Sea change: A new regulatory framework is expected to drive expansion

Over the past half decade the government has introduced a raft of new laws and regulations for its capital markets. The long-term goal is to overhaul and update numerous aspects of the country’s investment industry, from the operation of the Kuwait Stock Exchange (KSE) to the risk management policies currently in place at listed companies. As of the end of 2012 the KSE was the single largest exchange in the Gulf by number of listed companies, with 199. At the end of March 2013, the KSE boasted total market capitalisation of KD29.6bn ($105.7bn), according to data published by the Kuwait Projects Company’s (KIPCO) Asset Management Company (KAMCO), a major local financial services firm. As of the end of 2012 the KSE was the third-largest equity market in the GCC by market capitalisation, according to KAMCO, behind the Saudi Stock Exchange (Tadawul) and the Qatar Exchange.

CHALLENGES & DEVELOPMENTS: The KSE currently faces a number of challenges. In the short period of time since the government launched the Capital Markets Authority (CMA) in February 2010, the new regulatory entity has introduced a substantial number of new rules and regulations. While this legislation is expected to be beneficial in the long run, the current transitional period has resulted in some market discomfort as companies have worked to negotiate new requirements. Additionally, like many exchanges across the GCC, the KSE has experienced muted activity since 2007-08, when the international economic downturn kicked off a period of prolonged economic sluggishness throughout the region. Indeed, investor confidence remained slow through 2011 and much of 2012. “People are still sitting on the sidelines waiting to see what will happen,” Issam Z Al Tawari, the chairman and managing director of Rasameel Structured Finance, a local Islamic investment company, told OBG. “Confidence has been improving slightly, but it remains low and nobody is willing to take the risk.” Despite this challenging environment, the KSE’s long-term development outlook is bright, with a number of growth drivers expected to have a positive impact on the market in the coming years. As of early 2013 activity levels at the exchange were improving, albeit slowly. The government’s KD30bn ($107bn) National Development Plan (NDP), which was launched in February 2010 and extends to 2030, is expected to boost investor confidence across the board, for example. Similarly, short-term uncertainty aside, the implementation of the new legislation put forward by the CMA bodes well for future stability and market strength.

HISTORY: Kuwait’s capital markets sector can be traced back more than 60 years. In 1952 a group of local merchants established the National Bank of Kuwait (NBK) by issuing 13,100 shares, with a value of 1000 Indian rupees each. The institution was both the first national bank and one of the first shareholding companies in the Gulf. The predecessor to the modern KSE was founded in 1962, making it one of the first formal exchanges to be launched in the GCC. Through the 1960s and 1970s the exchange was underpinned by Kuwait’s oil economy. Large hydrocarbons revenues during this period drove a speculative boom, which, in turn, resulted in a sharp correction in 1977. The government responded quickly, bailing out investors and promptly introducing a tighter regulatory regime.

In response to stricter oversight, in the late 1970s and early 1980s many investors pulled out of the official exchange entirely, and instead undertook trading activities on the Souk Al Manakh (“camel market”), an unregulated, highly speculative financial market on the outskirts of Kuwait City. Over the next five years activity at the informal exchange ramped up rapidly, fuelled by inflated prices and a settlement system involving postdated cheques. In August 1982, after one such cheque bounced, the market crashed, prompting a chain reaction of defaults, which, paired with rising uncertainty in the region due to the Iraq-Iran war, rippled through the entire GCC region. When the dust settled, NBK was the only bank in Kuwait that had remained solvent. Over the following few years the state implemented a series of new programmes to save the country’s financial system and help institutions recover.

This effort was still under way in the early 1990s, when the Iraqi invasion and the ensuing Gulf War of 1990-91 brought activity at the KSE to a halt once again. As a result of the widespread destruction of financial documentation during the conflict, the government was forced to bail out the capital markets sector once again. In the years that followed the government invested heavily in the exchange, introducing a variety of stringent regulations and working to encourage new listings and increased activity.

