Panel Session 4: Stock Exchange and Capital Markets

Dr. Khaled Al-Fayez
Chief Executive Officer
Gulf International Bank, Bahrain


Safeguarding Financial Development

Learning from the Recent Experiences of
Middle Eastern Stock Markets

Ladies and Gentlemen,

I am pleased to be here to participate in a panel session appraising stock and capital markets.  At a time when Syria is in the early stages of liberalizing and reforming its financial sector, I believe our deliberations today will prove to be both timely and useful.   

Among the many aspects of economic reform, the undertaking of financial liberalization is perhaps the most challenging for any country.  Not surprisingly, this has become the most analyzed topic in recent years.  A large number of studies now advocate that the creation of an effective, easily accessible and globally integrated financial structure is key to improving economic efficiency, and more specifically facilitating important economic processes such as resource and risk allocation, wealth accumulation, growth, and social prosperity.  Among the many facets of this structure, capital markets, most notably stock markets, contribute significantly towards such benefits. 

Such a financial structure certainly appears a necessity in today’s globalized world of accelerated cross-border activities; growing interdependencies among market participants, markets and financial systems; and increasingly complex financial instruments.

But recent experiences across many Middle Eastern countries suggest that if policy makers are not careful, the financial liberalization process and with that the development of stock markets becomes more a tool of unbridled speculative behavior rather than the intended catalyst for economic development.

I would like to briefly share my views on this issue in light of the recent announcement that Syria plans to open its first stock market some time next year.
Within a very short period of time, stock markets across the Middle East, most notably the Gulf Cooperation Council (GCC) countries and Egypt, witnessed unprecedented levels of growth accompanied by a wave of initial public offerings (IPOs).  Consider these statistics:

  • Between 2000 and 2005, market capitalization in Saudi Arabia, the United Arab Emirates (UAE), Kuwait, Qatar and Egypt, skyrocketed.  In the UAE alone, market capitalization expanded as much as twenty fold with the bulk of the rise occurring between 2004 and 2005.
  • Growth in trading volumes across the region was also rampant. Between 2000 and 2005, volumes in Kuwait and Egypt expanded in the vicinity of four to five fold, while Saudi Arabia and Qatar recorded between twenty and thirty fold jumps.  The UAE stood out among this group with trading volumes increasing from a mere 24 million shares in 2000 to 33.8 billion by 2005!
  • There were a total of 37 IPOs launched across the GCC exchanges between 2003 and 2005, of which nearly 60% emanated from companies established after 2003.  In terms of size, the intensity of the IPO flow was particularly notable in Saudi Arabia, the UAE and Qatar where the total value of the IPOs launched after 2003 stood at US$2.4 billion, US$2.2 billion and US$1.7 billion respectively.  In terms of number of IPOs, the UAE led the way with a total of 11 launchings after 2003.  

By all counts, the seemingly gravity defying performance and frenzied pace of trading volumes initially appeared as a normal consequence of the excellent business fundamentals that prevailed across the region.  The confluence of remarkable corporate performance, abundant liquidity, and positive business and consumer sentiment, afforded by oil prices, had manifested themselves into the phenomenal pace of regional stock market growth.  Add to this was the flurry of sweeping economic reforms and business deregulation, particularly the introduction of a seminal piece of legislation in the form of the Capital Markets Law in Saudi Arabia and renewed reform momentum in Egypt.  These provided much confidence and thrust to investor demand for the Middle East as a whole.

However, for many of us, the rapid expansion of regional stock markets was still disconcerting, as it became abundantly clear that the initial growth spurt was snowballing into a definite hype, particularly from 2004 onwards.  A cursory review of the P/E ratios during the peak is a startling example of this.  In Saudi Arabia, there were far too many examples of listed companies with ridiculously high P/Es i.e. over 100x earnings in spite of either deteriorating earnings or outright losses. 

