In late December 2010, officials from the Saudi stock exchange (Tadawul) met representatives of 29 regional banks and brokerage houses to quiz them about their preparedness for handling foreign accounts.

When news of these discussions leaked in January, Riyadh’s financial community was agog with rumour. Was this finally the precursor to a full opening to foreign investors, heralding potentially the biggest reform to a Middle Eastern stock market since Egypt acquired emerging market status?

Things have since gone quiet, with the outbreak of political unrest across the region quelling policy activism on several fronts, beyond the increase in public expenditure.

Gradual opening of the Saudi stock exchange

The Tadawul is nonetheless heading, at its own pace, in the direction of a full opening for foreigners to Saudi equities. The discussion is now about the timing and the potential impact this opening could have on regional bourses.

Until now, the Tadawul has been indirectly open to foreign investors through swaps agreements, mutual funds and exchange-traded funds (ETFs). In 2007-10, the Capital Market Authority (CMA) moved progressively to widen participation as part of a calculated attempt to put the kingdom on the international investor radar – yet without offering them full direct access.

[The Saudi authorities] don’t want to launch something without a reasonable expectation of things working out

Jarmo Kotilaine, National Commercial Bank

In December 2007, however, inspired by moves to establish a regional common market, the market was opened up to GCC nationals for the first time. Then in August 2008, the CMA approved rules allowing non-Arabs to participate in share trading through swap arrangements with local CMA-licensed intermediaries. Previously, foreign investors’ access was restricted to mutual funds. Then in 2010, the authorities allowed ETFs to trade in the bourse.

This gradual market opening has given foreign investors a taste for Saudi equities, with swaps enabling foreign institutions to take positions in the Saudi market. 

But it has not radically transformed the Saudi market. More work is needed to dismantle the barriers to foreign access, and take advantage of latent institutional interest in the region’s largest stock market.

“People are put off by the method of market access – it’s that rather than the market itself that is disincentivising foreign investors,” says Paul Gamble, head of research at the local Jadwa Investment. Trading volumes among foreign investors remain low. In June 2011, foreign buys under swap agreements accounted for only 0.4 per cent of total buys on the Tadawul. In contrast, Saudi corporate and individual buys accounted for 95 per cent. 

Although swaps and mutual funds enable non-locals to dip their toes in the water, they are an inadequate means of exposure to the highly liquid large capitalisations that trade on the bourse. Yet even if the method of investment is unattractive, these swaps and ETFs could grow in popularity if it becomes clear the CMA is serious about moving to a full opening.

“You might find people using swaps quite a bit more as a precursor to getting in,” says Fahd Iqbal, strategy director at Egyptian finance house EFG Hermes.

While swaps – which do not give foreigners voting rights – do allow hedge funds to invest, they are unable to channel all-important institutional investment flows that would boost trading on the exchange. Retail investors account for about 95 per cent of trades on the Tadawul, which has made the bourse particularly vulnerable to volatile investment patterns. 

Any decision to sanction a full market opening to foreigners would require a political decision at the highest level. However, the regional turmoil has prioritised other areas of policy-making, meaning any decision is unlikely to be reached until at least the end of the year.

Preparatory work on Tadawul

That does not mean that opening up the Tadawul will be shelved. Behind the scenes, officials are working to position themselves so that if the decision is taken, they can implement it quickly, say insiders.

“What is less clear is to what extent regional turmoil has discouraged the authorities from proceeding with their plans,” says Jarmo Kotilaine, chief economist at National Commercial Bank. “But preparatory work is ongoing and they are in a position to mobilise the plan relatively quickly once the political will materialises.” 

The recent performance of the Tadawul demonstrates why opening up to foreign investment would be of major benefit.

Despite generally strong macro-fundamentals, Saudi share traders have shown heightened risk aversion in 2011. Political risk is expected to undermine investor sentiment in the rest of the year, provoking sharp moves in share prices. March was an extremely volatile month for the TASI all-share index. It hit a two-year low on the back of the unrest before new government spending commitments helped it to recover to almost exactly where it finished last year.

