How the Middle East Is Protecting Itself from Europe’s Ongoing Woes

As the Eurozone crisis remains a concern at the forefront of European markets, the Middle East region have taken steps to buffer itself from the European recession, according to Sony Kapoor, founder of Re-Define, an economic and financial think tank with offices in Belgium and Germany. "This has already started to lead to a strategic reorientation of the Middle East away from Europe to Asia. And that may not be a bad thing," he says. "Change always brings opportunity, good and bad," he adds.

In addition to his duties as Managing Director of Re-Define, Kapoor is also chairman of the Banking Stakeholder Group of the European Banking Authority and a visiting fellow at the London School of Economics. Kapoor has worked in investment banking, leverage financing at Lehman Brothers and traded derivatives with Aquila Energy. He also witnessed the Enron collapse firsthand which partly led him to leave his banking career and redirect his career to policymaking. Having worked in India, the United States and the Great Britain, he advises companies and governments all over the world on financial policy making.

An edited transcript of the conversation follows.

Arabic Knowledge at Wharton: Last September, you asked in the Wall Street Journal if the Eurozone was possibly turning a corner. Your answer then was "probably not." Now at the beginning of 2013, have we come to the end of the Eurozone crisis?

Sony Kapoor: Nothing has fundamentally changed. And the economic momentum remains downward. What has happened is some of the sense of panic we saw over the summer is gone but that effect may just be temporary. Unemployment in the Eurozone is at a record high and rising. Business confidence and consumer confidence both remain depressed. The banking system remains in a very deep crisis. Deleveraging is going on at the base and it’s unclear how and when the banking system will be restored to health. Fiscal contraction, because of the austerity dogma, means the growth prospects in the foreseeable future looks terrible. And this will continue to increase unemployment and weaken the banking sector and the rising side of the economic problems is making the already complicated politics of coming up with a solution even harder.

Arabic Knowledge at Wharton: How has the euro’s problems affected other regions like the Middle East, Africa and India?

Kapoor: The banking crisis and deleveraging has had a negative impact in terms of the financing of investment, in terms of trade financing and other activities in the Middle East and elsewhere. And that problem will not go away either. I think it will continue to have a negative economic impact and negative investment impact on the nearby regions, particularly in the Middle East, because the economic and financial ties with the Middle East and Europe are the strongest.

Arabic Knowledge at Wharton: What can the Middle East do to protect itself, since the European Union (EU) will likely be battling this financial crisis for at least the next five years?

Kapoor: We have seen a slight retrenchment of sovereign wealth fund investment away from Europe and the Eurozone to more dynamic regions. We have also seen some opportunistic buying-up of distressed assets by the Middle East, so there are also other opportunities that will arise. Change always brings opportunity, good and bad. At the same time, some of the sovereign wealth funds have been directed to a bit more domestic investment within the region, partly to compensate for reduction of exposure by European investors, pulling out and deleveraging by European banks.

To compensate for that as well as investments from the Middle East, [money] that has been going abroad are being redirected back with itself. So I think even though it’s a surplus region with significant source of wealth, there’s a lot that can be done to compensate for the reduced trade and financial flows from the Eurozone.

At the same time in terms of other geopolitical aspects, the crisis has made immigration more of a hot-button issue within the Eurozone and the EU. That will be a friction point, particularly with North Africa. I think that is partly because the EU is distracted by the prices and may be missing an opportunity to support the Arab Spring and entrenching democracy within the region. I think that distraction is particularly unhelpful.

Arabic Knowledge at Wharton: Are you suggesting that Europe could be missing opportunities in the Middle East?

Kapoor: Exactly. It would be both economic and political opportunities. The EU still remains vague and it has been one of the most successful promoters of democracy and open society across the world. What the E.U. has managed to do is enlargement. It’s something that is unparallel. A similar process could have been applied to a near neighborhood. Because of the destruction and the crisis and the fact that things such as immigration become hot-button issues, opportunities will be missed. This will be a detriment to Europe itself and North Africa.

Arabic Knowledge at Wharton: If the EU doesn’t grow, how will places like the Middle East be affected?

Kapoor: In the short-term, the effect is negative but because the Middle East at an aggregate level is self-sufficient in terms of financing, that is a surplus area. There is a sensible rebalancing of investment activity toward the region, away from Europe, apart from opportunistically buying up distressed assets.

