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SAFE HAVENS: SAFE ENOUGH?The safe havens aren't so safe anymore

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Dear Reader,

After starting from a fairly low base at the end of 2018, emerging market inflows have steadily improved through most of the first quarter of this year, driven in part by a less hawkish US Federal Reserve and an apparent détente in a rapidly escalating trade conflict between the US and China.

But at the same time, and as the era of ultra-cheap money draws further to a close, global growth has been revised down once again, with perennial concerns emerging around China’s economic performance, and policy uncertainty – in Europe, the US, and farther afield – weighing on business confidence and investment.

Against that backdrop, where do investors go for relief? And how do borrowers hedge against fickle market perception when raising capital? In this issue of Bonds & Loans, we look to challenge traditional notions of ‘safe havens’, and explore how borrowers from Chile to China and many places in-between are responding to capricious sentiment.

We hope you enjoy reading the latest issue of the Bonds & Loans magazine.

Kind regards,

Jonathan Brandon Managing Editor

4

CONTENTS

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ISSUE 18 - MARCH/APRIL 2019

6 Safe Enough: Investors Likely to Sit Out Volatility in Traditional Safe HavensThe safe havens aren’t so safe anymore, according to investors

12 Burning the House Down: Reserve Currencies and Emerging MarketsAshmore’s Jan Dehn on the eroding supremacy of the US dollar, and what that means for emerging markets

GLOBAL THEMES

16 The Growth of Sustainable Finance in MENAJean-Marc Mercier, Global Head of DCM and Farnam Bidgoli, Head of Sustainable Bonds at HSBC on the growth of sustainable finance in the MENA region

19 Boosting the Capital Corridor Between Asia and the Middle EastADCB’s Ludovic Nobili on why CFOs should look East as they seek to diversify their funding mix

22 Case Study: Al Dur Power & Water Company Secures USD1.34bn Refinancing Despite HeadwindsAl Dur Power & Water Company’s complex project refinancing package was a landmark for Bahraini corporates

24 Niche or Not: GCC Issuance Set to Dominate Sukuk Market for Coming Years – But Will it Go Mainstream? Sukuk supply is still largely dominated by GCC borrowers, but that could change in the years to come

MIDDLE EAST & TURKEY

55MARCH/APRIL 2019

36 After the Vote: Uncertainty, Liquidity Concerns Weigh on Infrastructure Outlook in AmericasDevelopers are redoubling efforts to target the region, but risks are everpresent

41 Latin America Loan Market Heats Up as Hard Currency Liquidity Comes into FocusMizuho's top LatAm bankers talk key trends in the region's funding markets

43 Scrapped New City Airport, Struggling Pemex Dominate Discussions at Mexico CFO RoundtableCFOs at an exclusive roundtable in Mexico City in February said policy concerns are weighing heavily on CAPEX – and borrowing – decisions

46 Mexican Borrowers Clean Up at This Year’s Latin America Deals of the Year AwardsBonds & Loans takes a closer look at Mexico’s Deal of the Year Awards winners

26 Viscous Fiscus: In Pursuit of Reform, South Africa Takes One Step Forward, One Step BackWithout a big shift in ideology, South Africa will find it challenging to reach the level of growth it aspires to

30 SA Institute of Race Relations CEO: Financial Innovation at the Heart of South Africa’s TurnaroundDr. Frans Cronje talks to Bonds & Loans about the kinds of reforms needed to put South Africa back on the path towards sustainability

32 Special Report: The Cost of Internet Shutdowns in AfricaEXX Africa’s Robert Besseling on the economic cost of internet shutdowns in Africa

THE AMERICASAFRICA

48 CIS Issuance Set to Outsize Russia as Sanctions Continue to PinchSanctions on Russia have sharpened focus on the country’s southern neighbours

51 AzFinance: We Anticipate Azeri Local Issuance to Reach AZN100mn by the End of 2019Abid Mamedov, CEO of AZ Finance talks to Bonds & Loans about rising appetite for local-currency Azeri debt

52 China: Onshore Bond Index Inclusion Marks Milestone in Financial LiberalisationIs the industry ready to gain exposure to the world’s second largest bond market?

RUSSIA, EU & ASIA

6

Global Themes

6 Investors Likely to Sit Out Volatility in Traditional Havens

12 Burning Down the House: Reserve Currencies and Emerging Markets

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Global Themes

On January 3, Apple, the American tech giant, announced that it was revising downwards its revenue growth forecasts for the Chinese market in 2019. The statement sent shockwaves across the financial markets and triggered a sell-off across America, Asia and Europe, with investors seeking relative safety in the bond markets. But Apple’s warning was just one of the many shocks hitting the global markets over the past year and, worryingly, it appears that assets historically seen as virtually risk-free may not be safe havens for much longer.

For the last decade, the QE-funded cheap credit in the developed world has supported nearly uninterrupted growth in many economies and significant asset price inflation across the board. But as the world’s largest central banks begin to unwind their balance sheets, cracks are starting to emerge.

The end of 2018 marked a net -6.1% drop in the S&P index, according to Bank of America Merrill Lynch, as well as -14.7% in MSCI EM index, -2.6% in global high-yield assets and -3.4% in investment grade assets. In fact, the only assets to have seen marginally positive returns were US Treasuries and cash funds. Overall,

93% of global assets recorded negative total returns in USD terms, a historic record that was not even surpassed by the sell-offs seen in 1920, when 84% of all assets ended the year in the red. That only 1% of asset classes stayed red in 2017 is a particularly stark but important juxtaposition that illustrates just how battered funds and investors were just one year later.

US stock markets, following a two-year rally on the back of Trump-led tax cuts, became increasingly shaky as the year progressed, with a painful drop in March 2018 setting the mood for the next nine months.

There were some notable differences between both ends of the Q1-Q4 period, not least of which was the temporary breakdown of one of the most consistent of market trends: the negative correlation between stocks and bonds. For a short period, both asset classes were on a synchronous downward path, with investors scratching their heads as standard hedging tactics began to falter. By contrast, the 4Q2018 sell-off saw a return to normality, with USTs and other DM sovereigns surging in negative correlation to US stocks.

There is fairly broad consensus that the Treasuries’ recovery is linked to the less hawkish mood emanating from the Fed following the December meeting; as for the stocks-bonds correlation changes, opinions vary.

“USTs behaved in a similar way in the two episodes (Q1 and Q4 of 2018), if we focus on the second derivative rather than the first,” explains Kasper Bartholdy, Chief EM Fixed Income Strategist at Credit Suisse. “In Q1 UST yields moved from strong increases to no increases. In Q4 they moved from no increases to sharp declines.”

Safe Enough: Investors Likely to Sit Out Volatility in Traditional HavensLast year marked the first in decades when global markets ended

with a net loss across most asset classes. As investors begin to earmark potential destinations for their retreat, they may be

hesitant to funnel everything into the historical safe havens such as US Treasuries, developed market sovereigns, and gold.

7MARCH/APRIL 2019

Global Themes

“The Q1 S&P selloff was triggered by investor concerns about US overheating and about the Fed potentially being behind the curve,” the banker continued So gold prices and the dollar strengthened while UST yields rose in the run-up to the selloff in equities, but all three stopped rising when equities tanked, because the fall in equities made overheating less likely. By contrast, Q4’s S&P selloff was set off by investor-concerns about equity valuations in the context of moderately flagging growth and about the Fed tightening policy as much as or more (rather than less) than it ‘should’.”

John Peta, an independent investment advisor, agreed that the drops in both periods reflected concerns over the Fed raising rates, but the sell-off over the last months of 2018 was largely driven by concerns around global growth and growing disparity between the performance of the American and Chinese economies.

“Eventually, as the US ended up converging with the rest of the world, stocks began to drop and it even looked like Treasuries weren’t acting as the traditional safe havens, unable to provide a buffer.”

But even though investors were concerned by the global cross-asset decline at the time, Peta points out that the rally in US Treasuries in the early weeks of 2019 partly reflects a less hawkish Fed, as well as a flight to quality and to safe havens.

EM ResilienceAnother interesting feature of the US stock 4Q2018 sell-off was its limited impact on emerging markets, which in the past would have been battered by the flight to quality. Bartholdy suspects that it reflected in part the EM-supportive valuation cushion that opened up in the period from April to August – a period with major EM asset underperformance (against comparable US assets).

Consistently solid and improving fundamentals in emerging economies over the past decade have contributed to their strength, as has investors’ voracious appetite for yield. The asset class’s resilience in the face of market turmoil last year is a testament to this paradigm shift.

The Asset Class Quilt of Total Returns

The Asset Quilt of Total Returns

Source: BofA Merrill Lynch Global Investment Strategy, Bloomberg. YTD annualised returns as of end Nov 2018

USTreasuries

14.0%

USTreasuries

0.8%

USTreasuries

6.0%

USTreasuries

1.1%

USTreasuries

2.2%

USTreasuries

5.9%

USTreasuries

2.4%

USTreasuries

3.7%

USTreasuries

-3.3%

USTreasuries

0.3%

USTreasuries

9.8%

MSCI EM79.0%

MSCI EM37.8%

S&P 50032.4%

S&P 50013.7%

S&P 5001.4%

S&P 50012.0%

Gold29.2%

REITS23.8%

Cash1.8%

Global HY14.8%

MSCI EM19.2%

MSCI EAFE25.9%

MSCI EAFE23.3%

REITS11.7%

Global HY62.0%

Global HY19.3%

MSCI EAFE32.5%

MSCI EAFE17.9%

MSCI EAFE-0.8%

MSCI EAFE8.2%

MSCI EAFE-43.1%

MSCI EAFE-11.7%

MSCI EAFE-4.5%

MSCI EAFE1.0%

MSCI EAFE-12.6%

S&P 50022.0%

S&P 50026.5%

S&P 50015.1%

S&P 5002.1%

S&P 50016.0%

Global HY8.0%

Global HY2.6%

Global HY-2.6%

Global HY-27.9%

Global HY13.9%

Global HY10.2%

Global HY-0.1%

Global HY4.2%

Cash0.1%

Cash0.1%

Cash0.1%

Cash0.1%

Cash0.1%

Cash0.3%

Cash0.8%

Cash0.2%

Cash0.0%

Cash2.1%

Commodites16.8%

MSCI EM18.6%

MSCI EM11.2%

MSCI EM-2.3%

MSCI EM-1.8%

MSCI EM-14.9%

MSCI EM-14.7%

MSCI EM-18.2%

MSCI EM-53.2%

REITS-1.1%

REITS31.7%

REITS15.9%

REITS0.7%

REITS-3.4%

REITS11.5%

REITS-9,4%

REITS-50.2%

REITS1.3%

Commodites11.8%

Commodites-35.6%

Commodites18.9%

Commodites7.6%

Commodites-11.6%

Commodites-13.3%

Commodites-9.5%

Commodites-1.1%

Commodites-17.0%

Commodites-24.7%

Gold8.9%

Gold12.9%

Gold0.1%

Gold8.6%

Gold25.0%

Gold-3.7%

Gold8.3%

Gold-10.4%

Gold-27.3%

Gold4.3%

Global IG4.5%

Global IG-8.3%

Global IG-3.4%

Global IG4.3%

Global IG-3.8%

Global IG11.1%

Global IG19.2%

Global IG6.0%

Global IG9.3%

Global IG3.2%

Global IG0.1%

S&P 500-37.0%

S&P 500-6.1%

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018*

8

Percentage of Assets with a Negative Total Return in USD terms

Source: Deutsche Bank. Bloomberg Finance LP, GFD. Note, returns YTD are until December 20

100%

80%

60%

40%

20%

1901 1914 1927 1940 1953 1966 1979 1992 2005 2018

1%

93%

0%

S&P 500 Volatility Outpaced Levels for EM Stocks in 2018

Source: Bloomberg, IIF

%, volatility over 360 days preceding 31 December 2018

EM stocks S&P

EM LC sov bonds

EM HC sov bondsUS HY

US IG Chinabonds

USTEM FX

%, 2018 return

-160

-14 -12 -10 -8 -6 -4 -2 0 2

2

4

6

8

10

12

14

Correlation Returns The historic inverse link between bonds and stock is back

Source: Bloomberg

2007

Correlation (SPX Index, PR005,60,0) (TLT US) -0.1154

iShares 20· Year Treasury Bond ETF (R1) S&P 500 Index (L1)

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

0.00

501000

2000

3000

100

150

U.S. dollarsIn

dex

Leve

l

0.20

0.40

0.60

0.80

www.BondsLoans.com

According to Sonya Dilova, Portfolio Manager at BMO Global Asset Management, the volatility in a rising rate environment (along with capital outflows) peaked in 2018, and coupled with the idiosyncratic stories in some high-beta countries (Argentina and Turkey for instance), led to negative returns on EM assets as a whole.

Nevertheless, EM corporates outperformed EM sovereigns last year by about 4%, and 4Q2018 drew more demand than US high yield, as IIF figures show.

“With the size of the asset class close to USD3tn, and EM corporates alone outpacing the size of US high yield, EM is clearly standing as an asset class of its own. Thanks to its geographical and sectoral diversity, it also plays a major part in alpha generation in other asset classes via multi-asset mandates, which have sprung off over the last couple of years,” Dilova explained.

Improvements in technicals – such as the inclusion of investment-grade Middle Eastern credits in the JP Morgan EM sovereign indices, may also imply stickier holdings and encourage more issuance.

"[Improvements in technicals] would contribute to an increase in net financing needs of EM sovereigns in 2019 compared to 2018,” Dilova says.

9MARCH/APRIL 2019

Curb Your EMthusiasmOther experts are more sceptical. While fundamentals are indeed stronger, and many are in fact less indebted than developed countries, EM economies are still not as wealthy and EM assets do get hit during sell-offs.

“It is true that there were fewer EM countries with large current account deficits when global equity markets turned south in Q1 2018 than when the taper tantrum episode played out in mid-2013. But that is probably as far as the improvement in fundamentals goes,” notes Bartholdy.

The investor points to comparable growth levels and the fact that the EM-DM grow th dif ferential has worsened as evidence that the gap is still significant. Instead, Bartholdy says that the main difference between the impact of the Q1 and Q4 bouts of volatility in EM assets was down to policymakers’ reaction, particularly among the most volatile markets like Turkey and Argentina.

“Sensible crisis-fighting measures were underway in Turkey and Argentina in Q4, and Brazil ’s election (and the run-up to that election) had led to an improvement in that country’s policy outlook. But the crisis in Turkey and Argentina in April-August was caused by policies that were not sustainable, and the fundamentals in both countries are arguably worse now than a year ago, or two years ago,” he concludes.

Nevertheless, sensible policy responses to the outflows in 1H2018 meant that the second time around, emerging markets were not hit as badly, and over recent months the asset class has shown impressive signs of recovery. EM funds attracted USD3.3bn in the f irst week of January, according to EPFR Global data, and recorded USD27.5bn of net inf lows over the three months ending mid-January. But the different modes of behaviour by investors as US stocks dropped has raised some fundamental questions about EM-focused funds’ tolerance for risk, and money managers’ propensity to f lee into safe havens – as well as questions around just where those havens may be.

Flight to QualityIn times of uncertainty and market volatility, investors most commonly seek refuge in the US Treasuries, European and Japanese government bonds and precious metals (namely, gold). The former, in particular, were seen as basically risk-free, even during the toughest periods in the US economic cycle.

At the end of 2008, in the midst of the financial crisis, net purchases of US assets reached USD500bn, driven by fear on the one hand, and the belief that the US government would support its ailing banks on the other. Likewise, Japan and the Eurozone, two of the largest economic blocks to emerge over the past 50 years, with reliable, steady currencies, and deep, highly liquid capital markets, seemed like the obvious alternative.

Those convictions seem far less axiomatic today, however. Donald Trump’s unconventional leadership approach has shaken American politics and global markets, with regular jibes at the Fed, end-of-the-cycle tax cuts that sent the economy into overdrive, a ballooning budget deficit and prolonged government shutdown weighing on US credit quality and the country’s reputation.

Looking across the pond, the ongoing Brexit debacle, emergence of populist politicians across the EU and internal wrangling within the bloc, slowing economic growth, resurgence of border

disputes and souring geopolitical climate are among some of the factors weighing on the minds of capital holders.

Even Japan, seemingly one the most boring (and therefore safest) markets in the world, is struggling (albeit less than its peers) with years of limited growth, a rapidly ageing population, and government debt that exceeds 230% of GDP.

“Today it is difficult to argue that Bunds and UST are risk free, with US debt climbing, potential spillover risks from Brexit or Italy to Bunds; that said, most fixed-income investors still regard in these instruments as de facto safe haven flights,” says Sergey Dergachev, Senior Portfolio Manager and Lead Manager for Union Investment Privatfonds.

According to Dergachev, there are a number of reasons for this continued confidence. Firstly, they are established havens that have proven their worth during previous crises. Secondly, there are, apart from cash, not many other “safe haven” opportunities available.

“Finally, it is the strong liquidity that makes UST and Bunds an attractive safe haven. Of course, JGBs or Swiss Government Bonds are interesting instruments as well but they are far less liquid and the market is not that deep compared with UST and Bunds. My sense is that if we will witness a risk-off event, UST rates and Bunds rates will again be key indicators

December saw very litte appetite for U.S. high-yield issuance,but more demand for EM corporate bonds


30

Jan

USD billion, high-yield corporate bond issuance

Feb Mar Apr May

USEM

Jun Jul Aug Sep Oct Nov Dec

25

20

15

10

5

0

10

Sentiment ShiftGold ETFs Saw Huge Rises

Rate of Change 1(60) (.GLDTONS G) 5.9985

0.00

2.00

4.00

6.00

-2.00

-4.00

-6.00

Source: Wisdom Tree

Investors Look to CashTotal US Money Market Fund Asset (USDtn) ($tn)

Source: ICI, FT

Q1 18 Q1 19

2.8

2.85

2.9

2.95

3

Q2 18 Q3 18 Q4 18

www.BondsLoans.com

of risk sentiment, and investors will prefer them as proxies for risk free assets," Dergachev concludes.

Meanwhile, Peta points out that even after the downgrade to AA by S&P a few years ago, the US not only remained a favourite destination, but US Treasuries actually rallied on the back of that decision. He therefore agrees that the basket of assets considered as “safe havens” is unlikely to change quickly.

“It took the US decades to push the USD into the status of reserve currency, and turn USTs into the go-to asset for global investors. There has been some attrition of the US status at the margins, especially as Trump has shaken up America’s allegiances and its global role; but ultimately it’s the most liberalized, deepest and most robust market in the world,” Peta says. “Where there is a true risk-off period with the economy heading towards inflation, in the long run inflation won’t remain a concern and therefore the demand for USTs would recover.

Yen, Gold, Crypto or Hard Cash?While government bonds have not been knocked off the pedestal just yet, there is room to speculate about potential alternatives – and whether the very notion of safe havens is even going to be relevant in the future.

Some of the more exotic alternatives – such as cryptocurrencies – have yet to prove themselves as effective hedging tools. After the crypto bubble spectacularly exploded last year, Bitcoin et al can still occasionally be used to shift funds from closed markets or “under the counter” transactions, but their viability as “safe havens” has all but disappeared.

“Where else do you go, if not USTs? I don’t think cryptocurrencies have any historical significance; gold is likely to remain a largely risk-free asset and a place for investors to hide in,” Peta believes.

In 2018 gold has indeed held steady above USD1.3k per ounce up until June, when it began to decline and bottomed out at USD1.18k in August, before recovering some lost ground in a spectacular rally that lasted into January. Bartholdy speculated that the

11MARCH/APRIL 2019

behaviour of gold in the two episodes reflects the metal’s role as a hedge against inflation.

“Gold arguably transitioned from being a particularly sought-after hedge against rising inflation to being a less-obviously-useful hedge against a still not-so-threatening rising risk of a growth-slowdown scenario. The fall in its prices in the run-up to August and their stagnation between August and mid-December may have reflected an investor view to the effect that inflation risk was falling or stagnating (as evidenced by stagnant breakeven inflation in the US) due to the combo of tight US monetary policy and weakening medium-term US growth prospects,” says Bartholdy.

“There may have been rising gold demand from people who feared a global recession scenario with great political risk, but that demand-increase may have been offset by a fall in demand from people who thought that the need for an inflation hedge was falling,” he added.

