Rana Al-Bahsh

1
The capital structure of enterprises in risky emerging economies under
liberalization: the case of the Middle East and the Gulf Region countries.
Rana Al-Bahsh
1
CR2M, University of Montpellier
Abstract
In my research, I try to examine disciplines known in earlier researches as topics influenced by
economic liberalization process like capital structure, disclosure and transparency on a sample of
emerging markets. Does financing behavior of this sample of emerging markets differ from that in
developed ones? What are the factors that have an important role on corporate capital structure in
these markets? Does political risk level have a significant effect on corporations’ financing options?
Do certain steps taken by these economies towards integration with the world market like the issues
of disclosure, investor rights, and law enforcement have an effect on the market performance and
stock valuation?
 The importance of this research is in its sample as well as in the period of the study. The Middle East
has always been rated as highly risky region, especially politically, but this region has also been a
target for investors both hedgers and risk takers. Also in late years countries in the Middle East and
the Gulf region have adopted strategies to liberalize their economies as they recognized the
importance of integrating into the world market. These influence of these strategies on corporate
financing behavior needs to be inspected, to my knowledge; there are few researches, if any, on
these topics that cover this region in recent years.
Professor Patrick SENTIS and I have conducted a research entitled: Determinants of capital structure
in Gulf Region states and Egypt. A brief about the research follows through the text of this paper.
                                                         
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 Rana Al-Bahsh - yahyabaraa@gmail.com,  (033) 642 409 950, address: 123 Rue Nivose, apt: 1, Montpellier,
43000 2
1-Introduction.
a-Liberalization:
Much has been learned about emerging markets finance over the past 20 years. These markets
have attracted a unique interdisciplinary interest that bridges both investment and corporate
finance with international economics, development economics, law, demographics and
political science. The designation ‘emerging market’ is associated with the World Bank. A
country is deemed ‘emerging’ if its per capita GDP falls below a certain hurdle that changes
through time. Of course, the basic idea behind the term is that these countries ‘emerge’ from
less-developed status and join the group of developed countries. In development economics,
this is known as convergence. History is important in studying these markets. Paradoxically,
many complain about the lack of data on emerging markets. This is probably due to the fairly
short histories available in standard databases. The International Finance Corporation’s
Emerging Market Database (EMDB) provides data from only 1976. Morgan Stanley Capital
International data begins ten years later. However, many of these markets have long histories.
Indeed, in the 1920s Argentina had a greater market capitalization than the UK (Harvey,
2002).
Part of what makes emerging markets research so interesting is that there is an immediate ‘out
of sample’ test of new theories as new markets migrate to the status of ‘emerging.’ In
addition, one cannot do emerging markets finance research in a vacuum. Emerging markets
finance research is touched by many different disciplines. That is, it is very difficult to
conduct meaningful research in emerging markets finance without having some knowledge of
development economics, political science and demographics—to name a few.
Researches learned that liberalizations have characteristics and may entitle different effects on
emerging markets, like:
1. The theory of market segmentation and market integration
Considerable research has focused on the evolution of a country from segmented to integrate
with world markets. There are at least two levels to this evolution. Economic integration
refers to decreased barriers to trading in goods and services. Financial integration refers to
free access of foreigners to local capital markets (and local investors to foreign capital
markets). In a completely segmented market, assets will be priced off the local market return.
The local expected return is a product of the local beta times the local market risk premium.
Given the high volatility of local returns, it is likely that the local expected return is high. In
the integrated capital market, the expected return is determined by the beta with respect to the
world market portfolio multiplied by the world risk premium. It is likely that this expected
return is much lower. Hence, in the transition from a segmented to an integrated market, the
theory suggests that prices should rise and expected returns should decrease. Harvey, 2002
found that this is, indeed, the case. The average annual average geometric returns for 20
emerging markets, the IFC composite portfolio and the MSCI world market portfolio, pre-
1990 and post-1990 shows a sharp drop in average returns which is consistent with the theory.
2. Dating market integration is complicated
Market integration induces a structural change in the capital markets of an emerging country.
Hence, for any empirical analysis, it is important to know the date of these structural changes.
Regulatory liberalizations are not necessarily defining events for market integration. Indeed,
one should be careful to distinguish between the concepts of liberalization and integration.
For example, a country might pass a law that seemingly drops all barriers to foreign 3
participation in local capital markets. This is liberalization—but it might not be an effective
liberalization that results in market integration. Indeed, there are two possibilities in this
example. First, the market might have been integrated before the regulatory liberalization.
That is, foreigners might have had the ability to access the market through other means, such
as country funds and depository receipts. Second, the liberalization might have little or no
effect because either foreign investor does not believe the regulatory reforms will be long
lasting or other market imperfections exist.
3. Market integration is often a gradual process
Market integration is a gradual process and the speed of the process is determined by the
particular situation in each individual country. When one starts from the segmented state, the
barriers to investment are often numerous. Bekaert (1995) details three different categories of
barriers to emerging market investment: legal barriers, indirect barriers that arise because of
information asymmetry, accounting standards and investor protection and risks that are
especially important in emerging markets such as liquidity risk, political risk, economic
policy risk and currency risk. These barriers discourage foreign investment. It is unlikely that
all of these barriers disappear at a single point in time (Harvey, 2002).
4. Market integration has an ambiguous impact on market volatility
Foreigners tend to abandon markets when risk increases (Lensink, 2000; Zak, 2006), leading
to higher volatility. Hence, the empirical evidence shows no significant changes in volatility
going from a segmented to an integrated capital market.
Harvey, 2002 analyzed the annualized standard deviation of 20 emerging market monthly
returns before and after 1990. While it is true that some countries have seen a dramatic
decrease in volatility (Argentina), there is no obvious pattern. In the 19 countries, 9
experience decreased volatility and 10 have increased volatility.
5. Market integration leads to higher correlations with the world
Theoretically, it is not necessarily the case that market integration leads to higher correlations
with the world. A country with an industrial structure much different than the world’s average
structure might have little or no correlation with world equity returns after liberalization.
However, correlations do, on average, increase. 17of 20 emerging markets experienced
increased correlation with the world after 1990 (Harvey, 2002). The correlation of the IFC
composite with the world return in 2002 has doubled since 1990.
6. Capital flows increase after liberalization
As barriers to entry decrease in emerging equity markets, foreign capital flows in. The initial
foreign capital flows bid up prices and help create a ‘return to integration’. While there is an
initial increase in flows, in general, these flows level out in the three years post-liberalization
(Stulz, 1999). While most countries welcome foreign equity investment, many are concerned
about the potentially disruptive impact of capital flight during a crisis.
7. Contagion happens
Contagion refers to the abnormally high correlation between markets during a crisis period.
Emerging markets have experienced many crises: Mexico in 1994–1995, East Asia 1997–
1998, Russia 1998, Brazil 2000 and Argentina in 2002. Some part of the increased correlation
is expected. Correlations are higher during recessions than during growth periods (Erb et al,
1994, 1998).  4
8. Emerging markets are relatively inefficient
While it is common for informational efficiencies to exist in new and smaller equity markets,
many emerging equity markets do not behave like developed markets.
Emerging market equity returns have higher serial correlation than developed market returns.
This serial correlation is symptomatic of infrequent trading and slow adjustment to current
information (Harvey, 1995). Moreover, emerging market returns are less likely to be impacted
by company-specific news announcements than developed market returns. The evidence
suggests that insider trading occurs well before the release of information to the public. While
there is no ‘prove’ that these markets are inefficient, the preponderance of evidence suggests
that these markets are relatively less informationally efficient than developed markets.
9. There are important links between the real economy and finance
Market integration is associated with lower expected returns. Effectively, the cost of capital
decreases. It makes sense that investment should increase as more projects have a positive net
present value (Henry, 2000). Finance also impacts other aspects of the real economy. In
addition to investment increasing, evidence shows that the trade balance worsens after equity
market liberalizations suggesting that the additional investment is indeed financed by foreign
capital. Finally, real GDP growth increases. The evidence suggests that real economic growth
increases, on average, by 1% per year over the five years following the opening of equity
markets (Bekaert, Harvey and Lundblad, 2002;  Bakaert et al, 2001, 2002; Luigi et al, 2004 ).
10. Corporate governance and the legal environment
In order to compete in world capital markets, a number of countries are grappling with setting
rules or formal laws with respect to corporate governance. There is a growing realization that
inadequate corporate governance mechanisms will increase the cost of equity capital for
emerging market corporations as they find it more difficult to obtain equity investors (Klapper
and Love, 2002). There are also important issues with respect to the legal environment. What
is the optimal level of securities regulation in these countries? Trying to replicate the US
Securities and Exchange Commission may cause firms to list on other exchanges with less
stringent regulations. The existence of regulations or the establishment of a regulatory body
does little, unless it is supplemented with credible enforcement (Harvey, 2002).
b- Corporate Capital Structure:
Liberalization process has an effect on financing sources that companies have depending on
the type and strategies of development and whether these strategies were successfully applied.
For example, the degree of financial openness and the credit market development have an
impact on leverage. An increase in emerging markets openness to foreign markets has a
positive correlation with levels of debt. In the contrary, increases in stock market development
(which allow firms to substitute equity for debt) may lead to decreases in debt ratios. Credit
and stock market development have an opposing effect on leverage, as each one’s effect will
outweigh the other’s effect. As a result, financial openness (and though the ability to obtain
debt financing from foreign sources) and credit market development may have contributed to
the increase in emerging markets leverage, but this increase is offset by the growth of
domestic equity markets (Mitton, 2007).
Although the relative costs and benefits of debt financing may be in question, clearly debt
financing has played an increasingly visible part in emerging market finance over the past 5
quarter century. The increase in debt ratios in emerging markets was due to that firms have
changed in a way that their optimal level of debt has increased (Mitton, 2007). Studying 34
emerging markets, Mitton, (2007) found that the median market-value debt ratios increased
from 4% in 1980 to 18% in 2004, a rise of 14 percentage points, exceeding that in developed
markets which decreased slightly (by half a percentage point) over the same period. Other
researches found that firms in emerging markets still employ low debt ratios relative to those
ratios found in developed markets (Pandey, 2001 Omet, 2006). Financial system is essential
to the long-term growth prospects of developing countries. Efficient equity markets are as
important as banks as engines of growth. Thus, even in the early stages of growth, countries
cannot afford to concentrate only on the development of banks at the expense of corporate
stock and bond markets. Doing so would stifle the most important source of capital in the
developing world. New equity finance plays a more central role in corporate growth in
developing country firms.
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 Glen, (1992), indicates that stock markets have played a vitally
important role in the growth of the developing country economies in the 1980s.
