The future for Mid East capital markets

Given the fact that the GCC countries are net lenders to the rest of the world, the creation of new investment opportunities through the provision of debt instruments solely with a regional focus is entirely appropriate.

Much investment in viable long term fundamental wealth creating infrastructure and new industries has already taken place. Much more needs to be undertaken but the sponsors are familiar and have already established a good reputation and a track record of successful management on many occasions, even during periods of adversity. Let us start by looking at the size of the GCC Debt Market.

The total amount of GCC syndicated loans and Eurobonds between 1997 and March 2002 is just under 65 billion US dollars, of which syndicated loans represent around 61 billion US dollars or 94% of the total, and Eurobonds represent US dollars 3.7 billion, or 6% of the total. These numbers exclude the in-country lending activities of local banks, much of which might be undertaken on a bilateral basis.

The peak of activity was in 1997 when the Kingdom of Saudi Arabia undertook some sizeable expansion programmes in the petrochemical and steel sectors.

What is noticeable is the relatively low volume of international bond issuance. The fact that the bank market has been extremely liquid and able to offer aggressive loan pricing, has a major influence on this outcome. Unlike other parts of the world, the sovereigns within the Gulf have had little reason to visit the international capital markets in recent times. This is as a consequence of a robust oil price favourably affecting their budgets, and also, for the reason that some of the major infrastructure investments in the oil and gas sector and in power, have been undertaken on a private basis - plus of course, some have utilised the domestic markets instead.

Outside of the sovereigns, there has been to date relatively little demand for private sector borrowers to pursue the Eurobond route as opposed to bank financing, which continues to offer flexibility and more recently, longer tenors.

The Middle East project finance market had a good year in 2001, with the amount of debt raised at US$ 8.6 billion, double the size of that in 2000. Many of the transactions were in fact closed after September 11th, and in this respect, the regional banks played a significant role.

Which countries have sourced the major financings?

Looking at the breakdown of syndicated loans per country between 1997 and 2002, we can see, not surprisingly, that Saudi syndicated loans represented 47% of the total at around 28 billion US dollars. Qatar comes in second place at 14% of total syndicated loans or 8.7 billion US dollars, with the UAE, Oman, the Kingdom of Bahrain around the same level with Kuwait at 7%.

These are predominantly the percentages of loans sourced by borrowers in these countries - they do not represent borrowings by the sovereigns.

Who exactly were the borrowers?

By far, the largest borrower group has been the corporates, both private and public corporates representing 72% of total loans. Banks and Financial Institutions represented 22% of total loans and governments 6%.

Examination of the borrower type also highlights the regional competitive advantage that prevails in the Gulf - it has huge strengths in the oil and gas sector resulting in the development of downstream projects by governments, government entities and more recently, by the use of limited recourse financings with international sponsors.

The presence of international project sponsors, the access to low-cost feedstock and fuel resources, and the strategic importance of the projects to the host countries, normally reflected by a government owned entity involved in the structures, are some of the key competitive advantages which make corporates the most significant borrower type.

What are the loans used for?

54% of total syndicated loans for the past five years was related to project financing (or US $ 33 billion), with Aircraft financing representing 17% of total loans (or US$10.4 billion), general corporate financing 11% and refinancing at 6%. Other loan purposes include facilities such as working capital, trade finance, and shipping.

The sizeable share of project financings reflects the privatisation initiatives undertaken by some GCC countries and the development and expansion projects by the big corporates in the oils & gas, petrochemical, and energy sectors, in addition to other major regional industries such as steel and aluminium.

It is worth noting here that the share of project Re-financing of total loans is expected to increase in the coming years as the first wave of projects become operational. The most recent example of this is the successful refinancing of the Oman LNG project at US$ 1.6 billion

Contrary to the activity of the syndicated loan market, the Eurobond market from GCC issuers is still in its infancy and very immature. The total amount of issuance between 1994 and March 2002 was around US dollars 5.4 billion from sovereign and banks or financial institutions and project bonds.

Eurobond issues by Banks and financial institutions from Bahrain have been regular over this period, with issue sizes ranging between 60 and 200 million dollars, paying floating or fixed coupons. The Sultanate of Oman came to the market in 1997 with a 5-year US $ 225 million fixed rate sovereign issue.

By far, the largest issues in the region have been from the state of Qatar. There was the first project bond for the Ras Laffan Gas project and, in 1999, Qatar issued a 10 year fixed rate 1 billion US dollar bond, which was followed by a 30 year fixed rate US $ 1.4 billion sovereign Eurobond in 2000.

