Subdued oil prices deflated investor sentiment across the GCC throughout most of 2017. However, mid-2017 brought some encouraging developments: news of a possible MSCI reclassification resulted in a spike in the main index of the Saudi Stock Exchange (Tadawul) in the summer of 2017. In 2016 the government launched the National Transformation Programme (NTP) 2020, with the goal of turning the economy around and taking steps towards achieving the objectives laid out in Vision 2030, the long-term national plan to become a modern, diversified economy.
While the onset of the NTP improved investor sentiment by clarifying the government’s long-term objectives, in September 2017 the NTP was revised, postponing some deadlines and removing other elements from the plan altogether. These changes make future progress towards Vision 2030 less certain, which could have negative effects on investor sentiment.
While this may discourage some investment in the short term, an ongoing process of reform carried out by the exchange authorities promises to attract more interest in new market instruments.
Rapid Development
In June 2017 MSCI, the influential index compiler, announced it had added Saudi Arabia to its watch list for possible inclusion on the Emerging Markets Index – a float-adjusted market capitalisation tracker that comprises the indices of more than 20 economies, including Brazil, China, Egypt, Greece, Hungary, India, Indonesia, Mexico, South Africa and Turkey. Inclusion in the index would bring many advantages, such as inflows of capital from the passively managed funds that follow the MSCI, and the secondary gains of greater market transparency and improved business operations as companies move to attract global investors. Although FTSE Russell held back from including Saudi Arabia on its own Emerging Markets Index after its September 2017 annual review, one month later the index provider launched the FTSE Saudi Arabia Inclusion Index Series, which can be used as a transition tool for the possible inclusion of the Kingdom in the FTSE Global Equity Index Series.
The watch list status of the Tadawul and the recent launch of FTSE indices are recognition of the market’s recent progress, thanks to reforms in 2015 that opened it up to foreign investment for the first time, catching the attention of investors worldwide.
History
Capital market development in Saudi Arabia began in the 1930s when the Arab Automobile Company became the first joint-stock company in the Kingdom. Economic growth and greater exploitation of the country’s oil resources meant the pool of firms soon increased in number, particularly in the power and cement industries. By 1977 there were 14 publicly traded corporations in the country.
The following decade saw a wave of nationalisation across the Arab world, and a number of foreign banks and other financial institutions were brought under central control. These provided the basis for another phase of capital market growth, beginning in the mid1980s, when the government tasked the Ministry of Finance (MoF), the Ministry of Commerce and Industry, and the Saudi Arabian Monetary Authority (SAMA) with establishing proper exchange infrastructure.
This new scheme was intended to replace the informal system, which relied on a network of private brokers. A new committee, made up of representatives from both the ministries and the central bank, was given the mandate to develop and implement the regulations and controls on which a formalised market could be built, while local commercial banks were authorised to act as its brokers. In 1990 SAMA established Saudi Arabia’s first electronic trading system, known as the Electronic Security Information System. The platform linked the central bank with 12 central trading units operated by individual lenders, resulting in a more streamlined market, increased trading activity and narrower price spreads. In October 2001 the stock exchange implemented a more advanced system capable of handling larger volumes that, after some expansions and enhancements, is still in place. In 2003 the government introduced the Capital Market Law, which resulted in the creation of a number of key institutions, including new regulators for the market: the Capital Market Authority (CMA), the Securities Disputes Settlement Committee and the Appeals Committee.
The Modern Market
The increasing points of contact between the Tadawul and the global investment community are reflected in the categorisation of market participants. Until 2017 listed equities were divided into 15 sectors, with their classifications determined at the time of listing and infrequently changed thereafter. In January 2017, however, the Tadawul reclassified its equity market in accordance with the Global Industry Classification Standard (GICS), a system that allows for closer alignment of a company’s business activities and revenue sources to its sector classification.
