Market Research Saudi Arabia June 2012

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1 Research Department MD Rahmatullah Khan, Economic analyst Tel , khanmr@alrajhi-capital.com Key themes There has been expectation in the market that Capital Market Authority could possibly allow foreign institutional investors to invest in Saudi stock market directly. We look at the readyness of the market for foreign investors. We find that the market is backed by fundamentally strong economy, robust banking system. The size of the market and liquidity are comparable to many emerging markets. Institutions are sufficiently placed to manage foreign investment in equity markets. Key positives Foreign investment in stock markets brings institutional benefits over medium to long term. These benefits come in terms of efficiency, transparency and practice of better portfolio management. These benefits are not guaranteed and depend on how market evolves over a period of time. However, Saudi market will possibly benefit the most from being part of frontier market index and later being part of emerging market index if foreign investors are allowed to invest directly. Key risks Key risks to the opening of the stock market to foreign investors come from the flow of hot money, lack of domestic institutional investors, lack of independent monetary policy and lack of domestic bond market.however, these risks are manageable as high official foreign reserve assests provide support and SAMA has proven track record of managing liquidity in banking system. Moreover, calibrated opening of the market will further diminish these risks. Overall assessment The benefits of allowing foreign investors, which is a slow process, outweigh the negative aspects of it in medium to long term. We believe that n equity market is ready for foreign investors. However, it should be done in a calibrated manner so that the advent of large investors does not destabilize existing stakeholders and negative aspects of it could be minimized. Performance of TASI over the last decade Tadawul: Ready for Foreign Investors There has been expectation in the market that Capital Market Authority could possibly allow foreign institutional investors to invest in Saudi stock market directly. There are apparent benefits of foreign investors investing in a stock market as generally, they bring in liquidity, efficiency, transparency and practice of better portfolio management. These benefits are not guaranteed and depend on how market evolves in medium to long term. Moreover, entry of foreign investors in stock market is believed to cause higher volatility due to flow of hot money and can potentially create an issue of liquidity management for the central bank. However, we find that data does not support high volatility belief and n institutions such as SAMA has tools available for managing liquidity concerns. Moreover, depth and breadth of the market supported by the fundamentally robust economy and strong core financial system make the market attractive for foreign investors. The interest of foreign investors in n economy is also reflected through strong flow of foreign direct investments. Expected positives for Saudi market from opening up: Foreign institutional investors (FIIs) help domestic capital markets improve their functioning in many ways. FIIs not only provide liquidity and enhance efficiency of the market but also provide discipline and knowhow. The opening up of the market is likely to lead to a change of status of Tadawul in global equity index such as MSCI. It is likely to get frontier market status at MSCI index which can be upgraded to emerging market status over a period of time depending on how market institutions evolve. Frontier market will provide the visibility among global investors who look for higher return. Moreover, the Saudi capital market will reap the benefit once it is classified as emerging market. This will allow the capital market to be part of investment targets by the large pool of global institutional investors who will actually bring institutional changes. Issues to be taken care by authorities: Expected benefits come with certain issues which need to be taken care by CMA and SAMA. Among these issues, some are general issues such as flow of hot money which most of countries face when they open up their markets for foreign investors. These issues require continuous surveillance and proper safeguards. On the other hand, some issues are specific to and structural in nature such as lack of independent monetary policy. However, we believe that even some of these structural issues such as managing liquidity in the absence of independent monetary policy and lack of government bond market could be managed by active intervention by SAMA May-02 May-03 May-04 May-05 May-06 May-07 May-08 May-09 May-10 May-11 May-12 Tadawul Source: Bloomberg, Al Rajhi Capital Strength of Saudi market: The pillars of strength for Saudi stock market are depth and breadth of the market, robust economic fundamentals, strong core financial system and evolving regulatory environment for the capital market. Although number of companies listed on s Tadawul stock exchange is 152, the market capitalization is significantly high. Market is liquid and most of stocks are traded daily. Long term market strength comes from robust economic fundamentals. Moreover, the stock market is backed by technology driven strong banking system. Disclosures Please refer to the important disclosures at the back of this report.

