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Bank of America’s tail-risk warning may indeed be precisely the impetus needed for another Abu Dhabi (the emirate of last resort?) -financed bailout, though there is some question as to whether the technical defaults of two state-owned firms–Dubai World, an investment firm, and Nakheel, a real-estate subsidiary of Dubai World–necessarily imply the defacto default of the sovereign emirate as a whole in the first place. In fact, argues Gavan Nolan, a research analyst at Markit Group, a financial information services company:
“It should be made clear that the Dubai sovereign is not in any immediate danger of a default. The standstill, if it is mandatory, may constitute a technical default on Nakheel and Dubai World. However, the Dubai government did not make an explicit guarantee on the companies’ debt, and are under no legal obligation to honour the debt. This is clearly the position Dubai’s wealthy sister emirate Abu Dhabi favors. Its actions this week seem to indicate that, while it will support the sovereign, its backing is conditional. The funds are available – Abu Dhabi has immense oil resources and the world’s largest sovereign wealth fund. Indeed, Dubai has already been advanced funds by Abu Dhabi. But it was quite clear that Nakheel and the rest of Dubai World will not be allowed to benefit from the largesse.”
The exact point was trumpeted by Saud Masud, a Dubai-based real estate analyst, in a comment made to Bloomberg:
“Abu Dhabi and Dubai have decided to seek to bolster long-term confidence in the market by forcing weaker parts of government businesses to take responsibility for bad decisions and could involve defaults at some Dubai firms, Masud said.”
Less debatable, however, is the absurdity of the hitherto resulting regional contagion, which immediately drove up the cost of protecting emerging-market sovereign debt against default. Default swap contracts on Abu Dhabi rose 23 basis points to 183, Qatar climbed 17 to 131, Malaysia was up 11 at 104, Saudi Arabia climbed 18 to 108, while Bahrain rose 22.5 to 217. Having said that, one could buy the theory that the Dubai announcement is merely the requisite impetus whereby the ‘risk rally’–which having essentially been on since March seemed destined to eventually taper–unwinds. If the rally does unwind, moreover, frontier and emerging markets, which represent the tail end of the risk curve, would be the first to feel it. Templeton Asset Management Ltd.’s Mark Mobius, for example, said on Friday that Dubai’s attempt to reschedule debt could indeed cause a “correction” in emerging markets.
Yet even a market correction per se should not correlate with a higher sovereign default risk–this is where the current, broad brushstroke of contagion should be arbitraged. Abu Dhabi and Qatar, for instance, remain as resource and reserve rich as ever, objectively speaking. But fund managers clamoring to keep in tact whatever YTD returns they have may be hesitant to brashly step in front of the bus so quickly–suggesting the sudden and drastic point spike may even have some more legs to it. Nevertheless, ultimately, as Silk Invest’s Baldwin Berges reminded investors on Friday, “the major driving forces for the GCC region’s economy are still intact: high reserves, low taxes (competitive advantage) and geographic location. It’s all about perspective, investor sentiment and above all valuation. The medium term investor could be looking at a great opportunity here.” Nolan concurs:
“The sovereign CDS market sometimes has a habit of conflating geographical proximity with economic similarity (eastern Europe earlier this year springs to mind). Unlike Dubai, the countries mentioned above have significant natural resources and their public finances are in better shape. To an extent this has been reflected in CDS spreads for some time (see chart above). It seems that Dubai is something of a special case and its problems are not necessarily found elsewhere.”
GCC insurance markets are still underdeveloped despite the relatively recent rise of takaful, a type of Islamic insurance wherein members contribute money into a pooling system in order to guarantee each other against loss or damage. Conventional insurance is incompatible with Islamic law because of Sharia’s prohibitions on transactions inherently founded on uncertainty/elements of luck. Moreover, conventional insurers store money in interest-bearing investments, which are similarly prohibited. In the face of increased wealth–Accenture, a consultancy, forecasts that household Islamic savings will amount to $24bn a year by 2020–analysts posit that the global takaful industry will grow by 20% and reach US$10-15 billion within the next decade, led mainly by the GCC countries and Malaysia. Per Ernst & Young’s inaugural World Takaful Report 2008, accepted contributions are expected to rise to more than $4.3 billion in 2010.
