Coming up to the end of the year, it is time to reflect back on the year just past and look forward to 2011. Kuwait Finance House Research prepared a report, which is summarized in a press release, which predicts that issuance in 2011 will surpass the $34 billion issued at the peak in 2007 (issuance in 2010 is estimated to be almost equal to the 2007 level). To avoid just repeating the KFHR report (I would suggest reading the press release summary) I will offer my own thoughts using a few of the statistics in the report.
First, there have been two themes in 2010 sukuk issuance: 1) sovereign issues; and, 2) the move eastward with GCC issuers tapping the markets in Malaysia instead of the domestic market (either through local currency issues or global USD issues). This is a mixed bag. It certainly aids the development of a more harmonized market for sukuk in terms of Shari'ah standards as GCC issuers are becoming familiar with Malaysian Shari'ah standards and tailoring their sukuk issued in Malaysia to the local market, while also issuing some sukuk in the GCC as well.
However, the move eastward by GCC issuers is also exaggerating the disparity between primary markets for sukuk in Malaysia and the GCC. Malaysia's GDP in 2009 was $193 billion compared with Saudi Arabia's GDP of $369 billion in the same year and the GCC as a whole representing $912 billion in GDP in 2009. Yet, sukuk issuance in Malaysia makes up 72.3% of the entire sukuk market in the first nine months of 2010 (9M10). There is also concentration of certain issuers: sovereigns make up 77.3% of issuers in 9M10 while financial services issuers (which make up a large proportion of conventional bond issuers) represented only 9.8% with utilities issuing 7.6% of sukuk issued.
The sukuk markets should ideally be representative of the size of the total market (measured by GDP) because they should finance real economic activity (at least if the spin from the press releases are to be believed). They should also be in proportion to the Muslim population of the countries they come from because the primary reason they exist is to provide a Shari'ah-compliant alternative to conventional bonds for both Shari'ah-sensitive investors and issuers. On both marks, the current sukuk market structure fails. Malaysia's GDP is roughly 20% of the GCC GDP. Malaysia also has a large non-Muslim population (40% according to Wikipedia, citing the Malaysian census).
Let's look at what the sukuk market should be in the GCC based on Malaysia, using a very rough approximation with many flaws. I use the following numbers to get a rough approximation: relative GDP of Malaysia to the GCC of 20%, the Muslim populations in Malaysia (60%) and GCC (assuming 90% Muslim population in the GCC) and the KFHR estimate of $34 billion in sukuk issued (or $24.5 billion originating from Malaysia). Adjusting for the differences in Muslim population and relative GDP, there should have been $184.4 billion in sukuk issuance in the GCC (taking the sukuk in Malaysia, dividing by the Muslim share of the population, dividing by the relative GDP of Malaysia and multiplying by my estimate of the Muslim population of the GCC). This leaves $175 billion in missing sukuk from the GCC assuming that all the non-Malaysian sukuk were issued in the GCC.
This number is essentially made up, but is based on a rough estimate about the potential for the sukuk markets in the GCC, if it were pulling its weight with Malaysia in terms of GDP and the Muslim population. It can be discounted heavily to adjust for my estimation process and still leaves a large number relative to the total sukuk issuance of 2010. There are two conflicting reasons for the gap. First, one of the primary uses for sukuk is to fill the need for high-grade, government or corporates of similar quality bonds to fill the portfolios of pension funds, takaful funds and for banks to earn a relatively safe return with their surplus funds. Second, many investors in the GCC and elsewhere would like to be able to include a sukuk component in their overall portfolio, but will hesitate if they are not able to change the components of that portfolio quickly with changing market conditions (or their own need for liquidity).
These two forces are pulling at each other, but generally the former is dominating. Sukuk are issued and snapped up by hold-to-maturity investors. There is a small, illiquid secondary market for sukuk and those markets were hit sharply by the Dubai debt crisis. Despite representing a small part of the GCC, the issuance from Dubai entities and other UAE issuers (who were caught up in the lack of confidence among investors) represented a large share of the GCC sukuk issuance in the boom years. This confidence will not be restored quickly and therefore issuers have either retreated from the market altogether (or fled to Malaysia) or focused their issuance on hold-to-maturity issues.
However, this serves to limit the size of the corporate sukuk market in the GCC and ultimately will hurt the hold-to-maturity investors, as it has already deprived the investors needing liquidity of many investment options. The flood of GCC issuers looking to Malaysia is making the problem more imminent as redeemed and defaulted sukuk are not being replaced by new sukuk issued in the GCC in a currency that does not create currency risk for local issuers (whose home currency is tied to the dollar, which is depreciating against the Ringgit, but which may reverse).
All the parties involved, from issues in the GCC, hold-to-maturity investors and investors seeking a liquid, fixed income investment, all need more local issuance. Issuers need a competitive pricing environment with no currency risk (at least until Shari'ah-compliant currency hedging becomes more common and less "new"). Whatever it takes for GCC countries to attract more issuance, they should do or else sukuk may become a Malaysian phenomenon, despite a size advantage in terms both of Muslim population and GDP held by the GCC.
Until the GCC markets are "fixed" (or an alternative market like the Luxembourg Stock Exchange becomes the go-to location for sukuk issuers), there will continue to be a large gap even in "one of the main components of the Islamic financial system" as KFH Research called the sukuk market.