Transforming Kuwait's capital markets

More than six years of strategic planning came to fruition in late April 2016, when Boursa Kuwait Securities Company (BKSC), a private firm established in 2014, took over management of the Kuwait Stock Exchange (KSE). The move was widely understood to indicate the beginning of a new era for Kuwait’s capital market.

Road To Privatisation

This shift follows on from a series of major reforms initiated by the passage of the 2010 Capital Markets Law (CML), under which the sector regulator – the Capital Markets Authority (CMA) – and other government entities have worked to transform the bourse, with the long-term objective of boosting the market’s performance and overall value.

BKSC, which is planning to float a significant portion of the KSE in an initial public offering (IPO) to Kuwaiti nationals in the future, will be an integral component of this strategy. “Today we have taken the first step on the road to privatising the KSE, and we are looking forward to working closely with BKSC’s management on making further progress,” Nayef Al Hajraf, chairman and managing director of the CMA, said in a speech at the time the KSE was handed over to the new operator. “This will include the development of [new] investment tools, restructuring the market to increase its competitiveness, working to increase liquidity and attract investments…, collaborating with other government stakeholders and determining a stake for an international operator.”

These changes have taken place during a challenging period for capital markets across the Gulf region. Global oil market volatility since mid-2014 has had a detrimental impact on national accounts, stock exchanges, banks and investment activity in all six GCC member states. According to data from the Kuwait Financial Centre (Markaz), a local investment bank and research house, the KSE price index ended 2015 down 14.6% on the previous year, and the country’s price-to-earnings multiple was at a five-year low of 14.4x. Stock turnover, meanwhile, dropped off by around 45% in 2015, from $20bn to around $11bn, according to Markaz. The declining liquidity on the KSE has been linked to the historically low market valuations and general economic malaise across the region.

History

Kuwait’s capital market is among the oldest in the GCC region. In the early 1950s a group of local businessmen issued 13,100 shares to form the National Bank of Kuwait (NBK), which was both the country’s first shareholding company and its first domestic bank. Informal trading of NBK stock and shares of other newly established local firms ramped up in the run-up to Kuwait’s independence in 1961, and continued to expand through the remainder of that decade and into the 1970s.

During this period the state published a raft of legislation related to the issuance and trading of shares in Kuwait, in an effort to ensure that these activities were carried out in line with international best practices. This early period of regulatory development corresponded with a broader effort on the government’s part to formalise the financial sector at large and resulted in the establishment of an official, albeit still loosely regulated, capital market in the country.

Beginning in the early 1970s, Kuwait’s increasingly high-profile financial sector and regional oil price volatility led to an influx of revenues among the domestic population. This was followed by a period of intense capital market speculation among local investors, which eventually led to a minor market crash in 1977. In response to this event, the government moved to bail out investors and implement a strict new set of capital market rules and regulations, with an eye towards protecting the market from similar events in the future. Paradoxically, the implementation and enforcement of a more tightly controlled formal market environment led aggressive investors to move a considerable amount of their money out of the official market and into a new, highly speculative informal market. Nicknamed the Souk Al Manakh (“camel market”) – after the building on the outskirts of Kuwait City from which it operated – beginning in 1978 this new exchange grew rapidly, with little oversight from the government. Over the course of the following half-decade, retail investors and corporations alike poured an enormous amount of money into the market, primarily in the form of post-dated cheques. In August 1982 one of these cheques bounced, which led to a cascade of defaults on the Souk Al Manakh and, eventually, the downfall of much of Kuwait’s financial system. By the time the damage had been contained, all of the nation’s banks and other financial sector players were insolvent, with the exception of NBK.

State-led Progress 

In the wake of the crash, the government bailed out investors and rebuild the financial system, this time in close consultation with the local financial industry. As a consequence, in August 1983 the KSE was formally launched. Initially the bourse served both as the official trading platform for all investment activity in Kuwait and, simultaneously, the regulator of said activity. As the country’s banks, brokers and investment firms slowly recovered over the following six to seven years, the KSE attracted a growing amount of new activity and posted a steadily expanding market capitalisation. In 1990-91, however, the country’s capital market – along with most other major institutions within and outside the financial sector – was decimated by the Iraqi invasion that lead to the First Gulf War. Once the war ended the government once again set out to rebuild the country’s financial system, re-establish the KSE and lay out a plan for recovery and growth.

