Impacts of Bubbles on Stock Performances of Saudi Arabia

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Stock Bubbles

Economic bubbles are a manifestation of globalization, and the Saudi Arabian economy characterized by a tremendous surge of oil revenues is likely to suffer if proactive policies are not implemented. Causes of market bubbles are projected to be brought about by; price coordination of demand and supply which fit together into a simple model of market forces known as equilibrium. Secondly, bubbles are proposed to originate from emerging social norms which co-relate in regular market activities from one sector of the market to the other. From this perspective, we can describe a market to be a social process that provides interaction of people from different backgrounds to exchange undesirable information to desirable ones. The manifestations of the ubiquitous nature of markets have made it difficult to analyze real stock values until bubbles bursts which are often too late.

Stocks are referred to be booming when the markets are doing well Khalid (2005) states that “both the boom and the bubble burst phases of prices are often reflected in the positive and negative feedback mechanisms in the equilibrium prices (1). Due to the oil surge, stock prices in Saudi Arabian markets deviate sharply from the intrinsic values making it impossible to predict prices from supply and demand alone. Other aspects that may influence stock bubbles include reforms, politics and regulatory variables which subject trade in high volumes at prices that are constantly at variance with intrinsic values. In another preposition, Khalid (2005) argues that “bubbles may be rational, contagious or intrinsic in nature and the causes of bubbles remain a challenge to many economists who believe that asset prices often deviate strongly from intrinsic values” (1). It has often been argued that bubbles appear even without uncertainty, speculation or even bounded rationality (Al-Rajhi Banking & Investment Corp 1; Khalid 1)

The Impact of stock bubbles

Saudi Arabia is experiencing unprecedented growth in its economy and more preciously the stock markets. Based on historical data that has been used to analyze the basis of Saudi Arabia’s stock exchanges, it’s quite evident that the markets are overheated. Stock markets have come under intense scrutiny and the questions often asked are whether the stock bubbles should be left to burst out and the inherent costs the economy is likely to encounter. Evidently, the stock markets are cyclonical and natural market corrections take their natural course. The bursting should therefore be left to the strategic and economic policies of the Saudi Arabian banks (Khalid 1; Al-Rajhi Banking & Investment Corp 1).

Saudi Arabian stock exchange is the largest financial market in the gulf region with a market capitalization of around $325 billion and held over 70% of the 2008 GDP. The markets have been reported to lag behind recently, a factor that can be attributed to margins caused by structural rigidities which have accelerated stock prices between the periods of 2005 to 2006. The correction of this market margins would require Saudi Arabia to undertake several reformatory measures such as regularity changes, corporate governance and transparency in the monetary system to attract foreign investment. These measures are seen to be inundated with short-term solutions for correcting stock bubbles such as investing in robust government spending and good external demands which will promote corporate economic growth and improvement of the regulatory structure and foreign involvement increase stability and enhance transparency (Khalid 1).

Rapid globalization of stock markets has given rise to bubbles and Saudi Arabia economy characterized with sudden inflows and outflows of foreign investment has not been an exception. Impacts of financial bubbles on stock performances as debated within the mainstream of economics can not be identified in advance and the multiplicity of plausible explanations suggests that bubbles can not be prevented from foaming. A number of economics have attempted to analyze the relationship of bubbles related and financial crisis but apparently, the data obtained did not permit a conclusive analysis of their relationship. They however argued that bubbles should instead be left to burst on their own and financial institutions and government should strengthen laws of capital markets that deal with the consequences through fiscal policy and monetary policies. The Saudi Arabian stock market crash was one of the biggest in history. In 2005, the country’s P/E ratio tripled the emerging markets before it fell again in February 2006. This causes most foreign investors to pull out of the markets due to weak regulations, manipulation of dumping and lack of foreign investors. The bubble impacts caused the market capitalization to fall by half during 2006 an equivalent of 96% of GDP (Vardy online: Mustaq 1).

With a strong economy such as the Saudi Arabian, bubbles are considered to have negative impacts on the stock performances. The stock market is the window that presents Saudi Arabia to the world of business and important decisions are made based on the strength of these markets. The sudden inflows and outflows of foreign capital in the stock markets are unprecedented and therefore require careful attention. It’s equally important to note that economic crises that usually follow economic bubbles often destroy the large volume of wealth causing financial meltdowns, which is often associated with the debt inflation theory of Irving Fisher. In addition, a continuing period of low risks premiums could mean a prolonged downturn of asset price inflation and devastate the economy of a nation which may subsequently reverberate beyond the country’s borders (Kabir & Jung 3).

