Loosening grip: Domestic control over capital markets set to be liberalised to attract foreign investment

As the largest and most liquid bourse in the MENA region, the Saudi Stock Exchange (Tadawul) accounts for around 50% of the GCC equity market, and yet it is one of the most difficult to access for foreign investors (although this is set to change when the market opens up in 2015). Gaining exposure to the nation’s listed firms, many of which have shown healthy earnings on the back of the nation’s sustained economic growth, has therefore been a long-held ambition of the global investment community.

Encouragingly, as regional exchanges gain recognition from influential index providers and attract increasing amounts of global capital, there are signs that Saudi Arabia’s exchange is preparing to join their number. While the exchange is currently classified as a “frontier market” by MSCI, this is largely due to its restrictions on foreign investors. MSCI’s decision to upgrade the UAE and Qatari bourses from frontier to “emerging market” status in June 2013 has only heightened expectations regarding Saudi Arabia. In many respects, however, given the market’s development, the distinction is somewhat academic. Yasir Al Rumayyan, CEO of Saudi Fransi Capital, told OBG, “When you look at the actual numbers, you realise that Saudi Arabia can be considered a developed index market even if it isn’t labelled as such. The market infrastructure, the daily volumes traded, and the overall GDP and GDP per capita of the Kingdom support this.”

RAPID DEVELOPMENT: The development of Saudi Arabia’s stock exchange mirrors the rapid expansion of its hydrocarbons-driven economy. The Kingdom’s first joint-stock companies emerged in the 1930s as the fledgling oil industry began to produce revenues, and by the 1970s the country was home to around 14 public corporations. The era of nationalisation, which commenced in the 1980s, saw the formation of many new companies, as foreign banks and other financial institutions were brought under domestic control. By this time it was apparent to the authorities that the network of private brokers through which all market activity was conducted was no longer adequate for the more complex economy that was emerging, and, with rising oil prices driving further corporate growth, the nation’s financial planners began to lay the groundwork for the establishment of a modern stock exchange.

In 1984 the government issued a royal decree that created 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 granted a mandate to develop and implement the regulations and controls upon 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 exchange implemented a centralised electronic trading system, which was replaced in 2006 with Nasdaq OMX’s SAXESS trading platform. In 2003 the government introduced the new Capital Markets Law (CML), which resulted in the creation of a number of key institutions including a new market regulator – the Capital Markets Authority (CMA), the Committee for the Resolution of Securities Disputes and the Appeals Committee. The CML also led to the creation of the Saudi Stock Exchange and the Securities Depository Centre.

MARKET STRUCTURE: The framework established then forms the basis of today’s capital markets, and the scope of activity undertaken on the exchange reflects the increasingly diverse nature of the economy. Equities are divided into 15 sectors: banks and financial services, petrochemicals 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.

Although still at a relatively early stage of development, the Saudi Stock Exchange has also begun to evolve from its initial function as a single-product equities market to introduce a wider array of financial instruments. Since early 2010 legislation has been in place that allows for the creation of exchange-traded funds (ETFs), which, by offering a basket of assets created from listed shares, provide an easy way for investors to formulate balanced portfolios. As of 2014, three ETFs are actively traded on the bourse – Falcom 30, Falcom Petrochemical and HSBC Saudi 20 – although trading volumes for these pioneering instruments remain muted.

Looking to the debt market, the exchange launched an electronic trading platform for bonds and (the sharia-compliant equivalent) in 2009. By 2013 this fixed-income market consisted of eight listings, with maturities ranging from 2015 to 2025. However, while the debt market contains instruments from some of Saudi Arabia’s most prominent institutions, such as Saudi Electricity and Sipchem, the creation of an actively traded secondary market remains in its early stages, with most of the demand for bonds and sukuks met on an off-exchange basis.

TRACKING THE MARKET: Just as the exchange has grown in both breadth and depth, so too have the means by which investors can evaluate it. The current set of indices dates from 2008, when the exchange restructured its market sectors. 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. As with other exchanges around the world, the Saudi Stock Exchange has succeeded in transforming the provision of market data into a source of revenue. The model it has adopted to do so is centred on licensed information distributors, whereby independent data vendors are authorised to redistribute market information, frequently with additional analysis. As of 2014, 33 such firms have secured distribution licences for market data, including global leaders like Thompson Reuters and Bloomberg, as well as regional information providers, such as Zawya. In addition, in May 2014 the Saudi Stock Exchange announced that it had signed an information licensing agreement with Google, allowing the technology firm to provide historical data for shares listed on the bourse in its search results and via Google Finance.

TECH PLATFORM: The electronic platform on which the Saudi Stock Exchange is based has also evolved in line with the market’s expansion, and the past year has seen some significant advances in this regard. Shares have been traded electronically since 1990, when the ESIS platform was first introduced. The 2001 upgrade of the system, which effectively created the modern exchange, resulted in larger volumes and greater functionality, including a T+0 settlement system which greatly reduced intra-trade risk. A number of expansions and enhancements to the system followed that allowed the exchange to accommodate rising trading volumes, which reached around 800,000 transactions per day in the years leading up to the global economic crisis.

