Trouble in the Desert

it is all about Shanghai, Mumbai, and Dubai: that was the chorus at the peak of the emerging-market boom in 2007. But although China and India are back in vogue, investors have bid goodbye to Dubai.

Its decline is symptomatic of the fading fortunes of the Middle East. The stock markets of the Gulf countries—including Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates—have been severely lagging their emerging-market peers. After falling by as much as 55 percent in 2008, they rose by a rather modest 18 percent last year, compared with an average gain of 80 percent for all emerging markets. The credit bubble that led to Dubai's debt crisis in late 2009 did not appear in the other Gulf countries, but the emirate's debt debacle highlighted problems that are common across the region: poor transparency, weak regulations, and opaque ownership structures.

The axiom of the dark old days of emerging-market investing in the 1990s was "What you see is not what you get," and in many ways that's still true of the Middle East today. The balance sheets of many Gulf companies are out of date with financial numbers disclosed well after the standard reporting period and few checks on insider trading.

There's also a major disconnect between economic and stock-market performance. Over the past five years, the GDP of the Gulf region expanded at an annual pace of nearly 5 percent, a rate in line with the average for all developing economies. Yet the Gulf stock markets fell 20 percent, while mainstream emerging markets gained 80 percent. The problem is that so many Gulf companies are privately held either by wealthy merchant families or by the state. Gulf exchanges list so few quality companies that they end up lacking the breadth to capture the region's economic growth.

These narrow markets reflect a larger problem: the Gulf lacks the homegrown human capital and technology needed to create a genuinely diversified manufacturing base. Dubai's apparent success building a glitzy service sector (including banks and tourism) inspired other countries such as Qatar to go down the same path. But the potential of finance and tourism in the desert has its limits, as Dubai's fall shows.

The only way to diversify the Gulf's oil economy in the long run is to create a skilled workforce through better education. Policymakers in Saudi Arabia, the region's largest economy, know this, and have begun allocating large sums of money toward improving primary-, -secondary-, and university-level education.

However, measures to improve the quality of the labor force take a long time to yield results, and so in the meantime Saudi leaders are spending heavily (and smartly) on modernizing their transportation networks and building new power plants. With combined financial reserves of more than $1.5 trillion accumulated from huge oil and gas exports, the Middle East, including Saudi Arabia, has the wealth to keep such major projects going. That should keep growth chugging along at a 4 to 5 percent rate over the next couple of years.

To translate that growth into stock-market returns, authorities need to push major reforms, starting with the financial system. The region's sovereign wealth funds control hundreds of billions of dollars, but tend to invest only a small part of their reserves at home. Better regulation and oversight of the financial markets would encourage more of that money to stay in the region. What's more, creating a regime that's friendly to global investors would help make the local economies more efficient, because higher standards for disclosure and transparency will reduce the cost of financing for domestic companies. Since the standoff over Dubai World's decision in November 2009 to delay its debt payments, Gulf corporations have been unable to tap international capital markets—thereby raising their cost of borrowing.

To be sure, the Gulf markets have come a long way in the last decade. The market capitalization of the regional markets has risen 700 percent, and trading volumes have increased more than 10-fold. But last year Dubai was only the most publicized of the Gulf debt blowups, which also hit corporations in Saudi Arabia and Kuwait. So it may be some time before anyone mentions Dubai, or any Gulf capital, in the same phrase as Shanghai.