Michael Grifferty is the president of Dubai-based Gulf Bond and Sukuk Association (GBSA), an independent professional membership body involved in developing the region’s fixed income market. Members of GBSA include ratings agencies Moody’s, Standard and Poors, regional and local banks such as HSBC Middle East, and law firms. Grifferty is a former consultant to the International Monetary Fund and a former U.S. Department of Treasury advisor for sovereign debt management and market development, having worked with over forty countries and regional organizations in Europe, Asia, Middle East and Africa.
In an interview with Arabic Knowledge at Wharton, Grifferty says that bond issuance in the region is expected to increase, particularly as companies seek to refinance their debt. Another factor he notes is that some Gulf countries continue pursuing ambitious development plans, despite the region’s unrest and the fragile recovery of the global economy. But the bond market still faces challenges, he adds, including inconsistent policies in the region toward developing local currency markets.
An edited transcript of the conversation follows.
Arabic Knowledge at Wharton: What are the main drivers for the Gulf sovereigns and corporates to tap the bond market? Is bond issuance expected to pick up or stagnate?
Michael Grifferty: Refinancing will be a key driver. We can expect that some companies will be looking to lengthen their maturity profiles to address risk and to lock in low rates. There is a higher-than-average degree of bank debt among corporates in the region, with many listed companies having no capital markets debt outstanding.
To some extent, bond issuance may be more out of necessity, than love for the rigors and transparency of debt capital markets. Banks remain risk averse, not ready to revert to their previous role as lender of first resort. Deposit growth has started to recover, but unevenly, liquidity remaining at a premium in some banks, especially in the United Arab Emirates (UAE). But even where liquidity does not pose a principal constraint, lending to the private sector has grown at a slow pace. Saudi Arabia is an important exception where credit is growing.
Banks are also more conscious of the maturity mismatch between assets and liabilities. As an aside, this mismatch will drive additional issuance from the banks themselves as they issue bonds for longer tenors. There are likely to be new corporate entrants to the public debt markets and with the refinancing numbers involved, even a modest number of new entrants to the bond market from this pool can impact volume significantly.
Issuance may also be supported by the willingness of states that can afford to pursue and continue to pursue strongly counter-cyclical fiscal policies, namely in Saudi Arabia, Kuwait and Abu Dhabi. The extent to which governments resist the urge to spend current or reserve funds on these projects will have a lot to do with the growth of capital markets. What is only dawning in the region is the realization that bond markets are not simply for opportunistic use in a pro-cyclical manner, but are at least as well suited to act as a strategic counter-cyclical shock absorber.
Arabic Knowledge at Wharton: Are there expectations for more sukuk (Islamic bond) issuances, or have the recent defaults dampened investor appetite for these instruments?
Grifferty: Certainly the high profile defaults have not helped. But remember, it was not the structures that caused those defaults, rather the economics behind them. Sukuk will continue to be in demand by both Muslim and conventional investors looking for good returns on quality paper.
Arabic Knowledge at Wharton: Why is the level of bond issuance low compared to other regions?
Grifferty: Historically, the region has relied on bank financing and equity capital markets. Family companies, non-rated and largely non-listed, have long had an important role. And they have traditionally had access to financing by means that allow more confidentiality and flexibility. Accessing the capital markets would represent a major shift and that will not come easily.
For non-investment grade or even lower-tier investment grade, the cost of funding in the international capital markets can be high. Witness the relative dearth of non-guaranteed issuances. For the combination of country and sector risk and relative illiquidity investors may require high single or even double digit yields, and there are few projects that can sustain that kind of funding cost.
In the near term, we know that investors will reward strong sovereign and sovereign-related credits. This brings up the whole debate about the value and role of government guarantees. Yes, the sovereign guarantee model allowed a lot of capital to be raised and development to take place before it began to be tested.
Rather than looking for the best business models, capital flew sometimes to those where support could be expected in case of trouble. Did the experience foster a reliance on the guarantee, explicit or worse implied? More explicit language is being used to describe what entities states will bailout if necessary. And investors now have to a greater extent sorted out who is under the sovereign umbrella and who is not. Though I would say there is still a good deal of grey area.