The long-term impact can be relatively limited. Maybe the crisis is going to accelerate, causing the Middle East to shift some of this attention, from trade and financial linkages, to more dynamic regions in world. This has already started to lead to strategic reorientation of the Middle East away from Europe to Asia. And that may not be a bad thing.

Arabic Knowledge at Wharton: You think that too many fiscal conditions in the name of austerity measures will inhibit growth. How can borrowing be encouraged and what sort of rates should different countries have?

Kapoor: I think the Eurozone is trying to answer the wrong question. There are concerns about the long-term sustainability of sovereign debt in some countries. Instead of asking, "What measures can be taken to make the debt sustainable in the long term?" the question that is being asked is how to reduce the deficit today. It may appear that these questions are compatible but they aren’t really.

Because as long as it’s a small country in the crisis, you can cut government spending and hope that other levers like private investment or exports will pick up. When the same contraction is applied to what is essentially the largest economic area in the world simultaneously, it’s much harder to accomplish because cutting back of fiscal spending in one country means demands from its neighborhoods. The EU is very integrated economically through financial flows and trade linkages.

So the bigger the group of countries that’s trying to reduce debt simultaneously, the less effective it is. So what we need to do in the short term is to follow a plan that doesn’t focus too much on the reduction of deficit, together with structural reforms and growth-enhancing measures that will increase the gross domestic product (GDP).

So rather than trying to decrease the numerator, which is the actual amount of debt, the focus of policy should be to increase the denominator, which is GDP. That is the best measure to achieve sustainability over the next five to ten years.

Arabic Knowledge at Wharton: So what kind of growth-enhancing measures can the EU take?

Kapoor: Most European economies now have the biggest constituent of economic activity in services, not goods. What we have in the European Union is a single market in goods or products. But we do not have a single market in services. So the single most positive boost to the economy can come from extending a single market in goods to a single market in services. The size of services is two to three times the size of goods in these markets. That is a step that has not been taken and would be enormously beneficial.

Arabic Knowledge at Wharton: Do you mean in banking, information technology?

Kapoor: Yes, banking, information technology, legal services – all kinds of services. It would be a very, very lucrative market.

Arabic Knowledge at Wharton: Within the Eurozone, how do you tailor strategies for different countries, i.e. Greece vs. France vs. Italy, depending on what’s going on with their financial system? Is it a challenge to get them to agree on fiscal plans?

Kapoor: Yes, that’s true. That being said, there are a number of things that have policies that are relatively uncontroversial where the same policies would have a beneficial impact. Liberalization is one. Another policy that is useful across the board is collective action against tax evasion and tax avoidance. That is something which is very poorly coordinated. Every country is scrambling for tax revenue. If the countries act collectively, the pressure that can be put on the likes of certain parties is much more significant. Greece is trying to do it on its own. That is another policy that can be helpful.

Another policy change is the European Central Bank can make bigger promises, to loosen monetary policy further, and increase quantitative easing which will benefit all of these economies simultaneously. These are just some of examples.

Arabic Knowledge at Wharton: Entrepreneurs in struggling countries are fleeing to more stable countries, you have noted. For example, Italian businesspeople might see more of an opportunity to move to Germany or buy real estate in London. How important are entrepreneurs to revitalizing these struggling economies?

Kapoor: I think they’re absolutely critical. This is one of the contradictions in the current approach. While there are some structural reforms being made — for example, making the start up of new businesses easier and deregulating some sectors of the economy — these changes are not happening at the same time. The overall macroeconomic climate is looking very unfavorable. It’s not clear there is light at the end of the tunnel.

The example I often use is that taxis have been a notoriously closed, uncompetitive industry in Athens, [Greece]. And now you can open up the licensing process for taxis so the entry costs are much lower but it’s hard to see why anybody in their right mind would go and buy a new taxi in Athens, given the economy is in bad shape. And the demand for taxis is likely to continue to shrink in the foreseeable future.

So what is happening is that because things look so bad in the near term and it’s not clear when the economy will start to improve, the most talented, the most educated, the most dynamic people who are most likely interested in entrepreneurship are leaving the crisis countries in numbers. This will mean that even sensible reforms will not have the kind of effect they would have if the system in the past had been more sensible.

Arabic Knowledge at Wharton: So it sounds like things will get worse before they get better?

Kapoor: Yes, even if you had opportunities, like you could speak a foreign language and start a business in another country, why would you stay in Greece? Why would you stay in Spain, for that matter?