Given that Middle Eastern capital markets are among the last to open up to international finance, it’s unsurprising that analysts’ research bulletins on the region often conjure up images of inertia. Consider the headings given to two reports published last year. Robert Fleming entitled a study on Egypt “The Sleeping Beauty”. ING Barings chose “The Sleeping Giant” as the title for the section on Saudi Arabia in its Arab Stock Markets Review.
The authorities in Cairo could justifiably take offence. Egypt is wide awake when it comes to opening capital markets, privatizing with gusto and providing international investors with a steady stream of GDRs. Saudi Arabia, by contrast, is still snoozing. Although it has stepped up its encouragement of foreign direct investment, non-GCC (Gulf Cooperation Council) nationals are still excluded from its stock exchange, the region’s biggest.
Saudi Arabia might argue that its economy does not need the drastic repairs introduced by president Hosni Mubarak’s government over the last few years. The most basic macroeconomic indicators for 1996 do indeed make encouraging reading: GDP, boosted by higher than expected oil prices, is estimated to have risen last year by 8.6% in nominal terms, compared with 4.3% in 1995 and only 1.7% in 1994. In spite of this, inflation last year was kept below 1%, compared with 5% in 1995.
More important, as Kevin Taecker, chief economist at Saudi American Bank (Samba), argues, private-sector activity in the kingdom seems to have picked up over the last year. In an economy that desperately needs to diversify its revenue stream away from crude oil, the private sector – by definition concentrated in the non-oil sector – is an important indicator of industrial diversification. As the Jeddah-based National Commercial Bank (NCB) explains in its latest economic overview, the private sector expanded by 3.5% in 1996, confidence mainly being bolstered by “higher oil prices and the payment of arrears by the government to contractors, farmers and suppliers, to the tune of SR22 billion [$5.9 billion]”. As a result, says the report, “several major private sector institutions which stretched their lines at local banks to the limit in 1995 were able to borrow again after receiving payments from the government”.
Looking to the future, there is a general recognition that Saudi Arabia needs to introduce widespread reform in its economy and its financial services industry if it is to build on oil revenue.
The NCB report implies that higher oil prices may not have been such a welcome development after all. “Even if oil prices maintain the high level attained in 1996,” it warns, “this would not solve any of the fundamental challenges that the country faces, be it overspending, increasing private sector participation, boosting productivity of public sector institutions, upgrading the legal and financial infrastructure, reducing unemployment and downsizing the public sector. It is hoped that the recent rise in oil prices would not lead to the postponement of the reform policies that were introduced in the past two years.”
Temptation resisted
To date, this has not been the case. As Samba notes in its spring 1997 Outlook for the Saudi Economy: “Temptations have been resisted to use the oil revenue uptick for quick-fix bail-outs of financially troubled enterprises. Rather, more fundamental solutions are sought where the aim is to bring these quasi-independent entities into the process of economic reform. As with the rest of economic policy – in uniquely Saudi ways – they will be moving to harmonize with IMF, World Bank and WTO prescriptions for economic openness and liberalization.”
Pressure from these institutions aside, there are good reasons why economic and financial policy needs to change. First, the western stereotype of a desert kingdom luxuriating in fantastic wealth is a myth. One London-based banker insists change has to come simply because “20 years ago Saudi’s per capita income was $15,000; today it is nearer to $5,000. Twenty years ago the kingdom ran no budget deficits; today it has a huge budget deficit to service.” The brunt of the decline in living standards has fallen not on the thousands of ruling princes, but on the poorer sections of society.
Alarmingly, Saudi Arabia’s social indicators are starting to reflect the free fall in per capita icome. A report last year in the Arab Review pointed to estimates that 30% of children in Saudi Arabia do not go to school and that the literacy rate of about 55% is lower than Jordan’s or India’s. Although they are rarely expressed publicly, there are concerns – not just in Saudi Arabia but in many of its neighbours – that this environment is starting to show uncomfortable similarities to that in Iran in the mid-to-late 1970s before the Islamic revolution.
Second, Saudi Arabia’s increasing need to reform its economy in general and its capital markets in particular is also a simple by-product of trends elsewhere in the region. Five years ago the kingdom could rightly claim that its policy on foreign portfolio investment was roughly in line with that of most of its near neighbours. Today, change is spreading rapidly, most notably in Egypt but also in Bahrain and Oman (which are opening their stock markets to foreigners), Lebanon (which is rejuvenating its capital markets), the UAE and Qatar. With even Kuwait reaching an agreement with Cairo and Beirut on the cross-listing of equities, the Saudi capital market is increasingly looking like the odd one out. None of these developments has been lost on the authorities in Riyadh. “From the Saudi perspective the other markets in the Gulf look pretty small,” says Taecker at Samba. “But Egypt is large by Saudi standards and the kingdom is very mindful of the changes which have been brought about there.”
