical to the emirate’s prosperity?

Rehman: Dubai’s remarkable success – and that of the United Arab Emirates (UAE) overall – is very much a story of visionary leadership. Dubai’s current ruler has built on the legacy of his father and brother to foster an “open-for-business” environment with superb infrastructure, streamlined government services, and business support facilities. Abu Dhabi, the dominant emirate in the UAE, has also benefited from extraordinary leadership. Other Gulf states were blessed with more oil, larger populations, and greater wealth – yet not all have developed and pursued a vision with the same effectiveness as the United Arab Emirates has.

Dubai’s inherent advantages were limited: the emirate has little energy resources and a small indigenous population. Over the decades, however, it has built itself up as trade center through infrastructure excellence and a welcoming business environment. For example, the government reportedly uses “mystery shoppers” to evaluate the quality of service at public agencies like airport immigration and motor vehicle registration. Dubai was short on resources but long on vision, and that has made a huge difference.

Other emerging markets can learn from Dubai’s example not by imitating its practices, but by understanding the approach the emirate took. Its leaders have focused on the emirate’s areas of comparative advantage – most notably location, trade, and legacy of business services – and fostered the “right” industries to capitalize on these areas of advantage, providing government stimulus and developing physical and social infrastructure with amazing vigor.

A business unit of Cisco Systems, according to a recent report in the Financial Times, has revealed an ambitious goal: networking entire cities. City-wide Internet Protocol (IP) networks would not only give Web access to residents but also enable the Web-based management of government services and infrastructure (traffic lights, ports, etc.).

Don’t be surprised if, in 2008, we find Gulf cities competing to be the first to attain “fully networked” status. Besides the PR splash, are there real benefits to such a move?

Depending on how the network is utilized, the answer could be yes. Becoming fully networked could nicely complement the economic development and e-government strategies of several the Gulf states, and suits the highly urbanized nature of Qatar, Kuwait, Bahrain and the UAE. As technology evolves, Qatar or Kuwait could – theoretically – even aspire to becoming the world’s first full country to be entirely networked.

One pillar of Gulf countries’ economic diversification strategies is to rapidly become “knowledge economies” and to promote knowledge-based sectors. Bahrain has long been the “Wall Street of the Gulf” (focused on financial services) and in recent years both Qatar and Dubai have invested heavily in attracting world-class educational institutions. Qatar’s Education City has drawn the likes of Cornell and Georgetown, with rigorous degree-granting institutions on the ground. Investing in internet technology is consistent with this push towards knowledge sectors – especially as today’s (home-user) broadband penetration rates across the Gulf reportedly top out around 35% (comparable to major EU countries but far behind the US).

(For more on the region’s investment in education, see Chapter 7 – Building Your Team: Human Capital Strategies for the GCC – of Dubai & Co.)

In the realm of e-government, the UAE – especially Dubai – has set a remarkable standard. Permanent residents and frequent flyers clear airport immigration with the swipe of an electronic card. Public spaces – including the shopping mall in the Dubai’s Emirates Towers – have kiosks where people can pay parking tickets and undertake other core transactions. Such facilities are far more sophisticated that the e-government initiatives of many OECD countries, and city-wide IP networks could help e-government initiatives develop even greater sophistication.

That Cisco could conceive of fully networking a city in the developing world (far from its US home market) reflects an important reality: the realm of what is possible expands when multinationals study global markets closely. To truly lead, global firms cannot simply replicate the business model of used in their home country – they must understand the unique opportunities and challenges available abroad. Nowhere is this truer than in the Gulf – where goals considered audacious elsewhere may sometimes be within grasp.

A “fully networked” city should not, of course, be a goal in itself. Web access and e-government must be understood as means to an end: the goal being more competitive, diversified economies. The hardest work is not building the network; it’s developing the human capital, knowledge, systems, and institutions needed for long-term success. If being “fully networked” helps, then seriously considering the idea is sensible.

