Foreign Portfolio Equity Investment in Egypt: An Analytical Overview

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

I-Introduction:
Egypt has enjoyed a relatively high economic growth rate over the last decade, in spite of its dismal saving rates, supported by credit granted under concessional conditions, and foreign investment. However, the expected reduction in concessional credits for Egypt means that, if the country wants to continue to grow at rates exceeding 5 per cent, it will either 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 in Egypt, its advantages and disadvantages, and the required institutional changes to take full advantage 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 to foreign investors and issuers. Institutional investors have been rapidly increasing their holdings of foreign equities. Financial innovations, specially equity-related derivatives, have offered more opportunities for borrowers to raise capital in foreign markets and for investors to make cross-border investments. Technological advances have increased efficiency in gathering and disseminating information and in processing transactions. Between 1986 and 1997, emerging stock markets capitalization grew, from $171 billion to $2.2 trillion, and their share of world stock market capitalization increased from nearly 4 per cent as of end-1986, to nearly 9 per cent as of end-1997. By the end of 1998, over 17,163 companies were listed and traded in emerging capital markets. [International Finance Corporation, (IFC), 1999]. However, of the total foreign portfolio equity flows (FPEFs) into the developing countries, the share of the Middle East and North Africa region only reached 1.21% in 1996, while Latin America and East Asia and the Pacific have been taking the lion shares. Moreover, between 1997/98 and 1998/99, Egypt has had an outflow of resources on this account, averaging over US$ 200 million per year, after relatively heavy inflows during the 1995/6-1996/7 period, averaging about US$ 850 million per year [ see, figure (1) and Table (1) in the text].

Figure (1)
Net portfolio investment to emerging markets ( 1990-1997) (%)
150% 100% 50% 0% 1990 -50% 1991 Asia 1992 1993 1994 1995 1996 Latin America 1997

Middle East & Europ

Source: Own calculations, from IMF, 1998a.

It is well known that, on the one hand, FPEFs expand investors opportunities for portfolio diversification and provide a potential for achieving higher risk-adjusted rates of return for foreign investors. In addition, from the perspective of the recipient country, foreign portfolio equity investment (FPEI) contributes to the financing of domestic enterprises and it allows risk sharing between foreign and domestic investors, as repayments depend mainly on the performance of the firms concerned. (United Nations, 1997). Increased foreign investment activity may also improve the depth and increase the liquidity of the local stock exchange, bringing benefits to other segments of the capital market, such as the bond market. Foreign participation in the domestic capital market may induce improvements in accounting, information, and reporting systems, as well as increase the analytical sophistication of the domestic securities industry. Also, as foreign practices are adopted by domestic shareholders, domestic companies may improve corporate governance. However, despite the above-mentioned benefits, FPEI, has particular features which raise serious concerns. FPEI usually has a short investment horizon, just a few weeks or months, although this horizon can extend to ten years or more under appropriate conditions. It is easy for portfolio equity investors to liquidate their investments by selling their equity positions in the secondary securities market. This may lead to an increase in the volatility of domestic asset prices and returns, greater exchange rate volatility or greater interest rate volatility, or both. Furthermore, if the stock of international reserves is at a low level, it may cause a balance of payments crisis. All this can create considerable uncertainty, discourage domestic and foreign investment, and can ultimately be very damaging 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 by the most volatile types of investors and instruments, in a recipient stock market that is not sufficiently 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. At the global level, from a peak of $104 billion in 1993. they fell to less than one-fourth of this level in 1995, in the aftermath of the Mexican peso crisis, then nearly doubled to $50 billion in 1996. After the Asian financial crisis and the severe financial difficulties of

Russia and Brazil, portfolio equity flows to developing countries fell again, from US$ 30 billion 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 in foreign ownership of domestic firms and the increase in systemic risk, since failure of a financial intermediary in another country could have an impact on domestic markets. In addition, it might reduce the effectiveness of monitoring and supervising financial intermediaries, because of difficulties in assessing the financial status of firms that are active in many markets. In summary, foreign portfolio equity investments represent an important opportunity and a tough challenge for developing countries in general and Egypt in particular. Egypt needs to encourage the more sustainable, long-term types of foreign portfolio equity investments and instruments, that contribute to economic growth and reduce the risks of volatile, unpredictable and speculative types of foreign capital flows. Thus, the aim of this paper is to identify the most suitable types of foreign portfolio equity investors and instruments for Egypt according to their degree of volatility and the stage 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 FPE investors and instruments and their likely effects on developing countries in general and on Egypt in particular. This section includes some statistical work to determine the causal relation between foreign investors trading in the Egyptian stock market and the change in the market price index. Section III reviews the literature on the determinants of FPEI flows to developing countries and examines Egypts recent economic performance, as well as the characteristics of the Egyptian stock market, to enable us to identify the main factors affecting FPE flows to Egypt. This section includes a statistical description of the stock return in the country. Section IV proposes a set of economic policies to allow Egypt to attract sustainable and long-term types of foreign portfolio equity investments, which should contribute to economic growth and reduce the risks of volatility, unpredictability and 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 and instruments and their likely effects in developing countries in general and in Egypt particularly. A.Types of investors and instruments of FPEI in developing countries: Foreign portfolio equity investors in emerging markets, may be institutional or retail investors. Institutional investors, such as mutual funds, pension funds, and insurance companies manage money for individuals and firms. These investors are particularly important for emerging markets, and offer fundamental advantages. They are often prepared to accept less liquidity than retail investors, and demand high standards of management. They

provide a potential source of large and more stable funds. Their investments are mostly in longer-term assets. Institutional investors provide individual investors with a low-cost method of realizing higher returns from a more diversified international portfolio than they could get by themselves, without having detailed knowledge of the countries and individual companies issuing the securities. (Chuhan, P. 1994). The process of internationalization of equity markets, has been driven by institutional investors. In seven major industrial countries, institutional investors had assets close to $17 trillion in 1994, compared with $5.3 trillion in 1985. The growth in the asset base of institutional investors and the growing internationalization of these assets has led to a rising volume of international investments. For example, total international investments by pension funds increased from $302 billion in 1989 to $790 billion in 1994, with the growth in asset base contributing to around 40% of the increase in international investments and greater 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 more speculatively than institutional investors, in emerging stock markets. They usually chase high 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 traded securities. (Chuhan, P. 1994). Foreign portfolio equity investment instruments in developing countries, take two main forms: -Equity instruments, such as: direct equity purchases in domestic stock markets, venture capital funds, country funds, American depositary receipts and Global depositary receipts. -Quasi-equity instruments, including: convertible bonds, and bonds with equity warrants. 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 both its advantages and disadvantages. This type of flow contributes directly to the finance of domestic firms, in the market of primary issues and indirectly when shares are traded in the local secondary market, by pushing up equity prices and thus lowering the cost of raising capital. This encourages new equity issues. Also, these foreign direct equity purchases increase the liquidity of the local stock exchange, and enhance its efficiency, by providing high standards of regulations and information, required by foreigners, especially institutional investors. In addition to high quality services such as brokerage, custody and settlement. (United Nations, 1997). The above-mentioned benefits encouraged the progressive dismantling of barriers to capital account mobility in developing countries. During 1991-1993, eleven developing countries undertook full or extensive liberalization of their exchange restrictions, 23 liberalized controls on foreign direct investment, 15 eased controls on portfolio inflows,

and 5 eased restrictions on portfolio outflows. By 1998, 30 emerging markets were classified as free, 15 markets as relatively free, and only one market was closed to foreign investment. (IFC, 1999; and IMF, 1994). The following figure summarizes the investment regulations for entering and exiting the emerging markets: Figure (2)- Entry and Exit restrictions for foreign investors in emerging stock markets (1991-1998)
Entry restriction for foreign investors in emerging stock markets ( 91 - 98 )

70 60
percentage %

57,69 48,57 48,15

50 40 30 20 10 0
3,7

28,57

28,85 20 14,82 11,54 11,11 2,86 1,92

Free Entry

Relatively

Restricted

Closed

Feb-91

End 1994

End 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 $23 billion in 1994 and 1995 respectively, partly in response to the Mexican financial crisis. In the second half of 1997, this type of flow witnessed another decline due to the East Asian crisis. For example, in 1997, due to the Thai baht crisis and its contagion effects, five Asian countries- Indonesia, Malaysia, the Philippines, South Korea, and Thailandrecorded an outflow of $12 billion, which was equivalent to about 10% of their combined GDP. (World Bank, 1997, 1999 a, and 1999b). These figures show that direct equity purchases by foreign investors in local stock exchanges are extremely volatile. Any loss of foreign investors confidence, may result in quick
liquidation of domestic security holdings, conversion of the proceeds into foreign currencies , and their repatriation. This is particularly true, when they are managed by retail investors who do

not have access to the sophisticated investment methods or the extensive information and resources for research typically available to large institutional investors. (Frankel, 1997). Moreover, information asymmetries between domestic and foreign investors, may lead to an increase in the volatility of domestic asset prices and returns. For example, a defensive reaction by local investors to the sale of domestic securities by foreigners who in turn are responding to events overseas, may magnify the impact of foreign stock market spillover effects on the domestic market. Since local investors generally do not know why foreigners are changing their holdings of domestic securities, they may react to such changes even though the fundamentals of the domestic market have not changed. (World Bank, 1997d). These disadvantages made many emerging markets, such as Korea , Indonesia, and Chile impose some restrictions on this type of foreign investment, and encourage other less volatile types, particularly in their first stages of financial integration, until their domestic stock markets were more prepared to receive direct foreign portfolio equity investments.