Money markets and private credit have also benefited from the sell-offs and the flight to safety.

On the fixed income side, according to a recent survey published by BlackRock, the shift to private credit continued, as over half (56%) of global respondents planned to increase their allocations. Respondents also planned to increase allocations to other fixed income assets, such as short duration (30%), securitized assets (27%) and emerging markets (29%), likely reflecting relative value opportunities in these asset classes.

“As the economic cycle turns, we believe that private markets can help clients navigate this more challenging environment. We have been emphasizing the potential of alternatives to boost returns and improve diversification for some time, so we’re not surprised to see clients increasing allocations to illiquid assets, including private credit,” writes Edwin Conway, Global Head of BlackRock’s Institutional Client Business.

Some asset managers have combined these different options into investment strategies that ought to provide an effective hedge against simultaneous collapse of stocks and bonds, for example, by balancing out their portfolio’s with illiquid assets, a move dubbed “endowment-style investing”.

“This approach enables the investors to combine the returns of liquid and illiquid investments, thus managing their cashflows and navigating the growing illiquidity on the secondary market. The latter is not only a feature of EM and high yield, but also of investment grade credit,” Dilova points out, warning that the downside of this approach is that it forces clients to lock in their capital in illiquid assets.

“The EM version of this strategy includes a combination of sovereign, corporate and local currency debt. Any high yield would imply higher level of illiquidity and some EM high yield (both sovereign and corporate) are more illiquid than others. Hence, stock picking would be paramount.”

Occasionally, when times are very tough and risks of a sharp repricing rise, some funds choose to close down entirely, instead focusing on preserving cash and existing capital while waiting for windows of opportunity.

“Safer” EMsExperts who spoke to Bonds & Loans were bullish on EM prospects when the next downturn hits, with the improved stability of the asset class allowing for a more discerning approach, instead of a blanket sell-off seen in the past.

Dilova pointed to increased political risk, often manifesting in tariffs and sanctions, as becoming the new normal in global relations. Some of this shock is absorbed by local investors, namely in risk-premium countries like Russia and Qatar, while more widely held assets continue to suffer more elevated spread levels – Mexico being a case in point. Elections and policy uncertainties are particularly acute in 1H2019 (both in EM and DM), which would create pockets of opportunities to add risk, and will also test the robustness of policy responses in others.

Another major factor is the Chinese economy, which has been slowing down due to structural readjustments. With Asia having the largest refinancing requirements in emerging world over the next few years, facing USD146bn of external debt coming due, and with offshore China’s dominant weight allocation in global EM corporate and sovereign indices, along with the recent moves to bring onshore Chinese bonds into the global indices, its ability to balance out adjustments in the rising tariff environment will be crucial in determining broader EM sentiment.

Safe havens in EM will be determined as those which face limited refinancing risk, a stable rating trajectory, low political risks and ideally strong local bid for the secondary market liquidity. Those credits, albeit limited, haven’t sold off enough, but are likely to be more robust than others in heightened volatility, which is largely expected to remain through this year,” Dilova says.

In time, some of the stronger emerging market credits could earn the reputation of a haven – if not “safe”, at least “safer”.

“Safe havens do change over time,” Peta believes. “I remember when Poland was still seen as a risky market. Nowadays, the Chilean peso is perhaps not a safe haven, but it no longer sells off when EM investor sentiment sours. Those transformations inevitably do happen, but take time.”

12

#1

Rank Reserve Currency Global Holdings

U.S. Dollar 63.5%

#2 Euro 20.0%

#3 Japanese Yen 4.5%

#4 British Pound 4.5%

#5 Canadian Dollar 2.0%

#6 Aussie Dollar 1.8%

#7 Chinese Yuan 1.1%

n/a Other 2.6%

Top Reserve Currencies

Source: BIS

www.BondsLoans.com

Global Themes

Suppose your house burns down. Does your bank immediately show up with a great offer of a new mortgage, or does it demand immediate repayment of your existing mortgage, while sharply jacking up the cost of new financing? From a macroeconomic perspective, the answer depends entirely on whether the country has a global reserve currency or just a normal currency. When accidents happen, financial markets tend to extend fresh finance readily to reserve currency countries, while they add insult

to injury by withdrawing funding from non-reserve currency countries.

In short, reserve currency status is insurance. Global reserve currency status almost guarantees counter-cyclical access to finance, because reserve currencies tend to outperform non-reserve currencies in risk-off episodes. Hence, financing tends to become more abundant during bad times. By contrast, issuers of ordinary currencies often experience reduced or complete loss of access to

finance during periods with negative market sentiment.

No other country benefits more from global reserve currency status than the United States. The US can access global capital markets at all times, even if it is the cause of crises, as was the case in the sub-prime crisis of 2008/2009. Moreover, the US largely determines the size of its own insurance pay-out by the amount of Treasuries it decides to issue to tie things over during the downturn. The

Burning Down the House: Reserve Currencies and Emerging MarketsReserve currencies are a kind of macroeconomic insurance, which

guarantees access to financing during economic accidents. Reserve currency status can be unknowingly squandered, but it can

also be sacrificed deliberately in place of undertaking macroeconomic adjustment. Which path is Trump taking?

Jan Dehn, Head of Research, Ashmore Group

13

U.S. Dollar’s Share of Global Payments, Loans and Reserves

Global paymentcurrency

Internationalloans

Foreign exchangereserves

50 1000

U.S. dollars Euros Yuan Yen Other

Source: IMF

MARCH/APRIL 2019

convulsion in turn destabilises Mexico’s local markets and tightens local financial conditions, thereby reinforcing old perceptions that EM countries are inherently vulnerable and risky. All EM currencies are liquidated to various degrees, even when the source of risk aversion emanates entirely from outside of EM.

Non-binary ViewThe binary classification of currencies into reserve and non-reserve currencies is not good for investors. Granted, a simple binary classification of currencies can provide a convenient rule of thumb for how to respond to binary risks in the immediate term. Beyond the here and now, however, simple binary rules are close to useless as other more powerful drivers influence the direction of currencies regardless of their status as reserve currencies or otherwise. What are those more powerful longer-term non-reserve currency related drivers?

First, policy interventions aimed at demand management can exert powerful temporary inf luence on currencies regardless of reserve status. For example, the election-motivated fiscal stimulus introduced in late 2017 pushed the Dollar sharply higher for a time, but because it was introduced at the point of full employment, it will impart more macroeconomic instability than higher sustained growth. The tariffs imposed on imports from China as well as steel and aluminium also support the Dollar in the short term, but undermine rather than enhance productivity and so weaken the Dollar over the longer-term.

Second, herd dynamics among investors can be extremely powerful medium-term drivers of currencies. Quantitative Easing (QE) is a good example: QE led to a strong bullish Dollar consensus among global asset allocators, who in turn pushed the Dollar up by some 50% against EM currencies between 2010 and 2015. Similarly, we expect the unwinding of these long Dollar positions to weigh on the Greenback for several years.

Third, big policy can also have lasting implications: the collapse of the Dotcom Bubble in the early 2000s ushered in a

Global Themes

Dollar even tends to rise with demand for Treasuries, so foreign capital often flows into other parts of the US economy as well at such times.

In addition, the US (and other reserve currency issuers) often benefits from the fact that regulators classify their bonds as risk free and credit rating agencies assign far better ratings than countries without reserve currency status, despite larger debt burdens in the former. To top things off, a pool of capital worth more than USD 11trn is currently allocated almost exclusively to reserve currencies, namely the stock of central bank FX reserves.

By contrast, currencies can be headache for issuers of non-reserve currencies.

Take Mexico for example. No other Emerging Markets (EM) country has done more to deepen and broaden its f inancial markets than Mexico. No other EM country has as a more solid commitment to open capital markets than Mexico. Yet, ask any Mexican official in Banco de Mexico or Hacienda what they think about Mexico’s open capital markets: while their commitment to keeping Mexican markets open is unwavering, they will readily acknowledge that open capital markets present challenges.

Every bout of global risk aversion triggers violent upheaval in the Mexican peso as investors sell the most liquid ‘risky’, or non-reserve currencies, and buy ‘safe’ reserve currencies. Each such

14

Spot On: EM Currencies

Forecasted spot returns until end of 2Q 2019

Polish ZlotyRomanian Leu

Colombian PesoSouth African Rand

Hungarian ForintIndian Rupee

South Korean WonPeruvian Sol

Singapore DollarRussian Ruble

Hong Kong DollarChilean PesoBrazilian RealCzech Koruna

Chinese RenminbiTaiwanese Dollar

Indonesian RupianMalaysain Ringgit

Mexican PesoPhilippine Peso

Thai BahtTurkish Lira

Argentine Peso


-15 -10 -5 0 5

www.BondsLoans.com

Global Themes

multi-year decline in US productivity (2002-2009), which in turn led to a 30% fall in the Dollar against EM currencies.

Fourth, the so-called Balassa-Samuelson ef fect says that EM currencies should appreciate versus developed market currencies, because currency appreciation is required to keep tradable prices low to offset rising non-tradable prices as EM countries experience more rapid productivity growth (economic convergence).

Fifth, issuers of non-reserve currencies generally pursue more responsible macroeconomic policies, because they cannot take external financing as a given. Facing general financing constraints and sometimes entirely unable to access foreign markets, EM countries are forced to self-insure by running smaller fiscal deficits, carrying less debt, maintaining higher stocks of reserves and focusing more on developing their local bond markets.

T h is ensures b e t ter overa l l macroeconomic conditions over the longer-term compared to issuers of reserve currencies, which tend to take access to financing as a given, which in turn results in heavy borrowing during recessions and a general preference of borrowing over reforms. Unfortunately, such preferences are time inconsistent and ultimately undermine the credibility of reserve currencies. This is why issuers of reserve currencies eventually inflate and debase their currencies in order to escape debt and productivity problems.

Hidden RisksIndeed, we believe that investing in reserve currencies is deceptively risky, with little in the way of compensation. Investors in reserve currencies in effect write financial protection on issuers in exchange for very low yields, since interest rates on bonds in reserve countries tend to be far lower than yields on bonds in non-reserve currency countries. Investors in reserve currencies can take enormous capital losses as the time for inflation and currency debasement arrives, although this is typically rare.

As far as the US is concerned, that time may now be approaching. The

US last seriously over-reached itself in macroeconomic terms in the 1970s, when the Dollar literally lost half of its value and Japan and Germany, the main reserve currency holders of the world at the time, saw the purchasing power of their reserves cut in half.

It is almost inevitable that something similar will happen again, not least because it is politically expedient for the US to use its reserve currency status to alleviate its own macroeconomic imbalances. With the right mix of monetary policy and verbal intervention with respect to the Dollar, the US government can help transform America’s debt and productivity problems into inflation and a weaker currency in the same way that water changes state from solid to liquid to gas.

Former Fed governors Arthur F. Burns and G. William Miller did exactly this. When they had transformed debt to inflation and a weaker Dollar, Paul Volcker was able to hike real interest rates and crush

inflation in the early 1980s. The whole point of first converting debt to inflation was to enable Volcker to restore equilibrium with as little economic pain as possible.

This raises an important but often underappreciated point about reserve currencies. Global reserve currency status is not just incredibly valuable as insurance in case of occasional macroeconomic mishaps. It is also very valuable to be able to ‘burn’ the currency’s status in a final bid to transfer the cost of final adjustment to foreign central banks by debasing the purchasing power of their FX reserves.

The Trump EffectIs the Dollar’s dominant status as global reserve currency at risk today? We believe the answer is yes. The credibility of a global reserve currency hinges on trustworthiness. The issuer of the currency must maintain sensible fiscal, financial and trade policies as well as sponsor and uphold rules in preference to discretion in foreign policy matters.

15MARCH/APRIL 2019

Global Themes

Until recently, the US has been able to satisfy these criteria with relative ease. After all, America designed the rules and institutions, which make up the global financial system and shaped them to suit its own national interests. This is precisely why the global governance system since WWII has comprised a relatively weak United Nations alongside a set of very pro-market institutions tasked with overseeing global financial flows, trade flows and international investment, respectively. The US-sponsored global governance system was, and remains, an extremely good deal for the US and every US president since World War II has known this.

Until now, that is. In a sharp change from the past, the current US Administration has been busy dismantling the pillars of the global governance system. Does President Donald Trump understand that his withdrawal of support from global and regional governance bodies, trade agreements and climate accords, his growing use of discretion in the application of sanctions and, above all, his abandonment of America’s long-standing commitment to free trade threatens the America’s most important macroeconomic insurance policy, the Dollar’s reserve currency hegemony?

Trump detractors have been quick to dismiss his policies as the actions of a man, who simply does not understand that he is squandering the enormous advantages implicit in the Dollar’s status as the pre-eminent global reserve currency. However, it is equally possible that Trump

knows exactly what he is doing. In other words, Trump may understand that, at this juncture, America’s national interest is actually best served by devaluing the Dollar and pushing up inflation.

Certainly, Trump’s frequent comments would be consis tent with this interpretation. As a successful populist, Trump understands the political advantages of restoring American competitiveness and eroding away the debt without imposing terrible, gut wrenching austerity on hard working Americans. This is why he leans so heavily on Fed Chairman Powell to lower interest rates. This is why he pushes for strong pro-cyclical fiscal spending. This is why he talks down the Dollar.

In turn, a lower Dollar and higher inflation will mainly hurt foreigners and savers, i.e. future generations, neither of whom vote in US elections, at least not the current ones. Perhaps Fed Chairman Powell’s destiny is to be the next Burns and Miller, not the next Volcker. Maybe EM central banks are destined to be the next Germany and Japan.

Dump the GreenbackRegardless of whether Trump is unknowingly squandering America’s reserve currency status or deliberately exhausting this valuable insurance asset in a bid to restore American greatness without inflicting costs on current generations, the investment implication is clear: reduce exposure to the Dollar.

Add to that the cyclical effects of unwinding years of Dollar bullish QE trades. The Greenback is about 20% over-valued versus EM currencies. America will benefit from a lower Dollar by gradually returning to competitiveness over the next few years. This will also benefit EM as flows return to local markets.

The most precariously exposed group of investors are EM central banks. EM central banks hold more than three quarters of the world’s USD11tn in FX reserves, and nearly two thirds are invested in USD. To take such concentrated risk in a single currency is unwise and unnecessary. It is entirely within the power of EM central banks to manage the Dollar in an orderly fashion by acting in concert to diversify into a broad range of their own currencies, i.e. other EM currencies. This reduces the risk associated with excessive Dollar exposure and makes their own currencies more liquid and stable.

The Dollar’s dominant role as the main global reserve currency is a legacy from the time, when America was willing and able to lead. It predates both the end of the Cold War and the rise of EM as a significant part of the global economy. If America continues to shrink from its responsibilities as global leader, central banks no longer have any excuse for not diversifying. The good news is that most EM central bankers understand the issues, but they face a major task in educating their political taskmasters on the need for action.

16 www.BondsLoans.com

The global green bond market has over the past five years grown from virtually nothing into a broad sustainability-linked fixed income asset class, paying financial dividends while tackling some of the world’s most pressing climate and sustainability-

related challenges. As Middle Eastern governments redouble their efforts to diversify their energy sectors and wider economies, will 2019 be the year ESG more broadly – and green bonds specifically – take the Middle East by storm?

The Growth of Sustainable Finance in MENA

Middle East & Turkey

In advance of the Bonds, Loans & Sukuk Middle East event in Dubai in March this year, the Bonds & Loans team sat down with Jean-Marc Mercier, Global Head of DCM and Farnam Bidgoli, Head of Sustainable Bonds at HSBC to discuss key trends in the global sustainable finance market, and take a look at why the Middle East may be on the precipice of a significant shift towards ESG that could see more CFOs and treasurers take the plunge and issue green.

Bonds & Loans: Whether by geography or sector, where do you see the biggest growth opportunities for green bonds specifically and sustainable finance more broadly?

Jean-Marc Mercier: We are now looking at a market that is roughly USD200bn, which has grown from virtually nothing over the past five years, so the pace of expansion has been tremendous. At a global level, we’ve seen a number of large sovereigns come to market including the Republic of Indonesia, Poland, Ireland and France; sub-sovereigns like Mexico City

and the City of Cape Town; financial institutions like First Abu Dhabi Bank and corporates like Repsol & Telefonica tapping into this market.

Although we haven’t historically seen high levels of interest from the Middle East, we have been encouraged by the uptick in interest towards the segment in recent months, and feel confident that we will see a rise in green or ESG-linked issuance from the region this year.

Farnam Bidgoli: There is a significant policy focus in most of the region’s largest economies, including Saudi Arabia, the UAE and Egypt, on renewable energy specifically and sustainability more broadly, and that is translating into an increased interest in the sustainable finance market as well. It is prompting many to start recognising that we need private capital alongside public funding to achieve some of those goals and targets.

We continue to see significant opportunities in the corporate sector. In 2018, corporates

only represented about 25% of ESG-linked issuance overall, and there are still quite a few sectors that haven’t taken their first steps yet. But what you often find is that once a pioneering company decides to take the plunge, others follow. A good example of this is Telefonica, which at the end of January this year became the first

Middle East & Turkey16 The Growth of Sustainable Finance in MENA

19 Boosting the Capital Corridor Between Asia and the Middle East

22 Case Study: Al Dur Power & Water Company Secures USD1.34bn Refinancing Despite Headwinds

24 Niche or Not? GCC Issuance Set to Dominate Sukuk Market for Coming Years – But Will it Go Mainstream?

17MARCH/APRIL 2019


and owners. We estimate there to be about USD120bn of ESG-linked bond funds, including both labelled green bond funds and themed funds. But when you look at the signatories to the UN PRI’s Principles for Responsible Investment, a commitment to incorporate ESG factors into investment decisions, they represent over USD80trn in AUM. That’s USD80trn in AUM that is meant to be invested with consideration to environmental, social, and governance risks and opportunities.

Bonds & Loans: HSBC took a leading role in structuring the first green-accredited sovereign sukuk. What were the main drivers behind blending features from the two types of credit instruments – green bonds and sukuk – together in one package? And what were some of the challenges you encountered, if any, of structuring a ‘world’s first’ in that sense?

Jean-Marc Mercier: The drivers for the Republic of Indonesia were fairly clear. It wanted to finance a wide range of green activities, including increasing the use of renewable energy and energy efficiency, raising climate resilience and the use of sustainable transport and agriculture, and developing a range of other green assets – waste-to-energy and eco-friendly buildings, for example.

The transaction was a first for the green bond segment and was very well-subscribed by a broad group of investors – including dedicated shariah-compliant investors, which bought close to 30% of the 5-year tranche and nearly a quarter of the 10-year. On the back of a strong orderbook, the transaction saw a 30bp tightening from initial price guidance, pointing to the strong reception from the market.

Farnam Bidgoli: There was definitely some education that had to take place, but nothing insurmountable. We needed to familiarise green investors with the sukuk structure, and give sukuk investors comfort about green. For green investors, the most important thing is the use of proceeds – and the sukuk structure doesn’t change this: we are still going to see proceeds from the transaction going to green projects; there will be regular reporting on how the proceeds are used and the impact of those projects.

telecoms operator to issue green bonds; they were followed almost immediately by Verizon in the US, and Vodafone – which recently announced the launch of its own green bond framework, meaning they will likely come to market in the near future. Telefonica really opened up that segment of the market to sustainable finance. We saw a similar trend in food and consumer goods in 2018. I think we will start seeing sustainable finance move from being limited to the energy and real estate sectors, and start to be embraced by a broader range of private and public sector borrowers.

Bonds & Loans: What is your sense of the size and pace of growth of the dedicated ESG-focused liquidity pool? Do you think traditional asset managers are under more pressure from investors or regulators to prioritise ESG in their investment analysis methodology?

Farnam Bidgoli: ESG is top-of-mind for asset owners and managers, and it is being driven by a number of different factors. Policy is one of them, especially in

Europe, where we are seeing a shift towards the integration of environmental and social factors into investment decisions. In France, for instance, you have Article 173, which obliges asset managers to disclose their ESG policies and analyse the climate risk of their portfolio. This means that any borrower thinking about tapping into French liquidity will need to consider how their own corporate activities are framed within that investment philosophy.