The market grew considerably during this period, encouraged by rising oil income and easy access to credit. In particular, from the late 1990s to mid-2000s low barriers to entry in the sector led to a rapid expansion in the establishment of investment companies (ICs). Many of these new firms acquired substantial real estate and equity holdings over the decade and were subsequently hit hard by the downturn (see analysis). “ICs that were hit hardest by the crisis were the ones suffering from fundamental management and investment problems,” said Fahed Faisal Boodai, the chairman and managing director of Gatehouse Bank, a UK-based sharia-compliant institution. “Companies which did not overstretch their boundaries are the ones which survived.”

THROUGH THE CRISIS: Indeed, while Kuwait was relatively well insulated against the direct effects of the crisis, investor confidence throughout the region took a hit. The prolonged period of global sluggishness since late 2007 has also had a negative impact on the sector. Over the course of 2008 the KSE lost around 42% of its value, for example, with the market index falling from 12,558.9 to 7782.6 by the end of the year, according to figures from the exchange.

Market capitalisation fell at a similarly precipitous rate over the same period, according to KAMCO data, from around KD62bn ($221.4bn) at the end of June 2008 to KD33.6bn ($120bn) by the end of the year. As of the end of 2012, market capitalisation at the KSE was at KD28.9bn ($103.2bn). According to data from the Kuwait Financial Centre (Markaz), as of late 2012 trading volumes at the KSE had fallen off by around $100bn from their peaks in 2007 and 2008.

OVERSIGHT: The government has responded to the slowdown in market activity in a variety of ways. In March 2009, for example, the Central Bank of Kuwait (CBK) passed the Financial Stability Law (FSL), which was designed as a mechanism through which local institutions could undertake debt restructuring with government assistance (see analysis). The state’s most ambitious response to the downturn, however, was the passage of the Capital Markets Law (CML) in February 2010. Prior to the passage of the CML, a wide variety of governmental entities were involved in regulating the bourse and related investment segments, including the CBK, the management of the KSE and the Ministry of Commerce and Industry.

The passage of the CML replaced this somewhat ambiguous system with a single, unified regulator (namely the CMA) and a comprehensive regulatory framework, developed and implemented in line with international best practice. The legislation is meant to serve as an effective and clearly defined regulatory framework for all market activities, thereby boosting transparency, improving risk management practices throughout the country and ensuring that all trading is carried out in line with real market values. By improving oversight throughout the country’s capital markets, the CMA aims to boost market performance in the coming years. The CML was based on guidelines laid out in a number of previously existing capital markets regulatory regimes, including those developed by the US Securities and Exchange Commission and Saudi Arabia’s CMA, the latter of which was launched in 2003.

In addition to the new regulatory framework, the CML included a clause aimed at privatising the KSE. In January 2012 the CMA announced that it had hired HSBC Holdings, a UK-based international financial services group, to serve as a financial advisor on the privatisation effort. According to the CMA, some 50% of the exchange will be sold to listed companies, though no KSE sector weight by market capitalisation, end-2012 single firm will be allowed to own more than 5% of the market. The remaining 50% will be sold to Kuwaitis in an initial public offering (IPO) (see analysis).

“Our track record shows that Kuwaiti companies perform well when privatised,” Adnan Al Bahar, the chairman and CEO of The International Investor, a local sharia-compliant IC, told OBG. “We need to continue with the process in every sector.”

BY THE NUMBERS: As of the end of March 2013, the KSE’s market index and market capitalisation were at 6721.52 and KD29.6bn ($105.7bn), respectively, compared to 5934.28 and KD28.9bn ($103.2bn) at the end of 2012; 5814.2 and KD29.3bn ($104.6bn) as of end-2011; and 6955.5 and KD36.2bn ($129.3bn) at the end of 2010, according to data from KAMCO.

The top three listed firms by market capitalisation at the end of March were NBK, with KD4.1bn ($14.6bn), which was equal to nearly 14% of the market; Zain, the Kuwait-based international telecommunications group, with KD3.4bn ($12.1bn), or 11.5% of the market; and Kuwait Finance House (KFH), one of the world’s largest sharia-compliant financial institutions, with KD2.3bn ($8.2bn), or just under 8% of the total. Altogether, the top 10 firms made up more than 57% of the KSE’s total capitalisation during this period.

