Osman Raie, Managing Director and Senior Advisor - Saudi Equities, HSBC Bank Middle East Limited, explains how reforms of the country’s capital markets, and upcoming inclusion in emerging market indexes are transforming Saudi Arabia as an investor destination.
What are HSBC’s estimates for foreign investor inflows when Saudi Arabia joins the emerging markets indexes next year?
MSCI announced earlier this year that it will include Saudi Arabia in its Emerging Markets Index, with a weighting of approximately 2.4% with 32 securities being included. This will be a two-step inclusion process, with the first inclusion in May 2019 and the second in August 2019. At HSBC, we expect to see around $8bn of passive flows over the two tranches. In addition, we anticipate active flows from fund managers to be significantly greater, potentially bringing the total to $25bn.
FTSE Russell also announced it will include Saudi Arabia in its Emerging Market index, with an expected 2.7% weighting. We expect this to trigger passive inflows of approximately $6.4bn, with active inflows amplifying this figure. Implementation is due to take place over five tranches between March and December 2019.
In total, we expect that the combined passive and active inflows of the two index events into Saudi Arabia’s stock exchange of roughly $35bn over the next two years. This huge liquidity event is likely to transform the share of foreign investor ownership of the Tadawul, the Saudi Stock Exchange. This currently hovers between 5% and 6% in contrast to foreign ownership levels in Qatar and UAE that fluctuate between 8% and 9%. In terms of capital flows into emerging markets in the last decade only the process of inclusion for China A shares in the emerging market indexes compares in scale.
We have already started seeing the active flows. Earlier this year we witnessed a surge in fund flows as investors pre-positioned for the FTSE and MSCI announcements, which were widely anticipated. These have been instrumental in the performance of the Tadawul which has gained 11% since the start of the year.
Can you explain the main features of Saudi Arabia’s current economic and social reform?
Spurred by the pressure of the decline in oil prices in 2014, Saudi Arabia’s economy embarked on a rapid plan to transition away from its historical dependence on oil, underpinned by the three pillars of the Saudi Vision 2030. In economic terms, the visible manifestations of this shift include plans for large scale divesting of government assets and an increase in corporate and financial transparency. The social reforms that the country is experiencing have been well documented, and include the lifting of the ban on women driving and the widespread opening of cinemas across the country. That many of these changes were unthinkable 18 months ago indicates both the speed and scale of change.
Less discussed is the Saudi-isation of the country’s skilled labour force. Talented and ambitious young Saudis who have been educated abroad and are now returning in increasing numbers with commitment to drive long term Business plans in support of the Saudi Vision 2030. They are drawn by the government’s commitment to reform, the opportunities this is creating and the commercial and social future that these secure. Careers in both the public and private sectors now have an allure to foreign educated and working Saudis that they lacked before. The planned result is a more productive, skilled and motivated workforce as talented young Saudis succeed in the country’s major firms.
How are the changes affecting capital markets in particular?
Just as these social and economic reforms are challenging traditional perceptions of life and work in Saudi Arabia, the reform of capital markets and the process of doing business there are challenging the traditional notions held by investors.
With the help of the Corporate Governance Code, the regulator, the Capital Market Authority (CMA), has demonstrated to listed firms the need for a more open, transparent and corporate governance-led approach. The result – especially over the last year – has been that firms are now far more open to shareholders, who have increasingly good access to the senior management of major companies as well as much more detail on growth plans and key performance data.
We have seen an increase in analysts’ days and quarterly conference calls as company management generally becomes more receptive to meeting institutional investors. In addition to the requirements made of them by the regulator under the Corporate Governance Code, companies are themselves seeing the benefits of greater transparency in attracting foreign capital. They appreciate the advantage of an open, transparent, proactive approach to investor relations as they seek to stand out among the large pool of investment targets in the emerging market indexes.
Among these recent capital market reforms which will be most instrumental in attracting global investors?
In January this year, the CMA issued the third update to its Qualified Foreign Financial Institution (QFI) scheme, which was initially introduced in 2015 to enable international investors to invest directly in Saudi’s capital markets.
The first pillar of this reform was a reduction in the minimum size of investors who could qualify for QFI allocations, from $1bn of assets under management to $500m. In addition to widening the pool of eligible investors in the Tadawul, this change has been important in communicating to international investors that Saudi Arabia welcomed all types of investors, regardless of their size.
Another change has been the increase in the share that a single investor can hold of a stock to 10% from 5%. This Increase is important in providing investors with the means to make strategic investments if needed: there is a large number of global managers who need a major share of a company to take high conviction positions. The total aggregate limit of foreign holdings remains at 49% overall. While the changes are important in and of themselves, they also signal to the wider market the readiness on the part of the Saudi authorities to respond to feedback provided to them by the international investor community.
On top of that, foreign investors are also now able to aggregate multiple orders for the same stock, a huge step forward in terms of ensuring best execution. This is the common matrix that all investment managers use to validate price, in order to ensure they are getting the best value for their clients – a crucial piece of compliance – but managed order aggregation also alleviates volatility and makes pricing more efficient.
Meanwhile, Tadawul also moved this year from a Volume Weighted Average Price to an auction method for determining closing prices, which is in line international best practice and will encourage greater price efficiency, increased liquidity, reduced reduced market volatility and enhanced security for both investors and intermediaries.
Again, these shifts illustrate the CMA’s responsiveness to feedback, acknowledging the priority of fund managers to be fair to every investor in their fund. Tadawul offers investors as fair a process of execution as well clarity of pricing and liquidity as any other exchange in the region.
How do investors gain short exposure to Saudi?
At the moment, short exposure to Saudi can only be gained via synthetic exposure through Swaps. However, the CMA released regulations last year allowing investors to trade covered short sells and the investment banks – including HSBC - are working hard to put in place an appropriate structure to enable this trade. Commitment to this process on the part of the regulator and wider Saudi government is an essential part of the development of Saudi Arabia’s capital markets infrastructure. There is clearly no taboo around the practice of short selling, but rather a high degree of comfort as illustrated by the regulations that have already been released.
This is the region’s largest and most liquid stock market, comprising 172 listed companies on the Main Market over a diverse range of sectors. A full regime for short selling will provide an invaluable mechanism for investors to hedge positions. It will also be essential in narrowing bid-offer spreads, thereby increasing liquidity and market efficiency in the same breath.
This is another important step forward in attracting greater interest from international investors.