Funding requirements have been growing in the MENA region as governments seek to build much needed infrastructure, create employment opportunities for the younger generation and diversify their economies from the traditional hydrocarbon-based industries.
Corporates - whether privately owned or government-related entities - rely on their shareholders, banking partners and sukuk/bondholders to finance their growth. This increasing need for funding has lifted the debt capital market in the GCC over the recent years.
However, because of the GCC economies' strong ties with the USD, it comes as no surprise that majority of bonds and sukuks issued in the region are dollar-denominated. In the last week of January 2013, for instance, the Dubai government and Qatar Telecom (Qtel) successfully raised debts at highly favorable rates.
The government of Dubai's Islamic bond issuance generated USD 1.25 billion and was oversubscribed by a factor of 12. Qtel, on the other hand, conveniently raised USD 1 billion from its 15- and 30-year bonds.
While this healthy demand for USD bonds may prove beneficial to government and private entities looking for funding, it does not help the central banks of the UAE and Qatar achieve their objectives of developing the local bond market (refer to Table 1 and 2).
At equivalent yields, international institutional investors will logically prefer to invest in USD-denominated bonds because they manage their exposure in USD and expect to benefit from greater liquidity provided by like-minded investors.
However, local investors collecting income in domestic currency are usually in need of local currency-denominated bonds. If the local currency is pegged to the USD, as is the case for the UAE dirham and the Qatari riyal (QAR), the incentive for the local investor to chase local currency bonds is minimal.
As long as the currency is pegged, local issuers are more inclined to issue debt instruments in USD if it can provide them with the lowest cost of funding, thanks to the increased liquidity enjoyed by the debt instrument. Only a happy few, however, can expect to join the "USD bond" club due to size, governance, government implicit support and international presence.
None of the bonds were issued in AED and QAR in 2012. Data sourced from Zawya Bonds Monitor
Aside from providing significant financing option to domestic issuers, local currency bonds/sukuks also help build regional financial hubs. In addition, they allow central banks to be less reliant on external funding in case of stress while minimizing dependency on the USD in the event of a de-pegging.
Recently, Qatar hinted at the possibility of issuing three- and five-year local currency sovereign bonds this year in a bid to "build the domestic bond yield curve so the new issuances will be tradable instruments," according to an International Monetary Fund (IMF) representative. The move has been seen as an effort to refinance the USD 14 billion worth of three-year bonds issued to local banks in January 2011.
While Qatar's initiative may be an important step to building the yield curve, there is a concern on whether this will lead to a secondary market. How can this effort convince both issuers and institutional investors to participate in the local bond market if liquidity is lacking?
Today, medium-sized companies and family holdings in Qatar, as well as the UAE, are left out as issues of USD 150 million or less are extremely rare. An entire funding segment that has been critical to the growth of US, European and Chinese companies is not available in these Gulf states.
As Qatar embarks on a massive infrastructure development in preparation for the FIFA 2022 World Cup, most local companies would have to stay on the sidelines. Without access to sufficient medium-term financing at reasonable cost, they will not be able to participate effectively in the development program.
This would not have been a critical issue if local banks were able to take up the entire requirements. However, there are a few good reasons why they cannot.
To enumerate, the Qatar Central Bank (QCB) is carefully monitoring the real estate/construction exposure of local banks as some have been discovered to be "flirting" with the limit. Personal guarantees are, in numerous cases, "used up" by banks when providing lending facilities. The limit on local deposits which can be raised in Qatar is also constraining banks in their ability to fund their loan growth. Prudential rules likewise entice banks to favor most liquid instruments and shorter term maturities.
In addition, Qatari banks have retained most of the Q-bills issued by QCB in 2011 instead of helping to create a liquid market. As a result, QCB is encouraging local banks to develop abroad in order to diversify their risk profile, thus reducing their onshore lending capacity.
Local demand on the rise
However, there is a growing number of local institutional investors (i.e. pension funds, insurers and high-net-worth individuals), who have long-term liabilities or residency in Qatar and are looking for fixed income type returns, preferably in local currency. They are the long-term resilient engine that will fuel Qatar's economy going forward and help the private sector reach financial maturity.
