The Middle East's Upgrade

A recalibrated index has helped investors rediscover the markets of the Middle East, and the largest may yet rewrite the index altogether

In 2007-08 a wall of money fell on the Middle East markets that almost buried the local sub-custodians. Keeping capacity in line with demand is the greatest challenge in emerging market sub-custody, because mismatches are impossible to fix promptly when expertise is in short supply. HSBC, which utterly dominates Middle Eastern custody, will be pleased that operations bolstered by automation and offshoring are comfortably absorbing a fresh surge of capital into the region.

The inflow could scarcely be more welcome, for it has taken the Gulf states a long time to recover from the financial crisis. In 2009, as other emerging markets began to pick up, Dubai was being rescued from its debts by Abu Dhabi, which continues to agree to generous terms with its neighbor. The Arab Spring, which began in Tunisia in December 2010, created further uncertainty, particularly after the overthrow of the Mubarak regime in Egypt in February of the following year.

Egypt, long the only material emerging market in the Middle East, lost half its value in 2011 as the revolutionary regime pursued any foreign investors thought to be associated with Mubarak. It would probably have lost even more if the central bank had not imposed currency controls and if wealthy Arabian neighbors had not topped up the foreign currency reserves. The Cairo market has recovered since the military took charge, but this year it only narrowly averted relegation by MSCI to frontier status.

In the Gulf states, by contrast, the recovery, which began in 2012, turned spectacular in 2013-14. From trough to peak, Dubai climbed 175%. Abu Dhabi doubled, and Qatar was up two-thirds. Only Kuwait failed to advance. The explanation for all four is obvious: recovery from a crisis-induced descent exacerbated by the Arab Spring and local defaults, plus an MSCI decision to upgrade the UAE and Qatar—but not Kuwait—from its frontier to its emerging markets index at the end of May 2014.

Arindam Das, regional head of the Middle East and North Africa for HSBC Securities Services, says that on May 29 itself the volume of trades settled by HSBC Qatar was up 20-fold on the daily average of 2013. In Abu Dhabi and Dubai, settlements rose 16-fold. Excitement has faded since, but daily volumes are still three-to-four times up on the rising markets of 2013, when local and international active managers piled into the UAE and Qatar ahead of the prospective wall of indexed money.

The upgrade of the three markets has even had a positive impact on the lackluster Kuwaiti market, which now looms larger than ever in the MSCI frontier markets index. And anyone who thinks that operations are not as influential as portfolio management should ponder this: it was local custodians who cleared a principal hurdle to an earlier upgrade by finding a solution to an infrastructural obstacle to emerging market status identified by MSCI.

The dual account structure in Qatar and UAE, by which stock is often held not in a custody account controlled by the custodian but in a trading account accessible by brokers, aims to eliminate settlement failure. But it exposes assets to the risk of being used to settle trades that are not genuine. Reforms led by custodians now allow trades to be rejected and oblige brokers to return stock (if necessary by buying or borrowing it) and compensate disappointed buyers with cash.

Network managers still gripe about the need to run trading accounts and having to reject trades a day before settlement—negative instructions are an unfamiliar idea—but they recognize moving securities continuously from a custody account to a trading account is too cumbersome and expensive an alternative. More importantly, the new investors driving up asset values would not have invested without some mitigation of the risk of misappropriation of assets by brokers.

Soon they will get the chance to sample a risk more appealing than that. In late July the Saudi regulator announced that foreign investors would be allowed to invest directly in the 167 companies listed on the local stock exchange, Tadawul. They operate in a rich, fast-growing and populous economy, with nearly twice as many citizens as Kuwait, Oman, Qatar and UAE combined, most of them young. The $531 billion capitalization of Tadawul accounts for half the stock market value of the region.

Hitherto accessible only via mutual funds or equity swaps, an open Tadawul would transform the weighting of the Middle East in international portfolios. Whether this is what happens depends on the regulatory caveats. The Saudis have ideas about which investors are worthy of admission and how much they will be allowed to invest. Custodians already freighted with inactive Saudi accounts would be wise to defer adding capacity. Riyadh is a place to invest on the news, not the rumor.