Global sukuk issuance surged in the first half of 2017, hitting $48bn, as sovereigns from the Gulf Cooperation Council tapped the Islamic securities market with verve.
Lower oil prices have strained budgets across the region in recent years, putting pressure on governments to raise funds by alternative means. This contributed to a 37.7 per cent year-on-year increase in sukuk transactions, according to S&P Global.
Yet, this sudden preference for Islamic securities illuminates a number of problems with the market.
Total sukuk issuance has been relatively muted since 2015, when Malaysia’s central bank stopped issuing short-term instruments to help the country’s banks manage their liquidity.
Collapsing oil prices were expected to fill the gap by stimulating transactions from cash-strapped corporates and sovereigns from across the Islamic world. Instead, 2015 and 2016 saw global deal volumes slip to multiyear lows.
“The Islamic finance industry is largely concentrated in oil exporting markets,” says Mohamed Damak, senior director and global head of Islamic finance at S&P Global Ratings. “With the collapse in commodity prices, a number of observers anticipated a windfall in sukuk issuance in 2016. This didn’t occur in the sukuk market but it did materialise in the conventional bond market.”
That core Islamic finance jurisdictions, facing immediate budgetary pressures, turned first to the conventional debt markets points to the complexity of issuing sukuk, says Mr Damak.
A lack of standardised legal documentation is one issue, while the asset-backed structure of sukuk makes identifying appropriate assets difficult for some sovereigns. These challenges warded most issuers off sharia-compliant financing at the time.
“Issuing sukuk can be a lengthy process. The real challenge is identifying an appropriate asset and having an effective legal framework in place,” says Farmida Bi, head of Islamic finance for Europe at law firm Norton Rose Fulbright. “If you’re issuing a $1bn sukuk, not a lot of sovereigns have a physical asset of that size available and ready to be used. Finding one can be problematic.”
For first-time sovereign issuers it can take years to align sukuk transactions with existing rules on financing and taxation, and with any regulations linked to the underlying asset.
Meanwhile, evolving interpretations of sharia compliance and the absence of central sharia authorities are raising new complexities. Dana Gas, a United Arab Emirates energy company, is contesting the legality of its own sukuk under national law by citing revised sharia interpretations.
So why have global sukuk transactions spiked in 2017? According to Mr Damak, sovereigns, particularly in the Gulf, bought themselves time by tapping the conventional bond market first.
A good liquidity environment, helped by improving oil prices in 2016, as well as a desire to diversify their investor base, has seen many of these governments turn to the sukuk market in the first half of the year. In April, Saudi Arabia raised about $9bn through its first dollar denominated sukuk.
But the prospects of this momentum continuing in 2018 are low.
“Given that we expect financing needs in the GCC alone to be about $275bn over the next three years, with about 50 per cent of that financed through debt or sukuk, there will be a natural preference by these sovereigns to look to the debt markets because it is easier,” says Mr Damak.
Hobbled by complexity, the sukuk market is in need of innovation to ease the issuance process. These challenges and others are being addressed by multilateral Islamic agencies but it will be some time before the market experiences any change.
“For the industry to have a sustainable future it needs to find a way to structure sukuk transactions that is widely accepted and that doesn’t always require a physical asset equal to the value of the issue,” says Ms Bi.
