Regulatory changes open the door for foreign participation in Saudi Arabia's capital markets

The transition to a new era of foreign participation in the Kingdom’s bourse, the Saudi Stock Exchange, also known as the Tadawul, has been a keenly anticipated event in the region’s financial markets. However, this is only the latest step in a longer process of market reform, where the exchange has evolved from a single-product market to an increasingly diverse investment platform. With a raft of regulatory changes in the pipeline, including alterations to the organisational structure of the exchange and its relationship with its regulator, the coming year promises to be an interesting one for the Saudi Stock Exchange’s increasingly broad base of market participants.

Ongoing Development

The Saudi Stock Exchange, now the largest exchange in the region, has undergone a remarkable transformation in its short history. In the early 20th century, stock dealing in Saudi Arabia existed only in rudimentary form: the Arab Automobile Company was established in the 1930s as the Kingdom’s first joint stock company, and it was one of a small number of public firms to become visible during the early days of the nation’s emergence as an oil economy. By 1975 there were 14 public corporations concentrated in the power and cement sectors. However, their number was to grow rapidly over the next decade as an era of nationalisation saw a raft of foreign banks and financial institutions brought under Saudi control.

Trading at this stage remained informal, and was carried out through a network of private brokers. By the mid-1980s, however, it was clear that Saudi Arabia’s increasingly complex economy and the expansion of its hydrocarbons-driven corporate sector warranted a more robust market mechanism. The government, therefore, began to address the question of establishing a modern stock exchange, and in 1984 it issued a royal decree creating a new ministerial committee made up of representatives from the Ministry of Finance, the Ministry of Commerce and Industry, and the Saudi Arabian Monetary Agency (SAMA). This group was mandated with developing the regulations and controls on which a formalised market could be built, while local commercial banks were authorised to act as its brokers. In 1990 SAMA, in conjunction with the banks, established Saudi Arabia’s first electronic trading system, known as the Electronic Security Information System (ESIS). The new platform linked 12 central trading units, operated by the banks, to a hub at the central bank, which resulted in a more streamlined market, increased trading activity and a welcome narrowing of price spreads. In October 2001 the stock exchange implemented a more advanced system capable of handling larger volumes. This system is still in place today, though it has been upgraded significantly. In 2003 the government introduced a new capital markets law, which resulted in the creation of a number of key institutions, including new regulatory bodies: the Capital Market Authority (CMA), the Securities Disputes Settlement Committee and the Appeals Committee.

The Modern Market

The framework established at the turn of the century forms the basis of today’s market and the wide array of companies that make up its members. One of the most striking features of the Saudi Stock Exchange is that its listed companies reflect the range of economic activity taking place in the country more comprehensively than its regional peers. Equities are divided into 15 sectors: banks and financial services; petrochemical industries; cement; retail; energy and utilities; agriculture and food industries; telecoms and IT; insurance; multi-investment; industrial investment; building and construction; real estate development; transport; media and publishing; and hotel and tourism. Though the Saudi Stock Exchange is still at a relatively early stage of development, it has also begun to evolve from its initial function as a single-product equities market to offer a wider array of financial instruments. Legislation introduced in 2010 allowed for the introduction of exchange-traded funds (ETFs) – instruments that became popular in North American markets during the 1990s thanks to their ability to offer a basket of assets created from shares listed on the exchange, thereby providing an easy way for investors to create balanced portfolios. Falcom Saudi Equity ETF, which launched in 2010 as the Kingdom’s first ETF, follows an index of 30 companies screened by the fund for sharia compliance. Falcom Saudi Equity ETF has since been joined by two more instruments, the Falcom Petrochemical and the HSBC Saudi 20. As with other markets in the region, trading in ETFs remains at low volumes, but their introduction represents an important diversification and aligns with the CMA’s longterm ambition to deepen the market.