This effort was aided by a regional economic boom, which contributed to rapid growth at the KSE, as measured by the overall number of listed firms, traders and investment companies (ICs) participating in the market, and by annual trading activity, which expanded exponentially during the mid- and late 1990s. A raft of newly established ICs set up shop in Kuwait during this period, driven by relatively low barriers to entry and easy access to investment capital from the domestic banking sector, plus high rates of return to be found in both equities and the regional property market. This activity, which carried on through the first half of the first decade of the 2000s, would set the stage for the 2007-08 global financial crisis.

During the 1990s and 2000s the KSE initiated a variety of technological and product-focused upgrades to the bourse, including the introduction of electronic trading in November 1995, a forward market in October 1998, a futures market in August 2003 and online trading in November 2003. These and other developments contributed to the KSE’s reputation as one of the most innovative bourses in the Gulf region during this period. Indeed, Kuwait was the first nation in the Gulf to introduce electronic trading on its capital market.

Ups & Downs

While Kuwait’s economy at large was relatively well protected against the 2007-08 downturn, the KSE posted a drop-off during the crisis, in terms of both valuations and trading activity. In this, the exchange was in line with other bourses throughout the Gulf region and, indeed, around the world. Hit hardest on the KSE were a handful of ICs that had borrowed excessively to buy real estate and equities, both of which saw a rapid decline in value after the downturn. As during previous financial crises, the government responded to the downturn quickly, announcing that it would guarantee all savings held in the domestic banking system, in an effort to avoid a run on local banks. This was followed, in March 2009, by the introduction of the Financial Stability Law (FSL), a Central Bank of Kuwait (CBK) programme designed to provide emergency debt restructuring assistance and refinancing options to the hardest-hit ICs and other companies impacted by the downturn.

In the years that followed, a number of ICs benefitted from the FSL. In 2011 local IC the Investment Dar, for example, entered into debt restructuring talks that continue today. As of late March 2016 the firm was in the midst of talks with creditors about a new KD813m ($2.7bn) restructuring plan, after an earlier agreement fell through.

Similarly, in May 2011 the Aayan Leasing and Investment Company, an automobile-financing firm, entered into a deal with CBK to restructure KD205m ($678.1m) in bad debt. In May 2016 the company secured approvals from creditors to restructure 66% of its outstanding debt. Approval from the remaining 34% of the firm’s creditors was still being sought at time of publication.

Other local firms, meanwhile, approached their creditors without the assistance of the CBK in order to begin restructuring after the crisis. Companies that took this more direct approach include Global Investment House, which wrapped up a $1.7bn deal in July 2013, and the Noor Investment Company, among others.

New Regulatory Framework 

To help protect investors and listed firms from future shocks, in February 2010 the government introduced the CML, a comprehensive set of regulatory upgrades and improvements aimed at bringing oversight and market operations at the KSE into line with international best practices. Based on similar legislation designed by neighbouring Gulf countries as well as the US Securities and Exchange Commission, the law established a new market regulator, namely the CMA, formally dividing the regulatory and operational aspects of Kuwait’s capital markets for the first time in the country’s history.

Since then, the CMA has taken a forward-looking, pro-active stance towards regulating activity at the KSE. In addition to keeping a close eye on operations at listed firms, ICs and among investors, the authority has introduced a host of new rules and regulations meant to encourage good corporate governance, boost transparency and facilitate improved risk-management capabilities throughout bourse operations. In the long term, the CMA plans to privatise the KSE, which may involve tendering up to 44% of the firm to an international company with experience operating exchanges. In the meantime, several recent changes should help boost activity on the exchange.