On the final day of 2007, the Financial Times formally dubbed the Middle East and North Africa “the next investing hot spot” – a weighty endorsement confirming a meaningful trend. The FT cites BlackRock, T Rowe Price, Mizuho Bank (Japan), and Permal as actively raising funds to tap this market. Permal’s “Silk Road” fund – capitalizing on the increased trade flows between the Gulf, MENA, and Asia – reflects an important insight on how the regions’ economies are evolving.

The fundamental growth of MENA economies – and especially the Gulf states – is certainly inviting. Investors and asset managers need, however, to recognize the limitations of listed equity markets in tapping into the region’s growth.

One market reality to note is that many of the region’s most dynamic companies are not listed on public exchanges. This includes energy giants like Saudi Aramco (fully owned by the Saudi government) and family-owned enterprises like the Al-Futtaim Group of the UAE – one of the region’s key conglomerates. While some major firms (like the UAE telecom providers Etisalat) have been partially or fully listed, a great many of them are still not on the public exchange.

A second market reality is that MENA exchanges – particularly in the GCC – have been highly volatile in recent years. Between 2001 and 2006, Gulf markets experienced an unprecedented boom – the Saudi, UAE, and Qatari exchanges all rose over 600%. This boom was followed by an extreme correction in 2006, in which some markets lost about 80% of their market capitalization.

(For more on the GCC equity market boom and bust, see Chapter 8 – “Capable Capital: The GCC as a Source of Capital – of Dubai & Co.)

A third reality – linked to the matter of volatility – is that GCC equity markets are driven far more by retail investors than are equity markets elsewhere. The boom and bust of 2001 – 2006 occurred largely because retail investors who had irrationally been pouring money into the market pulled out dramatically. More mature equity markets – though also subject to emotional run-ups and sell-offs – are shaped by institutional investors who approach investment with far greater sophistication.

These dynamics lead to a market in which a firm’s strong fundamental performance may not always lead to strong equity valuations. One great irony of the 2006 crash in the Gulf was that oil prices were at an all-time high and that listed companies’ earnings were growing strongly, in line with the region’s fundamental growth.

Yes, the MENA region is primed for strong growth and warrants significant investment. Publicly listed equities, however, have limitations which investors must bear in mind. The most savvy institutional buyers will look closely at private equity investment opportunities in regional conglomerates, family-owned businesses, and cross-border joint ventures – tapping into the fundamental strength of the region while limiting their exposure to highly volatile public markets.

In this usually quiet holiday period, the Financial Times broke a remarkable story (based on an unnamed source) that the Kingdom of Saudi Arabia (KSA) is contemplating a sovereign investment fund that would “dwarf Abu Dhabi’s $900bn” ADIA. The implications of such a fund, if and when created, would be far-reaching and profound.

For seasoned observers of the Gulf, the story raises more questions than answers.

One such question is which components of the Saudi investment apparatus might be re-organized to form the body. It is most prudent, at this point, to refrain from commenting on such a fund until more information is available.

By way of context, however, three important attributes of the Saudi economy (and its public sector in particular) are useful to remember when reflecting on the scope for KSA public sector overseas investment:

1. Saudi Arabia is the Gulf’s “core market”, far larger than any other GCC economy

The Saudi GDP – $400bn in 2006 and now significantly higher – is about half the total GCC economy. The KSA’s dominance in population is even greater – it has 25 million inhabitants, about two-thirds of the Gulf total. No global company, especially a consumer-facing one, can ignore Saudi Arabia if it wishes to build a large-scale Gulf presence.

In the critically important oil sector, Saudi Arabia far outweighs its neighbors: the Kingdom has 22% of the world’s known oil reserves, more than Kuwait and the UAE combined. Despite its (sometimes) lower commercial profile, Saudi Arabia is clearly the “core market” of the GCC, a point discussed in length in Dubai & Co.

(For more on Saudi Arabia as the Gulf’s “core market”, see Chapter 4 – “Silicon from Sand: Essential Background on the GCC” – of Dubai & Co.

