The sukuk market and Islamic finance as a whole are experiencing considerable growth. This article looks at the opportunities around the development of a euro sukuk market. By John Weguelin, managing director, European Islamic Investment Bank PLC (EIIB).
To-date, there have only been a few sovereign or quasi-sovereign issues predominantly made to promote Islamic banking or finance in local markets, but by far the largest issuers fall within what one might describe as the real estate or property developer category.
There are numerous drivers to the development of the sukuk sector and there are, in our view, many parallels that can be drawn with the development of international markets such as the Eurobond market, the swap market and the CDS market, to mention a few.
We have seen the first Islamic MBS, exchange or convertible structures are becoming quite commonly used, and Islamic derivatives, if one can call them that, are becoming more available. But there are some fundamental drivers that we need to be aware of:
* Sharia jurisprudence remains a hugely complex area and will remain a feature of our industry.
* Equally important is the alignment or harmonisation of Sharia interpretation and the international best practices relating to commercial and risk aspects of transactions.
* Legal frameworks and tax issues will also influence both structure and domicile of issues, while the current lack of liquidity at the short end of the Islamic financial markets, the lack of a repo market and issues of transferability, which in many ways represents that of the syndicated loan market in many cases, all influence the current development of the sector.
In deciding what unique characteristics will aid the development of a sukuk market, one has to look no further than the conventional market. A brief comparison highlights the following deficiencies:
* Issue size – To-date, there have been some 45 international sukuk issues, of which the top five (by size) account for more than 50% of the nominal issuance.
* Credit ratings – Most issues are not rated, which is still a function of the overall macro environment we operate in.
* Only recently have listings on recognised exchanges, such as London and Dubai, become a feature.
* Settlement mechanisms and standard settlement procedures are essential and the increasing use of such clearing systems as Euroclear will greatly help.
* The work currently being carried out by IIFM with ISDA and the ICMA will also greatly assist the development of the market. The standardisation of documentations to improve disclosure and transparency are essential in gaining the confidence of investors and improve pricing for issuers.
And finally, the development of Islamic derivatives is essential.
Sukuk product lifestyle guide
So where are we in the product lifecycle? If you describe a product lifecycle as consisting of four phases – introduction, growth, maturity and decline – we would suggest that the international sukuk market is in the transition phase from introduction to growth.
If we were to look at the Malaysian market, we would say it is definitely in the growth sector and further up the curve.
Having said that, there are signs that the market, and investor appetite, is such that spreads are tightening and narrowing with conventional markets. We have illustrated (see presentation) how the spreads of a number of issues have improved since issuance. This highlights how the gap between issuers' ratings and the market implied ratings continues to narrow. Assuming this trend continues, and we see no reason why it won't, the international sukuk market will increasingly become a viable alternative for all types of issuers.
Types of sukuk issuer
In the Islamic market, issuers fall into three categories:
* Sovereign or government or quasi-sovereign/government, such as the Central Bank of Bahrain, which through its programme has endeavoured to promote the development of the sukuk market and improve liquidity;
* Islamic issuers – such as Tabreed and a number of banks, and finally;
* Non-Islamic issuers such as Saad and Emirates Airlines, which have tapped into the conventional markets and the Islamic markets to diversify their sources of funding.
Why issue a sukuk?
From an issuer's perspective, there should be a number of benefits in issuing a sukuk:
* Tapping into substantial liquidity in the Islamic world, especially in the Middle East and Asia, seeking Sharia-compliant assets.
* Building a new investor base and source of funding beyond conventional investors
* Developing key relationships in the Islamic world, which is one of the fastest growth sectors of the global financial markets
* Meeting growing demand from conventional asset managers running alternative funds as Islamic products, because of their nature, fits into that category
* Conventional issues can only be bought by conventional investors – a sukuk issue can be bought by anyone!!
* The physical asset-based structure of Islamic instruments can make better use of an issuer's assets
The Islamic market
We are often asked whether the growth we are witnessing in the Islamic markets is sustainable and, more specifically, whether Islamic banking is a temporary aberration fuelled by the oil boom.
Part of our response is normally to quote some key statistics that highlight how Islamic finance is establishing itself on the global financial platform.
