Maturing Economies In the Persian Gulf

An Institutional Investor Sponsored Report on the MENA Region

Despite political unrest at the fringes, the GCC is emerging as the region’s voice of stability, thanks to maturing economies that are moving away from hydrocarbons.

By Adrian Murdoch

Emerging markets in general have had a stormy 18 months or so. But thanks to political stability and robust economies, it is the countries of the Gulf Cooperation Council (GCC)—Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates—that have stood out as oases of calm among the world’s emerging economies

The International Monetary Fund predicts gross domestic product growth of 4.2 percent for the GCC based on exchange rates pegged to the US dollar and strong sovereign balance sheets. They are all running large external surpluses with comfortable buffers.

The GCC has remained relatively immune to political unrest on its border and in the surrounding Middle East & North African (MENA) region so far. Neither the difficulties between Israel and Palestine, nor the threat of ISIS, the militant Islamic State movement in Syria and Iraq, have spilled over. “Political risk used to knock confidence in the Gulf, but not this time,” explains Paul Gamble, director, Africa and Middle East sovereigns group, at ratings agency Fitch in London.

More than that, a new role is emerging for the GCC as peacemaker. “It has a role in consolidating the fragile recovery and stabilizing economies in the rest of the region,” says Alia Moubayed, head of MENA research at Barclays.

One good sign is that the MENA economies seem serious in their shift away from a near-total reliance on hydrocarbons. “There is a diversification of flows away from oil and gas,” says Jan Dehn, head of research at specialist emerging markets investment manager Ashmore. In Saudi Arabia, for example, while growth slowed marginally to 3.8 percent in 2013 thanks to lower oil production, non-oil growth was robust, at 5 percent. GDP has outpaced growth in the oil sector itself for seven of the past eight years.

At a grass roots level this has been helped in the way that MENA banks are financing expansion of local non-oil businesses. In mid-August, for example, Qatar National Bank was the lead arranger with Goldman Sachs on a US$800 million loan to help Abu Dhabi-based entrepreneur B. R. Shetty acquire a majority stake in the world’s largest foreign exchange operator, Travelex.

It has also partly been driven by a boom in infrastructure financing across the region, for the most part underwritten by governments. Perhaps the most obvious is the new 72 km channel to the Suez Canal, announced by Egypt’s President Abdel-Fattah El-Sisi at the beginning of August. Part of a larger project to expand port and shipping facilities around the Canal, the Suez Canal Authority estimates that the US$4 billion project will boost annual revenues to US$13.5 billion by 2023.

“There has been very strong demand for project finance assets from banks as well as investors,” says Colin Fraser, executive vice president, group head - wholesale banking, Abu Dhabi Commercial Bank (ADCB). Although the growth in government spending might have declined across the region, the absolute amount remains very high.

Foreigners may get more access

All good news, but foreign investors have, for the most part, had to look on enviously. They have long enjoyed access – and profits – in, for example, Egypt. Good first half results in the banking sector saw Egypt’s main index, the EGX30, jump 1.32 percent in early August. Leader of the pack was Commercial International Bank (CIB) which rose 2.72 percent.

But despite the GCC’s growth, it has been difficult to gain access. All that is about to change. At the end of July it was announced that Saudi Arabia’s stock exchange, the Tadawul All Share Index (TASI), would open to foreigners in 2015. Frequently mooted in the past, there is a conviction this time that the Riyadh-based Capital Market Authority means what it says.

There are of course questions to answer and when the rules for participation are published in September, they will be examined closely. “We know that trading systems were tested a couple of years ago but it remains to be seen what thresholds will be set for foreign investors, in terms of assets under management and years of operation, and for aggregate foreign ownership in individual stocks,” says Hasnain Malik, head of frontier markets strategy at Exotix Partners.

Nonetheless the excitement is almost tangible. “This is not like a frontier market opening up,” says Kaan Nazli, senior economist for the emerging market debt team at investment management firm Neuberger Berman. The Saudi market is the largest and most liquid of those in the Gulf Cooperation Council region. With a market cap of more than US$500 million, it accounts for half of that of the GCC markets as a whole and 70 percent of trading volumes, according to Kuwait’s Global Investment House.

