MSCI says no to China

Last night, MSCI, the world’s largest indexing firm, announced that it will not be adding China’s A shares as constituents of its widely followed EM index.

It has also made a number of comments which were of interest to global emerging funds following Pakistan, Nigeria, Argentina and Saudi Arabia.

In summary:

1. For passive EM funds, the MSCI EM index is the most significant globally by far, with around $1.5 trillion of indexed investment. For active investors, any change in the weighting of the index (which they are benchmarked against) forces them to reassess the composition of their portfolios.

2. MSCI pointed to a number reasons behind their decision regarding China’s A share market, the main one perhaps being capital mobility. First and foremost, the monthly repatriation limit (the amount of his total capital the investor is able to withdraw from the market during one month) of 20% is considered too low, especially should the fund be faced with redemptions. The time-consuming and opaque process of receiving approval for a quota (allowing investors to invest in Chinese stocks) is also a factor. On top of this, the need for preapproval of financial products on foreign stock exchanges that are linked to A-share indices has not been yet addressed.

It is important to note that China is already the largest component of the MSCI EM Index, making up over 25% of the index. This is made of up of ADRs of Chinese companies listed in NY or Chinese shares quoted in Hong Kong. The domestic (A-share) stock market – the largest in the world after US – is not included in the index.

3. MSCI announced that Pakistan will be reclassified as an Emerging Market. Given its current account deficit and need for capital to drive steady growth, many observers agreed that Pakistan was the biggest winner from yesterday’s announcement.

4. Argentina will be reviewed for a potential upgrade. In December 2015, the Argentinian Central Bank abolished foreign exchange restrictions and significantly relaxed the capital controls that have been in place for a number of years. These changes have resulted in a floating currency, the elimination of cash reserves and monthly repatriation limits on the equity market, as well as a significant reduction in the capital lock-up period for investments.

5. Nigeria may be removed from MSCI’s Frontier Markets Index and reclassified as a stand-alone market due to capital mobility issues. This may even come as soon as November this year. Early last year its Central Bank pegged the local currency to the US dollar resulting in a sharp decline in liquidity on the foreign exchange market. Hence, the ability of international institutional investors to repatriate capital has been significantly impaired to the point where the investability of the Nigerian equity market is being questioned.

6. MSCI said that it welcomes the recent market enhancements announced in Saudi Arabia, which opened its market for the first time to foreign investors last summer. These include changes to the rules for qualified foreign investors, settlement cycle of listed securities, elimination of the cash prefunding requirement and the introduction of proper delivery versus payment. Many of these are on course to be implemented by mid-2017 and will bring the Saudi equity market closer to EM standards.

Sources: MSCI, FT, Natixis

Long March Forward

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The Saudi Capital Market Authority, under new leadership, has announced that qualified foreign institutions will have access to the Tadawul stock exchange from 15 June 2015 with the final rules to be revealed on 4 May. This comes as no surprise, given the announcement in July 2014 of plans to allow direct foreign purchases of shares in the first half of 2015.

But why does opening up the Saudi equity market matter? What could be some of the macroeconomic effects? With Saudi and other  oil exporters facing an oil price tsunami, economic policy should be directed at mitigating the negative consequences. The IMF estimates that there will be a massive loss of $380 billion in exports, equivalent to a 21 per cent hit to GDP. The expectation is that opening up the market will attract foreign capital that previously did not have access to Saudi investment opportunities. The capital inflow, in theory, could lead to increased investment in promising sectors, bring in new technology, boost IPOs, galvanise mergers & acquisitions and improve corporate governance all of which would translate into greater economic diversification and job creation, the overarching economic policy concern. The underlying risk is that asset prices get bid up, a bubble forms, Saudi investors sell and real invest does not happen.

LIBERALISATION AND OPENING UP

Opening of the market comes as part of a continuing policy of opening up, economic liberalisation and gradual international integration that  has been pursued  over the past  10 years. Saudi Arabia has been successful in upgrading infrastructure, strengthening education  and skills, boosting  access  to finance for SMEs, and significantly improving the business environment. Substantial progress has been made on lowering the cost of doing business  over the years. Saudi Arabia is today the only Middle East country and only OPEC member among the constituents of the G20. It joined the WTO in 2005 (which included clauses  like allowing 60 per cent foreign ownership in banking and insurance, and 75 per cent foreign ownership of distribution  within three  years). Saudi built  economic cities and industrial zones to move away from its over-dependence on oil. But oil still accounts  for about 92 per cent of government  revenues  and though the share of non-oil real GDP has increased over the past  two decades, non-oil sector exports remain limited. Foreign investment can support economic diversification.

