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Foreign Portfolio Equity Investment in Egypt: An AnalyticalOverview

This paper evaluates the recent history of foreign portfolio equityinvestment in Egypt, its advantages and disadvantages, and the requiredinstitutional changes to take full advantage of its potential positivecontribution to the Egyptian economy. The paper suggests ways ofmaximizing the benefits and minimizing the costs of the foreign equityportfolio investments through policies and market friendly regulationswhich (i) provide macroeconomic stability, (ii) generate incentives to usethe least volatile of the existing portfolio investment instruments, (iii)promote the use of institutional investors instead of individual investorsand (iv) strengthen the existing market infrastructure.

I-Introduction:

Egypt has enjoyed a relatively high economic growth rate over the last decade, in spiteof its dismal saving rates, supported by credit granted under concessional conditions, andforeign investment. However, the expected reduction in concessional credits for Egyptmeans that, if the country wants to continue to grow at rates exceeding 5 per cent, it willeither have to raise its savings rate or receive more foreign investment or, most likely,both. This paper evaluates the recent history of foreign portfolio equity investment inEgypt, its advantages and disadvantages, and the required institutional changes to take fulladvantage of its potential positive contribution to the Egyptian economy.

Since the early 1990s, equity markets have become significantly more globalized.Governments, including that of Egypt, have been opening domestic stock markets toforeign investors and issuers. Institutional investors have been rapidly increasing theirholdings of foreign equities. Financial innovations, specially equity-related derivatives,have offered more opportunities for borrowers to raise capital in foreign markets and forinvestors to make cross-border investments. Technological advances have increasedefficiency in gathering and disseminating information and in processing transactions.

Between 1986 and 1997, emerging stock markets’ capitalization grew, from $171billion to $2.2 trillion, and their share of world stock market capitalization increased fromnearly 4 per cent as of end-1986, to nearly 9 per cent as of end-1997. By the end of 1998,over 17,163 companies were listed and traded in emerging capital markets. [InternationalFinance Corporation, (IFC), 1999]. However, of the total foreign portfolio equity flows(FPEFs) into the developing countries, the share of the Middle East and North Africaregion only reached 1.21% in 1996, while Latin America and East Asia and the Pacifichave been taking the lion shares. Moreover, between 1997/98 and 1998/99, Egypt has hadan outflow of resources on this account, averaging over US$ 200 million per year, afterrelatively heavy inflows during the 1995/6-1996/7 period, averaging about US$ 850million per year [ see, figure (1) and Table (1) in the text].

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Figure (1)

Source: Own calculations, from IMF, 1998a.

It is well known that, on the one hand, FPEFs expand investors’ opportunities forportfolio diversification and provide a potential for achieving higher risk-adjusted rates ofreturn for foreign investors. In addition, from the perspective of the recipient country,foreign portfolio equity investment (FPEI) contributes to the financing of domesticenterprises and it allows risk sharing between foreign and domestic investors, asrepayments depend mainly on the performance of the firms concerned. (United Nations,1997). Increased foreign investment activity may also improve the depth and increase theliquidity of the local stock exchange, bringing benefits to other segments of the capitalmarket, such as the bond market. Foreign participation in the domestic capital market mayinduce improvements in accounting, information, and reporting systems, as well asincrease the analytical sophistication of the domestic securities industry. Also, as foreignpractices are adopted by domestic shareholders, domestic companies may improvecorporate governance.

However, despite the above-mentioned benefits, FPEI, has particular features whichraise serious concerns. FPEI usually has a short investment horizon, just a few weeks ormonths, although this horizon can extend to ten years or more under appropriateconditions. It is easy for portfolio equity investors to liquidate their investments by sellingtheir equity positions in the secondary securities market. This may lead to an increase inthe volatility of domestic asset prices and returns, greater exchange rate volatility or greaterinterest rate volatility, or both. Furthermore, if the stock of international reserves is at a lowlevel, it may cause a balance of payments crisis. All this can create considerableuncertainty, discourage domestic and foreign investment, and can ultimately be verydamaging to the economy as a whole. (Corbo et.al.,1994a and Corbo1996).

These potential risks of flow-reversal may be very harmful, if this reversal is driven bythe most volatile types of investors and instruments, in a recipient stock market that is notsufficiently prepared with a reliable infrastructure and effective regulatory framework.

No doubt, portfolio flows to the emerging markets during the 1990s have been volatile.The sharp fluctuations of net inflows into Egypt referred to above are evidence of that. Atthe global level, from a peak of $104 billion in 1993. they fell to less than one-fourth ofthis level in 1995, in the aftermath of the Mexican peso crisis, then nearly doubled to $50billion in 1996. After the Asian financial crisis and the severe financial difficulties of

Net portfolio investment to emerging markets ( 1990-1997) (%)

-50%

0%

50%

100%

150%

1990 1991 1992 1993 1994 1995 1996 1997

Asia Middle East & Europ Latin America

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Russia and Brazil, portfolio equity flows to developing countries fell again, from US$ 30billion in 1997, to an estimated US$ 14 billion in 1998. (World Bank, 1999a and 1999b).

Other concerns about FPEI are related to the implications of a potential increase inforeign ownership of domestic firms and the increase in systemic risk, since failure of afinancial intermediary in another country could have an impact on domestic markets. Inaddition, it might reduce the effectiveness of monitoring and supervising financialintermediaries, because of difficulties in assessing the financial status of firms that areactive in many markets.

In summary, foreign portfolio equity investments represent an important opportunityand a tough challenge for developing countries in general and Egypt in particular. Egyptneeds to encourage the more sustainable, long-term types of foreign portfolio equityinvestments and instruments, that contribute to economic growth and reduce the risks ofvolatile, unpredictable and speculative types of foreign capital flows.

Thus, the aim of this paper is to identify the most suitable types of foreign portfolioequity investors and instruments for Egypt according to their degree of volatility and thestage of development of the Egyptian stock market, and how to attract them.

The plan of the paper is as follows: Section II identifies the most common types of FPEinvestors and instruments and their likely effects on developing countries in general and onEgypt in particular. This section includes some statistical work to determine the causalrelation between foreign investors trading in the Egyptian stock market and the change inthe market price index. Section III reviews the literature on the determinants of FPEIflows to developing countries and examines Egypt’s recent economic performance, as wellas the characteristics of the Egyptian stock market, to enable us to identify the main factorsaffecting FPE flows to Egypt. This section includes a statistical description of the stockreturn in the country. Section IV proposes a set of economic policies to allow Egypt toattract sustainable and long-term types of foreign portfolio equity investments, whichshould contribute to economic growth and reduce the risks of volatility, unpredictabilityand speculation. Finally, the main conclusions of this study are presented.

II-The types of foreign portfolio equity investment investors and instruments :

The aim of this part, is to identify the most common types of FPE investors andinstruments and their likely effects in developing countries in general and in Egyptparticularly.

A.Types of investors and instruments of FPEI in developing countries:

Foreign portfolio equity investors in emerging markets, may be institutional or retailinvestors.

Institutional investors, such as mutual funds, pension funds, and insurance companiesmanage money for individuals and firms. These investors are particularly important foremerging markets, and offer fundamental advantages. They are often prepared to acceptless liquidity than retail investors, and demand high standards of management. They

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provide a potential source of large and more stable funds. Their investments are mostly inlonger-term assets.

Institutional investors provide individual investors with a low-cost method of realizinghigher returns from a more diversified international portfolio than they could get bythemselves, without having detailed knowledge of the countries and individual companiesissuing the securities. (Chuhan, P. 1994).

The process of internationalization of equity markets, has been driven by institutionalinvestors. In seven major industrial countries, institutional investors had assets close to $17trillion in 1994, compared with $5.3 trillion in 1985. The growth in the asset base ofinstitutional investors and the growing internationalization of these assets has led to arising volume of international investments. For example, total international investments bypension funds increased from $302 billion in 1989 to $790 billion in 1994, with the growthin asset base contributing to around 40% of the increase in international investments andgreater international diversification contributing around 60% of the increase. (World Bank,1997c and 1997 d).

Private foreign investors or retail investors, tend to invest directly and morespeculatively than institutional investors, in emerging stock markets. They usually chasehigh short-term returns arising from market anomalies, such as delays in price adjustment.However, they may also invest in international or domestic mutual funds that buy tradedsecurities. (Chuhan, P. 1994).

Foreign portfolio equity investment instruments in developing countries, take two mainforms:

-Equity instruments, such as: direct equity purchases in domestic stock markets, venturecapital funds, country funds, American depositary receipts and Global depositary receipts.

-Quasi-equity instruments, including: convertible bonds, and bonds with equitywarrants.

Following is a detailed analysis of the above-mentioned instruments:

A.1. Equity instruments:

A.1.1. Direct equity purchases by foreign investors in the domestic stock markets:

The acquisition of securities by foreigners, directly in the local equity market has bothits advantages and disadvantages. This type of flow contributes directly to the finance ofdomestic firms, in the market of primary issues and indirectly when shares are traded in thelocal secondary market, by pushing up equity prices and thus lowering the cost of raisingcapital. This encourages new equity issues. Also, these foreign direct equity purchasesincrease the liquidity of the local stock exchange, and enhance its efficiency, by providinghigh standards of regulations and information, required by foreigners, especiallyinstitutional investors. In addition to high quality services such as brokerage, custody andsettlement. (United Nations, 1997).

The above-mentioned benefits encouraged the progressive dismantling of barriers tocapital account mobility in developing countries. During 1991-1993, eleven developingcountries undertook full or extensive liberalization of their exchange restrictions, 23liberalized controls on foreign direct investment, 15 eased controls on portfolio inflows,

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and 5 eased restrictions on portfolio outflows. By 1998, 30 emerging markets wereclassified as free, 15 markets as relatively free, and only one market was closed to foreigninvestment. (IFC, 1999; and IMF, 1994).

The following figure summarizes the investment regulations for entering and exiting theemerging markets:

Figure (2)- Entry and Exit restrictions for foreign investors in emerging stockmarkets (1991-1998)

Source: IFC, 1996, p.7 and IFC, 1998, p.343.

Foreign direct equity purchases in developing stock markets increased rapidly, from$3.1 billion in 1990 to $34 billion in 1993. Then, they declined to $14.2 billion and $23billion in 1994 and 1995 respectively, partly in response to the Mexican financial crisis. Inthe second half of 1997, this type of flow witnessed another decline due to the East Asiancrisis. For example, in 1997, due to the Thai baht crisis and its contagion effects, fiveAsian countries- Indonesia, Malaysia, the Philippines, South Korea, and Thailand-recorded an outflow of $12 billion, which was equivalent to about 10% of their combinedGDP. (World Bank, 1997, 1999 a, and 1999b).

These figures show that direct equity purchases by foreign investors in local stockexchanges are extremely volatile. Any loss of foreign investors’ confidence, may result in quickliquidation of domestic security holdings, conversion of the proceeds into foreign currencies , andtheir repatriation. This is particularly true, when they are managed by retail investors who donot have access to the sophisticated investment methods or the extensive information andresources for research typically available to large institutional investors. (Frankel, 1997).

Moreover, information asymmetries between domestic and foreign investors, may leadto an increase in the volatility of domestic asset prices and returns. For example, adefensive reaction by local investors to the sale of domestic securities by foreigners who inturn are responding to events overseas, may magnify the impact of foreign stock marketspillover effects on the domestic market. Since local investors generally do not know whyforeigners are changing their holdings of domestic securities, they may react to suchchanges even though the fundamentals of the domestic market have not changed. (WorldBank, 1997d).

These disadvantages made many emerging markets, such as Korea , Indonesia, andChile impose some restrictions on this type of foreign investment, and encourage other lessvolatile types, particularly in their first stages of financial integration, until their domesticstock markets were more prepared to receive direct foreign portfolio equity investments.

Entry restriction for foreign investors in emerging stock markets ( 91 -98 )

3,7

48,15

14,8211,11

48,57

28,5720

2,86

57,69

28,85

11,54

1,92

010203040506070

Free Entry Relatively Restricted Closed

perc

enta

ge %

Feb-91 End 1994 End 1998

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A.1.2. Venture capital funds:

Foreign investors may provide financing and management guidance to new unquotedcompanies or high risk ventures with prospects for high growth and profitability, toparticipate in the high potential returns, particularly in the form of capital gains. Followingis a discussion of the mechanisms and structure of venture capital funds.

i-Mechanisms of venture capital funds:

The venture capital industry passes through three main stages: entry, operations anddivestment.

i-a-The entry phase: venture capital investors cannot sell out their investments (inunlisted shares) if performance is poor. Thus, these foreign investors, must assess theexpected return and when it might be realized, the investment size (because very smallinvestments are expensive to manage), and the investee company’s share in its relevantsector. Thus, venture capital needs a highly qualified fund manager.

The finance provided by a venture capital fund may be of various types:

-Start-up financing: for the setting-up of a new business, and involves investment infixed assets and working capital.

-Seed capital: for the research and development of new products or productiontechnologies before the setting up of commercial scale production.

-Expansion financing: to enter new markets, develop new products or introduceimproved technological processes.

-Replacement financing: for entrepreneurs who wish to purchase shares of theirassociates in the venture, and do not want a stock market listing.

