TThe Case for a Local Bond he Case for a Local Bond Market in the UAEMarket in the UAE

Abu DhabiAbu Dhabi12 March, 200612 March, 2006

Francesco U. GarzarelliManaging Director Macro & Markets ResearchGoldman Sachs International, Londonfrancesco.garzarelli@gs.comTel: +44 207 774 5078

2

AgendaAgenda

My remarks today will be centred around My remarks today will be centred around three specific three specific questionsquestions::

1.1. Why would the UAE benefit from the creation of a local Why would the UAE benefit from the creation of a local currency bond market?currency bond market?

2.2. How could the UAE go about developing one?How could the UAE go about developing one?

3.3. How would the term structure of dirham rates (tentatively) How would the term structure of dirham rates (tentatively) look like today?look like today?

3

Why Build a Bond Market?Why Build a Bond Market?

Contributions to the theoretical literature explain how countries Contributions to the theoretical literature explain how countries benefit from well-diversified financial systems.benefit from well-diversified financial systems.

At a high level of abstraction, equity finance encourages At a high level of abstraction, equity finance encourages risk-risk-takingtaking among investors, since holders of equity stakes share in among investors, since holders of equity stakes share in returns with losses truncated to the downside, while debt returns with losses truncated to the downside, while debt finance encourages finance encourages risk-aversionrisk-aversion, since debt holders do not , since debt holders do not share on the upside.share on the upside.

From the perspective of the potential borrower, however, the From the perspective of the potential borrower, however, the case for ‘outside’ (bonds) vs. ‘inside’ debt (bank lending), using case for ‘outside’ (bonds) vs. ‘inside’ debt (bank lending), using Fama’s (1985) broad taxonomy, is much harder to pin down.Fama’s (1985) broad taxonomy, is much harder to pin down.

Boot and Thakor, Financial System Architecture, Review of Financial Studies,1997, is the classic reference.Boot and Thakor, Financial System Architecture, Review of Financial Studies,1997, is the classic reference.

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The Choice Between Bonds and Bank LendingThe Choice Between Bonds and Bank Lending

Bank BorrowingBank Borrowing Open Market Open Market BorrowingBorrowing

Greater flexibility in Greater flexibility in the event of financial the event of financial

distressdistress

Potential reduction of Potential reduction of interest costs (?)interest costs (?)

Managerial Managerial counsellingcounselling

Lower interference on Lower interference on corporate strategycorporate strategy

Lower refinancing Lower refinancing risksrisks

Greater scope for Greater scope for tactical debt tactical debt managementmanagement

Lower disclosure to Lower disclosure to public marketspublic markets

Less demanding Less demanding covenantscovenants

In general, smaller, In general, smaller, younger firms operating younger firms operating typically in information-typically in information-charged areas of the charged areas of the economy would tend to go economy would tend to go to banks rather than tap to banks rather than tap the capital markets.the capital markets.

Average firm size and Average firm size and ownership structure, and ownership structure, and innovation, are factors in innovation, are factors in principle affecting the principle affecting the choice between bonds and choice between bonds and banks.banks.

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A Market Price for Time Money and Credit A Market Price for Time Money and Credit Risk Carries Benefits ...Risk Carries Benefits ...

But the supply set up is often But the supply set up is often times is dominant factor...consider times is dominant factor...consider the case of Euroland and Japan, the case of Euroland and Japan, where banks have the lion’s share where banks have the lion’s share in the credit markets, partly for in the credit markets, partly for historical reasons. historical reasons.

Even in these cases, however, a Even in these cases, however, a representative market price of representative market price of term money and credit risk (e.g., term money and credit risk (e.g., default swaps) exists and carries default swaps) exists and carries clear advantages for financial and clear advantages for financial and economic stability.economic stability.

0102030405060708090

100

Euroland US

InsideOutside

0

20

40

60

80

100

120

Total Short Long (banks) Long (bonds)

EurolandUS

6

... To the Health of the Financial System,... To the Health of the Financial System,

The existence of representative market prices for local money The existence of representative market prices for local money along the time dimension, and for credit risk holds several along the time dimension, and for credit risk holds several benefits:benefits:

It increases firm’s choice of funding, fostering healthier It increases firm’s choice of funding, fostering healthier competition between sources of capital. Bonds may represent a competition between sources of capital. Bonds may represent a ‘spare tyre’ at times of bank distress, avoiding a ‘credit crunch’.‘spare tyre’ at times of bank distress, avoiding a ‘credit crunch’.

