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“For
what do I need a bond market? I make 50 percent a month
on the stock market!” Such attitude has not been limited
to some manic enthusiasts on the fringes of the GCC
investment world, but has instead been more common –
more common that is until the beginning of March 2006.
Given the recent decline in the stock market, people
still make 50 percent but in the opposite direction. As
such, the insight has dawned on many that there are
other securities than stocks and that they are worth a
closer look. In the developed Western securities
markets, for example, bonds are much more important than
stocks. About 90% of the turnover there is attributable
to interest rate related securities and only 10% to
stocks, while in the GCC it is the other way around.
Bonds fulfill an important function in the economy. They
provide stable long-term financing for companies and
states alike and offer investors an important
alternative to stocks. Bonds might be less flamboyant
and more boring than stocks, but they are less volatile
as well and offer a more predictable flow of income. As
bonds are often negatively correlated with the stock
market – they move up when the latter moves down and the
other way around – they also play an important role in
balancing the portfolios of private households and
institutional investors like pension funds. Especially
the latter are in need of the fixed income provided by
the bond market, as these investors require a firm base
on which to calculate their future liabilities. Thus,
the discussions in the GCC about developing local mutual
and pension funds must go hand in hand with the logical
first step: the development of a GCC bond market.
Bonds may be more predictable and stable than stocks,
but since the days of Michael Milken and the advent of
junk bonds we know that one can loose his shirt with
them as well. In case of rising interest rates, the
prices of existing bonds decline. Furthermore, not every
bond is a secure one, i.e. one that is issued by a
government or a government backed institutions with an
investment grade rating of at least BBB. There are
corporate bonds as well and there is the increasingly
diversified realm of asset backed securities (ABS),
where existing assets like credits or rental incomes of
real estate are bundled and repackaged as a tradable
security. Many of these securities are considerably less
safe than government bonds but also offer a potentially
higher return for the risk they involve. In this risk
hierarchy, government bonds function as an orientation
point for the pricing of the more risky and less liquid
corporate bonds and ABS markets. Thus, at the heart of
every bond market is a bench mark yield curve, which is
constituted by government bonds of various maturities.
This being the case, the corporate bond sector can play
its role as an important part of the financing of
companies. The corporate bond sector is the first to
gather steam during a recovery, not the equity market.
After the NASDAQ bubble burst, for example, Warren
Buffet ventured into “new economy” companies for the
first time, and he did so by buying Amazon corporate
bonds, not Amazon stocks.
The Asian Crisis in 1997/ 98 revealed two important
problems: for one, the over-reliance on the banking
sector for financing and, second, currency and maturity
mismatches on the balance sheets of these banks. The
borrowing was done in the short term and in US dollars
while the lending was done on a long-term basis and in
domestic currencies. Once the crisis arrived and the
local currencies tumbled, the structure became untenable
and led to particularly negative outcomes. In the
aftermath, the Asian countries have tried to spurn a
domestic bond market in order to avoid these problems in
the future and to reduce their dependency on the US
dollar.
The purpose of the Asian Bond Market Initiative
(ABMI) is to encourage local financial intermediation
and invest Asian savings directly at home rather than
“round tripping” the capital via Western security
markets with an estimated opportunity cost of two
percent. Members are the ASEAN countries plus 3 (Japan,
South Korea and China) with India being associated via
the Asian Cooperation Dialogue (ACD). There exist
various contacts at the levels of governments, central
banks, finance ministries and the private sector. In the
Asian Bond Funds (ABF) I and II, the countries are
investing part of their reserves in domestic bonds
denominated in local currency or the US dollar. The
targeted size of ABF I is 8 to 32 billion US$ and ABF II
already contains 1 billion US$, which appears to be
small compared to the huge currency reserves of Asian
countries of more than 1.7 trillion US$. But compared to
an underlying investment universe of 70 billion US$,
this size is not so small at all and is likely to grow
with the developing Asian bond market. After the Asian
crisis, some countries also took great efforts in
establishing a local ABS market, which has developed by
leaps and bounds and already made up for a majority of
corporate bond programs in South Korea in 2000.
The GCC bond market is yet underdeveloped. In comparison
to traditional bank and equity financing, it appears to
be a pale shadow. Current high oil revenues put the
region’s governments in a comfortable position. They do
not need to issue debt in order to finance fiscal
deficits. Corporations on the other hand have had easy
access to equity financing during the boom of the stock
markets. Thus, the market is characterized by a lack of
benchmarks, a limited variety of issues and low
liquidity. Recently, some bigger sukuks and floating
rate notes of banks have been issued (e.g. Emirates
Airlines, Islamic Development Bank, Mashreqbank,
Emirates Bank International, Abu Dhabi Commercial Bank).
But longer maturities are absent and on the government
side, only Qatar and Bahrain have issued Eurobonds, but
not enough to form a benchmark all across the yield
curve. Dubai pioneered into the ABS market by
securitizing mortgages from the Palm Jumeirah project.
But many legal issues surrounding ABS (e.g. property
laws, true sale) are still in the process of being
sorted out and somehow the deal only took off because
the issue was fully guaranteed by deposited fixed income
securities in London in addition to the Jumeirah Palm
mortgages.
Thus, the development of a GCC bond markets will first
of all need a government bond market with the corporate
bond market to follow suit. The ABS markets have a
chance to develop once the former two have taken off and
after legal issues have been clarified. Taken together,
the proper market infrastructure will be necessary such
as the auctioning of new issues and liquid secondary
markets with the participation of banks, market makers
and emerging institutional investors like insurance
companies and pension funds. Currently, the GCC bond
markets are an illiquid buy and hold market and often
one can get better prices for GCC bonds in Hong Kong and
London than in the GCC itself. Working settlement and
clearing procedures which are compatible with
international standards (e.g. Euroclear) and a
surrounding rating culture which makes the involved
credit risk transparent and accessible would also be a
necessity. Once a bond market is in place, a market for
interest rate derivatives should follow suite to provide
hedging instruments. The latter remains an important
desideratum for the stock market as well and it remains
to be hoped that the plans of the Dubai International
Financial Exchange (DIFX) to establish such a local
derivative market will prove successful. The GCC
governments currently do not need to issue debt to
finance budget deficits. Neither do Hong Kong and
Singapore, but both countries are issuing bonds across
the yield curve to provide a benchmark for their
corporate bond sector. The GCC countries should do the
same and they should consider centralizing their efforts
by doing it via a supranational institution backed by
the GCC governments. Thus, the market would have more
depth and strength than if each single GCC country would
issue its own bonds. The GCC countries should also
consider strengthening their ties to the Asian financial
markets by investing in Asian Eurobonds and attracting
Asian investors to the nascent GCC bond market. This is
especially true for Malaysia, which has a thriving
Islamic Banking and sukuk market. But astonishingly, the
ties between Malaysia and GCC countries are
underdeveloped because no consensus about common Islamic
investment criteria has been achieved yet.
Overall a GCC bond market is not only part and parcel of
a successful development of the local capital markets;
it is also a necessity for the region’s economic
development at large. Given the absence of a free
floating currency and an autonomous interest rate policy
in the GCC, it will furthermore give the monetary
authority an important tool in steering the money supply
via open market operations. |
