New realities push transformation of Gulf financial markets

Developing financial markets has been the policy objective of countries in the GCC region for the last few decades.

Shaken by few global and local crises of their own, Gulf countries have overseen steady development of their markets at a more leisurely pace compared with the rest of the world thanks to the region’s bountiful natural resources.

However, the recent decline in oil prices is pushing these countries to evolve and deepen their markets, and, while significant progress has been made, challenges remain. Of special interest in the region is Saudi Arabia’s Vision 2030, which targets an accelerated series of capital market and economic reforms that are expected to have an impact on the entire region.

Here, we examine how developments are progressing across the region on a market-by-market basis.

Banking

The GCC is home to some highly capitalised banks by global standards, including First Abu Dhabi Bank – the post-merger of NBAD and FGB of the UAE. The sector has been growing; all countries have a high concentration of banking assets controlled by top banks, though in Bahrain and Saudi Arabia this concentration is less.

Banks are for the most part controlled by domestic investors due to long-term legacy restrictions on foreign holders and limited access to GCC cross-investments. While banks had favourable funding conditions when the economic environment was bullish and oil prices were high, the current reversal of such conditions poses a risk in lending.

During the financial crises of the last decade, banks in the region maintained resilience largely because of support from government and sovereign wealth funds. Saudi Arabia is one Gulf country taking concrete steps to attract foreign banks and institutions, with the aim of increasing foreign capital.

Equity capital markets

Stock markets have not yet reached their full potential due to significant government ownership of local assets and restrictions on foreign investment.

The UAE led reforms in opening its markets to foreign flows, receiving MSCI emerging market status in 2014, while Saudi Arabia is going through fast-track changes and is expected to achieve MSCI emerging market status in 2018. The kingdom has made many reforms, from the removal of foreign investor restrictions to the easing of rules for overseas access to equity markets.

At present, GCC equity markets are still heavily driven by domestic retail and institutional flows. Volumes are fragmented across many exchanges with few listings, with the exception of Tadawul. The Saudi Stock Exchange has discussed the possibility of a cross-listing initiative with GCC stock exchanges as part of an on-going series of reforms. The ambitious Saudi privatisation plans, including the Saudi Aramco IPO, may provide enough incentive for regional exchanges to collaborate.

Debt capital markets

The GCC countries’ main revenue is in USD (oil), which has enabled them to keep local currencies pegged (with the exception of the Kuwaiti dinar). With budget surpluses largely stemming from this strong oil revenue, debt securities – especially domestic currencies – have long remained the least-developed financial segment in the Gulf. Yet transformation is under way.

Investors have welcomed hard-currency issuances because of the strong credit fundamentals of the GCC countries. The region’s debt-market evolution has been different from that of most of the world, where issuance usually takes the form of government-issued domestic currencies.

Government debt markets in the Gulf have traditionally been small. For example, Kuwait and Saudi Arabia issued their first USD-denominated debt in 2017 and 2016, respectively. With the exception of 2009, non-government entities led issuances up until 2016. After the oil-price decline, however, government issuance increased, climbing to $40bn.

Ahead of its peers, Bahrain started issuing government debt through its central bank in 2003, followed by Kuwait. The bonds are issued in the primary market and held to maturity by local banks. Under Vision 2030, Saudi Arabia has established a Debt Management Office with a new domestic bond issuance programme. The UAE faces additional challenges because of its lack of a federal debt law and has thus lagged behind its peers in domestic government bond markets.

Going forward, the creation of liquid domestic debt capital markets will be one of the most interesting challenges for GCC countries.

Islamic finance

Although the Gulf is home to the highest number of Islamic financial institutions and assets, it has lagged behind in the creation and standardisation of a framework for its industry. In the last decade, however, the Gulf contributed to the growth of international Islamic capital markets through USD Sukuk issuance.

A challenge remains not only in creating GCC standardisation among Islamic institutions but also in facilitating activity between conventional banks and Islamic banks. Conventional banks face no restrictions in the Islamic market, other than to comply with the Islamic legal framework required by Islamic counterparts. But resultant transactions (relative to their conventional forms) can be complicated. Additionally, a lack of standardisation among Islamic banks means that their conventional counterparties can find compliance with different requirements more difficult still.

Despite this, their more conservative approach to risk sometimes gives Islamic banks extra liquidity, thus Islamic banks can serve as a critical source of borrowing to their conventional counterparts. The liquidity landscape has not encouraged development in this area, but, with the changing environment, such integration will become more critical. In the absence of standardisation, central banks may play as vital a role as federal regulators in creating standardisation and frameworks not only at country level, but across the Gulf as well.

Role of regulators: stronger regional and global integration

GCC states are members of the most important international organisations in financial regulation, including the IMF and UNCTAD. Saudi Arabia is a full member of the G20 and, by extension, the FSB and Basel Committee.

With regards to banking supervision, in particular capital and liquidity requirements, all GCC members complied with Basel II and announced their intention to implement Basel III. All GCC states are also full members of IOSCO, thus ensuring the following of international standards for securities-market legislation.

As the region continues to transition through a period of transformation, global markets are monitoring Gulf countries closely to discover their full potential. The current low price of oil has created a common will to and direction for change, but divergence on economic fundamentalss has created differences in the urgency surrounding implementation.

Ebru Boysan is a market specialist at Bloomberg