Monday, 20 August 2018

Dealing with the dollar

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If the financial world was asked to sum up 2008 in just two words, I’m sure you’d end up with a number of different options. In the Middle East, you would probably need a few more words. By David French.

Certainly, one of the most obvious phrases would be "credit crunch", or some other variant such as "liquidity crunch". Many others would name "Bear Stearns" or "Lehman Brothers" in their apt description of the year, highlighting that the financial landscape changed dramatically in a few short months. One or two jokers might even, with a touch of irony perhaps, come up with something along the lines of "for sale" or "game over" to show how everything went downhill so quickly for many in the Western world.

However, for those answering the question from a Middle Eastern standpoint, the tone might be slightly different. For example, "massive opportunity" might be one way to put it, or "new beginnings" could be another. For as the economies of the Western world struggled to cope with the destruction caused by sub-prime mortgages, Middle East countries, and the GCC in particular, were able to take advantage and build, in a matter of months, a global position of strength that it might have taken them years to reach otherwise.

The overriding factor that has allowed the Middle East to expand so rapidly has been the weakness of the US dollar. As the American economy headed south, it dragged investors' confidence in its currency with it, leaving other global currencies trading against the greenback at levels not seen in years. And while Middle Eastern bankers might not have enjoyed such pleasures due to the dollar peg, which most countries in the region employ, it did help fuel a massive spike in the price of oil, which reached a high of US$147.27 per barrel on July 11.

This huge profit on the region's main export gave Middle Eastern governments the wonderful problem of having too much money and not enough things to spend it on. As part of the drive away from oil dependency, much of this new capital was spent on diversifying economies into other sectors, such as real estate, financial services and transport.

Therefore, often through sovereign wealth funds and government-controlled private companies, Middle Eastern governments took stakes in a number of assets, such as Barclays (Qatar Investment Authority), Merrill Lynch (Kuwait Investment Authority) and the Chrysler Building in New York (Abu Dhabi Investment Council). They even brought an English Premier League football team in the shape of Manchester City (Abu Dhabi United Group).

However, while the weak US dollar was giving Middle Eastern governments tremendous spending power, both in the region and internationally, it was also creating a number of problems. The first, synonymous with massive outlays by state authorities, was rapidly rising inflation.

Inflation has been a major headache throughout the Gulf for most of 2008. Most countries in the GCC have had to cope with a double-digit figure, with July, for example, seeing 13.35% in Oman and 11.1% in Saudi Arabia. Like the rest of the world, rising food prices have been a key source of inflationary pressure. However, the expansive economic policies being employed in the GCC, on the back of record oil revenues, have caused further upward pressures on inflation.

To tackle this problem, most central banks would deploy higher interest rates, to try to stem the tide of pressure coming from all the money floating around the economy. For the GCC, however, this tool has not been available as their interest rates are linked to the US's through the dollar peg. And to make matters worse, the Federal Reserve has instead been cutting rates to try and stimulate the US economy, forcing the GCC central banks to follow suit, to the detriment of their own financial systems. This led to much speculation, especially in the first half of the year, about currency revaluations and de-pegging from the dollar.

It was this speculation that gave rise to another problem; that of liquidity. As speculators piled into the region and invested in local currencies, such as dirhams, riyals and dinars, the weaker dollar began to become scarce. At the same time, higher pricing on the money markets made dollars more expensive to acquire in comparison with local currencies. Therefore, the region began to run low on dollar finance, leaving governments and companies with a problem of how to fund projects in dollars. Some areas were particularly acute, with a number of bankers citing Qatar as a place with no dollar liquidity at all.

This left the region, and bankers operating there, with some major issues to overcome. The Gulf was booming and deals still needed to be done, regardless of the state of the dollar and its effect on the area. Therefore, a number of traits started to permeate GCC transactions that helped rectify the negative effects.

With the lack of dollars in the market and cheap local currencies available through the money markets, the obvious solution was to include a local currency tranche in deals. This kind of tranche had not been used that often prior to 2008, especially when it came to big deals involving international banks. Even earlier deals this year tended to be all dollar-denominated.