The Saudi Stock Exchange launched an electronic trading platform for bonds and their sharia-compliant equivalent, sukuks, in 2009. By 2014, this fixed-income market consisted of seven listings (after the delisting that year of the Saudi Electricity 2 sukuk), with maturities ranging from 2015 to 2030. However, while the debt market contains instruments from some of Saudi’s most prominent institutions, such as Saudi Aramco Total Refining and Petrochemical Company and Sipchem, the creation of an actively traded secondary market is in its early stages, with most of the demand for bonds and sukuk met on an off-exchange basis.

Regulation

The task of overseeing the exchange’s continued development falls to the CMA. The regulator has a broad range of responsibilities, including the issuance of securities and developing mechanisms to improve information and prevent unfair trading practices. Thanks to the efforts of the CMA, the Saudi Stock Exchange is widely considered to be one of the best regulated exchanges in the region. In an assessment of its regulatory framework published in 2012 the IMF declared that there are no major gaps in the regulatory and legal framework. At the technical level, the CMA has worked to introduce a supervisory regime that is risk-based and compliance-focused, while at a strategic level it has cooperated with officials at the exchange to open up the market to foreign investment.

The Kingdom’s journey towards a more open capital market has taken longer than for some of its neighbours. Where other exchanges allowed a limited amount of foreign ownership of listed companies, investors from outside the GCC were for many years barred from the Saudi bourse altogether, and could only indirectly access the Kingdom’s stocks through mutual funds.

In 2008 the CMA allowed limited access to foreign investors with the introduction of swap agreements— an event welcomed as an important first step towards eventual market liberalisation. The mechanism, however, placed constraints on international capital: although it allowed foreign investors to stock pick and receive dividends, they did not enjoy voting rights, and ownership of equities resided with Saudi entities that acted as intermediaries. For institutional investors accustomed to taking stakes in companies, making tender offers to shareholders and sitting in boardrooms, the swap agreement system held little appeal.

In August 2014 the CMA signalled its intention to take another major step towards exchange liberalisation with the publication of draft rules for the participation of foreigners, and in early 2015 it confirmed that it would open up the market to qualified foreign investors (QFIs) in June of the same year. The announcement heralded a new era of increased foreign investment in the Saudi Stock Exchange, although foreign participation is circumscribed in a number of ways. All QFIs must have at least $5bn in assets under management to qualify for market participation, and they will only be able to hold a maximum 5% of issued shares in any listed company. Taken together, QFI investment in a Saudi firm cannot exceed 20% of listed shares, and no more than 10% of the aggregate stock market value can be owned by foreign investors, either through swaps or the new mechanism. Despite these limitations, the opening up of the Saudi Stock Exchange is one of the most significant GCC market developments in recent years, and promises a range of benefits to international investors and Saudi businesses and institutions (see analysis).

Performance

The effect of the new investment regime on the performance of the exchange will be keenly observed. The principal measure of market performance is the Tadawul All Share Index (TASI), which establishes the general level of company prices based on the market value of free float stocks of the listed companies. The same methodology is applied to the sectoral indices, which make up the next tier of market data. After a buoyant performance in 2013, during which the TASI showed a 25.5% year-on-year (y-o-y) increase, the market entered a period of volatility in 2014. Having reached a high of 11,149 points in September, a downturn in market sentiment as a result of the sharp decline in oil prices led to a negative trend, which persisted throughout the fourth quarter. The TASI closed the year at 8333 points, representing a modest 2.37% decrease on the 2013 closing level.

Despite the drop, many sectoral indices showed gains over the year, led by the expansion of the retail segment, the index for which rose by 32.7% y-o-y in 2014 to 15,518. Other buoyant sectors included agriculture and food (up 26.9% y-o-y); real estate development (up 24.2%); and hotel and tourism (up 22.2%).

