Abdeljalil Ghanem and Said Elfakhani
Dr. Ghanem is an assistant professor at the Olayan School of Business, American University of Beirut. Dr. Elfakhani is the Harvey R. Wickes Chair in International Business and professor of finance, College of Business and Management, Saginaw Valley State University, Michigan.
The Gulf states have been debating privatization for 15 years, but with limited progress. This slow pace reflects several concerns, such as increased unemployment — already a major problem in Bahrain and Saudi Arabia and a potential problem in Oman and Kuwait — and rising prices, due, for example, to elimination of subsidies to the national electricity company. Furthermore, the Gulf states realize that rushing into privatization without planning could disrupt private-sector activities, especially since a successful privatization program requires prerequisites that some have only recently achieved: a functioning stock market, legislative infrastructure, sophisticated financial services and a functioning legal framework, among other things.
One major factor behind the Gulf Cooperation Council's (GCC) move toward privatization has been the need to relieve the governments of the financial burdens of capital expenditure. Another factor is the lack of equal opportunity among the citizenry. For instance, financial strains on state budgets may raise concerns over state revenues reserved for the ruling families. The implications of enforcing hardships (e.g., unemployment and rising prices) on the population, while the ruling elite maintain or increase their share of state revenues, could generate enormous public resentment. Privatization may reduce the current advantage of the ruling families in the private sector (such as preferential treatment by state authorities and immunity from judicial proceedings). On the other hand, alienating privileged members of the business community and the royal families could erode the rulers' support base and generate a political backlash.1 The recent pushes in the Middle East for radical reforms are political on the surface, but they are deeply rooted in the search for fair economic opportunities.
A closer look at the Gulf countries suggests that many of their ruling elite are now showing a will to forgo some of their control over economic power and to encourage participation of the private sector in the process of wealth creation, consequently alleviating poverty. This is being progressively achieved through privatization programs currently in progress in a number of Arab countries and the development of the region's financial markets.
Privatization of public institutions — such as telecommunications, water and energy supplies, banking and insurance — is gaining increased momentum across the GCC. For instance, Bahrain is attempting to diversify its economy through the Supreme Privatization Council. Abu Dhabi has taken steps towards privatizing utilities. Furthermore, a report by Kamco Research notes that the Capital Market Authority of Muscat's Securities Exchange has recently presented a "golden share" method, whereby strategically important state-owned companies are encouraged to provide stakes for public investing while giving the government veto power, even in cases where it is a minority shareholder.2
Nevertheless, privatization is a complex and lengthy process that requires careful conceptualization and planning. In general, it consists of stated policy objectives, applicable methods, re-engineered company structures, and an implementation plan, which in turn depends on the methods and the structure. Unfortunately, in many cases, privatization programs in the GCC were introduced only at the implementation stage, without the benefit of formal planning and defined strategic objectives or a consistent policy framework that would enable the various stages of the process to be implemented efficiently and effectively.
The purpose of this paper is to highlight the efforts that aim to encourage wider participation of the private sector in the economy and to discuss the key factors affecting the privatization of industrial institutions in the Gulf region. Hertog states that the private sector is in fact becoming more and more independent from state contracts and is playing a greater role, with private wealth in the Middle East being estimated at $1.5 trillion.3 The heightened participation of national citizens in the economy and in the financial markets is particularly notable. Gulf investors have begun to move from being renters to entrepreneurs who take an active interest in projects and routinely establish start-ups.4 These initiatives were encouraged as the bureaucratic impediments to starting a business were reduced in several Arab countries. Egypt, for instance, was identified as the top reformer of 2006-07 by the World Bank's "Doing Business 2008" report. Saudi Arabia was among the top ten reformers and was ranked twenty-third out of 178 countries in 2007 in ease of doing business.
A host of policy makers, national and international funding agencies, bankers, potential investors, regulators and researchers are interested in the discussion of the various key factors and options available to the state governments. The issue of privatization and transfers of assets in the context of reforms and the possible restructuring of state-owned industrial institutions in the Gulf is of public and international interest. Thus, this paper can provide a launching point for further discussions on privatization in the Gulf.
GOVERNMENT OBJECTIVES AND IMPLICATIONS
The most significant factor affecting the government's privatization strategy is the setting of objectives. What is to be achieved by the privatization of industrial institutions? Interviews in the Gulf (mainly with the staff of the General Industries Corporation [GIC] in Abu Dhabi), indicate that the core objectives of privatization in the GCC states are these:
• In general, to attain the broad range of benefits associated with economic efficiency, such as removal of distortions in the economy, generation of government revenues through share sales and improvement in national economic competitiveness.
• In particular, to foster an industrial investment culture that will provide opportunities for citizens to invest in manufacturing and thereby participate in national economic diversification. A knowledgeable, sophisticated and wealthy investment community is a prerequisite for advanced industrialization, not only to provide the necessary capital, but also to foster a body of well-informed economic opinion that will provide influence and discipline over the professional management community.
• To enable the government to continue to develop new projects in other economic sectors, by relieving it of the burden of managing existing enterprises.
The first objective can be directly realized by the removal of preferential treatment for some public industrial institutions (price preferences, subsidies on electricity and water, etc.). Otherwise, the industrial entities will not become economically efficient, undercutting potential benefits, and it is likely that public industrial institutions would emerge as private monopolies (having over 50 percent market share and the capability of influencing the prices and functioning of the market). Hence, privatization alone will not be sufficient.
