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Regional review: Middle East stock exchanges

Date 07/06/2004

Nigel Dudley

Middle East stock markets have taken a significant step towards maturity in the last year. They are better regulated, more liquid, are no longer quite so dominated by the financial sector, and are attracting more interest from both local and international investors. Privatisation and the use of a wider range of financial instruments are also helping to create a more sophisticated market.

There is still, however a long way to go, before they can plan an important role in global markets. While combined they make up a significant size, as individual exchanges they are very small. The largest in the region, Saudi Arabia, remains opposed to direct foreign investment, while other markets remain very volatile and too few of the shares are actively traded.

However, any investors who risked the 12 Arab exchanges (Kuwait, Saudi Arabia, the UAE, Qatar, Oman, Bahrain, Jordan, Lebanon, Egypt, Morocco, Tunisia and Palestine) in the last year would have come away with real profits ? during 2003 share prices rose by 70% across the region. Many IPOs in the region in recent months have been heavily oversubscribed.

Trading volumes which had started to grow in the early part of the decade took off dramatically last year. In 2001, the 12 exchanges traded some USD28bn shares, a figure that rose to USD42bn in 2002 and climbed dramatically to USD150bn last year.

As a result the region?s market capitalisation has risen to USD330bn from around USD200bn a year ago. Though this is still less than 10% of the emerging markets? stock exchange capitalisation, it is starting to be significant. It is for example larger than Russia and second only to China in emerging markets ? though this advantage will remain theoretical so long as the region is split into so many exchanges.

The reason for the strong performance of the market has been the availability of liquidity in the Middle East. Historically, Gulf governments, institutions and high net worth individuals have invested the overwhelming portion of their wealth through international banks into the West, either in equities, property or on cash deposit in dollars ? Arab currencies are effectively pegged to the dollar. The Arab world lacked the investable opportunities for the billions of dollars of petrodollar wealth, and regional institutions lacked the skills needed to manage the money.

That situation has changed in the last five years. First, the collapse of Western stock markets and particularly the end of the ?dot com? boom ? information technology companies were particularly popular with those looking for Islamically-compliant vehicles ? meant that Arab investors were no longer so keen on Western markets.

Second, a period of sustained low interest rates meant that there was little attraction in leaving the money on deposit.

And finally, in the aftermath of the September 11 terrorist attacks, Arab investors became reluctant to put their money in the West. Part of the motivation was political ? there was hostility towards the West because of the perception that the United States was adopting anti-Arab policies. It was also partly fear that Arab assets would be seized or frozen, either because the US authorities mistakenly identified innocent investors as terrorist financiers, or because they were targeted in class actions by some of the victims of the US terrorist attacks.

As a result, say Arab bankers, billions of dollars have returned to the region and a much higher proportion of newly generated money ? for example, the private sector in Abu Dhabi alone generates USD10bn of new investable money each year ? is being held locally.

At the same time, oil prices have remained at the top of the USD22-28 a barrel price range targeted by OPEC, with the result that for the last two years Arab countries have returned to budget surpluses after a period in which many of them, most notably Saudi Arabia, have recorded years of substantial deficits. This has meant that not only do governments have more money to invest but that the private sector has benefited from the economic investment and faster payments.

The combination of more money being generated locally and the return of money that had been invested overseas ? factors confirmed by the sharp increase in money supply in Arab states like Kuwait where it had remained at consistent levels for years ? has coincided with a maturing of the Arab stock markets. There has been a significant improvement in the quality of their regulation, a greater readiness of smaller investors to buy into regional equity funds, the availability of a wider range of instruments and considerable investment in new technology to enable the markets to move from manual to electronic trading.

The principle of an independent regulator is now widely accepted across the Middle East ? Kuwait remains the one outstanding significant market where its senior executives still seem wedded to self-regulation.

The most important change has come in Saudi Arabia whose current market capitalisation of more than USD155 million makes it by far the largest exchange in the region (the next largest are Kuwait at USD61bn and the UAE at USD42bn)

The passing last year of a Capital Markets Law, which transformed the Saudi Stock Market (known as Tadawul) from an over-the-counter to a formal market, established clearly the principle that the exchange is to be regulated by a Securities and Exchange Commission.

Other Gulf states to go down this route include the UAE ? though its growth is constrained by the continued determination of Abu Dhabi and Dubai to maintain their own trading floors ? and Bahrain. Bahrain brokers welcomed the decision to regulate their market through the Central Bank as the Governor, Sheikh Ahmed bin Mohammed Al-Khalifa had previously been in charge of the Stock Exchange.

Jordan, though one of the region?s smaller markets with a capitalisation of USD8bn, is another example of a market that has modernised by creating three separate entitities ? since 1997 it has been regulated through the Jordan Securities Commission, it is managed by the Amman Stock Exchange and there is a separate depository centre.

