In January, the UAE’s Financial Services Association – an industry lobby group comprising asset managers, law firms and banks active in the emirates – launched a five-year plan intended to breathe new life into the country’s capital market.

The main UAE bourses’ performance has been impressive, with the Dubai Financial Market (DFM) index rising almost 20 per cent in 2012. Participants believe, however, the emirates’ capital market is still far from reaching its full potential of becoming an effective platform for capital raising, acquisitions and divestitures.

Other indicators suggest all is not well with the market. Investment banks, such as the US’ Morgan Stanley and Zurich-headquartered Credit Suisse have reduced head counts in Dubai, with average daily trading volume in the emirate about 50 per cent lower than in the same period in 2008, according to Bloomberg.

Investor access

Significantly, the two UAE firms that launched initial public offerings (IPOs) last year, chose to list on an international rather than a local bourse. NMC Healthcare listed its shares on the London Stock Exchange in April in a $206m deal, while Amira Nature Foods launched its $90m offering on the New York Stock Exchange in October.

More troubling, given UAE authorities’ plans to encourage family-owned businesses to list on the local market, the IPO planned by Dubai-based conglomerate Al-Habtoor Group was scrapped, with the family firm choosing to seek alternative ways of growing the business.  

Against this challenging backdrop, the Financial Services Association’s new plan attempts to chart a long-term strategy to tackle the structural flaws undermining the capital market’s performance. For example, by fostering pension funds, and in the medium-term, soliciting sovereign wealth funds (SWFs) to provide additional liquidity by investing in local markets.

The plan sets out ways to improve investor access to the market and permanently raise volumes and liquidity. Development of pension and gratuity schemes, says the association’s co-founder, Arwa Hamdieh, would provide for steadier flows of liquidity to the capital market. At the practical level, pension funds – in their infancy in the UAE – could be obliged to provide an allocation to the local market.

Hamdieh is also seeking a UAE-wide harmonised approach towards industry regulations to create a comparable regulatory framework with other, more developed, markets.

“Our initiatives address the supply side, looking at rules and regulations for listing and offerings, with the aim of encouraging companies to list,” says Hamdieh. “On the demand side, we will look at investors’ activities. The liquidity coming into our market right now is dominated by retail investors and we are trying to balance that with institutional investors.”

Building up pension funds would help forge a base of institutional investors, but, says Hamdieh, to get to that point will take years. “In the meantime, our suggestion is to encourage the SWFs to have a greater participation in the market and to help kick-start institutional investment activity,” she says.

The strategy document comes amid a welter of changes to the UAE capital market. Last year saw the newly strengthened UAE Securities and Commodities Authority (SCA) acquire additional powers, covering conduct of business and consumer protection, leaving the Central Bank to take responsibility for macro-prudential issues, such as financial stability.

Waiting for liberalisation

Last year, the SCA courted controversy when it published revised rules targeting investment funds, granting itself powers to approve all domestic funds set up in the UAE. The move was made alongside additional requirements for documentation, investment policies, subscription, trading and the redemption of fund units. The SCA has also issued draft rules on market-making and short-selling, alongside new rules to provide bookbuilding for IPOs.

Meanwhile, the planned new companies law, currently being discussed by the Federal National Council, could open up local firms to majority foreign ownership, removing the current 49 per cent cap. Market practitioners, however, are still waiting for clarity on whether it will sanction full liberalisation and pave the way for higher capital flows from overseas.

The DFM outperformed the GCC average last year, and both it and the Abu Dhabi Securities’ Exchange reported 10 per cent increases in market capitalisation in 2012. The markets’ rebound does not mean the major structural challenges facing the UAE capital market have been addressed.

Non-bank financial institutions – pension funds, insurance companies and mutual funds – have only a small penetration of the market. The continued dominance of retail investors, with their short-term investment horizons, is stunting development of the market.

Yet incentivising institutional investment is no easy task, especially since the main UAE social security institutions – the UAE General Pensions and Social Security Authority (GPSSA) and the Abu Dhabi Retirement Pensions & Benefit Fund – were only recently formed. In total, they had just $3bn of assets under management in 2010.

The GPSSA accounted for less than 0.01 per cent of equity market capitalisation in 2010. By comparison, Saudi Arabia’s Public Pension Agency and the General Organisation for Social Insurance accounted for a combined 7.4 per cent of the Saudi market.