Two further developments should provide a catalyst to the industry. One, a proposed law to mandate the use of the still nascent “re-takaful market” should help fuel its development, in turn boosting the underlying takaful industry as well. Second, the expected passage of a GCC-wide insurance law will ensure compliance with international standards through the automation of underwriting, per consultancy A.T. Kearney, a practice it argues would improve insurers’ loss ratios, and also decrease the intermediation costs–thus making processes cost effective:
“In the UAE insurers cede more than 50% of their insured premiums to reinsurers with an obvious impact on their bottom line, as risk and profit is shared with the reinsurer. In comparison international benchmarks show that reinsurance is only 5-15% for global leaders with state of the art in-house underwriting operations. The companies that get underwriting right can hence look at exactly which segments require reinsurance and which are better kept within the company. It is however vital to get the underwriting process in place first so risk/premium profiles are optimized. Currently some segments (corporate mainly) have premiums which vary up to three times for the same risk. This can negatively impact competitiveness of insurers if premiums are above market evaluation or negatively impact bottom-line and risk profile of the insurer if too much risk is attracted at too low premiums.”
Continued Cyril Garbois, Principal, A.T. Kearney Middle East, “the [insurance] market is currently underpenetrated and the size of the prize remains significant – we estimate that insurance companies regionally can improve profitability with 20-30% while at the same time increasing market share if they get underwriting right. I believe the use of international best practices in underwriting along with the required level of sophistication in distribution is a key to driving future growth of the insurance market regionally.”
Such a move could bolster insurers’ balance sheets even in the event of prolonged economic slowdown reverberating from the credit crisis, which causes a reduction in new policies and also a larger cancellation of existing ones. It’s perhaps with this relatively rosy future in mind that insurance stocks in Kuwait, for instance, showed resilience in November by dropping only 1% while the broader market shed 5.48% during a one-week span that saw the country’s broad index fall to a seven-month low on the 15th.
The following appeared in the November issue of Business Diary Botswana:
Despite the IMF’s recent projection that Botswana’s economy will contract 10.3% this year, the lender expects a 4.1% uptick next year such that emergency funding would not be required. Back in June the country tapped a $1.5bn “budget support loan” from the African Development Bank–the largest such facility ever granted by the Bank–in order to finance part of a budget deficit then estimated at around 13.5% of GDP, and since revised to 14%. The IMF cited a renewal of demand for diamonds as a central facet of its optimistic forecast. Furthermore, it predicted, GDP growth across sub-Saharan Africa will rise to approximately 4% next year and 5% in 2011, up from 1.1% in 2009. “We think it should be possible for sub-Saharan Africa to recover quicker this time around and have a ‘V-shaped recovery,'” opined Antoinette Sayeh, director of the IMF’s African department. “A lot of that has to do with the good macroeconomic policies that have been pursued before the crisis and also the way many of the countries have managed the crisis.” For a growing contingent of economists and analysts, the V-shape recovery theme in fact extends across a variety of both “emerging” and “frontier” markets, underscoring these markets’ relatively strong fiscal positions–i.e. higher reserves and lower debt levels–in comparison to their more developed peers, whose recovery will more likely be ‘U’ shaped,” theorizes Antoine van Agtmael, chairman and CIO of Emerging Markets Management LLC, a U.S, investment firm specializing in emerging market equities. “Emerging markets are coming out of the [credit] crisis with greater respect and they now account for one third of the world’s gross national product,” said van Agtmael.
