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Middle EastSeptember 1 2016

Middle East sovereigns opt for Eurobonds to stem deficit drain

Two years of low oil prices are draining the ample state coffers of the Gulf's hydrocarbon exporters. The region's finances have been affected and sovereigns are now piling into the international bond market to plug budget deficits. Tom Stevenson reports.
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Abu Dhabi eurobonds embedded

Low oil prices continue to take their toll on the Middle East's major economies. Rich energy-exporting countries have been forced to raid savings and assets, with Saudi Arabia alone wiping off about $160bn from its stockpile of foreign reserves in the past 24 months.

The aggregate budget deficit of the Gulf Co-operation Council (GCC) sovereigns is expected to total well over $100bn in 2016 and ratings agencies expect Saudi Arabia, Bahrain and Oman to record fiscal deficits of as much as 12% of GDP for the next two years.

To fill the gaps, Middle East sovereigns have already tapped a record $30bn from Eurobond issuances in the first half of this year, a multi-volume increase over previous years.

Wave of deals

The first move came on April 19, when the government of Lebanon issued a $1bn Eurobond. One week later, the first of a set of larger deals came as Abu Dhabi issued a $5bn Eurobond comprising both five-year and 10-year tranches. Next in was Qatar, which issued the largest bond thus far when in May its $9bn issuance almost doubled the $5bn note expected by investors.

Saudi Arabia then formally invited banks to underwrite a debut Eurobond issue in mid-May, with the Bank of China reportedly hired to co-manage the deal, which regional observers believe will see a $10bn to $15bn issuance.

Meanwhile, in June, the government of Oman issued $3bn in Eurobonds – the country's first issuance since 1997. Lebanon has switched a further $2bn of its public debt into non-benchmark Eurobonds and in August the government of Bahrain hinted at plans to issue a Eurobond for the third time this year.

The trend looks set to continue. The Iraqi government plans to issue $2bn in international bonds, backed by World Bank guarantees, and the government of Kuwait hired US consultant Oliver Wyman to advise on its own first-time Eurobond.

Even Iran has shown interest, with the country's central bank announcing in March that it was also planning to issue a Eurobond.

Tunisia and Egypt may not have been hit directly by the oil price fall but they have their own fiscal troubles and, in the case of Egypt, are reliant on aid flows from hydrocarbon exporters Saudi Arabia and the United Arab Emirates who are now tightening the spigots.

On August 4, Tunisia issued a $500m Eurobond backed by USAID that was six times oversubscribed. On August 7, the Egyptian cabinet approved plans for a $3bn to $5bn Eurobond issuance that the authorities hope will ease its desperate funding needs.

The new normal

Andy Cairns, managing director and global head of debt origination and distribution at the National Bank of Abu Dhabi (NBAD), says the Eurobond swell is a landmark move by the GCC states.

“What we're really seeing is the emergence of a more diversified and coherent GCC funding environment,” he says. “The low issuance volumes we saw in 2012 to 2015 were the result of abundant regional liquidity due to triple-digit oil prices. I consider this elevated level to be the new normal.”

Total Eurobond issuance from the GCC countries came to about $24bn in 2015, a marker that has already been surpassed in 2016, and Mr Cairns expects the end point of this year to set the trend going forward.

When Abu Dhabi issued in April, the sovereign had one clear advantage over the later major issuers: it was in first. With plenty of dry powder around to drive the deal, Abu Dhabi had an early mover advantage and could obtain the tightest spread.

Mr Cairns says the deal was well executed and provided a backdrop that was critical to later issuance from fellow Middle East sovereigns. “The leadership that the Abu Dhabi Department of Finance showed in its issuance was very important,” he adds.

“It demonstrated that although it is the wealthiest GCC government with the strongest credit ratings, and therefore didn't need to tap capital markets, that it was decisive enough to do so, giving legitimacy to the idea and establishing a tightly priced benchmark benefiting later issuers.”

Home bias

Although sovereigns are looking for external buyers, Mr Cairns believes the cheapest liquidity and most aggressive risk premium is still available closer to home, in Middle East investors with an innate preference for Middle East debt.