Fostering an industrial culture will require careful planning in the sale of shares and future business operations. The privatization plan will, in particular, need to ensure that:
• Share prices are neither so high that investors are deterred from buying, nor so low that the excessive returns bring trading to a halt. The latter scenario might raise expectations to unrealistic levels.
• Shares are accessible to as many citizens as possible. This may require restrictions on the maximum number of shares that can be bought by any single individual (recommended at 1 percent of the total value of a company).
• The public is informed about the share offer and the benefits and risks of industrial investment. It is likely that there will be a need for general information about the industrialization of Saudi Arabia, the UAE, Kuwait, etc., as well as particular details about the industrial entities.
• Strategic business planning for industrial entities establishes clear objectives and a business model to increase shareholder value.
All these measures will be needed to ensure that shareholders are encouraged to invest in industrial projects and form a sophisticated investor community that in itself would be a vital influence over managerial efficiency and performance.
The government would want to sell the shares in its companies at as high a price as possible, so as to amass a "war chest" for re-investment in a new generation of projects.
INTERESTS OF SHAREHOLDERS
Besides governments, potential shareholders also have interests that need to be reconciled and incorporated into the privatization plan and the share offer. Who might be included among the possible shareholders? A shareholder is, in brief, any individual or institution that owns one or more shares in the equity of a company. However, the Gulf governments will determine who should be permitted to be a shareholder in these industrial public entities. At present, although Gulf corporate law allows foreigners to hold 49 percent of the shares of a company, current policy and practice permit only Gulf citizens to own and trade shares in Gulf-registered joint stock companies. Hence, the potential shareholders could be limited to the Gulf investment community.
However, discussions with some Gulf government agencies including the Dubai Financial Market Institution, which regulates the Dubai stock exchange, indicated that the current policies are regularly reviewed and that there is at least consideration of reducing restrictions on foreign investors. Furthermore, the Unified Economic Agreement of the GCC has provisions for the free transfer and ownership of capital by citizens among member states, and more recent official statements have called for a GCC-wide stock exchange. Indeed, some stock markets in the GCC (notably Oman and Bahrain) have liberalized their regulations. Potential shareholders could include the following:
• Private citizens in the GCC
• Financial organizations and companies owned by citizens of the GCC; joint ventures between them and foreign companies
• Foreign-owned financial institutions registered as residents of the GCC
• Individual foreign residents in the GCC
• Foreign individuals and companies registered overseas and wishing to invest in the Gulf, including investment funds in certain countries.
The objectives of these various potential shareholders are likely to be the same as a cross-section of investors in every other country in the world: a combination of capital growth and dividends that suit their particular needs. There are also likely to be GCC investors who are motivated by an interest in contributing to national development. We have been informed that the majority of GCC investors are interested in long-term capital growth and therefore unlikely to ever sell their shares, but they will need to be satisfied that the dividends are at least equivalent to the bank-deposit rate.
In addition to individual private investors, there are also likely to be some institutional investors in the form of companies and cooperative societies that may be interested in owing shares in industrial entities as a method of profitable diversification. Some GCC organizations are already active investors in the stock market, and others may be especially interested in the GCC industrial sector because of the combination of high cash flow from dividend yield and capital growth, which would strengthen their balance sheets.
Foreign investors are likely to have similar objectives. However, they are also likely to have demands for higher levels of dividend and capital growth and to be active investors, trading regularly in industrial and other shares. As will be shown in the sections below, the Abu Dhabi-UAE industrial shares, for example, appear to be very attractive in comparison to those of major international stock markets, but they will need to be very profitable in order to encourage external investors to enter a new (and potentially risky) stock market. Indeed, foreign investors are unlikely to participate unless they are confident that there would be an active share market and the opportunity to sell their shares. Hence, their involvement is likely to make the share price more volatile, moving up and down with increased trading. However, it would also be more stable, in that a diverse market would set a clearer trend, and it would not be dominated by a few large investors, reducing the risk of a sudden price collapse.
OBJECTIVES OF STAKEHOLDERS
In addition to the shareholders, it is necessary to consider the objectives of the actual and potential stakeholders in the industrial institutions. This helps to evaluate political and economic sensitivities and potential complications. The concept of "stakeholder" includes all the relevant interest groups that might be involved in the privatization process. It is, however, more complicated to identify and assess the other stakeholders in the privatization of GCC industrial institutions than to consider the potential shareholders.
Stakeholders are different from shareholders, who have a clear legal and financial interest in the company as owners. Stakeholders do not have any form of ownership of the company, but they still have a strong interest in the company's operations, behavior and success. The transfer of ownership from the state to private shareholders highlights the differences between the interests of shareholders and stakeholders. Hence, it is a necessary, but complex, exercise to go through the process of carefully analyzing all the potential stakeholders in the Gulf industrial entities to assess their potential impact on privatization. This exercise needs to be interactive, as the management and factory staff are in the best position to know the various stakeholders and their influence.
The transfer of a company to private ownership often involves the removal of government subsidies and protection, which were originally designed to help the company meet the needs of the consumer. The shareholders can deal with this new challenge by increasing prices to the customers up to the maximum the market can bear, and by reducing staff and benefits. This might mean that the numbers of the unemployed will increase substantially in the local community, which could, in turn, have a cumulative damaging effect throughout the local economy. Thus, the short-term direct interests of the staff, the customers and the local community might therefore conflict with the interests of the shareholders. The interests of the public are usually more complicated. In the short term, the public may experience price rises, but, in the longer term, they will benefit from the increased economic efficiency resulting from the privatization process.
