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Saudi alert

The suicide bombing in Riyadh, Saudi Arabia, on May 12, in which 34 died and 200 were injured, was a bloody reminder to members of the Saudi royal family that they sit uneasily on the throne. If Riyadh imagined that its refusal to allow the U.S. to stage the Iraqi invasion from Saudi soil (while offering sub rosa assistance), coupled with the impending pullout of American troops from the Arabian Peninsula, would mollify its more zealous domestic opponents, it was mistaken.

Combating terrorism at home must now become a higher priority. But the House of Saud faces a broader and not unrelated challenge: how to adapt Saudi Arabia to an intrusive global information age while maintaining ancient traditions and the strict religious values of the country's dominant Wahhabism, a fundamentalist form of Islam. And this daunting problem in turn is closely linked to one that is no less pressing but is often underplayed by outside commentators fixated on the religious issue: how to reform and revive this rich country's economy.

With an indigenous population of some 15 million, Saudi Arabia collected $54.4 billion in oil revenues last year. Its image abroad remains that of a plush welfare state. Yet much of the kingdom's oil-generated wealth has been dissipated over the years by grandiose projects, military hardware and maintaining the lavish lifestyles of the sprawling royal family -- or else invested abroad. Riyadh's debt now stands at nearly 100 percent of GDP. A rapidly increasing population is outstripping economic growth: Almost 60 percent of native Saudis are younger than 19, so the ranks entering the labor market will soon swell. Last September, for the first time, Riyadh published figures showing the jobless rate for Saudi nationals to be 8.1 percent. But for Saudis aged 20 to 24, unemployment in 1999 (the latest data available) was 28 percent. Such joblessness is especially worrying because it is seen as heightening the appeal of Islamic terrorism among marginalized and disaffected youth.

Voices calling for reform of the sluggish state-dominated economy have become more insistent. The International Monetary Fund has said that "unless addressed expeditiously, macroeconomic imbalances could weaken confidence, discourage investment and reduce nonoil growth, thus making it more difficult to achieve the employment objective." In a report last year, the U.S. embassy urged Riyadh to encourage foreign investment to stimulate the Saudi nonoil private sector, saying that this was a key not only to reducing the kingdom's overreliance on oil -- 80 percent of state revenues -- but also to creating badly needed jobs. The U.S. embassy report estimated that Saudi Arabia would need to invest $250 billion in its infrastructure over the next 20 years to cope with the population surge.

Just in time -- belatedly, some would say -- Riyadh is contemplating significant economic reforms, including opening up Saudi Arabia's capital markets to Western and other foreign participants. That measure, along with new legislation covering labor markets, commerce, taxation and monopolies, is currently under review at the highest level. Will the country's aging, deeply conservative leaders ultimately approve of these liberalizing laws, which include a natural-gas initiative that would let foreign oil companies tap into the kingdom's vast gas reserves? That will be as much a test of the House of Saud's resolve as its reaction to terrorism at home.

In broadest terms, the capital markets reforms, details of which are available only in draft form, are meant to advance the tentative progress made so far in making Saudi Arabian markets more receptive to foreign investors. As of October 1999, foreigners have been allowed access to the Saudi stock market, but only through open-end mutual funds offered by domestic banks that trade in Saudi stocks, and the closed-end Saudi Arabia Investment Fund. Saif, launched in 1997, was already traded on the London Stock Exchange. Previously, only Saudi nationals or citizens of the Gulf Cooperation Council states could gain access to the market.

The mutual funds run by the local banks have attracted limited foreign interest, reports Mazen Hassounah, general manager of Rana Investment Co. in Riyadh. By contrast, Saif, which is denominated in dollars and run by Saudi American Bank, has fared much better, according to Matthew Eyre of Blakeney Management in London, an emerging-markets money management firm. "It is big, liquid and has a good track record," he says.

