One consequence of Gulf Co-operation Council (GCC) countries striving to diversify their economies away from a traditional reliance on fossil fuels is their new-found enthusiasm for participating in the international debt market.
Although the fiscal and structural reforms that individual GCC members have undertaken to relieve their oil-dependence impacts sectors in different ways, they have been unambiguously positive for their credit worthiness, and the overall approach seems to have influenced market confidence of late.
In our view, the structural reform agenda is unfolding in three dimensions: governments are fighting corruption and other inefficiencies, rationalising expenditure and reforming tax systems. These plans include implementing value added tax by 2018, eliminating generous subsidies and introducing levies on tobacco, soft drinks and vacant lands.
Short-Term Challenges, Long-Term Benefits
While reform in the GCC region may be challenging for some sectors in the short-term, we think the reforms are unambiguously positive for the region. Industries in the region will likely be impacted in different ways as the cost base, margins and business models are altered to match the changing GCC landscape.
We’d expect that the health care and education sectors in particular would likely benefit from these government efforts to mobilise the private sector to make a more active role and improve service delivery standards. However, sectors that rely on cheap energy or inputs will likely face a new reality as policymakers eliminate subsidies on oil and gas, and implement reforms to tackle unemployment and promote the national workforce.
As part of that diversification agenda, local policymakers continue to make significant efforts to: articulate their vision, improve the regulatory and legal environment, attract foreign investors, open up capital markets, become part of established indexes and develop their respective bond markets. We think this combination of structural reform, coupled with an exciting market development story should support returns, help GCC countries gain a stronger international presence, and continue to offer potential for diversification for international as well as regional investors.1
Stabilising oil prices and large sovereign issuances from GCC economies have improved funding conditions. A record $71 billion of debt was issued in 2016, increasing the share of GCC debt from 12% to 18% of external emerging market sovereign debt in 2016. The GCC has more than 160 issuers that have tapped the market, and its growing corporate sector today represents approximately 16% of emerging market external corporate debt—more than Latin America or emerging Europe.
All of this recent capital market activity will improve domestic liquidity and operating environments in banks—which have been consolidating with recent mergers-and-acquisitions—and in our view, the outlook for growth. The bulk of rating actions are likely behind us and the trajectory of credit fundamentals will begin its gradual improvement.
So, despite a surge in debt issuance from the GCC region, its debt market is by no means saturated. We think it’s a region that is under-represented on the international stage and in which most participants are chronically under-invested.
Like any market that’s developing, the rise of sovereign debt issuance should open the door for benchmark inclusion and ultimately encourage more funding from banks and companies. We expect the current GCC bond market—currently valued at over $300 billion—to continue to evolve, and in many ways become an established leader in the overall eurobond market and a leader in the Shariah-compliant sub-segment of that market, too. Both eurobonds and Shariah-compliant bonds are attracting attention from yield-hungry investors. Given the region’s generally attractive yields per unit of duration, its high credit ratings and the global appetite for bonds, the demand for GCC bonds doesn’t look like it will slow down anytime soon, in our view.
However, we think investors who invest through emerging-market bonds or global fixed income mandates in the current environment will not be getting enough GCC exposure. In our view, that base level of exposure won’t be sufficient to reap the potential benefits. We almost have to encourage them to consider GCC bonds independently, to invest in tomorrow’s bond story today.
The considerable amount of oil reserves in the region allows policymakers a significant amount of time and leeway to implement planned policies to support new issuances and further structural reform.
We believe we will continue to see a measured pace of fiscal consolidation and structural reform that will ultimately place these countries on much more sustainable footing. The reforms and subsequent debt issuance, currently external but eventually domestic, will afford global investors a long-term opportunity to take advantage of some of the highest risk-adjusted returns, which collectively make the GCC bond market an exciting investment area today.
We think the evolution of the GCC region away from its reliance on oil promises to alter the make-up and influence of this regional debt market. We expect the GCC region to become a material component of global fixed income in the coming years and offer opportunities for forward-looking investors.
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What Are the Risks?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Investments in developing markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with their relatively small size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Such investments could experience significant price volatility in any given year. Investments in the energy sector involve special risks, including increased susceptibility to adverse economic and regulatory developments affecting the sector.
1. Diversification does not guarantee profit nor protect against risk of loss.