Dr Scacciavillani, director of Macroeconomics & Statistics at Dubai International Financial Centre, on diversifying into XXI century knowledge-based industries.

The GCC countries are embarked on a long-term effort to diversify their economies out of dependence on energy commodities, towards high-value-added sectors. Fostering this process poses a twofold challenge:
1) Detect which sectors could be more suitable and 2) Mobilising the financial resources needed to start new initiatives.

The answer to the first question is straightforward: the Gulf region should give priority to the innovative high-value-added sectors rather than traditional large-scale manufacturing. The workforce in the Gulf (particularly the nationals, but to a significant extent also the expatriates) enjoys salaries and a standard of living that would not confer a comparative advantage vis à vis China, India, south-east Asia (and tomorrow Africa) in the mass production of industrial goods (with the exception of petrochemicals and a handful of energy intensive sectors).

Hence, in order to diversify their economies, the GCC countries need to leap towards knowledge-based industries, where the key factors are advanced technology and sophisticated human capital. This requires on one side a determined effort to improve the education system and the R&D environment, but on the other, equally crucially, an overhaul of the financial sector.

Advanced sectors in the XXI century will be based less on the traditional combination of labour and machinery and increasingly on the value of visionary ideas and the business acumen required to translate them into commercially viable operations. This has far-reaching implications for the notion of risk that investors and financial institutions will be undertaking and should learn to manage.

In human capital intensive sectors (as the dot com bubble highlighted almost 10 years ago) defaults are very common. Innovation is a constant challenge. Initial success is no guarantee of a steady flow of revenues and obsolescence in technology is rapid: today’s innovators become quickly tomorrow’s dinosaurs.

Anecdotal evidence indicates that, roughly speaking, out of 10 projects in advanced technology sectors one or two are highly successful, four fail within a couple of years and the rest struggle to break-even in the medium term. More extensive research on venture capital-funded companies in Europe, between 1993 and 2004, showed that a portfolio of such firms had a probability of yielding losses in excess of five per cent with a 40 per cent probability.

How to deal with the hazard raised by such a business environment? The answer can be stated in a simple form: in the evolution from a physical capital intensive economy to a human capital intensive economy, the financial sector must assess the value of immaterial assets rather than the value of brick and mortars. But the implementation of this paradigmatic shift involves a revolution at the core of widespread banking and finance practices.

Risk management in traditional commercial banking (not only in the GCC, to be fair) hinges primarily on the collateral that the entrepreneur and the shareholders are able to provide. In practice, loan officers in examining the financial viability of a project rarely focus on its merit, but strive to gauge the residual equity value in case of bankruptcy. With well-established firms, banks judge their past profits, for start-ups they require collateral mostly unrelated to the future performance of the projects, because rarely traditional bank managers are capable of assessing financial viability through a market analysis, the scrutiny of the innovative features or the expectations of future developments. In a nutshell, visionary entrepreneurial aptitude does not score high in the checklist of credit committees.

There is a very compelling reason why traditional financial practices are not adequate for launching advanced knowledge-based industries. In a risky environment a traditional commercial bank is doomed to go bankrupt no matter how conservatively it behaves or how skilled its bankers. If, for example, half of the projects fail within a year, a bank that grants loans charging an annual interest might gain – let’s say, for the sake of the argument – between six and 10 per cent, with probability of one over two, and will lose most of its investment with probability one over two. In other words the income earned in financing successful enterprises through loans will never be sufficient to cover the losses sustained on the unsuccessful ones. So a financial institution must make a return much higher than the typical interest rate on the successful ventures, otherwise its capital sooner or later will be depleted.