SAUDI CAPITAL MARKET LIBERALISATION NEEDS ACCELERATION

The conservative Saudi capital market regulator had initiated several  steps to liberalise the market  over the last  few years, including aligning working days with other  GCC and international markets with Tadawul opening on Thursdays, and improving corporate governance standards to make the Saudi market attractive to foreign investors. Draft market  access  rules, shared  in August 2014, included a 10 per cent cap on foreign ownership of the market’s value and that  a single foreign investor could own no more than five per cent of any listed firm, while all foreign institutions combined could own no more than 20 per cent. If this limit is confirmed then the promised  Saudi overture  might prove to be too timid, a damp squib.

The Saudi and other GCC stock markets are massively dominated by retail investors. Retail investors currently account for more than 90 per cent of the share trading volume of the Tadawul, while foreign investors have been restricted to buying Saudi shares  indirectly through swaps or exchange- traded funds. But retail investors may be prone to fickleness and bouts of irrational exuberance leading to volatility. Institutional investors  such as pension funds, insurance companies, and investment funds are less likely to be prone to animal spirits, or so it is hoped. Increasing the share of institutional investors should help stabilise markets.

Opening of Saudi capital markets has been proceeding in phases, initially opening up to GCC investors, then opening to investment funds and now opening to qualified foreign investors.The opening up provides foreign investors access to the largest economy and

 

 

capital market in the Middle East. Saudi Arabia is the largest economy in the Middle East, with a nominal GDP of $752 billion in 2014. Tadawul has over 160 stocks, a market capitalisation of approximately $530billion and relatively more diversified compared to other exchanges in the region, with sector representation from petrochemicals, banking, telecom companies, retail and real estate. The chart below, shows the market capitalisation and turnover of the GCC markets, underscores the importance of the Saudi market: Tadawul alone accounts for more than 50 per cent of the market cap of the GCC countries and is the most liquid.

TADAWUL WILL MOVE FROM ‘FRONTIER’ TO ‘EMERGING’ MARKET STATUS

Saudi’s ouverture finally allows foreign investors to diversify risk and gain exposure  to GCC investment opportunities through UAE, Qatar and now Saudi markets. Indeed, it is only in the past  year (May 2014) that  both UAE and Qatar were reclassified from Frontier to Emerging Market Status by the MSCI. MSCI considers  both size and liquidity requirements and market  accessibility  for its country classification  into Frontier or Emerging. The former are based on the minimum investability  requirements while the latter are based  on qualitative measurements that reflect international investors’ experience in investing in a given market, including laws, rules and regulations that provide for investor protection.

Will Saudi Arabia go through this process of a reclassification as well? According to MSCI, based purely on the existing size of the Saudi market, Saudi Arabia would have an equivalent weight of about 63 per cent in the MSCI Frontier Markets index, and about four per cent in MSCI Emerging Markets – the inclusion would attract passive foreign institutional  investors  or index investors that would have to rebalance their portfolios to include Saudi. The index house has already stated that a market does not necessarily need to pass through frontier status before entering the Emerging Markets universe. The earliest Saudi Arabia could officially enter either the frontier market or emerging market (more likely) would be mid-2017 considering the usual timelines for the evaluation and consultative process. Saudi Arabia, at present, has a standalone classification from S&P.

FINANCIAL MARKET LIBERALISATION IS KEY TO ECONOMIC DIVERSIFICATION

What can Saudi Arabia look forward to with the opening up of its capital markets and subsequent foreign investment? Opening the stock market is only one step in what ought to be a Saudi financial markets development strategy. Efficient financial markets require breadth (a wide variety of financial securities and instruments), depth (sufficient size to enable transactions without leading to large bid-ask spreads) and liquidity (ability to enter and exit markets without affecting price).

