Oil exporters in the Middle East are becoming an important source of the flow of international bond issuances at the emerging markets level. With oil prices reaching historical lows in February 2016, several governments turned to the bond and Sukuk markets for funding. According to the Bank for International Settlements, overall, Africa and the Middle East contributed 32% of total net issuance in emerging markets, close to the 37% contribution from emerging Asia-Pacific and Latin America contributed 23% as of the first half of 2016. This is a new trend for such markets. BASHAR AL NATOOR explores.
Review of 2016
In 2016, we saw the return of Saudi Arabia, Abu Dhabi and Qatar to the sovereign international bond markets with issuances of US$17.5 billion, US$5 billion and US$9 billion respectively. This could be perceived as a shift from Sukuk to bonds; however, only Bahrain and Oman of all the GCC countries have issued both Sukuk and bonds at moderate levels in the past few years. We also saw Bahrain, Oman, Qatar, Malaysia, Indonesia, Turkey and Pakistan (seven out of the 10 key Sukuk markets) tapping the Sukuk market in 2016, with other GCC nations indicating that they would issue Sukuk, or a mix, in the future.
Many factors determine a government’s decision, whether to issue bonds or Sukuk, or indeed, a combination of these instruments. One of these factors is the intended investor and funding base. This plays a big part in the decision to select a Sukuk facility or a bond or both. The important variables are usually whether to issue Sukuk (or bonds) domestically or internationally, using either local or foreign currency denomination. These two features are often interlinked, as many issuances are denominated in the currency of the market in which they are issued. If the target is predominantly international investors, bonds may be the preferred instrument, as international investors are usually more familiar with bonds over Sukuk. On the other hand, if local and regional investors are the target, and there is a significant presence of Islamic investors, then Sukuk or both Sukuk and bonds may be the preferred choice.
The second consideration is the existence of a Sukuk-supportive infrastructure and an Islamic finance strategy for the issuing sovereign. Both factors could pose significant challenges in the selection of bonds or Sukuk. Of particular importance is the existence of an established legal framework that is acceptable to a government, investors and the Shariah boards (which is a prerequisite to issuing Sukuk).
Third is the size and requirements of the Islamic finance industry in the country of issuance. As Islamic banks are not allowed to invest in traditional bonds, the lack of high-quality liquid assets continues to be one of the key challenges Islamic banks face. Sovereign Sukuk plays a big role in bridging this gap, and a Sukuk facility could become a worthwhile option to help the Islamic finance industry overall.
We have seen some growth outside the key markets in 2016. For example, we saw Jordan and countries in Africa issuing Sukuk, which shows positive momentum. However, structural challenges remain. Reuters reported that in 2016, Togo’s initial Sukuk facility was XOF150 billion (US$242.42 million). This comes after Senegal launched its second XOF200 billion (US$323.23 million) Sukuk facility toward the end of June and Côte d’Ivoire issued the second phase of its XOF300 billion (US$484.84 million) Sukuk program.
Preview of 2017
Taking into consideration the shift in oil prices and our expectation that they will only recover to around US$65 a barrel in the long term, Fitch believe sovereign issuance (both bonds and Sukuk) from GCC members will become a more regular feature of these markets. Interestingly, the lack of a sovereign yield curve has been one of several factors holding back corporate bond issuance but we are beginning to see these dynamics change, and corporate issuance could also gradually start to take off in 2017.
Outside key markets, we still believe the short-to-medium-term prospects are positive but limited, owing to challenges from a lack of standardization in the industry. This prevents the establishment of legal structures and legislation to accommodate the issuance of Sukuk and therefore structuring Sukuk remains a relatively complex and time-consuming process compared to issuing a traditional bond.
Challenges lie ahead for the Sukuk market despite continued momentum. The time needed to tackle these obstacles will impact on how long it takes to implement Islamic finance and potentially lead to higher costs in relation to more conventional forms of funding until a standardized framework is established. However, several important trends could provide the necessary impetus for the development of Islamic finance in new Sukuk markets. This includes the growing government support for Islamic finance, the increasing acceptance of Sukuk and Islamic finance more broadly and the existing large investment and financing requirements.
Sukuk harmonization initiatives, in parallel with GCC funding needs and a return to capital markets; efforts to improve the capital markets and legal structure and improving regulatory environments support our expectation that Sukuk issuance will increase gradually over the medium to long term in key and emerging Sukuk markets. This increasing issuance in sovereign bonds and Sukuk is crucial because the yield on sovereign debt creates a pricing benchmark from which all other debt instruments in the same market can be priced, thus creating a pricing benchmark and growth for the GCC corporate bond market.