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By Dr. Eckart Woertz, GRC Program Manager (Economics)

  For what do I need a bond market? I make 50 percent a month on the stock market!” Such attitude has not been limited to some manic enthusiasts on the fringes of the GCC investment world, but has instead been more common – more common that is until the beginning of March 2006. Given the recent decline in the stock market, people still make 50 percent but in the opposite direction. As such, the insight has dawned on many that there are other securities than stocks and that they are worth a closer look. In the developed Western securities markets, for example, bonds are much more important than stocks. About 90% of the turnover there is attributable to interest rate related securities and only 10% to stocks, while in the GCC it is the other way around. 

  Bonds fulfill an important function in the economy. They provide stable long-term financing for companies and states alike and offer investors an important alternative to stocks. Bonds might be less flamboyant and more boring than stocks, but they are less volatile as well and offer a more predictable flow of income. As bonds are often negatively correlated with the stock market – they move up when the latter moves down and the other way around – they also play an important role in balancing the portfolios of private households and institutional investors like pension funds. Especially the latter are in need of the fixed income provided by the bond market, as these investors require a firm base on which to calculate their future liabilities. Thus, the discussions in the GCC about developing local mutual and pension funds must go hand in hand with the logical first step: the development of a GCC bond market.

  Bonds may be more predictable and stable than stocks, but since the days of Michael Milken and the advent of junk bonds we know that one can loose his shirt with them as well. In case of rising interest rates, the prices of existing bonds decline. Furthermore, not every bond is a secure one, i.e. one that is issued by a government or a government backed institutions with an investment grade rating of at least BBB. There are corporate bonds as well and there is the increasingly diversified realm of asset backed securities (ABS), where existing assets like credits or rental incomes of real estate are bundled and repackaged as a tradable security. Many of these securities are considerably less safe than government bonds but also offer a potentially higher return for the risk they involve. In this risk hierarchy, government bonds function as an orientation point for the pricing of the more risky and less liquid corporate bonds and ABS markets. Thus, at the heart of every bond market is a bench mark yield curve, which is constituted by government bonds of various maturities. This being the case, the corporate bond sector can play its role as an important part of the financing of companies. The corporate bond sector is the first to gather steam during a recovery, not the equity market. After the NASDAQ bubble burst, for example, Warren Buffet ventured into “new economy” companies for the first time, and he did so by buying Amazon corporate bonds, not Amazon stocks.

  The Asian Crisis in 1997/ 98 revealed two important problems: for one, the over-reliance on the banking sector for financing and, second, currency and maturity mismatches on the balance sheets of these banks. The borrowing was done in the short term and in US dollars while the lending was done on a long-term basis and in domestic currencies. Once the crisis arrived and the local currencies tumbled, the structure became untenable and led to particularly negative outcomes. In the aftermath, the Asian countries have tried to spurn a domestic bond market in order to avoid these problems in the future and to reduce their dependency on the US dollar.

  The purpose of the Asian Bond Market Initiative (ABMI) is to encourage local financial intermediation and invest Asian savings directly at home rather than “round tripping” the capital via Western security markets with an estimated opportunity cost of two percent. Members are the ASEAN countries plus 3 (Japan, South Korea and China) with India being associated via the Asian Cooperation Dialogue (ACD). There exist various contacts at the levels of governments, central banks, finance ministries and the private sector. In the Asian Bond Funds (ABF) I and II, the countries are investing part of their reserves in domestic bonds denominated in local currency or the US dollar. The targeted size of ABF I is 8 to 32 billion US$ and ABF II already contains 1 billion US$, which appears to be small compared to the huge currency reserves of Asian countries of more than 1.7 trillion US$. But compared to an underlying investment universe of 70 billion US$, this size is not so small at all and is likely to grow with the developing Asian bond market. After the Asian crisis, some countries also took great efforts in establishing a local ABS market, which has developed by leaps and bounds and already made up for a majority of corporate bond programs in South Korea in 2000.

  The GCC bond market is yet underdeveloped. In comparison to traditional bank and equity financing, it appears to be a pale shadow. Current high oil revenues put the region’s governments in a comfortable position. They do not need to issue debt in order to finance fiscal deficits. Corporations on the other hand have had easy access to equity financing during the boom of the stock markets. Thus, the market is characterized by a lack of benchmarks, a limited variety of issues and low liquidity. Recently, some bigger sukuks and floating rate notes of banks have been issued (e.g. Emirates Airlines, Islamic Development Bank, Mashreqbank, Emirates Bank International, Abu Dhabi Commercial Bank). But longer maturities are absent and on the government side, only Qatar and Bahrain have issued Eurobonds, but not enough to form a benchmark all across the yield curve. Dubai pioneered into the ABS market by securitizing mortgages from the Palm Jumeirah project. But many legal issues surrounding ABS (e.g. property laws, true sale) are still in the process of being sorted out and somehow the deal only took off because the issue was fully guaranteed by deposited fixed income securities in London in addition to the Jumeirah Palm mortgages.

  Thus, the development of a GCC bond markets will first of all need a government bond market with the corporate bond market to follow suit. The ABS markets have a chance to develop once the former two have taken off and after legal issues have been clarified. Taken together, the proper market infrastructure will be necessary such as the auctioning of new issues and liquid secondary markets with the participation of banks, market makers and emerging institutional investors like insurance companies and pension funds. Currently, the GCC bond markets are an illiquid buy and hold market and often one can get better prices for GCC bonds in Hong Kong and London than in the GCC itself. Working settlement and clearing procedures which are compatible with international standards (e.g. Euroclear) and a surrounding rating culture which makes the involved credit risk transparent and accessible would also be a necessity. Once a bond market is in place, a market for interest rate derivatives should follow suite to provide hedging instruments. The latter remains an important desideratum for the stock market as well and it remains to be hoped that the plans of the Dubai International Financial Exchange (DIFX) to establish such a local derivative market will prove successful. The GCC governments currently do not need to issue debt to finance budget deficits. Neither do Hong Kong and Singapore, but both countries are issuing bonds across the yield curve to provide a benchmark for their corporate bond sector. The GCC countries should do the same and they should consider centralizing their efforts by doing it via a supranational institution backed by the GCC governments. Thus, the market would have more depth and strength than if each single GCC country would issue its own bonds. The GCC countries should also consider strengthening their ties to the Asian financial markets by investing in Asian Eurobonds and attracting Asian investors to the nascent GCC bond market. This is especially true for Malaysia, which has a thriving Islamic Banking and sukuk market. But astonishingly, the ties between Malaysia and GCC countries are underdeveloped because no consensus about common Islamic investment criteria has been achieved yet.

  Overall a GCC bond market is not only part and parcel of a successful development of the local capital markets; it is also a necessity for the region’s economic development at large. Given the absence of a free floating currency and an autonomous interest rate policy in the GCC, it will furthermore give the monetary authority an important tool in steering the money supply via open market operations.


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