The literature on capital structure has focused primarily on developed economies, mostly the
US companies (Gaud, 2005), and since modern - financial markets in developing countries
emerged in the early 1990's (Joeveer, 2006), there  have been a limited number of empirical
studies that used data from developing countries. Some exceptions are international
comparisons that include emerging economies. Consequently, little is known about the
financing activities of firms operating in these countries at large (Omet, 2006).
c- Disclosure standards and transparency:
One of the main outcomes of liberalization is the increased level of governance and low
enforcement. Firms in countries with weak overall legal systems have on average lower
governance rankings; while firms with better corporate governance have higher market
valuation. Love (2004), found that operating performance (measured by ROA) of these firms
also is higher. In countries of weak shareholder protection and poor judicial efficiency, firmlevel corporate governance is more important to investors than country-level legal efficiency.
(Negative coefficient found between corporate governance and legal efficiency). In other
words, the legal system matters less for the well-governed firms, which is plausible because
firms with better governance will have less need to rely on the legal system to resolve
governance conflicts (Love, 2004). This conclusion does not replace firm-level corporate
governance for country-level judicial reform. Firms have on average significantly lower
governance rankings in countries with weak legal systems, which suggests that firms cannot
completely compensate for the absence of strong laws and good enforcement. Firms can
independently improve their investor protection and minority shareholder rights to a certain
degree, this adjustment mechanism is a second best solution and does not fully substitute for
the absence of a good legal infrastructure. Although the task of reforming investor protection
laws and improving judicial quality is difficult, lengthy, and requires the support of politicians
and other interest groups, improving corporate governance on a firm-level is a feasible goal.
                                                         
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  Turkish corporations financed about 60% of their growth from equity issues in the 1980s. This level of
reliance on external equity is way higher than Japanese and West German corporations which finance relatively
large part of their growth from external sources. (Glen,1992) 6
Even prior to legal and judicial reform, firms can work on establishing credible investor
protection provisions. Firm-level corporate governance is even more important in countries
with poor investor protection. However, the task of reforming the legal systems should remain
a priority on the policymaker’s agenda (Love, 2004). Countries with poorer investor
protections have smaller and narrower financial markets relative to the size of the economy,
individuals in these countries trade less often in financial markets; the value of publicly traded
securities is lower; and the overall number of market participants is also lower (La Porta,
1997).
The quality of law enforcement has a large effect on the valuation and breadth of both debt
and equity markets. There are large systematic differences between countries from different
legal origins in the size and breadth of their capital markets. Whether measured by
capitalization of equity held by outsiders, by the number of listed firms, or by IPOs, common
law (English) countries (which have higher levels of investor protection and law enforcement)
have larger equity markets than civil law ones (French, Scandinavian, and German laws).
Common law countries also have larger aggregate liabilities than do the civil law countries
(except the German). Faster growing economies have higher capitalization stock market to
GDP. For example, the anti-director rights score and the one-share-one-vote score have a
positive effect on the market capitalization ratio.  By raising the anti-director rights score from
it’s French origin average of 1.76  to it’s common law average of 3.39 raises the market
capitalization to GNP ration by 19%, which assures that the quality of the legal environment
has a significant effect on the ability of firms to raise external finance (La Porta, 1997).
Investor protection has a larger positive effect on growth for countries that impose lower
restrictions on capital flows (Macdonald, 2002).
c-1- Importance of transparency:
The concept of disclosure is difficult to measure. First, an important attribute of a trading
system is market transparency, defined by O’Hara (1995) as ‘‘the ability of market
participants to observe the information in the trading process.’’ Information, in this case, can
refer to knowledge about current or past prices, quotes, or volumes, the sources of order flow,
and the identities and motivations of market participants. Consequently, transparency has
many dimensions (Madhavan, 1995, P: 255). The dimensions to the concept of disclosure are
more or less difficult to measure. One can distinguish the timeliness (of press briefings), the
periodicity (quarterly results versus first and second-half results), the quantity, and the quality
(truthfulness) of disclosure (Nier, 2004). Second, there are a number of different channels of
disclosure. Firms may disclose information in published annual accounts, but they may also
communicate material information to analysts and the financial market using ad hoc press
briefings. Indeed, depending on their listing status, firms may be required to issue profit
warnings when there is information indicating that the firm may not achieve its stated
earnings target. Information may also be disclosed by third parties. Rating agencies have
access to information that is not available to the public at large and that the agency feeds into
the rating assigned to the firm. 7
The focus on transparency and disclosure has increased in the wake of recent events
beginning with the Asian crisis in the later half of 1997 and continuing with the recent
financial crisis in the US and the world markets. One of the main functions of regulators is to
ensure an investment environment where gains from private information are minimized exante and penalized ex-post. Financial literature has analyzed the agency problems arising from
the asymmetric information between a firm’s management and financial stakeholders for well
over 75 years, with an increasing focus over the last 25 years. Disclosure benefits firms in
different ways. For example, it lowers the cost of capital as the firm makes its shares more
accessible to nonresident investors who would otherwise find it less advantageous to hold the
shares because of barriers to international investment. And as disclosure increase shareholder
base, it consequently reduces their risk premium, to demonstrate with the case of cross-listing
in the U.S. markets. If U.S. investors face obstacles in investing in a foreign firm and if a U.S.
listing for that firm reduces these obstacles, the risk of the firm becomes shared more widely
following the listing provided that the cross-listing leads to an expansion of the firm’s
shareholder base. This greater risk-sharing reduces the risk premium investors require to hold
the shares of the firm (Stulz, 2002).
Also, disclosure facilitates access to developed foreign capital markets, and though increases
ability to raise equity. For example, by listing in the U.S., firms can issue securities in the
U.S. Since the U.S. capital markets are deep and liquid, foreign firms can raise funds at lower
cost than at home. Firms that cross-list in the U.S. become less credit-constrained in that their
new investment depends less on their cash flow after the U.S. listing than before. With this
benefit, firms that expect to have to raise funds would be more likely to cross-list in the U.S.
and firms that do not anticipate the need to raise funds would have no reason to list.
Disclosure also lowers stock volatility by reducing information asymmetries which in turn is
likely to increase the effectiveness and reduce the cost of stock-based executive compensation
(Nier, 2004, P: 32). It increases bonding and monitoring. For example, a cross listing in U.S.
markets enhances the protection of the firm’s investors and, consequently, reduces the agency
costs of controlling shareholders. Compared to the rest of the world, investors are extremely
well protected in the U.S. Foreign firms can obtain some of the benefits of the apparatus that
protects investors in the U.S. by listing in the U.S. The extent to which they gain these
benefits is high when they list on an exchange, these benefits are lower for over-the-counter
(OTC) listings or Rule 144a private placement issues. In particular, firms that list shares on a
U.S. exchange are subject to many of the same U.S. laws and regulations as U.S. firms. In
addition, firms that list in the U.S. are also subject to greater scrutiny and monitoring from the
press and from the investment community, which further increases the protection of minority
shareholders (Stulz, 2002).
Finally, firms with higher transparency and disclosure are valued higher than comparable
firms with lower transparency and disclosure (Patel, 2002). It seems that more disclosure
makes stock more liquid, and adds visibility, exposure, and prestige as reported Stulz, (2004)
in the case of cross-listing in highly transparent markets as in the U.S. exchange. 8
On the other hand, disclosure is costly, and this cost must be offset by resulting benefits for it
to be justified
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 (Nier, 2004, p. 31) like the existence of sophisticated investors who normally
require and need more transparency for their investing decisions. Moreover, too much
discretion (i.e., a lack of standardization) over what is disclosed will have a negative effect on
what, when and how to disclose, which will add confusion on investors interpreting not
unified data. Also, disclosure reveals proprietary information that could be used by
competitors.
An increase in quantitative disclosures may not necessarily increase transparency. In the
words of the Federal Reserve Chairman Alan Greenspan: “A more complex question is
whether greater volume of information has led to comparable improvements in transparency
of firms”. In the minds of some, public disclosure and transparency are interchangeable. But
they are not. Transparency challenges market participants not only to provide information but
also to place that information into a context that makes it meaningful” (Nier 2004, p. 31).
The available evidence in the U.S. suggests that the relatively law disclosure requirements for
OTC firms helped to create an environment where shareholders of these companies were
often poorly informed and had few avenues available to penalize management for failing to
maximize shareholder value. For example, in a study of a random sample of OTC securities
conducted in 1962 found that: more than a quarter of the firms did not provide any reports on
the firms’ financial position or results in that year; 73 percent of proxy solicitations involving
the election of directors failed to include the names of the nominees; only 16 percent of these
solicitations listed the directors’ qualifications; 95 percent of proxy solicitations for election
of directors failed to report on management compensation; 24 percent of the firms failed to
solicit proxies before shareholder meetings; and in two-thirds of the solicitations involving
modifications of securities, the effects of the modification on the rights of existing security
holders were not given (United States Securities and Exchange Commission [1963]).
Even if OTC firms released independently audited financial statements, the information may
not have been considered credible by market participants. In the case of firms not covered by
the 1934 Securities Act, state courts had generally ruled that investors could not sue
accountants for negligently prepared financial statements unless they had direct dealings with
them. In principle, investors in these companies could sue accountants for fraudulent
statements, but, in practice, the legal standard for fraudulence was very difficult to meet.
Consequently, these investors had little scope to penalize fraudulence through the courts. The
“vast majority of securities fraud occurred among firms not subject to the SEC’s period
reporting requirements”. Moreover, it was widely believed that many OTC firms chose not to
list on exchanges precisely to avoid the stricter disclosure requirements on the NYSE and
AMEX (Madhavan, 1996).
                                                         
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 The costs of disclosure include the direct costs of producing and disseminating information, but also
indirect costs that might arise when a bank’s competitors are able to exploit the information that the
bank provides to the financial market (Nier, 2004).9
2- A brief on the Middle East and the Gulf states economies: (Oxford Business Group,
country report, 2008, International Monetary Fund)
Egypt
Egypt has been pursuing an aggressive program of reform in recent years, with the opening of
both political and economic arenas. GDP annual growth was 7.1% in 2007, (World Bank).
Hydrocarbons are among Egypt's most valuable resources, though textiles and tourism play
important roles in the country's economy. The economy has managed to sustain high growth
for the past 10 years. The prime drivers of the economy are foreign direct investment (FDI),
remittances, Suez Canal fees and tourism. Changes in economic policy have been made to
minimize the state's role. More than 100 traditionally state-owned firms have been earmarked
for privatization, a program that brought in $3bn for the year 2006/07. A rationalization of the
tax code has worked to encourage more FDI (Foreign  Direct Investment), with 27 tariff
categories cut down to six and a reduction of duties of around 75%.
