"We’re back, of course we’re back,’ Dubai ruler Sheikh Mohammed bin Rashid Al Maktoum told Bloomberg TV in an interview on September 26. His confidence in Dubai’s economic resurgence was reinforced days later in a US$1.25 billion Dubai sovereign bond issue that was four times oversubscribed, signaling the emirate’s return to the fixed-income market. Renewed investor confidence in Dubai came on the heels of the debt restructuring agreement hammered between troubled state-linked conglomerate Dubai World and the majority of creditors to reschedule about US$25 billion of debt.
Dubai couldn’t have done any better. It now stands to benefit from investor perception that the United Arab Emirates (UAE) and Qatar are insulated from the protests that have rocked the rest of the Arab world. "The Dubai story may conversely have benefitted (from the unrest) as it is regarded as a more stable jurisdiction," says Giambattista Atzeni, corporate trust vice president and MENA business manager at BNY Mellon. "If Dubai had not put in place a coordinated action plan for its debt, it might not been able to be in the same position regionally today."
Even before protests began, Dubai’s US$1.25 billion issue triggered a flood of bond sales in the region, with investor demand for Gulf bonds proving so vigorous it prompted state-controlled Qatar Telecom to return to the market with a US$1.25 billion bond sale in October days after the Doha-based firm sold a US$1.5 billion bond that attracted more than US$15 billion in orders.
The flurry of issues from the UAE and the Gulf region as a whole since the third quarter of 2010 was driven by the improved economic outlook, tightening of spreads, and growing financing needs of issuers who were waiting for investor sentiment to improve before hitting the markets. Issuers in the six-member Gulf Cooperation Council, sold US$32.6 billion of bonds in 2010, compared with US$42.8 billion in 2009, according to data compiled by Bloomberg.
International investor thirst for emerging market bonds amid the low-interest rate environment and ebbing of sovereign default fears sparked by the Greek debt saga also helped Gulf issuers re-tap the bond market after a relative lull in the first half of 2010. But the political turmoil gripping the Arab world is threatening to ruin a good streak, as investors view the Middle East region as an unstable entity.
"It is quite clear that the risk premiums have gone up and rightly or wrongly investors are concerned about the political risk of the region,’ says Jarmo Kotilaine, chief economist of NCB Capital, the investment arm of NCB, Saudi Arabia’s biggest bank by assets. "For the near-term, investors will demand a premium to hold GCC (Gulf Cooperation Council) paper, which is unjustified given the economic fundamentals of these countries and the health of their economy.’
Uncertainty Troubles Investors
The uncertainty still gripping Egypt will continue to trouble investors, who are likely to demand higher yields for now. Overall political risk for the region has taken a turn as other countries such as Syria and Bahrain grapple with protests.
The impact of the political upheaval in North Africa has already taken a toll on Gulf debt. Credit default swaps for Gulf paper, including the sovereign debt of Saudi Arabia, have generally gone up by 10 points. Bahrain, which is grappling with its own political problems with a disenchanted Shiite populace, has found it difficult to access international debt markets because of its political instability. Its default swaps have risen by nearly 50% since January.
"This reaction (to the unrest) is similar to the Dubai World saga, when investors rightly or wrongly made assumptions about the Gulf region. But when this unrest stabilizes, people will begin to differentiate between Egypt and the Gulf,’ Kotilaine says.
There have been a segment of investors who are making those distinctions, says Abdul Kadir Hussain, CEO of Dubai-based Mashreq Capital, the investment banking and asset managment arm of Mashreq Bank. Hussain oversees roughly US$2 billion of total assets under management in fixed income assets for Mashreq Capital and Mashreq Bank.
"There was a sell-off in March that impacted the region, but people now are looking beyond the political impact," Hussain says. "People will demand a higher pricing than before [the unrest], but a lot less than they would have demanded in January or February or March. Countries where this crisis now is taking place are not big in terms of bond issuance. The bond market is dominated by Qatar and the UAE and they are viewed as relatively safe."
Despite the cloudy political future of the Middle East region as a whole, Gulf sovereigns and corporations are expected to continue to resort to the fixed-income market to finance vast state-led projects, finance spending needs and repay outstanding debt.
The Gulf’s embrace of the bond market has been building up since the global financial turmoil in 2008. Several issuers in need of cash held back on bond sales due to adverse market conditions. Several Gulf sovereigns, though, tapped the bond market in 2009 to create benchmark yield curves, cover their financings needs and help local corporates raise funds in international markets at a time when bank lending nearly screeched to a halt as banks began to clean up their balance sheets.
Though temporary, with oil prices once again exceeding US$120 a barrel, Hussain notes Gulf governments will have more flexibility and time to respond to financial demands than before the recent spike in oil prices. Atzeni expects another outcome to be more social spending. "Governments with budget surpluses [due to the increase in oil prices] will be in a position to finance social and infrastructure projects and also support, perhaps through guarantees, private sector financing," he says.
Those Gulf governments spending big on infrastructure while juggling deficits, and corporates seeking new sources of cash will continue to spur activity in the fixed-income market as banks lend cautiously and capital markets remain wobbly, analysts say.