2. Demands on the Saudi budget are, however, significant and growing

The KSA’s population of 25 million is spread over a vast territory and is growing quickly. The need for government spending on social services programs (e.g. schools and hospitals) is tremendous. At the same time, the Saudi infrastructure requires a great deal of capital investment – much of the infrastructure was developed in the 1970s and early 1980s and is showing wear and tear.

Huge projects such as a series of “Economic Cities” are underway, tapping deeply into the government’s income. Besides these capital projects, the operating budgets of government departments have grown as the KSA population and social needs have expanded greatly.

3. Generating a steady, long-term budget surplus is therefore a challenge

While high energy prices do create windfalls for the Saudi public sector, the KSA’s “break even” oil price is significantly higher than its neighbors. While analysts report that the UAE could balance its budget with an oil price below $20 per barrel, the KSA needs a much higher price to meet its spending needs.

In today’s environment, a budget surplus seems inevitable. As recently as 2003, however, the Kingdom reported a budget deficit. Should oil prices drop to the $50 level, the situation for the Saudi budget will tighten. If the dollar falls further and the prices of imported inputs continue rise, the KSA is less assured of a budget surplus than are its GCC neighbors Qatar, Kuwait, and the UAE.

Saudi Arabia is a massive economy and its public sector holds a great deal of wealth. A Saudi sovereign wealth fund like the one described by the FT would no doubt be a global powerhouse. Compared to other Gulf states, however, Saudi Arabia depends far more on high energy prices to enable and sustain the kind of healthy surpluses fueling the region’s celebrated sovereign wealth funds.

On Tuesday, the Financial Times published my letter regarding the recently-announced joint venture between Dow Chemical and the Kuwait Petroleum Company (KPC). The letter is entitled “Gulf Investors Exert New Control” and the text is as follows:

Sir, Francesco Guerrera’s report “Dow to invest plastics business into $11bn Kuwaiti joint venture” (December 14), on the deal between Dow Chemical and the Kuwait Petroleum Company (KPC), rightly identifies a trend of Gulf-based entities increasingly investing in global companies. As important as the increased volume of such investment, however, is the increasingly strategic nature of Gulf companies’ acquisitions.

The Dow-KPC deal differs from other recent transactions (such as Abu Dhabi Investment Authority’s $7.5bn injection into Citigroup) in two key ways. First, the sector itself (plastics and petroleum-related chemicals) is one in which the Gulf has an inherent advantage and is therefore credibly positioned to become a global leader. Second, the deal is a joint venture by which the Gulf investor exercises significant control and steers the enterprise: rather than take a passive role in a running concern, KPC is shaping the destiny of a new company. These two factors make the deal far more substantive than other high-profile stakes, enabling Dow and KPC to build a stronger business than either could do on its own.

Citi’s deal with ADIA has done little for its share price and strategic footing. Dow’s deal with KPC, on the other hand, sent its stock up 7 per cent in one day. As strategic capital creates more value than passive investments do, Gulf investors’ increasingly strategic view bodes well for shareholder value.

Aamir A. Rehman,
New York, NY 10021, US

Copyright The Financial Times Limited 2007

Understanding of the Gulf region and its business opportunities is, for the most part, highly limited amongst senior management at multinational corporations. This lack of “GCC awareness” is somewhat understandable: the GCC union did not even exist until 1981 and the region has only been exciting from a commercial perspective since the 1970s.

Less excusable is the low level of GCC awareness amongst business students today. While working on Dubai & Co., the research team conducted a survey of students at an Ivy League university (with one of the world’s top MBA programs) asking what a set of international abbreviations stands for. How many could identify the GCC?

We expected that awareness of the “EU” and “WTO” would be nearly universal – and it was. “OPEC” and “ASEAN” were less recognized, but broadly known. And the “GCC”? Astonishingly, less than 10% of students surveyed could identify the Gulf Cooperation Council.

(For more on raising GCC awareness and on the survey itself, see Chapter 11 – “Bringing it Home: Raising GCC Awareness in the Head Office” – of Dubai & Co.)