2 Tadawul: Ready for Foreign Investors The Saudi stock market is abuzz with the expectation of authority allowing foreign investors directly into the stock market. There are apparent benefits of foreign investors investing in a stock market as they bring in liquidity, efficiency, transparency and practice of better portfolio management. These benefits are not guaranteed as they come through institutional changes and depend on how market evolves over time. Moreover, entry of foreign investors in stock market is believed to cause higher volatility due to flow of hot money and can potentially create an issue of liquidity management for the central bank. However, we find that data do not support high volatility theory and n institutions such as SAMA has tools available for managing liquidity concerns. Thus, expected benefits outweigh concerns. Moreover, depth and breadth of the market supported by fundamentally robust economy and strong core financial system make the market attractive for foreign investors. The interest of foreign investors in n economy is reflected through strong flow of foreign direct investments. Possible benefits of foreign institutional investors FIIs enhance liquidity and efficiency of stock market over medium to long term They also bring in discipline and know how Corporate governance and transparency improve over a period of time FIIs create market for sophisticated products Liquidity and efficiency: Foreign Institutional Investors (FIIs) increase the liquidity of capital markets and develop market efficiency as well. As their entry helps higher liquidity along with making the market deeper and broader, the possibility of investment in wider range of companies is higher. Moreover, with deeper and broader market, savers have assurance that they will be able to manage their portfolio efficiently. This promotes longer term investment more attractive. Discipline and know how: FIIs bring in their experience of developed markets into the domestic capital market which helps market institutions. They, without the advantage of an insider s knowledge of the investment opportunities, are especially likely to demand a higher level of information disclosure and accounting standards. Institutional investors generally have quality research about macroeconomic environment as well as individual firm s potential. Moreover, interaction between regulators and FIIs also helps evolve regulatory environment for the market. Corporate governance and transparency: As mentioned above, FIIs require higher degree of disclosure and transparency in accounting standard, their entry brings in better corporate governance and transparency in companies. As companies compete for finance the market will reward better performance, better prospects for future performance, and better corporate governance. As market s liquidity and functionality improves, equity prices will increasingly reflect the underlying values of the firms, enhancing the more efficient allocation of capital flows. Introduction of more sophisticated instruments: Although it largely depends on the regulator and exchange of the capital market to introduce sophisticated instruments, entry of FIIs helps as they understand these instruments better. As they understand the risk and reward of different derivative products and use these products to hedge the portfolio risk in developed markets, they create demand for such products in domestic markets as well. Increased demand for these instruments would be conducive in developing these instruments in domestic markets, improving risk management opportunities for both foreign and domestic investors. Disclosures Please refer to the important disclosures at the back of this report. 2

3 Expected positives for Saudi market from opening up Benefits of foreign investments in stock market is typically realized over a long period of time The latent demand for Saudi equity among foreign investors seems to be high Opening up will lead the market to be part of global indices which in turn will result into the market getting attention of large global institutional investors The flow of foreign direct investments (FDI) over the last decade reflects the foreign investors interest in n economy. Foreign investors invest directly in production line through FDI. They are largely established players in their respective industry. Therefore, there is no dispute regarding the benefits of FDI. However, the benefits of foreign portfolio investments are not as direct and immediate as it is limited to the extent of investments in equity and/or debt markets. Many of the benefits mentioned above for either type of investment will not be immediately apparent. The portfolio investor s relationship to the domestic capital markets and effect on the markets efficiency will evolve over time. Few, if any, of these benefits are guaranteed. For instance in India, foreign investors allowed to invest in India in early 1990s. However, the meaningful flow of foreign funds started only in 2000s. However, entry of foreign institutional investors is likely to be beneficial for Saudi capital market in many ways. As mentioned above, foreign investors interest in s economy has been reflected through robust FDI inflows over the last decade. Thus, the latent demand for Saudi equity among foreign investors seems to be high. The opening