The global sukuk market experienced a significant slowdown in issuance in the first half of 2018, as we predicted in January.
Total sukuk issuance dropped by 15.3% compared with the same period last year, reaching $44.2 billion compared with $52.2 billion first half of 2017. This drop was even more pronounced for foreign currency sukuk issuance at 45%. We believe that this is due to the absence of major issuances from the Gulf Cooperation Council (GCC) countries seen in 2017.
In the second half of 2018, we expect sukuk issuance volumes will continue to be slowed by the global tightening of liquidity conditions as well as by lower financing needs of some GCC countries as a result of oil prices stabilizing at higher levels. The sharp increase in geopolitical risks in the Middle East will also likely weigh on investors’ appetite. Meanwhile, inherent challenges related to the sukuk market continue to drag on expansion of this market. That said, we think that Malaysia will continue to support market growth, owning to its strong market foundations and government support for Islamic finance. Overall, we maintain our expectations for volume of issuance at $70 billion-$80 billion in 2018.
Demand Is Dropping, But Why
Total sukuk issuance in the first half of 2018 dropped sharply compared with the same period in 2017 (see chart 1). The absence of jumbo local and foreign currency issuance by some GCC countries explains this mediocre performance (see chart 2). On a positive note, we understand that some of these countries are on the starting blocks with potential issuances in the second half of 2018. However, we expect the overall volume of issuance for 2018 to remain subdued, at around $70 billion-$80 billion, compared with $97.9 billion last year.
There are four main reasons that we expect the market will continue to lose steam:
Global liquidity is tightening
We expect the tightening of global liquidity that started in the first half of 2018 to continue. Specifically, we expect the U.S. Federal Reserve will hike its federal funds rate by another 50 basis points in the second half of 2018 after the two increases of the first half and that central banks of GCC countries will probably mirror such an increase due to the peg of their currencies with the U.S. dollar. In the same vein, after reducing the pace of asset purchasing (AP), the European Central Bank will likely wind down its AP program in December 2018 and start to raise interest rates in the third quarter of 2019. Overall, we think that the liquidity channeled to the sukuk market from developed markets will reduce and become more expensive. Currently, European and U.S.-based investors account generally for about one-quarter of sukuk investment in terms of volume.
At the same time, muted economic growth and declining lending activity in the GCC has shifted banks’ focus to capital market activities in hopes of achieving higher yields than with cash and money market instruments.
Geopolitical risk is flashing red
Over the past 12 months, geopolitical risk have heightened in the eyes of investors. It started with the boycott of Qatar in early June 2017 by a group of Arab states, which we think weakened investors’ view of the cohesiveness of the GCC countries as a block. The shifts in Saudi Arabia’s power structures and societal norms have also attracted a lot of attention from investors. That said, while increasingly centralized decision-making could lead to more uncertain policy implementation in Saudi Arabia, we don’t expect any major deviation from the stated policy course.
Additionally, the recent reinstatement of U.S. sanctions on Iran and the continued animosity between Iran and some of its GCC neighbors are not helping investors’ perceptions.
Financing needs are declining in the GCC
We consider that GCC countries’ need for financing is reducing as liquidity conditions improve. This is thanks to higher oil prices, which we now expect to remain at about $65 per barrel in 2018, and continued expenditure reduction by GCC countries since 2015. Overall, we think that the gross commercial long-term debt issuance of GCC countries will decline by 15% in 2018 from 2017.
By contrast, the repeal of the good and services tax in Malaysia without sufficient offsetting measures could result in higher fiscal deficit and financing needs for the country. This could further boost its sukuk issuance. In the first half of 2018, total sukuk issuance in Malaysia increased by around 50% compared with the same period last year, underpinned by higher government and corporate issuance.
Standardization is progressing slowly
Standard-setting bodies have made significant efforts to drive forward the standardization of sukuk, but there is still work to be done. Some market participants still think that standardization is unrealistic and that it would be better to aim for harmonization–that is having standards, although these may vary across jurisdictions–and leave some flexibility for implementation. We see this as the status quo. Cases similar to Dana Gas–where the issuer reportedly defaulted on its $700 million sukuk on the basis that the instruments were no longer compliant with Sharia law–will act as regular wake-up calls and bring the standardization debate back on the table.
We continue to see standardization as an important topic and note that fixed-income investors tend to shy away from instruments with limited visibility on post-default resolution. Standardized Sharia requirements could prevent potential uncertainty on compliance after a transaction closes, and is therefore key in helping investors better understand the risks involved. Similarly, standard legal documentation provides clarity for investors on the recourse options available in the event of a default of a conventional bond. This is still lacking in Islamic finance.
We recognize, however, that the Islamic finance market has achieved a certain level of standardization for the most common structures, while a few new instruments still need some refinement. In particular, investors are asking for additional clarity on the risks related to the Murabaha-Mudaraba structure that is widely used in some jurisdictions. We are of the view that standardization for cross-broader sukuk issuance is not only achievable, but will also boost the volume of issuance. It will improve the attractiveness of the instrument to issuers by making the issuance process smoother and faster and by providing more clarity on the underlying risks.
Dana Gas Dispute Highlights Unresolved Issues
The Dana Gas dispute raised several questions about the enforceability of the foreign judgments in the UAE. While the U.K. court ruled in favor of the investors, a local court in Sharjah ruled in favor of the company. Ultimately, in May 2018, Dana Gas reportedly reached a deal outside of court with the creditors committee of its sukuk (that attracted the support of the majority of sukuk holders in their extraordinary general assembly).
While we don’t attribute the recent drop in sukuk issuance in the GCC to the Dana Gas case, we do believe that the underlying issue is suppressing investors’ appetite for GCC sukuk. Positively, we note that since the dispute there have been a few changes in the legal documentation language for new sukuk issuances, reportedly, to reduce the risk of such disputes occurring. Restructuring of debt is a common practice in the global capital market. However, additional rules and clarity around restructuring or resolution of sukuk is needed for both issuers and investors, in our view. For the Islamic capital market, higher standardization could help in setting these rules and achieving clarity.
Mohamed Damak – credit analyst – Standard & Poor’s