Saudi Arabia Special Report: Labour laws hit private firms

Issue 27 8-14 July 2011

In Saudi Arabia, as in other GCC states, minimum quotas for employing nationals have long been in place Riyadhs Saudisation efforts have failed, as have minimum quotas for employing nationals elsewhere. Businesses have been able to exploit loopholes, taking on one or two token locals, who in reality contribute little to the workplace. Nine out of 10 employees in the private sector were non-locals in 2009. Prompted by the current wave of civil strife in the region, the kingdoms decision-makers have revised the Saudisation legislation and are now taking a much tougher line. Businesses that continue to flout the laws will be closed, they say. Given the dearth of suitably skilled Saudi professionals, the policy will, in the short-term, create an uneven playing field, in which the most talented individuals stand to gain. Long-term, however, if strictly enforced and accompanied by an overhaul of the antiquated education system, the Saudisation programme has the potential to transform society. An open job market would see the horizons of Saudi nationals expanded. Compared with a cushy job in the public sector, the experience will not necessarily be entirely positive. Yet, it is a further sign that Riyadh understands that its current social model is not working. Female representation in the workforce and equal pay is a long way off, with women still fighting for the right to drive. But change is certainly starting to happen.

Spending increases oil shock risks for Saudi Arabia

Issue 27 8-14 July 2011 | By Peter Salisbury Saudi Arabia must wean itself off its dependence on government money derived from the hydrocarbons sector, or risk economic crisis if oil prices drop significantly

Key fact
Inflows of capital into Saudi Arabia totalled about $40bn in 2010, up from $35bn in 2009 Source: MEED It is likely 2011 will go down in history as a challenging year for Saudi Arabias King Abdullah bin Abdul-Aziz al-Saud. The Arab uprisings have seen long-time allies ousted; Shia-Sunni tensions in neighbouring Bahrain grow, prompting Riyadh to offer military support; and have brought near social and economic collapse in neighbouring Yemen. A lot of the growth is directly attributable to the private sector, but indirectly still based on state spending Steffen Hertog, London School of Economics On top of this, a June Opec meeting ended in acrimony as Riyadh tried, and failed, to get member states to agree on an increase in production quotas. Popular unrest has also become more visible in the kingdom, with small protests being held across the country in recent months, and protesters reportedly shot in the Eastern city of Qatif earlier this year. Meanwhile, the imagination of the international press has been caught by a small movement of women that have taken to the roads in protest over legislation that bans them from driving.

Economic fallout
The worst is yet to come for Riyadh. If economists, bankers and academics who specialise in the country are correct, the kingdom will become more dependent on state spending, as private-sector growth falters. Even oil revenues are not enough to foster sustainable growth and stave off mass unemployment. Saudi budget scenarios With oil under $120 a barrel (SRbn) Year 2010 Reserves 1,650.00 Current 438.55 Capital 187.95

Saudi budget scenarios 2011e 2012f 2013f 2014f 2015f 2016f 2017f 2018f 2019f 2020f 1,700.00 1,845.00 1,896.50 1,845.15 1,706.34 1,515.05 1,292.28 1,050.62 797.62 537.82 595.00 654.50 719.95 791.95 853.17 889.90 925.50 962.52 1,001.02 1,041.06 255.00 280.50 308.55 339.41 365.64 381.39 377.28 359.15 331.98 298.74

e=Estimate; f=Forecast. Source: Steffen Hertog; London School of Economics The fallout of the Arab uprisings for Riyadh will not be political, but economic. Steffen Hertog, a lecturer at the UKs London School of Economics and an expert on the Saudi economy, believes by 2015, Riyadh may need an average oil price of $120-130 a barrel just to break even if current spending trends continue. Even in an age of $100-plus oil, this is a tough challenge. The regional political turmoil did not cause the kingdoms economic problems. Rather, it cast the final blow to plans to scale back the role of the state in the economy and boost the role of the private sector. Those plans were first fomented between 1998-2002, when oil contracts on international markets rarely rose above $25 a barrel and fell as low as $8.64 a barrel. Saudi budget scenarios With oil under $80 a barrel (SRbn) 2010 2011e 2012f 2013f 2014f 2015f 2016f 2017f 2018f 2019f 1,650.00 1,750.00 1,605.00 1,444.50 1,274.70 1,099.32 920.59 739.86 557.91 375.25 438.55 560.00 616.00 640.64 666.27 692.92 720.63 749.46 779.44 810.61 187.95 240.00 264.00 254.86 238.53 217.46 193.10 166.28 137.51 107.05