up of the market is likely to lead to a change of status of Tadawul in global equity index such as MSCI. It is likely to get frontier market status at MSCI index which can be upgraded to emerging market status over a period of time depending on how transparency and efficiency evolve. Frontier market will provide the visibility among global investors who look for higher return. Moreover, the Saudi capital market will reap the benefit once it is classified as emerging market. This will allow the capital market to be part of investment targets by the large pool of global institutional investors who will actually bring institutional changes. Issues to be taken care by authorities Expected benefits come with certain issues which need to be taken care by CMA and SAMA. Among these issues some are general issues such as flow of hot money which most of countries face when they open up their markets for foreign investors. These issues require continuous surveillance and proper safeguards. On the other hand, some issues are specific to and structural in nature such as lack of independent monetary policy. However, we believe that even some of these structural issues such as managing liquidity in the absence of independent monetary policy and lack of government bond market could be managed by active intervention by SAMA. Moreover, high foreign reserve assets of the central bank provides strong cushion against any unreasonable volatility in interbank and foreign currency markets. Flow of hot money is believed to be a problem for open markets. This can put pressure on liquidity and the currency. However, we believe that SAMA can manage these issues Flow of hot money: The benefits of foreign investment become nightmare for authorities when large amount of short-term capital moves in or moves out in short period of time. It is believed that such flows create problem not only in capital market with wild swings in equity prices but also in the banking system with either huge liquidity or reverse as may be the case. Large movement of funds in a country creates problem in foreign exchange market as well through wild swings in value of domestic currency against major world currencies like the US dollar. Although n Riyal is pegged against dollar, the movement of hot money can put pressure in forward market. Note that SAMA had to intervene in the foreign exchange forward market in 1993 and 1998 to reduce the volatility and discourage speculators. Even during the period of H and H forward market was expecting appreciation in Riyal. However, this issue does not pose any serious problem in foreseeable future as the central bank has foreign reserves almost equivalent to 100% of GDP. Moreover, liquidity in the banking system has been appreciably managed by the central bank. Disclosures Please refer to the important disclosures at the back of this report. 3

4 Statistical analysis does not support the belief of foreign investors creating higher volatility Closed markets are not necessarily less volatile n market lacks domestic institutional investors Difference in trading days can potentially create higher volatility on the first day and the last day of a trading week Lack of independent monetary policy is the biggest handicap for authorities Absence of government bond market is another handicap. But SAMA manages short term liquidity through T-bills As far as volatility in stock market is concerned, a simple statistical analysis based on standard deviation of stock market return does not provide any evidence that foreign investors create volatility in stock markets through flow of hot money. In fact standard deviation suggests otherwise that closed markets are generally more volatile. Most emerging markets in 1980s and 1990s were relatively more volatile compared to 2000s. A case in point is Chinese market which allowed limited access to foreigners in During 1990s, standard deviation of monthly return in Chinese markets was 26% compared to just 8.2% during a period of Similarly, standard deviation of monthly return in Brazilian market was 25% during 1990s compared to 7.4% in Indian markets were less volatile as standard deviation was around 10% in 1980s and 1990s compared to around 7.5% in Note that Indian market was opened in 1993 for FII and meaningful FII inflows started in 2000s. Some studies show that foreign investors diversify the local risk which reduces the volatility of the stock market. This means that foreign investment acts as buffer in case of rising risk aversion among domestic investors. Moreover, relatively closed stock market does not guarantee lower volatility as even witnessed by Saudi stock market in the last decade. Stock market witnessed a bubble like situation in which burst in early It again witnessed high volatility after Lehman demise in This proves that stock market can be volatile even if foreign investors are not involved. Lack of domestic institutional investors: The pool of large domestic institutional investors (DIIs) acts as a buffer against external shock in volatile market periods. When foreign investors sell during downturn, DIIs provide cushion by purchasing quality stocks which in turn averts sharp decline in stock prices. Lack of DIIs could be one of the handicaps in managing volatility in stock prices especially during downturns. Difference in trading days: The