Saudis and other Persian Gulf residents seem to find local mutual funds more appealing than do foreign investors. According to a report by Jeddah-based National Commercial Bank, the 134 open-end funds managed by the kingdom's ten commercial banks saw a 30 percent increase in their total assets, to 52.2 billion Saudi riyals ($13.9 billion), between 2001 and 2002, while the stock market gained just 8 percent. The number of participants in Saudi funds has burgeoned from 48,000 in 1997 to 171,000 in 2002.

In addition to warily encouraging foreigners to buy Saudi securities, Riyadh has been promoting foreign direct investment in the kingdom through the Saudi Arabian General Investment Authority, created in April 2000. The enabling law abolished the rule that a foreign investor had to find a local sponsor and banned the seizure of foreign investments without an explicit legal ruling. The government is also whittling away at a so-called negative list of 19 economic sectors that are out of bounds to foreign investors, including transportation, telecommunications and oil exploration, drilling and production. In February Riyadh opened the insurance sector.

The capital markets law in draft form has already been endorsed by the Supreme Economic Council, chaired by Crown Prince Abdullah bin Abdul Aziz, and approved by the Majlis al-Shura, a consultative council of 120 appointed by the king. But now comes a more formidable hurdle: consideration by the Council of Ministers, consisting of 31 members and King Fahd. Ultimately, approval or rejection rests with the king.

To an outsider, the mooted proposals hardly seem controversial. A new capital markets authority would take over securities regulation from the Saudi Arabian Monetary Authority and the Ministry of Finance and National Economy. Rodney Wilson, an economics professor at the Institute for Middle Eastern and Islamic Studies at the University of Durham, expects the new agency to be similar to the U.S. Securities and Exchange Commission but to most closely resemble the Malaysian Securities Commission, which regulates the largest stock market in the Muslim world according to Islamic precepts. Saudi Minister of Finance Ibrahim al-Assaf has said that a key goal of the new regulatory body is "ensuring transparency" and thus bolstering investor confidence.

Transparency, credibility and accountability are at the heart of the reforms, adds Bishr Bakheet, managing partner at Riyadh-based Bakheet Financial Advisors. He says that creation of a distinct securities agency is essential to eliminate the conflict of interest in the existing regulatory regime, in which the Saudi Arabian Monetary Authority oversees both banks and the stock market -- roughly half of whose capitalization comes from banks.

The central bank's inclination to protect investors rather than encourage risk-taking, Bakheet says, has resulted in only blue-chip stocks being listed on the market and a paucity of venture capital for small, dynamic firms. Not a single listed Saudi company has gone bankrupt in 20 years, he notes, but this is bound to change with the new law, as the monetary authority will no longer vet companies to be floated. Regulators will also gain new "teeth" to punish offenders, says Bakheet.

The law's other major initiative is to allow the establishment of stand-alone brokerage houses to foster greater competition and thus better services. Under the present system, banks conduct all trading through brokerage subsidiaries. Domestic and possibly foreign fund managers are expected to be eager to offer brokerage services.

Bakheet, however, cautions that Saudi Arabia must avoid emulating Egypt, which liberalized brokerage rules only to find itself with more brokerage firms than listed stocks. Saudi Arabia's commission rates are already among the lowest in emerging markets, so he anticipates brokers competing primarily on the quality of their research and services, to the benefit of investors.

Rana Investment's Hassounah hopes that the new law will at least indirectly address a host of shortcomings that hold back the Saudi capital markets. In particular, he cites the lack of variety in the instruments traded: The vast majority are equities. Bonds remain an undeveloped market segment; Saudi Orix Leasing Co. floated Saudi Arabia's first-ever domestic corporate bond in March (a $13.3 million, three-year issue).

The investment manager would also like to see more depth to the stock market. Of 69 listed companies, only 20 trade regularly, and only a fraction of those companies' shares trade actively. If the new capital markets law encourages transparency and helps entice investors and issuers to the markets, liquidity and variety should both gain.

That would certainly be the case if the new rules lure home some of the estimated $700 billion that Saudis have stashed abroad. This is, in fact, a key objective of the new legislation. Repatriation of even a fraction of this money would give a sizable boost to a Saudi stock market whose capitalization is just $105 billion.

