Blessed with the bulk of the world’s oil reserves and after more than four years of consistently buoyant prices, GCC economies have grown at sometimes staggering rates lately - hitting double figures in nominal terms. And their relatively young stock markets, in spite of the major correction in 2006, have also mushroomed in value. Sovereign ratings are constantly being upgraded while many of the region’s blue chip firms are well embarked upon ambitious regional and global expansion. Surely, then, any international investor worth his salt would be inclined to allot a sizeable chunk of his emerging markets portfolio to the Gulf. Yet the opposite is the case. “Investment flows to GCC bourses remain very small compared to other emerging markets,” says Alka Banerjee, the vice president of Standard & Poor’s Index Services. Even including the entire Middle East and Africa, out of the estimated $550 billion invested in emerging markets in 2006, only 11 percent was destined for the region, according to S&P figures. Gulf markets remain driven by domestic, mainly retail investors - a key reason first for the years of “irrational exuberance,” which saw the frothiest indices of Qatar, Saudi Arabia and the UAE rise by close to or more then 100 percent in 2005, and then for the dramatic fall to earth. Foreign investors’ absence is attributable to a host of factors. One is simple lack of awareness, either of the six states’ stunning macroeconomic picture or of the region in general, which - until recently - rarely made global headlines. On the other hand, the GCC is surrounded by troublesome neighbors and tends to suffer from association with nearby geopolitical turmoil, whether it be in Iran, Iraq or Lebanon. The phenomenon was evident last summer, for example, when the flow of international bond issues out of the GCC dried up and existing paper experienced selling pressure due to investor jitters over the war between Israel and Hezbollah. However, internal factors have also been very much to blame. Sophisticated foreign fund managers were discouraged by the obvious stock bubble developing from 2004, which drove valuations in the most overheated markets to levels clearly bearing scant relation to fundamentals, and market capitalizations doubling annually: at its peak of 20,634 points in February 2006, the average price/earnings ratio on Saudi Arabia’s Tadawul stood at 57, while on the Dubai Financial Market it reached 24 the previous November and on the Doha Securities Market (DSM) 25 the month before. Such international skepticism was evident in the chorus of “we told you so’s” when the inevitable crash finally kicked in. Regulatory regimes have also deterred international investors, both actively and by omission. In Saudi Arabia, foreigners are only permitted to buy shares through GCC-based funds and, since the crash, individually if they are resident in the kingdom. With the Tadawul All Share index standing well below 8,000 points in mid-April, the prospect is hardly attractive. “Only the more daring ones have invested and most who have now seem to be looking for a way out,” says Khan Zahid, the chief economist and vice president of Riyad Bank. In the UAE, many of the major listed firms forbid foreign equity ownership, while in Kuwait, overseas buyers face the threat of a punitive capital gains tax. The smaller and less liquid markets of Bahrain, Oman and Qatar are more open, but excite minimal interest from the global players. And, while differing in degree, standards of corporate governance, transparency and disclosure remain poor. “Corporate governance regimes are still being developed across the region, and management transparency is still at relatively low levels compared to the rest of emerging markets,” says Kingsmill Bond, an emerging markets strategist at Deutsche Bank. “There are concerns about insider trading in certain markets, and about the risks inherent in family controlled groups.” His point is echoed by local commentators. “Shareholder confidence is an essential component of a sound capital market and with that comes the need to ensure that investors are protected,” Habib al-Mullah, the chairman of the Dubai Financial Services Authority, told a conference in late March, referring to a World Bank study on investor protection in which the Middle East and North Africa scored worst at regional level and the UAE trailed the rest of the Gulf in the country-by-country breakdown, closely followed by Saudi Arabia. “Too many markets are paying lip service to the cause of investor protection and the gap is growing compared to the best practice found in the major financial centers.” The Dubai International Financial Exchange was established in 2005 with the explicit aim of replicating international best practice and professing the goal of sharing some of this expertise with the two local bourses. However, there is little evidence of the latter, while the fledgling market’s aim of attracting international investment - filling a gap between the major financial centers of East and West - has so far failed, with trading in the limited number of stocks available pitifully thin. In spite of all the obstacles, however, the outlook for international investment in GCC markets is improving on many fronts. At the most basic level, the region’s economic and business story is becoming more widely read. The states and their biggest companies feature with growing regularity in the world’s financial press, as soaring, oil-driven liquidity seeks a home abroad. And while the downturn on the region’s bourses has undoubtedly been devastating for many local retail investors, the silver lining is that stocks have become far more reasonably priced. “Value has started to emerge,” says a recent Deutsche Bank