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Middle EastMarch 3 2004

A clearer path for investors

Dr Nahed Taher discusses the necessity of corporate governance and potential impact of the new Saudi Capital Market Law.
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The Arab economies are increasingly adopting market-based operations in economic policy, and gradually the role of state is declining while the role of the private sector is evolving. Therefore, the concept of corporate governance and its implementation has been receiving more attention in the past few years, with particular reference to disclosure, transparency and accountability.

Better disclosure would allow governments and companies to react to underlying economic problems in a more timely manner. This is necessary to avoid corporate scandals (as in the US) which could result in reluctance by business to invest or expand. Moreover, unrestricted capital flows, and thus global integration of capital markets, can contribute to the spread of best practice in corporate governance, accounting rules, and legal traditions, as well as limit the ability of governments to pursue bad policies.

Main principles

While there is no single model for corporate governance, there are common elements which can be custom-tailored to companies in light of significant changes in circumstances and in different business environments, allowing them to remain competitive in a changing world. Therefore, corporate governance is an evolutionary process.

The main principles of corporate governance are to protect and guarantee shareholders rights which will increase investor confidence and capital utilisation deficiency. Those companies whose governance systems are not compatible with international standards will lose out in terms of attracting investment. Hence, corporate governance is not an optional extra for companies, but essential. It should receive prime attention from the company’s board which should ensure strategic guidance of the institution, and the effective monitoring of management by providing a benchmark of existing best practices.

Private sector

From a Saudi economist’s point of view, I would like to focus on the developments of private sector companies in Saudi Arabia and the role of the new Capital Market Law in enhancing corporate governance in these enterprises that are the engine of economic growth. Many of the large companies in the private sector of the Saudi economy are family-owned business. There are around 11,000 family businesses, of which only 126 are joint stock companies. As for the kingdom moving forward towards globalisation, and for these companies to continue to exist, they would have to be publicly listed and to separate ownership and management. Moreover, having large companies listed on the Saudi Stock Exchange could help to define and analyse their entire industry.

According to past international experience, large institutions could collapse in the future after a few generations if they do not widen the base of ownership. But if they are publicly listed and their shares are traded in the Saudi stock exchange, they would have to implement adequate corporate governance to protect the right of the shareholders.

Monitoring commission

Since corporate governance is a set of rules of conduct, it has to be supervised and monitored by an independent commission. In Saudi Arabia the newly released Capital Market Law has made provision for the establishment of Saudi Stock Exchange Commission (SSEC), which would set the rules and regulations that should be adopted by listed joint stock companies, supervise the implementation of these rules and penalise companies that fail to execute them. Having a watchdog body like the SSEC is a plus for the Saudi financial system.

Although protecting small investors is not an easy task, creating laws to enforce high standards of disclosure and transparency will minimise investor risk. The SSEC should also focus on increasing the board’s independence, clarify and harmonise the applicability of certain quantitative listing standards of the companies, and restrict the implementation periods that listed companies have to comply within. While fraud can never be eliminated, it can be prosecuted harshly to protect innocent investors in this market.

In the past some Saudi listed joint stock companies have failed to publish their financial statements for a few quarters and they were not penalised or prevented from trading their stocks in the market. The expectation under the new law, is that such practice will not be tolerated. The Saudi Stock market appreciated by over 60% in 2003 and total market cap exceeded 80% of GDP (SR565bn). Although, this gain was partially driven by fundamentals (corporate earnings rose by 43%), higher oil prices, and optimism on economic reforms, there has been some speculative movements in prices which have lead to corrections and damage to small investors.

Intentions revealed

The dealers in this stock market are divided in three types; investors that enter the market for long-term investment, traders for short-term investment, and speculators relying on quick profit-taking expectations while hurting other investors. There is a lot of hope that these speculative aspects will be limited through transparency and accountability in the market by having access to relevant information. This requires sizeable investment in IT to build sophisticated and advanced databases.

One of the elements in the new Capital Market Law is to allow companies to issue corporate bonds either conventional or Islamic (asset backed bonds). Such issuance would require a greater role by the independent commission to ensure that this structure meets global standards. Corporate governance would be crucial in this regard, revealing all the different aspects concerning ownership, performance, and the strategic objectives of these companies. As this is a new experience in Saudi Arabia, and in order to avoid any setbacks, the independent authority must try its best to guarantee the successful issuance of those bonds in the market. Any default, especially for new issuance would raise doubts thereby damaging investor confidence.

Bank constraints

Banks are under fire currently for their relatively low contribution to financing private sector enterprises or infrastructure projects with long-term loans. But banks have been constrained by the duration of their liabilities’ maturity of around 2-2.5 years, thereby they only offer short-term loans with the same maturity in order for them not to have liquidity shortages. Even if there are large deposits, banks are restricted by the 60% loans to deposits ratio (despite the loan/deposit ratio being indicative and more of a warning rather than a limit).

Under the new Capital Market Law banks can issue corporate bonds to finance petrochemical sector, infrastructure, or manufacturing projects which require long-term loans as short-term finance is too expensive. Economic reforms and the new Capital Market Law, through allowing the issuance of bonds, will help expand economic activities despite the expected deterioration of oil revenues in the future.

Saudi banks can shift from buying US and government bonds to local private sector bonds as well. Under the new Capital Market Law with more regulation and laws on companies, larger-scale and especially small investors could could buy these investments.

  • Banks also can package more consumer loans and credit cards as an investment portfolio and sell them to investors (securitisation of loans) as new loans will increase overall lending.
  • The new capital market will facilitate mortgage loans ( as long-term loans) if mortgage law is approved.
  • Banks have the opportunity to offer advisory services: - mergers and acquisitions; - IPOs valuation & offloading; - project finance (Build-Operate- Transfer and Build-Own-Operate- Transfer); - with privatisation banks can help offload government institutions; - helping family businesses to go publicly listed; - private placement.
  • l Banks could create independent brokerage houses and investment banking vehicles. Although they will have increased competition from new brokerage boutiques, banks have comparative advantages in resources (margin-lending), wider cliental base, long-term experience and networks of branches. Although banks offer brokerage services currently, yet they do not provide high quality research. Accordingly, specialised brokers need to focus on local equity research to provide good services.
  • l Corporate governance will need to be improved to promote the role of stocks and bonds in corporate fund-raising to enhance confidence of both local and foreign investors in the Saudi stock market.

 

Public-sector reform

It should be noted however, that the reform of the state-controlled enterprises is also considered as a basic instrument in the effort that many countries (specially developing ones) make in order to rationalise public sector management, to improve public finances, and promote growth and development. The setting of clear realistic targets, transparency, and better services to the public will only be achieved if the public company’s management is flexible, independent from political interventions, and operates resembling the management of the private company.

Likewise, corporate governance is not only vital to the private sector in the kingdom but should be first implemented by the public sector enterprises which comprise the largest share of the Saudi economy in general and the companies listed in the stock market in particular.

International experience shows that this approach will lead to more benefits in terms of public revenue, improved efficiency, increased investment, and better quality of services. Therefore, applying corporate governance practices to the government-owned companies in the kingdom will enhance their credibility and encourage investors to buy their stocks when they are privatised, as investors believe that these stocks will add value for shareholders and their rights will be protected. This will help the government in its privatisation process in different sectors; hence it will help accelerate economic reforms in the country.

Dr Nahed Taher is senior economist at The National Commercial Bank of Saudi Arabia E-mail: n.taher@alahli.com

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