The sukuk market performed strongly in the first half of 2017, but doesn’t augur an enduring trend. Issuance increased by 37.7% in the first six months of this year, compared with the same period of 2016, underpinned primarily by the jumbo issuances of some Gulf Cooperation Council (GCC) countries’ governments. What’s behind the surge? Sovereign issuers turned to sukuk as they had time on their side, wanted to diversify their investor base, and to benefit from the good liquidity conditions in local and global financial markets.
While S&P Global Ratings expects the volume of sukuk issuance to remain strong in 2017, this is likely to be the exception rather than a new norm. The large transactions in the first half of 2017 are unlikely to be repeated in 2018, in our view. We also continue to believe that the relatively complex process for issuing sukuk continues to deter some issuers. However, we note that some progress has recently been made by the Islamic finance industry standard-setting bodies.
- Volume of issuance of sukuk increased significantly in the first half of 2017, thanks to the jumbo issuances by some GCC governments, and we expect the total volume to reach $75 million-$80 billion in 2017.
- We still see this year as an exception rather than a new norm.
- We estimate GCC governments’ financing needs at around $275 billion between 2017 and 2019, about 50% of which will be debt-financed, through a combination of bonds and sukuk.
First-Half Issuance Augurs A Good Year
Total sukuk issuance in the first half of 2017 increased significantly compared with the same period last year (see chart 1). This was primarily driven by the jumbo local and foreign currency issuances by some GCC governments (see chart 2), including the $9 billion sukuk issued by Saudi Arabia in April 2017, which was one of the largest sukuk issued globally to date.
While this augurs a good year, we think it represents an exception rather than a new norm as some of the large issuances of 2017 are unlikely to be repeated in 2018.
We expect that total issuance will be around $75 billion-$80 billion in 2017, up from our previous expectations of $60 billion-$65 billion. Two main reasons explain our updated forecast:
- Governments are not under pressure to raise funds quickly and want to diversify their investor base,
- Regional and global liquidity remains good.
Governments are under less pressure to raise funds
Over the past 18 months, the stabilization of oil prices, the policy response of GCC governments, and the issuance of large bonds helped to reduce liquidity pressure on some GCC governments. After tapping the conventional markets, they have now turned to the sukuk market to diversify their investor base and tap pockets of local and regional liquidity. We still foresee significant financing needs for GCC governments, which we estimate at around $275 billion between 2017 and 2019. We think that around 50% will be debt-financed, through a combination of bonds and sukuk. Governments are likely to continue to prefer bonds over sukuk, however.
Regional and global liquidity remain good
GCC investors are among the main investors in sukuk (see chart 3). Within this universe, we understand that banks are playing the biggest role. Over the past two years, we have observed a reduction in liquidity in GCC banking systems due to lower deposit inflow. This situation started to reverse in the first half of 2017, thanks to the stabilization of oil prices. Moreover, we observe that GCC banks tend to keep sizable amounts of cash and money market instruments on their balance sheets. In their current challenging operating environment, marked by lower opportunities for lending, we think that some of them might divert a portion of their liquidity toward assets that generate higher income compared with cash and money market instruments. In this context, bonds and sukuk appear more attractive than interbank deposits or deposits with the central banks.
Global liquidity also remained abundant in the first half of 2017 and we expect this situation to continue in the second half. The European Central Bank (ECB) Quantitative Easing (QE) Program, the slow increase in the U.S. Federal Reserve Bank (the Fed) interest rates, and good liquidity in some Asian countries will continue to support market activity for both bonds and sukuk. The cost of funding might be on the rise though as the Fed increases its rates and the ECB starts to taper its QE program. We expect an additional 25-basis-point increase in Fed rates by the end of 2017, after the recent 25-bps increase in June 2017. However, we see the ECB normalizing over a very long period of time, with its QE program brought to (close to) zero by the end of 2018–with the risk of further delays into 2019 if external conditions (commodity prices, exchange rate) turn more deflationary–and interest rates starting to move in 2019. Given the low interest rates in developed markets, emerging-market issuers with good credit stories might still be on investors’ radars, as shown by the large oversubscription rates of some recent transactions. Therefore, we believe liquidity will continue to leak into the sukuk industry from developed markets.
It remains to be seen if the recent developments in Qatar will impact issuance out of the country. Qatar was placed under sanctions by a group of governments that cut diplomatic ties and trade and transport links. This event is likely, in our view, to deter the appetite of some investors to invest in sukuk issued by Qatar-based entities in the short term. The longer term impact will depend on how the situation evolves.
Reduce Complexity, And The Market Will Grow To Its Full Potential
Issuing sukuk is still more time-consuming and complex than issuing bonds, but the time and cost gap has reduced over the years. Positively, in the first half of 2017, we have seen the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) along with other heavyweights in the financial industry, pushing the market toward greater standardization. AAOIFI issued standard exposure drafts on Central Sharia Boards and sukuk accounting.
While the AAOIFI’s actions respond directly to the complexity related to Sharia compliance and legal structuring of sukuk, the process of sukuk issuance is still not as smooth as the process for issuing a conventional bond. Until we reach that point, we think that issuers will tend to have a preference for bonds.
Numerous issuers have looked at the sukuk market and decided to eventually walk away faced with the steps that must be completed. In order to respond to this issue, standard-setting bodies have identified the following areas for improvement:
- Sharia compliance,
- Legal documentation,
- Market education,
- Government issuance as an example for the market.
Sharia compliance. Sharia was interpreted in different manners across the various Islamic finance core markets, resulting in limited interaction between them. The market appears to have moved in the right direction with the proposal for central Sharia boards. However, we believe that standardization could be taken one step further by establishing standards that would be accepted globally, as well as moving from ex ante approval to ex post audit.
Legal documentation. Lawyers have made significant strides in standardizing the legal documentation of sukuk but we are still not yet at a point where the documents are as streamlined as for conventional bonds. In addition, we have observed in some structures requests from scholars to introduce what we consider as uncertainties in the legal provisions to ensure the respect of the principle of profit and loss sharing. Such an approach could destabilize the market if investors were faced with a sukuk default. Investors expect that sukuk sponsors would intervene to avoid such a situation. However, we discount this support and rate to the contractual obligations of the sponsors as we believe that Sharia scholars will prevent any extension of support beyond contractual obligations.
Market education. Investors need further education on the risks attached to sukuk, in our view, since, for the time being, most investors regard sukuk as if they entail the exact same risks as conventional bonds. Sukuk are not conventional bonds and they can sometimes entail different risks. For some sukuk, investors might end up exposed to residual asset risks, for example. For others, legal documentation that is subject to interpretation or issues related to Sharia compliance might open the door to unforeseen risks. This reinforces the case for the standardization of legal documentation and Sharia interpretation. Finally, sukuk structures used in Saudi Arabia combining Mudaraba and Murabaha are different from structures used elsewhere such Murabaha, Ijara, or Wakala.
Government issuance. Sukuk issuance by governments and their related entities is necessary to set an example for private sector issuers to follow. The lack of high-quality liquid assets (HQLA) and the progressive increase in the regulatory requirements for banks’ liquidity coverage ratios will further escalate Islamic financial institutions’ appetite for HQLA-eligible sukuk. Given the high amount of liquid assets sitting on the balance sheet of these institutions and governments’ significant financing needs in the GCC, more issuance of HQLA-eligible sukuk could be a win-win situation. Moreover, it could open the way further for private sector issuers.