Saudi Arabia’s emergence out of index exclusion

Saudi Arabia is now on course to be upgraded to emerging market status in June 2018, a move which would likely attract significant foreign inflows and rank it the seventh largest country in the emerging market index.

The Kingdom of Saudi Arabia – the cradle of Islam and a country soon to boast the world’s tallest building as well as one of the world’s largest listed companies – has long been a blind spot for index aware emerging market flows. Companies listed on the local exchange are considered by index provider MSCI neither developed, emerging or frontier, meaning they are in index limbo and as a result overlooked by most investors. This is, however, set to change. On June 20th 2017 MSCI announced the result of their annual market classification review, adding Saudi Arabia to the MSCI emerging market watch list. This move has put the country on course to be officially upgraded to emerging market status in June 2018, and to start trading as an MSCI emerging market in 2019.

The emergence of an emerging market
While Saudi Arabia has a rich history, it was only in 1987 that a stock exchange was opened and only in 2015 that foreign investors were allowed to invest in Saudi listed equity under the restrictive ‘Qualified Foreign Investor’ program. Capital market reform in Saudi Arabia has however gained pace as policy makers move to better diversify the economy and funding sources. Over the last two years, the regulator and Saudi Stock Exchange (Tadawul), have introduced a number of market reforms including raising foreign ownership restrictions from 20% to 40%, accommodating securities lending and short selling, and easing the foreign registration process. This has all been undertaken in a bid to attract more foreign capital into the economy, an ambition which should be significantly supported by MSCI emerging market inclusion.

Foreign ownership currently below 2%
Emerging market index inclusion would likely mean inflows of over $35bn and rank Saudi Arabia as the seventh largest country in the emerging market index. This would create a meaningful ripple in a market where foreign ownership is currently below 2%. Additionally, Saudi Arabia’s index clout could rise quickly if Aramco – Saudi Arabia’s crown jewel oil asset – is listed as anticipated in 2018. Valuations for the company are extremely varied, including at the high end Saudi’s own highly ambitious $2tn estimate, over double the size of the world’s largest listed company Apple.

Inclusion to support ambitious reform agenda
In anticipation of index inclusion – as has been the experience of other markets such as Pakistan – there will likely be a rise in equity prices, and a resultant reduction in the cost of financing. The lower cost of capital should subsequently support Saudi Arabia’s progress towards achieving its ambitious economic diversification targets under the 2020 National Transformation Program and Saudi Vision 3030. Goals for instance include taking private sector contribution to GDP from 40% to 65% by 2030, a significant change which will likely need financing support from abroad.

Investors will need to be selective. There are tremendous opportunities in Saudi Arabia, but also significant challenges as the world innovates out of the oil age and the economy adjusts. As the ex-Saudi Oil Minister observed, ‘The Stone Age did not end for lack of stone, and the Oil Age will end long before the world runs out of oil’. A rising tide due to index inclusion inflows may well lift all boats, however in our opinion it is the companies positioned to profit from underlying change that should really excel.

Charles Sunnucks, assistant fund manager on Jupiter’s Global Emerging Markets team

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