Saudi Arabia kicks off two-year market upgrade cycle

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SOURCE:Arab News

Time: April 08,2018

The Saudi stock market (known as the Tadawul) is large enough that its rapid inclusion could potentially destabilize other EM constituents. So it will instead join the FTSE Emerging Index in several stages between March and December 2019.
Over the years, Crown Prince Mohammed bin Salman and the Kingdom’s Capital Market Authority have made substantial modifications to Saudi Arabia’s equity market infrastructure. Developments include introducing a two-day settlement cycle for trades, requirements for cash payments to be made on delivery of shares (delivery versus payment), proper failed trade management, the introduction of short selling, and securities borrowing and lending facilities.
So it comes as no surprise that these steps to make the Tadawul exchange compliant with international trading standards are now being recognized by the EM investment community.
As the largest economy in the Middle East, Saudi Arabia will make up approximately 2.7 percent of the FTSE Emerging Index, which could potentially bring in billions of dollars in passive inflows.
And with the state-owned Saudi Aramco oil company set to be privatized, Saudi’s weight in the FTSE Emerging Index may increase to about 5 percent over time.
In our view, this is testament to Saudi’s ambitious capital market reform agenda. Now that the bulk of fiscal reforms have taken shape, coupled with higher oil prices and the anticipation of the Kingdom’s inclusion into the MSCI EM Index (widely anticipated to be announced in June this year), we expect investors’ appetite for Saudi stocks could likely increase.
Saudi Arabia remains a reform story on many levels; capital-market reform has culminated in FTSE Russell’s decision to classify it as an emerging market. In our view, it’s encouraging that the bold fiscal reforms we’ve seen will likely put Saudi’s economy on a more sustainable footing over the long term, as Saudi Arabia has already taken steps to reduce its reliance on oil revenues and to diversify its economy. While challenges persist, we think the overall macroeconomic fundamentals are on an improving trajectory.

The Saudi stock market’s classification last week to secondary Emerging Market (EM) status within the FTSE Russell Global Equity Index Series sends a strong signal to investors that the country has made significant progress in opening up its capital markets and has improved its levels of corporate governance and transparency.

Bassel Khatoun

Finally, social reforms continue unabated. The lifting of the ban on women driving and the introduction of new forms of entertainment will create additional investment opportunities. As a result, we remain constructive on equity market sectors where valuations do not capture this long-term potential. In particular, we believe the Saudi banking sector has growth potential through improving margins in a rising interest rate environment, as Saudi banks take largely non-interest bearing deposits. Banks are also generally well-padded against non-performing loans, and have capitalization levels above regulators’ stringent requirements. On the other hand, we also think stocks in insurance, health care, education and consumer staples industries look attractive, as the government implements policies to unlock their potential.
Looking further ahead, Saudi’s inclusion on the MSCI EM watchlist means it could also be promoted to EM status in June this year— though nomination is by no means a guarantee.
Pakistan’s upgrade to EM status in May 2017 came after just one year on the watchlist. We anticipate Saudi Arabia could follow a similar fast pace of index inclusion.
An MSCI consultation with asset owners, asset managers and those on the sell side will determine Saudi’s upgrade to EM status. So far, investor feedback has been positive. We’d expect Saudi Arabia’s journey through the MSCI process to likely play out as follows: inclusion in the MSCI EM Index to be announced June 2018, with a phased-index implementation starting in May 2019.
On current standing, Saudi Arabia would have a potential weight of 2.3 percent of the MSCI EM Index, and could almost double with the IPO of Saudi Aramco (the exact weight will depend on Aramco’s valuation and free-float).
Of course, there are risks to the Saudi market, including a potential oil-price decline. The Saudi Aramco IPO is its crown jewel, so there is a vested interest in higher oil prices. Increased “Saudization” — the removal of subsidies and imposition of levies — will likely also pressure some sectors, in particular those that are heavily reliant on expats or expat work-forces.
However, the FTSE Russell announcement marks the start of a two-year upgrade cycle for Saudi Arabia. With plans from the Saudi government to increase the number of listed companies in the Tadawul from 170 to 250 by 2022, we think this is just the tip of the iceberg.

  • Bassel Khatoun is managing director for frontier and MENA at Franklin Templeton Emerging Markets Equity.

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