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Middle EastNovember 7 2005

Saudi’s new bond market beckons

The pace of Saudi capital market reform is quickening, with the establishment of a secondary market in government bonds, write James Gavin and Jon Marks.
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Awash with liquidity, Saudi Arabia might traditionally have been expected to shelve its more ambitious reform plans, priming the pump instead with government-funded infrastructure projects fuelled by revenues from national oil company Saudi Aramco. But, while he was crown prince, King Abdullah Bin Abdul Aziz al-Saud showed himself to be an advocate of reform on all fronts, and, as the new Custodian of the Two Holy Mosques, he has been promoting the reform message since becoming monarch in July.

Welcome signal

This is a welcome signal to Saudi financial professionals, some of whom have long been privately lamenting the slow pace of stop-start reforms. The mood in Riyadh is bullish, helped by the establishment in mid-2004 of a functioning Capital Markets Authority, which has boosted confidence – even more so since it has shown willingness to tackle tricky issues such as insider trading.

An improving corporate performance and inflated oil prices caused the Saudi Tadawul All-Share Index (TASI) to rise by 76% in 2003, 85% in 2004 and 64% in January-June 2005, acting to bed down an emerging equities culture with big dividends for investors. By mid-October, the TASI was up by more than 75% since the start of the year and had broken the 15,000 barrier. Price/earnings (P/E) ratios have shot through the roof, many stocks’ averaging 30x-40x P/E.

This is a market with huge potential and in need of deepening. With change and big profits in the air, Riyadh is keeping up the pace of reform of the capital market architecture, with the latest decree endorsing the establishment of a secondary market in government bonds. This indicates another potentially revolutionary change for the kingdom’s economy as it looks towards its much-anticipated World Trade Organization (WTO) membership.

Boom time

Saudi Arabia will join the WTO during a boom. The kingdom’s improving economic and financial situation means that rating agency Moody’s Investors Service said on October 11 that it expected to upgrade its country ceiling (of Baa2) – and with it the long-term foreign currency deposit ratings of 10 Saudi banks.

Banks continue to report dramatic hikes in profit. The largest listed bank, Al-Rajhi Banking and Investment Corporation, reported that its January-September 2005 net profit rose by 82% to SR3.89bn ($1.03bn), while Arab National Bank’s nine-month net profit rose 57% to SR1.41bn.

“Business growth in Saudi Arabia remains strong, and banking sector revenues have received a significant boost from very strong investor participation in a buoyant stock market,” Saudi British Bank chairman Abdullah al-Hugail said, as his bank reported a record nine-month net profit rise of 50.8% to SR1.87bn.

Secondary market play

The absence of a domestic bond market has been a major bugbear for the Saudi investment community. The economy may be awash with oil-driven liquidity but investors are restricted in the number of financial instruments into which they can plough their surplus cash.

The cabinet’s instruction in October to establish a secondary market for government bonds was timed to coincide with an announcement promising a regulatory system for mortgages. Saudi Arabian Monetary Agency (Sama), which doubles as central bank and quasi-regulatory authority, is believed to have held talks with banks about establishing a primary dealership involving three or four banks, which would buy bonds from Sama and sell to other institutions. This will help to stabilise a domestic bond market in its infancy.

“If the mania that has hit the equity markets in the Gulf were to hit the fixed income market, the ramifications would be disastrous,” says Mazen Hassounah, general manager of Riyadh’s Rana Investment Company. “You need the big players, the market makers, to stabilise the market. They will be responsible and understand what they are doing.”

The primary market will come from Sama, which will issue the bonds. Although there is an active trade in floating rate notes, short maturity treasury bills and some longer-term development bonds inside the kingdom, this has until now never been formalised into a regulated secondary market.

“It’s still handled very much in an over-the-counter way,” says Mr Hassounah. “You have to go to different banks and get different quotes, but with a secondary market it will become much more active.”

Recent deal flow has been restricted, however, as the government has not issued any bonds for the past four months. This is not surprising, says Mr Hassounah: with oil at $50-$60 a barrel, “it doesn’t need to”, he adds.

With massive oil revenues filling the public coffers, the government has been expending more effort on retiring government debt – a major issue in Saudi Arabia since its debt problems of the early 1990s. The ratio of debt to GDP is now less than two-thirds.

Many banks have moved away from government lending, and increased their exposure to the rampant equity market.

The Capital Market Law is designed to boost corporate issues primed for the domestic market, although corporate bond offerings have been relatively few – in the past couple of years amounting to a small corporate bond issued by Saudi Orix and a sukkuk (Islamically-tailored bond) issued by a local car hire firm.

Bonds in pipeline

This calm could be shattered if rumours are confirmed that, the biggest player, Saudi Basic Industries Corporation (Sabic), is preparing a bond. Sabic has been seeking a credit rating that would make this possible. Saudi Electricity Company is also said to be preparing to take the same route.

The development of a secondary market has other attractions for the Saudis as they look to deepen their financial market. Like all Gulf bourses, the TASI has reaped the reward of rampant liquidity. But the mismatch between liquidity levels and the limited range of offerings available to the investor is stoking concern.

Many Saudi investors are heading elsewhere to snap up more liquid stocks – although in the post-9/11 climate there are limits to this because Saudi capital is largely staying inside the region. Tens of thousands of Saudi investors were reported to have gone across the border to snap up the initial public offering (IPO) in the United Arab Emirates’ $561m Dana Gas in early October, causing the Saudi riyal to register the largest drop in seven years.

One contributing factor to the flood of new investors entering the market has been the accelerated IPO process: more than half of all Saudi nationals received shares in the Al-Bilad Bank IPO earlier this year. Bankers say participation in IPOs has created a new investor class in Saudi Arabia that hitherto has not participated in the stock market. This is reflected in the rise in trading volumes.

Banks have encouraged the stock market boom by lending on the margin to retail investors. The highly leveraged market has raised fears that sentiment-driven buying could lead to a painful fall.

If nothing else, the emergence of a secondary market could provide more float. “The whole thing boils down to supply and demand,” says Mr Hassounah. “There’s a shortage of paper, a shortage of securities. On the whole of the Saudi market, there’s just one instrument – common equity. There’s very little actual float in the market because the supply isn’t there. At the same time, liquidity is hitting the roof because of the oil prices, yet there’s no channel for this liquidity.”

No date has been set for the formal launch of the secondary market. In Saudi Arabia, these formalities tend to move slowly.

WTO beckons

However, deadlines are emerging for momentous events. According to Dr Hashem Yamani, commerce and industry minister, the government has completed documentary requirements for WTO membership. It has signed 38 bilateral agreements, the last being with the US, and introduced 42 new laws and regulations.

Provided it confirms that everything is in order, the WTO should rubber stamp Saudi entry in early November. This would allow Riyadh to attend the key WTO ministerial meeting in Hong Kong in December as a full member of the organisation.

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Read more about:  Middle East , Saudi Arabia