By early 2006, the signs were all too clear.  The Middle East’s phenomenal bull run had begun to sputter and by the end of March, more than US$200 billion of market capitalization was wiped out in the GCC countries alone.  The correction was inevitable.  The heady stock markets had been standing on a fragile foundation that was dominated by inexperienced retail investors who followed a herd mentality and embraced risk without concern or understanding.  Worse still was the fact that many of these investors were buying stocks on the back of easily accessed borrowed bank funds.

So if the Middle East experience is anything to go by, are the advocated policy prescriptions for financial liberalization flawed?

My personal view is an unequivocal no.  There is little doubt in my mind that the sophistication of a country’s financial system, most notably the creation of a stock market, plays an integral part in supporting its economic growth and development.  Indeed, for market-based economies to thrive, there must exist a well functioning stock market.

However, beyond the compelling benefits, what the various studies promoting stock market development do not appear to emphasize enough are the “design and policy” aspects of such a system, and the pitfalls that can lurk when these are not appropriately heeded.

Let me now turn to some of these important aspects.

Few will argue that there are unequal blessings associated with liberalized financial markets and active stock markets.  This is in spite of the wealth of valuable insights that have been gained over time from the experiences of other countries.

Consider the Asian experience.  The ferocity of macroeconomic and financial turmoil that afflicted nations across Asia in recent times highlighted that stock markets and capital markets in general, are characterized by information asymmetries that can give rise to overshooting, sharp corrections, and in the extreme cases, crises.  Yet less than a decade later, stock markets in the Middle East went to dizzying heights with little regard to the fact that they faced startlingly similar risks, as did the Asian markets prior to their tumultuous collapse.

Fortunately, a correction in the largely unwarranted price escalations came early on in the Middle East and this has given regional markets at least some period for pause and reflection.  In the immediate aftermath, many regulators swiftly reacted by introducing measures to limit future opportunities for speculation and overvaluation in their respective stock markets, such as tightening prudential regulations on stock market and real estate related lending by banks and the encouragement of stock splits.  Albeit, there is little question that such enforcement should have been at the policy forefront from the very beginning.  

So what sort of policies can address the risk of speculation in stock markets?

With the understanding that instances of market volatility and turbulence are inherent to all stock markets, the challenge then is to create and impose mechanisms that at the very least limit these instances as far as possible.  This of course will depend to some extent on the structure and maturity of the stock market and the domestic financial system as a whole.

In the interest of time, I will limit my comments to stock markets in the early stages of development.

