Foreign inflows, investor quotas and Saudi Arabiaâs T+0 settlement system were discussed by our panel of asset servicers in Dubai. Chaired by George Mitton.
(regional head of investors and intermediaries, Middle East, North Africa and Pakistan, Standard Chartered)Arindam Das
(regional head of Middle East and North Africa, HSBC Securities Services)Jonathan Titone
(head of product development, National Bank of Abu Dhabi)
Funds Global: What effect will the low oil price have on government spending, custody flows and foreign investment in the Gulf region? Will the effects differ in different countries in the region?
Arindam Das, HSBC:
The oil exporters will be hit, whereas for the oil importers, it reduces the cost to their economies. We’ve already seen Egypt cutting interest rates and reducing subsidies. It gives them an opportunity to bring their economy back on the rails.
Among the oil exporters, Qatar, Kuwait and to some extent the UAE should not be impacted, but a country like Saudi Arabia, which has embarked on a significant amount of projects, will be affected if the oil price stays at sub-$50 a barrel on a sustained basis. They may have to scale down some of the projects.
The question is how long will the oil price remain at this level. If it swings back, in six months’ time, or in the next OPEC meeting, maybe they won’t have to cut the infrastructure spending. We have to wait and see how long this lasts.
Stewart Adams, Standard Chartered:
Depending on which reports you read, for Saudi Arabia the cost to extract a barrel of oil is very low, due to the abundance of supply and ever more efficient extraction methods. The burning question, excuse the pun, is how low does the price have to go before it has a major impact on the country’s economy? Some economists are saying Saudi can sustain very low oil prices for three to five years.
You asked, George, if the low oil price affects custody flows and foreign investment in the Gulf region. We have seen some impact already. There were outflows, across the region at the end of last year, and the falling equity prices wiped out most of the gains investors made earlier in 2014.
Reviewing our assets under custody, while the net result over the year is very positive, you can see a trend in certain countries where changes in strategy have seen some assets leaving. Also, the correlation between equity prices and oil has been very close, and even in Dubai, which is not oil dependent, the market has been affected.
Jonathan Titone, NBAD:
We’re already seeing some institutional investors on the sidelines. We’re seeing foreign traded volumes on the ADX [Abu Dhabi Securities Exchange] and DFM [Dubai Financial Market] decrease as investors wait and see what governments are going to do. Saudi Arabia can maintain current spending levels for a few years. Given the geopolitical situation in Saudi, our economists tend to think their spending will continue.
Funds Global: What about the likes of Bahrain and Oman, which are not as wealthy as Saudi Arabia. Can they sustain spending in this environment?
We’ve already seeing Bahrain and Oman cut gas subsidies to help meet the budget gaps, and they have said they’re likely to do that again. Those less wealthy governments probably will have to cut. The likes of Saudi, the UAE and Qatar probably can sustain spending for a few years, at these kinds of levels.
With the current pricing and without scaling back any of the capital investments, Oman and Bahrain are almost certain to run into a deficit. The chances are high that Saudi will also slip into one. That doesn’t mean they have to cut spending, but they can’t keep doing it for years.
The question really is, do they need to do it for years? Shale producers in the US are already cutting down their production. That will bring down the total amount of supply in the world and ensure that oil prices go up. We’re probably not talking about years of subdued oil prices.
The Saudi move is well thought out. They’re not expecting the oil price to stay low for several years, and they have made some bold moves. The fact that they said the next OPEC meeting will be in June or July means they will not take any decisions on pricing or supply for the next six months. That has sent a strong signal to the rest of the world that they are comfortable with this price of oil. The US seems to have responded and their supply has gone down to some extent already.
The impact across the region has been felt and I would expect the budget process in smaller countries to be aligned to the oil price cuts – hence some dependent projects may be delayed. Outside of the region, we have seen the production of shale oil in the US reducing and also the UK has delayed projects in the North Sea as the extraction cost are high, hence the profit required has been reduced or negated altogether.
