ROUNDTABLE: Charting the pace of reform

Saudi Arabian index inclusion, the onset of taxes and the Dana Gas controversy were among the issues discussed by our cross-industry panel. Chaired by George Mitton in Dubai.

Glyn Gibbs (regional head of business development, Apex Fund Services)
Abdul kadir Hussain (head of fixed income asset management, Arqaam Capital)
Salah Shamma (head of investments, MENA equities, Franklin Templeton Investments)
Kapil Seth (managing director and regional head, HSBC Securities Services)
Saleem Khokhar (executive director, head of fund management,First Abu Dhabi Bank)
Michael Slater (chief executive, The Northern Trust Company of Saudi Arabia)

Funds Global – What is your outlook for the regional equity markets and what factors are likely to sway investors in the coming months?

Saleem Khokhar, FAB – Some of the main factors are the oil price, geopolitics, the reforms equation, the onset of value-added tax (VAT), the diversification of revenue streams for regional governments, and valuations in the region, which are attractive.

On the oil price, it is important to keep an eye on the shale industry and how that’s going to react to the rising prices we’re seeing at the moment. That’s critical for the long-term picture.

The potential upgrades of Saudi Arabia by index providers MSCI and FTSE are also important and we seem to be moving forward on that front. A delay of six months to a year is not an issue as long as we’re going in the right direction.

The pipeline of initial public offerings (IPOs) is beginning to improve. As well as Aramco, we have a number of IPOs coming up in the region. It all comes together for a positive picture. I’m looking forward to some good returns over the next 18-24 months.

Salah Shamma, Franklin Templeton – On the macro side, the environment continues to be challenging. Reforms are being implemented but we’re still not sure how the private sector will react to those moves. However, a lot of these challenges have been priced in.

The potential MSCI inclusion is going to be the main event that drives market performance this year. It’s a landmark event – something we’ve been waiting some time for. Given the size of Saudi Arabia, index inclusion will move the market across the region.

Kapil Seth, HSBC Securities Services – In the short term, regional linkages to oil still remain the dominant influence on local economies and markets. However, we are witnessing large structural transformations playing out in economies across the region, which creates a much more optimistic outlook. In Saudi Arabia, there is a fundamental macro transformation as well as underlying financial market change. Kuwait has a market change story and Egypt is undergoing both – a macro and an underlying financial market change.

We are seeing increased activity throughout a fair number of these regional markets. As an asset service provider, our activity levels are generally higher this year than they were last year. Asset valuations are again going up and there are signs of positive intent.

Michael Slater, Northern Trust Saudi Arabia – The big ticket for me is understanding who is coming into the Gulf Cooperation Council (GCC) markets for investments, whether that’s insurance companies, pension funds or asset managers. In Saudi Arabia, Northern Trust has had a hundred queries from institutions about qualified foreign investor (QFI) status and 14 have secured the QFI investor status.

I do see potential risks. If Saudi Arabia joins the MSCI index as planned, will we see hot money coming in? I also wonder whether the liquidity of the marketplace in the GCC, especially in Saudi Arabia, can support the number of IPOs that are coming to market. The recent number in Saudi is up to 40 IPOs over the next 24 months.

Abdul Kadir Hussain, Arqaam Capital – The overriding factor is oil and the forward curve doesn’t look encouraging. You’ve had a sharp move up in oil but that’s more driven by short-term technicals like the recent hurricanes. If you look at the forward curve, it’s still stubbornly stuck at a cost per barrel in the mid-$40s range. That’s an issue.

There is a potential for correlation with global markets. If there is a correction in global equities, primarily driven by the US, you would expect an impact in this region. On the flip side, global valuations have outperformed regional equity markets in the past few years, so the valuations here aren’t particularly expensive compared with global ones.

Glyn Gibbs, Apex Fund Services – For me, it’s a tale of two cities, Saudi Arabia and the rest. In Saudi, the government is wrestling with the budget deficit issue. You’ve got a relatively new ruler who is trying to introduce change. He’s proceeding cautiously so as to take the population along with him. Even so, he is introducing economic changes which are good for the economy. Removing the ban on women driving, for instance, will have a positive economic impact because it increases the size of the local workforce. That’s a big positive.

That said, the budget deficit isn’t going away. I think we’re all agreed that the days of $100 oil – unless some unforeseen event happens – are gone.

Elsewhere, the Qatar issue is overhanging the entire region. That’s enough to create uncertainty if you’re looking at this region as an investment opportunity, because we really don’t know what’s going to happen next there. VAT is coming in Kuwait and the UAE. That’s taking money out of the economy to try to replenish these budget deficits.

