New reforms in Kuwait revitalise capital markets

After a year characterised by low trading volumes and a horizontal main index, the Kuwait Stock Exchange (KSE) opened 2017 as the fastest-growing market in the world. A number of reasons combine to make the KSE a destination of interest for investors in 2017, chief among them being new management, which has begun to implement an ambitious reform programme. With the ultimate goal of securing an upgrade for the nation’s bourse from frontier- to emerging-market status, regulatory reform is set to dominate the agenda over 2017 and 2018. This timely overhaul of the exchange’s rules and processes will tackle the KSE’s twin challenges of low liquidity and scant foreign interest head-on.

New Era

When Boursa Kuwait assumed control of the KSE in April 2016, it marked the beginning of a new era of development for the country’s financial markets. The new management company is a private entity first established in 2014 to reform and develop the KSE, with the ultimate goal of establishing the market as a modern and transparent platform capable of attracting international investment. Its stewardship of the KSE represents the fourth phase of the exchange’s development, the first of which began in the mid-20th century. During the 1960s and 1970s Kuwait experienced a boom in informal trading carried out at the Souk Al Manakh, whereby a constant stream of new shareholding companies attracted the capital of a rapidly growing investment community.

Early History

The subsequent crash of the Souk Al Manakh in the early 1980s was a milestone in Kuwait’s financial history, and heralded the second phase of market development. This saw the beginning of formalised trading, governed by a series of by-laws and decrees issued by the government in a bid to ensure stability. In 1983 an Emiri decree established a comprehensive framework that resulted in the start of fully regulated trading. However, while this represented an important advance, it did not bring an end to market crises, which occurred sporadically over the following years. While some precipitous index movements were a reflection of external factors, such as the global economic slowdown of 2008, others were attributed to the fragmented supervisory structure of securities trading in Kuwait.

The response to this challenge came in 2010 with the creation of the Capital Markets Authority (CMA), which was designed to regulate and supervise all activities related to securities trading, along with ensuring transparency and fairness, implementing corporate governance regulations and protecting investors from unfair practices. Beyond its supervisory duties, the CMA is also charged with enhancing public awareness of the benefits, risks and obligations arising from investments in securities. The establishment of a single regulator ushered in the third phase of market development, characterised by a more focused approach to areas such as governance and disclosure.

Today’s Market

Despite its relatively long history compared to other exchanges in the Gulf, the KSE remains a single-product market focused on equities, and has yet to develop a debt platform or move into the more complicated area of derivatives. Its equity instruments, however, cover a wide range of economic activity and, with 205 listings as of January 1, 2017, many of Kuwait’s most important companies are present on the exchange. In terms of market activity, the banking segment generally sees the largest value of shares traded each year. This important corner of the market is populated by some of the biggest financial brands in the country, such as National Bank of Kuwait and Kuwait Finance House. In 2016 the banking segment accounted for 34% of total traded value.

The financial services segment, which holds the largest number of listings (49) and includes prominent institutions such as the Kuwait Financial Centre and GFH Financial Group, accounted for 20% of traded value over 2016. Other active areas of the market included the real estate segment, which accounted for 13% of the total, followed by telecommunications (10%) and industrial activities (10%). The remaining market segments – including basic materials, consumer goods, consumer services, health care, insurance, investment instruments, oil and gas, and technology-related areas – generally account for a modest share of overall traded value at between 0% and 5%.

Debt Market

While the KSE lacks a debt platform, Kuwait is a significant regional player in terms of primary, off-market debt activity. Financial institutions and development firms are regular issuers in the domestic debt arena, with National Bank of Kuwait, Boubyan Bank, Burgan Bank, Gulf Investment Corporation, Kuwait Energy and the Kuwait Projects Company all issuing bonds in 2016. By the first quarter of 2017 there were 32 outstanding bond issues from Kuwaiti corporates, 18 of which were dollar-denominated, while 10 were issued in Kuwaiti dinars and four in Malaysian ringgit.

The most significant recent development in Kuwait’s debt market, however, is the decision by the government to issue its first dollar-denominated sovereign instrument. In 2016 dollar-denominated mega-bonds became a regular occurrence in the Gulf as falling oil prices encouraged regional governments to take advantage of low global interest rates to meet budget deficits with debt issuances. Kuwait’s budget deficit in 2016 was uncharacteristic for a country accustomed to generous surpluses, and the government’s need to raise debt is lower than others in the region largely due to its large sovereign wealth funds.

Successful Bond

The parliamentary system makes fiscal consolidation a slow and challenging process, frequently halted by opposition. Therefore, issuing sovereign debt enables Kuwait to meet its spending commitments and balance its books without radically altering fiscal policy, as well as building up a useful yield curve by which corporate issuances may be more accurately priced. After months of speculation, Kuwait’s first international bond issuance came in March 2017, raising $8bn for state coffers. The government chose to approach the market with two tranches: a $3.5bn offer of five-year notes issued at 75 basis points over similar maturity to US Treasuries, and a $4.5 issuance of 10-year bonds at a spread of 100 basis points.

