The Saudi stock market has undergone a severe crash moving from a bullish period in February 2006 when the index reached almost 22,000 points and the bubble was formed to a bear market afterward plunging the index to almost 4,200 points in November 2008. Casual market investors and observers will blame “irrational exuberance” as the main factor behind the collapse. An empirical analysis revealed many instigating factors behind the bubble. These factors commonly could have been prevented or mitigated had it not been for the lack of appropriate legislation and action by the government authorities. The lack of such intervention by the regulatory bodies, coupled with overvaluations and irrational behavior of investors made such a collapse inevitable.

The need for continuous prudent intervention from the Saudi Arabian Monetary Agency (SAMA) and the Capital Market Authority (CMA) in the stock market is crucial during and after the stock bubble particularly in times when the financial stability is threatened.

Considered as one of the pillars of the current financial crisis, the extended credit to the private sector needs to be more prudentially supervised. As a possible channel of irrational trading and subsequent losses, the increase in money supply and credit to private sector in Saudi Arabia, serves the link between the private credit and the possibility of trading with that credit.

There are different channels to regulate such flows from the banking sector to the stock market both at macro and micro levels. On the prudential level within the banking sector more attention needs to be given to the final use of the credit flows. In addition, the credit contracts may also include post-credit behavior of the borrower, covenants to restrict the credit to the activities specified in the contract. Needless to say, a differentiation needs to be made between ex-ante and ex-post monitoring. In the ex-ante setting, it is more difficult to limit the risky borrowers.

There was also a liquidity disbalance on the side of the stock shares available for trading and the amounts of credit given to the private sector. With only 30 percent of shares of major companies privatized and available through stock markets such as the Saudi Basic Industries Corporation (SABIC), Saudi Telecommunication company (STC), and the Saudi Electricity Company (SEC), on one hand and on the other hand with the excess liquidity created in the credit markets. This problem could have been avoided if the government unloaded its equity in the big companies and transfer them to available stocks for public investors. This would have increased the turnover rate for stocks and create more shares from major companies for the public trading and therefore increased the depth of the market. This suggests that more coordinated policy measures are needed for both monetary and prudential authorities including stock market regulators.

SAMA along with Ministry of Finance (MOF) need to encourage the development of financial institutions with experience in trading and investments; however, strict corrective measures should be taken on any financial institutions with large exposure to equity risk that could lead to risky investments.

Moreover, other measures need to be taken from the CMA side. CMA should take more roles in allowing investors trade on their floors. Also, on the part of stock exchanges, new hedging products, swap agreements to mitigate the risks involved needs to be introduced. More risk-shifting and more risk sharing instruments and facilities need to be adapted. Insuring losses and defaults would be just one major industry to develop. CMA should monitor companies to insure the transparency factor is met. In that the managers of a company shouldn’t be allowed to buy and sell unless the announcements of policies and procedures in addition to the performance of the company are revealed. CMA should transfer all the settlements of stocks market trading from commercial banks to Tadawul. CMA should strictly enforce regulations on both financial institutes and investors.

Media also has significance impact on investors’ behavior particularly in the event of a stock market bull. One should understand that “media exist to sell media, and speaking the truth may or may not be of their interests”. Therefore, strict measures have to be taken to reduce the impact imposed by media’s false speculations regarding stock prices and their values. In addition to advisory activities, services need to be institutionalized and regulated through registration, licensing and professional certification.

In the process of educating the public investors and eliminating information failures, CMA should provide accessible information, training tools, sponsor conferences and workshops to investors. This can also be achieved by opening stock trading academies in Saudi Arabia.

Improving the regulations and motivating the growth of institutional investors and market makers is another area yet to be modified. CMA should expand the scope of the entry requirement laws, removing the barriers to entry for non-Saudi residents, performing a thorough due diligence on both parties, enhance research and financial reporting standards in addition to corporate governance. More careful supervision needs to be undertaken regarding stock options, insider trading and takeover issues to avoid deliberate actions from the part of managers and also to insure adequate liquidity in the markets.

Taking these measures on both parts SAMA and CMA, will enhance transparency in the stock market, increase investors confidence and knowledge, and reduce the potential of unfair trading, hence reduces speculative and irrational investors.

Recovery pattern

The recovery pattern for the Saudi stock market is likely to undertake three stages.

During the first stage, market corrections are likely to be violent, with extreme price fluctuations further slowing down the market. The second phase of recovery will be relatively longer, but more stable and peaceful for investors. The final stage will lead to full market recovery and “realistic” pricing of assets.

“In the meantime, until the dust settles, prices will rise and fall intermittently and it may be a while longer before the Saudi market is ripe for new investments. Ultimately, continued influx of capital from oil revenues will ensure ample liquidity within the country in that every percentage point gain in oil (between 2003 and 2006) offered enormous amounts of spending to the rest of the economy which led to a three percentage point rise in the Tadawul All-Share Index.

Despite the fact that the bubble has severely damaged Saudi stock market, shaking investor confidence, there are some important lessons to be learned. As a result of these developments, Saudi investors are likely to be more careful and rational in their future investment decisions. To avoid a similar disaster in the future, the government is likely to take the necessary steps to prevent the heating up of the stock market.

(Abdullah Ahmed Hafiz, Ph.D. Finance & Economics, The George Washington University. E-mail: [email protected])