Although Saudi Arabia is already one of the biggest markets for Islamic finance, regulatory and religious impediments and a capital market that has been slow to take off have meant other jurisdictions often taking the spotlight. Yet with bumper growth, a booming Sukuk market, an expansionary government stance and growing foreign interest, could 2013 be the year Saudi Arabia finally rises into its rightful place at the center of the GCC solar system?
Record growth
The kingdom has seen record progress over the past few years, with growth in its Islamic financial sector exceeding the conventional industry by a comfortable margin. Ernst & Young data shows Islamic assets growing by 19% between 2008-11 compared to 14% for conventional assets, including insurance and loans. Home to some of the world’s biggest Islamic banks, Saudi Arabia held estimated Islamic assets of around US$94 billion in 2012 according to Deloitte & Touche: over a quarter of the GCC total and almost 10% of total global Shariah compliant assets. By 2015, Ernst & Young estimates that the kingdom will hold over half the region’s Islamic assets.
The capital markets are also booming, with a February study from KFH Research reporting around US$10.5 billion in Sukuk issued in 2012, making Saudi Arabia the second-biggest issuer in the world after Malaysia and representing an increase of 278% over 2011 levels. Massive state deals such as the US$4 billion General Authority for Civil Aviation launch in 2012 have changed the face of the market, and continued growth is expected to support the overall GCC Sukuk sector in 2013 with issuances set to reach US$35 billion. Goldman Sachs has already capitalized on this, with its first return to the market in three years, acting as lead arranger on the Dar Al-Arkan US$450 million Sukuk in May.
Sukuk strength
In June of this year Moody’s released a report entitled ‘Saudi Sukuk: Market Growth is Credit-Positive for Saudi Banks’ in which it noted that 2013 issuance in the kingdom is expected to exceed 2012 on the back of strong investor demand and massive infrastructure investment. “We believe that the growing Sukuk market will be credit positive for Saudi banks because it will provide a deeper pool of Shariah compliant securities to facilitate liquidity management and support profitability at Islamic financial institutions,” said Khalid Howladar, vice-president and senior credit officer at the ratings agency and co-author of the report. “We also believe that growth will support more term funding for all banks and ultimately encourage the reduction of persistent asset-liability mismatches, whilst facilitating further loan growth given regulatory constraints on loan-to-deposit ratios.”
A deeper Sukuk market in Saudi Arabia brings with it a myriad of benefits for both the kingdom itself and the wider regional industry. By providing competitively-priced longer-term funding in domestic currency, banks will be able to not only diversify but extend and lengthen their funding profiles, thus reducing the ever-present concern of funding mismatches between the maturity profiles of assets and liabilities; one of the biggest issues for Islamic banks in particular due to the dearth of long-tenor Sukuk. In addition, as banks approach the 85% net loans-to deposits ratio required by the regulator, the availability and cost of deposits will change, making Sukuk issuance more attractive to banks and thus likely to stimulate even further growth in the market.
Despite this growth however, demand continues to vastly exceed supply, with Ernst & Young estimating total demand for Sukuk in the kingdom at around US$300 billion last year, compared to just US$132 billion in 2011.
Much of this demand is coming from the conventional sector as well as from Islamic investors — not least because Sukuk continue to price at extremely attractive rates compared to the conventional bonds. The recent US$1 billion Islamic Development Bank (IDB) Sukuk in June, for example, was significantly oversubscribed after offering some of the lowest pricing on record, with a profit rate of just 1.535%.
Corporate finance
This interest comes on the back of an industry that is growing in both depth and sophistication, with far more taking place than just a thriving Sukuk market. Nabil Issa, a partner with King & Spalding based in Riyadh, told Islamic Finance
news that Shariah compliant financing in particular is seeing exceptionally strong growth this year. Earlier this summer, the law firm represented a group of lenders in an Islamic financing of over SAR4.3 billion (US$1.1 billion) backed by Saudi real estate; and is currently working on a number of other Islamic financing deals worth over SAR3 billion (US$800 million) due to close in the third quarter.
