The bickering among GCC members over their decision in May to locate the GCC Monetary Council, the likely precursor to a regional central bank, in Riyadh rather than Abu Dhabi obscures what is a milestone in the development of the kingdom's financial sector.

Critics' concerns over Riyadh's growing influence in the GCC - the Saudi capital already hosts the main decision-making body, the GCC General Secretariat - have centred on the political motivations behind the decision rather than its implications for the city as a future financial centre.

Regulatory experience

While many Western and Gulf bankers still have qualms about Riyadh's suitability as the regional financial centre, these concerns are more to do with the kingdom's lifestyle constraints than its credentials for the role.

Few question the ability of the country's central bank, the Saudi Arabian Monetary Agency (Sama), to oversee the Saudi capital market's development. "Saudi Arabia has the experience on the regulatory side far more than anyone else in the region," says John Sfakianakis, chief economist at Saudi bank Sabb.

Key to the kingdom's pitch to host the Monetary Council was the fact that Sama has proved itself a capable regulator, helping the Saudi financial sector avoid significant collateral damage from the global sub-prime crisis.

"Saudi Arabia has the largest economy, and arguably the best central banking system," says Eckart Woertz, head of the economics programme at the Dubai-based Gulf Research Centre. "It has done well in managing assets conservatively and reining in lending through conservative capital requirements far more decisively than other central banks in the region. However, visa requirements and lack of openness are concerns, and it may have been better to give it to Abu Dhabi to keep the power balance within the GCC."

As the research report Envy of the G20, issued in June by Banc of America Securities-Merrill Lynch Research, argues, Saudi Arabia is better positioned than most GCC countries to weather the global recession because it was more prudent during the boom and has a large internal market with growth potential.

The Saudi banking sector will suffer a deterioration in asset quality in line with the cyclical downturn, but this will not be part of a systemic problem, the report says.

"Sama has been proactive in ensuring sufficient liquidity, cutting rates aggressively and ensuring that what was happening elsewhere in the world would have limited impact here," says Nish Popat, Dubai-based head of fixed income at ING Investment Management Middle East.

This economic rationale helped the GCC governments overcome concerns over the limited openness of Saudi Arabia's capital market, and the banking sector's more domestic focus compared with that of Bahrain and the UAE, for example. Catering for a larger domestic market than those two financial centres, Saudi financial institutions are less internationally focused.

The argument for a single central bank has gained added impetus as a consequence of recent financial problems identified at major Gulf companies.

Sama's unexplained freezing of accounts held by Maan al-Sanea, chief executive officer of the local Saad Group, in late May is a sign of the need for greater transparency in the region's business affairs. With banks from Oman to Bahrain facing a trail of exposures to defaults by the Saad Group and Ahmad Hamad Al-Gosaibi & Brothers, the case for a unified central bank capable of stopping the cross-border rot has become more compelling.

With Riyadh's 'victory' confirmed, many believe the region should now move beyond the question of whether Riyadh, Abu Dhabi or Qatar is the best place to locate the monetary council, and focus instead on what kind of monetary policy should be pursued.

Saudi commentators point out that the Riyadh location does not mean Saudi Arabia will be able to dictate policy.

"We should not assume that because the new GCC central bank will be hosted in Saudi Arabia, the Saudi monetary authorities will dictate monetary policy," says Said al-Sheikh, chief economist at Saudi Arabia's National Commercial Bank (NCB). "There is no relation. The monetary council will represent different parties and will share the experience of different central banks."

King Abdullah bin Abdulaziz al-Saud has already given guarantees that monetary union decisions will be reviewed before implementation. In any case, with a smaller four-state group of Saudi Arabia, Qatar, Bahrain and Kuwait committed to monetary union, there are unlikely to be significant differences over policy, particularly in a pegged currency climate.

For Saudi Arabia, the more interesting question is whether the new monetary council's location will influence the development of its own financial market. There is evidence to suggest it already has.

The Saudi authorities' reforming zeal this year has impressed many. They have taken an increasingly active approach to deepening the country's capital market, focusing on the development of the debt market. In February, the new head of Sama, Mohammed al-Jasser, urged companies in Saudi Arabia to look at accessing the bond markets for funding.

