Moving from a frontier to an emerging market index

Including some of the GCC stock markets (like UAE and Qatar) in the MSCI Emerging Market Index is a favourite topic that media reports on a regular basis. While investors look eagerly on in frustration speculation remains high as to when this will eventually happen.

How is the MSCI Indices market structured?

While there are several MSCI indices, the three most popular would be MSCI Developed Market Index, MSCI Emerging Market Index and MSCI Frontier Market Index. The developed market index is comprised of 24 countries (USA, UK, Japan & Canada being the top 4) with a total market capitalisation of $23 trillion, yielding an average per country market capitalisation of approximately $1 trillion.

The emerging market index is comprised of 21 countries (China, Korea, Brazil & Taiwan being the top 4) with a total market capitalisation of approximately $3.3 trillion yielding an average per country market capitalization of $160 billion.

The frontier market index is comprised of 25 countries (Kuwait, Qatar, Nigeria and UAE being the top 4) with a total market capitalisation of $96 billion yielding an average per country market capitalization of $3.8 billion.

What is the status of GCC markets?

All the GCC markets except Saudi Arabia are part of the frontier index with Kuwait leading the table with a share of 28 per cent followed by Qatar at 14 per cent, UAE at 10 per cent, Oman 3.4 per cent and Bahrain 0.7 per cent of the total market capitalisation of the frontier index. While the UAE and Qatar are actively touted to migrate from frontier index to emerging markets, there are no such expectations when it comes to other markets.

What it takes to get there?

MSCI has three broad criteria for index inclusion i.e., economic development, size and liquidity requirements and market accessibility factors. The economic development criteria is sought to be measured by sustainability of economic development defined through a per capital threshold (25 per cent above the World Bank high income threshold of $12,276 for three consecutive years) and applies only for migration to developed market index. Curiously enough all the GCC countries qualify under this criterion.

The second criteria relates to size and liquidity requirements in terms of company size (full market cap), security size (float market cap) and security liquidity defined as a percentage of average traded value ratio. The requirements are updated on a semi-annual basis.

The third criteria relates to market accessibility implying mainly openness to foreign ownership, ease of capital inflows/outflows, efficiency of operational framework and stability of institutional framework.

Why are we not there yet?

While the first criteria of economic development does not apply for frontier and emerging markets, the GCC countries do make it to the second criteria concerning size and liquidity requirements. However, it fails in the third criteria especially concerning the openness to foreign ownership and operational framework. GCC countries have strict limits for foreign ownership (FOL) and foreign room level (e.g., Saudi Arabia permits foreign ownership only through certain swap transactions and ETF’s). There have been signals from Saudi authorities to gradually open up but guessing the timing is hazardous. In UAE and Qatar, listed companies in general are subject to a foreign ownership limit of 49 per cent and 25 per cent respectively, but companies may choose to set a lower limit. Even though some large companies permit higher foreign holding, their current ownership is low mainly because of higher government/promoter ownership leading to lower free float. The situation is relatively better in Kuwait where current CMA rules allow 100 per cent foreign ownership in all sectors, except banks. In Oman, companies are subject to 70 per cent foreign ownership limit but companies can choose to set a lower limit. Bahraini companies in general are subject to a 49 per cent foreign ownership limit but some companies are either fully open or fully closed to foreign investments.

As per the Market Accessibility Assessment report published by MSCI in June 2012, GCC countries also score poorly when it comes to efficiency of operational framework. This includes investor registration and account set up, information flow, clearing and settlement, custody, transferability, stock lending, short selling, implementing delivery versus payment (DVP) mechanisms, etc.

Why we need this?

Index inclusion will get the required focus, attention, pre-eminence and prestige for the GCC markets among institutional investors outside the region. This will eventually attract foreign investments and improve market liquidity. This then will broad base the market and will trigger broader reforms on governance, transparency, etc. All this will eventually improve local investors’ confidence. In short, it will be a positive feedback loop.

What impact will it have on local markets?

Past analysis has shown that countries which migrate to emerging market status experienced good growth in liquidity after their inclusion. China (37 per cent p.a), Russia (36 per cent p.a), Turkey (33 per cent p.a), Indonesia (29 per cent p.a.), and Poland (25 per cent p.a) are some cases in point. Only Peru (3 per cent p.a), Malaysia (7 per cent p.a) and Czech Republic (9 per cent p.a) experienced low growth in liquidity afterwards.

Total money tracking MSCI Emerging Market index is roughly about $1 trillion. If Kuwait, Qatar and UAE were to be included in the emerging market index, they will constitute (based on their current free float market cap) 0.81 per cent, 0.43 per cent and 0.29 per cent of the index respectively. Estimated gross inflow to all the GCC markets except Saudi Arabia would then be about $17 billion. However, if Saudi Arabia is included in the emerging market index, then it may account for nearly 3 per cent of the emerging market index which will place it right in the middle of the pack and may attract about $30 billion.

— Raghu Mandagolathur is a CFA charter holder and a founding Member of CFA Bahrain and CFA Kuwait. He works as a Senior Vice President & Head of Research for Kuwait Financial Centre S.A.K (Markaz).)