The opening of Saudi Arabia's bourse to international investors may double the amount of foreign money flowing into the Gulf's securities markets, making it more attractive to invest in the region but also bringing new risks.
Not only Saudi Arabia but other Gulf markets are likely to lure more foreign funds after Tuesday's announcement that the Saudi bourse will open to direct investment by foreign institutions in the first half of 2015. That is because the size of the Saudi market, the Arab world's biggest, means the Gulf will at a stroke become a much bigger and more diverse destination for international funds.
The Saudi bourse has a capitalization of about $550 billion, roughly the same as all other Gulf Arab markets combined, and it accounts for approximately two-thirds of the region's stock trading turnover. Limited liquidity has long been a complaint of foreign investors about the region; that will now improve.
Just as important is the fact that Saudi Arabia offers a range of companies which the rest of the Gulf can't match. They include giants such as petrochemical conglomerate Saudi Basic Industries Corp., but also firms in fast-growing sectors such as retailing, health care and food production that are directly exposed to the region's rapid population growth.
Leading Saudi firms in these fields include retailer Jarir Marketing, food producer Savola Group and hospital management firm Dallah Healthcare, all private firms. Other Gulf markets generally lack such listed firms and are heavily tilted toward real estate, banking and state-run enterprises.
There are also risks, which is why the Saudis delayed implementing their reform for years. The entry of foreign money could destabilize markets, partly by encouraging local investors to bid stock prices up to unsustainable levels ahead of time.
It will also expose markets to global instability in a way that the region has not experienced before. Previously, U.S. interest rate increases or emerging market crashes meant little to Gulf investors; now, those events could trigger mass pullouts of money by foreigners.
Overall, however, the Gulf looks likely to enjoy a "halo effect" from the opening of Saudi Arabia. As more foreign institutions find it worthwhile to establish operations in the region, money will spill over into many of its markets.
"Markets such as the UAE and Qatar will benefit from the additional investor interest in the region and the spillover effect from investor flows," said Salah Shamma, co-head of regional equities at big U.S. asset manager Franklin Templeton.
"We believe the region is taking the right steps in establishing itself as a single, identifiable subset within the general emerging-market universe. like Latin America, southeast Asia or emerging Europe."
Much will depend on decisions by major equity index providers such as MSCI on whether to include Saudi Arabia in the benchmarks used by many fund managers.
There is room for disappointment; Riyadh, which has not yet detailed the rules covering its reform, will have to balance its desire to keep control of its top firms in local hands with the need to satisfy MSCI's requirements that minimum amounts of stock are made available for foreign investment.
In the past, many up-and-coming bourses have started out in "frontier market" indexes, before being upgraded to "emerging markets" as they open up further.
That path looks difficult for Saudi Arabia, however, because it is so big; adding it to MSCI's frontier index would leave it and Kuwait combined accounting for well over half of the entire index. For that reason, some fund managers think Saudi Arabia will move directly to the emerging market index.
About $1.3 trillion of assets under management are benchmarked to that index globally. Fund managers think Saudi Arabia might get a weighting of up to 4 percent, which would be equivalent to $52 billion. There would be additional inflows from funds using other benchmarks or no fixed benchmarks at all.
There is some concern that in the initial phase, Saudi Arabia could end up sucking funds from other Gulf markets. Investors in Qatari petrochemical firm Mesaieed Petrochemical Holding, for example, may move money to the more liquid shares of SABIC.
The smallest Gulf stock markets, particularly Bahrain and Oman, may find it impossible to compete for attention with the Saudi leviathan. Most fund managers, however, think a majority of Gulf markets will benefit.
Asha Mehta, lead portfolio manager for frontier market equity strategy at U.S.-based Acadian Asset Management, predicted the region would develop a shared pool of foreign money that dipped into a range of markets.
"Other Gulf countries will benefit from bigger inflows into Gulf funds," she said, adding that markets in the region had distinct investment themes so foreigners would want to remain exposed to a range of them.
MSCI's upgrade of the United Arab Emirates and Qatar to emerging status in May caused a bubble to form. Local retail investors frantically bought stocks before the index change took effect, hoping to sell them to foreigners at huge mark-ups. The overheated markets crashed days after the upgrade happened, destroying about $50 billion of value in the UAE.
Mehta said it was "very reasonable to expect" a similar boom-bust cycle in Saudi Arabia. But there are reasons to think Riyadh can avoid such extreme volatility as it opens up.
For one thing, the UAE and Qatar markets were recovering from the global financial crisis and still cheap when MSCI announced last year that it would upgrade them.
Saudi Arabia is not cheap. After two years of gains, its index is trading at about 17.5 times last year's earnings, not far from its long-term average. So investors will have less temptation to bid up prices before the market opens.
Also, inflows of foreign money will be gradual. Index compilers will not add Saudi Arabia immediately; MSCI says it may not make a decision until June 2016, implying actual inclusion might happen in 2017 at the earliest.
Saudi regulators are likely to grant investment licenses only gradually to avoid destabilizing the market. Riyadh is expected to adopt an investment framework similar to one introduced a decade ago by China, which has expanded foreign participation in its market through incremental steps.
Another source of risk is the Gulf markets' growing sensitivity to movements abroad. Saudi Arabia will be opening up, for example, around the time that U.S. interest rates are expected to start rising after years at record low levels.
But Saudi Arabia and the other rich Gulf economies, the UAE, Qatar and Kuwait, are running big budget and current account surpluses. Unless oil prices plunge for a sustained period, these surpluses will probably keep the Gulf more insulated from global instability than other emerging markets.
Also, many analysts think the Saudi market opening may lead to additional investor-friendly reforms in the region. The UAE and Qatar, for example, may compete with Riyadh through steps such as raising ceilings on foreign ownership of their firms.
In Riyadh, there is speculation that the Capital Market Authority may soon follow the stock market reform with an opening of the market in riyal-denominated Islamic bonds to foreign investors.
"The CMA should seek to achieve this and provide the necessary infrastructure for it," said Ihsan Abu Hulaiga, a prominent Saudi economist.
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