Why Islamic finance has not yet reached critical mass
By Charlie Corbett. Available at: http://www.thebanker.com/news/fullstory.php/aid/7307/Why_Islamic_finance_has_not_yet_reached_critical_mass.html?current_page=NO_PAGE
Ikbal Daredia, managing director and head of capital markets and institutional banking at Unicorn Investment BankIkbal Daredia, managing director and head of capital markets and institutional banking at Unicorn Investment Bank. 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. Writer Charlie Corbett
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 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% 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.
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.”
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 Mr 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 Mr 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 Mr 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.”
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 Mr 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 Mr 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 Mr 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.”
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, Mr 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 Mr 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.
Neil Goldie-Scot, co-head of HSBC’s European structuring group, 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 adviser 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 Mr 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.”
Sunny Bhatia, GIH’s chief financial officer, 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 Mr Bhatia and Mr Goldie-Scot agree honesty was vital. “Being open and transparent with the banks,” says Mr Goldie-Scot. Mr 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.”