The global economy rebounded by about 5.8% in the current financial year of 2021 (CY21), recovering about 2.3% above pre-COVID-19 levels. However, since then, the rapid expansion in demand, coupled with the recent recession, has hit supply chains and revealed major vulnerabilities. As the supply chains struggled to keep up with the increased demand, major commodities entered into price spirals, with the added shock of the Russia–Ukraine war. Commodities price inflation, reduced availability and spiked prices of value-added products had a severe knock-on effect on multiple industries.
Stimulative economic measures taken during the COVID-19 pandemic and the ensuing economic overheating in combination with supply shocks have led to decades-high inflation rates across the globe. In a bid to combat the economic overheating and inflation, most central banks have lately begun to adopt monetary tightening in CY22. Subsequently, the financial markets and interest rates have become highly volatile, reflective of high uncertainty regarding growth outlooks, monetary policy and inflation. Islamic finance is no exemption.
CY21 closed with global Islamic finance assets growing to around US$3.6 trillion and are estimated to reach around US$4.9 trillion by the end of CY24, maintaining a compound annual growth rate of about 9.6%; given the prevalent worsening global economic outlook, the industry may lose some traction.
Of the segments in the Islamic finance industry, Islamic banks hold the largest share in terms of assets held, as they represent about 70% of total industry assets, followed by Sukuk which represent an approximately 19% share of industry assets, while Islamic funds and Takaful hold around 5% and 2% of industry assets respectively.
Review of 2022
Against all odds, the global banking system has remained firm throughout the COVID-19 pandemic and the conflict in Eastern Europe. However, with the current economic outlooks skewed toward a negative trajectory with hawkish stances of many central banks, lending conditions have become more restrictive. Meanwhile, the demand for loans is still resilient as firms have higher working capital needs on account of increased input costs.
Most core Islamic finance markets (with the exception of Turkiye) have remained largely resilient during the commodity inflation cycle and the war in Eastern Europe, as many are major petroleum exporters. Core Islamic finance economies, therefore, reflect stable outlooks. Given a relatively stable operating environment, bank financing has maintained traction.
Credit ratings in Islamic finance take due consideration of the impact of the operating environment in the performance of Islamic finance assets. The ratings of the top 10 largest Islamic banks have all remained above the investment grade long-term rating (ie above ‘BBB-‘ for Fitch Ratings and S&P Global Ratings and ‘Baa3’ for Moody’s Investors Service) and fall in the rating bandwidth of ‘A+’ to ‘BBB-‘. During CY22, the earlier assigned negative outlooks (majorly amid COVID-19 uncertainty) and rating watch have all reverted to stable and even positive outlooks in some cases. The key common rating drivers to the revision in outlooks for Islamic banks are the improved/strengthened operating and economic environments amid the stabilization of oil prices post-pandemic.
The global outstanding Sukuk market size by the end of the third quarter of CY22 reached about US$750 billion (up about 2.1% quarter-on-quarter (QoQ)). However, like other structured finance instruments, global Sukuk are yielding higher returns amid tight monetary policies, rising inflation and global geopolitical and economic vulnerabilities. This has led to an aproximately 14.4% QoQ decline in new Sukuk issuance.
The S&P MENA Sukuk Index yield-to-maturity (YTM) reached about 5.8% in November 2022 compared with about 1.8% a year ago, while the YTM of the Dow Jones Sukuk Investment Grade Index reached about 5.5% and the S&P Global High Yield Sukuk Index YTM reached around 7.7% compared with about 1.9% and 4.2% a year ago respectively.
Despite the increased yields, Sukuk ratings have remained largely stable with Fitch assigning about 79% of its rated instruments a rating above investment grade. Fitch-rated Sukuk issued by major players in key markets have a rating bandwidth of ‘A’ to ‘B+’. The largest Sukuk issue rated by Fitch to date is for Saudi Aramco, with an issue size of around US$6 billion.
Preview of 2023
Given the increasing fears of a global economic slowdown as a baseline assumption and the economic dependence of the core Islamic finance markets (the GCC and Malaysia) on energy exports (ie mainly petroleum products), the ratings and outlooks of Islamic finance institutions and bonds largely rely on the stability of crude oil prices. As the global economic growth weakens in the near term, energy demand is also expected to be subdued contemporaneously, as the two hold a high historic correlation. However, major exporting countries have managed to keep prices stable via strategic production cuts.
Seemingly, it is reasonably fair to conclude that the financial soundness and stability of the Islamic finance ecosystem, which ultimately set the direction of its credit ratings, would be driven by demand, supply and price dynamics of the oil markets in the near term.
Conclusion
The Islamic financial sector plays a significant role in most of the major Islamic economies. However, key industry participants are still centered around oil-exporting Islamic countries, with little to no additions beyond original territories. The industry must move quickly toward legal and regulatory standardization to cope up with its rapid expansion, as high complexity and relatively low standardization deter new entrants (non-Muslim jurisdictions in particular). This would not only allow better access to non-traditional territories, but also improve credit rating assessment criteria in the long term.
Muhammad Usman Sarwar is the research analyst at Pakistan Credit Rating Agency. He can be contacted at [email protected].