FAS_215-238.qxd 8/31/11 8:16 PM Page 215 CHAPTER 9 Capital Markets This chapter investigates the main constraints to the development of fixed-income and equity markets in MENA. Private fixed-income instruments such as corporate bonds provide alternatives to bank finance; mortgage-backed securities and mortgage-covered bonds provide long-term funding for banks to expand housing finance. Welldeveloped government securities markets are a precondition for the sound development of private fixed-income markets, as they provide the benchmark yield curve for pricing private issues and the institutional infrastructure required for market development and the management of financial risks. Local currency government bond markets have grown considerably in many emerging markets, but they remain relatively undeveloped in MENA. Several common weaknesses explain the underdevelopment of government debt markets in the region. Most important among these are the lack of development of money markets and a diversified institutional investor base, opportunistic primary issuance practices, and captive demand by banks, which dominate bond markets. These problems have led to highly concentrated buy-and-hold portfolios by banks and stateowned institutions, poor price discovery, and lack of liquidity in secondary markets. Well-functioning equity markets can also complement the banking sector and contribute to efficient resource allocation. Key functions of equity markets include providing complementary funding for investment projects and an exit mechanism for entrepreneurs, discovering market prices, privatizing state-owned enterprises, facilitating corporate restructuring, providing vehicles for savings and wealth accumulation, and promoting good corporate governance. The findings of this chapter indicate that MENA equity markets do not perform their key functions adequately. Despite high market capitalization, markets do not provide a meaningful complement to 215
FAS_215-238.qxd 8/31/11 8:16 PM Page 216 216 Financial Access and Stability bank finance for enterprises in most countries in the region, the quality of price discovery seems generally poor, there is scope for further use of equity markets for privatization of state-owned enterprises and corporate restructuring, and corporate governance could be substantially improved. This chapter is structured as follows. The first section examines fixed-income markets in the region. The second section examines equity markets. Fixed-Income Markets The Limited Development of Government Debt Markets outside the Gulf Cooperation Council This section examines the current stage of development of government securities markets in non-gcc countries in the region and highlights key bottlenecks of market development. 1 The focus is on five countries that have government bond markets of minimum size and greater potential for market development: the Arab Republic of Egypt, Jordan, Lebanon, Morocco, and Tunisia (MENA-5). These countries have sizable debt-to- GDP ratios and domestic tradable debt, and, to different degrees, have implemented measures to develop their debt markets (figures 9.1 and 9.2). However, the analysis is relevant for other countries in the region as well. FIGURE 9.1 Total Central Government Debt as a Percentage of GDP, in Selected Countries in the Middle East and North Africa, 2004 09 % of GDP 200 180 160 140 120 100 80 60 40 20 0 Lebanon Egypt, Jordan Morocco Tunisia Syrian Arab Algeria Arab Rep. Republic domestic government debt external government debt Source: World Bank database.
FAS_215-238.qxd 8/31/11 8:16 PM Page 217 Capital Markets 217 FIGURE 9.2 Total Central Government Debt in Selected Countries in the Middle East and North Africa, 2004 09 160 140 120 US$ billions 100 80 60 40 20 0 Lebanon Egypt, Arab Rep. Jordan Morocco Tunisia Syrian Arab Republic Algeria domestic government debt external government debt Source: World Bank database. The analysis focuses on the five building blocks that sustain deep and liquid public debt markets: money markets, primary markets (issuance policy and placement mechanisms), secondary markets, the investor base, and clearing and settlement infrastructure. Market development in MENA requires actions in all key building blocks, from improvements in monetary policy implementation and liquidity management to enhancements in issuance practices, price transparency, and clearing and settlement. Measures to improve the role of mutual funds and foster foreign investor presence are also critical to increase competition and investor diversification in these markets. Money markets The preconditions for well-functioning money markets are missing in MENA, depriving banks of the ability to actively manage liquidity. In advanced economies, well-functioning money markets are the cornerstone of efficient domestic debt and equity markets. MENA money markets are shallow, as a result of structural excess liquidity that is ineffectively sterilized, the central bank s choice of sterilization instruments that are not supportive of market development, and poor money market operational arrangements. Excess structural liquidity is not sterilized fully, as a result of difficulties in liquidity forecasting and the high costs of sterilization. Relatively
FAS_215-238.qxd 8/31/11 8:16 PM Page 218 218 Financial Access and Stability TABLE 9.1 high reserve requirements are used in all countries in the region as a first recourse to absorb excess structural liquidity. The choice of additional sterilization instruments, mainly short-term auctioned deposits and overnight standing facilities, is inadequate to support effective liquidity absorption. These instruments are used in advanced economies to fine-tune operations or when liquidity forecasting errors are smaller. The operational framework to support money market transactions is unevenly developed in MENA-5. In their infrequent liquidity operations, central banks use an ad hoc secured lending facility similar to a repurchase agreement. The interbank repo market is practically nonexistent, except in Morocco. In addition to the lack of incentives to manage liquidity actively, other regulatory, tax, and infrastructure constraints impede its development. Primary markets MENA-5 countries have basic market-oriented issuance policies, including the correct choice of instruments (discounted Treasury bills for the short term, fixed-coupon Treasury bonds for the medium and long term), but they prioritize low funding costs over market development. A sound issuance policy is the first step in a strategy to develop a liquid domestic debt market. To different degrees and depending on the country, key shortcomings are found in the maturity structure, auction calendars, concentration of demand, and lack of liability management techniques (table 9.1). The maturity structure is generally unbalanced and skewed toward the long term, which impedes the creation of liquid Main Features of Primary Public Debt Markets in MENA-5 Countries, 2008 Feature Egypt, Arab Rep. Jordan Lebanon Morocco Tunisia Preannounced Yes No No Yes Yes calendar Compliance with calendar Reopenings Bid-to-cover ratio Auction participation High n.a. n.a. Medium Medium Yes No No Yes Yes 1.5 1.4 1.5 7.0 3.0 15 exclusive Any financial Banks Banks and 12 banks and primary institution 6 nonexclusive 1 nonexclusive dealers primary dealers primary dealer Treasury bonds as percentage of total bonds 36 61 94 76 98 Average maturity (years) 2.1 2.0 1.7 5.9 5.3 Source: Ministries of finance and central banks (annual reports and web sites). Note: n.a. = not applicable.
