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Bonds key to Gulf growth

An active sovereign bond market will strengthen Gulf monetary policy tools. (RABIH MOGHRABI) 

By Sean Davidson

The key to growth and expansion in the Gulf is major economic reforms, leading analysts told Emirates Business.

And a need for change is highlighted by the fact GCC central banks do not have significant holdings of government bonds – which means there is no monetisation and no open market operations.

"We need to build a new infrastructure that creates an integrated market for local currency government bonds where the central, local and foreign banks, individuals and other institutional investors can participate," said Dubai-based economist Armen Papazian.

"In parallel with the creation of such a market monetary policy must be redesigned to cope with a managed floating exchange rate and a domestic currency issuance process that is no longer backed by foreign currency but by local government bonds.

"While the US and the UK issue currency against local government bonds – an internal value-creation process – GCC central banks issue local currency against foreign currency, with the value derived from an external benchmark. This is most clearly revealed by the absence of government debt holdings in the asset side of GCC central banks' balance sheets."

The UAE government, for example, has mooted plans to issue both conventional bonds and sukuk in the near future.

"The UAE will sell its first bonds to develop the tools for monetary policy. The nation plans to sell conventional and Islamic securities with maturities of up to 30 years," the Central Bank Governor Sultan Bin Nasser Al Suwaidi announced more than 12 months ago. Subsequent reports indicated that this would not happen before 2010.

However, Dr Mahdi Mattar, Head of Research and Chief Economist at Shuaa Capital, said the creation of a bond market three years ago would have helped to absorb the local impact of the current global financial crisis.

"Having an active sovereign bond market would give the fixed income universe a benchmark yield curve to act as a reference for interest rates and the pricing of securities," he said.

Fahmi Alghussein, Executive Director of Morgan Stanley, said a government-backed bond market would give the UAE Central Bank an additional policy tool to conduct open market operations like those in more developed economies.

"It would help to develop a sovereign yield curve that would serve as a benchmark for the pricing of corporate domestic debt," he said. "It would also give the government a way to finance any potential fiscal expansion that may be needed in response to the current crisis."

Dr Mattar said the government should create a clear framework for issuing and trading in these securities.

"A clear issuing mechanism should be adopted, with full transparency on the qualified broker or dealers, timing and frequency of issuance, and – most important – pricing," he said.

And Alghussein said the government should establish a framework to regulate the issuance, listing and trading of these securities in primary and secondary markets.

Cambridge scholar Papazian chalked out a model for a new economic architecture for the UAE. The structure would allow federal and local governments to borrow in dirhams to cover their dirham expenditure, while all foreign currency earnings could be invested in foreign assets. In parallel, the Central Bank would support the issuing of currency with government bonds, buying and selling them to monetise or extract liquidity as necessary.

"Reforming local architecture can be an invigorating project for the financial sector," he said. "Indeed, reforms could help to ensure that uncertainty and panic – imported or otherwise – do not stall or derail the region's dynamic transformation and growth momentum.

"Indeed an integrated GCC government bond market could be the right step towards monetary union. Alternatively, if bonds are out of favour it is still possible to find new innovative solutions that can provide central banks with appropriate monetisation power.

"Whether individually or as a union, the GCC states need to ensure that domestic monetary empowerment is a strategic priority. After all, where do bailouts come from?"

The analysts said that though public debt instruments were issued by governments and government-owned entities in dollars and local currencies, central bank participation did not seem to be on the agenda.

Papazian said: "The current structure limits the central banks' discretionary policy-making capacity. In other words while the dollar peg is maintained and interest rates here are determined by the Federal Reserve and domestic currency issuance is backed by foreign currency and while the central banks do not engage in open market operations, the central banks' toolkit is limited to controls over domestic credit."

While gross domestic product sector distributions have changed and diversification has increasingly become a top priority, government earnings are still predominantly derived from oil and gas and are denominated in US dollars.

This feature is reinforced by the tax-free environment where governments do not earn as much local currency as they would if they taxed individuals and businesses.

As a result, the cash flows of GCC governments are skewed towards the US dollar. Although fees and other forms of government duties have grown over the years they still form only a small chunk of government revenues.

One of the reasons the government had been unable to restructure its architecture to create a bond market was because the existing markets for such securities was not deep.

Mattar said: "Given the current financial conditions – the lack of liquidity in the banking system – it would be more challenging to jump-start the bond market now. However, it would not be impossible.

"Today, the government would have to initially attract investors by increasing yields."