Summer 2012

INSIDE VIEW: Patience needed in this ‘special frontier’ market

DubaiFixed income investors should not let the Dubai debt crisis deter them from seeking opportunities in the region, says Teeja Boye, of Insparo Asset Management.

Conventional credit in the form of tradable bonds is a recent development in the six-member Gulf Co-operation Council (GCC), comprising Saudi Arabia, the United Arab Emirates (UAE), Kuwait, Qatar, Bahrain and Oman.

Up to 2001, the region had accumulated credit issuance of around $5 billion, dominated by few sovereign issues and central bank treasury bonds and bills, directed largely towards the local market.

By 2005, total bond issuance from the region had reached close to $30 billion, but sovereigns and select corporates remained the dominant issuers.

Credit issuance really picked up between 2005 and 2007. Although bond issuance was a large component of this, another factor was the increased issuance of sukuk (Islamic bonds). In 2003, the Islamic Development Bank issued the region’s first international sukuk of $400 million, to be followed in the same year by a Qatar sovereign issue of $700 million. Dubai joined the fray in 2004-05 with a $600 million sovereign issue and a $3.5 billion issue by DP World in 2006.

Credit crisis
Government and related entities of the Emirate of Dubai became active in the sukuk and conventional credit markets, using funds raised to help finance the emirate’s infrastructure development and, in some cases, extravagant projects unlikely to be profitable in the short term.

By the end of 2009, the Dubai state and related entities had raised total debts close to 90 billion – 40% in the form of bonds and sukuk, taking external debt/GDP ratio to more than 150%.

Having issued many five-year debts in the boom years of 2005-07, the emirate faced total debt amortisation of $50 billion over the three years from 2010-12. Dubai World, the entity at the centre of the Dubai credit crisis, had amassed a total debt of almost $26.5 billion – about 80% due within three years.

Its real estate subsidiary, Nakheel, famous for its flagship palm-tree shaped man-made island development (pictured), had a debt pile of more than $6 billion. Though this project was an architectural and financial success, by its completion the company had so over-stretched itself that it had to shelve its next “World” project. The Dubai government had insufficient resources to address impending maturities and had to rely on the help of the neighbouring emirate of Abu Dhabi, which contributed at least $20 billion to help prevent a default of Nakheel in December, 2009.

Lessons learnt
Investors got a jolt from the Dubai crisis and woke up from their complacency. Assessing the stand-alone credit profile of specific entities became paramount. Even within Dubai, stronger credits with profitable underlying businesses and generating sufficient cash for debt servicing, such as Emirates Airlines and DP World, faced relatively tighter spreads even as overall spreads widened: it was the weaker credits that bore the greater brunt of wider spreads.

Credit rating agencies such as Moody’s, which a year before the crisis were comfortable with the “implicit” support of governments, now demanded more “explicit” statements of support from the respective governments.

Additionally, many GCC sovereigns sought to have more control and co-ordination of debt issues, especially of government-related entities (GREs).

Abu Dhabi is in the process of setting up a debt management office that will have an effective veto of borrowing by any state related entity; Dubai reorganised its many state-related entities and consolidated fiscal authority within the Ministry of Finance. Sovereigns and state-related issuers have also made attempts to improve communication with their investors and to establish more clearly defined processes for dealing with debt defaults and/or restructuring.

The challenges ahead
Dubai GREs and corporate issuers face a debt burden estimated to be slightly more than $100 billion over the next five to eight years.  We expect the debt overhang to remain for several years to come. The UAE banks still have around 20% of gross loans exposure to the construction and real estate sector, similar to levels at the height of the real estate bubble in 2008, even after some significant write-downs.

Many UAE banks have participated in loan restructuring of Dubai GREs, such as Dubai World, and have already made significant provisions for expected loan restructuring for this and other entities over the coming years.

We estimate a total debt maturity for Dubai corporates and GREs of at least $15 billion ($6 billion in bonds and $9 billion in loans) during 2012. Given the amount of debt facing these entities, we expect borrowers with limited internal resources to rely on a combination of refinancing and some form of restructuring to address impending debt maturities. Bonds so far have not been subjected to any form of restructuring, which has been restricted to loans – but investors should not assume this will continue to be the case in the future.

Additionally, the size of the required refinancing is quite large and could become a major challenge for these entities if the global funding environment deteriorates further in 2012. Our strategy, and advice to investors, is to focus on entities with better stand-alone credit metrics, good asset coverage and underlying businesses that provide strong and stable cash flows.

The opportunities
We view the GCC as a special frontier market with potentially huge rewards for the patient investors who spend valuable time to understand the complexities of the region. Our approach is to go beyond quantitative analysis by trying to understand the history, culture and interpersonal relationships.

Our conviction that Dubai will receive some form of help from Abu Dhabi was formed after several trips to the region meeting with key local players, who enlightened us about the intricate historical relationships. We were buyers of the Nakheel 2009 bonds at steep discounts while others were offloading them. Our analysis was proved right when the bonds were fully repaid on maturity.

Beyond this, we caution that investors’ perception of the region is not disproportionately coloured by the Dubai credit crisis. Dubai itself accounts for less than 10% of GCC GDP.  GCC issuers have debt/GDP ratios that are at the lower end of the global scale and governments maintain relatively strong fiscal balances.

The region’s hydrocarbon wealth continues to be supportive of economic growth that is expected to be maintained above 5% over the next two to three years, on average. Additionally, very large foreign exchange reserves estimated at more than $400 billion for each of Saudi Arabia, the UAE and Qatar provide an extra resource of liquidity to support expansionary fiscal policies and economic growth.

These factors should support an improving credit profile and tighter spreads for the region as a whole, over time, creating long-term opportunities for investors.

Teeja Boye is an investment analyst at Insparo Asset Management

©2012 funds global

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