Having long boasted the Gulf's most mature and sophisticated bourse, Kuwait is coming under increasing pressure to reform its capital market. It has performed strongly in the first few months of the 2008, posting 15 per cent gains on the start of the year, but controversy continues to blight the stock market.

Regulatory issues have arisen in the only Gulf state that still lacks an independent financial regulator. In mid-April, nearly one-third of listed Kuwaiti firms joined forces to demand that the Kuwait Stock Exchange (KSE) retract rules introduced in October 2007 intended to halt all trading in shares of companies that buy into or sell out to firms that have previously been turned down for listing, or have failed to list within a specific timeframe. The KSE also said it would halt trading for a year in companies that have more than quadrupled their share capital.

The new rules are designed to improve transparency and protect investors from investing in fake stocks, as happened in the financial crash that hit Kuwait in 1982 (see box page 46).

But key Kuwaiti blue-chip companies have spoken out strongly against the rules, among them the Zain mobile phone group, Islamic finance institution Investment Dar and the country's biggest industrial conglomerate, National Industries Group Holding Company. These market heavyweights claim the new rules are too bureaucratic and will deter the foreign investors the KSE is looking to attract.

So far, the Kuwait Chamber of Commerce & Industry has struggled to reach a compromise on the issue. However, another new set of rules has found more favour with business leaders. A new tax law clarifying foreign investors' tax position is primed to boost the number of non-Kuwaiti investors.

Under previous legislation that dated back more than 40 years, a 55 per cent duty was imposed on foreign companies' earnings. While this was not imposed on firms trading on the stock market - non-Kuwaitis are able to invest in all stocks - the absence of clarity on the issue proved a major disincentive to foreign portfolio investors.

The new law slashes the corporate tax to 15 per cent and provides assurances that the stock market will be exempted from this levy - even though this may not be enough for some.

"The recent tax law change is quite positive," says one Kuwaiti banker. "The big change is the exemption of trading profits on the KSE for foreign investors, but it is not yet clear whether the exemptions cover dividends as well as capital gains."

Kuwaiti tax officials have insisted that the exemption applies only to capital gains, but clarification is still needed over which contracts qualify.

Some analysts already detect a substantial increase in transactions from foreign investors, retail and institutional, in the wake of the tax law.

National Bank of Kuwait Capital has detected a doubling in the average value of trading to about KD200m since the law was implemented. "It shows that foreign investors are starting to look at Kuwait seriously as a market," says Faisal Hasan, head of research at local investment company Global Investment House. "They see attractive equities and are asking about evaluations."

Not all of this can be attributed to the after-effects of a more substantial tax regime. The KSE has staged a strong revival since the 2006 Gulf downturn, from which it suffered far less than other regional markets. In 2007, the KSE index closed up by almost 30 per cent year on year, while its current $213bn market cap is exceeded only by the UAE and Saudi Arabia. The 197 stocks traded on the bourse make it the largest in the Gulf in terms of the number of listed firms.

Positive returns

The 15 per cent rise in the index in the year to date is better than all GCC markets bar Oman. Kuwait is also the only GCC stock market to register positive returns in all three months of the first quarter of 2008.

Daily trading activity in March was above KD205m and all sector indices were up, with the exception of the food sector. The banking sector is currently the best performer, with the index soaring by 7.8 per cent in the month.

The bourse has been relatively untroubled by the recent political tumult in Kuwait after the parliament was dissolved in March. According to Global Investment House, despite a decline in the Kuwait market partly attributed to political uncertainties prevailing since the resignation of the cabinet on 17 March, the market should firm up in the coming months on the back of new positions taken up by investors.

Yet the KSE cannot claim complete immunity from Kuwait's fractious political and commercial environment. There is a need for better regulation. However, plans for a new independent regulatory authority remain deadlocked after the dissolution of parliament in March. The existing system of market self regulation - similar to the London Stock Exchange - has proved successful, but recent disputes suggest the KSE is finding it more challenging to arbitrate between divergent interests.

The courts have frequently been called on to settle disputes between the bourse and the big Kuwaiti companies, often finding in favour of the latter. For example, in 2007, the KSE banned local conglomerate Kharafi Group from trading shares in 10 of its firms, accusing them of violating disclosure rules. However, the courts overturned the decision. The continued adversarial relations between the stock market and trading companies could undermine attempts to attract more firms to list.

The feeling is that an independent regulator would have proved more effective in articulating a better working relationship between the KSE and listed firms. The listing dispute is essentially a turf war between the bourse and listed firms, the latter claiming inadequate consultation over key measures.

An independent stock market regulator would help to end such disputes. It would also enable the KSE to assert its status as a leading regional exchange in an increasingly competitive marketplace.

Kuwait has a compelling economic need for a strong stock market as the local banking sector lacks sufficient capacity to meet the financial needs of the private sector. Kuwait needs its stock market to work as a mechanism for raising capital for local companies.

Innovation may be the key to enhancing the Kuwait stock market's ability to compete with emerging regional hubs such as Dubai and Qatar. There is growing evidence of innovative thinking by key investment houses such as Investment Dar, which requested permission in 2007 to open up an Islamic stock exchange. Dar has applied to the Kuwaiti government for permission to set up the sharia-compliant equities market, in which it would become a founder member.

The KSE is making efforts to modernise its operations, and is reported to be in the market to buy a trading platform from a leading European exchange such as Deutsche Borse or Scandinavian bourse OMX. US management consultant McKinsey has been retained to review the Kuwait bourse's performance, and is making proposals for the reform of the trading and administrative system.

McKinsey's view is that the things Kuwait needs to do to make its stock market work properly can all be achieved. "The idea that foreign investors are not interested in KSE is not true, but the KSE needs to do things to make it more attractive to them," says a McKinsey analyst.

With political problems obstructing change, a stock market regulator still looks some way off, leaving a danger of more disputes disfiguring the corporate landscape. If the Kuwaiti leadership is serious about its stated desire of making the KSE the foundation stone for the transformation of Kuwait into a regional business hub, it needs to act fast to install the financial apparatus that would allow the Kuwaiti stock market to reach its full potential. A regulator would be a good place to start.

Kuwait all-share index - top 5 firms by market cap

1. Zain - $28.2bn

2. Kuwait Finance House - $21.8bn

3. National Bank of Kuwait - $20.3bn

4. National Industries Group - $8.2bn

5. Gulf Bank - $7.6bn

Source: MEED

When the bubble burst

Kuwaiti investors with long memories may be forgiven a sense of disquiet at the continued lack of a stock market regulator. Back in 1982, the emirate suffered the world's biggest ever speculation-driven stock market crash. The Souk al-Manakh - or camel market - was the name given to an unofficial and unregulated stock exchange that operated out of a converted garage in Kuwait City. It revolved around an arcane system of post-dated cheques with money borrowed from banks - an informal form of margin financing peculiar to Kuwait.

Many of the offshore companies whose shares were being traded could only boast paper assets, but investor appetite proved insatiable as many assumed that the oil boom would last forever. It did not. When the bubble burst in August 1982, total debts among Kuwait investors were estimated at more than $92bn - well in excess of the country's gross domestic product (GDP) at the time.

The government was forced to bail out speculators in September 1982, when the Finance Ministry ordered all dubious cheques to be turned in. The net result was a loss equivalent to $90,000 for every Kuwaiti person. The government swiftly shut down the Souk al-Manakh, building a new stock exchange from scratch. But the calamity still shapes Kuwaiti thinking.