2020 has hit the world with an unexpected pandemic to which governments and central banks have responded with unprecedented accommodative monetary policies and large fiscal stimulus to support economic recovery. Access to cash, ie liquidity management, has never been so critical during such a crisis whose negative impacts on the economy and the financial markets are still unknown. Islamic banks entered the pandemic with stronger capital and liquidity buffers than during the global financial crisis but have been facing challenges in managing liquidity efficiently.
Review of 2020
The coronavirus pandemic has left governments and the corporate sector scrambling for cash, and by the end of March 2020, it had caused a flash liquidity crunch. Large companies have benefited from their bank’s revolving credit facilities for short-term funding while sovereigns waited for a window of opportunity in early April 2020 to start raising funds in the capital markets even though at a premium. As a result, the pre-pandemic debt levels have since then exploded to record highs.
The global economic shutdown led to a decrease of household consumption and company investments which resulted in a sharp fall in oil prices. Most of the Islamic countries, including oil-based economies, favored bond issuances rather than Sukuk as their primary source of funding due to the emergency in keeping their economies afloat. Therefore, even though Sukuk issuances later picked up in the third quarter, the volume is expected to drop by US$62 billion this year according to S&P.
The economic recovery is expected to be achieved through liquidity injections from central banks. Indeed, in several jurisdictions, bank regulations have been loosened to increase the money supply with measures such as easing the cash reserve ratio and liquidity coverage ratio requirements under Basel III. Consequently, there has been ample liquidity available, but the velocity of money, the speed at which money changes hands, has fell sharply because of people saving more due to fears of a prolonged recession.
Conventional and Islamic money managers were in wait-and-see mode due to global uncertainties caused by the pandemic and other challenges such as the US election, potential no-deal Brexit and the resurgence of the US–China trade war. Investors were keeping as much cash as possible and invested in highly rated instruments with short maturities, waiting to redeploy their money at higher yields during more favorable times.
To address the market demand for high-quality Islamic cash alternative instruments, the International Islamic Liquidity Management Corporation (IILM) raised its issuance program size to US$4 billion and offered close to 35 short-term Sukuk with tenors from one month to seven months on a regular basis for a total of US$12 billion in 2020. There has been a shift in Islamic investors’ behaviors with rising demand for ultra-short tenors such as one-month papers.
Preview of 2021
Whereas several jurisdictions have been actively providing liquidity instruments and funding to support their local Islamic financial institutions, the global Islamic money market remains relatively underdeveloped. It may be due to a shortage of a wide offering of high-quality liquid Islamic assets or the common belief that Sukuk are not actively traded in the secondary market.
However, there is also a lack of industry will to evolve and explore innovative Shariah compliant liquidity solutions already available. Indeed, excess liquidity remains typically invested in commodity Murabahah but its effectiveness as a liquidity management instrument remains limited by non-tradability issues and wide Shariah acceptance. Liquidity management is not about the yield, it is about how fast and safe assets can be liquidated to raise cash when needed.
More issuers of short-term Islamic instruments as well as broad and active investors will definitely support a deeper Islamic money market and the establishment of a much-needed Islamic benchmark yield curve for the Islamic industry, especially with the upcoming LIBOR transition at the end of 2021. The IILM effort focusing on the short end of the curve by consistently issuing benchmark-sized sovereign-backed Sukuk, more than US$1 billion a month, in various short-term tenors could support the creation of a low-risk/risk-free rate curve.
The liquidity stress due to the pandemic this year has also clearly identified the need for an effective Islamic repo cross-border framework to support Islamic banks’ short funding needs globally. The lack of harmonization and wide Shariah acceptance has prevented the development of a strong liquid Islamic repo market and thus an additional source of liquidity to banks outside of their own jurisdictions. Secured short-term financing instruments are a cornerstone of the conventional banking industry whereby US$1 trillion in collateral value is traded per day in the US repo markets.
In addition, similarly to the conventional repo rates, profit rates on Shariah compliant ‘overnight repurchase agreements’ would be a key indicator of the ongoing liquidity among Islamic financial institutions as well as their short-term expectations.
Proper liquidity management requires not only relevant instruments that can be bought and sold actively at any point of time, but also liquidity risk monitoring tools for the Islamic financial markets.
The coronavirus pandemic should serve as a wake-up call and should be a catalyst for much-needed progress in the development of the Islamic financial markets globally, especially to deepen the Islamic money market and set up an active Islamic repo facility backed by high-quality assets. It calls for strong collaboration between regulators, Islamic market practitioners, Shariah scholars and standard-setting bodies.
As John F Kennedy once declared: “The best time to repair the roof is when the sun is shining.” Not that the current market conditions are ideal, but it could get worse and delaying the establishment of an efficient and liquid Islamic financial market would not solve the problem Islamic financial institutions have been facing.
Hichem Bouqniss is the executive director of the International Islamic Liquidity Management Corporation (IILM). He can be contacted at [email protected]