difference in trading days in Saudi market and global markets could possibly lead to sharp swings in stock prices especially on the first day and the last day of trading in a week. The Saudi market is closed on Thursday and Friday whereas global markets are open on those days. Since global markets are open these two days, equity prices factor in global economic and political news smoothly. Note that flow of economic and business information continues on these two days whereas there is hardly any new information on Saturday and Sunday. Therefore, Saudi market can have large gap-up or gapdown openings on Saturdays. The market can witness unusual large selling pressure on Wednesday if global markets are going through uncertain phase as investors will not like to keep their position open during two trading sessions in global markets. Lack of Independent monetary policy: Due to Saudi riyal peg to the US dollar, Saudi Arabian central bank does not have complete independence to conduct monetary policy. SAMA has to mirror the interest rate policy followed by the US central bank in order to defend the peg. In, Repo rate is 2% whereas Reverse Repo is 0.25% equal to Fed funds rate (0-0.25%) in the US. Now, this could potentially create problem when business cycles in the two countries diverge for longer periods. The problem could accentuate when country has open capital market. For instance, at the moment US policy makers believe that the US economy will need record low interest rate for an extended period as recovery is fragile. However, economic growth in has been robust which does not need such low interest rate. Now, if capital market is open for foreign investors, foreign investors will pump in money as growth is robust and monetary policy is highly accommodative. This will lead to more liquidity in the financial system as against central bank s effort to contain liquidity. Lack of government bond market: A deep bond market helps central bank manage liquidity in banking system through open market operations. But lack of government bond market leaves SAMA with fewer options such as T-bills and Reserve Ratio Requirements (RRR) for managing the liquidity. The central bank manages liquidity in banking system mainly through T-bills as RRR is more effective in managing structural liquidity conditions Disclosures Please refer to the important disclosures at the back of this report. 4

5 rather than short-term liquidity conditions. Having said that, the central bank has been able to manage banking system liquidity quite well. Strength of Saudi stock market The pillars of strength for Saudi stock market are robust economic fundamentals, strong core financial system, depth and breadth of the market and evolving regulatory environment for the capital market. Although number of companies listed on s Tadawul stock exchange is 152, the market capitalization is significantly high. Market is liquid and most of stocks are traded daily. In recent months volume has surged. Long term market strength comes from robust economic fundamentals. Moreover, the stock market is backed by the technology driven strong banking system which is crucial for functioning of the market and the overall economy. Economic strength One of the strong pillars for Saudi market is robust economic fundamentals of the economy Size of the Saudi market is good enough and comparable to the size of many emerging markets Economic strength of the largest economy of the Middle East and North Africa region is underlined by the fact that the country boasts of the largest crude oil reserves (20% of the world reserve). The largest reserves along with the largest production capacity in the world enable the country to be the largest exporter of the crude oil. The oil sector contributes almost 90% to the government revenue as well as to export revenue. Large trade surplus over the last decade has resulted into foreign reserve accumulation which is almost 100% of GDP. One of the largest reserve to GDP ratios coupled with one of the lowest public debt to GDP ratios among major economies provide strong buttress even against prolonged cyclical downturn. This was evident during global down turn when government in the country embarked on massive fiscal expansion. Depth and breadth of the market Market capitalization: s equity market comprises 152 listed companies with aggregate market capitalization of SAR1270bn (US$338bn) at the end of The market capitalization had moved up to SAR1371bn (US$365bn) at the end of May At the end of 2011, the aggregate market capitalization of the equity market was equivalent to 59% of GDP (2011 GDP) whereas it was 136% of non-oil GDP. Market capitalization as ratio of non-oil GDP has been relatively less volatile as it negates the volatility in oil sector GDP which largely depends on global oil prices and domestic production. Moreover, oil sector is not represented at the stock market as all companies are from non-oil sector. Floating market capitalization is around 40% of the total market cap which is equivalent to SAR548bn. Figure 1 Largest market in MENA in terms of market cap % 450% 400% 350% 300% 250% 200% 150% 100% 50% 0% Market capitalization Market capitalization as % of GDP-rhs Market cap as % of non-oil GDP-rhs Source: Tadawul, CDSI, Al Rajhi Capital Disclosures Please refer to the important disclosures at the back of this report. 5