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Kabir & Jung (2007) classify stock bubbles as market bubbles, price bubbles, financial bubbles or speculative bubbles. The tremendous surges in Saudi stock prices with inflate values of trading make market participants overvalue their stocks and spend more money and when the bubbles burst, those still holding their overvalued stocks cut down on their spending, hindering economic growth or even exacerbating economic slowdown. Banks in this case attempt to speculate on asset price fluctuations by either increasing or decreasing the price of the interest rates. Solving Saudi’s countries economic bubbles lies within the international participation as they have the potential to reduce volatility by buying when stocks are undervalued and withdraw when the prices increase and their focus stop bubbles from foaming, offer rigorous scrutiny of the markets hence improving corporate governance and avoid trading assets with inflated values (Kabir & Jung 3).

Possible causes

The high growth rates of the Saudi Arabian economy present a worrisome trend and it, however, is important to note that, if the stock market falls, foreign investors will withdraw and the economy will be exposed to the global slowdown. For example, Saudi oil production in 2004 rose from 9.1 MMBD to 9.5 MMBD in 2005 with nominal rates of $115.6 billion in 2004 to $150.1 billion in 2005 and $154.3 billion in 2006. The country’s economy is driven by the economic health of the country. The growth rate of 2.5 and it being the major exporter of oil should stimulate economic growth and stability of the country. The country’s economic outlook in 2005 as reported by Saudi American Bank projected a growth of 6.80% with inflation rates of 1.0%, a trend that was attributed to the high oil prices of $51 a barrel. The excess capital is also estimated to reduce the public debt to $158.6 billion projected to about 49% of the country’s GDP compared to 2004 $163.7billion and $166.6 billion in 1999. Its however clear that government funding of economic projects furthered economic growth from 2005 to 2006 (Khalid 8).

Although there is currently no theory that explains the occurrence of bubbles, computer-generated models often try to explain the excessive leverage to be linked to the financial bubbles. Khalid (2005) states that “bubbles also occur in highly predictable markets, where uncertainty is eliminated and market regulators are able to calculate the intrinsic of stocks and the expected dividend” (8). What is often not clear is what causes bubbles. According to Vivian, Noussair, Charles (2001)

fools theory suggests that bubbles are not caused by bounded rationality or the assumptions about the rationality of other market aspects and appear even if market participants are well prepared for pricing stocks correctly and when speculation is not possible (831).

In another preposition, bubbles may generate from excessive monetary liquidity in socio-economic aspects such as tax, financial systems, and irregularity in bank lending behavior which may cause temporary inflation in stock prices. For example, according to Vits and Meier (2010), the president of the Deutsche Bundesbank argued that

The past has shown that an overly generous provision of liquidity in global financial markets in connection with very low-level interest rates promotes the formation of asset-price bubbles. He explains that excessive monetary liquidity such as the easy credit and large disposable incomes normally occur while fractional reserve banks are implementing expansionary monetary policy such as getting money out from financial institutions and lowering interest rate (online).

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Therefore, when interest rates are going down, investors avoid putting their capital in saving accounts and leverage their capital by borrowing from banks and investing in financial assets such as stocks and real estate (Mustaq 1).

Since the Saudi Arabian economy has surged with oil revenues, bubbles may occur when the markets are floated with too much money and chasing few assets causing the stock prices to appreciate beyond unsustainable levels. Evidently, when bubbles burst, inflation goes higher and the country’s central bank should in this case craft sensible economic policy to absorb the liquidity in financial markets. The accommodation policy should raise interest rates making it hard for investors to borrow capital from the banks hence decreasing the money supply. In another preposition, the central bank increases capital reserve requirements during strong economic growth, a strategy that would reduce the over-expansion and lessen the impact of the downturn by strengthening financial institutions while the economy is strong (Mustaq 1).

Economic bubbles of stock markets can also be caused by social psychological factors as backed by certain theories on empirical research such as greater fool theory, extrapolation, herding and moral hazards. Greater fool theory states that bubbles are caused by the perennially optimistic market participants’ behavior. The term “fool” refers to a buyer who buys overvalued stocks and sells them to other buyers (greater fools). The bubbles are speculated to continue as long as there are buyers in the markets and can only stop when the fools stop buying overvalued. Extrapolation theory on the other hand is information obtained from historical data that has been used by market analysts on projecting the stock futures on the same basis. Therefore, if prices are anticipated to rise at a given period, market analysts anticipate that they will continue to rise at the same rate forever. Overbidding for this case may result in uneconomic returns to investors which triggers stock price deflations (Brigham & Ehrhardt 239).