Equally important has been the widening of instruments and the types of companies that are now tradeable on Arab markets. Privatisation has started to have an impact, most notably with the flotation of shares in Saudi Telecom (STC) towards the end of 2002.

The sale of the 30% stake in STC, the 14th largest telecommunications company in the world,  through an initial public offering generated some USD9.6bn in revenue for the Saudi Arabian government. This was the second largest flotation in the world in 2002 and by far the largest share offering in the Middle East.

The scale of this success was extraordinary, not least because only Saudi citizens were able to buy and the IPO took place in the run up to the American invasion of Iraq ? indeed many financial advisers in Riyadh were recommending the government to delay the share offering because of the region?s political instability.

In the event some 900,000 Saudis applied for shares, the issue was three and a half times oversubscribed, and since flotation it has dramatically outperformed the market and been the most actively traded share. Within months the price had doubled ? by the end of the first quarter of 2004 it was up 150% ? and the shares, which make up more than 20% of the market capitalisation, accounted for more than half the market trading.

Other important moves in recent years include bonds in both UAE dinars and dollars for Dubai?s airline flag carrier, Emirates. These bonds are now quoted on the Dubai Financial Market. In Jordan the sale of a small stake in its telecommunications company was oversubscribed.

Of particular interest was the success in Bahrain of regular sukuks, which are short term, liquid asset-backed tradable Treasury instruments. These are quoted on the Bahrain Stock Exchange and have been some of the most regularly traded instruments there.

Another important change has been in the attitude of investors towards the market. There is now a greater readiness to invest in other Gulf markets. In the last five years, Gulf markets have become enthusiastic about cross listing and most markets in the six Gulf Co-operation Council states ? Saudi Arabia, Bahrain, Kuwait, Oman, Qatar and the UAE ?  are now open to investors from other member states.

The markets are now benefiting from these decisions. Bankers say that investors, who had previously focused almost exclusively on their domestic markets, are now prepared to invest in other GCC markets. In part this reflects the change in corporate behaviour. Not so long ago many Gulf institutions ? either by laws or instinct ? were narrowly focused on their own company. More companies ? and particularly banks ? are operating across the region, which makes them better known.

Perhaps the most important factor is the increased transparency in Gulf markets. Until a few years ago, these markets were extremely volatile and there were many suspicions of insider dealings. A further factor in states like Kuwait was extensive cross holding of shares.

The greater transparency of Arab markets now means that there is less emphasis on direct local knowledge, while better regulation means there is less risk of insider dealing and extreme switches of sentiment. These are, say bankers, the first signs of a move towards the creation of a single Gulf stock market ? but they warn there is a long way to go due to the reluctance of some states to allow participation by non-Gulf investors. Some markets like Oman, Bahrain and Jordan are fully open, but Saudi Arabia is still closed and the UAE only allows foreign holdings in a very few shares.

Equally important has been the change in behaviour. Traditionally Arab investors have either been long term holders of their shares or government stock ? with the result that only a small proportion are actively traded ? or they have seen the markets as a way of making rapid short term gains.

This has meant that there was until recently very little of the capital markets culture and little incentive for the family companies that dominate business in most of the Middle East to raise money through bonds or equities. These firms were also deterred by the fact that they would have to reveal information about their companies when historically most of them have conducted their affairs in considerable secrecy.

There are the first signs of a change in attitude. All the regional exchanges have devoted considerable effort towards persuading these companies that it is much cheaper to raise money through the markets than through direct bank finance and bankers say that it is only a matter of time before the younger generation of business leaders, who are Western trained and more sympathetic to the markets culture than their fathers, start to raise money in this way.

It will also become essential as firms which have been run by a single dominant figure pass on an inheritance which will be split between several children. A further factor is that some of the younger generation of businessmen will want to develop their own companies and the only way to grow rapidly will be through raising debt or equity.

However, stock exchange managers are sanguine about the length of time it will take to achieve this and admit that for some time the shape of the Gulf market will be dominated by financial institutions and telecommunications companies.

So, the key question now for the Arab markets is whether the range of political and economic factors, combined with the speed at which the market is developing, will have provided a positive enough experience for Middle East investors to stay in local markets when Western investments become more attractive.

Gulf bankers accept that eventually political fears about placing money in the West will subside and that the New York and London indexes are likely to perform well as the international economy revives. Even if Arab investors are nervous about equities, more money will be placed in property.

This is likely to happen at a time when Arab markets perform less well than in the boom period of recent years. Instead of the 70% growth of the last year, bankers say that Gulf stock exchange indexes are unlikely to rise more than 10% in 2004 because in most countries markets are at a historic high price to earnings ratio.

However, this could be an underestimate if governments press ahead with privatisation and liquidity continues to increase ? some USD10-12bn of dividends alone were pumped into shareholders? pockets as a result of the markets? performance last year.