A.1.2. Venture capital funds: Foreign investors may provide financing and management guidance to new unquoted companies or high risk ventures with prospects for high growth and profitability, to participate in the high potential returns, particularly in the form of capital gains. Following is 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 and divestment. i-a-The entry phase: venture capital investors cannot sell out their investments (in unlisted shares) if performance is poor. Thus, these foreign investors, must assess the expected return and when it might be realized, the investment size (because very small investments are expensive to manage), and the investee companys share in its relevant sector. 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 in fixed assets and working capital. -Seed capital: for the research and development of new products or production technologies before the setting up of commercial scale production. -Expansion financing: to enter new markets, develop new products or introduce improved technological processes. -Replacement financing: for entrepreneurs who wish to purchase shares of their associates 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 the investee company by contributing its experience and contacts to business strategy, management organization and processes, and raising additional capital from other financial institutions. i-c-The divestment phase: the final and critical phase of the venture capital fund, is to manage the divestment or exit from the investee firm, once a substantial capital gain and high investment returns are achieved. Exit strategies are: an initial public offering, an acquisition of the investee company by another firm, or the repurchase of the venture capital 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 the former structure, the fund and its manager are incorporated in one entity, while in the latter, each of them is separately incorporated. A two- tiered fund, enables investors to control the managers performance and the funds strategy. It may also lower management costs. (Sahlman, A., 1990).

iii.Trends for venture capital funds: Since the late 1980s, venture capital institutions have been established in many countries, including several least developed countries. These funds have expanded fastest in the newly industrializing economies of Asia and in Central and Eastern Europe. By 1996, the International Finance Corporation, had invested $196 million in 49 venture capital funds. Asian and Latin American countries received 59% of these funds. In recent years, venture capital funds were established in Morocco, Tunisia and Egypt. (IFC, 1996). In general, venture capital portfolio investment horizon tends to be somewhat longer than for other types of FPEI instruments, and less volatile. Thus, it seems more suitable for developing countries, that need finance and managerial expertise for small and medium enterprises, that are applying privatization programs, and that are encouraging domestic companies 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 managing the money of multiple investors. These funds can invest on a global, regional, sub-regional or individual country basis. (IFC,1996; United Nations, 1997). The characteristics of country funds vary according to the structure of the fund, and the investor placement. i-The structure of the fund: country funds usually fall into two types: closed-end funds and open-end funds. i-a-A closed-end fund is an investment fund, which issues a finite number of shares at the 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 less developed equity markets. Closed-end funds, are less likely to contribute to market volatility. (IFC, 1996; and IFC, 1998). If the investment portfolio of the closed-end fund is concentrated relatively heavily in less liquid instruments in which trading activity is light, then the prices of the funds shares may vary independently of the value of the underlying portfolio of securities in which the fund invests. This, diminishes the diversification benefits from the investors point of view, but offers the emerging market, an insulating property when the local market in which the fund is invested is illiquid. Closed-end funds may be either diversified or non-diversified. Diversified funds face limits on the percentage of total assets which can be invested in a single security, whereas non-diversified funds face no such restriction. Diversified closed-end country funds usually pose no threat to the control of domestically owned private firms, because most of them limit their holdings to no more than 10 percent of a single firms equity. Nondiversified funds are relatively more risky, because of the potentially higher degree of concentration in their investment portfolio. i-b-An open-end fund is an investment fund in which new shares can frequently be issued and in which existing shares can be redeemed on demand. These funds grow or shrink as investors invest or divest. Open-end funds, when selling a portion of their

portfolio of securities in order to meet redemption requests, can create downward pressure on 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 and liquid markets. (IFC, 1998). ii-The investor placement: It may be private or public. A country-fund could be privately placed to a small, perhaps preselected group of investors. It may otherwise be publicly placed by selling it through underwriters to retail or institutional investors. Country funds offer significant benefits to investors, firms and host countries. The following figure (3), summarizes the main benefits of country funds. Figure (3)- Country-Funds Benefits

Firms

Improved access to capital, management, & to marketing and financial studies.

Host Government

Fund investors Risk diversification, professional management, and economies of scale in

Foreign investors often demand better infrastructure Refor Prices rise and liquidity Supply and liquidity increase, and demand expands More institutional Cost of issuing

More equity is issued

Recently, there has been an evolution towards specialized funds, such as : debt-equity conversion funds, and private-equity funds. *Debt-equity conversion funds: several heavily indebted countries in Latin America and Asia, swapped external debt obligations into domestic equity. The International Finance Corporation, advised some of these countries on legal frameworks and helped develop,

structure and market debt equity funds. In June 1992, the only fund in the Middle East and North Africa region was a debt-equity conversion fund for Egypt, investing in tourism projects. (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 target larger more developed projects. The market for these private-equity funds, developed in response to several factors, such as privatization, increased private provision and financing in infrastructure, improvements in stock market size and liquidity that have allowed private equity investors to sell through initial public offerings. From 1986 to 1996, the total number of emerging markets international equity investment funds, grew from 28 to 1435, while the net value assets of these funds increased from US$2 billion to US$135 billion. Asian funds, accounted for about 48% of the total net asset value of emerging markets equity funds. In September 1996, there were 298 global funds, 775 funds dedicated to Asia, 239 to Latin America, 88 to emerging Europe 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 that are listed and traded in the United States as well as on their own countrys stock exchange. When the securities of this foreign corporation, have been deposited with a custodian bank in the country of incorporation of the issuing company, this custodian bank informs a commercial 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 the securities of United States companies. The holder of ADRs is entitled to the same rights and 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 issuing company and the depositary. They provide the issuing company a relatively inexpensive method 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 the issuing company under rules provided in a deposit agreement. Sponsored ADRs, may be restricted or unrestricted: *Restricted ADRs are privately placed, are not registered with the Securities and Exchange Commission, and are exempt from its reporting requirements. Rule 144A, passed by the Securities and Exchange Commission in 1990, eased restrictions on the resale by qualified institutional buyers of private ADR issues amongst themselves once these issues were made under this rule. *Unrestricted ADRs are publicly placed and traded. There are three classes of unrestricted ADRs, each increasingly demanding in terms of reporting requirements to the Securities and Exchange Commission, but also allowing higher visibility and making the facility more attractive to potential investors.

It is difficult for small capitalization companies of emerging markets to issue unrestricted ADRs, because they must meet partial or full reporting requirements of the Securities and Exchange Commission and other specific minimum requirements with respect to the size of total assets, earnings and /or shareholders equity. Thus, emerging market ADR issuers tend to be large domestic companies with considerable financial resources and high international visibility. ii-Global Depositary Receipts [GDRs], are shares of a corporation that are publicly traded in London, Luxembourg, or other international stock exchanges as well as the home country. The only difference between GDRs and ADRs is that the former can be traded in more 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 companys access to international investors in foreign markets, and enable it to attract the capital of investors who are unwilling to go directly to the inefficient domestic markets, or are prevented from doing so by legal restrictions (World Bank, 1997). Depositary receipts lower the future cost of raising equity capital, by raising the companys visibility and international familiarity with it. The decision to issue a depositary receipt is not necessarily equivalent to raising new equity capital. Firms can choose to list existing shares in the foreign market, to gain access to a larger shareholder base, which may increase the value of their equity. At a future date, they may be able to raise new equity in the foreign markets. However, in countries like Chile, the firms are allowed to go to the international markets only with new issues of equity while the trading of existing shares is prohibited. For foreign investors, depositary receipts lower the cost of trading in foreign companies securities and lower information search cost. The depositary provides both settlement and clearance services, thus lowering the settlement time and risk. The depositary provides periodic financial reports on the issuing company to the investor, who bears 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 GDRs represented 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 value equivalent to US$337 billion were traded on United States securities exchanges, and an estimated 1.5 billion depositary receipts with a value between $20 and $25 billion were traded on European exchanges, or on the over-the-counter market. Nearly sixty three countries 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 of shares of the issuers stock, usually at prestated prices and at any time up to and including the maturity date of the bond. The holder of a convertible bond will exercise the right to

10

convert the bond into stock if the value of the shares for which the bond could be exchanged exceeds the value of the bond. Many convertible bonds include a call option, which gives the issuing company the right to redeem the bond before its maturity date. Once the call is exercised, the bond holder chooses either to convert the bond into shares or surrender it and receive in return the 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 the ordinary shares of a company for a given period of time [the exercise period], and at a fixed price. A warrant may sometimes be issued, bought and sold on the stock exchange, as a separate security. The holder of a bond with equity warrant, will exercise the warrant if the price of the shares exceeds the exercise price of the warrant, to realize a net gain. (French, 1989). Generally, the holders rights attached to convertible bonds and bonds with equity warrants will be exercised in the event that the company is successful and its market value and share price rises. If growth is not very high, the investor can retain the bond, and receive a stable relatively safe income flow. The interest payments on convertible bonds and bonds with equity warrants are lower than on straight bonds (because of the value of the right to convert and the value of the warrant, respectively). Thus, the issuing company will be able to apply a larger amount of financing towards expansion of the company or towards general operating expenses. Convertible bonds have been issued since 1985. During the past ten years, they accounted for 93 per cent of total emerging-market issues of equity-related debt instruments. 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 were issued. Only fifteen emerging markets had floated equity-related bonds in the international markets. Emerging markets, accounted for 4% of the international issues. These issues have emanated almost exclusively from the relatively large middle-income emerging markets, that are well known in international capital markets. [ China, India and Pakistan are notable exceptions]. Asian issues of convertible bonds have, on average, accounted for 81 per cent of all emerging-market convertible bond issues, and for 85 per cent of emerging-market issues of bonds with equity warrants. In 1995, the share of Africa and the Middle East in emerging markets issues of equity-related bonds, was 16%. (United Nations, 1997, annex table 21). B-Types of foreign portfolio equity investment mechanisms in the Egyptian stock market: 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 was registered 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 billion or 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, Egypt witnessed a surge in foreign portfolio investment, reaching their peak level of around $1.5 billion. (Central Bank of Egypt, Annual Report, 1996/97, and Monthly Statistical Bulletin, vol.39, no. 3, 1998/99). The following table shows the value of net foreign portfolio investment flows to Egypt, during the last six years. Table (1)- Net Foreign Portfolio Investment in Egypt [1993/94-1998/99] In US$ million
Fiscal Year Net value of FPI FPI as a % of market capitalization.

