Tuesday, December 14, 2010

Trouble in the GCC sukuk markets?

A couple news articles caught my eye and tie in with my forthcoming column in Business Islamica that expands on my analysis of the article about the equity market reactions to sukuk issuance by Malaysian companies (compared with issuance of conventional bonds).  The thrust of that post was whether sukuk may become marginalized if lower quality issuers dominate the primary market for sukuk (answer: yes, it could).  Another post I wrote explored whether GCC issuers are looking to Malaysia for new issuance.  This could create a negative feedback cycle in GCC sukuk markets as sukuk mature or default; if there are not new issuance to replace them, it could negatively impact the already low level of secondary market liquidity in sukuk.

Before setting out on what may be a gloomy outlook, I want to point out that there are positive signs just from the last few days about the sukuk markets in the GCC.  Although the National Bank of Abu Dhabi announced plans to return to the Malaysian market with a sukuk issuance, Saudi firm Sipchem is planning at least a $400 million (SAR 1.5 billion) sukuk and GE Capital is planning a follow-on sukuk to its benchmark $500 million issuance from 2009.  These should calm fears that GCC (and global) issuers are fleeing the GCC sukuk markets en masse.

Despite the petro-liquidity that continues to be generated in the GCC with oil prices between $80 and $90 per barrel, there are worrying signs for the sukuk markets' future development.  First, the liquidity situation is not really improving despite a rebound in the economy.  On this front, Malaysia has seen issuance fall in 2010 compared with 2009 (MYR18.9 billion in the first three quarters of 2010 versus MYR32.3 billion for the full year of 2009), as has the GCC.  However, a decline in sukuk issuance from 2009 (which trailed the peak year of 2007) is worrying.  If Islamic finance is to recover from the financial crisis, the wave of defaults in sukuk as well as the Dubai debt crisis (which was mostly conventional, but was triggered by the near-default of the Nakheel sukuk) it needs to grow strongly towards the 2007 levels each year.  Instead, there was a rebound in 2009, likely caused by issuers who had postponed issues in 2008 entering the market as things subsided followed by a drop in 2010.

There have also been very few sukuk issued by high-grade corporates, with a few exceptions.  The bulk of the issuance has come from sovereigns with a few high-yield issuers like Dar Al Arkan, which may be selling assets to meet its maturing debts.  The investment grade corporate issuance of sukuk should be the focal point because it provides the middle ground of higher yields than sovereign issues, less risk than high-yield and should represent a significant share of the portfolios of institutional investors.  For Shari'ah-sensitive investors, the lack of a liquid market for corporate sukuk leaves a pillar of asset allocation unfulfilled.  In the current low rate environment, sukuk may look unattractive for issuers given their illiquidity premium and high structuring costs compared to conventional bonds, but seeing sukuk issuance move from the GCC market to Malaysia will only make it harder for institutional investors to create well diversified portfolios that do not have the currency risk associated with investing in sukuk issued in Malaysian ringgit.

I don't have an answer for what can make the markets for sukuk in the GCC become more appealing for issuers, and so the outlook is gloomy as I stated from the beginning of the post.  Things change and this post may reflect a temporary preference by some GCC issuers to tap the hot Malaysian market based on its appreciating currency.  However, even if the ringgit weakens against the dollar (the currency that most GCC currencies are linked to) the illiquidity of the GCC sukuk markets will continue to make it more difficult for issuers to make a competitive argument for a sukuk versus a conventional bond as they pay not just the structuring cost that would be required for any sukuk issue, but an illiquidity premium for a GCC-based sukuk issuance.  And that trend continuing could cripple the GCC market for sukuk leaving mostly the high-yield or sovereign issuers.

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