It allows banks to better manage risks associated with maturity It allows banks to better manage risks associated with maturity transformation and currency/credit exposure.transformation and currency/credit exposure.

It facilitates the creation of financial assets that can ‘complete’ It facilitates the creation of financial assets that can ‘complete’ markets.markets.

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...And to Macroeconomic Stability...And to Macroeconomic Stability

It allows market discipline to operate; policymakers can detect It allows market discipline to operate; policymakers can detect areas of potential vulnerability before crises erupt (lesson learnt the areas of potential vulnerability before crises erupt (lesson learnt the hard way in Asia, 1997).hard way in Asia, 1997).

It adds an important degree of freedom in the conduct of It adds an important degree of freedom in the conduct of monetary policy, particularly when the exchange rate is managed monetary policy, particularly when the exchange rate is managed (e.g., MAS), and there are revaluation expectations leading to (e.g., MAS), and there are revaluation expectations leading to capital inflows. capital inflows.

All these aspects should resonate within the UAE financial All these aspects should resonate within the UAE financial community, particularly considering the current macroeconomic community, particularly considering the current macroeconomic challenges.challenges.

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UAE’s Money and Credit Expansion Is UAE’s Money and Credit Expansion Is Accelerating ...Accelerating ...

-20

0

20

40

60

80

100

120

02 03 04 05

% yoy

Bank claims on private sectorBank foreign liabilitiesMoney supply (M1)

UAE - Selected Money and Credit AggregatesUAE - Selected Money and Credit Aggregates

Source: Central Bank of UAE, Goldman Sachs calculations.Source: Central Bank of UAE, Goldman Sachs calculations.

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... Leading to Inflation in Asset Prices ...... Leading to Inflation in Asset Prices ...

0

5000

10000

15000

20000

25000

01 02 03 04 05

UAE - Stock Market IndexUAE - Stock Market Index

Source: Bloomberg.Source: Bloomberg.

10

... and Consumer Prices ... and Consumer Prices

0

1

2

3

4

5

6

7

98 99 00 01 02 03 04 05

% yoy

UAE - Year-over-Year Retail Price InflationUAE - Year-over-Year Retail Price Inflation

Source: International Monetary Fund, Goldman Sachs calculations.Source: International Monetary Fund, Goldman Sachs calculations.

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Three Further Reasons to Act Now!Three Further Reasons to Act Now!

Finance meets a strategic Finance meets a strategic diversification goal. The UAE can diversification goal. The UAE can flourish as the regional financial flourish as the regional financial hub of the planned monetary union. hub of the planned monetary union.

Competition is already rising: The Competition is already rising: The Bahrain Monetary Agency initiated Bahrain Monetary Agency initiated a number of strategies to broaden a number of strategies to broaden the bond market in 2003, the bond market in 2003, particularly in the Islamic segment particularly in the Islamic segment (80% of the roughly US$ 2bn public (80% of the roughly US$ 2bn public debt is debt is SukukSukuk))

0

10

20

30

40

50

60

70

Qatar Kuwait Oman SaudiArabia

UAE Bahrain

%

Share of Hydrocarbon in GDP in GCCShare of Hydrocarbon in GDP in GCC

Source: Institute of International Finance.Source: Institute of International Finance.

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US Monetary Policy Potentially UnstableUS Monetary Policy Potentially Unstable

US monetary policy is US monetary policy is more unstable because more unstable because of the high leverage and of the high leverage and dependence on external dependence on external funding. funding.

GS forecasts rate cuts GS forecasts rate cuts next year, which may be next year, which may be unsuitable for the UAE’s unsuitable for the UAE’s domestic demand needs.domestic demand needs. US 3-mth Rates

1

2

3

4

5

6

7

8

9

1998 2000 2002 2004 2006 2008

7Mar1996 9Mar2009US - 3mth Libor RateUS - 3mth Libor Rate

13

Debt Finance Is Historically ‘Cheap’Debt Finance Is Historically ‘Cheap’

Outside debt finance is ‘cheap’ for Outside debt finance is ‘cheap’ for firms: real rates are at very firms: real rates are at very depressed levels across the term depressed levels across the term structure, and credit spreads are structure, and credit spreads are tight. tight.