What investors and especially funds are really waiting for is potential entry to the MSCI indexes. Watchers reckon that thanks to its size, the Saudi stock exchange is unlikely to be placed in the MSCI Frontier Markets Index – the normal point of entry. The Saudi index would become a very large part of the whole frontier index. Instead, it is likely to be on the emerging markets index, where it would have a more modest weighting of around 4 percent of the index. And this could happen as early as July 2015.

The importance that the global investment community places on a presence on indexes should not be underestimated. In mid August, MSCI announced a tweak to the weighting of Qatar on its emerging market index from 0.47 percent to 0.59 percent. Cairo-based investment bank EFG Hermes estimates that this could result in passive inflows of around US$100 million. In Saudi Arabia’s case, Bank of America Merrill Lynch reckons that a place on the index could result in inflows of between US$13.3 billion to $26.6 billion, while Schroders puts the figures as high as US$40 billion.

The growth of Sukuk debt issues

If there is good news in the equity markets, the growth of Sukuk debt issuance appears unstoppable, too. Ernst & Young predicts that the Sukuk market as a whole will triple to US$900 billion by 2017, up from US$300 billion in 2012. This year already the Dow Jones Sukuk Index is up 4.39 percent, compared with a return of 0.22 percent in 2013.

Middle East debt issuance has followed similar growth. It reached US$30.46 billion in the first half of the year, up from a paltry US$13.13 billion in 2011, according to Dealogic. And H2 looks as though it will be as good.

But this is not just a MENA phenomenon. Luxembourg and South Africa are all considering Sukuk issuance. In Asia, Hong Kong, Indonesia and Pakistan are currently looking to raise up to a combined US$3.5 billion by the end of the year. This follows the British government which sold its inaugural £200 million (US$336 million) Sukuk at the end of June.

Several factors are behind the global interest in Sukuk issuance. “Low interest rates, with the Saudi Riyal sustainably pegged to what are currently very low US interest rates is prompting a raft of corporates to raise capital via debt and Sukuk instruments. The Sukuk structure is preferred by a number of corporates in the region because of their Shariah compliance. The appetite for Sukuk funding is driven by Sharia-conscious investors seeking fixed income-type returns and who are still faced with a fairly narrow range of corporate choices,” explains Exotix Partners’ Malik.

What has also helped is that the cost of Sukuk issuance has come down. The British Sukuk issue, which was sold flat to equivalent gilts, proved there is at most only a marginal difference in pricing between a Sukuk and conventional debt. “When it was new it wasn’t easy to do,” explains Fitch’s Gamble. “Familiarity has created a virtuous circle.”

Sukuk have also moved out of niche and into the mainstream. Investors who used to be wary, have taken heart from the point that in the wake of the debt crisis, the debt restructuring was with the banks and not with the bonds themselves. “The Sukuk market has become a dedicated investor market in the same way as the Eurobond market is,” says Neuberger Berman’s Nazli. He cites the example of Kenya, which sold its debut dollar bond at the end of June and now talking about Sukuk issuance.

Rising property prices

Perhaps the biggest sign of economic maturing in the region is how it is coping with rising property prices. At first glance, for example, it is hard to avoid a sense of déjà-vu when looking at property prices. It was a real estate crash in Dubai in 2009 that threatened the multi-billion-dollar default of some of the country’s state-linked firms.

At the beginning of the
year, HSBC analysts forecast a 10-15 percent growth in real estate prices in 2014, while rents have risen by an average of 45 percent during the past two years according to real estate advisor CBRE.

But this time it is different. ADCB’s Fraser points to the fact that in the UAE there has been a levelling off in pricing in recent months—while transaction volumes remain steady. “This indicates a pause for breath that suggests that the property market is sustainable,” he says. With property yields of 6-7 percent versus 3-4 percent in London or New York, there is still room for prices to rise.

It is the same in Dubai. “The property market is being driven by fundamentals rather than speculation. Only a third of deals are financed by banks. There isn’t the same amount of leverage as last time,” says Fitch’s Gamble.