A trailblazing program at the George Washington University (GWU) Business School is, however, setting a refreshing new example. In January, a group of MBA students will go to Dubai as part of a study abroad program, meeting business leaders, assessing the business environment, and – importantly – engaging in concrete projects for firms either already operating in the Gulf or seeking to enter it.

Prof. Salah Hassan, Chairman of the School’s Department of Marketing, is leading the initiative with colleagues from the faculty. The organizers were struck by the high level of interest in the Dubai program (over 100 students turned out for the information session) and by the quality of applicants. Admission into the program was highly selective.

The GWU program sets a model for international business schools in raising GCC awareness. Besides linking the program to tangible corporate projects and using a selective process to choose participants, the program has specifically drawn students with little or no direct exposure to the Gulf. I gave a presentation to the group earlier this month (they’re using Dubai & Co. as a main textbook), and was deeply impressed by the curiosity and passion with which they approach the region.

Ten days in the Gulf can have a lifelong impact on MBA students, raising their understanding of this increasingly key component of the global economy. Few, if any, will likely work in the region in the near future. A basic understanding of it, however, will allow them to shape global strategies that embrace the Gulf opportunity effectively.

As GWU’s example shows, MBA students today will recognize the importance of the GCC to global business if given the chance to learn more. It’s now time for business schools to foster and reflect this recognition in their curricula and academic programs.

Earlier this week, ConocoPhillips struck a deal with Qatar Petroleum International (Qatar Petroleum’s global arm) by which the two will collaborate on expanding the Qatari firm’s global presence. Conoco will reportedly help QPI on energy projects beyond the Qatari market – which is phenomenally well endowed from an “upstream” perspective though small from the perspective of local consumption.

In reporting the deal, the Financial Times sees the arrangement as reflective of the “weakened position” of global oil companies when dealing with natural producers. Another perspective is that it reflects increased parity between producers and oil “majors”. In either case, the trends driving the shift in posture are here to stay.

One trend driving the shift in posture is the increased savvy of oil producers in the Gulf and worldwide. As local strength and expertise have developed over the past decades, national oil companies have become less and less dependent on the “majors.” The story of Saudi Aramco is a striking example.

Profit-sharing terms between the Saudi government and US oil companies evolved drastically over the decades. The agreement morphed from a mere 5,000 British pound rental fee plus a modest royalty (before oil was discovered) to a 50-50 profit split in the 1950s to majority Saudi ownership in 1974. By 1988, Saudi Aramco’s ownership was fully Saudi. The producing country’s bargaining power grew as its economic clout increased.

(For more on the evolution of Saudi Aramco, see Chapter 4 – “Silicon from Sand: Essential Background on the GCC – of Dubai & Co.)

A second key tend is the growing global aspirations of Gulf firms. The Qatar-Conoco deal illustrates this: QPI and other Gulf firms increasingly seek to grow their overseas operations. Gulf leaders recognize the importance of such expansion in fostering the long-term competitiveness of the region and its firms.

A third crucial trend changing the posture of major oil companies is the rise of competition. Producers are keenly aware that they have options and can choose between technical partners from the US, EU, Russia, and Asia. There are a growing number of world-class oil and gas services companies, while the number of producer countries is fixed. Hence, a shift in negotiating power is inevitable.

(Nameer Siddiqui of Goldman Sachs commented eloquently on the impact of competition on producers’ negotiation power at the Harvard MENA Business Conference earlier this month. He is an old friend and fellow HBS alumnus.)

Whether one sees the shift in posture as “weakening” or as “increasing parity”, realities on the ground suggest that the shift will remain. Savvy multinationals must recognize the new landscape, in which one-sided deals are increasingly a thing of the past.

Sunday’s New York Times ran a headline story on energy consumption in oil-producing countries. The data-rich piece stressed how local demand is reducing the level of oil exports and therefore the quantity available in international markets. This is seen a troubling trend for non-OPEC countries that import more oil than they ship abroad.

Observers of the Gulf should note a fundamental reality: the strategic implications of increased oil demand disproportionately benefit the GCC states more than other oil-exporting countries.

