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Gulf markets open to international capital

07 Dec 2007

The Middle Eastern economies are some of the world’s fastest growing, and with oil likely to stay expensive, there are few clouds on the horizon. Rating agencies are still reluctant to give the Gulf states their top ratings, but banks are plunging eagerly into the region. Their enthusiasm is now being matched by local regulators’ new willingness to open markets to foreign players. Philip Moore reports.


Companies in the Gulf Cooperation Council states could be forgiven for being bemused by the perverse nature of the global capital market.

The six-member economic block continues to outgrow virtually all other parts of the globe, and its banks have almost no exposure to the US subprime mortgage meltdown. A Standard & Poor’s survey of 20 leading Gulf banks in August put their combined exposure at less than 1% of their total assets. "We estimate that the mark-to-market impact of the exposure will be minimal on bottom line profitability," noted the S&P analysis.

But that did not immunise the region’s banks or companies from the harmful shockwaves that spread across world markets in the wake of the subprime collapse and the credit crunch that followed.

The primary bond market all but closed down and Gulf issuers’ spreads in the secondary market widened.

Granted, the GCC’s stockmarkets have continued to turn in strong performances in 2007, helping the combined market capitalisation of the region’s exchanges to break through the $1tr level in September.

From January to mid-November, the markets in Qatar and Oman were both up by more than 40%, Kuwait and the United Arab Emirates by over 30%, while Bahrain and Saudi Arabia had gained 17%.

Those rises, however, need to be seen against the backdrop of the very sharp corrections in stockmarkets across the broader Middle East and North Africa region in 2006.

Peter Burnett, chairman of UBS Middle East in Dubai, explains the contrasting fortunes of the region’s fixed income and equity markets in the slipstream of the subprime fiasco. "The levels of correlation between the GCC’s capital markets and the rest of the world reflects the access that international investors have to them," he says. "The bond markets are now very open to investors from throughout the world, who have a major influence on pricing. GCC equity markets, on the other hand, are still fairly closed. Even those that are open to foreign investors tend to be under-researched and momentum-driven markets, dominated by local retail investors."

However, the influence of retail investors over local stockmarkets is beginning to wane.

"Although our markets are still largely retail-driven, participation by international institutions is growing," says Essa Kazim, chairman of Borse Dubai, which owns the emirate’s two stock exchanges. "International institutions now account for about 20% of daily volume in the UAE."

Foreign investors move in
Burnett believes the participation of foreign investors in the region’s equity markets will continue to rise. The $4.2bn IPO on the Dubai International Financial Exchange in November of DP World, Dubai’s state-owned ports group, could act as an ice-breaker and encourage a wave of new listings in the region, aimed at local and international investors alike.

It does not take a genius to see why the Gulf’s capital markets are so appealing to international investors.

For one thing, they offer a unique diversification play. "GCC equities are largely uncorrelated with other markets," says Anais Faraj, Bahrain-based head of Nomura’s Middle Eastern investment banking operation. "They are one of the last unexplored frontiers in the global emerging market story and the fact that they will be included in the MSCI [Morgan Stanley Capital International] indices from next year will put them on more investors’ radar screens."

Above all, however, it is the GCC’s astonishing economic growth rates that are likely to underpin rising investor demand.

As the IMF pointed out in a report at the end of October, growth in the broader Middle Eastern region will outstrip global growth in 2007 for the eighth consecutive year.

Qatar’s projected 14.2% expansion in 2007 (dipping only fractionally to 14.1% in 2008) makes it one of the fastest growing economies in the world.

The IMF expects the UAE to grow by 7.7% in 2007 and by 6.6% in 2008, with Bahraini GDP expanding by 6.8% and 6.5%, Oman growing by 6% and 6.3%, Saudi Arabia by 4.1% and 4.3% and Kuwait by 3.5% and 4.8%.

Against that backdrop, it is easy to see why bankers, investors and other market participants are perplexed that the Gulf governments are still unable to command triple-A ratings from the leading rating agencies.

In a recent report, Moody’s acknowledges that their modest ratings appear curious, but offers three reasons to explain them.

At a macroeconomic level, says Moody’s, GCC countries have exhibited "marked fluctuations", in contrast to the more stable economic performance generally achieved in triple-A rated economies.

Additionally, the agency advises that institutions in the GCC tend to be of a "more developing nature" than those in top-rated countries, and that the GCC member states are in a region with a "more troubled political history."

Other agencies agree that political risk remains a consideration in the GCC. In a recent analysis, for example, S&P cautions that sovereign ratings in the region are still vulnerable to adverse political influences ranging from the situation in Iraq to tensions between the West and Iran and — albeit "to a lesser extent" — developments in Lebanon.