From the demand side, domestic From the demand side, domestic bonds are under-represented in bonds are under-represented in household portfolios, while household portfolios, while international investors are hungry international investors are hungry for greater diversification of for greater diversification of returns (e.g., Gazprom and returns (e.g., Gazprom and Rosneft corporate debt ).Rosneft corporate debt ).

US 5yr Real Rate 5yr Forward US$ HY Aggregate Spread

2

2.2

2.4

2.6

2.8

3

3.2

3.4

3.6

3.8

4

200

300

400

500

600

700

800

900

Jul Jan Jul Jan Jul Jan

7Mar2003 7Apr2006

2003 2004 2005 2006

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What Is a Realistic Capitalization Objective?What Is a Realistic Capitalization Objective?

Economic theory has shed Economic theory has shed light on the factors light on the factors determining the capitalization determining the capitalization of a bond market.of a bond market.

Granted, the UAE suffers Granted, the UAE suffers from an ‘original sin’ problem, from an ‘original sin’ problem, lacking a minimum efficient lacking a minimum efficient scale.scale.

UAE

See Eichegreen and Luengnaruemitchai, Why Doesn’t Asia Have Bigger Bond Markets, NBER 2004. See Eichegreen and Luengnaruemitchai, Why Doesn’t Asia Have Bigger Bond Markets, NBER 2004.

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Cross-sectional evidence Cross-sectional evidence suggest a US$ 50bn suggest a US$ 50bn market is in the ball-park, market is in the ball-park, especially considering the especially considering the prospect of monetary prospect of monetary union.union.

A similar conclusion can be A similar conclusion can be reached by looking at the reached by looking at the share of credit provided by share of credit provided by the banking sector.the banking sector.

A US$ 50bn + Market Is FeasibleA US$ 50bn + Market Is Feasible

UAE

Source: Eichegreen and Luengnaruemitchai (2004), Goldman Sachs.Source: Eichegreen and Luengnaruemitchai (2004), Goldman Sachs.

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Is There Need for a Government Benchmark?Is There Need for a Government Benchmark?

The cross-sectional The cross-sectional evidence is consistent with evidence is consistent with a positive relationship a positive relationship between private and public between private and public sector bond market sector bond market capitalization. capitalization.

The relationship is far from The relationship is far from perfect, however. A big perfect, however. A big government bond market government bond market can ‘crowd out’ private can ‘crowd out’ private borrowing.borrowing.

UAE

Source: Eichegreen and Luengnaruemitchai (2004), Goldman Sachs.Source: Eichegreen and Luengnaruemitchai (2004), Goldman Sachs.

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Government borrowing can provide, if properly designed, liquid Government borrowing can provide, if properly designed, liquid benchmark points across the term structure, on which other benchmark points across the term structure, on which other assets can be priced off.assets can be priced off.

In the UAE’s case, government over-funding would come to the In the UAE’s case, government over-funding would come to the benefit of monetary policy, helping drain domestic excess benefit of monetary policy, helping drain domestic excess liquidity at market prices without having to resort to liquidity at market prices without having to resort to administrative measures.administrative measures.

The ‘quasi-fiscal’ costs appear manageable, especially The ‘quasi-fiscal’ costs appear manageable, especially considering the high sovereign credit rating and greater considering the high sovereign credit rating and greater propensity for funds to stay in the region. ‘Niche’ Islamic finance propensity for funds to stay in the region. ‘Niche’ Islamic finance can further contribute to limit costs. can further contribute to limit costs.

Public Issuance Can Alleviate Policy StrainsPublic Issuance Can Alleviate Policy Strains

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Some ‘Best Practices’ Drawn from Int’l Some ‘Best Practices’ Drawn from Int’l ExperienceExperience

Issue government paper according to a set auction calendar; Issue government paper according to a set auction calendar; concentrate on few liquid benchmarks. Start with OTC markets, concentrate on few liquid benchmarks. Start with OTC markets, possibly alongside a post-trade transparency system (e.g., the US’ possibly alongside a post-trade transparency system (e.g., the US’ Trade Reporting and Compliance Engine).Trade Reporting and Compliance Engine).