Prerequisites of equity
“Historical evidence,” says one London banker, “shows that volumes of portfolio investment tend to go hand in hand with volumes of direct industrial investment. Clearly if Egypt is going to win more and more investment from companies building a presence in the Middle East, economies which are reluctant to change are going to suffer in relative terms as a result.”
A third important impetus for change springs from Saudi Arabia’s demographic trends. The October 1996 Saudi Arabian Bulletin – a monthly newsletter distributed by the Saudi embassy in London – seemed almost enthusiastic when it reported that Riyadh is now “among the fastest growing cities in the world” – the capital’s population has swollen from 30,000 in the late 1960s to over 3 million today. There are probably more problems than advantages to this sort of growth. It is estimated that the high proportion of Saudi residents aged below 25 implies that over the next 25 years the population will more than double, from 18 million to 39 million.
So between now and 2010, well in excess of $100 billion will need to be invested in power and water alone. Factor in much-needed investment in other infrastructure – chiefly transportation and telecommunications – and it becomes clear that Saudi Arabia has funding requirements that far surpass revenue arising from oil windfalls or piecemeal subsidy cuts.
Henry Azzam, chief economist at the NCB in Jeddah, noted last year that “privatization and larger private sector participation could reduce the burden on the governments, cut the wage bill of the public sector and render several public sector institutions more efficient. Furthermore, the income generated from privatization could be used to retire existing public sector debt, and lower the debt service bill that is threatening to become a burden on governments’ budgets”.
Another well-respected Saudi-based economist, Muhammad Umer Chapra, economic adviser to the Saudi Arabian Monetary Agency (Sama, the central bank), has also called for reforms that will reduce debt and encourage more equity-based financing, although his views are grounded as much in religious precepts as in western economic theory. Over the last decade he has published two highly acclaimed books calling for a reform of the financial system based on Islamic economic guidelines.
Signs are already emerging that the Saudi authorities are prepared to engineer change, albeit cautiously. “The emphasis here is on growth led by the private sector,” says Taecker at Samba. “That came out very clearly in the five-year development plan drawn up two years ago. The first wave of private sector activity here was fuelled by the surge in liquidity which followed the Gulf War. Obviously we don’t want another war to stoke private sector participation in the economy, but I think the authorities recognize that the best way to encourage private sector growth is to invigorate the capital market.”
An invigoration of the capital markets would help lure back some of the vast wealth held abroad by Saudis. It might also help reduce the amount sent home every year by expatriate workers in Saudi Arabia: according to a 1996 UN report on the region, between 1990 and 1995 $100.3 billion in workers’ remittances was repatriated.
“The Saudi capital market must be developed further to encourage Saudis to repatriate their capital to the market,” says Elie El Hadj, managing director and chief executive officer of Arab National Bank (ANB) in Riyadh. “And the best way to do that is to develop an efficient and liquid secondary market.”
One way of doing that, suggest analysts, would be for the government to sell off some of the holdings it maintains in Saudi blue chips. “The government owned 35% of the total shares outstanding in the Saudi stock market by the end of 1995,” says NCB’s Azzam. Although some of this has been diluted by new issues on the Saudi stock exchange, state holdings remain disproportionately large.
Although Saudi Arabia has by far the largest stock market in the Middle East – market capitalization at the end of 1996 was SR172 billion – the large government holdings militate against liquidity. Total equity turnover in 1996 was SR25.4 billion, a turnover rate (shares traded as a proportion of capitalization) of below 15% – on the low side for emerging as well as developed stock markets.
A top-heavy market
Another shortcoming of the Saudi equity market is that it is dominated by eight companies (more than 60% of total market capitalization in 1996), with Saudi Basic Industries (Sabic) alone accounting for close to 24% of the total, and with a cluster of seven banks and electric utilities contributing another 36%.
The government has indicated that as part of the quest for a balanced budget by 2000, it plans to accelerate privatization. In April it announced it was contemplating a local flotation of up to a third of its 70% holding in Sabic. There are also sporadic hints of a long-term government plan to privatize national airline Saudia.
But bankers who insisted on anonymity are deeply sceptical about privatization prospects. “Privatization would lead to unemployment, which is the last thing the government wants,” says one, while another argues that the government has a vested interest in talking about privatization rather than implementing it. He says: “It is very obvious that the monarchy in Saudi Arabia controls the wealth of the country and the monarchy clearly recognizes that if it embraces privatization it will lose much of that wealth and, with it, much of its power. The monarchy is terrified by that prospect. If you’re waiting for widespread privatization under the present ruling monarchy, don’t hold your breath.”