However, with international banks becoming used to dealing with local Gulf currencies and moving to make working with them easier, the inclusion of a local currency tranche in GCC loans became standard. The benefits were many. As well as making the loan cheaper by reducing the dollar requirement, it allowed local and regional banks to participate in deals that they might have found difficult before, if it was strictly dollar-denominated. With the Gulf one of the few economic areas of the world still growing, it made sense to tap as many of the institutions in that area as possible.

Another indirect benefit for the region from pricing in local currencies was the opportunity afforded to Islamic financiers. In focusing deals on accessing liquidity from local and regional banks, borrowers needed to encourage these institutions to commit. However, many of the banks run themselves on Islamic principals, so they were unable to join deals structured around interest payments. Therefore, deals started to include a blend of conventional and Islamic financing, allowing Islamic banks to sign up to Sharia-compliant tranches and borrowers to tap further liquidity sources.

Towards the end of the year, loans began to appear that had a menagerie of different options to attract potential suitors. Take what looks likely to be the biggest transaction of the year, Investment Corporation of Dubai's US$6bn facility. Banks signing up to the deal can either commit to a conventional or Islamic tranche of either three or five years. Then they can provide the funds in either US dollars or UAE dirhams, showing that all options are being used to attract liquidity.

Away from the loan market, the weaker dollar was also creating positive change in the bond market. With dollars in short supply and potential buyers in the Western world battling with a faltering home market, GCC issuers had to look at alternatives. One key factor that helped them was the decision in January by Clearstream and Euroclear to allow UAE dirhams as a settlement currency. This opened up the possibility of Eurodirham issues, which a number of UAE firms would take advantage of as the year went on. It also meant that UAE tickets could be issued to a local audience, using a local method of payment, and attracting more potential investors.

However, with dollar markets being shut to all but the most determined issuers, GCC companies were forced into diversifying their target audience. This saw forays into a number of different currencies and markets, including the Swiss franc, the Japanese yen and the Malaysian ringgit. As well as shedding light on Middle Eastern companies around the world and building relationships for the future, it diversified these firms' holdings, making them much stronger in the process.

For Islamic banks looking to expand, it also provided opportunities to develop and stimulate new markets in other Muslim countries. This was particularly so in South East Asia, an area with a large Muslim population but with an Islamic banking structure that wasn’t as developed as in the Gulf. Therefore, demand for Shari’a compliant products in the likes of Indonesia and Malaysia was high and Gulf institutions could take advantage of this by issuing in the local currencies of the region.

So while the weak dollar was causing problems for those in the Middle East, the momentum it had, off the back of high oil prices, was maintained in both the debt and equity markets. With the credit crunch still affecting much of the world, the Gulf was still one of the few areas seemingly open for business and deals continued to be done. But as the year wore on, having avoided much that the world had thrown at it, it all started to break down and while the region continued to do its best to defy the global downturn, factors closer to home began to make themselves felt.

Bankers had been warning since the middle of the year about the ability of banks in the UAE to continue funding the massive expansion in loan demand. Both on the retail and corporate sides, UAE institutions were lending at a phenomenal rate. Consumer loans were up 46% in the first six months of 2008. Meanwhile, Dubai firms were making frequent trips to the international loan market, with local, regional and international banks tapped for about US$30bn worth of debt in the first nine months of the year. This caused its own problems, which will be addressed later in this article.

However, the general boom in the UAE loan markets was becoming unsustainable as loan/deposit ratios continued to deteriorate. By August, bankers were becoming concerned that pipeline loan business might have to be deferred as UAE institutions would soon be unable to meet any further demand on their resources. Interbank rates for dirhams began creeping up as supply became constrained, climbing by about 150bp between June and September.

At the same time, these banks were being squeezed by another factor. Foreign speculators, who had earlier in the year placed large sums in the country as speculation mounted about a potential currency revaluation, began to see that their bets were not paying off and begun withdrawing their capital from the UAE. On September 15, the UAE Central Bank announced that around 90% of these speculative funds had been transferred from the country, leaving banks that were already short of deposits from local investors facing a potential liquidity problem. Having survived the global credit crunch for so long, was the UAE about to experience a crunch of its own?

