Euromoney: Qatar prepares for MSCI boost

Euromoney, May 2011

Qatar is just weeks away from finding out if it will be included in the MSCI Emerging Markets index – a potentially pivotal event not just for the country’s stock market, but the whole GCC region. The Gulf has long been an oddity in index terms: prosperous, developed and resource-rich nations that don’t feature in major world benchmarks. Finally, the anomaly may be about to be corrected.

Gulf markets have been missing for a variety of reasons. Saudi Arabia, much the biggest and most liquid, can only be accessed by foreigners through a swap structure, which counts it out of major indices. Kuwait has accessibility issues too; and most of the rest have been deemed too small, too young, and often restricted as well.

But last year MSCI served notice that things could be about to change. The index provider reconsiders where countries fit in its indices once a year in its annual market classification review, completed at the end of May each year and announced in June; any changes then take effect a year later, giving markets and fund managers time to adjust. Last year, MSCI declined to move Qatar and the UAE from its frontier markets index, where they reside today, to the closely-followed emerging markets index. But it declined in such a specific way that the signal was very clear: deal with the issues we’ve identified, and you’ll be in next year.

In Qatar’s case, MSCI highlighted two things: strict foreign ownership limits (there is a 25% ceiling), and the frequent use of dual account structures, with segregated custody and trading accounts. The use of these structures, MSCI said, “because of unlimited access by local brokers to trading accounts remains an issue that needs to be addressed for the market to meet emerging marker standards.”

There’s a lot to be gained from market inclusion. Ryan Salam at Franklin Templeton Investments estimates that Qatar would take up 62 to 100 basis points of the MSCI Emerging Market Index if included, and since about $400 billion of institutional capital tracks the fund, that would translate to $2.5 billion to $4 billion of capital coming into Qatar (the UAE, by contrast, would get about $1 to 1.5 billion). “If you look at the last six months trading, that translates to a 70 to 100% increase in traded value in Qatar,” he says. “And if you assume all emerging funds are to track the index you can more than double those numbers.”

Qatar Exchange could clearly see the opportunity, and set about a review of its market infrastructure, upgrading its trading technology in September and then announcing a key new reform on March 17. This is the adoption of the Delivery Versus Payment (DVP) rules. These rules allow custodians to participate in the cash settlement cycle, and to confirm or reject trades for settlement, with rejected trades remaining with the broker for settlement. This means that custodians have full control of their securities – and so the dual account structure that MSCI objected to becomes optional (though it is not being removed outright). This was clearly done to comply with MSCI concerns – indeed, the potential upgrade was explicitly mentioned in the exchange’s March statement – and will be followed by other reforms: the exchange mentions a central counterparty, direct market access through sponsored access, securities lending and borrowing, margin trading and covered short selling as possible further innovations. “I strongly believe that Qatar will be included to the classification this year,” says Abdul Hakeem Mostafawi, country head for HSBC in Qatar – which, as the only custodian bank in the market, has been instrumental in the reform process and has been working with Qataris public institutions on the MSCI issue since 2007. “Every passing year the market has improved its systems and possesses growing investor confidence. The Qatar market has been able to live up to its promises and has been able to deliver on time.”

There hasn’t, though, been any mention of a change in foreign ownership rules, which is partly because it’s not the exchange’s place to change them. Instead, some close to Qatar believe that the foreign ownership limit could be lifted – perhaps to 49% – by an Emiri decree before the end-May deadline, that being the quickest way to get such a change through. Others are less sure. “There is still sufficient headway for foreign investments,” says Mostafawi. “I am confident during the coming months listed companies will work on improving their foreign ownership levels. Increasing the foreign ownership levels freely could have an adverse impact on the entire market. Therefore it has to be done systematically.” But others feel that, particularly if foreign ownership is perceived to be a deal-breaker, Qatar’s rulers are likely to think raising the limit a sacrifice worth making.

Salam says it’s not the end of the world if Qatar is not included. “There hasn’t been much chatter about it until last week, and it hasn’t been priced in,” he says. But it has become another reason for more and more investors to start to look more closely at the island state. Until now, global fund managers with any interest in Qatar – or any Gulf market – have had to express it through an off-index bet, which is a risk and an effort. Inclusion would not only alleviate that effort but also make it essential for global emerging market managers to consider the market. Under that arrangement, omitting Qatar would become the off-index bet instead.

Qatar has found itself in something of a sweet spot, and sometimes for unexpected reasons. The headlines are well known: one of the world’s largest bounties of natural gas, 16% GDP growth in 2010 which the IMF expects to grow to 20% in 2011, compound annual growth rates of 40% and 53% respectively in imports and exports between 2006 and 2009, and a diversification strategy anchored by $145 billion of projects over the next seven years. That’s before one considers the trophies: the successful World Cup bid for 2022, and the somewhat brazen asset-gathering approach of its sovereign wealth fund, the Qatar Investment Authority.