In the eastern Mediterranean Jordan is also likely to see similar levels of growth, but Lebanon is likely to be nervy as it is election year, and the Palestine Exchange, once seen as symbol of that region?s growing stability, will remain on the floor until the end of the current conflict.

Dubai asset managers say that the most attractive markets for this year could be in North Africa, where they predict that shares could rise by at least 20%. Egypt in particular is set for a better performance. In the late 1990s it was favoured by many Western financial institutions as one of the only two emerging markets ? alongside Hungary ? to be stable and attractive. The Cairo and Alexandria Stock Exchange is one of the most diversified markets in the region, with a strong core of commercial and industrial companies balancing the financial sector.

However, in the early part of this century the failure of the government to manage the economy ? and particularly the exchange rate, where there was a consistently wide gap between the official and market rate for the Egyptian pound ? meant that investor confidence collapsed, to the extent that market capitalisation fell from USD32bn to little more than USD7bn in 2002.

Now there are more positive signs. The appointment of a new Central Bank governor has impressed many banks, not least because of the way he has managed the currency; the official and unofficial rates are now virtually identical.

The economy is also performing well with foreign reserves now at sufficient levels to enable the Central Bank to intervene in the market with comfort. The economy is also in a much stronger position with the high oil price both boosting revenues from this sector and generating more expatriate remittances from the Gulf states, where there are large numbers of Egyptian workers. Tourism is also at record levels with numbers up from Europe and the Middle East.

Some Western investment institutions are overweight on Egypt ? one says it forms 2.8% of its portfolio compared with its official position accounting for 0.3% of the MSCI index. London bankers say the market is undervalued but that the shortage of liquid stocks means that its appeal will remain limited.

Other popular markets are likely to be Morocco and Tunisia. Morocco in particular has been particularly successful in privatising state industries and both countries have gained from increased tourism.

These factors will affect the short term decisions of the Arab investors. But in the longer run, the most important matter will be the structural developments of the Arab markets. And the key country will be Saudi Arabia.

The Kingdom, which is the largest market in the region, has taken an enormous step forward by passing the Capital Markets Law ? the success of the STC flotation, which took place before the law was passed, shows the potential in the Saudi market.

As well as the independent regulatory body, which will licence and regulate non-bank financial institutions ? including for the first time the world?s leading global investment banks ? the law establishes a privately owned exchange. A number of international banks, including Deutschebank, have already expressed interest in setting up in the Kingdom, where they will be able to manage not only local investments for Saudi clients but also manage international business for their customers more directly.

The Saudi market is modern and efficient, meeting or exceeding international standards. Trades are settled on a real time basis and transfer of ownership occurs immediately following execution.

However, it has taken longer than expected to agree the measures needed to implement the legislation, including the appointment of a chairman for the regulatory authority. And the major factor holding up the full development of the market is the continued refusal to allow foreign investors to hold shares directly in quoted Saudi companies ? shares can only be bought through a limited number of funds.

Senior ministers in the Kingdom accept that this will come eventually but the process of reaching agreement on such far-reaching changes can be slow in Saudi Arabia. Until this market is opened up to foreign investors, it will be unable to achieve its full potential.

One of the more intriguing long term developments in the region could be the reopening of the Baghdad Stock Exchange, which has the potential to be one of the largest in the Middle East. Trading is expected to start soon on the bourse which has 114 companies. The ruling Coalition Provisional Authority (CPA) has introduced new foreign investment laws that allow up to 100% foreign ownership of quoted Iraqi companies and repatriation of profits. Though the market has been small until now, there is considerable potential to expand, particularly as there are an estimated 192 companies which are in line to be privatised.

However, the real potential of the region?s debt and equity markets will not be realised until they become effectively a single entity. Bahrain has presented itself as a potential base for the Gulf?s stock market, but the leading candidate for the role is now the Dubai International Financial Centre. The aim is to create the ?platform of choice? for governments, institutions and individuals in an area stretching from Africa to the Indian subcontinent ? estimates suggest there are up to a trillion dollars of investable income.

Part of the plan is to create a regional equity market where the top 150 companies in the Middle East and Indian subcontinent can raise money through debt and equity issues. There are also proposals for a link with an international stock exchange, enabling investors to use the one window to access global shares directly rather than through Western markets.

The regulatory structure ? regarded as one of the most sophisticated in the world ? is already in place and the legal framework established.

But it has taken far longer than expected to receive approval from the UAE?s federal authorities ? Dubai is one of seven emirates that make up the UAE and financial matters are deemed to be a federal matter.

Dubai had hoped to get a decree which would allow it to set up its financial centre outside the normal jurisdiction of local law, with its rules enforced by its own courts and regulators. However negotiations with federal authorities have been long drawn out ? though there is still confidence in Dubai that they will eventually reach a successful conclusion.

Nigel Dudley is a freelance journalist.