FAS_215-238.qxd 8/31/11 8:16 PM Page 219 Capital Markets 219 benchmarks at all points of the yield curve. With the exception of Egypt, countries do not comply with a predictable auction calendar, and there is irregular supply at auctions of the whole range of debt maturities. The concentration of demand by state banks and other state institutions lowers the degree of competition in several countries. Countries in the region make limited use of liability management techniques to consolidate issues, enhance liquidity, and reduce rollover risk. All MENA-5 countries conduct multiple price auctions. The current debt term structure, which is biased toward long maturities in most countries in the region, combined with the illiquidity of secondary markets are the main obstacles to market development. Though extending the average debt maturity to reduce rollover risk is a legitimate objective of debt management, from a market development perspective, longer maturities are desirable only as long as their issuance is sustainable and pricing is market based. Issuing long maturities too quickly without price references at the shorter end of the yield curve creates uncertainty over the pricing of Treasury bonds. Without short-term price references, governments have been tempted to place their long-term debt at off-market prices. This practice has been facilitated in MENA-5 by captive demand resulting from excess liquidity; dominant state banks and institutions (for example, public pension funds); and lack of alternative investments. Relying on captive demand distorts pricing. Although this strategy may lower the cost of debt in the short term and reduce rollover risk, it creates a vicious circle, further reducing market liquidity. It introduces a strong incentive for a buy-and-hold strategy, which avoids the realization of latent capital losses. It weakens the balance sheet of financial intermediaries, even if losses are not realized, and increases liquidity risk in the financial sector, particularly in the event of a liquidity crunch. Finally, it unnecessarily segments debt into pools of locked-in portfolios, delaying reforms to create liquidity at the shorter end of the yield curve even further. Secondary markets Secondary markets are generally shallow in MENA-5 as a result of excess liquidity, inappropriate issuance policies, a nondiversified investor base, and a primary dealer system that does not perform its functions adequately. Therefore, reforms in all building blocks mentioned in this report are preconditions for improving secondary market liquidity and pricing. Government securities are traded predominantly in over-thecounter wholesale markets and marginally on exchanges. Reporting obligations are very minimal in all markets, as a result of low secondary market activity, and there are no pretrade price dissemination requirements in any MENA market.
FAS_215-238.qxd 8/31/11 8:16 PM Page 220 220 Financial Access and Stability Secondary markets in MENA-5 may be classified into three different profiles. In the first group, Egypt has the most active Treasury-bill market and a gradually increasing trade volume in the Treasury-bond market, reflecting an improved issuance policy. In the second group, comprising Morocco and Tunisia, the combination of long average maturity and low secondary market liquidity has led to a disproportionately high use of repos to manage liquidity. In Morocco, the general repo legal framework work is robust, but the spot market to sustain credible valuation of collateral is missing. Repos account for 99 percent of all trading activity in Morocco. In Tunisia the legal framework is weaker. Formal repos have not taken off there, although banks use an unregulated substitute called ventes à rémérés to manage liquidity. In the third group, Jordan and Lebanon have almost no secondary market trading, as a result of excess liquidity, a very fragmented debt structure, and poor market infrastructure. The common feature of all three primary dealer systems in MENA-5 (Egypt, Morocco, and Tunisia) is that primary market obligations are enforced and secondary market obligations are not. In general, primary dealer programs can be very useful to ensure primary market placements and supply liquidity in the secondary market. The lack of enforcement of secondary market obligations is in part explained by the structural difficulties of trading activity it is unrealistic to enforce market-making obligations as found in advanced markets. A potential solution is to reassess rules so that secondary market obligations are in line with the degree of market development. Investor base A large and diversified investor base is important for ensuring high liquidity and stable demand in the fixed-income market. A heterogeneous investor base with different time horizons, risk preferences, and trading motives ensures active trading and stimulates liquidity, enabling the government to execute its funding strategy under a wide range of market conditions. In Egypt, Jordan, and Lebanon, banks and state-owned entities are more dominant buyers of domestic debt than in peer regions. In MENA- 5, unlike many other emerging markets, there is no evidence of a declining trend in the share of these entities in favor of institutional investors. Egypt, Jordan, and Lebanon have the least diversified investor bases, with banks and state-owned entities holding more than 75 percent of issued debt (table 9.2). The main drawback for debt market development is not the predominant role of banks but the circumstances that make them buy-and-hold investors. Under normal conditions, banks should trade their securities portfolio to support their liquidity management operations. As explained above, excess liquidity and primary issuance policies
