The Changing Role of

the Banking Sector: Lessons from

Jordanian Experience

Presented to a Conference on

"opportunities for investment in the

Mediterranean  Region"

Held at 

The Royal Institute of International Affairs

London-United Kingdom

March 6-7,1997

Introduction

    Thanks to the peace process and the promise of security in our region, Jordan and other countries of the Middle East have been spotlighted as emerging economies of interest to international investors, especially since 1994. I can assure you that, despite some flagging optimism during this past year, Jordan abounds with attractive opportunities in the industrial and service sectors, including soon-to-be privatized utilities. These opportunities are matched by an increasingly investor-friendly legal and economic environment – including a network of professional banking and financial institutions ready to help you succeed.

    Jordan is enjoying a high rate of economic growth while maintaining stable macro-economic indicators achieved through unwavering commitment to a structural adjustment program initiated in 1989, well before the peace process took off. Still the peace process has made everyone aware that there is a limited window of opportunity that must be seized. It has motivated Jordan to accelerate other changes to create an environment attractive to the foreign investment needed to fully activate the economic potential of Jordan and our entire region.

     This presentation will review some shared characteristics of The Arab Middle Eastern economies, look at the status of Jordan's fast-developing economy and describe the capabilities and contributions of our banking sector. It also will consider some of the projected reforms and challenges still facing the Jordanian economy and thus, our banks and our investor-partners, in the near future.

Regional Financing Concerns:

     The 1990's may well be the most critical decade in the economic history of the Arab region in general and the Middle East region in particular. All future trends indicate the existence of real opportunities to transform the region into an active economic power. Missing this opportunity may lead to the erosion of previously achieved economic gains, putting the future well-being of the whole region at risk.

     If the Middle Eastern countries are committed to achieving and sustaining high rates of economic growth, they must address three challenges:

1-        Enhance domestic savings.

2-        Attract foreign capital.

3-        Encourage repatriation of the substantial capital held abroad by residents.

   Despite the significant diversity among nations of the region, levels of investment in the Middle East have remained well below the average levels in the fast growing Asian countries.

    Middle Eastern countries have missed both the benefits of direct foreign investment and the associated transfer of technology and managerial expertise.

    Furthermore, several countries within the region are hobbled by a significant financial gab caused by the persistent need to finance growth, cover trade and general budget deficits while meeting, at the same time, private sector demands and servicing the outstanding external debts.

    With the current level of sophistication, banks of the region will not be able to bridge this financial gab alone. Banks should be more innovative, however, in creating new sources and tools of finance. For example, our banks must strengthen their relations with the Arab funds, whose strong capital base has not been fully utilized.

    The financial gab is best addressed through cooperation among commercial banks, credit The Arab Middle Eastern economies and local, regional and international financial markets. This broader resource pool could effectively meet a significant part of the Arab world's need for longer-term financing.

    Within this context, the Arab banking industry continuously works to develop and modernize, to strengthen its financial and administrative resources, and to improve its efficiency in pooling and allocating resources.

    Governments have taken concrete steps to complement these developments within the banking industry by implementing comprehensive reforms. In addition, an attempt is being made to restructure government banks, promoting competition within the banking sector and enhancing the supervisory role of central banks.

     I personally believe that governments have initiated most of the actions necessary to provide a more favorable environment for our industry. The ball is now in the banking industry's court. We must upgrade our internal technical and managerial capabilities, if we want to keep moving forward.

Overview of the Jordanian Economy:

     Jordan is a country of 4.2 million people. The economy is dominated by trade and services-related activities, which accounts for more that two-thirds of GDP. Manufacturing, agriculture, mining and construction activities account for the remaining third.

     In recent years, Jordan has made major progress towards achieving macro-economic stability and sustained economic growth – it now enjoys one of the highest rates in the Arab region. The UN's economic and social commission for western Asia has just projected Jordan's 1997 rate of growth at 6.2%; that is a one percentage point increase over 1996. in the same report, ESCWA notes that Jordan has the lowest rate of inflation among the non-Gulf Arab states.

     Jordan's remarkable success in achieving high real growth without inflationary pressures and a significant improvement in its balance of payments, is mainly attributed to the stabilization and reform strategy adopted after the balance of payments crisis in the 1980's.

