Developing Capital Markets in Lebanon

Published on: 17 Feb 2018

PREFACE

Lebanon holds a special position in the region and has long understood the value of the banking sector and financial markets. Since the end of the civil war in Lebanon in 1991, everyone understood the value of money in reconstructing the country. Government officials and experts enforced the banking sector hereby facilitating the inflow of capital and increasing access to debt both to the public and the private sector. Indeed the Central Bank the main regulatory agency paved the way for a complex structure that enabled Lebanon to maintain an economic stability and a stable currency throughout the past 25 years. 

The Lebanese economy is mainly focused on the services sector followed by the industrial and the agricultural sector of course. An unconventional monetary policy and a complex economic situation helped growth despite corruption and disorganized public finances. This is a main factor in shaping the actual situation of the Lebanese economy. 

Further to that, the Lebanese economy shaped around many other factors amongst which family business structures, lack of judicial enforceability, and absence of capital markets along with an over regulated banking industry. 

With the lack of active capital markets, banks still play the biggest role in outside financing to private companies. Their conservative lending policies with high collateral requirements do create an underserved market, a situation that is inevitable considering the complex situation of the Lebanese economy. 

Capital markets are markets for buying and selling equity and debt instruments. It channels savings and investment between suppliers of capital being retail or institutional investors on one hand, and consumers of capital such as governments, business, and/or individuals on the other hand. There are 2 main types of capital markets: primary markets where new instruments are listed and secondary markets where existent instruments are traded. 

Capital markets include equity securities and debt securities both of which are traded on the primary market and later on the secondary market. These securities enable companies to raise capital in order to further invest and grow their business. The difference between equity securities (Stocks) and debt securities (Bonds) is pretty simple: the first one is basically selling shares of a business to investors while the second is a loan given by investors to the company for a fixed return (coupon). Both securities fluctuate when being traded and affect the overall market capitalization of the company. Suppliers of capital generally want the maximum possible return at the lowest possible risk while consumers of capital want to raise capital at the lowest possible cost. 

Capital markets are usually regulated by regulators which are agencies in charge of maintaining a certain order to the market. Their role is regulatory (enacting rules and regulations), sanctioning (punishing market manipulators and stakeholders who do not abide by these rules), and sometimes participatory (intervening in the market to stop certain activities or trades that might affect the market and overall the economy. in the United States, the 2 biggest regulators are the securities & exchange commission (SEC) and the Financial industry regulatory authority (FINRA) alongside the Federal reserves that overlooks the nation’s economy. 

The size of a country’s capital market is closely proportional to the size of its economy. As capital markets flow mont from people to institutions in order to maintain operating and invest, they are crucial to a well-functioning economy. 

Capital markets are different than “money markets” Capital markets are exclusively used for medium-term and long-term investments of a year or more while money markets are limited to the trade of financial instruments with maturities not exceeding “one year” Money markets use different instruments such as deposits, collateral, loans, acceptances, and bills of exchange. In fact, money markets are short-term instruments and often used to generate smaller amounts of capital or as a temporary repository for funds, as well as maintaining a certain regular level of liquidity.  

Capital markets function in a very complex manner involving 3 main actors being buyers, sellers, financial intermediaries operating on primary and secondary markets. Buyers and sellers can be entrepreneurs, investors, companies, pension funds and endowments, and governments. 

Buyers can be individual or insertional investors who come to the capital market with a variety of needs, one of which is to buy stocks or bonds in order to put cash to work by investing and earning a return such as for generating income on savings. It could be to gain or limit exposure to macro-economic trends or ties of companies. Sellers on the other hand come to the capital markets with a variety of needs and goals such as raising cash to reallocate into different investments, or realize gains on investments, or even issue equity or debt which can broaden ownership in a company, establish market value for it and create a “currency” for acquisitions and investments. 

To make it even clearer, Let’s suppose a huge empty land with people standing over it holding each 1 Million Dollars. In order to build the country from scratch, there should be an economy so these people will start planting to feed and sell agricultural products. These people will need to live in houses which will push them to divide the huge land into parcels and “invest” in building homes. People are now planting, eating, and living in homes. They will then start producing which will push them to build plants thereby growing the industrial sector which will, in turn, create jobs and spending. The industrial products will be sold for a profit and generate revenue. We now have an economy where agriculture and industry are thriving, people are eating, spending and living in homes. People will then start wanting services which will push towards the creation of companies offering services. The government would want to invest in infrastructure and sanitation systems, electricity, water, connectivity, and telecommunication etc. After that, each player would want to increase their activity and would need more money so more investors will join and so on and so forth. This, in brief, is the capital market where in order to be able to grow the economy people invested, others sold shares and increased debt to generate more revenue. 

