Saudi Arabia, The New Emerging Market

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About: iShares MSCI Saudi Arabia Capped ETF (KSA), Includes: GULF
by: Adrian Cabanelas

Summary

MSCI recently announced that Saudi Arabia will be granted Emerging Market status in 2019.

Through Vision2030, the Kingdom aims to modernize its stock market, embrace cultural openness and boost its capital inflow.

The Future Investment Initiative conference will offer the Kingdom an opportunity to show their non-oil economic potential.

Executive Summary

MSCI Inc. announced in June the addition of Saudi Arabia to the pool of Emerging Market Economies. This movement appears as a consequence of the rapid change that the country has undergone in the past few years, adopting international standards, creating additional opportunities for foreign investors and modernizing its society.

The measures included in Vision2030, the long-term plan initiated by the Crown Prince Mohammed bin Salman bin Abdulaziz in 2016 aiming to help the country become an investment powerhouse, have started to impact an economy based solely on oil production. Saudi Arabia’s openness to the world, both cultural and economically, is set to create opportunities for investors to participate in the Saudi market and benefit from its growth.

Saudi Arabia: Overview

Saudi Arabia, one of the Seven Arab States of the Persian Gulf, is the largest economy in the Arab World. Since its initial discovery in 1938, oil has been the dominant fuel of the Saudi economy. The foundation of the Organization of Petroleum Exporting Countries (OPEC) in 1960 by Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela gave these countries a significant influence on global oil prices, traditionally held by the American “Seven Sisters.” The 1973 oil crisis helped the Saudi economy, with GDP growing from $15 billion in 1973 to $184 billion in 1981, the development of its infrastructure and the optimization of the petroleum industry under the umbrella of Aramco.

The fall of oil demand after 1980 brought a recessionary period to the country, with falling GDP, high unemployment, budgetary deficit, and the introduction of production quotas for OPEC members. Despite the considerable efforts of the government to diversify its economy, its petroleum income still accounts for the majority of the country’s fortune, and oil prices are still driving the Saudi economy.

As of 2017, Saudi Arabia has the second largest proven petroleum reserves and is the largest exporter of petroleum in the world. The petroleum sector accounts for roughly 87% of budget revenues, 42% of GDP and 90% of export earnings. Increase in public spending and rebounding oil prices helped GDP grow 1.2% in 1Q18, but the recent slowdown has forced the Saudi government to take measures towards bolstering the non-oil economy.

The primary measure towards that purpose is Vision2030, a development plan initiated in 2016 aiming to boost all sectors of the economy. Vision2030 aims to modernize two main segments:

  • Through its Quality of Life Program, Vision2030 aims to diversify entertainment opportunities, enhance the participation of Saudi citizens in arts and culture and encourage investment in sectors directly related to the well-being of the population. The plan also aims to plug Saudi women into the system, through ending the guardianship system, empowering them in different sectors and lifting the ban for certain activities.
  • Through the diverse financial programs, Vision2030 aims to reinforce economic and investment activities in the region. Goals include empowering the private sector, introducing fiscal reforms (VAT, cut of energy subsidies), unlocking SOEs for investment, and boosting non-oil revenues.

Nonetheless, Vision2030 has brought some criticism from global researchers. According to Jane Kinninmont, Senior Research Fellow of the Middle East and North Africa Programme, the growth prospects of the country are hindered by the weak institutions, inefficient bureaucracy, and gaps between supply and demand in the labor market. The introduction of taxes to expatriates has driven many of them away from the Kingdom, hitting a private sector that is worse paid and attracts fewer nationals than the public sector. The challenge lies in moving the private sector away from the business activities that require very low-cost labor.

Furthermore, unemployment has reached a 10-year high of 12.9% in 2018. The combination of a reduction of budget dedicated to public employee salaries, increasing taxes and mismatch of skills and wage expectations will make it difficult for the Prince to meet the targets set.