Historically the KSE has been dominated by the banking sector. As of the end of March 2013 banks accounted for 46% of market capitalisation, according to data published by KAMCO, or around KD13.7bn ($48.9bn) in total; and eight of the top-10 listed companies by market capitalisation were banks. Other major sectors as of the end of March 2013 included telecoms, which comprised 15% of the country’s total market capitalisation; non-bank financial services, with 10%; industrial companies, with 9%; real estate, with 8%; consumer services and consumer goods, each with 3%; and basic materials and oil and gas, with 2% each.

CHANGE AT THE EXCHANGE: The KSE has instituted a number of major new initiatives in recent years. As part of a structural overhaul launched in late 2009, the exchange recently introduced a new market sector classification system and a new flagship index, the Kuwait 15 Index (K15), which is made up of the top 15 listed firms by a mix of market capitalisation and liquidity. As of the end of March 2013 the K15 boasted a total market capitalisation of KD19.1bn ($68.2bn), up from KD18.9bn ($67.5bn) at the end of 2012 and KD17.8bn ($63.6bn) as of the end of May 2012, when the index was launched. The March 2013 figure was equal to nearly 65% of total market capitalisation.

The K15, which is the first of a series of new indices the KSE plans to launch in the coming years, was designed to serve as an investable bellwether for the KSE as a whole. Like the larger bourse, the K15 is dominated by financial institutions, which account for eight of the listed firms. The top three companies – NBK, Zain and KFH – make up more than 51% of the total value of the index in terms of market capitalisation. The KSE also recently adopted the International Industry Classification Benchmark system, which replaced the exchange’s previous eight-sector system with 15 new sectors, in line with international best practice.

As of early 2013 the KSE was purely an equities exchange, though this is expected to change before the end of the year. In addition to the new oversight regime and in conjunction with the launch of the K15 and new sector classification system, over the past few years the KSE has undertaken a complete technical overhaul. In October 2009 the exchange signed a three-year joint-venture agreement with Nasdaq OMX, the largest bourse operator in the world. Under the KD18.3m ($65.36m) agreement, Nasdaq has been contracted to provide the KSE with new trading, surveillance and market data technology, in addition to strategic advisory and implementation assistance.

X-stream Trading, Nasdaq’s trading system, was launched at the KSE in May 2012 and has been operating continuously since. Nasdaq has deployed their X-stream system in more than 15 markets around the world. In addition to being substantially more efficient and transparent than the KSE’s previous electronic trading system, X-stream will also eventually allow for the development of a secondary bond market and other new products (see analysis).

The system includes a built-in market security application, which aims to ensure that market activity is carried out in compliance with CMA regulations. Despite a learning curve, in the first six months of operation most brokers and other market players used the new system mostly without incident. “In the past we provided brokers with computer terminals, so all they had to do was log on and trade,” Issam AD Alusaimi, an information technology consultant at the KSE, told OBG. “With the new system we only provide a feed. Everything else had to be built up around the data.”

RECENT PERFORMANCE: While market activity has remained considerably down on 2007-08 highs, in 2012 and early 2013 the KSE began to show some signs of recovery. The KSE price index increased by just over 2% over the course of 2012, which is a relatively minor rise compared to some neighbouring markets during the same period, but represents a major improvement on 2011, when the price index dropped by 16%. Indeed, 2012 was the first year the KSE ended in the black KSE most active stocks traded, June 2013 since 2007. The upward trend continued into early 2013, with the index rising an additional 31% in the first six months of the year. The recent increase in the price index reflects rising investor confidence as a result of a number of recent events in Kuwait. In May 2012, for example, the CBK announced new loan-to-deposit ratio rules for the banking sector, with the goal of encouraging local financial institutions to boost lending. Additionally, in early April 2013 parliament approved a law that will see the government spend up to KD744m ($2.7bn) to take over personal loans for some 47,000 nationals, on the basis that some local commercial banks have overcharged Kuwaitis for credit in recent years. The programme is expected to reduce debt obligations for much of the population, which could, in turn, result in increased investment activity.

These economic developments are widely believed to have contributed to the KSE’s recent expansion, as have the recent structural overhaul of the bourse and the establishment of a new regulatory regime. The CMA has recently taken action against a number of firms for failing to abide by the new regulatory framework. Over the past year and a half the authority has suspended and delisted a handful of companies, primarily for failing to disclose past financial statements.

