The paradigm shift associated with the high oil revenues and vastly increased liquidity has had its impact on the markets. Taking investment opportunities to a bankable stage is a challenge as the tenor of debt shifts from short-term securities, relatively expensive for issuers particularly banks, to longer maturities.
In the next decade, it has been calculated there will be over $1 trillion worth of investment opportunities in substantial projects in the Gulf region. The majority of these investments is in oil and gas, petrochemicals and infrastructure. Some of these investments are essential in overcoming structural imbalances that have emerged in the last two decades, while the remainder are designed to unleash the GCC members’ potential as emerging economies in the global markets.
It is notable that despite the high oil revenues that have accrued to Gulf countries since early 2003, there is still a significant funding gap. The average annual incremental increase in corporate loans within the GCC banking industry is around $7 billion, which is substantially below the annual average funding requirement of $38 billion needed just to finance the so-called mega projects. In addition, the maturity mismatch between short-term banking assets and long-term liabilities needed for energy-related and infrastructure projects represents a major obstacle to providing credit for such investments.
Increasingly, the Gulf governments are moving away from their traditional role as decision-maker, investor and producer of goods and services. The new trend in GCC public sector policies is to move toward privatization and economic reforms. The public-private partnership (PPP) is being used to allow the private sector, through long-term management contracts and operating concessions, to participate in public infrastructure projects designed to provide efficient services to the public. This financing method relies heavily on the availability of long-term securities in the capital market as a means of funding. It also needs strategic long-term planning, so that sustainable government revenue streams can repay such debt.
The present structural reforms in the GCC financial markets have produced ideal solutions to capitalize on such investment opportunities and maximize the use of the available financial resources to build up economic capacity. They will encourage the strong presence of institutional investors and investment banks, as well as the development of a capital market that covers both equity and debt. Without a healthy debt market, there would be no mergers and acquisitions activity or private equity activity to support such project financings and turn them into world-class assets.
The latest developments in Islamic banking securities have attractive liquidity and risk compared to conventional bonds. In the past, while Islamic equity funds became popular with investors who had a risk appetite for equity investment in long-term projects, institutional investors, driven by the nature of their intermediation, kept demanding asset-backed securities, known as sukuk, which could behave like conventional fixed-income debt securities but also comply with Shariah.
The issuance of globally-accepted sovereign Islamic sukuk with returns driven by the performance of real assets and noninterest-bearing financial assets has had a positive impact on reducing the risk of such instruments.
The financial evaluation of a privatized infrastructure project is complex and challenging because of the risks and uncertainties due to the large size, the long contract duration, nonrecourse financing and multiple project participants, all with different motives and interests. There is also the complexity of the contractual arrangements. Improved financial engineering techniques lower the cost of funding, increase the profitability margins for energy sector ventures and make infrastructure projects bankable. Water, power and public transportation projects usually have thin profit margins.
Moreover, in order for the debt market to be robust and healthy, it has to have the credibility that comes with debt ratings from major rating agencies. The assets backing sukuk enhance the confidence and reliance on such securities by mitigating risk factors. The lower cost of capital also means that such assets may obtain a better rating than the home country. The international experience of various fund returns demonstrates that the variance decomposition of investment gains (exceptional rewards) are sector-based, not country-based. In other words even though the GCC states are developing countries, this does not prevent them from having world class assets with high returns and top ratings.
On the other hand, international lending is very expensive, charging higher prices to the Gulf region. The previous dependence on international loans in financing development projects meant a significant higher funding cost and, therefore, eliminated private sector involvement. Under BASEL II banking regulations, international financial institutions based in advanced economies are obliged to use a notably higher cushion for their capital when lending to a project in a developing country. In addition to the long duration of such debt and regulatory or political risk premiums, this drives up pricing for infrastructure project funding in the Gulf region when provided by such international institutions.
Thus rating debt securities such as sukuk and listing them internationally will attract top class institutional investors and put Gulf projects on the global map. Moreover, the issuance of sukuk requires a company to create a special purpose vehicle (another company) for each project. This is set up to acquire assets and to issue financial claims based on the credit worthiness of the project. Such financial claims are calculated on the proportionate beneficial ownership for a defined period, at the end of which the yield, based on the risk-return formula associated with cash flows generated by an underlying asset, is passed to sukuk investors. This enhances the investment and borrowing culture. It also enlarges the funding capacity for projects, without depending on the mother companies’ balance sheets. Hence the professionalism of a company in delivering a project, rather than the size of its balance sheet and its corporate relationships, determines its borrowing capacity and will also reflect positively on investment returns.
Furthermore, developing the optimal financial structure based on international standards gives these GCC investments a better means of attracting foreign funds. The alternative, attracting foreign direct investments (FDIs), always poses difficulties because investors have other lucrative opportunities in more advanced systems with well-structured financial markets. In other words, capital market developments in the Gulf now give competitive advantages to investing in the region, in comparison with opportunities in other emerging economies such as China and India. More importantly, they will encourage domestic capital now abroad to participate in the development of regional markets. This will reduce the capital flight of previous oil booms, which sought better returns in the international markets.
Despite the rapid growth and innovation in sukuk issuance, Islamic debt is still very much in its infancy to meet the accelerating demand for such tools. The majority of issued sukuks in the Gulf region have been kept on bank books and not traded in the markets. However, the issuing of sukuk continues to expand into the non-Muslim world. In Germany, the state government of Saxony-Anhalt has funded projects through the issuance of a 100 million euro sukuk. The Japanese International Bank recently announced it will issue sukuk for $300 million-$500 million to tap petrodollars before the end of the year. Both reflect the recognition by some major global economies of the sukuk’s unique characteristics which offer significant benefits when raising money in the international capital markets. Continuing expansion and creativity in sukuk issuance and other innovative financial products will overcome weaknesses in existing funding methods and enhance the financing of business opportunities in the Gulf and Islamic world. Furthermore, this could also provide the momentum to integrate the Islamic financial markets within the framework of the international financial system. On another front, it will boost wealth creation by finding new and innovative investment channels. This is most important, because oil income is increasingly unable to meet growing government expenditures.
Moreover, ethical investing by no means suppresses the economic and business objective of achieving targeted returns. Employing solid structures in financing business opportunities will build a strategic, long-maturity savings and investment culture, which will enable the Gulf region to realize its potential. Meanwhile, it will increase high value-added job creation, increase financial depth and enhance transparency and sustainability of the GCC economies.
(Dr. Nahed Taher is founder and chief executive officer of Gulf One Investment Bank.)