Seven Reasons Sovereigns Can And Should Issue Debt (Or Sukuk)
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The impact of lower oil prices on GCC budgets is much debated, but a fact that is ignored is the massive borrowing capacity most of these governments have. In addition to large sovereign wealth fund (SWF) reserves, most GCC governments enjoy very strong credit profiles and have under-utilized the capital markets. In this article, the terms "debt" and "borrowing" are used liberally, but can equally designate sukuk or more conventional bonds, as long as they achieve similar economic profiles for the issuer. Here are seven reasons why GCC governments should issue bonds.
1. HIGH CREDIT QUALITY OF MOST GCC SOVEREIGNS The UAE, Qatar and Kuwait are rated Aa2/AA, and Saudi Arabia is only one notch lower at Aa3/AA- according to Moody’s and S&P respectively.
2. GCC SOVEREIGN BONDS ARE CONSIDERED A “RARE CREDIT” Due to this, they would be welcome by international bond investors.
3. INTEREST RATES ARE AT HISTORIC LOWS At the end of January, the U.S. government bond 10-year yield (which acts as a reference for other sovereign bonds yields), was at 1.77%. It has since risen to 1.92% and this is still a very low cost of financing by historical standards.
4. INTEREST RATES ARE EXPECTED TO GO UP FROM CURRENT LEVELS Despite the latest comments by the U.S. Fed, which reduced expectations of imminent rate hikes, I still believe that dollar rates in the long run are more likely to go up than down from these levels.
5. GCC GOVERNMENTS CAN HELP DEVELOP THEIR OWN DEBT CAPITAL MARKETS BY SHOWING LEADERSHIP AND CREATING A “BENCHMARK YIELD CURVE” This is true now more than ever, particularly as GCC sovereigns reduce their budgets and a bigger burden of the economic development falls on the private sector.
6. SOVEREIGN BONDS ARE THE LEAST EXPENSIVE INSTRUMENT FOR FINANCING A BUDGET DEFICIT Talks of implementing a GCC-wide Value Added Tax (VAT) have reemerged, along with the associated controversy. Kuwait is talking of taxing local corporations. While tax is a normal way of funding a budget deficit, raising debt should be done as a priority over that measure, as it has a more limited and less direct impact on the local economy and consumers.
7. ISSUING IN USD WOULD GIVE GCC ECONOMIES FOREIGN CURRENCY RESERVES The U.S. dollar is further strengthening against all major global and emerging markets currencies creating additional pressure on GCC economies, particularly Dubai which is partially dependent on touristic revenues from visitors from countries such as the Eurozone, Russia and India which have seen their purchasing power reduced. Issuing in USD now, while the currency is strong, would provide the GCC economies with precious foreign currency reserves. These can be used to import equipment required for the infrastructure from countries such as Japan or Germany which have seen their currencies fall sharply in tandem with oil. By contrast, this debt can be repaid in the future at a time in the cycle where the USD (in which oil revenues are denominated) is trading at more favorable levels.
The aforementioned seven points address the reasons why the governments would benefit from such debt issuance, but they don’t tackle other basic questions about budgeting, debt and finance.
IS THERE A BUDGET DEFICIT TO BE FINANCED? Why not cut the budgets instead? Sovereigns have multiple ways of dealing with the lower oil price. These include reducing budgets in line with reduced revenues, maintaining budgets and drawing on reserves such as those in the SWF, increasing non-oil revenues by raising taxes or other government income such as government fees, and of course, raising debt! For governments with vast reserves and debt raising capacity, running a counter-cyclical budget has many benefits:
- Provide a boost to the economy at a time when oil and gas revenues are down and risk slowing down the entire economic growth
- Accelerate the pace of diversification away from oil revenues which is a key long-term objective of GCC governments
- Avoid any social discomfort, particularly in the current volatile geopolitical environment
WHAT ARE THE ALTERNATIVE FINANCING ROUTES? WHY SHOULD DEBT BE AT LEAST PART OF THE SOLUTION? As we have already seen with most GCC budgets, governments have, by and large, taken the right decision of maintaining the budgets. Sovereign spending in most of these countries is key for economic and social development and this is probably the correct strategy. With regards to financing the budget, drawing on the massive SWF reserves seems like a natural idea. What is the opportunity cost of drawing on the SWF reserves relative to issuing government bonds?
The answer to this is contained in the cost of the government bond or sukuk relative to the average return the SWF is generating. This is a tricky question as the cost of the debt issuance is more easy to measure and transparent to observe than the average return on SWF assets. However, one may argue that the average return on SWF assets should always be much higher than the government cost of funding. The logic here is that the SWF should be providing very long-term returns for the future generations, and such long-term investment objectives should attract much higher yields than investment grade government debt.
At the margin, if the opportunity cost was seen as financially limited, there is still an argument for issuing bonds, based on a strategy of risk sharing and diversification, as well as the intangible benefits of developing the capital markets and getting the credit story out with investors. Today more than ever, our region needs some positive stories making the international headlines, and successful capital markets transactions would be a welcome breath of good news.
ISN’T DEBT A BAD THING? IF NOT, WHEN DOES TOO MUCH DEBT START CAUSING PROBLEMS? Common sense dictates that debt is a viable part of the financing of a sovereign, particularly one who has access to strong alternative sources of funding, such as vast natural resources, and the ability to levy taxes. It’s also common sense that too much debt can be counter-productive. No sovereign (or corporate, or individual) should be “addicted” to debt or unable to control the increase in its debt levels and costs. So what is the right level of debt as part of a sovereign’s balance sheet? There is definitely no easy or “one-size-fits-all” answer. Calculating a sovereign’s optimal debt capacity would require an extensive analysis of the sovereign’s budget, revenue streams and projections.
As an example, the European Union (EU) has rules in place which call for a 3% budget deficit to GDP ratio limit, and a 60% total debt to GDP limit. While these are interesting purely as a reference, it is important to note that even the EU countries have criticized these rules over the years and tried to make them more flexible, including by varying them through the cycle.
However, and as a reference, the International Monetary Fund (IMF) reports the following values for the “General Government Gross Debt” ratio to GDP of some of the GCC nations:
- Qatar 34.3%
- UAE 17.1%
- Kuwait 6.1%
- KSA 2.7%
This short list is a good reminder of the diversity we see within the GCC countries on many levels, and in this case in regards to the levels of government borrowing. In any case, it’s also a reassuring indicator that there is significant headroom for debt financing, particularly in the two largest economies of KSA and UAE. Rational economic theory, as well as the development needs of capital markets call for a wave of GCC sovereign bond issuance.
At the time of writing, there are limited signs of this happening, and increasing discussion of tax implementation including VAT and corporate tax. Let’s hope that sukuk or debt issuance also makes it as part of the final financing package of some of the sovereigns.