The appetite for the issuances was high, with the offer attracting around $29bn in bids, according to some local reports, with a wide geographical demand from the US, MENA and Europe. One explanation for the rush of investors to Kuwait’s sovereign offer, which allowed the government to pay less for its debt than Qatar, Abu Dhabi and Saudi Arabia did with similar offerings in 2016, is that the country is considered to be better cushioned against low oil prices than others in the region. Kuwait’s break-even oil price is the lowest in the GCC region, according to the IMF, which means its ambition to balance its budget is more easily met than other Gulf governments (see Economy chapter).

Investor Base

The international bond sale proved popular with local investors, who account for majority of trading activity on the KSE, while Kuwait’s benchmark stock index enjoyed a one-day rise of 1.2% on the back of the sale. However, the retail-heavy investor profile that produced this result is something that may change in the medium term as Boursa Kuwait’s strategy is fully implemented. One of the key concerns of Gulf exchanges over recent years has been how to alter the composition of their investor base. In the boom years before the financial crisis of 2008, many citizens of the region directed their disposable income to equities to take advantage of the double-digit returns offered on exchange floors at that time. The subsequent reversal of market direction inflicted financial losses on a large segment of Gulf households.

The flight from equities on the part of retail investors also highlighted the volatility risk associated with large numbers of small, individual investors in the market. Making the KSE a more attractive proposition to institutional investors, both local and foreign, is therefore a key element of Boursa Kuwait’s development strategy. For now, however, trading activity on the KSE remains dominated by local domestic retail investors. In December 2016 around 44% of total traded value was accounted for by Kuwaitis, with local companies responsible for 19.8% of buy trades and 17% of sell transactions, according to Boursa Kuwait. The remaining trading activity was undertaken by client accounts and investment funds. Only a small number of foreign individuals and companies have directed investment capital towards the KSE. In December 2016 GCC nationals were responsible for around 0.6% of buy trades, while GCC companies accounted for 2%. Non-GCC individuals contributed 3% to overall trading value over the month, a similar amount to foreign firms.

Performance

The “retail investor effect” was apparent in 2016, when for much of the year investors opted to stay away from the exchange. As with bourses across the region, the correlation between the index movement and oil price is a strong one. The oil price decline that began in 2014 has had a significant impact on the main index of the KSE, which followed a negative trend throughout 2014, 2015 and for the greater part of 2016. From the 2013 high of 8300, the index hit a low of 4946 on January 21, 2016, and thereafter followed a sideways channel for much of the year. The volume of trades also declined considerably in that period, from a high of around 6.5bn shares traded on May 25, 2013 to lows under 300m in September 2016.

This pattern of activity is closely aligned with other important exchanges in the Gulf: the Tadawul of neighbouring Saudi Arabia, for example, has shown a broad negative trend in the wake of the 2014 oil price decline, followed by sideways movement in 2016. Where the KSE differs from many of its regional neighbours is in the significant recovery of the index, which began in late 2016 and continued into 2017. In January 2017 the KSE main index performed better than any other market in the world, with its 12% rise more than double the gain made by the MSCI Frontier Emerging Market Index. Some of this rise is attributable to the partial recovery of oil prices and the fact that Kuwait’s sizeable financial reserves have allowed it to press ahead with major projects such as a new metro system and airport upgrade. A recent erosion of real estate prices is also likely to have encouraged investors to direct capital towards stocks as a more profitable alternative. However, the most significant market-moving factor that emerged in 2016, and which is still resonating in 2017, is the promise of substantial market reform resulting from the takeover of the KSE by Boursa Kuwait.

New Goals

The CMA and the exchange’s new management have clearly stated their ambitious long-term objectives, and Kuwait joining the International Organisation of Securities Commissions (IOSCO) in May 2017 will do much to establish the KSE on its new course of reform. The international body brings together the world’s securities regulators and is recognised as the global standard-setter for regulation.

IOSCO members have committed to applying consistent standards of regulation, supervision and enforcement in order to establish efficient and transparent markets, protect investors and reduce systemic risk. From the point of view of an exchange undertaking a process of reform, one of the key benefits of IOSCO membership is the sharing of information which takes place between affiliate, associate and ordinary members at both the global and regional level.

In the Gulf associate members already include the new Abu Dhabi Global Market, Dubai’s DIFC, the Qatar Financial Centre Regulatory Authority and the UAE’s Union of Arab Securities Authorities. Closer regulatory ties with the emerging markets of the region, as well as the developed markets of the US and Europe, will be of considerable assistance to Boursa Kuwait as it sets about implementing its local reform agenda. A market regulated according to international best practice will also help to propel the KSE towards its second strategic objective: a promotion from frontier to emerging market status by influential agencies such as MSCI and FTSE. The promotion of the UAE’s and Qatar’s principal exchanges to emerging market status by both MSCI and FTSE in 2014 was preceded by a rapid rise in their main indexes as investors positioned themselves for the announcement. More importantly over the longer term, an inclusion on the emerging market index would automatically open Kuwait’s exchange to an influx of liquidity from passively managed, index-tracking funds from the world’s biggest investment centres. It would also represent a seal of approval from global financial arbiters, placing Kuwait on the global investment map.

