Saudi Arabia Takes Cautious First Steps to an Open Market

It’s certainly true to say that it is early days, that big institutional capital takes time to move, and that this is a long-term game. It’s also important to note that Al-Ghamdi’s interview, like all the interviews in this article, took place on the sidelines of a global roadshow by the exchange and Euromoney Conferences specifically designed to answer questions and reach out to institutional investors, in Singapore, London and New York; it will be fairer to assess progress once those investor meetings are digested and decisions are made.

But among the international fund management community there are a few grievances, some more easily fixed than others, that are keeping managers out.

Most people think that the barrier to participation is the settlement situation. Saudi Arabia operates under T+0, which works just fine in a retail-dominated domestic market, but not so when international investors seek to engage. To get around the problem, they need to pre-fund.

It’s true that this presents a difficulty. “Part of the challenge is that, if you’re running a fund, you’re selling something and then buying,” says Deborah Fuhr, managing partner and co-founder of ETFGI, the ETF research and consultancy group. “In many cases, people don’t trade ETFs during the day: they wait until the end of the day to sell a fund they already have and then buy the ETF. You can imagine that pre-funding when you don’t have the cash is more challenging than trading at the end of the day.” It’s a relevant point of view, as ETFs are likely to be a first wave of international engagement with the market, hence Blackrock’s decision to start out with one.

But in truth, pre-funding is irksome rather than being especially damaging. “It’s inefficient but not insurmountable,” says Bassel Khatoun, chief investment officer of MENA equities at Franklin Templeton Investments. Custody, another frequently-mentioned bugbear, is not a huge deterrent either. “We would prefer the independent custody model, which is now coming on-line, as it would lead to better market infrastructure,” Khatoun says. “But we’ve operated in the existing form for the last seven years, so it’s not a problem.”

Instead, there is a single technical factor that is proving a much bigger barrier. This has to do with the fact that any individual pension fund can only be represented by one QFI in its dealings with Saudi Arabia. QFIs can apply for an exemption to this rule, but it’s a bureaucratic hurdle that asset managers think unnecessary. “Pension funds don’t just mandate one fund manager, they mandate 20 or a hundred,” says one person close to the QFI process at an international bank.

Khatoun confirms this is a challenge that has, so far, kept Franklin Templeton from applying. “At this stage, we are closely studying the QFI proposal, but we have not yet submitted for a QFI licence,” he says. “The real sticking point at this stage is some of the legal ambiguities that surround the governance of the relationship between a QFI and QFI clients.

“We think some areas surrounding how QFI and QFI clients can access the market – in particular how many QFIs the client can access the market through – are still subject to interpretation. There is some talk of waivers being issued, but for us, we need to see it in black and white before we could go ahead.”

One banker familiar with the QFI process says the Capital Markets Authority needs to be lobbied collectively in order to change the rule. “What it needs is Franklin Templeton, Fidelity, Lazard, all those guys to go in as a group and say: look, this is what’s keeping us out.”

This may just be a teething problem. The degree to which the Saudi authorities – and the stock market in particular – are willing to listen to the market has impressed and surprised many who have dealt with the Kingdom for many years, although it may suffer now that Al-Ghamdi – very much the focal point for international investors – has gone. There is already talk of tweaking the rules, particularly the one requiring a minimum of $5 billion in assets under management to qualify as a QFI, and Al-Ghamdi and his team consistently expressed a willingness to learn and amend as the programme gets underway.  The QFI client question came up from the floor several times in the roadshow and questioners were ushered into private meetings with the CMA representatives; if common sense prevails, it could be sorted out by the end of the year.

And it’s not as if money doesn’t want to come eventually. At Invesco, Nick Tolchard, head of the Middle East, says his fund managers are saying to him that “we’re set up internally to trade the market, but haven’t been able to execute so far, as our custodians have had some challenges around execution. I haven’t heard anyone say to me we’d like the rules and regulations to be changed. But it does seem that compliance with those rules and regulations is taking a while.” Invesco is expected to become a QFI at some stage. And Khatoun says that, for Franklin Templeton, “the ultimate objective is to become a QFI: we would like to become directly invested in the market, we see the benefits of owning the shares directly, of lower fees, and of IPO participation. It’s just a question of making sure there is no ambiguity around the legality.”

