Provisioning for investments in sub-prime-related assets may have been limited to a handful of banks in the region, but every Middle East business has been hit by the knock-on effects.

As their provisions for investment losses have mounted, Western banks have become more nervous about the quality of their balance sheets.

Interbank lending rates have rocketed, sending the interest rates that Middle East corporates pay for debt far higher than they have become used to.

“In some quarters there was an assumption that the Middle East would be insulated from what was occurring in global markets, but in reality the GCC was just slow to follow the trend,” says Simon Putt, Dubai-based head of fixed income at French investment bank Calyon.

On 19 July 2007, the Dow Jones Industrial Average index hit a record high of more than 14,000. However, any euphoria was short-lived. A month later, the Dow had dropped below 13,000, stock markets were crashing around the world and investors were becoming increasingly risk averse.

By May 2008, banks around the world were estimated to have reported $379bn in losses related to the credit crunch and loose lending practices on US home loans. While the short-sighted boasted that the Middle East would escape from the crisis unscathed, the reality has been very different.

The HSBC/Dubai International Financial Centre (DIFC) sukuk (Islamic bond) index shows that by July 2007, spreads on Middle East bonds in the secondary market were rapidly shooting up (see chart opposite).

After averaging about 50 basis points over the London interbank offered rate (Libor) for the first six months of 2007, pricing on the Middle East sukuk market has averaged 136 basis points over Libor for the past 18 months.

The spread on conventional financing has risen even further, averaging 190 basis points over the same period, and is now at more than 260 basis points.

Margins on loans in the primary market reached an unprecedented level in August 2007 with a deal from Saudi Basic Industries Corporation (Sabic) priced at 250 basis points over Libor.

But it is not just the impact of the credit losses elsewhere that has widened spreads
for regional borrowers. The situation has been exacerbated by the run of currency speculators betting on a revaluation of Gulf currencies, particularly the UAE dirham and Saudi riyal.

The US Federal Reserve, beginning with a move to slash interest rates by 50 basis points on 18 September 2007, cut rates from 5.25 per cent to 2 per cent on 30 April 2008.

The growing disconnect between the stalling US economy and the overheating GCC region has led many investors, and investment banks, to believe a revaluation of Gulf currencies is inevitable.

“The inflow of dollar investment that began in late 2007 has created huge local currency liquidity in the domestic banking system,” says one Dubai-based banker. “The flip side of this is that it has reduced the availability of dollars in the region even further.”

Jebel Ali Free Zone Authority (Jafza) was one of the first borrowers to try to capitalise on this trend by using dirham financing for an AED7.5bn sukuk issue launched in December 2007. Margins on the Jafza deal were 130 basis points when it was first priced, although they subsequently rose to 300 basis points in April 2008.

Also in December 2007, Dubai Electricity & Water Authority (Dewa) pulled a dollar deal at 125 basis points for being too expensive, only to later do a dirham-denominated deal at the same price, indicating how much further dollar debt had moved on in pricing.

A flood of issuance occurred in the dirham market as borrowers realised they had a cheaper alternative to dollars, although that source of liquidity is showing signs of drying up. Margins on dirham paper have begun to creep upwards as this relatively new market continues to find its feet.

Higher yields

The region has also been hit by a third factor that has pushed up prices. Just 12 months ago, international investors were eager to buy into Middle East paper because it generally offered a better yield than similarly rated corporates in European markets, but that appetite has since diminished.

Gilles Franck, head of capital markets for the Middle East and North Africa at Standard Chartered Bank, says that last year, about half of Gulf bonds and sukuk were being bought by European investors. This has dropped off as investors take profits from Middle East port-folios to shore up losses elsewhere, and worry about their ability to get good pricing in secondary markets.

The expectation of an imminent currency revaluation has also receded, putting many investors off holding their money in dirhams in the expectation that they will profit from an appreciation against the dollar.

“A number of international investors have expressed concern over the relative lack of liquidity they are finding on regional bonds,” says Putt. “Liquidity-sensitive investors in Europe and Asia need to see good, ongoing, two-way prices on their investments, but most GCC bonds tend to have a secondary market shelf life limited to just a few months before a buy-and-hold status sets in.”

Liquidity in the secondary market is increasing, with an influx of new banks. “There are now several more participants in the secondary market than there were 12 months ago,” says James Milligan, head of fixed income trading at HSBC.

More recently, the collapse of US bank Bear Stearns in March triggered another bout of spread widening, even in the Middle East, pushing margins to a high of more than 310 basis points.

The Bear Stearns crisis unfolded from mid-March, immediately affecting risk appetite on Middle East debt from when news of the JP Morgan and Federal Reserve bailout of the bank went public on 14 March.

Spreads subsequently bounced, and the optimism that followed the sale of Bear Stearns to JP Morgan proved short-lived as investors again grew cautious. The outlook remains uncertain for the rest of 2008.

A note of optimism in the current market is that widening spreads have been compensated for by falling interest rates. “While credit spreads have widened, central banks have been cutting interest rates, so there has still been a willingness of some corporates to issue given the relatively smaller moves in overall funding costs,” says Milligan.

Widening spreads

Aggregate spreads for Middle East bonds have risen from about 50 basis points to 250 basis points, an increase of 2 per cent, while Libor rates have fallen by about 3 per cent. This means the net effect on debt servicing costs is more limited than the figures initially suggest.

As the rest of the globe looks at reassessing risk premiums, the same will now inevitably occur in the Middle East. This should result in some narrowing of the difference between spreads in the primary and secondary markets.

For example, Qatar National Bank managed to price a five-year, $1.85bn syndicated loan at 19.5 basis points over Libor in September 2007, one of the lowest pricings ever achieved in the region. But some bankers question whether this is an accurate pricing of risk, or even fairly reflects the funding costs of banks financing these deals.

“There were a lot of deals pricing around 20 basis points last year, while those same companies had debt trading at around 200 basis points in the secondary market,” says the head of syndications at one Saudi bank. “The credit crunch has seen that gap decrease.

“Secondary market pricing is at an all-time high, with credit confidence at an all-time low. So there do not yet appear to be signs that the markets are normalising.”

One positive thing that should come out of the crisis is that bankers are expected to pay more attention to secondary market prices when pricing primary issuance. While they will welcome a more rational approach to pricing that reduces the difference between primary and secondary market debt, borrowers may not be so impressed when they realise the days of paying just 50 basis points are over.