Before Sukuk, conventional bonds had been commonly used by sovereigns to raise long-term money. Sukuk are no different save for its tenure which is until today limited to five years due to investors’ appetite, typically Middle Eastern investors. There are only a handful of government global Sukuk issuers, namely Malaysia, Qatar, Pakistan and the latest to join the elite club, Indonesia. There is talk about the other countries doing Sukuk but these have not materialized yet due (possibly) to unresolved tax and regulatory issues.
To attract new issuers (to tap into the sovereign Sukuk market), its structure has to be straight forward; hence, credit risk is attributed to the sovereign itself and not the structure of the Sukuk. Had the Greek government embarked on Sukuk and conventional bond issuances few years ago, the chances are it could have defaulted on both! Sukuk provides an alternative means for issuers to raise new money from investors, especially those new sets of investors — Islamic investors — in Asia and the Middle East.
The potential influx of Sukuk issuances by government and government related entities, if done properly, would not give birth to another fiasco in the future. The advisors, such as the bankers, need to go back to basics. A plain vanilla structure is the answer. We do not want unnecessary innovations which could lead to excessive speculations and uncertainties. The use of derivatives purely to hedge an issuer’s position is fine; unfortunately the advisers are not in a giant classroom aiming to score an A in financial management!
MOHAMAD SAFRI SHAHUL HAMID
Although the 2007-8 financial crisis had its origins in the sub-prime mortgage market and the earlier 1997 Asia crisis was also the result of irresponsible real estate lending, previous crises, notably the 1982 Mexican debt default, arose as a result of excessive government indebtedness.
Given the enormous overhang of government debt today, partly as a result of the last financial crisis, there is a strong possibility that the next crisis could be more like that of 1982, but on a much larger scale.
So far there has never been a default on a sovereign Sukuk, only on corporate issuance. It is inevitable, however, that as sovereign Sukuk issuances increase, there will eventually be a default.
The risks are greatest with Sukuk based on Ijarah structures paying a variable return, because if rates rise, governments will have to pay higher servicing costs. This is exactly what happened with the Mexican floating rate notes.
One answer is, of course, fixed rate Sukuk, but as governments would have to pay higher servicing costs for these in the short run, the temptation is to issue Sukuk with variable returns and hope for the best.
PROFESSOR RODNEY WILSON
Faculty of Islamic Studies, Qatar Foundation
Unrestricted private credit creation was the cause of the current crisis, and it will not make a return unless and until current wealth inequalities are rectified. This means that the only source of credit for the foreseeable future will be the public sector generally and national treasuries in particular. So, if and when there is another crisis, it can only be caused by sovereign risk.
But it is little understood that sovereign debt and sovereign credit (such as notes and coin and Quantitative Easing or QE) are two different things. The risk of non-repayment of sovereign debt, such as the principal, should technically be absent from sovereign Sukuk, which is a quasi-equity instrument. So the risk in sovereign Sukuk should — if the Sukuk is not a sham — be limited only to a failure to pay the return on the principal, rather than the principal itself.
A report mentioned that as governments need new instruments for raising finance, the time is ripe for breaking with the convention that sovereign liabilities must take the form of nominal debt. It appears to me that a quasi-equity credit instrument along the lines of sovereign Sukuk would be a good place to start, since sovereign risk would be massively reduced by the amount of the principal issued.
Principal, Partnerships Consulting
In light of current developments and the associated soaring sovereign debt levels, sovereign risk will need to be reviewed carefully in order to assess whether their risk ratings are still adequate. Generally, the market will already include this in the pricing of the paper. The holder of the paper will have to prudently assess whether he is exposed to concentration risk or higher levels of risk than initially assumed, and take the appropriate action.
The fact that Sukuk are becoming a popular instrument with governments does, however, signal two things. Firstly it shows that governments in general are increasingly viewing Sukuk as a viable instrument to raise long term funding, which in turn shows that there is wide acceptance of Islamic financial instruments.
Secondly, there appears to be a wide sense of desperation and with conventional investors hesitant to invest more in government paper, a different source of funds is actively approached.
From the perspective of an Islamic investor this is a positive development as it allows for greater diversification in the portfolio and offers an instrument that is close to what is known in conventional finance as the risk-free asset.
Financial crises are generally caused by asset bubbles, with prices for the underlying asset or instrument spiraling out of control. Unless the market is developing an increased interest in sovereign paper even at the relatively low returns it offers, and demand far outstrips supply, the risk of sovereign paper becoming at the heart of an asset bubble at this point in time is relatively low.
However, the demand for sovereign debt in combination with significant trade imbalances may in itself be sufficient to cause further economic turmoil.
DR NATALIE SCHOON
Head of product research, Bank of London and the Middle East
Sovereign risk factors are present for both conventional bonds and Sukuk. Sukuk, being asset backed in structure, are less risky than conventional bonds. This nature of Sukuk would prevent a financial crisis as seen in the recent credit crisis where exotic financial products such as derivatives collapsed to nothing. As an example, GM bond holders recently had their investments turn to pennies. Had GM issued Sukuk the investors would have had tangible assets as recourse for their investments.
President and CEO, UM Financial Canada