Absence of Saudi Arabia, Bahrain deprives IILM of key markets but peripheral Islamic markets should benefit

The absence of Bahrain and Saudi Arabia from the IILM deprive the institution of entry to key markets for Islamic finance, and may have cost the institution its top rating. While the reason for Saudi Arabia’s withdrawal, it could be due to concern over the possible use of IILM sukuk in Islamic repo transactions, or fears that the IILM sukuk program might curtail commodity murabaha participants profits. Even Qatar, which is more involved in the IILM as a result is showing signs it may not be confident in the IILM’s ability to succeed where others have failed by announcing its own plans for regular sovereign sukuk issuance.

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Saudi Arabia exits IILM, clouding the prospects for sukuk issuance

The withdrawal of Saudi Arabia from the IILM is an ominous development for the body which said in March that it was in the “final stage” of launching a $300 to $500 million sukuk.  It would be hoped that, for the good of the Islamic banking industry which needs additional liquidity management tools, no further delays will occur to the IILM’s maiden sukuk, but the withdrawal of Saudi Arabia could just be the first storm cloud gathering above that institution’s prospects, following several previous delays.

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Saudi Sukuk Markets potentially opening

Emerging and frontier market fund managers have been waiting on news from Saudi Arabia’s Capital Markets Authority (CMA), although not necessarily the replacement of the chairman of the CMA, Abdulrahman Al- Tuweijri, with Mohammed bin Abdulmalik Al-Sheikh.  Saudi Arabia is the largest economy and market (152 companies listed and a value of around $350 billion) within the six GCC countries, but has been closed to foreign investors, except for citizens of the remaining five GCC countries, a system of swaps where foreign investors are able to get exposure to the Saudi markets.

There have long been rumblings that the Saudi CMA will open the market up to foreign investors, most recently in July 2012 when the details of a draft law were released suggesting that investors would be limited to institutions managing more than $5 billion, with limitations on the sectors in which they can invest.  The former head of the CMA Al-Tuweijri said that the opening of the market would be “gradual”, which is likely to continue to be the speed of reforms under his successor.

The value of opening up the largest GCC market to foreign institutional investors is understandable: foreign equity investors focused on the MENA region generally have little exposure to one of the largest markets in the region.  Providing them with an opportunity to get exposure to the Saudi equity market makes sense, and can help the local stock market deepen further with a larger pool of potential investors.

However, for Islamic finance, there is a much larger reason for optimism that foreign investors will be allowed to invest directly in Saudi Arabia: sukuk.  While some Saudi companies’ sukuk are listed globally (the global sukuk, which are mostly listed on the London Stock Exchange) there are several local currency sukuk—which are lightly traded—listed on the Saudi stock exchange (Tadawul) including the recent $4 billion General Authority of Civil Aviation (GACA) sukuk.  

The light trading is a concern, but the introduction of greater liquidity in the market from foreign institutional investors could provide a spark to the liquidity.  It would be helpful if the liquidity could start with the GACA sukuk, although coaxing it out of the inventory of the many financial institutions which hold it may be challenging since it is repo-eligible and carries a zero risk weighting (since it is guaranteed by the Saudi government).  

The anticipation for the opening of the Saudi capital markets has been growing for years now, with most of the focus on the equity markets.  However, for Islamic finance, there are several sukuk listed on Tadawul that could attract investor interest if the market was open to foreign (non-GCC nationals) institutional investors.  It remains to-be-determined whether the replacement of the CMA chairman will hasten the change, or whether it will be a source of further delay.

A Saudi Fannie Mae

Saudi Arabia is proposing setting up a Fannie Mae-style company to create secondary market liquidity for mortgages (presumably using Shari'ah-compliant financial instruments like sukuk).  The institution would be at least 50% owned by the government with real estate finance companies being able to own up to 30% of the company and possibly a public listing of the shares. 

This would be a big step forward to set up a pipeline of sukuk that would create supply of new issuance to match the Malaysian housing company Cagamas, which issues similar securities (both conventional and Islamic) in Malaysia.  The plan is to broaden the share of mortgages in Saudi Arabia from the current 6% of GDP eventually, according to Arqaam Capital, to 12% of GDP (the comparable numbers in the US is 63.5% based on Federal Reserve  Flow of Funds reports [pdf, table D-3]).

The Reuters report notes several impediments to developing a secondary market for mortgages, in particular the lack of ability of mortgage holders to take possession of the property and evict the residents in case of non-payment.  This is a serious problem if a secondary market is to develop and, more importantly, if the financing is extended to middle class household where a more significant level of default is to be expected, compared to the high-income segment of the market where home financing is currently offered. 

I can't offer much advice on developing the domestic legal system for mortgages--that's outside of my ability--but I think there are a few lessons that the country should take from the US' experience with Fannie Mae during the housing crash in the US, the most severe test if faced, which left the government-sponsored enterprise in government conservatorship. 

