Saudi Arabia, like the entire Gulf region, lags behind other major regions in terms of financial development. This has made it more difficult to achieve the objectives of economic diversification and employment creation in the Kingdom. Moreover, while the level of development in financial markets in the Gulf was comparable to that of other emerging areas in the early 1980s, the gap has widened in ensuing years. A recent study by the International Monetary Fund (IMF) using various measures of financial development found that all other regions of the world except sub-Saharan Africa had achieved higher rates of financial development in the past three decades than the Middle East and North Africa (MENA) region — including the Gulf. That was salutary; international comparisons should always be the standard of measuring local performance of local markets. (See graphs)
There is not enough liquidity available from government grants, nor from aid institutions to finance necessary infrastructure. These projects are not only essential to meet serious demand, they create investment opportunities that solve bottlenecks, create high value-added jobs and accelerate economic reforms. On the other front, the flow of capital to the Saudi and GCC financial markets is an indication of a huge appetite from individuals as well as institutions for participating in future economic development — directing their savings toward more profitable investments to increase their earnings and make a better life for themselves and their families. The upcoming role of the Saudi capital market is vital in this move toward local and regional economic sustainability.
Although Saudi Arabia as an oil exporter has accumulated very large amounts of assets in past decades, limited domestic opportunities for market investment and the lack of a well developed financial system capable of deploying those funds within the region, have meant that earlier oil-related surpluses have often been invested offshore with financial intermediaries based in OECD (Organization for Economic Cooperation and Development) countries. One measure of the mobilization of financial assets is that bank assets and stock market capitalization account for relatively low shares of GDP. In Saudi Arabia, trading in debt securities does not exist. The only two methods of finance are bank assets and to some extent equity in stock market. Both are of short-term maturities.
Eventually finance for large projects will need to come from domestic capital markets and domestic banks. Saudi banks lack long-term liabilities on their balance sheets, hence their capacity and experience are very limited in providing long-term loans that are essential to finance those mega-infrastructure projects planned either by the government or the private sector. More importantly, government projects already awarded to the private sector, such as railway and some water and power projects, have ended up over budget by 70-80 percent because of rises in the cost of funds. This was a direct consequence of the lack of long-term debt instruments and hence high dependency on international institutions in providing funds. These leverage the situation to include high-risk premiums and extremely high rates of return on investments in Saudi Arabia as a developing country with no debt market. Furthermore, foreign borrowing on a large-scale is feasible only for infrastructural projects that earn foreign exchange (for example ports).
As a means of finance, private companies and banks may buy international bonds to finance long-term projects. Currently, local banks tend to provide short/medium-term finance to private companies, with particular focus on financing personal loans or corporate short-term loans. Such practice represents a financial burden on corporations as the need to repay loans over a short term, in comparison to the long time span of projects, particularly industrial ones, makes the interest on such loans and the frequency of installments economically unfeasible. Therefore, local banks have tended in the past to confine their activities to trade and construction, which are short term and high return. Industrial and infrastructure projects require long-term funding, involving as they do massive capital input. Thus recovery of costs and realization of profits need a longer time frame and necessitate extended terms of repayment. If banks were assisted in issuing and selling their bonds, in addition to assisting industrial and utility companies (such as water and electricity) to issue their own bonds, then abundant productive investment opportunities would become available, which would stimulate economic growth and with it the creation of job opportunities.
Moreover, bond financing is heavily tilted toward government debt in Saudi Arabia at present, with sovereign issues accounting for more than 90 percent of all issues. This is higher than any other region in the world. Conversely, financial institutions and non-financial corporations account for less of the total issuance than in any other region.
There are also serious shortcomings in the government debt market, such as incomplete yield curves, lack of hedging instruments and a broad investor base. Due to scarcity of fixed income assets, and lack of active traders, most bond issues are quickly bought by long-term institutional investors, with no secondary trading. With booming oil revenues, government bond issuance is likely to diminish, causing a contraction in the supply of government debt. Thus, the pool of investment assets may well contract in the face of rising revenue.
Government and semi-government institutions, such as Saudi Basic Industries Corp. (SABIC) or Aramco, should start issuing debt securities. There are two major reasons. The first is to avoid the crowding-out effect of large, profitable companies competing with smaller companies in accessing local banks. Such companies enjoy strong international demand for their products but are borrowing from the local banks despite the fact they can access the best international financial institutions. They thereby compete with smaller-size institutions that do not have that luxury. The second reason is that securities from such institutions will create a benchmark for highly rated bonds or Islamic sukuk. The use of government benchmark market indices of “A” class government bonds has to emerge on the financial scene. Over time, the index will be revised to reflect ongoing market and industry developments in the Kingdom. The construction and use of benchmark market indices will result in a dramatic transformation of the local financial market. Economic, industrial and corporate expansion, coupled with the sophistication, proliferation and diversity of instruments will lead to an increase in the number of benchmark indices and their greater use by an expanding investment community. Benchmark committees will deliberate over the construction of the debt market structure and determine the rules of the benchmark. Investors will need the benchmark indices as performance indicators of the broad market.
To conclude, it is imperative that new approaches to access these markets be developed in Saudi Arabia. The Kingdom and the whole Gulf region will emerge strongly on the international investors’ radar screens. This will help substantially strong and sustainable local economic growth, not to mention a rapid expansion in intra-regional trade. Also, investment will lead to a correspondingly accelerated pace of development of the regional capital markets.
(Dr. Nahed Taher is managing partner of Compass Consulting.)