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    1. 1. The Case for a Local Bond Market in the UAE Abu Dhabi 12 March, 2006 Francesco U. Garzarelli Managing Director Macro & Markets Research Goldman Sachs International, London [email_address] Tel: +44 207 774 5078
    2. 2. Agenda <ul><li>My remarks today will be centred around three specific questions : </li></ul><ul><li>Why would the UAE benefit from the creation of a local currency bond market? </li></ul><ul><li>How could the UAE go about developing one? </li></ul><ul><li>How would the term structure of dirham rates (tentatively) look like today? </li></ul>
    3. 3. Why Build a Bond Market? <ul><li>Contributions to the theoretical literature explain how countries benefit from well-diversified financial systems. At a high level of abstraction, equity finance encourages risk-taking among investors, since holders of equity stakes share in returns with losses truncated to the downside, while debt finance encourages risk-aversion , since debt holders do not share on the upside. </li></ul><ul><li>From the perspective of the potential borrower, however, the case for ‘outside’ (bonds) vs. ‘inside’ debt (bank lending), using Fama’s (1985) broad taxonomy, is much harder to pin down. </li></ul>Boot and Thakor, Financial System Architecture, Review of Financial Studies,1997, is the classic reference.
    4. 4. The Choice Between Bonds and Bank Lending In general, smaller, younger firms operating typically in information-charged areas of the economy would tend to go to banks rather than tap the capital markets. Average firm size and ownership structure, and innovation, are factors in principle affecting the choice between bonds and banks. Less demanding covenants Lower disclosure to public markets Greater scope for tactical debt management Lower refinancing risks Lower interference on corporate strategy Managerial counselling Potential reduction of interest costs (?) Greater flexibility in the event of financial distress Open Market Borrowing Bank Borrowing
    5. 5. A Market Price for Time Money and Credit Risk Carries Benefits ... <ul><li>But the supply set up is often times is dominant factor...consider the case of Euroland and Japan, where banks have the lion’s share in the credit markets, partly for historical reasons. </li></ul><ul><li>Even in these cases, however, a representative market price of term money and credit risk (e.g., default swaps) exists and carries clear advantages for financial and economic stability. </li></ul>
    6. 6. ... To the Health of the Financial System, <ul><li>The existence of representative market prices for local money along the time dimension, and for credit risk holds several benefits: </li></ul><ul><li>It increases firm’s choice of funding, fostering healthier competition between sources of capital. Bonds may represent a ‘spare tyre’ at times of bank distress, avoiding a ‘credit crunch’. </li></ul><ul><li>It allows banks to better manage risks associated with maturity transformation and currency/credit exposure. </li></ul><ul><li>It facilitates the creation of financial assets that can ‘complete’ markets. </li></ul>
    7. 7. ...And to Macroeconomic Stability <ul><li>It allows market discipline to operate; policymakers can detect areas of potential vulnerability before crises erupt (lesson learnt the hard way in Asia, 1997). </li></ul><ul><li>It adds an important degree of freedom in the conduct of monetary policy, particularly when the exchange rate is managed (e.g., MAS), and there are revaluation expectations leading to capital inflows. </li></ul><ul><li>All these aspects should resonate within the UAE financial community, particularly considering the current macroeconomic challenges. </li></ul>
    8. 8. UAE’s Money and Credit Expansion Is Accelerating ... UAE - Selected Money and Credit Aggregates Source: Central Bank of UAE, Goldman Sachs calculations.
    9. 9. ... Leading to Inflation in Asset Prices ... UAE - Stock Market Index Source: Bloomberg.
    10. 10. ... and Consumer Prices UAE - Year-over-Year Retail Price Inflation Source: International Monetary Fund, Goldman Sachs calculations.
    11. 11. Three Further Reasons to Act Now! <ul><li>Finance meets a strategic diversification goal. The UAE can flourish as the regional financial hub of the planned monetary union. </li></ul><ul><li>Competition is already rising: The Bahrain Monetary Agency initiated a number of strategies to broaden the bond market in 2003, particularly in the Islamic segment (80% of the roughly US$ 2bn public debt is Sukuk ) </li></ul>Share of Hydrocarbon in GDP in GCC Source: Institute of International Finance.