-Special situations financing: for mature companies that can yield attractive returns,and need financing to control an existing business by a new management team,either from within or from outside the company.

i-b-The operating phase: during this phase, the venture capital fund adds value to theinvestee company by contributing its experience and contacts to business strategy,management organization and processes, and raising additional capital from otherfinancial institutions.

i-c-The divestment phase: the final and critical phase of the venture capital fund, is tomanage the divestment or exit from the investee firm, once a substantial capital gain andhigh investment returns are achieved. Exit strategies are: an initial public offering, anacquisition of the investee company by another firm, or the repurchase of the venturecapital funds’ shares by the investee firm. (IFC, 1996 and U.N.,1997).

ii-The structure of venture capital funds:

A venture capital fund may be either a single-tiered or a two-tiered fund. In theformer structure, the fund and its manager are incorporated in one entity, while in thelatter, each of them is separately incorporated. A two- tiered fund, enables investors tocontrol the managers’ performance and the fund’s strategy. It may also lowermanagement costs. (Sahlman, A., 1990).

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iii.Trends for venture capital funds:

Since the late 1980s, venture capital institutions have been established in manycountries, including several least developed countries. These funds have expanded fastestin the newly industrializing economies of Asia and in Central and Eastern Europe. By1996, the International Finance Corporation, had invested $196 million in 49 venturecapital funds. Asian and Latin American countries received 59% of these funds. In recentyears, venture capital funds were established in Morocco, Tunisia and Egypt. (IFC, 1996).

In general, venture capital portfolio investment horizon tends to be somewhat longerthan for other types of FPEI instruments, and less volatile. Thus, it seems more suitable fordeveloping countries, that need finance and managerial expertise for small and mediumenterprises, that are applying privatization programs, and that are encouraging domesticcompanies to go public. (Barry, et.al.,1990).

A.1.3. International equity investment funds: “Country funds”.

International equity investment funds are financial structures for pooling and managingthe money of multiple investors. These funds can invest on a global, regional, sub-regionalor individual country basis. (IFC,1996; United Nations, 1997).

The characteristics of country funds vary according to the structure of the fund, and theinvestor placement.

i-The structure of the fund: country funds usually fall into two types: closed-end fundsand open-end funds.

i-a-A closed-end fund is an investment fund, which issues a finite number of shares atthe time of its initial public offering, and is not required to meet redemption requests. Thus,they take a longer-term view, are able to invest in less liquid instruments and in lessdeveloped equity markets. Closed-end funds, are less likely to contribute to marketvolatility. (IFC, 1996; and IFC, 1998).

If the investment portfolio of the closed-end fund is concentrated relatively heavily inless liquid instruments in which trading activity is light, then the prices of the fund’s sharesmay vary independently of the value of the underlying portfolio of securities in which thefund invests. This, diminishes the diversification benefits from the investor’s point of view,but offers the emerging market, an insulating property when the local market in which thefund is invested is illiquid.

Closed-end funds may be either diversified or non-diversified. Diversified funds facelimits on the percentage of total assets which can be invested in a single security, whereasnon-diversified funds face no such restriction. Diversified closed-end country fundsusually pose no threat to the control of domestically owned private firms, because most ofthem limit their holdings to no more than 10 percent of a single firm’s equity. Non-diversified funds are relatively more risky, because of the potentially higher degree ofconcentration in their investment portfolio.

i-b-An open-end fund is an investment fund in which new shares can frequently beissued and in which existing shares can be redeemed on demand. These funds grow orshrink as investors invest or divest. Open-end funds, when selling a portion of their

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portfolio of securities in order to meet redemption requests, can create downward pressureon securities prices in the market, and therefore, contribute to equity price volatility.

Open-end funds tend to invest more in larger companies and in more mature equity andliquid markets. (IFC, 1998).

ii-The investor placement: It may be private or public. A country-fund could beprivately placed to a small, perhaps preselected group of investors. It may otherwise bepublicly placed by selling it through underwriters to retail or institutional investors.

Country funds offer significant benefits to investors, firms and host countries. Thefollowing figure (3), summarizes the main benefits of country funds.

Figure (3)- Country-Funds� Benefits

Recently, there has been an evolution towards specialized funds, such as : debt-equityconversion funds, and private-equity funds.

*Debt-equity conversion funds: several heavily indebted countries in Latin America andAsia, swapped external debt obligations into domestic equity. The International FinanceCorporation, advised some of these countries on legal frameworks and helped develop,

investors

Host Government Fund

Firms

Risk diversification,professionalmanagement, andeconomies of scale in

Improved access to capital,management, & to marketingand financial studies.

Foreign investors oftendemand betterinfrastructure

Refor

Prices rise andliquidity

Supply and liquidityincrease, anddemand expands

Cost of issuing

More equity isissued

Moreinstitutional

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structure and market debt equity funds. In June 1992, the only fund in the Middle East andNorth Africa region was a debt-equity conversion fund for Egypt, investing in tourismprojects. (IFC, 1996).

*Private-equity funds: These funds invest primarily in growing unlisted companies.They differ from venture capital funds in size and stage of investment. They tend to targetlarger more developed projects. The market for these private-equity funds, developed inresponse to several factors, such as privatization, increased private provision and financingin infrastructure, improvements in stock market size and liquidity that have allowed privateequity investors to sell through initial public offerings.

From 1986 to 1996, the total number of emerging markets’ international equityinvestment funds, grew from 28 to 1435, while the net value assets of these fundsincreased from US$2 billion to US$135 billion. Asian funds, accounted for about 48% ofthe total net asset value of emerging markets equity funds. In September 1996, there were298 global funds, 775 funds dedicated to Asia, 239 to Latin America, 88 to emergingEurope and 35 to Africa and the Middle East. (U.N., 1997).

A.1.4. American depositary receipts (ADRs) and Global depositary receipts (GDRs):

i-American Depositary Receipts [ADRs] are shares of a non-United States company thatare listed and traded in the United States as well as on their own country’s stock exchange.When the securities of this foreign corporation, have been deposited with a custodian bankin the country of incorporation of the issuing company, this custodian bank informs acommercial bank in the United States known as a depositary, that the ADRs can be issued.ADRs are United States dollar denominated and are traded in the same way as are thesecurities of United States companies. The holder of ADRs is entitled to the same rightsand advantages as owners of the underlying securities in the home country. (IFC, 1998).

ADRs may be unsponsored or sponsored:

i-a-Unsponsored ADRs are issued without any formal agreement between the issuingcompany and the depositary. They provide the issuing company a relatively inexpensivemethod of accessing the United States capital markets. The investor bears certain costs,including those associated with the disbursement of dividends.

i-b-Sponsored ADRs are created by a single depositary, which is appointed by theissuing company under rules provided in a deposit agreement. Sponsored ADRs, may berestricted or unrestricted:

*Restricted ADRs are privately placed, are not registered with the Securities andExchange Commission, and are exempt from its reporting requirements. Rule 144A,passed by the Securities and Exchange Commission in 1990, eased restrictions on theresale by qualified institutional buyers of private ADR issues amongst themselves oncethese issues were made under this rule.

*Unrestricted ADRs are publicly placed and traded. There are three classes ofunrestricted ADRs, each increasingly demanding in terms of reporting requirements to theSecurities and Exchange Commission, but also allowing higher visibility and making thefacility more attractive to potential investors.

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It is difficult for small capitalization companies of emerging markets to issueunrestricted ADRs, because they must meet partial or full reporting requirements of theSecurities and Exchange Commission and other specific minimum requirements withrespect to the size of total assets, earnings and /or shareholders equity. Thus, emergingmarket ADR issuers tend to be large domestic companies with considerable financialresources and high international visibility.

ii-Global Depositary Receipts [GDRs], are shares of a corporation that are publiclytraded in London, Luxembourg, or other international stock exchanges as well as the homecountry. The only difference between GDRs and ADRs is that the former can be traded inmore than one currency and within as well as outside the United States. (IFC, 1998).

Depository receipts provide benefits to the issuing company and to foreign investors,and have become the most popular portfolio equity instruments among emerging markets’firms, nowadays.

Depository receipts, facilitate the issuing company’s access to international investors inforeign markets, and enable it to attract the capital of investors who are unwilling to godirectly to the inefficient domestic markets, or are prevented from doing so by legalrestrictions (World Bank, 1997).

Depositary receipts lower the future cost of raising equity capital, by raising thecompany’s visibility and international familiarity with it. The decision to issue a depositaryreceipt is not necessarily equivalent to raising new equity capital. Firms can choose to listexisting shares in the foreign market, to gain access to a larger shareholder base, whichmay increase the value of their equity. At a future date, they may be able to raise newequity in the foreign markets. However, in countries like Chile, the firms are allowed to goto the international markets only with new issues of equity while the trading of existingshares is prohibited.

For foreign investors, depositary receipts lower the cost of trading in foreigncompanies’ securities and lower information search cost. The depositary provides bothsettlement and clearance services, thus lowering the settlement time and risk. Thedepositary provides periodic financial reports on the issuing company to the investor, whobears certain costs. (Glen and Brian, 1994).

Over the period 1990-1996, the issuance of ADRs and GDRs in international markets,increased by an average growth rate of 30 per cent. By the end of 1995, ADRs and GDRsrepresented 6% of the market capitalization of the IFC Emerging Market Investable Index.(World Bank, 1997).

In 1996, a total number of 10.7 billion depositary receipts with an overall valueequivalent to US$337 billion were traded on United States securities exchanges, and anestimated 1.5 billion depositary receipts with a value between $20 and $25 billion weretraded on European exchanges, or on the “over-the-counter” market. Nearly sixty threecountries issued depositary receipts.

A.2. Quasi-equity instruments:

A.2.1. Convertible bonds:

A convertible bond is a bond that its holder may convert into a specified number ofshares of the issuer’s stock, usually at prestated prices and at any time up to and includingthe maturity date of the bond. The holder of a convertible bond will exercise the right to

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convert the bond into stock if the value of the shares for which the bond could beexchanged exceeds the value of the bond.

Many convertible bonds include a call option, which gives the issuing company theright to redeem the bond before its maturity date. Once the call is exercised, the bondholder chooses either to convert the bond into shares or surrender it and receive in returnthe call price in cash. (Julian, W., 1997).

A.2.2. Bonds with equity warrants:

An Equity warrant, is a security that offers the owner the right to subscribe for theordinary shares of a company for a given period of time [the exercise period], and at afixed price. A warrant may sometimes be issued, bought and sold on the stock exchange, asa separate security.

The holder of a bond with equity warrant, will exercise the warrant if the price of theshares exceeds the exercise price of the warrant, to realize a net gain. (French, 1989).

Generally, the holder’s rights attached to convertible bonds and bonds with equitywarrants will be exercised in the event that the company is successful and its market valueand share price rises. If growth is not very high, the investor can retain the bond, andreceive a stable relatively safe income flow.

The interest payments on convertible bonds and bonds with equity warrants are lowerthan on straight bonds (because of the value of the right to convert and the value of thewarrant, respectively). Thus, the issuing company will be able to apply a larger amount offinancing towards expansion of the company or towards general operating expenses.

Convertible bonds have been issued since 1985. During the past ten years, theyaccounted for 93 per cent of total emerging-market issues of equity-related debtinstruments. Bonds with equity warrants were first issued in 1989 in emerging markets.

During the last ten years, a total of US$314 billion of these equity-related bonds wereissued. Only fifteen emerging markets had floated equity-related bonds in the internationalmarkets. Emerging markets, accounted for 4% of the international issues. These issueshave emanated almost exclusively from the relatively large middle-income emergingmarkets, that are well known in international capital markets. [ China, India and Pakistanare notable exceptions]. Asian issues of convertible bonds have, on average, accounted for81 per cent of all emerging-market convertible bond issues, and for 85 per cent ofemerging-market issues of bonds with equity warrants. In 1995, the share of Africa and theMiddle East in emerging markets’ issues of equity-related bonds, was 16%. (UnitedNations, 1997, annex table 21).

B-Types of foreign portfolio equity investment mechanisms in the Egyptian stockmarket:

Since the Capital Markets Law no. 95 of 1992, which came into force on April 7th 1993,foreigners have been enjoying free access to the Egyptian stock exchange, which wasregistered by the International Finance Corporation as a free market for foreign investors.(IFC, 1998).

Over the period 1991/92-1995/96, capital inflows to Egypt have been about $6 billionor over $1 billion per annum. (Subramanian, 1997).

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In 1993/94, Egypt started receiving portfolio flows by small amounts. In 1996/97, Egyptwitnessed a surge in foreign portfolio investment, reaching their peak level of around $1.5billion. (Central Bank of Egypt, Annual Report, 1996/97, and Monthly Statistical Bulletin,vol.39, no. 3, 1998/99).

The following table shows the value of net foreign portfolio investment flows to Egypt,during the last six years.

Table (1)- Net Foreign Portfolio Investment in Egypt [1993/94-1998/99] In US$ million

Fiscal Year Net value of FPI FPI as a % of market capitalization.

1993/94 1.3 0.03

1994/95 4.1 0.06

1995/96 257.6 2.30

1996/97 1462.9 8.30

1997/98 -248.0 -1.10

1998/99* -197.2 -0.70 * first quarter of 1999. Sources: 1-Central Bank of Egypt, Monthly Bulletin, various issues. 2- Egyptian Ministry of Economy, Monthly Bulletin, various issues.

In 1997/98, portfolio investment witnessed a net outflow of $248 million, as theEgyptian stock market trended downwards. This was mainly a result of eight majornegative events that damaged local and foreign investors’ confidence. Seven of theseevents were mainly domestic factors.

-The government of Egypt announced that it would rescind the tax breaks allowed onthe revenue generated from treasury bills, and subsequently delayed in issuing theexecutive regulations of the new income tax law 5/1998.

-The privatization process slowed pace such that only three companies were privatizedin 1998.

-Investors feared that new public offerings of public-sector companies would probablybe very highly evaluated.

-Investors faced difficulties in tracking companies’ performance, as very few companiesprovided quarterly financial reports.

-The Commercial International Bank planned to distribute its shares among itsemployees and management.

-Cases of insider trading were reported.