     During this relatively short period of economic re-adjustment, Jordan managed to reduce its general budget deficit from 17% of GDP in 1989 to less than 4% in 1996. inflation was similarly reduced from 26% to 5% during the same period. During the same period of time, investment increased from about 24% to 35% of GDP, and savings leapt from the negative to 12%.

    The following selected macro-economic indicators reflect the progress achieved in the Jordanian economy through the period from 1992 to 1996:

    Jordan's fiscal policy to decrease budget deficit, rationalize public expenditure and decrease government consumption also has led to a major reduction in the public internal debt. The outstanding internal debt was reduced from JD 1.1 billion in 1992 to JD 0.8 billion in 1996, leaving more financing resources for the private sector, whose investment role is rapidly increasing.

     At the same time, the external debt exposure was reduced from 190% of GDP in 1990 to 90% in 1996. this lightening of Jordan's public debt, accompanied by improved financial management, has earned Jordan better credit ratings and increased its opportunities to borrow externally. Standard & Poor's rating for Jordan during last year stood at:

   In short, Jordan has made significant progress over the past eight years in the fields of macro-economic stabilization and transformation of its economic structure. Among the real achievements are structural reforms in the areas of energy, agriculture, telecommunications and water, and major changes in the regulatory framework to encourage private sector involvement and promote investment.

   This remarkable success was the result of a persistent, courageous and difficult process of adjustment and structural reform. The Jordanian government has stated its intention to continue pursuing all efforts to overhaul the entire economy.

    Privatization, legislative reform and trade liberalization are currently areas of focus attention. Legislation to reform the Companies Law and Securities Law has already been drafted and submitted to the Lower House of parliament for acceptance.

    In terms of external economic relations, Jordan is committed to joining the World Trade Organization, and a partnership agreement with the European Union is expected to be accomplished this year.

     In the area of privatization, there is a remarkable willingness on the part of the government to address the situation of such large public sector companies as the Tele-Communications Corporation/TCC, the Jordanian Electrical Authority/JEA, and Royal Jordanian, the national airlines. The TCC and JEA are the first slated for privatization, and the process is already underway.

     Despite these achievements, we face serious challenges to the realization of our goals, namely:

1-        Successfully fulfill our commitments in the remaining years of the economic re-adjustment program.

2-        Enhance the comparative advantages of Jordan.

3-        Build up an appropriate level of foreign exchange reserves.

4-        Create new employment opportunities.

5-        Enhance the level of domestic savings.

The Role of the Jordanian Banking Sector:

    While the role of banking in the economy is declining in some industrial countries, banks continue to dominate the financial systems in most developing countries and other countries in the transitional stages, such as Jordan. A reliable banking system is necessary because of the imperative role it plays in the economy: intermediation, maturity transformation, payment and credit allocation.

    Financial institutions also carry heavy responsibilities in the process of economic reform and transformation. These include fine pricing of banking products and expansion in extending long-term loans.

   Of course banks also continue to play an important intermediary role in facilitating the pooling of domestic savings, attracting foreign investment and directing it to the most efficient, productive and profitable projects.

   Two examples of such performance are the mixed finance packages put together for the US$ 170 million Indo-Jordan Phosphoric Acid project and the US$ 85 million Nippon-Jordan Fertilizer project. In both cases, local banks pooled resources with international agencies (IFC), foreign export credit agencies, and a group of international banks to get these projects off the ground.

    Banking is one of economy's most active and sophisticated sectors. It continues to achieve impressive growth and improvements in quality of services, while providing Jordan's growing economy with adequate amounts of credit in addition to the necessary financial and banking services.

   Today, the Jordanian banking sector consists of 14 commercial banks and 7 investment banks plus several specialized credit institutions that support the domains of housing, real estate, industry and agriculture.

    The present structure of the Jordanian banking sector is partly the result of government policies aimed at creating specialized institutions with the purpose of extending subsidized credit to certain sectors of the economy.

    Commercial banks, however, continue to dominate  other financial institutions in Jordan in terms of size of deposits and total assets. These banks also remain the main source of credit in the market due to the absence of competition from other institutions or lenders.

    Through a network totaling more than 430 branches, Jordan's 14 commercial banks conduct all lending activities including short, medium, and long-term loans for all purposes, including the financing of seasonal and working capital requirements and the acquisition of fixed assets.