But on top of that, unrest elsewhere in the Middle East has, if anything, served to help Qatar so far, particularly in comparison to neighbouring Bahrain, which until this year had built much of its prosperity on being a peaceful entrepot through which to serve the far bigger economies of Saudi Arabia and Kuwait. When the region’s landmark asset management conference, Fund Forum, announced that this year for the first time it will be held not in Bahrain but in Doha, it underlined the sense that Qatar (like the UAE) has been able to gain some of that stable and steady reputation. Qataris are, to be blunt, absolutely loaded: the country had the world’s highest per capita GDP in 2010, according to the IMF, and the wealth is distributed more widely than is sometimes the case elsewhere, with housing grants upon graduation, free land and amenities and almost 100% employment rates. There is little reason to revolt in such an environment, but the Prime Minister has nevertheless announced some changes in the elected parliament system to head off challenges; unlike Bahrain, it doesn’t face the issue of a minority group ruling over a majority (in Bahrain’s case, Sunnis ruling a majority Shia population).

“In my view, political stability in Qatar is very positive and will continue for the foreseeable future,” Mostafawi says. Indeed, following on from Qatar’s role hosting peace talks about Libya, he believes the country may be gaining a role as a moderator and mediator. While not all are quite so optimistic, there’s no question Qatar has escaped much of the unrest elsewhere in the region. Youssef Nizam, head of equity research at Audi Capital Saudi Arabia, sees the country’s size and GDP as clear assets. “They have deep pockets to tap, and with a small population it might be easy to minimize – not avoid, but minimize – political risk coming from unrest,” he says.

Nizam has made Qatar his key overweight. “The major reason is the GDP growth,” he says. “Qatar has made huge investments into the natural gas business and many investments are starting to materialise now and will be reflected in the economy. It is a country rich with resources but small enough to be able to deploy those resources within the country: a small prototype that is easily manageable compared to other countries in the region.” With MSCI inclusion, Nizam says, “definitely the multiples will tend to expand. It will be more covered by foreigners and Qatar will have its share of the huge inflow of funds that tracks the index. It will definitely be a positive catalyst.”

This coverage point is one of the many slow-burning benefits inclusion would bring, and in some senses the main one. “A lot of people are already cognizant of how attractive Qatar is economically,” says Emad Mansour, CEO of Qatar First Investment Bank, “so I’m not sure it’s going to lead to a major movement of assets into Qatar in the short term. But in the medium to long term I think it means the market becomes more in focus, with more companies covered by the big brokerage houses.”

MSCI inclusion would also be a major shot in the arm for the Qatar Financial Centre, which has so far not attracted the same volume of foreign institutions as has the Dubai International Financial Centre (though whether the DIFC has succeeded in bringing in much foreign capital, as opposed to helping foreigners to take capital out in the other direction, is a different question). The QFC shifted its focus some years ago to a focus on insurance, reinsurance and asset management, and on the last of these MSCI inclusion would clearly help. “Developing Qatar as the pre-eminent hub for asset management in the region is one of the Qatar Financial Centre Authority’s key strategic objectives,” says Yousuf Al-Jaida, director of strategic development for asset management and banking at the QFCA. “Qatar’s accession from frontier to emerging market status would therefore be hugely beneficial in delivering that aim as well as a big endorsement of what has already been achieved in Qatar developing world-class regulatory and financial market infrastructure.”

Al-Jaida says allocations to MENA-wide assets are going up already, and that MSCI inclusion “will clearly add a lot of momentum to Qatar’s financial services industry. We expect the long term upside for volume growth in assets management out of Qatar to be significant, beyond the direct benefits to the Qatar Exchange itself in terms of liquidity and capital inflows.”

BOX: Knock-on effects

If Qatar does get MSCI approval this year, it may well be joined by the UAE. Last year MSCI said it “continues to be encouraged by the planned future enhancements by the Emirati regulator,” which included increased foreign ownership limit levels, equal foreign access to the local equity market, and a DVP settlement system like Qatar. MSCI noted, though, that “these future enhancements were announced some time ago”, and that “international institutional investors are hopeful that [financial turmoil] will not bring any further delay in the implementation of the proposed enhancements. Investors would also welcome a public roadmap from the regulator and the exchanges providing visibility on the timetable of implementation of these changes.”

At the time of writing, the UAE was continuing to make the right noises but appeared to be behind Qatar in implementing changes. It is now running short of time, but fund managers in the region think the benefits of inclusion are such that the necessary changes will be made. The fact that the UAE has historically had three separate exchanges adds some complexity but is not considered likely to be too problematic as the MSCI has never raised it as an issue before.

An interesting question is whether the demonstration effect of new inflows coming into Qatar or the UAE, if included, could prompt others to act. Kuwait used to be considered a likely candidate for index inclusion, but the MSCI last mentioned it as a candidate in 2009, and then said access restrictions were too difficult. Might Kuwait change those restrictions in order to join GCC peers in the market?

But the bigger question is about Saudi Arabia – by far the largest economy and stock market in the Gulf. There has been a gradual opening up of the Saudi market to foreigners: where once they could only get access by buying mutual funds (and even then under some restriction), they can now get exposure to Saudi stocks through swap arrangements. This is some way short of the direct access that index providers would require, but clearly a step in that direction.

If Saudi did further liberalize, there would still be one headache to resolve: the fact that MSCI and Saudi Arabia are scarcely on speaking terms following a dispute about commission, royalties and licence approvals. That, though, is probably an argument for another day.