Saudi budget scenarios 2020f 192.15 843.04 75.06

e=Estimate; f=Forecast. Source: Steffen Hertog; London School of Economics Then Riyadh found itself overcommitted to spending both domestically and abroad, with public debt soaring to 100 per cent of gross domestic product (GDP) in 1999. Government spending outstripped revenues by 3.7 per cent of GDP on average, in the four years to 2002. With little fiscal room for manoeuvre, Riyadh initially cut back spending and opened its doors to outside investors. The plan was to create private-sector jobs for Saudi citizens, while weaning them off their dependence on the state. Radical reforms were proposed: taxation; immigration reform to boost non-oil revenues and create more opportunities for locals; as well as the creation of a national franchise to make the population feel more involved in the decisions being made at the top. Municipal elections were first held in 2005. Saudi budget scenarios With oil under $50 a barrel (SRbn) Year 2010 2011e 2012f 2013f 2014f 2015f 2016f 2017f 2018f 2019f 2020f Reserves 1,650.00 1,700.00 1,215.00 879.00 632.40 439.44 278.66 137.20 7.32 -115.61 -234.37 Current spending 438.55 595.00 654.50 674.14 694.36 715.19 736.65 758.74 781.51 804.95 829.10 Actual capital 187.95 206.75 141.61 96.31 62.72 50.00 50.00 50.00 50.00 50.00 50.00

e=Estimate; f=Forecast. Source: Steffen Hertog; London School of Economics But Riyadhs problems balancing the books were largely ended by rising oil prices and a burgeoning industrialisation programme. In 2005-08, when the value of crude oil only seemed to go up, the deficits of the previous decades were turned into surpluses that averaged 20 per cent of GDP, as revenue rose. Government spending also rose, as did foreign direct investment into the country, largely into major oil, gas and petrochemicals schemes. In 2010 alone, inflows of capital totalled about $40bn, up from $35bn in 2009.

On the face of it, the economy is in good shape, but there are serious structural weaknesses in its makeup, says James Reeve, London-based assistant general manager and senior economist at local bank Samba Group.

Saudi Arabis non-oil deficit

A key issue that is often neglected, Reeve says, is the countrys non-oil fiscal deficit a gauge of the states dependence on oil revenue. According to Samba, the deficit grew steadily from about 20 per cent of non-oil GDP in 2002 to 67 per cent in 2010. It forecasts the deficit could top 80 per cent this year. It shows the governments exposure to a sustained or severe downturn in the oil markets, he says. Figures from Riyadh-based Banque Saudi Fransi show that in 2010, about 80 per cent of state revenues came from oil and gas exports, down from 90 per cent in 2009. Those revenues are mainly used to generate employment. Hertog says about 43 per cent of government expenditure in 2009 went on public-sector wages. The share of wages in the Saudi budget is almost uniquely high among developing and developed countries, he says. Typically, current spending on payroll and expenses is protected within the countrys budgets, while capital expenditures on projects is more susceptible to fluctuations in income. The kingdoms response to the recent unrest was typical of this model; it announced an extra $130bn in spending, which included an additional months pay for state employees and plans to build 500,000 affordable homes. The payout is likely to be prioritised over the housing. They have always protected the public payroll, says Hertog. They have added new people every year at least since 1969 when records began, even at times of fiscal crisis. Meanwhile, most private-sector investment has gone into projects that are in some way dependent on oil and gas. Figures from the state inward-investment agency Saudi Arabian General Investment Agency show this ranges from refining and petrochemicals to energy-intensive industries such as metal production. These industries are made competitive by access to cheap feedstocks provided by state energy company Saudi Aramco, which mostly charges only the marginal cost the production cost to consumers. All of this, says Hertog, means the main drivers of economic growth in Saudi Arabia are government spending on wages, energy subsidies and a business climate made attractive by a lack of taxation. A lot of the growth is directly attributable to the private sector, but indirectly still based on state spending, he says.