A simple working definition of the concept of "stakeholder" is any individual or group that meets one or both of the following criteria:
• It has a direct interest in the entity concerned, in that any changes in the functions, costs or quality of production would have a perceptible impact (for public utilities like electricity or water, this criterion would cover the public at large as well as the local community).
• It has an influence over the privatization and subsequent operations of the factory and could directly influence the success or failure of the enterprise.
It is necessary to carefully consider who the stakeholders in the Gulf industrial institutions might be and whether they have any legitimate interests worth being safeguarded or the strength to influence the efficient operations of factories after privatization.
The stakeholders of any given enterprise usually include:
• The government organizations that currently own it and will hand over its shares to private investors — but will probably continue to have a "parental" interest in its success (not least because it will be held responsible by the public if the privatization is not successful)
• The company management and staff (who are usually not shareholders)
• The local community where the company is located
• The business partners of the enterprise (customers, end-users, suppliers and sub-contractors), who may want to see that the company continues to be independent
• The bankers, who are critical for providing credit lines for the company and its customers
• The company's competitors in the market, who influence the success or failure of the enterprise
• The general public, especially if the company has a monopoly on a basic necessity (such as flour, electricity or water)
It is a matter of judgment to identify the relevant stakeholders in any given enterprise. Where the enterprise is the largest employer in a particular region, the local community could be a very significant stakeholder. In other cases, the local communities are not likely to be significantly affected, as there would be many competing enterprises.
STAKEHOLDERS IN GULF INDUSTRIES
The particular stakeholders in Gulf industrial companies have been identified as follows:
• The end-users, the municipalities and government agencies that commission the contracts and want to be sure that the equipment is satisfactory
• The competitors, who will have greater opportunities after government preferment is relinquished
• The management and staff
None of the stakeholders is especially significant for the future of the factories other than their management and staff and their competitors. Nevertheless, it is considered vital that the factories' management and advisers continue to monitor the various stakeholders throughout the privatization process, in case any interest groups believe that they may be seriously affected by privatization and seek to influence the process.
The local communities are not dependent on the factories for a large part of their employment, nor for generating a wide range of small businesses. The factories do not have serious debts or any external financing; hence, the banks are not involved. Also, although the public factories have preferences in government purchasing, and some of them have an effective monopoly, there are plenty of alternative suppliers from other sources or other parts of the Gulf or imports, such that there is little danger of the consumer being affected by the changes.
Therefore, neither external organizations nor the public are seriously dependent on the Gulf factories as strategic suppliers. In this respect, these factories are relatively free from the influence of outside stakeholders. The most significant stakeholders (whose objectives will need to be considered in the privatization process) are those that are internal to the business: the management, the staff and the competitors.
The competitors will have greatly increased scope for their businesses after government preferences are removed and will have the objective of taking away a large part of the Gulf factories' market share. However, it is considered that none of the competitors is large or strong enough to put them out of business, especially if the factories have sufficient time to restructure themselves and prepare for open-market competition.
However, there is a possibility that the competitors might not support privatization, as it will produce more dynamic, aggressive companies and therefore competition in the market. At present, even though the Gulf industrial entities have a dominant position, competitors can operate in a well-known, structured and stable market. Privatization will make the market open and unstable, which might threaten competitors.
The management and staff will have the objectives of protecting their positions, influence, salaries and working conditions. At present, management and staff are all employees, and not shareholders, in the Gulf industrial institutions; hence, it would appear as though there should be no change in their status. However, the transfer of ownership from government to the private sector is likely to introduce a period of uncertainty that may encourage management and staff to question their positions. Moreover, they may be concerned about whether the new owners will provide the same job security, whether their incomes will be increased, whether there will be increased job satisfaction, and whether there might be new management requirements.
The central question relating to the issue of management and staff is not whether they will perform efficiently but, rather, how to ensure that they will work with the highest degree of commitment and dedication in order to maximize the interests of the shareholders. One of the main purposes of privatization is to improve efficiency and performance, but this may need to be applied to management and staff as well as the directors of the companies.
Privatization itself will enable the directors to introduce business strategies to maximize commercial advantage and return to the shareholders; however, privatization itself will not motivate managers and staff to improve their performance. Therefore, other methods will be needed, such as performance-related salaries and bonuses, improved working conditions and penalties for poor performance — and also the option for management and staff to become shareholders as well as stakeholders in their own factories. It is recognized that this option depends on a change in policy (though not in the companies law) to allow non-citizens to own shares in Gulf companies, but it is certainly a way to encourage staff enthusiasm and commitment.
STAKEHOLDERS IN THE PRIVATIZATION PROCESS
There are stakeholders not only in the Gulf industrial entities themselves, but also in the whole process of privatization. This sale of shares will be the first major privatization in the Gulf since the start of the UAE stock market in 1985. Stakeholders in the privatization process will include:
• The Gulf governments and the regional agencies concerned with the development of the Gulf stock market (the ministries of Economy and Commerce, Finance and Industry, the Central Bank, and the GCC and Arab Monetary Funds)
• Gulf as well as regional and international financial institutions. They will all be interested in opportunities in managing the privatization process and later in the investment opportunities offered by the Gulf as a leading emerging market. There is a strong interest among international banks and country investment funds to find new investment opportunities in emerging markets. These institutions include banks, stockbrokers, law firms, accountants, public-relations companies and management consultants.
