Spreading the financial risk in the region

08 December 2009

Dubai’s debt crisis is causing problems for issuers of government-backed bonds across the region

When Abdulrahman al-Saleh, director general of Dubai’s Department of Finance, said on 30 November that his government would not guarantee Dubai World’s debts, it was almost as big a shock to investors as when the conglomerate admitted, a week earlier, that it needed to restructure $26bn of debt.

The admission on 25 November that Dubai World was seeking a six-month delay on repaying its debts dismayed investors, who fear that sorting out the problem could be a long and ugly process. But the latest announcement by Al-Saleh could have far bigger repercussions for the region as a whole.

For years, the conventional wisdom in the financial markets was that Gulf governments would bail out struggling companies to avoid a default. It was the cornerstone of the region’s bond market.

Credit downgrades

“An empire has been built in the region off the back of implicit government guarantees,” says Saud Masud, Dubai-based analyst at Swiss investment bank UBS. “Investors never looked at the standalone credit profile of many of these businesses they lent to.”

“Investors always viewed these issuers as being state-guaranteed, even though in the documentation there was no explicit guarantee,” adds Fahd Iqbal, Gulf strategist at Egyptian investment bank EFG Hermes.

By distancing itself from the debts built up by one of the emirate’s biggest companies, which is majority-owned by the government, Dubai has set a dangerous precedent that investors fear could be copied elsewhere.

Already, the major international credit -ratings agencies have downgraded all of the Dubai government-backed firms they rate as a result of the indications from the government that it will not support Dubai World. Many of the firms have been downgraded to non-investment, or ‘junk’ status, which means there is a high expectation of default.

The investment grade ratings these companies previously enjoyed were a direct result of the strong links they had to their governments. Outside Dubai, government-backed firms still benefit from that link. Abu Dhabi property developer Aldar Properties, for example, has a rating of A3 from Moody’s Investors Service, four levels above junk status. Moody’s says if it was assessing the business as a stand-alone entity, it would be rated at Ba3, or junk status. However, Moody’s is reviewing all Abu Dhabi government companies for possible downgrade.

Bond market analysts say they are now expecting investors to demand explicit state guarantees of support for companies. If those assurances are not forthcoming, investors will start to demand far higher yields from corporate bonds.

Signs of this change of sentiment can already be seen. The difference in pricing between bonds issued by Abu Dhabi investment firm Mubadala Development Company and the Abu Dhabi government widened -significantly in the wake of the problems at Dubai World. On 24 November, Mubadala’s 2014 bond was priced at 169 basis points, compared with 167 basis points for government bonds. But by 2 December the gap had widened to 18 basis points, with Mubadala trading at 188 points and the government at 170.

“Dubai is unique in that it clearly does not have the balance sheet capabilities to finance a bailout”

Philipp Lotter, corporate analyst, Moody’s

Similarly, the spread on bonds issued by Aldar rose from 238 basis points on 24 November to 414 basis points on 2 December, its higher cost reflecting the more risky nature of its real estate business in the current climate.

“Clearly a reassessment of the kind of assumptions applied to government-related companies is taking place,” says one London based credit-analyst. “Investors are going to be telling government-related companies that, if they want lower funding costs, then they had better go away and get a written government guarantee.”

Companies with more proven business models should be less affected by this, according to analysts. Well-established corporations with consistent cash flow, such as Qatar’s Ras Laffan Liquefied Natural Gas Company and Abu Dhabi’s Dolphin Energy, will benefit from this reassessment, according to Timothy Ash, head of Central and Eastern Europe, Middle East and Africa research at Royal Bank of Scotland.

In contrast, Abu Dhabi-based businesses such as Mubadala, Aldar and Tourism Development & Investment Company, which are at the start of their investment cycle and could need more state support, will find that their borrowing costs increase.

In the wake of the Dubai World problems, many investors have blamed the credit ratings agencies for basing their evaluation of these companies on implicit support from governments – support that has not been forthcoming, in Dubai’s case at least.

But the agencies say that, although no guarantees have been given in writing, senior government figures have repeatedly assured them that support will be available, if needed.

“All ratings that benefit from some uplift because of shareholder support have been -verified by meetings with senior government officials, who have given us verbal confirmation that support would be forthcoming,” says Philipp Lotter, Dubai-based corporate analyst at Moody’s.

“We have assumed support and it has been articulated to us repeatedly that it would be there. We insist on speaking to someone from the government to assess the level of support that corporate entities may receive,” says Farouk Soussa, head of Middle East government ratings at Standard & Poor’s. “We also look at how closely the business is monitored and assessed by the government to get an idea how close the relationship is.”

Both Moody’s and Standard & Poor’s say they are not currently reassessing their ratings of government-linked firms outside Dubai, as the assumption that they will be supported by their local governments still holds. The third major ratings agency, Fitch Ratings, could not be reached for comment.

Funding shortfall

“Dubai is unique in that clearly it does not have the balance sheet capabilities to finance a bailout of government-related entities,” says Lotter. “The issue is one of both ability and willingness to provide [financial] support, whereas elsewhere in the region it only a matter of willingness.”

Even so, Dubai has set a precedent of treating its commercial operations as being at arm’s length from the government. Investors are concerned this may spread to other countries where governments might find it difficult to justify bailing out companies that do not have sustainable long-term businesses, particularly in the weakened real estate sector.

“The precedent of default needs to be interpreted in a broader context, given the growing number of debt-laden government-related -issuers without sovereign guarantees elsewhere in the Gulf,” says Lotter.

A bond trader at one London-based international bank says he previously advised investors to buy into whichever state-backed issuers were paying the highest return in the region, regardless of the merits of their business model, as it was assumed they would never default. But as investors now start paying more attention to the intrinsic credit quality of each issuer, he says only the companies with explicit government backing will be able to access the capital markets.

How this will affect the economic development plans of governments in the region will not become clear for some time. While about $35bn-worth of bonds have been issued from the Middle East so far this year, the majority by government-linked companies, there is little on the horizon in terms of new bond issuance, state-backed or otherwise.

But there are bound to be some repercussions for companies that do go to the market seeking new finance. “The Dubai World restructuring has done a lot of damage to Dubai’s creditability in the markets and it has torpedoed any chances of getting a new Dubai issue done for a while,” says the head of syndications at one Bahrain-based bank. “It has also undone a lot of the work Abu Dhabi and Qatar have done over the past year towards developing interest in the region’s bond markets.”

The situation is not helped by the impact of two corporate defaults in Saudi Arabia – by Ahmad Hamad al-Gosaibi & Brothers and Saad Group – which are together thought to have defaulted on more than $20bn of debt over the past year. “The perspective of bank head offices in Europe and the US on lending to the region has been severely damaged,” says the head of syndications.

To overcome all these difficulties, any company wishing to issue bonds successfully in 2010 will need to have an explicit government guarantee, preferably from countries with strong balance sheets, such as Qatar and Abu Dhabi. For others, the markets will either be very expensive to access, or closed. The days of relying on implied state support are over.

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