In a reversal of the situation in many other emerging markets, it is the foreigners who are proving to be more confident than the locals. Foreign investors remained net buyers in March, but net sales by Saudi individual investors were by far the largest since at least 2007, notes Jadwa in its March 2011 Saudi factbook. 

Net sales by foreigners through the swap agreement in January were worth SR905m ($241m), compared with average net purchases of SR290m a month during 2010. Local individual investors, who accounted for 86 per cent of transactions, made by their largest net sales since the data was first released in January 2008.

Stabilising role played by foreign investors

Foreign investors have played a stabilising role this year and remain positive in the market. “You would generally expect them to be long-term investors, since a lot of them are institutions with a long-term view,” says Gamble.

This phenomenon – of foreign investors being less risk averse than the locals – undermines the traditional argument put forward against reforming entry rules to the Tadawul.

“The main concern of Saudi authorities has historically been to do with hot money,” says Kotilaine. “They’ve seen the ups and downs of the Egyptian bourse [which allows full access to foreigners] and that is what they are mainly concerned with. They don’t want to launch something without a reasonable expectation of things working out to their satisfaction.” 

But the hot money argument is flawed. “The hottest of hot money is the local money, which comes and goes as it likes and is motivated by factors that have very little to do with fundamentals,” says Kotilaine.

An example of this is how the spending initiatives announce by King Abdullah have impacted on local investor sentiment. Jadwa noted a jump in trading by Saudi individual investors in April, accounting for 90 per cent of total trades by value, the highest since October 2009. Jadwa says this was the result of public-sector pay bonuses being used for stock market investment.

Even if foreign investors come and go, they could serve as example to locals.

The CMA instinctively prefers the institutional players, with their long-term strategies, their preference for research and their positive impact on retail investor behaviour. “The regulator likes the investment banks, pension funds and foundations that operate in emerging markets. In practice, you bring in more retail money as well, because investment banks also serve retail clients,” says Kotilaine.

The much-hoped-for transformation may not happen overnight, however. Foreign pension fund managers will need to gain comfort with Saudi risk, which could take time. “You can’t expect an overnight transformation, so the short-term impact could be quite limited,” says Iqbal.

However, in the longer term, removing barriers to foreign entry will have a huge bearing on the wider region’s capital market.

Saudi Arabia, if it allows direct foreign entry, would eventually be considered for inclusion on the MSCI Emerging Market index. In the meantime, EFG Hermes estimates that frontier market funds have about $12bn of assets under management. If subsequently one-third of that is geared towards Saudi Arabia, that will clearly have a decisive impact.

“Right now the Kuwait market represents a good 35 per cent of the frontier market index, but once Saudi Arabia comes in it will skew everything and will become by far the largest market. Suddenly, there could be a great deal of frontier market money that will need benchmarking to the Saudi bourse,” says Iqbal.

The prize for foreign investors is pretty clear: a market capitalisation of $318bn makes the Tadawul the largest bourse in the Arab world, and few fund managers would pass on taking positions in robust blue-chip firms, such as Saudi Basic Industries Corporation or Saudi Telecom.

An even split between institutional and retail investors

Saudi officials are unlikely to get too carried away and will be aware that since Egypt gained emerging market status, institutional money has started coming in increasing volumes, but the proportion of value traded that institutions accounted for has stayed more or less the same.

“The split between institutions and retail investors has remained even in Egypt, because as more money comes in from institutions, it attracts retail money as well,” says Kotilaine.

What is clear is that the Saudi authorities are serious about reforming their stock market and putting the kingdom firmly on the international institutions’ map. “There is one direction you go in and everything so far has to be seen as a step towards a wider opening. When they started the process they knew what the logical end would be. They obviously have the wherewithal to control the timing of process. but it is a process that is only going in one direction,” says Gamble.

Unfortunately, for potential investors, the Arab uprisings have clearly pushed back the time frame a little.