Industrial growth in Saudi Arabia

Meanwhile, the industrial growth seen over the first decade of the 21st century is unlikely to be matched over the next 10 years. Much of that development was based around access to cheap gas, particularly ethane, a key building block for basic plastics. In turn, much of the supply of that feedstock came from associated gas, which is produced at the same time as oil. Oil giant Saudi Aramco, which controls allocations of gas to industry, has not committed new volumes to a major industrial project since 2007. Saudi Aramco wants to push forward with industrialisation as it has been, but its competitiveness hasnt come from having a skilled, hard-working population, but on its competitive feedstock 5

advantage, which is unsustainable, says Samuel Ciszuk, a London-based Middle East analyst at the US IHS Global Insight. It looks like industrialisation has been creating jobs, but they have based it all on an even bigger reliance on hydrocarbons. Paul Hodges, chairman of UK petrochemicals consultancy International Echem, says the issue in the future for petrochemicals producers will not be so much of using new, less profitable feedstocks, such as naphtha, as recognising where demand lies. This, in turn, will come down to the ability of employees to adapt to changing markets. The Saudis, because of their strategic advantage, their route to China, have had an opportunity, says Hodges. But they arent going to maintain it through price, they will have to do it by assessing the need. Meanwhile, the more the economy grows, and the greater the spending power of Saudi nationals, the greater consumption of oil and gas, which Saudi Aramco sells domestically at the marginal cost of production. The more the population consumes, the less there is available for export and, hence, to generate government revenues. The kingdoms young population is quickly growing. Banque Saudi Fransi estimates 66 per cent of the countrys indigenous population of 18.5 million people are under the age of 30, a figure that will only increase in coming years. The overall population is growing at 2.3 per cent a year, according to the Washington-headquartered World Bank. That young population will need jobs.

Knowledge stagnation in Saudi Arabia

The kingdom has invested heavily in education: an estimated 100,000 Saudi students are being sponsored to attend academic programmes abroad, of whom about 10,000 return home every year, while up to 130,000 students graduate annually from domestics institutions. So far, the government has tried to absorb [the graduates] into the bureaucracy, says Madawi alRasheed, a Saudi-born academic and expert on society in the kingdom, currently working at Kings College London, in the UK. That creates an unhealthy situation. The private sector is not absorbing graduates either. As jobs in the public sector are relatively well paid and tend to offer high levels of security, the incentives for graduates to look to the private sector are limited. Saudis right now dont have many incentives to develop skills, Hertog says. Good education is not only a supply issue; it is also a demand issue. Right now the public sector is more attractive as employer and does not require cutting-edge education. In June, new employment regulations were unveiled aimed at creating incentives for Saudi nationals to join the private sector and forcing the sector to employ them. Firms will be assessed on how many locals they employ. If they do not meet the required standards, they face being shut down. The labour ministry has already forecast that 30-40 per cent of small and medium-sized enterprises, key drivers of economic growth, could fold as a result. As long as oil prices remain high, the underlying issues of the Saudi economy are unlikely to cause problems. Even then, the government has paid down much of its debt and has huge cash reserves. There will be no urgency as long as there is money to be distributed and there is foreign help, says Al-Rasheed.

But if there is a fall in demand or an increase in production, or both, the government could face serious difficulties in restructuring the economy. They are OK for the next five years, says Hertog. [But] there is a potential long-term fiscal threat if oil prices should fall substantially, as they have locked in their spending at a very high level.

Riyadh steps up nationalisation to ease unemployment

Issue 27 8-14 July 2011 | By James Gavin Saudi Arabia has unveiled new plans to intensify its Saudisation programme as part of efforts to reduce chronic unemployment among youths

Key fact
Riyadh plans to create 1.12 million jobs for nationals by 2014 Source: MEED Riyadhs bold relaunch of its Saudisation programme this year has forced the kingdoms difficult unemployment problem onto the corporate business agenda. Expatriates are anxious about the likely impact of the new regulations, which are designed to increase the number of Saudi nationals currently working in the private sector from less than 10 per cent. Policymakers are now taking a much harder line. Labour Minister Adel Fakieh has already hinted the Nitaqat programme could wipe out firms that fail to bring enough locals onto the payroll. The programme rates companies by their recruitment of nationals according to a colour-coded scheme into excellent, red, yellow and green. This sacrifice is seen as necessary to achieve a far more ambitious goal. Riyadh plans to create 1.12 million jobs for nationals by 2014, equivalent to 92 per cent of all new jobs created, as set out in the current national development plan.