6 Market activities in terms of trade volume and value have picked up Volume: Average volume and value traded in the equity market was declining after peaking in However, trend changed last year when both volume and value traded increased compared to the previous year even as overall market return was slightly negative. Volume traded increased from 33 billion in 2010 to 48.5 billion in 2011 whereas value traded moved up from SAR759bn to SAR1099bn during the period. The trend further accelerated in the first three months of the current year. Average volume traded was billion in Q Average value traded has also gathered further pace as it was SAR684bn during the quarter. However, both volume and value traded have eased in the month of April and May. Figure 2 Volume and value traded have picked up last year which continues this year 6,000 SAR bn billion , , , , , Value traded Volume-rhs Source: Tadawul, Al Rajhi Capital Financial system strength Saudi market is backed by robust banking system Interbank interest rates are well behaved and closely follow USD Libor as policy rates are linked s capital market is backed by a strong core financial system (banking system) regulated by n Monetary Agency (SAMA). The regulation by the central bank has rather been on conservative side which has limited the risk buildup in the banking system. This was the reason why banking system was unscathed during financial and economic crises. The central bank has managed liquidity conditions quite successfully even with fewer monetary policy tool available with the central bank. The effectiveness of monetary policy and ability of banking system to transmit the policy stance to the real economy is reflected through largely well behaved interbank rate. Saudi Interbank Offer Rates (SAIBORs) have moved in line with policy interest rate followed by the central bank of. The interbank rate closely follows London Interbank Offer Rate (LIBOR) in US dollar which again reflects that spread between policy rate and the market rate in is also very similar to that in the developed market (US). Figure 3 Largely well behaved inter-bank rate Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Source: Bloomberg, Al Rajhi Capital USD LIBOR SAIBOR Fed Funds rate Disclosures Please refer to the important disclosures at the back of this report. 6

7 All banks are well capitalized and boast of high credit ratings High capital adequacy ratio: Commercial banks in are well capitalized to withstand any downturn in business cycle. Average Capital Adequacy Ratio (CAR) was in excess of 17% which is almost double compared to the recommended 8% from BASEL ΙΙ. The CAR of the listed banks range from 14% to 19% and 8 out of 10 listed banks have total capital ratio in excess of 17%. Moreover, Tier Ι capital ratios are also high for the entire banking system. Overall credit ratings of the banking system are high with majority of them having high ratings due to strong fundamentals. Table 1 Strong capital base and high credit ratings Bank Credit ratings Tier 1 capital ratio Total capital ratio Samba bank Aa % 19.20% Al Rajhi Bank A % 18.92% Saudi Investment bank A % 18.15% Albilad bank NA 16.50% 18.08% Al Jazira bank A % 18.06% Arab National Bank A % 17.54% Saudi Hollandi Bank A % 17.10% Riyad Bank A % 17.10% Banque Saudi Fransi Aa % 14.36% Saab Aa % 13.84% Source: Banks Basel ΙΙ declaration, Moody s, Al Rajhi Capital Saudi banks have well diversified loan portfolio which reduces sectoral risk Loans are less than deposits and foreign exposures are limited Well diversified loan portfolio: Loan portfolio of banks in the country is well diversified in order to have minimum risk of exposure to any particular sector. Manufacturing and processing constitutes 13% of total banks credit whereas building and construction constitutes only 8.1%. Commerce has high share of 21.3% in total outstanding credit. Others which include agriculture and fishing, mining and quarrying, electricity etc, transport and communication and finance constitute 17% of the total credit outstanding. Miscellaneous category, which constitutes 37% of the total credit outstanding, includes largely retail consumer credit in terms of real estate loan, car loan, credit card loan and personal loan. Share of real estate loans outstanding in total credit outstanding is just 3.4% whereas car loan constitutes 5.8%. Unsecured credit card loans constitute less than 1% and have been declining since All figures mentioned above correspond to the end of Low loan to deposit ratio and limited foreign exposure: The strength of the banking sector is further bolstered by the fact that Saudi banks have the lowest loan to deposit ratio and lowest foreign exposure in terms of assets and liability in the GCC region. Deposits growth in recent years have been higher than credit growth which has resulted into the lower ratio at 77.8% at the end of 2011 compared to 86.8% in Low interest rate environment has resulted into higher proportion of demand deposits in total deposits which was 58% at the end of 2011 compared to just 40% in Foreign exposure has largely been stable in terms of foreign assets to total assets and foreign currency deposits to total deposits. Foreign assets to total assets has largely been in the range of 12% to 15% whereas foreign currency deposits to total deposits have been in the range of 12% to 14% since 2007 except in 2009 when it shot up to 17%. Disclosures Please refer to the important disclosures at the back of this report. 7