1993/94 1994/95 1995/96 1996/97 1997/98 1998/99

*

1.3 4.1 257.6 1462.9 -248.0 -197.2

0.03 0.06 2.30 8.30 -1.10 -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 the Egyptian stock market trended downwards. This was mainly a result of eight major negative events that damaged local and foreign investors confidence. Seven of these events were mainly domestic factors. -The government of Egypt announced that it would rescind the tax breaks allowed on the revenue generated from treasury bills, and subsequently delayed in issuing the executive regulations of the new income tax law 5/1998. -The privatization process slowed pace such that only three companies were privatized in 1998. -Investors feared that new public offerings of public-sector companies would probably be very highly evaluated. -Investors faced difficulties in tracking companies performance, as very few companies provided quarterly financial reports. -The Commercial International Bank planned to distribute its shares among its employees and management. -Cases of insider trading were reported. -Transparency issues and the poorly executed sale of Egypts two mobile phone companies, 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 an investigation 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 equity purchases by foreign investors in the Egyptian stock markets, international equity investment funds (country funds), and global depositary receipts. (see figure (4)).
Source: own calculations.
Types of foreign portfolio equity investment instruments in egypt in 1996

country funds 13 % foreignres value traded 67 %

GDRs 20 %

foreignres value traded

GDRs

country funds

B.1. Direct FPEI in the Egyptian Stock Exchange: In the Egyptian stock market, there are no restrictions on foreign trading. There is no ceiling on foreign ownership for companies established under Law no. 159 for 1981 as amended by Law no.3 for 1998. In addition, it is no longer required that the majority of board members be Egyptians. Capital gains taxes and taxes on dividends, were eliminated. There are no taxes on the repatriation of profits and foreigners are allowed to repatriate profits at any time. (Egyptian Ministry of Economy, 1998). Foreign securities companies are allowed to operate in Egypt and face the same licensing procedures as domestic firms. Branch offices of fund management firms that are not incorporated in Egypt are allowed to operate without any special license. Foreign brokerages 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, direct foreign trading was not registered before 1996. Although the highest share of foreign investors in the capitalization of Egypts stock market, was about 8% only in 1996/97, their share in the number of transactions, in traded shares, and in the value traded was very large, and increasing. [see table (2)]. In other emerging markets, foreigners shares in market capitalization and in trading, are relatively proportionate. For example, in 1995, these shares in Korea, were 13%, and 6%, respectively, and in Thailand they were 21% and 26%. (World Bank, 1997d).

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Table (2)- The share of foreigners, trading in the Egyptian stock market during the period from 1996- September 1999. [%]
Year 1996* 1997* 1998** 9/ 99** Share in the number of transactions 7.3 8.5 18.2 24.16 Share in the number of traded shares 19.7 23.6 40.2 45.5 Share in the value traded 22.4 23.5 44.5 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 mainly interested in short-term transactions, which may encourage destabilizing price speculations, and adversely affect the market price level. For example, in July 1998, foreigners share in the value traded reached nearly 64%, selling transactions represented 44.6% of it. This caused a further decline in prices. (IBTCI, June, 1998). Foreign investors are usually more experienced than local investors, and may play an important role in directing the market price. A foreign investor trades an average of 564 shares per transaction, while the average number of shares in a transaction by an Egyptian investor is 117. Thus, the average number of traded shares in a transaction by a foreign investor, is 4.8 times higher than that of an Egyptian investor. The average value per traded share 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 relation between foreign trading and changes in the stock market price index using regression analysis. They found a significant relation between the size of foreign investors transactions and the index of the Egyptian market. The coefficient of determination was 0.38, and therefore they concluded that foreign investors play an effective role in determining 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 the direction of the relation between these two variables. In order to investigate whether there is a causal relationship between the value of shares traded by foreigners and the change in the price index, and the direction of this relation, we employed Granger causality test. (Granger, 1969). The value of shares traded by foreigners was used as an indicator of foreigners size in the Egyptian stock market. (VSTF). Changes in two indexes for the Egyptian stock market price, were employed. First, the publicly traded securities index (PTSI), because foreigners trade in publicly listed companies, only. Second, the IFCG index (IFCG), as it includes the most 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

14

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 difference one with 99% confidence level. Changes in the two market price indexes are stationary at the level, with 99% level of confidence]. The results summarized in table (3), show that trading by foreigners in the Egyptian stock 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 price indexes. This result seems consistent with our previous analysis of this type of flows which emphasized 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 VSTF IFCG PTSI VSTF VSTF PTSI

0.771 3.4 2.4 3.01

0.385 0.07 0.12 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. Egypts country funds: Egypt has seven offshore funds, that are listed in London, Dublin, Luxembourg and Saudi Arabia. Five of these funds are closed-ended. Their aggregate issue value is approximately $ 414.3 million. These are few funds, if compared with other emerging markets, and considering their potential advantages that were previously mentioned. In 1996, 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 privateequity funds, should be encouraged. Transparency and improvements in disclosure and accounting standards will encourage foreigners to invest in Egyptian companies equities.

15

Table ( 4 )- Country funds investing primarily in Egyptian securities Fund Egypt Fund (Dublin) Egypt Growth Inv. (London) Egypt Investment (London) Egypt Trust (London) Faisal Fund (Dublin) Nile Growth (Luxembourg) Rajhi Egypt (Saudi Arabia) Starting date of operation. 8/96 6/96 Size in US$ million 43 46 Nominal value per certificate L.E. 9.98-10 10 Fund Type Capital growth Capital growth closed-ended Capital growth closed-ended Capital growth closed-ended Capital growth openended Capital growth closed-end Capital growth Fund Manager Hermes Concord

1/97

91

10.25

Concord

9/96

74

10

Lazard

3/98

15

10

Hermes

6/97 5/97

130 15.3

10.30 100

CIIC 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]. Issuing GDRs 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 relatively small. During 1996- July 1999, eight Egyptian companies issued GDRs, as shown in table (5), below. Egypts GDRs issues represent four sectors- financial, industrial, chemical, and food and beverage-out of 20 sectors classified by the Egyptian Stock Exchange. The eight issuers 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 domestic stock market price. When shares price increases in the Egyptian stock market, GDRs may be converted into local shares. This arbitrage process, may be beneficial to the company that issues GDRs, by reducing the volatility of its shares price in the local market. (see Hendi et al., 1999). As shown in the last column of table (5), the GDRs outstanding balance for five out of eight Egyptian GDRs issuing companies, was negative, as of end June 1999. This means that some of these five companies GDRs, were converted into local shares, implying that

16

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 Volume on offering date in million GDRs [1] 9.9 Volume in 30/6/99 in million GDRs [2] 7.9 Net balance ([2] - [1] in 30/6/99 -2.0 *

Commercial Investment Bank [CIB] Suez Cement Al-Ahram Beverages Al-Ahram Beverages Paints Chemicals [PACHIN]. Misr International Bank [MIB]. EFG-Herms. Al-Ezz Steel Rebars. Lakah Group and

Financial

July 1996

Cement Food beverages Food beverages Chemical & &

July 1996 February 1997 January 1999 October 1997

7.3 8.0 n.a. 6.3

5.7 7.2 n.a. 3.0

-1.6 * -0.8 * n.a. -3.3 *

Financial

April 1998

6.5

5.3

-1.2 *

Financial Industrial Industrial

August 1998 June 1999 July 1999

4.8 0.5 35.0

5.4 0.5 n.a.

0.6 ** 0.0 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 at providing an overview on Egypts GDRs trend and performance, the price changes of GDRs resulting from various emerging market disturbances and foreign investors responses toward information, especially timely local information. The index includes five GDRs, and its base period is October 1st 1997. (see: Ministry of Economy and Foreign Trade, 1999). The Egyptian GDRs index level, fell insignificantly by 2.48% over the year 1999. In January 1999, the index witnessed an increase of almost 25%, as the US dollar depreciated against the newly issued Euro currency. However, the index fell by 9.3% in March, due to the dollar shortage facing the country. It experienced a further decline of 9%, in May and June as a result of increasing fears in the international markets concerning the possibility that the Federal Reserve would increase the interest rate.

17

Egyptian companies should be encouraged to issue GDRs, especially that the value of the Egyptian market international issues in 1996 was $ 233 million only. This value is very small, compared to other developing countries. {In 1996, the value of international issues for India was $1.340 billion, for China was $1.3 billion, and for Indonesia was $1.237 billion} (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 these determinants is important because successful domestic policies, are the key to ensuring sustainable, 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 to developing countries, an examination of Egypts recent economic performance and of the characteristics of the Egyptian stock market, will enable us to identify the main factors that affected these flows to Egypt. A-Review of the literature on determinants of foreign portfolio equity flows to developing countries: The surge in private capital flows to developing countries since the early 1990s has coincided with a period of low international interest rates and a period of domestic policy reform in many developing countries. Thus, there has been considerable debate in the recent literature, on whether this surge was driven in large part by cyclical factors in the international economy or was a result of longer-term structural changes. (Hernandez and Rudolph, 1995; Fernandez-Arias, 1996; Fernandez-Arias and Montiel, 1995). The debate has been about the relative importance of push factors (factors in the global economy, that are external to the economies receiving the flow, such as the decline in international interest rates, and the slowdown of the economic activity in industrial countries, in the early 1990s), and pull factors (factors that are internal to the recipient economies, such as improved domestic policies and sustained high growth performance in them). (see, for example, Calvo et al., 1993; Claessens, 1995; Claessens, Dooley, and Warner, 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, to developing countries in general and Egypt in particular, the available studies on the determinants 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 be presented below. A.1. External factors: The major factors behind the increase in FPEI flows to emerging markets are the liberalization and globalization of financial markets, and the concentration of substantial financial resources in the hands of institutional investors. Also, the role of foreign interest

18

rates, as a push factor driving capital flows and determining their magnitude is well established by the empirical work undertaken on this issue. A.1.1. The regulatory environment: Financial-market liberalization, the major advances in financial instruments, and the rapid flow of market information, due to the improvements in communications technology, facilitated the globalization of financial markets, which implies that financial capital can move 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, the USA Securities and Exchange Commission adopted Rule 144A in 1990, which permits holders of shares in non-USA firms purchased in private placement, to sell them freely to qualified institutional buyers under certain conditions without being subject to a two-year holding period. Also, Regulation S in the USA, eliminated settlement delays, and facilitated 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 their portfolios, consider investing in emerging markets because the correlation between equity returns from different countries is lower than that between equity returns in the same country. This is especially true for investments in developing countries, because their stock returns 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 emerging markets largely because of the decline in global interest rates and the slow down in economic 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 19891990 and 1.1% in 1991-1993. USAs real GDP grew by only 1.2% in 1990 and declined by 0.6% in 1991 (Fernandez-Arias and Montiel, 1995). Taking the industrial countries as a group, the weighted aggregate short-term interest rate, fell from over 9% in 1990 to a little over 5% in 1993. Long-term interest rates in the G-10 countries, declined (on a weighted average basis) from about 9.5 percent in 1990 to 6.5 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 less attractive at the margin than investing abroad, (the asset substitution effect/channel); and appear to have improved the creditworthiness of heavily indebted countries that borrow at these rates, (the creditworthiness effect). (Goldstein, 1995). FPEI flows in emerging markets were found to exhibit a strong negative association with 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 FPEI flows: to all emerging markets, to Asia, and to Latin America were, respectively -0.7, -0.6 and 0.8. These coefficients were statistically significant and indicated that FPEI flows to