Debt capital market

Nonetheless, entities such as the GPSSA and the Abu Dhabi fund are seen as well suited to developing the debt capital market, by investing in fixed-income instruments. Dubai’s painful bout of debt restructurings at its government-related entities (GREs) has restored a semblance of confidence in the UAE’s debt market to the extent that, in January, it completed a $1.25bn sukuk (Islamic bond) issue that attracted orders of about $15bn.

UAE capital market issuance – compared to a relatively small population of 7.5 million – is large. “Billions of dollars are being raised by GREs and corporates based in the UAE,” says Debashis Dey, partner in UK law firm Clifford Chance’s Dubai-based capital markets practice. “Abu Dhabi’s GREs have been active participants in the debt capital markets since 2009 and we have seen significant debt issuance from the emirate across multiple currencies and tenors. To local and international investors, Abu Dhabi’s issuers are familiar, welcomed names with well-received credit stories.”

According to Dey, rather than simply seeking to develop a broader range of investors, key sectors need to be brought into the capital market, such as small and medium-sized enterprises.

“This is definitely a challenge, because the family-owned businesses, the big merchant families and the medium-sized but successful companies don’t yet access the capital markets,” he says. Al-Habtoor’s shelved IPO, and another delay to a planned IPO at Dubai-based Daman Investments – blamed on liquidity concerns – confirm how difficult it can be to list.

At the other end of the spectrum, there is growing clamour for SWFs, such as Abu Dhabi Investment Council and Investment Corporation of Dubai, to actively support liquidity in the local UAE market.

These funds remain globally focused, with most assets placed abroad, although this is starting to shift. Last year, 56 per cent of new money from Gulf SWFs was invested within the GCC, up from 33 per cent in 2011, according to figures from US asset manager Invesco. A greater domestic focus is tangible in SWF strategies. Qatar’s sovereign wealth fund has, for example, allocated $2bn to offer as seed capital to attract asset managers to the Gulf state.

Western investment banks and asset managers are increasingly alive to the opportunities of managing Gulf SWF investments. The US’ Wells Fargo – in which billionaire investor Warren Buffet is the largest shareholder – announced in February that it is looking to target UAE and Qatari SWFs. 

One reason SWFs may be more willing to invest locally is that the UAE market offers a broader range of instruments.

“Historically, the absorption capacity of the region was lower than the foreign exchange revenues generated by these economies, which is why these receipts were invested outside the region,” says Giyas Gokkent, chief economist of National Bank of Abu Dhabi. “Increasingly, the domestic economy’s absorption capacity is getting larger and there is a wider range of instruments available for investors to place funds.“

Over the long term, attracting additional foreign investors may prove more worthwhile than allocating a larger proportion of SWF wealth to the local market. The key is to press ahead with reforms that would ensure the UAE’s inclusion on the MSCI Emerging Markets index. This would automatically give it exposure to a range of portfolio investors beyond those that buy into frontier markets, under which the UAE is currently categorised. In June 2012, US-based equity index compiler MSCI announced the UAE was under review for possible reclassification, with a decision due in June 2013.

Driving reform in the UAE

“It’s not just the SWFs, it’s also about foreign investment,” says Gokkent. “As the UAE graduates to emerging market status, there will be a broader range of funds automatically targeting this market, because passive funds will automatically get [some] money coming here and proactive funds will see it as a place where they can generate some [returns]. The valuations are pretty good compared with the rest of world.”

If the UAE removed the 49 per cent foreign ownership ceiling, that would clearly help its chances of winning an upgrade. But most analysts think the UAE will struggle to achieve that target this year.

MSCI inclusion is not a deal-breaker, says Gokkent. Reform of the UAE capital market is about evolution, not revolution. “Valuations are good and the yields are good, so I think there will be investor interest in the UAE irrespective of what happens with MSCI,” he says.

Other necessary reforms include an enhanced bankruptcy law to resolve uncertainty over how creditors would be treated in complex insolvency cases. “Right now, the insolvency law is out of date, given the sophistication of the market. The UAE has a very sophisticated group of companies operating under a very antiquated set of laws around bankruptcy treatment,” says Dey. “The sooner both the company and bankruptcy laws are reformed, the more likely it is investors will gain the confidence they need.”