Hassounah cautions, however, that wooing investors -- Saudi and foreign alike -- will ultimately require a better overall investment climate. Despite improvements in recent years, Saudi accounting standards still lag, he notes. Reforms of company law and taxation also must be implemented, in his view.

While investors like Hassounah welcome any steps toward reform, some are reserving judgment until the capital markets law is ratified and made public. "We have seen a lot of false dawns with respect to Saudi reforms," says Jeff Chowdhry, joint head of emerging-markets investments at F&C Management in London. He remains skeptical that foreign investors will be granted full access to Saudi markets soon. Blakeney Management's Eyre agrees, suggesting that direct access for foreigners may have to wait for another round of reforms.

But suppose foreigners were allowed to buy Saudi stocks directly -- would they want to? Eyre points out that current valuations generally aren't as compelling as they are elsewhere in the Gulf, especially given the kingdom's economic woes and political uncertainty. Price-earnings ratios in the Saudi market are typically in the high teens -- almost double those of leading blue-chip stocks in Bahrain and Oman, for example, while average dividend yields are among the lowest in the Gulf, less than 3 percent. Many of the leading blue chips in Bahrain and Oman trade on single-digit P/E multiples and yield 5 to 12 percent, Eyre says, and Qatar is also a better value. Kuwait and the United Arab Emirates, meanwhile, trade at similar valuations to Saudi Arabia but offer better growth prospects, he adds.

On the other hand, asserts Henry Azzam, CEO of Jordanian investment house Jordinvest, the Saudi market is the most liquid in the region, and its listed companies are by and large well capitalized and profitable. He sees particular potential for outside interest in the Saudi banking sector and in Saudi Telecommunications Co., a 30 percent share of which was sold off by the government in December for some $4 billion. (STC now constitutes fully one fifth of total Saudi stock market capitalization.)

The telecom reported that its net profits doubled in this year's first quarter. The stock was up 62 percent as of mid-May. And growth prospects are bright: The penetration rate of mobile phones -- the main driver of telecom businesses in the Gulf -- is only 12 percent in Saudi Arabia, compared with 70 percent in the United Arab Emirates, more than 50 percent in Kuwait and Bahrain and 43 percent in Qatar.

The Saudi stock market has had a good year thus far, with the Tadawul all-share index rising 20 percent through May. The market has gotten a boost from the end of the Iraq war and the prospect that Saudi companies may benefit from reconstruction. Moreover, healthy profits for most Saudi companies, anticipation of the new capital markets law and low interest rates are all buoying the market, says Jordinvest's Azzam. Saudi interest rates closely track U.S. rates because the Saudi currency is pegged at SR3.75 to the dollar; in March the rate for three-month deposits hit 1.75 percent.

The outlook for the Saudi economy, meanwhile, is positive. Thanks to sky-high oil prices in the first quarter, Saudi American Bank has upped its growth forecast for the year from 3.8 percent to 6 percent. The conflict in Iraq played its part in a general slowdown in business and consumer activity; the bank projects growth in the nonoil private sector at just 3 percent. The surge in oil revenues should reduce Riyadh's projected budget deficit from $10.4 billion to $3.2 billion, says the bank. Both National Commercial Bank and Riyad Bank forecast small surpluses.

In years gone by positive figures such as these would have allowed Saudi Arabia's rulers to put off unpalatable reforms indefinitely. But the kingdom's economic problems are too deep-seated and too pressing for the usual stalling game. Crown Prince Abdullah, who has run the day-to-day affairs of state since his older brother King Fahd suffered a stroke in 1995, is credited with being the driving force behind the reform effort. A cabinet reshuffle at the beginning of May that revolved around economic and communications issues is taken as a further boost for the reformist camp and evidence of the crown prince's influence. Still, as Azzam warns, "Everyone is pushing for reform, but it still needs to come from the top." That is, from ailing, 80-year-old King Fahd.