Saudi Arabia opens doors for MENA stock markets

Such a development would elevate the status of the region in the eyes of international investors, inspire other MENA countries to pursue MSCI EM status and trigger increased liquidity flows across the region.

An MSCI EM place, alongside countries such as Brazil, India and China, would be just reward given the kingdom’s progress to liberalise its capital markets. Index provider MSCI acknowledged the work that has already taken place by adding Saudi Arabia to its MSCI EM watch list in June and will now consult with international institutional investors, gathering their feedback on Saudi’s stock market.

While Saudi’s place on MSCI’s EM watch list is no guarantee of future inclusion, the Saudi Capital Markets Authority (CMA) and Tadawul stock exchange have already made substantial modifications to the kingdom’s equity market infrastructure positioning it for a swift move into the widely-followed index.

In its recent review, MSCI cited improvements, including the expansion of the settlement cycle from T+0 to T+2, the introduction of delivery versus payment (DvP) settlement provision, proper failed trade management, and the introduction of short-selling, securities borrowing and lending facilities. These are all testament to the ambitious capital market reform agenda Saudi Arabia has pursued over the past two years.

Given the above, a June 2018 MSCI inclusion remains our base-case scenario. The recent decision to upgrade Pakistan to EM status after just one year on the watch list was the fastest move MSCI has made. We anticipate Saudi could follow a similar path. While Saudi’s inclusion will be determined by how well the Qualified Foreign Investor (QFI) framework is functioning, we expect Saudi’s journey through the MSCI process to play out as follows: inclusion in the MSCI EM Index announced in June 2018 with effective index implementation in May 2019.

Given the size of Saudi Arabia’s equity market, inclusion could be split into two phases, coinciding with the May 2019 semi-annual and August 2019 quarterly reviews. It is also worth noting speculation of an expedited inclusion for Saudi Arabia given MSCI can make country classification decisions twice a year. While theoretically possible for MSCI to make an inclusion announcement during the upcoming November 2017 review, we view this prospect as unlikely.

From a regional perspective, Saudi Arabia’s economic output and its $450bn equity market tower of the rest of MENA. On current standings, we believe Saudi could account for around 2.5 percent of the MSCI EM Index, which would effectively double to 5 percent with the planned initial public offering (IPO) of Saudi Aramco, a firm we estimate could be worth around $1 trillion.

In this scenario, the MENA region’s representation in the MSCI EM Index would grow from the current 2 percent, made up of the UAE and Egypt, to 7 percent, making it comparable to India (8.3 percent), Brazil (7.7 percent) and South Africa (7.1 percent). And this is just the starting point. A robust IPO pipeline, with government plans to increase the number of companies’ stocks from 170 to 250 over the next five years, means the kingdom’s equity capital markets are very much in a growth phase.

The benefits of inclusion in MSCI’s EM Index are substantial. With approximately $2 trillion in active and passively managed money tracking it, the popular stocks gauge is a key dictator of equity flows.

We expect Saudi Arabia’s inclusion in the MSCI EM Index to bring significant foreign investment.

A potential 5 percent weighting for Saudi in the MSCI EM Index, a figure corroborated by MSCI, may result in flows of $100bn assuming a benchmark weight, or $50bn excluding Saudi Aramco’s IPO. While vastly different in scale, foreign inflows witnessed when the UAE was upgraded to MSCI EM status in 2014 were three to four times the amount implied by their benchmark weights. Encouragingly, some of this flow is expected to trickle through to surrounding stock markets.

In terms of foreign share ownership, Saudi still has some way to go. Foreign investors currently account for less than 1 percent of Saudi equity ownership, or about $5bn. This compares to a ceiling of 49 percent allowed under the Saudi QFI programme and foreign ownership levels averaging 11 percent in the UAE.

Saudi’s upgrade could trigger significant upside for stocks in the kingdom, and sooner than expected. Based on the performance of 20 promotions to MSCI EM since 1994, the bulk of stock market gains occur well before implementation of MSCI changes.

Data shows the median share price rally 24-months before MSCI EM implementation is 67 percent, while the median rally 12-months prior to implementation is 55 percent. Closer to home, the preceding 12-month period before the UAE promotion saw stock markets surge 115 percent.

While there’s no doubting the significance of MSCI’s stock gauge to emerging market investors, a potential upgrade to secondary EM status in September by rival index provider FTSE Group is another important milestone. Saudi could constitute about 2.4 percent of this gauge, attracting more attention from international institutional investors who may be unfamiliar with the Saudi story.

The ‘halo effect’ of Saudi’s addition to the MSCI EM Index will likely prove a boon to regional bourses that have been buffeted by the impact of lower oil prices. It also outlines a clear path that other MENA countries, such as Kuwait, can follow in years to come.

Saudi’s MSCI EM inclusion, in our view, would also help eliminate a material disconnect between the GDP contribution of this region and its representation in MSCI EM, underscoring MENA’s transition from the peripheries of emerging market investment to the mainstream.

Bassel Khatoun, chief investment officer MENA Equities at Franklin Templeton Investments.