People are finding it hard here. Jobs are harder to come by. My own experience in the past year is that stalwarts within the industry – people at senior levels who I’ve been talking to for ten years – have moved on, and usually it’s not been of their own volition.

Funds Global – The last two years have seen a big rise in the value of bonds issued in the region, notably by governments. How have these issuances altered the landscape for fixed income investors?

Hussain – We had close to $70 billion of bonds issued last year, which was almost double what we had the year before. We had $50 billion in the first half of this year alone. Saudi Arabia, the biggest issuer, has put the region on the radar screen of global bond investors, particularly because there is now a full yield curve with 30-year, ten-year and five-year bonds. Investors such as insurers from Taiwan and the US are big buyers of 30-year paper.

On a rating-adjusted basis, Saudi offers good value. It is an A credit that trades cheaper than other A credits, whether in emerging or developed markets.

On the other end of the spectrum you’ve got Oman and Bahrain, the other big issuers in the last two years in the region, particularly on the sovereign side. Oman was a first-time issuer last year and has done many deals since then. In that period, its rating has gone from solid AA to a level that only just qualifies as investment grade. Bahrain is now firmly in high yield territory.

The issuance has brought the region into global emerging market indices. However, we haven’t had the knock-on effects that normally go with the evolution of bond markets. Usually, sovereign issuers are followed by financial institutions, corporates and then high yield issuers. You’ve not seen that in this region. Pure corporate issuance is still anaemic. Nearly all issues are from government-related entities and high yield issuance is pretty much non-existent.

On the plus side, there is a more diversified investor base. Regulations in the insurance industry have forced insurance companies to build out fixed income portfolios. There is more recognition from private banks and high-net-worth individuals to allocate to this asset class, too. There is a large amount of leverage provision, particularly from the Swiss banks, which are willing to leverage bonds two or three times at Libor plus a spread, which makes the returns more attractive.

Seth – The issuance and the interest from global investors are positive indicators and add to the stability of the forward curve. The positive flow of successful bond issuances in the region is reflected in terms of the vibrant dialogue we are having and the uptick in fixed income activity witnessed.

Shamma – What surprised us this year is the appetite for investment-grade issuance from the region. That alleviates a lot of the concerns the sovereigns had, and even the corporates within the sovereigns, about their ability to refinance in this environment.

Hussain – I’ll emphasise the “for the time being” part, though. The appetite has been strong because global central banks have flooded the world with liquidity. There was $40 billion of demand for a $12.5 billion Saudi issue because investors have so much liquidity hanging about. We’ll see how that plays out, particularly in the dollar world, once balance sheets shrink.

Gibbs – In the past, governments in this region did not need capital, so there was no impetus for change in terms of capital markets, regulatory conditions and rules. Now there’s a need for capital and, as we’re seeing, for example in Saudi Arabia, governments are trying to transform their economies to make their markets more attractive to outsiders.

Slater – I’m going to be a bit more negative. I look at Saudi Arabia’s $40 billion of issuance – plus some other bank financing that no one seems to discuss – and over half of that goes straight back to the government. These bonds are held by institutions such as the Public Investment Fund, the government pension funds and government agencies.

The figures for over-subscription seem excessive, making the issuance look more popular, or attractive, than it is. Of the $110 billion of regional issuance over the last two years, I suspect 10% is held globally. The rest is held locally. Although the issuance is helping the regional markets, it has not attracted fixed income managers globally, nor the pension and insurance industry globally – yet.

Khokhar – At a local level, investor demand used to be predominantly for equities, but we’ve seen a shift where it’s become far more interesting to be in that fixed income or sukuk space. We’re also finding a lot of interest coming through in terms of structured products.

Funds Global – MSCI says it will announce in 2018 whether Saudi Arabia will join the Emerging Markets index in 2019. What effect would index inclusion have on the regional markets?

Shamma – This is the most anticipated event of the year for us as equity managers. I’ve been looking forward to it over the past 15 years. Our expectation is that Saudi Arabia could constitute around 2.5% of the MSCI Emerging Markets index, which could increase to 5% if Aramco is included. That becomes significant.

Why? Because the region, if you take a look at it as a whole, with Qatar and the UAE and Saudi included, becomes almost 7% of the EM index, which puts us in the same vicinity as India, Brazil and South Africa.

Asset managers across the world are paying notice to that development. If we assume the 2.5% position at the beginning of the inclusion, and we estimate there is around $2 trillion following emerging markets globally, there is a potential inflow of between $50 billion to $100 billion into Saudi equities. That’s a milestone.

