In the last issue, Funds Global MENA predicted the Saudi Arabian market opening would get off to a gradual start. If anything, inflows have been even lower than we predicted. George Mitton
Sometimes events that seem insignificant on their own can have huge effects. Take the Tunisian street vendor who set himself on fire and ignited the Arab Spring, for instance. Other times, events can be anticipated for months, occur – and then be followed by nothing.
It is not quite true to say the opening of the Saudi Arabian equity market, the Tadawul, to direct investment from qualified foreign institutions has been a no-show, but so far, inflows have been lacklustre.
The low level of foreign direct investment – so far, it is still too early to pass judgement – is in contrast to the excitement that surrounded the planned opening. In the run-up to the June 15 event, asset managers breathlessly repeated facts and figures that showed why foreign investor access to the Tadawul would be the biggest change to occur in the region’s capital markets in a decade. They pointed to the Tadawul’s market capitalisation, currently about $550 billion, and explained how investors would be desperate to gain exposure to companies operating in a country with a young and growing population of 27 million.
So why have foreign investors failed, so far, to pile in?
According to Arindam Das, regional head of Middle East and Africa, HSBC Securities Services, onlookers expected too much. There has been some interest in the market, he says. Some foreign investors have registered and executed trades; others are in the process of registering. However, to many minds, the opening has been a disappointment.
“Part of the reason could be that the expectations of an explosive opening were unrealistic in the first instance,” he says.
As Das told Funds Global MENA in the last issue, foreign institutions were only able to register with the Saudi authorities – such as the Capital Market Authority (CMA), the regulator – from the beginning of June. The documentation required is comprehensive. Many institutional investors seem to have found it difficult to fill out all the documents in time.
Speaking again in July, Das explains that the registration process turned up difficulties that further delayed institutions from getting the licences they need to invest in the Tadawul.
One problem is that the CMA requires applicants to give declarations of the investment activities of their affiliates as part of the registration, thus multiplying the amount of paperwork required for asset managers that operate an affiliate or ‘multi-boutique’ model.
Another problem is that the CMA asks for disclosure of underlying beneficial ownership of collective investment vehicles, such as mutual funds, including those domiciled in European jurisdictions that prohibit such disclosures. You work that one out.
Yet another difficulty is Saudi Arabia’s T+0 settlement cycle. In a T+0 system, trades settle the same day they are executed. This is out of sync with much of the world, where custodians have two or three days in which to check and validate trades before settling them (hence T+2 or T+3). To meet the requirements of T+0, investors have to pre-fund their trades in Saudi Arabia. For custodians, it means post-trade activities cannot be carried out smoothly.
Perhaps the biggest cause of low foreign inflows thus far is that foreign institutional investors already had a means of accessing Saudi stocks before the market opened. For now, many seem to prefer this method, which uses swaps to gain exposure to Saudi equities. Although ownership is indirect, and there is some counterparty risk, institutional investors are familiar with the swap system, which also offers flexibility in the settlement cycle, higher ownership ceilings and relaxed disclosure requirements.
There are seasonal factors, too. “The holy month of Ramadan and the Eid holidays that followed the market opening could also have dampened the activity level,” says Das.
Despite all these challenges, there is a good chance foreign participation on the Tadawul will build over time. But it will take just that, time.
“The fact that the market opening has not ticked all the boxes in the wish list of a foreign investor is not surprising,” says Das. “Any major initiative of this scale is always an iterative process, where regulations are progressively relaxed based on feedback from investors and comfort level of the regulators, which in turn brings in more investors.
“In terms of next steps, it is important now that the industry – investors and intermediaries – provides feedback to the CMA and Tadawul on the key changes that it would like to see in the regulatory and operational framework, and how the market authorities respond to those change requests.
“Some of the changes will take longer than others, but a roadmap outlining the direction of travel will be very useful in assuring investors that this is a market that welcomes them.”
Das’s suggestion of a roadmap to show investors how the Tadawul will continue its opening-up process is a sensible one. The Saudi authorities have so far shown themselves to be fairly good at consulting with the industry – the CMA published draft rules for the opening-up process last year and gave several months for market participants to comment on them. Perhaps a roadmap to help solve some of the administrative challenges around the registration process will be forthcoming.
However, something that has been overlooked in this discussion is whether foreign investors actually want to invest in Saudi Arabia right now. Yes, the Tadawul is still as liquid and (almost) as large as it was last year, when the Saudis first announced the market opening. Stocks such as chemicals firm SABIC are trading there, offering a chance to gain exposure to the Saudi petrochemicals sector (SABIC uses petrochemicals as a feedstock). Investors can also buy stocks in the likes of Almarai, a dairy firm, which offers exposure to the consumer sector.
But the precipitous fall in oil prices that occurred at the end of last year has yet to reverse and it is looking less and less likely that prices will recover any time soon. Perhaps they will never return to their 2014 highs.
This is a pessimistic view, from the perspective of the Gulf oil-exporting countries, but it is gaining currency. At the time of writing, in early August, a barrel of Brent crude costs less than $50, close to the lowest price in six years. Earlier this year, when the price climbed to $70, it seemed as though the price was rebounding, but that now seems uncertain. Indeed, Khalid Alsweilem, a former chief investment officer of the Saudi central bank, now a fellow at the Harvard Kennedy School’s Belfer Centre, recently wrote a report suggesting the world had entered a period of sustained low oil prices.
A low oil price is terrible news for Saudi Arabia, where the petroleum sector accounts for almost all government revenues. Analysts are questioning how long the country can sustain public spending with oil at these prices, a situation that is complicated by costly hostilities in Yemen and continued high expenditure for public-sector salaries. (King Salman, the country’s new monarch, announced some $32 billion of payouts to workers and pensioners when he was crowned.)
As increased scrutiny on Saudi Arabia draws worrying conclusions about its public finances, and as the shale oil industry in the US proves itself resilient even in a low-oil-price environment, perhaps it is sensible for foreign investors to delay their plans to invest in the Saudi stock market. We will have to wait and see.
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