“There has been a definite upturn in the volume of such deals this year,” agrees Ahmed Butt, a partner with Simmons & Simmons. “We regularly advise on syndicated and bilateral Islamic financings in Saudi Arabia, including Murabahah, Ijarah, Musharakah and Mudarabah transactions.”
Interest is also rising in sale and leaseback transactions leveraged with Shariah compliant financing, according to Nabil. “We recently closed a ship financing and are currently handling the Islamic financing of a petrochemical facility. We also recently assisted a client to finance the receivables for one of the leading leasing companies based in Jeddah.”
Property push
Much of the interest is also in relation to real estate, following changes to the kingdom’s mortgage regulations. As of April 2013 three out of five new mortgage laws had already been issued, while the central bank is also considering the establishment of a Saudi Real Estate Refinancing Corporation similar in function to the US Fannie Mae, with a capital base of SAR2 billion (US$533.3 million), in order to encourage the development of a secondary mortgage market by issuing Islamic bonds or securities backed by mortgages or property. Following the introduction of the new laws, housing loans could eventually double to 12% of GDP according to local firm Arqaam Capital, equating to around US$78 billion.
“The new real estate finance laws have introduced procedural clarity and… have helped overcome the assumption by Saudi notaries public that any form of bank financing is not Shariah compliant,” explains Ahmed. However, given that only Ijarah-based financing is referred to in the new laws, banks which have been providing finance using other Shariah compliant structures (for example Murabahah) may need to familiarize themselves with Ijarah structures. “Whilst Murabahah financing is currently by far the most popular mode of financing in Saudi Arabia, if the availability of real estate security is limited to Ijarah-based financing, the new laws may be a precursor to a shift in market trend,” Ahmed suggests.
Commercial opportunity
It is also worth noting that although the new laws currently only apply to real estate, there is every possibility that they could soon be extended to impact the commercial sector. The new Mortgage Registration Law, for example, has a preamble which recommends that the existing Commercial Mortgage Law (which covers security over all types of assets) be reviewed by the Ministry of Commerce & Industry within 90 days of the new law being issued, in order to bring it into line with the new registration law.
These changes have led to a surge of investment in the sector, both domestic and foreign. Earlier this year Qatar-based The First Investor, the investment banking arm of Barwa Bank, signed a joint venture with Project Management & Development Company to invest an initial US$30 million in the kingdom, with a view to creating a portfolio of assets to yield attractive levels of rental income.
“Several of our financings are in relation to the development or expansion of malls, while a number of others are in relation to developments in the hospitality sector and others for middle income and high end residential developments or the acquisition of housing compounds,” confirms Nabil. “In relation to the growth of real estate, we are seeing growing interest in the development and financing of district cooling projects.”
Funding investment
Shariah compliant investment funds are another area that is continuing to grow in volume; as the asset management industry in Saudi Arabia not only expands but also finally starts opening up to foreign investors. One key trend is the growing use of privately-placed Shariah compliant Capital Market Authority (CMA) funds; structures which allow investment by both Saudi, GCC and non-GCC investors. The funds make it possible to pool money rapidly and then leverage the equity through Shariah compliant financing to invest across a wide range of sectors in the kingdom, and their accessibility means they are rapidly growing in popularity. However, Nabil warns that: “A number of Islamic banks do not utilize the structure, and may not understand the unusual advantages such a structure provides in making investments in Saudi Arabia.”
The investment universe in the kingdom is nonetheless growing and with it, the innovation and range of Saudi-based asset management firms. Aljazira Capital, Alkhabeer Capital, KSB Capital, MEFIC Capital, Al Rajhi Capital and Alawwal Capital all launched Islamic funds in 2012, while Nabil notes that: “Jadwa Investment and SHUAA Capital Saudi Arabia were both pioneers in developing Shariah compliant private equity and real estate funds.” Increased activity is also being seen from Malaz Capital, Alinma Investment, SaudiMed, AlBilad Investment, Global Investment House, Samba Capital, Emirates NBD, Wasatah Capital, Kuwait Finance House, Muscat Capital, Sidra Capital and Adeem Capital in developing funds and obtaining Shariah compliant leveraging.