Objectives of the Stakeholders
The Gulf central banks and government ministries are likely to be interested in how the sale of shares influences the development of the proposed Gulf stock exchange and stock-market law. In our meetings with central-bank officials, they did not indicate any definite opinions, but they might prefer to delay the sale of shares until the establishment of the official stock market, so that Gulf industrial companies could act as a launch vehicle for the stock exchange. In this case, the central banks will want to conform to whatever regulations and practices are introduced in the new stock-market law — for example, whether the shareholders should be UAE, Saudi or other Gulf citizens only, or whether the market will be extended to GCC citizens, to corporate or individual foreign residents in the Gulf countries or GCC, or opened up to all investors, regardless of citizenship.
The GCC, represented by its secretariat, and (to a much lesser extent) possibly the Arab League, represented by the Arab Monetary Fund (AMF), will also have certain objectives that might be realized through the sale of the factories. The GCC has discussed the possibility of a GCC-wide stock market, or at least links among the stock markets of the various member states, while the AMF has explored the possibility of linking all Arab stock exchanges. In this context, the GCC will likely watch the sale of the shares with close interest and may be expected to favor the participation of all GCC citizens, while the AMF is likely to prefer the participation of all Arab stock markets.
The Gulf financial sector will constitute a major stakeholder in the privatization process. Thus, the governments' objective is to use the opportunity of privatization to increase its own business growth and gain more experience in the privatization process. Banks, accounting companies, stockbrokers, law firms and public-relations firms are likely to be eager to compete for the chance to manage the sale of the factories, and intent on making these sales successful so that they may participate in other privatization projects. National financial institutions are also likely to want participation in the privatization process to be restricted to Gulf financial institutions only, while foreign financial institutions would also want to gain a reputation for managing the share sale. International financial institutions are likely to have an interest in extending share ownership to non-Gulf citizens, so that they could participate in the privatization of factories and other companies in the future. International investment companies have already offered a country investment fund for the Oman stock exchange, and it is evident that they would be even more interested in the larger, more diversified and dynamic economy of the UAE.
The GCC countries seem to recognize the potential benefits to be derived from the oil boom and are taking advantage of the increased liquidity in their markets to institute economic and market reforms. To Hertog, the current boom is better managed than the one that occurred in the 1970s; less money has been wasted and more has been invested in projects and utilized in sophisticated and diversified ways.5 The transformations and developments currently being observed in the Gulf financial markets are indeed unprecedented. Dubai, Qatar, Bahrain and even Saudi Arabia are putting substantial effort into creating special zones, administrations and economic cities to attract and retain capital. In a move towards liberalizing its markets, Saudi Arabia has finally entered the World Trade Organization (WTO). Its accession will facilitate its shift towards a more open and balanced economy, because it requires the introduction of structural changes to the economic and legal regimes, the institutionalization of reforms in public institutions and a commitment to economic diversification and privatization. A Credit Suisse report noted that Saudi Arabia has already created nine regulatory bodies and announced a complete overhaul of its judicial system.6
By expanding privatization programs for inefficient public companies and enabling a large number of companies to raise capital through the financial markets, the countries of the region have provided support for their stock markets. Also fueled by the excess liquidity, the region's stock markets have witnessed a long-lasting upward trend. With more than $700 billion in market capitalization, the Saudi stock market is expected to exceed South Korea's and approach India's in size.7
Further market-liberalization measures have been undertaken; some Arab countries have already started to take steps in favor of opening their markets to foreigners in areas such as investment and stock-market participation, where national privileges have been extended to other GCC nationals or to foreign residents and, in some countries, to international investors.8
A critical question for the strategy of privatizing factories is whether the stock market will be capable of absorbing some sales, such as one in the UAE that will be more than four times greater than the sale of shares in the Union Property Company, and 19 times greater than the sale of the Oman and Emirates Investment Fund.9
Another central question is how the structure of the market will influence the likely future trading and pricing of the shares after they have been sold to the private sector. There is explicit concern that the share price should not be so volatile or manipulated as to deter the small investor.
A review of the stock market indicates that there are legitimate reasons for concern about its absorptive capacity, but the conclusion was that the sale can be successfully carried out. In this regard, it is also considered that, with the previous experience of GCC stock markets, the investor interpretation of a successful sale or flotation means that it should be significantly oversubscribed (for example, the Union Property Company of the UAE issue was four times oversubscribed). This notion of including how many times privatized stock will be oversubscribed gives a new meaning to the market's absorptive capacity.
The Stock Market
Stock exchanges in the Gulf at present are small but effective markets. They operate on the basis of "curbside" trading of matched bargains; however, the level of trading is very sparse. The UAE market, for example, is represented by the National Bank of Abu Dhabi (NBAD) Index. This market-value-weighted index has 38 listed companies in both the Abu Dhabi and Dubai financial centers, representing about 75 percent of the overall active market. The UAE stock market has 65 registered and active companies with a market capitalization of nearly $200 billion. By comparison, there are 98 registered brokers in Dubai, but only 15 were active as of September 3, 2010.10 The country established formal stock markets and a regulatory body for capital markets in the year 2000. The trading of shares on the Dubai Financial Market (DFM) began on Wednesday, March 7, 2007.11 Oman's Muscat Stock Securities (MSM) Index includes 33 companies listed on the exchange in 2002. This market is very small and was recently plagued by scandals, giving rise to higher volatility than found in the other GCC markets.