FAS_215-238.qxd 8/31/11 8:16 PM Page 221 Capital Markets 221 TABLE 9.2 Composition of Investor Base for Government Debt in MENA-5 Countries, 2009 Type investor Egypt, Arab Rep. Morocco Tunisia Jordan a Lebanon Banks 55 23 33 81 62 Public sector and pension funds b 30 27 1 36 Insurance companies 3 12 0 0 Mutual funds 1 22 c 29 19 0 Foreign investors 10 1 0 0 1 Other 1 15 37 d 0 1 Total 100 100 100 100 100 Source: World Bank staff compilation based on national sources. Note: = not available. a. Holdings of banks and nonbanks only. b. Egypt: National Bank of Egypt and Social Security; Morocco: Caisse de Depôts et Gestion; Lebanon: Central Bank. c. Caisse de Depôts et Gestion holds 29 percent of the industry s assets. d. Individuals. are not supportive of secondary market trading, and the lack of alternative investments make banks buy and hold, reducing liquidity and investor diversification in public debt markets. The institutional investor base is generally small across MENA-5 countries. In other regions, pension funds, insurance companies, and investment funds typically play a major role in the development of government securities markets. In contrast, in MENA, private pension funds are still negligible and public pension funds are not playing a significant role in debt market development in most countries. Except in Morocco, the contribution of the insurance sector to public debt markets is very limited, as a result of the sector s small size across the region. Egypt, Morocco, and Tunisia have nonnegligible investment fund industries, but these markets do not focus on retail investors; they have a unique wholesale profile tightly linked to banks (see Garcia-Kilroy and Silva 2011). Foreign investors presence in MENA-5 government debt markets is negligible outside Egypt. Foreign investors have been key agents in developing local currency government bond markets in many emerging markets. They have supported the lengthening of the yield curve and been active secondary market traders. They have also been instrumental in the development of foreign exchange and derivatives markets as instruments to fund or hedge their investments in local currency (BIS CGFS 2007). Foreign investors hold less than 1 percent of government debt in Jordan, Lebanon, Morocco, and Tunisia; in Egypt, they held about 10 percent in April 2010, almost entirely in Treasury bills.
FAS_215-238.qxd 8/31/11 8:16 PM Page 222 222 Financial Access and Stability MENA markets have not attracted foreign investors because of their limited investability (Garcia-Kilroy and Silva 2011). Only Egypt and Morocco have met the minimum conditions required by foreign investors and for inclusion in the GEMX index, and they score among the lowest emerging markets. Although increased global integration through the presence of foreign investors can increase volatility in the local debt market, as demonstrated by the recent global market turmoil, there are ways to mitigate this risk, as discussed in chapter 10. Clearing and settlement infrastructure The clearing and settlement infrastructure in MENA-5 is adequate for the current stage of market development, but it needs significant upgrades to support more liquid and investable markets. Only Morocco s central securities depositary has the versatility required by wholesale and over-the-counter government debt markets. All other countries need to formulate a roadmap for a phased upgrade of their existing systems. An alternative option for some countries, such as Egypt, would be to follow the same strategy used for the real time gross settlement system and develop a state-of-the-art central securities depositary system. The rationale is the mutual dependency of both systems and the future need to have similar levels of information technology and operational performance. The Negligible Size of Fixed-Income Markets outside the Gulf Cooperation Council Underdeveloped government securities markets are a major constraint to the development of private fixed-income markets in MENA. Welldeveloped government securities markets provide a reliable benchmark yield curve for pricing and developing private instruments. Welldeveloped government securities markets also provide the institutional infrastructure for capital markets, including experienced dealers and brokers, dealer financing, futures and options markets, clearing, settlement, book entry, and registry functions, as well as oversight and regulation. The lack of development of government debt markets in MENA also helps explain why private fixed-income markets have not developed. Other regulatory and institutional constraints have also hindered the development of private fixed-income instruments. For example, no country in the region issued covered bonds, as a result of the lack of enabling legislation. Morocco is the first MENA country that is developing draft legislation and holding consultations with market participants. Securitization is in its infancy. Morocco and Tunisia were the first countries to develop a legal framework for securitization, in the early
FAS_215-238.qxd 8/31/11 8:16 PM Page 223 Capital Markets 223 2000s, but very few transactions were conducted. The subprime crisis of 2007 stalled the infant market shortly after the first deals. The lack of further market development also reflects regulatory weaknesses, such as the lack of a housing price index, the absence of rating agencies, and flaws in securitization structures, including concentration of roles by the loan originators, leading to conflicts of interest. The Status of Fixed-Income Markets in the Gulf Cooperation Council The GCC debt/sukuk market grew rapidly in the precrisis years. 2 The investment boom in Dubai led to corporate issues surpassing government issues in 2006 and 2007 (figure 9.3). The share of sukuk issues also increased in this period (figure 9.4). When the global financial crisis hit the region, in 2008, the GCC market in general and its corporate segment in particular suffered a setback. The sukuk market entered a turbulent period, following a string of standstill announcements in the GCC, with the real estate giant Nakheel s sukuk event in the United Arab Emirates the most prominent. The recent setback of the Islamic securities market has revealed challenges to the market s growth. FIGURE 9.3 Issuance of Debt/Sukuk Securities in the Gulf Cooperation Council, 2003 09 US$ billions 80 70 60 50 40 30 20 10 0 72.7 20.1 48.0 40.5 28.3 25.1 28.1 22.7 52.6 15.3 18.4 0.7 4.9 11.4 9.6 14.6 13.5 13.7 12.4 19.7 13.1 2003 2004 2005 2006 2007 2008 2009 sovereign corporate Source: World Bank staff compilation based on data from the GCC Bond Market Survey and Markaz database, 2010.
