Market Risk Management in the Middle East
The concepts of market risk management and hedging were until fairly recently almost unheard of in Middle Eastern markets. Importers and exporters, for example, would often adopt a ‘do nothing until you need to’ approach to hedging against adverse exchange rate fluctuations.
This was partly due to a culture that, for many years, encouraged the view that risk was something to be accepted, rather than to be reduced or eliminated. For example, even today only a small minority of motorists in a country such as Saudi Arabia have even a basic level of car insurance cover. Life insurance is similarly underused.
It was also an attitude fostered by the fixed exchange rate to the US dollar prevalent in most Middle Eastern countries, particularly because the most important export for most of these economies – oil – was priced in dollars.
The idea that market risk – the possibility of losing money on market exposures, trading positions, etc – can be hedged has however found a more willing audience in recent years, but the banks are a long way ahead of their customers in this respect.
The banks are certainly gearing up for an increased demand for derivatives, structured products and other exotics. A random glance at a few business cards recently collected from bankers in the region show job titles such as Chief Dealer (Risk Advisory and Structured Products) and Senior Trader (Structured Products Group), a clear indication of the direction they think the wind is blowing.
However the locally owned banks have often suffered from a lack of expertise, and this is a void the increasing number of foreign banks opening offices in the region are seeking to fill.
In Saudi Arabia, the largest of the Gulf Cooperative Council (GCC) economies, banks who have a partial foreign owner, usually from a more sophisticated market centre, have been seen to have an advantage when it comes to offering hedging or investment products to the local corporate market. Samba (formerly Saudi American Bank), for example, had Citibank’s global presence and expertise to draw on, although Citi has now relinquished direct involvement.
The appetite shown by corporate clients for the hedging products available from the banks varies enormously. There has been a clear reluctance, for example, to pay a premium for either exchange rate or interest rate options, so zero-cost structures have become more popular than they might otherwise have been.
Even taking this small step was not without difficulty. Many clients failed to grasp, despite the best efforts of the banks to explain the risks to them, that zero-cost did not mean zero-risk, with wholly predictable consequences.
On the funding side, corporate sophistication tends to reflect the size of the company. Simple interest rate swaps, whereby a floating rate borrower switches his interest paying obligations into a fixed rate, have become reasonably commonplace, helped no doubt by the relatively low interest rate environment we have seen in recent years. Yet even locking into cheap borrowing for longer periods has been a hard sell for the banks. The expatriate status of much of the corporate workforce, particularly in small or medium-sized firms, has left many finance managers reluctant to commit to paying a rate whose benefits may only be realised after their own employment contracts have expired.
The larger companies in the region do not seem to be bound by the same considerations. Saudi Aramco (which is, in effect, the entire Saudi oil industry), Bahrain Petroleum Company (BAPCO) and Qatar Gas are among those who are known to have wholly or partially hedged their longer-term borrowings.
Unsurprisingly, the level of sophistication is higher among this sort of company than among the small and medium-sized firms. The larger firms evaluate proposals from a number of banks, and have a clear understanding of the risk-reward profile. Many members of the treasury and finance teams at these companies have a banking background, either as product developers, risk managers or corporate finance practitioners.
The smaller companies are faced with a different set of problems. Their banks, particularly those who have major foreign shareholders, will often regard what might seem to be a significant amount to them as small. This is equally true of the size of an option premium.
Islamic considerations are increasingly becoming a factor, although the appetite for Islamic banking generally seems far greater at retail rather than at corporate level. In terms of access to funding, companies have tended only to look at Islamic financing methods if they think it will be either easier or cheaper to access the market that way.
This is further complicated by the fact that there is still no definitive agreement on what is or is not an Islamic banking product. For example, some scholars have suggested that paying a premium to buy options is contrary to Islamic law, as the premium represents a gamble, which may or may not produce a return. Others have said they are fine, because there is no equivalent Islamic product that can be used instead.
By definition, interest rate options are obviously forbidden, due to the nature of the underlying market to which they relate.
Yet the overwhelming reason why hedging products have not been more widely adopted in the Middle East remains a lack of knowledge and technical awareness of these products among market practitioners – both on the corporate and the banking sides of the fence.
A looser regulatory and supervisory environment than is found in more sophisticated market locations is no help in this respect. There is still no formal requirement for bank sales staff to be formally ‘qualified’ before attempting to sell these products to would-be corporate users, although Saudi Arabia’s new Capital Markets Authority may go some way towards addressing this issue there.
In terms of exchange rate hedging, a simple lack of understanding of the risks involved has, perhaps surprisingly, also been a limiting factor. For example, an importer of Japanese cars had persuaded the manufacturer to quote him prices in US dollars.
As his domestic currency was fixed to the dollar, he felt he had no exchange rate exposure. He had not thought about the effect of possible fluctuations in the exchange rate between the US dollar and the Japanese yen – the manufacturer was simply converting his selling price from yen to dollars, and quoting accordingly.
When the yen strengthened against the dollar between the date the order was placed and the date payment became due, the importer’s costs, in dollar terms, rose sharply, leaving him with the problem of trying to sell a shipment of expensive cars in a competitive Middle Eastern market.
There also seems to be a fundamental misunderstanding about how options and other derivative hedging products work. For example a premium paid for an option that expires out-of-the-money (i.e. worthless) is often regarded by the client as money wasted. They often fail to see that they have, in effect, bought the right to effect a transaction at an attractive rate.
When an option that was purchased to protect the client against adverse rate movements expires worthless, it usually means the underlying rate in the market has become more favourable.
The other factor holding back the use of these products has been a failure to realise that they can be used to ‘lock in’ an attractive rate (if that is what the current market rate happens to be at any given moment) as readily as to protect against adverse rate changes.
It is an inability to see this, and the lack of success among banks in trying to point these things out, that have contributed to what has been only a slow crawl towards acceptance of hedging products.
The corporate sector is slowly climbing the learning curve of risk management, helped as much as possible by an increasingly aggressive marketing drive by the regional banks, but it will be some time yet before understanding and usage of hedging products reaches levels seen in the more developed markets.