An emerging opportunity?

Executive summary

Despite enormous economic strides made by the financial sectors of the GCC countries in recent years, debt securities, as an asset class, have lagged substantially behind other areas. The reasons for this are numerous. The high oil revenues of recent years placed the region’s governments in a comfortable fiscal position, obviating the need to issue debt and creating the opportunity to seek macroeconomic stability through debt repayments. On the other hand, private corporations have mostly relied on bank credit, both domestic and external. Moreover, they benefited from easy access to equity financing during the recent stock market boom. At present, however, the reality of declining petrodollar surpluses, tight credit, and subdued stock markets, has once again led to more serious attention being paid to debt capital markets as a potential alternative.

• The still nascent debt security markets in the GCC have experienced heightened activity since 2006. This was primarily due to greater corporate issuances, partly linked to the growing popularity of sukuks. However, the market experienced a 40% decline to USD22.5bn in 2008, largely because of the global crisis, but in part also due to investors concerns about acceptable sukuk structures.
• The sukuk market has the potential to become a major beneficiary of the changed market conditions. Widely accepted sukuk structures have increased the popularity of debt securities in the Gulf and corporate sukuk issuances in recent years surpassed that of conventional bonds. In addition to their general popularity, Islamic financial institutions and their clientele constitute a captive market for these instruments. Moreover, the current global crisis has boosted the reputation of shariah-compliant products and institutions, which discourage a high degree of leverage, and are based on the principle of risk sharing.
• The GCC sukuk market is likely to recover in 2009, given a USD24.6bn pipeline. Listed sukuks are currently trading at attractive yields due to a deep correction in late 2008. The widening of spreads due to rising liquidity and credit risk premiums has taken average GCC corporate bond yields to 10–12% and average sukuk yields to 13–15%. Investors may increasingly turn to sukuks issued by government-backed firms with good track records and fundamentally strong assets.
• Barring a substantial deterioration in economic conditions, sovereign issuance is unlikely to be a key driver of the market. Except in Bahrain and Oman, reserves accumulated during the oil boom years will likely minimize the need for additional borrowing. In the absence of sovereign benchmarks, the corporate debt market has relied on foreign benchmarks for pricing issuances, thanks to the US Dollar peg.
• Developing an active debt capital market is an important step toward more established and diverse financial markets in the region. A vibrant debt market would offer greater flexibility for fiscal and monetary policy makers and broaden the range of funding sources for corporations. It would present investors, including retail investors, with an important asset class with qualities not found elsewhere. However, further standardization is highly desirable, to reduce delays, costs, and inefficiencies associated with sukuk issuance.

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