Red carpet

In late September, Richard Bowker, CEO of Abu Dhabi-based Union Railway, announced to great fanfare plans to build a rail link between Dubai’s port city of Jebel Ali and Abu Dhabi’s Khalifa Port. The line would be part of a broader US$11 billion project to create 1,500 kilometers of rail across the United Arab Emirates (UAE). Previous announcements have included plans to link Abu Dhabi’s Shah sour gas field to the coastal city of Ruwais, as well as a high-speed passenger train between Abu Dhabi and Dubai.
 
If the infrastructure splurge sounds familiar to China watchers, it is for good reason: In June, Industrial and Commercial Bank of China (ICBC; 601398.SH, 1398.HK) announced that it had partnered with Union Railway to provide "railroads plus finance" for infrastructure projects within the UAE.
 
Not coincidentally, the same day in June, Shanghai played host to the first-ever Abu Dhabi and China Economic Forum, jointly sponsored by ICBC and Abu Dhabi’s Department of Economic Development.
 
A delegation comprising UAE government agencies, banks and other large firms sought to persuade Chinese companies and investors to take a closer look at the country and the Middle East North Africa (MENA) region. They cited rapid infrastructure development as a potential draw for Chinese investment, and argued that UAE assets have been underpriced following the global economic downturn. Combined with recent government efforts to improve the country’s legal and financial infrastructure, they laid out their case: Now is the time for Chinese investment in the UAE.
 
The China of the Gulf
 
Their argument is bolstered by Abu Dhabi’s economic good fortune. Earnest Law, regional manager of the National Bank of Abu Dhabi’s (NBAD) Hong Kong operations, says that Abu Dhabi’s economic growth, expected to come in at 4% this year, is outpacing that of the UAE as a whole, which is expected to grow just 2.5%. (In better economic times, average growth in the country was around 9%.)
 
"Abu Dhabi’s economy has grown six-fold in the last 10 years," said Law.
 
Its success is heavily intertwined with that of the broader UAE and MENA region as the emirate positions itself to become a financial staging point for regional investment. Officials frequently cite Singapore as a model for Abu Dhabi’s development.
 
"There’s an exciting growth story in the MENA region," said Nazem al Kudsi, CEO of Invest AD, an Abu Dhabi-based government agency that encourages and facilitates foreign institutional investment in the Middle East and Africa. "That opportunity has been very underutilized historically – particularly by Chinese investors."
 
In many ways, the region’s growth story is similar to that of China. Rising consumerism and strong demand for housing and infrastructure have fueled a wealth boom. "The MENA story is not better than the China story," al Kudsi said of the comparison, "but it is as good as the China story."
 
Trade between China and the MENA region has also been rapidly increasing. It jumped more than fourfold to US$107.4 billion last year from US$25.4 billion in 2003. Al Kudsi says that China recently overtook the US as the biggest exporter to the Gulf Cooperation Council (GCC), which consists of the UAE, Bahrain, Kuwait, Oman, Qatar and Saudi Arabia. China’s annual exports to the GCC were US$60 billion in 2009, a tenfold increase over 10 years. The World Bank says that investment from China and India in particular is leading to rapid growth in trade and foreign direct investment in the MENA region.
 
Second fiddle no more
 
Yet despite its ambitions and rising trade, Abu Dhabi has historically been eclipsed by Dubai as the destination of choice for foreign investment routing into the MENA region. The economic boom until 2007 seemed to vindicate Dubai’s highly leveraged economic model, which invested heavily in speculative infrastructure, financial services and property projects.
 
This has changed in the wake of the global economic downturn. Reliance on foreign investment for eye-popping property works proved to be a double-edged sword for Dubai, as investor liquidity from Europe and the US dissipated when the recession hit in 2008.
 
Burdened by debt from projects that could no longer be financed, by late November 2009 Dubai was on the brink of a sovereign default. Abu Dhabi, the political capital and economic heavyweight of the UAE, stepped in to fend off an economic firestorm next door.
 
As a result, Dubai slipped four points on the annual Global Financial Centers Index of financial services hubs, while Abu Dhabi received a boost.
 
"Abu Dhabi has moved up substantially due to the crisis. It’s sad that [it has] moved up thanks to the misfortunes of others, but it’s a fact," said Salem al Noaimi, chief executive officer of Waha Capital, an Abu Dhabi-based investment holding company specializing in big-ticket asset leasing.
 