One immediate and stark byproduct of the economic turnaround among developing economies and concurrent paradigm shift concerning their ‘risk’ among investors can be seen in debt markets. Citing a record amount of capital inflow into emerging market bond funds, JPMorgan reported in late October that the credit spread between ‘riskier’ developing notes and comparatively ‘risk-free’ U.S. Treasuries had tightened considerably since last October–down from 8.65 percentage points to less than three. The sovereign credits of Argentina, Ecuador, Pakistan and Ukraine had risen more than 100% year to date on benchmark JPMorgan’s Emerging Market Bond Index Global, or Embig, reported the Wall St. Journal at the time. The post-crisis capital deluge has in fact reenergized a virtuous cycle of debt market development across emerging and even some frontier countries that many commentators attribute as the chief reason for these markets’ relative resilience and quick turnaround. “This is by no means universal, but those emerging market economies that are the most self-reliant and strong are the economies that have withstood the global financial crisis most effectively,” said Jason Toussaint, senior investment strategist in the Global Quantitative Management group at Northern Trust in London. For the majority of African nations, however, corporate and even sovereign debt markets remain vastly underdeveloped. Yet that is quickly changing, argues Stephen van Coller, the newly appointed CEO of Absa Capital, a South African investment banking group. “We’ve seen debt capital markets starting to open up in Botswana, Kenya, Tanzania and Nigeria,” van Coller says. “There’s actually been quite a lot of interest because the yields are quite good and I think people are seeing emerging markets as handling the recession better.”
The benefits of a mature debt market for both sovereign and corporate issuers and the underlying economy as a whole is too often understated and deserves repeating. Among myriad reasons, debt markets increase the competitiveness and efficiency of the financial system; enhance the stability of said system by creating alternatives to banks; and serve as a way to increase information sharing between policy-makers, financial markets and investors–such as when central banks gauge inflation expectations derived from the difference between yields on regular nominal bonds and CPI-indexed bonds with the same maturity, or when governments consider interest-rate expectations to better estimate the future cost of borrowing. Speaking to the first point, a 2002 paper disseminated by the Bank for International Settlements (BIS), the Basel-based international organization of central banks, pointed out that “when firms can raise funds by issuing bonds, they are less dependent on banks, less exposed to difficulties in the banking system and less vulnerable to the adjustments that banks need to make, including those required by bank supervisors.” More broadly speaking, wrote Philip Turner, then-BIS head of the secretariat group in the monetary and economics department, “the most fundamental reason [for developing debt markets] is to make financial markets more complete by generating market interest rates that reflect the opportunity cost of funds at each maturity. This is essential for efficient investment and financing decisions.” These market rates, wrote another observer, ultimately serve as a check on government spending as rate increases would also serve to increase the cost of government debt and thereby harness extraneous spending, tempering inflation. Thus, “the burden of interest rate targeting of inflation would be equitably shared between the public and private sector and therefore the average cost of borrowing for the private sector would be lower.”
One initial byproduct of debt market development relates to financial service providers such as banks, which can use low-risk sovereign debt to grow their loan book and subsequently expand the economy. Similarly, corporate issuance by banks tends to quickly follow. Per Daniel Broby, CIO of London-based Silk Invest, which in October unveiled a Luxembourg-domiciled fixed income fund to focus on frontier markets across Africa, the Middle East and Central Asia, “the financial sector, specifically banks, is the first to issue bonds due to their own balance sheet matching requirements. As a banking sector matures, the tenor of lending business is extended, compelling the banks to seek out longer term capital raising solutions such as raising funds on the debt capital markets.” Speaking to this same point of economic expansion, Turner noted that “the existence of tradable instruments helps risk management. If borrowers have available to them only a narrow range of instruments (e.g. in terms of maturity, currency, etc.), then they can be exposed to significant mismatches between their assets and their liabilities. If bond markets do not exist, for instance, firms may have to finance the acquisition of long-term assets by incurring short-term debt. As a result, their investment policies may be biased in favor of short-term projects and away from entrepreneurial ventures.” Moreover, as the BIS paper stated, a further evolved bond market accelerates the development of securitization, which remains theoretically sound in its method of spreading risk among those most willing and able to bear it, and of allowing lenders to more efficiently finance their businesses by selling loans they originated. Finally, economists underscore that it is far easier to mark-to-market in capital markets that offer an assortment of bonds, which in turn makes it easier for regulators to pin point “trouble spots” in the financial system.