Its introduction makes the Tadawul considerably easier to compare with other equity markets. Accordingly, the Tadawul, now at the second tier of the GICS hierarchical classification system, has 20 sectors, including everything from energy to real estate investment trusts (REITs). An important feature of the new system is the ease with which companies can move between categories: listed firms are reviewed annually and are under constant surveillance, and their classifications are altered in response to developments, such as changes in revenue sources or major corporate actions that redefine a company’s primary line of business.
While the Tadawul is primarily an equities exchange, it has begun to develop from its start as a single-asset-class platform to include a wider array of financial instruments. In 2010 it introduced the nation’s first exchange-traded fund (ETF), an instrument that facilitates investment in a basket of assets created from listed shares, thereby providing an easy way for investors to create balanced portfolios. The first of these instruments to be listed was the Falcom Saudi Equity ETF. The Falcom Petrochemical ETF and HSBC Saudi 20 ETF have since joined the market, and, according to the CMA, these three instruments had a total of 292 subscribers at the end of 2016.
Regulation
The continued development of the exchange is overseen by the CMA, which has a broad supervisory mandate, as outlined in the Capital Markets Law and its regulations. The authority supervises security issuance, listing, trading, settlement, credit ratings agencies, investment funds, disclosure and governance, licensing and enforcement of regulations.
Over recent years the CMA has worked closely with the Tadawul authorities to open the market to foreign investment. This process started in 2008, when it granted limited access to foreign investors through the introduction of swap agreements. In June 2015 the CMA gave foreign investors direct access to the Tadawul, based on the qualified foreign investor (QFI) model, which for the first time allowed them to become full beneficial owners of Saudi equities.
The QFI approach has proven popular in other emerging markets as a means of ensuring exchange stability, by placing a number of limitations on who can invest. In the Saudi case, the CMA started with a relatively conservative model, which stipulated that QFIs must be an institution, such as a bank, or a brokerage, insurance or fund management company with least SR18.75bn ($5bn) in assets under management. In 2016 these requirements were relaxed, with the minimum assets under management adjusted to SR3.75bn ($1bn), and the definition of QFIs expanded to include government entities, institutions affiliated with government entities, university endowments and any other financial institutions the CMA deems eligible. It remains the case, however, that QFIs are only permitted to hold a maximum of 5% of issued shares in any listed company.
The number of QFIs participating in the Tadawul grew by 176% over 2016 to reach 47 institutions. Early entrants to the market included some of the world’s most prominent asset management brands, such as HSBC Bank, Ashmore Investment Management, Silchester International Investors, Citigroup Global Markets, Ashmore Equities Investment Management US, Black Rock Fund Advisors, Ünlü Menkul Değerler and La Française Asset Management.
Strategy
The opening up of the Tadawul to foreign investment is part of a broader effort to transform it into the Middle East’s leading capital market and one of the top 10 in the world, a drive that is in line with the aims of the NTP and Vision 2030. While the results of the NTP’s September 2017 reformulation and how it pertains to the Tadawul are not wholly known, the government has indicated that the plan will be more focused and have clearer governance.
As the Kingdom moves away from its dependence on oil revenue, the Tadawul is expected to play a much larger role in the economy, acting as a platform for raising capital that will serve as an alternative to public expenditure and the banking sector. According to the CMA’s latest strategy, this will require a deepening of the market through the development of debt and sukuk (Islamic bond) instruments, as well as the strengthening of the role of funds. Greater levels of investment will be encouraged by diversifying investment products, attracting more institutional investors to the Tadawul, increasing the market’s attractiveness to foreign investors, and improving transparency through the provision of financial and economic data. The plan also outlines confidence and capacity-building measures, such as strengthening the regulatory framework and increasing the capabilities of authorised persons who interact with the Saudi Stock Exchange on a daily basis.
Deeper Market
In 2016 and 2017 the CMA and Tadawul authorities introduced a number of market functions directly linked to their desire to deepen the market and make it a more attractive platform for domestic and foreign investors alike.
In April 2017 the CMA implemented its securities lending and covered short-selling framework, which it approved in 2016. These innovations work together to allow investors to borrow and sell securities with the intent to buy them back later at a lower price. This is a basic function of developed markets, and allows investors to make gains in declining markets or hedge against other investments. While short-selling has been slow to gain momentum, in the longer term the trading mechanism could be advantageous in some areas, including liquidity and spread compression (see analysis).
