Is there a region that holds more potential for the capital markets than the Middle East? It would certainly be hard to find another part of the world where there is the same combination of sophistication, capital needs and domestic and international investor liquidity. Philip Moore reports.
Another day, another upgrade. An exaggeration, perhaps, but in the second half of 2005 and the early weeks of 2006 scarcely a week seemed to go by without one of the financial institutions from the Gulf Co-operation Council (GCC) region being upgraded by one or more of the leading ratings agencies.
True, the sheer quantity of upgrades attests to a structural weakness in the GCC's banking industry as well as to its strengths. Indeed, the Middle East remains one of the most over-banked regions in the world, with 60 or so commercial banks based in the six-nation GCC alone. As a consequence, a general upturn in credit quality will inevitably result in more upgrades there than it would in more concentrated banking markets.
Be that as it may, it was impossible not to be impressed by the welter of good news that came from the GCC banking sector in 2004 and 2005, with the financial services sector taking its cue from broader economic prosperity driven chiefly by the surging oil price.
A Standard & Poor's (S&P) review published in January 2006 reported that growth across the Middle East and North African (MENA) region averaged 5% in real terms in 2005, adding that "economic growth is expected to be sustained at similar levels in 2006, creating benign prospects for most countries in the region."
That average tells only part of the story, with growth rates in the GCC outpacing those elsewhere in the Arab world by a considerable margin. The UAE, for example, is expected by the IMF to be the world's fastest growing economy in 2006, with GDP rising by just under 14% following its breathtaking 16% expansion in 2005.
By the first half of 2006, that economic performance was filtering through to the sovereign credit ratings in the region, with S&P upgrading Saudi Arabia and Bahrain in April.
Meanwhile, the agencies' accolades for the region's top banks continued to flow, with their strap lines speaking volumes: "Strong economic and lending growth spurs stellar returns at Qatari banks" was the headline from S&P on April 20. "Saudi banks continue to benefit from buoyant economy" was a Fitch announcement the following week, while early in May a bulletin from the same agency was entitled "Kuwaiti banks to maintain strong performance in 2006."
True, a brutal stock market decline in the first quarter of 2006 threatened to take the shine off some of the banks' performance. Equity prices in Dubai fell by a startling 50% between January and late May, with the Saudi market also surrendering half its value between February and May, and Abu Dhabi tumbling by 30% in the same period.
That cataclysmic performance was a contributing influence to a Moody's report on Arabian banks published in May that raised concerns about "certain risk pockets relating to the rapid growth in lending and the possible build-up of asset bubbles."
But the same report added that "Gulf banks have been benefiting from the strong economic cycle underpinned by the substantially increased oil and gas prices. In particular, over the past two to four years, most institutions have been reporting strong business growth and material performance in their financial performance, which now compares favourably with that of higher rated institutions in emerging markets."
S&P, for its part, appears to be relaxed about the effect that the travails of the stock market will have on banks in the region. Indeed, in its analysis of Saudi banks published in April, the rating agency commented that the sharp losses in the stock market "reflect a healthy adjustment to more sustainable levels and have not, to date, affected the banking sector or the real economy."
Booming economies have inevitably fuelled a striking growth in the balance sheets of banks throughout the region, which is one reason why there has been an explosion in issuance in the international capital markets by banks in the region.
As equally important as their growth, however, has been the transformation in the banks' balance sheet structure. As demand in the Gulf has grown for longer-dated, project-related lending and personal loans, the maturity mismatch in the funding structure of GCC banks has become increasingly pronounced.
HSBC drew attention to the rising prominence of that mismatch in a research piece published last year focusing on the balance sheets of 12 leading GCC-based commercial banks. That report concluded that the "the tenor of the loans and advances by these banks were nearly equally split between short and long term (53.6% and 46.4%, respectively). However, these assets are primarily funded by short-term (less than one year) deposits, which made up 82.5% of the total deposits in the GCC banking system."
An increasingly receptive bond market has provided regional banks with an ideal mechanism for addressing that asset-liability mismatch, which explains why bond issuance from the Middle East as a whole exploded from $5bn in 2004 to $10bn in 2005.
"The explosion in terms of bank issuance came in 2005," says Gilles Franck, head of debt capital markets origination for emerging markets at BNP Paribas in London. "The main reason was that while these banks are sitting on large customer deposits those are regarded by regulators and the rating agencies as short term money. Although they could have lengthened maturities in the syndicated loans market, they recognised that the pricing differential between the bank and the bond markets was narrowing, and that issuing bonds would allow them to tap into a new lender base."