-Transparency issues and the poorly executed sale of Egypt’s two mobile phonecompanies, had a negative impact.

-Global market conditions were unfavorable, due to the ongoing financial crisis in Asia.(IBTCI, June 1998).

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Foreign portfolio investment flows to Egypt seem to be very volatile, and merit aninvestigation of their main types in the Egyptian stock market and their likely effects.

The main instruments of foreign portfolio equity investment in Egypt are, direct equitypurchases by foreign investors in the Egyptian stock markets, international equityinvestment funds (country funds), and global depositary receipts. (see figure (4)).

Source: own calculations.

B.1. Direct FPEI in the Egyptian Stock Exchange:

In the Egyptian stock market, there are no restrictions on foreign trading. There is noceiling on foreign ownership for companies established under Law no. 159 for 1981 asamended by Law no.3 for 1998. In addition, it is no longer required that the majority ofboard members be Egyptians.

Capital gains taxes and taxes on dividends, were eliminated. There are no taxes on therepatriation of profits and foreigners are allowed to repatriate profits at any time. (EgyptianMinistry of Economy, 1998).

Foreign securities companies are allowed to operate in Egypt and face the samelicensing procedures as domestic firms. Branch offices of fund management firms that arenot incorporated in Egypt are allowed to operate without any special license. Foreignbrokerages are not required to use local brokerages for the buying and selling of shares.(EFG- Hermes, 1999).

According to the Egyptian Capital Market Authority (CMA) published data, directforeign trading was not registered before 1996.

Although the highest share of foreign investors in the capitalization of Egypt’s stockmarket, was about 8% only in 1996/97, their share in the number of transactions, in tradedshares, and in the value traded was very large, and increasing. [see table (2)]. In otheremerging markets, foreigners’ shares in market capitalization and in trading, are relativelyproportionate. For example, in 1995, these shares in Korea, were 13%, and 6%,respectively, and in Thailand they were 21% and 26%. (World Bank, 1997d).

Types of foreign portfolio equity investment instruments in egypt in 1996

foreignres value traded

67 %GDRs20 %

country funds13 %

foreignres value traded GDRs country funds

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Table (2)- The share of foreigners, trading in the Egyptian stock market during theperiod from 1996- September 1999. [%]

YearShare in the

number oftransactions

Share in thenumber oftraded shares

Share inthe valuetraded

1996* 7.3 19.7 22.4

1997* 8.5 23.6 23.5

1998** 18.2 40.2 44.5

9/ 99** 24.16 45.5 41.1

Sources: [*] - IBTCI, 1998, June, p. 91-95. [**]- Cairo and Alexandria Stock Exchange Monthly Bulletin, vol. 1, no. 3, October 1989, p. 13. -Capital Market Authority, unpublished data for 1999.

Since foreigners’ share in capitalization is low compared to their share in value traded,then foreign investments’ turnover is very high. This means that foreigners are mainlyinterested in short-term transactions, which may encourage destabilizing pricespeculations, and adversely affect the market price level. For example, in July 1998,foreigners’ share in the value traded reached nearly 64%, selling transactions represented44.6% of it. This caused a further decline in prices. (IBTCI, June, 1998).

Foreign investors are usually more experienced than local investors, and may play animportant role in directing the market price. A foreign investor trades an average of 564shares per transaction, while the average number of shares in a transaction by an Egyptianinvestor is 117. Thus, the average number of traded shares in a transaction by a foreigninvestor, is 4.8 times higher than that of an Egyptian investor. The average value per tradedshare by a foreigner is L.E. 85, while that of an Egyptian is L.E. 56. (IBTCI, June 1998).

These speculative transactions, induced Hendi et.al., 1999, to investigate the relationbetween foreign trading and changes in the stock market price index using regressionanalysis. They found a significant relation between the size of foreign investors’transactions and the index of the Egyptian market. The coefficient of determination was0.38, and therefore they concluded that foreign investors play an effective role indetermining the market price.

However, a significant regression coefficient between the size of foreign investors’transactions and the index of the Egyptian market, does not help in identifying thedirection of the relation between these two variables.

In order to investigate whether there is a causal relationship between the value of sharestraded by foreigners and the change in the price index, and the direction of this relation, weemployed Granger causality test. (Granger, 1969).

The value of shares traded by foreigners was used as an indicator of foreigners’ size inthe Egyptian stock market. (VSTF). Changes in two indexes for the Egyptian stock marketprice, were employed. First, the publicly traded securities index (PTSI), because foreignerstrade in publicly listed companies, only. Second, the IFCG index (IFCG), as it includes themost active companies, which foreigners are very much aware of. (about 60 companies).Monthly data was used for the period 1996- third quarter of 1999. Statistical

15

tests for the stationarity and cointegration of the series, were run. Our series (VSTF),(PTSI) and (IFCG), are not co-integrated. [The series (VSTF) is stationary at differenceone with 99% confidence level. Changes in the two market price indexes are stationary atthe level, with 99% level of confidence].

The results summarized in table (3), show that trading by foreigners in the Egyptianstock market (VSTF), causes changes in each of the two market price indexes, (PTSI), and(IFCG).

Thus, foreign investors’ direct trading has an effect on the Egyptian stock market priceindexes. This result seems consistent with our previous analysis of this type of flows whichemphasized its potential negative effect on the volatility of domestic asset prices and returns.

Table ( 3)- Results of Granger causality test: (1996- 9/1999)

Null hypothesis F-statistic Probability IFCG VSTF

0.771 0.385

VSTFIFCG

3.4 0.07

PTSI VSTF

2.4 0.12

VSTFPTSI

3.01 0.09

Notes: * ( ), means no causal relationship. *(A change in an index is calculated as Log Pt/P t-1, where Pt and P t-1 represent the index in time t and t-1, respectively).

B.2. Egypt’s country funds:

Egypt has seven offshore funds, that are listed in London, Dublin, Luxembourg andSaudi Arabia. Five of these funds are closed-ended. Their aggregate issue value isapproximately $ 414.3 million. These are few funds, if compared with other emergingmarkets, and considering their potential advantages that were previously mentioned. In1996, international funds for China, Korea, and Brazil, were 108, 94, and 53 respectively,with total net assets $6680, $5150 and $1497 million. [United Nations, 1997, p. 284].

The establishment of more country funds, and other specialized funds such as private-equity funds, should be encouraged. Transparency and improvements in disclosure andaccounting standards will encourage foreigners to invest in Egyptian companies’ equities.

16

Table ( 4 )- Country funds investing primarily in Egyptian securities

FundStarting

date ofoperation.

Size inUS$ million

Nominal value percertificate L.E.

FundType

FundManager

Egypt Fund(Dublin) 8/96 43 9.98-10 Capital

growth Hermes

EgyptGrowth Inv.(London)

6/96 46 10Capital

growthclosed-ended

Concord

EgyptInvestment(London)

1/97 91 10.25Capital

growthclosed-ended

Concord

Egypt Trust(London) 9/96 74 10

Capitalgrowthclosed-ended

Lazard

Faisal Fund(Dublin) 3/98 15 10

Capitalgrowth open-ended

Hermes

NileGrowth(Luxembourg)

6/97 130 10.30Capital

growthclosed-end

CIIC

Rajhi Egypt(Saudi Arabia) 5/97 15.3 100 Capital

growth Hermes

Source: IBTCI, September 1997, p.16. EFG-Hermes, 1999, p. 63.

B.3. Egyptian global depositary receipts:

Since mid-1996, Egypt started to issue global depositary receipts [GDRs]. IssuingGDRs enables the Egyptian government to offer a large number of public companies’shares, and attract foreign investors, especially that the size of the local market is relativelysmall.

During 1996- July 1999, eight Egyptian companies issued GDRs, as shown in table (5),below. Egypt’s GDRs issues represent four sectors- financial, industrial, chemical, andfood and beverage-out of 20 sectors classified by the Egyptian Stock Exchange. The eightissuers represent almost 10% of total market capitalization of the Egyptian Stock Market.(Ministry of Economy and Foreign Trade, 1999, p. 6).

Global depositary receipts may have a positive effect on the efficiency of the domesticstock market price. When shares’ price increases in the Egyptian stock market, GDRs maybe converted into local shares. This arbitrage process, may be beneficial to the companythat issues GDRs, by reducing the volatility of its shares’ price in the local market. (seeHendi et al., 1999).

As shown in the last column of table (5), the GDRs’ outstanding balance for five out ofeight Egyptian GDRs issuing companies, was negative, as of end June 1999. This meansthat some of these five companies’ GDRs, were converted into local shares, implying that

17

these companies shares’ price in the Egyptian stock market was higher than their GDRs’prices.

Table (5)- The Egyptian GDRs issues

Company Sector Date of Offering

Volumeon offeringdate inmillion GDRs[1]

Volumein 30/6/99 inmillion GDRs[2]

Netbalance ([2]- [1] in30/6/99

CommercialInvestment Bank[CIB]

Financial July 1996 9.9 7.9 -2.0 *

Suez Cement Cement July 1996 7.3 5.7 -1.6 *

Al-AhramBeverages

Food &beverages

February 1997 8.0 7.2 -0.8 *

Al-AhramBeverages

Food &beverages

January 1999 n.a. n.a. n.a.

Paints andChemicals[PACHIN].

Chemical October 1997 6.3 3.0 -3.3 *

MisrInternationalBank [MIB].

Financial April 1998 6.5 5.3 -1.2 *

EFG-Herms. Financial August 1998 4.8 5.4 0.6 **

Al-Ezz SteelRebars.

Industrial June 1999 0.5 0.5 0.0

Lakah Group Industrial July 1999 35.0 n.a. n.a.

Notes: N.A. = not available. * = a negative balance, means converting GDRs into local shares. ** = a positive balance, means converting local shares into GDRs.

Sources: 1-Capital Market Authority, the public department for information. 2- Cairo & Alex. stock exchange monthly bulletin, 31/7/1999. 3- Egyptian Ministry of Economy, 1999.

In July 1998, the Egyptian Ministry of Economy constructed an index, aiming atproviding an overview on Egypt’s GDRs trend and performance, the price changes ofGDRs resulting from various emerging market disturbances and foreign investors’responses toward information, especially timely local information. The index includes fiveGDRs, and its base period is October 1st 1997. (see: Ministry of Economy and ForeignTrade, 1999).

The Egyptian GDRs index level, fell insignificantly by 2.48% over the year 1999. InJanuary 1999, the index witnessed an increase of almost 25%, as the US dollar depreciatedagainst the newly issued Euro currency. However, the index fell by 9.3% in March, due tothe dollar shortage facing the country. It experienced a further decline of 9%, in May andJune as a result of increasing fears in the international markets concerning the possibilitythat the Federal Reserve would increase the interest rate.

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Egyptian companies should be encouraged to issue GDRs, especially that the value ofthe Egyptian market international issues in 1996 was $ 233 million only. This value is verysmall, compared to other developing countries. {In 1996, the value of international issuesfor India was $1.340 billion, for China was $1.3 billion, and for Indonesia was $1.237billion} (World Bank, 1997).

III- The Determinants of Foreign Portfolio Equity Flows to Egypt:In this part, the central issue is to identify the main factors that are internal to Egypt, and

affecting foreign portfolio equity investment in the country. The assessment of thesedeterminants is important because successful domestic policies, are the key to ensuringsustainable, long-term FPE investors and instruments that contribute to economic growth;and to discouraging the highly volatile types, even if external conditions turn around.(Helmy, 1997).

A review of the literature on the determinants of foreign portfolio equity flows todeveloping countries, an examination of Egypt’s recent economic performance and of thecharacteristics of the Egyptian stock market, will enable us to identify the main factors thataffected these flows to Egypt.

A-Review of the literature on determinants of foreign portfolio equity flows todeveloping countries:

The surge in private capital flows to developing countries since the early 1990s hascoincided with a period of low international interest rates and a period of domestic policyreform in many developing countries. Thus, there has been considerable debate in therecent literature, on whether this surge was driven in large part by cyclical factors in theinternational economy or was a result of longer-term structural changes. (Hernandez andRudolph, 1995; Fernandez-Arias, 1996; Fernandez-Arias and Montiel, 1995).

The debate has been about the relative importance of “push” factors (factors in theglobal economy, that are external to the economies receiving the flow, such as the declinein international interest rates, and the slowdown of the economic activity in industrialcountries, in the early 1990s), and “pull’ factors (factors that are internal to the recipienteconomies, such as improved domestic policies and sustained high growth performance inthem). (see, for example, Calvo et al., 1993; Claessens, 1995; Claessens, Dooley, andWarner, 1995; Chuhan, Claessens, and Mamingi, 1993; Fernandez-Arias, 1996; Dooley,Fernandez-Arias and Kletzer, 1996).

In order to identify the main push and pull factors that have stimulated FPEI flows, todeveloping countries in general and Egypt in particular, the available studies on thedeterminants of these flows to Latin American and East Asian countries were examined.(see appendix (1), for the summary findings of these studies).

A survey of the main external “push” factors and internal “pull” factors, will bepresented below.

A.1. External factors:

The major factors behind the increase in FPEI flows to emerging markets are theliberalization and globalization of financial markets, and the concentration of substantialfinancial resources in the hands of institutional investors. Also, the role of foreign interest

19

rates, as a push factor driving capital flows and determining their magnitude is wellestablished by the empirical work undertaken on this issue.

A.1.1. The regulatory environment:

Financial-market liberalization, the major advances in financial instruments, and therapid flow of market information, due to the improvements in communications technology,facilitated the globalization of financial markets, which implies that financial capital canmove more freely and at lower cost between countries.