Privatization has a major effect on the banking sector. The dominance of public banks is
starting to subside with four of the country's major banks being sold. $500m loan from the
World Bank will allow the recapitalization required in order for two of the biggest public
banks to comply with Basel II standards. Along with privatization comes new legislation,
bringing the sector in line with international standards and causing a series of mergers and
acquisition. Banks are however treading carefully in some areas. Mortgages, for example, are
an area that could benefit the entire population, yet firms are waiting to see what happens in
courts regarding what some see as inadequately tested laws.
The Cairo and Alexandria Stock Exchange is an attractive destination for investors who can
find a plethora of industries among the top 30 companies listed within the 550 companies
listed on the bourse. The overall capitalization of the market has grown to $103.5bn in July
2007. The future is expected to offer a steady stream of IPOs from the private sector, as well
as new licenses for brokers to provide margin trading and short-selling services. The Capital
Markets Authority is also calling for higher standards of corporate governance, which will
surely lead to a more stable market. (Oxford Business Group, 2008)
Jordan
Even though inflation pushed its way up to the 13% mark in the first half of 2008, the shocks
to the system are far less than in neighboring Egypt where inflation crept up to around 23%.
Jordan’s economy has come under some pressure in 2007 and perhaps more so in 2008,
primarily from global increases in oil and food prices that have affected the government
budget and the current account balance. While Jordan is facing enormous economic pressures,
it is managing to sustain good levels of GDP growth and foreign investment. There are a
number of sectors that have performed well in 2007, including minerals, pharmaceuticals and
tourism. Light industry has to face stronger competition and rising energy costs. For the
construction materials sector, Chinese goods benefitting from low labor costs and Gulf
products capitalizing on low energy costs could make life difficult for many local producers
of light industrial goods. However, Jordan’s free trade agreements, investment incentives and
low transport costs for shipping to major markets are still drawing producers to the country.
Steel and cement producers are not expected to face the same challenges as light industry and
cement production is due to rise. The government is also pushing ahead with the 10
establishment of economic zones to attract new industry and services to less developed areas
of the country.
Overall results for Jordan’s banking sector in 2007 were good, with the total profits of the 15
listed banks up 14.89% to JD640m ($909m). Jordan’s strong growth of 6% in 2007 was
reflected in a 20.57% expansion in net credit to JD17.9bn ($25.4bn) by the end of the year.
Trade, construction and industry saw most improvement. Many banks suffered from the sharp
correction in the Amman Stock Market in 2006, encouraging them to focus on core banking
business in 2007, and this was reflected in a 16.65% rise in net interest and commission
income to JD1.32bn ($1.87bn). They were fortunate, however, that the stock market also
picked up in 2007 and total portfolio income losses decreased. Also, although Jordan’s
banking sector is small by global standards, it has attracted strong interest from regional
investors in Lebanon and the GCC. New regulations introduced by the CBJ, in addition to
historical political stability, have helped to create a favorable investment environment.
The resurgence in confidence and liquidity in the region as the price of oil began to fall
contributed to the positive turn in Amman Stock Exchange by the end of 2007. At the end of
2007 market capitalization rose by 39% over 2006 and equivalent to 289% of Jordan’s GDP
as a result of better prices, capital increases and a strong appetite for initial public offerings.
The number of companies that are listed on the market has increased from 161 in 2003 to 245
by the end of 2007. While inflation and the credit crunch mean that 2008 will be a challenging
year, the Jordanian market is less volatile than neighboring markets and there are hopes that
the effective presence of strong regulators and good reporting will help to mitigate the global
financial crisis.
Oman
Oman’s careful economic planning over the years has left it well-positioned as the global
economic crisis set in at the end of 2008. Over this period, public debt was reduced
significantly and Oman was also the first country in the region to establish a state general
reserve fund (SGRF) to provide a cushion against a reduction in income when prices
inevitably dipped. The government is committed to diversification and willing to move
quickly to keep the economy working smoothly when necessary. Under the Vision 2020
programme, the government’s long-term ambition is to move away from its strong reliance on
oil, and boost the GDP contribution of non-oil sectors such as industry and tourism, and boost
trade – already a strong point of Oman’s economy – in the wider region. Between the end of
2008 and the start of 2009, Oman enacted a free trade agreement (FTA) with the United States
and signed, along with its GCC partners, FTAs with India and Singapore. In 2009, GDP
growth is expected to slow. It registered a remarkable 13% in 2007.
Thanks to a highly capitalized market, Oman’s banking sector had little need to look outside
its borders for investment support and was thus relatively insulated from the sub-prime fallout
in the United States and Europe. Still, the country has not been entirely immune to the effects
of the global financial meltdown. In the second half of 2008 the Central bank of Oman (CBO)
had to shift its policy direction from one of tightening credit conditions in an effort to contain
rising inflation to helping an economy that was facing a shortage of liquidity. In late October
it began to offer dollar loans to local institutions to ensure they could find the cash they
needed. The debate over Oman’s currency peg to the dollar continued throughout 2008,
following the rise and subsequent dip in inflation that played out over the course of the year.
The CBO maintained its commitment to retaining the peg, clearly stating that it considered it 11
beneficial to the overall economy. Financing for small and medium-sized enterprises (SMEs)
also gained a more prominent role in the banking sector as the government looks to develop
this growth segment and encourage privatization. Despite a few negative signals, such as the
Bank of Muscat’s January 2009 reporting of international losses, Omani bankers remain
positive and are focusing on long-term prospects. Official reserves are strong and the
government can maintain its plans even in times of dull oil revenues.
Like most bourses in the region, the Muscat Securities Market (MSM) in Oman experienced a
rather steep correction in 2008, in a clear break with its stable and scrupulous history. For six
consecutive years leading up to 2008 the benchmark index of the Muscat Securities Market
(MSM) climbed steadily – a record unmatched by any of its Gulf Cooperation Council (GCC)
peers. By the spring of 2008 foreign ownership had risen from historic levels of 11% to
almost 28%, heralding the heavy influx of equity investors scared off by trembling American
and European markets.
Dubai
Nowhere has enjoyed as much success with diversification as Dubai. The emirate is full of
‘biggests'. The world's biggest airport is being constructed there, as is Dubailand, the world's
largest entertainment and leisure complex. Dubai is one of the leading lights in the Islamic
finance product sector. All this activity comes from within an emirate blessed with a stable
and liberalizing government that realized long ago the importance of diversifying away from a
total reliance on oil. The Dubai economic model consists of focusing on areas where the
government can quickly cash in – hydrocarbons for example – and then, by way of
diversification, investing in an economy largely based on the service sector. Indeed Dubai's
non-oil sectors grew by over 15% on average during  2000- 2005. Two major segments in
Dubai's economy are real estate and tourism (e.g., Dubailand). Part of the attraction of Dubai
for developers and tourists alike is its location; an estimated 1.8bn people, over one-quarter of
the world's population, living within a five-hour flying distance of the emirate. Dubai's
position also makes it an attractive market for the emerging powerhouses of India and China
while Dubai's local companies look outwards. In recent years Dubai International Capital
(DIC), part of the state-owned conglomerate Dubai Holdings, has purchased stakes in the
UK's HSBC Holdings and Standard Chartered. Dubai's  biggest economic challenge lies in
managing to curb its double digit inflation which was 21.8% in 2000 and 14.3% in 2005 for
all UAE, (the World bank). It is, meanwhile, expected that a single currency, modeled on the
euro, will be in place by 2010, following the launch of the GCC common market in January
2008.
In regard to the banking sector, the emirate is now known to be the financial centre of the
region. The number of banks in the UAE, both foreign and local, reached 52 in 2007. Despite
the unstable global economic climate, international banks are establishing local offices in the
UAE with Deutsche Bank, Credit Suisse, Citibank, Lazard and JP Morgan establishing a
presence in Dubai.
Dubai's capital markets performed well in 2007 and  the first two quarters of 2008 and are
back to pre-2006 correction levels, despite the volatility on the global markets. The drivers for
growth are internal: solid economic foundations; rapid non-oil related GDP growth and high
oil prices in the medium term. External factors are assisting the emirate too: low returns in
other equity markets and worldwide interest in Dubai, spurring overseas investment. In the
future, the number of IPOs is likely to be boosted  by efforts towards maintaining greater 12
transparency and oversight and new regulations on majority control. Segments to watch are
the debt market and sukuks; the Dubai International Financial Exchange (DIFX) is building
on its position as the world's largest sukuk (the Islamic, sharia-compliant equivalent of a
bond) exchange by establishing the first state-of-the-art product platform in the GCC to offer
sharia-compliant structured products. Meanwhile Dubai is set to benefit from the most up-todate trading technology as a result of its deal with the American stock exchange NASDAQ.
Abu Dhabi
Since the discovery of oil, revenues from oil and gas have transformed the emirate into one of
the world’s richest locations. Indeed, the UAE sits upon 9% of the planet’s natural gas
reserves, with Abu Dhabi enjoying the lion’s share  of this – 95% of oil and 92% of gas.
Government reforms aimed at minimizing dependence on the public sector and encouraging
privatization. Abu Dhabi's GDP has been on the rise on the back of strong oil revenues and
new investment in infrastructure, real estate, industry and tourism. Although the energy sector
continues to dominate the economy, non oil-based activity is increasing as a result of Abu
Dhabi's successful economic diversification and global integration program. In 2008, the
government unveiled its five-year strategic plan with an expenditure of $200bn on the new
infrastructure needed to support the diversification program, boost GDP growth and attract
foreign investment.
The UAE banking sector posted very strong results for 2007 and has become the largest in the
Gulf Cooperation Council (GCC) in terms of assets.  The UAE's expanding economy and
rising population have led to a notable expansion of credit in 2007, particularly mortgage and
personal lending. It rose by 40.1% to $19.7bn, while deposits rose 29% to $196.2bn. Banks
saw net profits rise by 23.6% to $6.65bn, with Abu Dhabi Islamic Bank (ABID) experiencing
the largest growth in profits. The number of Islamic banks in the UAE rose to eight in 2007.
Meanwhile, the global credit crunch has forced many US and European banks to stem lending
activity, creating an opportunity for local banks to provide the necessary funding for the everincreasing number of projects in the Gulf. The banks are currently showing more interest in
moving abroad - anywhere from the within the region to China - than in going for
consolidation at home.
The Abu Dhabi Securities Exchange (ADX) ranked fifth among the 15 Arab stock exchanges
in terms of 2007 annual turnover, and by market capitalization. Meanwhile, in October 2007,
HSBC became the first international bank to be awarded a license to trade shares on the Dubai
and Abu Dhabi domestic stock exchanges. Of the 66 securities listed in mid-2008, 47 were
open to non-UAE nationals, a sign of the increasing effort to encourage foreign investors in
the market and an indication that restrictions on foreign ownership are being eased. Many
foreign funds that left Abu Dhabi in August 2007 as a result of the US sub-prime fallout
returned to the country in early 2008. Abu Dhabi is not insulated from external events, but the
fundamentals remain strong. Besides, improvements in the quality of market research and
codes for disclosure and transparency are being improved.