With its September announcement on foreign speculators, the UAE Central Bank said it was prepared and willing to provide funding support for those institutions that needed it. On September 22, it followed through by announcing that it would be pumping Dh50bn (US$13.6bn) into the banking system to support liquidity. By that stage, alarm bells were beginning to ring and bankers were faced with a significant slowdown in the loan market, with deferrals now a very real possibility. More importantly, liquidity in the country was grinding to a halt and dirham pricing was climbing steeply, with one-month money jumping from 3.525% to 3.6875% the day after the provision was announced.

Liquidity concerns weren’t just an UAE problem. Across the GCC, anecdotes had been swapped for weeks about tougher syndication processes, especially when it came to real estate deals. Meanwhile, pricing for local currencies on the money markets had also been creeping up: three-month Saudi riyals doubled between May and August, while three-month Kuwaiti Dinar, having been impacted by a decision from the government to halt its interbank guarantee in an attempt to stabilise the currency, had gone up by 250bp between 4 August and 21 August. In Oman, Bank Muscat became the first private institution in the country to issue certificates of deposit (CDs) in an attempt to encourage deposit-taking.

While back in Kuwait, the following day to the UAE announcement, its central bank insisted that it would be ready to support the market where necessary. This came after a number of Kuwaiti banks reportedly called on the central bank to pump more liquidity into the market to stop further deteriorations in economic conditions. In a separate move the week before, aimed at improving the equity markets which had been hamstrung by large rights issue in August and September from the likes of Mobile Telecommunications Company (Zain Group) and the country’s new telecommunications company, Kuwait Telecommunications Company (Viva), the government used the massive Kuwait Investment Authority to try and halt a decline in the Kuwait Stock Exchange by buying into Kuwaiti blue chips. The Kuwaiti bourse had fallen over 20% in under three months.

Therefore, liquidity problems meant that borrowers were unable to turn to local and regional banks for funding, leaving the way open for international institutions to come in and fill the gap. However, having "filled their boots’ in the previous nine months, many international banks had used their quotas for the year and were beginning to close down operations until 2009. This meant that options were further restricted for those looking to approach the market, with bankers commenting through September on how many mandates were floating around looking for a home.

For Dubai in particular, the situation has become acute. Having borrowed so much through the course of 2008, the state-run companies known as "Dubai Inc" were not only coming up against liquidity issues but also "Dubai fatigue", with banks becoming concerned by how much risk they were taking on to their books from what was, essentially, one borrower.

With the massive Investment Corporation of Dubai loan coming through towards the end of this period, with its various payment options, it did the job of hovering up any remaining liquidity that was out there in the market. While this meant that this deal was getting done, a number of others were suffering as a consequence.

Port and Free Zone World's US$1.2bn loan was closed towards the middle of September after nearly three months in syndication, while Drydocks World was just about completed in a similar amount of time. However, some mandates, having appointed banks, just disappeared off the radar, including DIFC Investments' US$1.5bn loan and Palm District Cooling, a subsidiary of Istithmar World, and its US$500m facility.

So having escaped the worse that the global credit crunch had to offer for most of 2008, the GCC's runaway economies were reined in slightly in the end. However, while it has to solve its own liquidity crunch in the closing weeks of the year and into 2009, it can look back and see the massive strides it made towards becoming a more robust, global player.

While the US dollar has strengthened gradually, it is unlikely to regain the prominent position it had before, so as long as oil is priced in dollars and the dollar pegs remain, it will retain its importance to the GCC, but local currencies will play a much bigger role than previously. And with a Gulf single currency also in the offing, with a Gulf Central Bank set to be established next year and, perhaps, the single currency in 2010, the currency make up of the region could change yet further. What is beyond doubt though is that 2008 was the year that a weaker dollar produced a stronger Middle East.

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