The global Sukuk market is expected to see demand reach US$900 billion by 2017. Yet supply remains severely constrained and high levels of cash chasing limited issuances are causing distortions in the market. So why are issuers not raising enough Sukuk to meet demand, and what are the factors holding them back?
Issuance on the up
There is no doubt that Sukuk issuance has been steadily increasing over the last few years. In 2011 total Sukuk issuances reached US$84.4 billion, up 62% from US$52 billion in 2010; and in 2012 issues are expected to exceed US$100 billion.
The GCC market reached over US$19 billion in the first half of 2012, according to Standard & Poor’s (S&P) — already as much as for all of 2011 — while total Sukuk from Asia during the same period reached US$57.9 billion, compared to US$64.9 billion for the whole of the previous year. According to Allan Redimerio, a senior credit analyst at S&P in Singapore: “The reasons for the surge are low yields, relatively high liquidity, large capital expenditure needs, and strong investor appetite.”
Investor appetite
However, this is still not enough to meet the keen investor interest that the Sukuk market has seen develop in recent years. Stadtmiller explains that: “There is plenty of demand for Sukuk. Islamic banks tend to have very low loan-to-deposit ratios, which means that they have a lot of excess cash to invest. Since they are restricted to buying Islamic assets, they can’t touch conventional bonds. Also, Sukuk have a bigger pool of natural buyers than conventional bonds because both Islamic and conventional banks purchase them.”
The strong growth in the Islamic finance industry and a growing appetite for liquid Shariah compliant securities, combined with the debt crises in Europe and the US and restricted credit capacity from conventional banks, have driven increased interest in the Islamic market from a wider spread of investors. In Malaysia, Sukuk accounted for nearly half of total bonds outstanding in the first half of this year, reaching around RM421 billion ringgit (US$137.5 billion), compared with 35% in the same period last year.
Supply/demand imbalance
However, globally the Islamic capital market is still tiny compared to conventional bond issuances, and supply is struggling to meet demand.
According to Ernst & Young the global demand for Sukuk currently stands at around US$300 billion and is set to triple to US$900 billion in the next five years. Theoretically this should lead to a concurrent growth in issuance. The exceptional demand has cut the costs of issuing Sukuk by driving yields down, removing the ‘Sukuk premium’ that previously inhibited investment and making it actually cheaper to raise money Islamically compared to convenionally. Currently in the Gulf, Sukuk are paying yields of around 10-15 basis points (bps) less than conventional bonds, providing a clear cost advantage to the issuer. In Malaysia, the biggest market in Asia (and globally) for Sukuk, the central bank suggests that issuers can achieve savings of between 4-6 bps.
Yet despite the record issuance levels in 2012 demand continues to outpace supply. The global supply of Sukuk is barely a third of investor demand, with Sukuk issuance expected to top US$100 billion by the end of 2012, and in a recent report Ashar Nazim, the head of Islamic financial services at Ernst & Young, warned that this gap could widen further due to a lack of intermediary institutions with the necessary capabilities to lead the market. Currently Ashar believes that only 14 Islamic banks are currently big enough to be able to operate in the international Sukuk market, which is seriously hindering growth. “There is an urgent need for a new direction in the market to be led by leading Islamic financial institutions and multilateral institutions in a collaborative manner… Prerequisites are international connectivity, Sukuk structuring and trading expertise and balance sheet strength.”
Lack of trading liquidity
In the long-term the future of the Sukuk market looks promising, with massive infrastructure requirements in the Middle East and Asia coupled with booming economic growth in key Islamic markets. But in the short-term, as always, the market is desperate for a way to handle the excess liquidity currently overflowing in the Islamic finance space. And while Sukuk are the most popular instruments in which to invest, the lack of a secondary market in which to trade these products continues to be a real problem.
This could be solved, suggest market players, by increased primary issuance, which would encourage Sukukholders to start trading because there would be a more liquid supply of Sukuk available for repurchase. Currently we are seeing every Sukuk oversubscribed multiple times as subscribers jostle to buy and then hang on tight to their hard-won investment. So why is this not resulting in more issuances?
Currently, Sukuk issuance and trading is enacted on the proprietary platforms of individual banks which acts as a severe restriction to growth. The absence of a common global trading platform creates a “huge inefficiency”, according to Ashar, and encourages the self-defeating ‘buy to hold’ attitude of the majority of investors reluctant to trade out of a position to the limited opportunities for reinvestment.
