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Sunday, 12 October 2008

Global debt goes Islamic amid a credit cruch that is paralysing the lending market

"Global Debt Goes Islamic"

Despite a significant slowdown in the Islamic bond market, companies around the globe are turning to Islamic issuances amid a credit crunch that is paralysing lending markets. Now some corporations are adapting deals constructed to conventional specifications, in order to tap the riches on offer in the Gulf. Andrew White reports.

While markets in the us and Europe head for meltdown amid a slew of bank collapses and bailout schemes, attention is turning to the Islamic finance houses of the Middle East.

The Gulf's Sharia-compliant finance houses are obliged to conduct a closer scrutiny of assets they lend against than their conventional counterparts - many of whom have plunged into the subprime abyss as a result of ill-considered loans.

And with companies around the world now cut off from conventional lending streams, they are increasingly turning to the Islamic institutions of the Gulf to secure much-needed funding through Islamic bonds, or ‘Sukuk'.

"A lot of our clients are looking at the Middle East and at institutions in the Middle East to see if they can help with their business, and whether there are more opportunities for Western institutions to go into the Middle East and adopt Islamic standards," says Neil Miller, head of Islamic finance at international legal practice Norton Rose.

Moreover, in order to satisfy Sharia principles, conventional corporates are scrambling to adapt deals developed on a conventional basis.

The Gulf has the cash, and companies around the world are doing anything they can to gain access to those petrodollar billions - including reconfiguring transactions to avoid assets and structures deemed not to be Sharia-compliant.

"The arrangers are looking at if they can restructure their deals on a Sharia-compliant basis, or whether they can create a parallel investment opportunity fund or whatever it might be," says Miller. "So we're seeing that already and we're currently working on a number [of cases]."

The news will come as a boost to the Sukuk market, where growth had slowed in the first three quarters of 2009. Until this year Islamic bonds had been the fastest growing part of the global bond market. Its value had doubled every year since 2004 to $90bn worldwide at the end of 2007, and its position as a key pillar of the $1 trillion Islamic finance industry was unquestioned.

In the last two months alone Investment Corporation of Dubai, a state-owned holding company, said it will raise $5.6bn in a dual-currency loan, while Abu Dhabi National Energy Company borrowed $3.15bn to refinance debt, and Sorouh Real Estate, Abu Dhabi's third-biggest property company, sold $1.1bn of bonds.

However, 2008 has been a far from vintage year for Sukuk issuance, where banks sell debt by using assets to generate income equivalent to interest they would pay on conventional debt.

Total issuance worldwide stood at around $14bn in the eight months to August 31, 2008, down from around $23bn during the same period in 2007, according to ratings agency Standard & Poor's (S&P). What's more, analysts do not anticipate the market will pick up again before 2009.

"I think there's a natural hesitation because when you dig more deeply into the market you'll see a lot of the buyers of this paper are the Islamic windows of conventional banks," says Miller.

"The fact that they haven't got appetite at the moment has impacted the Islamic capital market exchange," he continues. "The linkage is partially because a lot of the arrangers of these instruments are conventional institutions acting in an Islamic capacity - for example, the two biggest arrangers of these instruments are Citi and HSBC."

Another factor in the slow progress of the Sukuk market has been the declaration by a group of influential Islamic scholars that most bonds fail to adhere to religious rules.

As with all Islamic financial instruments, the money cannot be used to finance gambling, guns or alcohol. However in February, the Bahrain-based Accounting & Auditing Organisation for Islamic Financial Institutions (AAOIFI) ruled that bonds don't meet religious requirements if they haven't transferred ownership of collateral to holders. About 85 percent of Sukuk failed this test, the board said.

"The industry is looking very closely at how it is going to do these deals in the future," says Miller. "In the current circumstances it's a hesitation rather than being symptomatic of anything more worrying, but the AAOIFI has caused the industry to reassess whether these instruments are moving away from Sharia fundamentals or whether they are permissible."

The credit squeeze and the religious edict have conspired to inspire nervousness among investors, and spreads have been hit hard. The HSBC-DIFX index of Sukuk has declined 0.7 percent this year, while the comparable conventional debt index has climbed over 1.3 percent.

Sukuk have on average yielded 320 basis points over US treasuries in 2008, while comparable conventional debt issued by Middle East borrowers has an average yield spread of 314 basis points.

"There's an element of bad synchronicity in the timing; had you had one of these on its own you wouldn't have seen so much hesitation," suggests Miller. "If there was no subprime crisis or credit crunch, people would have been looking at what the AAOIFI had to say, and then going out there much more confidently to work out what new structures could be created and how that would affect pricing."

