Navigating the Middle East credit storm
01 June 2016
The Saudi-led OPEC strategy to usher in an era of cheap oil was always expected to put the squeeze on new US shale drillers. What was perhaps less expected was the degree to which the pain would also be felt in the financial markets of the Middle East.
As the commodity bust collided with a reversal of liquidity it has effectively created a “perfect storm” in the desert. This has been particularly painful at the riskier end of the credit spectrum such as with thinly traded secondary loans and Islamic instruments.
Many funds and institutions now struggle to find a reason to be in a region without the prop of lucrative black gold. Yet for those willing to persevere, there should still be opportunities amid this dislocation.
In theory, the wealthy Arab oil producers are best placed to ride out the discomfort from lower crude prices, yet it has led to some jarring adjustments and a shakeout in the liquidity landscape.
Inevitably the collateral behind many loans looks a lot less reassuring.
According to a recent report from HSBC, Arab Gulf Cooperation states may struggle to refinance US$94bn of debt in the next two years.
Lower oil revenues have also led Middle East sovereign wealth funds to pull back tens of billions of dollars from money managers as governments’ sought to plug gaps in budgets. Both actual redemptions and the threat of redemptions have had a crippling effect, as large global funds retrenched to their core – and more liquid markets – and left non-core markets, such as the Middle East.
Illiquid credits have been particularly exposed due to a technical imbalance as international funds went from being net buyers to net sellers. This has led to prices weakening even without changes in underlying credit quality.
At the same time, other credits have faced the double whammy of fundamentals also deteriorating. As well as cases of impaired assets, cashflows have been under pressure from lengthening working capital cycles as both governments and corporates went into cash preservation mode.
The shift in the liquidity landscape was further underlined by the return of the Saudi government to the debt market after a 25-year absence. Last month it raised US$10bn via the loan market as it sought to shore up dwindling oil revenues and reserves. As IFR has reported, Saudi also plans to issue a US dollar bond, possibly to raise as much as US$15bn.
While this along with sovereign wealth fund redemptions is not dramatic in itself, it is again the secondary impact that is critical. The market must now adjust to Saudi moving from being a creditor to a debtor nation.
Here, the effect has been for the government to “crowd out” liquidity that might otherwise have gone into corporate markets as it issues both local and foreign currency debt.
This highlights a related problem for the Middle East: it is no-one’s core market, given the absence of locally based distressed credit funds.
While there are designated Asian funds and funds setup for Europe, the Middle East is somewhat stranded. It has always been reliant on global funds with an appetite for something more esoteric in the desert. Now it is struggling to find an argument for relative value, when the offering is illiquid paper in a far-flung timezone.
Furthermore, aside from these technicals impacting liquidity, the fundamental picture remains unhelpful. Lower oil prices have not just hammered government finances but have also sent a chill across the local economy.
Much like during the global financial crisis, there has been a resurgence in “skips” where business owners quietly leave the country to avoid defaulting on loans. Some estimates put resulting losses among UAE banks at more than US$1bn dollars last year.
Given this prevailing climate it is unsurprising that local institutions are not inclined to dip into secondary loans or the riskier end of the illiquid credit market.
This has contributed to a brutal trading environment for secondary loans, bonds and Islamic instruments. For example, the recent extreme volatility in the price of the loans of Dubai World is more driven by technical or liquidity factors, rather than any change in the underlying credit quality. It also makes price discovery more challenging.
Nonetheless, we remain convinced that for institutions willing to do the necessary homework, there are likely be attractive opportunities emerging.
The challenge currently is that there are few secondary liquidity providers active to enable institutions that take a view to trade.
A wise perspective is to assess the opportunity and associated risk first when deploying capital and not the location. It is important not just to have strong fundamental research but the relationships on the ground that ensure reliable and consistent pricing. This way one can create a bridge to a market where too many have simply been checking out.
– David Beckett has over 15 years’ experience within the restructuring and corporate finance markets. He has led SC Lowy’s sourcing capabilities since inception in 2009 and is now based in London