UAE's Bond Market: Friend or Foe!

A professional perspective for governmental approach

by Aiman Sadeq, CPA, Financial Economist, Partner
September 2009

The UAE federal government is entering into a new era of monetary policies by issuing sovereign bonds that have never been experienced before. This 1st issue of Meirc’s Monthly Financial Economics Series will attempt to explain the challenges ahead.

UAE’s Bond Market: Friend or Foe

In just a few months, financial markets in the UAE will enter into unchartered financial territories. History will be made as the UAE prepares to establish a local Bond market. What does this really mean, from the Financial, Social, Career and Educational points of view? We will attempt to explain the Good and the Bad of this endeavor.

Traditionally, Bond markets have been an excellent and convenient venue to raise capital for public and private sectors. Given that, issuing bonds by corporations has amounted to trillions of dollars in western capital markets and has competed with the equities and stock markets for almost a century. Governments, too, have taken advantage of this important financing tool for several decades. For example, the US government has financed its annual deficits by issuing bonds since the 1920’s, but this really started to skyrocket beginning in the 1970’s. The current US deficit amounts to more than $11 trillion and increases by almost $4 billion every day!

In the UAE, companies started issuing corporate bonds several years ago. Many publically-traded corporations have joined the same strategy and used bonds to finance their investment and growth. However, due the fact that the UAE is an oil-rich country, there was no need to finance monetary and fiscal expansionary policies by issuing bonds. The UAE had always enjoyed a budget surplus since its inception.

The situation has changed somewhat. The UAE finance ministry announced that it will start issuing sovereign bonds to finance the country’s fiscal expansion policies; i.e. infrastructure, healthcare, and education. The UAE feels that it is time to enter the capital markets; is this good or bad? Well, keep reading!

The fundamental principles underpinning a successful issuance of bonds is the creditworthiness of the issuer, the UAE federal government in this situation, and the risk the creditor is willing to take. As with any corporations requiring funding capital or operating projects, a rating must be established to create some comfort zone for the creditors that their money will be returned by the corporation and that they will be compensated on a regular and timely basis for the use of their funds by the borrower; this is called Credit Rating. As with corporations, governments are also required to establish sovereign credit ratings so that creditors can also be assured. The UAE federal government is currently in the process of selecting the rating company.

Should the UAE federal government establish a local bond market (and it probably will), challenges will arise from the ashes and start kicking in. These challenges are possible positives and negatives, but I will focus on the possible positives and then will look at potential risks of entering into a bond market.

First, let me give you a brief description of Bonds (skip to the next paragraph if you already know this!). Bonds are legal documents called indentures where two, or more, parties CREDITOR(S) (lender(s)) and ISSUER (borrower) enter into an agreement whereby the issuer receives financing from the creditor and promises to pay back the creditor in annual or semi-annual payments a specific cash flow for a specified period of time; then at the end of the contractual agreement, the borrower returns the borrowed funds to the creditor. Think of this as your monthly salary. You provide service to your employer, receive salary, spend more than you actually receive, what do you do? You tap into your credit card, right? Then you promise to pay back the amount borrowed and some interest back to the credit card company. The Bond agreement specifies the rate of return, term of the issue, periodic interest payment, convertibility to equity shares, guarantees, and other special requirements stipulated by the creditor and/or the issuer.

Bonds are typically used by governments and corporations to finance what is termed in economics, Fiscal Deficit. Fiscal Deficit simply means that the amount of cash received by the government from selling goods and services to the general public, selling oil, selling tourism, selling trade, …etc. is less than the amount spent maintaining these activities, paying for salaries of government employees, paying for investment activities in the country such as infrastructure, health care, education, employment, and retirement benefits, to name a few. Governments in this situation require funds to cover this deficit. Hence, they tap into credit cards. In this situation, governments issue what is called a Sovereign Bond to finance their deficit, sell to creditors, and receive funds. The government does this process by involving many parties: finance ministry, treasury department, budget office, central bank, commercial banks, internal and external investors, and financial capital and stock markets. This is really what the bond market is all about.

The real consequences of this Bond strategy (call it implications, challenges, benefits, or advantages) are many. I see the situation shaping up as follows:

THE GOOD

FINANCIAL & MONETARY

Clearly, the government will be able to access funds from cash surplus entities, such as local and international banks, international governments, and financial and equity markets, locally and internationally. This will allow a more dynamic flow of funds in the economy especially if the bonds are floated and traded in the local markets. All participants in the equity markets will take advantage of the availability of one more source of financing in the market. Market participants, especially corporations, can buy and sell the traded government bonds in the local market depending on their cash positions and expectation of cash needs in the future.

Banks will have a larger role to play in managing these transactions as banks will start to move to becoming dealers on government bonds, not only brokers. In this situation banks will work smarter in making investment decisions, and will have to compete more for that extra dirham.

SOCIAL

You probably never thought of that! As Governments start borrowing from others to fund fiscal agendas, we all pay a price for that development. Governments utilize these funds to pay for projects done at the local level in infrastructure, education, healthcare, etc. These services are used and enjoyed by you. But also they come at a certain cost and therefore you need to pitch in and start covering or subsidizing them. In developed economies this translates to a very famous but disliked word…TAXES!!! You got it; the social structure of our economies will change, not necessarily negatively, but rather positively. People in the local economy will start to make decisions on what they really need, how much of it, and how often. Everyone will need to start being more efficient. “More is better” no more!

CAREER and EDUCATIONAL

Building on the above, you would certainly have realized that a whole new market has just opened up for you. I mean career and educational markets. Recall the market participants mentioned earlier; commercial banks, government entities, financial markets, and corporate sector. All will start requiring and hiring professionals in the field of Bonds (also known as Fixed Income Securities - FIS). The job market will be hungry for professionals with expertise, knowledge and training in Fixed Income Securities, in the following fields:

a) Corporate Financial Analysts
b) Accountants
c) Dealers, Brokers, and Traders
d) Investment Professionals
e) Portfolio Professionals
f) Budget Officers in Government Organizations and Governmental Entities
g) Monetary and Fiscal Specialists at the Central Bank
h) Corporate Valuation Specialists
i) Cash and Treasury Professional
j) Money Market Professionals
k) Lawyers

THE POTENTIAL BAD

Banks are not the only lender in the market, anymore. Market participants can now borrow and redeem bonds at a lower transaction cost. Thus banks need to become leaner and more efficient.

The issue of professional development is extremely important for governmental employees, senior staff, budget officers, analysts, and any professionals involved in analyzing, issuing, managing, investing, contracting, trading, and governing business transactions related to Bonds or Fixed Income Securities.

Once governments start issuing sovereign bonds, monetary policy becomes the twin-side or the twin-face to bonds. Once the government issues and sells bonds in the local economy, the amount of currency in the local economy will decrease. This can have a negative impact on the economy if the economy is trying to expand. The reverse is true; should the government buy bonds and pump more currency in the local economy, this also might have a negative impact if the economy is expanding at a higher rate than expected because this will lead to inflation or hyper-inflation. These are real and serious results that will happen should the governing bodies lack professional, educational, and practical experience in the Bond markets.

Negative impacts of not well preparing for a Bond market have a serious effect on the economy and must be carefully analyzed.

CONCLUSION

All being said, it is important to believe that the local Bond market will certainly change our financial lifestyles. Drawing from lessons learned in the current financial crisis worldwide, in which the Bond market played a major role, whether the Bond Market becomes a Friend or a Foe really depends on the Government’s understanding the challenges mentioned in this analytical perspective and carefully planning, organizing resources, implementing, and controlling the financial, social, and educational implications of such major undertaking.