19

emerging markets were heavily influenced by developments in United States financial markets. (Burki, et al., 1997; Schadler, 1994). A.2. Internal Factors: Some studies observed that the timing of the external factors, did not coincide with the surge of private capital inflows in each recipient country. For example, Thailand and Malaysia, started receiving inflows as early as 1988 or 1989, respectively, while the Philippines and Peru, received them in 1992 or 1993, respectively. Furthermore, between 1989-1994, over 80% of private capital inflows went to a score of countries. This uneven geographical distribution of private capital flows, among regions and between developing countries within those regions, suggests that country-specific factors have played an important role in determining the size and composition of private capital flows to developing countries. Thus, the pull view holds that, inflows are attracted to the recipient countries mainly because of the fundamental economic reforms they have taken immediately preceding the inflow 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 and structural reform programs. For example, Bolivia, Chile and Mexico, implemented major disinflation programs prior to the surge in capital inflows. In several cases, fiscal adjustment (reductions in the share of government expenditure in output as well as lower budget deficits) played a key stabilizing role and was instrumental in attracting capital flows. Improved fiscal balances helped to lower inflationary expectations and conveyed a signal regarding the policymakers commitment to achieve and maintain macroeconomic stability. In countries like Argentina, Thailand, Mexico and Chile, significant reductions in fiscal deficits preceded the surge in capital inflows. (Corbo and Hernandez, 1996; Fernandez-Arias and Montiel, 1995). The rate of economic growth; as well as the potential rate of growth of the host country is an important influence on decisions on where to invest. The distribution of FPEI is skewed towards upper-middle income and large low-income countries with a high growth potential. Foreign portfolio investments are extremely sensitive to a countrys openness. The right to repatriate dividends and capital may be the most important factor in attracting significant foreign equity flows. In Korea, the surge coincided mostly with faster financial liberalization, particularly a shift to allowing foreigners to acquire domestic stocks and bonds. (Goldstein, Mathieson, and Lane, 1991; Schadler, 1994; Lee, 1997). Many developing countries increased openness of their markets, through the lowering of barriers to trade and foreign investment, the liberalization of domestic financial markets and 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 the privatization of state-owned enterprises. Of the $112 billion of privatization proceeds that

20

developing countries received during 1988-1994, almost 42% were from foreign investors. Thus, privatization programs offered foreign investors an opportunity to gain a stake in some 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 opportunities and risks of investing in the country, and are important in determining capital flows as well. Capital flowed initially to the rapidly growing countries in East Asia that never suffered a debt crisis. Many heavily indebted countries in Latin America, made significant progress towards improving relations with external creditors and restoring their creditworthiness. The restructuring of the commercial bank debt of these countries in the context of officiallysupported Brady-type initiatives, improved their debt indicators, and secondary market prices 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 rating from one of the two major international credit-rating agencies (Moodys and Standard and Poors). (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 recipient countries, and to the range of instruments available to foreign investors who wish to purchase developing countries equities. For example, many venture-capital fund investments in unquoted companies are made with the expectation of reaping capital gains subsequent 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 stock market. The broadening and deepening of developing countries securities, and the increase in their market accessibility, have offered investors significant opportunities for risk diversification (World Bank, 1997). During 1988-93, foreign investors were attracted to emerging equity markets whose returns tended to be higher than those in industrial countries. For example, during that period, the annual U.S. dollar rate of return according to the IFC composite index for Latin America 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 country stock markets have earned average annual returns of 8 percent while funds investing in the United States and Europe have earned 19 percent. Risks were also relatively high in emerging markets. The standard deviation of the return on funds was 22 percent for emerging markets and 13 percent for U.S. and European funds. The risk-adjusted return as measured by the Sharpe ratio was 0.2 for funds investing in emerging markets, much lower than 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

21

emerging markets may exceed returns in industrial countries over the medium term as output in developing countries is expected to rise significantly faster than in industrial countries, and as differences in patterns of population growth are likely to widen the differential in expected rates of return on capital between industrial and developing countries. 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 in emerging markets. In this respect, an adequate market infrastructure and the availability of exit mechanisms through stock exchanges, contribute to greater liquidity. Liquidity has increased in emerging markets as total trading values in the secondary market for developing 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 availability of market research on emerging markets has made foreign investors less reluctant than they used to be to send capital to developing countries, when the opportunities are viewed as favorable. A.2.4. Contagion effects: Contagion effect, may arise because investors decide to temporarily withdraw from a country (or a group of countries) in order to re-evaluate risks and returns following a crisis in 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, may generate externalities for the smaller neighboring countries. Some studies have found that correlation of equity price movements across countries, is greater 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 a country 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 pull factors. Following is an investigation of the Egyptian country specific factors that affect foreign portfolio equity investment. B. Egypts recent economic performance: Since 1991, Egypt has embarked on an economic reform and structural adjustment program. The aim was to restore macroeconomic stability, restructure the economy and enable it to face the challenge of global integration of production, trade and financial markets. Egypts stabilization policies have been highly successful. Inflation declined from an average of 20 percent over 1989-92 to 3.8 percent in 1997/98. Real output growth, rose to 5.7 percent in 1997 /98, up from 0.3 and 0.5 percent in the first two years of the stabilization. Fiscal deficit was brought down from over 15 percent in 1990/91 to 1.3 percent of GDP in 1998/99. The current accounts deficit improved from about 5 percent of GDP to 1.9 percent in 1998/99. Egypt has implemented various other reforms that will be discussed below: B.1. Financial liberalization:

22

In January 1991, interest rates on pound deposits and loans were liberalized, and treasury bill auctions were introduced. In October 1992 and July 1993, lending limits to the private and public sectors were eliminated, respectively. Financial liberalization was supported by a series of other reforms to strengthen the solvency and efficiency of the banking and securities markets. (for details see: World Bank, 1996; and Central Bank of Egypt). B.2. Exchange rate policy and free capital mobility: In October 1991, Egypt unified the exchange rate system and its exchange rate has become fully convertible. Since then, the nominal exchange rate of the Egyptian pound with respect to the American dollar has been roughly constant, as a result of heavy intervention 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 Foreign Exchange Law no. 38. Most banks were authorized to deal in foreign currency and foreign banks were allowed to deal in local currency. Currency transfers across borders by authorized banks were no longer restricted, thereby allowing complete international capital mobility. (Central Bank of Egypt, Annual Reports; IMF, 1997; and World Bank, 1996). Thus, free capital mobility, nominal exchange-rate anchor, together with financial liberalization, led to large capital inflows, and the accumulation of foreign exchange reserves. Also, the deceleration of inflation, the fiscal adjustment, the stable nominal exchange rate, the large capital inflows and foreign exchange reserves, have encouraged the rapid pace of dedollarization from almost 50 percent of the broad money supply in 1990/91 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 314 state owned enterprises. Over the period 1993-1997, Egypt has been rated as the fourth most successful privatization program in the world. Proceeds from the privatization program as of 1998 amounted to LE 7.8 billion. (IMF, 1998, and Egyptian Ministry of Economy, 1999). From April to September 1996, the privatization program progressed quickly. The majority share of nineteen companies was sold, with eighteen of them through the stock exchange. In 1997, another thirteen companies were sold. (IBTCI, 1999). Out of the original portfolio of 314 public sector companies, by the end of 1998, the government had sold controlling interests in 99 of these companies and minority interests in another 20. Of the total, 31 companies were offered for sale between July-December 1998 with a total value of LE 4.6 billion. (EFG- Hermes, 1999). Banking Laws no. 37 of 1992, and no. 101 of 1993, and their amendments adopted in 1996 and 1998, allowed joint venture banks to be 100% foreign-owned, and state-owned banks to be privatized. B.4. Trade liberalization: The government has removed almost all non-tariff barriers. It has reduced the range of import tariffs to 5 to 40 percent, while tariff preferences and exceptions to the maximum tariff have largely been eliminated. Tariffs on nearly all capital goods have been removed. The remaining few restrictions on exports have been abolished. (EIU, 1997).

23

B.5. Improvements in Egypts creditworthiness: After the Gulf War, Egypt received $7 billion in debt forgiveness from Gulf Arab States. The Paris Club agreed to reschedule $27 billion in official and government guaranteed debt. As a result of this debt forgiveness and restructuring, and the tight fiscal policies, the gross external debt amounted to slightly less than $ 30 billion or 36% of GDP at 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 private sector debt remains negligible at less than $ 300 million. The Ministry of the Economy calculated the net present value of the gross debt to be $18.7 billion as of 1997. At this level, Egypts external obligations are substantially inferior to its total foreign reserves and the net foreign assets of the banking system. Consequently, in present value terms, Egypt is a net creditor to the world (EFG- Hermes, 1999; and Subramanian, 1997). All of the above-mentioned reforms have led to improvements in Egypts creditworthiness risks, declines in investment risk, and increases in expected rates of return. The following table reflects the sovereign rating for Egypt, according to some international rating agencies (Standard and Poors, and Fitch IBCA). Table (6)- Sovereign rating for Egypt
Local Currency Longterm rating. Standard & Poor. Fitch IBCA. AAOutlook Shortterm rating A-1 n.a. Foreign currency Long-term rating. BBBBBBOutlook Shortterm rating A-3 F3*

Stable Stable

Stable Stable

Notes: 1- F3*: fair credit quality. The capacity for timely payment of financial commitments is adequate; however, near-term adverse changes could result in a reduction to non-investment grade. 2n.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 some important albeit, indirect factors that may limit foreigners access to the local stock market (Bekaert, G., 1995). The Egyptian stock markets infrastructure, size and liquidity, and return characteristics will be analyzed, and the main indirect barriers confronting foreign investors will be investigated. The Egyptian government has been fostering the revitalization and development of its capital markets over the past decade. The Capital Markets Law no. 95 of 1992, which came into force on April 7th 1993, restructured the securities and bond markets. It provided the framework for the establishment of capital market service companies including securities

24

brokerages, mutual funds, portfolio managers, underwriting institutions and venture capital companies. The legislation facilitated the issuing of corporate bonds, and encouraged the formation 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 67 percent in 1992 to 58 percent in 1996. This may reflect the growing importance of capital markets. (Subramanian, 1997; EFG-Hermes, 1999). C.1. Market infrastructure: Foreign investors- especially those who decide to invest directly in the local stock exchange- are very much concerned about the markets 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 depositary systems, the financial disclosure and accounting standards, and the availability of protection for investors. C.1.1. Listing requirements: Securities of joint stock companies must be registered in Cairo or Alexandria stock exchanges, either in the official or unofficial register. The official register includes companies with no less than 150 shareholders and in which at least 30% of the nominal capital has been floated publicly. It also includes Law 203 companies, which have undergone a public issue of shares regardless of the free-float percentage. Also, a company must be publishing its balance sheets for at least twelve months, before being listed in the official register. Securities, which do not fulfill the above criteria, and newly established firms are included in the unofficial register, as are foreign securities. [Egyptian Ministry of Economy, 1998, The Law of Business]. Table (7)- Companies listed in both the official and unofficial registers, at 13/7/.9991
Listing Type Official Unofficial Total Number of companies 137 838 975

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 being registered in the unofficial list, mainly because the Capital Market Authority allows closed companies to be registered in the stock exchange, thus enabling them to affect the liquidity of the market. ii- The Egyptian listing requirement system has no restrictions concerning the profitability and size of the company being listed in the stock exchange. Thus, the system does not guarantee the financial health of the listed companies and may adversely affect investors confidence.

