The Middle East is at long last starting to develop a capital markets culture. More companies are seeing the advantages of flotation while some Arab investors, who had until recently automatically looked to the Unites States and Europe, are now putting a portion of their money into local stock exchanges.
This trend is being helped by the readiness of most Middle East governments to allow foreign investors to buy shares and the replacement of the traditional over-the-counter markets with formal exchanges, which are independently and more rigorously regulated.
A further boost has come from a new generation of investment bankers, who have opened a series of funds specialising in Arab markets and the readiness of more Gulf countries to accept these instruments even when the funds have some foreign investors.
However progress has been painfully slow and Arab markets are still barely on the radar screens of even the international emerging market funds. It is still very small. Total capitalisation is around USD200bn, which is well under 10% of total emerging market capitalisation.
This is made up of a number of extremely small individual markets, with the Gulf states (Saudi Arabia, Kuwait, Bahrain, the UAE, Qatar and Oman) totalling more than 80% of the region's capitalisation. The largest, Saudi Arabia, accounts for half the capitalisation of the region and it is only USD97bn - which means that trading volumes are low and price movements can be extremely volatile.
There has been some improvement in this latter area. The markets are less prone to extreme peaks and troughs than in recent years though Kuwait, the second largest in the region, is particularly vulnerable to boom and bust. Egypt, once the darling of the some of the more naïve investment bankers, has, also a result of economic corporate mismanagement, plunged from a market capitalisation of USD32bn to little more than USD7bn.
Further problems are that the markets are parochial, attracting little interest even from other Arab states, and the suspicion that many are still suffering from insider trading.
As a result, the region's big merchant families have been even more reluctant to float their companies or raise bonds. This has meant that the financial sector, property companies and old economy shares have continued to make up more than half the equity markets.
There is also a lack of institutional investment from bodies such as pension funds, and research, though much improved, needs to be wider and deeper.
There are other positive signs that these problems are being addressed. Most Arab states now allow foreign ownership to a greater or lesser degree for all except in the most strategically important companies. However, Saudi Arabia only permits it through funds and the UAE, the third largest market, only allows non-nationals to buy shares in two companies, the property company EMAAR and Oasis Leasing.
The improvement in regulation is the most important advance as Arab exchanges move towards standards of transparency that are accepted as the norm in the west. For example, Saudi Arabia has just announced an independent regulator, while Bahrain earlier this year transferred responsibility for regulating the Stock Exchange to the highly respected central bank, the Bahrain Monetary Agency. Jordan's independent regulator is also well respected, and the UAE has also recently introduced a Capital Markets Authority.
There is also likely to be a source of new issues which will broaden and deepen the markets. Most Arab governments are either privatising state industries or using the private sector to develop power and water projects, which would have been the sole preserve of the state sector. This policy, driven by the need to attract new sources of capital, requires a thriving debt and equity market to attract investors.
This has already started to happen in the telecommunications sector, where several state land-line phones have seen blocks of equity floated and new entrants to the mobile phone sector have also been launched as quoted companies.
The enormous potential for a modernised telecommunications sector was demonstrated this year with the flotation by Saudi Arabia of a 30% stake in Saudi Telecommunications. This was the largest initial public offering in the Middle East and was 3.5 times oversubscribed even though sale was limited to Saudi individuals. The offer attracted USD10bn from one million subscribers.
The more active inter-regional market was shown by the purchase of Mobilecom, a Jordanian mobile phone company by MTC, which is quoted on the Kuwait exchange, from Orascom, an Egyptian public company.
Local stock exchanges are trying to persuade the big merchant families that the benefits of raising money from the debt or equity markets more than outweigh any loss of control or the need to reveal more about the company's activities. But most exchanges admit that this is a slow process and that there is little sign of a change in attitude from the older generation that still controls most of these organisations.
On the investment side, there has been an attempt to stimulate more interest by cross listing shares. But this is as yet limited and has failed to make the markets less parochial. Bankers estimate that up to 90% of turnover comes from local players with all but the smallest amount of the rest from other Arab investors. The companies themselves are almost all too small or too little traded to interest global or even emerging market funds.
However, there is a growing awareness of the need to kick-start markets. At present governments hold at least 30% of the equities and they tend to be long-term holders until privatisation. Families and strategic investors, including board members, who are also unlikely to sell, hold a further 30%. This leaves very few shares to be actively traded.
Dubai, one of the seven emirates that make up the UAE, and Bahrain have made determined efforts to create tradable instruments, which they hope will attract more liquidity and change these traditional investor habits.
Bahrain has taken the lead in launching Islamic bonds, both short-term and for three years. These instruments, which are traded on the Bahrain Stock Exchange, provide much needed short-term liquidity for Islamic institutions and also offer rates which could attract conventional investors.
Dubai has been one of the more innovative, raising bonds in the local currency (dirhams) for its national airline Emirates, and for the government. These are both quoted on the Dubai Financial Market.
Dubai has announced the most radical plans for a regional market, which, if they are implemented, will transform the way debt and equities are traded in the region, as well as the behaviour of regional investors.
The Dubai International Financial Centre (DIFC) is designed to provide the first genuinely regional and international stock exchanges in the Middle East - these will operate alongside reinsurance, Islamic finance and asset management markets.
