MODERNISING GCC CAPITAL MARKETS: 5 IMPORTANT STEPS

This article was originally published in Arab Times, Al Qabas, Gulf News and Akhbar Al-Khaleej

While the GCC countries generally enjoy a high standard of living and prosperity, they are still behind the curve when it comes to its capital markets. The definition of capital markets predominantly means equity markets primarily in this region due to the lesser role played by the debt market. Notwithstanding, there is an immediate need to modernize the GCC capital markets in a way that it can deliver its true function –efficient capital allocation.

While there are myriad factors that can contribute to these modernization efforts, the five most important factors are:

  1.       Integrate the Markets: GCC stock markets, like GCC states, are not a homogenous group. With Saudi Arabia’s market cap pegged at over $500 billion and that of Oman pegged at $18 billion, the comparison is never apples to apples.

Several efforts to unify GCC on many fronts including customs, currency, etc. achieved only partial success if primarily due to political differences. In spite of this, unifying the capital markets and creating one stock exchange representing all GCC markets that trades both equities and debt can be a great step towards modernizing. This will obviate the need to reinvent many things including state-of-art technology needed for a modernized stock market.

A unified GCC stock market can be worth more than $1 trillion in market cap and can list nearly 700 stocks, making foreign investors take a serious note of this region.

  2.       Institutionalize the markets: The major worry about GCC stock markets is the lack of institutional investors and therefore predominant presence of retail investors. The domination of retail investors is not bad per se, but the absence of credible long-term institutional investors is a serious worry.

While institutional investors provide the much needed stability and liquidity to the markets and can significantly deepen the market, they are presently quite under represented. Such institutional investors include sovereign wealth funds, mutual funds, pension funds, hedge funds, foreign institutional investors, insurance firms etc.

Attracting institutions to the market cannot happen through a decree. However, regulators and policy planners can take proactive steps in strengthening market microstructure in a way it can start appealing to institutional investors. Restrictions like foreign investment can be a big negative towards this process. Requiring market participants to adopt sound corporate governance codes can be a big positive.

 3.       Strengthen Information Base: A critical missing link here is the ability to obtain stock market related information from websites.

A diligent investor should sift through several pages (in English and Arabic) in order to even assemble some meaningful basic information about listed companies and markets. Technology can assist in this effort to seamlessly provide information across companies, sectors, family groups, etc., and this initiative can be taken by the respective stock exchanges. 

  4.       Improve Liquidity: The main casualty of the global financial crisis has been the stock market liquidity for GCC markets.

After hitting a peak of $1.6 trillion in 2006, value traded for GCC stock markets hit a low of $296 billion in 2010. At the end of 2013, total value traded was placed at $475 billion. It may be a long time before GCC stock markets return to the volumes of 2006. Even extrapolating IMF forecast for GDP and its linkage to market cap, the turnover value is expected to touch $875 billion by 2019, still a far cry from the peak of 2006. Liquidity is a key dimension for the survival and growth of the brokerage industry and can be a key input for foreign investment. It is also an important factor for including GCC markets in global indices like the MSCI Emerging market index. Presently UAE and Qatar have managed to enter this prestigious club but notable absentees still include Saudi Arabia and Kuwait. 

  5.       Provide more tools for Risk Management: GCC stock markets are inherently more volatile than their emerging market peers primarily due to their nascent stage of development. Hence, managing this risk or volatility is a key underpinning for institutional investor entry. A buy and hold environment may not enable this.

Availability of broader tools like derivatives (options and futures) can provide the needed tools for managing this volatility. Derivatives are often viewed with trepidation in the region primarily because of its debilitating effect in the Global Financial Crisis. However, a good tool in the hands of a bad person does not make the tool bad. Proper checks and balances can make this serve the original purpose for which it is invented – to hedge risk and protect downside. 

  Modernizing GCC capital markets can lead to several improvements that can be tangibly measured, including:

  ·         Increasing the role of capital market in the overall economy as measured by the market capitalization to GDP ratio. Currently it stands at 58% while many countries in the world enjoy a ratio of over 100%.

  ·         Enabling GCC markets to find a place in the MSCI Emerging Market index. Presently only UAE and Qatar have this coveted status.

  ·         Increasing the foreign institutional investment especially long-term investors like pension funds and endowments.

  ·         Improving the new listings, which is at the core of market development.

All of these results are measurable. Can we then think of making these the Key Performance Indicators (KPIs) for our regulators and policy planners? 

  

The Debilitating effect of Inflation on Investments

This article was published in The May 2014 issue of the Global Analyst

       ·      Rs. 1 lakh invested in Equities 25 years ago will now be worth Rs.47 lakhs before inflation and Rs. 7.6 lakhs after inflation!
·         Rs. 1 Lakh invested in Gold 15 years ago will now be worth Rs. 6.7 lakhs before inflation and Rs. 2.7 lakhs after inflation!
·         Rs. 1 Lakh invested in Fixed Deposits 10 years ago will now be worth Rs. 2 lakhs before inflation and Rs. 1 lakh after inflation!
·         What Rs. 6,700 could buy in 1980, you will now need Rs.1 lakh for the same!

