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Middle East

Could the GCC steal the EM mantle from Frontier Markets?

What underpinned the boom in frontier market issuance in emerging markets in 2013 -2014 and, given the retreat from risk, will GCC region issuers have the credit quality to take over the EM mantle from frontier markets when risk appetite returns?

Emerging Markets Under Pressure

A combination of US dollar (USD) strength and falling commodity prices has led many to question the growth story of many emerging market (EM) economies. As a result, funds were consistently withdrawn from EM debt funds in the second half of 2015, contributing to a fall in assets under management, to USD250bn by the end of 2015 compared to a peak of USD400bn in 2013, based on Lipper data.

Some emerging economies are particularly exposed to a strengthening USD and a lack of liquidity because of a high level of foreign currency borrowings by corporates, banks, governments and, in some cases, consumers. Simply put, as currencies weaken the real cost of servicing these debts in local currency increases, and refinancing becomes harder as the appetite to lend into a worsening situation wanes and foreign capital retreats.

At Fitch we take a deeper view and look at the currency an issuer borrows in as part of a broader range of exposures. Borrowing in USD may, for example, be entirely justified if companies are primarily exporters, and have foreign currency earnings to match borrowings. We see this in Russia where the list of foreign borrowers is dominated by the natural resources sector. Turkey is another story where often domestically-focused corporate borrowers have been keen to take out hard currency loans.

Weakening exchange rates can also be a boon for Natural Resources companies. In Russia and Brazil, the weakening of their currencies has taken a lot of the hit out of weakening commodity prices – a very large proportion of both opex and capex for companies in these countries is denominated in local currencies. Where currencies have depreciated less – possibly due to state intervention – this natural balancer has not been present.

Middle East And Africa Implications

Until last year, Sub-Saharan Africa had generated considerable interest from international investors. This, together with high commodity prices and low interest rates made many local companies – both foreign-owned and increasingly indigenous – look to the international capital markets to finance businesses. We saw deals for Nigeria’s Seven Energy (B-/Rating Watch Negative) and Kosmos Energy (B/Stable) among others and it wasn’t just natural resources companies – other sectors, such as telecoms and banks were also issuing bonds.

Looking at current markets it is hard to see these type of deals – all rated in single ‘B’ territory – being repeated in this more risk off environment for EMs. From our discussions with high yield and emerging market investors, there is limited appetite for ‘B’ range paper, particularly if it comes with numerous idiosyncratic risks. Analysing why these companies are not rated higher than the ‘B’ range is informative. The first reason is scale. While an indigenous Nigerian oil company may be huge compared to local businesses, in a global context a company with at best a handful of producing fields is, relatively speaking, a minnow.

The second common feature is jurisdictional risk. As part of our rating methodology we consider whether a company’s rating should be capped by that of the sovereign jurisdiction in which it operates. In the vast majority of countries it is, reflecting the fact that a sovereign default scenario will typically be accompanied by a significant weakening in the general economic conditions in the country. So with 13 of the 18 Sub-Saharan sovereigns we rate in the ‘B’ rating category, and only two at investment grade, there is a natural cap on companies’ ratings.

But country risk isn’t just about sovereign caps – physical security, governance, regulation, financial market development and the rule of law in a country also have major influences on standalone credit rating profiles. In Nigeria, for example, physical security remains an issue.

Despite steps taken to improve matters by the Buhari administration, theft from and sabotage of oil infrastructure remains endemic, as shown by another recent terrorist disruption to the Forcados terminal on which many companies rely as their sole route for oil sales. Corporate governance standards are typically less developed in frontier markets, although in countries with well-developed stock exchanges reporting can be regular and detailed.

But typically companies are controlled by a single dominant shareholder, with limited effective checks and balances to protect bondholders’ interests. This can act as a drag on the rating, although it can be mitigated to an extent by evidence of a track record. Regulation and rule of law can also be a limiting factor. In many sectors, regulation is a key determinant of company performance. Where it is either constantly changing or imperfectly applied companies can face rapid changes in their profitability. Rule of law is another factor – bribery and corruption can distort market outcomes and predictability.