  1. Policymakers must recognize that emerging stock markets share common characteristics including: a) market capitalization and trading tends to be concentrated in a few stocks; b) information and disclosure standards are deficient; and c) transparency of transactions tends to be weak.  Such an environment naturally invites rapid growth and speculative behavior particularly when set against buoyant business fundamentals as has been the case across the Middle East.  Therefore, before all else, policies safeguarding economic and financial stability must be the cornerstone of a financial liberalization process, and not simply the blind pursuit of economic benefits. These will anyway follow if stock market development is occurring within a steady and well-tempered environment.
  2. Although liquidity is a necessary prerequisite to develop stock markets, it can equally pose as a serious dilemma.  In many emerging stock markets, highly liquid conditions have actually hurt economic development, as it tends to encourage investor myopia and thereby, undermine the overall stock market’s development process and associated economic benefits.  Hence, from the very beginning emerging stock markets should have measures in place such as taxes on capital gains for short term trading along side high transaction costs to discourage speculative attitudes that may arise in the event the stock market experiences large liquidity inflows.
  3. The other aspect of overabundant domestic liquidity conditions in emerging stock markets is that it tends to make regulators inward looking, resulting in delays to open up the markets to foreign investors.  Of course, given what transpired during the Asian crisis, one can certainly argue that such exclusion is necessary in the early stages to protect the domestic market.  However, it is well documented that emerging stock markets that reduced impediments for foreign investors benefited from enhanced integration with the world capital markets and improved pricing of domestic securities.  There are other gains also.  As more foreign investors enter the local stock market, pressure will mount on domestic firms to upgrade information disclosure standards, while trading, regulatory, and legal frameworks will also be forced to improve and become more sophisticated. 
  4. Early synchronization of rules and regulations with international practices is central to the sustained and orderly development of emerging stock markets.  However, this is not usually the case.  Instead, adherence to international frameworks and standards only tends to sprout much later on, and usually only after a bout of speculation or even a crisis.  This was clearly exemplified in the stock markets of Saudi Arabia and the United Arab Emirates.  In spite of both markets having securities regulation and listing requirements in place, the authorities still found room to further strengthen standards and enforce requirements after the March 2006 correction.
  5. Another crucial aspect to the early enforcement of core international standards and stringent listing requirements is that it disciplines listed companies towards achieving higher standards of corporate governance.  This is very important as market efficiency can only be achieved if investors have faith in listed companies and the overall stock market structure as a whole.  It was reported in the media, for example, that the correction in the Egyptian stock market was unduly intensified as a result of a weak corporate governance culture which allowed the board of directors in many companies to directly and indirectly sell their stakes at high speed once the market downturn began.  If this indeed occurred, then such acts are counterintuitive to the generally prescribed role of board of directors; that of acting honestly and in good faith for the best interests of companies they are members of.  
  6. Policymakers should remain particularly wary of IPOs during the early stages of stock market development.  Consider the recent IPO surge in the GCC countries.  Early on, booming stock market conditions encouraged the successive launches of IPOs and for a while, this appeared as a natural trajectory to the overall development of the Gulf’s stock markets.  However, it was soon obvious that the situation had spiraled out of control.   Eventually, the sheer size and number of the IPOs began to overwhelm the limited absorption capacity of regional stock markets, with the situation becoming particularly acute in 2005 when a total of US$6 billion worth of IPOs were launched alongside over US$9 billion rights issues in the GCC region as a whole.  This led the stock markets to quickly reach a saturation point as investors repeatedly dumped existing shares to the buy the next new IPO.  A number of policy shortcomings contributed to this:  a) The lack of prudential control on individual shareholding concentrations in IPOs - a key underlying factor of the extreme volatilities witnessed across regional stock markets; b) The absence of firmer controls in order to stagger both the size and launch of IPOs, and discourage the simultaneous launches of large IPOs and rights issues; and most importantly, c) The apparent absence of market determined IPO pricing mechanisms which led to par values being significantly lower than the actual value of shares.  This created fantastic illusory gains, which were further inflated as the IPOs attracted massive oversubscriptions.  
  7. Finally, given the speed at which bank credit found its way into the Middle East stock markets, it is clear that in periods of booming economic conditions and high liquidity, even the most conservative stalwarts of a country’s financial system (i.e. banks) can get swept away and lose sight of responsible risk management practices.  In an environment of low interest rates and excess liquidity conditions, lending practices of regional banks allowed investors to have easy access to borrowed money.  A large portion of these loans entered the stock markets, pumping them until the panic selling that ensued in early 2006.  In this regard, the Middle East and emerging stock markets in general would gain much by paying heed to Chile’s approach to financial liberalization.  Through the careful application of taxes and reserve requirements on capital inflows, the Chilean financial system has built in a bias in favor of long term and foreign direct investment versus higher costs on short-term inflows.  The success borne out of this policy in neutralizing the negative effects associated with the influx of short-term capital is well documented and an important success story.  By the same token, the application of a similar logic with regards to bank lending can also go a long way in discouraging financial intermediaries from lending either directly or indirectly to stock markets

There is one recurring theme in my comments on the type of policies that can address the risk of speculation in emerging stock markets; it is the recognition that there is clear trade off between achieving economic and financial efficiency on the one hand, and economic and financial stability on the other.  In the early stages of financial liberalization and stock market development, nations would do well to initially pay closer attention to the latter.
Thank you for your attention.

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