Eurozone contagion hits Middle East

Europe’s sovereign debt crisis is forcing regional borrowers to turn to alternative sources of funding. Published in MEED, 7 October 2011

As European politicians struggle to hammer out deals to rescue Greece’s ailing economy and other eurozone countries, doubts have been rising over the health of the continent’s banking system. Much of the concern in recent weeks has focused on the French banks, given their high exposure to Greek sovereign debt, but across the continent, financial institutions are in trouble.

Unfortunately for the Middle East, the problems do not simply disappear at the borders of Europe; they are now also having a direct impact on the finance market in the region. European banks have been reducing their exposure to the Middle East and cutting back on staff numbers. Even for those still in the market, their cost of funding has risen in many cases. The banks’ credit ratings have been lowered which, in turn, has raised the rate at which they can profitably lend.

Changed market

As a result, project finance deals are taking longer to finalise and borrowers have been forced to seek new sources of funding.

“What is fairly clear is that a lot of the traditional market participants aren’t there, in particular European banks,” says Bill Appleby, head of infrastructure and energy finance for Europe, the Middle East and Africa at the US’ Citigroup.

“In terms of transactional activity, that’s obviously got a wider market impact. I don’t think activity has died down in the projects market, it’s just becoming harder to get that kind of deal away and you have to look at alternative sources of execution. People are looking at local banks, at Islamic [finance], at export credits and capital markets. They are rethinking their approach on how to execute deals and the deals may take longer to put together.”

Others suggest that insurance companies and pension funds could provide new sources of funding in the future, although that has yet to happen.

The changing nature of the market has been clearly evident in the deal for the $4.7bn Barzan gas project in Qatar, a joint venture between Qatar Petroleum and the US’ ExxonMobil. The financing package for the project involves some $4bn of commercial debt and Islamic facilities and is due to reach final close by the end of October. Banks submitted their financing offers in early September and the debt syndication was oversubscribed, helped by the strong prospects of a local economy that banks are keen to be involved in.

However, most of the banks that have subscribed to the debt are thought to have come from within the region or from Asia, with few European institutions involved. The level of interest from the Gulf and Asia has meant the pricing on the Barzan deal has been too low for many European banks. With the deal expected to come in at less than 200 basis points above the London interbank offered rate (Libor), many would find it impossible to achieve a profit.

According to industry executives, the Europeans are likely to remain out of the market until their pricing metrics improve. “All euro-denominated banks are feeling the pinch,” says one head of project finance at a European bank. “Fairly or unfairly, the French banks have been put in the spotlight, but other European banks have similar problems, although not to the same degree. Until pricing aligns with the bank market, I don’t see additional liquidity coming in.”

Future deals

Several other large deals are currently being finalised or could soon be launched, which will provide a strong test of the ability of project sponsors to find new sources of funding to replace the European banks.

Among the deals is the $2.5bn financing for the Qurayyah independent power project (IPP) in Saudi Arabia’s Eastern Province. This is being developed by the local Acwa Power and the finance is due to be in place by the end of October. Citigroup is involved in this deal and Appleby says it remains on track. The deal is benefiting from substantial liquidity among Saudi banks.

Other project financing deals which could be launched into the market over the coming year include the $20bn Sadara Chemical project being developed by Saudi Aramco and the US’ Dow Chemical; the PetroRabigh 2 joint venture between Aramco and Japan’s Sumitomo Chemical Company; and the expansion of Emirates Aluminium’s facilities in the UAE.

Until the situation begins to improve in their home markets, bankers in the region expect European institutions to have a relatively limited role in these deals.

“What has clearly happened is the situation of many [European] financial sector companies is quite fragile and the investor mood is quite fragile,” says a senior banker in Riyadh. “They may have too many messes to clear up in their home markets at this point.” Project finance transactions are at least still going ahead, even if they are taking longer to complete and involve a different mix of banks from those seen in the past. In other areas of the investment banking sector, the picture is rather more bleak. Few merger and acquisition (M&A) deals have been going ahead and there is little in the way of initial public offerings (IPOs) or other equity market activity. Such weak market activity will do little to convince troubled international banks to maintain a heavy presence in the region.

Middle East debt issuance reached $11.2bn in the first six months of the year, down 16 per cent from the first half of 2010, according to statistics compiled by US-headquartered business information provider Thomson Reuters. All the deals were in the financial, energy, and power or real-estate sectors.

The value of M&A deals fell even more sharply. They totalled $7bn in the first half of the year, some 40 per cent lower than in the first half of 2010. France’s BNP Paribas topped the league table for M&A deals in the region, with transactions worth a total of $10.1bn. It was followed by the US’ Goldman Sachs in second place with $9.3bn.

Major deals have included the government of Abu Dhabi’s bailout of the local Aldar Properties by buying $3bn-worth of the real estate firm’s assets in January. Other large deals, however, have failed to go through.

On 29 September, for example, Saudi Arabia’s Kingdom Holding and Bahrain’s Batelco withdrew their joint bid for a 25 per cent stake in Zain Saudi Arabia, a mobile telecoms operator. The deal was valued at $950m, but it collapsed through because the potential buyers could not reach an agreement with Zain’s banks on how to manage the $3.8bn of debt that the target company owes.

“The consortium concluded that the terms and conditions as set out in its non-binding offer could not be met to its satisfaction,” said Kingdom Holding and Batelco, in separate statements announcing their exit.

The lower levels of activity have led to sharply lower fee income for banks. Investment banking fees were down 46 per cent at $197m during the first half of 2011, according to Thomson Reuters. M&A fees totalled $74.1m, equity capital markets fees were $53.3m and fees from debt capital market activity and syndicated lending totalled $50m and $20.4m respectively.

“Regardless of whether or not Europe and the US were in difficulty, the reality is that a lot of these banks bulked up in the region thinking there would be more transactions and the reality on the ground is that those deals have not been forthcoming,” says the head of investment banking at one institution in the region. “The vast majority of transactions tend to be refinancing transactions, either through club lending or in some case through the bond market. There is little M&A or IPO [activity] going on.”

Staff cuts at international banks

Many of the big international banks in the region are thought to have laid off large numbers of staff as activity levels and fee income have declined, particularly sales and relationship staff.

“International banks are reducing their presence,” says one senior banker based in Abu Dhabi. ”The big international banks have higher costs. The pay scales and the costs of setting up here are usually higher than for local banks.”

The question now is how long the downturn might last in the US and European markets, and also how much enthusiasm international banks will show for the region in the future, if deal activity remains so muted.

“Some people think it’s a permanent quantum shift,” says Appleby. “Some people think if you have some political certainty in Europe, then things will get back to normal pretty quickly. Other people think it will take a few years to work its way through the system.”