Why China sets an example for Saudi’s MSCI inclusion

Investors across the Middle East are trying to figure out how many billions of dollars will flow to Saudi Arabia’s traded companies if it is eventually included in the MSCI Emerging Markets index, following MSCI’s recent move to add the kingdom to its watch list for a potential upgrade in 2018.

Earlier this year, Arqaam Capital estimated inflows of approximately $10.6bn into the Saudi market as a result of MSCI inclusion. Globally, more than $1.5 trillion in assets are benchmarked by money managers to the MSCI Emerging Markets Index family.

A good direction to look for indicative results is further east. MSCI’s decision to include mainland China shares in its main indices in the same review earlier this year is a minor tremor in the global investment landscape, but bigger seismic activity could come later.

Chinese domestic equities – A shares – will account for just over 0.7 per cent of the MSCI Emerging Market stock index when they enter the benchmark in the middle of next year.

In the near term, that doesn’t add up to a dramatic shift in global equity portfolios. But over the long run, it could be that the decision proves as transformative for the international capital markets as China’s 2011 inclusion in the World Trade Organisation (WTO).

In endorsing Beijing’s efforts to open up China’s securities to foreign investors, the MSCI could facilitate the country’s climb to the top tier of global financial markets in a number of ways.

For one thing, market reforms in the world’s second largest economy can now be expected to gather pace. The recent launch of a direct trading link between Shenzhen and Hong Kong exchanges and a reduction in trading suspensions are the beginning of what we believe will be a much deeper financial and regulatory overhaul.

What’s more, the emergence of an open and efficient stock market could help put the Chinese economy on a more sustainable footing by encouraging domestic firms to use equity as a source of finance rather than debt. As things stand, corporate borrowing amounts to an eye-watering 156 per cent of GDP in China. This ought to give international investors even greater confidence in Chinese securities.

In Saudi Arabia, a similar story is unfolding. The government is already undertaking dramatic privatisation efforts to wean the Kingdom off oil, spearheaded by the Saudi Vision 2030 economic plan, and characterised by the upcoming listing of Saudi Aramco – expected to be the world’s largest IPO.

Inclusion of the kingdom’s stock exchange – the Tadawal – to the MSCI would further improve financial regulatory standards and give international investors greater confidence in Saudi securities.

Saudi Arabia is already making quick progress. In September 2016, a new version of rules supporting an increase in Qualified Foreign investors was implemented. This was followed by a series of progressive new legislation in 2017 including spinning off the central securities depositary to a new independent wholly owned subsidiary, and launching a public consultation on the proposed new market operating model.

There are, of course, no guarantees when it comes to reform.

China’s change programme is ambitious yet complex and unlikely to progress smoothly. Currently, around two thirds of Chinese listed companies are part owned by the state in some shape or form, while governance standards do not compare favourably with those of developed economies.

Similarly in Saudi Arabia, such a ‘promotion’ would require the government to further relax its control on the market and significantly improve governance levels. This move may be tricky since many of the country’s largest companies, and particularly Saudi Aramco, are closely integrated with the state.

It would, however, boost Saudi Arabia’s global economic stature, placing it in good stead to achieve its Vision 2030. It may even attract investor interest to markets across the Middle East and North Africa ahead of the planned share sale of Saudi Aramco.

James Kenney is senior investment manager at Pictet Asset Management