It has been argued that the long-term dominance of retail investors in the Saudi Arabian country may have contributed to the volatility of the markets. The 2005 run-ups in the TASI attracted a huge influx of small first-time investors who bought a huge number of underpriced stocks. And therefore, investors were advised to sell part of their stocks to raise capital to invest in new stocks, hence increasing volatility. Khalid’s (2005) reports indicate that the periods between 2003 and 2006 reported an increase of 700% in volatility with market capitalization soaring to $800 billion, which was higher than the nominal GDP. By February 2006, stock valuations increased with an average of 47 in price-to-earnings ratios which was reported to be even higher in other GCC countries. The market irregularities were linked to the fact that companies heavily invested in stock markets and booked unrealized earnings. TASI was therefore severely affected since it lost almost half its value in a shorter period and reported a 53% low at the beginning of the year and more than $480 were removed from the value of the stock exchange which was equivalent to 140% of the 2006 GDP. The government quickly stepped up increasing the size and depth of the markets and improving transparency and disclosures and considered cutting down on insider trading (Khalid 5).

According to Khalid (2005), the Tadawul index in Saudi Arabian market increased by 540% within the last five years. For example, between 2003 to 2005, Saudi Arabia represented an index of 14,808.12 with 107.02% in YTD in 2005 while the 2003 stock represented 85% of growth and 73% of GDP in 2004. The Al-Rajhi Bank of Saudi Arabia also reported an increase of 92% between the periods of September and January 2005. Towards the end of 2005, the stocks reached $1.042 trillion compared to the previous year’s stock of $543 billion in 2004 and $119 billion in 2000 (Khalid 3).

Herding theory explains market activities are stimulated by market trends. And market trends here are evident in the sudden oversubscription of stocks. Saudi Arabian Telecom and Dana Gas investors oversubscribed by 140% in October 2005. The Saudi American Bank (SAMBA) reported that the stocks were 2.4 times oversubscribed in STC, while the Saudi Sahara petrochemicals were 124 times higher while Ettihad Ettisalat was 50 times oversubscribed (Saudi American Bank 3). Saudi stocks were also reported to have had higher price-earnings ratios (PE) during the same period. According to Khalid (2005),

the Saudi Arabian American Bank PE ratio for the first quarter of 2005 in the agricultural sector was 88.6, electricity was 71.3, service was 54.2, and insurance was 34.2. It is also equally important to compare these numbers to roughly a PE ratio of 20 for the Dow Jones (online).

We should base our analysis of market stocks on a variety of factors. There is usually no warning of stock bubbles and few people can predict the oncoming bubble. The impacts of stocks bubbles remain uncertain. The Saudi Arabian stock markets present with high PE ratios and unpredictable rapid growth in the market capitalization are alarming. Speculative reports indicate that when the bubbles are left to burst on their own are bound to cause adverse effects to the economy. When stock prices drop below the original price, assets are forced to be written down as worthless. The country should therefore implement an active monetary policy to absorb the excess money supply since the capital markets are still young and the economy highly depends on the volatility of prices (Khalid 3).

Moral hazard theory is the risk that a party to a transaction has not entered into the contract in good faith, mostly for speculative purposes. Stock market analysts can often interfere with prices if they do not accurately balance the possibility of returns which can steer inflation hence increasing bubbles. This, therefore, explains that bubbles are based on market communication of economic factors. It has also been perceived that bubbles are caused by irrationally valuing assets primarily based upon stock returns in the recent past without relating to the underlying analysis of the fundamentals (Mirrlees 3).

Reasons for Bubbles

The Saudi Arabian capital markets may not be as experienced as other developed markets in the world and therefore the bubbles may have extreme implications for the economy. There has been an explosion of studies that claim that high oil prices in Saudi Arabia will not necessarily sustain high growth rates in the economy. This is could be attributed to the fact that current high growths of stock markets are sold are intrinsic values and this alone cannot support the growth to real structural economic changes. The rapid growth can be attributed to an array of factors such as the dominance of natural resources such as oil and petrochemical sectors which represent more than 75% of the country’s budget and approximately 90% of export revenues. Khalid (2005) states in the EIA report that “Saudi oil export revenues, in constant 2000 dollars, were $59.64 billion in 2001 compared to $108.03 billion in 2004, representing roughly an 81% increase” (5). The growth could also be attributed to the country’s high budget surpluses. Embarked on similar patterns of spending, Saudi Arabia uses its budget surpluses on an ambitious expansion program in such as modernization of educational systems, public debt payment and repairing its infrastructure. For example, in 2004, the country set aside $26.1 billion of surpluses to repay its Kingdom’s public debt and modernize the infrastructure. There are also underway projects the country is proposing to undertake such as the construction of energy production firms to increase the production capacity to approximately 12.5 MMBD by 2009, which will cost about $16.5 billion. The country’s spending patterns may prevent the future onset of financial bubbles (Khalid 5).