Monetary policy

On 13 June, the financial markets regulator, the Capital Market Authority (CMA), gave approval for brokerage firms to buy and sell both Islamic bonds (sukuk) and conventional bonds. Bonds and sukuk can now be issued, listed and traded by licensed brokerage firms on the Saudi stock market.

On the first day of trading, SR21bn ($5.6bn) worth of bonds changed hands, dominated by the two large debt issuers: Saudi Arabian Basic Industries Corporation (Sabic) and Saudi Electricity Company (SEC).

The speed with which the authorities brought the system on stream has won plaudits. "They made the announcement and then one week later the electronic system was able to start trading," says Popat.

Though liquidity is still limited in the kingdom, the CMA is looking for corporate issuers to become more proactive. "This move suggests there will be a number of issues in the pipeline over the coming months, and hopefully liquidity will rise over time," says Popat.

The creation of a bond trading market is a response to pent-up demand for alternative capital raising avenues on the Saudi stock exchange (Tadawul).

"Institutions have been calling on the authorities to open up the debt market for trading for a long time," says Popat. "They realise there is great value in opening up the bond market and reducing volatility, by creating a more stable investment opportunity."

The bond market announcement coincided with Riyadh's nomination to host the monetary council, indicating to some a link between the authorities' reform efforts and Saudi Arabia's pretensions to regional financial centre leadership. The lack of an active debt capital market in the kingdom represented a clear gap that the authorities needed to fill quickly, particularly given that Saudi Arabia lags behind its Gulf neighbours in terms of debt issuance. For example, the kingdom did not figure in the top 10 Gulf conventional bond issues last year.

Riyadh will need to maintain this momentum. "It is important for them to follow through by ensuring that corporates start issuing paper, and coming to the debt market rather than going to the banks," says Popat.

A key theme of the Saudi capital market reforms is a growing openness to non-Saudi investors. US investment bank Morgan Stanley's Saudi unit signed the country's first swap agreement in early June, a vehicle allowing foreigners to buy into listed stocks through intermediaries. This followed a CMA decision in August 2008 to allow foreigners to buy shares listed on the Saudi stock market through licensed intermediaries. Under the new system, foreign investors would be entitled to returns related to their share purchases.

These changes have been prefigured by reforms to the Saudi financial institutions' architecture. The establishment in March this year by the General Organisation for Social Insurance of a new fund to invest in local, regional and international stock markets will provide a potential rival to Sama, which has traditionally managed the kingdom's investment portfolio.

The accumulated impact of Saudi financial reform efforts will add depth to a capital market that is already significantly larger than its Gulf neighbours, and compared with some, far less exposed to the global real estate and financial market turmoil of the past two years.

All the kingdom now needs to crown its achievement is a physical manifestation of its burgeoning supremacy. This is due to take shape with the creation of King Abdullah Financial District, a SR36bn project on the outskirts of Riyadh.

It will take time for the project to reach the critical mass of Dubai and Bahrain's financial centres, but it is intended to be more than a Gulf vanity project - it could cement Saudi Arabia's financial market elevation.

"Riyadh offers benefits in terms of capital concentration, regulatory experience and financial depth," says Sfak-ianakis. "Even the existence of Bahrain and Dubai as financial centres stems in part from Saudi Arabia's capital concentration and its ability to generate fresh money."

Key financial sector reforms

• April 2000 - Foreign Investment Act is passed allowing non-Saudis to invest in minority, majority or 100 per cent foreign-owned ventures. It also established the Saudi Arabian General Investment Authority

• October 2000 - Saudi Arabian Monetary Agency grants a licence to Bahrain-based Gulf International Bank to open an office in Riyadh, the first licence issued to a non-Saudi bank since the early 1980s

• June 2003 - Capital Market Law is introduced, creating a regulatory structure including the new Capital Market Authority (CMA) as the regulatory body for the Saudi stock exchange (Tadawul)

• July 2003 - New Insurance Law passed, requiring all insurance com-panies to be locally registered

• 2004 - CMA issues three by-laws to encourage the public to invest in stocks with confidence, and prevent fraudulent practices

• 2005 - CMA announces the licensing of non-bank financial intermediaries. Regulations on the establishment of brokerages are issued, ending Saudi commercial banks' monopoly on share trading in the kingdom

• June 2009 - CMA approves the creation of a domestic bond market