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Local Bond Markets as a Cornerstone of Economic Development Strategy

Dr. Nasser Saidi,Chief Economist, DIFC Authority24th January, 2010

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Agenda

Introduction

Bond and Sukuk Market Development 2003-09

Importance of Debt Market Development

Policy Recommendations

Role of the DIFC in Debt Market Development

Local Bond Markets as a Cornerstone of Economic Development StrategyDIFC Economic Note # 7 by Nasser Saidi, Fabio Scacciavillani & Aathira Prasad

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Financial Depth Across Regions•In the Middle East, capital markets are dominated by bank assets and equities•Debt securities make up just 5.6% of the Middle Eastern capital markets

Source: IMF Global Financial Stability Report, Oct 2009

0%10%20%30%40%50%60%70%80%90%

100%

World European Union

North America

Emerging Asia

Latin America

Middle East

Bank Assets Total Debt Securities Stock Market Capitalization

$83.2 trn $61.5 trn $21.9 trn $5.5 trn $2.2 trn$214.4 trn

Financial Depth Across Regions

Bahrain3%

Lebanon14% Egypt

4%Kuwait

2% Morocco0%

Oman1%Qatar

9%

Saudi Arabia

7%

South Africa18%Tunisia

2%

United Arab Emirates

40%

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International Bonds OutstandingBond financing in MENA is tilted towards sovereign issuers, as opposed to a relatively more balanced distribution in other regions.

Source: BIS Quarterly Bulletin, Sep 2009

(in USD bn) Sovereign Corporate Financial

Institutions Total All countries 2113.5 2813.7 20186.2 25881.0 Developed countries 1598.7 2562.8 19503.7 23665.2 Developing countries 477.8 214.0 512.1 1203.9 Africa & Middle East 43.7 35.7 82.3 161.7 Asia & Pacific 57.2 89.8 208.3 355.3 Latin America & Caribbean 206.0 55.5 97.0 358.6 Bahrain 1.1 - 5.1 6.2 Kuwait - - 3.2 3.2 Oman - - 1.0 1.0 Qatar 4.4 5.9 3.3 13.6 Saudi Arabia - 1.9 7.8 9.7 United Arab Emirates 8.8 14.4 42.5 65.7

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Bond Market Development 2003-09• Bond issues have risen dramatically since 2003, but as in the rest of the world, 2008

recorded a dip in the number and size of issues.

• Total issuance in 2009 shows a significant pick-up in issues post-Ramadan.

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2340

74

58

33

155

0

20

40

60

80

100

120

140

160

180

05

101520253035404550

2003 2004 2005 2006 2007 2008 2009

BH KW OM QA SA UAE GCC (RHS)

Total number of bond issues: 2003-09number number

0.5 3.7

13.1

28.2 22.5

12.7

84.4

0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

80.0

90.0

0.00

5.00

10.00

15.00

20.00

25.00

30.00

35.00

40.00

2003 2004 2005 2006 2007 2008 2009BH KW OM QA SA UAE GCC (RHS)

Total amount outstanding: 2003-09USD bnUSD bn

Source: Bloomberg, Reuters, DIFC Economics

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Sovereign Issues Dominate in 2009

Source: Bloomberg, Reuters, DIFC Economics

Conventional Corporate, 21.6%

Sovereign Sukuk, 5.81%

Corporate Sukuk, 0.26%

BH, 3.4%KW, 11.6%OM, 3.5%

QA, 29.9%

UAE, 24.0%

Conventional Sovereign, 72.4%

Conventional Sovereign Issues formed 72.4% of debt issuance*

* data as of Nov 22, 2009

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The Emergence of the Sukuk MarketIssuance of Sukuk dampened in 2008 and 2009 compared to 2007

• Sovereigns and government-related issuers were the most common Sukuk issuers – for funding programs amid declining economic activity, fiscal deficits and lower commodity prices.

• Share of US dollar-denominated Sukuk dropped from 85% in 2002 to 10% of issuance in 2008; Speculation of GCC currencies de-pegging directly led to a shift in currency choice

• Malaysian ringgit was the top currency choice in 2009

• Among the GCC countries, Bahrain dominated the number of Sukuk issues in 2009 while Saudi Arabia raised the maximum value of issues

Source: IFIS Sukuk Database, DIFC Economics

0

500

1000

1500

2000

2500

BH SA UAE

Sovereign sukuk

Corporate sukuk

Corporate and Sovereign Sukuk Issuance in 2009USD mn

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Comparison of Bond Returns• The impact of the Lehman tsunami on the markets is clearly evident.• Emerging market returns are catching up; outperformance of lower-rated, higher-yielding

bonds in 2009

Source: Bloomberg, Reuters, HSBC-DIFX indices, DIFC Economics

60

70

80

90

100

110

120

8/16/2007 04/01/2008 26/05/2008 12/11/2008 08/04/2009 01/09/2009Merril Lynch High Yield & Emerging Markets Total Return Index JP Morgan Aggregate Bond Index

Bond performance: Global vs. Emerging Markets1 Jan 08 =100

80

90

100

110

120

130

140

1-Jan-07 1-Jul-07 1-Jan-08 1-Jul-08 1-Jan-09 1-Jul-09Middle East GCC UAE

Bond market returns took a hit post- Lehman

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Underdeveloped Debt Markets in MENAThe markets in the MENA region are still underdeveloped:

Lack of breadth, depth and liquidity,

A small investor base

Absence of a clear legal & regulatory framework

Lack of credit rating culture

Unsatisfactory market transparency

Lack of benchmarks

Lack of long maturities

Lack of a broad spectrum of institutional investors

Absence of a derivatives market for managing interest rate and credit risk.