When the price of oil goes up, all sellers capture incremental revenue per barrel. From a strategic perspective, however, the GCC states grow in importance more than other oil exporters do. The reason in rooted in two key statistics:

1. The GCC states, combined, provide 22% – between a fifth and a quarter — of the world’s oil supply.
2. At the same time, these states hold 40% – two fifths – of the world’s known oil reserves.

(Source: BP Statistical Review of World Energy 2007)

The Gulf States therefore enjoy a huge “Reserve Advantage” – their long-term ability to supply is far greater than their actual output amounts.

So, while the Gulf states play a central role in oil markets today, their role grows even more central as time goes by. GCC member states – and especially Saudi Arabia, Kuwait, and the UAE – are better positioned to increase output and meet global demand than are other countries are. In good times, they can raise their production with least risk of “running out.” In bad ones, their cost of production is remarkably low, protecting their profit margins more than those of other competitors. In the natural gas sector, Qatar alone (with the world’s third largest reserves) it by itself a formidable supplier.

(For more on projected oil demand and prices, see Chapter 8 – “Capable Capital: The GCC as a Source of Capital” of Dubai & Co.)

The “Reserve Advantage” means that as oil grows more scarce, the Gulf states will proportionately have more of it. As long as oil is precious, the Gulf can expect sustained prosperity. It’s no wonder, therefore, that countries with booming demands for energy – namely, China and India – are building ties with the Gulf like never before.

Wednesday’s Financial Times reported that the Qatar Investment Authority (QIA) no longer seeks to increase its stake in the Nordic exchange OMX. This step leaves a joint offer by Borse Dubai and Nasdaq as the likely buyer of OMX, through a multi-step process. The process involves Borse Dubai purchasing the Nordic exchange and transferring it to a Nasdaq in exchange for (i) equity in a new JV and (ii) equity in the London Stock Exchange (LSE). The end result is that Borse Dubai is poised to end up holding pieces of both OMX and LSE, with Nasdaq as its partner.

Snatching up an exchange is, of course, a high profile acquisition. This begs the question: are Gulf buyers chasing exchanges as “trophy assets” or are there financial and strategic benefits to such transactions?

It appears, in fact, that investments in exchanges can – if approached properly – can yield both financial and strategic rewards. The exchange sector is evolving rapidly, with rapid consolidation occurring (it is, after all, a scale, network, and technology-driven industry). Being either the driver of M&A activity or an attractive target can lead to significant financial rewards.

The more interesting rewards for Gulf buyers, however, are the strategic ones. First, access to exchange capabilities and technology can be a source of advantage as GCC cities vie to position themselves as international centers. While exchange capabilities alone will not draw the listings, investors, and talent required to be a major global exchange, they are at least a start. It’s no surprise, therefore, that the two countries pursuing OMX were Dubai and Qatar – both of which have established free zone financial centers with global aspirations. It’s also not surprising that the QIA is already a large shareholder in LSE.

(For more on the region’s evolving financial centers and exchanges, see Chapter 8 – “Capable Capital: the GCC as a Source of Capital” – of Dubai & Co.)

In addition, partnering with Nasdaq for the transaction is a highly savvy move. Not only does it give Borse Dubai eventual holdings in both OMX and LSE, but the cross-holdings place Borse Dubai squarely within a prestigious club of established exchanges. The affiliation brings credibility and “insider” status – increasingly important as wariness of foreign buyers grows in some quarters.

With its growing wealth, the Gulf could no doubt afford some “trophy assets.” Borse Dubai’s investment in OMX and Qatar’s stake in LSE, however, appear to offer more than marquee status if approached strategically.

This past weekend, I spoke at a conference at Harvard on business in the Middle East and North Africa (MENA) region. Other speakers included the COO of Mubadala, Goldman Sachs’ Head of MENA Investment Banking, and the founder of McKinsey’s Dubai office. The first of its kind, the weekend-long event was a great success with over 400 participants.

The most powerful message of the conference was not the content presented, but the confidence with which the region was showcased.

