In recent press announcements about Abu Dhabi’s rating getting upgraded to AA by the rating agencies Standard & Poor’s and Fitch, an important detail went unnoticed: The emirate plans to issue government bonds to serve as a benchmark for the corporate bond sector. In the aftermath of the GCC stock market crash of 2006, the Gulf Research Center had argued for such a step at the GCC level to widen and deepen the region’s immature and volatile capital markets. It is much more than a mere technical detail, a benchmark of government bonds all across the yield curve functions in all developed capital markets as an orientation point for the corporate bond sector as well as for the increasingly important market of securitized mortgage and loan portfolios. Without such a benchmark there is no sensible way to measure the risk that is attached to a certain bond and quote a price for it in terms of its spread to a comparable bond of the benchmark yield curve.
(Dr. Eckart Woertz is program manager, economics, at the Gulf Research Center in Dubai.)
The bond and sukuk markets of the GCC countries still lack important ingredients of a functioning securities market like variety of issues, rating culture and transparency, liquidity, market makers and a broad-based spectrum of institutional market participants. Too often, one encounters isolated five-year floating rate notes, which command limited liquidity as local investors gobble them up and sit on them until the end of their maturity. Thus, the market has been dominated by foreign investors who have started to develop a strong appetite for local credit risk and have dominated the trading in a couple of issues like the $1.3 billion Al Dar Islamic convertible bond for example. Not surprisingly, it has been often easier to get prices for GCC bonds in London and Hong Kong than in the Gulf region.
Still, important developments have taken place in the region’s bond markets. Rating upgrades of the respective GCC countries in the last two years have raised the country ceiling for the corporate sector and improved the conditions for issuing of its bonds. The rating agencies assume a strong inclination and capability of the governments to intervene in case of possible financial crises. There are now more rated companies and institutions, some bonds with tenors of more than five years are available and the number and sizes of issues have increased dramatically. In the UAE, arguably the most active GCC bond market, the value of issued bonds increased fourfold in 2006. Especially large issues like the $3.5 billion sukuk of the Dubai Ports, Customs and Free Zone Corporation or the $2.5 billion bond issue of Dubai Holding have become a more frequent occurrence. Should Abu Dhabi go ahead with its plans to issue benchmark bonds of more than $500 million issue size, and all across the yield curve, it will constitute a major step not only for the UAE markets but for the GCC markets at large. Although other GCC countries do not reach the AA rating of Abu Dhabi, they are not too far away with their mostly A ratings. Further, despite considerable differences between individual GCC countries, political and commercial risks in the region show a certain similarity. Thus, for the first time there would be a government benchmark for corporate bonds in the region. Certainly, a GCC-wide benchmark (e.g. issued by a supranational GCC institution) would be preferable, but the Abu Dhabi benchmark would be a very important step and could fulfill a comparable role that German government bonds do for the euro zone.
Sure, Abu Dhabi does not need to issue bonds to refinance itself; strong oil revenues have led to a current account surplus that stands at more than 200 percent of GDP. That’s world record territory and it is no wonder that such strong financials led to the rating upgrade by S&P and Fitch. But Singapore or Hong Kong also does not need to issue bonds for refinancing needs, as they have substantial surpluses. Still, they have been doing it since years simply to provide a benchmark for their corporate sectors. These are the successful examples that Abu Dhabi is about to follow. Like in the rest of the GCC bloc, huge infrastructure investments have been undertaken and the market for project finance is booming. From new petrochemical, power and desalination plants to heavy industries, construction projects and transport schemes, there is a need for financing. Albeit being a major capital exporter and financer on international capital markets, GCC countries themselves have financing needs in these sectors. The Arab Petroleum Investments Corporation (APICORP) in Dammam, for example, estimates that the downstream sector of refining and petrochemicals is 70 percent debt financed; only the national oil companies and the upstream sector finance themselves exclusively via retained earnings. Overall, the National Bank of Kuwait assumes a $1.25 trillion market for GCC project financing over the next six years and only 35 percent of this sum will come purely from government sources. A strong upsurge in the region’s bond issuance and securitization activity can be expected in this ongoing finance boom and the Abu Dhabi benchmark will be an important cornerstone of this growing market.
An important issue will arise with regard to the currency of the issued bonds. So far, international bonds in the GCC countries have usually been issued in US dollars and one can expect this practice to continue for some time to come, given the established arrangements of dollar currency pegs in the region. The growing uneasiness with the dollar’s weakness has however led to discussions about pegging to currency baskets or even reaching a free floating unified GCC currency by 2015. With the recent show of GCC disunity in the case of Kuwait’s unilateral withdrawal from the dollar peg and Oman’s exit from the unified currency project, the latter solution doesn’t seem to be on the cards in the near future, but the question of a nascent GCC bond market will be closely linked to these questions of currency policy. There are good arguments for reducing the GCC’s dependence on a fundamentally weak dollar, but in the largely capitalized bond markets, isolated national GCC currencies will not be able to gain international attention that a unified GCC currency could. Thus, Abu Dhabi’s establishment of a government benchmark could only come to full fruition if it would go hand in hand with monetary initiatives at the GCC level.