25

In most other emerging markets, only public offering companies are allowed to be registered in the stock exchange and they are usually organized in various sections according to the companies profitability [see appendix (2)]. To enhance the efficiency and liquidity of the Egyptian stock market, it should be organized in more than one section, with each section differing in its listing requirements such as the percentage of the companys shares publicly offered, the companys 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 exchanges are to be sold only through licensed brokers. The number of brokerage firms has increased from 2 companies in 1992, to 152 in 1999( CMA, 1999). Brokerage firms must adhere to the capital adequacy requirements, according to the type of business in which they are engaged. (CMA, 1996). As of April 1999, an integrated computerized trading system links Cairo and Alexandria Stock Exchanges and all independent bookkeeping activities to the Central Depository and allows for automatic electronic matching of bids and offers. This has resulted in greater speed 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 depository systems, moving towards international norms. In October 1996, Misr for Clearance, Settlement and Depositary, [MCSD], was the first company to be established in Egypt to provide greater efficiency in the settlement of transactions, according to the delivery versus payment principle. Egypt uses the rolling settlement system, by which trades are scheduled for settlement a certain number of days after execution. Settlement is completed at T+4. This improvement in the clearing and settlement system is a positive indicator for foreign 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 other emerging markets, as can be seen from the following table. Table (8)- Clearance and settlement period in selected emerging markets
Country Period
Egypt* Kuwait * Saudi Arabia* Bahrain * Jordan * Lebanon * Brazil ** Chile ** Argentina ** Korea **

T+4

T+0

T+1

T+3

T+3

T+3

T+1

T+3

T+3

T+2

Source: * Data base for Arab Capital Markets, April 1997. ** http.www.emgmkts.com.

The number of companies with immobilized shares listed with [MSCD], increased from 84 in May 1998, to 143 in February 1999. As of April 1999, 158 securities were being traded through MCSD, including nearly 75% of all actively traded shares. (IBTCI, March 1999; EFG-Hermes, 1999). A transition period is needed until all companies and securities become listed with MSCD.

26

C.1.4. Financial Disclosure and Accounting Standards: The efficiency of the domestic stock market and its integration with international capital markets, demand transparency to be enhanced and information to be prepared according to international standards. All Egyptian listed companies are required to publish audited quarterly financial statements adhering to internationally accepted accounting practices. Fully audited financial statements and the report of the board must be produced within three months of the end of the fiscal year, made available to shareholders, and published in two daily widely distributed newspapers. Companies are also required to make timely disclosure of all 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, after three months notification. (CMA, 1996). However, as the CMA has not executed this legal right to date, only one tenth of all listed companies do publish their financial statements regularly and no more than 50 percent of them send their quarterly financial statements to the Capital Market Authority. (Al Borsa Magazine, August 1999). It seems that disciplinary measures should be strictly applied against the companies that fail in making the required disclosure. C.1.5. Investor protection fund: Most emerging markets protect investors, by supervising the settlement system to increase the confidence in the market. Until end of June 1999 there were no procedures concerning investors protection from losses arising from negligence, error or malfeasance. As of July 1st, 1999, the Capital Market Authority (CMA) established a compensation fund to protect local and foreign investors against potential settlement risk. All securities service companies are required to carry insurance for these potential losses and all companies deposit fidelity guarantee money with the MCSD, to enable it to open an independent account for a compensation fund, whose resources may be used to help fulfill the obligations of a member, who is involved in a troublesome transaction but this fund has not started working yet . (Al Borsa magazine, no. 163, August 1999). The (CMA), has created an Arbitration Board to address complaints and legal disputes raised by investors C.2. The size and liquidity of the Egyptian stock market (ESM): Foreign investors, especially institutional investors, are attracted to larger and more liquid stock markets. C.2.1.The size of the market: Various indicators, such as market capitalization as a percentage of GDP, and the number of listed companies usually measure the stock market size. Although the Egyptian stock market is still relatively very small, in comparison to other emerging markets, it has been developing in recent years and its share in the international market has been increasing since the early nineties. Over 1994-98, the capitalization of the ESM increased rapidly at an annual average growth rate of nearly 45.6%, and from 8.3 percent of GDP to 29.9 percent of it. In the third quarter of 1999, market capitalization relative to GDP reached 31.4% and the number of

27

listed companies increased to 1004, and the value of new issues augmented. (Ministry of Economy, July 1999). In 1998, the Egyptian market capitalization was nearly 1.3 percent of the total value of emerging markets capitalization, (compared to 0.2 percent only in 1990), and represented about 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 3.2 percent of the total emerging markets listed companies, and nearly 60 percent of those listed in the Arab emerging markets (Arab Monetary Fund, 1999). Table (9)- Egyptian stock market size indicators (1994-1998). -LE Million1994 No. of listed companies. Value of new equity issues. Value of Capitalization.
2

1995 146 11251 27420

1996 646 20478 48086

1997 650 19485 70873

1998 861 36300 83140

1999/Q3 1004 n.a. 95799

100 4879 14480

8.3 13.4 21 27.7 29.9 31.4 Capitalization (% GDP) Sources: 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 emerging markets, is still ranked as number twenty-one with respect to market capitalization, and as the 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 are excluded, the value of market capitalization will drop sharply. According to the Capital Market Authoritys report in 1998, the capitalization of the companies whose shares are available to the public reached LE. 23.57 billion only and represented about 28 percent of the 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 number of public offering companies, the Egyptian stock market is actually very thin. Allowing closed companies, to be listed in the stock exchange a phenomenon, not found in other emerging markets- affects the market badly and is considered a restraint on the value of trade. It is worth mentioning that in 1997, the share of the Egyptian stock market 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 emerging countries and to other markets in the rest of the world. As of end 1998, according to the IFC 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 very attractive to local and foreign investors, particularly institutional investors, and are unable to 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 annual growth rate of about 68.2 percent. During 1994-98, the value traded increased at a rate

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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 the turnover ratio decreased for reasons that were detailed in section II. Table (10)- ESM Liquidity.
1994 1995 3849 14.0 55.4 n.a. 1996 10968 22.8 52.1 n.a. 1997 24220 34.2 40.7 29.8 1998 23363 28.1 36.0 21.0

Value traded by Million LE. Turnover ratio* Market concentration** Concentration in the IFCG index***

2557 17.7 n.a. n.a.

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 other emerging markets as shown in the figure below. Figure (4)- Turnover ratios in selected emerging markets- 1998.
200,00% Egypt 150,00% 100,00% 50,00% 0,00% Turnover ratio Malaysia Argentina Brazil China Korea

Source: IFC, 1999.

The concentration ratio of the value traded decreased from 55.4 percent in 1995, to 36 percent in 1998. (Capital Market Authority, 1999). Thus, the market is becoming relatively more 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 Brazil represented 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).

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C.3. Return characteristics: The degree of correlation between the Egyptian stock market and some selected markets, and the properties of equity return, will be investigated. - Degree of correlation: Diversification benefits arise when lower risks are achieved for equivalent returns, or higher returns are realized for equivalent risks. These diversification benefits are stronger across international financial markets than within domestic markets. The following figure (5), shows the degree of correlation between the Egyptian stock market and some other markets. Figure (5)- IFC Egyptian index correlations [22-month period ending 12/98]. According to
0.5 0.4 0.3 0.2 0.1 0 -0.1 -0.2 -0.3 Correlations IFCI composite IFCI regional U.S. S&P 500 UK. FT-ST 100 Japan Nikkei FT. Europac

Source: IFC Factbook 1999.

figure (5), the correlation between equity returns in Egypt and other countries, using the IFC index for these markets is very low. For example, the correlation between the Egyptian equity return and the U.S. S&P 500 is 0.33, and is lower than that between other emerging markets and the U.S. index. (the correlation with Argentina, Brazil, Chile and Malaysia, is 0.64, 0.47, 0.49, and 0.43, respectively). This implies that foreign investors, especially American investors consider Egypt as a highly diversified market. (IFC, October 1998).

- Properties of return: Table (11) below, presents the main statistical properties of the Egyptian stock market return, that are of particular interest to foreign investors, during the period of 1996- August 1999. The return used here is the IFC Global Index (IFCG), as it is considered the base for all other indexes employed by the IFC. In 1999, the IFCG includes about 66 companies representing nearly 60 percent of the market capitalization. The rate of return was so high in 1996 due to progress in the privatization program. This high return, and its low correlation with equity returns in industrial markets, attracted foreign investors to the Egyptian market. (Portfolio inflows to Egypt, reached $1.463 billion in 1996/97 up from $ 258 million in 1995/96). Due to the high increase in equity return, the financial authorities, established a price adjustment mechanism in February 1997. Trading may not exceed a five-percent price band above and below the previous days close without the permission of the stock exchange.

