Why Islamic finance has not reached critical mass
Charlie Corbett
The market for Islamic bonds, or
sukuk, is expected to pick up in 2010, but its appeal will remain
limited until the industry can agree a set of global standards and
proper legal protection for creditors in case of default.
The idea that the conservative strictures of Islamic finance somehow
offered protection from the wider global financial crisis was proven
false in 2008 and 2009.
The market for Islamic bonds, or sukuk, is expected to pick up
in 2010 |
The nascent market for Islamic bonds, or sukuk, was hit hard by the
financial crisis.
Since their peak in 2007, when almost $35bn worth of sukuk financing
was issued worldwide, volumes have plummeted. About $15bn worth of sukuk
were issued in 2008, recovering to $23bn in 2009. The sector, however,
is tipped to rally strongly in 2010.
Ratings agency Standard & Poor's (S&P) estimates about $20bn of sukuk
issuance is due to come to market this year, with other estimates as
high as $30bn to $40bn.
"We're going to see a good sustained pick-up in volume of issuance
this year," says Mohammed Dawood, director of global capital markets at
HSBC Amanah.
"Despite Islamic finance taking slightly longer to recover than other
markets, there is still a lot of liquidity around looking for a home.
Right now there is an extremely good opportunity for issuers generally
to be able to tap the Islamic market."
This issuance will largely be driven by sovereign or quasi-sovereign
deals, according to most sources The Banker spoke to.
Sukuk are expected to originate from across the world, but issuance
will likely be dominated once again by Asia.
Malaysia alone accounted for 54 percent of all sukuk activity in
2009.
It is a sign of the broadening appeal of the asset class that many of
these deals will also originate from non-Muslim countries. The UK is
mulling a potential sukuk, as are the governments of France and Germany.
Debut issuers this year could also include Kazakhstan and Jordan.
Elsewhere, Malaysia, Indonesia, Singapore, Hong Kong and South Korea are
all considering issuing sovereign sukuk in 2010.
Untested appetite
If achieved, this pipeline would exceed the upper limits of volumes
in 2007 and signal a return to the previously strong growth in the
sector. The success of any potential sovereign issuance could also lead
to a rush of corporates to the sukuk market, further boosting confidence
and, in turn, volumes.
However, the appetite for sovereign sukuk has yet to be tested by any
issuance so far this year. In fact, the only activity reported in the
asset class to date in 2010 has been a $450m Islamic bond for Saudi
property developer Dar al-Arkan.
The only other news has been negative. The Philippines cancelled its
debut $1bn sukuk in March after fears its Islamic finance industry did
not have a sufficiently robust sharia-compliant legal and regulatory
system.
Furthermore, in April the Qatar Islamic Bank decided to postpone a
$500m sukuk due to a reported lack of investor confidence.
Away from raw market sentiment, a number of other obstacles stand in
the way of so many new deals coming to fruition. While not directly
affected by the collapse of the subprime market in the US, Islamic
finance was indirectly hit by the repercussions.
Tightening global credit conditions, combined with the bursting of
the property bubble in the Middle East, led to two high-profile sukuk
defaults last year - that of Kuwait-based Investment Dar and Saudi
Arabian conglomerate the Saad Group.
A third sukuk default in the region was only narrowly avoided when
Dubai property company Nakheel was rescued at the last minute.
Perhaps more important than the defaults themselves, however, was the
way in which creditors were treated afterwards.
And it is this that has sparked wider questions about how such deals
are structured in the first place and will undoubtedly affect the
market's development.
"I don't expect the sukuk market will experience the same kind of
growth as in the past," says Mudassir Siddiqui, head of Islamic finance
at law firm Denton Wilde Sapte and a sharia scholar.
"Islamic finance is nascent. It's still work in progress. There will
be more emphasis on sharia compliance and on better contracts."
Structural difficulties
It did not help confidence in the market that at the height of the
crisis, in late 2008, the body which regulates Islamic finance, the
Accounting and Auditing Organisation for Islamic Financial Institutions
(AAOIFI), announced that a number of sukuk issued since 2002 did not
conform to Islamic principles.