The stock markets of the GCC countries have been known to be very volatile because of their connection with the oil markets and the geopolitics of the region.12 Most of the sudden changes in the GCC markets are due to global factors, specifically the 1997 Asian Crisis, the 1998 Russian Crisis, the collapse of oil prices at the end of 1998, OPEC's adoption in 2000 of a new oil-pricing mechanism, the September 11, 2001, attacks and the collapse of oil prices in 2008-09.
Difficulties are also created by the legal frameworks in some of the Gulf countries, which may hamper the creation of capital markets with active foreign investors. There are a number of legal or regulatory issues that need to be addressed before the Gulf markets will be able to attract substantial funds from overseas. There is, for example, little public information on the performance of listed companies, and there are allegations of market manipulation and insider trading. Moreover, often nationality restrictions or qualifications require that 51 percent of the share capital be held by nationals of the country concerned. Such restrictions create difficulties, as a structure must be put into place to ensure that those shares are never sold to a non-qualifying national. Those countries that most wish to encourage foreign capital, notably Oman and Bahrain, have made considerable efforts towards overcoming problems of this kind by introducing new laws permitting foreign ownership of shares and generally creating a more flexible legal framework.
Because of the very limited local investment options available, private investors mainly invest in cash deposits, property or foreign-investment vehicles. Following the positive performance of the Abu Dhabi stock market in 2002 and 2003 (respectively +25 percent and +33 percent total return in each year, including dividends), some larger investors have repatriated cash to Gulf countries, in general, and to the UAE, in particular, because of the positive domestic political environment, the strong growth rate at present, and the weakness of several major international markets in recent months.
While the interest return available on cash deposits is currently low, commensurate with the perceived risk involved, interest rates are now on a rising trend. This may put some downward pressure on stock-market prices, where average yields are now below that which is obtainable on bank deposits — and on loans collateralized by stocks. Despite the adverse trend in interest rates, there still appears to be a significant appetite for new equity issues in the market, especially where the companies are perceived to be well managed.
A committee led by some Gulf central banks is currently studying the implementation of a regulated stock market in the Gulf. It is projected that a new law to govern this activity with an official market will be set up by the end of 2014. Information received from the active participants in the market (such as Mohamed Ali Yassine, an active stockbroker in the UAE and a VIP Portfolio trader at Direct Broker for Financial Services) confirmed that there are 10,000 private investors in the UAE alone (although there are an estimated 10,000 additional holders of Etisalat shares who have not bought any other shares). These 10,000 investors are estimated by the stockbrokers to be distributed mainly in Abu Dhabi (about 7,000), Dubai (about 2,000), and the northern emirates (1,000). Even though the number of investors is small, there is a common perception that they are very wealthy. In fact, the UAE has one of the highest per capita incomes in the world (approximately $20,000), and the stockbrokers are convinced that such a large sale of shares could be covered by the investor community without difficulty.
It is to be noted that, in addition to private individual investors, there is also scope for corporate investors to participate in the share issue. These corporate investors would include wholly-owned Gulf companies and possibly also cooperative societies, which have been described as very rich and searching for new investment opportunities. In order that the participation of corporate investors does not lead to any form of takeover, conflict of interest or undue influence by actual or potential competitors, the maximum shares held by a single investor could be limited to 1 percent of the total value of the company. However, most Gulf investors are passive and simply buy the shares on first issue and hold onto them. This is especially true for the shareholders of STC (Saudi Telecommunications Company) and Etisalat (the national telecommunications company of the UAE).
Market conditions in the region are progressing significantly. For instance, in August 1996, the Kuwaiti government passed Law 25, which enforces full transparency and accountability in any government contracts in excess of 100,000 dinars (approximately $300,000) and requires the disclosure of paid commissions of any kind, as well the amount of the commission, the type of currency, and the place and manner of the commission. Violations result in civil and criminal penalties, even imprisonment.13 With regard to Transparency International's 2003 Corruption Perception Index (CPI), Kuwait ranked fourth among Arab countries and thirty-fifth out of 133 countries worldwide, with a score of 5.3 on a scale from 1 to 10, where 10 represents no corruption.14
In the Doha (Qatar) securities market, introduction law 13/2000 was enacted in October 2000 to confer privileges, benefits and protection upon foreign investors. This law allows "foreign investors to invest in all national economy sectors except banking, insurance, commercial agencies and trading in real estate."15 Upon the inauguration of the Doha Securities Market, Hussain Al Abdullah, the director, advised that integrity, liquidity, efficiency and transparency are the key success factors for the Doha Securities Market.16 Qatar is ranked third in the Arab world on Transparency International's CPI, with a worldwide score of 5.6.17
Bahrain, the smallest state in the GCC, has been renowned for its low level of corruption. It ranks in the top quarter of all countries worldwide on Transparency International's CPI, with a score of 6.1, and it is second in the Arab world after Oman.18
The United Arab Emirates Stocks and Commodities Authority (ESCA) sets specific rules to protect the investors at all times by ensuring the reliability of supply and demand in the setting of prices. In terms of Transparency International's CPI in 2003, the UAE ranked fifth among Arab countries and thirty-seventh out of 133 countries worldwide, with a score of 5.2.