    12. 12. US Monetary Policy Potentially Unstable <ul><li>US monetary policy is more unstable because of the high leverage and dependence on external funding. </li></ul><ul><li>GS forecasts rate cuts next year, which may be unsuitable for the UAE’s domestic demand needs. </li></ul>US - 3mth Libor Rate
    13. 13. Debt Finance Is Historically ‘Cheap’ <ul><li>Outside debt finance is ‘cheap’ for firms: real rates are at very depressed levels across the term structure, and credit spreads are tight. </li></ul><ul><li>From the demand side, domestic bonds are under-represented in household portfolios, while international investors are hungry for greater diversification of returns (e.g., Gazprom and Rosneft corporate debt ). </li></ul>
    14. 14. What Is a Realistic Capitalization Objective? Economic theory has shed light on the factors determining the capitalization of a bond market. Granted, the UAE suffers from an ‘original sin’ problem, lacking a minimum efficient scale. See Eichegreen and Luengnaruemitchai, Why Doesn’t Asia Have Bigger Bond Markets, NBER 2004.
    15. 15. Cross-sectional evidence suggest a US$ 50bn market is in the ball-park, especially considering the prospect of monetary union. A similar conclusion can be reached by looking at the share of credit provided by the banking sector. A US$ 50bn + Market Is Feasible Source: Eichegreen and Luengnaruemitchai (2004), Goldman Sachs.
    16. 16. Is There Need for a Government Benchmark? The cross-sectional evidence is consistent with a positive relationship between private and public sector bond market capitalization. The relationship is far from perfect, however. A big government bond market can ‘crowd out’ private borrowing. Source: Eichegreen and Luengnaruemitchai (2004), Goldman Sachs.
    17. 17. <ul><li>Government borrowing can provide, if properly designed, liquid benchmark points across the term structure, on which other assets can be priced off. </li></ul><ul><li>In the UAE’s case, government over-funding would come to the benefit of monetary policy, helping drain domestic excess liquidity at market prices without having to resort to administrative measures. </li></ul><ul><li>The ‘quasi-fiscal’ costs appear manageable, especially considering the high sovereign credit rating and greater propensity for funds to stay in the region. ‘Niche’ Islamic finance can further contribute to limit costs. </li></ul>Public Issuance Can Alleviate Policy Strains
    18. 18. Some ‘Best Practices’ Drawn from Int’l Experience <ul><li>Issue government paper according to a set auction calendar; concentrate on few liquid benchmarks. Start with OTC markets, possibly alongside a post-trade transparency system (e.g., the US’ Trade Reporting and Compliance Engine). </li></ul><ul><li>Promote financial risk education and facilitate information disclosure: in too many circumstances, credit-risky securities (whose returns are comparable to being short a put option) end up in the hands of captive/un-experienced investors. </li></ul><ul><li>Enfranchise the private banking system: These will likely be warehousing government-corporate risk and making markets. </li></ul>
    19. 19. Some ‘Best Practices’ Drawn from Int’l Experience <ul><li>Asset/mortgage-backed markets, REITs, and securitization could be important to increase supply, and encourage intermediaries to play ball. </li></ul><ul><li>Limit the number of regulators (or create an umbrella scheme like Malaysia’s National Bond Market Committee), and make regulations simple, in line with international standards and functional to ongoing disclosure. Promote industry self-regulatory bodies. </li></ul><ul><li>Do not promote bank guarantees of corporate debt to underpin the market ( a la Korea), as it defies the purpose of risk discovery, and can exacerbate financial instability risks. </li></ul>
    20. 20. Some ‘Best Practices’ Drawn from Int’l Experience <ul><li>Bankruptcy law is of quintessential importance. </li></ul><ul><li>Technical issues regarding clearing, settlement, custodians, and repo are well understood; (and will authoritatively illustrated by other speakers today). </li></ul><ul><li>Avoid dubious tax distortions, where possible (e.g., capital gains tax on bond sales but tax exemption for derivatives (repos). </li></ul><ul><li>Last, but not least, consider introducing more flexibility in the exchange rate arrangement.... </li></ul>
    21. 21. Case Study no. 1: Singapore - Over-funding for Multiple Goals Singapore is US$ 120bn economy running large fiscal and external surpluses. The decision to develop Singapore Government Securities (SGS) market originally taken to provide a matching asset for the long-term liabilities of defined contribution system. Under the Government Securities Act, MAS undertakes issuance and management of SGS and is also responsible for the microstructure of the market. A Government Securities Fund collects all the proceeds and is charged with interest and expenses. Source: Monetary Authority of Singapore, Goldman Sachs.