A recent report from S&P warns that from an investor's point of view,
"major questions remain about the treatment of sukuk holders and
recovery in the event of default".
This uncertainty, perhaps more than any other market-related issue,
is what could potentially hold back sukuk issuance in 2010.
"What we need to agree on is structure, in view of the recent
defaults and what that has brought out in the courts," says Ikbal
Daredia, managing director and head of capital markets and institutional
banking at Unicorn Investment Bank in Bahrain.
"We need some kind of consensus in structure from the legal side and
the sharia side. That could be one of the hindrances in terms of take-up
of sukuk."
The key point here is that many sukuk contracts are governed by UK
law but refer to assets located in the Gulf. Investors also fear that
the definition of what deals are sharia-compliant and what deals are not
sharia-compliant could change and thus have an impact on their status
after a potential default.
One case that has spooked investors in Islamic finance was
Kuwait-based investment house Investment Dar's (TID's) default on a
commonly used Islamic financial instrument called a 'wakala' agreement.
Lebanese lender Blom Bank took TID to court in July last year over
the non-repayment of a $10m wakala, which had defaulted in 2009. TID
argued that the instrument was void as it did not comply with Islamic
law and was therefore outside the company's remit.
Yet more uncertainty was caused in the case when a UK court ruled
that if the case went to a full hearing, Blom Bank would probably win,
but it conceded that TID also had an "arguable case".
Legal experts say this could result in Islamic companies potentially
attempting to overturn contracts on the basis of whether they comply
with Islamic law.
Fortunately, however, cases like this are few and far between in
Islamic finance and it is worth noting also that the restructuring of
$2bn of debt for Kuwait-based Global Investment House, much of which was
Islamic finance, was a huge success and set a benchmark for all others
to follow.
Harris Irfan, head of Islamic products at Barclays Capital, notes
another obstacle to the development of the sukuk market in the future.
He says AAOIFI guidelines from 2008 have put issuers off asset-backed
sukuk - which allow assets to be placed in trust to a special purpose
vehicle - and encouraged the use of more inflexible asset-based sukuk.
"Almost no issuer has had the courage to issue an investment-based
sukuk - in other words, a non-ijara sukuk such as 'musharaka' - using
the new guidelines," says Irfan. AAOIFI requires that issuers are not
allowed to guarantee to buy back a maturing investment-based sukuk at
par. Instead, they can only buy back at market price.
According to Irfan, this has placed a huge structural constraint on
new sukuk and, as a result, all those issued since early 2008 have been
lease-based, which typically have a property as the underlying sale and
lease-back asset.
"It has not been a very courageous market and I suspect issuers will
remain reluctant to put their head above the parapet," says Irfan.
"This may change in terms of sovereign issuance, but only if
sovereigns are willing to take the brave step of securitising some of
their assets.
I'd like to see a move towards securitisation by sovereigns as this
will encourage corporates to follow suit and we will see the
re-emergence of the musharaka and mudaraba sukuk."
Broadening appeal
For many commentators the global sukuk market will not truly grow in
popularity until such issues as legal jurisdiction in case of default
and standardisation of deal structure, in terms of Islamic law, have
been codified. It is the case today that many Islamic financiers in the
Middle East do not consider sukuk issued in Asia to be fully sharia-compliant.
According to Jinesh Patel, head of investment banking and strategy at
Gulf Finance House, some scholars and companies in the Gulf Co-operation
Council (GCC) question the Malaysian interpretation of sharia, believing
it to be too liberal.
"There is a lack of globally accepted standards, not least regarding
the legal environment and sharia compliance," says Patel. "If there is a
default, then it remains unclear as to which jurisdiction the laws
apply."
However, most in the market are confident these issues can be ironed
out. The Islamic capital markets are in an early stage of development
and it is inevitable some teething pains will be felt.
In terms of future issuance there is optimism that investor appetite
will be strong.
HSBC's Dawood believes more and more investors are looking at sukuk.