    The following figures reflect the size of the banking sector in Jordan and its development over the past four decades:

                                                ( In J.D. Millions )

   Among the commercial banks operating in Jordan, Arab bank is considered the largest with a market share of more than 33% in terms of total assets. It is the only bank, which has, in addition to its strong local standing, a solid regional and international presence, enabling it to exercise a significant role in financing trade and investment.

   The performance of the whole financial system was further enhanced by the establishment of the Amman financial market in 1978. Since then, it has expanded its operations and become one of the most active emerging markets in the Middle East region.

   Jordan's financial system has expanded considerably over the past 25 years, as evidenced by the increase in the ratio of M2(money and quasi money) to GDP from 60% in 1970 to over 100% in the late 1980s, and about 115% in the 1990s.

  Since 1989, the financial system has been subject to significant reform designed to address weakness and adverse effects of the difficult 1980s.

   These reforms have been successful, aided by the government's macro-economic reforms and liberalization programs, which succeeded in stabilizing the economy. Stabilization and the unexpected inflow of funds into the country, in the wake of the Gulf crisis in the early 1990s, led to a boom in the Jordanian economy. This boom made a significant improvement in the quality of bank assets and boosted the overall profitability of the financial institutions.

   One of the major problems facing the Jordanian financial market is fragmentation. The market is divided into several compartments functioning individually and in isolation from each other, by laws, regulations and special privileges extended to some institutions. This fragmentation negatively affects the market's efficiency and competition. It also limits the financial limits the growth potential for financial institutions' potential for growth. Ongoing reform of the financial sector, which will fundamentally change its current structure, will most likely result in a more competitive and efficient industry.

   Although the banking system is deeper now than ever before, it is still dominated by a small number of domestic banks. The variety of financial instruments for users and providers of funds is also rather limited. For example, municipal bonds, commercial papers and CDs are not active or available. Total bonds are very minimal; the only non-government bonds are corporate bonds, of which the total outstanding balance amounted to only JD 4 million by November 1996, with negligible trading. The capital market, with the exception of the Stock Exchange, is thin.

    Like its counter parts in many other developing countries, the Jordanian financial system is challenged to find the most efficient investments, while, at the same time, managing risks and integrating with the world financial markets.

    The banking system in Jordan has been effectively intermediating short-term savings and long-term financing requirements. Total outstanding credit facilities of commercial banks increased from 20% of GDP in 1970 to more than 72% of GDP in 1996, reflecting a strong deepening of private sector financing. Additionally, the role of the specialized credit limits the growth potential for financial institutions expanded considerably. Total loans extended by these credit limits the growth potential for financial institutions reached 20% of GDP in 1996 compared to 7% in the 1970s.

   A shift from cash preference to time and saving deposits was reflected in the tremendous increase in banking deposits, which – in local and foreign currencies – reached 125% of GDP by the end of 1996 (76% of GDP for deposits denominated in local currency compared to 68% in 1984).

Reforming the Industry:

    Mobilizing funds to finance development depends mainly on the safety and efficiency of the banking system. The banks' ability to attract saving through creative plans, while investing those funds within the most convenient, safe and productive channels, also is critical. Therefore, the banking sector was the first sector of the economy to be the focus of reforms. The first phase of reforms of the Jordanian banking sector, during the period 1989 to the present, addressed such areas as:

-         Capital adequacy.

-         Reinforcement of capital base.

-         Credit concentrations.

-         Floating interest rates.

-         Replacing direct with indirect supervision.

-         Encouraging merger operations to create larger units.

-         Freedom to lend in local and foreign currencies.

-         Full disclosure.

-         Elimination of credit ceilings.

   Authorities are still considering further reforms to develop and deepen the domestic financial market in order to promote the mobilization of savings and to integrate Jordan with the world financial markets.

    Reforms slated for the next two years will focus on increasing competition by creating a level playing-field for all institutions. This mainly affects the specialized lending institutions by phasing out the special privileges that those institutions now enjoy. The reforms of 1997 and 1998 will bring about the privatization of the two major institutions (Housing Bank and Industrial Development Bank), while ensuring that they will continue to provide medium and long-term financing for housing and industrial development.

