Emerging Markets: Low Oil Prices and the Middle East Capital Markets

Emerging Markets, IMF Editions, October 2015

It is an unfortunate coincidence that at exactly the point when Saudi Arabia opened its equity capital markets to international capital, the sustained low oil price started to dampen foreign appetite to invest in the region anyway.

In the long run, it won’t matter: Saudi Arabia’s decision to open the $570 billion Saudi Stock Exchange to qualified foreign investors from June 15 will change the way its markets behave, and foreigners engage with it, for decades to come, through numerous ups and downs in commodity prices. But for the moment, in the eyes of the world investment community, a low oil price means little reason to invest.

That’s actually not the most sensible way of looking at things, but nevertheless, it reflects a common view.

“The oil price has, at the very least, affected sentiment; and at worst has actually dented earnings,” says Akber Khan, director of the asset management group at Al Rayan Investment in Qatar. “For a SABIC or other petrochemical companies it has had a real impact on revenues and profits.”

And, although the same is not true in other sectors that are well-represented in Gulf markets – consumer and healthcare, for example – that doesn’t make any difference to investor sentiment. “A number of companies continue to have excellent medium-term fundamentals,” says Khan. “Yet share prices of many of these have weakened because top-down asset allocation decisions are being taken thousands of miles away to reduce exposure to oil exporting countries, in some cases to reallocate to oil importers.”

Clearly, the asset management story in the Middle East is bigger than just Saudi, but that’s the market everyone is looking at as they seek to assess how capital is responding to the new opportunity. So far, there is no sense of floodgates having been opened. “We’re not seeing a huge amount of money coming in,” says Nick Tolchard, head of Invesco Middle East. “There is not a lot of IPO activity. There is a sense of a creation of infrastructure that sentiment is not pursuing at the moment.”

The interesting question is why, and in this respect, we can overstate the impact of the oil price. Asset managers and bankers say that, if there is reticence to pile money into Saudi today, it is for other reasons: one, they are still going through the process of registration with the Capital Markets Authority to be registered as QFIs anyway; two, many fund managers who have long used the P-note system to gain access to Saudi Arabia until now are continuing to do so for the moment and are not in a major rush to make the switch; and three, it is likely that the bigger flood of money into Saudi will come when the market enters the MSCI Emerging Markets index, which could well be three years away.

“You remember when the Chinese market liberalized many years ago it took some time before you saw real capital flow,” says Tolchard. “Our observation is that sentiment is very positive despite the oil price. They are opportunistic about the opportunity in Saudi from a long-term perspective. It’s just that the global environment is such that people might hold off until they get a better price.”

Certainly, from the Saudi side, the oil price doesn’t make much difference to the asset management picture. “Saudi Arabia has long been committed to liberalizing its economy ever since joining the WTO in 2005,” says John Sfakianakis, Middle East Director for Ashmore, which is unique among foreign fund managers in having set up its main investment capability for the region not in Dubai or Doha or Bahrain but in Saudi Arabia itself. “Hence, whether oil is at $100 or $40, Saudi Arabia will do what is necessary to open up its capital markets. In fact, the announcement to foreigners investing directly in the stock market took place this past summer, whilst oil prices slumped by more than 45% since 2014.”

If oil is relevant, it’s more about forming a top-down, macro view. “The oil price seems to be affecting sentiment in terms of what government surpluses will look like, more than anything else,” says Tolchard. “Instead, inward investment into Saudi Arabia is more driven by global investors and their perceptions of emerging markets and the Middle East generally.”

Also, while all Gulf states are clearly linked very closely to commodity price movements, they are trying to shift away, and it is always a surprise to newcomers to the Gulf stock markets that it is actually very hard to get pure listed exposure to oil, Saudi included. “Saudi Arabia’s economy is still revenue-dependent on oil,” says Sfakianakis. “However, today more so than any other time in the history of the country, the economy is making important steps to de-link itself from its oil dependency.” The Saudi non-oil economy will grow 3.2% in 2015 and 2.8% in 2016, he says, “which accounts for the bulk of the economy’s output on an annual basis. Although the oil price has gone down by 50%, it doesn’t mean that the non-oil economy has gone into a recession.”

In any event, if the oil price – and consequent national fiscal considerations – are dampening asset prices, sooner or later that will create an irresistible buying opportunity. “Patient investors can pick up some fantastic bargains in our region,” says Khan.

Multinationals agree.  “Foreign appetite should be picking up in the coming months as valuations look very attractive,” says Sfakianakis. “Foreigners are beginning to be keenly aware of the stocks they should select.”
“The Saudi equity story is a story of value as well as growth,” Sfakianakis adds. “There is a demographic growth story that is delinked from oil and has its own domestic drivers. Foreigners will be looking at these local dynamics to invest in.” Half of the population is below the age of 25, and they have comparatively high purchasing power.

Then there’s the debt side, as sovereigns and banks have started to return to the markets for the first time in years after finding that oil is no longer balancing their budgets. In July, the governor of the Saudi Arabian Monetary Agency announced that the government had issued a SAR15 billion (US$4 billion) bond, which was followed by another SAR20 billion in August and is expected to be followed by SAR20 billion more per month until the end of the year. This heavy borrowing was the first time the sovereign had tapped the bond markets since 2007. Up until July, Saudi Arabia had been drawing on its foreign reserves to sustain government spending in the face of an oil shortfall; foreign exchange reserves fell from $746 billion in August 2014 to $675 billion in June 2015.

Moody’s estimates that even if Saudi does go ahead with such vigorous issuance for the rest of the year, the total of SAR115 billion would only cover about 32% of the projected fiscal deficit for 2015, which is about 15% of GDP.

That’s no cause for alarm; “Saudi Arabia has ample space to issue debt,” says Moody’s. Government debt stood at 1.6% of GDP at the end of 2014. But the needs for funding are increasing. Moody’s says the fiscal deficit is climbing “driven by social spending pressures and increased security expenditures surrounding geopolitical developments in Yemen and the threat posed by ISIS.”

Meanwhile, it creates some interesting fixed income opportunities for investors. “A sovereign issuance will provide a benchmark for other entities that may want to borrow from capital markets, which would promote financial sector development and diversification away from overreliance on the banking sector,” says Moody’s. Granted, Saudi’s sovereign deals are in riyals, but its bigger corporations and banks have routinely issued in dollars and would find an interested market were they to do so again.

“There’s been some talk of economies wanting to build a yield curve,” says Tolchard. He says that local debt markets will develop more as pension funds begin to gather mass in the region. “Given their liabilities, they will be looking to meet some of them through local fixed income markets. It’s a positive trend.”

The oil price may create one more market of interest to investors in the region: FX. Today, most currencies are pegged to the dollar, but scrutiny is increasing of the Saudi riyal. “The combination of lower oil prices and a peg to an appreciating US dollar is likely an uncomfortable one for Saudi Arabia,” says Robert Burgess, chief economist at Deutsche Bank. “Markets are thus beginning to question the sustainability of its peg,” he says, the more so following China’s devaluation of its exchange rate in August. After that, forward rates spiked to their highest levels in over a decade.

Still, Burgess concludes that the riyal is fine for now. “Will the Saudi riyal be the next peg to break? We think the short answer is no,” he says. “The peg has stood through thick and thin for almost 30 years. If anything, the government’s ability to defend the peg is now stronger than it has ever been. Foreign reserves are higher and government debt is much lower than in the 1990s when the peg was last attacked.”