Unemployment concern in Saudi Arabia

The urgency is dictated by statistics that reveal the private sector has actually regressed in its deployment of local talent. The booming economy in the 2000s succeeded in hiring more expats than young nationals to satisfy the employment needs of a rapidly growing services sector. The private sector has perpetuated the kingdoms unemployment problem rather than alleviating it. Some 6.21 million of a total 6.89 million private sector employees in 2009 or nine out of every 10 were non-Saudis, up almost 30 per cent from 2006. Under Nitaqat, each category of firm graded according to size will have its own set of rules designed to increase the percentage of local employees, policed by 1,000 new labour inspectors hired to monitor compliance. Once the grace period elapses, severe penalties could be levelled on violators. The state will impose a six-year cap on residency visas for expatriate workers if their employers fail to meet the stated quotas. Accompanying the stick is a slightly less conspicuous carrot. Nitaqats offer of a more dynamic 8

methodology for applying quotas is aimed at incentivising firms to develop local talent in their ranks. And those that do most will be suitably rewarded, according to the details of the new Saudisation programme unveiled on 11 June. This time they are linking Saudisation numbers with visas and that is rather new for the system John Sfakianakis, Banque Saudi Fransi Companies that failed to hire nationals under the previous regime will be offered incentives to hire nationals and invest in training. Whereas the previous Saudisation quota system required all sectors to have a blanket nationalisation rate of 30 per cent, the new system applies 205 categories of quotas that vary based on the line of work and size of the company. Those achieving more than 30 per cent nationalisation would be reclassified as excellent or green and would enjoy greater privileges in sponsoring non-locals and obtaining new visas electronically. Nitaqat applies another strategy to foster best practice. The sizeable expatriate community will be afforded far greater mobility under the new system, with green companies entitled to recruit foreign workers freely from the yellow and red categories and transfer their sponsorship visas without their current employers consent. The one thing that is very different this time is that they are linking Saudisation numbers with visas and that is rather new for the system, says John Sfakianakis, chief economist at the local Banque Saudi Fransi.

Flexible job market

Fostering a far more flexible expatriate labour force will require firms to think more carefully about employing non-Saudi nationals. It also makes experienced expatriate workers the big winners of the new scheme, by encouraging companies to do more to recruit nationals in order to stand a better chance of hiring the best foreigners too. This linkage may prove to be schemes genius. Taking a positive view, one might say that the new regulations provide a more nuanced approach to the current Saudisation policy, by distinguishing between companies in terms of size and activity in a more standardised way, says James Reeve, economist at local investment house Samba Group. The penalties for not meeting Saudisation targets are clearly onerous, says Reeve. But they might force private companies to invest more in training and raise wages, which would clearly be positive. On the other hand, there is clear potential for small firms to suffer, given that the marginal cost of hiring a national will be higher for them than for a larger firm. If they fail to meet the targets, the penalties might be enough to send them out of business. This is potentially a major concern, since SMEs [small and medium enterprises] are the backbone of all successful economies, says Reeve. They are in fact the main driver of employment growth in the kingdom, albeit of non-Saudi employment growth. Foreign businesses active in the Saudi private sector are clearly anxious about the impact. A sense of panic has taken root, not helped by alarmist press coverage indicating that small firms may go out of business or will all be forced to hire at least one national.

Counter productive policy

One expatriate business leader, speaking on condition of anonymity, told MEED that the Nitaqat strategy appears to be contradictory. It represents weak policy coordination at the leadership level; one initiative to invigorate the economy, a second to expand local employment opportunities, but little forethought towards how the two may conflict, he says. He warns it is at odds with and poorly coordinated with parallel initiatives to place the kingdom as a regional hub, citing King Abdullah Financial District in Riyadh and the new Jeddah airport as examples. Despite the attempts at greater differentiation in categorising Saudisation levels, the concern is the government is tackling the problem with a rather crude implement and not offering enough in compensation. The approach that better balances the interests of local job seekers and foreign employers would be to seek solutions that make it attractive to foreign companies to hire Saudis, says the foreign business leader. These could include education opportunities and reform, more English at an earlier age in the schools, and less protectionism towards Saudi employees in the workplace. Quota regimes also have the potential to deter foreign direct investment, which is an important potential source of employment growth and technology transfer. Ultimately, the key to Nitaqats success lies not in the fine print but in the interpretation. Many of the shortcomings of the previous strategy were down to failures of implementation. Its very important that these initiatives are coordinated with the private sector, says Sfakianakis. The private sector must guide the trainers and ensure training suits the needs of the private sector. Training cant be done in a vacuum without consideration of what the needs of the private sector are. As important as shifting the goalposts on Saudisation is that the government undertakes efforts to change mindsets, for example by ending the blanket reassurance that locals will always find employment in the public sector. The government must signal to society that it will not be the employer of last resort, and at a time when the government is recruiting new employees, this isnt easy, says Sfakianakis. Equally, maintaining an open-door immigration policy may not be conducive to fixing the disparity between recruitment of expatriate workers and nationals in the private sector. If all Nitaqat ends up doing is creating a sellers market for the best expatriate talent, it will have failed in its mission of turning the local population into the main recruiting ground for the kingdoms most dynamic businesses. If the government can give the Saudisation programme a greater focus on education and training and implement the strategy in a suitably business-friendly manner, it should at least put the kingdom on the right track to redress its chronic labour market imbalance. Ultimately, there is no substitute for better education and training if creating jobs for nationals is the priority, says Reeve.