First, the role of the government needs to be clear and laid out in advance.  Fannie Mae operated on the assumption that it would be propped up by the US government if the need ever came, which held true as the financial crisis led to the effective nationalization of both Fannie Mae and Freddie Mac.  The important point here is that the implicit government backing allowed Fannie and Freddie to borrow at lower rates in the debt markets, compared with private sector mortgage-backed securities (MBS) originators. 

With the government backing assumed, there was little role for the private sector in originating MBS backed by prime mortgages, so they turned much more heavily towards (more risky) subprime.  The difference between prime and subprime is determined by the quality of mortgage accepted by Fannie and Freddie, with prime mortgages accepted and subprime and most larger, or jumbo, mortgages not accepted. 

If the Saudi government wants to monopolize the secondary mortgage market, it should make that decision explicit and extend the full faith and credit of the Saudi government to the refinancing agency and regulate the giving and packaging of any mortgages that are not bought by the refinancing agency.  If it wants to develop a vibrant market to allow banks to issue MBS, it will need to limit the ability of the refinancing agency to some share of the market, or else it will drive the other issuers out. 

The latter point is particularly important if the government-owned refinancing agency has private ownership.  These private owners will demand that the refinancing agency maximize profits for shareholders and if there is no pre-set limit for how much of the market it can take, it will be driven to take all of the market because of its lower funding costs (from the government backing). 

Whatever the decision about whether the government refinancing agency will be the sole provider of secondary market liquidity (and that decision should be based on an analysis of whether it could become a systemically important financial institution), the role of the government in supporting that institution should be explicit.  If it is not government-backed, and particularly if the profits are privatized to give it the incentive to stretch creditworthiness, it will be tested at some point should housing prices fall and the government will be on the hook for the losses to avoid a total collapse in the market.  

And that leads to a decision for the government: should the mortgage refinancing agency be a government-backed agency or should banks in the Kingdom be responsible for issuing MBS?  Personally, I believe that there benefits to a government-backed housing agency, but it does create systemic problems if it were to run into problems when housing prices decline.  But the risks should be considered in advance, rather than ex post as the US dealt with. 

A solar project financed by sukuk in Indonesia

An Australian solar company Solar Guys, is installing a 50MW solar facility in Indonesia and it will finance the project using a sukuk.  The project is part of a 250MW plan dubbed 'one solar watt per person', and is an area where I think Islamic finance should be used more widely, since it will provide an additional area where Islamic finance can offer value to Muslims and non-Muslims by promoting greater sustainability. 

The companies say that solar PV offers the lowest levelized cost of energy in many Southeast Asian nations, compared to alternatives, which may be true if it can be sited near areas that are more distant to the existing generating capacity to lower the electricity loss from transmission.  It will certainly be more environmentally friendly, which has become of increasing concern, even in areas like the GCC that are dependent upon oil and gas for most of their export earnings and electricity generation.

For example, Saudi Arabia is planning on investing over $100 billion in solar capacity to try and reach one-third of generating capacity from renewable sources by 2032.  Other GCC countries have announced significant (although less ambitious) goals for renewable energy, but Islamic financial institutions have not been actively involved in most of these projects yet.  I wrote in my newsletter on May 20th (pdf) and questioned why concern for the environment has not played as much of a part in Islamic finance to date.  Hopefully the Indonesian solar facility will act as another step towards changing that. 

Observations on the possible structure of the QIB mudaraba sukuk

The brief description from Fitch's rating announcement of the yet-to-be-launched $1.5 billion sukuk contains an interesting few points (this post is not a recommendation to buy or sell anything; see full disclaimer on the right side of the screen):

1) QIB's obligations under the documentation rank pari passu with QIB's other unsecured obligations; 

2) QIB's undertaking to purchase the relevant Sukuk assets on the scheduled or any earlier dissolution dates from QIBSL and to liquidate the relevant mudaraba assets; and 

3) On any periodic distribution date, if the returns generated from the Sukuk assets are insufficient to cover the periodic distribution payments due, QIB may pay further amounts to the SPV to remedy such shortfall via a liquidity facility. Fitch views the provision of a liquidity facility as an obligation of QIB as failure to provide liquidity if required would lead to payment default under the certificates and in the agency's view this would also constitute an event of default for QIB.

Without having read a copy of the offering documents, it is impossible to understand exactly the structure being used, but it is interesting that a sukuk of such large size is being issued as a mudaraba, given the questions raised by AAOIFI in their ruling from 2008 (specifically relating to the redemption of the sukuk and liquidity facilities provided by the originator (QIB) to the issuer (the SPV issuing the sukuk).

Initially, it was unclear whether the liquidity facilities would be provided in a way that fits within the AAOIFI guidance, since Fitch would view the "provision of a liquidity facility as an obligation of QIB" and failure to make the liquidity available would constitute a payment default according to Fitch.  AAOIFI restricted the use of liquidity facilities to cover shortfall between the actual return and the anticipated return (based on LIBOR) which the mudaraba sukuk will expect. 