Promote financial risk education and facilitate information Promote financial risk education and facilitate information disclosure: in too many circumstances, credit-risky securities disclosure: in too many circumstances, credit-risky securities (whose returns are comparable to being short a put option) end up (whose returns are comparable to being short a put option) end up in the hands of captive/un-experienced investors. in the hands of captive/un-experienced investors.

Enfranchise the private banking system: These will likely be Enfranchise the private banking system: These will likely be warehousing government-corporate risk and making markets.warehousing government-corporate risk and making markets.

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Some ‘Best Practices’ Drawn from Int’l Some ‘Best Practices’ Drawn from Int’l ExperienceExperience

Asset/mortgage-backed markets, REITs, and securitization could be Asset/mortgage-backed markets, REITs, and securitization could be important to increase supply, and encourage intermediaries to play important to increase supply, and encourage intermediaries to play ball.ball.

Limit the number of regulators (or create an umbrella scheme like Limit the number of regulators (or create an umbrella scheme like Malaysia’s National Bond Market Committee), and make regulations Malaysia’s National Bond Market Committee), and make regulations simple, in line with international standards and functional to ongoing simple, in line with international standards and functional to ongoing disclosure. Promote industry self-regulatory bodies.disclosure. Promote industry self-regulatory bodies.

Do not promote bank guarantees of corporate debt to underpin the Do not promote bank guarantees of corporate debt to underpin the market (market (a laa la Korea), as it defies the purpose of risk discovery, and Korea), as it defies the purpose of risk discovery, and can exacerbate financial instability risks.can exacerbate financial instability risks.

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Some ‘Best Practices’ Drawn from Int’l Some ‘Best Practices’ Drawn from Int’l ExperienceExperience

Bankruptcy law is of quintessential importance.Bankruptcy law is of quintessential importance. Technical issues regarding clearing, settlement, custodians, and Technical issues regarding clearing, settlement, custodians, and

repo are well understood; (and will authoritatively illustrated by repo are well understood; (and will authoritatively illustrated by other speakers today).other speakers today).

Avoid dubious tax distortions, where possible (e.g., capital gains tax Avoid dubious tax distortions, where possible (e.g., capital gains tax on bond sales but tax exemption for derivatives (repos).on bond sales but tax exemption for derivatives (repos).

Last, but not least, consider introducing more flexibility in the Last, but not least, consider introducing more flexibility in the exchange rate arrangement....exchange rate arrangement....

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Case Study no. 1: Case Study no. 1:

Singapore - Over-funding for Multiple GoalsSingapore - Over-funding for Multiple Goals

0

510

1520

25

3035

4045

50

95 96 97 98 99 00 01 02 03 04 05

USDbn

-2

02

46

8

1012

1416

18% of GDP

Bonds (lhs)Bills (lhs)Budget Surplus (rhs)

Singapore is US$ 120bn economy Singapore is US$ 120bn economy running large fiscal and external running large fiscal and external surpluses. The decision to develop surpluses. The decision to develop Singapore Government Securities Singapore Government Securities (SGS) market originally taken to (SGS) market originally taken to provide a matching asset for the long-provide a matching asset for the long-term liabilities of defined contribution term liabilities of defined contribution system.system.

Under the Government Securities Act, Under the Government Securities Act, MAS undertakes issuance and MAS undertakes issuance and management of SGS and is also management of SGS and is also responsible for the microstructure of responsible for the microstructure of the market. A Government Securities the market. A Government Securities Fund collects all the proceeds and is Fund collects all the proceeds and is charged with interest and expenses.charged with interest and expenses.

Source: Monetary Authority of Singapore, Goldman Sachs.Source: Monetary Authority of Singapore, Goldman Sachs.

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Case Study no. 1: Case Study no. 1:

SingaporeSingapore

Particularly since 1998, the authorities have stepped up the Particularly since 1998, the authorities have stepped up the efforts for the development of a liquid market for bond efforts for the development of a liquid market for bond securities. SGS, now amounting to US$ 50bn (of which 20bn securities. SGS, now amounting to US$ 50bn (of which 20bn <1yr), are now included in JP Morgan’s, Lehman’s and <1yr), are now included in JP Morgan’s, Lehman’s and Citigroup government bond indices. Citigroup government bond indices.

