The region has seen its fair share of systemic stresses over the past five years. While many may argue that the root causes of these stresses were exogenous, the majority will agree that indigenous factors eventually exacerbated the pains.
In this article I demonstrate how the lack of a modern bankruptcy framework is denying private sector borrowers access to the international debt markets, while raising the risk premium for regional banks and governments alike.
The Crowding-out Effect
The debt landscape of the Middle East and North Africa is a treacherous one to navigate in the best of times, let alone in a global credit crisis. In the recent past we saw how the prospect of quasi-sovereign defaults in Dubai shook investor confidence in the UAE so severely that the only way out was a large-scale bailout from the federal government.
In Kuwait, despite having one of the healthiest sovereign balance sheets in the world, policy paralysis and weakened state institutions have left a number of investment firms in perennial distress and local bank balance sheets beyond repair.
In Saudi Arabia, total apathy on the part of regulators to address two mammoth private sector defaults and the perceived preferential treatment that ensued onto local lenders have raised the premium on corporates in the Arab world's largest economy.
Clearly there is no "one size fits all" solution to these situations, but what is certain is that they have all increased the risk perception and pushed the moral hazard in our bond markets to levels it will prove very difficult to retreat from in the near term. Despite the unprecedented bond and sukuk issuance in the first half of the year, the GCC market remains very much one-dimensional and lacking in diversity and depth.
According to Thompson Reuters data, of the approximately USD 150 billion raised in the GCC bond market since 2009, 60% was raised by corporate borrowers. A closer look at the data, however, reveals that some 90% of all such borrowings in hard currency have come from state-controlled or government-related borrowers.
This sharp rise in public debt issuance by quasi-sovereign entities can be justified by their dominant presence in the local economies and the role they play in expanding regional infrastructure. However, the trend is alarming as it may have inadvertently led to the crowding out of many creditworthy private sector borrowers and crystallized their eventual exclusion from the international capital markets.
A Vicious Cycle
Data shows a significant disconnect between regional activity in the loan market and that in the bond market. Total loan syndication activity in MENA during the first half of 2012 has slumped to an eight-year low of USD 9.86 billion, compared with USD 15.9 billion in the same period a year ago. On the other hand, bond issuance reached USD 17 billion over the same period, the bulk of which was raised by quasi-sovereign entities.
This strong demand for regional bonds is partly a result of globally accommodative monetary policies which have anchored real rates ardently in negative territory and increased the appeal of regional bonds. However, low rates alone fail to explain the collapse in loan syndication, a traditional source of funding for most private sector borrowers in the region.
The real driver for bond demand in MENA and the fall in syndication activity lies in the fact that our governments continue to reward bond investor with more government sponsored issuance and additional guarantees. Call it Ras Gas, Aldar, Emaar, Saudi Electric Company or Kuwait Projects Company, the common theme in all these issuers is the bond investor's perception of them as contingent sovereign liabilities.
Bond investors are demanding, as a precondition, the explicit government guarantee or the implicit sovereign link (vis-a-vis government ownership or control) as downside insurance without paying much heed to the underlying fundamentals. The sad consequence is that virtually any issuance from the private sector is instantly shunned by bond investors and automatically priced out of the market, leaving these borrowers ever more reliant on the scarcer and increasingly shorter term bank funding.
Ultimately of course, this is raising the concentration risks in our banking system and further narrowing our term structure.
A vicious cycle is already in formation in MENA and the crowding-out effect is manifesting itself through this rapid expansion of the bond market to the benefit of quasi-sovereign borrowers and the deep contraction of the loan market at the expense of the private sector.
The Call for Structural Reform
One of the very basic features of a healthy debt market is a legal framework that fosters private entrepreneurship and protects creditor rights. Unfortunately, our region is lacking on this front and the weak insolvency codes present today are singlehandedly the largest impediment to the development of our bond markets and possibly one the biggest components in our risk premiums.
The current insolvency codes, a legacy of Napoleonic statutes, are simply inadequate. These laws have all but criminalized bankruptcy and stigmatized the unwinding process when in reality they are a natural, albeit extreme, cost of doing business. Business owners languish in fear and disrepute when declaring bankruptcy; lawyers are reluctant to take on insolvency cases while judges are too eager to block them altogether. The end result is continued uncertainty and further misallocation of capital.
Bond investors, local and foreign, are united in their view of our insolvency laws. The existing frameworks are weak, archaic and unworkable. Many a lender has painfully realized the limitations of our judiciary after failing to recoup basic rights under the law, while those who were successful have endured very costly and time-consuming legal proceedings to achieve meagre recoveries.
Take a look at the UAE which, despite having one of the most liberal economies in the region and possibly its deepest fixed income market, ranked 151 out of 180 countries in the World Bank's Doing Business 2011 survey in terms of resolving insolvency. This is simply unacceptable for a country that hosts one of the fastest growing financial hubs in the world with aspirations of surpassing Hong Kong and Singapore in the near future.
Failing to address this structural deformity today will hinder the growth of our bond markets and compound the moral hazard by inviting more volatile and speculative capital. I believe that the impetus to develop modern bankruptcy laws and frameworks is stronger than ever and it is in fact a prerequisite for diversifying our economies and promoting growth. Need I share with you the benefits?
1. Enacting modern insolvency legislation will go a long way in invigorating investor confidence easing the flow of credit to its most eligible recipients, independent of any sovereign linkage.
2. Entrepreneurs can rely on a fair bankruptcy framework that allows for the equitable reduction in the debt load of businesses with genuine going concern value so that they may continue operating while in the process saving jobs.
3. Alternatively, businesses with little or no going concern value can be liquidated efficiently such that lenders are made whole in accordance with statutory priorities and capital can be re-injected into the economy and allocated to better uses as quickly as possible.
It is a virtuous cycle and the groundwork needs to commence without any further delay. Society as a whole is the beneficiary here and the call for action is louder than ever before. Please, let us not waste another golden opportunity and let us rise up to the challenge we face today.
Ahmad Al Anani joined Exotix in May 2008 as a director within the fixed income sales and trading team in London covering the Middle East and North Africa and is presently the SEO of the Dubai branch where he heads a team of seven. Prior to joining Exotix, Ahmad worked for a family office in London as the director of risk management and securitization where he was responsible for structuring term securitization products to manage liquidity within targeted portfolios.
© Zawya 2012
