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The return of Middle East dollar lending

25 July 2013, 10:40 GMT | By Matthew Martin

After several years of retreat, there are signs that dollar liquidity in the Middle East is picking up

Back in mid-2007, as the global financial crisis was rapidly unfolding, a conversation with a senior international banker turned to the difficulty local banks had providing dollars for new loans. Some regional institutions were suggesting they could lend in local currencies to get around the problem, something that was virtually unheard of at the time.

The international banker said borrowers had no appetite for taking local currencies. Coupled with that, the complexity of structuring deals with several different currency tranches just to satisfy a small group of lenders would mean that multiple currency deals would never catch on.

The next year, more than 20 per cent of syndicated loans in the UAE were in dirhams, according to data provider Dealogic, up from less than 1 per cent in 2007.

Dirham loan tranches peaked at 33 per cent of the total loan market in 2012. In Saudi Arabia, the volume of riyal-denominated loans was 71 per cent in 2012. The largest dirham-denominated loan in the UAE was a AED4.4bn ($1.2bn) loan for Jebal Ali Free Zone (Jafza) in August 2012. In Saudi Arabia, it was a $2.7bn deal for telecoms operator Mobily from February 2012.

Riyal loans

Banks in Saudi Arabia had become so averse to funding loans in dollars that National Commercial Bank (NCB), one of the largest banks in the kingdom, offered to fund an entire a SR4.5bn ($1.19bn) loan for Power & Water Utility Company for Jubail & Yanbu (Marafiq) itself in 2011.

There are now signs that this trend is starting to reverse. In the first half of 2013, less than 4 per cent of UAE loans were in dirhams, all the rest were in dollars. It was the lowest proportion of local currency loans in the UAE since before the financial crisis.

In Saudi Arabia, riyal-denominated loans dropped to 45 per cent of total loans in the first six months of the year.

Earlier in July, Abu Dhabi’s Emirates Steel started trying to refinance a $1.1bn loan signed in 2010. The existing deal was mostly funded by local banks lending in dirhams, reflecting where the liquidity was at the time. With the refinancing, the company wants the deal to be funded primarily in dollars, and is targeting international banks as lenders.

“Our loan book has definitely shifted more towards dollars from two years ago,” says one banker in Dubai.

Most of the largest corporates in the region prefer to borrow in dollars as it better matches the cashflows of their business. “There are two types of borrowers in the region,” says the Dubai-based banker. “Those that would like to borrow in dollars and have enough influence over banks so that they always get them and those that want to borrow in dollars, but can’t get them.”

When the financial crisis started and interbank markets froze, local banks found their own cost of dollar funding was so high that lending on to clients was prohibitively expensive.

Libor manipulation

The treasurer of one of the largest banks in the UAE says London interbank offered rate (Libor) manipulation also contributed to local banks being unable to source dollars.

“Some of the strongest banks in the region found themselves unable to match the Libor rates being quoted in 2008,” he says.

“With hindsight, we know that is probably because of the Libor manipulation going on, but at the time, it meant many local banks could not fund dollar loans, or would be making a substantial loss if they did.”

Another effect of the financial crisis was that local interbank rates spiked as foreign funds in the region departed. As a result, local lenders started offering higher interest rates to attract deposits. This led local currency interbank rates during 2008-09 to be significantly higher than the dollar rate.

“Regional banks are in a much stronger position, so the willingness to lend in dollars is coming back”

Syndications head at one regional institution

Borrowers are typically charged the interbank rate plus a spread based on credit risk, although competition among banks to book a deal can push that spread lower.

Many corporates found that if they borrowed in local currencies and then swapped those loans into dollars, their total funding costs were often still cheaper than borrowing in dollars because spreads were higher. As the health of the region’s banks began to improve in 2010 onwards, the dollar lending spread has dropped. A raft of dollar-denominated bond issues from regional banks over the past 12 months has also given local banks access to new sources of dollar funding.

The net result of this is funding in local currencies is not necessarily a cheaper option any more. “The pressure on dollar liquidity has fallen, and the emphasis on funding deals in local currencies has faded away in the last year or so,” says a syndications head at one regional institution.

“Banks had become very protective over their dollar liquidity, reserving it only for their top-tier clients. Now, the regional banks are in a much stronger position, so the willingness to lend in dollars is coming back.”

In Saudi Arabia, where the drive towards local currency funding was most pronounced, it is more difficult to identify a clear trend back towards dollar deals. In 2009, when overall credit growth was flat, local currency loans made up 90 per cent of total loan volumes. That dropped to about 50 per cent in the years following, but shot up again to 72 per cent in 2012. This year it looks like being under 50 per cent.

In a sign of how much dollar liquidity some banks have at their disposal, one lender recently offered to fund an entire $900m deal to fund the expansion of the Al-Jubail Petrochemical project, also known as Kemya. Ultimately, the deal is being funded by a group of around eight banks, including National Bank of Abu Dhabi (NBAD) and National Bank of Kuwait (NBK) in a rare cross-border deal that further indicates that dollar liquidity is recovering.

The green shoots of a recovery in dollar lending are present, but not yet assured. Some banks complain that they have yet to see their dollar liquidity improve significantly.

“A lot of borrowers are telling us that we should now be able to fund in dollars at similar rates to riyals,” says one structured finance head in Saudi Arabia. “I’m not sure how they have come to that conclusion.”

“There has been a lot of pressure to do deals in dollars over the past year, but I think that may have run its course now,” adds the UAE bank treasurer. That pressure has been exacerbated by the excess liquidity in the banking system driving competition between banks to book new assets, which has driven down lending margins.

While most local banks would prefer to lend in their local currencies, being able to fund a deal in dollars has become a differentiating factor. In an increasingly competitive market, this has become an important way for banks to win or retain business. Ultimately, the shift could start to impact profitability at the banks as it eats into lending margins.

External factors

The return of international banks to the region has also helped improve the conditions for dollar liquidity. This is due to a combination of the eurozone crisis abating and Japanese banks looking to do more business in the Middle East. “We could not compete with regional banks a year ago,” says a syndications head at one French bank. “Now, we are finding that our cost of funding as dropped and we can be competitive again.”

This suggests that the switch back to dollars as the major currency of the loans markets could be prolonged. The biggest risk on the horizon will be what happens when the US Federal Reserve begins to scale back its quantitative easing programme, which has helped create a glut of liquidity around the world. Already Federal Reserve chairman Ben Bernanke has indicated that this could begin before the end of the year, a statement to which the markets reacted badly.

Depending on how this is handled in the months ahead, it could prompt a new wave of risk aversion among banks and investors that hits dollar liquidity in the Middle East.

While that is a considerable risk, for now the pressure will remain on banks to go back to doing more corporate loans in dollars.