It isn’t just being driven by regulators; most investors we speak with say that ESG is increasingly a factor in almost every single RFP they encounter. This means that whenever asset managers look to win mandates, they are increasingly being asked how they are incorporating ESG into their wider investment methodology, whether that’s being achieved through a thematic portfolio approach, or an internal integration process that gives preference to green or sustainable bonds, or borrowers that have strong ESG-related profiles. It has come to the forefront for major asset managers



While there was a bit of education at the outset, the fact that Indonesia has now been in this market twice over the past year in Green format should give more traditional sukuk issuers from other geographies or sectors comfort that they can tap into this market and reap some of the benefits of added diversification and investor exposure.

Jean-Marc Mercier: Indonesia tapped the international markets via its second green sukuk in February this year reflecting investor demand. Investors value issuers looking at green and ESG as a core part of their funding plans with a commitment to tap markets in a consistent and transparent manner. Given sukuks are typically asset-based to begin with, the tagging and monitoring of use of proceeds – typically one of the more challenging aspects of setting up and managing transactions after they have taken place – is often already implied in the structuring and issuance of sukuk.

When we first hit the road with the Republic of Indonesia, there were a range of questions from investors around the government’s convictions in the area of sustainability and their intention to tap this market on an ongoing basis. On their most recent green sukuk, the government benefited from a third party review with reports on how they’ve used their proceeds and the impact of those investments, which has again helped to familiarise investors with green instruments and showed borrowers that there is real value in developing green frameworks and robust tagging and reporting capabilities.

Both of these factors may not lead to an easily quantifiable benefit in terms of basis points, but certainly do translate into long-term investor diversification, and how it trades in the secondary market.

Bonds & Loans: The MENAT region has seen less than a handful of green bond issuance, despite the region’s shifting emphasis on renewable energy, sustainable transport infrastructure, and other areas of the economy that lend themselves nicely to sustainable finance. But why is sustainable finance still lagging in the region? Do you think, given the prevalence of sukuk in the MENAT region, that the ‘green sukuk’ could change that?

Jean-Marc Mercier: That’s what makes the Indonesian sovereign sukuk one of the more interesting developments for this region. Packaging ‘green’ and ‘sukuk’ together opened up many conversations in the Middle East, particularly given the size of the sukuk investor base in the region, and that the sovereign has hit the market again with a very similar green transaction has bolstered its appeal. But beyond that, the fact that we continue to see a range of ‘firsts’ across the sustainable investment landscape globally continues to give confidence to borrowers in the Middle East who may be looking to come to market – in large part because all of those ‘firsts’ were extremely successful. It shows that the work – in terms of transparency, data collection, setting up a reporting framework and seeing it through to implementation – is worth it.

Farnam Bidgoli: Early scepticism was driven by the fact that people were searching solely for additional pricing benefits – and were trying to understand the potential value or benefits of issuing in this format in those terms. What we’ve seen normally is that green bonds price in line with conventional issuance.

But that being said, although the pricing advantage might not be there, borrowers are becoming increasingly attuned to the benefit of investor diversification and growing investor interest in ESG. We have seen a significant increase in the number of US and European investment funds asking for sustainability-related data, even on conventional transactions; investors are applying pressure to issuers to think about issuing green bonds, which is accelerating the growth of the segment.

We are also starting to see more awareness of this in other product segments, too. For example, in October last year, DP World secured a USD2bn green shariah-compliant loan which has an interest rate linked to

the company’s carbon emission intensity, a first for a corporate in the Middle East. Climate risk more broadly is something that more banks are concerned about. We are in the process of analysing our own portfolio for climate risk in accordance with our commitments to the Task Force on Climate-related Financial Disclosures (TCFD), and we know a number of our clients are doing similar things. This is trickling into our lending process as well. HSBC has for instance been active on a number of sustainability-linked revolving credit facilities with clients. We are including ESG into the lending conversation on a more frequent basis, and it can lead to a difference of one or two basis points – but more importantly, it contributes to a further alignment between ESG commitments and the price of borrowing.

Bonds & Loans: If you could bust any myths and give them a sense of what to look out for, how would you advise borrowers taking their very first steps in the sustainable finance area?

Farnam Bidgoli: The most important thing to consider is the use of proceeds and project identification. I always flag to issuers that this is a very collaborative market. Investors are very forthright in providing feedback on what use of proceeds qualify in terms of their own eligibility, and we at HSBC are always willing to work with them to make sure that they come to market with a credible framework that investors support. There is often this fear around whether they will be ‘green enough’ or ‘sustainable enough’, and it ’s important to note that there is flexibility in the market. Investors want to see a diverse, broad market and are accepting of issuers that are transitioning, as long as their commitments are credible.

19MARCH/APRIL 2019


Whether in terms of trade, commerce, or cultural linkages, Gulf Co-operation Council (GCC) states have become increasingly diverse in their international ties over the past decade – with those linking the region to Asia emerging as one of the most critical corridors of economic activity. But how can GCC borrowers capitalise on emerging funding opportunities brought

about by these deepening relationships?

Ludovic Nobili, Head of Investment Banking, Abu Dhabi Commercial Bank

The Ties that BindTrade and migration between the two regions has increased significantly over the past 20 years.

The GCC’s aviation sector was one of the early beneficiaries of rising trade, labour migration and tourism from Asia. The GGC’s flagship carriers have over the past twenty years used their strategic geographic positions as global and regional hubs to drive increasing freight and passenger travel between these regions. With their sizeable fleets of widebody long-haul aircraft and home airports located within a five-hour flight of two-thirds of the world’s population, few carriers globally are as uniquely well-equipped to service travel to Asia or other destinations further afield.

Many of the first Asia-based companies to expand into the GCC region had done so to take advantage of new growth opportunities in the retail segment, as local tastes shifted in line with migration patterns. In the UAE alone, large Chinese, Japanese and Indian retailers like Dragon Mart,

With global growth set to moderate in 2019 and 2020, the need to diversify funding sources will become much more acute.

Daiso, and Future Group (respectively) have partnered with local players to establish their presence in large retail centres, with these and other companies looking to bolster their presence across the GCC and wider MENA region in the years to come.

But the growing corridor linking Asia with the GCC is perhaps most pronounced in the hydrocarbons and logistics sectors, which has largely mirrored investment flows between the two regions.

Asia accounts for a significant portion of the GCC’s oil exports, and a number of large GCC producers have sought to ink new joint ventures with Asian petrochemicals leaders to enhance their downstream capabilities and squeeze more value from every barrel.

Saudi Aramco, the world’s largest oil exporter, announced last year that it would push ahead with refining ventures across Asia, including a preliminary agreement to acquire a stake in Zhejiang Petrochemical’s new refinery project, an agreement with Malaysian state-

Boosting the Capital Corridor Between Asia and the Middle East

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Chinese Investment: Going Farther Afield

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owned operator Petronas to jointly develop a refinery and petrochemicals complex to refine Saudi crude, and recently announced plans to acquire a 19.9% stake in South Korean refiner Hyundai Oilbank.

Aramco has also partnered with Abu Dhabi National Oil Company (ADNOC) to invest alongside three Indian refiners in a multibillion dollar refinery venture off the west coast of India. ADNOC bolstered its own fuel trading businesses in 2018 in a bid to secure new export markets in the Far East, while at the same time inking new E&P agreements with oil and gas majors from China – the company’s largest export market.

China’s Belt and Road Initiative (BRI), the state’s flagship USD900bn programme that sees it invest in strategic global infrastructure projects to secure high-value supply chains, has made significant inroads in the region. As part of that strategy, Oman Wanfang, a consortium of six Chinese firms, is putting more than USD10bn towards transforming a once sleepy port city, Duqm, into a vibrant trading hub that could one day rival existing trade centres. This includes the development of the China-Oman Industrial Park, a large plot of land that will eventually house a raft of Sino-GCC joint ventures spanning numerous sectors.

From Funding Projects to Funding OrganisationsChina’s participation in funding and developing GCC projects has grown alongside increasingly active lenders and export credit agencies from Japan, Taiwan, Singapore and Korea, eager to deploy capital in a region where infrastructure investment is almost unrivalled in terms of scale. As I have written elsewhere, the Middle East is increasingly becoming one of the most attractive regions to lend into for Chinese banks. Data from Baker McKenzie suggests loans from China-based lenders to energy and infrastructure projects among a broadening number of sectors in the region jumped dramatically since 2014, underscoring growing demand for the region’s risk from the Far East.

Those liquidity pools are starting to play a larger role in broader corporate

funding in the GCC, and should play a much more meaningful role in every CFO or treasurer’s funding strategy as they seek fur ther investment diversification.

A key segment ripe for increased investment from Asia is renewable energy, as well as assets more broadly linked to environmental, social or governance (ESG) improvement objectives. This aligns well with the current project-centric focus of a significant portion of Asian investments in the GCC. Saudi Arabia and the UAE among other GCC states have set their sights on expanding the contribution of renewable energy to the overall energy mix as part of their Saudi Vision 2030 and UAE Vision 2021, respectively.

This complement s paral le l ing developments in Asia. China is emerging as one of the biggest proponents of the Paris Climate Agreement, and it accounts for nearly 20% of global green bond issuance, establishing a strong domestic investor base keen to deploy capital for ESG-linked assets This will become increasingly important as the country’s regulators continue to ease restrictions on outbound investments.

The funding package arranged for the Sharjah Waste-to-Energy Facility, a first for the UAE and developed by Emirates Waste to Energy Company, a joint venture formed by Masdar and Bee’ah in 2017, is just one example of how ESG-linked assets can attract strong

demand from Asia; the USD162mn soft mini-perm transaction, which won Structured Loan Deal of the Year at the Bonds, Loans & Sukuk Middle East Awards in 2018, saw strong interest and participation from Asia-based liquidity pools.

Asian investor interest in the GCC stretches well beyond ESG and energy, partly due to a confluence of macro and credit fundamentals. The record-low interest rate environment that dominated many developed markets in Asia and more broadly in recent years has pushed Asian investors to hunt for yield in emerging markets, particularly in the GCC, where a high proportion of the issuer base qualify as investment grade. As a large share of the region’s borrowers are quasi-sovereigns with implied or explicit sovereign support, GCC paper often offers better relative value compared with other emerging markets assets. Investors based in Asia actually participated in more than a third of all bonds issued out of the GCC in 2017, more than double the rate of participation seen just two years prior.

The region’s markets are likely to get a further boost from global investors following JP Morgan’s recent move to phase-in additional sovereign, quasi-sovereign and corporate issues from all GCC countries into its suite of emerging market bond indexes. Analysts anticipate the move could bring more than USD30bn in passive investment flows to the region, and is

Middle East & TurkeyMiddle East & Turkey

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highly likely to prompt greater international focus on the region’s credit investment opportunities while increasing GCC credit exposure to a much wider group of investors.

Similar developments are taking place in the equities markets. MSCI recently inked a partnership with the Saudi Stock Exchange, Tadawul, to launch an index comprised of the 30 biggest securities listed on the bourse, and both MSCI and FTSE Russel are expected to include Saudi equities in a suite of emerging market indexes later this year.

Global Headwinds, Domestic Evolution to Refocus Investors on QualityOne of the financial industry’s chief objectives over the coming years should be to ensure capital flows linked to a broadening group of activities, organisations, and innovations or market evolutions like the above, are nurtured and remain buoyant. Indeed, as the West’s share of GCC trade declines and the East’s increases, financial flows will continue to mirror that, particularly as Asian investors become more familiar with the region’s borrowers and credit fundamentals.

This also means local funding partners need to play their part in promoting engagement between GCC borrowers and investors based in Asia and elsewhere; in that respect, we are proud to be a regional leader and help facilitate capital flows between Asia and the Middle East.

However, the pressure on borrowers to seek more diverse sources of funding will only increase as GCC governments move forward with privatisation efforts. With global growth set to moderate in 2019 and 2020, the need to diversify funding sources is likely to become much more acute. This will inevitably force CFOs and treasurers to look further afield to diversify risk away from the GCC, and bolster their engagement with new investor communities.

CFOs and treasurers can ensure they stay ahead of the curve by proactively gaining exposure to new investors in Asia; with Asian investor interest in the GCC only set to grow in the years ahead, not doing so could mean missing out over the long term.




BackgroundFirst awarded to a consortium of ENGIE and the Gulf Investment Corporation in February 2008, Al Dur is Bahrain’s flagship independent water and power project (IWPP). As the largest IWPP in the country, Al Dur accounts for around one third of the country’s power and water production, and features a contracted capacity of 1,234MW and 48 MIGD. The project also enjoys a long-term Power and Water Purchase Agreement (PWPA) with the Electricity and Water Authority of the Kingdom of Bahrain, due to mature in June 2036.

The project company’s original plans to secure financing by the end of 2008 were scuppered by the financial crisis. But in June 2009, Al Dur reached financial close, making it one of the first transactions to reach closing since the advent of the crisis. The financing was structured on a hard mini-perm basis, with a total project cost of USD2.2bn, and a debt-to-equity ratio of 73:27, resulting in total borrowing costs of approximately USD1.6bn in debt. The significant balloon repayment of the international facilities, the domestic facilities, US Exim and Korean ECA covered facility, and the Islamic facility necessitated the transaction’s eventual refinancing and streamlining.

As the project commercial operation date had been slightly delayed, and following some disputes regarding performance-related matters, the company faced some discussions with the off-taker and EPC contractor that needed to be settled before refinancing could begin. Once these disputes were resolved in 2016, refinancing plans began in earnest.

Swimming Against the TideAfter launching the Project’s original financing in the midst of the financial crisis, Al Dur understood how to successfully execute deals during times of market turbulence. A cocktail of difficult macroeconomic factors in Bahrain posed a particularly difficult challenge to the project’s refinancing: a double-digit fiscal deficit, a high debt-to-GDP ratio, low oil prices, and a recent sovereign rating downgrade, all dampened investor appetite in the country. Compounded with the sheer amount required, USD1.3bn, accessing capital within Bahrain was increasingly difficult. However, Al Dur enjoyed a strong 7-year long operational

Case Study: Al Dur Power & Water Company Secures USD1.34bn Refinancing Despite HeadwindsFollowing Al Dur Power & Water Company’s (Al Dur) debut project financing transaction in 2009, the project company returned to the financial markets last year to refinance its outstanding debt. Navigating difficult macroeconomic conditions, alongside broader EM volatility, Al Dur secured a complex USD1.3bn refinancing package from an assortment of national and international lenders.

Deal At A Glance

Deal Type: Project Refinancing Facility

Deal Structure: Dual Tranche Project Finance Refinancing

Issuer: Al Dur Power & Water Company

Deal Size: Dual Tranche USD1.3bn:

(1) USD800mn 10-year tenor tranche provided by 20 banks

(2) USD500mn 14-year tenor tranche provided by 6 banks

Issue Date: 26th November 2018

Governing Law: Bahrain

Location: Bahrain

FA: Standard Chartered

Legal Adviser – New Lenders: International – Latham & Watkins

Sponsors’ Legal Advisor: Clifford Chance

Legal Adviser to Existing Lenders: Shearman & Sterling

Sponsors’ Local Counsel: Hassan Radhi & Associates

Lenders’ Local Counsel: Zu’bi & Partners

Use of Proceeds: Refinancing of approx. USD1.18bn existing financing, hedging termination payments, funding DSRA and refinancing related costs

record, the backing of two reputed sponsors, and was strategically vital to the Bahraini government, all of which went some way towards offsetting negative sentiment at a time when the country’s macroeconomic strain was weighing on other corporates in the country. Additionally, as construction risk no longer weighed on its financials, Al Dur was in a far stronger position than many of its counterparts.

With the support of its financial advisor, Standard Chartered, Al Dur began sourcing a wide spectrum of refinancing options, including bank and project bond products as part of a liquidity analysis. Early plans for a dual-tranche project bond/bank debt tranche refinancing plan were

23MARCH/APRIL 2019


USD1.3bn Dual Tranche Project Refinancing Facility:

(1) USD800mn 10-year tenor fully amortising tranche provided by:• International: • MUFG• KfW• BNP Paribas• CACIB• Societe Generale• Export Development Bank of Canada• SCB• Regional• Ahli United Arab Bank• Arab Bank• Arab National Bank • Mashreq Bank • Gulf International Bank • NBK• ABC• ABC Islamic• BSF• NCB• Kuwait Finance House• APICORP• Riyad Bank

(2) USD500mn 14-year tenor, back-ended structure with partial cash sweep starting in Y6, provided by: • Al Rahji Bank• Bank Saudi Fransi • National Commercial Bank • Riyad Bank • APICORP

initially considered with the aim of attracting EM investors looking for longer tenors as a complement to shorter-dated bank liquidity. However, as the Fed continued to hike rates throughout Q2 and Q3 2018, EM liquidity began to dry up for Bahrain.

Consequently, the plan was mothballed and the refinancing team instead chose to substitute the project bond for a longer-dated bank debt tranche anchored around regional pockets of liquidity – predominantly from within Saudi Arabia.

The end result was a USD1.3bn fully uncovered PF refinancing scheme, consisting of:

1) USD800mn 10-year tenor tranche provided by 20 banks

2) USD500mn 14-year tranche provided by 6 banks

The dual tranche structure ensured that the facilities with a c9.5-year tenor provided annuity profiles, while facilities with a notional tenor of 14 years provided a largely back-ended repayment profile, while benefitting from a cash-sweep profile in order to ensure a weighted average life of 9 years.

Perhaps most remarkable about the refinancing facility was its complexity. With swaps having been initially entered in 2009 in a much higher interest rate environment, Al Dur had material negative mark-to-market exposures complicating a smooth execution process. A vast array of institutions took part in the deal, including participation from over 20 regional and international lenders via both conventional and Islamic facilities. Due to a strong bookbuilding process, all commercial lenders active in the Middle East project financing space remained part of the financing facility.

Al Dur’s refinancing transaction marked the project’s second successful transaction during a time when Bahrain faced significant headwinds. Securing a sizeable refinancing facility from an assortment of regional and international lenders, the deal assures the continued operation of a strategically vital operation for the years to come, and sets an important benchmark for other borrowers in the country and the wider GCC region.

24

Global Sukuk Issuances

Malaysia

34.9

27.7

SaudiArabia

UAE Indonesia

28.6

18.6

3.9

8.6 7.95.9

SupraNational

3.1 3.9

Qatar

3.15.1

Turkey

2.32.7

Oman

1.82.6

Bahrain

1.31.2

Rest ofthe World

0.63.7

2017 2018

Source: Bloomberg, KAMCO Research

Sukuk Issuances - 2018 vs. 2017 (in USDbn)

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Niche or NotGCC Issuance Set to Dominate Sukuk Market for Coming Years – But Will it Go Mainstream?

Since Saudi Arabia’s debut sovereign sukuk issuance in 2017, the size of global sukuk markets has grown exponentially. But primary market activity has been dominated by

sovereign issuance, with corporates continuing to make up only a small share of the pipeline. Whether this trend will continue remains unclear, and raises serious questions about the long-term potential of the asset class.

The final quarter of 2018 saw a number of corporates approach the market in the hopes of accessing conventional financing, before backing down and instead turning to the sukuk markets. Such was the case for NMC healthcare, which abandoned its plans to issue a USD400mn bond in favour of an equivalent sized sukuk. Nakheel, a Dubai-based property developer, also began to explore sukuk alongside conventional syndicated loans, before ultimately deciding to shelve the borrowing plans due to rising interest rates.

Sukuk are often the best option for first-time issuers in the GCC, in part because regional investors are typically more familiar with local corporates and have a better understanding of the risks they face, and because issuing conventional bonds would exclude Sharia-compliant investors – a prevalent constituency of the domestic investor base.

“Investors would have absolutely no qualms with either paper because the risk is the same. The only suggestions

and recommendations we tend to give to clients are that the borrower will want to be able to access as much liquidity as is available for their need,” said one UAE-based DCM banker.

However, given the small size of sukuk markets relative to conventional bond markets, the more restricted investor pool, and the lack of long-term domestic institutional investors like pension funds in the region, corporates seeking longer-term funding may be forced to turn to multi-tranche dual conventional and Islamic instruments. Such was the case for DP World, which launched a multi-tranche, multi-currency transaction in September 2018 in an effort to borrow beyond the typical 5-year sukuk tenor.