We would expect good returns after Saudi Arabia joins the index. Out of the 20 inclusions that we’ve seen historically, more than 70% have outperformed after inclusion.

Khokhar – Yes. If you look at Pakistan, Argentina, Qatar and UAE, there was a significant return for investors prior to these markets being included in the index. There should also be a benefit in terms of the institutionalisation of the Saudi market. The regulatory environment will get upgraded and the underlying infrastructure for investments will improve.

Shamma – Before joining the EM index, the UAE and Qatar were dominated by retail investors with a very low level of institutional participation, but this participation has now increased to almost 10%-12% of the market. Clearly, inclusion supports the long-term development of the market.

Seth – Institutional investor interest is showing in anecdotal dialogue with our clients. From a recent Asia roadshow, a large proportion of the asset managers are currently taking exposure to Middle East markets through non-direct routes including derivative swaps. However, buoyed by potential Saudi inclusion in the EM index, all but one of the investors we met have plans to review direct access to the market. The potential inclusion of Saudi lends scale and enhances regional visibility.

We are also seeing a build-up of the QFI system in Saudi itself. There are 80 or 90 QFIs right now that are registered to invest, but if you look at the QFI pipeline of registrations, it is multiples of that.

Slater – I have been involved in dialogue about the QFI process. It’s cumbersome, it’s time-consuming, it’s inefficient. You end up doing KYC and AML [know-your-client and anti-money laundering] at three or four different levels. It really is ineffective. Talking with the international providers in Saudi Arabia, they suspect that there are 400 QFIs that are going to enter into the Saudi market. As mentioned, there are about 80 today, and they represent about 0.9% of the market. If you have 400 more QFIs coming to the market, the numbers quoted are exactly where the Capital Market Authority [the Saudi regulator] expect it to be, which is $50 to $100 billion of money coming into the marketplace.

Gibbs – Index inclusion can only be a positive development. The question is, how big a positive? For the MENA asset managers around the table, it’s fantastic news, because they have the freedom to position their books ahead of the benchmark trackers, so obviously they will do very well when the announcement is made, which creates a positive momentum elsewhere as well.

Funds Global – What developments have you seen in the world of Islamic finance in recent months? Is this as promising a growth area for your business?

Khokhar – It is not a substantial part of our assets under management, but it’s been growing. It’s an area where I think there have been some interesting developments, but a lot of the low-hanging fruit has been captured already. There’s a problem with standardisation of documentation which needs to be addressed.

Seth – From our securities services perspective, we don’t provide a specific Islamic offering, it’s pure conventional.

Hussain – I would say that, unfortunately, the developments in the last few months have been more negative than positive. There have been a lot of negative headlines around the Dana Gas situation [Dana Gas, a UAE-based energy company, has refused to pay back holders of its sukuk, which it claims were structured illegally. Sukuk holders are challenging the company in court].

I hear from a lot of my colleagues globally that this case has caused concern. To some extent, it’s ironic because the issue is not really a sharia issue, it’s a technical legal issue, but it’s been publicised as being a sharia issue, and that has not gone down well with global conventional investors.

The case is being heard in the English courts. Precedent would indicate that the sukuk holders are in a strong position, but if we were to get any sort of adverse judgment, it could have a major negative impact on conventional demand for sukuk paper.

In general, while there has been significant growth overall over the last three to five years, the sukuk market is extremely concentrated. We’ve been waiting for Egypt for a while. Some of the other MENA countries, such as Jordan or Morocco, have talked about creating the regulatory structures needed for sukuk, but we haven’t seen them yet. Oman has done one public and one private placement sukuk. There is an imbalance between supply and demand and a high concentration of UAE issuers.

In terms of standardisation, Dubai is making a move to have a standardised board, like Malaysia does, at the country level. But the question then becomes, will these standards be acceptable in Saudi Arabia? We’re still not there, but at least there is a recognition that something is needed. The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) is a step in that direction. A lot of Islamic investors, particularly the more stringent and technical investors, will demand you meet AAOIFI standards in your Islamic products. So, it’s developing, but standardisation is tough.

Gibbs – And, for all those reasons, we still see the popularity of real estate both in the region and outside. We see commodity trade finance funds coming through, but the story continues to be real estate.

Funds Global – What regulatory issues are occupying your time at the moment and what regulatory events are on the horizon that could affect the asset management industry?

Seth – When it comes to risks, there are two or three themes that we see. There is a theme of segregation of responsibilities between the trading and the clearing side, which requires regulatory change and compliance. Central counterparty clearing structures are coming through, and that requires investment, time, effort and dialogue. Another area is taxes, both VAT and withholding tax, which is kicking in in some markets.