    Almost always we make investment decisions based on absolute performance rather than inflation adjusted performance. In my humble opinion, this approach can have very costly consequences in terms of our wealth and overall financial well-being.

     Without considering the effect of inflation, the investment performance can look really dramatic. For eg., Rs. 1 lakh invested in 1979 in equities can now be worth Rs. 1.88 crores!. But when adjusted for inflation it is worth only Rs. 12.6 lakhs, still better than other investments like gold and fixed deposits. Also, inflation creates more havoc in the long run than in the short run as it is a steady and silent killer. For eg., if you have invested Rs. 1 lakh in a fixed deposit in 1979, it is now worth Rs. 15.5 lakhs. But when adjusted for inflation, it is worth only Rs. 1 lakh! In other words, for 34 long years your investment worth has remained unchanged.

Source: RBI, BSE, and other sources. All data for period ending 31^st March 2013. 

     The table above reflects the complete picture across time and investment category. Let us analyse by investment category. At this stage, it may be worthwhile to explain what is nominal and real. Nominal rate of return is the absolute rate before adjusting it for inflation. Real rate of return is the performance after adjusting for inflation. For eg., during the last five years fixed deposits have returned an annualized return of 8% while inflation was also running at more or less same speed causing the real rate of return to be nil.

      

      Fixed Deposits

     If you are a fan of fixed deposits, think again. Most of us, deal with bank fixed deposits without realizing the meagre return (after inflation) that it offers. It has failed to produce any reasonable real rate of return in any time period. While banks have benefitted by the fixed deposits as they make nice spreads (the difference between lending rates and deposit rates), the investors have not made any returns since inflation eats away all the returns leaving nothing on the table. Whenever inflation increases in the economy, the RBI uses interest rates as a tool to contain the inflation (though I am not sure how effective that strategy is so far). In other words, when inflation increases, interest rates also increase thereby technically protecting the real rate of return. However, as data shows, inflation seems to have had the upper hand resulting in the dismal performance of fixed deposit. Over the long-run, a 0% real rate of return can hurt seriously. 

     

      Gold

    Your wife’s obsession with gold after all is not a bad idea! Gold has always produced good real rate of return across all time periods unlike fixed deposits. Gold seems to be having a gala time of late (during the last 5 years) compared to say last 25 years or 34 years. Gold has generated nearly 25% nominal returns annualized (before inflation) and 15% real return (after inflation) during the last five years making it as the best performing investment. It also had a nice run when seen from a ten year context with inflation adjusted annualized returns at nearly 11%. However, in the long run (25 years and 34 years), its real return (inflation adjusted) seems to be moderate but still better than fixed deposits.

    The recent good performance of gold in the last five years could be more due to global financial crisis and its aftermath all across the world. So long as global uncertainty persists, we can expect gold run to continue.

      Equities

      Indian Equities by far has the best story to narrate, especially in the medium to the long-term. In the short-term, (last 5 years), the equity performance is negative after adjusting for inflation but this is only expected given the volatility with which this asset class evolves in the short term. As said before, the global financial crisis has a direct bearing on the performance of equities and hence it is no surprise that its performance has been lack lustre. However, if you can muster some patience, it is by far the best hedge against inflation. It produced a real return of 8.5% annualized in the last 25 years compared to 1.7% for gold and 0.9% for fixed deposits. The same trend can be observed for the last 34 years where it produced a real return of 7.7% compared to 2.7% for gold and 0.1% for fixed deposits.

     It is thus clear that if we can have a time frame of 10 years+ then we can expect equities to protect us from the inflation beast. In the absence of treasury inflation protected securities (TIPS) as it exists in US, the only place to hide against inflation seems to be equities. Though there is no statistic to back the claim, I also feel Real estate doing a good job of protecting value against inflation.

      Welcome to the world of Finance!

     On a side note, while inflation is certainly not benefitting investors, it is benefiting insurance companies in terms of launching products. Recently Aviva launched “Family Income Builder” scheme which states as under:

    “You would be surprised to know that the cost of living has doubled in the last 12 years, and this trend is expected to continue. Are you sure that your savings are also growing at a similar pace? Presenting Aviva Family Income Builder - a life insurance plan that doubles your money. Pay an annual Premium for 12 years and get double of what you have paid every year, for the next 12 years, guaranteed”

    Simply put, what they are saying is that they will double your money in 12 years! A back of the envelop calculation says that the annualized return of such a proposition is just 6%, far lower than the fixed deposit returns that you get in banks! The catch is not in doubling, it’s how soon you double. Welcome to the world of finance!