“Everyone would like the size and tenors of sukuk to grow, but I don’t think it will happen. It hasn’t happened for ten years now on the sukuk front, and I don’t see it going beyond here as the liquidity is not available,” the source added.


25MARCH/APRIL 2019

Evolving SupplyFor the first time in three years, 2018 saw an overall decline in global sukuk issuance volume. Although corporate issuances rose by around 20%, government issuance fell by a third, resulting in an overall decline of 14.1% in 2018 to USD105.9bn.

As GCC states embark on ambitious but necessary reform programmes to diversify their economies away from oil, sovereign sukuk issuance will remain vulnerable to commodity price volatility. According to a recent S&P report, which forecasts an average price of USD55 per barrel of oil in 2019, the total global volume of issuance is expected to fall between USD105bn-USD114bn in 2019 – with total issuance lower than in 2017 (USD120.5bn) and higher than 2016 (USD87bn). Issuance in the GCC alone totalled USD77bn in 2018; down from USD85bn in 2017, according to data from Emirates NBD.

As sovereign sukuk primary market activity begins to recede, corporate issuance is occupying a growing share of the sukuk space.

GCC regulators raised interest rates in line with the Fed throughout 2018 due to the currency peg prevalent in most markets in the region, shielding corporates somewhat from the volatility endured by other emerging markets. Corporates sought to capitalise on this, with overall issuance reaching USD28.5bn in 2018 – a 4.2% increase from the previous year, according to data from KAMCO Research.

Within the GCC, corporate primary market activity grew at four times this rate, totalling USD12.0bn in 2018. Although this appears to indicate a strong rate of development for the region’s corporate sukuk market, this rise may also be attributed to broader fiscal reforms in GCC states, which has forced quasi-corporates to stand on their own two feet.

Enhancing Liquidity Despite an explosion in the size of sukuk markets over the past few years and growing investor interest, appetite for sukuk is restrained by two factors: lack of standardisation and the level of issuance. Unlike conventional debt instruments, a universal standard for sukuk does not exist, which dampens investor interest by making them more dif f icult to understand. Whilst many investors welcome the idea of greater standardisation, operating across multiple legal jurisdictions poses a number of problems.

“Every jurisdiction has a different interpretation of sukuk and its structure. In the international sukuk market, the Fatwa issued by each programme is vouched for my respective sharia boards before an investment decision is made, which I think is sufficient. While the effort for greater standardisation is welcome, it remains challenging as issuers must deal with multiple sets of law for different agreements under each sukuk programme,” stated Fakrizzaki Ghazali, Head of Income Assets at SEDCO Capital.

Counterintuitive as it may seem, efforts to standardise sukuk have enjoyed greater success in local currency markets. The Malaysian Securities Commission has sought to facilitate the domestic market by condensing the documentation requirements for issuers. Meanwhile, Nasdaq Dubai is in the process of creating a number of Sharia-compliant instruments, such as an ‘Islamic repo’ contract, a sharia-compliant version of the short-term loans of securities which banks use to adjust their liquidity.

Beyond standardisation, liquidity in the secondary market is hindered by the established practices of Islamic investors. According to Ghazali, more than 50% of Sharia investors rely on a buy-to-hold strategy, with only around 20% of assets tradeable on a daily basis.

Although sovereigns will continue to dominate primary market activity, the danger of crowding out corporate issuers appears to be marginal. With demand for sukuk currently outstripping supply, there is no lack of appetite for Islamic instruments. Sovereign and corporate issuances tend to appeal to different investor pools, largely due to the low yields of the former.

The Sukuk ‘Premium’Contrary to the notion that the structure of sukuk, which is often perceived as being more complex than conventional financing options, the ‘sukuk premium’ is no longer an issue. This is due in part to lower costs involved when issuing sukuk; although there may be additional legal fees and the ratings process may take longer, these costs have fallen significantly and are largely negligible.

Some claim that the costs can be made up by better overall market performance. According to Mohammed Khnifer, Senior Associate, Debt Capital Markets for the Islamic Cooperation for the Development of the Private Sector (ICD), sukuk typically fare better than their conventional counterparts in times of broader market volatility, as credit spreads are more stable because they tend to change hands less frequently. Whilst market turbulence wracked returns on all EM assets in 2018, sukuk fared better than their conventional counterparts – offering returns of 0.9% and 0.1% respectively, according to JPMorgan Chase & Co. indices.

Over the coming years, the evolution of sovereign sukuk supply will be closely tied to the price of oil, as states attempt to plug their fiscal deficits. According to KAMCO Research, deficits across the GCC region narrowed to around USD14bn, or 0.9% of GDP, at the end of 2018.

“Another concern is geographical diversification. Over the past two years there have been more GCC issuers coming to the USD sukuk markets. Following the UK, Hong Kong, and Indonesia, for example, there have been fewer issuances from the non-GCC space. As a result, the index composition for GCC sukuk rose over 70% in 2018. If this continues then investors will have fewer opportunities to diversify their portfolios going forward.”


26

Africa

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Cyril Ramaphosa unveiled the African National Congress’s (ANC) election manifesto to much fanfare in Durban January 12, timed appropriately with the party’s 107th anniversary celebration. Analysts believe the 66-year old politician, former businessman and trade union leader who took over following the resignation and trial-by-popular-opinion of former president Jacob Zuma, is likely to secure a mandate at the polls in May.

For keen observers and the market practitioners, the manifesto, expounded over a five-day conference, was as notable for what it contained as that which it lacked. Flagship commitments, such as the government ’s bid to attract ZAR2.1tn (approx. USD87bn) in new investment over five years; an acceleration of land reform; increasing transparency and reducing contingent liabilities through reorganisation of state-owned enterprises; and a promise to curb unemployment – especially youth unemployment – by encouraging the creation of more than 270,000 new jobs per year, double the current job growth rate, are all largely regurgitated from the previous 12 months.

The manifesto also paid homage to real and pressing issues, like boosting promotion of water conservation, a hot topic in the wake of Western Cape’s worst drought in decades, or the

need to boost social infrastructure, without articulating a vision of how those objectives would be achieved.

“What’s new? As far as I can tell, nothing,” says Peter Montalto, Head of Capital Markets Research at Intellidex. “Many of the flagship policy proposals are recycled from the past year, and more importantly, lack more clarity around the steps to see implementation through, or a fundamental shift in mindset.”

This was followed by the release of the 2019 budget in February, which among other things finally revealed the government’s turnaround plan for Eskom: a ZAR150bn equity injection over the next decade – rather than a debt transfer. There is purportedly strict conditionality attached to the funding, Montalto explains in a recent note, but those conditions have not been made public as of yet – a blow to investors and the wider market as they search for ways to police the utility’s financial discipline.

“The surprise, a positive one, was that as a result of the choice of form of bailout, and indeed the panic we perceive within Cabinet on Eskom, [the National Treasury] managed to force through major underlying cuts in expenditure to the tune of ZAR50bn over the MTEF (or 0.5pp GDP per year), half

of which is from the public sector wage bill. Given other issues, such as higher debt service costs, weaker revenue and pencilling in contingency reserve for other SOE bailouts, so this ZAR50bn only partially covered the Eskom bailout meaning it wasn’t overall deficit neutral and additional debt will be raised and cash drawn down. It also meant the expenditure ceiling had to be broken, a negative, though it can regain some credibility if still stuck to going forwards. SAGB net issuance levels for the coming year moved up by 1.9% vs the MTBPS,” Montalto explains in a note following the budget’s release.

“Going forwards the problem is that there is virtually nothing ‘easy’ left in

Viscous FiscusIn Pursuit of Reform, South Africa Takes One Step Forward, One Step Back

Markets have hung their hopes on the upcoming 2019 election and the avoidance of a blowout at troubled state-owned utility Eskom as potential reasons for optimism in South Africa, but

without a monumental shift in mindset, or an end to the factionalism that has increasingly defined the executive and the ANC, both reform and growth will remain elusive.

Africa

26 Viscous Fiscus: In Pursuit of Reform, South Africa Takes One Step Forward, One Step Back

30 SA Institute of Race Relations CEO: Financial Innovation at the Heart of South Africa’s Turnaround

32 Special Report: The Cost of Internet Shutdowns in Asia

27

Africa

MARCH/APRIL 2019

the revenue policy cupboard but also now in the expenditure cupboard to aid further consolidation. Add in further expenditure pressures on NHI and higher education (both of which saw no mention). The bailout of Eskom is also a ‘minimum’ per year payment in our view whilst growth forecasts are still too high. Put simply the risks are still skewed to the negative side – even if today showed a crisis can generate political space for [the National Treasury] to occupy, from here things will be more challenging given there is no real flexibility left – only Narnia is left at the back of the fiscal cupboard.”

The deficit is forecast to widen to a peak of 4.5% of GDP in the next fiscal year, mostly on lower revenues and despite a tax adjustment that would bring in an extra ZAR10bn; expenditure cuts mostly came in the form of adjustments to the wage bill. Growth will also take a hit, with 2020 figures revised down from 2.1% to 1.7% of GDP; Montalto says growth expectations for this year – 1.5% - are still too optimistic, with 1.2% looking much more realistic. And despite the government’s decision to lean on equity as a solution to Eskom’s funding woes, the government’s funding requirements will still rise in the near term; it also had to revise up its expenditure ceiling by ZAR14bn, which most analysts see as a negative.

“The results of the budget are that most of the Eskom bailout is taken in the expenditure cuts in the medium run, though before these fully bed in, in the coming fiscal year 2019/20, most is not deficit neutral and has to be supported by debt increases.”

Rising Costs Boxing-in the TreasuryThe manifesto retains a number of costly Zuma-era commitments that could weigh heavily on a an already stretched fiscus, including an initiative announced in December 2017 that would see the government scrap tuition fees and subsidise skills retraining and higher education for pupils from lower-income families.

The move, which would see the government switch from a loan to a grant scheme for funding post-school education, could add close to USD13bn to the national budget – equivalent to nearly 3.5% of GDP – by 2022, and may actually serve to aggravate youth unemployment rather than generate an up-skilled economy, according to an analysis carried out by the World Bank.

“The policy agenda of expanding the Post School Education and Training (PSET) sector clearly illustrates the trade-off between maintaining fiscal restraint and addressing key structural constraints that may be costly to the

fiscus,” the World Bank noted in the analysis.

In South Africa, acquiring skills through programmes like PSET is among the best guarantors of escaping poverty according to the institution, as income inequality continues to be mostly driven by labour market developments which create demand for skills many lack.

"The financial cost of studies can be a major barrier to enrolling poor students in PSET institutions… it also suggests that the quality of education, in TVET notably, is very poor and is not meeting labour markets’ demand – making private returns from TVET very low, likely discouraging enrolments.”

The policy is just one of a growing number of proposals which sit at the increasingly uncomfortable nexus of fiscal prudence and populism embraced by the ruling party in the run-up to the election in May. Others include a generous expansion of the social security system (though concrete spending and implementation measures are somewhat sparse), and a long-delayed National Health Insurance (NHI) programme, which has stalled in recent months in part because the National Treasury raised several concerns about its implementation and cost.

28

Components Shift of the Budgetpp

shi

ft

% G

DP0.8

0.6

0.4

0.2

0.0

-0.2

-0.4

-3.5

-3.7

-3.9

-4.1

-4.3

-4.5

-4.7

-4.0

-4.2

-4.1

-4.5

-4.3

-3.9

-3.6

-4.0

-0.6

-0.8

-1.0

Changes to contingency

2017/18

Eskom

Other changes in expenditureEnd (Budget) deficit

Source: Intellidex, National Treasury

2018/19 2019/20 2020/21 2021/22

Changes in DSCRevenue adjustment

Start (MTBPS) deficitUnderlying (Budget) deficit

Fair Value: Estimates (6-month view) for SA's 10-year Bond Yield

Moody’s downgrade to non-IG fully priced in

Moody’s downgrade to non-IG not priced in

9.20%9.70%

8.60%

Fair value estimate

US 10y yield Credit risk Inflation risk

Source: Nedbank CIB Markets Research, Bloomberg

3.20 3.70

3.00

3.00 3.00

2.40

3.20

3.00

3.00

10.009.008.007.006.005.004.003.002.001.00

-

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Africa

The reforms could edge public debt as a percentage of GDP up past 60% from its current 57.5% mark, putting its precarious investment-grade rating from Moody’s at risk, as well as its position in Citi’s World Government Bond Index (WGBI).

The ramifications of it sinking into junk territory, particularly in terms of forced-selling and asset prices, aren’t entirely clear because a downgrade has been priced-in for the past 12 to 18 months.

Some put the dollar value of forced-selling in the country’s bond markets at around USD2-3bn, but that’s probably a very conservative number and largely accounts for Japanese institutional investors, which tend to have more rigid mandates by comparison with other emerging market investment pools. Conversely, some investment banks have estimated we could see up to USD15bn in forced-selling, which is probably too high and does not take into account the scale of pull-back already seen amongst discretionary funds.

“The real number is probably somewhere in the region of USD5-10bn, but it ’s pretty much impossible to forecast,” Montalto concedes.

Eskom and the Fiscus: Bailout is a Foregone ConclusionMounting costs don’t include what looks set to become one of the biggest bailouts in the country ’s history. Caught between unsustainable tariff levels set by energy market regulator NERSA, inefficient and ageing assets, and a bloated headcount, state-owned utility Eskom in December last year sought a National Treasury bailout of around ZAR100bn, or approximately USD7.2bn – about USD1.5bn of which is needed by March this year to stave off f inancial collapse.

It managed to secure ZAR150bn over the next ten years through equity injection via existing shareholders and a ZAR69bn loan from the government, and initial plans suggest the company’s generation, transmission and distribution businesses will be restructured into at least three separate entities, laying a path to at least partial privatisation.

Eskom is unique in the scale of the financial and administrative challenges it faces. To begin, it is excessively bulky. There aren’t many utilities that own their own mines, for instance. And a headcount of more than 40,000 makes challenging

29

Eskom: Operating Costs vs. Income

2018 interimresults (A)

2019 interimresults (A)

2018/19 (E)* 2019/20 (F)* 2020/21 (F)*

PrimaryEnergy Costs

EmployeeBenefit Costs

Ops andMainenance

Other operatingexpenses

Depreciation&Amort.

Eskom has reported froman IFRS perspective that it

can contain operating costsBreak-evenpoint

Cost

% o

f Rev

enue

An indication that allowable revenues will lag costs,although the regulator believes Eskom’s cost-control

is not robust enough for efficient operations

Note: A - actual, E - estimated; F - forecasted; * MYPD4 forescastsSource: 2018-2019 – Eskom’s interim financial statements; 2019/20-2020/21 – Eskom MYPD4 Application Nedbank CIB Markets Research

140%

120%

100%

80%

60%

40%

20%

0%

56%

13%

8%7%

34%

53%

12%

8%6%

30%

48%

13%

13%

8%6%

47%

17%

8%1%

13%

43%

16%

7%3%

11%

MARCH/APRIL 2019

Africa

unions representing its employees nearly impossible from a political standpoint; wage negotiations last year saw Eskom move from a starting position of 0% wage increases to 12%, capitulating after sabotage-induced electricity blackouts caused an outcry from companies and the wider population.

That said, putting the company on the right path means more than just firing a sizeable portion of its workforce, a cash injection or wholesale privatisation, Jones Gondo, a senior credit research analyst at Nedbank CIB, explains. Critics fairly argue that its clunkiness is one of the factors making it difficult for NERSA, the country’s electricity regulator, to find a tariff that effectively balances consumer demands for a fair price of electricity and producer demands for a tariff ceiling that allows it to generate revenue sustainably.

Rating agencies are consolidating around the view that NERSA’s tariff decisions are structurally inhibiting Eskom’s flexibility in generating sustainable cashflows, but analysts believe this is in large part due to its regulatory mandate – which some say needs to be reformed to help set in motion a turnaround that outlives a short-term cash injection.

“But the reality is, even in a best-case scenario, that still wouldn’t fix the issues facing it or the rest of the country.”

Fork in the Road: Overreliance on SOEs Damaging Over the Long-TermEskom is just one of a number of state-owned enterprises struggling under the weight of chronic administrative and financial mismanagement, and structural inefficiencies. State-owned broadcaster SABC will need another USD216mn in funding to stave off collapse, while state logistics firm Transnet, national airline South African Airways (SAA), and arms manufacturer Denel are all eagerly positioning themselves for further budgetary support.

“The ways in which Eskom and most others need to reform is actually fairly clear. Tough decisions need to be made, but those decisions are for the most part clear. For longer-term stability, we need

to see a radical change in mindset, one that sees the country move from the old centrally-managed, public ownership model to one that is able at to foster more private sector participation and innovation in critical sectors of the economy,” explains David Makoni, an executive director and fixed income research director within the global emerging markets team at Bank of Singapore.

Many believe that shift in mindset needs to start with an overhaul of the country’s outdated and unnecessarily complex labour and collective bargaining rules, including simplification of the archipelago of minimum wage laws applied in different sectors of the economy.

But this is a politically toxic portfolio that has seen attempts at amendment scuppered in the past. It also requires the deployment of significant political capital needed to stand up to very large and powerful unions, something the country’s political leaders seem increasingly unwilling to do – as Eskom’s own wage negotiation late last year illustrates quite vividly.

“I would be much more optimistic about the country ’s long-term prospects were we to see the government standing up to the teacher’s union or the National Union of Metalworkers of SA, for instance, than any specific policy I can think of,” Montalto says, adding that the status quo is unlikely to change until the country reverses its overreliance on SOEs.

Other elements contained in the initial

manifesto beyond those related to Eskom and renewable energy point to increased reliance on SOEs – and rising risk. For example, the ANC wants to amend the Banks Act to allow SOEs to obtain banking licenses, the aim of which would be to boost competition among the country’s existing commercial banks and less than a handful of public sector lenders. But the move could increase macroprudential risk because publicly-owned banks currently fall outside the supervisory purview of the South African Reserve Bank.

Ultimately, Cyril Ramaphosa’s ability to carve a viable path forward after an election – an ANC government seems to be the likeliest outcome, according to pollsters – will depend on the extent to which he can bridge bitterly divided factions within his own party, particularly those loyal to ousted leader Jacob Zuma, and the party’s more populist upper strata – including Deputy President David Mabuza, and Secretary General Gwede Mantashe. That Zuma’s name was added to a list of potential lawmakers after the elections, however symbolic, is telling of just how influential the former leader remains, and how important it will be to keep Zuma loyalists in the fold.

But against that backdrop, a significant risk going forward is that the ANC digs its heels further into unaffordable, populist policies that appease key constituencies within the party base in the short-term to the long-term detriment of the economy's sustainability and competitiveness.


SA Institute of Race Relations CEO: Financial Innovation at the Heart of South Africa’s Turnaround

With a potential credit downgrade in the offing, yawning fiscal gaps to fill, and an election on the horizon, South Africa has found itself at yet another critical junction,

forcing government and state-owned companies to weigh short-term wins against long-term objectives. In advance of our Bonds, Loans & Sukuk event in Cape Town in March, we speak Dr Frans Cronje, CEO of the South African Institute of Race Relations about the upcoming election, policy reform, and the role of financial innovation in transforming the country’s nascent and increasingly important services sector.

Q Bonds & Loans: What do you make of this year’s State of the Nation Address? What were some of the key takeaways?

A Dr. Frans Cronje: Perhaps the biggest takeaway was the absence or scarcity of any structural reforms that would be sufficient to see South Africa pull out of its current economic trajectory, and with that secure – over time – much higher levels of economic participation and much improved living standards.

A relevant comparison to draw is back to the early 1990s, when, at the point of the transition from Apartheid, the ANC confronted a macro environment that wasn’t dissimilar to what we are seeing today: very weak growth; relatively high levels of debt; significant levels of formal economic exclusion. Real per-capita GDP had been slipping for a decade. And at that junction, between 1991 and 1996, the ANC proved itself very capable of dramatic structural reform, and in a sense, ideological reform. It was willing to introduce policies that were deeply unpopular at the time, which had the effect of converting a substantial inherited deficit, around 5% of GDP, into a surplus 13 years later; halving government debt levels; doubling the number of people in employment; and bringing annual growth back up to

5%. Before the 2004-2007 period, the last time annual growth reached 5% was 1970.