Corporate incentives
The biggest factor that would stimulate primary issuance in the Sukuk market and thus encourage the development of secondary trading, however, is an increase in corporate issuance, which currently accounts for only a tiny propertion of transactions. According to Ernst & Young, in 2011 just 14% of total Sukuk issuances were from corporates. Even in Malaysia, the world’s largest and most advanced Sukuk market, corporate Sukuk only accounted for around 15% in the first half of 2012 (RM64 billion [US$20.9 billion] out of RM421 billion [137.5 billion]).
The low cost and high liquidity in the Islamic market is indeed driving an upswing in interest from conventional issuers, such as the rumored EUR1 billion (US$1.28 billion) Sukuk to be issued in Malaysia next year by Ireland’s Electricity Supply Board (ESB). However, this is a drop in the ocean compared to the vast corporate opportunities that exist in the Gulf and Malaysia. What is holding these firms back from issuing Islamic debt?
Name recognition
One reason is that Sukuk remains a relatively unfamiliar market for many firms, particularly in the Gulf markets. Stadtmiller explains that: “It is not as easy as just saying we can snap our fingers and create more Sukuk. Entities have to go through the process of doing structuring Sukuk, which can be an expensive and complicated process for first-time issuers. If you look at the Gulf entities that are active in conventional bond issuance, they tend to have long-standing relationships with international investors, and they can already borrow at quite cheap rates. They already have good name recognition in the global market in the conventional market, so there is not as much incentive for them to move over towards Sukuk.”
Alternative avenues
In addition, one of the most important issues inhibiting corporate interest in raising Islamically, especially in the Middle East, is the historical reliance on bank financing. In the past, the big private issuers in the Gulf have always been able to access sufficient funding at good prices from banks, many of whom they have built up relationships with over decades. Obviously however, as market forces shift the global economy, bank financing is becoming harder to access and rates are going up.
Stadtmiller agrees. “Ultimately if regional companies are unable to get the money from bank financing that they need for their future expansion plans, then they will through natural market forces be encouraged to look at raising funds through the capital markets.”
Although this could be either Islamic or conventional, one advantage to the Sukuk market is that because the investors are primarily in the GCC and Malaysia, Islamic banks have higher name recognition than they do in other locations such as London or New York.
“At some point it is inevitable that local companies will grow to a point where they need to make accessing the capital markets part of their financing strategy,” says Stadtmiller. “The historical reliance among Gulf companies on bank funding is eventually going to come to an end. Clearly with the way things are going in Europe and North America right now, it is smart for local entities to look for other sources of financing.
“Historically it was the European and American banks that financed a lot of the expansion here in the Gulf; so looking towards regional capital markets and looking towards Asia for further financing is definitely something that they should now be doing. That inevitably means looking towards Sukuk, as Sukuk are a very big part of the Malaysian market and the regional capital market.”
Governance
Another key constraint on the supply side that affects Gulf issuances is the absence of a unified set of regulations on the admissability of certain Islamic finance structures. While in Malaysia a unified set of standards exists for Shariah compliance, in the Middle East most entities that issue Islamic products have their own Shariah boards. According to a UAE practitioner: “This adds an extra layer of complexity and confusion here, where issuers have to ensure that the structure of any sort of Sukuk instrument complies with the interpretation of the Shariah boards of all the different investors, rather than everyone looking to one set of standards, which obviously acts as a huge deterrent.”
Transparency is another inhibiting factor for corporate issuance in the Gulf. Firms rarely reveal their financials publicly, but issuing Sukuk or bonds requires the publication of company financials. This has exacerbated the traditional reliance on the more discreet bank financing avenue and inhibited take-up of Sukuk issuance especially from non-Islamic institutions, and it will take some time for the culture to change and for local companies to incorporate the kind of transparency and governance they need in order to access the capital market.
Age and pricing
Jawad Ali, the deputy global head of the Islamic finance practice and the managing partner of the Middle East offices at international law firm King & Spalding, based in Dubai, comments that: “The bond market is very mature and covers a wider geographical area in terms of markets and issuers. Therefore, it is not surprising that there are more bond issuances than there are Sukuk issuances. This is natural given that the depth and age of the conventional debt capital markets as compared to the Islamic debt capital markets.”
The Sukuk market in the Gulf is also younger than in Malaysia by a good decade. The majority of issuers therefore have considerably more experience with conventional international investors than with Islamic issuers. This has meant that a lot of the Sukuk issuances from the Gulf in the past few years have been maiden sales.
“As a result,” explains an industry player, “they have to go through and identify assets on their balance sheet that can be used as part of a Sukuk transaction, and they have to consult accountants, lawyers and bankers to ensure that they have a structure that is actually going to work. They have to create a new financial structure unique to that company in order to put it into the market. And that makes it a lot more expensive — whereas if you just do another conventional bond, it’s more of a cookie cutter operation. So the expense of doing a Sukuk transaction has to be justified; either through a lower profit rate, a lower cost on the borrowing, or by tapping a new source of investors that give you easier placement. Some economic justification has to be there to pay the extra fees to set up a Sukuk.”