An immediate advantage of the SGS issuance (and related An immediate advantage of the SGS issuance (and related repo) is the support offered to the conduct of monetary policy repo) is the support offered to the conduct of monetary policy under a heavily managed exchange rate regime. The bulk under a heavily managed exchange rate regime. The bulk (>70%) of SGS are held by financial intermediaries.(>70%) of SGS are held by financial intermediaries.

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Case Study no. 1: Case Study no. 1:

SingaporeSingapore

A liquid benchmark curve has offered support to the SGD A liquid benchmark curve has offered support to the SGD corporate bond market (and a fertile private banking business), corporate bond market (and a fertile private banking business), which has developed alongside the deeper SGS space.which has developed alongside the deeper SGS space.

Companies are generally cash-rich, bank lending networks and Companies are generally cash-rich, bank lending networks and equity capital markets are natural obstacles to the growth of the equity capital markets are natural obstacles to the growth of the private market.private market.

The stated objective of the authorities wish to expand the The stated objective of the authorities wish to expand the domestic asset base, and establish the island-state as a regional domestic asset base, and establish the island-state as a regional financial services hub (MAS’ FDD).financial services hub (MAS’ FDD).

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Case Study no. 1: Case Study no. 1:

SingaporeSingapore

Special Purpose Vehicle47.1%

Corporations (Excluding Property)

18.6%

Property Companies

11.1%

Finanical Institutions

20.9%

Supranational0.9%

Government & Statutory

Boards1.4%

In order to sustain S$ corporate In order to sustain S$ corporate issuance, the authorities have issuance, the authorities have ‘encouraged’ GLCs to tap the bond ‘encouraged’ GLCs to tap the bond market rather than opt for bank market rather than opt for bank lending, and opened up the bond lending, and opened up the bond market to foreign investors (with an market to foreign investors (with an mandatory FX-swap constraint). mandatory FX-swap constraint).

Since ’97, the stock of S$ corporate Since ’97, the stock of S$ corporate bonds with maturity trebled to around bonds with maturity trebled to around US$20bn. The maturity profile remains US$20bn. The maturity profile remains short 1-3yr (only US$8bn > 1yr), and short 1-3yr (only US$8bn > 1yr), and more than half of new issuance is more than half of new issuance is structured credit sold to domestics structured credit sold to domestics through SPVs. through SPVs.

Source: Monetary Authority of Singapore.Source: Monetary Authority of Singapore.

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Case Study no. 1: Case Study no. 1:

SingaporeSingapore

An on-shore non-S$ denominated An on-shore non-S$ denominated market has been in place for market has been in place for longer, and is comparatively longer, and is comparatively bigger.bigger.

Most of the issuance is shorter-Most of the issuance is shorter-dated, predominantly denominate dated, predominantly denominate in US$. Securities are mostly in US$. Securities are mostly vanilla issued by nonfinancial vanilla issued by nonfinancial corporations and privately placed corporations and privately placed to off-shore investors. to off-shore investors.

Source: Monetary Authority of Singapore.Source: Monetary Authority of Singapore.

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Case Study no. 2:Case Study no. 2: Malaysia – Privates Take an (Islamic) LeadMalaysia – Privates Take an (Islamic) Lead

Malaysia is US$ 130bn economy (comparable to the UAE’s and Malaysia is US$ 130bn economy (comparable to the UAE’s and Singapore’s), with a pegged exchange rate and a history of budget Singapore’s), with a pegged exchange rate and a history of budget deficits of around 4-5% of GDP, feeding government bond supply. deficits of around 4-5% of GDP, feeding government bond supply.

The 1997 bank crisis and subsequent corporate restructuring was The 1997 bank crisis and subsequent corporate restructuring was among the triggers for a rapid growth of private ringgit debt market, among the triggers for a rapid growth of private ringgit debt market, supported by the successful promotion of Islamic finance. supported by the successful promotion of Islamic finance.

The stock of ringgitt nonfinancial corporate bonds now stands at The stock of ringgitt nonfinancial corporate bonds now stands at around US$45bn, comparable in size to public sector debt. 95% of around US$45bn, comparable in size to public sector debt. 95% of local currency corporate securities are >1yr (compared to 50% in local currency corporate securities are >1yr (compared to 50% in Singapore). Another US$ 20bn is represented by securities issued Singapore). Another US$ 20bn is represented by securities issued by financial institutions, predominantly (70%) short-term.by financial institutions, predominantly (70%) short-term.