In April 2017 the Tadawul also officially transitioned to a T+2 settlement cycle for all listed securities, replacing the old T+0 framework, under which equity transaction dates and settlement dates were the same. The T+0 framework required investors to pre-fund their securities account when an order was entered into the trading system, which allowed them to meet the instantaneous settlement requirement triggered when a trade order was carried out. However, this type of process can result in liquidity pressures. The T+2 model requires trades to be settled within two working days of execution. The Tadawul is adopting an international standard that allows investors to fund their securities accounts only in response to equities orders that have been executed. The adoption of International Financial Reporting Standards (IFRS) for company disclosures from the first quarter of 2017 is another move towards greater harmonisation with global markets. Additionally, the Tadawul has reduced the tick size – the incremental price movement of a traded instrument – on all instruments other than bond and sukuk issuances. This results in a decreased gap between bid and ask prices, which provides more price options for investors and leads to better price discovery.
The three biggest structural advances in 2017, however, have been the introduction of REITs and the government’s Sukuk Issuance Programme, as well as the launch of a new parallel market with more lenient listing requirements than the main board. The Kingdom is the first in the region to achieve this.
REIT
The CMA introduced its new regulatory framework for REITs in November 2016, marking a significant milestone in the development of the Tadawul. Relatively new to the GCC, but popular in both developed and emerging markets globally, REITs grant investors the ability to direct capital to the real estate market in an easier and more straightforward way than direct investment in developments, which requires large amounts of funds and often does not yield returns for many years. The Saudi model defines a REIT as a close-ended investment company that owns income-producing real estate. It also establishes further stipulations to ensure the long-term sustainability of the REIT as an investment tool: at least 75% of the total asset value must be invested in income-producing real estate; at least 30% of the REIT must be publicly owned; and a REIT’s borrowing costs must not exceed 50% of the fund’s total assets. In terms of assets, REITs are free to invest in residential, commercial, industrial and agricultural properties, while a maximum of 25% of the fund’s total asset value can be invested abroad.
For investors, REITs are an attractive alternative to standard equity investment. In seven of the 11 years from 2005 to 2016 the FTSE US National Association of REITs All Equity REITs Index managed higher annualised returns when compared to Standard & Poor’s 500 Index, according to a recent research paper by Riyadh-headquartered Jadwa Investment.
The advent of REITs in Saudi Arabia is particularly significant in terms of diversification. The Tadawul is primarily an equities market, and as the real estate market – which supports REITs – exhibits different responses to economic conditions, the new instrument offers a non-correlated investment alternative to stocks. The array of property types available to Saudi REITs represents a further level of diversification, as hotels, health and education facilities, and residential properties follow different cycles.
The absence of a minimum value requirement for REIT participation, along with zero tax on remitted dividends, has underpinned the success of Tadawul’s REIT rollout. In May 2017 the initial public offering (IPO) of the Jadwa REIT Al Haramain Fund was oversubscribed by 1257%, raising SR4.53bn ($1.2bn) from 5800 investors. One month later, the Taleem REIT finished with an 890% oversubscription. As of December 2017 a total of seven REITs were listed on the exchange: the Riyad REIT, the Al Jazira REIT, the Jadwa REIT Al Haramain, Al Maather REIT, Taleem REIT, Musharaka REIT and the Mulkia REIT.
The boom in listed REITs is expected to continue into the first quarter of 2018, with a SR1.1bn ($293.3m) vehicle owned by Derayah Financial announced in December 2017. The Derayah REIT starts on December 27 and runs to January 7, 2018. Around the same time, Al Rajhi Capital announced an IPO of the Al Rajhi REIT running from January 1 to 14. The issuance will have a fund size of SR1.62bn ($431.9m), and investors will be offered around 43m units at SR10 ($2.67) each.