   Commercial banks will be subject to a closer supervision and stricter regulation. As of this year, banks will be required to increase their capital to a minimum of JD 20 million. The banks will be subject to stricter disclosure requirements that are comparable to the acceptable international standards.

    Provisions will be made for the establishment of a secondary market for short and long-term papers. The availability of medium and long-term saving instruments will be expanded during the period 1996-98 through the development of pension and social security funds, mutual funds, and insurance companies. To develop the Jordanian capital market and promote international investments, the following reforms in the structure of the stock market are still targeted for the very near future:

-         Separation of the supervisory functions from the operational functions.

-         A complete overhaul of the trading, clearing, settlement, and depository systems.

-         More complete financial disclosure.

   Legislation was completed in early September 1996 for a number of financial market reforms. These include the complete computerization of the Amman Financial Market, and the possibility of privatizing it. A new Securities Law also will be enacted, and the government will establish a separate securities exchange commission and a central depository for clearing and settlement. The existing Companies Law will be amended to harmonize with the new Laws, including the abolition of tax on stock dividends.

   The remaining laws include financial leasing and copyright legislation. Jordan's Intellectual Property Law will be amended to conform with tighter restrictions in the European Union.

    Completion of these reforms, and the ongoing reform process, will definitely produce a more sophisticated financial market with all kinds of financial institutions and instruments to serve our investors and entrepreneurs with greater resources and efficiency.

    These institutions will be much more capable of anticipating and responding to the financial needs of the economy and more skilled in the filed of financial engineering.

Challenges Facing the Banking Industry:

    The Jordanian banking industry must be considered an emerging one when compared to financial sectors of advanced countries. When compared to other developing countries, parallel to Jordan in terms of economic growth and progress, however, one finds that Jordan surpasses many of them in terms of the quantity and quality of banking services.

    Having overcome the problems that plagued the financial sector in the 1980s, Jordanian banks now face a new set of challenges in the newly-liberalized competitive markets. The most serious of these challenges are:

1-        Management of risk.

2-        Erosion of barriers between financial markets.

3-        Increased need for highly qualified human resources.

  Our banking industry, with all its significant achievements, has yet to meet the new era of development's different financial requirements.

   These emerging needs are different in terms of risk, amounts, maturity and instruments. For instance, in the case of the Indo-Jordan project, mentioned earlier, we had to develop a mixed financing package, comprising long-term loans from a multinational institution and medium and short-term financing from local commercial banks and the French government agency COFACE. The only guarantee for all of these loans is the project's viability.

    The absence of a market to pair lenders and borrows in Jordan outside the banking system is not expected to last much longer. Eventually, other investors will enter the market and draw deposits away from commercial banks. Borrowers also will learn to seek lenders directly, avoiding the cost of intermediation. This will raise the cost of the banks' liabilities and decrease the yield on the banks assets. The resulting erosion of the banks profit margins will force bank managers to seek other sources of revenue to improve income.

    Anticipating such changes, the Jordanian banking industry has begun to introduce measures that will increase its efficiency and responsiveness, such as:

-         Enhancing administrative expertise.

-         Adopting sophisticated balance-sheet-management techniques.

-         Introducing new products in both the assets and liabilities sides.

-         Developing the capital markets.

-         Developing the inter-bank market.

-         Investing in telecommunications technology.

-         Integrating with the regional and world markets.

-         Developing better risk management skills.

The Jordanian Capital Market:

   The Jordanian capital market is almost exclusively limited to the shares of companies listed on the Amman Financial Market. The bonds market is still in its primary stage of development in terms of the volume of issues and trading. This can be attributed to the absence of credit rating institutions and underwriters in the market.

    Although the stock market has experienced impressive development since its establishment in 1978, it has yet to become a major force in financing investment in Jordan. The Jordanian capital market does have sizable potential, as suggested by the following figures:

                                                                 (JD Million)

N.B. JD 1 is equivalent to US$ 1.408

   This set of indicators reflects the important potential role that the financial market could play in providing finances needed for investment. It should be noted that the downward trend in recent years is due to tight monetary policies and increased interest rates.

   Recent reforms aiming to enhance the performance of the Jordanian capital market will most likely give the stock exchange a major role in investment financing. This likelihood is all the more sure, knowing that interest rates are expected to ease as the monetary and fiscal policies successfully approach their targets.