Capital markets are the engine that fuels the economy and are the backbone of capital and investments. Governments can use these instruments through treasury notes, municipal bonds etc… Corporations can use asset-backed securities, corporate debt and /or equity to raise money. Just consider for a moment the leverage that is being created through such capital markets. 

This system performs 3 main functions: it handles payments, channels savings to investments and manages economic risks. 

- This system enables monetary transactions for the purchase of goods and services. 

- The allocation of resources to productive use by transferring savings to Investments in infrastructure or businesses. A framework for corporate governance is also vital to protect investors and deal with agency problems. 

- It allows risk management, allocating such risk between economic entities with different preferences for risk and returns. This requires agencies and bodies to regulate and control such agents to ensure obligations are met. 

Banks provide payment services, as well as credit and deposit services (capital allocation through debt). A central bank guarantees the currency and manages inflation. A stock exchange provides an alternative means of capital allocation through equity (shares) or debt (bonds) and also oversees corporate governance through listing rules for issuers. The stock exchange also plays a monitoring role by supervising insider trading and has a role in information dissemination (of share prices and corporate disclosures, such as financial statements). Credible media plays a vital role in dissemination of information related to the economy. Risk allocation is facilitated by insurance companies, but increasingly also by derivatives markets, which can provide products to manage risk in everything from price fluctuations in shares or oil, to weather events or credit defaults. And a regulatory authority controls corporations, banks, and exchanges, according to laws and regulations.

A well-functioning capital market facilitates the allocation of capital to productive use in companies by encouraging the placement of shares and bonds in the primary market. It gives investors an efficient means of buying or selling assets in a liquid secondary market, and it requires companies to provide accurate information to investors too that they make sound investment decisions and by doing so promotes good corporate governance.

Although capital markets and financial markets, in general, are not the only solution, they do provide leverage so that both the public and private sector can increase its activity and grow faster. 

The Beirut stock exchange is located in Beirut. It is a public institution run by a committee including a chairman and eight members appointed via a decree issued by the council of ministers based on a recommendation by the minister of Finance. 

The BSE is the second oldest market in the MENA established in 1920 by a decree of the French commissioner. In the 19003s the stock exchange flourished following the established of French Lebanese joint-stock companies that were listed on both the Paris and Beirut stock exchange. In the 1950s and 1960s, the activity increased to grow with over 40 listed bonds and major companies and banks listing their stock. 

After the civil war a new automated brokers system was introduced, based on the fixing price instead of the traditional OTC voice brokers and the BSE was relaunched with the support of the Paris stock exchange. in the year 2000, new forms of securities were listed such as GDR (Global depository receipts, investment funds, preferred stocks and other tradable derivatives. 

In 2011, the capital market authority was created in order to regulate all activities on financial markets in Lebanon. Today Lebanon has a stock exchange that is regulated by a capital market authority under the broad supervision of the ministry of finance and the Central Bank of Lebanon. The economy is underserved in matters of financing and access to capital. Unfortunately, the BSE has a no more than 10 companies listed most of which are financial institutions. The average traded volume revolves around 200,000 shares.

The current situation shows clearly what needs to be done although results to such strategies remain uncertain. The infrastructure is being slowly put in place with plans to private the Beirut Stock Exchange and the creation of an electronic trading platform. The Capital markets authority is being activated in enacting rules and regulations to organize a soon to be capital market, and the Central Bank is working very hard to structure a monetary policy that will ensure stability moving forward. 

There are many steps yet to be implemented in order to be able to activate capital markets in Lebanon and such steps are divided into 2 sections: Economic steps and financial and fiscal reforms. 

1. PREREQUISITES

  • Macro-fundamentals have been established or addressed: There should be sustained macroeconomic and political stability, capital account liberalization the fundamental rule of law, a strong institutional framework and a sound banking system;
  • Government is committed to the corporate bond market development process: Government sponsorship has supported successful examples of developing emerging-market corporate bond market; and
  • Government’s policy actions are communicated clearly and applied consistently: While investors are able to account for known market risks and price accordingly, the unpredictability of doing business in a country dissuades them from entering altogether. 

2. ECONOMIC STEPS

The economy has long been suffering from lack of organization and planning. As stated above the Lebanese economy revolves around the services sector followed by the industrial and agricultural sectors. In order to build a healthy functioning capital market system, there should be an economic background that supports such prospects. 

Does financial integration promote business growth? Understanding whether a causal channel runs from integration to growth is central to several areas of economics. In industrial organization, this channel informs our account of the effects of financial market structure on the size and sectoral distribution of firms and the dynamics of entry and exit. These effects, in turn, matter for regulatory policies toward financial institutions and industrial policy toward key technological sectors. Developing or transition economies continue to place significant restrictions on the mobility and scope of financial institutions. Predicting and managing the process of financial deregulation in these economies requires an understanding of the size and sectoral reallocations that accompany financial integration. And in macroeconomics, empirical estimates of the effect of integration on firms can inform models of business cycle volatility and help to forecast the consequences of increased financial openness or monetary union. The transmission of credit shocks across previously unintegrated markets through the banking channel is a topic of special contemporary relevance. 