Additionally, says Franck, bond issuance has been encouraged by changes in central bank guidelines in countries such as Saudi Arabia and Qatar which have allowed proceeds from bond issues to be included in loan-deposit ratios for regulatory purposes.
At Dresdner Kleinwort Wasserstein (DrKW), managing director of EEMEA origination Ray Harte points out that in the early stages of the market's development, the new issues from the region's banks were all very similar. "From 2002 to 2004 we saw the banks coming to the capital market for the first time on a standalone basis, issuing dollar-denominated FRNs in the $300m-$500m range," says Harte. "These were generally targeted largely at investors within the Middle East, with some distribution into Europe and Asia, and they all tended to pay a premium over similarly rated western European financial institutions."
One key trend in the Middle East's market in the last six to 18 months, say Harte and other bankers, is that the size of individual transactions has risen conspicuously. $500m is now regarded as a sensible minimum, although as Abu Dhabi Commercial Bank demonstrated last year, the strength of investor demand is such that single-tranche transactions approaching $1bn can be accommodated.
Its $800m 2010 FRN led in June 2005 by BNP Paribas and HSBC was tapped within a week to bring its total size up to $900m, making it the largest FRN ever issued in the region. In February 2006, a tap of $100m via Daiwa SMBC brought this deal up to the magical $1bn threshold.
Another important sign that the new issue market is becoming increasingly flexible has been the recent diversification of primary market activity away from its staple fare of US dollar deals. In March, for example, Abu Dhabi Commercial Bank launched the first Swiss franc-denominated FRN for a Middle Eastern bank, with a Sfr300m five year deal led by BNP Paribas which was placed entirely with Swiss accounts.
Since then, euros have also started to play an important role in the funding repertoire of Middle Eastern banks. Saudi British Bank set the ball rolling for GCC borrowers in the euro market in April, with a five year Eu325m FRN led by HSBC. "Although between 65% and 70% of Saudi British Bank's previous dollar transaction had been placed outside the region, it was keen to diversify into the base of investors which only buy euros," says Andrew Dell, head of emerging markets debt finance at HSBC in London.
"We advised Saudi British Bank that by issuing in euros it would gain a small funding advantage relative to the dollar market and strategically diversify its investor base." With more than 80% of the transaction placed outside the Middle East, HSBC was true to its word.
A more recent euro issue was the Eu400m five year floater from Gulf Investment Corporation (GIC), which was launched into a highly turbulent market via ABN Amro and UBS at the end of May.
In spite of that inauspicious backdrop, the deal was increased from its originally targeted Eu300m and priced at 35bp over Euribor, which was the bottom of a price range that had been revised downwards.
"Far from having to pay up for the euro deal, the borrower ended up pricing inside where the price on its dollar curve would have been," says George Niedringhaus, global head of emerging market syndicate at ABN Amro in London. "If you do the basis swap, GIC came at dollar Libor plus 34bp. That compared with 33bp over dollar Libor for its outstanding 2010 bonds which are eight to nine months shorter dated. I would have expected a new deal to come at a Libor equivalent basis of more like 37bp."
The cultivation of the European investor base has helped transform the typical distribution of bonds from the region. "We are no longer seeing the majority of deals placed with Gulf-based investors," says Nicholas Hegarty, Barclays Capital's Dubai-based regional managing director. "In the transactions we've been involved in, up to 80% of the order book has been in Europe and Asia, and bonds have not flowed back to institutions in the Gulf as they did in the past."
The ability to tap into a broader range of investors via the euro market, say bankers, has dovetailed with a conspicuous trend of reduced pricing in international markets for GCC banks. "Pricing today is definitely much tighter than it was a year ago," says Franck at BNP Paribas. "Look at the pricing of GIC's recent euro deal, which was 35bp over euribor and would have been similar in dollars. That compares with pricing of 50bp over Libor when we lead managed a $500m five year FRN for the same borrower in June 2005. GIC was upgraded between those two transactions, but there has also been a more general process of spread compression."
In tandem with the evolution of the public market for Gulf-based banks, bankers say that increasingly vibrant opportunities have opened up for them in the private placement market. Those private placements have ranged in size from $10m to $60m, with maturities of between 12 months and as long as seven or 10 years, and have been denominated in currencies ranging from euros to Hong Kong and Singapore dollars.
"I think investors have woken up to the fact that many of the Gulf banks issuing off MTN programmes, rated single-A or better, are offering good value relative to other similarly rated financial institutions," says Harte. "Although these banks have balance sheets which compare very favourably with their competitors in Western Europe, they have tended to trade at a premium, and as investors have become more comfortable with the banks' credit stories they have become very attracted by the yield enhancement."