At the other end of the scale, the telecoms and IT index posted a 26.9% decrease for 2014, as confidence in the industry faltered due to a poor technical performance by some of its major participants. A 22.4% decline in the petrochemical industries sector, meanwhile, resulted from concerns regarding overvaluations and a reduction in global demand for petrochemical products. However, despite the TASI decline of late 2014 and the muted performance of some sector indices, the renewed interest in Saudi equities that has been exhibited by investors since 2013 has persisted. A smooth royal succession, the formulation of another expansionary fiscal policy, a stabilisation of global oil prices and the payment of two salary bonuses to public sector employees have done much to allay the fears of investors in early 2015. By April of 2015 the TASI had recovered to around the 9880 range, buoyed by the anticipation of an influx of foreign investment on the implementation of the QFI law, and it was only slightly lower, at around 9715, as of the beginning of June. Following the opening of the markets on June 15, 2015 the TASI dropped, given the lack of immediate investment by foreign companies. Experts predicted this and said QFIs will enter slowly and cautiously, but it has been enough to cause some apprehension in the retail dominated day-to-day trading.

A particularly notable feature of the TASI’s performance in 2014-15 has been the partial de-coupling of index movement and oil price. “When the oil price went down in 2014, so did the stock market,” John Sfakianakis, Middle East director at UK-based investment management company Ashmore Group, told OBG. “The index fell by 28% in the latter part of the year, and that shows the correlation between oil price and the market, but when Brent rose by 10% the market rallied by about 2500 points. A pattern has emerged where the correlation between oil and the market still exists on the downside, but not so much on the upside.”

Sovereign Bond Issue

The government’s recent return to the bond market also appears to mark a significant shift in state policy, with the capital markets being tapped to meet the budgetary gap left by falling oil revenues rather than siphoning off reserves. The SR15bn ($3.99bn) issue in mid-July 2015 was the first sovereign bond opened by Saudi Arabia since 2007, with further forays into the markets foreshadowed by senior officials. According to Reuters, the bonds were seven- and 10-year conventional issues with yields of 2.57% and 2.88%, respectively, and were sold to quasi-sovereign Saudi institutions (see analysis).

Currently, Saudi Arabia’s credit rating from Standard & Poor’s (S&P) is “AA-”, though in early 2015 the country’s outlook was cut to “negative” from “stable” due to falling oil prices and the threat to its liquid assets. However, increased use of the capital markets to raise funds, rather than draining off reserves, should help halt any weakening of the Kingdom’s fiscal position.

New Listings

The same upturn in market sentiment is expected to attract new listings over the coming year. The Saudi Stock Exchange did not suffer the same initial public offering (IPO) drought as some of the smaller regional exchanges in the wake of the global economic crisis, and listing activity since 2013 has been high. After five offerings in 2013, six companies went to the market in 2014, starting with the Saudi Marketing Company’s offering of 7.5m shares in February. The summer months saw the most listing activity, with Umm Al Qura Cement Company and the Abdulmohsen Al Hokair Group for Tourism and Development Company listing in June, followed by Al Hammadi Company for Development and Investment in August. In terms of IPO value, the latter part of the year brought the most impressive results. The $6bn offering of the National Commercial Bank (NCB) in November 2014 was not only the largest in the region that year, but also the largest ever to be held in the Middle East, and the second largest in the world behind the $25bn IPO of China’s Alibaba Group (see analysis). December 2014 saw the Electrical Industries Company go to the market with an offering of 13.5m shares priced at SR54 ($14.39) each. In total, the six IPOs of 2014 represented a combined offering of SR25.23bn ($6.72bn), driving total market capitalisation to SR126.10bn ($33.6bn).

One welcome development in the IPO arena is the range of activity in terms of sectors. In 2014 listing activity emerged from the banking and financial services, cement, retail, construction, and hotel and tourism sectors. This trend is likely to continue thanks to a government diversification strategy that seeks to give the private sector a larger role in the nation’s economic development. Improving investor sentiment and the continued expansion of the economy add to this positive momentum. “IPOs are a reflection of private sector activity,” Fahad M Alturki, the chief economist and head of research at Jadwa Investment, told OBG. “The Saudi economy has been growing at a rate of around 3-4% over the last 20 years, and since the financial crisis we have seen expansionary fiscal policies pushing growth to 5% and more. When you have that level of growth you will continue to see a strong IPO pipeline.”

