For the past few years, reports have circulated each January that Saudi Arabia is on the verge of opening up its stock market to foreign investors. These rumours would escalate for a few weeks before the regulator, the Capital Market Authority (CMA), would subsequently deny it.

This year was no different. If anything, the stories seemed even more convincing that the Saudi Stock Exchange (Tadawul) was about to open its doors to foreign investors. The market rally since the beginning of the year is thought to be partly the result of buying on the expectation that foreign investment would soon be flooding in.

Tadawul trading activity 2010-2012

Predictably, the CMA came out in early April to talk down expectations of an imminent liberalisation of foreign trading restrictions.

Opening up to foreign investment

But this year really was different. Multiple senior sources in the kingdom confirm the CMA is now technically ready to start opening up to foreign investment. The head of capital markets at one local lender says his bank has already executed trades on the Tadawul from a London-based trading desk. The trades were part of “systems testing” for the CMA, says the banker, and took place in late 2011.

Another senior figure at an international bank says the CMA has been technically ready to open the market since late last year, and had hoped to do so this year. It has since had to delay those plans because of a lack of consensus within the government.

“The CMA was ready late last year, but now it is getting more delayed and they are taking things more slowly,” says the banker. “It is not yet agreed at the Council of Ministers level.”

The Riyadh-based head of trading at one international bank confirms the sentiment. “We know they are ready and prepared to do it, but no one has any idea when it will actually happen,” he says.

There are also suggestions that Riyadh may have been talking with index provider MSCI about gaining a classification as an emerging market. If that happens, Saudi Arabia could attract billions of dollars of investment from funds that take their direction from MSCI classifications. It would also mean the Tadawul would leap-frog exchanges in the UAE and Qatar, which have been striving for emerging market status for years.

“The MSCI rules are a bit of a grey area, but in terms of liquidity and market capitalisation the Tadawul would dwarf other frontier markets, so it could make more sense for it to be classified as an emerging market,” says the trading head.

For the Saudi authorities, the rationale for opening the market to foreign investors is clear, but that does not mean they are without their concerns. While institutional investors will help the retail-dominated capital markets in Saudi Arabia mature, a flood of foreign money risks creating another equities bubble.

The allure of investing in Saudi Arabia has only increased as a result of its prohibition. “Appetite and investor interest in Saudi Arabia is enormous,” says Tiernan O’Rouke, executive director of trading at the US’ Morgan Stanley in Riyadh.

Tadawul an active exchange

The attractions of investing in Saudi Arabia are clear. The kingdom is currently one of the strongest economies in the world, with hardly any debt, more than $500bn in foreign savings and is the world’s second largest oil producer. The Tadawul, meanwhile, can boast of being one of the largest and most active exchanges in the region. Its market capitalisation dwarfs that of the Egyptian bourse, the only regional exchange recognised by index provider MSCI as an emerging market. Average daily turnover, at more than $1bn, is higher than in Turkey, Egypt and Mexico. In the UAE, it is about $100m.

Tadawul market breakdown, 2011
Registered investors by type
Individual 4,099,527
Company 2,225
Government 202
Mutual fund 382
Swap agreement 25
Registered investors by nationality
Saudi Arabian 4,046,079
GCC 4,751
Arab resident 22,187
Foreign resident 29,312
Swap agreement 32
Source: Tadawul

At present, the only way to gain access to the Tadawul for foreigners is through swap contracts. These were launched in 2008, but have failed to gain traction as they force investors to waive voting rights and do all their trading through local counterparts, which adds to both the risk and cost of transactions. As a result, penetration of international investors has been low and is estimated at less than 2 per cent of all trading activity.

For the kingdom, opening up the market would offer several benefits. Replacing fickle local retail investors with foreign institutions should reduce volatility over the longer term and bring share valuations more into line with business fundamentals. At the moment, market rumours often lead sentiment.

As international investors gain more prominence in the local market, they would also help to improve standards of corporate governance and financial transparency, and drive more strategic decision-making. They would also boost trading volumes and potentially lowering transaction costs while making the economy more efficient through better allocation of capital.

Foreign investment brings volatility fears

Riyadh is well-aware that not all the implications of foreign investment are positive; increased foreign ownership will lead to greater correlation with global markets. There are fears that a sudden flood of foreign investment could disappear as quickly as it arrives, actually increasing volatility. After the crash of 2005, the government faced intense pressure to find a way to prop up the stock market and stem the losses being suffered by individuals.

Perhaps more significant, and most politically sensitive, is that stock markets have typically been used as a tool for distributing oil wealth through the population. Petrochemicals firms make up 35 per cent of the Saudi stock market. They also benefit from cheap gas allocations from the government. There is a prominent view that allowing foreigners to own those shares would amount to national wealth leaking out of the country.

Saudi Arabia is also in the fortunate position of not really requiring foreign investment. “We want to open the market, but also want to make sure that we do not jeopardise the stability of the system,” says one government source. “We would like to have the investment, as it will make the market more efficient, but if we have to wait another six months or one year, it doesn’t matter. We are under no pressure to do it and we will do it when it is good for us.”

It is expected that the opening up of the market will be incremental rather than a sudden removal of all restrictions. The first step is likely to be approving some qualified financial institutions (QFIs). These are expected to be large international investors with emerging market expertise, although the criteria is understood to still be under development. Initially, they will probably face a range of restrictions, such as foreign ownership limits on local stocks, restrictions on dividend payouts and exclusion from initial public offerings.

The CMA is then expected to start amending the rules and approve more QFIs, thus expanding the participation of foreign ownership on the exchange. “Over time, limitations will change, but there will be no big bang,” says one banker in Riyadh.

Despite the CMA pouring cold water on optimism about the market opening imminently, there is still confidence that it will happen. “The market will open,” says David Dew, managing director of SABB. “There has been a lot of groundwork prepared to ensure there is the right regulation and supervisory environment, but there will be modest and gradual steps on a sustained path to a full market opening.”

In a further sign the government is determined to modernise its capital markets, King Abdullah bin Abdulaziz al-Saud sent a well-publicised letter to the CMA in April, demanding that traders profiting from abuse of the market be punished, even if they are members of the royal family. Those sorts of intentions will be a relief to foreign investors. Plans to update the listing rules and even allow foreign companies to float shares in Saudi Arabia are also signs that a gradual opening up is taking place.

Pandora’s Box

Ultimately, both sides have something the other wants. Investors would love to be able to gain exposure to Saudi companies that benefit from the country’s vast oil wealth and economic growth. Riyadh, meanwhile, recognises the need for its economy to diversify and the role deep capital markets maintain in achieving this. But if the process goes wrong, it is the government that will be left to deal with the fallout of yet another stock market crash, while foreign investors cut their losses and leave. That means that even if moves to open the exchange are announced in six to 12 months, it will only be an incremental change.

“The Saudi’s will continue to be very cautious,” says one international trader based in Riyadh. “They know that once you open Pandora’s Box you can’t shut it again.”

Key fact

The Tadawul’s average daily turnover, at more than $1bn, is higher than in Turkey, Egypt and Mexico

Source: MEED