Kuwait
With an estimated 10% of the world's oil reserves,  every sector in Kuwait has reaped the
benefits of oil profits. Kuwait is slowly beginning to diversify its economy, with the hopes of
reducing its dependency on oil profits. Kuwait's GDP increased 176% between 2000 and
2006, with growth averaging 26% a year.  13
The banking sector has greatly benefited from the recent oil boom. The economy doubled
between 2003 and 2006. Bank profitability reached record levels in 2007.
4
 Islamic banking in
Kuwait is becoming increasingly popular and now claims 25% of total bank assets in the
country. In some cases it has managed to take business away from conventional banks and
draw in customers who had previously avoided formal banking. The Islamic finance industry
is expected to grow significantly, with some estimates indicating that the demand for Islamic
financial products will rise from $400bn to $4trn in the next five years. Kuwait currently has
three Islamic banks. All three are experiencing strong growth and have expanded their
operations internationally.
Kuwait's capital markets experienced some turbulence in 2006, but quickly bounced back in
2007 and recorded impressive growth. High levels of liquidity, strong oil prices and increased
government spending have led to greater investor confidence. The Kuwait Stock Exchange
(KSE) is the second largest in the Gulf Cooperation Council, recording a total market
capitalization of $207bn in August 2007. This can be largely attributed to Kuwait’s strong
macroeconomic environment, with the financial sector ranking 27 out of 122 countries in
2006 and first among Arab countries. However, the lack of a mature bond market and
availability of foreign capital have caused some concern. In addition, regulatory activities are
governed by a confused array of official bodies that often lead to complaints about
transparency. The government needs to simplify the  regulatory structure and impose stricter
penalties for those who violate market rules. Plans are also in the works to establish an
independent authority to monitor the exchange. If these problems were addressed, the flow of
new companies onto the bourse would increase and therefore ensure the KSE's growth.
Qatar
Qatar possesses some excellences in terms of its hydrocarbons supplies and its political role
as a mediator in the Gulf region. The current Emir, Sheikh Hamad bin Khalifa Al Thani, is
bringing in many liberalizing changes while steering his country's economy towards a wellplanned diversification process for when, one day,  the oil and gas run out. The industrial
sector is key to this, as are the financial services and tourism sectors. The Qatari population is
one of the richest in the world, with surging GDP growth of over 8% and 2007 per capita
GDP estimated at $78,754.439 (Table 1). Indeed, Qatar is unlikely to find it hard to attract
foreign investment, with the IMF projecting an average annual growth rate of 12.3% between
2008 and 2012, with real GDP set to rise from an expected $83bn in 2008 to $134.4bn by
2012. Bringing inflation under control is one of the major challenges for the future;
Qatar’s banking sector is on a roll, off the back of an expanding economy and a growing
population. The combined net profits of the listed banks rose by an impressive 56% in 2007.
The retail market is where the big prizes could lie, with predictions that it could be worth
$1.7bn by 2011-2012; there is room for growth, as use of internet banking and ATMs are well
below the global average. Corporate lending to the  construction and real estate sectors is
growing quickly, as is Islamic banking. New Islamic Financial Services institutions, both
local and foreign, have appeared and existing ones have broadened their activities. Even nonIslamic banks are getting in on the act and opening up Islamic windows. This follows a GCCwide trend towards sharia-compliant services, in particular investment and banking.
                                                         
4
  Profit growth averaged 30% per year between 2004 and 2006 as a result of an increasing asset prices and
large-scale developments in construction which have kept the demand for project financing strong. (Oxford
Business Group) 14
Meanwhile the global sukuk, or Islamic bond market, could grow by as much as 35% globally
in the next few years, according to Moody’s Investor Services.
When operations on the Doha Stock Market (DSM) began in 1997, there were 17 listings, a
market capitalization of about $1.7bn and trading was limited to Qatari citizens only.  As of
late March 2008 there were 43 listings and a market capitalization of slightly over $110.2bn,
with the market opening up to limited participation by non-Qataris in 2005, although
foreigners still cannot participate in IPOs. An extra push towards market security could come
from the London Stock Exchange, which is developing a multi-faceted strategic relationship
with the DSM.
KSA
Despite the stumbling of the global economy in 2007 and 2008, The Kingdom of Saudi
Arabia, the world's largest exporter of oil, continued to register double-digit growth, a large
budgetary surplus for the sixth consecutive year and a rise in imports. The Kingdom is
committed to encouraging foreign investors; it improved its ranking for ease of doing business
on the World Bank's “Doing Business” report from 33rd place in 2006 to 23 rd place in 2007,
making it the highest ranking country in the Middle East. Saudi Arabia is well on track to
reach the goal set by Saudi Arabian General Investment Authority to be one of the top-ten
most competitive economies in the world by 2010. Owing to the increased liquidity from
strong oil revenues and recent liberalization measures, the Saudi banking sector is wellrecovered from the 2006 stock market correction. Regulatory changes are also afoot - in 2007
the foreign equity limit was increased from 40% to 60%, and in early 2008 the Saudi Arabian
Monetary Authority (SAMA), the central bank and banking regulator, adopted Basel II
banking regulations. The Basel regulations aim to ensure that capitalization of banks is
adequate and sensitive to varying degrees of risk.
With the arrival of Al Inma Bank and its $2.8bn IPO in April 2008, Islamic banking in Saudi
Arabia seems to have hit its stride. One estimate puts Islamic assets at over 60% of the
Kingdom's total banking assets. As more and more Saudis opt into the system, the financial
services sector as a whole has been strengthened –  the sector's contribution to GDP is
expected to rise from approximately 3% of GDP today to 6% by 2015, while assets of purely
Islamic banks enjoyed a compounded annual growth rate of 18% between 2003 and 2007.
Economic reform and a new regulatory regime have made Saudi scholars more receptive to
sukuk and the West has become more aware of the potential within the market - Standard &
Poor's estimates it will break $100bn by the end of the decade. While the Islamic Finance
sector is not without its problems, namely a lack of human resources and a need for regulatory
reform, it is built upon strong local demand and should see a path to robust success.
Robust oil revenues, healthy government spending, and increasing foreign investment in
recent years have combined to provide ample liquidity in Saudi Arabia's markets. The Saudi
stock exchange, the Tadawul All-Share Index (TASI), is however subject to market volatility
due to the highly speculative, individual investor-driven nature of the market. The regulatory
body, the Capital Market Authority (CMA), is focused on addressing these issues through
investor education and increased transparency. The regulator also authorized the use of a new
book-building system for IPOs, which was first utilized in May 2007, while merger and
acquisition (M&A) regulations were signed into law on October 2007. The CMA stated that
new disclosure laws are likely to be released in 2009.  15
Bahrain
GDP growth in Bahrain was estimated at between 6.8% and 7% in 2007, while the rate of
inflation stood at 4.8% in February 2008 according to the International Monetary Fund (IMF).
Bahrain has had petrodollars in abundance for decades, and, over the past 30 years, has built
up a banking sector to service them, with just over 400 financial institutions currently
operating in the Kingdom. Indeed the CBB (Central Bank of Bahrain) is facing up to the
competition by improving market transparency and conditions through adjustments to its rules
and regulations. Meanwhile Bahraini investors are looking overseas, in particular at Central
and Eastern Europe's transport, logistics, finance and real estate sectors
Investors are attracted by the ethics behind Islamic finance, with its precepts of risk sharing.
Bahrain is now home to 29 Islamic banks, both retail and wholesale, with their assets
representing just fewer than 7% of the total banking system and balance sheet assets of
$16.4bn at the start of 2008, up 34.4% from the beginning of 2007. The Kingdom's Islamic
banks had a stellar year in 2007, with healthy profits for most of the big lenders, including, for
example, $144m in 2007 for Al Baraka Banking Group, up 79% on 2006.
The Bahrain Stock Exchange (BSE) has made steady progress to be the best-run and most
stable financial services industries in the GCC in  recent years. New innovations include the
offering of Indian stocks by the Bank of Bahrain. Growth and liquidity could accelerate
thanks to new trading mechanisms on the BSE, bringing technical capacity on the bourse to
the level of its regional neighbors.  16
Table 1: Gross domestic product, current prices, in Billion U.S. dollars units for the sample
economies.
International Monetary Fund, World Economic Outlook Database, April 2009
Country  1995 1998 2001 2004 2007
Bahrain 5.848 6.183 7.969 11.233 18.443
Egypt 60.163 84.821 95.399 78.802 130.346
Jordan 6.731 7.912 8.975 11.411 16.532
Kuwait 27.189 25.945 34.901 59.439 111.755
Oman 13.803 14.085 19.949 24.772 40.391
Qatar 8.138 10.255 17.538 31.734 71.041
Saudia Arabia 142.457 145.967 183.257 250.673 381.938
United Arab
Emirates 40.726 48.514 68.677 107.304 180.180
Table 2: Inflation, average consumer prices, Index, 2000=100.
International Monetary Fund, World Economic Outlook Database, April 2009
 Country  1995 1998 2001 2004 2007
Bahrain 98.140 102.057 98.781 102.190 110.484
Egypt 78.472 93.720 102.425 117.060 147.245
Jordan 87.292 98.740 101.768 108.866 126.160
Kuwait 91.402 95.511 101.448 104.563 118.371
Oman 100.132 100.697 99.159 99.658 111.186
Qatar 84.996 96.267 101.436 111.052 153.734
Saudi Arabia 102.183 102.451 98.862 100.025 107.213
United Arab Emirates 89.405 96.637 102.736 114.564  147.708 17
3- Literature review
a-Capital Structure :
The major theoretical models that explain the choice of capital structure are: The trade-off
theory (TOT) and the pecking order theory (POT). The trade off theory states that capital
structure is the result of an individual firm’s trading off the benefits of increased leverage
(e.g., a tax shield) against the potential financial distress caused by heavy indebtedness.
Financial distress includes the costs of bankruptcy or reorganization, and the agency costs that
arise when the firm’s solvency is called into question (Fernandez, 2005; Gaud, 2005).
The pecking order theory, developed by Myers and Majluf (1984) and Myers (1984), is a
consequence of information asymmetries existing between insiders of the firm and outsiders
(i.e. the capital market). Under the assumptions that managers are better informed about the
firm’s investment opportunities than outsiders, and that corporate managers act in the best
interest of existing shareholders, the model leads managers to adapt their financing policy to
minimize the associated costs. More specifically, they will prefer internal financing to
external financing, and risky debt to equity (Gaud, 2005).
