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Middle EastJanuary 2 2018

International banks lead charge to fill GCC project finance gap

While Gulf Co-operation Council countries have announced a slew of infrastructure programmes of late, the region is suffering a reported $270bn project finance gap. This is opening the way for international and local banks to find innovative new mechanisms, as James King reports.
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Abu Dhabi infrastructure

The project finance market of the Gulf Co-operation Council (GCC) is booming. Governments across the region are making huge investments in power generation, transport infrastructure, health and education facilities, among other sectors, as they contend with growing populations and the need to diversify economic activity.

Between 2016 and 2019, Gulf administrations are expected to spend about $330bn on projects, a figure that includes infrastructure contracts awarded over the period, according to research from S&P Global.

Hidden financing gap

But this market buoyancy conceals several challenges. For one, project finance has not been immune to the impact of lower oil prices. Tightening fiscal positions across the region are contributing, in some cases, to project delays, rationalisation or even cancellations. In tandem, as government spending has diminished, a yawning project financing gap has emerged, which S&P Global puts at about $270bn. (This is the difference between the value of contracts expected to be awarded by 2019 and the $330bn total capital expenditure committed by regional governments over this period.)

Against this backdrop, increasing capital requirements stemming from Basel III implementation are affecting regional banks’ ability to support projects with longer tenors. In addition, liquidity pressures linked to lower oil prices persist in some markets while in others they arise intermittently. Question marks over the role of Gulf banks in the regional project finance market have, unsurprisingly, emerged as this list of difficulties has expanded.

“Banks in the GCC region traditionally operate with high levels of capital, but we expect Basel III (and Basel IV) to make less of it available for project finance,” says Michael Wilkins, managing director of infrastructure ratings at S&P Global.

The role of regionals

So how will this funding gap be filled? Two dominant trends are emerging across the region. First, the growing presence of large international banks, particularly from Asia, is having a positive impact on the market. Backed by huge balance sheets and the expertise gleaned from many decades of engagement with global project finance deals, these lenders are adding an extra dimension to the regional funding landscape. Second, innovative new methods of financing, including a growing role for regional capital markets, are slowly opening up new funding options for project finance participants.

This is not to say that regional banks are losing out. Well-capitalised lenders in stronger markets, including Saudi Arabia and the United Arab Emirates, will continue to play an outsized role in domestic and regional project finance deals. But adjusting to higher capital requirements will leave many regional lenders with less room to support project finance deals.

“In terms of Basel III implementation, Saudi Arabia is doing quite well. Our estimate is that the average core Tier 1 capital ratio for Saudi banks is 17.5%. So Saudi lenders are well placed to continue engaging with project finance deals. Even UAE banks are well capitalised by global standards; we estimate that their average core Tier 1 capital ratio is about 14%,” says Chiradeep Ghosh, research manager at Bahrain’s Security and Investment Company (SICO).

Japan's role

Meanwhile, the role of international banks is expected to grow in the GCC. Though non-regional lenders have played an important role in the Gulf’s project finance for many years, various 'push' and 'pull' factors are elevating their contributions to new heights. Negative interest rates in Japan, for instance, have contributed to a large-scale push by the country’s banks to seek better returns overseas. Three Japanese banks topped a Thomson Reuters global league table for bookrunners or main underwriters for project financing by value in 2016.

Coming out on top was Mitsubishi UFJ Financial Group (MUFG). In the GCC, the bank has had a stable presence in the region over the past few decades. “Project finance is an asset class that the bank understands very well, including the risks associated with it. It enables us to support our core clients across the globe and it’s been a cornerstone, particularly in Europe, the Middle East and Africa, in terms of driving our corporate business,” says Stephen Jennings, managing director and head of energy and natural resources at MUFG.

This expertise, as well as the bank’s scale, has seen MUFG lead on some of the Gulf region’s most significant project and infrastructure deals of recent years. One example is the financing of Abu Dhabi’s largest solar power plant, a 1.17-gigawatt facility located in Sweihan, which included $650m raised from local and international banks. MUFG was the lead arranger for the loan.

“As an organisation we have been involved in all but one of the independent power producer and independent power and water producer projects in Abu Dhabi dating back over the past 20 years,” says Mr Jennings.

A moving target

But the regional project finance market, though booming, is nevertheless something of a moving target. Delays or even the re-tender of projects have occurred in recent times. This has meant that some bigger project finance markets have offered less stability than in the past.

“During the course of 2017 we have seen some parts of the GCC that we had hoped would bring a lot of promise to the project finance market, such as Kuwait, stall a little bit,” says Mr Jennings. “Conversely, we have seen a stable build-out schedule in Oman and we expect that to continue. Oman is interesting because, on the power and water side, projects are detailed under a seven-year statement that is provided by the Oman Power and Water Procurement Company. This sends positive signals to the market,” he adds.

Looking ahead, S&P Global expects local bank funding across the region to become more expensive. This reflects slow deposit growth in some markets as well as higher capital requirements, which will force many institutions to be more selective when it comes to their balance sheet allocations. As a result, space is opening up for capital market financing for project and infrastructure finance. In a briefing note published in the first quarter of 2017, S&P Global noted that under these conditions, the Gulf will be fertile ground for the emergence of innovative new financing mechanisms.

“We are seeing more avenues open up for other investors coming into the market who are comfortable taking on longer term asset risk. Certainly there is a lot of interest, particularly in the GCC, for debt capital market and institutional investors and we have seen different pockets of liquidity open up in that regard,” says Mr Jennings.

Kangaroo bonds' bounce

But there is a long way to go before alternative financing mechanisms reach a meaningful scale. Across the GCC region, local currency debt markets are largely underdeveloped. In addition, research from S&P Global says bank loans accounted for about 90% of total corporate and infrastructure financing over the first eight months of 2016, up from about 74% in 2013.

For their part, regional banks are adapting to this new environment by addressing some of the challenges they face head on. “Regional banks have, in the past, turned to samurai or kangaroo bonds to raise debt at a lower rate and to diversify their liabilities. These funds were then lent back to corporates involved in project finance deals. We expect this to continue as the US dollar interest rate rises,” says Mr Ghosh.

In October 2017, for example, Abu Dhabi Commercial Bank raised A$400m ($301.5m) in kangaroo bonds. Indeed, SICO’s Mr Ghosh is bullish on the role of regional banks in the GCC’s project finance landscape, despite the growing number of hurdles on the horizon. This is particularly true of Islamic banks and lenders with a large proportion of sharia-compliant deposits. He says: “In a normalising interest rate environment we expect to see banking lending go up. This is because, in a market such as Saudi Arabia, banks have an abundance of sharia-compliant current account deposits. This means they can lend at a lower rate compared with funding from other sources.”

Cumulatively, these trends bode well for the region’s project finance aspirations. Though the immediate financing gap may be severe, GCC markets are at least adapting to the environment in which they find themselves. If, over time, a wider range of banking institutions, coupled with a more diverse array of funding sources, begins to address the project finance gap, the outcome can only be positive for all concerned.

“A project finance market of the size and scale of the Middle East doesn’t work with just one or two big lenders. You need a good number of primary banks and also secondary interested parties, including debt and institutional investors. We aren’t afraid of competition. We want to encourage the participation of a range of players in order to have a sustainable market,” says Mr Jennings.

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