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UAE Local Bond Market: A Remedy for Ailing Banks

Global Arab Network - - Mohamed Tamer

Tuesday, 07 July 2009 14:55

Obviously the banking sector of the UAE, the other engine of break-neck growth of the past after the property sector, has suffered far more from the global credit crunch than previous estimates.

At the start of the crisis, late last year, the central bank maintained consolidation within the financial sector as it choice of outcome and appeared satisfied with the emergency funds injected or made available to avoid a systemic crisis. But the recent move to open yet another window of fund raising, this time through federal-government guaranteed 5-year bonds, means the ailing industry needs a lot more to turn healthy. The new fund-raising option might help banks avoid a consolidation similar to the one now emerging in the property sector and might force the country to live with far more banks than needed.

On the flip side, some say, the emergence of a legal framework for debt management and bond issuance might provide the much needed foundation for the development of a secondary market, where debt can be traded and, more importantly, term money and credit risk can be priced.

Bank loans, and to a limited extent, equity issuances had been the choice of fund raising for local corporate and government entities in the UAE. But most of them have tested the debt market in one way or another. Banks, especially, went berserk during the last leg of the boom days and raised quite a bit of short- to medium-term funds abroad. Over $10 billion of those debts would be maturing this year and the next put together, large enough for the federal government to come up with the guarantee law which will be applied selectively though.

Given that the country’s leadership is still very much committed to growth and progress, development of a bond market is the next logical step in deepening and diversifying the financial sector for the benefit of both the corporate sector and investors.

The world of finance is all about packaging risk in various ways and forms. Equity finance encourages risk-taking among investors, since shareholders stand to pocket capital gains and dividends. But losses could be heavy as well, and we have seen quite a bit of that lately. Debt finance, however, encourages risk-aversion, as debt holders do not share the upside but are guaranteed return at maturity.

From the fundraiser’s perspective the choice between taking a bank loan, going for an initial public offering of equity or issuing bonds is a tough one. In general, small to medium-sized startups would rather go for a bank loan than tap the capital markets. Borrowing from bank ensures, to an extent, flexibility in event of financial distress, lower refinancing risk, and of course low disclosure requirements. Borrowing from capital market offers lower interest cost, lower interference on corporate strategy, greater scope of tactical debt management and in some ways less  demanding covenants.

There is also enough academic literature available to show how policy-makers could benefit from a functional bond market in terms of managing monetary and exchange rate environment with the aim of achieving financial and economic stability.

Representative market prices for local money along the time dimension and for credit risk helps in many other ways. It increases choice of funding, fostering healthier competition between sources of capital. Bonds may represent a spare wheel at times of bank distress, avoiding a credit crunch. It allows banks to better manage risks associated with maturity transformation and currency/credit exposure.

On the macroeconomic front it allows market discipline to operate; policymakers can detect areas of potential vulnerability before crises erupt. A domestic bond market adds an important degree of freedom in the conduct of monetary policy, and helps manage the exchange rate, especially if there are revaluation expectations leading to capital inflows.

What is missing is a government-bond yield curve that represents the credit risk of the state. The curve will also be used as a benchmark by local issuers. The federal government had so far not needed debt to fund its development needs, but there are other surplus nations who have gone ahead with the development of a bond market. Maybe their experience could be used as a guidance.

Global Arab Network

Ovais Subhani, (Khaleej Times)

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