The strength of those credit stories will inevitably vary from country to country, not just within the Middle East, where there are huge differences between the risks from one region to another, but also within the six-nation GCC itself.
How much investors are yet able or willing to price geopolitical risk into different credit stories from one GCC member to another, however, is open to question. "The majority of the deals we've seen so far have come from Dubai and Abu Dhabi, and there is very little to choose in terms of political risk between those two emirates," says one banker. "People also see Bahrain and Qatar as very similar credits. But there ought to be more downside based on political risk in Saudi Arabia, which investors may not be fully pricing into deals."
Outside the comfort zone
Beyond the energy-rich and investment grade members of the GCC, bankers say that credit quality, growth prospects and economic and political stability in the Middle East vary so much that securities issued in different regions should scarcely be seen as belonging to comparable asset classes.
They report that they would regard issuers within the Maghreb region (which includes Tunisia and Morocco) as one distinct group, and those in politically-sensitive economies such as Egypt and Jordan as another. Iran, meanwhile, which was once seen as a very promising source of issuance, is clearly in a league of its own as far as political risk is concerned, given US sabre-rattling over the country's nuclear ambitions.
Another market that is viewed as a very idiosyncratic risk is Lebanon, rated B3 by Moody's. The agency says that the rating reflects the country's "significant economic and political risks, notably the government's overwhelming debt burden." A consequence of that debt, adds Moody's, is a "wide fiscal deficit, which constrains productive public expenditure, inflates domestic interest rates and diverts private savings."
Not a pretty economic picture, perhaps, but it does mean that Lebanese issuers have been more active in the international capital market than those from most MENA economies outside the GCC. That has put Lebanese risks and return on to the radars of a growing number of international investors. "Lebanon is a very specific credit because there is a substantial domestic bank investor base," says DrKW's Harte. "Recently we have seen a growing international bid for Lebanon on the back of investors' search for yield."
For the foreseeable future, therefore, it seems likely that primary activity in the Middle Eastern capital market will continue to be dominated by borrowers from within the GCC, and the long term reasons are easy enough to identify. While oil revenues are very welcome, there has been a very prudent recognition by governments throughout the region that neither the current boom nor their longer term oil reserves will last for ever. As a recent IMF review comments, "policymakers have so far acted as though the oil price rise is largely temporary."
Individual GCC governments have different reasons for exercising this caution. For Dubai, it springs from a recognition that its oil reserves, which will run out in 20 years and only account for 6% of the emirate's income, do not represent its future.
For Saudi Arabia, things are altogether more sensitive and have implications well beyond the kingdom. There, a non-labour intensive oil sector will fall well short of providing enough jobs for the majority of the population that is now below the age of 15. The dangers associated with rising unemployment combined with an upsurge in religious fundamentalism are all too obvious, which is why Saudi Arabia needs to diversify its economy, provide new jobs and redevelop its infrastructure — and to do all of the above quickly.
None of this is lost on governments throughout the GCC. "There has been a key generational change in terms of the decision makers in the region," says Hegarty at Barclays Capital. "The young professionals who have trained as lawyers, bankers and accountants are now looking to be more creative with the windfalls from oil than they were during previous booms. They are more commercially-focused and looking to a world beyond oil — a world where they will need to develop manufacturing industries or services such as finance or tourism."
The sums which these governments will need to spend in order to do so are of a jaw-dropping magnitude, and Hegarty rattles them off as though he were reading a shopping list. Bahrain, $27bn; Kuwait, $211bn; Oman, $34bn; Qatar, $114bn, Saudi Arabia, $202bn; UAE, $297bn. "These are known projects, and even those numbers are conservative," says Hegarty. "Another estimate I've heard is that Saudi Arabia will need to invest $900bn in its oil and gas sector alone over the next five to 10 years."
Against that backdrop, it is little wonder that a progressive and liberal emirate like Dubai is setting so much store by the development of a financial centre characterised by an infrastructure that is already starting to make London and New York look primitive in comparison. And probably the best proof that Dubai has positioned itself for a long and sustainable role as the financial pivot of the Middle East is the degree to which the world's leading banks, law firms, accountants and ratings agencies have committed resources to building a presence there.