It may in fact be a great opportunity, because when everything is rosy and there are bountiful oil revenues, you are not challenged to make yourself efficient. Some of these shocks may force governments in the Gulf to look at whether all the new projects really add economic value to the country.
Funds Global: That’s an optimistic view. On the other hand, might the low oil price have a trickle-down effect on the economy, causing projects to be scaled back and job losses?
The low oil price will not be sustained long enough to cause a large-scale economic crisis. From a custody-flows perspective, assets under custody have come down, but in our experience that’s because the markets have fallen, rather than because foreign investors are taking their money out. A lot of the money that has gone out is local retail money, rather than foreign investment.
Maybe I am an optimist, but I see an opportunity here, because investors had started to ask if regional equities were overheated. In a way, these sorts of corrections help to make the markets more attractively valued.
Funds Global: What demand do you expect to see for equities this year? Could low oil prices put an end to the rally that has boosted MENA equity prices in the last two years?
Opening the year, equities will be softer, given the recent market setbacks, the loss of wealth and the high volatility we’ve seen. It’s going to take time for institutional investors to come off the sidelines and look again at the fundamentals. There isn’t a clear picture in the near and medium term, so they seem to be playing a wait-and-see game.
However, let’s remember many of the significant regional projects are not oil-related. Look at the Dubai Canal or Mohammed Bin Rashid City. The developers require thousands of people for these projects, hence the economy feels the benefit of the onward spending. Some of their original investments may come from oil reserves. However, other funding sources are being used and these projects will still be completed.
You asked, will investors stay away from the equity markets? They are probably eager to get back into the markets and take advantage of the low prices. If I was looking to launch a fund, I may go now, because prices are low, and take the advantage of the equity growth.
It’s an interesting question because for several years we have complained about the lack of correlation between economic growth and capital markets growth. The reason is that many of the stocks listed in the local markets are not directly related to the petrochemicals industry. When the economy in UAE grew, three to four years back, the capital markets did not grow at the same pace, and it is only in the last year or two that we have seen the capital markets bounce back.
Now, it is the other way round. There is a possibility of an economic shock or, at the least, a slowdown, and the capital markets have responded very quickly. But if you take a step back and ask how deeply certain individual stocks will be affected by the price of oil, it is not clear why they would be. There may not be a huge correlation, and that is why institutional investors haven’t moved out en masse. It is retail investors who have reacted more adversely to the developments.
It is more of a sentimental reaction than a scientifically backed reaction. However, if the oil price continues to fall or stays at these low levels for a sustained period, this will impact on capital expenditure as well as the performance of listed companies, which will in turn impact on foreign investments.
Remember that the institutional investors watch the market daily, hourly, whereas the retail investor doesn’t. The retail investor can catch a cold very quickly, because he’s taken his eye of the market, even for a few days. Some of the retail investors may have leveraged their positions and, by not being alert to the changes, many will have received a margin call.
Yes, if you look at the UAE in the recent slight uptick in stock prices which followed the price of oil, it was primarily driven by retail investors, per the stock exchanges’ published statistics. It was sentiment-driven, while the institutional investors have not re-engaged in trading despite the lower stock prices.
Funds Global: It was recently reported that the opening of the Saudi stock exchange to qualified foreign investors, scheduled for the first half of 2015, will happen in April. Are regulators and market participants ready for the change?
It would be wrong of me to say that everybody is ready and waiting for the market to open up. Everybody is getting ready, which is fine because there is still time. I don’t know the source of the report that suggested an April opening. We haven’t heard anything from the regulator about the market opening in April. What might happen is – and I’m just guessing here – they might say the market is open in April for registration, so new QFIs [qualified foreign institutions] can register themselves as QFIs, open accounts with custodians and brokers, and actual trading will start from, say, June. This is just speculation, though.
While I can’t comment on the April opening, I would be very surprised if the June deadline is missed. I believe the market will open and custodians will get themselves ready. But will that readiness meet all the requirements of the foreign institutional investor community, or the global custodians? I don’t think so.
