With a large population and sound industrial base, Saudi Arabia presents considerable
Bassel Khatoun
opportunities for asset managers targeting the GCC region. With most of the population under the age of 25 and numbers rising by 2.5 percent a year, demographics are likely to drive even more development and consumption in the coming years. Only the closed nature of the market has held back investment in Saudi Arabia and strict regulations there look to be loosening. MENA Fund Review spoke to Bassel Khatoun, portfolio manager, asset management, Franklin Templeton Investments (ME) Limited, about the opportunities and risks of investing in Saudi Arabia
SAUDI ARABIA is the giant of the GCC, with a strong manufacturing base and demographic trends that could drive further asset management opportunities in the future.
It is by far the most populous country in the region with 28 million people, which is rising at a rate of around 2.5 percent per annum with the majority below the age of 25.
In contrast to other countries in the GCC, nationals form the large majority of the population with expatriates representing less than 25 percent.
According to Bassel Khatoun, portfolio manager, asset management, Franklin Templeton Investments (ME) Limited, “The country is characterised by two interrelated dynamics – a young and growing population with mounting needs combined with a willing and able government that appreciates the necessity of addressing its population’s concerns. The combination of these two factors creates the backdrop for a strong macroeconomic climate.”
The need to cater for this young and growing population provides an attractive backdrop for demand growth across many areas of the economy and in the face of this the Saudi Arabian government has shown a serious commitment to support its economy.
“It has taken active counter-cyclical measures to boost the economy through its budget and this continues to underpin the short- and long-term prosperity of the country,” says Khatoun. “Through its expansionary budget, it is clear that Saudi Arabia is both able and willing to support the economy.”
Testament to this is Saudi Arabia’s recent budget announcement which, supported by high oil prices and record production levels, envisages a 19 percent increase in state expenditures over the 2011 budget. The commitments for 2012 emphasise infrastructure and social spending as allotments to education, health, and infrastructure and are all anticipated growing by double digits. This underpins the state’s plan to continue building the infrastructure necessary to support its population and diversify away from its reliance on oil, according to Khatoun.
The Saudi Arabian economy has emerged relatively unscathed from the global financial crisis with real GDP growth remaining positive throughout the period.
“That achievement is owed, in large part, to the active counter-cyclical measures taken by the government to boost the economy through its budget,” says Khatoun.
“At the same time, the Saudi government used its ample reserves to deleverage the economy by reducing government debt to GDP to currently less than seven percent compared to over 100 percent in 1999. The central bank, too, played an important role by taking steps to ensure that the banking sector remained adequately liquid and strongly capitalised.”
Despite the country’s relative isolation from the damaging effects of the financial crisis, the event did provide valuable lessons, according to Khatoun. “Playing an important role in forming greater consciousness of bubbles, it has forced better regulation and it severely damaged the concept of name lending – all positives that will shape Saudi Arabia for a stronger future,” he says.
The Arab Spring too has had no negative impact on the Saudi market. It has allowed investors to differentiate between Gulf countries, according to Khatoun, seen as far more affluent and able to withstand the shocks from the Arab Spring than some of the less wealthy countries.
In that context, Saudi Arabia has amassed substantial surpluses that support its supplementary spending programmes, which are estimated to be in the order of $100 billion, announced in response to political tensions.
“Overall, the increase in government expenditures in response to social unrest is likely to have a positive impact on long-term economic growth in Saudi Arabia,” Khatoun believes. “Consumer demand is likely to grow in the medium term as social spending boosts household income. Unsurprisingly, the Saudi Arabian authorities have focused their attention on job creation, subsidies and policies that are people-friendly. These policies will further improve long-term consumption patterns. While that has, in many cases, calmed public sentiment, it has put greater economic pressure on the government as it navigates through an uncertain global economic environment.”
The combination of organically high growth rates, ample reserves and pro-growth fiscal measures driven by necessity creates highly compelling investment opportunities in Saudi Arabia, according to Khatoun.
“At a sector level, it goes too often unmentioned that Saudi Arabia offers high structural profitability in many areas,” he says.
“Petrochemical companies show world leading margins as a result of cheap gas agreements with the government. In a similar vein, Saudi Arabian banks offer investors some of the highest spreads in the world as a result of non-interest bearing deposits driving down their funding costs.
“Also, there are certain retail plays that command margins that are double those of emerging market comparables thanks to limited product penetration. Finally, the strong underlying demographic trends and the shortage of affordable housing have created an interesting opportunity in certain segments of the real estate market.”
Overall, these factors give Saudi Arabia a structurally high return on equity which investors dedicated to the MENA markets can take advantage of.
“In the face of this, there is widespread confidence now that the market in Saudi Arabia is finally opening up to foreign direct equity investment,” says Khatoun.
“We are optimistic that Saudi Arabia will take a first step marketing this direction very soon and we expect an announcement from the Saudi regulator to clarify their position imminently.”
To date the Capital Markets Authority in Saudi Arabia has taken a cautious approach to foreign access, driven by fear of hot money flows creating increased volatility. With this in mind a soft opening with stringent restrictions on qualified foreign institutional investor licensing, combined with restrictions levels a ownership within certain sectors of the economy, is likely.
“We are extremely excited about the opening up of the largest market in the region, a market which offers better liquidity and sector breadth than its regional peers,” says Khatoun.
“We believe that the Saudi market offers compelling valuation levels given the impressive growth prospects that are driven by its robust macroeconomic environment.”
Opening of the Saudi market would likely bring with it a higher degree of institutionalisation, adding sophistication and maturity to the market over time. Corporate governance would also improve and market liberalisation would potentially pave the way for a future upgrade of Saudi into the MSCI Emerging Market index, which would provide an additional liquidity boost, according to Khatoun.
“The market has reacted positively to this development and, in fact, daily traded values have trebled since last year to almost $3 billion a day. We are expecting positive news flow from Saudi Arabia in the short-term which will likely support our constructive outlook on the market.”
Of course there are well known barriers as well as risks associated with investment in Saudi Arabia. Foreign investors can only indirectly access the market through swap agreements with authorized investors who would legally own the underlying shares and this has resulted in very limited foreign participation.
“On the economic front, government revenue remains highly reliant on oil exports, which in turn makes it sensitive to oil prices,” says Khatoun.
“If oil prices were to decline substantially for a prolonged period of time, then the Saudi Arabian government’s ability to execute its spending plans may be compromised. That said it is also important to mention that any potential shortfall in a lower oil price environment can be temporarily covered by the generous store of foreign assets held by SAMA, which stands at around $525 billion, equivalent to almost a full year of GDP.”
Execution risk is also an issue. Despite its impressive resources, Saudi Arabia has yet to fully convince investors that it intends to focus its enormous wealth on projects that generate positive returns for all stakeholders.
“Its track record here remains untested but the government is taking steps in the right direction. Further progress could come in the form of a reduction in bureaucracy and improved labour and investment laws that would facilitate doing business in the country,” according to Khatoun.