Loan market makes the move
The key question, for many of the institutions that have set up shop in Dubai for the long term, is whether the region's capital market can push ahead and add more diversity to its existing range of products. That diversity, say bankers, is already gathering momentum within the syndicated loans market, which has become an increasingly important source of financing for projects and corporates. "The loan market is becoming less vanilla and more complicated in terms of structures, especially as it is used as a financing technique for companies acquiring assets both within the region and outside," says HSBC's Dell. That process has already gathered momentum. One of the landmark deals to emerge from the region last year was the $3.36bn acquisition by Kuwait's Mobile Telecommunications Co (MTC) of Celtel in Africa, which was funded via the loans market.
A highlight of this year, meanwhile, has been the financing via a $6.5bn five year facility arranged by Barclays Capital and Deutsche Bank of the acquisition by the Dubai port operator, DP World, of P&O.
"The DPW deal is perhaps an exception because it is in a sector that is consolidating, and DPW had the vision to take advantage of an opportunity to benefit from that process," says Hegarty at Barclays Capital. "But we will certainly see more acquisitions by GCC-based companies in the corporate sector, the real estate sector and, slowly but surely, even in the financial sector."
Bankers are also hopeful that corporate issuers will become more active in the bond market. An encouraging pointer for corporate issuance was the $225m five year bond sold in April by the BBB- rated Kuwait Projects Co (Kipco), which is the first company from the region outside the financial sector to have been rated by S&P.
Led by BNP Paribas, DrKW and HSBC, the Kipco groundbreaker met with a receptive audience among investors from beyond the Gulf, with 29% of the bonds placed in Europe and 18% in Asia. "The background to the Kipco deal was that the company has extensive access to the local bank market but wanted to promote its name more actively internationally," says Harte. "We approached the transaction in a very careful way by presenting the credit to investors in a non-deal roadshow at the end of 2005, and investors responded very positively to the company and its credit story. So we were delighted to have the opportunity to help the market diversify away from the FIG sector."
More diversification was injected into the market for GCC borrowers at the end of May with the $650m debut five year deal from Qatar Petroleum led by Citigroup and Credit Suisse. Launched into an uncertain market in the wake of the sharp falls in global equity markets, the Qatar Petroleum deal was priced at 65bp over Treasuries and was twice oversubscribed by an investor base attracted by the defensive qualities of the oil-rich issuer.
Harte and others are hopeful that more corporates will follow in the footsteps of Kipco and Qatar Petroleum sooner rather than later. "In the next few months we will see some more corporate supply coming out of markets like Kuwait, UAE, Qatar and potentially Saudi Arabia," says Harte.
This optimism mirrors a more general belief among bankers about the potential for corporate issuance, although a number caution that the process will not be one that develops overnight. "In the Middle East the concept of bank finance and of underwritten deals is very strongly engrained and that will take time to change as companies get used to the whole disclosure and ratings process," says Franck. "But corporate CFOs in the region are aware of how successful the bank deals have been and are thinking hard about the potential of the bond market."
That is confirmed by the ratings agencies that are voting on the prospects for the region's capital markets with their feet and setting up offices in Dubai. Fitch, for example, opened for business in Dubai in March, relocating Stephen de Stadler from the agency's Johannesburg office to manage the new outlet. Since arriving in Dubai, de Stadler has been energetically travelling around the region talking to prospective new clients. "Our main client base is of course financial institutions, but the next logical step is corporates and I'm very pleased to say we have seen a great deal of interest from them," says de Stadler. "In the next few weeks I will be travelling to Bahrain, Saudi Arabia and Kuwait to see potential new corporate clients rather than existing ones in the financial sector."
Whether or nor those corporate transactions will emerge as instruments structured to be compliant with Islamic Shari'ah law is something of an open question. Franck at BNP Paribas says that to date the volumes generated by Islamic bonds or sukuk structures has been on the disappointing side, with limited issuance following on from the Bahraini and Qatari sovereign deals that were designed, inter alia, to serve as benchmarks for other non-government borrowers.
According to figures published in a report by Moody's at the end of May, of the total global sukuk market of $41bn, the Gulf accounts for only $11bn, with Malaysia contributing the remaining $30bn. Moody's is bullish on the growth potential of sukuk in the GCC, commenting in its analysis that the market will expand "as part of the systemic Middle Eastern growth in long-term conventional debt financing, combined with a drive to tap the deep pool of Islamic liquidity."
For the Dubai International Financial Centre (DIFC), the development of the Islamic capital market is a key priority, and Khalid Yousaf, head of business development for the Islamic finance sector, is also very upbeat about its potential. He points out that the published figures on the Malaysian market are slightly misleading, given that all but about $2bn of that market is accounted for by local, ringgit-denominated instruments, whereas most issuance in the GCC has been internationally-targeted, dollar deals.