Regulatory changes in major creditor countries made it easier for developing countries’firms to place their equity under more attractive conditions to investors. For example, theUSA Securities and Exchange Commission adopted Rule 144A in 1990, which permitsholders of shares in non-USA firms purchased in private placement, to sell them freely toqualified institutional buyers under certain conditions without being subject to a two-yearholding period. Also, Regulation S in the USA, eliminated settlement delays, andfacilitated registration and the payment of dividends. [El-Erian,1992; Goldstein, 1995).

A.1.2. International diversification of investments:

International investors, who are willing to reduce their risks and diversify theirportfolios, consider investing in emerging markets because the correlation between equityreturns from different countries is lower than that between equity returns in the samecountry. This is especially true for investments in developing countries, because their stockreturns tend to have a low correlation with those of industrial countries (Bekaert, 1995).

A.1.3. Low interest rates and recession in many developed countries:

Available empirical studies suggest that foreign investors initially turned to emergingmarkets largely because of the decline in global interest rates and the slow down ineconomic activity in industrial countries, in the early 1990s.

The period 1989-1993, was a slow-growth period in the industrial world as a whole.The rate of growth of real GDP for the G-7 countries, as a group averaged 2.8% in 1989-1990 and 1.1% in 1991-1993. USA’s real GDP grew by only 1.2% in 1990 and declined by0.6% in 1991 (Fernandez-Arias and Montiel, 1995).

Taking the industrial countries as a group, the weighted aggregate short-term interestrate, fell from over 9% in 1990 to a little over 5% in 1993. Long-term interest rates in theG-10 countries, declined (on a weighted average basis) from about 9.5 percent in 1990 to6.5 percent in 1993. In the USA, short-term nominal interest rates peaked at 9.1% in 1989,and had fallen to 3.2 % by 1993. Long-term rates also fell dramatically, by roughly half(Fernandez-Arias and Montiel, 1995, Goldstein, 1995; Calvo, 1993).

Other things equal, lower interest rates in creditor countries, make investing in them lessattractive at the margin than investing abroad, (the asset substitution effect/channel); andappear to have improved the creditworthiness of heavily indebted countries that borrow atthese rates, (the creditworthiness effect). (Goldstein, 1995).

FPEI flows in emerging markets were found to exhibit a strong negative associationwith interest rates in developed countries. On an annual basis over the period 1986-1995,the correlation coefficients between United States interest rates on Treasury bills and FPEIflows: to all emerging markets, to Asia, and to Latin America were, respectively -0.7, -0.6and –0.8. These coefficients were statistically significant and indicated that FPEI flows to

20

emerging markets were heavily influenced by developments in United States financialmarkets. (Burki, et al., 1997; Schadler, 1994).

A.2. Internal Factors:

Some studies observed that the timing of the external factors, did not coincide with thesurge of private capital inflows in each recipient country. For example, Thailand andMalaysia, started receiving inflows as early as 1988 or 1989, respectively, while thePhilippines and Peru, received them in 1992 or 1993, respectively. Furthermore, between1989-1994, over 80% of private capital inflows went to a score of countries. This unevengeographical distribution of private capital flows, among regions and between developingcountries within those regions, suggests that country-specific factors have played animportant role in determining the size and composition of private capital flows todeveloping countries.

Thus, the “pull” view holds that, inflows are attracted to the recipient countries mainlybecause of the fundamental economic reforms they have taken immediately preceding theinflow episode including the restructuring of their external debts and privatization efforts.

(Schadler et.al., (1993); Schadler (1994); Gooptu, S., (1994); (1994); Bekaert, (1995);Fernandez-Arias, and Montiel, (1995).

A.2.1. Policy performance in the host countries:

Since the mid-1980s, several developing countries have embarked on stabilization andstructural reform programs. For example, Bolivia, Chile and Mexico, implemented majordisinflation programs prior to the surge in capital inflows.

In several cases, fiscal adjustment (reductions in the share of government expenditure inoutput as well as lower budget deficits) played a key stabilizing role and was instrumentalin attracting capital flows. Improved fiscal balances helped to lower inflationaryexpectations and conveyed a signal regarding the policymakers’ commitment to achieveand maintain macroeconomic stability. In countries like Argentina, Thailand, Mexico andChile, significant reductions in fiscal deficits preceded the surge in capital inflows. (Corboand Hernandez, 1996; Fernandez-Arias and Montiel, 1995).

The rate of economic growth; as well as the potential rate of growth of the host countryis an important influence on decisions on where to invest. The distribution of FPEI isskewed towards upper-middle income and large low-income countries with a high growthpotential.

Foreign portfolio investments are extremely sensitive to a country’s openness. The rightto repatriate dividends and capital may be the most important factor in attractingsignificant foreign equity flows. In Korea, the surge coincided mostly with faster financialliberalization, particularly a shift to allowing foreigners to acquire domestic stocks andbonds. (Goldstein, Mathieson, and Lane, 1991; Schadler, 1994; Lee, 1997).

Many developing countries increased openness of their markets, through the loweringof barriers to trade and foreign investment, the liberalization of domestic financial marketsand removal of restrictions on capital movements.

Foreign investor involvement in developing countries, [Argentina, Chile, Hungary,Indonesia, Malaysia, Mexico, and the Philippines], has been further boosted by theprivatization of state-owned enterprises. Of the $112 billion of privatization proceeds that

21

developing countries received during 1988-1994, almost 42% were from foreign investors.Thus, privatization programs offered foreign investors an opportunity to gain a stake insome of the host countries’ firms (World Bank, 1977).

A.2.2. Improved relations between heavily indebted countries and external creditors:

Credit ratings and secondary-market prices of sovereign debt, reflect the opportunitiesand risks of investing in the country, and are important in determining capital flows aswell.

Capital flowed initially to the rapidly growing countries in East Asia that never suffereda debt crisis.

Many heavily indebted countries in Latin America, made significant progress towardsimproving relations with external creditors and restoring their creditworthiness. Therestructuring of the commercial bank debt of these countries in the context of officially-supported “Brady-type” initiatives, improved their debt indicators, and secondary marketprices of bank debt, over the 1989-1993 period. (Cline,1995); and Dooley et.al., 1994).

By 1994, eleven developing countries had established an investment grade credit ratingfrom one of the two major international credit-rating agencies (Moody’s and Standard andPoors). (Mathieson and Rojas-Suarez, (1992); Chuhan, Claessens, and Mamingi, (1993);World Bank, 1994, and 1997; Bekaert, 1995].

A.2.3. The growing maturity of the market for developing countries’ securities:

Flows of FPEI are intimately linked to the development of stock markets in recipientcountries, and to the range of instruments available to foreign investors who wish topurchase developing countries’ equities. For example, many venture-capital fundinvestments in unquoted companies are made with the expectation of reaping capital gainssubsequent to the listing of such companies on the stock market once they become mature.Also some country funds are set up in anticipation of the establishment of a local stockmarket.

The broadening and deepening of developing countries’ securities, and the increase intheir market accessibility, have offered investors significant opportunities for riskdiversification (World Bank, 1997).

During 1988-93, foreign investors were attracted to emerging equity markets whosereturns tended to be higher than those in industrial countries. For example, during thatperiod, the annual U.S. dollar rate of return according to the IFC composite index for LatinAmerica was 38.8 percent, while the U.S. Standards and Poor was 14.4 percent.(Claessens, 1995).

However, over the period 1992-97, U.S. mutual funds investing in developing countrystock markets have earned average annual returns of 8 percent while funds investing in theUnited States and Europe have earned 19 percent. Risks were also relatively high inemerging markets. The standard deviation of the return on funds was 22 percent foremerging markets and 13 percent for U.S. and European funds. The risk-adjusted return asmeasured by the Sharpe ratio was 0.2 for funds investing in emerging markets, much lowerthan the 1.1 ratio for funds investing in the United States. (World Bank, 1998).

Despite the lower returns and higher risk of emerging markets over these five years,foreign investors will probably continue to be attracted to these markets. Returns in those

22

emerging markets may exceed returns in industrial countries over the medium term asoutput in developing countries is expected to rise significantly faster than in industrialcountries, and as differences in patterns of population growth are likely to widen thedifferential in expected rates of return on capital between industrial and developingcountries. Moreover these returns are not highly correlated. (World Bank, 1998).

The degree of market liquidity is also a crucial element in the decision to invest inemerging markets. In this respect, an adequate market infrastructure and the availability ofexit mechanisms through stock exchanges, contribute to greater liquidity. Liquidity hasincreased in emerging markets as total trading values in the secondary market fordeveloping countries’ instruments exceeded $790 billion, and $1 trillion in 1992 and 1993,respectively (Goldstein et.al.,1994; and Goldestein, 1995).

Improving accounting and disclosure standards in host countries and greater availabilityof market research on emerging markets has made foreign investors less reluctant than theyused to be to send capital to developing countries, when the opportunities are viewed asfavorable.

A.2.4. Contagion effects:

Contagion effect, may arise because investors decide to temporarily withdraw from acountry (or a group of countries) in order to re-evaluate risks and returns following a crisisin a neighboring country. (Goldstein, 1995, Calvo et al., 1996).

Thus, a great shift in capital flows to one or two large countries in a region, maygenerate externalities for the smaller neighboring countries.

Some studies have found that correlation of equity price movements across countries, isgreater during times of turbulence than in normal times. (Goldstein, 1994).

The conclusion to draw from existing evidence in the literature surveyed above, is that,both external (push) and internal (pull) factors that influence private capital flows in acountry may be interrelated, and both play a role in attracting capital inflows. However,their relative importance is still unclear. [1-g, Fernandez-Arias, (1994)].

The previous review of the literature, enabled us to determine both the push and pullfactors. Following is an investigation of the Egyptian country specific factors that affectforeign portfolio equity investment.

B. Egypt’s recent economic performance:

Since 1991, Egypt has embarked on an economic reform and structural adjustmentprogram. The aim was to restore macroeconomic stability, restructure the economy andenable it to face the challenge of global integration of production, trade and financialmarkets.

Egypt’s stabilization policies have been highly successful. Inflation declined from anaverage of 20 percent over 1989-92 to 3.8 percent in 1997/98. Real output growth, rose to5.7 percent in 1997 /98, up from 0.3 and 0.5 percent in the first two years of thestabilization. Fiscal deficit was brought down from over 15 percent in 1990/91 to 1.3percent of GDP in 1998/99. The current account’s deficit improved from about 5 percentof GDP to 1.9 percent in 1998/99.

Egypt has implemented various other reforms that will be discussed below:

B.1. Financial liberalization:

23

In January 1991, interest rates on pound deposits and loans were liberalized, andtreasury bill auctions were introduced. In October 1992 and July 1993, lending limits to theprivate and public sectors were eliminated, respectively. Financial liberalization wassupported by a series of other reforms to strengthen the solvency and efficiency of thebanking and securities markets. (for details see: World Bank, 1996; and Central Bank ofEgypt).

B.2. Exchange rate policy and free capital mobility:

In October 1991, Egypt unified the exchange rate system and its’ exchange rate hasbecome fully convertible. Since then, the nominal exchange rate of the Egyptian poundwith respect to the American dollar has been roughly constant, as a result of heavyintervention by the central bank. This, in turn, eliminated foreign-exchange risk. In 1994,capital transactions in the balance of payments were also liberalized with the ForeignExchange Law no. 38. Most banks were authorized to deal in foreign currency and foreignbanks were allowed to deal in local currency. Currency transfers across borders byauthorized banks were no longer restricted, thereby allowing complete international capitalmobility. (Central Bank of Egypt, Annual Reports; IMF, 1997; and World Bank, 1996).

Thus, free capital mobility, nominal exchange-rate anchor, together with financialliberalization, led to large capital inflows, and the accumulation of foreign exchangereserves. Also, the deceleration of inflation, the fiscal adjustment, the stable nominalexchange rate, the large capital inflows and foreign exchange reserves, have encouragedthe rapid pace of dedollarization from almost 50 percent of the broad money supply in1990/91 to about 18 percent in 1998.

B.3. The privatization program:

In 1991, the government adopted Public Sector Law no. 203, for the privatization of 314state owned enterprises. Over the period 1993-1997, Egypt has been rated as the fourthmost successful privatization program in the world. Proceeds from the privatizationprogram as of 1998 amounted to LE 7.8 billion. (IMF, 1998, and Egyptian Ministry ofEconomy, 1999).

From April to September 1996, the privatization program progressed quickly. Themajority share of nineteen companies was sold, with eighteen of them through the stockexchange. In 1997, another thirteen companies were sold. (IBTCI, 1999). Out of theoriginal portfolio of 314 public sector companies, by the end of 1998, the government hadsold controlling interests in 99 of these companies and minority interests in another 20. Ofthe total, 31 companies were offered for sale between July-December 1998 with a totalvalue of LE 4.6 billion. (EFG- Hermes, 1999).

Banking Laws no. 37 of 1992, and no. 101 of 1993, and their amendments adopted in1996 and 1998, allowed joint venture banks to be 100% foreign-owned, and state-ownedbanks to be privatized.

B.4. Trade liberalization:

The government has removed almost all non-tariff barriers. It has reduced the range ofimport tariffs to 5 to 40 percent, while tariff preferences and exceptions to the maximumtariff have largely been eliminated. Tariffs on nearly all capital goods have been removed.The remaining few restrictions on exports have been abolished. (EIU, 1997).

