Direct investors, not index traders, will really drive the UAE economy

It is not clear how the index-based investors who do end up investing will benefit the UAE market.

Inclusion in an equity index is a sign of the maturity of a market based on past accomplishments and has little direct effect on the future. The main point raised by the supporters of index inclusion is that international funds and investors who are benchmarked to the index will have to invest in the market.

This is not entirely correct. There are multiple reasons, not least of which is statistical, as the low weighting of the UAE in the MSCI Emerging Markets Index means that the effect on tracking error is low, which usually leads index trackers to skip investing in the market and save on the costs of managing a new market (tracking error is the difference between the asset manager's return and that of the index).

Furthermore it is not entirely clear how investors being forced to invest in a market via a change in MSCI’s guidelines is a positive development. Foreign investors interested in the UAE equity markets have been investing for more than a decade, both directly and via swaps. These active investors, who sought out the UAE markets because of conviction, are the country’s real financial supporters.

It is also not clear how the index-based investors who do end up investing will benefit the UAE market. There is, of course, a surge in price as they enter the market, the benefit of which is to equity traders and not to the listed companies, but then what? As the one-time spike in demand retreats, market prices will drop back down to rational levels. Furthermore, index-based investors are, by and large, passive. There will be a small increase in liquidity but nothing market moving.

Inclusion in the MSCI Emerging Markets Index is best seen as recognition of a job well done in developing the equity markets. It also signals to investors from around the globe as to the improvement in the maturity of the equity markets.

It is not, however, a catalyst to further development of the economy. Unfortunately the public relations spin, which helps froth up the markets to the benefit of a small number of stakeholders, is ignoring the lessons of 2003 to 2008, when the main focal point of regional investment was the public-equity markets, including initial public offerings and pre-IPO private equity. This focus on a single oversupplied segment of the funding structure of companies led to an overheating of the market with disastrous results. Market events of the past 18 months exhibit an eerie similarity to that period.

Most companies in the UAE are SME’s, a demographic true in most if not all markets globally. SME’s rarely seek IPO funding, as private-equity and mezzanine debt funding is far more appropriate. For the UAE economy to continue to thrive, the focus needs to be shifted to these areas to allow these markets to mature in the same manner.

This would mean reviewing and overhauling ownership and bankruptcy laws as well as laws and regulations governing financial instruments, such as convertible debt and other hybrid securities. Developing the private and so-called illiquid markets to reach the same maturity as the public-equity markets will open up the foreign direct investment funnel and provide a more balanced source of funding for companies and a pipeline of mature companies ready to list on equity markets hungry for new opportunities.

Furthermore, foreign-direct investment, known as FDI, has many knock-on effects on the economy. A foreign investor buying shares on the public-equity markets is simply engaged in a transaction – the seller and the broker benefit, but that is the extent of it. FDI into the market, however, is an investment that can lead to equipment purchases, new employment, demand for services and a myriad of other benefits to the economy. Trading shares has never grown an economy. Direct investment in productive companies always will.

Expansion of the public equity markets, although important, will not lead to expansion of FDI let alone the economy. Direct stimulation of the SME market on a broad, multi-sector basis is a far more effective way to create sustainable growth in the economy. It isn’t sexy. But it works.

Sabah Al Binali is an investor and entrepreneur with a track record of financing, building and growing companies in Mena

Follow us on Twitter @Ind_Insights