Dominic Barton and Kito de Boer
July 4, 2006

The Silk Road between the Middle East and Asia was until the 13th century the world's most important trade route. After 700 years during which merchants looked instead to Europe and the Americas, trade and investment is once again flowing between these regions.

While Asia's thirst for Middle Eastern oil is well understood, less often recognised is the increasing flow of direct and portfolio investment. Thus Sheikh Mohammed bin Rashid al-Maktoum, the ruler of Dubai, used a recent state visit to Pakistan to announce a multi-billion dollar package of infrastructure, property and other investments. Prominent Saudi investors, led by Prince Alwaleed bin Talal, are paying $2bn for a stake in China's second largest state-owned bank. Bahrain's Gulf Finance House wants to invest up to $1bn in Singapore's financial, health, tourism and leisure industries.

The traffic along the New Silk Road is not one way. An alliance of seven companies known as the Singapore Specialist Construction Consortium is pursuing Middle Eastern construction projects. Dubai is already home to Chinamex Mart, a mini-city of Chinese companies distributing their products throughout the region. In the technology sector, Samsung Electronics is among Asian companies intensively cultivating Middle Eastern markets.

From a macroeconomic perspective, these developments make perfect sense. In the five years to 2010, Asia is likely to require about $1,000bn of foreign direct investment, with China alone consuming more than half of that total. With oil prices riding high, meanwhile, Gulf states' investors and companies have money to invest.

Recent interviews with more than a dozen Gulf investors, who collectively control more than $300bn in assets, revealed that they are set to shift their portfolio asset allocation toward Asia by 10-30 per cent. We believe that up to $250bn will be available for investment in Asia over the next five years. While the west would remain Asia's dominant source of investment, this would represent an important shift in the pattern of global capital flows.

Such portfolio rebalancing would allow Gulf investors to benefit not only from Asia's strong internal growth but also from the emergence on the world stage of Asian companies such as Haier, Lenovo, Petronas, Ranbaxy, Samsung, Sterlite and Huawei. Another straw in the wind: Etisalat, a telecoms group located in the United Arab Emirates, earlier this year acquired a controlling stake in Pakistan Telecommunications Company for $2.6bn.

These Asian companies, many of them low-cost competitors, in turn are well positioned to help meet the Gulf's massive infrastructure needs. Electricity, highway, telecoms, water and other infrastructure projects - along with agriculture, education, healthcare and information technology initiatives - will consume more than $500bn over the next five years.

The two regions have more in common than a desire for trade and investment. Commercial links between the Gulf states and Asia should go hand in hand with growth of Islamic banking in accordance with Sharia, which prohibits the use of interest or speculation. Today, almost 20 per cent of private investors in the Gulf say they are prepared to accept lower than conventional market returns or service for full Sharia compliance. Investors with similar attitudes live in parts of Asia such as Indonesia, Malaysia and even China.

This helps explain why Gulf banks such as Al Rajhi Bank and Kuwait Finance House have launched - or are about to launch - operations in Malaysia, why Malaysian and Singaporean banks are eyeing opportunities to facilitate capital flows between the regions and why Kuwait Finance House has secured a mandate to structure the first Islamic bond (Sukook) in China.

To be sure, these are still early days for the New Silk Road. There remains a lot more opportunity than activity. It is difficult for companies and investors to shake long-held habits of focusing on western markets, investing in western companies and purchasing western equities and bonds.

Both regions need to improve mutual understanding through educational and political exchanges. Governments also need to move beyond symbolic events such as state visits to create a more hospitable investment climate.

This means dismantling barriers to competition, such as restrictive licensing rules and product market regulations. It means boosting the transparency of financial reporting, creating more effective markets for corporate control and improved corporate governance. Such measures would enhance the attractiveness of both regions and the efficiency of capital allocation.

The good news is that there are signs of progress. In addition to Dubai and Bahrain (historically the financial capital of the Gulf region), Saudi Arabia recently decided to allow foreigners to invest directly in Saudi companies through the stock exchange. Similarly, the Gulf Co-operation Council is strengthening capital markets through modern laws and exchanges.

Improving capital markets and corporate governance in Asia and the Gulf states would be valuable under any circumstances. At a time when companies and investors are just starting to build a New Silk Road, the need for reform has never been greater.

Dominic Barton is a director in McKinsey's Shanghai office; Kito de Boer is a director in Dubai.

This article was originally published in the Financial Times.