Latent demand is currently estimated at over USD 5 billion. Local institutional investors' perception of the Qatar sovereign risk is less than what the credit default swap spread (CDS) implies. They are pleased with the returns offered by the USD bond type instruments issued by Qatari entities and would welcome more options.
However, these investors require liquidity and if they had a choice between a Qatari issuer offering a USD bond and another with a QAR bond, they would require a premium for the latter. When considering how much of a liquidity premium will they require for local bonds, it really depends on the issue parameters and timing of the issue.
To credibly launch a QAR bond market, the QCB needs to entice local institutional investors to take up local bonds with issuers not having to pay the liquidity premium until the local bond market is sufficiently developed and the premium has disappeared.
When the Qatar government issues a USD bond, it agrees to pay a premium to bondholders, equivalent to the CDS. Although the CDS and the liquidity premium are different parameters altogether, they both affect Qatar entities' ability to fund themselves.
From an ethical viewpoint, it would be difficult to justify a subvention based on the behavior of imperfect book-building exercise influencing the liquidity premium. At the same time, the issuer in Qatar should not be penalized for being based there when it is looking to access funding to help Qatar's economy grow.
Subsidize QAR bonds
To achieve financial freedom for Qatar and successfully launch a QAR bond/sukuk market, the suggestion is to subsidize QAR bond issuers with an amount equal to the actual CDS.
If the Qatar government, through QCB, decides to sponsor the CDS cost to issuers of QAR bonds, it would help issuers either by being able to choose between issuing a USD bond at a cost of Libor+margin or a QAR bond at Libor+CDS+margin if such issuer is financially strong enough to have the alternative, or just having the opportunity to raise a bond.
The following parameters should be added to ensure that the scheme is as successful as possible:
- Minimum maturity of two years and maximum of seven years.
- Minimum size issue at QAR 250 million and maximum at QAR 2.5 billion with maximum volume of issues per issuer at QAR 2.5 billion
- Issuer to be approved by QCB and relevant authorities.
- A 25% limit to foreign investors at the time of listing and no limit thereafter to ensure maximum liquidity.
- In case of a government-related entity (GRE) using the scheme, the cost saving could be reimbursed to the company as a dividend, thus reducing the net cost to the Qatari government. Given the current infrastructure funding requirements in Qatar, we expect infrastructure bonds to be first candidate for the scheme and help create the relevant benchmarks yield curve.
- Although the lack of international credit rating for medium-sized Qatari corporates may limit international investors' appetite, local investors are expected to invest and benefit from more attractive coupons.
- To further entice international investors to invest in QAR bonds and de facto make deposits in QAR in local banks, QCB may explore compensating the currency swap cost linked to the initial bond purchase (and coupon payments, too).
- Duration of the scheme would hopefully be limited to bonds issued within the next three years.
Cost of a QAR bond scheme
Assuming QAR 20 billion worth of bonds (across 20 issues) are sold per year, for a five-year average maturity, with a five-year CDS priced at 100 basis points (see graph below), the bond scheme would cost approximately QAR 1 billion per year for the first year and will increase pro-rata in line with the duration of the bond.
This effort to achieve financial freedom is roughly comparable to the yearly incentive provided to banks through the ongoing monthly Q-bills auctions.
Upon Qatar being able to attract recurrent issuers, QCB should expect to enhance the QIBOR fixing and build a robust yield curve in its local currency. Over time, non-Qatari corporates may also look into issuing QAR bonds.
Moreover, the scheme would support the launch of local QAR bond funds (conventional and Islamic), offering a new QAR investment alternative for Qataris and helping them constitute personal savings nets, in addition to government sponsored pension schemes.
This will also significantly help in reducing capital flights to offshore centers and overexposure to real estate or stocks while offering attractive returns than bank deposits. Thus, a simple temporary local bond market launch incentive scheme may go a long way for Qatar.
Alex Carre de Malberg is executive general manager at the Commercial Bank of Qatar and Global Head of Commercialbank Capital. The views expressed here represent his own and do not implicate Commercialbank in any manner whatsoever.
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