Economists have long sought to understand the relationship between financial institutions and business growth. In his \Theory of Economic Development," Joseph Schumpeter emphasized the role of financial institutions in identifying and promoting innovative technologies, ideas, and business methods [Schumpeter 1969]. Joan Robinson, in contrast, argued that financial institutions played little role in inducing growth and that the development of such institutions was a natural consequence, as opposed to a cause, of a growing economy [Robinson 1952]. The systematic empirical investigation of this question extends back to Goldsmith [1969], who pointed out a persistent correlation between economies with high growth levels and developed financial institutions.

The empirical difficulty in this area has been to identify plausibly exogenous changes in the characteristics of financial institutions in order to consistently estimate their impact on firms. As a result, the mechanism through which financial structure impacts business formation, investment, and growth, as well as the magnitude of these effects, remain a subject of considerable debate.

This close relationship between economics paves the way to examine the economics needs in order to establish financial markets in emerging economies. 

Reshape economic sectors

In order for capital markets to flourish in a sustainable way, economic sectors should be shaped in a way to have a sort of equilibrium where agriculture, industrial and services constitute quasi-equal parts of the economy especially in a country where family businesses are major players in commerce and trade. It does not mean that this is a necessity in every situation nevertheless it is crucial in Lebanon to permit a strong long-term expansion

Encourage producers and providers: Agricultural producers occupy a third of the Lebanese territory and produce various agricultural products that are consumed on the local market and exported. Indeed, the Bekaa Valley and the mountains provide a excellent terrain for plantations that can be much better exploited. 

Lebanese industrials have extensive experience in various fields and should be encouraged and incentivized. 

Fiscal incentives: Fiscal incentives should be introduced to push producers and providers to increase their productions and services enabling decent profit margins. Although taxes are being imposed on imported products this strategy is far from being complete and new strategies should be implemented to promote local products and services. The government should move aggressively towards radically decreasing taxation on these products whether vegetables, fruits, canned goods, frozen products, services, and artwork. 

Trade deals: Governments can use trade policy instruments to shift profits from foreign to domestically owned firms, raising national economic welfare at the expense of other countries. We should examine a 2 stage game: the first stage, the government is able to enact and export subsidy for the home producers’ output of the homogenous product. In the second stage, producers of each country choose the quantity to produce and sell to other countries through trade deals. The subsidy lowers cost and makes producers wanting to export more and government intervention may have a powerful effect on the willingness of a later-comer to enter the industry. Targeted government intervention may enable late entrants to successfully challenge first movers. By doing so, government intervention shifts the excess returns available in a particular industry from a foreign country to the national economy. 

Even though a state-centered approach directs our attention to the important role that states play in shaping the structure of their domestic economies, it does have some important weaknesses. A number of studies point out to some problematic issues of the strategic trade theory.

Horstmann and Markusen (1986) focus on assumptions regarding production technology. They suggest that subsidies and tariffs can promote entry by less efficient firms and raise the industry average cost. Dixit and Kyle (1985) argue that it is important to consider the question of who is behaving strategically with respect to whom. Potential responses such as government retaliation and changes to market structure are ignored in the Strategic Trade Theory.

Another critique focuses on the fact that one nation's citizens may own stock in both domestic and foreign firms. Thus the notion of a "domestic" firm is less meaningful in a world of international capital movements. Irwin (1996) argues that concern about international market share is a characteristic of mercantilism. Such a perspective views world trade as fixed and divided among a few countries.

A number of practical concerns make many observers skeptical of the theory's potential application. For example, national governments are unlikely to have the analytical capacity to determine the optimal form of trade intervention. Additionally, the national political process may compromise the government's ability to apply such policies. A government that shift rents from other exporters may invite retaliation in those or other markets

Regional and international trade deals should be negotiated by a special commits part of the ministry of economy and trade comprised of expert negotiators and merchants able to negotiate the best deals out there. Such trade deals with Egypt (for potatoes), Turkey and other regional and international players are crucial to open new markets for agricultural producers. The Ministry of Agriculture has established a strategic plan for 2015 -2019 and created ten groups within the ministry in order organize the agricultural sector. There should be a similar approach to all industries.

Knowledge economy

Lebanon has long gone down the road of knowledge economies whit the central bank injecting more than 400 million $ in the startup ecosystem and the entrepreneurship scene helping remodel the country’s economy into a technology and knowledge-driven economy. 

A knowledge economy is typically directed at the production, distribution and consumption of knowledge and data and sectors centered on knowledge are growing very fast.  

