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Waiting game

August 2012

GCC investors are still waiting for a key upgrade to regional bourses which could inject billions of new dollars, but are the exchanges doing enough to speed up the process

by Rosamund de Sybel
[email protected]

The failure of the United Arab Emirates and Qatar to secure an upgrade earlier this summer from MSCI, a provider of investment decision support tools to investment institutions, came as no surprise to analysts. Any flames of optimism had, for the most part, been extinguished weeks before the index provider announced in late June that it would keep both the MSCI Qatar Index and the MSCI UAE Index on review for upgrade.

For Gulf Co-operation Council (GCC) investors it was familiar territory: the bourses have been on review for an upgrade from frontier to emerging market status for years. Their review for inclusion on the MSCI emerging market index – which tracks stock markets with a total market capitalisation of around $3.2 trillion – has now been extended until December. An upgrade is expected to bring billions of dollars of investment into the stock markets.

Georges Elhedery, head of global markets, MENA, at HSBC says that for Qatar the problem remained its low foreign ownership levels. “The amount of stock a non-Qatari can buy is limited. To international investors, these limits are more of a sign of a ‘closed’ or at least restricted market rather than an open one,” he says.

Most companies in Qatar cap foreign ownership at around 25 per cent. In the UAE, foreign companies must have Emirati nationals as their sponsors and are limited to a maximum 49 per cent ownership of businesses, except in free zones.

However for the UAE, the major sticking point was technical: “The market has operated a delivery versus payment – or DVP – model now for a year, meaning that there’s no time lag between stocks and cash being exchanged,” explains Elhedery. “The main concern of investors was control of the assets should settlement instructions not match. The model introduced last year did not address this issue and since December 2011 no further changes have taken place.”

Nevertheless he says that the exchanges are looking at how they can improve the model to meet MSCI’s, and hence investors’, concerns.

The focus on the UAE and Qatar’s upgrade in recent months has however overshadowed another important issue in the development of the region’s equity markets – the anticipated opening up of Saudi Stock Exchange (Tadawul) to direct foreign investment. The Saudi bourse has long been eyed by foreign banks, keen to tap into the largest Arab economy’s stock market. Riyadh’s long-term plans to reduce its dependence on oil income, create jobs and improve the competitiveness of Saudi companies have also pushed it to support openness.

“The much bigger story for the region as a whole is what happens with the Saudi market, given that in recent years it has if anything become even more dominant,” argues Jarmo Kotilaine, chief economist at Saudi Arabia’s National Commercial Bank. “Whether the UAE and Qatar become emerging markets or remain frontier markets is almost a marginal phenomenon.”

The Tadawul, which has a market capitalisation of $379 billion, accounts for more than half of the collective market capitalisation of all the GCC exchanges – currently more than $700 billion. The Tadawul’s share of the GCC’s total market capitalisation has risen from 45 per cent in 2008 to 53 per cent in 2012, according to recent research from Global Investment House, a Kuwaiti bank.

Qatar was the only other country to witness a rise in its market share over the past five years, rising from 10 to 14 per cent. Meanwhile, Kuwait – home to the Gulf’s oldest stock exchange – has seen the worst erosion of its share, tumbling from 21 per cent to 14 per cent.

Speculation that the Saudi bourse is to soon grant foreign access has been steadily growing, with many analysts predicting an opening up of the exchange by the end of the year. In January, the Capital Market Authority announced rules to allow foreign companies to cross-list, which observers saw as an indication that regulators are contemplating change.

Currently foreign direct investment on the Tadawul is not allowed. However, since 2008, foreign investors have been able to buy Saudi shares indirectly using total return swaps via licensed brokers. Foreigners can invest on the exchange through buying participatory notes – equity-linked certificates that allow foreign companies to invest in stocks in Saudi without being licensed to trade there. Regulators are now fine-tuning the draft law on Qualified Foreign Investors in the hope of attracting institutional fund managers. Once foreign access is granted, the process of qualifying for a benchmark index would begin.

“This has been talked about for years and the general consensus is that the authorities and the stock exchange are committed to doing this,” says Kotilaine. “On the other hand it is likely to be a very gradual process. So what is on offer even on the more optimistic scenario is something along lines of what happened in India – a foreign institutional investors scheme – which would deliberately limit foreign investors to big institutions, which would be pre-screened and licensed. Anything beyond that is some time down the line.”

Large investors such as pension funds are keen to obtain the right to buy shares directly rather than going through Saudi intermediaries who technically own the stock under the current rules. Regardless of the current lack of direct foreign investment the Saudi index is one of the most liquid frontier markets.

Foreigners currently make up only a fraction of trading. According to data from the Tadawul website, foreign investors accounted for just 0.2 per cent of trade volumes in May. Saudi individual traders on the other hand accounted for 95.5 per cent of all selling and 94 per cent of all buying. Other GCC nationals accounted for 0.1 per cent, and investors from other Arab states, just 2.6 per cent. Saudi mutual funds meanwhile account for only 0.9 per cent of selling and 1.1 buying (See table).

“The bigger problem exists on the demand side, in the sense that the market is very much retail driven,” says Kotilaine. “Part of the reason for the Saudi aspiration to permit foreign institutional investors – and specifically institutional rather than individual investors – is because they tend to be more long term thinking and active owners.”

Those institutional investors would likely be those with at least $5 billion in assets under management, limiting access to those companies that would remain in the market for the long term.

Recent research from Al Rajhi Capital, a Saudi financial services firm, noted that foreign investors “bring in liquidity, efficiency, transparency and practice of better portfolio management.”

However the firm warned that “these benefits are not guaranteed”. The firm also cautioned that the “entry of foreign investors in the stock market is believed to cause higher volatility due to flow of hot money and can potentially create an issue of liquidity management for the central bank.”

By only allowing institutional foreign investors, such risks are expected to be dispersed. Al Rahji argues that though the Saudi equity market is ready for foreign investors, opening up the bourse “should be done in a calibrated manner so that the advent of large investors does not destabilise existing stakeholders.”

The advancement of both the Saudi equity market and those of its neighbours remains a work in progress. The fact that GCC markets remain retail driven, with a relative absence of institutional investors, leaves them volatile. The small insurance and mutual fund industries have been another weakness holding back development, as have the region’s lack of private pension funds.

“In practice, if we look at the international experience it’s difficult to boost the role of institutions in the absence of proper pension reform. The pension funds in the Gulf are still government pension funds which certainly do invest in equities but you don’t have significant occupational funds, you don’t have any voluntary funds,” says NCB’s Kotilaine.“I don’t see anybody rushing towards pension reform.”

Partly this is because of the Gulf’s youthful demographic, he says.

Another issue is that there are still very few actively traded stocks in the region. Exchanges are, however, actively encouraging companies to list.

“In some cases, especially in the UAE and Qatar there have been discussions about creating separate boards for small and medium companies to come to the market and broaden the base of the market by allowing for easier access,” says Kotilaine.

Despite such positive moves, the Gulf’s equity markets are likely to see a moderate pace of evolution, rather than revolutionary growth. And far more will need to be done to better structure the region’s capital markets with the needs of the region’s economies, and investors, say analysts.

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