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Case Study no. 2:Case Study no. 2: Malaysia – Privates Take an (Islamic) LeadMalaysia – Privates Take an (Islamic) Lead

Private sector issuance received a boost in 2000 thanks to the Private sector issuance received a boost in 2000 thanks to the introduction of a disclosure-based regulatory framework (Security introduction of a disclosure-based regulatory framework (Security Commission’s Guidelines on the Offering of Private debt Commission’s Guidelines on the Offering of Private debt Securities), which has cut drastically the approval process for Securities), which has cut drastically the approval process for issuance. issuance.

A shelf-registration scheme has also been introduced, allowing A shelf-registration scheme has also been introduced, allowing eligible corporations to make multiple issues of securities within a eligible corporations to make multiple issues of securities within a 2-yr period with a one-time approval.2-yr period with a one-time approval.

Guidelines such as those disciplining the offering of Asset-backed Guidelines such as those disciplining the offering of Asset-backed securities (2001) and Islamic securities (2004) have also facilitated securities (2001) and Islamic securities (2004) have also facilitated registration and issuance process. The latter has freed issuers registration and issuance process. The latter has freed issuers from the legal concept of debentures (debt-based products). from the legal concept of debentures (debt-based products).

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Case Study no. 2:Case Study no. 2: Malaysia – Privates Take an (Islamic) LeadMalaysia – Privates Take an (Islamic) Lead

Convertiable bonds, 15%

Islamic bonds, 32%

Islamic medium-term notes, 17%

Asset-backed bonds, 11% Conventional

medium-term notes, 9%

Straight bonds, 16%

All bond securities bond securities need All bond securities bond securities need to be rated by one of the two local to be rated by one of the two local rating agencies, but since 2000 the rating agencies, but since 2000 the mandatory BBB minimum rating mandatory BBB minimum rating requirement has been lifted.requirement has been lifted.

Currently the main nonfinancial issuers Currently the main nonfinancial issuers are construction, and utility are construction, and utility companies, with the bulk of companies, with the bulk of financing tenures 5- 10-yrs.financing tenures 5- 10-yrs.

Source: Bank Negara Malaysia.Source: Bank Negara Malaysia.

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Case Study no. 2:Case Study no. 2: MalaysiaMalaysia

First introduced in 1990, the First introduced in 1990, the Islamic market has boomed since Islamic market has boomed since 2000, representing half of total 2000, representing half of total gross issuance. gross issuance.

Regulations (and tax breaks) in Regulations (and tax breaks) in 2004 have facilitated the issuance 2004 have facilitated the issuance of securities via the principles of of securities via the principles of ‘profit-sharing’, and leasing of ‘profit-sharing’, and leasing of specific assets. specific assets.

The government has been second-The government has been second-mover issuing bills and Investment mover issuing bills and Investment Issues, creating a benchmark yield Issues, creating a benchmark yield curve. Both the IFC and the IBRD curve. Both the IFC and the IBRD have both issues in Islamic have both issues in Islamic securities.securities.

0

10

20

30

40

50

60

70

80

90

99 00 01 02 03 04

MYRbnPublic Islamic debt

Private Islamic debt

Conventional bonds, 75%

Islamic bonds, 25%

Source: Bank Negara Malaysia.Source: Bank Negara Malaysia.

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A Tale of Two Domestic MarketsA Tale of Two Domestic Markets

0

10

20

30

40

50

60

97 98 99 00 01 02 03 04

USDbn GovernmentBanksCorporates

0

10

20

30

40

50

60

97 98 99 00 01 02 03 04

USDbn GovernmentBanksCorporates

SingaporeSingapore MalaysiaMalaysia

Source: Bank for International Settlements.Source: Bank for International Settlements.

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How Would a UAE Yield Curve (Tentatively) How Would a UAE Yield Curve (Tentatively) Look Like Today?Look Like Today?

Using pooled regression techniques, we can estimate a hypothetical Using pooled regression techniques, we can estimate a hypothetical UAE government yield curve based on the country’s fundamentals.UAE government yield curve based on the country’s fundamentals.