Speaker after speaker touted the scale and dynamism of opportunities in the Middle East. Reflective of the business environment, discussions focused almost entirely on the Gulf – the most promising business cluster, despite its small population relative to North Africa and the Levant.

Newfound confidence, especially in regional and local firms, was especially evident in two aspects of the conference: the roster of speakers and the list of firms actively recruiting young talent.

The closing keynote speaker (and, arguably, the most anticipated of the conference) was neither a Nobel Laureate academic nor a partner at a top-tier global consulting firm: it was Waleed Al Mokarrab Al Muhairi, COO of Abu Dhabi’s Mubadala Development Company. Attendees and Al Muhairi himself had every reason to be confident in Mubadala – the Abu Dhabi Investment Authority had, after all, just made a $7.5 billion capital injection into Citigroup while many other leading investment firms have run for the hills due to the subprime financial crisis.

Throughout the event, representatives of top-notch local firms – including Dubai’s Istithmar and Abraaj Capital, Bahrain’s Investcorp, and Kuwait’s Agility – held equal billing to their counterparts from global banks and advisory firms. And speakers from local firms in many ways generated greater “buzz” amongst attendees.

The Career Fair component of the weekend featured an impressive number of 18 leading firms. As one would expect, McKinsey, Goldman, Booz, and Monitor – traditional participants in Harvard recruiting events – were well represented. More remarkable was the fact that 11 of the 18 firms (including Saudi Aramco, Etisalat, Mubadala, Istithmar, and more) were local or regional companies. For the first time, “blue chip” consulting firms found themselves competing on their home turf with these Gulf-based firms for top MBA talent.

(For more on recruitment strategies for Gulf businesses, see Chapter 7 – “Building Your Team: Human Capital Strategies for the GCC” – of Dubai & Co.)

Just a few years ago, such a prominent showing of Gulf and MENA firms at Harvard would have been unimaginable. Today, however, firms in the region increasingly represent some of the most exciting opportunities in global business. As long as the Gulf’s “opportunity formula” – sustained prosperity, attractive demographic shifts, and ongoing regulatory reform – remains in place, expect to see the international confidence of its leading firms grow.

Last week, Deliotte announced the appointment of Mufti Hassan Kaleem, a classically-trained Islamic jurist, as its (presumably global) Shariah scholar. The appointment is a reflection of the fact that no financial institution – or advisory firm seeking to serve financial institutions – can be truly global without expertise in Islamic finance.

Reports in the press, including in the Financial Times, do not describe the scholar’s new role in detail. There is a reference to “signing off on products” and another to “different work with different exposure.” Were I defining the role, it would have three key elements:

1. Deepen the firm’s awareness of Shariah and Islamic finance matters

Islamic finance is growing rapidly and is here to stay. An advisory firm, as a whole, needs to understand this sector. As there are many accounting and tax implications of Shariah-compliant structuring, firms like Deloitte need to climb the learning curve fast.

In addition to leading the development of firm-wide training courses, I would ask the scholar to present at a worldwide partner’s meeting in the near future. This would raise awareness quickly and signal the topic’s importance and relevance.

(For more on how to raise Gulf awareness in a global organization, see Chapter 11 — “Bringing it Home: Fostering GCC Awareness in the Head Office” — of Dubai & Co.)

2. Integrate the Shariah perspective into the overall advisory proposition

Islamic law is a deep and rich tradition, and Shariah scholars are by necessity specialists. The Shariah perspective cannot, however, be confined to a small group of specialists and absent from the overall client service team.

Mufti Hassan Kaleem has the unique opportunity to work with clients and client services teams on adopting a more holistic perspective on what the Shariah intends: matters such as meritocracy and fairness, environmentalism, and full transparency with customers. These areas are governed more by principles than by “bright line” rules, which makes them more a matter of dialogue than decree.