Sukuk
To help address the fiscal deficit, in July 2017 the government, acting through the MoF, turned to the sukuk market via its newly introduced Sukuk Issuance Programme. The second half of 2017 saw the year’s first issuance valued at SR17bn ($4.5bn), followed by three more in August (SR13bn, $3.5bn), September (SR7bn, $1.9bn) and October (SR10.3bn, $2.7bn).
In December 2017 the MoF announced it was re-opening its October IPO for a second time. The volume of the additional issuance was set at SR4.8bn ($1.3bn), with a coverage rate of 216%. It is divided into three tranches that will mature in 2022, 2024 and 2027, with respective values of SR2.4bn ($639.8m), SR1.8bn ($479.9m) and SR575m ($153.3m).
The MoF has forecast 2018’s fiscal deficit at SR195bn ($52bn), or 7.3% of GDP, a reduction on 2017’s estimated deficit of SR230bn ($61.3bn), or 8.9% of GDP.
Parallel Market
The Tadawul and the CMA officially launched Saudi Arabia’s new parallel market, Nomu, on February 26, 2017.
While other exchanges in the region have developed secondary markets for private joint-stock companies, the Tadawul is the first in the GCC to offer a parallel market for the public listing of companies. Nomu is governed by a more lenient regulatory regime, which is hoped will encourage more companies to consider the exchange as a fundraising platform. Although there is no upper limit to the size of companies that can list on the new market, the initiative will be of particular interest to small and medium-sized enterprises (SMEs), especially as Vision 2030 has identified these as key drivers of economic growth in the coming years. “The launch of the parallel market was one of the important steps to boost the private sector participation in capital markets,” Hesham Abo Jamee, CEO at Alistithmar Capital, told OBG. “Continued reforms for the sector will draw a positive response from investors.”
Establishing a balanced regulatory framework has been a key consideration of the exchange authorities: the requirements must be sufficiently accommodative to attract businesses that are less accustomed to disclosure rules, and are keen to retain a sizeable stake in their business and its operation, yet robust enough to enable investors to direct capital to the market with confidence. Consequently, there are a number of important differences in the listing requirements between Nomu and the main board. The most obvious is the SR10m ($2.7m) minimum market capitalisation required of Nomu entrants, compared to the SR100m ($26.7m) threshold for Tadawul All Share Index (TASI) listings.
Companies listing on Nomu must also have operated for at least one year – as opposed to three years for the TASI – and they have slightly longer to comply with their quarterly disclosure requirements. Moreover, they are asked to offer a minimum of 20% of their company as free float, while companies on the main board are required to list 30%. There are also important safeguards on the investor side of the framework: only qualified entities are permitted to invest in shares listed on Nomu, including corporates, government-owned companies, GCC funds and companies, investment funds, discretionary portfolio managers, and individuals who have at least SR40m ($10.7m) invested on the TASI, a portfolio size of over SR10m ($2.7m), or the relevant CMA-recognised certificates. The CMA’s exclusion of retail investors, combined with precise provisions, such as disclosure requirements, reporting deadlines for audited financial statements and operational disclosures – represents a relatively cautious approach by the authorities. By comparison, listed firms on the UK’s FTSE Alternative Investment Market disclose their quarterly data on a voluntary basis and have 120 calendar days to meet their annual disclosure requirements. Nomu remains at an early stage of development; it started with five listings in February 2017 and had a total of nine companies by December, ranging from trading companies to ICT and bookstore firms. In October 2017 the CMA announced that foreign investors would be given full access to Nomu from January 1, 2018.
Investor Base
The Tadawul is a retail investor-dominated platform, thanks in large part to the volume of disposable income in urban centres, such as Riyadh and Jeddah. In the third quarter of 2017 corporates accounted for just 16.6% of exchange ownership, while individual investors held approximately 27.3%. A large proportion of these investors are classified as high-net-worth individuals (HNWIs), with portfolios in excess of SR1m ($267,000); or individual professional investors, with portfolios larger than SR50m ($13.3m). Together these two investor groups make up 23.6% of stock market ownership. However, a shift towards more institutional ownership is considered advantageous in terms of the stability of the exchange. “Overall, HNWIs from Saudi Arabia are investing more cautiously, but at the same time we are seeing increased interest from Kuwaiti and Emirati investors, in addition to more institutional investment from the UAE,” Ahmad Nasralla, CEO at Maceen Capital, told OBG.