Similarly Farah Foustok, CEO of Lazard Asset Management’s Middle East business, says that Lazard has decided, for the moment, to stay with the existing P-note structure for investment in Saudi rather than QFI, specifically because of a concern that it can’t hold both P-notes and direct shares simultaneously, which presents some logistical concerns. “It is clearly important to understand all the legal implications, and we will seek guidance from the CMA.”

Besides, it must be said that Saudi Arabia has been extraordinarily unlucky with its timing. “There was 10 years of very rapid economic growth: 10 years when global appetite for emerging market stories was very, very strong,” says Simon Williams, chief economist at CEEMEA for HSBC. “That’s diminished now. Oil at $100 a barrel is a very different proposition for Saudi Arabia at $50 a barrel. The decade of abundance was an extraordinary period for the Gulf, but I think that period may well be done.”

And in the middle of this plunge, Saudi happened to open its markets to international capital. “This makes it very difficult for this market to claim its share of global attention,” Williams says. “The timing is unfortunate and has worked against the Kingdom.”

Still, that’s perhaps a cyclical issue and investors both within and without Saudi Arabia do see plenty of reason to be excited about it in the long term. “From an asset management perspective what excites us is the domestic economy,” says Tolchard. It’s got all the right ingredients: demographics, a regulator that is very much first world, and an opportunity not so much about the oil price or the banking sector but the medium-sized enterprises that serve the Saudi consumer.” Khatoun notes the “unique positioning” of a market that combines scale, growth prospects and remarkably high credit quality, all combined with a dollar peg.

John Sfakianakis, regional director for GCC at Ashmore Group, is a particular fan: Ashmore was the second QFI to be qualified after HSBC, and is the only major international asset management group to have put its head office for the region in Saudi rather than Dubai or some other Gulf centre. He is bullish on everything from the “demographic dividend – an asset for future growth, with 52.2% of the population under 25”, to education, with around 200,000 Saudis educated in the world’s best universities under the King Abdullah scholarship , the future of women in the workforce, which he sees as not only a social but an economic necessity, and the prudence of fiscal reform against a backdrop of the lowest debt to GP ratio in all emerging markets. “Corporates are extremely healthy,” he concludes. “Banks are extremely well-maintained and monitored, with good balance sheets and low NPLs.” And he has little truck with any questions around the potential for social unrest. “I am often asked: are people out in the streets demonstrating? My basic answer is that these are idiotic questions.”

All well and good. But there’s a big potential misconception around Saudi opening, and it relates to the one subject that crops up in every single conversation on the Saudi markets: the country’s potential inclusion in the MSCI Emerging Markets index.

It seems to be taken as fact that Saudi will be included from 2017, but in fact, an interview with MSCI reveals that this is far from a certainty.

Sebastien Lieblich is executive director of index management research at MSCI, and is a member of a number of MSCI committees including, crucially, the MSCI index policy committee. He explains the process of ascension to the MSCI Emerging Markets index.

“It is a question we are answering on a daily basis,” he says. “There is great interest from international investors to see Saudi moving to international indices. But it is important to note that, as of this moment, there is no proposal on the table to include the MSCI Saudi Arabia into our emerging market index.”

This seems extraordinary: for all the talk, nobody’s even proposed it? But it is not quite as it sounds. It is not a question of the Saudi exchange or CMA having to pitch for inclusion and being remiss in doing so; in fact, the proposal has to come from MSCI itself, and is then followed by a period of public consultation, normally (but not always) for 12 months.

