Near East increasingly meets the Far East

Real estate, tourism and energy investments in Asia offer Gulf investors the chance to expand overseas in areas in which they already have significant experience at home, provided barriers are overcome

While it will be some time before the absolute level of Gulf investment into Asia even comes close to rivalling that allocated to the US, European, and domestic assets, there is little doubt that the importance of Asia for Gulf investors has increased significantly in recent years.

A number of factors help to explain this trend. At the highest level, rising Gulf interest in Asia is simply part of a larger global trend.

With the emergence of China and India and their rapidly progressing integration into the world economy, long-term investors are taking note and looking to diversify into these markets and the rest of Asia.

Broadly, the changing preferences of Gulf investors simply mirror the investing world's increased recognition of the opportunities in Asia.

There are, though, four main trends specific to the two regions that have underpinned the growth of capital flows between them.

First, changing investment preferences in the Gulf. To a certain degree, the rise in investment flows to Asia is a function of the fact that the countries of the GCC have more cash to invest than they did pre-2002.

However, a fundamental difference driving the growth of GCC-Asia capital flows now is the new approach taken by the sovereigns of the region to managing these surpluses.

In previous oil booms, most of the billions of dollars in private capital was invested in the international banking system and US Treasuries, with the leading international banks and private banks in London and Switzerland.

High-net-worth GCC families have historically preferred cautious investment strategies, and their portfolios have tended to favour capital preservation over yield maximisation.

However, in the last decade, the rising sophistication of the GCC banking sector and investors (both the sovereign investment agencies and high-net-worth individuals), the rise of Islamic finance, the deepening integration of emerging markets into the world economy, and an increased emphasis on portfolio diversification have together resulted in a sea-change in GCC investors' investment strategies.

Second, changes in Asia making investment in the region more attractive. While there is still some way to go, a number of Asian countries have made substantial progress in recent years in liberalising their capital accounts, strengthening their business environments and improving conditions for foreign investors.

The government in China has overseen a slow but steady integration of the country into the world economy, authorities in India have begun to relax restrictions on foreign investment, and governments around the region are investing in physical, communications, and transport infrastructure.

Meanwhile, growth in the region has also been robust over the past five years. GDP in the region expanded in real terms by an average of 5.5 per cent per year in 2002-07, led by China, which has registered double-digit GDP growth every year since 2003.

India's economy grew by 7.8 per cent per year in 2002-07, and will continue to grow at around eight to nine per cent per year over the medium term.

This growth has in part been driven by large, long-term public investment programmes, which have opened up a new array of opportunities for Gulf investors, but also by rapid export growth and corporate profit growth.

This means that the pool of investible assets-good companies, in other words-has deepened substantially.

Another important driver is the rapid urbanisation taking place in India, China, Malaysia and Indonesia, which is creating significant opportunities for further investment in infrastructure, housing, retail and other supporting facilities.

As of 2003 only some 38 per cent of China's 1.4 billion people lived in urban centres, but with China in the midst of a major urbanisation drive, that percentage is expected to rise to more than 47 per cent by 2012.

This drive in China and elsewhere has in turn underpinned a heavy policy emphasis on upgrading housing stocks in a number of Asian countries. This links nicely with GCC investor preferences.

Sourav Kumar, Head of Middle East Sales and Marketing, Prudential Asset Management, says, "(For Gulf investors) real estate is likely to remain the most important asset class after equities".

Real estate, tourism and energy investments in Asia present Gulf investors with an opportunity to expand into areas in which they already have significant experience at home.

Third, significant strengthening of broader economic links between the GCC and Asia. In some sense, the rising interest in Asian assets among Gulf investors is a natural outgrowth of the steadily deepening economic links between the two regions.

China and Japan are Saudi Arabia's largest export markets for oil and oil products, and Asia purchases the overwhelming majority of GCC oil exports.

More broadly, without question much of the incremental demand for Gulf exports-not just oil and gas, but also petrochemicals, base metals and services such as finance and tourism-will come from Asia in the near future. In the past five years trade volumes between the GCC and Asia have tripled.

At the same time, high-profile FDI into the region by Gulf investors have been on the rise.

Fourth, geopolitical trends favour strategic diversification. Traditionally the Gulf states have aligned themselves closely with the US, for both economic and strategic reasons.

This close relationship will undoubtedly remain the centrepiece of foreign and economic policymaking in the region for some time, but there is also little doubt that the GCC countries are increasingly seeking to diversify away from their political and economic reliance on the US.

In the short term there is little question of the Gulf states withdrawing from or reconsidering economic and political relations with the West. On the contrary, these countries are still purchasing the US and European assets in substantial quantities.

Rather, the increased interest in Asia is a natural strategic extension of the region's long-term aims to diversify the nature of its economic activity, and a recognition that future relationships with the leading Asian nations will take on major strategic importance, should current economic and consumption trends continue over the medium term.

Barriers and constraints
In some sense, portfolio investment in Asia is similar in nature to that in any emerging market around the world. However, there are a number of features particular to the business environment and investment climate in the region that pose challenges for GCC investors.

The essential problem is generating quality deal flow, especially in the major markets of China, India and Indonesia.

In the real estate sector-an important area of focus for many Gulf-based investors-the major constraints are around planning approvals and execution.

For instance, a change in leadership at a municipality can require a complete renegotiation of planning approvals for a project, and more broadly large real estate investments require both a thorough understanding of on-the-ground regulations (which vary widely) and also a close relationship with the authorities.

Gulf banks suggest that these operational risks are greatest in Pakistan, Indonesia and India.

The chief executive officer (CEO) of one leading Gulf-based investment bank agrees that the biggest challenges in markets such as China and India are related to planning and transparency: "Many Chinese and Indian cities don't have master plans. Singapore, on the other hand, has five- and ten-year plans, describing which site can be used for which purpose.

"We want to have transparent structures for planning applications, joint ventures, capital flows and management of investment vehicles. The better these processes, the easier it will be for foreign investors to be reactive in the market," he advises.

India and China are considered the most challenging business environments, because of slow bureaucratic processes, relatively high corruption and cumbersome legal systems. In both places, legislative frameworks are evolving at such a rapid pace that new regulations are introduced virtually every quarter.

Malaysia, Singapore, Japan and Australia have far more developed planning, financial, regulatory and legal architectures. The Iskandar Development Region (IDR) in Malaysia, for instance, has a one-stop shop regulatory authority in place.

The dramatic rise in investment flows between the GCC and Asia will undoubtedly ultimately drive reforms in legal and regulatory framework.

However, this can take time to evolve - in both Japan and Hong Kong the process has taken decades. As such, investors will require staying power in the markets of the region - and it is still early to consider any of them as fully-fledged regional hubs for investment.

Meanwhile, the key question for Gulf-based investors is how to overcome the various barriers to investment in a still unfamiliar and challenging environment. Practitioners point to three main risk-mitigation strategies.

With big new deals between Gulf and Asian companies being announced on an almost daily basis, breathless references to a "new Silk Road" appear regularly in the Western media.

A bit of perspective is required, however - Gulf investment into Asia still represents a small portion of total outward flows, at around 10 per cent, and despite the rising importance of the region for GCC leaders, safe Western assets will continue to form the core of Gulf portfolios for some time to come (as indeed they do for most large, long-term investors).

At the same time, strengthening relations with Asia is clearly on the long-term agenda for Gulf countries.

There is clearly a relative, if not an absolute, shift, under way that will have significant implications for the economies of both regions and the global economy more broadly as it unfolds.

This article is an abridged version of a report by the Economist Intelligence Unit, sponsored by Arcapita