Since the 9/11 attacks, most Arab investments moved from the European and US countries to their own regions since the implementation of regulations which seemed harsh. Re-investment of foreign capitals domestically greatly boosted the economy hence the increase of capital flow which could have accelerated bubbles. Saudi Arabia’s access to information technology has enabled it to effectively monitor its capital markets. Fifth, the country signed a deal with the US that opened access to World Trade Organization as a strategy to liberalize its economy. But in order to participate in the WTO, Saudi Arabia was required to open its capital markets to international investors hence streamlined investment flow. Sixth, there has been a recent increase in wealth distribution in the country. Saudi American Bank (2005) reported that a large population oversubscribed to the Al-Bilad Bank’s IPO in 2005. The sudden interest in stock markets could be attributed to the young population with diverse educational and economic backgrounds, and more willingness to take risks (Saudi American Bank online: Khalid 5).

South American Bank (2005) report indicated that most of GCC big companies such as Dana Gas, Al-Bilad Bank, Electricity Co. (SEC), Saudi Arabian Basic Industries Co. (SABIC) and Saudi Telecom co. (STC) holds about 45% of Saudi stocks hence the reason for high economic growth. My last proposition for enormous high growth rates could be linked to the low interests rates and inflation and high liquidity levels the country has been experiencing. For example, in 2004, Saudi Arabia’s GDP was 254 billion with a growth rate of 5.3%, the interest rate at 0.20%, and the inflation rate at 0.6%. the attraction of low-interest rates is attributed to the country’s high dependence on oil export revenues and high fuel prices. Therefore, the high nominal growth could be linked directly to the high oil prices without the inflation pressure. Since the GCC economies are highly dependent on oil export and bubbles can extend beyond the borders of the Gulf and the market uncertainty can contribute to the price instability in the oil markets, the global economy and international security (Khalid 6).

Short-Term Economic Uncertainties

Should short-term bubbles call for interventions or should they be left to burst on their own? Since there is no conclusive evidence to back this claim, bursts and booms should be left to price equilibriums of demand and supply. However, experts have attributed that economic crunch in GCC countries would have great impacts on the global energy markets and stability of the countries. Financial bubbles for this case could have been attributed to the huge profits announced by banks as a result of increased transparency in the banking sector which increased confidence in capital markets. It’s however not certain that the huge profits experienced by these financial sectors would sustain the country in the long run since the banks only represent a portion of the country’s stocks. It has also been stated that countries in the GCC state including Saudi Arabia peg their currency to the US dollar which makes it difficult for the country to know its value of volatility. Therefore, in the case of bubbles, the country would severely be affected since they are unable to support a reasonable value in a short period. Khalid (2005) argues that “Saudi Arabia has failed to implement necessary mechanisms to deal with excess capital and the repatriated capital from west countries” (6). It should therefore provide a level of transparency on the flow of capital and obtain data from large financial institutions to base their analysis from. Establishment of entrepreneurship will flash out the high capital inflows to vibrant domestic companies in high technology and IT sectors, hence an environment to attract investors (Khalid 6; Brigham & Ehrhardt 240).

In just one-year, Saudi Arabia jumped to 29th position among the 135 countries followed by other Arab nations. The problem, however, is that the country may not be able to sustain rapid economic growth in the coming years. The meaningful market reforms to cushion the impacts of bubbles on the economy remain uncertain whether they will translate into realistic remedies to curb the serious risks the economy is likely to be subjected to. However, the uncertainties, the country should try and implement these capital market reforms in ensuring the markets and the economy is strong enough to withstand market bubbles and to eject excess capital to meaningful structural economic reforms (Khalid 7).