24

B.5. Improvements in Egypt’s creditworthiness:

After the Gulf War, Egypt received $7 billion in debt forgiveness from Gulf ArabStates. The Paris Club agreed to reschedule $27 billion in official and governmentguaranteed debt. As a result of this debt forgiveness and restructuring, and the tight fiscalpolicies, the gross external debt amounted to slightly less than $ 30 billion or 36% of GDPat the end of December 1998. Debt service currently averages $1.7 billion per year or 11%of exports of goods and services. Total public and private short-term debt, amounting to$1.8 billion is only 6% of the overall debt and 2% of GDP. Medium and long-term privatesector debt remains negligible at less than $ 300 million. The Ministry of the Economycalculated the net present value of the gross debt to be $18.7 billion as of 1997. At thislevel, Egypt’s external obligations are substantially inferior to its total foreign reserves andthe net foreign assets of the banking system. Consequently, in present value terms, Egypt isa net creditor to the world (EFG- Hermes, 1999; and Subramanian, 1997).

All of the above-mentioned reforms have led to improvements in Egypt’screditworthiness risks, declines in investment risk, and increases in expected rates ofreturn.

The following table reflects the sovereign rating for Egypt, according to someinternational rating agencies (Standard and Poors, and Fitch IBCA).

Table (6)- Sovereign rating for EgyptLocal Currency Foreign currency

Long-termrating.

Outlook Short-term rating

Long-termrating.

Outlook Short-termrating

Standard& Poor.

A- Stable A-1 BBB- Stable A-3

FitchIBCA.

A- Stable n.a. BBB- Stable F3*

Notes: 1- F3*: fair credit quality. The capacity for timely payment of financial commitments isadequate; however, near-term adverse changes could result in a reduction to non-investment grade. 2-n.a.: not available.

Source: Egyptian Ministry of Economy and Foreign Trade, unpublished data.

C. Characteristics of the Egyptian stock market:

International investors’ decision to invest in an emerging market is affected by someimportant albeit, indirect factors that may limit foreigners’ access to the local stock market(Bekaert, G., 1995). The Egyptian stock market’s infrastructure, size and liquidity, andreturn characteristics will be analyzed, and the main indirect barriers confronting foreigninvestors will be investigated.

The Egyptian government has been fostering the revitalization and development of itscapital markets over the past decade. The Capital Markets Law no. 95 of 1992, which cameinto force on April 7th 1993, restructured the securities and bond markets. It provided theframework for the establishment of capital market service companies including securities

25

brokerages, mutual funds, portfolio managers, underwriting institutions and venture capitalcompanies. The legislation facilitated the issuing of corporate bonds, and encouraged theformation of a debt market. (Capital Market Authority, 1996 and EFG-Hermes, 1999).

The share of financial assets accounted for by the banking system declined from 67percent in 1992 to 58 percent in 1996. This may reflect the growing importance of capitalmarkets. (Subramanian, 1997; EFG-Hermes, 1999).

C.1. Market infrastructure:

Foreign investors- especially those who decide to invest directly in the local stockexchange- are very much concerned about the market’s operational framework.

The most important processes that affect the liquidity and efficiency of the market, are:the listing requirements, the trading, clearance and settlement, and central depositarysystems, the financial disclosure and accounting standards, and the availability ofprotection for investors.

C.1.1. Listing requirements:

Securities of joint stock companies must be registered in Cairo or Alexandria stockexchanges, either in the official or unofficial register. The official register includescompanies with no less than 150 shareholders and in which at least 30% of the nominalcapital has been floated publicly. It also includes Law 203 companies, which haveundergone a public issue of shares regardless of the free-float percentage. Also, a companymust be publishing its balance sheets for at least twelve months, before being listed in theofficial register.

Securities, which do not fulfill the above criteria, and newly established firms areincluded in the unofficial register, as are foreign securities. [Egyptian Ministry ofEconomy, 1998, The Law of Business].

Table (7)- Companies listed in both the official and unofficial registers,at 13/7/ .1999‏

Listing Type Number of companiesOfficial 137Unofficial 838Total 975

Source: Cairo and Alexandria Stock Exchanges Monthly Bulletin, July 1999.

The listing requirement system in Egypt has two main weaknesses:

i- As can be seen from the previous table, the majority of the companies are beingregistered in the unofficial list, mainly because the Capital Market Authority allows closedcompanies to be registered in the stock exchange, thus enabling them to affect the liquidityof the market.

ii- The Egyptian listing requirement system has no restrictions concerning theprofitability and size of the company being listed in the stock exchange. Thus, the systemdoes not guarantee the financial health of the listed companies and may adversely affectinvestors’ confidence.

26

In most other emerging markets, only public offering companies are allowed to beregistered in the stock exchange and they are usually organized in various sectionsaccording to the companies’ profitability [see appendix (2)].

To enhance the efficiency and liquidity of the Egyptian stock market, it should beorganized in more than one section, with each section differing in its listing requirementssuch as the percentage of the company’s shares publicly offered, the company’s size,performance and profitability.

C.1.2. Trading system and the related subsystems:

According to the Egyptian law, shares listed in Cairo and Alexandria stock exchangesare to be sold only through licensed brokers. The number of brokerage firms has increasedfrom 2 companies in 1992, to 152 in 1999( CMA, 1999). Brokerage firms must adhere tothe capital adequacy requirements, according to the type of business in which they areengaged. (CMA, 1996).

As of April 1999, an integrated computerized trading system links Cairo and AlexandriaStock Exchanges and all independent bookkeeping activities to the Central Depository andallows for automatic electronic matching of bids and offers. This has resulted in greaterspeed and efficiency in the settlement process.

C.1.3. Clearance, Settlement and Central depository system:

Egypt has been able to gradually improve its clearance, settlement, and depositorysystems, moving towards international norms. In October 1996, Misr for Clearance,Settlement and Depositary, [MCSD], was the first company to be established in Egypt toprovide greater efficiency in the settlement of transactions, according to the delivery versuspayment principle.

Egypt uses the rolling settlement system, by which trades are scheduled for settlement acertain number of days after execution. Settlement is completed at T+4.

This improvement in the clearing and settlement system is a positive indicator forforeign investors, as it leads to more efficiency, transparency and liquidity of the market,and helps in eliminating forgeries.

However, the settlement period in Egypt is still relatively long compared to otheremerging markets, as can be seen from the following table.

Table (8)- Clearance and settlement period in selected emerging markets

Country Egypt* Kuwait * SaudiArabia*

Bahrain*

Jordan*

Lebanon*

Brazil**

Chile**

Argentina**

Korea**

Period T+4 T+0 T+1 T+3 T+3 T+3 T+1 T+3 T+3 T+2Source: * Data base for Arab Capital Markets, April 1997. ** http.www.emgmkts.com.

The number of companies with immobilized shares listed with [MSCD], increased from84 in May 1998, to 143 in February 1999. As of April 1999, 158 securities were beingtraded through MCSD, including nearly 75% of all actively traded shares. (IBTCI, March1999; EFG-Hermes, 1999).

A transition period is needed until all companies and securities become listed withMSCD.

27

C.1.4. Financial Disclosure and Accounting Standards:

The efficiency of the domestic stock market and its integration with international capitalmarkets, demand transparency to be enhanced and information to be prepared according tointernational standards.

All Egyptian listed companies are required to publish audited quarterly financialstatements adhering to internationally accepted accounting practices. Fully auditedfinancial statements and the report of the board must be produced within three months ofthe end of the fiscal year, made available to shareholders, and published in two dailywidely distributed newspapers. Companies are also required to make timely disclosure ofall news that may affect their business and earnings (Egyptian Ministry of Economy,1999)

Companies that do not comply with the disclosure requirements are to be delisted, afterthree months notification. (CMA, 1996). However, as the CMA has not executed this legalright to date, only one tenth of all listed companies do publish their financial statementsregularly and no more than 50 percent of them send their quarterly financial statements tothe Capital Market Authority. (Al Borsa Magazine, August 1999).

It seems that disciplinary measures should be strictly applied against the companies thatfail in making the required disclosure.

C.1.5. Investor protection fund:

Most emerging markets protect investors, by supervising the settlement system toincrease the confidence in the market. Until end of June 1999 there were no proceduresconcerning investors’ protection from losses arising from negligence, error or malfeasance.As of July 1st, 1999, the Capital Market Authority (CMA) established a compensation fundto protect local and foreign investors against potential settlement risk. All securities servicecompanies are required to carry insurance for these potential losses and all companiesdeposit fidelity guarantee money with the MCSD, to enable it to open an independentaccount for a compensation fund, whose resources may be used to help fulfill theobligations of a member, who is involved in a troublesome transaction but this fund has notstarted working yet . (Al Borsa magazine, no. 163, August 1999).

The (CMA), has created an Arbitration Board to address complaints and legal disputesraised by investors

C.2. The size and liquidity of the Egyptian stock market (ESM):

Foreign investors, especially institutional investors, are attracted to larger and moreliquid stock markets.

C.2.1.The size of the market:

Various indicators, such as market capitalization as a percentage of GDP, and thenumber of listed companies usually measure the stock market size.

Although the Egyptian stock market is still relatively very small, in comparison to otheremerging markets, it has been developing in recent years and its share in the internationalmarket has been increasing since the early nineties.

Over 1994-98, the capitalization of the ESM increased rapidly at an annual averagegrowth rate of nearly 45.6%, and from 8.3 percent of GDP to 29.9 percent of it. In the thirdquarter of 1999, market capitalization relative to GDP reached 31.4% and the number of

28

listed companies increased to 1004, and the value of new issues augmented. (Ministry ofEconomy, July 1999).

In 1998, the Egyptian market capitalization was nearly 1.3 percent of the total value ofemerging markets’ capitalization, (compared to 0.2 percent only in 1990), and representedabout 20 percent of the capitalization of the Arab emerging markets. (IFC Factbook, 1999;Arab Monetary Fund, 1999).

The number of listed companies, in the Egyptian stock market represents about 3.2percent of the total emerging markets’ listed companies, and nearly 60 percent of thoselisted in the Arab emerging markets (Arab Monetary Fund, 1999).

Table (9)- Egyptian stock market size indicators (1994-1998). -LE Million-1994 1995 1996 1997 1998 1999/Q3

No. of listed companies. 100 146 646 650 861 1004Value of new equity issues. 4879 11251 20478 19485 36300 n.a.Value of Capitalization. 14480 27420 48086 70873 83140 95799

Capitalization (% GDP)2 8.3 13.4 21 27.7 29.9 31.4Sources: 1-Capital Market Authority, annual report. 2- Ministry of Economy, Economic Monthly

Bulletin, July 1999.

Despite this remarkable improvement, the ESM in comparison to the 32 emergingmarkets, is still ranked as number twenty-one with respect to market capitalization, and asthe fifteenth according to the number of listed companies.

The ESM size has some negative characteristics:i- The value of capitalization shows the market value of all listed shares, and therefore,

has to be interpreted cautiously. When listed shares that are not available for trading areexcluded, the value of market capitalization will drop sharply. According to the CapitalMarket Authority’s report in 1998, the capitalization of the companies whose shares areavailable to the public reached LE. 23.57 billion only and represented about 28 percent ofthe total market capitalization. The share of closed companies not available to the public,in the market capitalization was nearly 71 percent. Thus, by only considering the numberof public offering companies, the Egyptian stock market is actually very thin.

Allowing closed companies, to be listed in the stock exchange– a phenomenon, notfound in other emerging markets- affects the market badly and is considered a restraint onthe value of trade. It is worth mentioning that in 1997, the share of the Egyptian stockmarket capitalization in the total emerging markets capitalization was nearly 1 percent,while its share in the value traded was only 0.2 percent. (IFC Factbook, 1998).

ii- The average size of the listed companies is very small relative to other emergingcountries and to other markets in the rest of the world. As of end 1998, according to theIFC world ranking, Egypt was number 72 with respect to the average companies’ size.(IFC Fact book, 1999). Small sized companies cannot compete in the market, are not veryattractive to local and foreign investors, particularly institutional investors, and are unableto issue shares in the international markets.

C.2.2. Market liquidity:

As shown in table (10), the value traded in the ESM, increased by an average annualgrowth rate of about 68.2 percent. During 1994-98, the value traded increased at a rate

29

higher than that of capitalization and consequently the turnover ratio (value traded/capitalization), increased from 18 percent to 28 percent. [In 1998, value traded and theturnover ratio decreased for reasons that were detailed in section II.

Table (10)- ESM Liquidity.1994 1995 1996 1997 1998

Value traded byMillion LE. 2557 3849 10968 24220 23363

Turnover ratio* 17.7 14.0 22.8 34.2 28.1

Marketconcentration** n.a. 55.4 52.1 40.7 36.0

Concentration inthe IFCG index*** n.a. n.a. n.a. 29.8 21.0

Notes: *Turnover ratio: is the value traded relative to the size of the market. It measures the market liquidity A high turnover ratio means lower transaction costs. **Market concentration is the share of the ten largest stocks in total value traded. *** Market concentration the share of capitalization held by the ten largest stocks. A decrease in the concentration ratio, means that the market is becoming more liquid n.a.: not available. Source :Capital Market Authority , and IFC Fact book 1998, 1999 .

Despite this increase in the ESM turnover ratio, it is still lower than some otheremerging markets as shown in the figure below.

Figure (4)- Turnover ratios in selected emerging markets- 1998.

Source: IFC, 1999.

The concentration ratio of the value traded decreased from 55.4 percent in 1995, to 36percent in 1998. (Capital Market Authority, 1999). Thus, the market is becoming relativelymore liquid. This ratio is less than in Latin American countries, but higher than in Asia.According to the IFC, in 1998, the ten most active stocks in Argentina and Brazilrepresented 89.3 percent, and 54.1 percent of the value traded in these countries,respectively, , while in China, Korea and Malaysia, they reached 5.5, 24.1 and 31 percents,respectively. (IFC Factbook 1999).