Real estate is unsurprisingly a key focus, and leading investment firm SEDCO Capital last year launched one of the first REITs in the kingdom since the failed attempt by Sumou Holding and Geneva-based Encore Management in 2008. The firm also recently announced that it would expand its Islamic fund range to 15 this year, including commodities, real estate and private equity products. Speaking to Reuters in April, CEO Hasan Aljabr confirmed that: “We have definitely seen growth in asset management companies setting up in Saudi Arabia.”
Local firms are also spreading their wings overseas, reaching out into new markets including private equity, structured finance derivatives and mutual funds. Jeddah-based National Commercial Bank in December 2012 announced the launch of two Islamic equity funds on the Dublin platform, while Sedco Capital plans to increase assets on its Luxembourg platform to US$1.6 billion (from a current US$1 billion) by the end of 2013.
“We are seeing a growing interest in Shariah compliant venture capital structures and financings,” confirms Nabil. “The level of competition for Shariah compliant private equity deals is extremely high with a number of companies in Saudi Arabia now competing against regional and international private equity houses.”
Public policy
Much of this activity is being supported by proactive public policy, with a strong economy and expansionary government measures strengthening regulatory standards and driving up lending. New regulations were recently passed which clarified the jurisdiction of the Saudi Monetary Agency (SAMA) Committee for the Settlement of Banking Disputes and new registration systems to take liens over shares of closed joint stock companies and over movables. “Banks are also not reliant simply on deposits for liquidity but now have a means of passing on some of their risk in the form of Sukuk,” points out Nabil. “And lenders are seeing significant contributions of equity coming from CMA funds, giving them confidence that the level of financing is commensurate with the security being provided to the lenders.”
The government is also putting its own money where its mouth is, diverting massive funds towards the construction of long-term projects such as residential, educational and healthcare facilities, transport infrastructure and alternative energy investment as well as entering into partnerships with the private sector to drive development. This is already translating into a boost for the Shariah compliant industry, as firms seek to source the best pricing in the market.
“The sector in which we have seen the most increase in Islamic financings is energy and infrastructure,” confirms Ahmed of Simmons & Simmons. “Saudi Arabia has also announced a generous investment stimulus program to increase infrastructure spending on an unprecedented scale; with most projects partly funded by the government and partly by commercial banks, including Islamic banks.” In addition, a number of the projects announced relate to the holy cities of Makkah and Madina and are therefore fundamentally required to be Shariah compliant.
Domestic focus
This surge in activity is attracting increasing attention from overseas investors, and Nabil notes that: “We are seeing interest from US, European and other Middle Eastern parties investing in Saudi Arabian CMA private equity and real estate funds. There is also interest from US and Canadian clients investing in the petrochemical and manufacturing sectors, in addition to venture capital. We are also seeing interest from Asian (primarily Malaysian and Indonesian) clients investing in a wide range of sectors.” Ahmed also comments that: “Where international investors are involved in a transaction, UAE banks appear to be leading the way.”
However despite this interest the industry continues to face limitations stemming from its own insularity and domestic focus, particularly in terms of investment scope. The biggest investors continue to be Saudi Arabians and GCC nationals, and Islamic financing in the kingdom remains relatively domestic compared to other GCC counterparts, with Saudi Arabian banks rarely providing finance on a cross-border basis. This is primarily due to the high liquidity of Saudi banks, along with strong domestic demand and generous state funding from vehicles such as the Saudi Industrial Development Fund which mean Saudi firms have less interest in turning to international investors for their fundraising requirements. The requirement to obtain regulatory approval before considering a transaction outside of Saudi Arabia is also a factor, and Ahmed suggests that: “The scarcity of cross-border Islamic banks in Saudi Arabia may be seen by some as holding back the development of Saudi Arabia’s Islamic finance industry as cross-border transactions are often more complex and innovative than wholly domestic transactions.”
The story so far may suggest success, but unless Saudi Arabia can broaden its vision to encompass the world outside its own borders, rain may yet mar an otherwise sunny forecast. —LM