Taking the credit

18 October 1996

Project finance in the Middle East is stepping into the limelight. A series of major deals are either in the market or are on their way - a petrochemical plant in Kuwait, gas plants in Qatar and Oman, a refinery in Egypt and power projects across the region.

These deals show that where governments are no longer willing or able to pick up all of the bill for development, banks are stepping in to take the risk. In some cases, such as the Equate project in Kuwait, they are even ready to finance large projects without the security of guarantees from states or export credit agencies.

The rash of new oil, gas and power schemes is also providing new business for a select few Middle Eastern banks with the assets and technical ability to get involved, and may prove in the longer term to be a growth area for the expanding Islamic finance industry.

Most of the large projects are in the Gulf, and their origins can be linked to a combination of rapid population growth and years of volatile and relatively weak oil prices. The Gulf Arab states are seeking to diversify away from selling crude oil - into liquefied gas and petrochemicals.

At the same time, domestic power demand is rising fast across the Arab world, creating the need for more generating capacity. Outside the Gulf, the need for new infrastructure like roads is also creating demand for finance that goes hand in hand with new ownership models like build-operate- transfer (BOT).

For a number of reasons, governments are increasingly reluctant to provide sovereign guarantees to the financiers of such projects, preferring that borrowings be paid back through the projects' earnings. The weakness of oil prices is one major factor. In the case of the Gulf states, both Saudi Arabia and Kuwait were also hit financially by the costs of the 1991 Gulf War, while Qatar and Oman have used up much of their existing reserves of oil. Only the UAE can still pay for all the large projects it plans in cash. Outside the Gulf, indebted governments often lack the resources to pay for the necessary levels of investment in infrastructure.

At the same time, banks are flush with funds and looking for higher returns than those available from commercial lending in the West. 'The banking market is pretty liquid at the moment, and corporate lending margins have pretty much gone to hell,' comments one London-based banker. Thus the flurry of project financings reflects the needs of both borrowers and lenders.

One of the most talked-about deals this year has been the $1,200 million loan package for the Equate petrochemical plant in Kuwait. The deal, signed last month, has several notable features - it was arranged by a domestic institution, National Bank of Kuwait (NBK) and contains no export credit agency (ECA) cover. It also includes a

$200 million tranche of Islamic finance.

The original plan was for ECAs,

principally the Export-Import Bank

(Eximbank) of the US, to guarantee the whole amount. But Eximbank wanted sovereign guarantees before it would extend cover, while the Kuwaiti borrowers

preferred a non-recourse approach, according to NBK Executive Manager Bill Rhodes.

NBK then set about arranging a loan package without ECA cover. Rhodes says the bank picked up from the work done by Eximbank and financial advisers JP Morgan and Chemical Bank of the US (since merged with Chase Manhattan).

Rhodes says that when international banks learned that Eximbank was not providing cover for Equate, it was assumed that there was a political problem with the project on the US side. However, NBK was able to bring Gulf banks on board by pointing out the positive market fundamentals for Equate and the security offered to Kuwait by its alliance with the US. The international banks then got involved. 'We overcame the problem with logic,' Rhodes says.

Not only was the whole complex package arranged by a Kuwaiti bank, but the emirates's banking sector has also underwritten a $500 million chunk of the financing. Other regional banks are also taking a prominent part in the second tranche of lending, worth $700 million - of 48 subscribing institutions, 13 were Arab.

Bankers concur that Arab banks have the assets to lend more to projects in the region, but the sheer number of billion-dollar schemes currently being proposed in the Gulf means that international banks will retain their leading role. However, they may face more competition for arranging and advisory mandates, as Gulf banks become more confident and experienced.

Media coverage of the Gulf from outside can make the region look like a risky place to tie up funds for eight years or more without government guarantees. But banks seem to be taking a sanguine view. 'The Gulf, surprisingly, is seen as a very reasonable risk,' says Mohannad Farouky, assistant general manager of Gulf International Bank (GIB).

GIB itself is increasingly active in Gulf project finance deals, both as an arranger and as a financial adviser.

'About two years ago we decided that project finance would be a very important part of the business for the next five to ten years,' says Farouky. He says GIB's government connections help it to win business, insofar as 'our ownership helps us to distinguish between the real projects and those which are at an early stage of development and won't come to fruition for some time.'

A key issue is the role of the export credit agencies.'If a project can be structured with an element of ECA support, it is very much sought after. Of course, this is not possible with every project,' says GIB's Farouky.

There are others who argue that deals are better done without ECA involvement, if possible. 'They come at a cost and it's a time-consuming exercise, so if it can be done on a commercial basis a clean loan is preferable,' says one Gulf-based Western banker. However, ECA-backed financing can be longer-term than purely commercial lending, and the presence of an ECA also draws in a wider range of lenders. In addition, the sheer number and size of projects in the Gulf may make it hard for arrangers to raise enough finance on a commercial basis, because of the limits that each bank sets

on commercial exposures to a particular


If the host country's own banks can take on a large part of the risk, as was the case with the Equate financing, this is clearly less of a problem. But in the case of a less affluent Gulf state without a sizeable banking industry, such as Qatar, raising the necessary commercial loans could prove harder without ECA support. 'To do a pure financial credit (for a country like Qatar) you would need every last savings bank in Germany to put a sufficiently large credit together,' says one London banker.

Saudi Arabia, a major source of projects in oil and infrastructure, has used English law for two major recent borrowings to encourage international banks - a $700 million loan to the Saudi Petrochemical Company (Sadaf) to build a methyl tertiary butyl ether plant and a $500 million credit for the Ghazlan power station expansion. However, one senior international banker notes that this is uncharted legal territory.

The ECAs themselves have adapted their requirements to take on board the concept of non-recourse finance. Martin Crane, senior underwriter for civil projects at the UK's Export Credits Guarantee Department (ECGD) feels that co-operation is improving between the different national ECAs which come together on projects and the investment banks that arrange financings. 'If anything, the role of the ECAs will become even more important. The ECAs give banks enormous confidence,' he says.

An emerging trend in regional project finance is a greater role for Islamic institutions. Islamic banking is growing steadily in size and complexity, but until now activity in the Middle East has focussed on short-term financings, often related to trade.

Things are changing. Equate had an Islamic financing component underwritten by Kuwait Finance House, while the ANZ Group arranged a chunk of istisna (leasing) finance for the Hub power project in Pakistan, which achieved financial closure in 1995.

However, one senior Islamic banker believes that Islamic banks will take a

cautious approach to non-recourse financing and are likely to concentrate at first on deals within their domestic markets. The preferred technique for medium and long-term financing is likely to be through leasing.

'Islamic financiers are very careful about non-recourse financing. They have been in business for less time than conventional banks, and with project finance there's a lot of other risks in addition to cross-border and commercial risk,' he says.

Whatever the sources of finance for the Middle East's oil and infrastructure development, the trend towards borrowing on a non or limited-recourse basis seems likely to continue as the needs of states continue to outgrow their ability to fund them.

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