   

     Trends and Challenges:

     There are 3 trends that are worth noting from a lifestyle point of view:

     ·        You will live longer than you think-more importantly your wife will live longer than you (based on life expectancy)
·         Your investment will produce lower returns as you age yielding lower income &
·         Your cost of living will increase more than what you estimate

      The power of inflation probably comes in directly in the last trend i.e., cost of living and to an extent in the second trend where after inflation the net returns will be lower. The final outcome of these 3 important trends is that you will experience a lower standard of living in retirement.

     

      How to beat it?

        ·         Focus on health-don’t just be content with maintenance. Spend money on building a healthier body.
·         Develop an investment strategy that is inflation proof (and fixed deposit is certainly not one of them)
·         Work longer-move your retirement age from 65 to say 70 or even 75

      The author thanks Karthik Ramesh and Rajesh Dheenathayalan for assistance. 

Why is Liquidity important?

Liquidity is at the backbone of any market development and GCC stock markets are no exception. Strong oil price backed wealth effect coupled with retail nature of the market triggering speculative activity contributed to very robust liquidity levels in the past, especially before the financial crisis. Liquidity is generally measured as total value traded and is expressed as a % of total market capitalization to arrive at the velocity. A high velocity may indicate that liquidity is running ahead of the market and vice versa. Also, improved liquidity has many benefits including cost of transaction. In the context of GCC stock markets, the following questions beg answers:
1. By how much did the liquidity drop for key index movers measured in terms of before and after Global Financial Crisis?
2. What impact such a drop had on the bid-ask spread (a proxy to measure transaction cost)
3. Are there any inconsistencies in this and if so what can explain it?
Before we answer these questions, let us quickly explain the methodology of this small research:
1. We collected daily volume, value traded, market capitalization, bid-ask spread on 15 heavy weights in the GCC stock markets
2. We organized this data in terms of pre financial crisis (before 2008) and post financial crisis (after 2008).
3. We calculated Average Daily Value Traded (ADVT), a measure of liquidity for all the stocks
4. We also calculated the Turnover ratio (defined as total volume traded/number of outstanding shares).

Now let us turn to our findings in a quest to answer our questions:
Table 1- % change between Pre-crisis (2003-2008) and Post crisis (2009-2013) 

1. By how much did the liquidity drop for key index movers measured in terms of before and after Global Financial Crisis?

Regarding the first question liquidity dropped across the board in the aftermath of the crisis as expected. For example SABIC’s daily average value traded (ADVT) stood at  USD 178 mn dollars during the period from 2003-2008. Post 2008 the ADVT fell by 27% to USD 130 mn dollars. Saudi Telecom saw a large decline in ADVT from USD 100 mn before the crisis to USD 11.9 mn a drop of almost 90%. The table above shows the effects of the crisis on the average value traded.

Table 2- Summary of finding

2. What impact such a drop had on the bid-ask spread (a proxy to measure transaction cost)
In general, as liquidity improves, bid-ask spread reduces thereby reducing the cost of transaction. In the case of heavy weight GCC stocks, spreads increased in response to a fall in the liquidity for most of them. SABIC’s  Spread was 0.23% prior to the financial crisis while after the crisis it increased to 0.3%. In the case of Saudi Telecom the Spread increased marginally from 0.27% to 0.29%. The biggest increase in spreads is seen in Zain where before the crisis the spread was around 0.75% (high compared to Saudi companies) while after the crisis it increased by  88% to 1.42% though this cannot be totally attributed to a fall in ADVT as ADVT declined only by 9% compared to pre-crisis numbers
3. Are there any inconsistencies in this and if so what can explain it?
Finally were there any inconsistencies? Some companies in our study showed positive correlation in that while liquidity decreased, the bid-ask spread also decreased and vice versa. Examples include Emaar, First Gulf Bank and industries Qatar. However the main reason behind this positive correlation is that the mentioned companies did not have sufficient history for us to make meaningful comparison between pre-crisis and post crisis numbers. The only company with sufficient data was SAMBA and we could attribute the fall in liquidity to the financial crisis and attribute the fall in spread to peers. In other words, before the crisis SAMBA had the highest spread among Saudi banks under our coverage thus the number after the crisis had to drop to be in line with other Saudi banks.

Concluding Thoughts:Leading GCC stocks today have more bid-ask spread than a few years before thanks to poor liquidity. The bid-ask spread ranges from a low of 0.18% (Industries Qatar) to 1.52% (National Bank of Kuwait). Going forward, as liquidity improves, the bid-ask spread should reduce and may reach levels seen before the financial crisis. Market attractiveness to institutional investors can be significantly increased if liquidity improves and reduces the bid-ask spread.


By -  M.R. Raghu & Humoud Al Sabah