With no activity at all in 2001, 2002 has started with National Bank of Kuwait launching its successful US $ 425 million 3 year FRN. We are confident that other financial institutions will visit the market this year to lock into the low interest rate environment.

A total of only 12 Eurobonds were issued between 1994 and March 2002 and it is interesting to note that all the bond issues were well received by the markets.

In percentage terms, how does the bond issuance look on a country-by-country basis?

Qatar eurobond issues between 1994 and March of 2002 represented 73% of the total amount of Eurobonds for this period, followed by Bahrain at 15%, Kuwait at 8% and Oman at 4%.

It is important to point that only Oman and Qatar have issued Eurobonds at a sovereign level, having formally sought and been assigned investment grade ratings from Standard & Poors. In this regard, it was pleasing to see Qatar upgraded by Standard & Poors yesterday to A-.

On issuer type, we can clearly see that the sovereign issues of Oman and Qatar represented the bulk of issuance from the GCC at 54% of total issuance, and corporate and project bonds at 24 and 22% respectively. This, of course, is quite different to that evidenced in the syndicated loan market where project financings formed the largest portion.

Why have project financings not featured more predominantly following the success of the Ras Laffan US$ 1.2 billion issue, which was a petrochemical project with an Asian offtaker. The subsequent change in the Asian market dynamics, has meant that few petrochemical projects have exhibited the characteristics to achieve investment grade ratings, particularly at the time of initial financing. Asia, which is a fundamentally important market for Middle East petrochemical producers, is one reason.

But more generally, few institutional investors were prepared to re-enter the project finance capital markets after severe losses in 1998 (though not in the Middle East). Nevertheless, this resulted in limited demand for emerging market paper - 75% of project bonds issued since 1999 have been in North America.

However, going forward, I do see more scope for capital markets to be used in some of the project re-financings because we have seen evidence already that the rating agencies are prepared to offer higher ratings for projects when completed, than the sovereigns where they are domiciled.

In order to put GCC volumes into perspective, we have compared the volumes here to other developing regions namely: Latin America and Asia.

The volume of GCC loans and Eurobonds compared to that of Latin America and Asia is indeed very thin.

Total Syndicated loans for the GCC between 1997 and March 2002 at around US $ 61 billion represent 26% of Latin America's volume and 58% of Asia's volume.

For Eurobonds, the difference is even more marked. GCC Eurobond issuance at around 3.7 billion US dollars represents a mere 2% of Latin American Issuance and 10% of Asian issuance. Indeed, it is pertinent to note that Argentina alone has outstanding capital market debt of more than 50 times than that of the GCC region.

What then of the Domestic Capital Markets in the GCC? Here, the position is unique to each country and data is not so readily available.

In Saudi Arabia, the bond market is dominated by government bonds with maturities of between 2 and 10 years - this is an activity which first commenced in 1988 - there is no corporate bond market to speak of.

Since 1987 the government of Kuwait has issued a number of securities predominately short tenors (3 year maximum). There were several corporate issues towards the end of the 1980's and in the last couple of years, more corporate issues have come to the market with amounts ranging between 15 and 40 million Kuwaiti Dinars with maturities between 3 and 5 years.

In the UAE there has been no Government bond programme to date, Emirates, the Government of Dubai owned Airline, was the first corporate to issue a FRN to be listed on the Dubai Financial Market in July 2001. This issue was an outstanding success. It was launched at 750 million Dirhams, and was more than twice oversubscribed, with Emirates finally choosing to take 1.5 billion Dirhams.

This landmark issue marked the birth of debt capital markets in the UAE. It set a benchmark for future issuers and we, at HSBC, were pleased to act as Advisor, Arranger and Lead Manager for this issue.

In Bahrain, the government has issued a number of securities predominantly with maturities of up to 5 years. Recently, the government issued two Government Islamic Leasing Bonds denominated in US Dollars with maturities of 3 and 5 years.

In Oman, there is a local debt market for Government Treasury bills with maturities of 3, 6 and 12 months. There are also government development bonds used for the finance of infrastructure projects. These have maturities of 3, 4 and 5 years. Oman has also seen recently some corporate bonds with maturities of 3 and 5 years (Bank Bonds)s.

Qatar, on the other hand, is the only GCC country not to have a local capital market to date.

Against this somewhat uneven background, one is tempted to suggest that there might be in the course of time, room for the creation of a regional debt capital markets establishment similar to that often contemplated for equities. Indeed, if the region proceeds with a common single currency for the GCC, it would further strengthen this argument.

What then is the scorecard on bond issuance within the GCC Region?

To date only Oman as a sovereign has issued bonds in the international and domestic markets. Is it possible that the dynamics of the GCC Debt Market might change?

