The superlatives around Middle East project financing abound; cheap feedstock, high capital costs, fine debt pricing. But precisely because of the scale, depth and speed with which project finance is impacting all facets of economic life in the Middle East, the underlying trends need dissecting.
Society has much at stake. The regions' governments are pinning their hopes of providing employment for their overwhelmingly youthful populations by investing in labour intensive industries that leverage the availability of competitively priced feedstock.

Since the beginning of 2006, the Middle East and North Africa became the largest geography of infrastructure-related project finance in the world, accounting for $33 billion, one-third of the global total. To give context to the extent that project finance is impacting economic life, debt raised in the Middle East in 2006 represented over 5% of the region's Gross Domestic Product (GDP) compared to less than 0.25% in Western Europe. The 2007 percentage is similar.

Privatization

Privatization galvanized Middle Eastern project finance. The extent of the privatization pipeline across all industries is estimated in the several hundreds of billions of dollars on the low side and one trillion dollars on the high side. Power leads the pack with Independent Water Power Plants (IWPPs) while wastewater, transportation (particularly ports, airports and trains), petchem, refining and mining also represent a significant pipeline.

Projects planned or underway as of mid-2007
USD billion 

                      27 July 2007     28 July 2006       % change

Bahrain          32.4                  29.6                    9.6
Kuwait           250.9                212.3                 18.2
Oman             45.3                  37.5                   20.6
Qatar             138.0                117.3                 17.6
Saudi Arabia  364.3                269.0                 35.4
UAE              660.8                352.9                 87.3
GCC total      1491.6              1018.6               46.4
Source: MEED Projects

Unlike other regions in the world, the attraction to privatization was not driven by the need for cash, but rather an acknowledgement that the imminent power, water and employment shortages could be tackled only through productivity efficiency enhancements and superior know-how.

Privatization needs to be well planned. For any privatization process to be successful, a private policy and regulatory framework needs to be in place before privatization of assets takes place. Moreover, infrastructure assets should be unbundled and regulation should be imposed only on that element of the chain that is monopolistic (for example transmission in the power sector) whilst competition is created where barriers to entry are low (for example generation of power). Privatization is a means to an end; not an end in itself.

The Middle East countries did well on this count and did not make the mistakes some other countries did where private capital deployment was ill timed with respect to the privatization framework being put in place.

Traditionally, the power sector was at the forefront of privatization where the need was particularly acute. The long term and tight Power Purchase Agreements (PPA) contracts with sovereign backed guarantees was the correct model and its success is acknowledged by the financing community. Power is vital to fuel the more advanced stages of industrialization. Middle East industrial energy consumption is expected to grow at an annual rate of 3 percent over the next 10 years primarily due to energy intensive industrial sectors such as petrochemicals, steel, aluminum, a population growth rate and the demographics of the region. There is also the increased demand from the emerging industrial zones set to come on line before 2012 including the Industrial City of Abu Dhabi II, Dubai Industrial City, King Abdullah Economic City and The Qatar Energy City. Cash alone could not buy the requisite infrastructure upgrades.

Unbundling of infrastructure assets across a range of sectors will intensify in the next five years. For that to happen, the GCC countries need to focus on the regulatory framework to attract the vast sum of funds needed to attract capital. Two types of Regulatory methods which could be followed are the "US type cost push" method or the UK style "CPI-X" method; the UK style method is the most suitable for this part of the world. However, there still needs to be more work on establishing independent regulators with powers to take swift and decisive decisions.

But this is only one side of the story. Apart from the domestic forces of increasing employment opportunities, plugging infrastructure shortages and diversifying the economy, the Middle East has unrivalled comparative economic advantages with international investors keen to capitalize. This is in stark contrast to the import substitution industries popular in certain developing countries in the 1960s, and largely deemed an impediment to economic growth. This is reflected through structuring of project finance deals; the market has accepted increasingly high leverage and long tenors from sponsors.

Structuring

"Quasi sovereign risk" is the refrain often heard when structuring and pricing privatized assets. In a large number of deals, indirect sovereign ownership remains through either state-owned oil companies or the power utilities and there is an optimal return offered to investors for the risks that they are undertaking.

Typically in the power sector, completion risk is mitigated by a single lump sum turnkey Engineering Procurement and Construction (EPC) contract from reputed EPC contractors, whereas in the case of refinery and petchem sectors, sponsors typically provide completion guarantees.

Some can argue that financing documents in deals in this region may not have the rigorous covenants typical of traditional project financing but lenders have got comfortable due to the perceived risk sharing of government and quasi-government entities in these projects and the overall economics of the projects, often in the bottom cost quartile.