3. Support “Shariah Execution Audit” activities within Islamic banks

Islamic banks customarily conduct Shariah Audits – exercises by which an audit team makes sure that the bank’s management has complied with the processes mandated by their Shariah Committees. Global firms like Deloitte can help apply best practices to the process of making sure banks live up to the promises they make to their Shariah Supervisory Boards.

One responsibility I would not suggest, however, is to “sign off that products are fully Shariah compliant.” Shariah Supervisory Boards who advise banks – especially in the Gulf – have a diversity of opinions as to what is and is not Shariah compliant. Malaysia has made the Shariah approval process for Islamic products uniform through its central bank, but the Gulf states have not done so. Requiring Deloitte’s “sign off” would have the effect of giving Deloitte’s Shariah scholar veto powers over the Shariah Supervisory Boards of all its clients. Such a measure limits Shariah diversity, dynamism, and consumer choice.

Fostering Shariah expertise within a global advisory firm is laudable and makes commercial sense. The role of the Shariah experts, however, should be more to enable than to approve.

Business headlines around the world are abuzz with news of the Abu Dhabi Investment Authority (ADIA) and its $7.5 billion capital injection into Citigroup. Today’s Financial Times opines that such liquidity injections from cash-rich sovereign investors could prove a “template for other banks hit by the US subprime crisis.” The FT may be right, but the point is even broader – it’s not just the banks that are affected by subprime woes.

ADIA – one of the world’s most important institutional investors – is a stable, conservative investor seeking solid returns mainly in mature markets. Citigroup, believed by many to be undervalued these days, fits ADIA’s investment criteria nicely. Look for ADIA to make a healthy, passive, long-term return.

Citigroup has another major Gulf investor – Prince Alwaleed Bin Talal of Saudi Arabia – whose approach is far more active. Alwaleed holds about 4% of the bank’s equity, and is a hands-on member of Citigroup’s board. Insiders report that Alwaleed has been known to interact directly with management and drill down on the details of the bank’s operations. Alwaleed bought into Citigroup at a similar dip, and has played a meaningful part in the company as the firm’s largest individual shareholder. Alwaleed is also a major shareholder in the Four Season’s Hotel (with Bill Gates), Apple, and a host of other prominent companies.

Alwaleed’s influence on Citigroup has not, interestingly, yet translated into any apparent increase in the bank’s focus on the Gulf. Having divested from the Saudi American Bank (Samba), Citi – unlike HSBC, ABN Amro, and Credit Agricole – has no joint venture bank in the lucrative (but protected) Saudi market. In the UAE, Bahrain, and elsewhere, Citi’s growth ambitions appear to be comparable to those of its peers. Alwaleed’s interventions at Citi – like elsewhere – are apparently at the global, portfolio-wide level.

(For more on the JV banks in Saudi Arabia, see Chapter 5 – “A Piece of the Action: Strategies for Entering the GCC Market” – of Dubai & Co. For more on ADIA and Alwaleed, seeChapter 8 – “Capable Capital: The GCC as a Source of Capital.”)

Yes, ADIA’s investment is playing a meaningful role in helping Citigroup through tough times. Alwaleed, however, will almost certainly have greater impact – and far more direct involvement – in charting the global bank’s path.

In a post two days ago on Mubadala’s investment in AMD, I noted that “Gulf investors have choices, especially towards the East.” Yesterday, another UAE-based investor announced a major stake in a high-profile global firm: Dubai International Capital (DIC) is making a “significant investment” in Sony. According to the Financial Times, DIC now seeks to deploy 30% of its capital in Asia. Significantly – and not surprisingly – DIC increasingly finds the East a welcoming destination for its capital.

The FT reckons the (yet undisclosed) stake to be less than 5%, as a stake that size would trigger a reporting requirement to Japanese authorities which has not yet been undertaken. News of the investment sent Sony’s shares up 4.6% in Monday’s trading.

DIC has no shortage of reasons to invest in Sony: regional diversification, Sony’s combination of content and digital platforms, and a relatively attractive valuation lead the list. What’s perhaps more interesting is why Sony would want greater linkages with Dubai.