All of this is to say that the last time the country confronted this degree of trouble, the ANC’s response was quite enlightened, highly effective and in many ways the correct course of action. In that sense, this year’s state of the nation address was rather disappointing.

Q Bonds & Loans: That being the case, what are the top three reforms you think the next government should prioritise?

A Dr. Frans Cronje: It’s an important and controversial question, and it’s made more complicated by the fact that there really are two types of policy discussions taking place: the discussions that takes place in the public view, which tend to be subject to a high degree of political correctness and at times misconstrues policies or the objectives they aim to achieve through very superficial and glossy treatment; and the discussion that goes on between policymakers behind closed doors.

The government needs to rework the basis of empowerment policy in South Africa. The current policy is failing to draw suff icient numbers of black

South Africans out of poverty and accelerate them into the middle class. That empowerment policy as structured and practiced is currently seen as a tax on investment that weighs on South Africa’s global competitiveness.

Property rights need to be addressed. If South Africa is not able to guarantee that if you bring capital into the country, you will see a return on that capital, then it will never be able to draw in the investment needed to encourage a long-term economic recovery.

Finally, labour policy needs to be addressed. Government policy has, especially given the poor quality of schooling on offer to young South Africans, had the effect of effectively pricing half the school leaders out of the labour market, which also helps underpin the problem of structural unemployment.

If these three areas of policy are not addressed, South Africa will continue to underperform with additional downside risk. If those three areas are addressed, the potential upsides become very interesting – and there is no reason, as long as global economic and political conditions play along, that South Africa cannot once again aspire to grow at 5% annually.

Africa

31MARCH/APRIL 2019

Q Bonds & Loans: The current challenges have also magnified attention on state-owned enterprises like Eskom, Transnet and South African Airways, and have highlighted an ideological divide at the heart of the ANC and the wider public sector. As long as key SA industries continue to be centrally managed in their current form, do you see any of the big improvements being aimed for – on efficiency, productivity, economic sustainability – likely to come to fruition?

A Dr. Frans Cronje: As you know, there are several hundred state-owned enterprises. My view follows an old rule of thumb: sell them quickly; and if you can’t sell them quickly, give them away. South Africa does not have the luxury to continue using taxpayer funds to sustain an airline, particularly when half of the country’s youth is unemployed. I don’t think it’s out of place to consider what this really says about priorities. Our sense, if you consider the quality of those in the civil service, and the track record of many of these businesses, is that it is most unlikely that the South African state is in a position to manage any complex organisation or firm any better than would be the case if that firm were in the hands of private sector individuals.

So with the competition authorities keeping a watchful eye, these organisations should be slowly privatised. Short of that, I don’t honestly believe there is a solution to the myriad of crises that arise almost daily around state-owned enterprises in South Africa.

Q Bonds & Loans: The ideological divide is also at the heart of the ANC. And that said, do you think the upcoming election will resolve any of the tensions between different ANC factions?

A Dr. Frans Cronje: Our own polls suggest the ANC should end up with between 57.5-59% of the vote, which is a comfortable majority. But the party will largely be bolstered by its historical base, which consists of mostly rural constituencies of lower-skilled workers. Amongst young, highly-skilled, urban voters, we think the party will struggle to get 50%. In a sense, this foretells its future defeat at the hands of its inability to modernise sufficiently so as to capture

the imaginations of younger, better-educated urban voters.

These tensions cannot be resolved; they are fundamental in the sense that they speak to opposite worldviews. The tension is between a civil rights culture and an authoritarian, centralised and centrally-managed system; between a market economy and a state-directed economy. There just isn’t enough room for common ground.

Would the election resolve this conflict? I don’t think it does. A very strong result for the ANC would strengthen all factions, not just those loyal to Cyril Ramaphosa. It’s also important to recognise that the election result is irrelevant in so far as it relates to the internal structure of the ANC. There is approximately a 70% overlap between the Cabinet and the National Executive Committee of the ANC, and the result of the election won’t change the National Executive Committee.

Additionally, to argue that an election would strengthen Ramaphosa’s hand to introduce a cabinet that would implement key structural reforms is to overlook the fact that it would require the National Executive Committee to reform itself, which is unlikely.

I think the stalemate remains for the foreseeable future. In fact, there is a downside risk if the ANC does really well; it may embolden the factions on the other side of the Ramaphosa divide to try and remove him as early as 2020.

All of this is to say that none of this is as simple as analysts are making this out to be. The stalemate will continue, but with downside risk.

Q Bonds & Loans: What role do you see financial innovation playing in the broader context of the country’s domestic development goals?

A Dr. Frans Cronje: It’s a good question – we actually see a very important role for financial innovation in pushing the country forward. The makeup of South Africa’s GDP has changed considerably over the past few decades; for example, manufacturing’s share of GDP has fallen by half since 1994. We are increasingly in an economy where the primary and

secondary industries are surrendering their place as drivers of growth to the high-tech, highly-skilled tertiary economy. Finance and financial innovation are central to that. When these trends, which are so deeply established and have taken root over the past twenty years, clash with policymakers and ideologues, the trends always win.

Instead of trying to turn the clock back to foster the kind of economy we saw in the 1950s, it would be a far more intelligent policy to prioritise financial innovation as South Africa’s key strength on the continent. Compared to where the continent was 40 years ago, it has made tremendous progress, in terms of infant mortality, literacy rates, rate of urbanisation, and so forth; and in terms of growth, Africa – as a region – is second only to China. The ratio of aid disbursement to fixed investment has in recent years turned in favour of fixed investment.

While the ‘Africa Rising’ story was very much overdone, overall, the long-term trend in the continent is well-established. Africa, increasingly, will need a service industry and providers that can facilitate the flow of financial and human capital that comes along with being a buoyant and upwardly mobile region of the world. South Africa is not going to turn the clock back on primary and secondary industries, but it can draw significant benefits from positioning itself as Africa’s service provider – and financial innovation is very much at the centre of that. Drawing more people into that economy – providing services to the rest of Africa – creates significant opportunities for lower-skilled South Africans to find their way into the formal economy. Our argument therefore is that South Africa should become a services economy, and that the middle class born out of that will be able to more effectively draw in lower-skilled workers.

The shortcut to high growth and getting out of debt is thwarting the expansion of the welfare system, one that is currently more expensive than any emerging market, but the real solution is in financial innovation and the services sectors. This could double the size of the middle class over the next 15 years, and if you achieve that, the knock-on effect on society will be significant. There is no point turning the clock back.

Africa


So far in 2019, there have been internet shutdowns in at least f ive African countries, most prominently in Zimbabwe, as well as in the Democratic Republic of Congo (DRC), Gabon, Cameroon, and Sudan. The rate of internet shutdowns has steadily increased over the past few years. According to global digital rights group Access Now, there were 21 shutdowns across Africa last year, up from 13 in 2017. Togo, Sierra Leone, Cameroon, Chad, Ethiopia, Uganda, Zambia, and Egypt were among the countries implementing connectivity restrictions over the past two years.

Cameroon’s Anglophone regions spent 230 days without internet access between January 2017 and March 2018.

Precedent and Legal Justification

While the practice of shutting down the internet is nothing new in Africa, the frequency and duration of shutdowns is steadily increasing. During the 2011 Arab Spring, North African governments regularly orchestrated shutdowns of connectivity and social media. Between 2015 and 2016, most instances of internet shutdowns occurred in West

and Central Africa, in countries such as Mali, Chad, Gabon, Republic of Congo, and DRC. Since 2017, the practice has become more common in East Africa and southern Africa.

Governments usually implement these shutdowns through order requests sent to Internet Service Providers (ISP) or telecommunications operators, some of which may be government-owned. Shutdowns are easier to achieve in countries with few ISPs, unlike South Africa which has more than a hundred internet providers. The legal basis of such order requests

How do telecom operators and governments shut down an entire country’s connectivity? In Africa, where is the risk highest in 2019? And, what is the commercial and economic impact of the shutdowns?

Robert Besseling, Executive Director, EXX Africa

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33MARCH/APRIL 2019

lies in the contracts that ISPs sign with the communication regulator in each country. Usually, the regulator will have the power to order ISPs to restrict access to the internet or block social media apps at the regulator's request.

The implementation of such order requests may create a total internet blackout (as most recently in Zimbabwe), or a restriction of access to certain websites, specif ically social media (as in Cameroon), or the throttling of bandwidth (as in Sudan). Sometimes, domain name ser vers can be manipulated to send traf f ic away from intended destinations and toward servers controlled by the government. African governments have depended on tested practices in China to censor the internet. China is heavily involved in Africa's internet,

with state-backed firms like Huawei and ZTE building internet backbones and other infrastructure for many African countries.

According to Access Now, the top three reasons given for internet shutdowns are public safety, stopping the spreading of illegal content, and national security. However, the legal justification for internet shutdowns is often vague or non-existent. Some governments have in the past denied issuing order requests to ISPs and have instead blamed technical problems, although ISPs are becoming more transparent in announcing government-ordered shutdowns. African governments increasingly link their orders to the necessity to protect the public order, particularly during election cycles or bouts of civil or military unrest.

While internet shutdowns may often violate domestic law, the international legal framework remains vague and relies on assurances protecting the right to freedom of expression or UN Guiding principles on Business and Human Rights. In 2016, the United Nations Human Rights Council released a non-binding resolution condemning intentional disruption of internet access by governments. The resolution reaffirmed that “the same rights people have offline must also be protected online”. However, the non-binding nature of the UN resolution, as well as entrenched internet censorship by countries such as China, has hampered attempts to implement broader prevention of internet shutdowns by governments.

In the absence of a clear framework governing the right to internet access, African governments will maintain their responsibility to protect the public order or to curb ‘fake news’. The below case studies are aimed at finding patterns on internet shutdowns in Africa and to assess the commercial impact of shutdowns.

“Total” Internet Shutdown in ZimbabweOn 21 January, the High Court said Zimbabwe’s government exceeded its mandate in ordering an internet blackout during recent civilian protests and ordered mobile operators to immediately and unconditionally resume full services. Zimbabwe’s biggest mobile phone operator Econet Wireless subsequently restored all internet and social media services. The sporadic internet blackout was ordered by Security Minister Owen Ncube on 15 January following the start of often violent protests against high fuel prices.

Many people were left without access to social media platforms and email amid accusations that the government wanted to prevent images of its heavy-handedness from being broadcast around the world. Zimbabwe’s millions-strong diaspora raised the attention of the world to the internet blackout through various social media campaigns that were picked up by traditional media and triggered criticism from

Africa


foreign governments, such as the UK.

While some internet users sought out virtual private networks (VPN) to bypass the controls, Zimbabwe's shutdown did cut off crucial access to electronic bank deposits. The cash-strapped government uses such transfers to pay public sector workers, such as teachers, who were already on strike. Moreover, electronic remittances from the large Zimbabwean diaspora were also affected, further exacerbating Zimbabwe’s economic and financial crisis.

Some estimates assess that the shutdown will cost the countr y USD5.7mn per day in direct economic costs. However, the widespread international condemnation of the Zimbabwean internet shutdown and the judicial ruling that the service order to ISPs was illegal does mitigate further risk of internet restrictions in 2019.

Social Media Restrictions in DRC Election CycleThe government of DRC President Joseph Kabila shut down internet and text messaging services ahead of and following disputed elections

in December, claiming to preserve public order after “fictitious results” were circulated on social media. The government warned of “chaos” in case unofficial results were published on the internet or social media. Diplomats from the US, European Union, Canada, and Switzerland criticised the internet shutdown. The shutdown heightened fears of electoral fraud in presidential and legislative elections that were already marred by delays and violence.

Data leaked from the state’s electoral c o m m i s s i o n u n a m b i g u o u s l y contradicted the of f icial results, triggering a dispute over the election results. The leaked data covers over 80% of the votes cast in the 30 December general election and closely matches voting data gathered independently by a parallel vote tabulation held by the Catholic bishops’ organisation, as well as three recent polls.

Internet provider Global and telecom operator Vodacom said that they had cut web access on government orders, although some NGOs claim that interruption to connectivity was being carried out at the discretion of commercial operators. Congolese authorities specifically targeted social

media platforms like WhatsApp, Facebook, YouTube, and Skype in order to hamper communication among protesters, while allowing businesses and banks to operate as usual. Nevertheless, disruption to mobile communications was widespread. The economic cost of a shutdown in DRC is estimated at USD3mn per day. The DRC’s restrictions on internet connectivity were similar to those that occurred in recent elections in Mali and Equatorial Guinea, as well as those that followed an attempted military coup in Gabon in early January.

Tanzania Cracks Down on Online MediaSome African countries have extended authoritarian practices to the online media sector by amending local legal frameworks. Tanzania’s government is a relevant case study since its implementation of the Electronic and Postal Communications Online Content Regulations Act in March 2018. The new law facilitates the government’s ongoing clamp-down on blogs, online content providers, and users alike with stringent regulatory requirements. These include a USD924 licensing fee, the disclosure of ‘strategic’ information and the auditing of content by the Tanzania Communications Regulatory Authority

COUNTRY RISK OUTLOOK TELECOMS OPERATORS / ISP

Cameroon Localised shutdown to counter insurgency in Anglophone regions Camtel, MTN, Orange, Vodacom

Sudan Ongoing throttling of bandwidth and restrictions on social media Zain, MTN, Sudatel, FedEx

TanzaniaRestrictive regulations on online media poses rising risk to

operatorsAfrica online, Airtel, Vodacom, Millicom,

Viettel

Uganda New social media tax poses rising risk to operators and users MTN, Airtel, Vodafone, Africell

ZambiaAuthoritarian government seeks to duplicate Tanzania/Uganda

modelMTN, Zamtel, Zamnet, Bharti Airtel,

Vodafone

Senegal Crackdown on NGOs ahead of elections indicates rising risk Millicom, Sudatel, Globacom,

Algeria Strict terrorism laws may be applied ahead of elections Mobilis, Djezzy, Ooredoo Algeria

Tunisia Strict terrorism laws may be applied ahead of elections Ooredoo, Tunisie Telecom, Orange,

Malawi Upcoming elections are likely to be disputed and trigger unrest Bharti Airtel, TNM, Access Communications

Kenya New cybercrimes law poses rising risk to operatorsSafaricom, Airtel, Telkom, Orange, Zuku,

Acces Kenya

Africa

Source: EXX Africa

35MARCH/APRIL 2019

(TCRA), failing which transgressors may be subject to severe penalties.

After dealing with the online media sphere, the Tanzanian government has turned his attention to broadcast media, especially foreign-owned companies. Last year, the TCRA threatened to suspend the operating license for the Multichoice and Simbanet television companies. This action follows a string of contentious media-related regulatory measures, beginning with the Media Services Bill and Cybercrime Act. The Act criminalises ‘defamatory’ remarks and content that is deemed ‘seditious’ while authorising greater government oversight. This is an apparent bid to regulate public ly accessible information so as to manage the narrative on a problematic political and economic agenda.

In targeting such entities with rigid operating requirements and colouring his persecution with nationalist rhetoric such as the “my country first initiative”,

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the government of President John Magufuli stands to gain both politically and economically. This, through increased revenue, royalties and penal payments as well as an appreciation in political stock in a country where economic nationalistic sentiments are still prevalent.

Various other African governments are implementing strict regulations on online media, which may set the tone for future crackdowns on internet connectivity and mobile telecommunications. Last year, Uganda’s government passed a new tax on social media, under which users must pay USD 0.05 a day to use popular platforms like Twitter, Facebook, and WhatsApp. Both Tanzania and Uganda’s restrictive cybercrime and media laws were inspired by similar measures imposed in China.

Other than Tanzania and Uganda, countries where such authoritarian practices are most likely to be implemented over 2019 include

Zambia, Zimbabwe, Togo, Senegal, DRC, Guinea, Algeria, and Egypt.

Risk Outlook for Internet Shutdowns in Africa in 2019In 2019, a number of countries are likely to impose full or partial internet shutdowns that will pose severe risk of contract frustration to operators, as well as broad economic disruption to investors. Some of these countries will hold highly contested elections this year and have already been identified in EXX Africa’s recent Africa Elections Special Report. More than half of Africa’s 54 countries will hold some form of election next year.

Other countries, like Tanzania and Uganda, are implementing restrictive cybercrime and media laws to crack down on dissent and protests. EXX Africa has selected the ten countries where the probability of internet shutdowns or other forms of connectivity disruption is highest and where the risk of commercial disruption is most severe.

36

Total investment in infrastructure by LAC country, 2008 vs. 2015

2008 2015

Source: Infralatam database, www.infralatam.info.Note: For Chile (2014) and Uruguay (2013) latest available investment figures are reported

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Last year saw new administrations take the helm in key regional powerhouses across the Americas, including Chile, Mexico, Colombia and Brazil. But far from producing a feeling of optimism, one gets the sense the reshuffle has left many with an acute sense of unease, and few more than those involved in the infrastructure and energy sectors.

“When we look at the Americas, [2019] is definitely going to be the ‘wait and see’ year,” explains Javier Martinez-Pardo, Head of Project Finance at Cintra, a large toll-road developer that is part of the Ferrovial Group, one of Spain’s largest multinational transport and urban project developers. “We will continue to look for traffic-

After the Vote: Uncertainty, Liquidity Concerns Weigh on Infrastructure Outlook in Americas

The dust is beginning to settle following one of the busiest election years in Latin America’s recent history, but concerns around policy reversals and a lack of sufficient liquidity in certain markets

could mean infrastructure developers and investors focused on some of the region’s largest economies may not particularly like what they see. The early signs are worrying, to say the least.

Americas36 After the Vote: Uncertainty, Liquidity Concerns Weigh on Infrastructure Outlook in Americas

41 Mizuho Feature 43 Scrapped New City Airport, Struggling Pemex Dominate Discussions at Exclusive Mexico CFO Roundtable

The Americas

risk opportunities across the region, but heightened instability is making us much more cautious.”

Investing in Mexico: Policy Uncertainty Causing Self-HarmMartinez-Pardo says he is most concerned about policy stability in

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MARCH/APRIL 2019

Mexico, and if sentiment among a broad swath of global and local market stakeholders and observers is anything to go on, reasonably so.

One of the first big moves taken by the country’s newly elected left-leaning president Andres Manuel Lopez Obrador, better known as AMLO, was to cancel a USD13bn airport project backed by a large group of local and international investors. The new Mexico City airport, about one third of the way through construction, was due to replace Benito Juarez International, one of the region’s busiest; the government instead plans to construct two runways at the Santa Lucia Military Airbase and improve Mexico City Toluca airport, though details of how the new initiatives would be financed were scarce.

It isn’t clear what sums the government would have to fork out to f inance them, either, after a bond buyback with bondholders owning about USD6bn in debt to fund the new Mexico City Airport was botched, with the concession only managing to repurchase just enough of the notes to stave off default (about USD1.8bn

a USD100mn four-lane expansion of the 208 kilometre-long Bacalar-Tulum highway in Quintana Roo State, near Belize; a USD60mn brownfield reverse-osmosis water desalination plant in Los Cabos, Baja California Sur; a USD183mn Puerto Vallarta Bypass project in Guadalajara; and a raft of social infrastructure projects, including several hospitals and universities.

Energy and OilLopez Obrador has also raised further investor concerns with his handling of the energy portfolio. After temporarily suspending renewable energy auctions in December last year, just days before bids were due and days after the new president took office, the National Centre for Energy Control (CENACE) announced at the beginning of February that it would scrap the country ’s 5.9TWh auction round altogether.

The move dealt a blow to the renewable energy developers who had high hopes for the country after the previous incumbent, President Enrique Peña Nieto, passed a series of laws to centralise auctions for both oil and electricity, and liberalise pricing. Details around how Lopez Obrador plans to move forward on this – or a broader renewable energy programme – remain scarce.

“It ’s a very interesting market, one of the more competitive markets to deploy renewable energy on both the private and regulated side,” says Carlos Barrera, CEO of Atlas Renewable Energy, a developer that counts Mexico as one of its core markets. “A wholesale reversal of the energy reforms – which I view as being extremely successful, contributing to project delivery and reduced costs – would be bad. [The administration] have been cancelling power auctions and transmission projects... But I also think that we need to give the new administration more time to land on its feet. Given the market’s potential and track record, I am cautiously optimistic.”

