Under the microscope
Mar 10th 2008
From the Economist Intelligence Unit ViewsWire
Does the Islamic bond market comply with sharia law?
Global issuance of sukuk, or Islamic debt securities, is expected to expand by 30-35% in 2008, maintaining the momentum of the past two years which took total volumes to US$97.3bn, according to a report released in late February by Moody’s Investors Service. However, while the instrument is the best-known and fastest growing in the Islamic financial world, its structures remain controversial. Publication of the Moody’s study came shortly after the debate on the sharia-compliance of outstanding sukuk was rekindled at a London conference and subsequently in the financial press. At the heart of the controversy is the extent to which returns to investors genuinely involve the element of profit and risk-sharing with the borrower demanded by Islamic financial tenets.
A degree of debate surrounds virtually all Islamic products, with standardisation a much-vaunted but ultimately impossible goal: some structures win more widespread approval than others, but an element of subjectivity and differing interpretations by sharia boards of broad principles laid down more than a millennium ago will never be completely eradicated. Yet the size and growth of the Gulf sukuk market makes this disagreement particularly important for the global industry. It was sparked by chairman of the board of scholars at the Bahrain-based Accounting & Auditing Organisation for Islamic Financial Institutions, Sheikh Mohammed Taqi Usmani, who said in November that some 85% of sukuk issues in the Gulf Co-operation Council (GCC) member states failed to comply with sharia principles owing to the repurchase undertaking attached to the notes. This entails the borrower guaranteeing repayment of the securities at face value on maturity or in the event of default—violating, according to Sheikh Mohammed, the risk- and profit-sharing requirement.
He is not alone in this view. Some major GCC or GCC investor-backed Islamic institutions—among them Abu Dhabi Islamic Bank, Arcapita and European Islamic Investment Bank—avoid such structures. However, the rampant growth in the sukuk market is currently being driven largely by a combination of conventional investors attracted by the strong creditworthiness of the borrower, regardless of the technicalities of the marginally differing structure, and by conventional borrowers seeking to broaden the investor base by appealing to the more religiously observant. “The GCC’s rapidly growing sukuk market is particularly luring global investors less concerned about religious strictures and keener on less risky investment, as well as exposure to the region’s currencies and equities,” said Swati Taneja, conference manager for the International Islamic Finance Forum, in late February. On the issuer side, Japan, Thailand and the UK are all expected to launch debut sovereign sukuk during 2008 to tap the Muslim investor base, creating benchmarks for domestic corporates to follow suit.
However, shifts are occurring for separate reasons in the structuring of sukuk which may render them more acceptable to the stricter schools of sharia thought, most notably the development of asset-backed rather than merely asset-based instruments. Under the former, no repurchase undertaking exists and the related assets are legally isolated by the borrower into a special purpose vehicle, the cash flows and risk profile of which depend on the performance solely of the assets rather than of the borrower.
“These risk-sharing characteristics make securitisation closer to the sharia-ideals of participating in the collective legal or beneficial ownership of an asset and its ‘value’,” says the Moody’s report, predicting that in the GCC, real estate will drive the nascent securitisation industry, “due to the sizeable financing needs of the sector, and the market’s familiarity with and interest in the underlying assets”. Dubai-based home finance company Tamweel launched the Gulf’s first rated Islamic securitisation in July last year, transferring legal ownership of residential property and the associated financing contracts to investors, with the deal illustrating a further advantage of securitisation for corporates: the paper was rated Aa2 by Moody’s, in line with the UAE’s country ceiling, while Tamweel itself is only rated A3.
Project finance fit
The ratings agency report also flagged up project finance as an area in which the potential for growth in the use of asset-backed sukuk structures is strong, with billions of dollars-worth of energy, industrial and infrastructure schemes on the drawing board, especially in Saudi Arabia, where in addition sponsors frequently come under pressure from shareholders to ensure sharia-compliant financing is deployed. Furthermore, the international banks that currently provide the bulk of Gulf project financing—regional banks tending to be deterred by the squeeze in pricing of recent years and capital markets solutions being rare so far outside Qatar—are in danger of hitting country risk-allocation ceilings due to the volumes required. Qatar’s finance minister, Yousef Hussein Kamal, said at a conference in December that funding of US$70bn would be required over the coming years for projects in the energy and telecoms sectors and that some US$15bn would be raised by way of long-term fixed-income securities, Islamic and conventional.
Basel II looms
As GCC banks prepare for implementation of Basel II rules on capital adequacy ratios, securitisation is increasingly attractive in order to remove project and real estate lending from the balance sheet. Similar reasoning is behind the Moody’s prediction that 2008 will see the first subordinated sukuk issues out of the Gulf: “Unlike senior debt, subordinated debt could be more favourable to Islamic banks in terms of capital requirements and investors may be attracted by the potentially higher yield of the paper,” it says. Meanwhile, the vogue for convertible sukuk—alongside that for conventional equity-linked bonds—such as the multi-billion-dollar issues staged by Dubai’s DP World and Nakheel is likely to persist, as stockmarkets in the region continue to perform well following the 2006 meltdown (which was an important factor in encouraging debt capital markets development in the first place).
So, while some borrowers might be persuaded to look a little more carefully at the structuring of sukuk issues, scholarly objections are unlikely to put the brakes on the sector’s growth.