Investor Base

One of the interesting features of the NCB IPO of 2014 was that it was open only to retail investors. Indeed, individual investment of this kind plays a major part in market activity on the Saudi Stock Exchange. The growing levels of disposable income that have driven key lifestyle indicators such as new car registrations – which rose from around 570,000 in 2013 to nearly 633,000 in 2014, according to Euromonitor – and consumer expenditure on food – which saw an increase of around 5.4% over the same period – have allowed Saudis to direct their capital towards various investment instruments, including domestic stocks. As a result, retail investors are more prominent in the investor base than in many advanced markets. For example, in the second half of 2014, individuals controlled SR613.6bn ($163.5bn), or 33.8% of market capitalisation, compared to the SR444.3bn ($118.4bn), or 24%, accounted for by companies. Funds claimed a relatively small amount of market value, at SR90bn ($23.98bn), or 4.9%, while the limited appeal of swap agreements was demonstrated by its modest share of around SR20.4bn ($5.44bn), or 1.1%. In terms of value traded, the central role of the retail investor is even more starkly defined, with trades by individuals typically accounting for 90% of the total in any given month.

The revival of interest in the Saudi Stock Exchange among the domestic investment community is a welcome one in terms of liquidity, but it also brings its own set of challenges. The preponderance of retail investors in trading activity means that the market is prone to speculation and volatility. A good example of this came in early 2012, when the TASI jumped around 1500 points on the back of solid growth in 2011 to reach nearly 8000, before a market correction pushed the index back down to around 6800 in May. Similarly, the sell-off that occurred in late 2014 was largely attributable to retail investors concerned that low oil prices would compel the government to cut expenditure, thereby reducing corporate profits.

This was exacerbated by the need for many retail investors to liquidate securities in order to deleverage from margin calls as collateral values declined. The large volume of retail activity on the bourse also results in a seasonal trend whereby the volume of trading falls off during the hot summer months – which have coincided with the Islamic month of Ramadan in recent years – before rebuilding momentum in late autumn. The market generally picks up somewhat in the Hajj and Umrah periods, during which Saudi Arabia hosts as many as 2m-3m Muslim pilgrims. The prospect of more institutional investors entering the market as a result of the QFI legislation is therefore a welcome one for many observers. “Saudi Arabia is currently a retail market,” Ziad Aba Al Khail, the managing director and CEO of Aljazira Capital, told OBG. “Foreign investors will bring a good balance, as they will be longer-term buyers, which will help reduce trading volatility.”

Outlook

The Kingdom’s exchange continues to evolve, and the coming years are likely to bring some key structural innovations as well as the introduction of new instruments and processes. At the organisational level, the Saudi Stock Exchange is establishing a selfregulatory function – a transformation that is part of its long-term development strategy.

Having successfully created a map of regulatory responsibilities with the CMA in 2014, the exchange is new finalising its plan. While the self-regulatory model is not common in the GCC, the Beirut Stock Exchange, the Amman Stock Exchange, the Qatar Exchange and the Egypt Exchange all have some self-regulatory power. While the full details of the exchange’s revised relationship with the CMA are yet to be revealed, the first product of this self-regulatory process, according to the Saudi Stock Exchange, will be a set of new securities depository rules, which will be approved by the exchange’s own regulatory and oversight committee.

Even with these developments, the implementation of the QFI law promises to be the regulatory highlight of the year. Much of the benefit of the new rules will come in the form of the general institutional enhancement in areas such as analytical coverage, transparency and market processes that increased institutional investment will encourage. With the QFI legislation in place, the focus of the exchange is already turning to another goal – the elevation of the exchange to emerging market status by influential indexer MSCI.

“It’s not about whether we qualify for emerging market status,” Adel Al Ghamdi, CEO of the Saudi Stock Exchange, told OBG. “Rather it is a matter of when we qualify based on how fast we enter the review cycles of the major index providers.” Indeed, while the timing of this development has yet to be signalled, the regulatory enhancement of the exchange in recent years means that it is well positioned to meet the parameters for inclusion on the MCSI Emerging Markets Index.