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Tuesday, 2 September 2008

The rise and rise of the sukuk

September 2008
From being little more than novelty investments just a few years ago, Islamic bonds are fast becoming firm favourites for investors in the Gulf and further afield. By Yadullah Ijtehadi, managing editor of Research by Juhaina Kasimali.

From being the flavour of the month, sukuk have been elevated to become a viable long-term funding instrument for many of the Gulf's corporations. This meteoric rise from being an alternative proposition to a mainstream reality has not gone unnoticed in the rest of the world, as international financial centres such as London, Tokyo and Hong Kong are altering their laws to accommodate sukuk and Islamic finance. The German state of Saxony-Anhalt has already issued an AAA five-year sukuk, while China, Japan and Thailand are reportedly planning to issue sovereign sukuk this year.

But for now the momentum is with the Gulf states. This year alone, firms in the Gulf have raised $7.73 billion (or 61 per cent) in 22 issues of the total sukuk issued to date. Gulf corporates raised $18.72 billion, or 55 per cent, of all sukuk issued last year.

While the governments are putting in place the framework, it is the private sector that is taking the lead in sukuk issuance.

So critical is the demand for funding in the Gulf that regional corporations are shrugging off the global credit crisis and the depreciating American dollar, and issuing domestic-currency denominated sukuk.

"The demand for domestic-denominated bonds remains high in the GCC at present as banks remain flush with local currency with limited assets to invest in," says Nish Popat, Director of Fixed Income, at National Bank of Dubai. "In addition, the continued rumour of revaluation by various central banks continues to attract foreign money into the bonds.

As long as speculation remains in the region concerning revaluation, demand for local currency bonds will remain high.

Going forward, we see the government of various countries in the GCC issuing bonds with different duration thus creating a sovereign curve."

The rise of sukuk is part of a much bigger tide that has swept across the Gulf states. On the back of triple-digit oil prices, GCC Sovereigns have now become one of the biggest exporters of capital globally, investing in high-profile international companies including HSBC, MGM and Time Warner. Gulf wealth has also made its presence felt in places as diverse as India, China, Peru, Kazakhstan, Canada, the US and Egypt, to name a few.

These Gulf companies are seeking funds from the market to raise capital for their ambitious domestic and global expansion either in the form of public offerings, private placements, syndicated loans and bonds. All these options are in huge demand and sukuk is no exception.

Deutsche Bank's outlook projects more prominence for the sukuk market going forward. "In our view, if we assume that only 10 per cent of the region's investment needs will be met by international sukuk issuance this would still imply a doubling of the existing international sukuk stock within two years, reaching close to $100bn by 2010.... we are starting to see the tip of the investment iceberg," says the bank in a report on sukuk.

Malaysia and the UAE remain the most active markets for sukuk, but many other markets seem ripe for development. Indeed some of the players are just warming up. Saudi Arabia, Kuwait and Qatar, among the Gulf states, and the UK, Pakistan and Indonesia all offer strong potential going forward. Malaysia, of course, remains a sukuk power house, having raised 38 issues valued at $3.77 billion this year to date, but it remains ringgit oriented and focused on the local market.

There is an urgent need for regional corporations to raise funds as they gear themselves up to capture a slice of the boom that is cascading across the Middle East and North Africa region. Dubai Electricity and Water Authority is one company that sought to raise funds in a dollar sukuk offering in late 2007, but pulled back when it realised the market was not enthusiastic. Undeterred, it returned to the market a few months later with a dirham-denominated offering.

Clearly, Gulf corporations can not wait for the international markets to right themselves. "The dominance of the local currency-denominated sukuk finds its origins in the weakness of the US dollar," Mohamed Damak, ratings specialist at Standard & Poors, told "It also reflects some expectations that the GCC central banks will revise their exchange rate policy. Another reason is the widening of the credit spread in the market. We expect to see more sukuk issuances in local currency, although in the long run, the dollar should return as the currency of choice."

Faisal Hijazi, Business Development Analyst for Structured Finance - Middle East & Islamic Finance at Moody's, agrees that issuers in the region are resorting to issuing local currency denominated sukuk more frequently in Saudi riyals and UAE dirhams. "I think with the growing speculation on the depegging of GCC currencies from the US dollar, the prospect of further local currency issuances will take more precedence," says Hijazi. "A growing number of institutional and retail investors are seeking local currency denominated bonds/sukuk in a bid to reserve profit yields under difficult credit market conditions and a declining dollar." Financial institutions and real estate companies account for half the sukuk issuance in the Gulf this year, and the trend is likely to continue. Financial institutions (FIs) are looking for funding to cater to a huge need for long term lending especially for the housing market.