8 Figure 4 Ratios point healthy balance sheet of commercial banks 80.0% 77.8% 60.0% 58.1% 40.0% 20.0% 13.5% 12.4% 0.0% Private sector loan to total deposits Foreign assets to total assets Demand deposits to total deposits Foreign currency deposits to total deposits Important ratios Source: SAMA, Al Rajhi Capital Conclusion The s stock market is backed by fundamentally strong economy and robust banking system. The size of the market, largest in the MENA region, is comparable to many emerging markets. Volume and value traded are also comparable to many emerging markets when measured as percent of market capitalization of the stock market. The accrual of benefits of allowing foreign investors, which is a slow process, outweighs the concerns in medium to long term. Therefore, we believe that n equity market is ready for foreign investors. However, it should be done in a calibrated manner so that the advent of large investors does not destabilize existing stakeholders. Disclosures Please refer to the important disclosures at the back of this report. 8

9 Disclaimer and additional disclosures for Equity Research Disclaimer This research document has been prepared by Al Rajhi Capital Company ( Al Rajhi Capital ) of Riyadh,. It has been prepared for the general use of Al Rajhi Capital s clients and may not be redistributed, retransmitted or disclosed, in whole or in part, or in any form or manner, without the express written consent of Al Rajhi Capital. Receipt and review of this research document constitute your agreement not to redistribute, retransmit, or disclose to others the contents, opinions, conclusion, or information contained in this document prior to public disclosure of such information by Al Rajhi Capital. The information contained was obtained from various public sources believed to be reliable but we do not guarantee its accuracy. Al Rajhi Capital makes no representations or warranties (express or implied) regarding the data and information provided and Al Rajhi Capital does not represent that the information content of this document is complete, or free from any error, not misleading, or fit for any particular purpose. This research document provides general information only. Neither the information nor any opinion expressed constitutes an offer or an invitation to make an offer, to buy or sell any securities or other investment products related to such securities or investments. It is not intended to provide personal investment advice and it does not take into account the specific investment objectives, financial situation and the particular needs of any specific person who may receive this document. Investors should seek financial, legal or tax advice regarding the appropriateness of investing in any securities, other investment or investment strategies discussed or recommended in this document and should understand that statements regarding future prospects may not be realized. Investors should note that income from such securities or other investments, if any, may fluctuate and that the price or value of such securities and investments may rise or fall. Fluctuations in exchange rates could have adverse effects on the value of or price of, or income derived from, certain investments. Accordingly, investors may receive back less than originally invested. Al Rajhi Capital or its officers or one or more of its affiliates (including research analysts) may have a financial interest in securities of the issuer(s) or related investments, including long or short positions in securities, warrants, futures, options, derivatives, or other financial instruments. Al Rajhi Capital or its affiliates may from time to time perform investment banking or other services for, solicit investment banking or other business from, any company mentioned in this research document. Al Rajhi Capital, together with its affiliates and employees, shall not be liable for any direct, indirect or consequential loss or damages that may arise, directly or indirectly, from any use of the information contained in this research document. This research document and any recommendations contained are subject to change without prior notice. Al Rajhi Capital assumes no responsibility to update the information in this research document. Neither the whole nor any part of this research document may be altered, duplicated, transmitted or distributed in any form or by any means. This research document is not directed to, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in any locality, state, country or other jurisdiction where such distribution, publication, availability or use would be contrary to law or which would subject Al Rajhi Capital or any of its affiliates to any registration or licensing requirement within such jurisdiction. Contact us Dr. Saleh Alsuhaibani Head of Research Tel : alsuhaibanis@alrajhi-capital.com Al Rajhi Capital Research Department Head Office, King Fahad Road P.O. Box 5561 Riyadh Kingdom of research@alrajhi-capital.com Al Rajhi Capital, a subsidiary of Al Rajhi Bank, is licensed by the n Capital Market Authority, License No /37. Disclosures Please refer to the important disclosures at the back of this report. 9