Default became a dirty word in the United Arab Emirates after 2009, when Dubai World requested a six-month delay on payments on US$26 billion in debt. So much so that when UAE energy company Dana Gas this month missed repayment on a US$920 million Islamic bond, local press hesitated to label it as a default.
In the midst of the global economic and financial crisis, the country and Dubai in particular took a drubbing from credit rating agencies, investors and the international press, which harshly questioned its economic model. A multibillion-dollar bailout from oil-rich sibling Abu Dhabi averted the worst, but the experience left a sting.
Based in Dubai’s neighboring Emirate of Sharjah, privately owned Dana Gas became the first example of a UAE corporation to miss a debt repayment — others had sought and received restructuring before deadline. It also presented a test for the Islamic financial market, as no sukuk had been restructured or unpaid upon maturity. Yet the Middle East’s largest natural gas firm quickly announced a restructuring deal soon after its troubles became public.
A matured, deeper Islamic finance market, the Arab Spring, and Dubai’s economic resurgence are all reasons why observers say the debt issues of Dana Gas caused little concern, despite Dubai entities looking at almost US$50 billion of maturing debt in the next four years.
The 2009 "potential event of default was the first of its kind, and therefore a step into the unknown for all parties involved," notes Rizwan Kanji, debt capital markets partner at law firm King & Spalding in Dubai. "Naturally the initial response is a doomsday scenario. This time around, the market has gone through this. It is not a step into the unknown anymore — hence the relatively muted reaction by the market."
A Maturing Market
The Islamic financial market was hurt by the global financial and economic crisis, and then Dubai’s restructuring request soured some investors on Islamic bonds from the Gulf. 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 Bloomberg.
Much of that reaction had to do with a lack of understanding of Islamic bonds among investors, Kanji says. Unlike conventional bonds, sukuk does not trade on debt, as interest is forbidden in Islam. Instead, its returns are linked to the leasing of a tangible asset, such as real estate, and the sukuk investor purchases a proportional ownership of that asset, and earns profit off the leasing arrangement.
The market offers two types of sukuk: An ‘asset-backed’ sukuk, which follows the traditional ideal of providing an asset as the basis of the issue; and ‘asset-based’ sukuk, which is structured on the expected profit of an asset, or the worth of the issuer, rather than a tangible asset. Asset-based sukuk do not provide the opportunity to recoup lost investment, since they are not associated with assets that can be valued.
The difference came as a surprise to investors hoping to benefit from the woes of Dubai’s entities such as property developer Nakheel — known popularly as ‘Dubai Inc.’ "The whole underlying aspect of sukuk was tested," Kanji says. "The whole asset-based concept came into the open, wherein Dubai Inc. investors thought they had recourse to the assets. When they realized they did not, the less savvy investors had a reality check. This time around, there is a wider appreciation of the structures and how sukuk work."
Additionally, since 2008, investors in the relatively young Islamic finance market have witnessed sukuk in default and dispute, and the process taken to reach a resolution. One example was a $US100 million sukuk default in 2009 by Kuwaiti shareholding firm Investment Dar. The sukuk was restructured in 2011, and creditors received equity in the company.
Having precedent has removed some fear, and in fact emboldened investors. When Dana Gas’s debt issues came to light, so too came a lawsuit threat from its sukuk holders. "Dana Gas is not a government-related entity and is making the right moves towards restructuring so there is hope that its default won’t reflect negatively on the broader UAE," says one attorney. "But if you look at recent lawsuits, it appears that creditors are no longer willing to sit back and take whatever offer is given to them."
Arab Spring Factor
There is also enough momentum in the market that Dana Gas was viewed as an outlier rather than an indication of a trend. Investors seeking alternatives to the eurozone have generously fed Sukuk, as this year has seen over US$100 billion in issuances, with demand being driven by Malaysia and Saudi Arabia, according to research firm Zawya.
There isn’t enough sukuk issuance to meet global demand, noted a report by Ernst & Young, which valued Islamic bond demand at US$300 billion, and expected it would grow to US$900 billion by 2017. Qatar Investment Bank, for instance, issued a US$750 million sukuk in October — and orders were reported over US$6 billion.
"The Middle East sukuk market is far more deeper now," Kanji says. "There has been a doubling of issuances over the same period compared to 2011. The deepened market has allowed for the Dana Gas potential default to be absorbed by the market."
"Imminent maturities for quality credit entities may be easily refinanced by new sukuk or similar debt, noting that we have seen the appetite from recent issuances," Kanji adds. "The challenge will be to refinance maturing sukuk from entities that may have lost their quality creditworthiness during the financial and economic crisis. These entities will need to consider their options carefully."
After the debt crisis fallout, Dubai too enjoyed new momentum, with a US$1.25 billion sovereign bond issue in 2011 that was four times oversubscribed. Several entities have paid back their debt, and according to data provider CMA, the Emirate’s five-year credit default swaps have dropped 200 basis points this year.
Dubai and the UAE as a whole have basked in the role of safe haven in the wake of the Arab Spring. Arab expatriates fleeing conflict in the region have driven real estate sales and rental increases, while a number of companies have relocated to the UAE from elsewhere in the region. With traditional destinations marred by conflict, UAE tourism and retail sectors have also performed well — Dubai so far has welcomed a 10% increase in tourists from last year, and its retail sector grew 5.5% this year. Ironically, Dana Gas’s financial problems were tied to the Arab Spring, as insufficient revenues from its Egyptian and Kurdish operations were the reason it could not make payment on its debt.
"The indicators by all accounts are showing a positive trend," Kanji says. "From the most basic measurements of road traffic, hotel bed space to restaurant seats to the sophisticated measurements of property prices, CDS spreads and repayment of its US$10 billion debt — it’s an upward trend. This does inspire confidence in my opinion in UAE and particularly Dubai."
There is still cause for caution; in a recent report, Standard Chartered noted that Dubai still faces a debt problem and has raised little from asset sales. Its entities will see almost US$50 billion of maturing debt over the next three years, the report noted. "Without a material improvement in either Dubai World’s or Nakheel’s financial profile, this debt could be subject to another round of potential restructuring when it matures," the report said.