Opening the market: When current plans are finalised, foreign capital is poised for action

The size and buoyancy of Saudi Arabia’s hydrocarbons-driven economy mean that the country has long been of interest to foreign investors. As the most obvious point of entry for investors, the Saudi Stock Exchange has therefore been the focus of mounting interest into the possible opening of the economy to investment from non-residents. Following a series of moves aimed at preparing the market for greater foreign participation, in July 2014 the Capital Markets Authority (CMA) made the long-awaited announcement that it intended to open the market in the first half of the following year.

RULES TAKE SHAPE: Rules for qualified foreign investors first began developing in 2008, and these were originally slated for promulgation in 2013. Despite the delay, the opening of the Saudi Stock Exchange has been a key component of the government’s long-term economic diversification strategy, by which it aims to develop the Kingdom’s non-oil economy and private sector, boost the competitiveness of domestic firms, and create employment opportunities for the Kingdom’s young and growing population. Indeed, the upgrade in June 2013 of the UAE and Qatar from “frontier” to “emerging market” status by MSCI, one of the most influential providers of investment decision support tools, heightened expectations concerning Saudi Arabia’s exchange.

GRADUAL PROGRESS: Long-term observers of the Kingdom’s economy had previously pointed out that changes of this significance have typically been incremental in nature. This has also been true of the Saudi Stock Exchange’s gradual opening to foreign investment, a process that has seen steady progress over the past half-decade.

For many years investment in mutual funds was the only means by which non-resident foreign investors could participate in the Kingdom’s exchange, but in 2008 the regulator introduced new legislation which allowed foreigners to enter the market via swap contracts. This enables foreign investors to gain exposure to Saudi stocks through licensed domestic brokers, which hold shares on their behalf. While this was an important step on the road to opening up the market, the swap model has its drawbacks: investors abroad are able to receive dividends and profits from their investments, passed on to them by their Saudi brokers, but they are not granted voting rights. The introduction of swap agreements, therefore, has had a limited effect on the exchange: between April 2009 and April 2012 they accounted for a total of SR76.6bn ($20.4bn) worth of transactions, according to a report issued by HSBC, for an overall capital inflow of SR4.8bn ($1.3bn) – or just 2.2% of the total transaction value of SR3.5trn ($933bn) for the two-year period.

ETFS: In 2010 the door to foreign investment was nudged open a little wider with the introduction by the CMA of legislation governing exchange-traded funds (ETFs), according to which foreigners can also invest in the new instruments. Having achieved considerable popularity in global markets thanks to the easy access they grant to a diverse array of stocks and indices, there was some expectation that their implementation would bring about an influx of capital from abroad. However, as with other markets in the region, ETFs have not caught the interest of investors. The challenge of establishing ETFs as a popular instrument on the exchange is exacerbated by the fact that market makers (the entities licensed by the CMA to provide the ETF market with liquidity by providing continuous bids and offers to traders) are not able to short-sell, according to the current regulatory framework. As of late 2012 only three of the funds had been listed and trading frequency and volume remains low for all of them.

January 2012 saw yet another step towards the introduction of new foreign investment rules, with the announcement by the CMA that foreign companies would be allowed to cross-list on the exchange for the first time. The technical details have yet to be finalised, but officials from the exchange expect that a fully defined listing framework for foreign companies will be in place after the successful completion of the regulatory transition currently under way between the exchange and the CMA.

RECENT SIGNALS: A number of more recent changes in the Kingdom have also been regarded as preparatory steps for the opening of the market. The June 2013 shift of the weekend from Thursday and Friday to Friday and Saturday brought Saudi Arabia into line with the other GCC countries and allows for greater coordination with global business. More specifically to the bourse, the appointment of Adel Al Ghamdi, former general manager of the corporate finance and issuance division at the Saudi CMA, as CEO of the Saudi Stock Exchange in August 2013 was widely interpreted as positive. “The indications are that the plans are being put in place to open up to foreigners. It’s encouraging that someone who understands foreign investors is put in an important place,” Oliver Bell, London-based money manager at T. Rowe’s Africa & Middle East Fund, told Bloomberg at the time of Al Ghamdi’s appointment.

The CMA has also been engaging in a little housekeeping over the past year. In November 2013, for example, it introduced a regulatory framework that governs the trading of companies with large accumulated capital losses. Under the new regime, firms with losses of more than 75% of their capital will be “flagged”, and will have to publish a financial rescue plan to maintain their listing. Companies with losses of over 100% of their capital face the prospect of having trading in their shares suspended for a minimum of two full financial years and until such time as their capital is restored to a position below the 75% loss level. The move brings a welcome improvement in transparency and prudential oversight as far as Saudi investors are concerned, but it is also an important accommodation to international best practice and will therefore reassure foreign investors.

THE BENEFITS: The impact of the new rules that are set to open the exchange to direct foreign investment is likely to be significant. For foreign investors, the possibility of gaining exposure to the economy with the largest GDP in the Arab world is clearly an inviting prospect, but there are numerous potential gains on the Saudi side of the equation as well – the most obvious of which is a boost in liquidity. Just how much capital might be brought to Saudi stocks by foreign investors is difficult to forecast: according to press reports, the draft rules for qualified foreign investors specify that only foreign investors with assets under management of $5bn or greater will be invited to interact with the exchange, a stipulation which reflects the CMA’s concern that the market is not flooded with “hot money” that is likely to disappear as quickly as it arrives.

However, despite the short-term drawback of capital from emerging markets as the US Federal Reserve tapers its quantitative easing programme, it is likely that asset managers will continue to see them as a useful place to park money in the coming years. Some analysts foresee capital inflows of up to $35bn once the rules allowing direct foreign investment in the market are implemented, which represents a considerable volume in comparison to a total market capitalisation of around $525bn as of July 2014.

The proposed rules, with their focus on institutional investors, also carry the promise of improving market efficiency, as longer-term investments help to offset the shorter and more volatile trading patterns of the exchange’s retail investors. Moreover, the increasing participation of institutional investors would help to drive yet more improvements in market transparency and corporate governance, as well as provide a receptive client base to which the exchange can introduce advanced instruments. Some uncertainty still surrounds the implementation of the rules, both in terms of timing and their technical details, but the opening of the market to foreign investors will be an historic moment for the exchange.