Having said this, no real default has occurred in the Middle East and that the strength of the commitments has not been tested in a default scenario. But regional governments have little interest to renege on commitments precisely because the very lynchpin of capital raising is the perceived rock solid strength of these guarantees. Governments are likely to be aware that the goodwill they have managed to acquire over the past decade can vanish should the rock solid perception change, especially in less favourable market conditions.

Risk-reward

The risk rewards in the GCC deals are skewed in favour of the EPC contractor primarily due to a paucity of good contracting capacity. From a long term sustainability point of view this is not healthy and a more favourable balance needs to be shifted in favour of sponsors and lenders.

After consistent squeezing of margins on term loan debt, prices bottomed out in the middle of 2007. The influx of liquidity in recent times has reduced pricing such that regional lenders who have a relatively high cost of funds and limited access to long term capital find it increasingly difficult to justify providing debt to projects priced at the tight end of the market.

There are early signals of gradual higher pricing of risk, thereby naturally gravitating towards a more judicious risk reward equation. Although so far the project finance market has been largely unaffected by the "sub prime" crises, the risk pricing issues that have emerged from this episode has catalysed banks to reprice risk appropriately. This will have a positive impact on regional project financing.

Developing capital markets and new liquidity pools

New liquidity pools are vital because traditional local and international project finance banks are becoming more exposed to project finance debt in the region. One positive development is the fact that rating agencies have made a huge impact in the Middle East over the past three years. An increasingly large number of regional corporates and sponsors are willing to submit the sensitive financial information to obtain a rating – something almost unheard of five years ago – and this will facilitate the development of a more sophisticated financial market with a larger investor base and more robust secondary market. Securitization of assets and more frequent and larger bond issuance have significantly strengthened disintermediation – the natural forerunner to a sophisticated capital market.

There are five main channels of new liquidity injection. Firstly, considerable fresh liquidity is expected to come from Asia over the next decade, which has shown a strong interest in the Middle East. This is reciprocated with large investment from the Gulf in several Asian projects. Asian contracting companies such as Doosan have already brought with them large Export Credit Agency (ECA) Funding from KEXIM and KEIC and there is considerable potential appetite from a range of Malaysian, Brunei and Indonesian Islamic institutions for Islamically structured regional assets. Asian Islamic investor banks include Maybank, RHB Islamic, Hong Leung, Bank Islam, Bank Muamalat, Islamic Bank of Brunei and Islamic Development Bank of Brunei.

Secondly, the power of sovereign wealth funds will undoubtedly also make a large impact. The total size of regional funds is not known but the Abu Dhabi Investment Authority's size alone is estimated in the region of one trillion dollars. Where previously the lion's share of these funds was invested outside the region, the funds are showing more appetite for regional investments. For example, the Abu Dhabi owned investment company Mubadala is becoming one of the most active regional investment companies with projects ranging from power to metals and mining to soft infrastructure such as education.

Thirdly, high oil prices have boosted local bank liquidity, enabling local banks to take on large take and hold assets on their books, greatly reducing syndication risk in large underwritings, while international banks are coming under increasing cost of capital pressure. For this reason, sources of funds will become more diversified. The local banks are likely to play a more vital role as both underwritings and risks become larger. In recent large Saudi transactions, for example, a significant portion of the commercial Bank debt is from local banks.

Fourthly, the ECAs are becoming significantly more active as are local development institutions such as PIF and SIDF.

Finally, project bonds, a mainstay of US project financing, enable much longer tenors as long as construction risk is covered by strong completion support; the Middle East has entered the Bond space slowly but the pace is likely to increase rapidly as the Sukuk market progressively becomes more comfortable with tenors beyond ten years.

Conclusion

All macroeconomic indicators point to continued regional demand for project finance solutions from both sponsors and investors. The pace of industrialization is only set to increase once the industrial cities are operating at full capacity and regional economies still have a long way to go to achieve real economic diversification. Government population projections, particularly the need for youth employment, will encourage continued government incentivization to give up its strategic assets to the private sector and loosen its grip through regulation.

However, a time will come, be it from adverse market conditions, be it from operational issues, when a project will default. Then the strength of the 'quasi sovereign' refrain will be put to the test.

The involvement of sovereign wealth funds, new liquidity pools from Asia (particularly Islamic institutions) and greater use of project bonds in the larger financings will help take regional project finance to the next level. This will serve a dual purpose of allowing sponsors to increase their international profile and enable already exposed project finance houses to have smoother syndications.

The risk reward dynamics ultimately drive the long term success of any financial product. The speed and scale of local project finance growth has stretched this dynamic to the limit. The large pipeline of the project finance deals ultimately kept the international banks in the market, but now that risk pricing seems to be levelling out to more realistic levels, barring any force majeure event, one can conclude that regional project finance has an exciting, sustainable and socially beneficial future.

Contact: Ravi Suri, Head of Project & Export Finance Middle East, Standard Chartered, ravi.suri@ae.standardchartered.com