Historically, the dominance of retail investors in the market has resulted in exaggerations in both positive and negative movements of the main index, such as a 1500-point index jump in early 2012 on the back of encouraging economic news, as well as the more recent sell-off, which began in late 2014, when retail investors grew concerned that low oil prices would compel the government to cut spending. The downward movement has been exacerbated by individual investors’ liquidation of securities in order to deleverage from margin calls as collateral values declined. The large number of retail participants on the exchange also results in seasonal volatility: trading volumes tend to decline during the hot summer months before regaining momentum in late autumn. While admittance of QFIs to the market in June 2015 has opened the door to more institutional investment, the effect has been gradual. In the first nine months of 2017 the total value of shares purchased by QFIs amounted to SR884.2m ($235.7m), representing 1.33% of buying activity. The total value of sales by QFIs reached SR1bn ($266.6m), representing 1.55% of selling activity. QFIs, therefore, have yet to substantially impact index direction.
Performance
With the parallel market at a nascent stage of development, the TASI remains the principal measure of market performance. The fall in oil prices, which began in the second half of 2014, has placed downward pressure on the Tadawul’s main index: in September of that year the TASI hit its recent high of just over 11,000 points, but by early 2016 the absence of any substantial recovery in oil prices resulted in the index falling to around 5400, which marks a recent low. While it experienced a modest recovery over 2016 – passing the 7200 mark just before the close of the year, up 4.32% – the muted investor sentiment prevailed for much of the first half of 2017.
However, the June 2017 news that the Tadawul was placed on the MSCI watch list for an upgrade to emerging market status resulted in an uptick on the TASI, which rose from approximately 6800 to nearly 7500, before settling again into a horizontal channel.
The third quarter of 2017 saw the TASI close at 7283 points, an increase of 1660 points and up 29.51% over the close of the same period of 2016. Total market capitalisation also increased, rising by 29.9% year-on-year to SR1.72trn ($458.55bn). As of late December, the TASI stood at around 7200, roughly on par with end-2016.
In terms of sectoral activity, banks accounted for the highest value of shares traded over the first three quarters of 2017 – 28.7% of the total – followed by materials (21.9%) and the insurance sector (10.2%).
In the absence of any substantial rise in the cost of oil, many see the structural reform of both the stock exchange and the broader economy as important drivers of market growth. “The MSCI announcement this year has put a floor under the market, and there is quite a lot happening in other areas. Each sector is going through a process of reform, with new regulations being applied to them,” Ziad Aba Al Khail, managing director and CEO of Aljazira Capital, told OBG.
Outlook
With most forecasts seeing only modest rises in oil prices, investors are waiting to exploit other market disruptions. One of these may come from the flotation of Saudi Aramco, the state-owned petroleum and natural gas company. The government is expected to divest itself of 5% of the energy giant, and plans to channel half or more of the proceeds into domestic investment. Aramco will be listed on the Tadawul and other exchanges, and is expected to raise almost $2trn.
Over the short term, the Tadawul is set to introduce its new tradeable rights framework, which enables right entitlements of listed companies undergoing rights issues to be listed and traded. It is also working with the government on a framework that will result in the listing of government debt on the exchange, where it can be traded on the secondary market. This would represent progress in the development of the debt market, as it would create a yield curve by which corporate issuers could gauge their offerings. The rollout of a range of equity derivatives is also expected to take place with the launch of a central counterparty clearing house.
The Tadawul claims these reforms are being undertaken for their own sake, rather than as a means to secure an MSCI upgrade. However, the potential listing of the stock exchange on the MSCI Emerging Markets Index would be a key development, and would both attract foreign capital and strengthen the appeal of the Tadawul to domestic investors, who might see international oversight as an indicator of good governance.
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