Will Sukuk Issuance Volumes Beat The Forecasts This Year?

Last year, global sukuk issuance fell short of market expectations, although it was higher than in 2015.

When oil prices started falling in 2014, several market observers predicted an issuance boom from 2015, arguing that governments in oil-exporting countries would tap the sukuk market to maintain their spending levels. However, as we anticipated, this didn’t happen. Issuance of sukuk increased only marginally in 2016 compared with 2015, and was much lower than that of conventional bonds in some core Islamic finance markets.
S&P Global Ratings believes sukuk issuance will remain subdued in 2017, since the process to tap the sukuk market is still quite complex.

Negligible Volumes Compared With Conventional Bonds
Total sukuk issuance in 2016 was slightly higher than in 2015, but weaker than market expectations (see chart 1).
Several observers anticipated a surge of issuance in core markets, and particularly in the Gulf Cooperation Council (GCC), when oil prices started dropping at midyear 2014. The windfall materialized, but only in the conventional debt market, where issuance in the GCC almost doubled in 2016 compared with 2015, while sukuk issuance dropped by 6% (see chart 2).

In our base-case scenario, we assume the sukuk market will be fairly quiet in 2017, with total issuance reaching around $60 billion-$65 billion. We expect this will be the case for two main reasons:

1. There has been little progress in reducing the complexity of sukuk issuance
One of the reasons why issuance is dropping relates to the difficulties inherent to launching sukuk, which we continue to see as an important issue. It is still more time consuming and complex to tap the sukuk market than to issue a conventional bond, even though the time and cost gap has reduced over the years. Although several heavyweights in the financial industry are pushing the market toward greater standardization, little was achieved in 2016, and we believe that the desired level of standardization is still some way off. However, we think that some market players might resort to an intermediate solution, which is to establish large sukuk programs to reduce the time and costs of issuance, thereby allowing for issuance as opportunities arise. Such a strategy might support market activity in 2017.

2. The Fed is increasing its interest rates
Our economists expect that the U.S. Federal Reserve Bank (the Fed) will raise its federal funds rate target by 50 basis points (bps) in 2017, after the 25-bps hike in December last year. Although the increase is minimal, it might squeeze global liquidity and make funding more expensive. This will inevitably dampen investors’ appetite for sukuk, which are part of the global capital market and therefore also subject to changes in general financing conditions.
The positive news is that, in the context of increased global economic uncertainty and likely market volatility, the European Central Bank (ECB) will likely adopt a more dovish stance. We therefore now consider that tapering of bond purchases by the ECB will occur later than we previously expected, and is unlikely before the end of 2017. Moreover, given the low interest rates in developed markets, emerging-market issuers with good credit stories might still be on investors’ radar; so we believe liquidity will continue to leak into the sukuk industry from developed markets.

Significant Financing Needs Will Lead Some Issuers Back To The Market
We think the GCC will need around $275 billion of financing in 2017-2019 and assume that, on average, around 50% of this amount will stem from conventional/sukuk issuance. Some market stakeholders attribute the region’s low sukuk issuance last year to governments’ strategy to ease liquidity pressure in local banking systems. However, there are other factors at work, in our view. For instance, the buyers of sukuk are not only in the GCC or Malaysia, but come from a broad range of investors, including conventional financiers in developed markets. More importantly, there is reportedly a large gap between sukuk issuance and demand.
We do not foresee a substantial increase in sukuk issuance in the GCC this year; rather, we think some member countries might take the Islamic finance route alongside a conventional one. Bahrain will most likely remain a prominent player after issuing $3.2 billion of sukuk in 2016. Other GCC members will probably tap the market in 2017.
Among the other issuers that we believe might return to the market are certain Asian and African countries, but with modest volumes. We also anticipate that Malaysia and Indonesia will continue playing a significant role after issuing $28.4 billion and $7.3 billion of sukuk, respectively, in 2016.

Regulatory developments might be a game changer but only in the medium term
Basel III and its liquidity coverage ratio (LCR), bank resolution regimes, and banks’ need for additional loss-absorbing capacity (ALAC) will be significant subjects on regulators’ agenda in core Islamic finance markets over the next few years. The lack of high-quality liquid assets (HQLA) remains a key impediment to the Islamic finance industry’s development, in our view, and could be resolved by larger issuance volumes. Of the $67.4 billion in sukuk issued globally in 2016, around $40 billion stemmed from governments and specialized institutions; the International Islamic Liquidity Management Corporation, for instance, issued $6.85 billion. For an industry with an estimated $2.1 trillion of total assets at year-end 2016, the amount of HQLA available is clearly insufficient.
Besides the LCR, resolution regimes and ALAC requirements could, if implemented, create significant opportunities for the sukuk market, depending on the amount of ALAC required. They could also help the industry apply its profit-and-loss sharing principle. Only a few loss-absorbing instruments were issued over the past three years. They were primarily in the form of mudaraba sukuk that regulators classified as additional Tier 1 instruments (mainly in the GCC), and subordinated sukuk that allow loss absorption at the point of nonviability (that is, on breach of the minimum capital adequacy regulation), mainly in Turkey.

The Increasing Focus On Sharia Governance Could Spur Growth
The Islamic finance industry has come a long way in terms of Sharia governance, thanks to its standard-setting bodies.
In late 2016, the Islamic Finance Services Board published an exposure draft seeking market participants’ views on the current disclosures for sukuk and proposing measures to strengthen them. In our view, the Sharia governance framework for Islamic finance still needs improvement. For sukuk, we think that one possible direction for the market is a move toward ex-post audit from ex-ante approval, in an attempt to minimize risks related to noncompliance with Sharia, which could cause issuance volumes to tumble, as we saw in 2008. Strengthening Sharia governance could also help reduce issuance complexity and the time to market.
We have noted two proposals in the industry. The first is similar to what was recently implemented in Bahrain and is already in place in Oman and Pakistan, and involves the adoption of local Sharia standards and external audit. The second proposal is to implement global standards coupled with external Sharia audit, which although appearing difficult to achieve, might help the industry reach the desired level of standardization in Sharia interpretation. Such advances in governance could also result in further integration of the Islamic finance industry, thereby increasing its attractiveness to new players and furthering growth.

Mohamed Damak – Primary Credit Analyst – Standard & Poor’s