0,00%

50,00%

100,00%

150,00%

200,00%

Turnover ratio

EgyptMalaysiaArgentinaBrazilChinaKorea

30

C.3. Return characteristics:

The degree of correlation between the Egyptian stock market and some selectedmarkets, and the properties of equity return, will be investigated.

- Degree of correlation:

Diversification benefits arise when lower risks are achieved for equivalent returns, orhigher returns are realized for equivalent risks. These diversification benefits are strongeracross international financial markets than within domestic markets.

The following figure (5), shows the degree of correlation between the Egyptian stockmarket and some other markets.

Figure (5)- IFC Egyptian index correlations[22-month period ending 12/98].

Source: IFC Factbook 1999.

- Properties of return:

Table (11) below, presents the main statistical properties of the Egyptian stock marketreturn, that are of particular interest to foreign investors, during the period of 1996- August1999.

The return used here is the IFC Global Index (IFCG), as it is considered the base for allother indexes employed by the IFC. In 1999, the IFCG includes about 66 companiesrepresenting nearly 60 percent of the market capitalization.

The rate of return was so high in 1996 due to progress in the privatization program. Thishigh return, and its low correlation with equity returns in industrial markets, attractedforeign investors to the Egyptian market. (Portfolio inflows to Egypt, reached $1.463billion in 1996/97 up from $ 258 million in 1995/96).

Due to the high increase in equity return, the financial authorities, established a priceadjustment mechanism in February 1997. Trading may not exceed a five-percent priceband above and below the previous day’s close without the permission of the stockexchange.

-0.3-0.2-0.1

00.10.20.30.40.5

Correlations

IFCI compositeIFCI regionalU.S. S&P 500UK. FT-ST 100Japan NikkeiFT. Europac

According to figure (5), thecorrelation between equity returns inEgypt and other countries, using the IFCindex for these markets is very low. Forexample, the correlation between theEgyptian equity return and the U.S. S&P500 is 0.33, and is lower than thatbetween other emerging markets and theU.S. index. (the correlation withArgentina, Brazil, Chile and Malaysia, is0.64, 0.47, 0.49, and 0.43, respectively).This implies that foreign investors,especially American investorsconsider Egypt as a highly diversifiedmarket. (IFC, October 1998).

31

Any sharp increase in prices that does not depend on fundamentals will fall sharplyupon abrupt change in market conditions causing speculative bubbles. (El-Erian,M. andKumar, 1995).

Table (11)- Properties of ESM return 1

1996 1997 1998 As of August 1999

Average daily mean. 0.001 0.0006 -0.001 -0.00085

Average daily median. 0.00 0.00 -0.0002 -0.001

Annual volatility2 0.09 0.193 0.13 0.13

Annual rate of return 3 0.32 0.165 -0.35 -0.146

D.F. unit root test. 4 -28.12 -27.8 -27.07 -13.6

Sharpe ratio. 5 2.4 0.39 -3.3 -1.8

Skewness. 6 0.424 0.955 -0.084 1.3

Kurtosis. 7 4.69 8.77 5.779 8.7

P/E ratio. 11.3 11.5 8.7

Notes: 1-The stock market return is defined as (r t), where r = log (Pt/ Pt-1) and Pt is the daily IFCG index at day t. 2-Annual volatility is the annualized average of the daily standard deviations of the returns. The average daily standard deviation* number of days. 3-Annual rate of return is the sum of the continuously compounded log (Pt/ Pt-1). 4- D.F. unit root test during the whole period is significant at 99%. ( Enders, 1995). 5-Sharpe ratio is a measure of the risk-return trade-off. It is computed as (RR-RF) / σσ , where RR is the change in the index and represents return on assets which include risk, and RF represents the return on risk free assets (Treasury Bills). (σ ) is the standard deviation for RR. (Sharpe, 1966). 6-Skewness: The skewness of a symmetrical distribution, such as the normal distribution is zero. If the upper tail of the distribution is thicker than the lower tail, skewness will be positive and vice versa. 7-Kurtosis of a normal distribution is three, if the distribution has thicker tails than does the normal, its kurtosis will exceed three.Source: Own calculations.

Stock market prices declined in 1997 to 16.5 %, but they stayed high relative to those inindustrial countries. The rate of return declined dramatically in 1998, for the reasonspreviously discussed in section II, then improved slightly during the first three-quarters of1999, but stayed negative (– 0.146).

Since 1997, the sharpe-ratio started to decline. It fell to –3.3 in 1998, down from 2.4 in1996. A negative sharpe ratio implies that there is no return versus risk.

Thus, net portfolio equity flows continued to decline till the second quarter of 1999 andbecame negative (capital outflows).

The abnormal change of return is reflected in the following calculated indicators:

i- The volatility is relatively high and fluctuating.

ii- The statistical distribution of the change in return is positively skewed in 1996 and1997, but negatively skewed in 1998.

32

iii- The kurtosis’ value is bigger than three so the distribution has thicker fatter tails thanthe normal distribution.

iv- The unit root test strongly rejects the hypothesis of nonstationarity. This implies thatthe market is inefficient, as there is time dependence in stock returns that may allow forpast information to be used to improve the predictability of future returns. The negativecorrelation between current and past returns means that the variance of return will tend tobe higher following bad news than after good news. (for more details see, Mecagni, M. andShawky, 1999; and Moursi,T., 1999 that examined the behavior of stock returns andmarket volatility in Egypt).

The inefficiency and volatility of the Egyptian stock market may be due to variousreasons:

i- Companies provide investors with little information.

ii- Companies are not subject to thorough investment research.

iii- A small market suffers some structural and institutional weaknesses causinginvestors to have shorter horizons, and encouraging speculative bubbles, as observed fromthe dramatic changes in market return.

Highly experienced foreign investors can realize benefits from these characteristics dueto their ability to predict the return. These foreign investors did affect the marketnegatively especially during 1998 and 1999, and played a substantial role in maintainingthe drop in the Egyptian stock market values (IBTCI, February 1999).

So, there is a clear relation between the trend in return and the trend in foreign flows.This conclusion emphasizes our previous finding that there is a causal relation between thevalue traded by foreigners and the change in stock prices.

The previous analysis revealed that, although returns in industrial countries wereincreasing over the period 1992-97, in comparison to the late eighties, yet Egypt startedreceiving FPEFs, since 1993/94. Thus, these flows are mainly affected by: the fundamentaleconomic reforms the country has undertaken, the complete freedom enjoyed by foreignersin the local market, the privatization program, and the improvements in the country’screditworthiness. In addition to the remarkable progress in the characteristics of theEgyptian stock market, specially the infrastructure, size and liquidity. Moreover, theEgyptian return has low correlation with returns in industrial countries.

The following table summarizes the main factors affecting foreign portfolio equityflows to Egypt.

yearNet FPI in

mill. $

Real GDP growth rate%

Annual Average Inflation%

Dollarization Ratio (%)

Fiscal deficit % of GDP

external debt % of GDP

Majority Privatized companies

public offering

Interest rateSovereign

RatingTurnover

ratio

Capita-lization % of

GDP

Concen-tration Ratio

Clearance and

Settlement*

Return in Egypt**

Sharpe Ratio

Volatility P/E Ratio

1993/1994 1.3 3.9 9.1 23.4 -2.1 59.9 0 13.95 - 17.7 8.3 n.a. 0 n.a. n.a. n.a. n.a.

1994/1995 4.1 4.7 9.4 25.1 -1.2 54.8 0 11.1 - 14 13.4 n.a. 0 n.a. n.a. n.a. n.a.

1995/1996 257.6 5 7.3 22.9 -1.3 45.9 0 10.4 - 22 21 55.4 0 n.a. n.a. n.a. n.a.

1996/1997 1462.9 5.3 6.2 19.4 -0.9 38.1 20 10.4 stable 34.2 27.7 52.1 1 32% 2.42 0.09 11.3

1997/1998 -248 5.7 3.8 17.9 -1 34 13 9.9 stable 22.3 29.9 40.7 1 16.50% 0.39 0.193 11.5

1998/1999 -197.2 6 3.8 17.3 -1.3 31.4 6 9 stable 23.5 31.4 36 1 -35% -3.3 0.13 8.7

33

*- (0) indicates no MCSCD, while (1) means MCSCD was established.- **- US S&P 500 = 18.01 during 1996- 1999, (IFC, 1999 & W.B., 1998).

Table (12)- Main Factors Affecting FPEFs to Egypt.

02468

1993/1994 1994/1995 1995/1996 1996/1997 1997/1998 1998/1999-5000500100015002000

Real GDP grouth rate% Net FPI in mill. $

02468

10

1993/1994 1994/1995 1995/1996 1996/1997 1997/1998 1998/1999-5000500100015002000

Annual Average Inflation% Net FPI in mill. $

0

10

20

30

1993/1994 1994/1995 1995/1996 1996/1997 1997/1998 1998/1999-5000500100015002000

Dollarization Ratio (%) Net FPI in mill. $

-2.5-2

-1.5-1

-0.50

1993/1994 1994/1995 1995/1996 1996/1997 1997/1998 1998/1999

-5000500100015002000

Fiscal deficit % of GDP Net FPI in mill. $

020406080

1993/1994 1994/1995 1995/1996 1996/1997 1997/1998 1998/1999-5000500100015002000

external debt % of GDP Net FPI in mill. $

0

5

10

15

1993/1994 1994/1995 1995/1996 1996/1997 1997/1998 1998/1999-5000500100015002000

Interest rate Net FPI in mill. $

0

10

20

30

40

1993/19941994/19951995/19961996/19971997/19981998/1999-5000500100015002000

Turnover Net FPI in mill. $

010203040

1993/19941994/19951995/19961996/19971997/19981998/1999-5000500100015002000

Capit alization % of GDP Net FPI in mill. $

-0.4

-0.2

0

0.2

0.4

1993/19941994/19951995/19961996/19971997/19981998/1999

-5000500100015002000

Return Net FPI in mill. $

-4-3-2-10123

1993/1994 1994/1995 1995/1996 1996/1997 1997/1998 1998/1999

-500

0

500

1000

1500

2000

Srarpe Ratio Net FPI in mill. $

0

0.050.1

0.150.2

0.25

1993/1994 1994/1995 1995/1996 1996/1997 1997/1998 1998/1999-500

0500

10001500

2000

Volatility Net FPI in mill. $

05

10152025

1993/1994 1994/1995 1995/1996 1996/1997 1997/1998 1998/1999-5000500100015002000

Majority Privatized companies public offering Net FPI in mill. $

34

IV- Egypt’s financial integration: Opportunities and Challenges:

With the important potential benefits provided by foreign portfolio equity investmentflows for Egypt, have come tough challenges. This type of flow, subjects Egypt to moresources of external disturbances, increases the speed at which these disturbances may betransmitted, and makes the country more susceptible to external shocks. Foreign investorshave become very important in direct trading activity, and their value traded causeschanges in stock prices. Foreigners are increasing the likelihood or magnitude of marketbubbles, with securities prices rising far above the underlying fundamentals, which may befollowed by a market crash. These risks raise serious concerns particularly that our resultsshowed also that the market suffers from inefficiency and some weaknesses. Increasingforeign ownership of domestic firms, may be another concern.

It has been shown, that the risk of volatile flows, varies according to the type of investorand instrument. The most suitable types according to the Egyptian stock market stage ofdevelopment are not yet fully utilized, and some are non-existent.

Egypt needs to take full advantage of the substantial opportunities offered by the leastvolatile types of foreign investors and instruments, and minimize the potential risks of theother more volatile types, whose likely reversal will have adverse consequences on thevolatility of domestic asset prices and returns.

Although the improvements in the Egyptian stock market have been remarkable, yet themarket is still in its early stages of development. Egypt needs to enhance the reliability ofthe system to settle transactions, to reduce principal risk and the opportunity cost of adelay. Investors demand reliable systems that record ownership, ensure safe custody ofsecurities, and protect property rights. They want a reliable system that ensures disclosureof material information to evaluate investment choices. Also, enhancing the liquidity of theEgyptian stock market, is desired to enable investors to liquidate securities or change thecomposition of their portfolios without incurring high costs.

Egypt should develop the institutional and policy requisites to attract a higher level ofportfolio equity flows, encouraging the least volatile types which Egypt has not yet utilizedand reduce the risks of instability.

The following chart shows the main factors that enable Egypt to maximize benefitsfrom foreign portfolio equity flows and to minimize their potential risks:

Figure (6)- Maximizing the Benefits and Minimizing the Risks.

Macroeconomicstability

Strengthening themarket infrastructureand the regulatory

Maximizing Benefits ..Minimizing Risks.

Choose theleast volatilei t t

Promote localand foreigninstitutionalinvestors

35

Following is a discussion of these main factors:

1-Macroeconomic stability: Commitment to achieve and maintain macroeconomicstability is a prerequisite to attract foreign flows and enables the country to face anypotential risk that may be caused by the volatile types of these flows.

FPEI flows to Egypt are mainly affected by the fundamental economic reforms thecountry has undertaken, including the privatization efforts, the improvements in thecountry’s creditworthiness and the remarkable progress in the characteristics of theEgyptian stock market. In addition to the complete freedom enjoyed by foreigners in thelocal market and the low correlation between equity returns in Egypt and other countries.

2-Institutional investors: They are particularly important for the Egyptian stock market,and offer fundamental advantages. These investors provide a potential source of large andmore stable funds. They dominate investment in private equity funds and in venture capitalfunds, two of the least volatile types of flows. Also, institutional investors are oftenprepared to accept less liquidity than retail investors.

If a growing share of foreign portfolio equity investment is accounted for byinstitutional investors, this could magnify the positive impact on liquidity, sinceinstitutional investors are very active traders (Samuel,1996).

