Asha Mehta, CFA
Senior Vice President, Portfolio Manager
- MSCI likely to upgrade Saudi Arabia into its Emerging Markets Index.
- Saudi Arabia has made significant strides toward modernizing, globalizing, and diversifying its economy.
- Saudi Arabia would enter the index at a 2.3% weight with the potential for higher weighting in the future, especially in the event of a proposed Saudi Aramco IPO.1
In June 2015, Saudi Arabia opened its market to foreign direct investment. While a milestone for the country, the conditions set forth for foreign participants were highly restrictive and significantly limited global investment. Prior to the market opening, foreign investors could only gain access through complicated swap protocols and were limited in both the size and scope of their investments. On June 1, 2015, MSCI launched the MSCI Saudi Arabia Indexes as standalone market indexes and noted that improved market accessibility was a precondition for advancement to the MSCI Emerging Market (EM) Index.
In June 2016, Saudi Arabia launched its “National Transformation Plan,” a broad based initiative to modernize, globalize, and diversify its economy. A pillar of this program is an effort to increase foreign investment. The progression of Saudi Arabia from standalone status to a constituent within the MSCI EM Index would further this objective, offering the potential to increase investor awareness, generate regional and international capital inflows, and provide greater integration with global markets.
With the goal of being reclassified into the MSCI EM Index, the Kingdom implemented the reforms advocated by MSCI, including relaxing the eligibility constraints on foreign investors. Saudi Arabia’s Capital Market Authority (CMA) opened its Qualified Foreign Financial Institutions (QFI) program to additional investors by streamlining the process to become licensed and registered and by lowering the assets under management required from $5 billion to $500 million. Regulators raised foreign investment limits from 20% to 49% to attract additional foreign inflows. The CMA aligned its trading practices to be consistent with global norms. First, the settlement cycle was extended from T+0 (requiring pre-funding) to T+2.
Second, Saudi Arabia accepted the use of omnibus account structures for clearing and settling trades. Prior to this, investors were required to operate within segregated trading and custody accounts. Saudi Arabia, in response to investor demand and independent of MSCI’s criteria, has also opened its market to short selling and securities lending.
MSCI Upgrade Decision
On June 14, 2016, as part of its annual Market Classification Review, MSCI acknowledged Saudi’s plan to liberalize its capital markets, a critical step toward gaining acceptance into the EM index. For promotion, the country must pass three levels of evaluation. The first is to demonstrate that MSCI’s guidance has been incorporated into a strategy. The second is to show that the plan has been executed. Saudi Arabia embraced this step in 2017 by addressing both market accessibility and operational deficiencies. In recognition, MSCI added the country to its watch list for a potential 2018 upgrade. The third level is for MSCI to solicit feedback from market participants on the effectiveness of the reforms. If investor feedback is supportive, MSCI is expected to announce that Saudi Arabia will be promoted into the MSCI EM index as part of its June 2018 Annual Market Classification Review.
Promotion to the MSCI EM index, and even growing expectations of inclusion, likely would influence trading in affected stocks. Actively managed funds might opportunistically buy into the market, anticipating flows from EM passive funds, which typically are precluded from entering the market prior to actual implementation of the index change.
If MSCI upgrades Saudi Arabia, we estimate inflows from passive investors on the order of $9 billion. The magnitude of net flows from active investors, and their timing relative to reclassification, would be difficult to project. For example, active investors may use reclassification as an opportunity to exit positions.
History has shown a pattern of rallying local markets ahead of EM inclusion events, e.g., UAE and Qatar in 2014 and Pakistan in 2017, consistent with anticipatory active inflows.2 Recent EM inclusion events also suggest underperformance after upgrades. This was the pattern in both UAE and Qatar as well as in Pakistan, which plummeted 15% after its 2017 upgrade.
In the Saudi case, valuations are attractive relative to historical levels but high on a forward PE basis relative to the broader MSCI EM Index: 15 versus 12, respectively. (MSCI, April 30, 2018) 3 Saudi Arabia might institute measures to avoid post re-classification market underperformance, but it’s not clear what steps it might take or how effective they would be.
Promotion to MSCI’s EM Index would be a landmark event for Saudi Arabia’s capital market evolution. It would represent a vital step toward globalization, diversification, and expansion of its economy. The Kingdom’s goal is to lift itself from the 19th largest global economy into the top 15. Inclusion in the MSCI EM Index would support this goal, as increased investor awareness might translate into increased foreign investment, tighter integration with global markets, and reduced risk premium.
We see significant merit in investing in Saudi Arabia. It is an under-developed, under-exploited market whose leadership has the conviction to implement social, political, and economic reforms. Risks of investing in Saudi Arabia include geopolitical concerns within the region, stability of the monarchy, the country’s economic dependence on oil, as well as a myriad other factors inherent in investing beyond developed markets.
Saudi Arabia is, however, very much a story of reform, both economically and socially. Inclusion in the MSCI Emerging Markets Index would acknowledge the Kingdom’s establishment of a reliable market system and, in turn, would likely increase investor confidence and attract foreign capital.
1 Nothing herein should be considered investment advice or a recommendation to buy or sell a specific security.
2 “Transition Strategies Around MSCI Country Reclassifications.” Acadian Asset Management. December 2015.
3 It is not possible to invest directly in any index. Every investment program has an opportunity for loss as well as profit. Past results are not indicative of future results. Index Source: MSCI Copyright MSCI 2018. All Rights Reserved. Unpublished. PROPRIETARY TO MSCI.
Potential Index Weight
Reclassification would be implemented in two steps, coinciding with the May 2019 Semi-Annual and the August 2019 Quarterly Index Reviews. Upon acceptance, Saudi Arabia would be granted a 2.3% weight, making it the third largest representative from the EMEA region in the index (behind South Africa with 6.7% and Russia with 3.4%). While MSCI is deliberating inclusion, FTSE announced in April 2018 that it will promote Saudi Arabia into its Emerging Market Index from its prior unclassified status. In March 2019, Saudi Arabia will join the index with a 2.7% weight, positioning it as the tenth largest constituent.
Saudi’s index weight within EM indices is expected to grow as the country implements its ambitious reform programs, which include reducing the country’s reliance on oil revenues and promoting growth through privatization. The Institute of International Finance (IIF) reported that the Kingdom plans to privatize several state-owned enterprises, potentially doubling the size of its stock market and, commensurately, its index weightings.
Most prominent among potential privatizations, the Kingdom may sell shares in Saudi Aramco, the world’s largest oil exporting company, potentially offering a 5% stake later this year or next. The valuation is widely debated, often estimated from $1-$1.5 trillion to as high as $2 trillion. The uncertainty derives from a variety of factors, including oil prices, dividends, royalties, and the size and location of listing.
The current IPO proposal would offer up to 5% of the company. Assuming a conservative $1 trillion company valuation, the deal would set a new record, exceeding Alibaba’s $25 billion sale in 2014. It would inject $50 billion into the Saudi stock market, materially increasing its total capitalization, by approximately 10%. If Aramco were to meet criteria for EM Index inclusion, Saudi’s post-IPO weight might double, surpassing Mexico and Russia.
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