FAS_215-238.qxd 8/31/11 8:16 PM Page 224 224 Financial Access and Stability FIGURE 9.4 Sukuk versus Conventional Debt Securities in the Gulf Cooperation Council, 2003 09 percent 100 90 80 70 60 50 40 30 20 10 0 60 64 72 88 89 88 84 77 40 36 28 12 11 12 16 23 2003 2004 2005 2006 2007 2008 2009 total sukuk conventional Source: World Bank staff compilation based on data from the GCC Bond Market Survey and Markaz database, 2010. As a result of large debt/sukuk issues by corporations in the United Arab Emirates and issues by the federal government to finance its intervention in troubled corporations in Dubai, the United Arab Emirates accounts for the largest cumulative issuance in the GCC. Its issuances amounted to 50 percent of total GCC stock in 2009 (figure 9.5, panel a). A significant part of those issues financed real estate development projects and banking operations in the United Arab Emirates. By contrast, most of Kuwait s issues were government bonds, which were issued regularly for the central bank s open market type operations to drain liquidity from the banking system. The Qatari government s large issues with maturities of 5, 10, and 30 years totaled US$7 billion, putting it in third place in 2009. Nearly three-quarters of GCC issues were denominated in U.S. dollars, with issuances concentrated in a few sectors. The United Arab Emirates and Qatari issues accounted for 98 percent of U.S. dollar denominated GCC issues in 2009. Kuwaiti dinar denominated issues represented the largest outstanding amount among GCC currency issues in 2009. The sectoral composition of the GCC debt/sukuk stock reveals that among corporate issues, the financial services and the real estate sector accounted for more than half of the outstanding amount, followed by the oil and gas sector and utilities (figure 9.5, panel b). This sectoral composition is in line with the undiversified structure of GCC economies and is similar to that of equity markets in the region (see next section).
FAS_215-238.qxd 8/31/11 8:16 PM Page 225 Capital Markets 225 FIGURE 9.5 Outstanding Debt/Sukuk Securities in the Gulf Cooperation Council, 2009 a. By country Oman, 0.4, 1% Saudi Arabia, 4.5, 6% Bahrain, 2.0, 3% Kuwait, 14.0, 19% United Arab Emirates, 36.6, 50% Qatar, 15.3, 21% b. By sector power and utilities, 11.98, 5% transport, 9.19, 4% others, 4.61, 2% real estate, 18.81, 8% oil and gas, 15.28, 6% government, 135.06, 55% financial services, 47.94, 20% Source: World Bank staff compilation based on data from the GCC Bond Market Survey and Markaz database, 2010.
FAS_215-238.qxd 8/31/11 8:16 PM Page 226 226 Financial Access and Stability Islamic securities (sukuks) have been meeting the financial needs of many issuers in the Islamic world by observing the teachings of Islam in the context of modern investment banking. 3 The Islamic investment banking community has developed an array of sukuk structures to meet particular investment, financing, or Sharia compliance needs. In all structures, a special purpose vehicle is set up as the issuer of Islamic securities and the trustee of assets underlying the securities. The great majority of sukuks are variable rate securities, for which secondary market trading is thin. Fast-growing Islamic banks are the primary investor base for sukuks. The GCC sukuk market is entering a critical stage of its growth, following several years of high-paced expansion. Challenges for market development include the generally nascent nature of the GCC market, uncertainty about the legal treatment of Islamic characteristics of sukuks in a secular legal system, the unresolved nature of religious legitimacy in Islamic securities structuring, and excess liquidity and the lack of government financing needs in the GCC. The bankruptcy resolution of sukuk defaults has not been clarified; it is related to the ranking of sukuk holders claims, creditors access to the underlying assets, and the local enforceability of foreign legal decisions (Standard & Poor s 2010). The workout of recent bankruptcy cases is expected to set some precedence for resolution of bankrupt sukuk issuers. In many ways, the development agenda in the GCC is similar to that of non-gcc countries, but budget surpluses and low debt in GCC countries pose additional challenges for market development. In order to build a reliable benchmark yield curve, policy makers need to build their internal debt management capacity, conduct regular and predictable issues, build an appropriate market structure, and introduce market making and repos. Developing the market in GCC countries would involve overfunding the budget, entailing nonnegligible costs. Sustaining a liquid government debt market would require that monetary, fiscal, and debt/asset management policies be well coordinated. Market segmentation between conventional and Islamic securities is another potential problem, as the cost of maintaining liquid benchmarks for both types of securities could prove prohibitive. There is significant potential for regional harmonization of market regulation and infrastructure in the GCC. Primary areas for regional harmonization include accounting and auditing rules, intermediary licensing, and securities offering and trading. Likely areas for regional integration or networking in market infrastructure would be those sensitive to economies of scale, in particular securities depositories and payment systems. So far, progress has been limited.