The UN appears to agree with this prognosis, although it uses slightly more diplomatic language in a recent overview of the Economic and Social Commission for Western Asia (ESCWA) region. “Most likely in the next few years the government will move very cautiously with its privatization plan,” this notes, “and implement it through the sale of a portion of its shareholdings and would avoid outright sale of government assets whereby it would lose control of decision-making.”
If over the short to medium term the implications for the equity market of privatization (or its lack) are neutral, there have been other developments over recent months that bode well for longer-term growth. The first is the rapid proliferation of equity mutual funds set up by local Saudi banks tapping both local and international investors. This is helping to foster a rudimentary equity culture among Saudis. It marks an important change: at the end of 1995, according to an update published by NCB, “the number of active investors in the Gulf region as a percentage of total adult population [was] still very low, on the average less than 5%, compared to 20% to 30% in the developed world”.
In part, the explosive growth of the mutual fund industry in Saudi Arabia has been the result of a more relaxed interpretation by Islamic scholars worldwide of the permissibility of equity investment. For years, the problem area for conservative Muslim investors contemplating equities had been not so much the danger of investing in companies involved in “un-Islamic” lines of business, such as brewing and gambling, as misgivings about interest-bearing borrowing. The bigger problem arose as a result of the Islamic ban on riba – a term that encompasses interest as well as usury – which is technically outlawed throughout the Saudi banking industry, but is used daily under a variety of different names.
Disappointed bankers
Given that all companies in which it is possible to invest either borrow regularly (and therefore pay interest) or hold surplus funds they invest in interest-bearing instruments, it became virtually impossible for investment managers to find any suitable FTSE, Dow Jones, Dax or Nikkei listed stocks. The result, throughout the mid to late 1980s, was a succession of smartly attired western investment bankers lining up at the British Airways and TWA check-in counters at Riyadh and Jeddah airports to make their disappointed way home.
Today, Islamic scholars have shifted their stance to a lesser or greater extent. Most are agreed that investment in companies that earn or receive interest is acceptable if these companies are not outrageously geared, and as long as a proportion of the returns are stripped out and passed on to deserving charities.
The result has been so-called Islamic equity funds launched not just by leading Saudi banks, such as NCB, Al-Rajhi and others, but also by foreign banks such as Flemings and Banque Nationale de Paris. These are being marketed to Muslim investors (and sometimes even non-Muslims) worldwide. Their popularity with Saudi investors springs not only from their religious acceptability but also because they have tended to outperform other vehicles. Addressing a conference last year in the US, Said Al Martan, assistant general manager at NCB – which has mutual funds under management of more than $2.4 billion – pointed out that since its inception on January 1 1995, NCB’s Global Trading Equity Fund had risen in value by just over 30%, compared with the MSCI benchmark performance over the same period of 26.4%.
Much of the money generated by the Saudi mutual fund bonanza over the last couple of years has been channelled into overseas markets – Arab National Bank’s latest three capital-guaranteed funds, for example, are linked to the performance of the US, UK and German equity indices. However, the local market has also benefited from increased inward capital flows combined with a more widespread Saudi awareness of the merits of equity investment. Although the 11.7% rise posted in 1996 by the National Center for Financial and Economic Information (NCFEI) index was more a reflection of positive macroeconomic indicators in the wake of the oil price increase than of inflows from mutual funds, increased investor sophistication is also playing a constructive role.
Local equity valuations have also been boosted by the generous dividend yields on offer in the market: by the end of the fourth quarter of 1997, the average yield on equities was around 5%, close to money market deposit yields.
Samba, for one, believes there is scope for further share price increases over the medium term, noting in a recent economic update that the outlook for corporate profitability remains strong and that “the stock market’s P/E multiple is low at 12.8 as compared to P/Es in the low to mid 20s for other emerging markets. In sum, views are that the Saudi market continues to appear undervalued.”
The next key step for the Saudi capital market, bankers agree, would be for it to follow Bahrain and other Middle Eastern markets in opening its doors to foreign investors. As ING Barings noted in its Arab Stock Markets Review last year: “The Riyadh Chamber of Commerce recently commented on a private study of money flows in the Kingdom, noting that foreigners should be allowed to buy property in Saudi Arabia and buy shares on the stock market, although this would call for changes in the law”.
Unlocking equity value
At Salomon Brothers in London, which blazed a trail for the Arab world in November when it led the first non-bank international equity issue from an Arab borrower – a GDR for Suez Cement of Egypt – Mahamed Metwally is convinced that the Saudi stock market will have to open itself up to non-GCC investors. “Sabic is currently trading on about six times earnings,” he argues, “which compares with a P/E ratio for western oil companies of up to 17 times. I am certain that if the company were to open up to foreign capital it could at least double its earnings multiple up to 12 times. That would mean that instead of being capitalized at $10 billion it would be worth $20 billion.”