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Nitaqat what it means

Companies are characterised as excellent, green, yellow and red, according to their rates of Saudisation Excellent: Companies deemed excellent or green will enjoy greater privileges in sponsoring nonSaudis and obtaining new visas electronically. This includes transferring sponsorship with change of profession and free of any requirement to spend at least two years with the original employer. They will have a one-year grace period to retain full sponsorship privileges should any government licenses or certificates expire. Green: Entities in compliance with the rules qualify for a range of incentives, including visas for foreign workers; one replacement visa for every two exit-only visas; freedom to change expatriate workers professional designations; free recruitment of expats from red and yellow employers. Yellow: Entities out of compliance with Saudisation requirements are designated yellow and are given nine months from June 11 to improve their nationalisation rates. Yellow companies will be barred from transferring non-Saudi visas to their sponsorship; submitting new visa applications; transferring expatriate workers to their sponsorship; changing their workers profession; or retaining expatriate workers seeking to transfer their services to green or excellent companies. Red: Companies not in compliance with Saudisation requirements are designated as red and given six months to improve. They will be deprived of the facility to change workers professions, transfer expatriate workers services, denied new, replacement or seasonal visas, opening files for new enterprises at labour offices and renewing work permits. They lose control over expatriate workers, giving them the right to leave.

The kingdoms unemployment crisis

Saudi Arabia boasts the unenviable record of having the Gulfs second highest youth unemployment rate, after Iraq. In 2009, some 27.4 per cent of Saudis under the age of 30 were without work, including 39.3 per cent of those aged 20-24. According to Banque Saudi Fransis June report on the new Saudisation strategy, in the 1990s, the ratio of expatriates to the total population remained relatively stable, fluctuating at slightly above or below 27 per cent. But in the past five years this shifted noticeably as recruitment of expatriates intensified during the 2004-08 economic boom. Since 2004, the ratio of non-Saudis to the total population rose sharply, reaching 31 per cent of the 27.6 million people living in the country at the end of 2010. Today, almost one in every three Saudi residents is a foreigner. Many of the new jobs created during the boom years went to foreigners rather than to nationals. In 2009, almost 674,000 new jobs were created in the private sector and another 42,189 in the public sector. Yet that year, unemployment among Saudi nationals rose to 10.5 per cent, from 9.8 per cent in 2008. With unemployment benefits being paid to Saudi nationals for the first time this year, it is expected that official unemployment figures could increase as more individuals register their status.

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Downstream move under way in Saudi Arabia

Issue 27 8-14 July 2011 | By Kevin Baxter Many of Saudi Arabias planned petrochemicals projects are geared towards providing feedstock and raw materials for the automotive and electronics industries

Key fact
There are about $50bn-worth of petrochemicals projects planned or under way in the kingdom Source: MEED Projects Petrochemical producers have two choices when it comes to the location of a new facility: building next to the intended market or close to the feedstock source. Saudi Arabia has always located its plants near supplies of cheap feedstock and the majority of the chemicals it produces are aimed at the export market. The problem with this model is that the countries providing the cheap feedstock to produce base chemicals are not adding much value to their energy resources. It is the nations that make the end products that gain the full advantage. Riyadh has identified this as a problem and is now making an effort to build a petrochemicals industry that serves its overseas customers, as well as developing and expanding its domestic market. A strong home market makes a compelling case and helps an economy mitigate against external factors such as high transport costs, trade barriers and any slumps in world demand.

Export focus in Saudi Arabia

Currently, base chemicals such as olefins, polyethylene terephthalate (PET), propylene and polypropylene are exported in bulk to manufacturing hubs in China, India and Europe, where they are made into end products and shipped out again. If you also include the PetroRabigh complex, it signals the considerable extent of Aramcos petrochemicals plans Contractor based in Al-Khobar Until now, this has worked for both Saudi Arabia and the countries with large manufacturing bases that received the shipments. For example, in 2010, China imported 5.9 million tonnes of non-oil exports from Saudi Arabia. The vast majority of this was petrochemicals and plastics. Riyadh has identified key industries where value can be added to petrochemicals production, such as automotive manufacturing and plastics and polymers.