Saudi needs active money markets, bond and Sukuk markets, and a mortgage market  for housing finance. Saudi Arabia should however use the opening up of its capital markets to encourage more listings of both Saudi and GCC companies (dual listings). The exchange is largely dominated by energy-related companies and financial firms. It is necessary to reduce the high concentration of capitalisation in a limited number of stocks: for example, the top FIVE names (including SABIC and Al Rajhi Bank) account for more than one-third of Tadawul. Developing the financial markets should also be part of a strategy of economic diversification, via attracting capital into promising sectors such as tourism and hospitality, transport, education, health, services etc. but the time is also opportune to start a programme of privatisation e.g. Saudi Airlines and greater PPP in infrastructure and logistics.

OPENING TADAWUL SHOULD BE PART OF A ‘LONG MARCH FORWARD

The ouverture of Tadawul should be part of the equivalent of a Chinese ‘Long March Forward’ of a continuing modernisation and reform strategy and of greater regional and international economic integration. The move should be a harbinger of further reform providing wider market access and establishment of foreign companies and persons via deep legal and regulatory reforms,public private partnerships,and privatisation and labour market reforms to create a dynamic,vibrant economy able to create jobs for generations of young Saudis, both women and men. But why stop there?

As the region’s biggest economy, Saudi can and should be the region’s engine of growth. Given Saudi’s massive wealth and being a major capital exporter, the Saudi market should be open to foreign listings (including government and corporate bonds and Sukuk) and cross-listing from the other GCC and Arab markets. An example would be allowing Egyptian companies  and government  to list equity, bonds and Sukuk that  would help finance Egypt’s infrastructure, inclusive economic growth and development.  Finance and trade are better than aid! Saudi’s Tadawul should move away from being insular and inward–looking to become a regional market helping finance economic growth and development across the Arab world and wider region.

This is a guest blog post by Dr Nasser Saidi. It originally appeared in CPI Financial

 

Saudi Arabia to Open its Equity Market to Direct Foreign Investment

         Saudi Arabian banknotes & coinsAfter a number of years in the making, the Saudi Arabia authorities finally announced last week that Qualified Foreign Institutions (QFIs) will be allowed to invest in shares listed on the Tadawul starting from June 15th, 2015. While foreign investors have been able to invest in Saudi Arabia since 2008, this has been limited to ETFs, swaps and P-notes, none of which allow direct ownership of the underlying equity. Opening the market to QFIs as a first step is a tried and tested approach in emerging markets (e.g. China in 2002, India in 1992, Taiwan in 1991). Institutional investors who do not meet the criteria for investing directly will likely continue to use the existing products mentioned above.

The Tadawul is the Middle East’s largest and most liquid market, and effectively the largest closed emerging market today. The 165+ listed companies have a combined market capitalisation of over $550bn, with petrochemicals and financials industries the dominant sectors. Recent IPOs have added more consumer and non-cyclicals to the market. A number of commentators are speculating that Saudi Arabia could receive an emerging market classification from index provider MSCI within the next two years, which is in turn likely to drive additional investor interest. MSCI’s Sebastien Lieblich was quoted last year as saying that if Saudi Arabia were added to the Emerging Markets Index it would constitute around 4 per cent of the total market, similar to Mexico and Russia. This development would mean that Saudi Arabia could make it into the top 10 rank of EMs as classified by the MSCI (see graph below).

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The Kingdom presents investors with a unique set of dynamics. Its economy has gone from strength to strength in recent years as it has benefited from high oil prices and output, strong private sector activity, increased government spending, and the implementation of a number of domestic reform initiatives. Rising oil prices and oil production have also resulted in large external and fiscal surpluses, and government debt has declined to almost zero. With a population of over 30 million, over half of whom are under 25 years old, it is the region’s youngest and most populous nation. Of course, there are risks. First, the Kingdom’s dependence on oil revenue (over 90 percent of fiscal revenues and 80 percent of export revenues come from the sale of oil) leaves it hostage to fluctuating oil prices, as have been seen since the summer of 2014. Geopolitical tensions in the region further added to such worries.  As with all emerging markets, there have been some corporate governance-shaped bumps in the road, however the opening of the market to foreign investors will undoubtedly help smooth the path to transparency and benefit companies and investors alike.

Sources: International Monetary Fund, Bloomberg, Morgan Stanley, MSCI