"What was interesting last year was that a number of the sukuk we were
involved in saw very strong support from private banking clients. I
think the market is reaching a critical mass, which now finally allows
Islamic and private clients to actively view sukuk as a genuine part of
their portfolios," he says.
"Some of the earlier issuances weren't rated, were smaller in size
and had questions of liquidity. Whereas last year we saw a healthy
number of large benchmark, liquid issues that have all performed
remarkably well in the secondary market."
The key to unlocking the market's true potential, however, lies in
awakening retail interest in the asset class.
This could be an uphill struggle, according to Mr Irfan. "The
investor base has typically been conventional.
What we haven't really seen to date is a driver of the sukuk market
by the end Islamic investor," he says. "We're in a time of limbo and
waiting for investor education to catch up."
Establishing liquidity through a true secondary market will also be
critical to attracting more mainstream investors.
"With sukuk there is increasing liquidity, but it is nowhere near the
kind of scale one would expect of a truly global sukuk market to be
operating under," says Patel.
"Once these liquidity issues are resolved, you will find sukuk is
traded a lot more - and that will bring in more conventional investors.
At the moment, just a few fringe players are making the market."
Future expansion
Looking ahead, despite its growing pains it is clear that the market
for global sukuk will continue to increase in size and expand its
investor base.
The remaining months of 2010 are critical for the industry and one
successful issue by a sovereign state could provide the impetus for many
more.
Until that first big issuance, however, the market will remain on
tenterhooks. It is also worth remembering that about $1000bn worth of
infrastructure projects are slated to take place across the GCC over the
next 10 years, much of which will be funded by sukuk.
In terms of concerns over last year's defaults and the impact they
could have on the market, Irfan is clear.
He concedes that confidence was shaken but stresses this was not
because these were sharia-based instruments but because the credit of
the companies that issued them was not very good. "This was a commercial
issue not a sharia issue," he says.
The only obstacle that will truly hold back the growth of the sukuk
market is internal, according to Patel.
"We need to address the issues of standardisation, legal enforcement
and also acceptance of the jurisdiction where the deal is launched. A
couple of high-profile defaults did not help the market last year."
Setting a benchmark
Kuwait-based Global Investment House's (GIH) $2bn debt restructuring
started out in December 2008 as a landmark deal for all the wrong
reasons. It was the first ever publicly declared default in the region
and the first default to have an Islamic element.
However, by the time the restructuring was completed almost one year
later, it had become a poster child for the region and set a benchmark
for others to follow.
The deal also stood out because there was no recourse to government
coffers, and all matters were settled through a commercial process.
The restructuring, which has a tenor of three years, was a
groundbreaking transaction in a region where most investors are entirely
unused to the concept of default.
HSBC's European structuring group Co-head Neil Goldie-Scot, played a
leading role. He says at the start of the process there was a sense of
shock, denial and "quite a lot of anger and frustration at what had
happened".
This is unsurprising given GIH's problems were a first in a region
governed by strict financial principles.
HSBC was the sole advisor and managed to forge a deal between 53
banks, 50 private institutional and corporate bondholders, multiple
derivative products and a number of murabaha counterparties. "We had to
get every one of them over the line," says Goldie Scot.
"The vast majority were relatively straightforward but there was a
small handful that took a lot of effort to persuade, but ultimately this
was achieved with no special deals for these creditors."
GIH's chief financial officer Sunny Bhatia, agrees this was by far
the toughest element of the restructuring. "Some of the banks were not
prepared to co-operate initially and a small minority of regional banks
kept holding the process up," he says.
"More than two months were wasted convincing a very small amount of
banks, but the best part was that even those banks eventually realised
this was the way forward."
So what was the secret of the deal's success? Both Bhatia and
Goldie-Scot agree honesty was vital. "Being open and transparent with
the banks," says Goldie-Scot.
Bhatia echoes this and says GIH was determined to admit the problem,
rather than hide away from the issue. "After the initial anger the
creditors realised we were serious and genuine in our desire to address
the problems."
(Global Islamic bond volume by issuer - April 2009-March 2010 The
Banker) |