For a country such as Botswana, the risk associated with its underdeveloped debt market are now especially pressing. Analysts have pointed out, for instance, that the country must develop its debt market in order to utilize excess liquidity in the local market to help finance its current budget deficit and, as Razia Khan, Head of African Research for Standard Chartered Bank Group noted this past spring, “increase the scope of its borrowing.” Specifically, debt-financed spending increases could be targeted to the most productive sectors of the economy, Khan said, stimulating growth and growing the nation’s tax base, which in turn would help to refinance and ultimate repay the country’s liabilities. At the same time, issuing debt would allow the government to protect its foreign reserves, a central component to maintaining a high credit rating and associated low borrowing costs. While demand for Botswana’s sovereign debt has been historically high–as evidenced by the oversubscription of the its bond offer last year by over 500%, the market overall remains woefully undercapitalized and illiquid. But its maturation is inevitable, and will be a process. One ultimate result will be the further development of local currency markets, Broby points out, especially as pension and insurance industries begin to more efficiently “emancipate their long term investments from hard currencies” and match them up with their long term liabilities. But, as Broby argues in “The Case For Frontier Market Fixed Income,” a paper presented by his colleague Mohamed Bahaa at the “Challenges of Globalizing Financial Systems” conference held at the Hashemite University in Jordan in late October, the successful evolution of a fixed income market depends on several factors, including the presence of a non-restrictive fee structure for prospective issuers and the difficulty in being able to properly price issuances–a function of liquidity–to a benchmark in an environment where liquidity by definition is lacking.
Kuwait-based Abyaar Real Estate Development Company (Abyaar), which develops and manages properties in the UAE and in Dubai in particular, recently announced a net profit for the first nine months of 2009 of KD5 million ($17.5 million) and an EPS of 6.90 fils (a subdivision of currency used in many Arab countries, where KD1 roughly equals 1000 fils). Per its chairman, Hesham Abdul Wahab Al Obeid, the firm reduced financing debt during the period by 30%, down to KD 77 million, compared to KD108 million during the same period of 2008. Owners’ equity also increased, up to KD146 million.
The strong showing begs the question how quickly Abyaar will return to the debt markets; in October 2008 it postponed a proposed sale of Islamic bonds worth up to $1 billion in order to finance its expansion plans. Rashed Al-Rashdan, its managing director, said in the summer of 2008 for instance that the developer was looking to expand “aggressively” into other “high growth” markets in the region, including Saudi Arabia and Qatar. At least the market seems convinced of its future operating and financing revenue stream–earlier in the year the company successfully increased its capital base from KD 53 million in 2008 to KD 106 million in 2009 through a new share subscription.
Credit Suisse, for one, is maintaining an “overweight” rating on Egyptian equities in light of the country’s robust GDP growth–the strongest in 2009-10 GDP in the mainstream Europe, Middle East and African (EMEA) region–as well as its “solid external position and low currency risk.” In particular, the investment bank views Egypt as a “manufacturing base for neighboring Gulf Cooperation Council (GCC) countries, with excellent growth prospects [underpinned by] strong demographic support,” while also referencing a solid banking sector that “offers excellent asset growth potential funded by deposits” against the overall backdrop of an economy with an “extremely accommodative monetary policy.” Per Bloomberg, economic growth in Egypt, the most populous Arab country, rose from 4.9% in Q3 from 4.7% the previous three months. Yet growth is still below the average 7% seen from 2005-2008.
Sticking with Egypt, many analysts expressed surprise earlier this week when the central bank announced that the country’s core annual inflation rate had ticked up to 6.5% YOY in October, up from 6.3% the month prior. While some analysts noted that despite the October rise, the second derivative of this increase was falling compared with September, others focused more on the reported CPI for urban areas–considered the most reliable proxy indicator–which jumped to 13.3% in the year to October versus 10.8% in September, albeit on the back of increases in food and drink. Yet don’t except an imminent rate increase soon, Alia Mamdouh, senior economist at Cairo-based investment bank CI Capital, told Bloomberg: “It’s still not the time to raise rates because the economy is still in the recovery stage.” That said, Egypt’s Minister of Economic Development on Thursday reiterated the continuation of economic indicators in the direction of recovery. When hikes do occur may depend largely on future readings of the recently introduced core inflation index, a measure that typically strips out potentially volatile items such as food and energy.
