Saudi Arabia is proving to be the region's most ambitious, as well as most important, capital market. The kingdom's financial authorities have been implementing reforms to overhaul the region's largest stock market and open up bond trading.

Once the most prohibitive of the Gulf's stock exchanges, the Saudi stock exchange (Tadawul), with a market capitalisation of $460bn, is finally opening up to foreign investors. In August 2008, the kingdom's market regulator, the Capital Market Authority (CMA), allowed international investors to buy local equities through swap agreements with local companies, giving them indirect ownership of shares.

After a slow start, foreign investors have started to enter the swaps market. In June, they bought SR867.12m ($231m) worth of swaps, compared with SR269m in March.

Implementing reform

Large international investment houses, such as HSBC Saudi Arabia, have welcomed the change. "The swap development was very interesting as for the first time it has allowed foreign institutions to take positions in the Saudi market," says Tim Harrison, head of corporate communications at HSBC Middle East, which runs the largest brokerage in the kingdom.

"The authorities had thought it through, in that although these are swap arrangements, the investor does own the underlying share."

The swap arrangements were preceded by other developments, such as allowing foreigners to buy mutual funds, but it has been a painfully slow process. It is only since December 2007 that GCC nationals have been allowed to invest directly in Saudi equities.

But the pace of reform is picking up. In April, the CMA announced that it was considering introducing investment instruments such as options and futures, and the trading technique of short selling, to the Tadawul. It is also considering introducing exchange-traded funds (ETFs), which allow a group of stocks to be traded in the same way as shares in an individual company.

On 13 June, the CMA launched a new market for trading Islamic bonds (sukuk) and conventional bonds via licensed brokerage firms. This is the kingdom's most ambitious foray yet into developing its debt capital market.

The momentum is being maintained. On 7 July, the Tadawul signed an agreement to allow the US' Dow Jones Indexes to use real-time prices and data to create Saudi indices. The largest index provider worldwide, the US' MSCI, does not include Saudi Arabia in its global indices, but its inclusion is thought to be not far off.

The launch of a Dow Jones index is a significant step in opening up the Tadawul to foreign investors. "The real-time data flow that will be generated should allow foreign investors to access a greater range of products based on the Saudi indices, such as mutual funds and ETFs," says Howard Handy, chief economist at the local Samba Financial Group.

Individually, these measures may not have the kind of impact that would trigger foreign interest in the Saudi capital market, but local investment experts say that together the reforms demonstrate an unprecedented drive to open up the market.

"The significance of the component parts by themselves might not seem meaningful but collectively they point to a determination on the part of the CMA to broaden and deepen the Saudi capital market," says Jamal al-Kishi, chief executive officer of Deutsche Securities Saudi Arabia.

Underscoring these innovations is a focus on improving governance and transparency standards, which is vital if Saudi Arabia is to build and maintain investor confidence. The CMA has been strengthening its oversight of the market - one example being the fines meted out in May to Saudi investor Mohammed bin Ibrahim bin Mohammed al-Issa for insider trading.

"Saudi capital markets have traditionally suffered from a lack of transparency and the recent penalties issued by the CMA are a strong signal to potential foreign investors that it is prepared to use its powers to create a level playing field for all investors," says Handy.

In July 2008, the CMA introduced rules forcing listed Saudi companies to disclose the names of major shareholders who own at least 5 per cent of their shares. In November 2008, the CMA also made earning disclosures, which had previously been voluntary, mandatory in the case of listed firms. It is also considering establishing an autonomous department to monitor listed companies' compliance with CMA rules.

Long-term investors

The governance efforts are part of a concerted approach to attract more institutional investment to the Tadawul. Better transparency standards are also intended to prevent the boom-and-bust cycles that have undermined investor confidence in the market. Dramatic market falls in 2006 and 2008 shook local retail investors, which still account for more than 93 per cent of share trades.

Saudi Arabia has yet to stage a full recovery from the October 2006 market crash, when the Tadawul's market capitalisation hit a peak of $530bn.

