Too few sukuk!

Much of my research on Islamic finance has focused on the GCC because I think that the combination of petrodollars and a large Muslim population who opt for Islamic finance over conventional finance, the region has the potential to be center for Islamic finance in general and sukuk in particular.  I still think that in the long run that will be the case, but I think it will not be the case in the near term.  Instead, I think that Malaysia has the potential to see its Islamic capital markets remain the world's largest, even though it is much smaller in terms of economic size and population than the GCC. 

If you look at the population and economic sizes of the GCC and Malaysia, it isn't even a question that the GCC should dominate the Islamic finance market.  The GCC has 47 million people, most of whom are Muslims, while Malaysia has just under 27 million.  Malaysia' GDP is $237.8 billion according to the World Bank, while the GCC GDP is $1.4 trillion.   Malaysia is also reputed to have more liberal Shari'ah standards, which limits its ability to attract money from the GCC. 

However, Malaysia represents the majority of sukuk issued and has a much more liquid sukuk market than the GCC.  In years past it was legitimately mentioned that many of the sukuk issued in Malaysia would not pass muster by Shari'ah boards in the GCC, but this is a thing of the past with so many GCC-based financial institutions looking to Malaysia to issue sukuk.  Whether or not these institutions are looking to Malaysia, they are still subject to their own Shari'ah board rulings, which would subject them to the 'tougher' Shari'ah standards that prevail in the GCC. 

Add in the fact that the new issuer of global short-term sukuk, the International Islamic Liquidity Management Corporation (IILM), is to be based in Kuala Lumpur with Dr. Zeti Akhtar Aziz (governor of Bank Negara) heading it, and it becomes more clear which region is leading in facilitating sukuk issuance and secondary market activity in sukuk.  In the last two newsletters, which should be posted next week (sign up on the right side of the blog), I have analyzed the shortage of sukuk with respects to the effects on pension funds and takaful providers. 

One thing that surprised me about the shortage was that it was being articulated by Malaysian pension funds.  Even with the domination of the sukuk markets by Malaysia, the pension funds there were finding it hard to expand their sukuk holdings because of a shortage of sukuk. 

In my opinion this suggests that there remains much more demand for sukuk than there will likely be supply, even if there is $125 billion in issuance that is predicted for 2012.  When pension funds and takaful providers run into shortage of sukuk, it is indicative of one of the following situations: 1) there are too few sukuk being issued overall; 2) there are too many low-quality sukuk issuers trying to tap the Islamic capital markets ; or, 3) there are too many conventional funds trying to "find a new asset class". 

Explanations 2 & 3 might have held water before the financial crisis and Dubai's debt crisis, but are not the case today when most of the GCC-based sukuk issuance (and a good deal of the Malaysian issuance) is in sovereign sukuk.  The quality of sukuk being issued globally is of higher quality than it has been for many years, but there is just too little of it to satisfy the demand for it.   Unfortunately for lower quality issuers, there is probably not the same level of demand for lower-quality corporates (Malaysia, perhaps, being the exception). 

The sukuk markets are in a bit of a quandry.  The thriving market is in Malaysia, but most of the issuance from Malaysia is denominated in Ringgit, which adds currency risk compared to the GCC countries whose currencies are all linked with the dollar, which is viewed as the 'safe' currency.  The GCC has the economic size to compete with (and probably outweigh) Malaysia, but has is slowed by political unrest in the region and uncertainty about the stability and predictability of the legal systems. 

Will there be more dollar-denominated issuance out of Malaysia?  Will the GCC focus on creating more legal predictability for sukuk backed by assets located in that region?  Or will the shortage of sukuk continue and the long process of greater sukuk issuance along the lines we have seen in the past 3 years continue?  As much as I would like a quick fix, I think the third option is the most likely.