A precedent for this sort of revaluation has been set by the performance of Egypt’s Suez Cement since its GDR. In July 1996, says Metwally, most local brokers were maintaining bearish “sell” recommendations on the stock on the somewhat flimsy grounds that its 10-year tax holiday was coming to an end. Since then, with foreign investors clamouring for the oversubscribed GDR, the share price has risen from around E£40 ($12) to E£72.
Extrapolating the Sabic ratios for the Saudi market as a whole would imply a doubling of market capitalization from $45 billion to $90 billion. Small wonder bankers reckon there are no sensible arguments against liberalization: $45 billion is a large opportunity cost to pay to keep foreign investors at arm’s length.
The first sign that this message is at last being transmitted to the Saudi authorities came in April, with a breakthrough regarded by most analysts as the most important the Saudi market has seen. Two months ago Sama authorized Samba to launch a closed-ended mutual fund that will be listed on the London stock exchange and allowed to invest directly in Saudi-listed stocks. As countries such as Oman and Mauritius have demonstrated, this tends to be a preliminary to the opening of an exchange to foreign capital.
To Azzam at NCB, the significance of the launch of the Samba fund has less to do with the modest extra liquidity it will bring and more to do with the added sophistication and maturity that will emerge if all goes well. “It’s part of the globalization of capital markets and means that Saudi Arabia is at last joining a sort of international club,” he says. “Hopefully by inviting new and more sophisticated investors into the market we will encourage improved transparency and deeper fundamental analysis, which is what the stock market needs.”
Azzam adds that it is a mistake to see the sanctioning of the Samba fund in isolation. He points, for example, to the introduction earlier this year of a government floating-rate note market as a helpful initiative for investors in a rising interest rate environment. At its bi-weekly auction of government paper, Sama now offers investors three- and five-year FRN issues paying 15 and 30 basis points respectively over floating interbank deposit rates.
Samba’s Taecker is bullish about the medium-term prospects for the capital markets. He notes that “imminent” new legislation will do away with many technical and regulatory hurdles associated with taking companies public. He believes corporates will respond positively to initiatives paving the way for an increased flow of IPOs in the Saudi market for two reasons.
First, with many of the arrears owing to the corporate sector now having been cleared by the government, companies’ balance sheets are in better shape. Second, Taecker says that “one of the exciting things associated with the demographic picture in Saudi Arabia is that you have many of the sheikhs who built up successful companies when they were in their 20s and 30s now approaching retirement age”. The expectation is that they will either increasingly look for exits from their investments by floating them on the local exchange or will pass them on to a younger generation of dynamic, well-educated managers who may also seek to add value via flotations.
Away from the capital market, bankers insist there are other positive indications that point to an increasingly receptive market for international capital.
International banks’ participation in the syndicated loans market for Saudi credits, for example, was given a new lease of life in November 1995 when Saudi Petrochemical Company (Sadaf) launched a $700 million, 8.5 year loan via Bahrain-based GIB and Chase Manhattan that was structured under British rather than Saudi law. Since then, there has been a boom in the market for Saudi loans, with companies increasingly turning to the international syndicated market for funding to support large expansion projects.
In July 1996, an important landmark was established when a big power project – the Gazhlan scheme being developed by state-owned Saudi Consolidated Electric Company for the eastern province (Sceco-East) – raised part of its funding requirement as a syndicated loan. Of the $1.5 billion required for this development, which is being built by Japan’s Mitsubishi Heavy Industries (MHI), $500 million was raised via a 10-year facility arranged by GIB, Chase Manhattan, Al-Bank Al-Saudi Al-Fransi, NCB and the Saudi British Bank (SBB). It was a reflection of the improved international appetite for Saudi risk that the transaction was priced well inside the Sadaf deal at 90bp over six-month Libor, compared with 124bp for the earlier deal.
Syndicated acceleration
This year activity in Saudi syndicated loans has been accelerated, with prices continuing to fall: in January a syndicate of eight banks including Arab National, JP Morgan and IBJ arranged an $850 million 10-year facility for the Arabian Industrial Fibre Company (Ibn Rushid), priced at 82.5bp over Libor, to fund the construction of a new aromatics plant. Other big-ticket syndications have since followed for Hadeed Steel, which pushed the cost of its $370 million facility led by ANZ Grindlays and Sumitomo Bank down to just 70bp over Libor, and the Saudi Chevron Petrochemical Company. Both deals were healthily oversubscribed.
The next stage in opening the Saudi market to private international capital will be the country’s first build-operate-transfer (BOT) power project to fund the expansion of the Shuaiba power station, for which bids were due to have been submitted by the beginning of last month. Bankers expect a number of similarly structured projects will need to be implemented if the kingdom is to eliminate its budget deficit by 2000.