“That being said, we are now actively engaging with the international investors that have applied and been granted a QFI licence. We are engaging them on how easy or difficult it was to gain a QFI licence, and now that they are QFI-holders, the ease of trading in the market. This feedback will form the backbone of the decision to add MSCI Saudi Arabia on our review list for potential inclusion.”

If that’s where we’re up to – not even at the stage where it’s ready to be put on review – then the 2017 date seems optimistic. “This May or June 2017 date was given at the time of the announcement of the potential release of the regulation, and it was a purely theoretical, mathematical date based on the processes – that if everything was to be squeaky clean from the opening onwards, then the earliest MSCI Saudi Arabia cold move into the emerging market index would be May 2017,” Lieblich explains. “Now we are gathering feedback, and if the feedback is positive we may issue a proposal, and once we get feedback on that proposal we will be deciding whether or not to add it to the index, and that again would take 12 months to implement.

“So the 2017 date is not completely off the table, but it’s not an automatic date.” Is it feasible? “It is feasible, but it is highly dependent on the feedback we are getting from international investors, and more importantly on the effectiveness of QFI.”

So the investors themselves will be absolutely crucial to the decision, and therefore have a lot of power, which might well be remembered when the CMA considers objections about the QFI one-client rule.

What are the barriers to inclusion? Could pre-funding prove to be an obstacle?

“There are two different levels of potential barriers,” says Lieblich. “There are operational ones, like T plus zero and pre-funding; and then there are issues around regulation and opaqueness, where things may potentially need to be looked at again by the CMA to bring more clarity.” He also says that the foreign ownership limit of 20%, while not an issue yet, is relatively low compared to emerging market standings.

Naturally, MSCI is not the only index in town, and others are looking equally closely at progress in Saudi. FTSE Russell, for example, is a little further ahead than MSCI in its process, having put Saudi on its watch list for secondary emerging market status in September 2015; MSCI’s equivalent date rolls around each June, and the Saudi opening simply happened too late for it to be considered in this round.

“When we judge markets, we sort them against 21 criteria,” says Christopher Woods, managing director of governance and policy at FTSE Russell. “These are split into four broad areas.” The first is the regulatory environment, where Woods says they see no problems at this stage; the second is custody and settlement. “That’s a bit more problematic. There needs to be more competition in the custody space, and settlement is only pre-funded, which isn’t desirable for international investment.” Then there’s the dealer landscape, such as brokerage; and the fourth, around derivatives, isn’t yet relevant.

Pre-funding, says Woods, is “a very important issue and one that needs to be addressed.” So is it a specific change that needs to happen for emerging market index inclusion? And if so, what, precisely – T plus 2? “We’re not that prescriptive, and that’s not desirable,” Woods says. “The country classification committee draws upon experts in custody, in trading, and fund managers who operate in the region. That input is crucial to us, because it is one thing to look at what is theoretically in place, and another to see what is practically in place.” So, as with MSCI, the fund manager perspective is very influential. “It’s more than that,” says Woods. “It’s absolutely essential.”

What practitioners do agree upon is the enormous effect that emerging market index inclusion would have on this market.

“We think it would be utterly transformative,” says Khatoun. “Today MENA represents 7% of emerging markets GDP but its representation in MSCI Emerging Markets is less than 2%. That’s a material disconnect. The Saudi market opening up should bring a better alignment of economic weight with equity representation. It’s a massive step.”

Lieblich says that it’s also about much more than passive money being forced to go into Saudi when index inclusion comes. “If you look at the split of passive to active capital that follows the benchmark, the passive would be 20-25% and the active 75-80%, so the bulk of the funds actually come in on the active side,” he says.

But in Lieblich’s view, we shouldn’t get too hung up about a date. “A market opening up is a process which takes time,” he says. “Korea, India, Taiwan, the Chinese domestic market: these are experiences that take many years to come to a conclusion.” The other Gulf states to have joined the benchmark, Qatar and the UAE, took five years apiece, though Lieblich says the urgency and commitment from Saudi now is far greater than it was for those smaller states. “Joining the index is transformative, but the most important thing is to get the opening right.”