On the positive side of the spectrum, the first quarter fiscal results show progress in growing non-oil revenues and raising spending efficiency in the Kingdom after the contraction in 2017. The Government Budget deficit accounts for 8.9% of the GDP, but projections aim for a reduction to 7.3% in 2018 and full balance by 2023. Foreign Direct Investment in the region is up by 90% in the first two quarters of 2018 after the 80% drop in 2017 partly due to the acquisition on Bank Saudi Fransi (TADAWUL: 1050) by The Kingdom Holding Company (TADAWUL: 4280) and Shell Group’s sale of its 50% stake in the SADAF venture to Saudi Basic Industries Corporation (TADAWUL: 2010).

Investing in Saudi Arabia

Tadawul, the only securities exchange in the country, has nearly 200 listed companies and is heavily weighted towards the financial services and energy industries. The Saudi Stock Exchange offers equities, Islamic bonds, ETFs and mutual funds, but does not yet offer derivative products. The Tadawul All Share Index (TASI) is the primary measure of the Stock Exchange, with movements usually tied to oil fluctuations. The Tadawul is positively correlated to U.S. stock markets due to the currency peg officially implemented in 2013.

$3 billion worth of capital has entered the Kingdom in 2018, with Saudi Arabia's TASI up by 11.1% since the start of the year. The official classification as an emerging market and the inclusion in the MSCI EM Index is a boom for the country as it seeks to attract foreign investment. This effect will be in line with the study of Hacibedel and Van Bommel (2006), whose paper analyses the returns of emerging market stocks after inclusion on the MSCI EM Index, presenting empirical evidence of positive (negative) permanent price impacts upon index inclusion (deletion).

According to EFG Hermes, Saudi Arabia could see $30-45 billion of portfolio inflows within the next two years, taking foreign ownership in stock markets in UAE and Qatar as reference. As of June 2018, the ownership breakdown of the Saudi $524 billion stock market is still quite local, despite of the efforts from the government to ease requirements for foreign investors such as lowering the minimum amount of assets under management to get the status of qualified foreign investors, and aligning trade settlement times with international standards.

One of the questions global investors are focused on when it comes to the modernization of the Saudi stock market is related to its national oil company, Saudi Aramco. The Crown Price disclosed in an interview with Bloomberg that the strong demand for petrochemicals within the next 40 years requires Aramco and Sabic to follow a common downstream strategy, and the possibility of a merger is on the horizon. Therefore, the sale of 5% of the company with expectations to be valued at $2 trillion after the IPO will not happen before late 2020.

Historical NAV of iShares MSCI Saudi Arabia ETF (Source: iShares)

Passive investment to the Saudi economy can be achieved through the iShares MSCI Saudi Arabia ETF (KSA). Franklin Templeton Investments recently sought approval for another Saudi Arabia ETF, according to a filing with the U.S. Securities and Exchange Commission. Further exposure to the Middle Eastern economies can be achieved through the WisdomTree Middle East Dividend Fund (GULF).

Aside from the strong correlation to oil prices, one of the principal risks of investing in Saudi Arabia is its form of government, where the king combines legislative, executive and judicial functions. This has resulted in higher corruption ratings by bodies like Transparency International. The Ritz Carlton arrests and the recent disappearance of a Saudi journalist in the Saudi consulate in Istanbul have not helped clean the image of the government.

Concluding thoughts

Saudi Arabia has been recently granted Emerging Market status for its efforts to modernize its economy and to open it to facilitate inflows of foreign money. With the addition of 32 stocks to the MSCI Index, Saudi Arabia will now become the third largest MSCI country from the EMEA region. This milestone will lead to significant inflows that will help the Crown Prince’s plan to boost the kingdom’s economy through non-oil related activities.

While Vision2030 is a well-thought plan to convert the country into a global investment force and a hub connecting Europe, Asia, and Africa, the reality shows that such a goal is still further away from completion. Underemployment is at a record high, public spending will be required to make up for the sluggish private sector, and foreign investors are still wary of the Saudi government.

With Aramco’s IPO fading in the horizon as oil prices remain high, the Future Investment Initiative conference in late October will be the perfect opportunity for Saudi Arabia to show how they can attract foreign capital and whether they can do it in the non-oil sector.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.