What is different from in the past is that you have a more disciplined approach developing, whereby in some states at least, guaranteed issuers are going through more of a central vetting process before announcing an issuance. This should restrain the kind of undisciplined rush to issuance we have seen in past years when the financial press warned of a "deluge of issuance."
Arabic Knowledge at Wharton: What are the issues facing the Gulf fixed-income market?
Grifferty: The Middle East capital market has some challenges. Secondary market trading, a key link in vibrant debt markets, is underperforming compared with issuance volume, particularly on the sukuk side. If you look at the trading volume figures for the Middle East, you note that the Middle East accounts for almost 8% of global emerging markets trading. But, strip out Turkey and Israel, and the figure is 3.5%. Gulf Cooperation Council (GCC) states alone account for less than 1% of global emerging markets turnover. Moreover, trading volume data is hard to come by as compared with other regions. We are working with our members and The Emerging Market Trading Association to ensure that regional trading figures are fully credited, so that potential buyers into the region will be assured they can find a bid when they want to exit a position.
We can expect that fixed income here will continue to be mainly over-the-counter though a number of exchanges are already offering or planning to introduce fixed income platforms. We are also going to review some proposals for trade reporting.
Transparency has traditionally been a challenge in the region. But the greatest long-term challenge will be to deepen the institutional investor base. There is huge potential to drive the markets here if pension funds can be professionally managed within a regulatory prudential framework. Insurance is catching up, but prudential regulation has been slower. You still have insurers funding long-term liabilities with short-term assets.
Retail investors remain less interested in fixed income. But I do sense that intermediaries, brokerages and fund managers are focusing more now on fixed income.
Arabic Knowledge at Wharton: Which segment is likely to issue more bonds in the future, sovereigns or corporates — and why?
Grifferty: Again, the global trend is instructive. Over the past 10 to 15 years, the emphasis has shifted from the sovereigns to corporates, who now issue about 80% of global emerging market debt. The sovereigns have an important role to play in establishing the national credits, creating awareness and issuing benchmarks. But once access to international markets is secured, the sovereign may continue to issue, but its relative weight may be less. The sovereigns’ focus then can turn to developing their own capital markets, especially in local currency.
Arabic Knowledge at Wharton: What attraction do Gulf bonds have for international investors?
Grifferty: You have some great credits in the region, both sovereign and corporate. And to some extent, this region is still under-represented in institutional portfolios, and so you have some rarity premium. But the attraction drops off as you go down the credit curve. Lets face it: International investors have become adept at scouring the globe for a bit of yield in this low interest rate environment. In this respect, the Gulf has done a pretty good job of putting out sufficiently sized benchmark paper, up from virtually none a decade ago. But it still strikes me as ironic that this capital-exporting region relies so heavily on international investors.
Arabic Knowledge at Wharton: What are the prospects for a local currency bond market, and is that expected to develop in the near future?
Grifferty: There is great potential here as a pool of liquidity waits, but it is waiting for a stronger signal from the governments in the region. Qatar has issued in size, but does not seem inclined to issue on a regular basis. Oman has a framework for issuance of development bonds, but does so sparingly. Kuwait issues frequently, but does not go out on the yield curve. Saudi Arabia has been redeeming debt with goal of reducing its debt to GDP to 10%. The UAE’s federal issuance is long anticipated, but reasonably waits for creation of a proper risk management framework. Bahrain of course has a long and enviable history of domestic issuance that has served it well.
So the policies in the region toward developing local currency markets are not consistent. Now, that is the reality, but it is incumbent on the industry to step up and ensure that policy makers understand the economic benefits of leading the market and ensure those governments know they will be supported by the industry if they take the brave step of issuing regularly. That is one of the roles of GBSA. If those government yield curves develop, and we know that they are not simply shadows of the U.S. dollar curve, in spite of the currency anchor, then corporates will be enticed into the local currency market as well.
So my hope for the regional capital market rests in large part on the states and their agencies committing to taking a more active role in developing this market. For that, we need consensus and official commitment. The commitment should start at the GCC level and involve all the states and the regional regulators. The truth is no jurisdiction in the world could the official sector be relied on to establish a market without an active industry partnership. That is what we are doing with GBSA.