For example, a typical foreign investor, global custodian or broker dealer will not be comfortable with the T+0 system. There are workarounds. You can extend credit so clients don’t have to prefund the market, but there are nuances to it. Who will extend credit? Is it a local bank in Saudi Arabia or an international bank? Who will you extend credit to, a global custodian or the end investor?
But pre-funding is not the only challenge in a T+0 model. The point is that in a T+0 cycle, a trade will settle without any instructions from a global custodian. That is, pun intended, very unsettling for a global custodian because a trade takes place, and instantaneously it settles, which makes their settlement instruction almost redundant.
So, to answer your question, I am quite confident that the market will open in the first half of 2015 and we will be ready, but there will be caveats. Not every box will be ticked.
There’s not much more I would add to what you’ve said, Arindam. Companies, investors and service providers are getting ready for the market. However, we need to set the expectations at the right level as statements are made and people can get excited; however, we have experienced a change in the timelines. It is key to keep the communication lines open.
We have large investments from our client base in Saudi, and went there on a due diligence trip a couple of weeks back. I guess it’s the same story everybody is hearing. The market opening is said to still be happening in the first half of 2015, but there are a lot of things that still need to be sorted out.
To my knowledge, the QFI application has still not been published. There are also some questions over the foreign ownership limits – for instance, the QFI limit per security, and an aggregate 10% market capitalisation limit on foreign investment. How that’s all monitored, recorded, how any breaches get reversed, and whether offshore instruments such as p-notes are included in the calculations remains unclear.
While we are all awaiting the final regulations, HSBC has been working with the Saudi authorities to get clarity on some of these points. We believe the 10% limit is on the overall market cap. So let’s say the market cap is $500 billion, that means $50 billion is the aggregate foreign investment through all routes taken together, which includes the p-note route. The 5% and 20% per-security limits are specifically for the QFI route – the former for a QFI or QFI client plus affiliates, and the latter for all QFIs and QFI clients taken together.
Many of the limits are market-level, or across QFIs, so no one institution can monitor it, but the Tadawul can. However, unlike some other emerging markets, these are pre-validated trades, which helps to prevent a breach.
The 10% of market cap limit is the issue where you might see a breach, because the overall market cap can change significantly. Last year, it was almost $600 billion; now it’s about $500 billion. Even if you stop further inflows, you may still breach the cap. Our recommendation is not to force a sale because of a market movement. Over time, the breach should get addressed either if market goes up or because of sales by QFIs.
Funds Global: Estimates for the amount of foreign investment into Saudi equities after the opening-up have varied widely. What do you expect to happen?
The last HSBC report I saw talked about $27 billion coming in, but only after an upgrade by MSCI, and that was before the oil price decline. I would like to remain optimistic, but I don’t think there will be a phenomenal inflow immediately after the market opening. We need to be reasonable in our expectations given that Saudi will not be included in the MSCI EM index in 2015 and there will always be some teething problems with any new market opening – the important point here is that the largest market in MENA is opening, and that augurs very well for the region in the medium to long term.
It could be a big range – I would think from $10 billion-$20 billion. If you do the maths on the MSCI GCC index, Saudi Arabia’s weighting is about 57%.
But if you’re talking about 2015, that’s too optimistic. If the estimate is based on inflows attracted by the UAE and Qatar, we have to understand that UAE and Qatar are already in the emerging markets index, which investors follow. Earlier, they were in the frontier markets index, which investors also follow.
Saudi Arabia will not be in any of these indices for at least the next one year, after which they can be included in the EM index, which is when passive investors will allocate their funds to Saudi. Before that it will mainly be active investors with specific interest in Saudi. It will also depend on how comfortable investors will be with the settlement and custody model.
We don’t see a massive stampede going in initially, especially with the limitations on qualified foreign investors. It will be only the largest management companies, limited to those with at least $5 billion in assets under management, and will be further limited based on how long it takes to overcome the legal and compliance obstacles. Near term, the conservative estimates on new inflows are probably correct.
Funds Global: Asset servicers have been promoting a variety of value-added services, such as risk analytics and middle- and back-office outsourcing in recent years. Is this a profitable way to engage with institutional clients in the MENA region?
