Emerging market investors were galvanised by news that Saudi Arabia would open up its $580 billion stock exchange to direct foreign investment. But many hurdles must still be overcome. George Mitton reports.
Getting into Saudi Arabia is not easy. This secretive country only issues visas in select circumstances: for pilgrims going to Mecca; for a handful of tourists who meet strict conditions; and for businesspeople with a local sponsor. The bureaucracy can make it feel as if crossing the border requires more paperwork than a skyscraper of origami.
For years, it has been almost as hard for investors to access the Saudi stock exchange, the Tadawul. Unless you are resident in Saudi Arabia or a national of one of the Gulf countries, you cannot directly own Saudi stocks.
International investors must resort to investing in a mutual fund or holding stocks indirectly, via swap arrangements.
That is all about to change according to plans announced by the Saudi cabinet in July and confirmed by the Saudi regulator, the Capital Market Authority (CMA). The authorities hope to open the market to direct investment from qualified foreign institutions in the first half of 2015.This is a big change for the market and the region. The Tadawul has a capitalisation of about $580 billion (€435 billion), similar to Mexico.
If foreign participation reaches the same level as other stock exchanges in the region, the Saudis can expect an inflow of foreign money in the region of more than $31 billion.
No wonder emerging market investors are excited. But the party shouldn’t start just yet. There are still hurdles to overcome before Saudi Arabia gets to become a viable market.
Perhaps the biggest obstacle concerns Saudi Arabia’s T+0 settlement system. In Saudi Arabia, equity trades are settled the same day they are executed (hence, plus zero).
It is a fairly efficient system that suits Saudi Arabia’s large retail investor base, which accounts for the vast majority of share trading.But international share trading does not operate to such tight deadlines. The problem of time lags in communicating between countries, and the incompatibility of time zones, means global custodians generally need two or three days to confirm settlement instructions, hence they operate on a T+2 or T+3 system.
“One solution is that Saudi changes settlement to T+2 or T+3, which is unlikely to happen,” says Arindam Das, regional head of Middle East and Africa, HSBC Securities Services. “The other is that in the market the settlement happens on T+0 but custodians settle outside with the broker on T+2, as long as that is permitted by the market.”
In this solution, the broker in Saudi Arabia executes a trade and pays the seller on the same day, but settlement with the buyer’s custodian happens two days later. It is not a perfect solution: the seller’s sub-custodian would have to deliver the shares on T+0 without having time to get instructions from the seller or the seller’s global custodian. Then, if the buyer disputes the trade, the broker could be saddled with unwanted shares, which it would have to sell to recoup its money.
However, the alternative, in which foreign investors stick to T+0, is problematic too. Buyers would have to pre-fund the custodian to pay for any share trading or arrange a system of credit limits.
“I’m not expecting a perfect solution but I’m hoping for the least imperfect one – and one that works,” says Das, who points out that the nearby markets of UAE and Qatar worked with imperfect solutions for years.
For instance, Qatar only made the transition to delivery-versus-payment settlement in 2011, as part of the country’s preparations to be upgraded to emerging market status.
Another question to answer is who meets the Saudis’ requirements as a qualified foreign institutional investor. At time of writing, the CMA had yet to release the draft of the regulations covering this topic, but there was a widespread assumption that the authority would limit participation to institutions with an investment track record of several years and a pool of assets in billions of dollars, perhaps $5 billion.
Such requirements would aim to prevent the entry of so-called “hot money” than can leave the market as quickly as it enters. The CMA wants to attract long-term institutional investors, not short-term speculators.
But how can the authority tell the difference? Some multibillion-dollar hedge funds, for instance, are infamous for rapid share trading and speculation.
Khalid Murgian, managing director of Neuberger Berman in Dubai, wonders if the CMA will impose specific requirements, perhaps on a case-by-case basis, to separate the committed investors from the fly-by-nights.
“Five billion dollars is not a big amount of money when you consider the biggest asset managers,” he says.
“Will the CMA say that $5 billion must be in the MENA region or in emerging or frontier markets, to show you are a serious investor in this region?”
So far, the CMA is being more transparent that the Chinese authorities, which tend to keep private the criteria by which they decide who gets qualified foreign institutional investor (QFII) status.
Perhaps the CMA will issue guidelines on how it measures the $5 billion criteria (if indeed that is the threshold). On these grounds it could exclude, say, US equity fund managers who invest solely in the US market, with no emerging market exposure.
Once foreign institutions gain access to the market, they may find there are limits on how much equity exposure they can buy.
“The Tadawul will be very cautious in ensuring [opening up] does not bring short-term volatility to the stock market,” says Jahangir Aka, managing director, SEI Investments, Middle East. “I expect to see the introduction of some caps per stock, controls around which firms can buy, potentially a registration process for those who want to buy, etc.”
As well as helping to control volatility, ownership limits may help to placate any fears in Saudi Arabia that the opening up process will mean surrendering control to foreigners. Murgian of Neuberger Berman suggests the fear of foreign control may discourage some unlisted Saudi firms from listing, which would be against the CMA’s aim of creating a large and vibrant capital market.
What this will mean for Saudi Arabia’s status in the eyes of index providers remains to be seen. In the several years while Qatar was on review for an upgrade to an emerging market, MSCI said foreign ownership limits were among the factors holding it back from promotion. The Qataris gradually increased foreign ownership limits and were rewarded with promotion earlier this year.
What is for sure is that MSCI will only grant emerging market status to Saudi Arabia after a long consultation period.
If, in that time, international investors decide foreign ownership limits hamper their ability to invest in the market, Saudi Arabia may not become an emerging market.
If Saudi Arabia is denied entry to the emerging market index and instead joins the MSCI Frontier Market index, its arrival would be akin to a large whale depositing itself in a small pond. Saudi Arabia could account for up to 60% of the Frontier Market index.
Investors now await the publication of draft regulations from the CMA that will describe the opening-up process. The authority has promised there will then follow a 90-day consultation period in which market participants can submit feedback.
Providing all goes to plan, international investors can look forward to owning shares in companies, such as SABIC, one of the world’s largest chemical firms, in the first half of 2015.
©2014 funds europe