Improved liquidity in the domestic market, will lower the investors’ demand for higheryields, reflecting their ability to sell securities at decreasing costs, and the cost of capitalwill decline. The declining cost of capital and the enhanced risk diversification shouldinduce the corporate sector to issue initial public offerings and additional shares. Also, asliquidity improves, new domestic investors will be attracted to the market.

3-Encouraging the least volatile portfolio equity instruments:

The characteristics of each type of foreign portfolio equity investment instrumentsreveal that the volatility of FPEI flows may vary with the type of mechanism throughwhich an investment is made. Some mechanisms are more suitable to the stage ofdevelopment of the Egyptian emerging market than others.

-Foreign direct equity purchases in the domestic stock markets:

Egypt approached liberalization, first by allowing foreigners complete freedom intrading directly in its securities markets. Foreign direct equity purchases in the stockexchange, are mainly short-term transactions, which encourage destabilizing pricespeculations, and adversely affect the market price level.

Granger-causality test showed that trading by foreigners in the Egyptian stock marketcauses changes in each of the publicly traded securities index and the IFCG index, and hasa clear effect on the Egyptian stock market price volatility.

It is worth mentioning that complete openness of a country’s securities market forforeigners should come after appropriate regulatory structures are in place and suitablecorporate governance levels.

Various emerging countries in their first stages of financial integration, opened theirsecurities markets first through the establishment of country funds and/or GDRs’ issues.When their domestic stock markets were more prepared to receive direct foreign portfolioinvestments, foreigners were allowed to trade directly.

36

The emerging markets shown in the table below followed this sequence ofliberalization.

Table (12)- Market liberalization dates for some emerging markets.

Country Depositaryreceipts issuance

Country fundestablishment

Liberalizationdate forforeigners� directtrading.

Korea * 1990 1984 1992Indonesia 1991 1989 1989Philippines 1991 1987 1991Thailand n.a. 1986 1987Brazil 1992 1987 1991Chile 1990 1989 1990Mexico 1989 1991 1989Turkey n.a. 1989 1989India 1992 1986 1992

*Until 1992, foreigners could only buy Korean equities through country funds. (IFC, 1996, p.4).Sources: 1-IFC, 1996; 2-Korean Stock exchange, 1996, p.70; 3-Egyptian Ministry of Economy and Foreign Trade, 1999, p. 4.

Thus, direct equity purchases by foreign investors in the local stock exchange seem tobe the most volatile form of FPEI, particularly when retail investors manage them.

In order to mitigate the price volatility that may be caused by high turn-over foreigninvestments, Egypt should:

a-Develop a strong domestic institutional investor base. Such investors will be able tomobilize significant amount of resources, increase liquidity in domestic capital markets,and thereby serve as a counterweight to foreign investors. They also reduce thevulnerability of domestic capital markets in the event of a rapid liquidation of assets byforeign investors. Active domestic institutional investors, by increasing depth and liquidityin domestic markets, would reduce the sensitivity of domestic markets to small trades.Also, they benefit domestic savers by reducing transaction costs and facilitating portfoliodiversification.

Developing a domestic institutional investor base, requires reforming and expanding thelegal and regulatory framework, in particular in the area of investor protection.

b-Encourage foreigners to keep Egyptian securities for a longer time period. It may beuseful to follow the American system, which imposes 30% taxes on mutual fund profits, ifthey arise from securities that are not kept for at least three months.

c-Attract venture capital funds. The investment horizon of these funds tends to be somewhatlonger than that for other types of FPEI instruments and less volatile. A two-tiered venturecapital fund with limited life and a common goal for shareholders seems more suitable fornew unquoted Egyptian companies to encourage them to grow and go for an initial publicoffering. The two-tiered structure, will also enable investors to control the manager’sperformance and the fund’s strategy, in addition to lowering management costs. Moreover,the various types of finance provided by a venture capital fund (start-up, seed capital,expansion, replacement, ..) are suitable for different developmental phases, for small andmedium enterprises, and those that are applying privatization programs.

37

In 1996, the IFC reported that Egypt has one foreign venture capital fund, with nofurther details. Consulting various local sources, no information was provided concerningthis mentioned fund. This reflects the unawareness with the potential benefits of thisimportant instrument, which other emerging markets have largely made use of in theirearly liberalization stages.

Attracting venture capital funds requires positive macroeconomic conditions, an activeand liquid capital market, and a transparent legal system.

d-Establish more closed-end diversified country funds and private-equity funds. Egypthas seven offshore funds. Five of these funds are closed-ended. These are few funds, ifcompared to other emerging markets, and considering their potential advantages.

Closed-end diversified country funds offer significant benefits. They are not required tomeet redemption requests, and therefore, they are less likely to contribute to marketvolatility, and more likely to take a longer-term view. They usually pose no threat to thecontrol of domestically owned private firms. These funds may also participate in localtraining programs, with positive effects on human development. Country fund managersalso press for growth of local credit-rating agencies.

The establishment of more country funds, and other specialized funds such as private-equity funds, should be encouraged. They require improvements in stock market size andliquidity, and in disclosure and accounting standards. In addition to, high standards ofcustody, clearing and settlement, and regulatory oversight.

e-Issue more depositary receipts. During 1996-July 1999, eight Egyptian companiesissued GDRs, representing four sectors only, whose value is very small, compared to otherdeveloping countries.

Global depositary receipts have a positive effect on the efficiency of the domestic stockmarket price, through the arbitrage process, which reduces the volatility of the issuingcompanies’ share prices. Issuing GDRs may enable the Egyptian government to offer alarge number of public companies’ shares, and attract foreign investors, especially that thesize of the local market is relatively small.

Egyptian companies tend to be small with modest financial resources and lowinternational visibility. It is difficult for small capitalization Egyptian companies to issuedepositary receipts, because they must meet the partial or full reporting requirements, forlisting abroad, and other specific minimum requirements with respect to the size of totalassets, earnings and /or shareholders equity.

Thus, mergers between Egyptian companies operating in the same field of activityshould be encouraged. In addition to improving the disclosure, accounting and auditingstandards. All this will enable them, to meet developed markets’ requirements for listing,or publicly offer their securities in the international stock markets, particularly that the IFCranked the Egyptian market as number 71, within emerging markets, with respect tocompanies’ size. {Mexico, Taiwan, Brazil, and Chile, were ranked as numbers 12,14,20and 36, respectively}. [IFC, 1998].

f-Create quasi-equity instruments; such as convertible bonds, and bonds with equitywarrants. These instruments have not yet been developed in Egypt. The creation of thesetools, may lead to a more balanced mix of debt and equity, that might attract moreinvestors, especially institutional investors and increase the liquidity of the market.

38

Moreover, the issuing company will be able to apply a larger amount of financing towardsexpansion of the company or towards general operating expenses, as the interest paymentson these bonds, are lower than those on straight bonds.

Developing the local bond market, is required. Issuing companies should provideattractive dividends and interest rates compatible with those on banking deposits, takinginto consideration that bonds are relatively less liquid than deposits.

4-Strengthening the market infrastructure and the regulatory framework:

Among the most important domestic factors that affect foreign investors decision toinvest in Egypt are the degree of reliability of the stock market’s infrastructure and theeffectiveness of the regulatory framework. Strengthening these two areas, will help in:

1-Attracting more foreign portfolio equity inflows and institutional investors.

2-Enhancing the efficient use of some suitable types (depositary receipts, country funds,venture-capital funds,..), creating new types (bonds), and reducing the risks of all typesparticularly foreign direct trading.

a-The settlement, clearance, and depository systems:

To accelerate the settlement flow, a good matching system should work quickly. Tradematches between direct market participants should be accomplished in the same day of thetrade (T+0).

The rolling settlement system used in Egypt, has the advantage of effectively limitingthe number of outstanding clearances and reducing the time between trade and settlementdates. It is recommended that the rolling settlement system have final settlement occur byT+3. However, efficiency and reliability rather than speed of settlement should be theprimary objectives. (International Organization of Securities Commission, 1992b).

To concentrate settlement risks, the central clearing agency should:

1-Set stringent standards for membership, at least during the transition period, untilother risk reduction systems are in place and domestic investment firms become financiallystronger. However, due to inadequate information and weak disclosure standards, it may bedifficult to develop a comprehensive picture of the agency’s members.

2-Limit its net exposure to each participant and require collateral for some types ofexposure.

3-Develop a risk control system that timely reveals the exposure of its members.

4-Design procedures so that participants themselves have more of an incentive tomanage and contain the risks they bear. For example, loss-sharing rules among participantsin the event of a default could be established.

5- Have quick access to sufficient liquidity and be adequately capitalized.

6-Have branches in the main Egyptian governorates, or expand its activities incooperation with the banking sector.

It is worth mentioning that a settlement guarantee fund was established in Egypt, in thesecond half of 1999, but has not come into force yet. Imposing penalties should discourageresorting to this fund.

39

For the central depository to be cost-effective, firms’ participation should beencouraged. More book-keeping companies should be established to cover the country.Securities lending and borrowing should be encouraged as a quick method for thesettlement of securities transactions.

b-The regulatory framework should carefully balance between investor protection andsafety on the one hand, and market development or liquidity on the other.

*Disclosure: Among the most critical functions of a regulatory framework is to increasetransparency in the market by mandating public disclosure for all material information on atimely basis, such as the disclosure of developments that may have an effect on thecompany’s business or the stock price. Public disclosure is required both at the initialphase, when a firm issues securities to the public, and continuously thereafter. Improvingdisclosure will address investor concerns and will also reduce market volatility resultingfrom asymmetric information.

The Egyptian Capital Market Authority should strictly apply its legal right in delistingthe companies that do not comply with the disclosure requirements, after three monthsnotification.

There are three types of disclosure requirements:

i-Listing requirements: These are particularly important for the Egyptian stock marketfor two main reasons. First, because of lack of experience and financial expertise, investorsmay not be able to judge the relative merits of alternative investments. Second, badperformance of a listed firm causes negative externalities resulting from investors losingconfidence in the market.

The disclosure requirements for a firm to list in a securities market or trade publicly,should include: minimum requirements regarding the number of shareholders and the valueand volume of public shares, earnings, balance sheet criteria over a number of years; anassessment of the potential of the firm and industry it belongs to; qualitative criteriaregarding corporate governance; ...etc. There should also be continuing listing ormaintenance requirements.

For Egypt, if listing requirements are too stringent, few firms will be able to list and themarket will not be liquid. To solve this dilemma, the market could be segregated into morethan one section, with each section differing in its listing requirements. For example, thedistinguished companies that are compatible with the listing requirements for theinternational issues will be in the first section while other firms with less established trackrecords could be listed in a special, perhaps over-the–counter market. The listingrequirements should consider the size of the company and the percentage of its sharesbeing offered to the public.

ii-Initial offering requirements: The disclosure mandated for a firm to issue newsecurities, is of two types:

-information that allows investors to evaluate the overall condition of the firm issuingthe securities, including risk factors and prior performance.

–more specific information about the new issue: amount of capital to be raised and itsintended purpose, how the offering price was determined,..etc.

40

iii-Accounting standards: In order to be at par with international practice, joint stockcompanies must prepare their accounts based on International Accounting Standards. Thisis essential for investors to be able to evaluate the financial performance of a company.Egyptian-auditing standards and practices need further improvement to ensure thereliability of disclosed information.

*Insider trading should be prohibited: In 1998, insider trading was reported as one ofthe main reasons behind the sharp decline in the Egyptian stock market index. Thus, Egyptshould try to eliminate insider trading. First, by defining what information is consideredillegitimate, (usually all facts that can have an impact on a company’s business and theperformance of its stock), who is subject to insider trading rules, the reportingrequirements for insiders, and what types of companies are subject to these rules. In somecountries, owners of more than a specific amount of a certain stock are considered insidersand are required to file reports on their trading activities. Insider legislation also definesinsiders’ responsibilities. Second by imposing civil, administrative and criminal sanctions.(World Bank, 1997).

*Self-regulatory organizations (SROs): Drawing from other countries experiences, itwas found that competing financial intermediaries in the stock market do have theincentive to monitor one another, to develop fair and efficient markets. Market participantsare more able than the government to formulate good rules and procedures, and to keepthem current with new technology and industry practices. They will be better able tomonitor compliance, especially that self-imposed rules are usually better accepted thanrules mandated from the outside.

Applying this model in Egypt, will reduce the Egyptian Capital Market Authority’ssurveillance burdens, and increases its efficiency. However, care should be taken as theESM is still in the early stages of development, with limited competition, insufficientinstitutions, human capital, disclosure and accounting standards, such that self-regulationmay not be enough to ensure fair and efficient markets. Thus, regulatory responsibilitiescan be transferred first to the exchanges, clearinghouse, and depositories, since they wouldbe better able and more willing to develop and monitor rules of conduct. (Chuppe, andAtkin, 1992).

V-Main Conclusions :As concessional foreign credit flows to Egypt diminish, the country will have to find

alternative sources of finance for its investment. The present domestic saving levels, lessthan 15 per cent of GDP, are far too low to allow Egypt to grow at 5 per cent per year,which, besides the need to increase domestic savings, suggests an important role forforeign investment in the country. One type of this investment takes the form of equityportfolios, the subject of this paper.

As pointed out in the introduction, foreign equity portfolio flows provide a number ofvery important benefits to the country, but they might also have, if not appropriatelyregulated, very significant costs. The trick is therefore to implement policies andregulations which maximize the benefits and minimize the costs, of foreign equityportfolio investments. In the paper the list of benefits and costs of these investments havebeen derived from the international literature on the subject, from the comparative analysis

41

of the characteristics of the different available investment instruments and from empiricalwork on some aspects of the behavior of the Egyptian stock exchanges.

