Developing the Regional Debt Capital Markets

The Gulf region has experienced a quiet revolution in its financial sector over the past year.

The need for a regional bond / sukuk market was discussed for years, whether for monetary policy management reasons or in order to address the problem created by tenor mismatches as banks for a long time operated effectively as the sole sources of private-sector capital.

The progress made remained minimal, however, partly because of cultural reservations about interest-bearing debt securities, partly because the more recent efforts by regional governments to repay the debts they accumulated in the 1990s made them unenthusiastic about new debt issuance.

Now, however, the situation has begun to change, potentially in fundamental and lasting ways. However gradually, progress has been made on a broad range of issues: product development, market institutions, issuance volumes, regulatory reform and, perhaps most importantly, attitudes.

A situation of economic distress has helped revive and reshape a regional debt capital markets by highlighting the risks of relying on bank credit and equities. At the same time, the relative stabilisation of the economic situation in the wake of a turnaround in oil prices has further boosted interest in this ‘new’ alternative. Especially outside of Dubai, there is less distress issuance, which entails better terms and planning.

Moreover, public sector and blue chip issuers have created a number of examples for others to emulate. At the same time, the crisis has also created new issuance needs by underscoring by drawing attention to the urgency of long-term capital spending as well as corporate restructuring and consolidation.

Echoing the experiences of some of their far-sighted East Asian emerging market peers (notably Hong Kong and Singapore), some GCC governments have taken a proactive role in fostering the emergence of debt capital markets in spite of their strong reserves and macroeconomic fundamentals.

Sovereign issuance, mainly composed of conventional bonds, has taken place in Kuwait, the UAE (Abu Dhabi, Dubai, Ras al Khaimah), Bahrain and Qatar during the past year. Especially the Qatari government has made deliberate efforts to establish a benchmark yield curve for the market. These steps in turn have encouraged issuance by large corporate names, led by government-owned companies.

In Saudi Arabia, 2009 saw the launch of a dedicated sukuk / bond secondary trading platform on Tadawul, the national stock exchange. Following an initial burst of activity, the market has remained relatively moribund. Nonetheless, the platform represents one of the necessary building blocks for a proper market and is likely to come to its own over time.

In spite of the prospect of a second year of budget deficits, issuance activity in Saudi Arabia is unlikely to be led by the government. Instead, the partially state-owned blue chips Sabic and Saudi Electricity have been the leading issuers and the new national mortgage company to be created by the pending Mortgage Law will be another important market driver.

Especially the Bahraini government has taken a lead in fostering the development of shariah-compliant debt securities in order to contribute to the efforts of the Kingdom to position itself as a hub of Islamic finance. The Islamic Development Bank has been another key player in this regard.

In spite of a turbulent year and ongoing ‘teething problems,’ the outlook for the GCC debt capital markets is increasingly favorable. Barring major upsets in the global economy, 2010 is shaping up to be one of normalisation. Some $73.2 billion of new debt was issued in 2009 with the pace dramatically accelerating in Q4 which alone accounted for roughly half of the total for the year.

Sovereign issuance was particularly important, led by conventional bonds from Qatar and the UAE. By contrast, the sukuk market, in spite of considerable promise, remained relatively anemic with the GCC experiencing a 4.3 per cent fall in issuance during 2009. This was partly because sukuk issuance had been dominated by financial sector and real estate corporations which have led the retrenchment in capital-raising during the downturn.

However, the market has also been depressed by wider spreads and residual anxiety about the rules for shariah-compliance issued by the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) in 2008. This year, the situation is likely to stabilize and the aggregate GCC sukuk pipeline for this year is put at as much as $50 billion as compared to annual totals of less than $8-8.5 billion in 2008 and 2009 alike.

In spite of impressive progress, a number of challenges remain to be overcome by the regional markets. Human capital constraints remain a problem but the current crisis has particularly highlighted the need for better defined procedures for distress situations.

The market took off during an exceptional economic boom which not only saw a dramatic increase in volumes but also considerable innovation, especially with the emergence of sukuk as an alternative asset class. There was little apparent need at the time to worry about defaults and comparable problems and while such procedures have been relatively well established for conventional bonds, this downturn has been the first true test for sukuk.

Progress in addressing these situations inevitably relies critically on ‘learning by doing.’ High-profile corporate defaults in the region have resulted in some debt restructuring agreements, most notably in the case of Kuwait’s Global Investment House and The Investment Dar. Both companies announced restructuring deals in December and the procedures adopted are likely to create valuable precedents.

Nonetheless, progress can be painfully slow as reflected by the current uncertainty around Dubai World.

In addition to boosting supply, the regional debt capital markets need to develop the demand side. Foreign investors offer an important opportunity, not least for further liberalisation of the regional capital markets. But just as important is the gradual anchoring of debt capital in the minds and portfolios of retail investors.

Although they have so far been held back by limited issuance and large minimum investment requirements, the appeal of the asset class, especially now, is obvious enough: it tends to offer a very high degree of capital guarantees along with predictable and often fairly reasonable returns.

The creation of funds should improve access and broaden investor portfolios in ways that are now the norm in many advanced economies with a long history of retail bond savings.

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