Finally, the Saudi market is highly sensitive to changes in the oil market. Among the six GCC countries, Saudi Arabia has the second-highest oil dependency after Kuwait, as measured by oil-exports-to-total-exports (80 percent), and after Oman, as measured by oil revenues-to-total-government revenue (73 percent), during the period 1998-2002.19 All the above characteristics should be considered when setting objectives for privatization and understanding its processes.
ATTRACTIVENESS OF THE GULF SHARES
An equally critical issue in addition to the absorptive capacity of the Gulf stock markets for the success of privatization is the attractiveness of the new shares to potential investors. Furthermore, the shares must be able to both attract investors when they are first offered for sale, and maintain their attraction for many years to come. It would clearly be disastrous for the policy of privatization and for the reputation of Gulf companies if the initial sale were highly successful, but then prices declined, disrupting the shares' attractiveness to investors.
Entrepreneurs in the region were motivated to offer their companies for public subscription through more liberal listing rules related to the pricing of the offer or the reduction of the minimum-percentage stake of the offer. This process has resulted in IPO spikes in the past few years. The total amount raised from IPOs in the GCC increased by 40 percent between 2006 and 2007, and the potential for further increases is still expected.20
In Saudi Arabia, the Saudi stock-market boom has been shared by a large proportion of the population, helping generate wealth for millions of Saudi investors and creating a middle class in the country.21 The Saudi IPO oversubscription rates of 10 or 12 times are, in fact, illustrations of the high participation of the population in wealth creation. The IPO of the petrochemical company Yansab attracted more than a third of Saudi Arabia's population of 17 million, according to the country's finance minister.
Concerning the initial attractiveness of Gulf industrial shares at the time of the first offer for sale, field interviews with investors and stockbrokers indicate that the attractiveness of the shares is determined not simply by price but by a combination of factors:
• Careful and competitive pricing of the share sale so that the amounts that can be bought are low and simple enough for small investors, yet large enough to attract the big investor
• The promise of a good return on investment (estimated to be 15 percent per year), composed of both a high dividend yield at least equivalent to the bank deposit rate (before the financial crisis at 6-6.75 percent) and good capital growth
• Credible and well-trusted individuals serving as chairman and members of the board of directors of the company (it was frequently mentioned that many investors did not bother with details of the sale but would invest according to the reputation of the chairman and directors)
• A credible business plan for the company's future growth, with clear plans for ways to increase shareholder value
• A good public-information campaign to explain all aspects of the factory's operations and restructuring, so that investors can clearly see the advantages of the share sale
• The retention of government shareholding. This was considered especially important, in that it would convince the private shareholders that the government is not abandoning the factories but would continue to support them to some extent in the same way that any other major shareholder would. In addition, the continued government shareholding was stated to be an important factor in sustaining public confidence that the interests of the public and other stakeholders would be safeguarded.
These factors should be accounted for in the implementation plan for the privatization of the factories.
Increasing Shareholder Value
There is explicit concern that the Gulf shares will continue to grow in value after privatization, and that there will be no collapse or serious instability in the share price. It has to be recognized that the continuing attractiveness of the shares after privatization will depend very much on the success of the new directors and management, who will need to concentrate their efforts and their whole approach on the fundamental strategy of increasing shareholder value. If the Gulf factories continue to be successful, the share price will continue to rise and the shares will continue to be attractive, but the continuing attractiveness of the share price cannot be guaranteed by prior planning. It must be achieved by good management.
It has to be recognized also that the structure of the stock market might have an impact on the stability of the share price. The small number of investors and the lack of share liquidity have both advantages and disadvantages. One of the possible advantages is that the investors' practice of holding onto their shares (and thereby causing share illiquidity) means that there is little share-price volatility. There are no wild buying and selling sprees to cause the price to be high one day and low the next.
However, there might not be a steady increase in price (because there is little trading to establish a market price), and the price might collapse completely if, for example, only a few large Saudi investors lost confidence in the shares and decided to dump theirs. This means that, although the price is not volatile (swinging up and down), it is unstable and vulnerable to a complete collapse. This instability also makes the company vulnerable to deliberate share-price manipulation and takeovers, in that a small group of investors would be able to cause a price collapse by selling their shares and then buying them back again at a lower price when other smaller investors have dumped their own.
Management Policies to Increase Value
The main requirements for increasing shareholder value are the following:
• Sufficient cash flow to sustain an attractive dividend of at least 6 percent
• A substantial cash surplus (after paying dividends) to reinvest in business expansion and diversification for future growth. This element of converting the cash to reinvestment is vital to sustain the share price; otherwise investors could simply leave their own cash in the bank.
• Steadily increasing profits and market share for existing businesses, demonstrated by annual profits
• A credible business plan for growth and re-investment, which would need to be outlined to investors and revealed in greater detail in confidential discussions with professional investment analysts and stockbrokers. It is not enough to produce good short-term results and maintain a dividend to stimulate growth in the share price; it is also necessary to demonstrate that the profile levels will increase in the future.
• Efficient management to increase productivity of staff and assets.
The new shareholders and management will have sufficient resources to increase shareholder value, proxied by rising share price. The financial projections for the companies (given in detail in Table 1) demonstrate that they will generate substantial profits over the next 10 years, sufficient to yield a total 15 percent annual return to investors. This will be able to produce an acceptable dividend yield and a large surplus for reinvestment.