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I know that all of the talk in Saudi Arabia now is of moving the [petrochemicals] industry downstream and building clusters that provide jobs, says a petrochemicals executive based in the kingdom. But the fact is that up until now the export arrangement worked well for everyone. Either way there is no denying that there is a boom in petrochemicals projects at the moment. According to regional projects tracker MEED Projects, there are about $50bn-worth of petrochemicals projects planned or under way in the kingdom, with a chemical mix that is more diverse than exportorientated base chemicals. Most of the chemicals are intended to be used as feedstock in industries that the government is keen to attract investment in, such as vehicle and electronics production. Riyadh is fortunate to have the worlds largest energy company, Saudi Aramco and the Middle Easts largest petrochemicals company, Saudi Basic Industries Corporation (Sabic), at its disposal to execute its downstream ambitions. With an estimated budget of $18bn, the integrated petrochemicals complex at Jubail is the largest facility currently planned in the kingdom. The scheme is a joint venture between Aramco and the US Dow Chemical. It will house a mixed-feed cracker using ethane and naphtha that will produce 1.2 million tonnes a year (t/y) of ethylene and 400,000 t/y of propylene. These base chemicals will be used as a feedstock to produce a diverse range of products, including metallocene-based elastomers, glycol ethers, solution polyethylene, methyl/polymethyl methacrylate, nylon and ethylene propylene rubber. The sheer scale of Aramco/Dow is incredible, says a Saudi contracting source based in Al-Khobar. If you also include the PetroRabigh complex, it signals the considerable extent of Aramcos petrochemicals plans. PetroRabigh is Aramcos joint venture with Japans Sumitomo Chemical on the kingdoms Red Sea coast. The partners recently issued tenders for the schemes $5bn phase two expansion, which will produce more than 2 million t/y of specialty chemicals and products. The bulk of this will be used at an industrial park being constructed next to the complex.

PetroRabigh delay
Although the engineering, procurement and construction (EPC) tenders have been issued to bidders, there is still uncertainty over the projects timeline. Banking sources have cast doubt on the scheme achieving financial close before late 2012, which means construction work will not start until 2013. As far as EPC contractors are concerned it is business as usual [at PetroRabigh phase two], the contracting source says. But if financial close is not going to be until late 2012 then this could cause problems. No work can start onsite, but the engineering could be started. While Aramco is becoming an important player in the kingdoms petrochemicals industry, Sabic is the undisputed champion. The firm has a number of schemes planned or under way. The $2bn elastomer project is a joint venture between Sabic and the US ExxonMobil Chemical that will be built at the Al-Jubail Petrochemical Company (Kemya) in the Eastern Province. The project will produce about 400,000 t/y of carbon black, rubber and thermoplastic speciality polymers. ExxonMobil will provide the technology and the products will be sold to local and international markets. 13

Carbon black is used by the automotive industry to add strength to plastic and rubber products. Despite initial delays, three EPC packages are currently being tendered for the project, including the ethylene propylene diene monomer/polybutadiene rubber facilities, the halobutyls rubber plant and the offsites and utilities. At an earlier stage is Sabics methyl methacrylate (MMA) joint venture with Japans Mitsubishi Rayon subsidiary Lucite. The Alpha 2 scheme will see a 250,000-t/y MMA plant built at an undecided location in the kingdom. About 80 per cent of MMA produced will be used in the construction and automotive industries. Riyadh is hoping that building downstream facilities will attract global carmakers such as Japans Toyota and the US General Motors to set up vehicle assembly factories in Saudi Arabia. It is not just Aramco and Sabic that are developing downstream projects. Many of the kingdoms private petrochemical companies are also expanding. The local National Petrochemical Industrialisation Company (Tasnee) and Sahara Petrochemical are building a $1.5-2bn acrylic acid plant at Jubail, along with the US Rohm & Haas. We are confident that we can get the finance in place soon, says Moayyed al-Qurtas, Tasnee chief executive officer and vice-chairman. Everyone concerned with the project is confident that the necessary funding will soon be in place and we can build a world-class facility. What is clear from the scale of the awards that have been made since the global economic crisis is that Saudi Arabia believes that both local and international demand and prices are going to rise to pre-2008 levels by the middle of the decade. With many of the facilities due for completion in 2015-16, Riyadhs ambitious expansion plans should come onstream when the market is firmly on an upward swing. The kingdoms push to develop its downstream industries is set to intensify as the decade progresses. A surge in smaller facilities will also add further value to the feedstock from the major plants. Saudi Aramco chief executive officer Khalid al-Falih has said the kingdoms petrochemicals industry in the kingdom will enter its golden age during the next 10 years. It will become a major global hub that will compete against China, Europe and the US. The past few years have been about increasing the kingdoms oil and gas output, but the next decade will be about adding value to that output. With more domestic gas supplies being developed, the kingdom will soon have all core ingredients in place. A world-leading petrochemicals industry is just the beginning. Beyond that, Riyadh aims to establish a local specialist manufacturing sector that utilises the output from the petrochemicals facilities. The development of the industrial sector will only be considered complete when the kingdom exports products stamped Made in Saudi Arabia.