According to Abdulla Salatt, chairman of the company’s fertilizer unit (QAFCO), Industries Qatar–the country’s largest firm by market cap–will increase production of urea (used as a nitrogen-release fertilizer) and related products to supply growing global demand with a specific focus on South America, and in particular, Brazil. “We are thinking of sending more products to Brazil because it is a big agriculture country, consuming a lot of urea, and we see their appetite for urea opening up year after year,” Sowaidi told reporters. The company is currently contemplating a proposed $610 million plant which would increase urea production to 5.6 million tons/year by 2012, up from the current rate of 3 million. Upon completion the fertilizer unit would hold 15% of global urea production, say analysts. Urea has the highest nitrogen content of all solid nitrogenous fertilizers in common use (46.7%).
The company overall is still reeling from recession, as last month it announced a 47% drop in 9 month profit due largely to decreased demand for petrochemicals, fertilizers and steel, as well as new capacity across the region. In 2008, the fertiliser unit alone accounted for almost half of the firm’s total profitability. That said, the future looks bright. Bloomberg noted that petrochemical production in Qatar, which is the holder of the world’s third-biggest natural gas reserves, is expected to rise to 4.3 million tons a year by 2015, an increase that would parallel an increase in natural gas output to 23 billion cubic feet by 2014. Moreover, analysts maintain that by 2013, income from the natural gas sector and the petrochemicals business will be more than double that of Qatar’s oil revenue. As for urea, it could be the lynchpin for the company’s ROE going forward: “If Qafco can guarantee the sale of this new urea capacity, this should be very positive for the company’s revenues and bottom line,” said Hala Fares, an analyst for Shuaa Capital, an investment bank, on Thursday. “Fertilizer prices are relatively stable currently, so any increase in sales volumes should reflect positively on revenues. Any improvement in fertilizers prices should further increase revenues.” Additionally, Last month EFG Hermes, an Egyptian investment bank, projected that it remained “positive” on fertilizer price estimates for 2010.
UAE-based budget carrier Air Arabia, the Arab world’s largest listed carrier, announced its intentions to build a new hub in Egypt that would offer connections to Europe, Africa and the Middle East, one month after formalizing a partnership with Egypt’s Travco Group, the Middle East’s largest travel and hospitality group. “At a time when the global aviation industry is witnessing serious challenges as a consequence of the worldwide financial crisis, we continue to move forward with our strategic expansion strategy, as demonstrated by this important announcement,” said Air Arabia Chairman Sheikh Abdullah Bin Mohammed Al Thani.
Despite the airline industry’s overall close historical correlation with broad market indices, “budget travel” represents an industry subgroup that, from an investment standpoint, can be as good a defensive play as any medical and consumer product company, brewery or tobacco firm. Air Arabia may be a case in point, having been named the best low-cost carrier globally in a study conducted by Aviation Week magazine earlier this year. Its gross (20.31%) and EBITDA (16.94%) margins are leaders in the industry, as is its 3.1 quick ratio. The company’s net profit for the first half of this year stood at AED 193 million, an increase of 21% from the first six months of last year. Moreover, during the first half of 2009, the company registered a turnover of AED 922 million, up 6% from the first half of 2008. Finally, its “average seat load factor,” which measures passengers carried as a percentage of available seats, was 80% for the first half of 2009.
However, those numbers dampened afterwards on the back of excess capacity diluting yields, and it remains to be seen whether or not Air Arabia will stand up to both economic and intra-industry pressure. According to its CEO, Adel Ali, Middle East airlines are suffering disproportionately from yield dilution than carriers in other regions worldwide, due to excess capacity as a result of strong aircraft ordering, new market entry and the global economic downturn. “There has been an 18% yield dilution in the Middle East basically because the capacity is more than the demand at the moment because of the recession. This is more severe than the global average yield dilution of 12%”. In the Middle East, the demand is growing, but not as fast as the capacity is growing. Also because demand is growing, it becomes an attractive place for other GCC carriers and international carriers,” he told reporters.
Forecasts of three analysts for Air Arabia’s third-quarter profit ranged from AED 110 million to 129 million in a Reuters survey earlier in October. And the airline also faces increased competition from local rivals, such as Kuwait’s Jazeera Airways and Dubai-owned flydubai.
JGW
Frontier Markets 