* There are about 1.5bn Muslims worldwide, representing 20% of the world's population and this could grow to 30% over the next 20 years.
* In Europe, (if you include Turkey) there are about 88m Muslims out of a population of 450m, or 20%
* Global assets, which are estimated to be in excess of US$500bn, are growing by about 10%–15% per annum.
* Issuance of global sukuk is estimated to total in excess of US$70bn, with forecasts that it could grow to US$100bn in the near future.
* International sukuk are estimated to total in excess of US$27bn, with expectations that outstandings may reach US$50bn by the end of 2007
* Total high net worth assets in the Middle East are about US$1.5trn and are the fastest growing sector in wealth management
* It is estimated that US$3bn–$5bn of commodity murabaha transactions are executed each day in London
* There are somewhere in the region of 500 Sharia-compliant funds.
Much of the new wealth is being used to build infrastructure, create jobs and establish sustainable and diverse economies, with recent reports suggesting upwards of US$1,000bn planned for investment in infrastructure projects over the next 10 years.
In our opinion these factors demonstrate that not only is the exponential growth likely to continue, as more and more Muslims choose to conduct their affairs in a Sharia-compliant way, but also that they bode well for the development of global financial markets.
Islamic financial structures
There are certain well-documented prohibitions that must be observed in Islamic finance, but it is acceptable for investors in Islamic products to make a financial return, either from owning a physical asset, such as property, leasing a physical asset, such as an aircraft or ship, or sharing in a commercial venture, such as a private equity or a real estate development project.
Islamic financial structures, therefore, normally involve the raising of finance on a physical asset and may in some ways be similar in nature to a securitisation.
There are, of course, many existing Islamic financing techniques from commodity murabaha, wakala, ijara, arboun, mudaraba, to salam, musharaka and profit rates swaps, but the most widely used in the international sukuk market are the murabaha, ijara and musharaka.
I say international sukuk market because in Malaysia, where there is a mature and well established Islamic financial system, they have other instruments that are not yet so widely used internationally.
Murabaha is most commonly used for short or medium-term financings, similar in nature to syndicated loans, while ijara and musharaka are more generously used in sukuk structures.
International sukuk universe
In order to understand some of the drivers in the sukuk market it is important to agree a common understanding of the sukuk universe and to aid the discussion we will focus specifically on the international sukuk universe.
The global sukuk market is estimated at about US$74bn worldwide, with Malaysia the single biggest geographic representation.
* The international sukuk market is still in its infancy, with global issuance estimated at US$27bn, made up of some 45 issues with the five biggest issues comprising over 50% of the universe.
* Most issues are still not rated.
* Maximum tenor tends to be five years
* Exchange settlement is not necessarily a feature.
* Repeat issuers are still a scarce commodity.
* Most issues are US dollar denominated, as can be seen from the graph (see presentation) with a few euro-denominated issues, ie, Arcapita with €46m (repaid early 2007) and Saxony Anhalt with €100m.
* Islamic investors prefer floating-rate issues due to an inability/difficulty to hedge fixed versus floating-profit rate risk.
* Lately, a number of large exchangeable issues have been structured as fixed-rate financings and have largely been taken up by conventional investors
Conclusion
There are already clear signs of the development of a euro sukuk market, which we saw earlier from the investor demographics of some of the recent sukuk issues such as DIFC, Nakheel, Kazanah, ADIB and Al Daar. Others have also seen as much as 80% of issues subscribed to by non-Islamic investors.
However, for international sukuk markets to achieve their full potential, they not only need to address some of the infrastructural issues, such as harmonisation of documentation and the Sharia interpretation referred to earlier, but they need end-users – issuers and investors, both Islamic and non-Islamic, that will create a steady and growing stream of Sharia-compliant products and services.
We need to develop more domestic markets. I know of no successful international market that didn't have as its base, a domestic market, or series of domestic markets to feed it.
Government initiatives, such as those already demonstrated by Bahrain, Malaysia, Dubai and more recently, the UK, are crucial not just in terms of the issuance of sukuk or Islamic instruments, but in terms of addressing the tax or regulatory changes that need to be made to create level playing fields.