As long as they’re getting paid for it. The problem is, nobody wants to pay!
Correct. That’s exactly the issue. You see a lot of “scope creep”. Clients think if they buy custody, some of the above services are part of the basic solution.
With regard to middle-office outsourcing, the key question is, what is the scope of middle office, as there are a variety of definitions in the market?
Another consideration is: are the managers sophisticated enough, and large enough, to want to outsource these functions? It can be a costly process to outsource, and savings may not be immediate. In Europe, the significant cost saving was the reduction in staff as the fund manager could reduce the wage bill. This may not be as easy in our markets – the concept of TUPE [Transfer of Undertakings (Protection of Employment) Regulations] has not evolved.
Is this a profitable way to engage with institutional clients? Yes, if you receive the appropriate fee. For a service such as risk analytics and performance measurement, this gives the client an independent report that could be used as a marketing tool to generate new investments and clients
The value-adds actually have to add value and be applicable to the client base to whom we offer them. Here, shops tend to be smaller, they have more diverse needs, and it’s more bespoke, and not necessarily scalable. In this region, relationships and trust still matter foremost.
In terms of broker, middle-office and back-office outsourcing, there are likely significant opportunities. If we want to encourage the mutual fund industry here, a product that eases market entry and distribution barriers, that’s up to international standards, where they can focus on their investment, would be useful. But it’s not like in more developed markets where a plug-and-play, one-size-fits-all solution would be relevant.
Yes, the key drivers in outsourcing are scale and skill. There isn’t scale in most of the sectors here, and because there is no scale, it is hard to create a standardised proposition. The other point is skills. In the more developed markets, the middle office is complex, so it makes sense to outsource it. Here, the asset classes are fairly simple. You can employ a few people doing spreadsheets and manage them until such time there is a problem.
Funds Global: How important are family offices among clients in this region? Do you see signs of increasing sophistication from these investors?
I do. We have seen chief investment officers appointed to some of the larger family offices. They are looking to become more sophisticated, more professional, in their approach, and they’re looking further afield in their investments to Europe, the US, Asia and Africa.
The family offices tend to be linked, obviously, to large corporates, and I have even seen corporates launching fund structures, not under the family office banner, but because they see growth and investment potential. This will continue to develop, but the good thing is the corporates have critical mass and the potential to invest immediately.
They have more needs in terms of holistic reporting, so we’re seeing an uptick in interest there, looking at different asset classes, and requiring the consolidation of reporting. However, an interesting balance is needed, to see who can offer them the products that will achieve these things while maintaining the privacy, confidentiality and trust that is important to family offices.
The asset classes they invest in are becoming more diversified and sophisticated. The new generation is more adventurous in terms of investment. Family offices have, historically, had a closer affinity to private banks, which in turn use sub-custodians. But from a sub-custodian perspective, the growth of these investors is good for us because it leads to bigger custody flows.
In a few cases, I’ve seen larger family offices asking for an NAV [net asset value] to be struck, because they want to look at their assets as if they were invested in a fund. This allows the family members to understand exactly what they have invested in and is another step in sophistication.
Funds Global: Have you seen any moves toward mutual fund passporting in the MENA region in recent months or does it remain a dream? What other regulatory developments do you hope to see in the coming year?
The short answer is I haven’t seen any concrete moves. I have seen steps in the reverse direction in terms of barriers on distribution of funds domiciled elsewhere, such as fees for foreign funds.
There are many ways to improve cooperation between the Gulf Cooperation Council countries, such as a single point of entry for account opening for investors, or a GCC fund passport. The single point of entry could be a simple first step. If there could be one standard, one system, the same training of the regulatory staff, to get everybody comfortable with sharing information across them, with having multiple entry points for that – this would be a step forward. If they could do that, I’ll believe the mutual funds passportability is possible. It’s something for us to work together on, as custodians, to lobby the market for such improvements and efficiencies.
It would be great, but it will be difficult to implement. As organisations, we can keep discussions open around the subject, but a solution is a long way off.
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