The above-stated privatization process should be preceded by the restructuring of the factories to be privatized. This issue will require a focus in the area of financial management and reporting. The managers, chairmen and directors of the restructured companies will need to extend their financial horizons to consider not only the short-term sales and profits they are generating, but also the increasing shareholder value, including return on investment, return on equity, the dividend they can afford to pay and the share price — the lead indicators of their performance. They will need to be sure that they never have to resort to the extreme and unpopular measure of cutting the dividend (a move that is often followed by pressure from the shareholders for the resignation of members of the top management) or allow the share price to fall below its par level. In this respect, the share price will be influenced heavily by the management reports of the factories' market share, sales trends and reinvestment plans for long-term growth, as well as short-term profitability.
In addition to the importance of increasing the share price through confidence in the future growth of the company, it will be vital for the directors and management to have a clear and realistic vision and consistent direction for the future growth of the company and to be able to present these ideas to the new shareholders when the factories are privatized. Hence the preparation of a long-term business strategy — and a more detailed medium-term plan for the growth of each factory — is a must, and would result in the increase in shareholder value. The plan would start with an assessment of the efficient utilization of every factory resource, aimed at determining whether any greater value can be extracted from the physical assets or improved utilization of the human resources.
The decision on how much of the cash flow to allocate to dividends and for reinvestment in the privatized company will need to be taken by the chairman and board of directors, answerable to shareholders. There may be pressure from some shareholders to use the high profits to increase the dividend for their own short-term gain. The validity of these demands will need to be assessed and the pressures, if necessary, resisted by the chairman.
The projected combined income stream for all UAE-Abu Dhabi major public factories, for example, can be represented in Table 1. The table indicates that the choices range from distributing almost all of total earnings with a 15 percent dividend, to distributing only one-third of the total earnings and retaining two-thirds for reinvestment, through a 6 percent dividend. Since the 15 percent dividend would leave very little for reinvestment, the share price could be expected to progressively deteriorate in the course of the 2010–20 decade, because the shareholders and management would not be adding value to the companies through reinvestment.
We recommend a dividend policy of about 7.5 percent initially. This is a high dividend yield, higher than the highest available bank-deposit rate (6.75 percent offered by UAE banks), and it still leaves a substantial war chest for the directors and management to use for reinvestment and expansion.
POLICIES TO PRESERVE SHARE-PRICE STABILITY
As noted above, the structure of the stock market leads to a relatively low risk of price volatility but a relatively high risk of price instability and manipulation. Both of these features derive from the limited size of the investor pool; hence the solution would be to widen the number of investors by allowing non-Gulf citizens to own shares.
In order to see if the probable performance of the Gulf industrial companies would be attractive to sophisticated investors, both within the GCC and outside, we compared the performance of major world stock markets (Table 2 – Panel A) with the projected performance for the Gulf-industrial floated companies (Table 2 – Panel B). The tables show that Gulf industrial companies are expected to offer better yields and return, but that P/Es would be significantly lower due to a relatively modest float price. However, estimates of increases in share prices were made for the projected years, averaging around 14 percent, with a gradual decline as the market becomes more stable. Based on these extrapolations, by year nine, the yield of the shares would be comparable to "normal" yields, and P/Es would have risen to be equivalent to most of the large markets. However, return on equity remains significantly higher than elsewhere. This would seem to indicate that the performance of the Gulf companies would be competitive compared to other world markets over the medium term.
|General Industry Corporation Cash-Flow Projections|
Total Dividends Paid Out (Dhs M)
Remaining Cash for Re-investment (Dhs M)
Total Earnings (Dhs M)
|Source: Consolidated projected cash flows for 10 years as per General Industry Corporation (GIC) statements (2010-20)|
CONCLUSIONS AND RECOMMENDATIONS
Any privatization plan has to reconcile conflicting objectives. The seller normally wishes to obtain the highest possible price for the business it is selling. On the other hand, the buyer wants to pay the lowest possible price. When the seller is the government, the scheme is normally different. Generally, European governments starting privatization programs have sold businesses through a public offer for sale (IPO) at prices that allow buyers to see an immediate gain. This has had the effect of creating and retaining investor interest and creating a positive environment for future privatization issues, when pricing can be tighter. In Eastern Europe, various other methods have been used, including the virtually free distribution of investment vouchers to all citizens, exchangeable into shares of companies being privatized.
With regard to the Gulf region, the first recommendation is to privatize via a public offer for sale, the standard method of privatization in any market that has sufficient capital for investment. Other methods (including private placement, the trade sale and the management buyout [MBO]) are essentially used in countries that have a capital shortage. The public offer for sale is generally used when there is a liquid stock market (as in the Gulf stock markets) and a known demand for shares in the company to be privatized. Thus, the major British privatizations (the majority of privatizations to date in Europe) have been handled by means of public offers for sale.
|Table 2: Panel A|
|Comparative Statistics of Share Performance on Key World Stock Markets|
Average Price/Earnings Ratio
Average Return on Equity
|Source: Morgan Stanley Capital, Ltd.|
|Table 2: Panel B|
|Probable General Industrial Companies – UAE Performance for the Future 9 Years|
Average Price/ Earnings Ratio
Average Return on Equity
|Source: GIC statements – June 2005|
Generally, an offer for sale is managed by a merchant or investment bank, which is responsible for preparing the detailed information on the business and its prospects. Depending on the requirement of the vendor, the lead manager may be asked to guarantee the price received by the seller by underwriting the issue, in collaboration with a syndicate of investors, banks or brokers. Alternatively, a public offer may be made without any underwriting. This method was used by Emirates Bank when floating 55 percent of its previously wholly owned subsidiary, Union Properties, in December 2003 and by the National Bank of Abu Dhabi when floating Oman and Emirates Investment Company in October 2003. The Union Property issue, which raised 141 million dirham ($1=3.685 UAE dirham) was two-and-a-half times oversubscribed, with 6,270 individual subscribers and a minimum subscription of 9,900 dirham. The part of the Oman and Emirates Investment Company issue available for UAE nationals (6 million dirham out of a total issue of 30 million dirham) was eight times oversubscribed. In each case, the issue price was fixed to provide a yield higher than prevailing stock-market and bank-deposit yields. This pricing ensured a successful launch of the privatized issue.