FAS_215-238.qxd 8/31/11 8:16 PM Page 227 Capital Markets 227 Equity Markets Market capitalization in MENA is large by international comparison, but free floats are thin in many countries. 4 Between 2005 and 2010, 1,500 or more companies were listed on MENA s major stock exchanges. Their total market capitalization reached US$1.2 trillion in 2007, declining to US$870 billion by end-2009, as a consequence of the global financial crisis. GCC countries account for half of MENA s listed companies and three-quarters of the region s market capitalization. Free floats appear very reasonable in Kuwait, Tunisia, and the United Arab Emirates but small in other MENA countries, especially outside the GCC (figure 9.6). Thin free floats often reflect large residual state shareholdings in (partially) privatized companies or large family shareholdings in companies whose small public share offerings may have been motivated by the desire for prestige or other factors, such as tax incentives. Average market capitalization of listed firms varies widely across the region. It is generally high in the GCC. The average is highest for firms in Saudi Arabia (US$4.2 billion), Qatar (US$2.0 billion), and Abu Dhabi (US$1.5 billion). It is US$80 million US$150 million for firms in Jordan, Oman, and the West Bank and Gaza. Especially in GCC countries, where average market capitalizations exceed those in most developed markets, equity markets are dominated by banks and large former state-owned enterprises. In both the GCC and the rest of MENA, there is substantial potential for medium-size manufacturing and service firms to list and become active. Financial institutions account for half of MENA s market capitalization, a larger share than in any other region except Africa (table 9.3). Industry commands a smaller share of market capitalization than it does in any other developed or emerging region, and the service sector s share is equal to that in Africa. This pattern reflects both the lack of economic diversification in some countries, especially in the GCC, and the fact that firms in the industry and service sectors do not see advantages in listing. The transparency and disclosure requirements for listing are considerable. Financial firms, especially banks, are generally subject to higher reporting requirements than nonfinancial firms, and some countries require financial firms (banks in the Arab Republic of Syria, insurance companies in Saudi Arabia) to list. However, family-owned firms in industry and services generally avoid the transparency and disclosure requirements that accompany stock market listings. Industry and service sector access to equity markets is especially low in Kuwait, Lebanon, Morocco, Qatar, Saudi Arabia, Syria, the United Arab Emirates, and the West Bank and Gaza. The large share of financial institutions in Bahrain reflects that economy s status as an offshore financial center.
FAS_215-238.qxd 8/31/11 8:16 PM Page 228 228 Financial Access and Stability FIGURE 9.6 Free Float as a Percentage of Market Capitalization in New York Stock Exchange and Selected Economies, End-2009 New York Stock Exchange Canada United Kingdom Australia Ireland Kuwait Japan Germany Spain Brazil Netherlands Tunisia France Hong Kong SAR, China New Zealand South Africa Italy Korea, Rep. Greece Belgium Switzerland United Arab Emirates Oman Portugal Thailand Norway China Saudi Arabia Poland Malaysia Bahrain Philippines Indonesia Kazakhstan India Chile Egypt, Arab Rep. Jordan Colombia Croatia Morocco Peru Singapore 0 10 20 30 average = 54.1 40 50 60 70 80 90 100 percent Source: World Bank staff compilation based on data from World Federation of Exchanges and national exchanges.
FAS_215-238.qxd 8/31/11 8:16 PM Page 229 Capital Markets 229 TABLE 9.3 Sectoral Composition of Market Capitalization, by World Region, 2009 (percent) Region Financial Infrastructure Industry Services East Asia and Pacific 28.0 33.1 29.9 9.0 Europe and Central Asia 25.5 37.1 32.6 4.8 High-income OECD 22.8 32.0 33.1 12.1 High-income non-oecd 40.4 26.2 20.0 13.4 Latin America and the Caribbean 40.7 28.8 25.3 5.3 Middle East and North Africa 49.5 29.5 17.1 3.9 GCC average 47.1 31.4 16.8 4.8 Non-GCC average 51.6 27.9 17.3 3.1 South Asia 22.4 36.7 36.4 4.4 Sub-Saharan Africa 54.0 9.7 32.3 4.0 Source: World Bank staff calculations based on data from Bloomberg database. Note: OECD = Organisation for Economic Co-operation and Development. Countries in the region generally compare very well with countries outside the region in market turnover (turnover/market capitalization), but high turnover ratios do not necessarily reflect effective price discovery. Turnover ratios in MENA look high controlling for GDP per capita, demographics, and status as an oil exporter (figure 9.7). Actual turnover ratios exceed predicted values by a wide margin in Saudi Arabia and are above expectations in most other MENA countries. Countries in the region also compare well in other indicators of market trading and liquidity, such as the ratio of turnover to GDP and the share of the top 10 companies in turnover (see appendix C). However, the large volume of trading revealed by these indicators does not necessarily reflect effective price discovery or equity valuation, as discussed below. This rest of this section explores how effective these large and active MENA stock markets are in contributing to overall economic development. Although equity markets can be a valuable dynamic mechanism for price discovery facilitating capital investment, entrepreneurial equity finance, privatization, corporate restructuring, and corporate governance there are grounds for concern that MENA s stock markets are falling short in performing these functions. Price Discovery MENA equity markets display reasonable turnover indicators, but they do not seem to perform well in price discovery. Developed equity markets enjoying more disclosure and transparency, stronger governance standards, and professional asset management should promote arbitrage trading based on information about a firm s fundamentals. In such an
