Inclusion in global benchmark can boost GCC inflows

(IMAD ALAEDDIN)   

Inclusion of Gulf stock indices in Morgan Stanley Capital International’s Emerging Markets Free (MSCI EMF) index has the potential to channel up to $50 billion (Dh183.5bn) worth of foreign capital into the region, analysts have said.

However, this inclusion can only be accomplished when countries and companies in the Gulf allow changes in their rules restricting foreign ownership of corporate entities.

“Since the MSCI EMF has become the reference index for global emerging equity markets and by far the most widely adopted benchmark for appraising emerging market fund managers, this inclusion would likely channel a large amount of funds, both benchmarked against and tracking the index, into these countries.

“In addition, this flow would be mostly from institutional funds with a long-term investment horizon, unlike most of the current flow that is characterised by short-term opportunistic hedge fund money,” analysts at Dubai-based investment bank Shuaa Capital wrote in a research note.

An initial estimate is that around $1.5 trillion is benchmarked against the MSCI EMF index.

If the UAE, Kuwait and Qatar are included in the index, around $50bn of net inflow could find its way into these markets from emerging market funds, assuming a neutral weighting for the region, Shuaa said.

Some GCC countries are better positioned than others to allow these changes. “The UAE, Kuwait and, to a lesser extent, Qatar, are relatively more accessible to foreign investors given their levels of liquidity and foreign investor limits,” Shuaa said.

“Of these, the UAE is expected to amend its company law soon, increasing foreign ownership beyond the current limit of 49 per cent for qualifying companies to, possibly, as high as 75 per cent sometime in Q2-2008 or Q3-2008.

This, however, does not necessarily mean immediate adoption by qualified companies, which have the final say in whether or not to allow and expand foreign access to their shares.”

In January, Kuwait amended its tax laws to remove any risk of capital gains taxes on foreign investors, which had been the main hurdle to foreign participation in the emirate’s stock market.

“It’s a chicken-and-egg situation,” said one stock analyst on condition of anonymity.

“Stock markets in the region can benefit from stable and researched fund flows from the outside world.

“But these cannot come in because most companies have hit their foreign ownership limits. Foreign capital wants access to this region because of the economic strength here, but needs to know that these markets are tracked by a respected index, which will not happen until restrictions are eased.”

The Saudi Tadawul, the largest Gulf market comprising around 45 per cent of total capitalisation in the region, is still fully closed to direct investment from foreign asset managers.

Currently, foreign investors can only access the Saudi market through funds and instruments.

Other GCC countries also impose high foreign ownership restrictions, with some of the sectors and large-cap companies fully closed to foreign investment.

Shuaa’s research report said: “There are no clear signs when the Saudi market will open up and liquidity levels in both Bahrain and Oman remain low.

“Given these conditions, we believe that inclusion will be carried out over two stages. The first stage, and most likely to occur over the next 18 months, is the inclusion of UAE, Kuwait and Qatar to the [MSCI EMF] benchmark.

“The second stage, likely to happen only after Saudi Arabia loosens its foreign ownership restrictions, will entail the inclusion of the rest of the GCC countries,” Shuaa said.

Gulf equity markets have managed to develop significant depth and attracted global attention over the past two years driven by economic growth reflected in the strong fundamentals of regionally listed companies.

In an increasingly value-strapped international equity situation, GCC markets have attracted the attention of international institutional investors and have seen large inflows from foreign money managers.

“The theme follows through into 2008,” Shuaa analysts wrote, “as we continue to see burgeoning interest from foreign investors as the GCC economic story remains intact, despite fears of a slowdown in the aftermath of the credit crisis in the United States.
 
However, the inflow of funds has been timid if compared to the combined size of the markets and has been concentrated in a couple of markets originating primarily from the more risk-tolerant, shorter-term pools collectively referred to as hedge funds.”

Shuaa attributes this restricted inflow to foreign ownership restrictions and the absence of GCC markets in the MSCI EMF index, “which is considered by most investors as the benchmark for tracking emerging markets performance”.

The exclusion of GCC markets from this “reference index” has kept the GCC markets “off the radar screen of most emerging market funds – removing them from the possible investment universe of most traditional fund managers”.

Local Market Performance

The UAE stock markets ended last week at an average price-to-earnings (P/E) ratio of 12.46 times, which one analyst called “eminently attractive and investible”. This positive figure is expected to drive liquidity flows into the markets this week.

The Dubai Financial Market General Index ended last week with a 2.4 per cent gain – a ray of optimism amid troubled world markets. But

year-to-date performance is still in negative territory with a 5.9 per cent decrease from the level at which it began 2008. Conversely, the Abu Dhabi Securities Market index gained only 0.7 per cent last week but is 7.9 per cent higher than where it started the year. The ADI was driven by gains in the Industrial Sector Index, which increased by 7.3 per cent last week and is 29.8 per cent higher year-to-date.

Aggregate UAE volumes was 13.7 per cent lower in the week compared to the first week of April, with 1.8 billion shares changing hands compared to 2.1bn shares in the previous week. Value of traded shares also dropped 10.3 per cent from Dh9.9bn to Dh8.9bn.

Analysts believe that rising rents will push UAE inflation higher in the first quarter of this year from last year’s 11 per cent average, while a Central Bank proposal to increase the lending limit to individual borrowers will fuel liquidity and inflation even further.

Foreign Ownership

If the UAE relaxes foreign ownership limits and finds inclusion in the MSCI EMF index, its equity markets could weigh up to 2.5 per cent of the resultant benchmark, Shuaa estimates. The UAE would then have a weight three times that of Egypt, twice that of Turkey, and slightly ahead of Malaysia.

Although MSCI already provides a GCC-wide index and individual GCC country indices under the “frontier” banner, the inclusion of these indices in the MSCI EMF requires a period of consultation and a further grace period that could extend to 12 months once the decision has been made public in order to avoid market distortions as well as allow investors time to adjust their portfolios.