Importance of High Economic Growth

Though uncertainty lies in the Saudi Arabian stock, high fuel prices and rapid economic growth provide significant opportunities to use excess capital on the proposed projects. It’s anticipated that the proposed projects will provide employment opportunities, improve internal security and military forces and reduce the overdependence on foreign labor. Given the nature of globalization, it’s anticipated that stock markets in Saudi Arabian are likely to experience a general decline in the coming years. The issue here is how the country will correct the market bubble, the long-term economic implications and strategic implications it has on the nation as well as the Gulf regions. The country is evidently lacking inflation pressures which may absorb the oncoming bubbles, but it’s necessary for the banks to start now by slowly increasing the interest rates. Hyping and dumping of stock markets should also be reduced by being transparent in public traded companies and crafting strong capital market laws. It’s also evidenced that the country will experience high oil revenues in the coming years and it would only be appropriate if the country implemented vibrant investment projects to develop the economy at the same time support infant industries (Khalid 7).

Conclusion

Saudi Arabia’s excess earnings should be directed at sponsoring domestic projects that will stimulate the economic system. The country’s population is majorly dominated by the youth and if the vibrant economic stimulus is not implemented, the youth will eventually put a strain on the resources and security systems. The excess capital should therefore be plunged into youth training, educational systems and improved job markets. Since most businesses in Saudi Arabia are family-owned, liberalized economies should be able to enable the companies to compete on global markets by crafting sensible economic policies that will enable a smoother transition into public-owned companies. As it has already been indicated, opening markets to international operations attracts foreign investment. In order to attract foreign investors, Saudi Arabia should build a business hospitable environment with limited regulations and incentives (Khalid 6).

Stock markets have come under intense scrutiny and the questions often asked are whether the stock bubbles should be let to burst out and the inherent costs the economy is likely to encounter. Evidently, the stock markets are cyclonical and natural market corrections take their natural course. Some of the strategies the country needs to implement to minimize the impacts of bubbles bursts are to undertake several reformatory measures such as regularity changes, corporate governance and transparency in the monetary system to attract foreign investment. It should therefore provide a level of transparency on the flow of capital and obtain data from large financial institutions to base their analysis from. It should publish credible reports on an annual, monthly and quarterly basis as a strategy to improve transparency and attract foreign interest. Potential investors reviewing the financial statements of the banks will have a well-informed knowledge of the company to invest in due to the comprehensive notes provided by the reports.

The government should also provide sound economical regulatory agencies to suppress the impacts of bubbles. It has previously been reported that countries in the Gulf region including Saudi are often exposed to dumping, hyping and rumored investment. The country should therefore create regulatory agencies that will monitor bond trading, equity and security. The country should also consider providing uniform accounting rules and regulations. Saudi’s central bank should increase capital reserve requirements during strong economic growth, a strategy that would reduce the over-expansion and lessen the impact of the downturn by strengthening financial institutions while the economy is strong. Symantec Support Services should be incorporated into stock exchange markets information as a strategy to increase the degree of confidence, support and eliminate unwary unscheduled outages, lower costs and maximize its return on investment and offer solutions and support port high availability and optimized service performance. The establishment of entrepreneurship should also be the country’s top priority to flash out the high capital inflows to vibrant domestic companies in high technology and IT sectors.

Works Cited

“Al-Rajhi Banking & Investment Corp”.Monthly Newsletter, 20th Issue, 2005.

Brigham, Eugene & Ehrhardt, Michael (3rd ed.). Corporate Finance: A Focused Approach. Mason, OH : South-Western/Cengage Learning, 2009.

Kabir, Hassan & Jung-Suk YU. “Rational Speculative Bubbles: An empirical Investigation of the Middle East and North African Stock Markets”. Networks Financial Institute, vol. 32 (2007):pp.1-25.

Khalid, Al-Rodhan. “The Saudi and Gulf Stock Markets: Irrational Exuberance or Market Efficiency?” Center for Strategic and International Studies, October (2005): pp.1-11.

Lei, Vivian; Noussair, Charles N.; Plott, Charles R. “Nonspeculative Bubbles in Experimental Asset Markets: Lack of Common Knowledge of Rationality Vs. Actual Irrationality”. Econometrica 69 (2001): 831.

Meier, Simone & Vits, Christian. “Weber Says ECB Has Used Room to Cut Interest Rates (Update3)”. Web.

Mirrlees, James. “The Theory of Moral Hazards and Unobservable Behaviour: Part 1”. Journal Review of Economic Studies, vol 66 (1999): 3-21.

Mustaq, Khan. “Managing Domestic and Global Expectations: The Policy Challenges Facing the GCC”. Citi Economic and Market Analysis, November (2008): pp.1.

Saudi American Bank. “Saudi Economy at Mid-Year 2005”. Web.

Vardy, Nicholas. “The Petrodollar Power of Saudi Arabia”. Web.

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