FAS_215-238.qxd 8/31/11 8:16 PM Page 230 230 Financial Access and Stability FIGURE 9.7 Market Turnover in the Middle East and North Africa and in Peer Markets, 2008 350 a. Full view turnover ratio, actual value 300 250 200 Saudi Arabia 150 United Arab Emirates 100 Kuwait Jordan 50 Egypt, Arab Rep. Oman Morocco Qatar 0 Tunisia 0 Bahrain 50 100 150 200 250 300 350 Lebanon turnover ratio, predicted value turnover ratio, actual value 100 50 Kuwait Jordan Egypt, Arab Rep. Oman Morocco Tunisia Bahrain b. Expanded view Qatar United Arab Emirates 0 Lebanon 0 50 100 turnover ratio, predicted value Source: Bank staff calculations based on data from World Federation of Exchanges and World Bank. Note: Orange diamonds indicate countries in the region; grey diamonds indicate countries outside the region. environment, prices will incorporate more firm-specific information and co-move less with the market (Morck, Yeung, and Yu 2000). Two indicators of price synchronicity the first measuring the co-movement of stock prices, the second measuring the portion of stock returns explained by the market (that is, the average R 2 of a regression of a company s biweekly stock returns on overall market returns for the period 2004 09) were computed, in order to assess the quality of price discovery (see appendix B). The two indicators are highly correlated; the second is used here, because it has been more extensively used in the empirical literature to measure price synchronicity and allows international comparisons. Low R 2 values indicate low levels of price synchronicity and suggest an effective price discovery function. The results for MENA (table 9.4) are compared with a similar exercise for 40 countries outside the region (table 9.5) (Alves, Peasnell, and Taylor 2010).
FAS_215-238.qxd 8/31/11 8:16 PM Page 231 Capital Markets 231 TABLE 9.4 Portion of Biweekly Returns Explained by the Market in Selected Countries in the Middle East and North Africa, 2004 09 Country 2004 2005 2006 2007 2008 2009 Mean 2004 08 Bahrain 0.15 0.21 0.22 0.16 0.25 0.18 0.20 Egypt, Arab Rep. 0.17 0.26 0.30 0.12 0.41 0.27 0.25 Jordan 0.27 0.23 0.26 0.14 0.30 0.16 0.23 Kuwait 0.21 0.14 0.31 0.16 0.37 0.32 0.25 Lebanon 0.19 0.32 0.62 0.39 0.39 0.43 0.39 Morocco 0.27 0.21 0.29 0.30 0.32 0.36 0.29 Oman 0.21 0.22 0.27 0.17 0.41 0.27 0.26 Qatar 0.30 0.56 0.38 0.30 0.53 0.51 0.43 Saudi Arabia 0.33 0.18 0.54 0.37 0.52 0.50 0.41 Tunisia 0.11 0.12 0.15 0.16 0.8 0.13 United Arab Emirates 0.26 0.25 0.32 0.25 0.39 0.40 0.31 Mean 0.22 0.25 0.33 0.23 0.36 0.34 0.29 Source: World Bank staff calculations based on data from Bloomberg database. Note: = not available. TABLE 9.5 Portion of Weekly Returns Explained by the Market in Selected World Economies Ranking portion of weekly returns explained by the market in sample of 40 markets outside the Middle East and North Africa Ranking Economy R 2 Ranking Economy R 2 1 Canada 0.03 22 India 0.12 3 Ireland 0.04 24 Japan 0.12 5 United Kingdom 0.05 26 Indonesia 0.15 7 Peru 0.05 28 Mexico 0.17 9 Portugal 0.06 30 Italy 0.19 11 United States 0.06 32 Philippines 0.20 13 Denmark 0.06 34 Poland 0.22 15 Colombia 0.08 36 Taiwan, China 0.22 17 Germany 0.08 38 Greece 0.27 19 Netherlands 0.11 40 China 0.29 Source: Alves, Peasnell, and Taylor 2010. Note: Means were calculated over the 1997 2004 period. The MENA indicators of price synchronicity seem very high by international comparison, suggesting that the price discovery function is not very effective. They fluctuate over the sample period and spike in periods of crisis, such as 2006 (the local GCC crisis) and 2008 (the global crisis). These fluctuations are expected, as the co-movement of stock prices increases in periods of boom and bust. However, the MENA mean (29 percent) is equal to the mean of the lowest-ranked country in the
FAS_215-238.qxd 8/31/11 8:16 PM Page 232 232 Financial Access and Stability international sample, and countries in the region generally fare poorly in this comparison. Admittedly, the methodology has limitations. For example, the R 2 captures factors other than the institutional quality of the equity market. In addition to bubbles and bursts, it could reflect the size and composition of the market and idiosyncratic factors. The high R 2 for countries in the region could partly reflect the large share of financial firms, whose stock prices tend to move together. 5 These possibilities notwithstanding, the differences between countries in the region and other markets are impressive, suggesting weak price discovery. The combination of strong trading volumes and weak price discovery may reflect the large and active participation of uninformed retail investors and the lack of a well-developed base of private domestic institutional investors. MENA s base of private institutional investors is very small by international comparison (see chapters 3 and 8). Institutional investors are more likely than individual investors to support efficient price discovery by basing investment decisions on fundamental research rather than rumor or sentiment. Institutional investors may also be less likely to be taken in by market manipulation. In 2008, individual investors accounted for 60 80 percent of the value of shares traded in Dubai, Kuwait, Egypt, and Qatar and more than 90 percent in Saudi Arabia (table 9.6). Reactive and only partially informed trading by individuals investing on their own rather than through institutional investors may have contributed to high price synchronicity in the United Arab Emirates, Qatar, and Saudi Arabia. Other empirical research is consistent with this conclusion. For example, after examining the large volume of trading in the Saudi Arabia stock exchange in the past decade, Haddad and Hakim (2008) conclude that such trading was dominated by uninformed retail investors. Foreign investors seem to have contributed to price discovery, but their presence in MENA is uneven. Relying more on fundamentals and less on rumor, foreign investors may aid price discovery. In many MENA TABLE 9.6 Percentage of Retail and Institutional Investors in Selected Economies in the Middle East and North Africa, 2008 (percent) Economy Retail investors Institutional investors Saudi Arabia 91 9 Dubai 80 20 Kuwait 71 29 Egypt, Arab Rep. 66 34 Qatar 62 38 Source: World Bank staff compilation based on data from NCB Capital and EGX.