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Slow progress to foreign access to the Saudi stock exchange

Issue 27 8-14 July 2011 | By James Gavin The Saudi stock exchange is committed to increasing foreign access to the bourse beyond exchangetraded funds, but the regional uprisings mean other concerns are taking priority

Key fact
Foreign buys under swap agreements accounted for just 0.4 per cent of total buys on the Tadawul in June 2011 Source: Tadawul In late December 2010, officials from the Saudi stock exchange (Tadawul) met representatives of 29 regional banks and brokerage houses to quiz them about their preparedness for handling foreign accounts. When news of these discussions leaked in January, Riyadhs financial community was agog with rumour. Was this finally the precursor to a full opening to foreign investors, heralding potentially the biggest reform to a Middle Eastern stock market since Egypt acquired emerging market status? Things have since gone quiet, with the outbreak of political unrest across the region quelling policy activism on several fronts, beyond the increase in public expenditure.

Gradual opening of the Saudi stock exchange

The Tadawul is nonetheless heading, at its own pace, in the direction of a full opening for foreigners to Saudi equities. The discussion is now about the timing and the potential impact this opening could have on regional bourses. Until now, the Tadawul has been indirectly open to foreign investors through swaps agreements, mutual funds and exchange-traded funds (ETFs). In 2007-10, the Capital Market Authority (CMA) moved progressively to widen participation as part of a calculated attempt to put the kingdom on the international investor radar yet without offering them full direct access. [The Saudi authorities] dont want to launch something without a reasonable expectation of things working out Jarmo Kotilaine, National Commercial Bank In December 2007, however, inspired by moves to establish a regional common market, the market was opened up to GCC nationals for the first time. Then in August 2008, the CMA approved rules allowing non-Arabs to participate in share trading through swap arrangements with local CMA-

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licensed intermediaries. Previously, foreign investors access was restricted to mutual funds. Then in 2010, the authorities allowed ETFs to trade in the bourse. This gradual market opening has given foreign investors a taste for Saudi equities, with swaps enabling foreign institutions to take positions in the Saudi market. But it has not radically transformed the Saudi market. More work is needed to dismantle the barriers to foreign access, and take advantage of latent institutional interest in the regions largest stock market. People are put off by the method of market access its that rather than the market itself that is disincentivising foreign investors, says Paul Gamble, head of research at the local Jadwa Investment. Trading volumes among foreign investors remain low. In June 2011, foreign buys under swap agreements accounted for only 0.4 per cent of total buys on the Tadawul. In contrast, Saudi corporate and individual buys accounted for 95 per cent. Tadawul trading by nationality type, June 2011 (Percentage of buys by volume) Saudi individual Saudi corporate Saudi mutual fund Arabs (non-GCC) GCC citizens Foreigners (swap agreement) Foreigners (non-Arab/GCC) Source: Tadawul Although swaps and mutual funds enable non-locals to dip their toes in the water, they are an inadequate means of exposure to the highly liquid large capitalisations that trade on the bourse. Yet even if the method of investment is unattractive, these swaps and ETFs could grow in popularity if it becomes clear the CMA is serious about moving to a full opening. You might find people using swaps quite a bit more as a precursor to getting in, says Fahd Iqbal, strategy director at Egyptian finance house EFG Hermes. While swaps which do not give foreigners voting rights do allow hedge funds to invest, they are unable to channel all-important institutional investment flows that would boost trading on the exchange. Retail investors account for about 95 per cent of trades on the Tadawul, which has made the bourse particularly vulnerable to volatile investment patterns. Any decision to sanction a full market opening to foreigners would require a political decision at the highest level. However, the regional turmoil has prioritised other areas of policy-making, meaning any decision is unlikely to be reached until at least the end of the year. 89.6 5.1 2.1 1.7 0.9 0.4 0.2