On the cheap
 
Besides bolstering Abu Dhabi’s symbolic financial standing in the region, the global economic downturn may have also turned the UAE into a bargain destination for global investors. Invest AD’s al Kudsi notes that stocks on Dubai’s public equity markets trade at a price-to-earnings (PE) ratio of around 14, compared with the low 20s in other emerging markets, notably China and India.
 
Equity valuations aside, Abu Dhabi firms and officials also argue that diversification is a compelling reason for foreign investment into the UAE. They say that  the MENA region’s markets, and in particular the UAE, are "decoupled" from US and European markets.
 
"Historically, they have a very low correlation to other markets," said al Kudsi. Hence, some proponents argue that investors could look to the UAE as a hedge against volatility in the US and Europe.
 
Such arguments must be cold comfort to investors burned by Dubai’s property tailspin following the recession. But whether or not Abu Dhabi has successfully "decoupled" from developed market economies, some argue that it is nonetheless an appropriate hedge for Chinese investors.
 
"The Chinese economy is getting overheated at the moment, and we recommend our Chinese clients to diversify their portfolio of investments by capturing opportunities in stable economies like Abu Dhabi," said Vik Pangam, business development manager of Sovereign Group, a global corporate services firm.
 
Indeed, many outbound investment firms have noticed rising Chinese investor demand for a foreign market hedge. Walkers Global, a corporate services company specializing in corporate and international finance law, observes that outbound investment is a prime focus for China at present.
 
"Not only is the Chinese government actively investing outside of China, with the acquisition of resources and investments in infrastructure, private sector companies are also taking advantage of the current levels of liquidity and advantageous exchange rates, to expand by way of outbound M&A," said Denise Wong, a Walkers Global partner based in Hong Kong.
 
Abu Dhabi is actively positioning itself to soak up this excess liquidity by solidifying its future as a highly developed economy with a sophisticated financial services sector. The government is engaged in an ambitious, multi-decade project dubbed the Abu Dhabi Economic Vision 2030, under which Abu Dhabi aims to boost the non-oil share of its economy to over 60% of GDP by 2030.  
 
Originally, this goal was to be achieved by diversification into tourism and financial services. But since the implosion of Dubai – which pursued exactly these objectives to disastrous results – the focus has shifted onto massive, government-sponsored infrastructure projects, which it expects will have knock-on effects for the private sector. These projects include new airports, schools and hospitals, a railway connecting the entire UAE, and two residential zones.
 
Such development projects are not limited to Abu Dhabi. Across the entire MENA region, al Kudsi estimates some US$2.4 trillion worth of infrastructure development is planned or underway.
 
Enter China
 
Massive infrastructure projects are a familiar subject for Chinese firms, and Sovereign Group’s Pangam observes that Chinese contractors have begun aggressively moving into the region. Their bids are often successful.
 
"Chinese businesses are now heavily involved in UAE projects, including road building and construction. And Chinese contractors are very competitive on pricing," said Tim Buckley, managing partner of Walkers Global’s Dubai office.
 
General Holding Corporation (GHC), the UAE’s largest industrial conglomerate and a prime mover in implementing the Abu Dhabi government’s industrial diversification policy, provides a case in point.
 
"We use Chinese construction companies, particularly in real estate, as well as in setting up manufacturing plants. We have a cement plant which was constructed by China Building Material Corporation, a Chinese state-owned enterprise," said Suhail Mubarak al Ameri, GHC’s director general.
 
Price was a crucial factor in GHC’s decision to go with Chinese contractors. In GHC’s piping business, for example, products are sourced from Chinese contractors at just one-quarter the cost of their Western competitors.
 
SOE dependence
 
The GHC case also exemplifies the reliance on investment from China’s state-owned enterprises (SOEs), rather than private sector firms. While all Chinese firms theoretically have government support to venture abroad, in practice it is usually only large, state-owned conglomerates that are able to acquire financing from China’s large, state-owned banks to actually make foreign acquisitions.
 
Investment opportunities in Abu Dhabi also tend to concentrate on large infrastructure projects, which again favor large SOEs with ample access to funding and economies of scale. The emirate’s private sector commercial market, by contrast, is not large enough to attract large flows of investment, even from private Chinese firms looking to expand abroad.
 