For underwritten issues on major European stock markets, the launch is followed by a period of price "stabilization" in which the lead manager smoothes price fluctuations by selling or buying stocks in the market for a limited period. At the present stage of the Gulf stock market, it is not certain that stabilization would be practical since it requires an experienced and liquid market environment.
In some major recent international issues of shares, the fixed-price offer for sale has been replaced by a "book-building" exercise whereby the lead manager, as part of the pre-launch marketing for the issue, discusses a range of pricing options. As demand for the issue is clearly identified, the issue price is finally fixed.
The cost of an offer for sale is relatively high, not only because of the possible need for underwriting, but also because of the advertising and public-relations costs. For example, the overall costs, including all professional fees and expenses of the issue made by Union Properties (not underwritten), totaled 2.4 percent of the gross proceeds of 141 million dirham.
The main advantages of a public offer are that it
• permits immediate wide distribution of shares
• generates publicity for the company, the vendor and the privatization processes
• involves an investment bank that will usually improve the price realized
• guarantees an agreed price to the vendor through an underwritten issue
• permits simultaneous gathering of new capital and the realization of the holdings of existing shareholders.
The main disadvantages are that it
• is expensive
• requires an experienced and extensive investor base to achieve maximum effect.
Next, we recommend a common GCC stock market. In light of the dominant similarities among the six GCC financial markets, the notion of an integrated GCC market continues to prove feasible.22 The fact that the region's six markets tend to rely on relatively similar regulations, such as capital and liquidity requirements and registration procedures, among others, indicates that the prospect of joining forces in one market would not only increase trade volume, but would also provide the region with further international recognition as a dominant body. Moreover, creating a unified GCC market would imply a boost in capital inflow to the region from increased foreign trade and would lead to more solid domestic investment grounds.23
There is no doubt that the Gulf as a whole is emerging as a new capital market, and privatization programs are gathering momentum.24 Programs are being implemented with a view to further boosting the growth of the economies of the Gulf states. Notwithstanding legal and other restraints in force, innovative structuring would be certain to provide an increasing number of attractive investment opportunities in the Gulf in the future, particularly for foreign investors.
1 Oxford Analytica Daily Brief Service, "Gulf States: Dilemmas Delay Necessary Privatization," June 22, 2001, p. 1.
2 KAMCO Research, GCC Equity Markets Monthly Review, December 2007.
3 Steffen Hertog, "The GCC and Arab Economic Integration: A New Paradigm," Middle East Policy, Vol. 14, No. 1, 2007, p. 52.
6 Credit Suisse, "Saudi Arabia: Strong Inflationary Pressures Are Likely to Persist Near Term," December 19, 2007.
7 Sam R. Hakim, "Gulf Cooperation Council Stock Markets since September 11," Middle East Policy, Vol. 15, No. 1, 2008, p.70.
8 Hertog, "The GCC and Arab Economic Integration," op. cit., p. 52.
9 Jane Pittaway, "Privatization and the Growth of Financial Markets in the Gulf," International Financial Law Review, Vol. 14, Issue 2, February 1995, pp. 23-25.
10 Dubai Financial Markets, www.dfm.ae, accessed on Sept 3, 2010.
12 Shawkat Hammoudeh and Li Humin, "Sudden Changes in Volatility in Emerging Markets: The Case of Gulf Arab Stock Markets," International Review of Financial Analysis. Vol. 17, Issue 1, 2008, pp. 47-63.
13 Ali & Partners, "Middle Eastern Laws – Kuwait," www.mideastlaw.com.
14 Pogar, "Programme on Governance in the Arab Region," 2004, http://pogar.org/index.aspx.
15 Sultan M. Al Abdulla, 2001, www.hg.org/attorney/The_law.
16 Hussain Al Abdullah, Interview with ABC Qatar, 1997.
17 Transparency International's 2003 Corruption Perception Index, www.transparency.org, accessed on Oct. 5, 2010.
18 Pogar, op. cit.
19 Ugo Fasano and Iqbal Zubair, "GCC Countries: From Oil Dependence to Diversification", 2003, www.imf.org/external/pubs/med/2003/eng/fasano/index.htm.
20 Shuaa Capital, "Vision 2008, Saudi Arabia Equity Markets," January 16, 2008.
21 Anoushiravan Ehteshami and Steven Wright, "Political Change in the Arab Oil Monarchies: From Liberalization to Enfranchisement," International Affairs, Vol. 83, No 5, 2007, p. 913.
22 James Reagan McLaurin, "A Review of the Financial Markets in the GCC," Allied Academies International Conference. Academy for Studies in International Business Proceedings, Cullowhee, Vol. 6, Issue 1, 2006, pp. 19-24.
24 Pittaway, "Privatization and the Growth," op. cit.