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Any sharp increase in prices that does not depend on fundamentals will fall sharply upon abrupt change in market conditions causing speculative bubbles. (El-Erian,M. and Kumar, 1995). Table (11)- Properties of ESM return 1
1996 Average daily mean. Average daily median. Annual volatility2 Annual rate of return 3 D.F. unit root test. 4 Sharpe ratio. 5 Skewness. 6 Kurtosis. 7 P/E ratio. 0.001 0.00 0.09 0.32 -28.12 2.4 0.424 4.69 11.3 1997 0.0006 0.00 0.193 0.165 -27.8 0.39 0.955 8.77 11.5 1998 -0.001 -0.0002 0.13 -0.35 -27.07 -3.3 -0.084 5.779 8.7 As of August 1999 -0.00085 -0.001 0.13 -0.146 -13.6 -1.8 1.3 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) / , 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). ( ) 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 in industrial countries. The rate of return declined dramatically in 1998, for the reasons previously discussed in section II, then improved slightly during the first three-quarters of 1999, but stayed negative ( 0.146). Since 1997, the sharpe-ratio started to decline. It fell to 3.3 in 1998, down from 2.4 in 1996. 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 and became 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 and 1997, but negatively skewed in 1998.

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iii- The kurtosis value is bigger than three so the distribution has thicker fatter tails than the normal distribution. iv- The unit root test strongly rejects the hypothesis of nonstationarity. This implies that the market is inefficient, as there is time dependence in stock returns that may allow for past information to be used to improve the predictability of future returns. The negative correlation between current and past returns means that the variance of return will tend to be higher following bad news than after good news. (for more details see, Mecagni, M. and Shawky, 1999; and Moursi,T., 1999 that examined the behavior of stock returns and market volatility in Egypt). The inefficiency and volatility of the Egyptian stock market may be due to various reasons: 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 causing investors to have shorter horizons, and encouraging speculative bubbles, as observed from the dramatic changes in market return. Highly experienced foreign investors can realize benefits from these characteristics due to their ability to predict the return. These foreign investors did affect the market negatively especially during 1998 and 1999, and played a substantial role in maintaining the 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 the value traded by foreigners and the change in stock prices. The previous analysis revealed that, although returns in industrial countries were increasing over the period 1992-97, in comparison to the late eighties, yet Egypt started receiving FPEFs, since 1993/94. Thus, these flows are mainly affected by: the fundamental economic reforms the country has undertaken, the complete freedom enjoyed by foreigners in the local market, the privatization program, and the improvements in the countrys creditworthiness. In addition to the remarkable progress in the characteristics of the Egyptian stock market, specially the infrastructure, size and liquidity. Moreover, the Egyptian return has low correlation with returns in industrial countries. The following table summarizes the main factors affecting foreign portfolio equity flows to Egypt.

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

Net FPI in mill. $ Real GDP growth rate% 3.9 4.7 5 5.3 5.7 Annual Average Inflation% 9.1 9.4 7.3 6.2 3.8 Dollarization Ratio (%) Fiscal deficit % of GDP external debt % of GDP 59.9 54.8 45.9 38.1 34 Majority Privatized Sovereign companies Interest rate Rating public offering 0 0 0 20 13 13.95 11.1 10.4 10.4 9.9 stable stable CapitaClearance Turnover ConcenReturn in lization % of and ratio tration Ratio Egypt** GDP Settlement* 17.7 14 22 34.2 22.3 8.3 13.4 21 27.7 29.9 n.a. n.a. 55.4 52.1 40.7 0 0 0 1 1 1 n.a. n.a. n.a. 32% 16.50% -35% Sharpe Ratio

year

Volatility

P/E Ratio

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

1.3 4.1 257.6 1462.9 -248

23.4 25.1 22.9 19.4 17.9

-2.1 -1.2 -1.3 -0.9 -1

n.a. n.a. n.a. 2.42 0.39 -3.3

n.a. n.a. n.a. 0.09 0.193 0.13

n.a. n.a. n.a. 11.3 11.5 8.7

-197.2 6 3.8 17.3 -1.3 31.4 6 9 stable 23.5 31.4 36 *- (0) indicates no MCSCD, while (1) means MCSCD was established.- **- US S&P 500 = 18.01 during 1996- 1999, (IFC, 1999 & W.B., 1998).

8 6 4 2 0 1993/1994 1994/1995 1995/1996 1996/1997 1997/1998 1998/1999

2000 1500 1000 500 0 -500

0 -0.5 -1 -1.5 -2 -2.5

Fiscal deficit % of GDP Net FPI in mill. $

2000 1993/1994 1994/1995 1995/1996 1996/1997 1997/1998 1998/1999 1500 1000 500 0 -500

40 30 20 10 0 1993/1994 1994/19951995/1996 1996/1997 1997/19981998/1999

Turnover Net FPI in mill. $

2000 1500 1000 500 0 -500

Real GDP grouth rate%

Net FPI in mill. $

10 8 6 4 2 0 1993/1994 1994/1995 1995/1996 1996/1997 1997/1998 1998/1999

Annual Average Inflation%

2000 1500 1000 500 0 -500

Net FPI in mill. $

80 60 40 20 0 1993/1994 1994/1995 1995/1996 1996/1997 1997/1998 1998/1999

external debt % of GDP Net FPI in mill. $

2000 1500 1000 500 0 -500

40 30 20 10 0 1993/19941994/19951995/19961996/19971997/19981998/1999
Capit alization % of GDP

2000 1500 1000 500 0 -500

Net FPI in mill. $

30 20 10 0 1993/1994 1994/1995 1995/1996 1996/1997 1997/1998 1998/1999

Dollarization Ratio (%) Net FPI in mill. $

2000 1500 1000 500 0 -500

0.4 15 10 5 0 1993/1994 1994/1995 1995/1996 1996/1997 1997/1998 1998/1999

Interest rate Net FPI in mill. $

2000 1500 1000 1993/1994 1994/19951995/1996 1996/1997 1997/19981998/1999 500 0 -500

Return Net FPI in mill. $

2000 1500 1000 500 0 -500

0.2 0 -0.2 -0.4

0.25 0.2 0.15 0.1 0.05 0 1993/1994 1994/1995 1995/1996 1996/1997 1997/1998 1998/1999
Volatility Net FPI in mill. $

2000 1500 1000 500 0 -500

3 2 1 0 -1 -2 -3 -4
Srarpe Ratio Net FPI in mill. $

2000 1500 1000 1993/1994 1994/1995 1995/1996 1996/1997 1997/1998 1998/1999 500 0 -500

25 20 15 10 5 0
1993/1994 1994/1995 1995/1996 1996/1997 1997/1998 1998/1999 Majority Privatized companies public offering

2000 1500 1000 500 0 -500

Net FPI in mill. $

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IV- Egypts financial integration: Opportunities and Challenges: With the important potential benefits provided by foreign portfolio equity investment flows for Egypt, have come tough challenges. This type of flow, subjects Egypt to more sources of external disturbances, increases the speed at which these disturbances may be transmitted, and makes the country more susceptible to external shocks. Foreign investors have become very important in direct trading activity, and their value traded causes changes in stock prices. Foreigners are increasing the likelihood or magnitude of market bubbles, with securities prices rising far above the underlying fundamentals, which may be followed by a market crash. These risks raise serious concerns particularly that our results showed also that the market suffers from inefficiency and some weaknesses. Increasing foreign ownership of domestic firms, may be another concern. It has been shown, that the risk of volatile flows, varies according to the type of investor and instrument. The most suitable types according to the Egyptian stock market stage of development are not yet fully utilized, and some are non-existent. Egypt needs to take full advantage of the substantial opportunities offered by the least volatile types of foreign investors and instruments, and minimize the potential risks of the other more volatile types, whose likely reversal will have adverse consequences on the volatility of domestic asset prices and returns. Although the improvements in the Egyptian stock market have been remarkable, yet the market is still in its early stages of development. Egypt needs to enhance the reliability of the system to settle transactions, to reduce principal risk and the opportunity cost of a delay. Investors demand reliable systems that record ownership, ensure safe custody of securities, and protect property rights. They want a reliable system that ensures disclosure of material information to evaluate investment choices. Also, enhancing the liquidity of the Egyptian stock market, is desired to enable investors to liquidate securities or change the composition of their portfolios without incurring high costs. Egypt should develop the institutional and policy requisites to attract a higher level of portfolio equity flows, encouraging the least volatile types which Egypt has not yet utilized and reduce the risks of instability. The following chart shows the main factors that enable Egypt to maximize benefits from foreign portfolio equity flows and to minimize their potential risks: Figure (6)- Maximizing the Benefits and Minimizing the Risks. Macroeconomic stability Strengthening the market infrastructure and the regulatory

Maximizing Benefits .. Minimizing Risks.

Choose the least volatile i t t

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Promote local and foreign institutional investors

Following is a discussion of these main factors: 1-Macroeconomic stability: Commitment to achieve and maintain macroeconomic stability is a prerequisite to attract foreign flows and enables the country to face any potential risk that may be caused by the volatile types of these flows. FPEI flows to Egypt are mainly affected by the fundamental economic reforms the country has undertaken, including the privatization efforts, the improvements in the countrys creditworthiness and the remarkable progress in the characteristics of the Egyptian stock market. In addition to the complete freedom enjoyed by foreigners in the local 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 and more stable funds. They dominate investment in private equity funds and in venture capital funds, two of the least volatile types of flows. Also, institutional investors are often prepared to accept less liquidity than retail investors. If a growing share of foreign portfolio equity investment is accounted for by institutional investors, this could magnify the positive impact on liquidity, since institutional investors are very active traders (Samuel,1996). Improved liquidity in the domestic market, will lower the investors demand for higher yields, reflecting their ability to sell securities at decreasing costs, and the cost of capital will decline. The declining cost of capital and the enhanced risk diversification should induce the corporate sector to issue initial public offerings and additional shares. Also, as liquidity 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 instruments reveal that the volatility of FPEI flows may vary with the type of mechanism through which an investment is made. Some mechanisms are more suitable to the stage of development 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 in trading directly in its securities markets. Foreign direct equity purchases in the stock exchange, are mainly short-term transactions, which encourage destabilizing price speculations, and adversely affect the market price level. Granger-causality test showed that trading by foreigners in the Egyptian stock market causes changes in each of the publicly traded securities index and the IFCG index, and has a clear effect on the Egyptian stock market price volatility. It is worth mentioning that complete openness of a countrys securities market for foreigners should come after appropriate regulatory structures are in place and suitable corporate governance levels. Various emerging countries in their first stages of financial integration, opened their securities markets first through the establishment of country funds and/or GDRs issues. When their domestic stock markets were more prepared to receive direct foreign portfolio investments, foreigners were allowed to trade directly.