As an example of a groundbreaking Islamic deal, he points to the blow-out $3.25bn convertible sukuk led in January by Barclays Capital and Dubai Islamic Bank for the Ports, Customs & Free Zone Corp (PCFC), the owner of Dubai Ports. "The PCFC transaction showed that the sukuk market is capable of achieving innovation as well as size," says Yousaf.
Demand for that transaction was such that it raised 25% more than its original target, which mirrors the more general imbalance between supply and demand in the sukuk market. "Demand for sukuk far exceeds supply," says Yousaf. "As a result, whenever a new sukuk is announced it is immediately oversubscribed and institutions that are allocated certificates just sit on them until maturity. To date there has been no secondary market activity in the sukuk market at all."
The illiquidity in the sukuk market is one area that is being addressed by a task force that has been set up by the DIFC to explore ways in which efficiencies within the Islamic capital market could be enhanced. Liquidity, thinks Yousaf, will start to flow when the primary market gains a critical mass of perhaps $100bn, which suggests an almost 10-fold increase from today's total.
But another precondition of liquidity, he explains, is its acceptance by Islamic scholars, many of which regard the trading of debt instruments as contrary to Shari'ah law. Liberal interpretation of this law has allowed for the secondary market trading of sukuk instruments in Malaysia, says Yousaf. Whether a similar interpretation can be agreed on in Dubai will depend on discussions with local scholars.
While the promotion of liquidity in the sukuk market is one objective of the DIFC's task force, another is to look at ways in which some of the costs and administrative burdens associated with a sukuk transaction can be minimised. "In every new sukuk transaction you need to appoint a Shari'ah advisory board which inevitably costs money and increases the time it takes to structure a deal" says Yousaf. That, he says, means that in spite of the huge demand for sukuk instruments — within and beyond the Middle East — the ancillary costs can still make them less competitive than conventional, interest-based bonds.
Yousaf concedes that it will take time to resolve these potential roadblocks to the expansion of the Islamic capital market in Dubai. But he is convinced that solutions will be found. "There is overwhelming demand from retail as well as institutional investors for Shari'ah-compliant investment opportunities, and with $200bn worth of projects announced in Dubai already, Islamic funding will clearly play an ever-important role," he says.
|Securitisation set to burst into life|
A promising growth area for the GCC's capital market is securitisation. "I've been covering the region's structured finance, sukuk and securitisation markets for over two years, but until the last 12 months not much really happened that required our extensive involvement," says Khalid Howladar an analyst at Moody's in London. "Now almost every week market participants are coming to us with new ideas and questions, and asking us about the issues involved in rating new structures."
Stephen de Stadler, who runs Fitch's office in Dubai, has a similar story to tell. He says that his agency has already been mandated to rate two securitisation structures, and he believes plenty more are in the pipeline.
Howladar says that much of bankers' new-found confidence in product innovation in the structured finance market is based on clarifications to the legal regime in the region. "Previously although they might have talked to us about deals in the early stages, they invariably encountered a legal complication somewhere down the line which made it impossible for them to proceed," says Howladar. "Now, the lawyers I speak to feel much more confident and seem able to provide the legal opinions necessary to support securitisation structures to the satisfaction of Moody's credit committees. Having spoken at length with several securitisation lawyers, an increasing number of which have relocated from London to Dubai, I am confident that we will start to see the first real securitisations out of the region before the end of the year."
There is no shortage of consumer assets in the Gulf region that would lend themselves very effectively to securitisation. Credit card receivables and auto loans are regarded as possible growth areas, although they fade into virtual insignificance alongside the potential of commercial and above all residential mortgage-backed securitisation, given the outlook for the housing market in the region.
Take the compelling example of Saudi Arabia, which according to figures published by the Islamic investment bank, Unicorn, has a mortgage to GDP ratio of just 1.9%. With annual demand for new housing units now at 300,000, according to the Unicorn estimates, the Saudi mortgage market may be worth as much as $45bn a year.
"Securitisation is certainly the next step," says George Niedringhaus, global head of emerging market syndicate at ABN Amro in London. "We are already seeing more banks exploring subordinated debt as a means of helping with their capital ratio needs, and with Basle II just around the corner I definitely see more innovation. It is happening in Russia and Asia so why not in the Middle East?"
|Distribution of the sukuk market (Jan 2006)|
|Rank||Country||Amt $ m||Market share %|
|3||United Arab Emirates||1, 165||4|
|Source: Report of the Islamic Capital Market Task Force of the IOSCO and Islamic Finance Information Service website|