And, if the worst happens – i.e. default - strong legal frameworks can help creditors recover what they are due.

How Do GCC Companies Compare?

While it is clearly hard to generalise across a large region with a heterogeneous set of countries, we can draw some conclusions about how the best placed companies might compare against these criteria. The first place to start is the big picture, and how the countries in the region are being affected by the current oil price slump. Equipped with vast fiscal and external reserves, Abu Dhabi, Qatar and Kuwait are best positioned of the GCC sovereigns, maintaining high government spending levels while reforming their economies and public sectors; all three are rated ‘AA’ with a Stable Outlook. Oman (not rated by Fitch) and Bahrain (BBB-/Negative) are more vulnerable, with lower reserves, higher debt levels and higher political risk. Saudi Arabia (AA/Negative) has large buffers but is rapidly depleting them. All GCC economies remain largely undiversified, with oil production plus government spending ranging from 56% of GDP in Bahrain to 86% of GDP in Kuwait in 2015.

In Saudi Arabia in particular the pressure on public finances is being felt through the banks. As the sovereign withdraws some of the long-standing deposits it has built up and seeks to borrow from the domestic banks (which were the key buyers of recently issued sovereign bonds and sukuk), banks’ appetite to lend to the private sector is being tested. This phenomenon has in the past been a spur for highly rated/blue chip companies to turn to the international capital markets as an alternative source of funding.

So how does the credit quality of the raft of potential new GCC corporate issuers compare to the frontier names which were so popular two years ago? Firstly, the GCC sovereigns are far higher rated than the Sub-Saharan African names discussed earlier, with the majority at high investment grade. So there is no country cap barring the strongest blue chips in the region potentially gaining an investment-grade rating. Saudi Arabia’s Sabic, for example, is rated at A+/Stable based solely on its standalone merits.

But Sabic, which while stock market listed remains partly state owned, also illustrates the more active role played by the state in many of these countries than in developed markets. Governments show stability which has typically led to an understood status quo. This status quo often favours government related entities, where the government owned entity can flourish typically with a view to it helping achieve broader government goals.

While this is a different approach to Western regulation, in the case of GCC telecom companies and banks for example the relatively modest levels of competition in the market allow for healthier financial profiles. Governance standards and legal frameworks also do not typically follow a Western model, so it is important for us as a rating agency to understand the key drivers of companies’ decision making and whether this poses any additional risks to bondholders. For example, insolvency regimes in GCC countries are on average ranked 107th in the world according to the World Bank’s latest Doing Business Survey, with Saudi Arabia sharing last (189th) place with countries like Iraq and South Sudan.

To work out how a company – regardless of ownership – fits into this requires a detailed analysis of the markets that it is present in and an understanding of public policy. Reporting quality can be good, but inconsistent especially below the top tier of companies. Established stock-markets and the widespread use of IFRS-like accounts, as well as the presence of international audit firms, can help many companies past this hurdle. However, for debut issuers that have not been subject to this level of reporting discipline, the process of preparing IFRS accounts and keeping third parties informed of their performance can be daunting. Whether GCC companies represent the next big wave of EM issuance will ultimately be driven by market dynamics.

While there are undoubtedly hurdles to clear, and risks to be understood, we believe there are many potential issuers of good credit quality in the region which could satisfy market demand if it emerges.

Middle East Energy Ratings Africa

Alex joined Fitch in London in 2005 as a corporate analyst, and has held a number of different roles, most recently as Fitch’s Credit Policy Group with responsibility for monitoring the quality of global corporate ratings. He started at Fitch as an analyst specialising in Telecoms, Media and Technology, then became Head of Research for EMEA and Asia-Pacific. Between 2012 and 2016 he ran the EMEA Natural Resources team.

Prior to this, Alex spent eight years with Deloitte's audit practice, where he gained experience ranging from transaction services work to audit, IFRS transitions, expert witness assignments and sector research.

Alex read economics at St. Catharine’s College, Cambridge, and is a fellow of the Institute of Chartered Accountants in England and Wales.