Local country factors could be especially significant in explaining firm leverage. The tradeof- theory and pecking order theory find that country institutional factors matter to firm
leverage. Trade-off theory argues that firms balance the tax benefits of loans with potential
bankruptcy costs to achieve an optimal leverage level (Miller 1977). Hence, local tax levels as
well as bankruptcy codes matter. In pecking order theory of capital structure, firms prefer
internal funds to outside sources since the latter  are miss-priced due to the asymmetric
information between owners and investors (Myers, 1984). Hence, the transparency of the
firm's activities is important. This asymmetric information is expected to be especially large
in transition economies, meaning that firms are less likely to turn to outside sources of finance
even if the investment opportunities exceed the internal funds (Joeveer, 2006). Delcour,
(2007) found that neither the trade-off theory, nor the pecking order theory, explained the
capital structure choices in central and Eastern Europe companies (CEE). Rather, Companies
follow the modified “pecking order” where the consequence of their financing was the
retained earnings followed by equity issuance then debt instead of what is usually practiced in
developed countries’ firms where their second alternative is debt followed by equity as a last
choice.
Capital structures vary across countries. For instance, American, German, and Canadian firms
have lower book debt ratios than do their counterparts in other industrialized nations, such as
Japan, France, and Italy (e.g., Rajan and Zingales, 1995). Capital structures also display
industry pattern, which are similar around the world. Utilities, transportation companies, and
capital-intensive manufacturing firms have high debt-to-equity ratios as opposed to service
firms, mining companies, and technology based manufacturing firms, which employ very
little long-term debt, if some at all (Fernandez, 2005). 18
a-1- The Determinants of Capital Structure:
Despite decades of intensive empirical research after Modigliani and Miller (1958), there is a
surprising lack of consensus as to what factors determine optimal corporate capital structure.
Empirical literature suggests a number of factors that may influence the financial structure of
companies. The choice of the explanatory variables  is fraught with difficulty. This is why
different researchers have considered different key variables- like company size, profitability,
asset tangibility and firm growth prospects- in their respective studies as possible determinant
variables of the capital choice.
1. Profitability
According to the pecking order theory (Myers and Majluf, 1984), and as a result of
asymmetric information, firms prefer using internal sources of financing first, then debt and
finally external equity obtained by stock issues (Gaud, 2005; Omet, 2006; Supanvanij, 2006;
Mitton, 2007; Jong, 2007). All things being equal, the more profitable the firms are, the more
internal financing they will have, which means lower debt levels and higher retained earnings,
and therefore we should expect a negative relationship between leverage and profitability.
In the trade-off theory framework, and according to the interest-tax shield, an opposite
conclusion is expected. When firms are profitable, they should employ more debt to benefit
from the tax shield. In addition, if past profitability is a good proxy for future profitability,
profitable firms can borrow more as the likelihood of paying back the loans is greater (Gaud,
2005; Omet, 2006; Supanvanij, 2006; Mitton, 2007; Modigliani and Miller, 1963). Hence, a
positive relationship between leverage and profitability will support the trade-off theory,
whereas a negative relationship will support the pecking order theory. Rajan and Zingales,
(1995) report a negative relationship between profitability and leverage in the G-7 countries.
The negative influence of profitability on leverage becomes stronger as firm size increases.
This is indeed the case for firms in the U.S. for small size firms, a unit increase in profitability
decreases leverage by -0.26, whereas for large size firms, a unit increase in profitability
decreases leverage by -1.09, over 4 times the effect as that for the smallest firms (and is
significantly different).
The empirical researches have a consensus over the relation between firms’ leverage and their
profitability in emerging markets as to be negative, which is more profitable companies do not
rely on greater levels of debt than less profitable companies, but results differentiated in the
significance of this relation. Some empirical evidence found that the relation between firms'
leverage and their profitability is negative and statistically significant (Delcour, 2007; Guad,
2007; Daskalakis and Psillaki, 2007; Mashharawe, 2003; Supanvanij, 2006; Pandey, 2001;
Nivorozhkin , 2005), which supports the pecking order hypothesis in the argument that as a
result of asymmetric information, and because external finance is costly, firms prefer to rely
on internal sources of finance. Other empirical researches found a negative relation between
profitability and leverage, but not of much significance (Omet, 2006; Supanvanij, 2006),
which does not support neither the Myer's pecking order theory, nor the tax deductibility (tax
shield) hypothesis.  19
The empirical evidence that supports the pecking order hypothesis in explaining negative and
statistically significant relations between firms' leverage and their profitability revealed that
the order of the external financing choices appears to be different.  Managers may perceive
retained earnings to be the quickest and easiest source of financing followed by new equity
issuance, bank borrowing, and possible new debt issuance. These results collaborates Chen's
(2004) explanation of the modified pecking order hypothesis in corporate capital structure
among developing countries. Under the modified pecking order hypothesis, emerging
countries follow a different “pecking order” in their capital structure decisions— retained
earnings, equity, and at last debt. The relation between profitability and leverage in emerging
economies is negative as it is in developed economies, but the reason for this negative relation
is different. While it depends on a company’s strategies, target leverage and available costs of
financing sources in developed economies, it occurs that companies in emerging economies
have to rely on equity as a first external financing source to finance their capital investments.
This is due to that the bond market in the majority of emerging countries is still developing.
Banks provide short-term liquidity loans rather than long-term financing to enterprises. In
addition, shareholders' protection laws are still weak. Thus, managers prefer equity to debt
financing. (Gaud, 2005, Titman and Wessels; 1988, Rajan and Zingales, 1995; Supanvanij,
2006) suggest using the ratio of operating income to total assets as indicators of profitability.
2. Tangibility
Tangible assets are likely to have an impact on the borrowing decisions of a firm because they
are less subject to information asymmetries and they usually have a greater value than do
intangible assets in case of bankruptcy. Myers and  Majluf, (1984) pecking order theory
suggests that firms may find it advantageous to sell secured debt. Since there may be costs
associated with issuing securities about which the  firm’s managers have better information
than outside shareholders, issuing debt secured by  property with known values can avoid
these costs. Hence, firms with assets that can be used as collateral may be expected to issue
more debt to take advantage of this opportunity (Gaud, 2005; Mitton 2007). Tangible assets
are easy to collateralize and thus reduce moral hazard and agency costs of debt because this
constitutes a positive signal to the creditors who can request the selling of these assets in the
case of default. As such, tangible assets constitute good collateral for loans (Gaud, 2005;
Mitton, 2007; Pandey, 2001).
If a large fraction of a firm’s assets are tangible, then assets should serve as collateral,
diminishing the risk of the lender suffering the agency costs of debt. Assets should also retain
more value in liquidation (Rajan and Zingales 1995). Leverage ratios seem to be negatively
correlated with perceived costs of bankruptcy and financial distress. Firms rich in
collateralizeable assets (e.g., commercial, real state, and transportation) are able to tolerate
higher debt ratios than firms whose principal assets are human capital, brand image or
intangible assets (Fernandez, 2005). Therefore, the greater the proportion of tangible assets on
the balance sheet, the more willing should lenders be to supply loans, and leverage should be
higher (Rajan and Zingales, 1995). 20
Based on the agency problems between managers and shareholders, Harris and Raviv, (1990)
suggest that firms with more tangible assets should take more debt. This is due to the behavior
of managers who refuse to liquidate the firm even when the liquidation value is higher than
the value of the firm as a going concern. Indeed, by increasing the leverage, the probability of
default will increase which is to the benefit of the shareholders. In an agency theory
framework, debt can have another disciplinary role: by increasing the debt level, the free cash
flow will decrease (Grossman and Hart, 1982; Jensen, 1986). This disciplinary role of debt
should mainly occur in firms with few tangible assets, because in such case it is very difficult
to monitor the excessive expenses of managers (Gaud, 2005).
It seems that the relationship between tangibility  and leverage depends on the type of debt.
Tangibility has a positive relationship with long term debt, and a negative relationship short
term debt (Omet, 2006). Most empirical studies concluded a positive relation between
collaterals and the level of debt in developed economies (Rajan and Zingales, 1995; Kremp et
al., 1999). With some exceptions like Daskalakis and Psillaki, (2007) who reported that asset
structure has a negative relationship with leverage in small and medium sized enterprises
(SMEs) using a sample of Greek and French firms for the period 1998-2002.
In emerging markets, the coefficient is positive and significant (Delcour, 2007; Supanvaij,
2006; Omet 2006; Gaud, 2005; Mashharawe, 2003; Nivorozhkin, 2005), which are consistent
with the trade-off hypotheses, and also consistent with previous studies on firms in the United
States. The results are consistent with the view that there are various costs (agency and
bankruptcy) associated with the use of debt funds and these costs might be moderated by
collateral. In some other researches, results were  negatively related to debt (Joeveer, 2006;
Daskalakis and Psillaki, 2007; Nivorozhkin, 2005).  Pandey, (2001) found it significantly
negative with short-term debt. The results imply that tangible assets remain a poor source of
collateral in less advanced economies, although  Nivorozhkin, (2005) found that the effect of
tangibility on target leverage is moving towards the positive relationship observed in
Germany, France, Italy and the UK of Rajan and Zingales, (1995). In the case of KSA (Saudi
Arabia), the coefficient of tangibility was found negative and significant. The reason for this
finding could be because certain percentage of the total liabilities are provided to companies
from “Islamic” sources where fixed assets have no importance in the lending activity of
Islamic banks. Moreover, Saudi companies have “large” cash holdings (cash to total assets is
8.83 percent), which make banks pay less attention  to the value of collateralized assets
(Mashharawe, 2003).
Even though that the rationale underlying tangibility is that tangible assets are easy to
collateralize and thus they reduce the agency costs of debt. Berger and Udell, (1994) showed
that firms with close relationships with creditors  need to provide less collateral. They argue
this is because the relationship substitutes for physical collateral. In Japan, stronger bank-firm
relationships imply a lesser role for tangibility.  Rajan and Zingales, (1995) found that a
standard deviation increase in tangibility increases book leverage by about 20% of its standard
deviation in all countries in G-7, in Japan leverage increases by 45%. Perhaps Japanese firms
with fixed assets such as land could borrow more over the 1980s because the collateral value
of the land appreciated and the appreciation was not reflected in the book value.  21
3. Company Size
The relation between size and leverage is somehow not obvious. While most empirical studies
report a positive sign for the relationship between size and leverage. (Gaud, 2005; Daskalakis
and Psillaki, 2007), others report a negative relation (Rajan and Zingales, 1995). Large firms
have easier access to equity markets. They can also borrow at better conditions. That is, lower
costs in issuing debt or equity (Omet, 2006).