Sample – 1998 to 2005 (8X4 annual obs on the time-space domain)Sample – 1998 to 2005 (8X4 annual obs on the time-space domain)

Countries – Malaysia, Singapore, Indonesia, and Saudi Arabia (surplus Countries – Malaysia, Singapore, Indonesia, and Saudi Arabia (surplus economies with heavily managed currencies)economies with heavily managed currencies)

Government bond yields (2-yr, -5yr, 7-yr, 10-yr) as functions of the following Government bond yields (2-yr, -5yr, 7-yr, 10-yr) as functions of the following economic fundamentals:economic fundamentals:Real GDP growth (UAE: 5.6%)Real GDP growth (UAE: 5.6%)Trailing CPI Inflation (6.0%)Trailing CPI Inflation (6.0%)3-months interest rates (4.0%)3-months interest rates (4.0%)Moody’s rating for long term local debt (assumed to be A1)Moody’s rating for long term local debt (assumed to be A1)Yield on corresponding US Treasury bondsYield on corresponding US Treasury bonds

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A 75-125bp Positive Spread to the USA 75-125bp Positive Spread to the US

4.0

4.5

5.0

5.5

6.0

6.5

2Yr 5Yr 7Yr 10Yr

%

UAE (estimate)

USA

115bp

Source: Central Bank of UAE, International Monetary Fund, Goldman Sachs calculations.Source: Central Bank of UAE, International Monetary Fund, Goldman Sachs calculations.

33

What Would the Costs to the Government Be? What Would the Costs to the Government Be?

The ‘direct’ costs of over-funding are estimated to be in the region of The ‘direct’ costs of over-funding are estimated to be in the region of US$ 280 mil per annum (or 0.2% of GDP). The main factor contributing US$ 280 mil per annum (or 0.2% of GDP). The main factor contributing the higher funding costs relative to neighbouring countries is inflation.the higher funding costs relative to neighbouring countries is inflation.

Under the following assumptions:Under the following assumptions:

Costs given by: Costs given by: ΣΣi(Ri,UAE - Ri,US)*Vii(Ri,UAE - Ri,US)*Vi

Target outstanding stock of US$ 25bn, proportional to Bahrein’sTarget outstanding stock of US$ 25bn, proportional to Bahrein’s

Issuance volume evenly spread across 2-, 5-, 7-, 10-yr maturitiesIssuance volume evenly spread across 2-, 5-, 7-, 10-yr maturities

The cost of maintaining a yield curve is pro-cyclical. The cost of maintaining a yield curve is pro-cyclical.

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ConclusionsConclusions

Issuance of government securities will facilitate the conduct of Issuance of government securities will facilitate the conduct of monetary policy like in Bahrain, and Singapore, and at the same monetary policy like in Bahrain, and Singapore, and at the same time set the foundation for the development of a broader private time set the foundation for the development of a broader private sector market, catering to individuals, public-sector sponsored sector market, catering to individuals, public-sector sponsored retirement and insurance schemes, allowing the UAE to take a retirement and insurance schemes, allowing the UAE to take a leading role in the region ahead of the prospected monetary union.leading role in the region ahead of the prospected monetary union.

A dirham corporate bond market needs to be supported by A dirham corporate bond market needs to be supported by international best practices. A functioning price formation international best practices. A functioning price formation mechanism rather than capitalization should be the primary mechanism rather than capitalization should be the primary valuation metric. Size is necessary but not sufficient.valuation metric. Size is necessary but not sufficient.

35

Outstanding IssuesOutstanding Issues

Realistically, banks, construction and energy companies will be the Realistically, banks, construction and energy companies will be the first to tap into the domestic savings pool. Islamic finance could first to tap into the domestic savings pool. Islamic finance could represent a viable opportunity, but regulations (and bankruptcy represent a viable opportunity, but regulations (and bankruptcy rules) need to be spelled out clearly when ‘times are good’. ‘Shari’a rules) need to be spelled out clearly when ‘times are good’. ‘Shari’a risk’ should be minimized.risk’ should be minimized.

Mopping up of liquidity will be instrumental in bringing inflation Mopping up of liquidity will be instrumental in bringing inflation down. That said, like elsewhere in the region, statistics on domestic down. That said, like elsewhere in the region, statistics on domestic prices need to be improved –they are key to functioning bond prices need to be improved –they are key to functioning bond markets, as investors settle for a nominal claim. markets, as investors settle for a nominal claim.

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Copyright 2006 The Goldman Sachs Group, Inc. All rights reserved.Copyright 2006 The Goldman Sachs Group, Inc. All rights reserved.

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