Gulf banks are also looking to tap into the sukuk market to reduce their maturity mismatches as for the time being their funding profile remains dominated by short-term deposits.

The environment seems more fertile for the emergence of securitisation, notes a report from UAE-based Damac Investment. "As the region becomes more familiar with securitisation techniques, the sukuk market is set to benefit from a wave of opportunities and innovation."

Furthermore, as financial institutions are hungry for growth, notably in the real estate finance sector, asset backed sukuk issued by these institutions in the Middle East are expected to have great potential, states the Damac Investment report.

Moody's Faisal Hijazi adds that while the financial and property companies will dominate sukuk issuances in the medium future, there is also growing issuances in the oil and gas, power and utility and infrastructure investment sectors.

Seeking a Yield Curve
While the sukuk industry has risen quickly, it has not been without its short-term hiccups and long-term challenges. Apart from the fact that the market is not immune to the global credit crises, the industry faces a number of challenges to sustain growth: such as standardisation, structure harmonisation and the availability of expertise and human capital.

For example, the Gulf and Malaysian interpretation of sukuk differ greatly and there are concerns that it will lead to a fragmentation of the industry if it has not already. The handful of Islamic scholars also reflects the shallow talent pool available in the industry. According to a Forbes report, there are only 20 Sharia'ah scholars in the world that dictate Islamic finance.

"It's a limited specialisation with limited practitioners, and even among the people with the specialisation only a handful are suitable for working with international financial institutions," Yusuf Talal DeLorenzo, a US-based scholar told the magazine. "A passing knowledge of English is generally not enough when a scholar has to wade through hundreds of pages of a prospectus or legal documents."

Lack of scholars is not the only problem. The sheer dearth of Islamic finance professionals also means that the industry has very little talent to pick from. These issues, if not addressed soon, could derail the sukuk gravy train.

On a macroeconomic level, sukuk issuance have been on the rise in the absence of an active monetary policy in the Gulf. Most Gulf currencies are pegged to the American dollar making GCC's monetary policies subservient to the US Federal Reserve. The lack of monetary instruments in the Gulf central banks' arsenal has made the development of conventional bonds difficult, although not impossible. "The lack of local currency denominated government bonds renders the construction of a yield curve more challenging," says S&P's Damak, but argues that this development has paradoxically spurred the nascent local sukuk and bond markets. "Economic uncertainty in the past 12 months led the Fed to cut its reference rate on several occasions and the Gulf countries have moved in accordance with that policy to ensure the stability of their exchange rate regimes. As a result interest rates are low, encouraging growth in local denominated bonds."

Hijazi thinks Gulf governments are less likely to issue sukuk in the short to medium term, given the robustness of their fiscal and current account surpluses. "On the contrary, GCC governments with the rising fiscal surplus are gradually reducing their sovereign debt levels."

GCC governments, represented by central banks, could step up their monetary policy operations by issuing short term liquidity sukuk instruments, similar to the Central Bank of Bahrain (CBB) monetary instruments, CBB Sukuk and Al Salaam Sukuk programmes.

"Globally, I think the governments of Japan, Hong Kong and the UK more likely to issue sovereign sukuk much earlier," says Hijazi.

Global Reach
Indeed, the sukuk bug is not restricted to the Gulf. In June, Indonesia decided to remove taxes on sukuk issued by the government to make their offering more attractive to foreign investors. Meanwhile, Japan Financial Services Agency (FSA) has submitted an amendment to the banking law to the Diet (Japanese parliament) which may allow Japanese banks to offer Islamic finance products through a subsidiary, according to media reports. Hong Kong, London and Singapore are also looking to leverage their financial services hub status to attract the Islamic finance market.

"I get a call virtually every day from companies in countries as diverse as South Korea, the United States and Brazil, looking to issue sukuk and tap into the liquidity in the Gulf," says the CEO of one of the largest international banks based out of Dubai International Financial Centre. It appears that sukuk have already gone global.


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