Combined with the general trend in certain markets in the Americas which sees power purchasing agreements becoming much more short term in nature, with offtakers opting to take spot-market risk, some believe

worth across multiple maturities). The government says the new upgrades will cost less than building a brand-new airport, which appears to be a silver lining few appreciate.

“The whole debacle very much appears to have set the pace for the new administration in terms of how it deals with investors, and its willingness to reverse course on flagship policies put in place by previous administrations,” explains one fund manager who owns paper issued by Grupo Aeroportuario de la Ciudad de México (GACM), the funding vehicle used for the new Mexico City Airport, but declined to sell back to the issuer. “[The airport cancellation] is one of a number of things leaving a bitter taste in the mouths of investors.”

Bankers say a broad array of sizable infrastructure projects, previously announced by the former administration and currently at the pre-investment stage, have been halted following last year’s changing of the guard, pending further analysis – raising fears that they will be cancelled. These include two new electricity transmission projects - one in Veracruz and another in Chiapas;

38

Public and private investment in infrastructure as a share of GDP by LAC country, average 2008-2015

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The Americas

renewable projects are likely to become more expensive to finance – despite rapidly declining equipment costs and robust demand.

Then there’s the oil sector more broadly, and Petroleos Mexicanos (or PEMEX) specifically, the debt-laden state-run oil company which also happens to be one of the most prolific emerging market bond issuers.

Faced with more than a decade of production declines and a rapid build-up of debt (from USD77.5bn in 2014 to roughly USD107bn today, according to Bloomberg data), Lopez Obrador attempted to calm markets in early February by suggesting a turnaround plan was in the works after Fitch downgraded the company two notches to BBB-, just above junk territory.

“The ratings are constrained by Pemex’s substantial tax burden, high leverage, significant unfunded pension liabilities, large capital investment requirements, negative equity and exposure to political interference risk,” Fitch said in a statement.

Lopez Obrador has promised to honour existing contracts in the oil and gas sector, but his actions so far haven’t inspired much confidence. Since his inauguration, two oilf ield auctions were cancelled, one of which was related to strategically important non-conventional resources such as shale gas. Furthermore, farm out biddings were delayed from February to October 2019, and the rest of the E&P auctions have been suspended for the next 3 years in order to “see results of private sector participation before moving forward”, according to Lopez Obrador and Rocio Nahle, the country’s new energy minister.

“Mexico is tough at the moment. We’ll have to wait and see how things work out given the policy uncertainty at present. There is tremendous opportunity there, but there are definitely big question marks over whether some of these projects will proceed – especially in the energy sector,” explains Benoit Felix, Managing Director of Structured Finance at Santander, and global head of the bank’s energy practice.

“International investor exposure to Mexico, and PEMEX specif ically, is at an all-time high, so we could see a cascade effect if a credit event were to materialise, like wholesale reversal of the policies put in place by the previous administration, a cancellation of projects or a deep cut in the growth outlook.”

Infrastructure Outlook in Key Economies: Mix of Sun and CloudIn Colombia, another darling of pan-regional and international project developers, the outlook is decidedly mixed.

Colombia was one of the few countries in the region to have finished 2018 with minimal net capital outflows, according to economists at BBVA, and was able to differentiate itself by “a low deficit that was under control, a low or diminishing external deficit, and an increase in their raw material exports, prices of which had been moving upwards until the outset of the fourth quarter of 2018.”

But its outlook for this year – much like that of neighbouring Peru – is likely to be constrained by softening Chinese demand for commodities, lower oil prices, rising global interest rates and lower fiscal headroom.

“The current account deficit increased in 2018 to an estimated 3.5% of GDP, even though the average price of oil over the year was 32% higher than in 2017, when the deficit had been 3.3% of GDP. The deficit will widen even further in 2019 to 4.1% of GDP, as a result of lower oil prices, the dispatch of dividends abroad and the boost on

imports provided by expected higher domestic demand. In this latter factor, the recent, and anticipated, momentum in machinery and equipment investment has been decisive. These types of goods had accelerated since 2017, but were consolidated in 2018,” BBVA economists said in a recent Q1 outlook piece.

“What is more, from 2020 onwards, the central government will have to obtain new revenues and/or make new spending adjustments, even larger than those it had to obtain/make before passing the Finance Act.”

On the energy front, many are closely watching the first long-term (12-years) renewable electricity auction taking place at the end of February, a pivotal step in the country’s bid to diversify its energy sources. The country hopes to generate at least 1,500MW from renewables over the next four years, and an auction taking place at the end of February has already seen close to 25 bids submitted, with many of the proposed projects concentrated on the Caribbean coast.

“Colombia will be one of the most interesting markets this year. There are a very interesting mix of players involved in the bidding process, many of which were smaller, more domestically-focused players. The long-term potential there is huge,” Atlas’ Berrera says.

But the tenders will also be a crucial test of the government in the eyes of global investors, who for years now have decried the fact that the ‘rules of

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Infrastructure investment by sector as a percentage of total annual infrastructure investment in LAC, 2008-2015

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The Americas

engagement’ around investing in energy infrastructure in Colombia have typically favoured local investors, he explains.

“Tenders have been much more favourable for local investors rather than internationals, but the new administration is making encouraging noises that it wants to level the playing field and adjust tenders such that it could open up more investment from outside the country, thus enabling more efficient pricing.”

Life after 4GBeyond energy, this remains to some extent one of the main criticisms levelled against the country’s flagship 4G road development programme.

Colombia won accolades from global finance professionals for its pioneering 4G programme, with large foreign lenders known for funding infrastructure like SMBC and Mizuho, multilaterals like the IFC and IADB, traditional asset managers like Ashmore Group and BlackRock and many others arriving to her shores in search of attractive and well-structured transactions to participate in.

But five years on, the programme’s success has been mixed. After stumbling in the early years with geological issues that forced key projects to be delayed, an investment structure that made it difficult for foreign lenders and investors to access, and more recently the damage to local banks and companies caused by the wide-reaching Odebrecht scandal, 17 of the 32 projects slated for development in the first two phases of the programme have achieved financial close, attracting roughly USD8.4bn in new investment – over a quarter of which has come from outside the country, according to the Economist Intelligence Unit. That’s just over half of the USD15bn it sought to secure by 2021.

Despite President Iván Duque’s insistence in February this year that the government has put in place a plan to ‘reactive’ the programme, with the aim of getting more than 70% of announced 4G deals financed by March, observers see 2019 as a crucial year that will determine whether the government needs to change tac to achieve its target.

Cintra’s Martinez-Pardo, who recently helped Ruta del Cacao, a road concession of which Cintra owns 40%, structure a COP1.68tn transaction to finance the COP2.6tn Lebrija-Barrancabermeja-Yondó corridor, says that a big part of the challenge is still the lack of availability of long-term local liquidity or adequate long-term FX hedging instruments that can match the tenors on projects.

“Funding long-term in hard currencies is getting easier, especially with the Japanese and French lenders stepping up in the region, and the multilaterals as well… but the oligopolistic nature of the local banking sector and size of the market relative to others in the Americas means we generally have to go further afield. Often, there just isn’t enough liquidity at the right price for us,” Martinez-Pardo says. “It doesn’t appear as though the local market will be capable of absorbing the sheer scale of projects on the horizon, including 4G.”

“It also means we have to be much more proactive in how we manage currency risk as a treasury,” he adds.

Other funding specialists eyeing infrastructure opportunities in the Americas agree. Oscar Yunta, CFO of Bow Power, the energy-focused developer arm of Spanish multinational construction giant Grupo Cobra, says he plans to strengthen his team’s FX capabilities as the company looks to bolster its presence in the region.

“The stronger these economies get, the more likely they are to start pushing to do transactions in local currencies, which can make it challenging for us

because someone ultimately has to manage that basket of currencies. We’ve traditionally seen this in places like Brazil and Colombia, but we’re increasingly finding it to be the case in Peru and Mexico. That is why we are looking to strengthen these capabilities.”

Despite Headwinds, Opportunities AboundWith less than a handful of local commercial banks active in banking the country’s larger infrastructure deals, and Colombia’s National Development Financer (FDN) limited by mandate to fund no more than 25% of the total value of transactions, others are stepping in to fill that gap.

Multilaterals like the IFC and IDB Invest, the private sector-focused arms of the World Bank and Inter-American Development bank, respectively, have been supporting a number of companies involved in 4G concessions and the broader mining and energy sectors, while their public sector-focused sister organisations have advised the government on structuring investment programmes.

In November 2018, the government has teamed up with Caisse de depot et placement du Quebec (CDPQ), one of the country’s largest public pension funds, to create a COP3tn (approx. USD927mn) private equity fund to invest in Colombian infrastructure, with about half that sum coming from the FDN and local pension funds including Colfondos, Old Mutual, Porvenir, and Proteccion.

Old Mutual’s Head of Investments AFP in Colombia, Juan Sebastián Restrepo, is optimistic about the partnership and the infrastructure investment outlook


The Americas

in the country this year. But he also warned that Colombia still remains vulnerable to political risk, echoing the warnings of others focused on the wider region.

“There are significant opportunities in the country – not just in toll roads, but in transpor tation, energ y, telecommunications…. But I would say the biggest risk – beyond Odebrecht rearing its head again – is the regulatory framework and political environment, which are still quite fragile.”

“Governments always signal their commitment to these kinds of programmes, but governments also change with relative frequency and can completely reverse what came before. Mexico’s approach to energy and infrastructure at present is a case in point.”

All Eyes on Brazil, Smaller EconomiesIndeed, Berrera points out that all of the post-election uncertainty in much of the region makes countries like Uruguay, a smaller but far more stable market, much more interesting for project developers. Atlas closed USD114mn in long-term financing for its El Naranjal and Del Litoral solar PV projects in Salto, Uruguay, in the summer of last year.

The government last year announced a new USD12bn energy and infrastructure investment drive, building on its successes of developing world-class logistics and transport infrastructure, while at the same time transitioning from a net energy importer to a net exporter, selling excess generation to Argentina and Brazil.

“Especially during times of heightened volatility, it is much more attractive to go to countries that offer flexibility on financing, have a robust policy framework, and offer stability and attractive commercial terms – and Uruguay very much fits that profile.”

Although elections in flagship economies throughout the region last year largely left project developers and investors with a sense of anxiety, those who spoke with Bonds & Loans were unanimous

in their optimism about the continued turnaround in Brazil, where Jair Bolsonaro, a controversial right-wing politician and former military officer, clinched the presidency last year.

Joaquin Camacho, who recently left his position as Chief Control Officer and Finance Director at large multinational developer Sacyr to join Key Capital Partners and found an infrastructure investment fund with an appetite for deals globally, says he is looking closely at opportunities there as the fund scales up.

“We think there is huge pent-up appetite for deals in the country, particularly from family offices and other investors pools looking to deploy capital.”

Economists expect the economy to rebound this year, with growth topping 2.5% by the end of 2019 – up from 1.4% last year, according to UN estimates, and growth potentially accelerating at a faster pace if the government can pass social security reforms quickly. Among measures aimed at overhauling social security, including a prohibitively expensive pension system, a reform plan that leaked in early February looks to be among the most stringent yet.

If successful, the plan to require 40 years of (defined) contributions before pension recipients would qualify, and would see the minimum retirement age pushed to 65, or fifteen years beyond the minimum retirement age that public sector workers are currently entitled to.

The local market for infrastructure funding is very deep in Brazil, with BNDES, the country’s overstretched infra-focused development bank, heavily involved in many of the country’s flagship projects across a broad range of sectors. The country also has a deep and vibrant infrastructure debenture market centred around the buying and selling of Certificados de Recebíveis Imobiliários, or CRIs, which are securities backed by real estate receivables, resembling mortgage pass-through securities in the US.

But for foreign developers looking for a slice of the pie, infrastructure deals in Brazil have in the past been

hamstrung by the need to have BNDES involved in some capacity, to fund the transaction in reais, and to secure a corporate guarantee – making true project finance extremely difficult for borrowers. The prospective plan was met with cheers from investors who had spent years hoping that one of the region’s largest markets would take important steps towards financial sustainability.

With BNDES now looking to scale back its role in projects, some believe that will create a significant opportunity for new liquidity pools outside the country to complement what many see as a relatively conservative local banking market. Reports already suggest some large international investment banks that had previously exited or significantly scaled back their activities in Brazil are now looking at returning to redouble their support for existing multinational clients while hunting for new opportunities to lend.

“With BNDES retrenching and more talk of the government potentially making it easier to do deals in hard currencies, Brazil could become very interesting for developers and even international investors. We are keen to boost our presence in the country, but let ’s see how things progress,” Martinez-Pardo says.

After a hectic 2018, the post-election dust does appear to be settling across the Americas. But the uneven domestic growth outlook in the region appears likely to be confronted by significant macro headwinds that shouldn’t be discounted. A slowdown in the US and China, exacerbated fur ther by global trade tensions, regional instability (Venezuela and Argentina, primarily) and economic uncertainty could dampen the attractiveness of some of the region’s powerhouse economies.

That ’s why, with an infrastructure deficit running into the tens of billions of dollars and the global economic cycle on the downward march, the region’s governments should prioritise making investment into the sector as frictionless as possible for a broad range of funding stakeholders.

41MARCH/APRIL 2019

The Americas

Latin America Loan Market Heats Up as Hard Currency Liquidity Comes into Focus

Latin American borrowers continue to see strong demand from lenders and investors following a hectic year of elections in many of the region’s largest economies. We speak with David Costa, Managing Director, Head of Latin America Finance; Mauricio Voorduin, Managing Director, Latin America Regional Head; Sara Pirzada, Managing Director, Loan Capital Markets; and Mark Tuttle, Managing Director, DCM

at Mizuho Securities, a regional funding leader, about some of the key trends prevalent in the region’s markets throughout the first quarter of this year, and why it’s never been a better time for borrowers to move into the dollar markets.

Q Bonds & Loans: The loan markets in Latin America have really taken off in in the first quarter of 2019. In your view, what are some of the primary drivers in play?

A Sara Pirzada: There has been a fair amount of supply. During much of the first quarter the pipeline was dominated by large Brazilian corporates. That was to some extent a shift that was likely to take place following the past few years, which saw a broad-based anti-corruption effort in the country that in a sense also weighed on supply. While liquidity has consistently been strong, and continues to be strong, there is also much more optimism about the direction of the economy following last year’s election.

We started to see this trend accelerate last year, particularly after Petrobras came to the market with its upsized USD4.35bn revolving credit facility in March. That was the first top-tier entity in the country to put forward a large-scale transaction that was attractively priced for the client and attracted significantly more liquidity than was originally sought. But more importantly, the company went to great lengths to show the investment community that it is committed to improving its corporate governance and improving its credit rating. This was followed closely by Suzano, which closed a series of very successful transactions totalling more than UDS9bn related to its merger with Fibria.

These transactions together were a significant anchor that inspired more borrowers, like Klabin and Haizen more recently, to come to market and bolstered investor confidence in Brazil’s political and economic direction. Borrowers are feeling more comfortable that they are able to secure liquidity at a fair value from the loan market, and cut through some of the headline or political noise.

Another key driver to touch on is liquidity – which remains very robust for companies with strong business models.

Q Bonds & Loans: Revolving credit facilities seem to be picking up in the region as well. Is this a sign that Latin American corporates are strategically positioning themselves for growth and new investment? Is this growing preference for RCFs being driven by other macro factors?

A David Costa: One of the main factors to consider in Brazil, for instance, is the low interest rate environment. In that market, over the past two years, rates have moved from just over 14% to 6.5%, where they are today, which has pushed more borrowers to seek a broader range of funding mechanisms that are more attractive from a rates and flexibility perspective.

If negative carry becomes an acute pain-point with other funding instruments, then revolving credit facilities will become an attractive and effective way of managing an organisation’s liquidity. That is one of the reasons why this product has taken off in recent months.

Q Bonds & Loans: One of the more interesting developments in the Americas in the early months of 2019 seems to be a reversal of sentiment in Brazil and Mexico. Simply put, CFOs in Mexico seem much more cautious, and in some cases quite bearish, compared with those in Brazil – who seem to be much more optimistic about the funding outlook. What are some of the factors driving this shift in sentiment? Have you noticed these trends playing out in the transaction pipeline?

A David Costa: In Mexico, from an investor point of view, I don’t see too much negativity. Yes, to some extent, investors and borrowers appear more up-beat in Brazil. In Mexico, I get the sense that investors and borrowers are shifting into ‘wait-and-see’ mode. So far, we haven’t seen much change on the ground, and in terms of the country’s fundamentals,


The Americas

we don’t anticipate a shift that would be significant enough to justify a narrowing of the pricing gap between Brazil and Mexico. From a ratings and economic perspective, Mexico is still more sound on a fundamentals basis than Brazil.

A Mark Tuttle: In Mexico, there is certainly caution. In the capital markets, outside of the caution and potential concern around the new administration and its policies, primarily those that would be impacted are CFE and PEMEX, or companies operating in value chains linked to those organisations. There is not a lot of concern in the private sector however, as investors are quite comfortable with Mexico. For example, we haven’t seen private sector bond yields increase significantly. The lack of private sector issuance through much of last year and into this year wasn’t necessarily a reflection of borrower or investor sentiment, but more the fact that borrowers have termed out their maturities very, very well.

Mexico and Brazil are the two ‘alphas’ in the region, and over the past few years, certainly in the first year or two following Lava Jato in Brazil, you’ve seen Mexico go positive and Brazil go negative; I think what’s happening now – where you have PEMEX bonds trading wider to Petrobras, for example – is an overshoot on negative sentiment in Mexico, whereas in Brazil, you have positives priced in – largely focused on the government’s ability to push through its ambitious pension reforms. In any event, fund flows to Mexico continue to be strong, and concerns around borrowers there seem, for the time being, to be restricted to the energy sector.

A Mauricio Voorduin: I think it’s also important to look through the noise and focus on fundamentals. Top-tier Corporates in Mexico are still very strong, and we are seeing some borrowers in Mexico refinancing past transactions this year with better terms, lighter covenants, and better pricing. Access to funding and liquidity is very much still there.

Q Bonds & Loans: Infrastructure still presents a huge opportunity for developers, lenders and investors across Latin America. If we distinguish between larger projects like metros, airports, railways, and toll-roads, and smaller projects in the energy and mining sectors, what does the funding pipeline look like for projects in the region?

A Sara Pirzada: Supply for the larger projects tends to be lumpier by nature – we will often see a bunch of deals at once across the region or in tandem with a country’s PPP-related tendering stage, then spend the next year or two seeing just one or two transactions. Currently, we are seeing an upswing, with discussions around new metro and rail projects moving at an accelerated pace and creating new opportunities from Panama to Peru and a number of countries in between.

There are regional or country-level nuances to that. In Colombia, for instance, expectations were extremely high for the country’s 4G toll road programme, and the strong momentum initially seen there has tapered off to some extent;

part of that is related to the strong local currency funding requirement for many of those projects, which was a deterrent for international banks and investors. But the irrevocable government guarantee certificate system implemented by the Colombian authorities in the 4G programme was successfully replicated elsewhere in the region. In Peru and Panama, those risk mitigants have been instrumental at times when investors have been more cautious about which borrowers they lend to, and have led to a healthy supply of projects emerging.

On the energy and mining front, we are also seeing an upswing. For years, commodity prices – particularly copper and oil – were in the doldrums, which meant that most companies operating in these sectors had to scale back CAPEX. Now we are seeing a reversal of that, which has led to a great deal of focus on how to monetise large cashflow-generating assets and secure liquidity at a time of record low funding costs, particularly for international project developers based in Europe. I would expect for the next 12-24 months, we’re going to see that positive upswing continue.

Q Bonds & Loans: Where do you see the biggest opportunity for infrastructure in the Americas? And how can these projects be sufficiently funded in an environment where countries in the region increase their prioritisation of local-currency funding?

A Sara Pirzada: In terms of the next big infrastructure opportunity – both in terms of larger transport or logistics-related projects as well as the energy sector – all eyes are on Brazil. Because so many of those projects have historically been financed by state-owned development bank BNDES, and the lender is now taking a step back.