Knowledge economy and access to technology and data can drastically help the establishment of capital markets through better access to information and news. 

The merchant’s brain 

What should most importantly be changed is the Lebanese merchant’s brain. Lebanese merchants should understand the value of international exposure, access to capital and leverage. A massive awareness program should be organized by the government and the private sector to promote corporate life, leveraging and international exposure as things are moving very rapidly.

Corporate life: this is a major topic to work on and to raise awareness that there should be an active corporate life in order to better reach results and to make sure to preserve transparency and control. Company owners should understand the value of selling shares and raising debt levels to further produce and should be less attached to a full ownership rather than being preoccupied to grow the business. Government intervention can play a role in rendering corporate ownerships more flexible. 

Leveraging: Corporations should be able to work with leverage and securitize certain types of assets to further pursue growth. This will enable higher liquidity levels and an increased activity level. 

International exposure: International exposure and branding are crucial in building tomorrow’s economy and making sure Lebanese corporations can compete on a regional and even international level. 

3. FINANCIAL AND FISCAL REFORMS

There is a full strategy to redefine the financial sector and to ensure that capital markets are able to grow exponentially fueled by the various agents involved. Based on the world economic forum’s efforts to develop capital markets in several countries the main factor that was promoted is the public-private dialogue with a goal of identifying key barriers to development and defining measures suitable for overcoming existing challenges. Several common factors are considered best practices in promoting capital markets: 

Transparency and confidence in market mechanisms are essential 

A Legal framework is fundamental to provide market participants with the confidence to enter the market. A strong institutional framework should lay out robust corporate governance standards and protect both issuers’ and investors’ rights. This framework should supply clear legal guidance on how business is conducted and what happens in cases of bankruptcy. Moreover, clear and applicable accounting standards are crucial to allow effective and efficient price discovery, credible credit ratings and relevant company information and data. 

Attractive and diverse investment opportunities 

Issuers must create a sufficient pool of attractive products for investors. There should be sufficient volume and liquidity to drive the markets and spur business to issue both equity and debt. 

Diversification of investors is crucial 

Capital markets require a broadly diversified investor base. Capital inflows to emerging markets can increase market liquidity, and foreign investors frequently provide pressure for reforms during a market’s early development stages. Domestic investors, on the other hand, provide stability to the market as geopolitical changes and other macroeconomic conditions can trigger rapid outflows of foreign capital. Separately, retail investors create demand in core markets, such as for bonds and stocks while institutional investors support the development of more complex financial products. 

Financial education of investors and issuers promotes market participation.

Before engaging in building capital markets, there should be a clear strategy to promote financial education and to further explain the issuance process and the options available to issuers such as types of products, corporate governance set-ups etc.. Investors must, in turn, understand the functioning of financial markets and risk-return profiles attributed to different financial products. 

Encourage greater issuer participation

How to minimize the obstacles for issuers to the market and the relative costs to participate in it: 

  1. Limit market distinction that boas against corporate bond markets 
  2. Optimize the issuance process and costs 
  3. Streamline issuance processes 
  4. Expand issuance options to cater fora diverse set of corporations
  5. Converge with the regional issuance framework. 

This will lead to expanding access to and use of corporate bond, lower the cost of financing, and improve efficiency and time to market. 

Improve the investor value proposition 

These recommendations respond to how emerging markets can encourage the development of a domestic savings pool and lower actual and perceived risks of participating in the market for domestic and international investors. 

  1. Introduce reforms to encourage domestic long-term savings 
  2. Encourage an investment culture through education 
  3. Provide incentive for a mandate private domestic savings
  4.  Strengthen the regulatory and legal framework to offer credible investor protection 
  5. Develop an effective and efficient process for setting despite’s
  6. Strengthen the insolvency regime
  7. Establish a strong corporate governance framework

This will grow the size of the local capital pool, improve market certainty and investor confidence in entering the market, and improve recovery rates. 

Attract global interest 

Global interest should be spurred by a national direction for market development and improve the domestic market’s attractiveness relative to goal markets. 

  1. Form and communicate a clear strategy for developing capital markets 
  2. Implement a tax regime aligned with financial development objectives 
  3. Position country to be included in global indices and portfolios. 

There are many steps and metrics to use to kickstart capital markets in Lebanon, yet the backbone remains transparency, efficiency, and strongly fighting corruption. Lebanon is getting closer to a turning point and the government and the people will have to make radical decisions before we can revisit technical needs for igniting the Beirut Stock exchange and capital markets in Lebanon. 

Written by: Rami Alamé

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  1. The economist, capital markets in emerging countries, Adam Higginbotham 
  2. Central Bank of Lebanon, laws, and decrees
  3. Capital Markets Authority Lebanon