The reclassification of Qatar and the UAE has created much excitement, but will take effect officially with the MSCI’s May 2014 semi-annual index review.

Significant potential benefits include an increase in portfolio flows with the entry of foreign institutional investors and passive or index-tracking investors. Many market participants are now anticipating windfall investment flows and research houses have been quick to calculate the expected flows into the UAE and Qatari exchanges. We believe it is premature to quantify the immediate effects due to several variables. However, we are encouraged by longer-term prospects and expected institutionalisation of these markets.

Hopes for the MSCI upgrades and entry of new investors helped boost stocks in Qatar and the UAE, currently among the world’s top performers year-to-date. We believe the long-term implications are even more meaningful. The upgrades could attract additional liquidity, providing policy makers with an ongoing impetus to reform.

Typically, reclassification is followed by economic and financial policy reforms, including market infrastructure improvements. As with any reclassified market, Qatar and the UAE have already undertaken several market reforms to adhere to MSCI EM listing guidelines: Qatar raised limits on foreign ownership of companies and the UAE improved trade settlement systems. More encouragingly, the UAE has revived a proposal to merge its two stock exchanges, the ADX and DFM, in a state-backed deal that could boost trade in the local market, while attracting more foreign investment. The proposed merger would deepen the equity market of the UAE, encouraging more companies to list and international institutions to buy.

GCC governments will likely push ahead and further liberalise market access by raising foreign ownership limits for investors and adopting flexible legislative frameworks. Regulators are showing serious signs of commitment to further develop their markets to properly reflect the underlying economies. Governments are encouraging local family businesses to go public on the different exchanges.

Listed companies are working to improve corporate governance in accordance with international standards, including current disclosure and transparency practices. We are encouraged by these actions, believing they would improve market competitiveness and promote further investment.

Saudi Arabia: The final frontier

We believe MSCI’s Qatar and UAE upgrade could motivate Saudi Arabia to accelerate foreign ownership plans for its own bourse. The potential opening up of Saudi Arabia to foreign investors remains one of the most anticipated events in the Mena (Middle East and North Africa) region. Lately, market chatter surrounding the imminent approval of a foreign investment law by the council of ministers has increased.

General consensus seems to make this a question of “when” and not “if,” but when such a development occurs is unclear. However, we highlight that the recent appointment of a new Capital Market Authority head and realignment of the Saudi weekend with other regional markets as positive developments in the potential opening up of the market.

With a market capitalisation of $400 billion (Dh1.5 trillion) and average daily traded value of $2 billion in 2012, Saudi’s equity market is the largest in the Mena region, and would be the largest in customary frontier market indices if it were included. Increasing foreign ownership to 10 per cent would imply an approximate $38 billion in new equity purchases, according to our estimates.

Over the medium term, we would expect foreign investor interest to rise steadily in preparation for Saudi Arabia’s eventual inclusion in global indices. This could prove to be the single largest event in the development of capital markets in the Mena region in recent history.

Great news, bad timing

While this sounds like good news, MSCI’s decision couldn’t have come at a more delicate juncture for emerging markets, which have experienced some volatility recently. The recent announcement by US Fed Chairman to taper bond purchases has sparked a sizeable rally in the dollar and a sell-off in the US Treasury market, sending bond yields to their highest levels in over a year.

Emerging markets, a main beneficiary of the quantitative easing policy, saw fund outflows intensify following the spike in yields as investors rushed to sell EM bonds, foreign exchange and equities. Against this backdrop of higher yields coupled with weaker currencies and lower growth prospects, emerging market central banks have their work cut out formulating appropriate policy responses.

Unlike typical emerging market economies, GCC countries that are pegged to the USD could actually benefit from a stronger greenback; they enjoy considerable account surpluses on the back of higher oil prices and increased production. Government debt to GDP (gross domestic product) ratios in the region are low, ranging from five per cent to 36 per cent. Consequently, GCC countries have enjoyed strong credit ratings and healthy external balances. Increased oil revenue windfalls have allowed GCC countries to reduce their debt profile considerably and build ample foreign currency reserves.

GCC governments have been committed to supporting their economies through record budgets and massive infrastructure spending plans. Non-oil real GDP is expected to grow by some five per cent in 2013, according to latest IMF forecasts.

In our view, valuations remain historically cheap. GCC markets are trading at about 14 times 2013 earnings estimates with a strong growth outlook, and dividend yields remain high at 3.8 per cent with low payout ratios that have room to grow.

The positive liquidity boost following MSCI’s decision coupled with attractive valuations will support regional markets over the medium term. The economic outlook in the majority of GCC countries remains positive. Huge stimulus efforts in GCC countries that have none of the fiscal constraints of the developed world could earn Mena equities renewed attention, especially if 2013 global economic prospects remain subdued.

The MSCI decision sends a very strong positive message for the Mena region as a whole and for the UAE and Qatar in particular, as these markets will be firmly entrenched in emerging market investors’ minds.

— The writers are co-heads of Mena equity, Local Asset Management at Franklin Templeton Investments (ME).