Despite the global economic slowdown, collapse in oil prices and domestic credit issues, Saudi Arabia’s economy has shown resilience. Although the Saudi economy is this year likely to contract by about 1 percent, it is widely expected to grow by 4 percent next year.
The continuous efforts of the Saudi government to diversify the economy and increase contribution from the non-oil sector are paying off. The Kingdom continues to see a huge surge in foreign direct investment (FDI), attracting $38 billion in 2008 (compared to $24 billion in 2007).
Over the past five years, the Saudi securities market regulator, the Capital Market Authority (CMA), has taken various prudent measures to improve market micro-structure, increase investor confidence, and boost transparency. CMA has also gradually opened up the market, as evident by its decision in August last year allowing non-GCC investors access to the Saudi market through swaps; since official data became available in March, net purchases by foreigners through swaps amount to $795 million.
Clearly, there is demand for Saudi stocks among foreign institutional investors (FIIs). But given the risk of heightened volatility caused by speculative flows, it is prudent of the CMA to adopt a cautious approach as it opens the market to FIIs.
The Chinese Qualified Foreign Institutional Investor (QFII) regime is a model worth exploring for Saudi Arabia. In December 2002, the China Securities Regulatory Commission (CSRC) and the People’s Bank of China (PBOC) jointly issued the QFII regulation allowing foreign investors to invest in the domestic securities market.
Seven years later, a review of the country allocations of MSCI Emerging Markets Free Index reveals that at 10.4 percent, China now occupies the third largest weight in emerging market countries (after Brazil and Korea).
While the combined quotas for all QFIIs investing in China’s capital markets amount to $30 billion, China has so far granted about 50 percent of the total quota to QFIIs. This is less than one percent of China’s combined stock market capitalization of $3.1 trillion for the Shanghai and Shenzhen stock exchanges.
In China, a QFII is defined as any foreign fund management institution, insurance company, securities firm, and asset manager that meets the requirements stated in the QFII regulation and obtains approval from the CSRC and investment quota from the State Administration of Foreign Exchange; qualifications also include minimum assets under management and years of business operations.
A QFII can invest in publicly listed shares on the Shanghai or Shenzhen stock exchanges other than B shares, publicly-traded treasury bonds, convertible bonds and corporate bonds, and other financial instruments approved by the Chinese regulator.
Saudi Arabia can study the implementation and related impact of a similar regime. To prevent stock concentration with a few investors, constraints can be imposed limiting an individual QFII to hold no more than 5 percent of the total outstanding shares of any single Saudi-listed company. Similarly, the total combined shares held by all QFIIs may not exceed 15 percent of the total outstanding shares of the listed company.
In September this year, China relaxed restrictions on its QFII initiative reflecting a growing awareness of the challenges it faces in attracting overseas capital following the global financial crisis. Analysts opine that the new draft regulations, including a provision to raise the upward limit for individual QFIIs to $1 billion (from $800 million), are likely to be followed by more changes to encourage buy-side investors and expand institutional activity in the market.
In order to discourage frequent trading by non-GCC speculators into the Saudi market, certain conditions for repatriation of principal can be imposed. For example, a QFII may repatriate its principal in stages, and the amount of each repatriation may not exceed 20 percent of the total principal, while the interval between two repatriations should not be less than one month. In addition, when a QFII remits all or part of its principal out of Saudi Arabia, it will have to apply for a new investment quota in order to bring the principal back into the country.
At the state level, Saudi Arabia does not require FII funds. However, in an increasingly integrated global economy, for a G20 member, the prestige factor is important. Perhaps importantly, FIIs would allow the Saudi market to be better integrated with global markets by demanding best practices in valuation, corporate governance and investor reporting; even a minority holding by foreigners can act to improve the market for corporate control and thus enhance the resource utilization of the economy. Furthermore, at the corporate level, many Saudi companies can benefit from a more diversified international shareholder base through a QFII program; their future capital-raising efforts will be easier and larger.
Through a QFII program with a quota of 2 percent of market capitalization (or about $6 billion), Saudi Arabia can continue to attract investment into its equity market from FIIs. The inclusion of stable, long-term oriented buy-side investors will help broaden Saudi Arabia’s stock market while some QFIIs may be able to assume the role of stabilizer in case of market volatility.
(Farhan Mahmood is head of investment management at Morgan Stanley in Saudi Arabia. The opinions expressed are that of the author himself and do not represent that of the organization he represents.)