Anzal agrees, suggesting that in addition the balance sheet requirements for asset-based Sukuk issuance can also be an impediment for smaller corporates. “It’s a question of asset base – its easier for sovereigns and, in particular, financial institutions with large asset-related financings on their balance sheet to find a sufficient quantity of assets to be able to issue. You need to have suitable assets that you can use in an asset-based transaction. For a corporate which wishes to raise, for example, US$500 million, that can sometimes be a challenge.”
Tax incentives
Redimerio believes that especially within Asia the biggest issue preventing corporate issuances is a lack of proactive tax incentives to encourage players to access the market. “There is no shortage of demand — the problem is supply. Where Malaysia has done well compared to other countries is tax incentives which make it cheaper for corporates and banks to issue Sukuk than conventional bonds. If you issue a Sukuk in Malaysia all the issuance costs are tax deductible so the effective cost is cheaper.”
This has been a driving factor in the success of the Malaysian Sukuk market. Redimerio notes that: “There is more Sukuk issuance this year in Malaysia than in the conventional market by far, and this has been a trend for the past five years. Last year out of the total capital market issuance in Malaysia about 60% was Sukuk. In 2012 I have a feeling it will be closer to 70-75%.”
In comparison, other Asian markets are lagging far behind. “For other countries like Singapore or Hong Kong it is more of a level playing field. So if you are a corporate the problem is that although there is a lot of liquidity in the market, a conventional issue is easier, cheaper and faster so what is the incentive to issue a Sukuk? It all comes back to pricing. If there is no incentive then why would they issue?”
A driving factor has to be political will, and many countries in Asia are keen to promote the Sukuk market in order to attract investment and trade from the GCC region, whether they have a Muslim majority or not. However, Redimerio explains that: “The question is whether there is a willingness to actually make it cheaper for a corporate to issue Sukuk.” Indonesia for example is relatively likely to introduce incentives due to its large Muslim population and pro-Islamic stance. However other locations such as Singapore or Hong Kong, which are secular societies with well-established conventional finance industries, may find it harder to take that step.
However “without tax incentives to make Sukuk issuance more cheaper than convential”, warns Redimerio, “it will be difficult for new markets to meaningfully add to the supply of Islamic assets to meet the growing demand. “In three or four years from now, with the absence of tax incentives, we may still be just discussing Malaysia and the GCC, rather than other countries like Indonesia”, he added.
Gradual growth
Nevertheless despite all the inhibiting factors and while newer markets may be lagging behind, the Islamic finance hubs of Malaysia and the Middle East are finally seeing promising issuance growth in the corporate sector.
Mohd Redza Shah Abdul Wahid, the president of the Association of Islamic Banking Institutions Malaysia, recently announced that Malaysian corporate issuance was expected to increase by up to 20% in 2012 to reach RM90 billion (US$116 million), driven by strong demand, low borrowing costs, robust governance and high liquidity. In the Gulf, Kronfol notes that: “The market share of Sukuk to conventional bonds among corporates in the GCC region has gone up from 14% in 2010, to 30% in 2011 and 50% year-to-date in 2012.”
Increased private sector interest has also been driven by strong regional activity with several financial institutions tapping the market, along with a few landmark corporate issuances. Many Islamic institutions, particularly in the Middle East and Southeast Asia, have ample liquidity and are looking to deploy money into new investments. Sukuk offers regional issuers a means of diversifying their sources of funding away from Europe and into new geographies.
A new class
Perhaps the most exciting event to happen in the corporate Sukuk market this year has been the watershed US$400 million Wakalah issuance in February by Majid Al Futtaim Group, the highest rated private corporate in the Middle East. The vital importance of this transaction is that Majid Al Futtaim is 100% privately owned; while almost every other issuance from the Gulf has been from a sovereign, a government-related entity or a firm with a significant sovereign shareholding. Stadtmiller explains that: “For a purely private company like Majid al Futtaim to go and access the Sukuk market really opens up that market to other private companies in the region. If more private companies start looking beyond bank financing and begin to access the Sukuk market, you could see a big wave of new issuance.”
While this won’t happen overnight, or even in the next six months, the entry of private companies into the Sukuk market could over the next few years potentially open up a whole new class of issuers to the market. Should this happen, we might finally see a correction in the supply/demand imbalance which could subsequently transform the opportunities available in the Islamic finance industry.
For now, however, all we can do is wait and hope. — LM