"The balance sheet strength of the rated GCC states means that the possibility of these risks materially affecting the sovereign’s creditworthiness, even were they to materialise, is in practice small," says S&P. "Nevertheless, those risks differentiate the GCC states from higher-rated sovereigns, and the positive ratings prospects for most will continue to be tempered by the higher risk political environment."

That may be. But for the cohorts of bankers and other members of the global financial community who have beaten paths to Dubai, Bahrain or Doha (in some cases, all three) in recent years, modest ratings and continued political uncertainty amount to little more than a detail.

Of incalculably more importance to them are the eye-watering sums the Gulf states are planning to spend on infrastructure development over the coming decade.

Huge investment planned
While some of those developments are headline-catching projects such as higher skyscrapers, larger airports, trendier shopping malls and more luxurious villas, much of the investment will be used to improve basic services — which in some regions are urgently required.

"What I find shocking when I drive around Saudi Arabia is that 90% of the country still looks like the Third World," says one banker in Dubai. "With oil at over $90 a barrel that is outrageous and ludicrous."

Estimates of the amounts that have been earmarked for spending on infrastructure vary wildly, and will in any case fluctuate to reflect volatility in commodity prices and interest and exchange rates, as well as inevitable project overruns.

But a recent report published by the Dubai private equity house, Abraaj Capital, puts the total for the coming five to 10 years at more than $630bn. That comprises transport and ports projects ($188bn), power and utilities ($155bn), water ($130bn), petrochemicals ($87bn), healthcare ($49bn) and education ($18bn).

The scope of that potential leads some bankers to rank the GCC alongside some of Asia’s largest emerging markets as one of the world’s most promising regions.

"The GCC is now one of the four priority territories for our global investment banking emerging market operation, alongside China, India and Russia," says Jean-Christophe Durand, regional director for GCC countries at BNP Paribas in Bahrain.

Nor does that potential end with project finance. Because the region’s governments are so committed to using their oil windfalls to build broad-based economies that could flourish without oil and gas revenues, opportunities are being created in virtually every pocket of the financial services industry.

Those hunting for M&A advisory work in the GCC, for example, are unlikely to be deterred by the collapse of the Qatari bid for the UK supermarket group, J Sainsbury.

Bankers say that even after the subprime crisis, sovereign and quasi-sovereign buyers from the Gulf are unlikely to be very price-sensitive when pursuing top quality assets.

"Governments in this region are single-minded about diversifying their economies and making certain that they don’t remain completely dependent on what comes out of the ground," says Brendan Goffinet, executive director of global capital markets at Morgan Stanley in Dubai.

Liberalisation gathers pace
The emergence of this vista of opportunity coincides with a growing commitment from regulators throughout the GCC to open the doors of local markets to investors from beyond the region and liberalise their financial services industries.

That process has already gathered visible momentum in the UAE, Bahrain and Qatar. But it is opening the Saudi Arabian capital market to global banks and investors that is generating the most excitement among international investment banks, many of which are now establishing a direct presence in the Kingdom for the first time.

"Saudi Arabia is 50% of the GCC in terms of population and GDP, so it is the engine room of the economy," says Simon Stockley, chief operating officer of the Kingdom Instalment Co, which in 2006 issued as the first Saudi mortgage securitisation.

Bankers are confident that it is only a matter of time before Saudi Arabia throws the doors of its equity and bond markets open to global capital flows.

For the time being, Saudi riyal bonds remain the preserve of investors in the GCC, but bankers hope this market will be progressively opened.

"We have been involved in conversations recently with the Saudi regulators that suggest they are looking for ways to open their local market to international players," says James Milligan, head of fixed income trading at HSBC in Dubai. "In the UAE last year we arranged a deal for Emirates Airlines that was denominated in dirhams, which was made possible because the dirham was added as a deliverable currency to the Clearstream system. If Saudi Arabia were to allow its currency to be settled via Clearstream or Euroclear, that would be a big step towards opening up the local bond market to international investors."

This liberalising approach by regulators dovetails, say market participants, with increasing openness throughout the corporate sector to the requirements of the global capital market.

"The signals from the corporate sector in markets like the UAE and Saudi Arabia have been very encouraging," says Philipp Lotter, senior credit officer at Moody’s in Dubai. "Companies there have been increasingly receptive to rating agencies, as well as to improved corporate governance standards. They have become much more transparent and willing to open their books to analysts and investors."

Where information flow may be difficult, problems stem not so much from companies being secretive or obstructive, but more from the relative immaturity of the region’s capital market, says Lotter.

"The challenge we face isn’t access to companies’ management," he says. "It is the absence of historical information. The majority of companies we’re dealing with in the GCC have a very limited track record. They have very little history but a tremendously ambitious future, and putting that into the perspective of a conservative but realistic and creditor-focused assessment can be a challenge."

07 Dec 2007