FAS_215-238.qxd 8/31/11 8:16 PM Page 233 Capital Markets 233 stock markets, foreign investors account for 30 percent or more of value traded (table 9.7). Foreign participation varies widely in the GCC, ranging from less than 10 percent in Kuwait and Saudi Arabia to 40 50 percent in Bahrain and Dubai. Major GCC markets limit foreign ownership of shares in listed companies, though some countries have been gradually relaxing these barriers. The limited presence of foreign investors in Saudi Arabia may have contributed to high price synchronicity, while trading by better-informed investment companies may have offset Kuwait s nearly as low level of foreign investment and contributed to better price discovery. Conversely, relatively high levels of foreign trading in Bahrain, Egypt, and Tunisia may partly explain the good rankings for price discovery within MENA. Appendix B provides an econometric analysis of the determinants of stock price synchronicity for MENA markets. It suggests that the presence of foreign investors may have reduced price synchronicity (for the original analysis, see Mako, Feyen, and Sourrouille 2011). Raising Entrepreneurial Finance Initial public offering (IPO) activity was relatively high in some countries in the region in the precrisis period, although IPOs were concentrated in financial services and infrastructure. IPOs peaked in 2007 08, declining sharply thereafter, as a result of the global financial crisis. During 2006 10, IPOs on MENA stock markets raised US$41.5 billion. 6 However, four GCC states (Saudi Arabia, the United Arab Emirates, Qatar, and Bahrain) accounted for 84 percent of this total. Relative to GDP, amounts raised through IPOs in these countries in 2006 09 exceeded the worldwide TABLE 9.7 Foreign Investor Share of Value Traded in Selected Markets in the Middle East and North Africa, 2005 08 (percent) Economy 2005 2006 2007 2008 Abu Dhabi n.a. n.a. n.a. 25.9 Bahrain 52.2 57.7 48.0 47.7 Dubai n.a. n.a. 32.0 37.9 Egypt, Arab Rep. 30.3 30.2 31.7 30.0 Jordan 12.8 14.0 22.9 20.8 Kuwait n.a. n.a. n.a. 8.5 Saudi Arabia n.a. n.a. n.a. 4.0 Tunisia n.a. n.a. n.a. 33.0 Source: World Bank staff compilation based on data from NCB Capital and EGX. Note: n.a. = not applicable.
FAS_215-238.qxd 8/31/11 8:16 PM Page 234 234 Financial Access and Stability average (figure 9.8). As an offshore financial center with a large share of financial listings, Bahrain ranks high. Non-GCC markets are noticeably below the worldwide average, with the exception of Jordan. More important, industry and services have accounted for a small share of IPOs: between 2006 and 2010, infrastructure accounted for 58 percent and financial services for 19 percent of total IPO amounts, whereas industry accounted for 15 percent and services 8 percent (Mako, Feyen, and Sourrouille 2011). Some countries have tried to facilitate access to equity finance by small and medium enterprises so far with limited success. In Tunisia, for instance, the stock exchange provides three tiers of listings, with varying listing requirements, to facilitate the listing of different-sized firms. The number of listed firms actually declined slightly, however, from 77 at end- 2008 to 76 at end-2009. To encourage small and medium enterprise IPOs in Egypt, in October 2007 the Egyptian Exchange established a separate and distinct board (NILEX) for small and medium enterprise listings. NILEX offers more flexible listing rules on the minimum number of IPO subscribers and issued shares, audits (annual financial statements only), financial history, and listing fees. Despite these changes, as of end-2009, only nine small and medium enterprises had listed on NILEX, and none had raised equity finance through an IPO. Worldwide it has remained difficult to induce small and medium enterprises to raise equity finance through IPOs. As of end-2011, at least 17 small and medium enterprises and at least 1 IPO were listed. Privatization Several countries in the region have undertaken significant privatization programs over the past 10 20 years that included IPOs in the local stock market. However, the pricing for many privatization IPOs in the GCC has been highly artificial, undermining development of local markets capacity to price new issues. Unlike the book-building process followed in other emerging markets, GCC markets have priced IPOs at an arbitrary par value chosen by the government. In order to share hydrocarbonbased wealth with all citizens, GCC governments distributed the equity from state-owned enterprises at deep discounts to market value. Deep discount distributions resulted in massive oversubscriptions, creating the need for a rationing process. There remains a huge potential for many MENA governments to transfer shareholdings in numerous state enterprises to private institutional and retail investors. To avoid retarding the development of the markets price discovery function, it will be important to follow a more traditional book-building approach to pricing privatization IPOs.