Upgrades

Among them are systems upgrades. The government and the CMA have overseen implementation of a series of technical improvements in the recent past. In 2009, for example, the KSE installed NASDAQ OMX’s X-Stream Trading, a new, KD18.3m ($60.5m) trading platform designed and installed by NASDAQ OMX, the technical services arm of the US-based multinational financial services firm NASDAQ. X-Stream, which serves as the trading platform at more than 15 exchanges globally, can handle a wide array of tradeable products and services, including derivatives, futures, short selling, exchange-traded funds (ETFs) and automated margin lending. Though most of these products have yet to be rolled out at the KSE, as of mid-2016 the new bourse operator was reportedly planning to introduce them in the next few years.

Regional market connectivity has also improved. Measures to ease international share transfers were taken in mid-2014, when local clearing house Kuwait Clearing Company signed a deal with Bahrain Bourse to facilitate electronic transfer of shares between the two countries’ stock exchanges – a significant step as Kuwaiti investors own about a third of shares listed in Bahrain, according to Sheikh Khalifa bin Ibrahim Al Khalifa, deputy CEO of Bahrain Bourse.

Moving Forward

The handover of the KSE to BKSC, the purpose-built firm that took over management of the exchange in April 2016, has been in the works since 2010. Indeed, under the 2010 CML, the government issued a mandate to privatise the bourse. BKSC, which was established by the CMA in 2014, represents the first step towards achieving this goal. Under BKSC’s 2020 transformation strategy, over the next four years the operator plans to implement a series of reforms aimed at upgrading the KSE’s technical infrastructure, trading rules, risk management schemes and price discovery mechanisms in an effort to address a handful of challenges to development identified by private sector market participants.

Following this initial phase of development, the new operator will work to broaden both the investor base and the number of listed companies, in order to broaden and deepen the market. Eventually, new products are slated to be added to the bourse, including bonds, ETFs and sukuk ( sharia-compliant debt instruments), among others.

The aim of these upgrades is to attract new investors to Kuwait’s capital market, particularly new foreign institutional investors, many of which have fled the Gulf region over the past five years.

“People have been getting out of the stock exchange in recent years,” Hassan Al Azem, a research consultant at the Kuwait-based investment bank The International Investor (TII), told OBG. “At one point Kuwait was the most liquid stock exchange in the GCC, but this is no longer the case. The new operator and the privatisation plan is a positive step.” Nonetheless, it will be challenging to fully implement BKSC’s ambitious programme to revitalise the KSE within the relatively short time frame that has been planned.

Top-line Performance 

Following the 2007-08 international economic downturn, the KSE, like many other Gulf bourses, saw a few tough years followed by a period of resurgent investor interest. Indeed, in 2008 the KSE’s weighted index and price index declined 43% and 38%, respectively, according to data from Markaz. The indices fell off by an additional 5% and 10% in 2009, meanwhile, followed by growth on the weighted index of 26% in 2010, while the price index declined by just 1% that year. After an additional decline of 16% on both indices in 2011, the market returned to a growth trend, with the weighted index up by 3% in 2012 and 8% in 2013, and the price index rising by 2% and 27% in the same two years.

Beginning in mid-2014 the price of Brent crude, the international oil price benchmark, dropped from more than $115 per barrel to less than $30 per barrel over the following year, before levelling out again at $45-50 per barrel in early 2016. This loss of value in international oil markets hit Gulf economies – many of which, including Kuwait, are reliant to a large degree on hydrocarbons revenues – particularly hard. Since then, many regional capital markets have seen large capital outflows. In Kuwait, the KSE price index fell by 13% in 2014 and 14% in 2015, for instance, while the weighted index dropped by 3% and 13% over the same period. Though just 1.1% of the KSE’s total value was directly tied up in hydrocarbons-related securities, the great bulk of Kuwait’s economy relies to some degree on oil and gas revenues.