Creane, Goyal et.al. (2004) underscore

six broad themes identifying more

specific drawbacks in:Monetary policy

Banking sector

Nonbank financial sector

Regulation and supervision

Financial openness

Institutional environment

Local Debt Markets: Cornerstone of Development PolicyPotential drivers of MENA Debt Market:• Finance infrastructure and development projects in the region

• Corporate Debt: Well functioning debt markets will help reduce dependence on bank finance at a time when the banking sector is in a process of deleveraging

• Government Debt: Diminish macroeconomic and financial vulnerability from energy price fluctuations by providing governments with an alternative source of funding to smooth out volatile revenues

• Enable monetary policy by providing central banks with a market to conduct open market operations & control liquidity

• Mortgage Markets: cornerstone of housing finance

• Local currency bond markets are a cornerstone of development strategy

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Why Local Currency Market Development? Developing debt markets in local currencies would allow to:

• Deal with currency mismatching & exchange rate risk

• Absorb volatile capital flows and reduce financial instability

• Provide institutional investors instruments that offer safe and stable long term yields in local currency

• Develop a stable source of capital to fund public and private ventures

• Provide Central Banks an effective monetary policy tool: open market operations feasible => help maintain an inflation target without a peg to a major currency

• As a by-product, debt market would:

enhance transparency in pricing and intermediation,

facilitate constant monitoring of macro-economic expectations,

ensure disclosure of information and periodic communication regarding public policies.

 

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Role of Central Bank & Ministries

• Ministry of Finance (MoF) has key role as the developer and executor of the state budget and sovereign borrower for the country

• Fiscal authorities have to consider how important projects will be funded; choices on how to fund projects – domestically, internationally, bond or loan market - will impact the level of market development.

• The Central Bank role as monetary authority => operate in the market to inject or withdraw funds using market mechanisms

• The Central Bank is the designated fiscal agent of the government => conduct the sale of securities; may also maintain and operate the securities depository

• The Central Bank as a regulator of the banking system => involve in the creation of a liquid yield curve => allow banks to price their assets more accurately

• The Central Bank could boost the market if banks were required to hold a minimum percentage of their statutory liquid reserves in government paper

• Establishment of a repo market could facilitate open market operations and also facilitate banks / participants to manage their own liquidity flows

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Policy Recommendations• Government bond issuance across the maturities spectrum (eg.1, 2, 5, 7, 10 and 30

years) can provide the building blocks for a yield curve. (“market breadth”)

• The issuance must be conducted systematically over a number of years with appropriate pre-announcement of auction dates, size &characteristics of the issue etc.

• The calendar interval should be conveniently spaced with three objectives in mind:

creation of a critical mass of tradable paper (“market depth”)

avoid the drying up of longer dated maturities

prevent concentrated refinancing activity from straining markets’ absorptive capacity.

• Issuance must be large and liquid enough to be traded actively by a number of agents; features should maintain consistency across maturities (“market liquidity”)

• Primary market could be activated through an auction mechanism once the Authorities establish a Primary Dealer system

• To allow for maximum liquidity and participation, bonds and Sukuk can be either listed on exchanges as well as traded in OTC markets.

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Role of DIFC in Debt Market Development • The DIFC has put in place a financial platform incorporating international best

practice and characteristics:

Legal and regulatory infrastructure embodying international best practice Multi-currency Trading platform and Settlement System Transparency and disclosure are predominant criteria for issuers, with timely flow

of information Sound insolvency and creditor rights regime Experienced debt market participants (e.g. GBSA)

• NASDAQ Dubai is a fully integrated electronic regional securities exchange that operates to international standards and is strategically located in the DIFC.

The Asset Classes traded on NASDAQ Dubai 

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Development of Debt Markets is a Policy Imperative• Debt markets required for financing for Infrastructure & development projects

• Monetary Policy: tool for central banks to conduct monetary policy and control liquidity

• Fiscal Policy: essential tool for deficit financing & to smooth volatility of revenues

• Corporate finance: diversify from reliance on bank financing

• Real estate & housing finance

• Pension funds & assets for expatriate population

• GCC bond market attractive to international investors:

• backed by the region’s energy commodities reserves, accumulated private and public wealth & political stability.

• value of the GCC fixed income securities would be underpinned by strong fundamentals: positive growth prospects, economic diversification, shift of the epicenter of the world economy

• Safe haven & hedge against episode of extreme risk aversion.

• Boost after the launch of a common currency in the Gulf: new international financial architecture

Thank You!Q&A