The most substantial upgrade of recent years came in 2006, when the exchange signed a contract with OMX (which subsequently became Nasdaq OMX) to supply and implement a trading, information dissemination and surveillance system for the Kingdom’s bourse. The greatly improved infrastructure, which connects directly with the systems of brokerage firms, has been the base from which the exchange has expanded its business and product offerings, and therefore an announcement in 2013 that the electronic platform is to be further upgraded has been received by the investment community with considerable interest. Under a new deal with its technology provider, the Nasdaq SAXESS trading system is to be replaced with the more powerful Nasdaq OMX X-Stream INET platform, which has already been proven in 22 other markets around the world. The upgrade will deliver a number of technical improvements, such as the ability to sustain an order rate of 40,000 per second with a latency of under 40 microseconds, which combine to produce greater stability and capacity.

“This is an exciting time for the Saudi Stock Exchange. The responsibilities being activated and those we are transitioning from the CMA will provide us with a greater freedom and ability to create a more sophisticated market. The Saudi Stock Exchange is already the largest and most liquid platform in the Middle East and North Africa,” Adel Al Ghamdi, the Saudi Stock Exchange’s CEO, told OBG. Importantly, the new platform offers scalability across asset classes – a crucial functionality for an exchange at the Saudi bourse’s stage of development.

PERFORMANCE: The Saudi Stock Exchange entered 2014 on the back of a strong performance in 2013, during which the TASI reached a high point of 8561.84 points on December 23rd before closing the year out at 8535.60 points – which represented a 25.5% year-on-year (y-o-y) increase. Similarly, total market capitalisation grew throughout the year, rising 25.17% to reach SR1752.86bn ($467.31bn).

In terms of market indices, much of the growth was underwritten by activity in the hotel and tourism segment, the index for which rose by 123% y-o-y in 2013 to reach 16,174. Other buoyant sectors included retail, the index for which rose by 55.9%, real estate development (up 42.2%), and agriculture and food industries (up 39.5%). At the other end of the scale, the insurance index posted a -11.34% decrease for 2013, as confidence in the industry faltered due to a poor technical performance by many players, while a 5.97% decline in the media and publishing sector was the only other index retreat for the year.

In terms of value, much of the growth exhibited in what turned out to be the best annual performance since 2009 came from some of the traditional heavy-hitters of the exchange: banking, telecoms and petrochemicals. Their strong showings took place against a favourable economic backdrop, characterised by steady government spending, consumer growth and private sector expansion, but just as important has been a change in sentiment with regard to the nation’s exchange. After severe stock market corrections in 2006 and 2008, the focus of Saudi investors switched to foreign equities markets, but that trend has begun to change. “In 2013 we saw a structural shift in the way locals viewed the market, and the appetite picked up substantially. [The year 2013] represented a definite landmark for a change of mind-set,” John Sfakianakis, chief investment strategist at Riyadh-headquartered investment firm MASIC, told OBG. Adding to this momentum, according to Ibrahim Abdulkhaliq, alternative investments portfolio manager at MASIC, is reduced interest in the domestic real estate market. “The uptick of interest in the exchange is in direct correlation with the reduced appetite for investment in real estate. Historically, Saudis have invested in real estate, but the market has become quite heated. The returns are not there for the average investor, and there is a fear that the real estate crisis hasn’t fully played out,” Abdulkhaliq told OBG.

NEW LISTINGS: This renewed interest in the Saudi Stock Exchange is likely to boost IPO activity. While the smaller bourses of the GCC have suffered from a shortage of new listings since the onset of the global economic downturn, Saudi Arabia’s IPO market has remained relatively buoyant over recent years, establishing it as the regional IPO leader. In 2013 five companies were listed on the exchange for the first time, starting in February with the offering of 90m shares at SR10 ($2.67) per share by Northern Region Cement. The following month saw the National Medical Care Company join the index with an offering of 13.5m shares at SR27 ($7.20) per share, and the traditionally quiet summer trading period was enlivened four months later with the July flotation of Aljazira Takaful Taawuni Company – an offering of 10.5m shares at SR10 ($2.67) per share. The final quarter saw a further two listings on the exchange, to bring the annual total to five: in November MetLife AIG ANB Cooperative Insurance Company listed with an offering of 5.25m shares at SR10 ($2.67) each, and in December Bawan Company successfully completed an IPO of 15m shares at SR36 ($9.60) per share.