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The emerging markets shown in the table below followed this sequence of liberalization. Table (12)- Market liberalization dates for some emerging markets. Country Korea * Indonesia Philippines Thailand Brazil Chile Mexico Turkey India Depositary receipts issuance 1990 1991 1991 n.a. 1992 1990 1989 n.a. 1992 Liberalization Country fund date for establishment foreigners direct trading. 1984 1989 1987 1986 1987 1989 1991 1989 1986 1992 1989 1991 1987 1991 1990 1989 1989 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 to be 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 foreign investments, Egypt should: a-Develop a strong domestic institutional investor base. Such investors will be able to mobilize significant amount of resources, increase liquidity in domestic capital markets, and thereby serve as a counterweight to foreign investors. They also reduce the vulnerability of domestic capital markets in the event of a rapid liquidation of assets by foreign investors. Active domestic institutional investors, by increasing depth and liquidity in domestic markets, would reduce the sensitivity of domestic markets to small trades. Also, they benefit domestic savers by reducing transaction costs and facilitating portfolio diversification. Developing a domestic institutional investor base, requires reforming and expanding the legal 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 be useful to follow the American system, which imposes 30% taxes on mutual fund profits, if they 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 somewhat longer than that for other types of FPEI instruments and less volatile. A two-tiered venture capital fund with limited life and a common goal for shareholders seems more suitable for new unquoted Egyptian companies to encourage them to grow and go for an initial public offering. The two-tiered structure, will also enable investors to control the managers performance and the funds 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 and medium enterprises, and those that are applying privatization programs.

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In 1996, the IFC reported that Egypt has one foreign venture capital fund, with no further details. Consulting various local sources, no information was provided concerning this mentioned fund. This reflects the unawareness with the potential benefits of this important instrument, which other emerging markets have largely made use of in their early liberalization stages. Attracting venture capital funds requires positive macroeconomic conditions, an active and liquid capital market, and a transparent legal system. d-Establish more closed-end diversified country funds and private-equity funds. Egypt has seven offshore funds. Five of these funds are closed-ended. These are few funds, if compared to other emerging markets, and considering their potential advantages. Closed-end diversified country funds offer significant benefits. They are not required to meet redemption requests, and therefore, they are less likely to contribute to market volatility, and more likely to take a longer-term view. They usually pose no threat to the control of domestically owned private firms. These funds may also participate in local training programs, with positive effects on human development. Country fund managers also press for growth of local credit-rating agencies. The establishment of more country funds, and other specialized funds such as privateequity funds, should be encouraged. They require improvements in stock market size and liquidity, and in disclosure and accounting standards. In addition to, high standards of custody, clearing and settlement, and regulatory oversight. e-Issue more depositary receipts. During 1996-July 1999, eight Egyptian companies issued GDRs, representing four sectors only, whose value is very small, compared to other developing countries. Global depositary receipts have a positive effect on the efficiency of the domestic stock market price, through the arbitrage process, which reduces the volatility of the issuing companies share prices. Issuing GDRs may enable 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 relatively small. Egyptian companies tend to be small with modest financial resources and low international visibility. It is difficult for small capitalization Egyptian companies to issue depositary receipts, because they must meet the partial or full reporting requirements, for listing abroad, and other specific minimum requirements with respect to the size of total assets, earnings and /or shareholders equity. Thus, mergers between Egyptian companies operating in the same field of activity should be encouraged. In addition to improving the disclosure, accounting and auditing standards. 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 IFC ranked the Egyptian market as number 71, within emerging markets, with respect to companies size. {Mexico, Taiwan, Brazil, and Chile, were ranked as numbers 12,14,20 and 36, respectively}. [IFC, 1998]. f-Create quasi-equity instruments; such as convertible bonds, and bonds with equity warrants. These instruments have not yet been developed in Egypt. The creation of these tools, may lead to a more balanced mix of debt and equity, that might attract more investors, especially institutional investors and increase the liquidity of the market.

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Moreover, the issuing company will be able to apply a larger amount of financing towards expansion of the company or towards general operating expenses, as the interest payments on these bonds, are lower than those on straight bonds. Developing the local bond market, is required. Issuing companies should provide attractive dividends and interest rates compatible with those on banking deposits, taking into 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 to invest in Egypt are the degree of reliability of the stock markets infrastructure and the effectiveness 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 types particularly foreign direct trading. a-The settlement, clearance, and depository systems: To accelerate the settlement flow, a good matching system should work quickly. Trade matches between direct market participants should be accomplished in the same day of the trade (T+0). The rolling settlement system used in Egypt, has the advantage of effectively limiting the number of outstanding clearances and reducing the time between trade and settlement dates. It is recommended that the rolling settlement system have final settlement occur by T+3. However, efficiency and reliability rather than speed of settlement should be the primary 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, until other risk reduction systems are in place and domestic investment firms become financially stronger. However, due to inadequate information and weak disclosure standards, it may be difficult to develop a comprehensive picture of the agencys members. 2-Limit its net exposure to each participant and require collateral for some types of exposure. 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 to manage and contain the risks they bear. For example, loss-sharing rules among participants in 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 in cooperation with the banking sector. It is worth mentioning that a settlement guarantee fund was established in Egypt, in the second half of 1999, but has not come into force yet. Imposing penalties should discourage resorting to this fund.

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For the central depository to be cost-effective, firms participation should be encouraged. More book-keeping companies should be established to cover the country. Securities lending and borrowing should be encouraged as a quick method for the settlement of securities transactions. b-The regulatory framework should carefully balance between investor protection and safety on the one hand, and market development or liquidity on the other. *Disclosure: Among the most critical functions of a regulatory framework is to increase transparency in the market by mandating public disclosure for all material information on a timely basis, such as the disclosure of developments that may have an effect on the companys business or the stock price. Public disclosure is required both at the initial phase, when a firm issues securities to the public, and continuously thereafter. Improving disclosure will address investor concerns and will also reduce market volatility resulting from asymmetric information. The Egyptian Capital Market Authority should strictly apply its legal right in delisting the companies that do not comply with the disclosure requirements, after three months notification. There are three types of disclosure requirements: i-Listing requirements: These are particularly important for the Egyptian stock market for two main reasons. First, because of lack of experience and financial expertise, investors may not be able to judge the relative merits of alternative investments. Second, bad performance of a listed firm causes negative externalities resulting from investors losing confidence 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 value and volume of public shares, earnings, balance sheet criteria over a number of years; an assessment of the potential of the firm and industry it belongs to; qualitative criteria regarding corporate governance; ...etc. There should also be continuing listing or maintenance requirements. For Egypt, if listing requirements are too stringent, few firms will be able to list and the market will not be liquid. To solve this dilemma, the market could be segregated into more than one section, with each section differing in its listing requirements. For example, the distinguished companies that are compatible with the listing requirements for the international issues will be in the first section while other firms with less established track records could be listed in a special, perhaps over-thecounter market. The listing requirements should consider the size of the company and the percentage of its shares being offered to the public. ii-Initial offering requirements: The disclosure mandated for a firm to issue new securities, is of two types: -information that allows investors to evaluate the overall condition of the firm issuing the securities, including risk factors and prior performance. more specific information about the new issue: amount of capital to be raised and its intended purpose, how the offering price was determined,..etc.

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iii-Accounting standards: In order to be at par with international practice, joint stock companies must prepare their accounts based on International Accounting Standards. This is essential for investors to be able to evaluate the financial performance of a company. Egyptian-auditing standards and practices need further improvement to ensure the reliability of disclosed information. *Insider trading should be prohibited: In 1998, insider trading was reported as one of the main reasons behind the sharp decline in the Egyptian stock market index. Thus, Egypt should try to eliminate insider trading. First, by defining what information is considered illegitimate, (usually all facts that can have an impact on a companys business and the performance of its stock), who is subject to insider trading rules, the reporting requirements for insiders, and what types of companies are subject to these rules. In some countries, owners of more than a specific amount of a certain stock are considered insiders and are required to file reports on their trading activities. Insider legislation also defines insiders responsibilities. Second by imposing civil, administrative and criminal sanctions. (World Bank, 1997). *Self-regulatory organizations (SROs): Drawing from other countries experiences, it was found that competing financial intermediaries in the stock market do have the incentive to monitor one another, to develop fair and efficient markets. Market participants are more able than the government to formulate good rules and procedures, and to keep them current with new technology and industry practices. They will be better able to monitor compliance, especially that self-imposed rules are usually better accepted than rules mandated from the outside. Applying this model in Egypt, will reduce the Egyptian Capital Market Authoritys surveillance burdens, and increases its efficiency. However, care should be taken as the ESM is still in the early stages of development, with limited competition, insufficient institutions, human capital, disclosure and accounting standards, such that self-regulation may not be enough to ensure fair and efficient markets. Thus, regulatory responsibilities can be transferred first to the exchanges, clearinghouse, and depositories, since they would be better able and more willing to develop and monitor rules of conduct. (Chuppe, and Atkin, 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, less than 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 for foreign investment in the country. One type of this investment takes the form of equity portfolios, the subject of this paper. As pointed out in the introduction, foreign equity portfolio flows provide a number of very important benefits to the country, but they might also have, if not appropriately regulated, very significant costs. The trick is therefore to implement policies and regulations which maximize the benefits and minimize the costs, of foreign equity portfolio investments. In the paper the list of benefits and costs of these investments have been derived from the international literature on the subject, from the comparative analysis

