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The imperative of developing local currency debt markets

By Dr. Nasser H. Saidi

GCC member states should prioritize the development of debt and sukuk markets through regular local-currency government issuance with different maturities, writes DIFC chief economist Dr. Nasser H. Saidi.
The global economy faces headwinds from a conjunction of uncertainties including the Eurozone sovereign debt crisis, effects of Western banks' deleveraging, fiscal austerity, slowdown in consumer demand, supply-chain disruptions resulting from catastrophes in Japan and Thailand, and geo-political risks in the Middle East region - the latter, currently driving oil prices up to near-highs last witnessed in 2008.

The immediate impact from the Eurozone sovereign debt crisis on the Middle East region is disparate, given the divergence in economic developments between MENA oil exporters and oil importers and countries undergoing transition and transformation. Recession in the euro area is likely to negatively affect growth and unemployment in North Africa as a result of lower exports to Europe and a reduction in tourism receipts, remittances, and investment flows. Countries like Egypt, Lebanon and Jordan will be less affected, given weaker links with Europe and stronger links with the GCC.

The direct impact of the sovereign debt crisis on the GCC has been relatively muted so far. However, European banks, which have been the leading providers of Middle East syndicated loans, are likely to retrench. The region's bias and dependence on bank financing raises multiple risks. Indeed, the financial structure in the Middle East is unbalanced: the bulk of finance - 60% to 65% - comes from the banking sector. Another 30% is derived from the equity markets while the debt markets are severely under-developed.

But MENA banks are facing an increasingly restrictive regulatory environment under Basel III, requiring an increase in capital availability and adequacy along with the introduction of liquidity requirements, while facing a more challenging lending environment. Though they are better capitalized and with less leverage than their Western counterparts, their ability to meet the financing requirements of governments and the private sector will be constrained.

Second, they are reliant on the European MTN market for medium-term funding. But European credit markets are in crisis as investors and creditors are increasingly averse to investing in bank securities. Third, there are contagion and spill-over effects from Europe's sovereign debt crisis. European banks have the largest exposure of international banks to the region: they provide international trade finance and more than 50% of cross-border loan syndication. But, European banks face the five Rs' of recapitalization, retrenchment, regulation, restructuring and recession that undermine their ability to continue providing finance to the region.

Faced with weaker balance sheets EU (and Western) banks will continue a process of deleveraging. For the MENA region, the implication is a loss of bank financing and increasingly difficult and more costly access to European credit and financial markets. The gap will have to be filled by local banks - themselves facing constraints of long-term funding and relatively low underwriting capacity - and by Asian banks. We will have to re-orient our banking relations towards Asia and China.

Mortgage markets, which should be the mainstay of housing finance for countries with young and fast-growing populations, are largely absent. The over-reliance on bank loans for financing led to core infrastructure and development projects being financed largely through short-term commercial bank loans. The predictable result was maturity mismatches, large risk exposures, and balance sheet constraints, limiting the ability of banks to refinance with the onset of the Great Financial Crisis.

Meanwhile, financing needs are growing in the region. One, the region has ambitious investment plans and infrastructure projects, driven by demographic factors (60% of the population is below 29 years), growing incomes and aspirations, and the need to create jobs for a rapidly growing labor force, with some 70 million new jobs to be created by the end of the decade. The MENA region needs to invest some USD 100 billion annually for core infrastructure and faces a USD 40 billion to USD 50 billion funding gap. Two, countries in transition and those destroyed by war and violence require massive infrastructure and public works investments for reconstruction and development in addition to the need to fund growing budget deficits in the aftermath of the Arab Firestorm.

How do we make this happen? How do we finance these obvious opportunities and turn them into realities? Development of local government and corporate debt and sukuk markets would reduce reliance on foreign capital flows, which are volatile and subject to 'sudden stop' effects, as happened in 2008-2009. It is absurd for a region that is a major capital exporter, with enormous net foreign assets to have economic stability and the security of the assets of its future generations, subject to the investment risks of too-interconnected to fail (TITF) and too-big-to-fail financial (TBTF) centres like London and New York and their TBTF/TITF institutions.

To move forward, the GCC member states should prioritize the development of debt and sukuk markets by instituting a program of regular local-currency government bond and sukuk issuance with different maturities. This should entail direct government obligations, rather than quasi-sovereign or State-Owned-Enterprise issuance, across the full term structure in order to develop a risk-free benchmark yield curve, which can act as a reference for the pricing of corporate issuances.

With the countries of the region pegged to the US dollar, they lose monetary policy independence. However, developing local bond and sukuk markets, which are imperfect substitutes for foreign government securities, would help improve liquidity and its management, and strengthen the ability and effectiveness of central bank monetary policy by building their arsenal of monetary tools and instruments. These instruments have to be augmented by an efficient liquidity management framework, enhancing the lender of last resort function and widening the scope of eligible collateral.

We need to institutionalize the tools that have been developed during the 2008-2009 crisis into permanent facilities and markets including: repo and reverse-repo, swap, discount windows with a wide variety of collateral (government, corporate and bank securities) eligible for discount and re-discount (including for Shariah-compliant securities), and term facilities.

Recent and bitter experience over 2008-2010 exposed the risks of using short-term loans to finance long-term projects (especially in the financing of infrastructure). It is necessary and preferable to raise funds through securities issuance, backed by future cash flows, as in project financing. Infrastructure and development projects should be financed through the bond and sukuk market and not via the banking system.

In a nutshell, the development of local currency debt and sukuk markets is an imperative and a foundation for sustained economic development of the MENA region. The markets would help to finance infrastructure and development projects in the region; reduce the dependence of the business sector on bank finance; enable governments to mitigate macroeconomic and financial vulnerability from energy price fluctuations by providing alternative sources of financing; enable monetary policy by providing central banks with government securities in order to conduct open market operations and control liquidity, and last but certainly not the least, develop mortgage markets which are the cornerstone of housing finance.

Dr. Nasser H. Saidi is the chief economist of the Dubai International Financial Center and executive director of the Hawkamah-Institute for Corporate Governance. He is a member of the IMF's Regional Advisory Group for MENA and Co-Chair of the Organization of Economic Cooperation and Development's (OECD) MENA Corporate Governance Working Group. He is a member of the Private Sector Advisory Group of the Global Corporate Governance Forum, an institution of the World Bank driving global corporate governance reform. He is also chair of the regional Clean Energy Business Council. In 2011, Dr. Saidi was named among the 50 most influential Arabs in the world by The Middle East magazine for the third consecutive year.

Read his blog here.

© Zawya 2012

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