Despite an improvement in investor sentiment over the past six months, the Tadawul's market capitalisation at the end of June 2009 was still down almost 40 per cent from the same point in 2008, at SR1.07 trillion ($286.5bn).

At the root of the market's volatility is the dominance of retail investors. On the largest Western bourses, such as the London Stock Exchange, institutional investors account for at least 90 per cent of share buyers. In the kingdom, it is the other way around.

"The Saudi bourse has long been driven by individual investors," says Handy. "One should not lose sight of the fact that one of the bourse's primary functions is to allow ordinary Saudis to share in the wealth of the country through deliberately underpriced initial public offerings [IPOs]. This has helped to spread ownership, but the corollary has been significant volatility."

The authorities' response has been to try to attract more institutional investors to the market, an approach that plays into a wider strategy to diversify the kingdom's sources of finance. The Tadawul has until now failed to fulfil its mandate as a major source of funding for Saudi firms.

The CMA's new ethos is to rebalance the market so that institutional funds eventually constitute the bulk of the investor community.

"It is clear that the Saudis are committed to creating a normal capital market, one that broadly speaking looks and feels like any capital market in the developed world," says Jarmo Kotilaine, chief economist at local bank NCB Capital.

The Saudi capital market is therefore likely to be trading derivatives and commodities eventually. ETFs are particularly attractive to foreign investors as they offer greater transparency than mutual funds. "The Saudis want to move out beyond retail investor-driven volatility and recognise the experience of other emerging markets that have successfully brought in large volumes of foreign money," says Kotilaine.

The authorities' caution, stretching out reforms over time, is understandable given concerns about inflows of 'hot money' from currency speculators amplifying local market volatility. Though the pace of change has picked up, conservatism remains the watchword.

"The CMA's strategy in being gradual and incremental [in its reforms] is the right one under the circumstances," says Al-Kishi. "It is a new market and a young regulator and it will pay to proceed on a well-thought-out basis."

The global economic downturn has had a catalytic effect on the CMA. Before the sup-prime fallout of 2008, it feared that an open capital market would propel an influx of foreign money at a time when liquidity was already abundant. Now that inflation and the attendant problems of the oil boom have subsided, an influx of foreign investment would be welcomed.

"The Saudis need long-term 'sticky' money that does not come and go," says Kotilaine. "If they can generate long-term institutional money, that would be helpful as even at the best of times Saudi banks were struggling to fund projects due to their short-term asset bases."

The series of measures rolled out over the past year form a necessary but not yet sufficient environment for a modern capital market. Additional improvements will be needed. "The most obvious measures would be to allow direct foreign participation in the bourse without the need for a Saudi intermediary," says Handy. "Most analysts also think that the CMA needs to make adherence to corporate governance regulations compulsory for listed firms instead of just voluntary. It is still easy for firms to avoid revealing the size of their debts or levels of cash flow. In addition, company statements tend to be made only in Arabic, [unlike in most other Gulf markets]."

Derivatives may be the next big step, although the CMA is unlikely to allow the range of products that many say helped cause the global banking crash.

"It is very hard to run collective investment schemes in a prudent manner if investors are not able to hedge," says Kotilaine. "In that sense, derivatives are a crucial building block, but certainly no one would advocate the kingdom introducing the most complex and risky instruments."

The debt capital market will also be supported by further innovations. In May, Saudi Finance Minister Ibrahim al-Assaf announced the establishment by the end of 2009 of a new state-owned mortgage securities company, which will buy mortgages from lenders and securitise the loans into sukuk that will be traded on the secondary market.

The consensus is that the CMA will persist with its gradual approach to opening up the market. "Changing the culture will not happen overnight, but progress over the past year is significant," says Handy.

For foreign investors, the ultimate prize is worth waiting for. "Saudi Arabia has the biggest and most actively traded stock market, with the biggest volumes," says Harrison. "It is the most attractive market out there."