report. “[For those willing to risk the fact that the floor has yet to be reached], we would recommend the UAE in the first instance. This is the market that started to fall first, has fallen the most, and has a number of the cheapest companies in the region.” The slump also prompted a bout of productive soul-searching among regulators, with change partly driven by the conviction that boosting foreign institutional investment could help stabilize the Gulf’s retail-driven markets. Qatar allowed foreigners to invest directly in the DSM before the slump, allowing up to 25 percent ownership of listed companies’ stocks in April 2005. However, there is talk of Riyadh also opening the door to international institutional investors. “The authorities want to put the market in the hands of institutional players, both local and foreign, who will take the longer view, rather than the day traders who currently dominate,” says Zahid. “The impression is that the change could happen quite quickly.” And Kuwait and Abu Dhabi allow global custodian accounts to facilitate foreign trading. Bold moves have also been made to crack down on market manipulation, with Saudi Arabia’s Capital Markets Authority last year barring a number of traders for illegal practices and suspending trading in two firms earlier this year for failing to accurately report losses. Corporate governance guidelines are also being tightened in the UAE, while some listed firms in Kuwait have found themselves barred from the market for failing to publish their results on time. Listed firms themselves have responded to the hemorrhaging of their share prices with attempts to woo foreign investors. “Companies are making more of an effort to promote themselves,” says Banerjee. Greater disclosure is emerging, as is an enhanced willingness to engage with potential international buyers. And in the UAE, where a significant proportion of firms forbid foreign ownership, share structures are being opened up. In February, Abu Dhabi developer Aldar Properties moved to allow foreigners to hold up to 40 percent of shares, while the following month, the second of the emirate’s largest developers, Sorouh Real Estate, followed suit, setting a 20 percent ceiling. The reforms recall a similar reaction by Dubai developer Emaar Properties back in 1999: following a share price crash, ownership was opened to non-nationals and revival eventually ensued. The increasing involvement in the region of international rating agencies is also assisting in familiarizing foreign investors with the region and increasing their knowledge of and comfort with local players’ creditworthiness. In early April, Moody’s Investors Service opened its first regional office, in Dubai, and recently rated Sabic. And a few days later, S&P launched its first indices for five of the Gulf states - Saudi Arabia already had an index - in addition to a GCC composite index. The composite covers 151 regional companies - reflecting only those in which non-GCC nationals can trade - and represents market capitalization at late-March prices of some $110 billion. “The S&P/IFCI series provides international investors with a new vehicle for accessing the Gulf’s highly concentrated equity markets, where values traded are the lowest among global emerging markets,” says Banerjee. Whatever the obstacles, GCC bourses appear in many ways attractive plays compared to those of other emerging markets. Aside from the rosy economic outlook - few now expect an oil price crash in the near future - and strong GDP growth, average returns on equity are high across the region. Prospects for mergers and acquisition activity are strong, due both to the expansion ambitions of wealthy local blue chips and to the need for consolidation in sectors such as cement and banking - although the latter, long counseled, has been painfully slow in coming. Furthermore, Gulf markets are relatively uncorrelated to those elsewhere in the world, offering international investors greater balance of risk in their portfolios. “In the principle markets, the Middle East boasts strong and well-protected currencies and limited debt, meaning that it is not susceptible to global risk appetite or spreads, unlike many emerging markets,” says Bond. “Moreover, as there is a very strong domestic growth story, markets tend to move to their own dynamics, making the region a safe haven for those seeking to avoid uncertainty in the US.” The growing global awareness of the GCC’s strong credit story is evident in and aided by the vogue among the region’s heavyweights for tapping the international bond markets as an alternative to raising fresh equity or bank debt. An earlier trickle of issues became a flood in 2006, with at least $40 billion of issuance in 2006, more than double 2005’s total. Most paper originated from banks, but major government-related corporates also joined the trend - the likes of Dubai developer Nakheel, Dubai Ports, Customs and Free Zone Authority and Abu Dhabi Energy Co. And whether the instruments were structured conventionally or Islamically, the bulk was placed with investors from outside the region amid significant oversubscription. When Aldar issued a $2.53 billion sukuk in February, Western investors snapped up more than 70 percent of the paper. “One of the motives for this trend toward tapping the global capital markets is to capture greater international brand awareness,” says Philipp Lotter, the vice president and senior credit officer of corporate finance at Moody’s. With a healthy economic outlook, strong corporate profitability and growing momentum behind regulatory reform, the positive trend toward greater foreign involvement in Gulf markets appears set to continue.

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