The big challenge there is that the majority of infrastructure-related funding is denominated in local currency. Cheap local funding from BNDES, coupled with strong appetite from local banks, has helped cement this over the decades. But if the country wants to achieve critical mass and tap into international appetite to secure its infrastructure investment ambitions, it will have little choice but to shift into hard currency markets. I don’t think this will happen overnight, nor does it need to, but we will likely see some kind of shift that encourages a blend of local and hard-currency funding. The Transportadora Associada de Gás (TAG) pipeline sale in Brazil is a good example of what we might start to see, with the consortium formed by Engie and Caisse de dépôt et placement du Québec (CDPQ) looking to raise a blend of hard and local-currency funding to finance the acquisition of that asset from Petrobras.

Projects like ports and airports are ideal candidates for hard currency funding because the receivables or income are often denominated in dollars. Road infrastructure and to a lesser extent rail are also great candidates for blended local and hard-currency funding. So, things could change, particularly as dollar liquidity is so strong, and as the quantum of funding increases.

Scrapped New City Airport, Struggling Pemex Dominate Discussions at Mexico CFO Roundtable

Mexican borrowers are gradually adjusting to the new market environment that has emerged since the inauguration of Andrés Manuel López Obrador, and amid broader emerging market volatility driven by the rise in global interest rates. Nevertheless, CFOs at a Breakfast Roundtable hosted by HSBC and Bonds & Loans in Mexico in February have raised important questions about some of

the new administration’s policy decisions, highlighting the need for clear, consistent and transparent decision-making as essential in their bid to secure stronger growth and investment.

43MARCH/APRIL 2019

The Americas

Despite some challenges, participants saw 2018 as a moderately successful year, with the new budget in December seen as robust and fiscally responsible. Many issuers over the past 12 months have switched to “wait and see” when it comes to the new leadership, before committing any additional capex (although there has been some variation and divergence in that regard between different sectors).

While the energy sector, for example, continues to struggle due to a confluence of factors, industries such as telecoms infrastructure are already reaping benefits of the government’s commitment to expanding internet coverage and connectivity to the farthest reaches of the country, including through private investment.

External and geopolitical challenges – namely the new USMCA deal and US-China trade wars – have lingered into 2019, albeit in a less acute form than seen in the previous year. Exports have formed a crucial part of Mexico’s growth story in recent years, and finalizing the “new NAFTA” is still seen as a major achievement.

For the automotive and manufacturing sectors, for instance, the new deal largely maintains the status quo, which is positive considering the tense and aggressive rhetoric prior to the renegotiations. Increase in regional value content should also prove beneficial to Mexico, and should see a rise in onshore development, especially from Asian and European manufacturers.

The 16 dollar-per-hour rule (the agreement calls for 40-45% of automobile components to be made by workers who earn at least USD16 an hour by 2023) was less welcome, but a five-year phase-in period should provide sufficient time to readjust.

But although the substance of new policies has been largely welcomed (or at least tolerated), a few CFOs expressed reservations about the way they are being implemented, with the debacle following the cancellation of the New Mexico City Airport featuring prominently in the discussion. This inevitably led to some concerns being expressed about the future of some of the other projects in development.

“It’s hard to see the logic behind this, or what the next steps would be,” lamented one CFO, who preferred to remain anonymous.

“For us it’s a matter of managing the risks, which becomes a lot harder when the goal posts shift so much during the game,” said another corporate chief.

Some of the participants were also unimpressed by the new administration’s use of social media to announce or promote policies: while not a problem in itself, tweets that potentially reveal or hint at policy moves ahead of official announcements, particularly if coming from senior Ministers, can seriously affect market performance, while the lack of existing regulations in this sphere creates additional challenges by adding to the speculation.

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Top risks facing your organisation’s fundingstrategy primarily domestic or external

Domestic

External

Equal parts both

36.36%

9.09%

54.55%

Text Response

12.50%

12.50%

25.00%

25.00%

37.50%

37.50%

If you planned to execute a credit transactionin the past 3 months but postponed, what was the reason in your view?

Change in internal strategy

Sovereign credit downgra..

Lack of investor demand

Unattractive pricing

None of the above

Poor market conditions

Text Response

Source: Bonds & Loans CFO Survey

www.BondsLoans.com

Still, CFOs were encouraged about the new finance ministry’s willingness to engage with other market players and react appropriately to their feedback; that assessment referred to the Hacienda’s low and mid-level officials, executives and civil servants, while some of the top-level administration officials were deemed less engaging – at least so far. As some of the key positions in the finance ministry continue to be filled going into 2019, the responsiveness and steadfastness of those departments is expected to improve.

Macro Risks in 2019Views of the roundtable participants largely reflected some of the feedback from the semi-annual 3Q 2018 Bonds & Loans Market Insights CFO & Investor Survey Report. In particular, the Mexico-specific survey results showed less concern about external risks (9.09% of CFOs) compared to the broad LatAm average seen in the same survey (20%), with internal and external challenges weighing equally heavily on Mexican company chiefs’ minds (54.6%) than across the continent (40%).

Among the broad macro and political risks CFOs at the roundtable were anticipating in 2019, the most frequently referenced was ailing state-owned oil giant Pemex, which is sitting atop a USD106bn debt pile. Even the latest round of measures – including a number of tax cuts - by the government to prop up the company is largely seen as a “fig leaf” that doesn’t provide a long-term solution.

While not all industries would be equally impacted by Pemex’s challenges, a possible negative credit event and growing pressure on the country’s fiscus could cascade across the borrower universe by influencing broad investor sentiment in a way that could negatively affect credit market performance, as well as on economic growth and consumption.

With uncertainty remaining over NAFTA and global trade, along with internal issues like the sustainability of Pemex’s balance sheet, CFOs in the country are already preparing for another challenging and important year, which may very well set the tone for the domestic and global market outlook for the next decade. Some of these concerns were tied to developments and dislocations seen around the world, such as the election of populist leaders in the developed world, Brexit, and other anti-globalist trends.

Seeing Mexico and the country ’s challenges as part of a global trend – rather than a black sheep among peers – means that investors have compatible “country” risks to weigh up when picking a destination for investment. Therefore, managing the increase of idiosyncratic country risk – including headline risk – becomes a primary objective for CFOs and treasurers intent on drawing strong appetite for their companies’ credit.

The flipside of this is that companies that are able to extend their presence beyond the country’s borders and diversify to regionally or globally will have a better credit outlook and can hedge their risks. “It ’s all about finding

the perfect balance between representing the Mexican market and minimizing the exposure to the country risk,” one CFO explained.

Debt Capital Markets – Loans over BondsRefinancing, deleveraging and locking in longer-term debt – trends that were already becoming apparent in the second half of 2018 – continues to be the dominant theme for Mexican borrowers. Some have hit their funding targets early – in 2016, or start of 2017 – to get ahead of the elections; and some decided to sit out the election noise, and are now trying to assess market conditions for refinancing.

From the investor perspective, the trend to maintain strong liquidity and minimize risks will likely continue through a tricky 2019, when the new administration will be settling into power. In terms of issuance volume, 2018 saw a moderate drop of about 15% from 2017.

Corporate issuance was, however, “top heavy” last year, with most deals completed in 1H2018, followed by a slow second half. While investors have ample liquidity to deploy, they are more defensive and reluctant to extend tenors under current conditions, stemming from concerns about inflation and rising rates – even when it comes to USD-denominated issues.

The main questions, then, are around the supply side – corporates have to decide whether to come to market now or hold out and refinance. There is a formidable maturity wall in 2021, which is likely to coincide with the impact of the government’s fiscal reforms, adding some urgency for corporates to refinance over the next 12-18 months.

But pricing remains the main variable: over the past six months, the cost of borrowing has risen dramatically, both locally and internationally.

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45MARCH/APRIL 2019

End of Hiking Cycle in Sight?

There has been some reprieve for Mexican assets, along with broader EM, since the Fed signalled at the end of December last year that it may pause or even end the hiking cycle, but market-watchers are weary that this sort of sudden boost will also bring bouts of volatility, creating a danger of sudden outflows were the Fed to reverse direction again.

Relative value then has become a key factor for investors. For example, recent issues by Credito Real and by the Mexican sovereign saw a fairly high premium: Mexico’s USD2bn April 2029 notes priced at +185bp over US Treasuries, coming wider than Colombia (165bp) and Uruguay (which arrived the same week – with a longer bond rated two notches below), and far wider than Peru’s, which came in at 86bp wide of the UST curve. From the issuers’ perspective, it is increasingly a market of windows, which means that astute timing and swift execution are essential in getting the best deal.

Some CFOs conceded that in this environment, they are much more comfortable going into the loan market than issuing bonds: at a time of rising rates and uncertainty, relationship banks are able to offer better prices than bond investors, which tend to focus more on the macro conditions among a range of other exogenous factors when pricing transactions. The traditional pre-conditions associated with the bond markets include a large issuance size, a convincing use of proceeds etc, which means that borrowers are preferring syndicated loans – typically, with their relationship banks.

The caveat here is that this trend has a propensity for reversing very quickly, as the 2008-09 financial crisis demonstrated: when push comes to shove, credit officers can close the bank market doors very swiftly. What this means is that while a loan is still a safer route in times of volatility, hedging your bets by keeping both avenues open – wherever possible – is the most sensible solution.

“After all, the USD4BN bond earlier this year can be considered a success, even though the price paid was wider than other comparable credits. That is just the reality at the moment,” Yamur Munoz concluded.

Rate ExpectationsGoing into 2019, roundtable participants generally expect growth to remain subdued in 2019. Many of the banks have priced in a slowdown in 2019, but other key variables – namely the FX and interest rates – are becoming increasingly harder to predict. Black swans aside, there will be at least two major developments in 2019 that will weigh on Mexico’s growth. The first is the NAFTA revamp, the USMCA, which still has hurdles in each countries’ legislative branches. The second is the US economy.

“We are now seeing the US recession talk turning into slowdown talk, which is positive. And the progress in tariff discussions with China is also encouraging,” said one participant.

Mexico can reap some rewards out of a US-China standoff. It has long-term competitive fundamentals and can better service the US market, which ought to help draw in investors that have been sidelined by the tariff wars. Some production is already switching from China into Mexico – a trend that is likely to continue through 2019.

In terms of policy expectations, the government sticking to the budget and resisting the urge to introduce additional taxes, while being responsive to the Fed’s movements, are the main objectives for 2019 from a market perspective.

On the budget side, more clarity is needed from the finance ministry regarding the primary deficit goals. So far, its stated figures have been somewhat nebulous. The new administration also needs to demonstrate that it can react adequately and effectively to potential missed growth targets, rather than shifting blame or retroactively “reworking” the forecasts.

At the same time, the government will need to be realistic about the budget’s sustainability, particularly as government and state-linked entities are being slimmed down.

Policy-makers also need to come up with a solution to the growing issue of labour protests and strikes, which occurred recently in the “maquila” factories in Matamoros and are threatening to spill-over into other regions. This kind of social unrest has the potential to hamper the reform agenda and stifle economic growth, and needs to be addressed quickly.

Pemexed OutThe energy and fuel sectors remain the elephant in the room – particularly the case of Pemex. International banks for now are bullish about Mexico’s medium and long-term projects, although those with large exposure to Pemex are growing jittery as its wall of maturities approaches. The company will need to refinance them soon, which means government support in some form or another will be essential.

The bigger challenge, for the company and for this administration, is to streamline and reform Pemex to make it a more attractive credit for global investors – and not just those already exposed to it.

The gossip around the roundtable was that the Ministry of Finance was expected to propose a more robust and tangible solution, as the company focuses on refinancing existing maturities, rather than issuing new debt.

Shortly after the discussion those measures were announced – in the shape of a cash injection of USD3.9bn and a further USD1.6bn in revenue. While it is a positive step, more aid may be required going forward.

Pemex today is a company that is too big to fail, but too bulky to fully succeed. But the government has some time to introduces structural changes to streamline and deleverage the oil giant, resolve some of its long-standing inefficiencies and secure its future.

The Americas

• Borrower: Fermaca• Size: USD814.8mn• Format: Multi-tranche Structured Term Loan Facility• Issue Date: June 2018• Joint Lead Managers / Bookrunners: Norddeutsche

Landesbank Girozentrale; BNP Paribas; ING Capital; Mizuho Bank; Sabcapital

• Lead Investor: Allianz Global Investors• Legal Advisers to the Borrower: Latham & Watkins;

Galicia Abogados• Legal Advisers to the Joint Lead Managers:

Milbank, Tweed, Hadley & McCloy LLP; Ritch, Mueller, Heather y Nicolau

Mexican Borrowers Clean Up at This Year’s Latin America Deals of the Year Awards

Mexico’s political environment and markets experienced unprecedented levels of volatility in 2018, but against that backdrop borrowers took to the markets to launch

landmark transactions that still broke barriers and paved the way for others to follow.

The challenging market environment – driven largely by delicate NAFTA negotiations, election uncertainty, souring emerging market sentiment and rising interest rates – was enough to delay or prohibit fundraising plans for many borrowers, leaving hard currency bond volumes subdued while bank lending and overall credit demand flatlined. That so many borrowers still took the opportunity to break new ground on innovative funding programmes and achieve a number of firsts despite the volatility is even more impressive.

With so many high-quality deals nominated from Mexico and the wider region, this year’s Awards selection was more difficult than ever before. Following our recent Bonds, Loans & Derivatives Mexico conference in February at the Four Seasons in Mexico City, we wanted to take a closer look at some of the landmark transactions deserving of recognition and originating from one of Latin America’s deepest and most developed markets.

• Borrower: Grupo Bimbo• Size: USD500mn• Format: 5.95% Perpetual 5NC3 Hybrid Notes NC5• Issue Date: April 2018• Joint Lead Managers / Bookrunners: Bank of

America Merrill Lynch; Citi; HSBC; ING; JPMorgan; Santander

• Legal Advisers to the Borrower: Skadden, Arps, Slate, Meagher & Flom LLP; Galicia Abogados

• Legal Advisers to the Joint Lead Managers: Cleary, Gottlieb, Steen & Hamilton; Ritch, Mueller, Heather & Nicolau

• Borrower: Vitro• Size: USD700mn• Format: Senior Unsecured Term Loan Facility due in

July 2023• Closing Date: July 2018• Joint Lead Arrangers / Bookrunners: BBVA; HSBC• Legal Advisers to the Borrower: Cleary Gottlieb Steen

& Hamilton LLP; Kuri Breña Sánchez Ugarte y Aznar• Legal Advisers to the Joint Lead Managers:

Skadden, Arps, Slate, Meagher & Flom LLP; Greenberg Traurig, S.C.Mexico: Corporate Bond Deal of the Year

Mexico: Syndicated Loan Deal of the Year

Mexico: Structured Loan Deal of the YearAdopting a unique structure not often embraced by non-financial corporates, Grupo Bimbo’s inaugural hybrid subordinated perpetual notes achieved a number of key milestones for the region’s markets and the borrower – including improved balance sheet efficiency due to the instrument’s 50% equity treatment from major rating agencies, which helped bolster the company’s deleveraging story. The strong pricing, particularly given the adverse market conditions and the challenge of finding comparable securities, is a testament to the razor-sharp timing of the deal’s execution. It was also the first hybrid security issued by a Mexican consumer company, and a rarity in the region’s wider international capital markets, paving the way for future transactions and broadening the investor base for both Grupo Bimbo and similar borrowers. This transaction also took home top prize for the region’s Latin America Sub-IG Deal of the Year

Amid a fairly volatile political and economic environment given the recent presidential elections in Mexico, leading glass manufacturer Vitro was able to successfully refinance its existing debt facilities, while extending its debt maturity profile, reducing its interest expense cost and improving its overall terms and conditions – several key wins for the borrower. The quickly-executed facility had an initial margin of LIBOR+2%, allowing the company to reduce interest payments by close to USD12mn per year. The deal was oversubscribed by 60%, and saw the participation from a healthy mix of local, regional and international lenders, allowing the company to further diversify its sources of funding.


• Borrower: Unifin• Size: UDS250mn• Format: Subordinated Perpetual NC7 Notes 8.875%

Coupon• Issue Date: January 2018• Joint Lead Managers / Bookrunners: Barclays; Citi;

Morgan Stanley; Scotiabank• Legal Advisers to the Borrower: Cleary Gottlieb

Steen & Hamilton; Mancera• Legal Advisers to the Joint Lead Managers:

Skadden, Arps, Slate, Meagher & Flom LLP; Galicia Advogados

• Borrower: Actis LLP• Size: USD860mn• Format: 144A/RegS Senior Secured Notes 6.375%

Coupon due April 2035• Issue Date: April 2018• Joint Lead Managers / Bookrunners: BNP Paribas;

Citi; JP Morgan; Scotiabank; SMBC Nikko• Legal Advisers to the Borrower: Millbank; Galicia

Abogados• Legal Advisers to the Joint Lead Managers:

Shearman & Sterling; Gonzalez Calvillo

• Borrower: Fondo Nacional de Infraestructura (FONADIN)

• Size: MXN15.38bn • Format: Dual tranche ABS consisting of MXN12.74bn

equivalent in UDIs and USD2.64bn equivalent in MXN (Coupon: UDI: 5.07%; MXN: 9.12%)

• Closing Date: March 2018• Joint Lead Manager / Bookrunner / Structuring

Agent: HSBC• Joint Lead Manager / Bookrunner: BBVA• Legal Advisers to the Borrower: Ritch Mueller• Legal Advisers to the Joint Lead Managers: Galicia

Abogados

Mexico: Financial Institutions Deal of the Year

Mexico: Structured Bond Deal of the Year

Mexico: Project Finance Deal of the Year

This highly structured multi-tranche loan to finance the El Encino gas pipeline, a critical part of Mexico’s energy reform and transition to cleaner and cost-efficient power generation, saw the borrower blend cost efficient commercial debt (with shorter tenor) with very competitively priced 24-year private placement notes that left less than 1-year of tail under the offtake agreement. The sponsor was also able to increase leverage from the original project financing (mini-perm) and receive a meaningful dividend recap at financial closing. The blended fixed-rate notes and commercial loan, a rarity in the country’s oil & gas sector, resulted in a highly efficient permanent financing structure that helped the borrower achieve all of its key objectives while carving a path for future similar transactions.

Issued as part of a wider deal by Cometa Energía S.A. de C.V., an indirect wholly-owned subsidiary of Actis LLP, to acquire InterGen Mexico, these structured 144A/RegS notes included a tailored amortisation profile based on varying DSCRs for contracted cash flows, uncontracted cash flows and cash flows from a joint venture, as well as a traditional cashflow waterfall (including Debt Service Reserve and O&M Reserve Accounts). The flexible covenant package combined with the borrower’s strong balance sheet allowed the notes to secure an IG rating affirmation. The overall acquisition financing deal included the USD860mn structured notes, along with USD316mn in sponsor equity, a USD60mn revolving credit facility, and USD120mn in letters of credit.

Unifin’s inaugural perpetual bond was priced attractively for investors and marked one of the first transactions to reopen the Latin American perpetuals market. The execution followed an extensive two-week roadshow covering key EM real money managers in Los Angeles, Hong Kong, Singapore, London, Geneva, Zurich, Boston and New York, which paid off in the form of strong demand from a well-diversified set of investors; at its peak, the orderbook reached USD1.5bn, allowing the issuer to upsize the deal by USD50mn and still price 37.5bp inside initial guidance. The offering significantly improved Unifin’s capital structure and strengthened its credit profile.

Faced with the task of financing the Mexico-Puebla toll road, Mexican Federal Government Trust fund Fondo Nacional de Infraestructura (FONADIN) managed to achieve extremely tight pricing through the sale of a one-of-a-kind asset-backed security – a feat made even more impressive given the market backdrop and tense NAFTA negotiations ongoing at the time. The deal team was able to market the transaction at benchmark size, a first in the local market, and the structure – heavily influenced by those seen in the US structured securities markets – enabled FONADIN to attract a broad swath of investors, culminating in the largest transaction of its kind in Mexico and Latin America and the tightest pricing for a toll-road to date in Mexico.