Three main debt drivers are identified: 1) Infrastructure development 2) Asset / liability management and 3) Corporate structures.

As for the sources of finance, again 3 main sources are identified: 1) Banks, 2) Agencies and 3) the capital markets.

It is expected that the number of Greenfield projects will continue apace as the economies continue to grow. New downstream projects and expansions in the oil and gas and petrochemical industries and the provision of new generating capacity in the power sector, will be major driving forces.

Some observers have indicated that over the next 10 years, a total of US$ 200 billion will be spent on the oil and gas and power sectors alone in the Gulf region, with the Kingdom of Saudi Arabia accounting for a significant percentage of this expenditure.

Another driver will be the Re-financing of projects when the construction is completed. I believe that this trend will continue as sponsors seek to take advantage of a lower interest rate environment and bank liquidity which is available to re-finance on better terms, now that construction risks have been removed and many of these re-financings could also be candidates for debt capital markets because of the long term cashflows associated with them.

Considerable expenditures will also be undertaken in the real estate sector as markets look to plan for the longer term with the development of first class tourist facilities and the supporting infrastructure.

The next major driver category is Asset / liability management. Whilst regional financial institutions enjoy the best capital ratios in the world, the tradition however, has been for their deposits to be relatively short term. As the regional banks become more active players in the major project financings with longer tenors, then more will look at international loan facilities or the capital markets to obtain longer term funding as part of prudent asset / liability management.

At the same time, governments or government owned entities will continue to use domestic markets for their longer-term budgeting, and some, might also be tempted back into the international capital markets where there is huge interest from the investing community to welcome new participants from the Middle East.

Under corporate structures, we might see more merger / acquisitions activities as Gulf institutions might look to expand across / or outside the region - a recent example is the proposed SABIC acquisition in Holland. More pertinent might be the establishment of corporate structures which address issues of succession within some of the major Gulf family businesses and these structures will require the raising of debt to complete the process.

Natural corporate expansion will, of course, take place as enterprises gear up to take advantage of obvious market opportunity - such examples being in the airline and tourism industry.

Governments might look to accelerate the privatisation process alongside inward private investment for new projects, by also selling down some existing assets or stakes in well-established government owned entities - again, another opportunity for debt to play a role.

So, who will be the debt providers?

From our experience as one of the leading international bookrunners in the region, we see that banks, both regional and international, will continue to be significant players in major financings with the regional banks playing an increasingly prominent role. The role of Islamic institutions with appetite to undertake long-term financings is very recent with their involvement in the Shuweihat and the Al Hidd financings and we believe that this involvement will grow significantly.

With regard to agencies, the historical participation of export credits in financings could arise again because of the sheer size of new financings necessary. All the OECD ECA agencies are fully open to support financings in the Gulf and some of the features of ECA credits could become fashionable again as interest rates rise. There are also some regional funds which are available as a source of attractive financing for new investments.

The last category is the capital markets. All the evidence that we have seen to date is that apart from some sovereigns such as Saudi Arabia, Kuwait and Oman being regular issuers in their domestic market this has been the least used source of finance to date. However, there is scope and particularly demand for this to change - so is the growth of capital markets particularly for corporate issues : is this the natural next stage?

The scale of planned development in the Gulf over the foreseeable future is very substantial - it will not be funded by governments alone. The debt markets will play a significant role, but given the sheer size of debt requirement, there is probably a need to widen the investor base so that there is a natural progression between bank led finance into the capital markets arena.

Banks obviously are very liquid at present, generally hungry for assets and therefore are prepared to bid very aggressively for debt transactions. This makes it very compelling for borrowers to look no further than the bank market. However, there is a possibility that the banks themselves might be more constrained in the future because of the challenges on capital adequacy under the Basel II Accord.

This will force banks to adopt new risk weighting measures. Discussions on the proposals are still underway but a possible outcome might be that this would affect the cost of their funding such that they become more selective in the use of their capital. A knock on effect is that loans could become more expensive.

Coupled with the fact that regional investors need to find new outlets to apply their own liquidity, this could lead to the establishment of more active domestic debt capital markets across the GCC, and further utilisation of the international debt capital markets.


Issuing local currency bonds has advantages to both issuers and investors.

To issuers, it is an opportunity to diversify their investor base by tapping a wider pool of investors and relying less on traditional bank lines.

Where possible, issuers should seek formal credit ratings. Ratings add value to an organisation because it offers independent confirmation of its creditworthiness to its respective counterparties. They lead to greater transparency and investor protection and improve corporate reporting and disclosure of financial information.

However at the same time, it is recognised that for some names their activities are already familiar to the investor community and the local regulator might be more pragmatic when it comes to the need for ratings.