The other area to highlight is the trend towards alignment of settlement cycles. Egypt went through that process of realigning to a common settlement cycle. Kuwait is moving to an interim post-trade model to align settlements and Saudi moved to an aligned T+2 cycle. There is some directional trend towards making the markets simpler and more manageable.

We expect these trends to continue. Saudi Arabia has delivered a fairly large book of work and market development with more expected. We could spend a full day on Saudi regulatory change. The UAE markets have gone through this process earlier and are ahead of the curve.

Gibbs – I see three different things. Bahrain is trying to address its budget deficits and the risk to its rating with supportive regulation. It introduced new trust regulations for last year, which are quite attractive. It’s trying to amend its fund regulations to facilitate more business. The question is, can it recover to any degree, given how far it’s fallen behind?

We look at the Abu Dhabi Global Market (ADGM) versus the Dubai International Financial Centre (DIFC). Both are driving each other on in terms of new fund structures, marketing, reaching out to Singapore, India and elsewhere to try to bring business in.

But if there’s one thing within the UAE that could change more than anything else, it is pension regulation. There is a working group within the DIFC looking at pensions and we hear that, on a federal level, it’s being considered. If that were to happen, it would have a big impact.

Slater – You’re absolutely right that the changes in Saudi Arabia are significant. The regulatory changes are critical to the success of financial services in Saudi. Unfortunately, there are more regulations and guidance required to support the changes that they are looking to implement. As market participants, Northern Trust has an important role to meet with the regulators and explain differences and challenges compared with other markets.

Khokhar – In terms of the international markets, the second Markets in Financial Instruments Directive (MiFID II) in Europe is likely to have an impact. That’s something we’re looking at at the moment.

Funds Global – Do you see signs of increased institutionalisation of the regional markets, in terms of more stability and long-term decision-making, or are short-term retail investors still driving the markets?

Shamma – Yes, but not nearly at the pace we should be at. Part of the allure for international asset managers coming to the region was not to manage international money here, but to manage local money within the region. When 80% of the population in the UAE are expatriates, and 35% in Saudi, the lack of some sort of collective investment scheme is counter-intuitive. A private pension system would be a game-changer for us in terms of the institutionalisation of the market.

Hussain – On the fixed income side, there has been an increased institutionalisation, primarily driven by insurance company regulation, particularly in the UAE. But the holy grail is some sort of pension fund regulation. For the last ten years, I’ve been harping on about the Singapore example. It’s a country with a high percentage of expats that has a Central Provident Fund (CPF) that both expats and locals have to contribute into. The CPF has been the main contributor to the development of the local currency Singapore bond market.

Slater – Speaking to numerous people in Saudi Arabia about this, it seems that, from a marketing/PR perspective, it will be necessary to create pension schemes that look like Dutch-themed pension funds for workers in construction, for example.

At the moment, the end-of-service gratuity plans in the region are not funded and are a mere liability on an organisation’s balance sheet.

Seth – The directional trend is positive. But, does the market require it to be at a faster pace? I think that’s the real question. We are looking for a pick-up in Saudi Arabia and potentially that will flow through to other markets.

Funds Global – When you look ahead to the next 12 months, are you optimistic or pessimistic about the opportunities for your industry?

Seth – We are encouraged by what we can expect to happen in Egypt, for example, once price stability flows through and the investment cycle kick-starts. Kuwait is attracting a lot of attention and Saudi change and index inclusion dynamics are well understood. So, looking at the pipeline, looking at the client dialogue, we have good reason for optimism in terms of activity levels in the market.

Gibbs – I’m cautiously optimistic, but I am never surprised by the abilities of this region to pull out a sudden shock from left field. I’ve seen it too many times. That’s what makes it interesting.

Khokhar – If we get a stabilisation of the oil price, continuation of reforms, diversification of revenue streams, that’s all positive.

Hussein – We’re a young industry in this region, so we’re coming off a pretty small base, but clearly the trend is positive allocations and institutionalisation of the money.

From a global market perspective, there are a lot of uncertainties, particularly around interest rates. If we see significant volatility on that front, that could be a headwind for us.

Shamma – From an industry point of view, the pressure on fees is going to persist. However, there is still appetite for performance and alpha. In terms of geopolitics, geopolitical risk is a fact we need to deal with, whether in the region or outside.

Slater – We are optimistic because of the risk and regulatory changes that are going on in the marketplace. As a company, we are investing in the region by doubling our staff.

©2017 funds global mena

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