Large size firms tend to be more diversified, and hence their cash flows are less volatile.
Relatively large firms tend to be less prone to bankruptcy.  Direct bankruptcy costs appear to
constitute a larger portion of a firm’s value as that value decreases. Therefore, size may be an
inverse proxy for the probability of bankruptcy (default). If so, it should be strongly positively
related with leverage, especially in countries where costs of financial distress are low like
Japanese firms. Japanese firms are tied to a main bank; they may face a lower cost of financial
distress because the main bank organizes corporate rescues. Size is found to be important in
Japan; a standard deviation increase in size increases book leverage by 33% of its standard
deviation (compared to 23% in the U.S.). Hence, size should have a positive impact on the
supply of debt (Titman and Wessels 1988; Mitton, 2007, p.137; Supanvanij, 2006; Rajan and
Zengales, 1995).
In small firms, the conflicts between creditors and shareholders are more severe because the
managers of such firms tend to be large shareholders and are better able to switch from one
investment project to another (Grinblatt and Titman, 1998). The result is that small firms tend
to have less long-term debt. However, this problem may be mitigated with the use of short
term debt, convertible bonds, as well as long term bank financing (Gaud, 2005). Daskalakis
and Psillaki, (2007) indicated that size is positively related to debt (debt to asset) ratio in small
and medium sized enterprises SMEs of Greek and French firms for the period 1998-2002.
Contrary to expectations, Rajan and Zingales, (1995) found a negative relationship between
size and leverage in Germany. Large firms have substantially less debt than small firms. That
is contrary to theories expecting a positive relation between size and financial distress, and
that liquidation is very costly that makes small firms wary more of debt than do large firms
(Rajan and Zengales, 1995). However, the negative relationship is not due to asymmetric
information, but rather to the characteristics of the German bankruptcy law and the Hausbank
system, which offer better protection to creditors than is the case in other countries (Gaud,
2005). The informational asymmetries tend to be less severe for larger firms than for smaller
firms. Informational asymmetries between insiders in a firm and the capital markets are lower
for large firms. So large firms may be more capable of issuing informationally sensitive
securities like equity, and hence, have lower debt (Rajan and Zengales, 1995). Hence, it is not
quite fully understood why large firms are reluctant to issue equity. Furthermore, there may
be other unknown forces at work. Dynamic capital structure models (Fischer et al., 1989) take
into consideration the costs of adjusting toward the target debt-to-equity ratio. Empirically,
this behavior suggests that firms may follow a pecking order in the short term even though a
long term target policy exists. 22
In emerging markets, researchers found consensus results over the relation between firm size
and debt as to be a significantly positive relation (Omet, 2006; Delcour, 2007; Supanvanij,
2006; Gaud, 2005; Joeveer, 2006; Pandey, 2001; Nivorozhkin, 2005). This means that larger
firms will finance more from debt than do smaller firms. This is in accordance with both
trade-off theory and pecking order theory, and hence, large firms in emerging markets find it
easier to raise debt finance. Yet the maturity of debt matters, size is more positively correlated
with short term debt, it is negatively correlated with long term debt in some cases. In Central
and Eastern European (CEE) countries, Delcour, (2007) had different results when she found
that long-term leverage coefficients for the Czech  Republic, Poland, and Slovakia were
negative ( -0.101,  -0.116, and -0.225 respectively) and is 0.210 for Russia. She attributed the
negative relations to: existence of information asymmetries and an underdeveloped state of
the bond market in these transitional economies, laws dealing with financial distress are still
developing, leaving debt holders unprotected in the event of default and forcing companies to
acquire funds through short-term loans. The positive relation for Russian companies could be
attributed to the progress in the transition from a banking to a market economy, the high
Russian government ownership in enterprises, and the government directing credit programs
to preferred sectors with price control in these sectors may have a significant impact on
corporate financing patterns (Delcour, 2007).
Nivorozhkin (2005) found that firm size is positively and significantly related to target
leverage in Bulgaria, the Czech Republic, and Romania, but it wasn’t significant in Estonia
and Poland. Results are consensus with the fact that size serves as a stability proxy for
creditors, and that larger companies in these markets are also targets of government bailouts
due to the higher social costs imposed by their distress. They are also often subject to some
form of government-sponsored investment programs (Nivorozhkin, 2005). The same results
were found by Delcour, (2007) when leverage was measured as total liabilities to total assets.
4- Non-debt tax shield
In emerging markets, Delcour, (2007) found that the coefficient for corporate tax liability is
positive and statistically significant, which implies that the corporate tax rate affects firms'
financing decisions in transition economies. In the contrary, Mashharawe, (2003) found that
tax structure do not have a significant impact on the capital structure of a sample of listed
non-financial companies. Delcour, (2007) also found a strong positive relation between the
total, long-term, and short-term leverage and non-debt tax shield in Central and Eastern
European companies. A possible explanation is that non-debt tax shield may be viewed as a
measure of the firm's assets sociability, with more securable assets leading to higher leverage
ratio. The factors that influence firms' leverage decisions in the CEE firms are the differences
and financial constraints of banking systems, disparity in legal systems governing firms'
operations, shareholders, and bondholders rights protection, sophistication of equity and bond
markets, and corporate governance structure (Delcour, 2007). Mitton, (2007) shows that nondebt tax shield is positively correlated with debt  ratios and the correlation is statistically
significant. However, the interaction relation between tax and non-debt tax shield is negative
and significant. One interpretation of this result is that firms increase their levels of debt when
faced with higher tax rates, but that they are less likely to increase levels of debt in response 23
to higher tax rates if they are protected by having non-debt tax shields in place. In other
words, firms with large non-debt tax shields have a lower incentive to use debt from a tax
shield point of view, and thus may use less debt (Mitton, 2007).
5- Risk
Many authors have included a measure of risk as an  explanatory variable of the debt level
(Titman and Wessels, 1988; Gaud, 2005; Pandey, 2001). Previous studies found evidence that
leverage and business risk are negatively related.  High business risk should reduce the
quantity of debt supplied to the firm at any given  interest rate. The standard deviation of
earnings is expected to be negatively related to leverage. But in a sample of Asian firms,
Supanvanij, (2006) found that leverage increases with increases in operating risk.
According to the trade-off theory, higher risk (earnings volatility) increases the probability of
financial distress. Thus, it predicts a negative relationship between leverage and risk (Pandey,
2001). The pecking order theory too predicts a negative relation between operating risk and
leverage. Firms with high volatility of results try to accumulate cash during good years, to
avoid under investment issues in the future. Hence, risk has negative relationship with longterm debt but it has a positive relationship with short-term debt as high variability shifts
financing from long-term debt to short-term debt and equity (Pandey, 2001, Page: 4).
The empirical evidence in emerging countries shows different results on to how risk affects
leverage. Delcour, (2007) found that leverage is inversely related to earnings volatility in
Central and Eastern Europe (CEE) countries (Rassia, Poland, Czeck Republic, and Slovakia)
during 1996 to 2002 period, which corroborates the  trade-off theory. With positive
bankruptcy costs, larger earnings volatility entails a lower leverage. The negative coefficient
is higher in Russia than in other CEE countries. This difference may be explained by the fact
that, in Russia, the bankruptcy law has been strictly enforced since March 1998. Contrary to
the Russian Federation, creditors' rights in the Czech Republic are poorly protected. This
affects banks' willingness to provide long-term loans and creates difficulties in collecting
existing ones. Another problem that Czech corporate bankruptcy law faces is that most Czech
judges lack experience with bankruptcy proceeding,  causing a 3- to 4-year backlog in the
bankruptcy courts. Furthermore, the secondary market for the liquidation of seized assets is
small (Delcour, 2007). Pandey, (2001) reported a negative relation of earnings volatility with
book and market value long-term debt ratio in Malaysian listed companies, which is
consistent with the trade-off theory, but he reported a positive relation between risk and shortterm debt ratios. He suggested that high variability shifts financing from long-term debt to
short-term debt and equity (Pandey, 2001, P: 11). Contrary to Delcour, and Pandey,
Supanvanij, (2006) found that in Asian emerging markets, and between 1991 and 1996,
volatility had a positive but not significant relationship with leverage.  This result is consistent
with the findings in US firms where leverage increases with increases in operating risk.
6- Political risk
The Arab countries have gone through a process of privatization and stock market
liberalization reforms. These reforms have had an impact on the relationship between risk and 24
return. Girard, (2007) determined that despite economic, financial and political reforms, and
despite the privatization process and stock market  liberalization in the Arab countries to
deepen their markets and to improve corporate governance, political instability still a
powerful obstacle to investments in these nascent emerging markets.
According to the Morgan Stanly Capital International (MSCI) index, the credit rating for U.S
and Japan are 92.6 and 90.8 respectively ( the highest rating is 100), the ratings for emerging
markets range from 15.2 (Nigeria) to 75.5 (Taiwan), which suggests that the average level of
country risk is sharply higher in emerging markets  (Erb, 1998). Country credit rating has
predictive power in discriminating between high expected returns and low expected returns
countries. The difference in performance between the highest and the lowest credit risk
portfolio is almost 12% /year according to the MSCI and the IFC index until 1993, (Erb,
1995).
Correlation between emerging markets portfolio return and the world wide portfolio is higher
in recessions and lower in recoveries than the average. Moreover, emerging markets could
hold what is called the contagion phenomena (regional markets responding to regional crisis).
The correlation between the IFC emerging market composite with the world index  increased
from 0.42 for the period (1981-1998) to 0.61 in the last 5 years (1994-1998), while the
standard deviation of the returns was lower (from 22.1 for the whole period to 19.1 in the last
5 years), that is reflecting the impact of the 2 regional crises.
5
 But the contagion phenomena
hold dramatically when the neighboring countries shared the same fundamental problems with
the country in crisis. For example, The Mexican crisis was a more one country crisis, and the
Asian crisis involved multiple countries with similar problems (Erb, 1998).
There are different country risks like economic risk, political risk, and policy variability.
Political instability is the most important factor associated with international investments and
though, capital flight. Political risk exerts a significant influence on country ratings, it is of
greater relevance since most of the government decisions affect the economic factors directly
and it is difficult to define an accurate measure to predict cross border risks (Vij, 2005). Firms
that face significant business risks (e.g., their exposure to political risk) have incentives to
mitigate the costs of these risks by adjusting their capital structures (Desai, 2007). Political
instability and uncertainty are particularly important in explaining the flight of capital:
residents faced with such instability and uncertainty take their money and run to avoid the
possibility that the government may in one way or another erode the future value of their asset
holdings (Lensink, 2000; Quan, 2006). Studying 45 developing countries, Quan, (2006)
showed that several types of political risks accelerate capital flight, including unconstitutional
government change, internal uprisings, and the variance of policy implementation.