With some 205 stocks as of the end of 2015, the KSE is one of the largest exchanges in the region in terms of listed companies. According to KSE data, the bourse’s end-2015 market capitalisation was KD26.65bn ($88.1bn), down from KD29.39bn ($97.2bn) at the end of the previous year and KD30.59bn ($101.2bn) at the end of 2013. Indeed, the decline in overall exchange capitalisation is in line with a number of other falling metrics in recent years. As noted by BKSC, over the past decade liquidity on the exchange has declined dramatically, from KD33.9bn ($112.9bn) in total value traded in 2007 to KD5.9bn ($19.5bn) in 2014, for instance, the latter of which was a record 10-year low. Similarly, value traded as a percentage of market capitalisation also dropped off considerably over the same period, from 37% in 2007 to 19% in 2014. Finally, between 2010 and 2014 the KSE’s traded value as a percentage of GDP – a metric that aims to reflect a given bourse’s health as compared to the health of its domestic economy – fell from 36% to 11%, according to BKSC data.

Classifying The Market 

Banking stocks accounted for just under 50% of the KSE’s total market capitalisation at the end of 2015. The banking index, which tracks the performance of listed banks, declined by 9.7% over the course of 2015, largely as a result of slowing deposits and government spending. NBK, the country’s largest lender, is the market leader by capitalisation (see Banking chapter). The next-largest sector as measured by market capitalisation was real estate, with 9.9% of the total, followed by industrials with 9.3%, financial services with 9.1%, and telecoms with 8.7%.

In 2015 most sector indices declined, with those industries that are related closely to hydrocarbons falling off by the largest percentages. Indeed, the oil and gas sector index fell by 34.4% in 2015. The financial services industry, which has deep ties to hydrocarbons, declined by 24.2%. Telecoms and consumer goods, meanwhile, dropped off by 24.1% and 19.3%, respectively, according to Markaz, followed by basic materials, which fell by 13.8% and industrials, which were down 13.6%. The only two sector indices that did not post a decline in value during the year were insurance and health care, which grew by 4.6% and 3.8%, respectively (see Insurance and Health chapters).

A major challenge facing BKSC is the predominance of small-cap stocks on the KSE. Some 177 of the 205 listed stocks on the exchange have a market capitalisation of less than $500m. These firms tend to be largely ignored by market analysts and, as a consequence, by investors and brokers. As such, they are rarely traded.

By comparison the KSE’s 11 mid-cap stocks (those with a market capitalisation of between $500m and $1bn) and 17 large-cap listings (firms with a market capitalisation of more than $1bn) tend to attract a majority of trading activity and analysis, despite accounting for 13% of the total market as a percentage of listed stocks.

IPOs & Bonds 

Given the volatility in the market and broader economy, the KSE has attracted only a handful of new listings in recent years. The most recent new market participant was the Kuwait Telecommunications Company (operating under the brand VIVA), which was added to the market in mid-December 2014, following on its July 2008 sale of KD25m ($82.7m) in stock to Kuwaiti nationals. In November 2015 VIVA’s largest shareholder, the Saudi Telecom Company, which currently owns 26%, submitted an offer to the CMA to acquire an additional 24% of the firm from the Kuwait government. Prior to the VIVA listing, the most recent IPO on the KSE was the Al Imtiaz Investment Group’s 2011 share float. While in 2012 and 2013, in particular, a handful of domestic corporates announced plans to float shares on the exchange, these have yet to take place. Given the current economic volatility throughout the region, many firms are likely currently holding off on expansion plans, including IPOs. Once the current challenging period ends, however, the government is widely expected to prepare share sales for a range of state-owned entities, including Kuwait Airways, the flag carrier (see Transport chapter).

Outlook

Given their reliance on oil prices and the broader economy, local stock markets look headed for a slower period. IMF data show that Kuwait posted GDP growth of just 0.9% in 2015, down from a 2004-12 average of 6.1%. Forecasts for 2016 show GDP growth accelerating to 2.4%. “At the moment the situation is challenging for all players involved with the capital market,” the TII’s Al Azem told OBG. Despite the challenging economic environment, many investors, CFOs and brokers see good reasons to be optimistic about the bourse’s future. The most compelling of these lie in the regulator’s ongoing efforts to overhaul the sector, which began in earnest in 2010 and are expected to eventually lead to a more mature, transparent and attractive market. Major upgrades to the bourse’s classification system, technical specifications, regulatory capacity and capital requirements portend major improvements to the market, and bode well for participants of all kinds.