As a result, while liquidity has long been scarce on the international markets, it is becoming increasingly hard to find on local markets. The UAE, for example, has endured its own liquidity crunch in the last fortnight - as evidenced by the intervention of the central bank, which last month said it would make $13.6bn available to bail out banks in the Emirates.

And while Miller insists that there is still plenty of appetite amongst issuers for Islamic instruments, the Sukuk market has found itself in a "crossover area". "The difficulty is that the banks are lenders to the conventional market and the Islamic market, and they've stopped lending to both - and so both markets get hit," he says.

Fortunately for the Sukuk market, 2008 is unlikely to be remembered as an annus horribilis - at least compared to the travails of its conventional counterparts. Indeed, S&P's forecasts that Sukuk issuance will reach around $20bn in 2008, still a "good year", according to Mohamed Damak, a credit analyst at S&P in Paris.

"When you look at the pipeline of the Sukuk that have been announced or even rumoured in the market, you will see that it is extremely strong," he says. "We are talking about deals in excess of $40bn - but that doesn't mean that all these Sukuk will come to market in 2008. In fact, only a small portion of them will be issued before year-end."

The difference will remain on hold, as investors watch how the market develops in these uncertain times.

"Transactions that we're processing are effectively being ‘warehoused' for a period of time," says Miller at Norton Rose.

"I think people will come and look at them after ‘x' months' time and see what the state of affairs is, as people are waiting to see what the implications are of the main global situation.

"It's a moveable target - before Ramadan, based on what our clients were telling us, we would have thought that things would start picking up in the last quarter of this year," he continues. "The reality is that may now have shifted to next year. These are interesting times, and I wouldn't want to speculate as to when things may kick off again."

Some analysts argue that sovereign Gulf Sukuk could represent the catalyst required to spark life back into the sector.

A large offering by a highly rated government such as Saudi Arabia would act as a benchmark for the rest of the market and help investors and issuers to price the transactions according to the risks. However, there is no sign the oil-rich governments of the Gulf have any intention of taking the Sukuk route.

"Issuances that are conducted by government-related entities or that benefit from government support or guarantees, could help improve pricing," says Damak at S&P. "However, we do not expect Gulf sovereigns to be significant issuers of Sukuk in the foreseeable future."

Instead, the immediate future of Sukuk will most likely be determined by the behaviour of the conventional banks. According to Miller at Norton Rose, the Islamic way of banking is often considered a "return to basics" as it involves a much closer scrutiny of assets - and financing opportunities in the Islamic space will be greater if conventional banks are lending less.

"If conventional banks stop lending to corporate credits then those corporates will have to cast their net wider, and it may well be that they can do that in a Sharia way and look for funding from the Middle East," he explains, adding that while the cost of putting an Islamic deal together is typically higher than that of its conventional counterpart, such differences could be forgotten as the hunt for funding intensifies.

"If there's a willingness to make funds more available on an Islamic basis, it might be more expensive, but at least they're willing to make the funds available in circumstances when their conventional rivals can't even do that," he says. "That then begs the question whether it will be full-blown Islamic institutions who will participate in these, as opposed to the Islamic windows of conventional banks."

S&P continues to see significant appetite from issuers in a larger number of countries - both Muslim and non-Muslim. Entities located in more than 15 countries, predominately non-Muslim, have expressed interest or announced their intention to issue Sukuk, and the ratings agency therefore expects the Sukuk market to continue globalising.

"We are seeing an increasing number of issuers coming to the Sukuk market," says Damak. "We expect the number of countries issuing Sukuk to widen because it helps the issuers to attract additional investors - namely the investors that are looking for the Sharia-compliant aspect of the product."

Thailand, Singapore, the Philippines and Pakistan have all announced issuances or are rumoured to be considering them, while in Europe the UK government has set out plans to become the first Western government to issue Sukuk. If that happens, then it will pave the way for other corporates to raise money through Sukuk.

At the same time, transactions that have been assembled on a conventional basis are being restructured to make them more acceptable on an Islamic basis.

"It's not just in Sukuk, but on a wider basis through the whole of Islamic finance, that people are looking more closely to see what Islamic finance has to offer, and whether or not these existing transactions and businesses can raise funds in a different way, using Islamic methods," says Miller. "And I think that will be a good news story for the Islamic finance industry."

(Arabian Business/12Oct08)

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