Reform-ready Saudi accelerates MSCI ambitions

The speed and scale of capital market reform underway in Saudi Arabia continues to impress and underlines the kingdom’s determination to diversify its economy away from hydrocarbons. It also means the country’s stock market, the Tadawul, is quietly ticking the boxes required for membership to the major equity indexes that track emerging markets.

Few can argue that this market liberalisation push won’t eventually lead to inclusion in MSCI Inc.’s Emerging Market Index (MSCI EM), and recent signs suggest this may end up happening earlier than many expect. The positive signals from the kingdom regarding reform are encouraging, and increasingly more frequent.

In August, the Saudi regulator lowered the amount of assets under management required by qualified foreign financial institutions (QFIs) to buy Saudi shares, while also raising the amount they can own in an individual company.

Other recent measures include allowing sovereign wealth funds and university endowments to invest in Saudi shares, while from next year QFIs should be able to participate in local initial public offerings (IPOs).

With many of the planned reforms now likely to be implemented this year, having originally been scheduled to take place by mid-2017, joining the MSCI EM is firmly on Saudi’s radar. This ambition was reiterated recently by the chairman of the country’s Capital Market Authority, Mohammed Al-Jadaan, who suggested to Bloomberg that the Kingdom is on track to join MSCI EM in 2018.

The reason for this new sense of reform urgency in Saudi Arabia is relatively straightforward: Saudi needs to attract more international investment at a time when the country’s finances are stretched.

With hundreds of billions of dollars in active and passively managed money tracking it, MSCI’s EM Index is a significant dictator of where equity market money flows. And while MSCI EM might be considered the preeminent benchmark, it is not the only global stocks gauge that has Saudi in its sights. The country is already on the review list for an upgrade to EM status by index provider FTSE Group, an event that could take place in September 2017.

In terms of MSCI EM, if Saudi were to be included today, it would represent about 3 per cent of the benchmark index. When one considers that the UAE, Qatar and Egypt combined currently account for around 2 per cent of MSCI EM, a 5 per cent weighing for MENA makes it a region that investors will find hard to bypass.

The potential IPO of Saudi Arabian Oil Co. (Aramco), considered by many to be the most valuable company in the world, makes the investment case for Saudi Arabia and the wider region even more compelling. Even at the lower end of predicted valuations, a $2 trillion Saudi Aramco would be worth more than the four largest companies in the world combined. Aramco itself would likely demand a 3 per cent weighing in MSCI EM, making it the largest single constituent in the index, while the MENA region would become the fourth largest block ahead of major EM countries like Taiwan and South Africa.

Also read: Saudi Aramco eyes 2018 for mega IPO – CEO

Saudi’s potential upgrade to EM status could make for an interesting opportunity. In the case of Qatar and UAE, much of the stock market rally, boosted by strong fundamentals, occurred in the run-up to their actual inclusion in May 2014.

But for Saudi to make the MSCI EM grade in 2018, current reform momentum needs to be maintained. Specifically, it needs to eliminate cash pre-funding, enhance custody controls, and introduce a proper delivery-versus-payment (DvP) mechanism.

Allowing the short selling of securities is another aspect that needs to be addressed. Making these changes as quickly as possible during the first half of 2017 will give sufficient time for MSCI to test these processes in order to review the kingdom for an upgrade in June or November 2017.

There is little doubt that the injection of foreign cash from inclusion in the MSCI EM could provide some welcome economic relief to Saudi. The collapse in crude oil prices over the past 24 months has proved a significant drag on the economy. The government has attempted to plug the fiscal budget gap through fiscal restraint and reserve drawdowns, but the adjustment to lower oil prices has been painful.

According to Tadawul data, as of September 8 the Saudi stock market is 45 per cent lower compared with two years ago and the Saudi Interbank Offered Rate (SAIBOR) has spiked recently due to a lack of liquidity in the banking system.

While one can argue that the current level of the Tadawul already reflects the new economic realities faced by Saudi Arabia, stock specific opportunities are starting to emerge, particularly when one considers that many defensive stocks are trading well below historical valuations and their EM peers. Clinching an MSCI EM upgrade might just be the shot of confidence needed to narrow that discount.

Bassel Khatoun is the chief investment officer of MENA Equities at Franklin Templeton Investments (ME) Limited