Returns on investment in politically risky countries are more volatile than returns elsewhere.
American firms investing abroad face significantly greater risks than they do when they invest
in the United States. Political risk is manifest in more volatile returns at the affiliate level.
Firms respond to political risk by reducing their US and worldwide leverage. As these
adjustments are costly, their magnitudes reveal one aspect of the costs that investors bear in
                                                         
5
 The Mexican crisis in late 1994, and the Thailand crisis in 1997 Claude, (1998) 25
politically unstable foreign environments. Multinational firms reduce their leverage in
response to these political risks: a one standard deviation increase in foreign political risk is
associated with 3.5% reduced leverage (Desai, 2007). Results were inconsistent with what is
known as that more highly leveraged firms will undertake riskier investments. Risky
investment returns faced by multinational firms appear to have implications for capital
structure that are stronger than any effects of capital structure on the risk profile of foreign
investments.
In the Arab world stock markets, political risk is  likely to remain significant. Finance
literature shows that changes in political risk in general tend to have a strong effect on local
stock market development and excess returns in emerging economies, suggesting that political
risk is a priced factor. In this context, the Arab  economies are no exception. They have a
relatively closed and highly concentrated political system with a poor mode of national
governance. Consequently, any changes in political  risk in these countries will be strongly
associated with growth in stock market development  indicators. Political risk has strong
implications for stock market development. The problem of political risk has an important
policy implication for growth in these thinly traded Arab markets. A great need exists to
improve political risk in these Arab countries in order to attract more investment and better
allocation of resources through stock markets. To achieve this, more institutional (stock
market) reforms are needed with all other relating issues like improving the institutional and
legal frameworks accountability, transparency and disclosure, corruption, rule of law and
contract enforceability (Girard, 2007).
Other factors applied in researches as determinants of capital structure are tax, growth
opportunity, ownership structure, liquidity, age, and trade credit.
b- Disclosure:
If volatility is a measure of investor uncertainty, and if disclosure reduces volatility, then
volatility may be an indication that more disclosure reduces uncertainty in financial markets
(Nier, 2004, P: 32). Disclosure has a strong negative effect on volatility, banks that disclose
more information on key items of disclosure show lower measures of stock volatility than do
banks that disclose less information (Nier, 2004; Diana Hancock). Benefits of negative effect
of disclosure on volatility may be important for investors. But banks also do benefit from this
effect. In particular, lower stock volatility may result in a lower cost of capital and increase
the effectiveness of stock-based compensation. Benefits of disclosure also could reach
supervisors that use market indicators of bank performance alongside supervisory
information. In particular, a lower volatility of equity returns may reduce the likelihood that
the stock price gives the wrong signal on the relative performance and risk of the bank (Nier,
2004).
Contrary to Nier and Hancock, Madhavan (1996) and Bushee (2001) reported different
findings. Madhavan (1996) investigated the impact of greater transparency during the process
of price formation on asset prices and market liquidity. He demonstrated that market
transparency always reduces volatility and improves market quality only in sufficiently large
and liquid markets; otherwise transparency can actually increase price volatility and lower 26
market liquidity. This case occurs even though transparency increases the precision of traders’
predictions about the asset’s value. Also, Bushee, (2001) investigated the impact of corporate
disclosure practices on the composition of the firm’s institutional investor base and the
volatility of its stock price. He found that institutional investors are attracted to firms with
more forthcoming disclosure. These attracted institutions are of very different types. The first
one exhibits long investment horizons and low portfolio turnover. This type of institutions
reduces the volatility of the firm’s stock price. The second type of institutions is firms that
exhibit short investment horizons and aggressive trading strategies, which in turn exacerbate
the firm’s stock return volatility. The second type of institutions immediately increase their
holdings  when firms improve their disclosure practices. Where the first type does not, leading
to a significant increase in the firms stock return volatility (Bushee, 2001).
Healy et al. (1999) found that increases in disclosure are associated with increases in
institutional ownership. Bushee and Noe (2001) confirmed this association, but find that
increases in ‘‘transient’’ institutional investors (institutions that trade aggressively) are
associated with increases in stock price volatility. Assuming that increases in stock price
volatility are costly, this finding is consistent with the intuition that partial disclosure is
optimal, and that too much disclosure can be as costly as too little disclosure.
The 1964 Securities Acts Amendments in the U.S. extended the mandatory disclosure
requirements that had applied to listed firms since 1934 to large firms traded Over-theCounter (OTC). Analyzing the effect of the 1964 mandatory disclosure laws on stock returns
and operating performance of firms newly affected by this legislation found that firms that
were required to begin complying with all four disclosure requirements outperformed
(measured by differences in abnormal returns, and operating performance in terms of greater
income and sales growth) firms that were only required to begin complying with two
disclosure requirements. Results imply that with more commitment to more disclosure
requirements, more positive effect would appear in the form of more abnormal excess returns
and better operating performance results.
Moreover, the most affected firms outperformed OTC firms that were not targeted by the
legislation. Complying OTC firms had abnormal excess returns of about 3.5 percent in the
weeks immediately surrounding the announcement that they had begun to comply with the
new requirements. OTC firms that were newly required to begin complying with all four
forms of mandatory disclosure had statistically significant positive abnormal excess returns
ranging between 11.5 and 22.1 percent, relative to size and book to market value matched
NYSE/AMEX firms
6
 Operating performance also improved after the Amendments were in .
force. The most affected OTC firms had greater income and sales growth from 1962 to 1966
than unaffected NYSE/AMEX firms, suggesting that the market’s expectations of improved
performance were justified and helps to explain these firms’ higher stock returns. Overall, the
benefits of the 1964 Amendments substantially outweighed the cost of complying with this
law as measured by stock returns (Greenstone, 2005).
                                                         
6
 OTC firms do not generally outperform the NYSE/AMEX firms. 27
The same results were found by Stulz, (2002) when investigating the effect of cross listing in
the U.S markets on the company’s premium in 1997. Higher disclosure standards in the U.S.
were found to be important determinant for firms decision to cross-list in the U.S., firms listed
in the U.S. have a Tobin’s q ratio
7
 that is 16.5% higher than the Tobin’s q ratio of firms from
the same country that do not list in the U.S. Love, (2004) also reported that firms that trade
shares in the United States have higher governance rankings, especially in countries with
weak legal systems. The cross-listing premium (excess value of listed firms relative to nonlisted firms) depends on the type of listing a firm chooses (whither it is Rule 144a or OTC or
Exchange-listing). It reaches as high as 37% for companies that list on major U.S. exchanges
where disclosure requirements are large and more frequent. Cross-listing premium is much
smaller for over-the-counter listings OTC and private placements where disclosure
requirements are less than those in major U.S. exchanges. The premium persists after
controlling for a number of country-level factors and firm-specific characteristics.
The average cross-listing premium for Rule 144a private placement listings is 0.149, and
0.105 for OTC listings
8
 But when firms choose to list in a major U.S. exchange, the average .
cross-listing premium is 0.486
9
 (t-statistic across countries of 3.85), which corresponds to an
average cross-listing premium of 36.5%. This average cross-listing premium is 226% of the
average cross-listing premium for Rule 144a listings and 362% of the premium for OTC
listings (Stulz, 2002).
T&D (transparency and disclosure) score varies highly among different regions, for example,
Patel, (2002) reports that Asia has a score of 43; Europe and Middle East have a score of 36,
while Latin America has a score of 29. The average T&D score present in annual reports,
exhibit a low level of transparency and disclosure among emerging markets. Moreover, the
number of companies disclosing information on more than 60% of the attributes is 15 (about
4% of the sample). The relationships between T&D scores and cross-holdings (1- float)
10
  is
                                                         
7
 Tobin’s q ratio = (book value of total assets - subtract the book value of equity + market
value of equity)/ book value of total assets).
8
 Listings with Rule 144a private placements do not require compliance with U.S. GAAP or
SEC disclosure rules. These listings are capital-raising issues in which the securities are
privately placed to qualified institutional buyers and trade OTC among such buyers with very
limited liquidity. There are only 116 such listings from 20 countries in the sample. Listing
with the OTC. They are referred to as Level I ADRs for non-Canadian listings. They trade
OTC as Pink Sheet issues with limited liquidity and require only minimal SEC disclosure and
no GAAP compliance. These firms are exempt from filing Form 20-F. It allows home country
accounting statements with adequate English translation, if necessary (Stulz, 2002).
9
 The listing comprise ordinary listings (mostly Canadian firms and New York Registered
Shares for Dutch firms) and Level II and III ADRs. As the most prestigious and costly type of
listing, these require full SEC disclosure with Form 20-F and compliance with the exchange’s
own listing rules. Firms listed in exchanges are on average larger than the other firms from
their home country that are also listed in the U.S.
10
 A company with a low float is a company owned by government and strategic investors and
is less transparent than a company with high float. (Patel, 2002) 28
negative for the emerging markets (Brazil, Poland, South Africa, India, Thailand) varying
between -42% and -51%. Correlation between price-to-book ratios and T&D scores is positive
suggesting that the market places a premium on better transparency and disclosure, and that
market places a premium on companies with lower asymmetric information problem (Patel,
2002). Bushee, 2001 found that firms with greater analyst following and greater institutional
ownership are less likely to have conference calls that provide open access to all investors.
This evidence is consistent with the intuition that informed investors prefer less disclosure,
but is also consistent with the notion that analysts and institutions produce information, and
reduce information asymmetry and the need for conference calls.
I will investigate the effect of applying disclosure standards on stock prices and volatility, as
well as to how much did firms commit to mandated disclosure standards, in other words, to
find if mandated disclosure standards are well enforced.
Table 3: mandated disclosure standards dates of enforcement in a sample of countries in the
Middle East and the Gulf states region.
Bahrain 01/01/2004
Palestine 30/09/2006
Amman 01/03/2004
Oman 01/10/2007
4- Thesis advancement:
In the aspect of capital structure, Professor Patrick Sentis and I have conducted a study to
evaluate the determinants of leverage in a cross-country setting in the Gulf region states and
Egypt’s listed firms, over the years 2004-2007. Data were hand collected from their original
sources for a sample of more than 80 firms. We questioned if the theories of the pecking order
and the trade -off - which came out as results of researches on the US market, and which were
successfully applied to the other developed countries - if these theories are also applicable to
the sample of emerging markets in light of the fact that these markets have started and are still
going through an extensive economic liberalization process. Some stylized findings emerged
from our data set. Among others, Political risk has a significant influence on firms’ capital
structure. It occurred that the period of the study (2004-2007) was going on in parallel with a
period of developments in the region as our sample countries have adopted many strategies to
construct and reform their economies with higher and better readiness to integrate and emerge
in the world market, the thing that added more importance to the study in this vital period.