The present plan is for the DIFC stock exchange to have two elements. There will be a regional market, where it will be possible to float and trade in stocks and bonds from a region extending from the Indian sub-continent to Africa. And the DIFC is reaching an agreement with a western stock exchange to set up a trading platform in Dubai.
The main selling point for the DIFC is the quality of its regulation and legal structure. These are being drafted to meet the highest international standards. This, the DIFC hopes, will attract the world's leading financial institutions, some of which have already indicated their readiness to participate.
There is no doubt that the region needs a regional exchange and that over the years the smaller local markets will have reduced importance and eventually disappear. It is also likely that the contest to be the regional exchange will be between Bahrain, which has a long history of efficient financial regulation, and Dubai's plan for independent western-style controls.
However this will not happen overnight. There are issues of national pride and also a reluctance to lose control over key elements of the economy - the dramatic withdrawal of funds from emerging markets after the 1997 emerging markets crash in Asia and Russia has made many Arab countries reluctant to open their markets up fully.
However, there are some signs which suggest that this is probably the best time of all to try and create such an exchange. Arab investors have been looking more closely at the regional markets, following the crash in western equity markets and low returns from keeping money in cash deposits.
Private Arab investors alone control some USD800bn in assets and it will not take much of a shift in their deployment to give a major boost to local equity markets. Bankers think there will be an additional appeal if it is possible to meet investment managers locally and also to trade international shares on a local trading platform.
Of critical importance will be whether markets like Saudi Arabia, which are closed to direct foreign investment, are prepared to open up and see shares in its top companies quoted elsewhere in the region.
Saudi Arabia matters because it is the largest market and one in which there is most active trading - annual turnover is around USD250m a day. The demand for STC shares shows the level of potential demand if there are more investment opportunities.
Saudi Arabia is determined to transform its over-the-counter market (Tadawul) into a properly structured one. This is a key part of the Saudi government's strategy of opening up the country gradually to foreign investment.
Steps have already been taken to create an integrated trading, depository, clearing and settlement system, which is transparent and tightly supervised. All brokers have to attend a trading course and pass an exam.
Most importantly, it has now passed legislation to set up a capital market supervisory body, which operate as a 'Securities Commission', and a formal independent stock market, which will be owned and operated by the private sector. There is also talk about lifting the restrictions on direct foreign investment in the market - many bankers see this as inevitable if Saudi Arabia is to raise thebns of dollars needed to finance its power and water projects. Indeed, as these new flotations happen, Saudi Arabia's dominance of the regional can only grow.
Kuwait and the UAE, with capitalisations of USD35.4bn and USD31bn respectively, vie for the position of the second largest exchanges. However the UAE is constrained by the fact that there are two trading platforms, each with its own set of quoted companies and depository. There is also still an over-the-counter market, though this is gradually disappearing. The restrictions on foreign ownership are also holding the market back.
However the real difference between the UAE and Kuwait is in the level of trading. Turnover in the UAE is little more than USD2m a day while in Kuwait it is up to USD80m. Kuwait has recently announced measures to allow foreign ownership but this is not yet expected to lead to a major boost in activity.
Kuwait's problems stem from high levels of cross ownership which make the market even more volatile and a perceived lack of robust regulation. There are also no custody arrangements and no central depository. A high level of capital gains tax also deters investors.
Bahrain (capitalisation of USD5.7bn) is also open to foreign investors, while Oman (USD2.8bn capitalisation) is raising its foreign investment ceiling to 75% for all but strategically important companies. Qatar (USD7.4bn capitalisation) is planning legislation to open the market up to foreign investors through mutual funds - at present the only share that can be bought by non-Qataris is Qtel, the telecommunications company.
Probably the most respected market in the Levant is Jordan (USD7.3bn capitalisation), which is fully open to foreign investors and well regulated. The market will benefit from further privatisations - the government has already boosted liquidity by selling off many of its industrial holdings.
Full foreign ownership is allowed in the Palestine Stock Exchange (capitalisation USD500,000), which was one of the boom markets a couple of years ago but now shows little activity.
The Beirut Stock Exchange is also open and well regulated but it has yet to achieve the levels of interest or activity one would have expected from such a trading-oriented country. The market is also lopsided with Solidere, the company set up to revive the war-ravaged centre of Beirut, accounting for 60% of the USD2.2bn capitalisation.
Only a couple of years ago the Cairo Stock Exchange would have been the major focus of most articles on Middle East exchanges. But, even though it is open and well-regulated, it is a shadow of its former self and abandoned by local and international investors alike.
It can no longer even claim to be the largest market in North Africa, where the markets are open to foreign investors. The biggest is now Morocco with a USD9.4bn capitalisation, while Tunisia (USD1.86bn capitalisation) also has an active market.
Middle East brokers and bankers have talked about developing their capital markets for more than a decade. In this period they have been too slow at developing the debt and equity investment opportunities that would attract local and foreign investors. As a result that money has continued to find its way into western markets, which removed any incentive to create more products.
There are, though, now more products to invest in and more liquidity looking for a home than for several years. It remains to be seen if the exchanges can create a new virtuous circle of instruments that attract liquidity, which in turn will lead to the creation of more debt and equity investment opportunities.
