The credit crisis has breathed new life into the Middle East’s young bond markets, both of the Islamic sukuk and conventional variety. Companies realise that a healthy local currency bond market can provide an alternative source of funding to bank loans and equity issuance.
An active sovereign bond market would give governments an additional policy tool to control domestic credit. It would facilitate implementation of open market operations of the region’s central banks, and make it possible for them to use quantitative easing, as in more developed countries.
The appetite for local currency bonds has been rising and the recent surge of issuance by governments and their subsidiaries is helping the development of the region’s debt markets.
Middle East and North Africa bond and sukuk issuance has totalled $23.2bn in the year to date, excluding the $10bn Dubai government bond issue. Total outstanding fixed-income debt in the region is estimated at about $250bn, of which $45bn are sukuk. The total constitutes only 15 per cent of the region’s gross domestic product, considerably less than comparable markets elsewhere. Nearly half the debt has been issued by governments and the balance mainly by financial institutions.
There are no active secondary markets and most of the trading is done over-the-counter by international banks. While world capital markets consist of an average 35 per cent bonds, 28 per cent equities and 37 per cent bank assets, in the Middle East the capital market is dominated by equities (46 per cent) and bank assets (49 per cent), with debt securities comprising just 5 per cent.
Several ingredients of well-functioning debt capital markets are lacking in the region. These include: greater institutional demand, which in the more developed markets comes mainly from pension funds, insurance companies, mutual funds, and corporate treasuries.
Retail demand remains weak as well. There are about 20 bond funds in the region with assets under management of no more than $1bn compared to 250 equity funds managing some $30bn of assets.
Transparency and disclosure issues also play their part. There is a lack of a proper rating culture. Many companies are uncomfortable about obtaining a credit rating, with the transparency requirements it entails.
Clearing, settlement and custody services are needed. Leading international banks in this field have been investing to provide these services. This will complement government efforts to create platforms for the trading of bonds and sukuk, such as in Saudi Arabia recently.
Investors’ appetite for local currency bonds will greatly increase if there is a secondary market for them to liquidate their holdings when cash is needed unexpectedly.
The presence of fixed income expertise in the form of lawyers, investments bankers, traders, researchers and custodians is also important. Attracting such professionals and developing local talent will constitute another building block for a local currency bond market.
Such markets could receive a further boost from the region’s thriving project finance market. Funds could be raised through bond-like structures to complement money coming from sponsors, the export credit agencies and bank loans.
A central question for debt capital market issuers in the region will be whether to sell conventional bonds or sukuk. The preference in recent years has been for the sharia-compliant debt, but uncertainty has clouded this market because of the first default, that of the Kuwaiti company Investment Dar on its $100m bonds. As more sukuk are likely to default or be restructured, because of the crisis, the young market will face legal and regulatory tests.
This will ultimately be healthy because it will clarify to sukuk holders how they are going to be treated in worst-case scenarios. Defaults will undoubtedly change the way sukuk are structured and marketed. Investors will be looking more carefully at the quality and marketability of the underlying asset and the strength of their claim in the event of default.
Henry T. Azzam is CEO, Middle East & North Africa, Deutsche Bank