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UAE must tap local currency bond market

Dr Allen Baby/Dubai
Filed on July 30, 2016 | Last updated on July 30, 2016 at 05.50 pm
UAE must tap local currency bond market
Bond issuances in the UAE in USD are influenced by global investor sentiment. Foreign investor appetite for UAE bonds can dry up if there are challenging macro-economic conditions.

(KT file)

Contribution of equity and Islamic sukuk to capital market stand at 12% and 3%

The contribution of equity and bond funding in the UAE has been relatively low as the capital markets are still in their evolving stages. Almost 85 per cent of the total infrastructure and other iconic projects have been financed by banks, while the contribution of equity and conventional bond funding or Islamic sukuk stand at 12 per cent and three per cent respectively, according to the IMF Global Financial Stability Report (2016). What's needed is a further deepening of the bond markets.

Currently, the UAE's evolving bond market mostly comprises bond and sukuk issuances by some emirates, in most cases Dubai and Abu Dhabi, public sector companies, government-related entities, banks and the private sector. However, bulk of these borrowings is still denominated in US dollars (USD).

The advantages of issuing USD denominated bonds for UAE entities are as follows: No currency risk as the UAE dirham (AED) is pegged against the US dollar; low interest rate regime in the US lowers borrowing cost; issuances in USD also create the much-needed liquidity in bond markets. Also, as a large segment of investors are foreign entities, they prefer issuances which are in USD.

Despite the advantages of borrowing in a foreign currency, there exist seven compelling reasons for the country to develop local currency bond markets (LCBM).

Strengthening monetary policy

The UAE Central Bank's ability to control monetary policy is constrained by its peg to the US dollar. Hence, interest rates in the US and in the UAE cannot vary much. If they do, investors will get arbitrage opportunities of borrowing in one country and investing in the other. This raises significant challenges before the UAE Central Bank in conducting its monetary policy independently of the US. For example, when the US Fed raised interest rates last December, the UAE could not afford to have high interest rates amid a slowdown in the economy due to low oil prices. An active local currency bond market will be a tool which will help the Central Bank to conduct monetary policy functions and liquidity management.

Avoid dollarisation of liabilities

If borrowings are made in the foreign currency, it leads to a dollarisation of the liabilities. This implies that the issuing country has no control over the currency in which the liabilities are raised. In the event of any external macro-economic shocks, the volatile capital flows could dry up and the USD reserves could fall drastically. Any future possibility of de-pegging the currency can raise additional challenges for these debts issued in USD as the value of debt in AED terms could zoom up, in case there is a major currency depreciation accompanying it.

Avoid dependence on global investors

Bond issuances in the UAE in USD are highly influenced by global investor sentiment. Foreign investor appetite for UAE bonds can dry up if there is a challenging macro-economic condition in their countries or if there are other better investment opportunities. This can become a major challenge for companies based in the UAE in difficult times.

Reduce reliance on bank finance

The major source of finance for companies in the UAE are from the 50-plus banks operating in the country. This also results in the concentration of bank assets in certain sectors such as real estate due to its importance in the economy. In most advanced economies, bank finance is not the most important source of debt for companies. Companies approach debt markets, equity markets, etc., for long-term fund raising.

Boost to insurance, pension fund sectors

The presence of a local currency bond market can offer a significant boost to the insurance and pension fund industry in the UAE. These industries, which are a key component of any developed economy, desperately need long-term investment options due to the nature of their business. Currently, for example, the life insurance market is underdeveloped in the UAE because of the absence of long-term investment options for insurance companies.

Effective implementation of Basel III norms

Effective implementation of Basel III norms also hinges on the presence of a local currency bond market. Basel III norms specify high levels of liquid assets to help banks withstand risks arising out of sudden liquidity shortages. Currently, as government bond issuances are less significant in the UAE, banks are forced to invest in bonds of corporates or foreign bonds. The liquidity and quality of these investments can undergo major challenges such as during the economic downturn in 2009.

Yield curve development

The absence of an active AED-based bond market results in the absence of a yield curve for different maturities. This poses a major challenge before banks as how to price long-term loan offerings. It has to be noted that the USD yield curve cannot be considered as a proxy for the AED yield curve due to major differences in economic factors of the US and the UAE.

The writer is a lecturer at the Emirates Institute for Banking & Financial Studies, Sharjah. Views expressed are his own and do not reflect the newspaper's policies.





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