    22. 22. Case Study no. 1: Singapore <ul><li>Particularly since 1998, the authorities have stepped up the efforts for the development of a liquid market for bond securities. SGS, now amounting to US$ 50bn (of which 20bn <1yr), are now included in JP Morgan’s, Lehman’s and Citigroup government bond indices. </li></ul><ul><li>An immediate advantage of the SGS issuance (and related repo) is the support offered to the conduct of monetary policy under a heavily managed exchange rate regime. The bulk (>70%) of SGS are held by financial intermediaries. </li></ul>
    23. 23. Case Study no. 1: Singapore <ul><li>A liquid benchmark curve has offered support to the SGD corporate bond market (and a fertile private banking business), which has developed alongside the deeper SGS space. </li></ul><ul><li>Companies are generally cash-rich, bank lending networks and equity capital markets are natural obstacles to the growth of the private market. </li></ul><ul><li>The stated objective of the authorities wish to expand the domestic asset base, and establish the island-state as a regional financial services hub (MAS’ FDD). </li></ul>
    24. 24. Case Study no. 1: Singapore <ul><li>In order to sustain S$ corporate issuance, the authorities have ‘encouraged’ GLCs to tap the bond market rather than opt for bank lending, and opened up the bond market to foreign investors (with an mandatory FX-swap constraint). </li></ul><ul><li>Since ’97, the stock of S$ corporate bonds with maturity trebled to around US$20bn. The maturity profile remains short 1-3yr (only US$8bn > 1yr), and more than half of new issuance is structured credit sold to domestics through SPVs. </li></ul>Source: Monetary Authority of Singapore.
    25. 25. Case Study no. 1: Singapore <ul><li>An on-shore non-S$ denominated market has been in place for longer, and is comparatively bigger. </li></ul><ul><li>Most of the issuance is shorter-dated, predominantly denominate in US$. Securities are mostly vanilla issued by nonfinancial corporations and privately placed to off-shore investors. </li></ul>Source: Monetary Authority of Singapore.
    26. 26. Case Study no. 2: Malaysia – Privates Take an (Islamic) Lead <ul><li>Malaysia is US$ 130bn economy (comparable to the UAE’s and Singapore’s), with a pegged exchange rate and a history of budget deficits of around 4-5% of GDP, feeding government bond supply. </li></ul><ul><li>The 1997 bank crisis and subsequent corporate restructuring was among the triggers for a rapid growth of private ringgit debt market, supported by the successful promotion of Islamic finance. </li></ul><ul><li>The stock of ringgitt nonfinancial corporate bonds now stands at around US$45bn, comparable in size to public sector debt. 95% of local currency corporate securities are >1yr (compared to 50% in Singapore). Another US$ 20bn is represented by securities issued by financial institutions, predominantly (70%) short-term. </li></ul>
    27. 27. Case Study no. 2: Malaysia – Privates Take an (Islamic) Lead <ul><li>Private sector issuance received a boost in 2000 thanks to the introduction of a disclosure-based regulatory framework (Security Commission’s Guidelines on the Offering of Private debt Securities), which has cut drastically the approval process for issuance. </li></ul><ul><li>A shelf-registration scheme has also been introduced, allowing eligible corporations to make multiple issues of securities within a 2-yr period with a one-time approval. </li></ul><ul><li>Guidelines such as those disciplining the offering of Asset-backed securities (2001) and Islamic securities (2004) have also facilitated registration and issuance process. The latter has freed issuers from the legal concept of debentures (debt-based products). </li></ul>
    28. 28. Case Study no. 2: Malaysia – Privates Take an (Islamic) Lead <ul><li>All bond securities bond securities need to be rated by one of the two local rating agencies, but since 2000 the mandatory BBB minimum rating requirement has been lifted. </li></ul><ul><li>Currently the main nonfinancial issuers are construction, and utility companies, with the bulk of financing tenures 5- 10-yrs. </li></ul>Source: Bank Negara Malaysia.