The paper suggests ways of maximizing the benefits and minimizing the costs of theforeign equity portfolio investments through policies and market friendly regulationswhich (i) provide macroeconomic stability, (ii) generate incentives to use the least volatileof the existing portfolio investment instruments, (iii) promote the use of institutionalinvestors instead of individual investors and (iv) strengthen the existing marketinfrastructure.

Of all the suggested measures, the significance of macroeconomic stability can never besufficiently stressed. As shown in the paper, equity portfolio investments are extremelymobile, macroeconomic instability invites speculation and, as experience shows, it is hardto find a practical way in which governments can prevent capital flows to move in and outof countries. The paper, given its financial focus, does not discuss the necessary recipes toachieve macroeconomic stability, but they are at this point in time relatively well known,although very difficult to implement in practice.

The volatility of these portfolio investment flows can be further reduced by providingincentives to use more of those investment instruments which are less volatile. In thisrespect the paper suggests an optimum order of opening-up the economy to portfolioinvestments, first country funds and GDRs and only thereafter direct investments, orderwhich was not followed by Egypt. At this stage it would, however, not be advisable to turnback and therefore alternative means of achieving a similar end are proposed in Section IIIof the paper. In particular, taxes and tax-exemptions can be used to induce a preference forlonger term investments in general, for venture capital investments, country funds, GDRs,and convertible bonds, in particular, until the necessary institutions to handle direct equityportfolio investments have fully developed.

The paper stresses the advantage of institutional investors over individual investors,since the former are more likely to provide stability to the market, given that they havemore expertise and information . Therefore it proposes to use the regulatory framework todevelop capital market institutions, especially in the area of investor protection.

A final, but related and also important concern of the paper, is the regulatoryframework, which should balance carefully investor protection and safety, on the one hand,and market development and liquidity on the other, as way to reduce the destabilizingeffects of equity portfolio investments. In this respect, the paper addresses needed reformsin the areas of disclosure, insider trading and regulatory organizations. As is the case withmost measures proposed in the paper, these regulatory reforms are not only important toincrease the net benefits of foreign equity portfolio flows, but they will also contribute tothe improvement of the workings of the whole Egyptian capital market.

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Appendix (1)- Review of the recent literature on the determinants of FPE flows:

summary findings.A- The cyclical downturn in industrial countries and the associated decline in global

interest rates were the main factors driving private flows to developing countries: (A reversalof favorable global conditions could induce a capital outflow from these countries).

Study conductedby: Main findings:

1-Calvo, Leidermanand Reinhart (1993).

Investigated whether private capital flows to ten Latin Americancountries, for the period January 1988 to July 1991 were drivenprimarily by cyclical factors in the international economy [particularly,U.S. interest rates, the U.S. recession and the slowdown in U.S.industrial production], or by improvements in these countries’economic fundamentals.

Taking international reserves and the real exchange rate as proxiesfor private capital flows, they analyzed the degree of co-movement inthese variables using principal component analysis. They found that:

* there was a significant co-movement among countries’ foreignreserves and among their real exchange rates, and that the degree of co-movement increased in 1990-1991, compared with 1988-1989.

* the first principal component of both reserves and the realexchange rate exhibited a large bivariate correlation with several U.S.financial variables, including interest rates.

This suggested that the main factor driving private flows to LatinAmerica was the cyclical downturn in industrial countries and theassociated decline in global interest rates.

2-Fernandez-Arias,(1994).

Fernandez-Arias argued that some studies like that conducted byChuhan, Claessens and Mamingi, (1993), may have overstated theproportion that could be attributed to improvements in domesticfundamentals, because it considered country creditworthiness as beingsolely determined by improvements in the domestic economy, whereas,in reality, global interest rates also affect country creditworthiness.

By decomposing the improvements in creditworthiness into thosearising from the decline in global interest rates and those arising fromimprovements in the domestic environment, Fernandez-Arias foundthat global interest rates accounted for around 86% of the increase inportfolio flows for the “average” emerging market during the period1989-1993.

3-Frankel andOkongwu (1996).

In an analysis of the determinants of portfolio capital flows in nineLatin American and East Asian countries (Argentina, Chile, Mexico,the Philippines, Korea and Taiwan) using quarterly data covering theperiod 1987-94, found that U.S. interest rates had a major influence onthese flows.

43

B- Country-specific factors: improvements in countries� economic fundamentals allowinvestors to achieve higher returns and offers them opportunities for risk diversification.

Study conductedby: Main findings:

4-Chuhan,Claessensand Mamingi, (1993).

Using panel data for 1988-1992, they found that improvements incountries’ economic fundamentals- the country credit rating, secondarybond prices, the price-earnings ratio in domestic stock markets and theblack market premium- were as important as cyclical factors inattracting portfolio flows to Latin America. Domestic factors,moreover, were three to four times more important in explainingcapital inflows to Asia.

5-Gooptu,S., (1994). Examined econometrically whether portfolio investmentflows to one region in the developing world weresignificantly related to those that went to another region.An inverse relationship between total portfolio flows toemerging Asian stock markets and those to Latin Americawas found. This result indicated that developing countriesmust compete for portfolio flows and that increasing thepace of reform is essential for an emerging market to beable to sustain this type of flows.

6-Hernandez andRudolph, (1995).

A panel regression of total private long-term capitalflows/GNP, was run on total investment/GNP, privateconsumption/GNP (as private investors may considerprivate savings to be a sign of confidence in a country’sprospects), the stock of total external debt minusinternational reserves/GNP, volatility of the real effectiveexchange rate, a dummy for the successful completion of aBrady deal, real export growth, the 12-month U.S. treasurybond rate and a dummy for U.S. interest rates, during1990-1993.

The results showed that countries with strong economicfundamentals have received the largest proportion of private flowsrelative to the size of their economies. When foreign direct investmentwas excluded, the downturn in U.S. interest rates during 1990-1993,was a significant factor in explaining flows to developing countries,although domestic economic factors were also important. [foreigndirect investment may be more sensitive to domestic factors than themore-liquid portfolio flows].

7-Motaal (1995). Examined the determinants of capital movements in some Middle-Eastern countries (including, Jordan, Egypt, Morocco, and Tunisia) andAsian countries (Bangladesh, India, Pakistan, and Sri Lanka).

His analysis suggested that external factors (reductions in worldinterest rates) played a less important role in the increase in capitalinflows to these countries; more important were internal factors (themomentum for reform), which led to improvements in the longer-termeconomic prospects of these countries.

44

8-UNCTAD (1997). A survey of international emerging market equity fundmanagers was conducted by UNCTAD in January 1997, inorder to determine what elements they considered to bemost important in making investment decisions at thecountry level. The survey found that the potential rate ofeconomic growth was identified most frequently as beinghighly important in investment decisions. Market size canhave an indirect influence because larger markets tend tohave better developed capital markets, greater marketcapitalization, higher degree of liquidity and a wider arrayof investment opportunities. In less-developed emergingmarkets in which total capitalization is especially small,market size may become a constraint on foreign portfolioequity investment by some large institutional investors thattend to invest in large blocks. The degree of volatility ofexchange rates and political stability are also importantconsiderations. The overriding motivation for foreignportfolio equity investors is their participation in theearnings of local enterprises through capital gains anddividends. Hence, it is more important for them that capitalbe easily transferable and that disclosure standards be high.Thus, the level of ease of capital repatriation and disclosurestandards for companies operating in the local marketappear to be very important.

Other factors frequently identified as being importantinclude the existence of a good settlement system, thecomprehensiveness of securities market regulation, thedegree of securities market liquidity.

More mature markets also tend to offer a superior levelof regulation regarding information-disclosure andaccounting standards.

45

9-World Bank,(1997).

Explored the influence of global interest rates onportfolio flows in particular. It analyzed the extent to whichportfolio flows from U.S. to twelve emerging markets inLatin America and East Asia moved together and thedegree to which this co-movement was related to U.S.interest movements.

Co-movement in flows was measured by the firstprincipal component of the flows. The analysis was donefor countries in each region separately and then inaggregate.

The results showed that there was a high degree of co-movement in flows during 1990-1993, for both regions andthat this co-movement was related to movements in U.S.interest rates. This supports the hypothesis that U.S.interest rates played an important role in driving portfolioflows during 1990-1993.

However, since 1993, there has been a decline in the co-movementof portfolio flows to both regions, especially for East Asia, suggestingthat country-specific factors are becoming more important.

10-Taylor, andSarno, (1997).

Examined the determinants of U.S. capital flows directed to nineLatin American and nine Asian countries over 1988-92. In particular,they investigated whether bond and equity inflows were induced bypush or pull factors, differentiating between short- and long-rundeterminants.

The authors, considered in their set of country-specific factors thedomestic credit rating and the black market exchange rate premium aswell as a set of global factors including two U.S. interest rates and thelevel of U.S. real industrial production.

They examined the long-run determinants of portfolio flows byemploying two complementary cointegration techniques.

The results provide unequivocal evidence that:

* long-run equity and bond flows are about equally sensitive toglobal and country-specific factors and, therefore, that both sets ofvariables help to explain U.S. portfolio flows to the developingcountries considered.

* Both push and pull factors seem to be equally important indetermining short-run equity flows for Asian and Latin Americancountries.

* When bond flows were considered, however, global factors seemto be much more important than domestic factors in explaining theshort-run dynamics of flows. In particular, changes in U.S. interestrates are found to be the single most important determinant of short-runmovements in bond flows to developing countries.

C- Diversification benefits from investing in emerging markets.

Study conductedby:

Main findings:

46

11-Divecha, Drachand Stefak, (1992);

12-Harvey, (1993),and (1995).

* Examined the risk-return trade-off from emerging marketportfolio investments.

* Only a handful of emerging markets were found to havesignificant exposure to five global risk factors (the world market equityreturn, the return on foreign currency index, the change in oil price, thegrowth in world production and the world inflation rate). Thus, manyemerging markets are not well integrated into the global economy.

The results showed that developing countries’ stock returns tend tohave low correlation with those of industrial countries. This lowcorrelation should reduce the volatility of portfolio flows in emergingmarkets.

It was concluded that there are significant diversification benefitsfrom investing in emerging markets relative to asset portfolios thatfocus solely on industrial country securities.

D- The removal of barriers by industrial and developing countries on foreignparticipation in developing countries� securities markets:

Study conductedby:

Main findings:

13-Claessens andRhee, (1994).

Showed that the removal of barriers by industrial and developingcountries on foreign participation in developing countries’ securitiesmarkets has been a significant factor that has contributed to this surgeof private capital flows to the emerging markets. These measuresinclude, the removal of restrictions on foreign ownership, liberalizationof capital transactions, improved general accounting principles,addressing the financial securities clearing and custodial problems andenhanced disclosure requirements by securities issuers.

14-Bekaert, (1995). Several barriers to portfolio equity flows in recipient countries wereidentified. By relating these barriers to various measures of marketintegration, it was found that the most effective barriers were:macroeconomic instability, poor credit rating, high and variableinflation, lack of a high-quality regulatory and accounting frameworkand the limited size of the domestic stock market.

15-Claessens andGlen, (1995).

Found that some emerging markets function inefficiently due to“insider trading”. These markets will be stacked against outsiders andwill be less likely to attract new investors.

16-Daveri, (1995). Using a model with partial irreversibility of investment derives anegative relationship between foreign investment and costs of entryand exit from financial markets.

Appendix no.2Listing requirements in selected emerging markets.

Emergingmarket: Requirements

Korea (*) Korea�s stock exchange is divided into two trading sections. Themain requirements for the first section are:

*Paid-in capital for the last business year must be five billionwon or more.

*The ratio of net profit to capital, must be 10% at least, for the

47

last three business years.

*The firm�s debt ratio must be less than the average debt ratiofor the relevant industry, for the last three business years.

The Korean stock exchange authority, evaluates the last annualbusiness report of all the listed companies to determine whetherthey meet the requirements needed to assign for the first section, ornot.

Companies that can not meet the requirements for section oneand the newly listed stocks are automatically assigned to the secondtrading section for at least one year. [http://www.Kse.or.kr/operate/sm.htm].

Argentina The stock exchange is divided into a special section and ageneral section.

Shares listed in the special section are for companies having:

*a capital of over $60 million, and sales or service revenues inexcess of $100 million.

*1000 stockholders, that are not related together by agreementsconcerning the governance or management of the company.

*The par value of listed securities should be higher than $60million.

Companies not fulfilling the above-mentioned requirements areincluded in the general section.

http:www.bcba.sba.com.ar/bolsa/requi.cot.ing.htm.

Malaysia 1- The main board listing requirements are:

*Minimum paid-up capital is RM 50 million, comprisingordinary shares of RM 1 each.

*Profit track record for the last three financial years.

*After tax profit of not less than RM 4 million per annum.

*Aggregate after tax profit of no less than RM 25 million, overthe last three financial years.

2- The second board listing requirements are essentially thesame as those of the Main Board, but differ in the amount of capitaland profits. For example, the profit track record needed here is forfive financial years with an after tax profit of not less than RM 2million per annum.

Sources: Korea: [http://www. Kse.or.kr/operate/sm.htm]. Argentina: [http:www.bcba.sba.com.ar/bolsa/requi.cot.ing.htm]. Malaysia:

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Zhaohui, Chen and Khan, Mohsin S., 1997, “Patterns of Capital Flows to EmergingMarkets: A Theoretical Perspective”, IMF Working Paper, WP/97/13, January.

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Cairo University.Faculty of Economic and Political Science.Economics Department.

Foreign Portfolio Equity Investment in Egypt:An Analytical Overview.

Submitted by:Dr. Nagwa Abdallah Samak

AndDr. Omneia Amin Helmy

To the:Economic Policy Initiative Consortium.

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