Besides being a source of capital, Dubai plays a meaningful role in Sony’s global strategy. For one, Sony runs its entire Middle East and Africa business from Dubai’s Jebel Ali Free Zone. Sony, like many other multinationals, has come to understand the value of both the “hard” (e.g. ports) and “soft” (e.g. business services) infrastructure available in Dubai. Jebel Ali is, after all, the largest man-made harbor in the world.

Further, the GCC and broader Middle East represent an important growth opportunity for Sony. While China and India offer larger customer bases, GDP per capita in the Gulf is about 3 times that of China and 5 times that of India. In a discretionary category like electronics – and especially for a higher-end player like Sony facing commoditization in many product lines– the most attractive customers are those with the ability to pay a premium for quality goods. Hence, greater Gulf focus seems like a wise step for Sony.

(For more on Jebel Ali and the infrastructure advantages of the GCC, see Chapter 9 – “Getting Things Done: Operations Strategies for the GCC” of Dubai & Co.)

It’s not yet clear whether DIC’s investment in Sony will come with a board seat. Considering the strategic benefits the Gulf brings to Sony’s business, inviting DIC’s involvement may prove helpful indeed. Leveraging Gulf connectivity could generate superior results for Sony and all its shareholders – including DIC.

On November 16, the chip maker Advanced Micro Devices (AMD) announced that Abu Dhabi’s Mubadala Development Company has acquired an 8.1% equity stake in the California-based firm. The $622 million investment provides a major cash boost for the struggling US company.

Commentators on the deal have noted that government review of the matter is possible, as some see security risks in a foreign company owning a meaningful stake in a high-tech US company. Some assert that Mubadala – despite having less than 10% of AMD and not having a seat on the board of directors – could somehow compromise our national security. What happens in the weeks ahead will be closely watched by sovereign wealth funds and other international investors with portfolios in the US.

Observers would, however, be well-served to bear in mind the following key facts:

1. Gulf capital is nothing new in US markets

Gulf economies, and Gulf-based sovereign funds, have been investing in the US and other OECD economies for decades. Gulf economies generated a whopping $120 billion budget surplus in 2006, and much surplus capital is channeled to global investments. The Abu Dhabi Investment Authority (ADIA) is one of the world’s most important institutional investors; Morgan Stanley estimates its assets to be $875 billion and growing. Much of these assets is held in the form of US treasury bills. Were ADIA and other Gulf investment funds to sell their holdings in US treasury bills, our domestic interest rates would face a real impact.

2. Minority investments represent diversification of Gulf investors’ portfolios

The high-profile stakes taken by Gulf investors in US and other global companies represent a diversification strategy within their portfolios. Gulf institutions have long held fixed income securities in developed markets – now, there is increased appetite for equity stakes as well. Gulf investors hold meaningful minority stakes in such prominent firms as Citigroup, Apple, News Corp., Daimler Benz, and Ferrari.

Such minority stakes are financial investments seeking diversification and return. Majority buyouts like the purchase of GE Plastics by the Saudi industrial firm SABIC are strategic in nature, seeking to enhance the competitive positioning and capabilities of the purchaser.

3. Gulf investors have choices, especially towards the East

Gulf investors have increasingly found attractive investment opportunities in China, India, and other Asian economies. When the Industrial and Commercial Bank of China went public, the biggest single investor was the Kuwait Investment Authority. The Dubai Investment Group has taken a 40% stake in Malaysia’s Bank Islam Group. The less welcoming western markets become, the more Gulf investors will look towards the east.

Chapter 9 (“Capable Capital: The GCC as a Source of Capital”) of Dubai & Co. discusses these topics and more, including a more comprehensive discussion of Gulf investments in the OECD world.

Observers should not be surprised that Gulf investors – already major holders of US fixed income and other debt instruments – are also interested in equity investment opportunities. They should also not be surprised if Gulf investors turn elsewhere if given reason to believe their capital is unwelcome here. Capital markets are best served is to when deals are evaluated based on their merits – most critically, the intent and influence of the buyer – rather than political factors like the investor’s country of origin.