For investors, who have had to traditionally go offshore because of lack of investment opportunities in their domestic market, a local currency bond gives them the ideal opportunity to invest onshore, in their own currency and to participate in the success of names they understand. Such local currency bonds will prove to be an attractive alternative investment.

A strong domestic capital market can be an excellent protection against volatile capital flows. The need to develop domestic bond markets has increasingly attracted the attention of both national and international policymakers. The World Bank and the IMF have developed guidelines for public debt management.

By their nature, strong domestic capital markets should attract the 'right' kind of investor, such as pension funds or insurance companies, that are not as preoccupied with liquidity as investors with a shorter-term horizon, such as hedge funds.

In summary, the characteristics are there for the domestic markets to grow particularly for financial institutions and corporate issuers - what it needs is some more leadership and creativity to develop further.

Now let us look at the international bond position again.

Bond issuance out of the Middle East, even including Turkey and Lebanon, remains extremely light, at just over 0.5% of total bond issuance in 2001. This is despite EMBI weightings for Middle Eastern bonds currently at around 7.50%, suggesting a strong demand - supply mismatch.

Under proper management, the long-term benefits of Sovereign Eurobond issues can be quite influential. Ultimately, through a managed issuance programme, governments can develop diversified and cheaper sources of budget finance. The maturity profile can be extended beyond limits of bank commercial borrowing, particularly on an average life basis because of bullet structures as opposed to amortisation.

An investor base can be built up and this can be used when new funds are being sought for government-sponsored projects. What is perhaps the most important consequence of a sovereign taking the lead in this way is that benchmarks are set enabling corporates to enter into the international debt markets thus giving them enhanced access to foreign capital to support long term economic development.

So, there are strong arguments to suggest that there is investor appetite for new liquid bond issuance by borrowers from the Gulf.

Rarity of issuance from the region - investors are increasingly looking for regional diversification within their portfolios to avoid over-exposure to specific regions (Latin America too volatile, Central Europe too tight and Russia too unpredictable).

Lack of competing supply - As seen in the previous chart, the current volume of liquid Middle East bond issuance is smaller than portfolio weightings for the region would suggest.

Strong Regional Demand: with a lack of liquid Middle East bond issuance, investors will have a strong bid for new liquid supply at competitive levels. We have recently seen a convergence of spreads between loans and bonds in favour of bonds.

Sovereign / Benchmark Credits: certain institutional investors favour liquid benchmark bonds and will be attracted by the diversification opportunity that a new Gulf issuer will bring.

Investors moving along the credit spectrum - in the current low interest rate environment, investors are increasingly moving into the BBB product for better yield.

Increasingly sophisticated investor base: investors are better able to evaluate individual credits and take a longer-term view on their credit strengths.

All these points apply to international bonds but some are also appropriate to domestic issues.

What then, is the way forward?

Will the debt markets grow? Yes most certainly because there are likely to be Re-financings of projects as well as the financing of new projects. Yes, because financial institutions will seek to manage their asset/liability positions by arranging longer term funding. Yes, because corporates will be looking at expansion opportunities which will arise as a natural consequence of the economies growing.

The region needs creative financial institutions who can meet the changing financial requirements of the GCC region, regulators who can put in place the necessary procedures for an organised market, issuers who are prepared to proceed in accordance with international standards and investors with the correct level of sophistication who are able to weigh up risks for an acceptable return - there have been false dawns before, but I believe that now there is a coalition of factors which is moving the GCC region much closer to a considerable upsurge in capital markets activity.

Investors, both individuals and institutions, can see at first hand the measures being taken by GCC governments to improve infrastructure, create wealth generating industries using the region's natural resources, and at the same time diversifying into new sectors. This will ensure that there is economic stability and prosperity for future generations when some of the oil and gas dependencies have peaked.

The international bond markets will require ratings, full transparency and the need for secondary market liquidity to protect their investors. It is recognised that for some issuers, there might be a reluctance to undertake some of these steps and the reasoning for this is perfectly understandable and logical. However, I do believe that it should be possible to marry the region's requirement for future investment with the aims of regional investors who seek stable investments offering stable returns. So in the event that perhaps a sovereign does not issue, encouragement should be given towards a suitable flagship alternative.

Regional investors want to be associated with the region's progress - this is only available to a limited extent in the equity markets. Some of the more successful stories lie outside this.

After all, much of the wealth which is invested today in offshore markets by the Gulf investor community, has its origins in local investment.

This is an ideal time for the debt capital markets to become more prominent in the region's future and I encourage issuers to look closely at this opportunity and investors to respond equally to the challenge to further secure the prosperity and wealth of the regional markets.