Potentials of the Banking System:

   It is difficult to quantify accurately the amount of finance needed from the banking system in the next few years. However, we know that in normal conditions, banks have to make available amounts sufficient to meet the requirements of the economy's growth in the areas of investment, export and consumption.

    Given that commercial banks lending is the major source of investment funds, and based on the strong correlation between GDP and banking credit and the derived regression equation, and assuming a 6% compound rate of growth in banking credit for the coming four years, it is estimated that banks must provide a net increase in credit facilities of US$ 3.8 million until the year 2000. this figure represents 73% of outstanding loans as of December 31,1996.

    These estimated financial requirements are based on normal conditions. Jordan, however, is approaching a point where it will have to finance other local, regional and infrastructure projects needed for the coming stage. If we also consider privatization trends, most recently affecting telecommunications, electricity, and transportation, then the additional volume of financial requirements will probably exceed US$4.5 billion during the next four years.

   Falling volumes of international aid and foreign assistance to Jordan also will pressure banks to shoulder greater responsibility in financing domestic projects as well as foreign investments, and to utilize unconventional sources and tools of finance.

    The resources of the Jordanian banking system have not been fully exploited. While the industry has made very efficient use of its deposits denominated in local currency, it still holds a huge surplus of foreign deposits, estimated at US%3.5 billion of semi-idle funds, awaiting investment through proper channels.

    I believe these channels started to materialize clearly when the Central Bank of Jordan liberalized lending in foreign currencies in 1995. Banks are now permitted to lend up to one-half of their foreign currency deposits.

     The liberalization of foreign exchange, stability of exchange rate, and the floating of interest rates are all encouraging factors for both lenders and borrowers, promising less costly loan opportunities.

Capital Formation and Savings:

   Jordan has been characterized by a high percentage of Gross Fixed Capital Formation, as it stood at JD 1.7 billion in 1996, representing 32% of Gross Domestic Product. The share of the private sector in this field was 81%. In fact, Jordan is eagerly looking forward to keeping this level of capital formation at its high level during the coming years, with even greater emphasis on private sector involvement.

    On the other hand, domestic savings in Jordan are still relatively limited, reaching just 12.1% of GDP. This level of savings barely covers one-third of the Gross Fixed Capital Formation. This creates a financial gab that needs to be bridged with appropriate financing.

    In the mean time, more emphasis is being placed on the rationalization of private, as well as public, consumption in order to increase the share of savings in GDP to 17% by the year 2000. Nevertheless, Jordan still needs to rely, to a certain extent, on external financing to be provided by regional and international banks and financial institutions.

Role of External Financial Institutions in Jordan:

   Both regional and international institutions have expressed interest in the Jordanian market. Many regional banks in the area show mounting interest and several Bahraini banks already have participated in loans extended with in the market.

    Other Arab regional institutions with demonstrated interest in the Jordanian market include the Arab Fund for Economic and Social Development, Kuwait Development Fund, Abu Dhabi Fund for Economic Development, and Saudi Fund, in addition to the expanded opportunities extended by the Islamic Development Bank in the fields of external lending, leasing and participation.

   Among various international institutions, the International Financial Corporation (IFC), has participated in several loans extended to the private sector for the manufacture of tissue paper, fertilizers, pharmaceuticals and aluminum, and in the telecommunications field. Additionally, many international banks expressed serious interest in bond issues for Jordanian companies.

   Jordanian banks are eager to work jointly with regional and international financial institutions in order to raise adequate funds to finance future projects planned in Jordan.

Conclusion:

   Empirical studies over the past twenty years have proved that a nation will enjoy economic growth and social welfare to the same extent that it enjoys economic freedom. I recently came across a newly published ranking of the world's countries according to economic freedom. While it came as no surprise that Hong Kong, Singapore, New Zealand, the USA and Switzerland headed the list, I was very pleased to find that Jordan – while farther down the global listing – ranked highest of all the Arab countries surveyed – including Tunisia, Egypt and Morocco.

     I hope I have helped to convince you that the time is ripe for investment in Jordan. The macro-economic indicators are truly encouraging, the peace process is pushing ahead despite some setbacks, the legal environment is investor-friendly and a professional financial services network is in place to guide your entry and serve your needs in this promising emerging market.

     We welcome you as partners and look forward to sharing many future successes with you.