While the regulator has attracted criticism from some companies for moving quickly to enforce new regulations, other firms have praised its actions in the wake of the downturn. “The inexperience of the country in dealing with a financial crisis of this magnitude made the problem even worse,” said Mansour Al Mubarak, the managing director and CEO of the Aayan Leasing and Investment Company. “At the end of the day companies need to be responsible and accountable for their actions and fix their own problems.”

GROWTH TRENDS: A number of upcoming events are expected to further boost the development of Kuwait’s capital markets in the coming years. The country’s bond market – one of the oldest in the GCC – has shown potential for expansion recently, even in spite of low interest rates and the passage of the CML, the latter of which introduced some uncertainty to the bond issuance process. The CBK, for its part, has issued a steady stream of short-term Treasury bills and other debt instruments since the downturn, primarily in an effort to absorb liquidity in the banking system.

Corporate issues, meanwhile, have been few and far between since the downturn, though they have picked up some in recent years. Since late 2011 a handful of bonds have been successfully issued in Kuwait, including a KD80m ($286m) issuance by KIPCO in early 2012, a major regional investment group; Burgan Bank’s KD100m ($357m) bond sale – the single largest dinar-denominated bond ever issued in the country – in December 2012; and the KD60m ($210m) bond issuance of the United Real Estate Company in June 2013. With these recent issuances in mind, and a handful of regulatory changes under way, the bond market is expected to grow through 2013 (see analysis).

Additional upcoming technical upgrades at the KSE will also likely result in increased market activity before the end of the year. While Nasdaq’s X-stream trading KSE market capitalisation, 2005-April 2013 system has been up and running since mid-2012, as of the first quarter of 2013 the exchange had yet to welcome any financial products other than equities, despite the fact that the new platform can handle a wide variety of trading activity. “The introduction of the new equities trading system has been a success,” said Alusaimi. “We plan to introduce a derivatives platform by summer 2013.” In addition to the new derivatives component, which will initially allow for options and futures, the KSE has also announced that it plans to eventually add a secondary bond market, exchange-traded funds and sharia-compliant debt instruments, among other new products, to the exchange. NEW IPOs: Finally, after a lengthy period of no new listings, the KSE could very well see a handful of IPOs in the coming years. While a number of firms have announced plans to list in the years since the crisis, most have been put on hold or cancelled outright. The country’s IPO pipeline has been dry since 2010, in line with markets throughout the region and, indeed, around the world. Kuwait Energy Company (KEC), a major local oil and gas producer, initially announced its plans to float an IPO on the KSE in 2010, but was delayed due to weak market conditions. However, in late 2012 KEC announced that it planned to move forward with the listing before the end of 2013. The company aims to issue nearly 200m shares at 155 fils ($0.55) per share in a dual listing on the London Stock Exchange. Other firms that cancelled plans to list in the years immediately following the crisis include Sahaab Leasing, a subsidiary of the local low-cost airline Jazeera Airways; and Gulf Holding Company, a sharia-compliant real estate investment firm. The government’s privatisation programme could also potentially lead to a number of new listings in the coming years, including by the state-owned national carrier, Kuwait Airways (see analysis).

OUTLOOK: The past few years have seen many investors considerably reduce their exposure to Kuwaiti capital markets. Consequently, many institutions and individuals are now seeking to invest substantial amounts of money. The country’s high liquidity levels are widely considered to be synonymous with the extensive degree of latent demand for secure, long-term investment opportunities. With this in mind, so long as the CMA-led overhaul of Kuwait’s capital markets continues to progress according to plan, the KSE is expected to attract steadily rising levels of investment for the foreseeable future. Major growth drivers include the NDP, which is expected to bolster activity throughout the economy; and the addition of derivatives and other new trading instruments to the KSE.

“There is demand for these new products,” Alusaimi told OBG. “Furthermore, all of our studies indicate that they will lead to a substantial jump in market activity.” While the new regulatory regime and the CMA’s enforcement efforts thus far have resulted in some short-term uncertainty throughout the capital markets sector, the long-term impact of the CML is expected to be broadly positive. The increased transparency, improved risk management and more clearly defined legal framework bode well for the market’s future performance.