The empirical literature has been to identify some stylized factors that relate to capital
structure. There are few studies that provide evidence from emerging markets in the Gulf
region states and Egypt. The selection of countries (in the Middle East and the Gulf region)
                                                                                                                                                                                    29
depended on acquiring a sufficient number of enterprises that consolidated their annual
statements during the period 2004-2007, if holding companies that consolidated were few in a
country (e.g., Oman, Jordan, and Palestine), then the country will be exempt from our sample.
Our final Sample included markets in Abu Dhabi, Bahrain, Dubai, Kuwait, Qatar, and Saudi
Arabia from the Gulf region and Egypt. The selection of the variables (dependent and
independent) is primarily guided by the results of the previous empirical studies in the context
of some developed and developing countries, as well as the availability of data in our sample
to measure these variables through the whole period of the study. Data limitations forced us to
measure debt in terms of book values rather than market values, which forced us to exclude
the dependent variable debt-to-equity as a measure of leverage where equity is measured in
term of market value. Since independent variables may have different effects on the types of
debt, we use three measures of leverage: Long-term debt to total assets, short-term debt to
total assets and total debt to total assets ratios. Each debt ratio is measured in book value
terms. The final independent variables were company profitability, tangibility, risk, political
risk, size, and non-debt tax shield
The analysis relied on the following variables:
Leverage (1) = Long-term debt / Total assets (e.g., Omit, 2006; Delcour, 2007; Masharawee,
2003; Pandy, 2001)
Leverage (2) = Short term debt / Total assets (e.g., Delcour, 2007; Pandy, 2001).
Leverage (3) = Total debt / Total assets (e.g., Omet, 2006; Gaud, 2005; Mashharawe, 2003;
Joeveer, 2006; Mitton, 2007; Pandy, 2001; Daskalakis, 2007)
The explanatory variables are the following:
- Profitability = Earnings before interest and tax to total assets
- Tangibility = Book value of tangible assets (net property, plant, inventory, and
equipment)  to total assets
- Risk = Standard deviation of earnings before interest and tax to total assets over the 4
years’ observations.
- Political Risk = Classification from 1 (low risk) to 4 (high risk) according to
Moody’s, Standard and Poor’s and Fitch rating
11
 (see table 2)
- Size = Natural logarithm of sales
- Non-debt tax shield = Depreciation and amortization to total assets
We have affected a rank to each market according to it’s political risk rating in the main risk
rating agencies as shown in the following table.
                                                         
11
 This data has been collected on the following web site:
http://www.pri-center.com/country/index.cfm?pgid=2.30
Table 2: Political risk ranking of sample markets
 S&P Moody's Fitch Our
ranking
Tadawul AA- A1 AA- 1
Qatar AA- Aa2  2
Dubai, Abu Dhabi  Aa2  2
Bahrain A A2 A 3
Egypt BB+ Ba1 BB+ 4
Kuwait AA- Aa2 AA 1
http://www.pri-center.com/country/index.cfm?pgid=2
Two kinds of regressions are run. We estimate a classical pooled-OLS regression. This
regression considers each single point as an individual. However, pooled-OLS only relies on
the between comparison which is not well adapted to our historical data. Although time period
is short (4 years) we could expect some within variation. Thus, we perform a panel regression
in order to take into account both between and within effects. To choose between fixed and
random effects, a Hausman test has been run. For each panel regression, the test has
concluded in favor of random effects. All pooled regressions have been corrected for
heteroscedasticity.
According to the hypotheses, the main model tested is the following:
Leverage = α + β1 Profitability + β2 Tangibility + β3 Size + β4 Non-debt Tax Shield
+ β5 Risk + β6 Political Risk
Because, non-debt tax shield is incomplete for many firms, we omitted this variable from the
regression:
Leverage = α + β1 Profitability + β2 Tangibility + β3 Size + β4 Risk + β5 Political Risk 31
Moreover, when we control for multicollinearity, we observed that two variables are linked:
Size and Political Risk.
To correct this effect we chose to perform regressions without Size variable:
Leverage = α + β1 Profitability + β2 Tangibility + β3 Risk + β4 Political Risk
Furthermore, since many of the indicator variables  are scaled by total assets or average
operating income, we were forced to delete a small  number of observations that included
negative values for one of these variables. This procedure is similar to the one of Titman and
Wessels (1988).
Results:
The median total debt to total assets ratio was (.4159) for the whole sample, which is still
much lower than the global median total debt to total assets ratio reported by Glen (2004)
which was (.51) in 2000. Median total debt to total assets ratio  in our sample was also lower
than that in a sample of developed countries of (.52) and lower that  in a sample of emerging
markets of (.49) in 2000 (Glen, 2004). This finding suggests that companies in these countries
are mainly equity capital financed.
- Results on the capital structure determinants: Pooled-OLS
Profitability is found to have a significant negative impact on long term debt which is
consistent with previous studies. One explanation for this inverse relationship between
profitability and leverage comes from Myers’ pecking order theory; as more profitable firms
prefer internally-generated funds (retained earnings) on externally funds in the form of debt
because the later is more costly. An alternative explanation is that high profitability is
associated with high risk which would also lead to a negative relationship via the bankruptcy
cost theory. Moreover, results are consistent with the fact that bond market in the majority of
these countries is still underdeveloped. However, the coefficient is not significant for shortterm debt; it seems that banks in our sample are less reluctant to provide enterprises with
short-term loans than they do with long-term loans.
Tangibility is a measure of the collateral value of assets. The coefficient of tangibility is
positive and statistically significant which is consistent with the bankruptcy cost theory.
Creditors can moderate costs associated with debt by obtaining security interests in property,
plant, equipment and inventory which permit them to take possession in case of failure.
The relation between size and leverage is still not obvious. While most empirical studies
report a positive sign for the relationship between size and leverage. (Gaud, 2005; Daskalakis
and Psillaki, 2007), others report a negative relation (Rajan and Zingales, 1995). We found
that size have no effect on financial decision. It is right that large firms can borrow at better 32
conditions, but they also have easier access to equity markets. That is, lower cost is associated
also with issuing equity as well as issuing debt.
Non debt tax shield was negatively related to only  short term debt decision, and was
consistent with   the trade-off theory that focuses on the substitution between non-debt and
debt tax shields. Tax deductions for depreciation seem to act as a substitute for the tax
benefits of short term debt financing.
Long term financial decision is positively related  to operating risk. This counter-intuitive
finding has been previously reported by other findings in the US firms where leverage
increases with increases in operating risk, and with the findings in the Asian emerging
markets where volatility has a positive relationship with leverage ( Supanvanij, 2006). An
explanation of this result could be that long term debt increases the incentive of management
to invest in profitable but risky projects.
Finally, the political risk didn’t affect long term debt financing. However, the coefficient
between political risk and short-term debt is positive and, this indicates that due to political
risk, banks shift their lending preferences towards short-term debt rather than long-term debt.
A possible explanation to the puzzling finding in risk and size variables could be in the
existence of information asymmetries and an underdeveloped state of the bond market in
these economies, investor and debt holders protection rights and law enforcement are still
developing, leaving, in one hand, debt holders unprotected in the event of default and though
they may show reluctance to provide long term debt  even to big sized companies when
information asymmetries are high, and, in other hand, making the issuance of stock an easier
financing option for big firms who may make use of it’s well known names and reputations in
what could be described as an immature investor markets.
When regressions are performed without the Non debt tax shield variable, this step eliminated
many observations for which data about this variable could not be calculated. Results remain
consistent with those found earlier except for short-term debt financing which is significantly
negatively related with risk. Again, this result differs from theory and findings in previous
studies. Our explanation is that in a context of high political risk, financial intermediaries
prefer to allocate short debt to less risky firms.
Because of the multicollinearity between Size and Political Risk variables, we performed the
regression without the size variable. Results were  consistent with the previous regressions.
The main difference was in the increase of explanatory powerful of Political Risk variable.
This variable is significant for all leverage measure except for Long Term Debt / Total Asset.
- Results on the capital structure determinants: Panel Regressions
Findings are globally consistent with the previous ones. Long-term leverage still seems to be
negatively related to profitability and positively linked with tangibility. Short-term leverage is
also positively related with tangibility. Political risk is a significant variable depending on the
regression. Total leverage is positively linked with Political Risk. On the restricted
regressions, Short term debt appears also positively related to Political Risk. Globally, these 33
results lead us to conclude that Political Risk influences the capital structure of firms. In order
to further examine an eventual size effect, we split the sample into five size quintiles and form
two samples: the first sample gathers the first two quintiles and the second sample gathers the
last two ones. The median quintile was deleted. Then, we perform panel regression (and a
restricted regression without size and non-debt tax shield variables) for each both samples.
We found contrasted results according to the size of the firms. Interestingly, the long-term
debt ratio of the small-size firms is only driven by the tangibility whereas the short-term debt
ratio is solely affected by political risk. However, long-term debt seems to be mainly
negatively related to profitability for the large-size firms consistently with pecking order
theory as pointed out above. Short-term debt is explained by none of the regression variables.
In others words, when the political risk is high, the small firms are provided with short-term
debt which is not the case for the large-size firms.
Capital structure has been extensively examined in many countries, mainly in economically
and politically developed ones. Addressing the question of capital structure in other areas of
the world turns rapidly to be challenging. The main problem is that researchers are faced with
a lack of reliable data. The purpose of this research was to revisit capital structure using a
unique dataset collected from the Gulf Region and Egypt firms. We try to examine if political
risk influences firm’s leverage, since the financial patterns of these firms are particularly
interesting to observe because they exist in an economically and politically risky environment.
The empirical results imply that some of the Western capital structure theories are transparent.
The pecking order, trade-off and agency theories partially explain corporate capital structure
choices in our countries. Firms in our sample tend to rely more heavily on short-term debt
than long-term debt in their capital structure than is typical in companies in developed
markets. Some variables (e.g., operating risk, size) did not produce robust results, but were
interesting in regards to the intensive official plans in these countries to open their markets
economically and financially.
We found some stylized facts about the variable political risk indicating that when the
political risk increases, banks shift their financing to short-term debt from long-term debt,
especially for smaller-sized firms, which is not the case for bigger-sized firms.
The above differences and similarities reflect the emerging nature of the Gulf region countries
and Egypt markets and their corporate environment.  This paper contributes to the existing
body of knowledge about emerging economics in this region, by testing traditional theories of
capital structure and it’s applicability to the Gulf region and Egypt firms in the years between
2004-2007.
Further work needs to be done to determine how some firm-specific factors (ownership,
dividend policies) and country-specific factors (economic and financial openness) affect
financial leverage in this particular region which combines between being politically risky on
one hand and a haven of investment on the other hand. 34
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