Challenges

Many systemic and regulatory hurdles must be overcome, however, before an upgrade of market classification can become a reality. Moreover, the exchange’s new management has assumed control of the market at one of the most challenging times in its recent history. Despite the recent uptick in trading activity, the predominant trends of the exchange in recent years have been a reduction in trading quantity and value, and a decrease in market capitalisation. This lack of activity has made it difficult for stock owners to execute big block trades, which are taking increasingly long periods of time to complete. The lack of foreign investment in the market exacerbates the problem of low liquidity. While attracting international investors to the KSE is made more difficult by competition from markets around the Gulf, the CMA has identified a number of systemic obstacles which place the local exchange at a further disadvantage, such as the complicated procedures involved with opening trading accounts.

The listing profile of the exchange is also problematic in terms of attracting new investors: according to the CMA, only 8% of the listed companies can be described as large, when classified according to the criteria established by the World Economic Forum. A preponderance of smaller companies on the exchange negatively affects overall information efficiency in the KSE. Lacking the investor relations capacity usually associated with larger firms and blue chips, many listed companies are slow to disclose financial information.

Transparency, accuracy and timeliness with regards to information are not prominent in the domestic trading culture, a situation which acts as a block to investment and the exchange’s efforts to boost liquidity. Creating a more attractive and transparent issuers base is therefore a priority for the new management.

First Steps

For this reason, one of the first steps taken by Boursa Kuwait has been to enter into a data provision partnership with Thomson Reuters, a move that will greatly enhance the ability of investors to assess the market. The KSE’s new management has also stated that it intends to make transparency its watchword when it comes to market reform. In practical terms, this means extensive consultation with all stakeholders prior to any regulatory change, a model already well established by early 2017 (see analysis).

By the first quarter of 2017 the KSE’s reform programme was well under way. One of the most significant regulatory advances in the first part of the year was the introduction of market-making regulations, which had first been put out for consultation in October 2016. The new framework allows financial institutions to hold an itinerary of stock for which they offer both buy and sell prices, thereby acting as an easily accessible market for investors to trade in. Market-making regulations have been rolled out in exchanges across the Gulf in recent years, and are considered vital to attracting liquidity.

Boosting Liquidity

Boursa Kuwait also has a number of liquidity-boosting innovations that it plans to introduce over the short term. For example, segmenting the market into different bands of stocks is one of the key changes in the pipeline. Under the proposal, shares will be grouped according to criteria such as liquidity, market value, disclosure and compliance, operating years and price to the par value, and as a result investors will have much greater visibility over the market. Introducing a short-selling capacity to the exchange is also a priority from a liquidity perspective, although this function is likely to be restricted to market makers at first. Both the CMA and Boursa Kuwait have also expended considerable effort on planning an enhanced Post-Trade Model (PTM). Upgrading the processes that follow the execution of a trade is particularly important with regard to the KSE’s effort to establish itself as an emerging market with indices such as MSCI and FTSE. An interim PTM, due to be launched in 2017, will see, among other things, a move to T+3 settlement and the upgrading of brokers’ risk management capabilities.

The CMA’s plans for the final phase of PTM implementation, expected in 2018, will see the establishment of a central counterparty to further limit the settlement risks of securities transactions, as well as the introduction of cash settlement using central bank money.

Looking beyond the KSE, the CMA also proposes to provide a platform for the off-market capital activity. Kuwait’s over-the-counter ecosystem includes non-listed shares, bonds, sukuk (Islamic bonds) and private equity, for which the CMA plans an online trading platform that will boost liquidity, provide transparency and engender more efficient price discovery.

Outlook

The scale of market reform currently under way is expected to boost investor interest in the KSE throughout 2017 and early 2018. The uptick of the main index in the first quarter of 2017 is evidence of this renewed appetite for domestic stocks, and as the exchange moves towards its target of an upgrade to emerging market status, the index is likely to be further buoyed. However, for many market observers the short-term index movement will be less important than the underlying process of reform over the coming years. Given the breadth of proposals put forward by Boursa Kuwait and the CMA, all stakeholders in the market will face adjustments. These include the exchange itself, the brokerage companies which serve it, investment companies, commercial banks, the central bank and the clearing infrastructure proposed by the CMA in its PTM reform. The model of consultation, fine-tuning and implementation that the authorities have implemented since late 2016 will continue over the medium term. The true test will be whether the KSE can deepen its market by attracting new issuers and investors, particularly much sought after foreign institutional investors.