40

of the characteristics of the different available investment instruments and from empirical work on some aspects of the behavior of the Egyptian stock exchanges. The paper suggests ways of maximizing the benefits and minimizing the costs of the foreign equity portfolio investments through policies and market friendly regulations which (i) provide macroeconomic stability, (ii) generate incentives to use the least volatile of the existing portfolio investment instruments, (iii) promote the use of institutional investors instead of individual investors and (iv) strengthen the existing market infrastructure. Of all the suggested measures, the significance of macroeconomic stability can never be sufficiently stressed. As shown in the paper, equity portfolio investments are extremely mobile, macroeconomic instability invites speculation and, as experience shows, it is hard to find a practical way in which governments can prevent capital flows to move in and out of countries. The paper, given its financial focus, does not discuss the necessary recipes to achieve 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 providing incentives to use more of those investment instruments which are less volatile. In this respect the paper suggests an optimum order of opening-up the economy to portfolio investments, first country funds and GDRs and only thereafter direct investments, order which was not followed by Egypt. At this stage it would, however, not be advisable to turn back and therefore alternative means of achieving a similar end are proposed in Section III of the paper. In particular, taxes and tax-exemptions can be used to induce a preference for longer term investments in general, for venture capital investments, country funds, GDRs, and convertible bonds, in particular, until the necessary institutions to handle direct equity portfolio 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 have more expertise and information . Therefore it proposes to use the regulatory framework to develop capital market institutions, especially in the area of investor protection. A final, but related and also important concern of the paper, is the regulatory framework, 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 destabilizing effects of equity portfolio investments. In this respect, the paper addresses needed reforms in the areas of disclosure, insider trading and regulatory organizations. As is the case with most measures proposed in the paper, these regulatory reforms are not only important to increase the net benefits of foreign equity portfolio flows, but they will also contribute to the 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 reversal of favorable global conditions could induce a capital outflow from these countries). Study by: 1-Calvo, Leiderman and Reinhart (1993). conducted Main findings: Investigated whether private capital flows to ten Latin American countries, for the period January 1988 to July 1991 were driven primarily 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 proxies for private capital flows, they analyzed the degree of co-movement in these variables using principal component analysis. They found that: * there was a significant co-movement among countries foreign reserves and among their real exchange rates, and that the degree of comovement increased in 1990-1991, compared with 1988-1989. * the first principal component of both reserves and the real exchange 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 Latin America was the cyclical downturn in industrial countries and the associated decline in global interest rates. 2-Fernandez-Arias, (1994). Fernandez-Arias argued that some studies like that conducted by Chuhan, Claessens and Mamingi, (1993), may have overstated the proportion that could be attributed to improvements in domestic fundamentals, because it considered country creditworthiness as being solely determined by improvements in the domestic economy, whereas, in reality, global interest rates also affect country creditworthiness. By decomposing the improvements in creditworthiness into those arising from the decline in global interest rates and those arising from improvements in the domestic environment, Fernandez-Arias found that global interest rates accounted for around 86% of the increase in portfolio flows for the average emerging market during the period 1989-1993. 3-Frankel Okongwu (1996). and In an analysis of the determinants of portfolio capital flows in nine Latin American and East Asian countries (Argentina, Chile, Mexico, the Philippines, Korea and Taiwan) using quarterly data covering the period 1987-94, found that U.S. interest rates had a major influence on these flows.

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B- Country-specific factors: improvements in countries economic fundamentals allow investors to achieve higher returns and offers them opportunities for risk diversification. Study by: 4-Chuhan,Claessens and Mamingi, (1993). conducted Main findings: Using panel data for 1988-1992, they found that improvements in countries economic fundamentals- the country credit rating, secondary bond prices, the price-earnings ratio in domestic stock markets and the black market premium- were as important as cyclical factors in attracting portfolio flows to Latin America. Domestic factors, moreover, were three to four times more important in explaining capital inflows to Asia.

5-Gooptu,S., (1994).

Examined econometrically whether portfolio investment flows to one region in the developing world were significantly related to those that went to another region. An inverse relationship between total portfolio flows to emerging Asian stock markets and those to Latin America was found. This result indicated that developing countries must compete for portfolio flows and that increasing the pace of reform is essential for an emerging market to be able to sustain this type of flows. A panel regression of total private long-term capital flows/GNP, was run on total investment/GNP, private consumption/GNP (as private investors may consider private savings to be a sign of confidence in a countrys prospects), the stock of total external debt minus international reserves/GNP, volatility of the real effective exchange rate, a dummy for the successful completion of a Brady deal, real export growth, the 12-month U.S. treasury bond rate and a dummy for U.S. interest rates, during 1990-1993.
The results showed that countries with strong economic fundamentals have received the largest proportion of private flows relative to the size of their economies. When foreign direct investment was 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. [foreign direct investment may be more sensitive to domestic factors than the more-liquid portfolio flows].

6-Hernandez Rudolph, (1995).

and

7-Motaal (1995).

Examined the determinants of capital movements in some MiddleEastern countries (including, Jordan, Egypt, Morocco, and Tunisia) and Asian countries (Bangladesh, India, Pakistan, and Sri Lanka). His analysis suggested that external factors (reductions in world interest rates) played a less important role in the increase in capital inflows to these countries; more important were internal factors (the momentum for reform), which led to improvements in the longer-term economic prospects of these countries.

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8-UNCTAD (1997).

A survey of international emerging market equity fund managers was conducted by UNCTAD in January 1997, in order to determine what elements they considered to be most important in making investment decisions at the country level. The survey found that the potential rate of economic growth was identified most frequently as being highly important in investment decisions. Market size can have an indirect influence because larger markets tend to have better developed capital markets, greater market capitalization, higher degree of liquidity and a wider array of investment opportunities. In less-developed emerging markets in which total capitalization is especially small, market size may become a constraint on foreign portfolio equity investment by some large institutional investors that tend to invest in large blocks. The degree of volatility of exchange rates and political stability are also important considerations. The overriding motivation for foreign portfolio equity investors is their participation in the earnings of local enterprises through capital gains and dividends. Hence, it is more important for them that capital be easily transferable and that disclosure standards be high. Thus, the level of ease of capital repatriation and disclosure standards for companies operating in the local market appear to be very important. Other factors frequently identified as being important include the existence of a good settlement system, the comprehensiveness of securities market regulation, the degree of securities market liquidity. More mature markets also tend to offer a superior level of regulation regarding information-disclosure and accounting standards.

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9-World (1997).

Bank,

Explored the influence of global interest rates on portfolio flows in particular. It analyzed the extent to which portfolio flows from U.S. to twelve emerging markets in Latin America and East Asia moved together and the degree to which this co-movement was related to U.S. interest movements. Co-movement in flows was measured by the first principal component of the flows. The analysis was done for countries in each region separately and then in aggregate. The results showed that there was a high degree of comovement in flows during 1990-1993, for both regions and that 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 portfolio flows during 1990-1993.
However, since 1993, there has been a decline in the co-movement of portfolio flows to both regions, especially for East Asia, suggesting that country-specific factors are becoming more important.

10-Taylor, Sarno, (1997).

and

Examined the determinants of U.S. capital flows directed to nine Latin American and nine Asian countries over 1988-92. In particular, they investigated whether bond and equity inflows were induced by push or pull factors, differentiating between short- and long-run determinants.
The authors, considered in their set of country-specific factors the domestic credit rating and the black market exchange rate premium as well as a set of global factors including two U.S. interest rates and the level of U.S. real industrial production. They examined the long-run determinants of portfolio flows by employing two complementary cointegration techniques. The results provide unequivocal evidence that: * long-run equity and bond flows are about equally sensitive to global and country-specific factors and, therefore, that both sets of variables help to explain U.S. portfolio flows to the developing countries considered. * Both push and pull factors seem to be equally important in determining short-run equity flows for Asian and Latin American countries. * When bond flows were considered, however, global factors seem to be much more important than domestic factors in explaining the short-run dynamics of flows. In particular, changes in U.S. interest rates are found to be the single most important determinant of short-run movements in bond flows to developing countries.

C- Diversification benefits from investing in emerging markets. Study by: conducted Main findings:

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11-Divecha, Drach and Stefak, (1992);

* Examined the risk-return trade-off from emerging market portfolio investments. * Only a handful of emerging markets were found to have significant exposure to five global risk factors (the world market equity return, the return on foreign currency index, the change in oil price, the growth in world production and the world inflation rate). Thus, many emerging markets are not well integrated into the global economy. The results showed that developing countries stock returns tend to have low correlation with those of industrial countries. This low correlation should reduce the volatility of portfolio flows in emerging markets. It was concluded that there are significant diversification benefits from investing in emerging markets relative to asset portfolios that focus solely on industrial country securities.

12-Harvey, and (1995).

(1993),

D- The removal of barriers by industrial and developing countries on foreign participation in developing countries securities markets: Study by: 13-Claessens Rhee, (1994). and Showed that the removal of barriers by industrial and developing countries on foreign participation in developing countries securities markets has been a significant factor that has contributed to this surge of private capital flows to the emerging markets. These measures include, the removal of restrictions on foreign ownership, liberalization of capital transactions, improved general accounting principles, addressing the financial securities clearing and custodial problems and enhanced disclosure requirements by securities issuers. Several barriers to portfolio equity flows in recipient countries were identified. By relating these barriers to various measures of market integration, it was found that the most effective barriers were: macroeconomic instability, poor credit rating, high and variable inflation, lack of a high-quality regulatory and accounting framework and the limited size of the domestic stock market. Found that some emerging markets function inefficiently due to insider trading. These markets will be stacked against outsiders and will be less likely to attract new investors. Using a model with partial irreversibility of investment derives a negative relationship between foreign investment and costs of entry and exit from financial markets. conducted Main findings:

14-Bekaert, (1995).

15-Claessens Glen, (1995).

and

16-Daveri, (1995).

Appendix no.2 Listing requirements in selected emerging markets.

Emerging market: Korea (*) Requirements Koreas stock exchange is divided into two trading sections. The main requirements for the first section are: *Paid-in capital for the last business year must be five billion won or more. *The ratio of net profit to capital, must be 10% at least, for the

46

last three business years. *The firms debt ratio must be less than the average debt ratio for the relevant industry, for the last three business years. The Korean stock exchange authority, evaluates the last annual business report of all the listed companies to determine whether they meet the requirements needed to assign for the first section, or not. Companies that can not meet the requirements for section one and the newly listed stocks are automatically assigned to the second trading 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 a general section. Shares listed in the special section are for companies having: *a capital of over $60 million, and sales or service revenues in excess of $100 million. *1000 stockholders, that are not related together by agreements concerning the governance or management of the company. *The par value of listed securities should be higher than $60 million. Companies not fulfilling the above-mentioned requirements are included 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, comprising ordinary 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, over the last three financial years. 2- The second board listing requirements are essentially the same as those of the Main Board, but differ in the amount of capital and profits. For example, the profit track record needed here is for five financial years with an after tax profit of not less than RM 2 million 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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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 And Dr. Omneia Amin Helmy To the: Economic Policy Initiative Consortium.

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55