"We are going to be in an environment for the next 12, possibly 24 months, where banks continue to tighten credit standards and deal with increasing provisions and increasing or maintaining capital adequacy ratios,’ says Mohieddine Kronfol, managing director of Dubai-based asset management firm Algebra Capital, in which California-based Franklin Templeton Investments has a 40% stake.
"A lot of what contributed to the crisis in this region are companies financing medium and long term projects with short-term funding from banks, content by the lower cost of funding, but obviously assuming significant liquidity risk."
Among the issuers expected to tap the fixed-income market in 2011 is Dubai’s debt-troubled state-linked property developer Nakheel, while the UAE could issue its first sovereign bond. Saudi corporates are expected to lead in 2011 in issuance of sukuk — Islamic bonds — as the government boosts expenditure.
Several Gulf issuers are turning to the fixed-income market to help finance the massive project pipeline that is planned in the Gulf region, where governments are ramping up spending to propel economic growth, create private sector jobs for a growing young population and diversify the state-led and oil-dependent economies. The pipeline of projects planned in the Gulf is estimated at over US$1.3 trillion, according to Dubai-based research firm Proleads.
Moody’s estimates that rated and unrated corporates in the six Gulf states have a total of US$212 billion of outstanding debt that will need to be financed in the coming years. Out of that total, Gulf rated corporates have about US$145 billion in debt outstanding, according to Moody’s.
Nearly a fifth of the $145 billion in outstanding debt for Gulf rated corporates will mature in 2012, according to Moody’s, presenting challenges particularly to vulnerable companies. Meanwhile, the same estimate shows unrated corporates in the Gulf account for over US$67 billion of debt outstanding.
"The bond issues need to start trickling down and smaller companies need to approach the bond market,’ says NCB Capital’s Kotilaine. "There is a need for a better rating system and a better understanding of the risk profile of issuers.’
Government Guarantees Questioned
The subject of risk gained prominence with Dubai’s debt travails, where creditors and debt-laden state-linked companies grappled with the controversy of implicit government guarantees. Many state-linked companies in the region borrowed heavily over the years, bolstered by the notion of implicit government guarantees to support the companies in case of financial trouble. That assumption was shaken when the Dubai government initially said in 2009 it wouldn’t bail out its debt-laden state-linked companies, although it eventually did.
This dilemma over government guarantees led issuers, including Qatari Diar, the property arm of Qatar’s sovereign wealth fund, and Waha Aerospace, a subsidiary of Abu Dhabi’s Waha Capital, to include in their bond prospectuses in 2010 with explicit government guarantees to address investor worries. Some analysts have questioned the viability of having explicit or implicit government guarantees, arguing investors need to focus on the fundamentals of the companies, rather than government support or the lack of it.
"The implicit government guarantee model that not only Dubai but the whole Gulf region relied on for the past 15 years has been broken and should be replaced,’ says Algebra Capital’s Kronfol. "Explicit government guarantees are hopefully just a short term reaction to mitigate the lack of confidence in corporates earlier this year.’
Despite Egypt’s continuing difficulties, there is little expectation that investment funds planned for North Africa will come to the Gulf region. "Political events are taking place all over the region," says Osama D. Sweidan, Associate Professor of Economics at the University of Sharjah. "Secondly, the private sector and small savers lack confidence in the financial markets.
"The priority should be given to re-activate economic growth in the region, re-establish economic stability and support financial markets, Sweidan adds. "The governments in the Gulf region can use the oil revenues to enhance the bonds market of the region. I believe right now cooperation among nations is necessary."
The fervor in the conventional bond market in 2010 has not caught on in the sukuk market after the instruments took a beating during the crisis, with high-profile defaults or near defaults in the Gulf region and lingering issues with the structure of sukuks and their conformity to Islamic rules.
Despite the lackluster Gulf sukuk sales in 2010, borrowers from the region and elsewhere in the world are expected to continue to seek sukuks, with France expected to issue in 2011 its first Islamic bond and join the fold of European countries and companies tapping the Islamic financial markets.
Sovereigns, especially in Bahrain and Kuwait, often issue bonds and treasury bonds to soak up bank liquidity as a tool to keep money supply and inflation in check. Gulf governments are also eager to develop local trading in bonds. GE Capital, a unit of General Electric listed in 2009 a US$500 million sukuk on NASDAQ Dubai, while the Saudi stock exchange launched a bond and sukuk market in 2009.
More recently, Gulf states have been toying with the idea of creating a local currency bond market, but actual implementation is expected to take time in a region that lacks the regulatory framework for such a market.
"Available local currency markets in the GCC have not been set up to attract foreign capital flows in a meaningful way or deepen financial markets and provide access to capital for companies. They are more of a liquidity management tool for domestic banks,’ says Algebra Capital’s Kronfol.
"Foreign investors would like to take on local currency exposure from the region because this part of the world has generally very good macro-economic fundamentals and are exposed to commodity prices that have a favorable outlook globally,’ he adds.