The prospects for a continuation of IPO activity over the short and medium term remain good. By the start of 2014 a number of companies had made known their ambition to hold IPOs. Amongst them is the Al Habib Medical Group (HMG), one of the Kingdom’s largest private health care operators, with facilities in its home market as well as in Bahrain and the UAE, which has appointed Saudi Fransi Capital to act as its financial advisor, lead manager, book runner and underwriter. Another health care possibility for 2014 is Almana General Hospitals (AGH), which is reported to be finalising plans for an IPO provisionally slated for late 2014. Meanwhile, utility ACWA Power recently flagged its intentions to hold an IPO in 2014 or early 2015, a move that would help the company realise its plans to invest more than $3bn in solar energy facilities in the coming five years. In an interview with Reuters at the end of October, ACWA’s chief executive, Paddy Padmanathan, said the firm had completed a study of its IPO readiness with consultants KPMG and had chosen Banque Saudi Fransi to arrange its share sale.

From a diversification standpoint, these potential listings are welcome news for an exchange on which IPOs have traditionally been dominated by banks and petrochemicals firms, but the offering of large financial institutions continues to attract significant interest when they come about. A likely candidate from the banking sector in 2014 is the National Commercial Bank, which as the nation’s largest lender will garner considerable interest with a proposed 15% share sale. Estimates place the offering at between SR15bn ($4bn) and SR20bn ($5.3bn), making it one of the biggest in the Gulf region to date.

INVESTOR BASE: Part of the reason that IPOs attract such interest in Saudi Arabia is the high degree of interaction that exists between ordinary citizens and the nation’s stock market. The growing levels of disposable income that have driven key lifestyle indicators such as new car registrations and consumer expenditure on food have allowed Saudis to direct their capital towards various investment instruments, including domestic stocks.

One of the results of this is a market that is dominated by the trading activity of individual investors, who accounted for 89.3% of the total value traded in December 2013 compared to the 9.5% traded by institutional investors. As current regulations only allow for trades to be undertaken by Saudis, foreigners resident in Saudi Arabia and foreigners participating through swap agreements, in terms of geographical origin the market is also dominated by domestic investors. In December 2013, foreigners resident in the country or participating through swaps accounted for only 2.9% of the value traded, while GCC citizens added 1.5%, and trading activity by nationals accounted for 95.6% of the remainder. The revival of interest in the Saudi exchange among the domestic investment community is a welcome change in terms of liquidity, but it also brings its own set of challenges.

“There is currently a very high level of liquidity in the market,” Ziad Aba Al Khail, the CEO and managing director of Al Jazira Capital, told OBG. “There is momentum being felt as the stock exchange transitions from being rumour driven to being one with greater sophistication and depth.”

During this transition, the preponderance of active individual investors means that the market is prone to speculation and volatility, a good example of which 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 correction pushed the index back down to around 6800 in May.

Seasonal trends are also particularly pronounced, whereby activity typically 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 during the Hajj and Umrah periods as well.

REGULATION: Developing exchanges have traditionally sought to attract foreign institutional investors as a means to combat volatility, and in recent years Saudi Arabia has moved incrementally towards opening up its market in this way. The CMA, as the market regulator, is the principal authority overseeing the development of the exchange – including its steps towards allowing investment by non-resident foreigners.

The responsibilities of the CMA are broad, spanning such activities as issuance of securities, credit rating agencies, investment funds, disclosure and governance, licensing, and supervision and enforcement of its regulations – which comprise the CML and its implementing regulations.

Thanks to its efforts the Saudi Stock Exchange is widely considered to be one of the best regulated exchanges in the region, and in an assessment of its regulatory framework published in 2012 the IMF declared that there are no major gaps in the current regulatory and legal framework.

At the technical level, the CMA has worked to introduce a supervisory regime that is both risk-based and compliance-focused, while at a strategic level it has followed a cautious route towards opening up the market. Investors from abroad have been able to interact with the Saudi Stock Exchange through swap agreements since 2008, and the 2010 legislation which governs ETFs also allows for foreign participation in those instruments.

More recently, the CMA has included general regulatory provisions in its revised listing rules allowing the cross-listing of foreign companies on the Saudi Stock Exchange, while tougher regulations on how long companies that have accumulated large capital losses can have their shares traded on the exchange have been interpreted as an important move in bringing the exchange into line with international best practice (see analysis).

This momentum came to a head in July 2014, when the CMA announced that it intended to open the Saudi Stock Exchange to direct foreign investment in the following year. The regulator plans to release the draft rules that would govern foreign investors in August 2014, and allow a 90-day period during which investors and the public could provide feedback.

OUTLOOK: Increasing investor appetite, sustained earnings growth by Saudi companies and the relatively robust nature of the Kingdom’s economy make for a positive outlook for the Saudi Stock Exchange. These internal criteria are reinforced by an improvement in the regional socio-political scenario over the past year, as well as an improving global economy, with IMF forecasts predicting economic expansion internationally of 3.7% in 2014 and 3.9% in 2014 as compared to 3.0% in 2013, which in turn is expected to drive continued growth in the petrochemicals sector. On the regulatory front, much attention will be paid to the CMA’s actions in the coming months, as the regulator prepares to open the market to direct foreign investment. This development, once completed, will represent one of the most significant advances in the Saudi Stock Exchange’s history.