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Preparatory work on Tadawul

That does not mean that opening up the Tadawul will be shelved. Behind the scenes, officials are working to position themselves so that if the decision is taken, they can implement it quickly, say insiders. What is less clear is to what extent regional turmoil has discouraged the authorities from proceeding with their plans, says Jarmo Kotilaine, chief economist at National Commercial Bank. But preparatory work is ongoing and they are in a position to mobilise the plan relatively quickly once the political will materialises. The recent performance of the Tadawul demonstrates why opening up to foreign investment would be of major benefit. Despite generally strong macro-fundamentals, Saudi share traders have shown heightened risk aversion in 2011. Political risk is expected to undermine investor sentiment in the rest of the year, provoking sharp moves in share prices. March was an extremely volatile month for the TASI all-share index. It hit a two-year low on the back of the unrest before new government spending commitments helped it to recover to almost exactly where it finished last year. In a reversal of the situation in many other emerging markets, it is the foreigners who are proving to be more confident than the locals. Foreign investors remained net buyers in March, but net sales by Saudi individual investors were by far the largest since at least 2007, notes Jadwa in its March 2011 Saudi factbook. Net sales by foreigners through the swap agreement in January were worth SR905m ($241m), compared with average net purchases of SR290m a month during 2010. Local individual investors, who accounted for 86 per cent of transactions, made by their largest net sales since the data was first released in January 2008.

Stabilising role played by foreign investors

Foreign investors have played a stabilising role this year and remain positive in the market. You would generally expect them to be long-term investors, since a lot of them are institutions with a longterm view, says Gamble. This phenomenon of foreign investors being less risk averse than the locals undermines the traditional argument put forward against reforming entry rules to the Tadawul. The main concern of Saudi authorities has historically been to do with hot money, says Kotilaine. Theyve seen the ups and downs of the Egyptian bourse [which allows full access to foreigners] and that is what they are mainly concerned with. They dont want to launch something without a reasonable expectation of things working out to their satisfaction. But the hot money argument is flawed. The hottest of hot money is the local money, which comes and goes as it likes and is motivated by factors that have very little to do with fundamentals, says Kotilaine. An example of this is how the spending initiatives announce by King Abdullah have impacted on local investor sentiment. Jadwa noted a jump in trading by Saudi individual investors in April, accounting for 90 per cent of total trades by value, the highest since October 2009. Jadwa says this was the result of public-sector pay bonuses being used for stock market investment. 17

Even if foreign investors come and go, they could serve as example to locals. The CMA instinctively prefers the institutional players, with their long-term strategies, their preference for research and their positive impact on retail investor behaviour. The regulator likes the investment banks, pension funds and foundations that operate in emerging markets. In practice, you bring in more retail money as well, because investment banks also serve retail clients, says Kotilaine. The much-hoped-for transformation may not happen overnight, however. Foreign pension fund managers will need to gain comfort with Saudi risk, which could take time. You cant expect an overnight transformation, so the short-term impact could be quite limited, says Iqbal. However, in the longer term, removing barriers to foreign entry will have a huge bearing on the wider regions capital market. Saudi Arabia, if it allows direct foreign entry, would eventually be considered for inclusion on the MSCI Emerging Market index. In the meantime, EFG Hermes estimates that frontier market funds have about $12bn of assets under management. If subsequently one-third of that is geared towards Saudi Arabia, that will clearly have a decisive impact. Right now the Kuwait market represents a good 35 per cent of the frontier market index, but once Saudi Arabia comes in it will skew everything and will become by far the largest market. Suddenly, there could be a great deal of frontier market money that will need benchmarking to the Saudi bourse, says Iqbal. The prize for foreign investors is pretty clear: a market capitalisation of $318bn makes the Tadawul the largest bourse in the Arab world, and few fund managers would pass on taking positions in robust blue-chip firms, such as Saudi Basic Industries Corporation or Saudi Telecom.

An even split between institutional and retail investors

Saudi officials are unlikely to get too carried away and will be aware that since Egypt gained emerging market status, institutional money has started coming in increasing volumes, but the proportion of value traded that institutions accounted for has stayed more or less the same. The split between institutions and retail investors has remained even in Egypt, because as more money comes in from institutions, it attracts retail money as well, says Kotilaine. What is clear is that the Saudi authorities are serious about reforming their stock market and putting the kingdom firmly on the international institutions map. There is one direction you go in and everything so far has to be seen as a step towards a wider opening. When they started the process they knew what the logical end would be. They obviously have the wherewithal to control the timing of process. but it is a process that is only going in one direction, says Gamble. Unfortunately, for potential investors, the Arab uprisings have clearly pushed back the time frame a little.

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