FAS_215-238.qxd 8/31/11 8:16 PM Page 235 Capital Markets 235 FIGURE 9.8 Initial Public Offerings as a Percentage of GDP in Selected Countries, 2006 09 Slovenia Bahrain Singapore India Vietnam United Arab Emirates Norway United Kingdom Australia Ireland Saudi Arabia Austria Qatar Jordan Brazil Kenya China Poland Kazakhstan Switzerland Spain Malaysia Colombia Papua New Guinea Morocco Thailand Israel Nigeria Canada Egypt, Arab Rep. Russian Federation Cyprus Panama Bulgaria Korea, Rep. United States Indonesia Ghana Turkey Germany Tunisia Philippines Oman Syrian Arab Republic Italy Pakistan New Zealand Czech Republic Mexico Bangladesh Greece Chile Kuwait Argentina 0 1 percent 4.5 2 Source: World Bank staff compilation based on data from the Arab Monetary Fund (AMF) for MENA countries and the World Federation of Exchanges for other countries. Note: IPO amounts from the AMF and World Federation of Exchanges are identical or reasonably close for Bahrain, Egypt, Saudi Arabia, and the United Arab Emirates. For other MENA countries, World Federation of Exchanges data may include transactions (new listings, secondary offerings) that are not strictly IPOs.
FAS_215-238.qxd 8/31/11 8:16 PM Page 236 236 Financial Access and Stability Corporate Governance The ability of a country s equity market to promote good corporate governance depends on opportunities for shareholders and other stakeholders to be aware of and influence events at listed companies. A 2008 survey of 155 listed companies in 11 countries in the region found that not a single company could claim to follow best practice in corporate governance (IFC and Hawkamah 2008). Surveyed companies lack basics for effective board oversight, such as a sufficient number of independent directors and a separate audit committee with a majority of independent directors that reports to the board. Both internal and external audit practices are underdeveloped in many cases, and financial and other disclosure is spotty. Minority public shareholders may lack ready access to give voice and protect their interests. A 2009 report focusing on corporate governance of MENA banks confirms the need to upgrade boards of directors, improve nonfinancial disclosure, and control conflicts of interest and related-party transactions (OECD, Hawkamah, and UAB 2009). Notes 1. This section is based on Garcia-Kilroy and Silva (2011). 2. This section is based on Endo (2011). 3. The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) defines sukuks as certificates of equal value representing undivided shares in the ownership of tangible assets, usufructs, services, or (in the ownership of) the assets of particular projects or special investment activity. 4. This section is based on Mako, Feyen, and Sourrouille (2011). 5. Alves, Peasnell, and Taylor (2010) stress these limitations and the need to account for confounding factors. 6. MENA markets also support some level of secondary public offerings (SPOs) but definitions of SPOs are not uniform in the region. Estimates of SPOs vary widely, perhaps because of differing definitions. Private placement type SPO transactions may account for 90 percent of SPO proceeds in the region. References Alves, P., K. Peasnell, and P. Taylor. 2010. The Use of the R 2 as a Measure of Firm-Specific Information: A Cross-Country Critique. Journal of Business Finance and Accounting 37 (1): 1 26. BIS CGFS (Bank for International Settlements, Committee on the Global Financial System). 2007. Report on Financial Stability and Local Currency Bond Markets. Basel: BIS. Endo, T. 2011. Debt/Sukuk Market Development in the GCC Region. World Bank, Washington, DC.
FAS_215-238.qxd 8/31/11 8:16 PM Page 237 Capital Markets 237 Garcia-Kilroy, C., and A. C. Silva. 2011. Reforming Government Debt Markets in MENA. Policy Research Working Paper 5611, World Bank, Washington, DC. Haddad, M., and S. Hakim. 2008. Irrational Exuberance in the Saudi Stock Exchange. Paper presented at the 15th annual conference of the Economic Research Forum, Cairo, November 23 25. IFC (International Finance Corporation) and Hawkamah Institute. 2008. A Corporate Governance Survey of Listed Companies and Banks across the Middle East and North Africa. Washington, DC: IFC; and Dubai: Hawkamah. Mako, W. P., E. Feyen, and D. Sourrouille. 2011. Arab Equity Markets. World Bank, Washington, DC. Morck, R., B. Yeung, and W. Yu. 2000. The Information Content of Stock Markets: Why Do Emerging Markets Have Synchronous Stock Price Movements? Journal of Financial Economics 58 (1 2): 215 60. OECD (Organisation for Economic Cooperation and Development), Hawkamah, and UAB (Union of Arab Banks). 2009. Policy Brief on Improving Corporate Governance of Banks in the Middle East and North Africa. Global Corporate Governance Forum. Paris: OECD. Standard & Poor s. 2010.