Of Abu Dhabi's bond, 46% of the five-year tranche and 38% of the 10-year was sold into the Gulf region. “Although the oil price has fallen sharply, regional liquidity remains robust. This is a very wealthy part of the world – yes, less so than two years ago, but still very wealthy with a lot of investable liquidity,” says Mr Cairns.

The role Eurobond transactions are playing in financing deficits varies from country to country, but generally international bonds are being folded into wider financing plans, according to Krisjanis Krustins, associate director of sovereign ratings at Fitch.

Mr Krustins points out that where Abu Dhabi's issuance was modest compared with the outflows from its sovereign wealth fund and the rundown of its deposits, Qatar's $9bn Eurobond covers most of its budget deficit.

In the case of Bahrain, which does not have the sovereign assets of its larger neighbours, Eurobonds are expected to play a major role in financing deficits. “We expect Eurobonds to become as important as domestic issuance this year in financing the deficit for Bahrain,” says Mr Krustins.

The government of Kuwait plans to issue what will perhaps be the biggest Eurobond of the second half of 2016, after Saudi Arabia's planned jumbo bond. The country will issue almost $6.6bn in dollar bonds in addition to $10bn in local debt. Kuwait also plans to tap about $4bn from its General Reserve Fund.

“This is a very different year to what we've seen before. Countries that were never on the Eurobond market before, such as Kuwait and Saudi Arabia, are expected to issue,” says Mr Krustins. 

Regional banks left out 

For a Eurobond in the $10bn to $15bn range, Saudi Arabia's pricing will have to be generous, according to Mohamed al-Jamal, managing director of capital markets at Abu Dhabi-based investment firm Waha Capital.

“Saudi Arabia is the biggest economy, it has the biggest equity market and the most liquidity, but in Eurobonds, the UAE and Qatar are much larger markets,” he says. “Next year, the Saudi budget deficit will still be very large and $20bn-plus in Eurobond issuance wouldn't surprise me.”

Mr al-Jamal says despite the interest of local investors in Middle East Eurobonds, regional banks have been offered only few opportunities in advising or arranging the deals.

Large regional banks in the Gulf have privately expressed frustration at the lack of opportunities offered to them by the sovereigns, which have preferred to approach international banks such as Deutsche Bank and Bank of China.

“The sovereign issuers are after international money, not local money. It's outside liquidity that's needed, so you're likely to see a skew towards involving international banks to attract US, European and Asian money,” says Mr al-Jamal.

The region's real heavyweight, Saudi Arabia, is facing the biggest challenges. As the government's finances have deteriorated, Saudi banks have faced a liquidity squeeze. In July, the central bank extended $4bn in short-term loans to boost the banks' liquidity. The rating agencies have all downgraded the country this year, with Fitch moving it to AA- in April and Standard & Poor's and Moody's following suit in May.

All eyes on Saudi Arabia

Saudi Arabia is facing real problems but its rulers have the right idea, according to John Sfakianakis, the director of economic research at the Gulf Research Center and a former adviser to the Saudi finance ministry.

The concern for investors is that Saudi Arabia needs to radically reform its economy in light of the oil price shock. Officials recognise this and have launched a major reform programme.

“It's the largest reform project of an oil-dependent country in the history of oil over the past 70 years,” says Mr Sfakianakis. “In terms of the breadth and depth of the project, it's the most reform-minded target-based plan I have seen from all the oil-producing countries.

“Is it on the right track? Yes, definitely. Of course, there's always the question of the state delivering on the targets and adjusting the reform programme in due course, but so far, so good.”

High-flying ideas

The proof will be in the pudding and some of the Saudi government's targets are lofty. The reform plan aims to more than triple the size of its economy, to reach $2100bn by 2030.

“A lot of things will have to happen in the right order for the economy to reach its economic size target,” says Mr Sfakianakis. “It isn't the first to try to reform the country and it won't be the last.”

However, he adds that whatever problems Saudi Arabia is facing, and however large its budget hole is, when it issues its first ever Eurobond, it is likely to be oversubscribed. “It will be tapped by international investors in the region and beyond. Everyone will want to own Saudi debt in the short to medium term,” says Mr Sfakianakis.

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