The risk of an economic fallout from the US subprime housing crisis has decreased following the recent 0.5 percent cut in US Federal Funds rates, nevertheless its impact on the world financial market will continue to unravel in the weeks and months ahead. Historically, widening credit spreads are followed by rising corporate defaults and volatile movements in debt and equity market.
The loss of trust and a fear from the unknown or uncertain losses at financial institutions and their counterparties (e.g. hedge funds) is compounding the problem. No one has a clear assessment of the size of the questionable assets, and nobody knows where the risks are. Investment banks have aggressively reduced their underwriting of new debt issues to cover their own anticipated and unanticipated funding needs. Early estimates put subprime losses at $250 billion, which is a relatively small figure compared to the value of residential real estate in the US of $21 trillion, total assets of banks worldwide of $ 64 trillion, world GDP of $45 trillion, world stock market capitalization of $42 trillion ($23 trillion in the US), and an annual mortgage business of $3 trillion.
The stock markets of the Middle East, dominated mainly by retail investors, have traditionally shown low levels of correlation with global markets and as such they are not expected to be directly affected by the crisis in any major way. Investors from the region, mainly banks, institutions and high net worth individuals, who have long positions in the global markets will incur losses on their exposure to the collateralized debt obligations, hedge funds and leverage buyout activities.
While banks from the region face little or no risk from the subprime crisis, some private equity firms operating in this part of the world will be affected, albeit in a limited way. The vast majority of Arab banks have insignificant exposure to the US subprime instruments and the risk for those holding subprime related assets is manageable. According to a recent survey by Standard & Poor’s, the aggregate exposure of Middle Eastern banks to the US subprime instruments in less than 1 percent of their total assets, with the bulk of exposure concentrated in structured products of high investment grade. The financial profiles of banks in the region is quite strong, with good asset quality, robust capitalization and high profitability and they can easily cope with whatever losses they may have incurred in this respect.
Another negative impact of the current crisis is the delay and/or the repricing of new debt issues coming from the region. For example, new Sukuk may have to be priced slightly higher to reflect rising debt market volatility and the slight drop in investors’ demand for these products both globally and in the region. Credit market spreads that reached very low levels before the crisis are likely to widen, both in the region and for emerging markets as a whole.
Private equity firms operating in the region are less dependent on leverage finance compared with those in the West. For the few large ones who are able to acquire 70 percent or 80 percent leverage, new deals are suddenly costlier to finance and harder to do. The widespread de-leveraging that is taking place at the global scene will undoubtedly impact Middle Eastern markets as well. The credit risk aversion we are witnessing has made banks more selective in financing leverage buyouts activities at a time when investors’ appetite for risk has been on the decline. Some transactions relying on extremely favorable financing schemes from the local and regional debt markets may have to be repriced or canceled, others based on sound fundamentals are likely to be financed more from companies’ cash flows and to a lesser extent from bridge finance provided by the banks. Shariah-compliant financing schemes supporting private equity firms in their future acquisitions will be the next big thing in the region.
The debt markets worldwide and in the region will be affected more than the stock markets. Nevertheless, the volatility in global markets appear to have touched some of the region’s stock markets as well. This is mainly due to the recent flows of international institutional portfolios into the Middle Eastern markets. While still small relative to total trading volumes, nevertheless these flows have managed recently to provide the general directions to these equity markets. It is true that Saudi Arabia, which is the largest stock market in the region in terms of capitalization, is still closed to direct foreign portfolio investment, nevertheless, others such as UAE, Kuwait, Egypt, Qatar and Jordan have been witnessing increasingly more foreign investor coming to their markets.
A number of hedge funds that have recently become active in the Middle Eastern markets have started to sell some of their holdings to improve their overall cash positions. Another layer of support for the domestic markets is being removed as less leverage buyout activities targeting companies listed on the region’s stock exchanges is likely to materialize in the months ahead. The sliver lining here is that greater difficulties in the financing of leverage buyouts could encourage companies to switch their energies to growing their businesses organically.
The recent pull back by global institutional investors from the region’s stock and debt markets should not be seen as structural or of a long term nature. The strong economic fundamentals of the region and the dynamics of the markets provide a buying opportunity for investors looking for high growth companies at relatively inexpensive valuations.
The biggest risk to the region is the prospect of a major slowdown in world economic growth. Falling housing and other asset prices in the US, coupled with credit squeeze will undoubtedly have an impact on the highly indebted American consumer. A crisis in credit card finance could follow together with rising corporate defaults. Slower growth in the US would put downward pressure on oil prices. With most of the region’s currencies pegged to the dollar, monetary authorities here would have to follow the US lead and lower domestic interest rates to protect their currencies from market speculation. This will increase credit expansion and add to rising inflationary pressures. The weaker exchange rates of the dollar and the currencies of the region will further boost imported inflation.
To conclude, the current turmoil in the US subprime mortgage market is likely to have only a limited effect on the equity and debt market of the Middle East region. Its impact will be more visible if world economic growth is to decline. Nevertheless, even if oil prices drop from their current high levels to the $60 a barrel level, economic conditions in the Gulf countries, that act as the economic engine for the region as a whole, will remain strong supported by huge investments in infrastructure and a confident private sector positioning itself for growth and expansion.
There is still a good chance that the dynamics of post stock market crash of 1987 will reassert themselves, with central banks cutting interest rates fast if conditions deteriorate. This would help market participants to regain confidence. History shows that panicky conditions end when information improves. Markets would stabilize when banks, hedge funds and other institutional investors start disclosing more about their holdings of questionable assets by the end of the third quarter.
The stock market crash of 1987 has shown that when financial markets suffer a loss of trust and over-reacts to a crisis, it provides good buying opportunities for savvy investors looking to acquire undervalued assets. With less aggressive competition from leverage buyout firms and given the sizable surpluses that the region’s sovereign state funds and other institutional investors have, we would expect them to step up their acquisitions of companies struggling to raise cash. (Henry T. Azzam is CEO Middle East & North Africa, Deutsche Bank.)