    29. 29. Case Study no. 2: Malaysia <ul><li>First introduced in 1990, the Islamic market has boomed since 2000, representing half of total gross issuance. </li></ul><ul><li>Regulations (and tax breaks) in 2004 have facilitated the issuance of securities via the principles of ‘profit-sharing’, and leasing of specific assets. </li></ul><ul><li>The government has been second-mover issuing bills and Investment Issues, creating a benchmark yield curve. Both the IFC and the IBRD have both issues in Islamic securities. </li></ul>Source: Bank Negara Malaysia.
    30. 30. A Tale of Two Domestic Markets Singapore Malaysia Source: Bank for International Settlements.
    31. 31. How Would a UAE Yield Curve (Tentatively) Look Like Today? <ul><li>Using pooled regression techniques, we can estimate a hypothetical UAE government yield curve based on the country’s fundamentals. </li></ul><ul><li>Sample – 1998 to 2005 (8X4 annual obs on the time-space domain) </li></ul><ul><li>Countries – Malaysia, Singapore, Indonesia, and Saudi Arabia (surplus economies with heavily managed currencies) </li></ul><ul><li>Government bond yields (2-yr, -5yr, 7-yr, 10-yr) as functions of the following economic fundamentals: </li></ul><ul><li>Real GDP growth (UAE: 5.6%) </li></ul><ul><li>Trailing CPI Inflation (6.0%) </li></ul><ul><li>3-months interest rates (4.0%) </li></ul><ul><li>Moody’s rating for long term local debt (assumed to be A1) </li></ul><ul><li>Yield on corresponding US Treasury bonds </li></ul>
    32. 32. A 75-125bp Positive Spread to the US Source: Central Bank of UAE, International Monetary Fund, Goldman Sachs calculations.
    33. 33. What Would the Costs to the Government Be? <ul><li>The ‘direct’ costs of over-funding are estimated to be in the region of US$ 280 mil per annum (or 0.2% of GDP). The main factor contributing the higher funding costs relative to neighbouring countries is inflation. </li></ul><ul><li>Under the following assumptions: </li></ul><ul><li>Costs given by: Σ i(Ri,UAE - Ri,US)*Vi </li></ul><ul><li>Target outstanding stock of US$ 25bn, proportional to Bahrein’s </li></ul><ul><li>Issuance volume evenly spread across 2-, 5-, 7-, 10-yr maturities </li></ul><ul><li>The cost of maintaining a yield curve is pro-cyclical. </li></ul>
    34. 34. Conclusions <ul><li>Issuance of government securities will facilitate the conduct of monetary policy like in Bahrain, and Singapore, and at the same time set the foundation for the development of a broader private sector market, catering to individuals, public-sector sponsored retirement and insurance schemes, allowing the UAE to take a leading role in the region ahead of the prospected monetary union. </li></ul><ul><li>A dirham corporate bond market needs to be supported by international best practices. A functioning price formation mechanism rather than capitalization should be the primary valuation metric. Size is necessary but not sufficient. </li></ul>
    35. 35. Outstanding Issues <ul><li>Realistically, banks, construction and energy companies will be the first to tap into the domestic savings pool. Islamic finance could represent a viable opportunity, but regulations (and bankruptcy rules) need to be spelled out clearly when ‘times are good’. ‘Shari’a risk’ should be minimized. </li></ul><ul><li>Mopping up of liquidity will be instrumental in bringing inflation down. That said, like elsewhere in the region, statistics on domestic prices need to be improved –they are key to functioning bond markets, as investors settle for a nominal claim. </li></ul>
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