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Thu 9 Aug 2007 07:00 AM

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Prime concerns

The impact of volatile global credit markets has hit the Middle East, so how has the Gulf been affected?

As the Gulf's summer heat reaches boiling point a chill has swept across global financial markets. Just how far will the malaise spread and how far will it impact markets in the Middle East?

Vulnerabilities in the US sub-prime mortgage market have triggered nervousness among investors. This has resulted in a sharp downturn in the performance of the world's financial markets since mid-July. Nowhere is this more apparent than in the global credit market. And the impact is now being felt here in the Gulf.

Any turmoil in the US markets, unless it affects the real economy, is unlikely to spread contagion in the Middle East.

According to Raj Madha, senior research analyst at regional investment bank EFG-Hermes, these are "tougher times for the credit market in which raising significant amounts of credit has become more difficult".

A partner at a UAE-based private equity house says that he detects a feeling in the market that bankers are more cautious. "People are now asking themselves whether they are pricing risk correctly" he tells Arabian Business.

In July alone no less than three major companies in the region have been forced to postpone plans to release bonds as the consequences of a surge in defaults on sub-prime mortgages in the US ripple across the globe.

UAE-based Dana Gas, Abu Dhabi-based First Gulf Bank and Bahrain's Ithmaar Bank have all experienced delays with their bond plans. Also in July, Barclays Capital postponed a US$937m bank loan to DAE Aviation Holdings, a US subsidiary of Dubai Aerospace Enterprises.

On July 27, Hamid Dhiya Jafar, Dana Gas' executive chairman, stated: "In the light of the extreme weakness currently being experienced in the global credit markets, Dana Gas has been advised by Barclays Capital and Citi to postpone the pricing of its equity-linked Sukuk offering until September."

Keeping things in perspective analysts at EFG-Hermes note that the current climate represents what is in fact a modest sell-off in global markets by historical standards. However, emerging markets are feeling the consequences.

Of those in the Middle East and North Africa, the Gulf may be particularly exposed as a result of higher levels of foreign investment in the area. Attracted by the stability of the GCC, institutional investors are more active here than elsewhere in the Middle East. According to EFG-Hermes, anecdotal evidence suggests that western institutional investment in the UAE market tops that among Gulf nations, with Qatar following.

Furthermore, private equity shops in the oil rich Gulf states are seeking investment opportunities at home and abroad. In the business of borrowing, should the current situation persist, they will find difficulty raising the huge amounts of capital required to complete takeover transactions.

In recent years high levels of liquidity in global markets have created a buoyant environment in the world's banking sector. This has seen banks with large funds seeking opportunities to place money where healthy returns can be made.

Significantly, these opportunities included financing the debt behind complex and often heavily leveraged M&As.
The result has been the creation of a borrower-friendly market. One in which, according to a senior analyst at a leading European investment bank, "Deals have been getting riskier and riskier as banks have tried to win business in a highly competitive bidding environment".

He adds, "There is no doubt that banks have realised that they have been in a sweet spot for the last few years with lots of liquidity around. Things were good."

Now banks are wary of underwriting debt to the same extent as only a few months ago. Recent events have been something of a "wake-up call."

Raj Madha agrees, noting that "the current situation has added challenges to those issuing debt."

Sub-prime mortgages are high-interest loans offered to borrowers with poor credit records. Bundled into pools these mortgages are securitised and the risky assets sold on.

Defaults on these homeowner loans have been rising since the second half of 2006 and the US housing market has slumped. Issuers have been forced to pay out for damages and portfolios have been left with losses on their books.

"As with so many other things in life the world's financial markets are fashion-led and one market event triggers another creating a ripple effect across a far wider area," explains a senior analyst at a leading European investment bank. The cascading reactions are symptomatic of the psychological impact that events in global finance can have. A contagion of risk adversity has spread among investors making borrowing more expensive and increasing pressure to incorporate better lender protections. This adds further complexity to the construction of lending mechanisms that are already quite opaque.

The summer was expected to render a rich yield for companies across the region exploiting the global appetite for Sukuks. Now major businesses have to wait before they are able to issue their bonds.

Short-term restrictions on business growth seems inevitable. On July 11, Abu Dhabi-based First Gulf Bank postponed the launch of its US$3.5bn Eurobond programme due to uncertainties in the market. Plans are on hold pending market improvement. Bahrain's Ithmaar Bank is also delaying its US$300m sale of Islamic bonds.

Dana Gas finance director, Neeraj Agarwal stated on July 27: "The Dana Gas investment opportunity was very well-received by investors in Europe, the Middle East and the Far East, with its unique identity as a listed company with a focus on the rapidly growing Middle East natural gas sector. However, in view of current extreme levels of volatility in the financial markets, and especially global credit markets, we were advised that it would be preferable to delay the Sukuk pricing to secure better terms and this would be in the best interest of our shareholders."

But it is not all bad news. While there have been delays these appear to have been caused by unfavourable market conditions rather than internal difficulties.

Madha draws attention to the fact that the recent delays to bond plans by Gulf companies may not necessarily be due to actual problems with financing debt.

"It is more a question of letting pricing considerations affect market timing. Credit markets may as well wait unless they have an urgent financial need before they issue bonds," Madha tells Arabian Business. "Certainly there would be little point in under-pricing bonds in the current situation when a few weeks delay may see short-term negative sentiment settle."
Although vulnerabilities in the sub-prime market should not necessarily affect other lending, many banks are heavily exposed and a number of hedge funds have taken losses.

The impact has been exacerbated by troubles faced by some high-profile firms and close media attention. Notably two hedge funds run by Wall Street giant Bear Stearns' asset management unit suffered significantly from bad bets on bonds linked to sub-prime mortgages. Both filed for bankruptcy protection on August 1. Bear Stearns is among the largest underwriter of securities associated with the falling US housing market. With investor confidence shattered, on August 6, Bear Stearns ousted co-president Warren Spector. In June this year, well before its troubles began, the company announced its intention to enter the Middle Eastern market with an asset management joint venture in Saudi Arabia.

Could the success of this venture be compromised by events in the US?

Analysts believe the impact of Bear Stearns' current situation in the US is unlikely to appreciably damage its interests in Saudi Arabia in the long-term.

The chance of Bear Stearns going bankrupt is remote, however, a continued and significant deterioration in the US and a loss of investor confidence will do the company no favours. The performance of the Bear Stearns' Saudi venture will be the one to watch.

Since April the value of stocks has rallied in the UAE. In broader terms the Gulf region continues to enjoy steady economic growth. The current situation is indicative of the interrelated nature of global markets and the power of the cascading consequences of events in one corner of the world. Yet in real terms the impact of the sub-prime lending crisis on markets in the Middle East is limited.

Madha concludes: "Any turmoil in US markets, unless it affects the real economy, is unlikely to spread significant contagion in the Middle East region."

The Gulf's bond market has experienced some minor setbacks, but activity in the Sukuk market has surged in the past 12 months. It is not only the world's Muslim population seeking innovative Sharia-compliant investments.

In the first half of 2007 the Sukuk market reached a high of US$24.5bn. Momentum may have slowed but global markets are resilient. It is only with a prolonged downturn that the economies of the Gulf will be seriously affected.

The partner we spoke to at a regional private equity house believes "overall things are going to ease." What we are witnessing is a "temporary period where people will revise what they have been doing," he adds.

Encouragingly, according to one senior investment bank analyst, although it is a "bleak time to be in the lending market we are witnessing more of a settling than a long-term downward trend."

After a stark wake-up call it is hoped that things will soon start to warm up again.

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