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Thu 22 Jun 2017 03:12 PM

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Saudi economic potential lures investors

Comment: Aruba Khalid, senior analyst at The Delma Institute, says Saudi Arabia's reforms have helped its potential inclusion on the MSCI Emerging Market Index

Saudi economic potential lures investors

Last week was a pertinent reminder that Saudi Arabia is at a pivotal point in its economic and political development. In a royal decree announced on June 21, Crown Prince Mohamed bin Nayef was replaced by Deputy Crown Prince Mohamed bin Salman.

With the backing of 31 of the 34 members on the Allegiance Council, Mohamed bin Nayef was also replaced by Prince Abdulaziz bin Saud bin Nayef in his position as interior minister.

The announcement came on the back of Tuesday’s news that Saudi Arabia was finally added to the MSCI watch list and is now on the path to being classified as an emerging market country, joining its neighbours Qatar and the UAE.

Although the two events are seemingly unrelated, they both hold one key implication: The rate of change in Saudi Arabia is likely to accelerate in the near future.

Given that Mohamed bin Salman has been the key force behind the implementation of the Vision 2030 economic reform programme, we can expect the overall reform agenda to continue as planned. Vision 2030 is the foundation of the kingdom’s plans to diversify its economy, including the privatisation of Saudi Aramco and opening of the Saudi economy to foreign direct investment.

On the other hand, it is difficult to immediately appreciate why the inclusion of Saudi Arabia on to the MSCI watch list may also be a historic event.

After all, the only thing we know for sure is Saudi Arabia will start the formal process of applying to the MSCI Emerging Market Index, a process that is unlikely to be completed before 2018, or even 2019.

Surely, being added to an index that already tracks the performance of 23 other stock markets cannot be such a game changer, particularly given the actual upgrade is still a year or two away.

However, Saudi Arabia’s inclusion on the watch list highlights that a number of important underlying developments are gaining momentum. Not only does it suggest an acceleration in the pace of Saudi Arabia’s economic development, it also shows that the economic status of the largest country in the GCC is finally being elevated.

With the kingdom on the MSCI watch list, the region will be recognised as an important subset of the global economic landscape.

In order to fully appreciate the implications of the impending upgrade, it is important to understand why Saudi Arabia had been excluded from the index until now.

While the kingdom was included in the MSCI GCC Countries Index in 2015, its neighbours Qatar and the UAE were upgraded to emerging market status that same year.

Saudi Arabia’s financial markets were perceived to be some of the world’s most conservative. In order to be included alongside other emerging markets, the country first needed to develop a certain level of openness and roll back restrictions on foreign ownership.

For several years, Qatar and the UAE were also denied inclusion on the index due to restrictions on foreign ownership.

Over the past three years, however, Saudi Arabia has consistently rolled out a number of key reforms to open and liberalise its capital markets. As early as 2014, before oil prices plummeted, Saudi Arabia’s Capital Markets Authority announced it would open its long-closed equity markets to international investment.

Observers understood it was a landmark moment for the global economy. The opening of those markets to foreign investment would, essentially, give international investors access to a market with the capitalisation of $590bn – approximately equal to that of Russia, and representing half of the entire Gulf region.

Put simply, Saudi Arabia’s economy is too large to ignore.

Although developing countries are typically first added to the Frontier Markets Index, a rung before the Emerging Markets Index, Saudi Arabia’s economy was so large it would have swamped it by accounting for more than 60% of its capitalisation. It would have had to be upgraded to emerging market status right away.

The MSCI upgrade will have a notable positive impact on the financial front, but also on two other areas of Saudi Vision 2030.

Primarily, passive funds that track the emerging markets index will be obliged to direct capital into the country, bringing in approximately $9bn-$12bn in Saudi equities. Similarly, active funds are likely to commit further capital, potentially bringing in $30bn-$35bn.

Moreover, the upgrade will likely trigger a number of positive effects in other area’s of Vision 2030, including employment, technology transfer, and foreign direct investment. The arrival of foreign institutional investors to Saudi Arabia’s financial market will stimulate stronger governance across Saudi companies, thus encouraging unlisted local firms to list publicly.

Although progress has been slow and difficult, the culmination of Saudi Arabia’s efforts to achieving an upgrade and eventually a wholly advanced and sophisticated economic environment will be a game changer not only for the kingdom but also for the wider region, its geopolitical significance, security, and future.

Aruba Khalid is a senior analyst at The Delma Institute, a risk advisory firm located in Abu Dhabi.