The over-representation of state-owned construction firms in Chinese outbound investment may help to explain the findings of a 2008 World Bank report on investment into the MENA region. To facilitate long-term development plans, the region needs to attract more than just capital investment – it needs to attract investment that adds to human capital, management expertise, networking and job creation.
 
But the report found that Chinese FDI in the MENA region added little in terms of knowledge transfer or job creation. China has not yet established strong links with regional firms or added to production capacity.
 
The World Bank argues that this is likely the result of China’s state investment strategies and business models, as well as local conditions. It may also be the nature of one-off construction projects by SOEs, which are very different than private-sector firms looking for a long-term presence in the UAE’s domestic market.
 
While oil-exporting countries in the GCC could attract sizable FDI into their energy sectors, this is not happening because they restrict the equity participation of foreigners, the report found. They also failed to attract significant high-quality, export-oriented FDI, particularly from China and India, due to a combination of legal infrastructure, skill supply and costs related to bureaucracy, tax and labor issues.
 
Abu Dhabi exemplifies many of these issues. According to Sovereign Group, around 3,000 Chinese enterprises have been registered in the Ministry of Economy and Free Trade Zones of the UAE. Their total investment in joint venture projects exceeded US$4 billion as of June 2010.
 
But private Chinese businesses and investors seem to shy away from Abu Dhabi. Buckley of Walkers Global observes that investment has been flowing from the UAE to China, rather than the other way round, as UAE firms seek to cash in on the growing China market. "China is a strong investment opportunity for UAE investment funds," he said.
 
Part of the reason for the reluctance of Chinese firms to enter the emirate is that starting Abu Dhabi partnerships can be risky for Chinese investors. "The markets are still fairly young by global standards, so it can be difficult to find the right mix of international financial expertise, in-depth knowledge of the region, and high standards of corporate governance," said al Kudsi.
 
Dealing with business partners can also be particularly tricky in a developing legal environment. Law explains that while most businesses in the region enjoy low tax rates, the regulatory regime can be difficult. This particularly applies to regulations around development of capital markets and debt frameworks.
 
Moreover, while the UAE has staked out its claim to fame in the world of Islamic finance, which accounts for around 20% of Abu Dhabi’s banking sector, it risks remaining a niche market for Islamic investors, competing with the likes of Malaysia’s Labuan instead of New York, London, Hong Kong or Singapore.
 
To allay investor concerns about the quality of its judicial branch, Dubai has developed the Dubai International Finance Center (DIFC), which promotes foreign investment by guaranteeing that contracts are settled in a legal system separate from that of the state itself. The DIFC is based on British common law, and employs many international judges who hail from common law countries.
 
But Abu Dhabi as yet lacks a comparable system."The lack of a finance center can make it quite difficult to do business [in Abu Dhabi]," admitted Law, and may partly explain why more private Chinese firms have not taken the plunge.
 
A liberal instinct
 
The emirate is taking steps to rectify this. "Abu Dhabi now also offers full foreign ownership of businesses in the renewable energy and media sectors. More and more Chinese enterprises are establishing a foothold in Abu Dhabi by setting up 100% foreign-owned media and/or publishing companies and renewable energy businesses in the free zones," said Sovereign Group’s Pangam.
 
Efforts to reform the legal procurement system are similar to a broader regional push by which MENA governments are actively reforming their legal frameworks to adapt to international business and investment.
 
According to the World Bank report, all MENA countries have embarked on "second-generation" reforms, such as privatization, financial sector reform and business-entry regulatory reform.
 
"I wouldn’t say there’s the right legal framework entirely. But there’s a huge push to improve it. There’s a huge push [by the government] for private companies to develop," said al Noaimi of Waha Capital.
 
Abu Dhabi representatives emphasize their desire for long-term, strategic Chinese partners whose involvement in the MENA region will result in other positive spillover effects. Waha Capital is seeking Chinese partners for its real estate projects, and the Sovereign Group notes that many UAE firms in the renewable energy and media industry are also primed for partnerships.
 
The UAE is likely to remain the region’s economic center, helped by a head start on legal and financial reforms, and by hydrocarbon reserves that permit a nearly tax-free business environment. Nevertheless, the real question is whether Abu Dhabi can draw Chinese investment not only from competing emirates, but also from other global financial centers.
 
"It’s the right time to invest in Abu Dhabi," said al Noaimi. So far, however, China’s private-sector investors don’t appear to be listening.