Israel will need to institute new measures to increase liquidity and broaden the base of portfolio investors in an effort to compete as a developed-status country on the MSCI Inc. and to counteract the resulting liquidity risk, according a report by the Milken Institute published on Monday.
"The reclassification is a testament to Israel's success, but it also presents some significant challenges," said Glenn Yago, director of Capital Studies at the Milken Institute and head of the Institute's Israel Center. "The potential outflows and stock reductions could negatively impact Israeli market liquidity in the short term, increase the cost of capital and reduce overall portfolio investment.
"Increasing transparency and liquidity can help Israel overcome these new challenges and are required to attract international investors."
In June 2008, Israel was raised to developed-market status from emerging-markets status by MSCI Inc, whose stock indexes are tracked by investors. The findings of the report suggest that investor reaction could cause an outflow as high as $2.5 billion, while the size of potential inflows that might offset this loss is unclear, given the sector-based investment strategy commonly used by developed-market investors.
Among market makers and investment houses, there has been much concern that as a result of the upgrade, which will come into effect next May, Israeli stocks may initially suffer because their weighting in the developed-market indexes will be lower than in emerging-market benchmarks.
Israel comprises about 3 percent of the emerging-market index, which makes it heavily weighted in the index, attracting a good amount of both passive and active investment. In the developed market, Israel would comprise about 0.37% of the market and have a much smaller "footprint" for index investors.
"Reclassification changes the ball game for the Israeli capital market," Yago said. "This is not a time for 'business as usual' as reclassification approaches."
The report is calling upon Israeli-based businesses, government agencies and capital-markets regulators to swiftly step up measures for significant regulatory and market changes to enhance the transition to developed-market status. Based on interviews with investment experts and asset managers, the report estimated that at least 50% of the $4.75b. index-related foreign investments in the TASE could face disinvestment through index reclassification if no measures are put in place to counteract the resulting liquidity risk.
"Israeli entrepreneurs, venture-capital and private-equity investors, government and municipal corporations seeking private investment, and project finance markets all need greater liquidity, transparency, corporate governance rules and reduced concentration of holdings to encourage foreign investors," Yago said. "Without the continuation of financial reforms that deepen and broaden local capital markets, the transmission of savings to investment in Israeli firms, both locally and internationally, could weaken."
Among the recommendations put forward in the report are an increase of the free-float requirement (the percentage of shares of a public company that are available to the investing public) for leading indices and the creation of alternative investment products, such as exchange-traded funds, mutual funds, private investments in public equity, and unit-investment trusts to represent the Israeli market as a whole (including firms that do not meet the MSCI requirements) and emerging sectors in which Israel has strengths such as health, clean-tech and information and communications technology.
The report suggests the expansion of Israeli firms on the MSCI by encouraging target companies that could accomplish a small percentage change in free-float market cap to meet the MSCI minimum through divestment, spin-offs, and diversification of concentrated and centralized holdings. Nine potential companies are suggested in the report: Dan Hotels, Granite, IDB Holdings, Netvision, FMS, Delek Israel, Jerusalem Econ, Industrial Building and Delek Energy.