Is the Middle Eastern Economy Rebounding?

COUNTRY BRIEFING - FROM THE ECONOMIST INTELLIGENCE UNIT

The graph of Gulf stockmarket indices has flattened out over the past two weeks, in a sign that the dramatic correction in share prices that started at the end of February may have finally run its course. If that proves to be the case, and if Gulf markets move into a phase of steady recovery for the rest of the year, it will signify that the fall-out from the recent crash will not be too severe, in terms of household incomes, consumer spending and the integrity of the regional banking system. That is no doubt what the region's regulators and governments are hoping for. The alternatives--another unsustainable boom or further sharp declines--would lend substance to warnings issued in some quarters about increased systemic risk in the Gulf financial markets.

Saudi first

The Saudi Arabian stockmarket, which is by a considerable margin the largest in the region, has tended to set the tone for the other bourses. The appointment of a political heavyweight as the new (acting) chairman of the Capital Market Authority (CMA) has had the effect of stabilising the market. The new regulatory chief, Abdelrahman al-Tuweijri (he is also the secretary-general of the Supreme Economic Council) has promised to take a number of measures that should help to build confidence in the period ahead. These include technical measures to upgrade the trading platform, a move to license non-bank mutual funds so as to increase the involvement of institutional investors, and a plan to set up an independent authority that will license financial analysts.

Saudi Arabia's Tadawul all-share index moved up sharply from its recent low of 9,471 on May 11th in the immediate aftermath of Mr Tuweijri's appointment the following day, but then briefly fell back below 10,000 before climbing steadily to reach 10,760 on May 30th. Market capitalisation is now about US$420bn, compared with a record of almost US$800bn when the market peaked on February 25th. Other Gulf markets have shown a similar pattern, bottoming out in early May and showing modest overall gains since then.

The paper losses on Gulf stockmarkets over the past few months have been roughly equivalent to the entire GDP of the states concerned. However, the plummeting of prices followed an extremely rapid increase over the previous six months and substantial, albeit less spectacular, rises in all these markets since the oil price started its upwards spiral in 2003. There have so far been no quantifiable signs of serious adverse effects, although the picture is expected to become clearer once the region's banks report on their second-quarter performance n the next few weeks.

Adapting banks

In Saudi Arabia most banks reported continued strong earnings growth in the first quarter, following a highly successful 2005 in which all ten Saudi banks made returns on equity in excess of 20%. (Saudi banks have a strong equity base, with average capital adequacy of more than 18%, according to the Saudi Arabian Monetary Agency, the central bank). Total assets increase by 15% year on year, and aggregate net profit rose by almost two-thirds. A large portion of the enhanced revenue last year stemmed from brokerage fees, however, accounting for up to 70% of some Saudi banks' operating income. This also affected the first-quarter results, as the market continued to rise in January and February before the correction. The decline in turnover since then will clearly have an impact on fee income, and banks have also had to reckon with a decline in market share as non-bank brokerages are finally preparing to enter the fray as part of a belated programme of reform of the Saudi equity market. In addition, Saudi banks will have to contend with broader competition from foreign institutions, with up to ten new banks preparing to start operations in the kingdom by year-end.

The main area of concern as regards Saudi and other Gulf banks is the scale of their exposure to the stockmarket through lending for the purpose of equity trading--whether overtly or under the cover of general consumer borrowing. Moody's Investors Service highlighted this issue in a recent report in which it referred to "a build-up of new risks, which are largely systemic in nature". Moody's stated that margin lending for stockmarket investment accounted for note more than 15% of total loans, and appeared to have been adequately safeguarded through provisions. However, the agency also expressed concern about the risk that a substantial portion of other retail lending could have been linked to stockmarket activity. The Saudi central bank maintains that this is not a serious problem, as it had already imposed tighter curbs on margin lending and general consumer lending before the equity crash. Saudi banks also have plenty of alternative means of generating income, with corporate finance continuing to be stimulated by high levels of economic activity in the oil, gas, petrochemicals, infrastructure and non-oil industrial sectors, and new avenues for consumer finance opening up in the housing and insurance markets.

Equity comeback

A critical issue in the boom-and-bust cycle of Gulf equities has been the erratic behaviour of market participants, in particular individual investors. In the wake of the crash it might be assumed that investors will pay closer attention to the assessment of professionals, and that regulators will do more to ensure that analysts have the prompt and comprehensive information on which to base recommendations on particular stocks. A rational analysis of blue-chip Gulf stocks at present points to some attractive buying opportunities. Bakheet Financial Advisers of Saudi Arabia reckons that the forward P/E ratio (the current share price divided by forecast earnings per share for 2006) of most of the prime Saudi stocks is around 16, which is roughly the same level as at the start of 2005, when the Tadawul index stood at just over 8,000. There are also some new stirrings in the initial public offering (IPO) market. The Albaraka Banking Group, a major Jeddah-based Islamic finance house, is launching a US$580 IPO, following a successful private placement of US$425m worth of shares with institutional investors. There is also a large number of prospective IPOs in the pipeline associated with the licensing of new insurance companies in Saudi Arabia.

The bottom line for the Gulf markets is the sustained high oil price, which provides the underlying economic growth and strong liquidity required to create shareholder value and drive demand for equity investments. This tends to suggest that the Gulf has witnessed a powerful corrective jolt, which has not inflicted serious lasting damage.