MENA MARKETS: Eyes on the Gulf

Against a backdrop of fiscal and structural adjustments, a large increase in bond issuance in Mena countries will continue, say Amanda LaMarca and Jaymeson Kumm of HSBC Global Asset Management.

The Middle East North Africa (Mena) region has entered the radar for many investors given the increase in external debt issuance by corporates and sovereigns in the region over recent years. Stock of outstanding Mena sovereign bonds has increased from $70 billion in 2014 to more than $210 billion (€185 billion) today. This means Mena bonds now form a larger composition of emerging market hard currency indices, which has led to a heightened focus on them from emerging market and global investors alike.

Across the countries comprising the Mena region, there are broad similarities as well as important distinctions. The similarities consist of demographics, domestic challenges, geopolitical tensions and the pressing need for structural reforms. The notable differences include availability of natural resources, currency regime (fixed or floating), and the pace and depth of required structural reforms.

Challenging demographics with high levels of youth unemployment – which average around 30% – is one similarity within the region and highlights the need for structural reforms that tackle labour laws, education, and encourage investment by the private sector.

For decades, the public sector has been the main source of economic activity and employment – particularly in the Gulf Cooperation Council (GCC) countries, where public employment can account for over 70% of total employment. This means transformation will not be easy. Private sector investments have historically been constrained due to preferential treatment of public sector companies, which benefit from government contracts and access to financing.

The importance of oil and gas to the region is well known. Oil and gas have served as the centrepiece of the region’s model for stability. For most of the 21st century, higher energy prices supported the external balances of energy-exporting countries while also allowing these countries to provide donor aid to energy-importing countries. In 2014, the price of commodities began to fall, which exerted pressure on this operating model, resulting in weaker external balances and less income to finance budgets for energy-exporting countries.

For oil-importing countries, this translated to less aid provided by the energy-exporting countries. In a lower oil price environment, the historic operating model is no longer viable, forcing long-delayed efforts of economic transformation.

The result is that Mena countries have had to undergo both fiscal and structural adjustments.

On the fiscal front, lower oil prices turned surpluses into deficits, which will need to be addressed by tax revenue measures and a reduction in spending on public wages and subsidies.

In terms of structural adjustments, these countries will need to diversify their economies as well as broaden employment by increasing labour participation in the private sector.

Across the region, the transformation of the model has not been uniform and these adjustments are occurring at a diverging pace. Some countries have implemented reforms and taken harsh measures that are beginning to yield some benefits; however, other countries have yet to adapt.

As a result, it is important to differentiate across the approximately 20 Mena countries that issue external debt. We have created the following three categories based on severity of required structural reforms and willingness/ability to act.
    1. Countries without a pressing need for macroeconomic adjustment. These countries have historically benefited from higher energy prices which allowed them to build large external reserves, and as a result the adjustment is more gradual, particularly with oil prices higher in 2018. Examples include select GCC countries: Kuwait, Saudi Arabia, Qatar, and United Arab Emirates.
    2. Countries undergoing macroeconomic adjustments. Many countries are in the process of undergoing an adjustment through both fiscal consolidation and structural reforms. They are adopting flexible currency regimes and in some cases are turning to the aid of the International Monetary Fund. Examples include Egypt, Morocco and Tunisia.
    3. Countries not undergoing necessary macroeconomic adjustments. Some countries have a pressing need for a macroeconomic adjustment but have so far delayed the necessary measures. They have weaker fundamentals and require the support of foreign aid to prevent a balance of payments crisis. Examples include Lebanon, Bahrain and Jordan.

Many of the GCC countries fall into the first category and have garnered particular attention given the rapid growth in issuance, which came after a drop in oil prices resulted in large budget and current account deficits. During this period of very low oil prices, many of these countries began to draw down on the sizeable foreign currency reserves accumulated in prior years. Driven by the reduction in foreign currency reserves, they turned to borrowing US dollars in international markets. Some of the countries – such as Saudi Arabia and Kuwait – issued hard currency bonds for the first time, resulting in the stock of outstanding GCC sovereign bonds increasing from $25 billion in 2014 to nearly $150 billion today.

Reserve buffers
We anticipate these markets will continue to rely on international dollar bond markets, even as oil recovers, in an effort to rebuild reserve buffers that had been partially drawdown, as well as to raise funds to help diversify their economies. This significant growth in hard currency issuance has contributed to JP Morgan’s decision to include sovereign and quasi-sovereign bonds from this region (Saudi Arabia, Qatar, United Arabs Emirates, Bahrain and Kuwait) in its EMBI hard currency indices beginning in early 2019 (Oman was previously added in 2016).

This family of emerging market debt indices is one of the most widely tracked by benchmarked investors. With $360 billion of assets tracking the JPM EMBI indices, the inclusion of GCC countries will result in heightened investor demand. These countries should also benefit from continued access to markets, given the large investor base.

Further benefits resulting from the index inclusion include fostering liquidity, compressing borrowing costs, diversifying the investor base and finally supporting the rollover of 40% of outstanding short-term sovereign bonds.

We also expect continued reliance on international debt markets by those countries featured in the second and third grouping of the country categories. However, we believe that investors will begin to differentiate among the countries in these two categories and in fact we are already beginning to see evidence of this by diverging performance in credit spreads and access to international markets.

Egypt, for example, has shown a commitment to undertaking economic reforms and, despite challenging fundamentals, we have started to see gradual improvements which have afforded the country access to international markets (Egypt has issued over $12 billion in external debt over the past two years) and compression of credit spreads. On the other hand, Lebanon has delayed implementing the needed reforms, which has resulted in a meaningful widening of credit spreads and limited access to international debt markets.

The evolution of the debt market for the Mena region, including the GCC index inclusion, will have a notable impact on the JP Morgan indices with the weight of the broader Mena region increasing from approximately 10% to over 20% (JPM EMBIG Diversified).

As a result of these changes, the benchmark will experience a one-notch rating upgrade. We believe these changes present opportunities for active management with differentiation and selectivity being critical, given the diverging fundamentals and pace of transformation among the countries within the Mena region.

Amanda LaMarca is a senior product specialist and Jaymeson Kumm is a portfolio manager in emerging markets debt at HSBC Global Asset Management

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