Saudi Arabia is hardly an emerging market success story at the moment, with a bout of austerity driven by low oil prices resulting in public sector pay cuts and a slump in non-oil growth to 0.07 per cent in the second quarter of 2016, putting the country on the brink for its first non-oil recession in 30 years.
Yet Saudi could be on the verge of attracting more than $30bn of foreign capital to its $380bn stock market, according to estimates by Bank of America Merrill Lynch.
A buying spree of this magnitude would represent a seismic shift for a widely ignored bourse that accounts for just 0.2 per cent of the holdings of the global emerging market fund sector.
“There is a level of apathy towards the market,” says Hootan Yazhari, research analyst at BofA, who estimates that foreign investors account for only 1 per cent to 1.5 per cent of Riyadh’s daily trading volumes.
The Saudi stock exchange’s problem is that the country is not in either of MSCI’s emerging or frontier markets indices, meaning it is entirely ignored by passive funds following these indices, and largely ignored by the myriad of “closet-tracking” active funds that do.
It does attract some interest from actively managed frontier market funds, many of which are perfectly happy to invest outside of their benchmark. Saudi Arabia accounts for about 4.5 per cent of the assets of frontier funds, according to EPFR, a data provider, making it the eighth largest market for these funds.
However, Riyadh would attract far larger flows if it could win access to one of the MSCI indices, ideally the EM one.
To this end, in May the Saudi Capital Markets Authority doubled the limit on the amount an individual foreign investor can hold of a stock to 10 per cent and scrapped a rule limiting foreign ownership of the overall market to 20 per cent, although it retained a 49 per cent cap on foreign ownership of an individual company. It also introduced stock lending and covered short selling, becoming the first Gulf market to do so.
Moreover, the CMA said foreign groups with as little as $1bn under management (rather than $5bn) could now enrol in its Qualified Foreign Investor programme, which is necessary to enter the market (other than by investing via swaps), and made some other technical changes to this regime.
While there are no specific requirements a country needs to meet to be deemed eligible for the MSCI EM index, Riyadh’s moves to ease the restrictions on foreign investment will certainly strengthen its case for inclusion.
As of May, some 25 overseas investors had entered the Saudi market, known as the Tadawul, but Mr Yazhari says that “in the last two or three months the number of QFIs has gone up quite sharply”.
He sees the May reforms not only as bringing Saudi “one step closer” to inclusion in the MSCI index, but also as indicating the country “is seeking an expedited path to inclusion”.
Such a move would potentially fit with Riyadh’s National Transformation Plan, an ambitious project launched in June designed to ween the country off its over-reliance on oil.
“Given the NTP is seeking heavy involvement and investment from the private sector, we believe the measures introduced by the CMA to attract direct capital inflows to the country are likely [to be] linked with the larger NTP process,” he says.
BofA’s core thesis is that Saudi Arabia is likely to be admitted to the MSCI EM index in 2019, with an announcement made in 2018. However, Mr Yazhari believes the reforms mean inclusion in 2018, with an announcement in November 2017, “is by no means out of the question”.
As things stand, Saudi Arabia’s weight in the EM index would be about 1.5 per cent. With about $740bn worth of active and passive funds tracking this index, according to EPFR, this would imply inflows of about $11bn as foreign investors get up to weight.
However, if Riyadh were to ease its restrictions on foreign ownership still further, something BofA thinks very possible, this would raise the “foreign ownership limit” factor that MSCI uses in its weighting calculations, potentially raising the Saudi weight to nearer 3 per cent and attracting $22bn of inflows.
Furthermore, inflows of this size could ensue even if the CMA does not loosen its regulations further. Under the NTP, Saudi Arabia is planning a series of privatisations over the next two years, probably led by the listing of a 5 per cent stake in Saudi Aramco, a company Riyadh is believed to value at about $2tn.
Assuming that these privatisations go ahead, BofA calculates that Saudi Arabia’s putative weighting in the MSCI index could be about 4.3 per cent, implying inflows of about $30bn.
In this scenario, Saudi would be the seventh largest country in the MSCI EM index, behind only China, South Korea, Taiwan, India, South Africa and Brazil, but ahead of Mexico, Russia and Turkey, as the first chart shows.
Moreover, if Saudi Arabia did succeed in engineering an expedited entry into the index, Mr Yazhari believes these flows would largely occur during 2017.
“What we have typically seen [in previous cases of entry into the MSCI index] is that passive and active funds that track an index will start the process of gaining exposure to the market well ahead of the event itself. The announcement of inclusion is when you really start to see the inflows,” he says.
The lessons from neighbouring Qatar and UAE, which both joined the MSCI index in May 2014, are a little unclear, however. Both countries’ accession was announced in June 2013. During the course of that calendar year the Dubai Financial Market, the largest bourse in the UAE, surged 108 per cent, while the Qatari market rose 23 per cent. Both markets also saw smaller gains in 2014 itself.
“We saw record levels of market activity and a massive pick-up in liquidity. It was a one-way trade,” says Mr Yazhari.
However, part of those gains would have been driven by high oil prices, as suggested by the fact that the Saudi market also rose 25 per cent, as the second chart shows, despite its lack of index inclusion.
Mr Yazhari remains confident that the examples of UAE and Qatar “provide a very good precedent” and that index inclusion “would have a profound effect” on the Tadawul.
However, he does caution that the impact of index inclusion on the Saudi bourse may be smaller than for its neighbours, given it is more liquid than they were before entry.
“Saudi is already a very liquid market, even without international investors, so maybe it wouldn’t have the same effect because you are not doubling or tripling liquidity overnight,” he says.
At present, 19 of the 168 stocks on Tadawul are included in MSCI’s standalone Saudi market index, suggesting that they would be likely beneficiaries if Riyadh were given the nod.
This index is dominated by state-controlled petrochemicals group Saudi Basic Industries, also known as Sabic, with a weighting of 25.6 per cent, followed by Saudi Telecom, (13 per cent) and Al Rajhi Bank (10.1 per cent).
Overall, banks account for about a third of the index, followed by petrochemicals and real estate, at 10 per cent.