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As Russia enters its fifth year under sanctions and the deal pipeline in the region continues to be squeezed, south of the border some CIS and Central Asian states are undergoing remarkable

transformation. But sanctions against Russia will not necessarily free up credit for potential issuers in the former Soviet states, all of which makes for an increasingly uncertain debt capital market for the region in coming months.

CIS Issuance Set to Outsize Russia as Sanctions Continue to Pinch

Russia, Europe & Asia

Since American sanctions against Russia were first imposed in March 2014, primary market activity has been squeezed. Asset freezes targeting the highest echelons of Russian government and business (which are often intertwined) has seen certain sectors become increasingly isolated from foreign markets, and culminated in fasttracked plans to de-dollarise the economy.

Looking beyond Russia’s southern borders, however, spring appears to be on the doorstep of a region long marred by dictatorships and stagnant economies. Some countries in the Central Asia – notably Kazakhstan, Uzbekistan, and Tajikistan – are making strides towards global financial integration, and have embarked upon ambitious plans for liberalisation.

Although American economic restrictions were largely targeted at select individuals within, or close to, the Putin regime, the close ties many officials have with the private sector or quasi-corporates have resulted in sanctions impacting broad sectors of Russian industry. Rusal, the world’s second largest aluminium manufacturer, has felt the pinch as a result of sanctions against its owner, famed oligarch and Putin ally Oleg Deripaska.

With many sectors facing increasing difficulties, some corporates in the country – particularly those with a need for hard-currency funding – are now operating in a tangibly less comfortable funding environment than before, with credits often suffering a 30-50bp risk premium. According to Alexander Bulgakov, Executive Director of Debt Capital Marketers at Raiffeisen bank in Moscow, Russian issuance decreased by 80% in 2014 and 90% by 2015, compared with 2013 figures; 25% of that decline was directly related to financial sanctions against state companies.

“Although this is a lot, it is far from critical as the bond supply often varies by up to 20% due to global volatility.”

According to one structured commodity finance banker, activity in the country’s oil and gas sector has also been throttled as the US has continued to tighten the screws.

Even the recent decision by Moody’s to upgrade the sovereign to investment grade appears unlikely to alleviate the impact of sanctions.

“The upgrade hasn’t impacted [Russian] Eurobonds at all,” argues Egor Fedorov,


48 CIS Issuance Set to Outsize Russia as Sanctions Continue to Pinch

51AzFinance: We Anticipate Azeri Local Issuance to Reach AZN100mn by the End of 2019

52China: Onshore Bond Index Inclusion Marks Milestone in Financial Liberalisation

Senior Credit Analyst at ING Bank in Moscow, “Other agencies had already rated them investment grade – Moody’s was just catching up. Investors familiar with the region were already familiar with the level of risk before the upgrade.”

Further EscalationDespite Congress’ recent decision to lift sanctions from Rusal, further punitive measures may be on the horizon. Following the Democrats’ victory in the US midterm elections, the issue of Russian sanctions may return to mainstream American political discourse with renewed vigour.

49

OFZ Holdings

OFZ holdings (Rbs, trillion)

Source: Central Bank of Russia

2013 2014 2015 2016 2017 2018

Non-residents

Residents

April 2018US sanctions

5

4

3

2

1

MARCH/APRIL 2019


As Bulgakov argues, any further measures against Russia may well be the product of domestic American party politics, regardless of Russian foreign policy. As the Mueller investigation gathers pace, the Democrats may adopt a more confrontational posture against Russia, with further sanctions being used to bolster the opposition’s credibility.

“Given [the Democrats’] own political goals, further sanctions against Russia could be used as a card in a game for power in the US.”

Even if this does not occur, Bulgakov argues, total CIS issuance in 2019 could feasibly outsize Russian issuance, as was the case in 2016.

Central Asia South of the Russian border, the historically isolated region of Central Asia is making tentative steps towards financial liberalisation.

For some countries in the region, politics is in a state of flux: Kazakhstan, Uzbekistan, and Tajikistan are making headway towards global financial integration.

Kazakhstan, which has reaped the benefits of foreign direct investment since its independence from the Soviet Union

in 1991, recently began to undergo a renewed wave of liberalisation. Following a recent change in government, plans are now underway to privatise seven of the country’s bulky state-owned institutions. Efforts to develop the country’s financial infrastructure came to fruition last year when Kazakhstan signed a memorandum of cooperation with Euroclear bank, opening its USD28bn KZT-debt market to foreign investors.

But some are sceptical about the scale of benefits to be reaped by the latest wave of modernisation sweeping the region, and question whether the fanfare over its global integration is premature.

“From my experience of talking to investors, they are very reluctant to go deep into the corporate market [in central Asia]; they still prefer to invest in hard currency listed under English law or under international legislation,” argues Fedorov.

As Kazakhstan continues to be buoyed by strong growth, low inflation and icnremental domestic reform, the country’s Eurobond spreads have tightened in relation to Russia, in part due to the negative bearing of sanctions risk on the latter.

For investors looking at this part of the world, holding assets in the region may serve as a potential hedge against

50

Eurobond yields (%), estimated for Uzbekistan

Source: Bloomberg

-3.0

3.5

1 2 3 4 5

Modified duration

6 7 8 9 10

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

GEORG-21

ARMEN-20

AZERBJ-19

AZERBJ-24

AZERBJ-29

ARMEN-25

BELRUS-23

BELRUS-27 BELRUS-30

AZERBJ-32

UZBEK-29

UZBEK-24

www.BondsLoans.com

Russian sanctions, but the fortunes of Central Asian economies still – to an extent – rise and fall with the latter.

“The Kazakh economy is mildly exposed to Russian markets – around 4% of GDP, but potential rouble weakness attributed to possible sanctions remain a major risk for the tenge,” argue analysts from Renaissance Capital in a recent investor note.

Uzbek to the Future February 2019 saw Uzbekistan come to market with its debut USD1bn Eurobond issuance. During a press conference at the London Stock Exchange in February, the Head of the Debt Management Office, Odilbek Isakov, was candid about the country’s intention to become a regular in the capital markets.

“We would like to offer a fresh benchmark to the market on a regular basis. It doesn’t mean we will issue large amounts – in fact, we don’t need the money… The point [of the issuance] was to access capital markets and create a benchmark for Uzbek five and ten-year credit. Hopefully, subject to government approval and subject to markets, we will come [to market] on an annual basis and hopefully our banks and companies, when ready, will follow in our footsteps.”

In a recent report, Renaissance Capital underscored Uzbekistan’s potential to become a trailblazer for reform in the region. The country benefits from a large natural resource base, and perhaps more importantly, a relatively active non-oil sectors; the manufacturing and food industries, for instance, accounted for 45% of GDP in 2018. One of the most impressive aspects of this economy is its export base.

“As much as a quarter of all exports are manufacturing items – something Russia and Kazakhstan can only dream about,” Isakov explains.

Clemente Capello, Founder and CIO of Sturgeon Capital, shares this optimism.

“We’re very keen on Uzbekistan. It’s a kind of ‘fall of the Berlin Wall’ moment without the chaos, and the government is carrying out some pretty bold reforms. It’s very exciting because they don’t have these transitions very often – from a

Soviet-style economy to a more market-friendly economy.”

Only time will tell whether the reform agenda will lose momentum; notwithstanding the conviction to see them through, the country faces relatively limited risks when compared to its peers.

“We think this is a good story and we are bullish about Uzbekistan’s transformation, but if we had to name two potential areas of caution they would be: 1) weaknesses of state-owned enterprises increased (or were revealed), leading to higher contingent liabilities; and 2) market access leads to a large amount of borrowing over the coming 5-years. Many debut Eurobond issuers in 2012 initially looked great to the markets, but after several issues, plus domestic borrowing and large bilateral infrastructure and commercial loans, debt sustainability concerns grew quickly,” the Renaissance Capital report notes.

Yet the combination of continued Western pressure on Russia and wide-reaching reform programmes in Central Asia does not appear to be tempting investment banks to expand operations in the region. Although reform projects in some states are promising, they are in their early stages.

Uzbekistan’s Eurobond issuance has paved the way for corporates to follow suit; how long it will take before domestic firms meet the necessary conditions to come to market – whether fiscal or governance-related – remains unclear.

“[Central Asia and CIS] is a very concentrated market in terms of names,” explained Fedorov, warning that opening the local corporate bond markets may well subject these markets to dangerous levels of volatility.

The last five years have shown that Russia is capable of surviving under sanctions. The question is no longer whether sanctions against Russia will be fully removed, but rather, how the financial sector will continue to adapt to the new status quo. It is perhaps unsurprising, then, that many banks are not considering expanding their physical operations in the region. According to one UK-based banker, the core Western banks that have been historically active in the region will continue to solidify their footing there, but there are fewer and fewer new entrants showing interest in the region.

“We know which borrowers are going to come,” the banker said, “nothing really comes as a surprise anymore.”


51


MARCH/APRIL 2019

Abid Mamedov, CEO of AzFinance Investment Company CJSC talks about the rising appetite for Azerbaijani paper, exposure to Russian risk, and expectations for the local currency bond market in 2019.

AzFinance: We Anticipate Azeri Local Issuance to Reach AZN100mn by the End of 2019

Q Bonds & Loans: How is CIS bond supply over the coming year likely to evolve? Who will be the main issuers in the region? How is overall issuance likely to change?

A Abid Mamedov: The last two years following the devaluation were quite difficult for Azerbaijan economy, as well as Banking Sector and Financial Securities market. Thus, we again perceived the importance of the non-oil sector for country. After the 2H2018, the withdrawals from bank deposits and the convertible capital on foreign currency gradually returned to market, while investments have increased on the back of a more stable AZN, from a long-term perspective.

As AzFinance Investment Company, we participated with two stock offerings and four bond issuances during the first month of 2019; this is pretty high compared to a similar period in previous years. With that in mind, we are anticipating local bond issuance to total AZN100mn by the end of 2019.

Credit, leasing and other industry organizations have expressed an interest in financing themselves via the bond markets

in recent months. The high yield of deposit accounts and the fact that all the bank deposits are insured until February of 2019 saw investors flock to the local FI issuances. We consider that if the stable environment remains, the appetite for these bonds will keep growing.

Q Bonds & Loans: Are we likely to see more corporates from Azerbaijan and the broader region come to market this year?

A Abid Mamedov: We expect to see an increase in the issuance volumes, and the number of issuers. Based on our discussions with clients and research, we can say that there is strong interest for this sector and are taking steps to channel this interest into concrete deals. The challenge at the moment is that there is a thin line-up of companies that are interested in tapping the bond market. Often the roadblock lies in strict compliance and reporting regulations associated with issuing internationally.

Q Bonds & Loans: How are Azerbaijani bonds performing in the secondary market relative to the assets of comparable peers in the region?

A Abid Mamedov: A big portion of bondholders of Azerbaijani paper are real-money investors. The reason is that a functional bond markets are a relatively new feature in the country’s capital market landscape, developed over the past 10-15, so many of the market players are still familiarizing themselves with it. But these days more steps are being taken to educate them and we expect to see significant improvements in this space over the next 2-3 years.

Q Bonds & Loans: What do you see as the major risks threatening the key markets you invest in at present? How have sanctions against Russia impacted markets in the region?

A Abid Mamedov: We recognize that sanctions against Russia remain a threat and therefore we've closed all our positions on the Russian market, preferring to take a wait-and-see stance. But most local companies are financed by local investors. Companies which have relationships with Russia have increased their capital during last year. We currently do not observe any difficulty about this issue. For the local market the main risk is currency risk.

52


The recent announcement that Chinese government bonds (CGBs) and policy bank bonds will be included in the Bloomberg Barclay’s Global Aggregate (Global Agg) Index marks a huge milestone in

China’s gradual integration into global markets. Not only does index inclusion herald the beginning of an influx of foreign investment, but it has the potential to mould credit markets across the region.

China: Onshore Bond Index Inclusion Marks Milestone in Financial Liberalisation

China market size to exceed Japan’s this year

Source: BIS, Standard Chartered Research

US

Corporate credits Financials

2019E: CNY 98th(c. USD 14.5tn)

5

0

Governments

Global bond market size as of Q2-2018 (USD tn)

10

15

20

25

30

35

40

45

JP CN GB FR DE IT CA NL BR

www.BondsLoans.com

Caution has long been the watchword guiding China’s integration into the global economy; as the senior Communist official Chen Yun once argued, China will “Cross the river by feeling the stones.”

Tension remains between the government’s somewhat contradictory desire to reap the benefits of globalisation and preserve the insular nature of the Chinese economy. The plight of other emerging markets over the past two years has not gone unnoticed by China’s leaders, who have sought to limit China’s exposure to global turbulence by temporarily halting the liberalisation of China’s credit markets.

Since 2002, when China first began to open its bond markets to foreign investors, the country has made strides towards global financial integration. Foreign investors enjoyed growing access to Chinese debt, culminating in the phased introduction of the China Interbank Market (CIBM) Access scheme in 2015-16. Soon after this, however, progress slowed. The unexpected devaluation of the RMB in August 2015, alongside volatility in the FX, equity and bond markets dampened investor appetite and worried the Chinese authorities. The advent of Bond Connect – a platform allowing offshore investors access to

the domestic Chinese bond market in Hong Kong – has led to a further 300 registered users since its introduction in July 2017.

Reforming the Capital MarketsGiven the strides China has made towards reform, Bloomberg Barclay’s recently announced that onshore CGBs and policy bonds will be phased into their Global Aggregate Index beginning April 2019 at 5% per month over a twenty-month period. According to forecasts

by Standard Chartered, the domestic bond market will grow by c15% to CNY 98tn (cUSD14.5tn) in 2019, whilst overall foreign holdings of CGBs are set to rise from c3% to near 10% in 2019. Assuming tracking funds worth USD2.5tn, a Global Agg Index weight of 5.49% will result in c.USD140bn of foreign inflows, according to HSBC Global Research.

Although foreign institutions have only been able to trade CGBs for less than a decade, they have quickly become a

53


Chinese onshore bonds exhibit low correlationwith their global peers

Source: Bloomberg, QICGlobal Aggregate represents yield to worst of Bloomberg Global Aggregate Index

US

US Australia Germany China GlobalAgg

Australia

Germany

China

BardaysGlobalAggregate

Weekly correlation of 10-year government bonds (July 2013-July 2018)

1.0 0.71 0.21 0.18 0.94

1.0 0.20 0.15 0.73

1.0 0.11 0.27

1.0 0.23

1.0

Potential foreign inflows from index inclusion breakdown

Source: Standard Chartered Research

Global Agg

GBI-EM

WGBI

Total

Passiveinflows(USD bn)

2019

CGB PFB Total

23 26 50

- - -

- - -

23 26 50

2020

CGB PFB Total

28 32 60

14 - 14

81 - 81

123 32 155

2021

CGB PFB Total

- - -

- - -

81 - 81

81 - 81

2019-2021

CGB PFB Total

52 58 110

14 - 14

162 - 162

228 58 286

MARCH/APRIL 2019

popular asset amongst managers. For international investors, their go-to risk free asset class is typically US Treasury Bonds. Korean, Japanese and Australian government bonds also offer similar attributes; CGBs dwarf these assets in terms of sheer scale. As a result, despite their falling yields, they have become a popular means of diversification for fund managers.

Historically, and perhaps quite crucially, CGB performance has also borne very little correlation to interest rates in developed markets.

“From a global investors’ perspective, that’s very interesting in its own right, let alone the fact they [CGBs] grant you access to a new market. For example, if you backdate a world government bond index, and substitute in 5-10% static allocation over the past ten years, one will have received a similar return, or a little bit higher but with lower volatility,” adds Bryan Collins, Head of Asian Fixed Income at Fidelity International.

Despite fears that index inclusion may threaten to erode the unique qualities of CGBs – low volatility and reasonable yields – some investors believe these attributes are here to stay.

“China still has the highest growth within the G7. Last year, as the trade war was in full swing, CGBs were negatively correlated to most developed bond markets. While in the latter, investors lost money, returns in China were positive. We don’t think that qualities like higher growth and low to negative correlation will change due to index inclusion,” argues Holger Martens, Head Portfolio Manager, Global Credit at Nikko Asset Management.

As a growing number of index providers look to incorporate Chinese assets, China’s exposure will be restricted by the weight limits of each index. The JP Morgan Government Bond-Emerging Market Index (GBI-EM), widely tracked among EM sovereign fund managers, has a weight limit of around 10%, for instance.

54

We see 10Y CGB yield declining to 2.8% in H1

10Y CGB historical yield and forecasts (%)

Source: Wind, Standard Chartered Research

20142.00

2.50

3.00

3.50

4.00

4.50

5.00

2015 2016 2017 2018 2019

www.BondsLoans.com

Brad Gibson, Senior Vice-President and Co-Head of Asia Pacific Fixed Income, believes that inclusion will erode the exceptional status of Chinese bonds somewhat.

“They [CGBs] will become less exceptional; they will become increasingly responsive to global developments… They may begin to move in line with the economic cycle in China. As active managers, this is a positive development. It will allow us to take view from our outlook on the Chinese economy, on the shape of the Chinese yield curve.”

Lucinda Downing, Senior Asset Allocation Analyst at Aon, argues that whilst there are strategic advantages to including CGB in funds – namely, diversification and China’s relative insulation from global markets turbulence – from a tactical perspective low yields relative to other emerging bond markets and lingering RMB risk have dulled the appeal of Chinese assets.

Further down the line, Chinese corporates may come to be included in the indices. But for now, Gibson argues that this remains a peripheral concern.

“When we talk about ‘crossing the river by stepping on stones’, the corporate bond market is a rock on the other side of the river. Nevertheless, for active managers like ourselves, if we can find additional yield in the onshore Chinese corporate market, that our internal research team supports, then we will naturally start looking”.

A Challenge to US Treasury Bonds? Index inclusion has the potential to heighten the appeal of Chinese assets at the expense of other low-yield sovereign issuers across Asia-Pacific. Standard Chartered forecasts that world reserve allocations in CNY will rise to 2.5-2.7% by the end of 2019 – exceeding both AUD and CAD holdings.

“The further opening of the China Bond market may impact other regional markets. Foreign ownership is quite high in the Malaysian and Australian market, for example. Overall, the effect [of CGB index inclusion] on

large, developed markets will likely be marginal, but it could be felt more acutely in these smaller, regional markets,” Gibson added.

Incorporating the second largest bond market in the world into the global economy has the long-term potential to challenge the hegemony of American assets, particularly in Asia. US Treasury Bonds have long dominated global bond markets, dictating to a great extent the direction of their performance. But Gibson argues that index inclusion and the global integration of China’s bond market, has the potential to rebalance America’s worldwide influence over credit markets and lead to greater regionalisation of the markets.

“In 3 to 5 years we may start to look at Australian, Korean, Thai and Malaysian bonds, for example, on a spread with CGBs – they could eventually become a regional anchor. It will be interesting to watch how this develops over the medium term. For now, investors will focus more on the diversification benefits that an allocation to CGBs provides.”

Indexision Fears of delaying the inclusion of CGBs into the Global Aggregate Index have been abated, with Bloomberg reaffirming it would continue steaming forward in a statement at the end of January. From 2020 onwards, the GBI-EM and FTSE World Government Bond Index (WGBI) indices will likely begin to

phase in CGBs, according to Standard Chartered estimates.

But questions remain as to whether other index providers will follow suite. Although the inclusion of CGBs and policy bank bonds (and eventually a wider variety of Chinese assets) in global indices is deemed inevitable by many, one source with close knowledge of the topic stated that other indices may delay inclusion over concerns surrounding Chinese policy.

We heard from some of the index providers that they may delay inclusion. In part this is because some large investors have stated that they are not operationally ready, but some question marks remain around tax clarifications, liquidity, and the access to onshore CGB futures as a hedging tool. As such, we may see the creation of new indices, either including or excluding Chinese assets in order to allow investors to opt out.”

Short of a radical change in China’s political trajectory, the question of further financial integration into the global marketplace is a question of when, not if. The pace of liberalisation will be checked only by the natural caution of the Chinese authorities. How exactly this process will play out remains to be seen; it not only offers a fresh stream of assets for investors, but China’s emergence will undoubtedly influence regional, and perhaps global, markets too.


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