However, paying the fixed return of 'anticipated' profits plus redemption of the principal is not the requirement; it is the provision of liquidity.  This reminds me of the structure used by Saudi Hollandi Bank for its post-AAOIFI ruling mudaraba, which also contained a liquidity facility to meet profit shortfalls (as well as a reserve account that would collect profits in excess of the periodic distribution amounts). 

The way the liquidity and redemption are set up to be both likely to be attractive to investors who are looking more for regular income and redemption at par, as well as within the bounds reaffirmed by AAOIFI worked like this:

• Each period (semi-annually, for example), the profit accruing to the SPV on the basis of its investments in the originator would have a portion set aside for the periodic distribution (based on a spread over LIBOR).  
• Any excess would be put into a reserve account; any shortfall would be covered through a qard loan from the originator
• At the redemption date, the originator would buy the assets back (with no guarantee that this would be at par).  The redemption amount would be first used to repay any qard loans for periodic payment shortfalls.  The remainder would be distributed to investors to redeem the sukuk. 

Although I have not seen the QIB sukuk offering documents, I would expect that it would use a similar mechanism that both makes the likelihood of redemption at par and full payment of the periodic distributions high and includes enough loss-sharing (at least in theory) to fit within the AAOIFI guidelines.  

Will Saudi Hollandi return with another mudaraba sukuk

The news that Saudi Hollandi Bank is planning a SAR1.4 billion ($373 million) sukuk to raise the bank's capital levels could serve as a 'tell' on the future for sukuk markets, depending on the structure.  If SHB returns with another mudaraba sukuk (it issued one of the first using that structure after AAOIFI issued a ruling significantly limiting some of the features used in mudaraba sukuk that made it more 'fixed income'-like). it could indicate that the structure may see a resurgence in the future.

If, however, SHB abandons the mudaraba structure in favor of, for example, an istithmar sukuk backed by receivables (ijara, salam, istisna'a and murabaha), it will be more support for that structure.  Istithmar has become more common with issuance by the Islamic Development Bank and the ability of financial institutions--which tend to have few physical assets to base sukuk on--to raise money through sukuk issuance (istithmar can include up to 67% in debt-based receivables like murabaha, although most istithmar sukuk limit this percentage to 50%). 

Only time will tell. 

Tawarruq versus musharaka using mobile minutes

In my latest newsletter, I included a quote from a paper presented at the OIC Fiqh Academy about the permissibility of tawarruq products, and the essential point made in the paper about the permissibility of tawarruq versus impermissible 'inah was summarized:

“Financing is essentially intended to facilitate exchanges and to serve real productive activity; the return on financing becomes deserved when it is a cause of wealth creation. [The relationship is inverted when] exchange becomes a means and financing becomes the goal, and the sale becomes ancillary instead of primary.”

As a bit of context for the connection between 'inah and tawarruq, the author Dr. Sami ibn Ibrahim al-Suwaylim, the VP of IRTI describes:

It is clear from what has been mentioned that 'inah is not restricted to simple two-way (binary) transactions in which the commodity returns to the seller. It encompasses all formats by which the debtor acquires ready cash in exchange for an obligation to pay a larger amount later by buying a commodity for which he has no need on credit and then selling it for cash.

Transactions based on bay' al-inah (like BBA) are accepted by some schools of Islamic thought, notably Shafi'i fiqh, which is used in Malaysia.  Based on the conclusion from al-Suwaylim, a broader form of 'inah (notably organized tawarruq) is accepted for use in Islamic finance, even if it remains controversial (the OIC Fiqh Academy called organized tawarruq a 'deception' in a fatwa in 2009). 

I am not qualified to rule on whether one interpretation is correct compared with another, it is interesting to view the discussion in the context of a sukuk that used mobile phone minutes as the asset to back a sukuk.  The sukuk was compared with an earlier tawarruq that was also based on mobile phone minutes:

In March 2008, Mobily raised a $2.875 billion syndicated Islamic financing facility, which was based on mobile phone airtime, whereby Mobily was able to sell minutes of airtime to the financiers involved, and then taking on the role of agent to these banks and selling the minutes for a profit.

The sake of minutes in the whole transaction is arguably being used to finance the sale of these minutes from the phone company to the consumer, but the structure of the transaction inserts the syndicate banks as middlemen to add another level of exchange that does not facilitate exchange, but is used to create a financial transaction, with the syndicate investors buying and reselling to the consumers with the mobile provider as the agent.  However, the profit for the banks is likely to be fixed in advance to be the difference between the price paid by consumers and the price the mobile company sells to the syndicate.

Why was this transaction structured this way and not using a musharaka with the mobile company providing the minutes and the banks providing the funds needed by the mobile company?  If the transaction is providing a share of the profits from the sale by the mobile provider to the investors using a tawarruq is viewed as stable enough to fund the periodic payments, why could the investment be made differently to bring cash and minutes together with profit payments determined by the actual sale of minutes?

Undoubtedly, the answer is because the issuer and syndicate banks are more comfortable with something that looks like a conventional loan.  The use of tawarruq, it is often argued (including by me) may not be an optimal structure for Islamic finance to use, but it is often one of the few structures that can finance inter-bank money markets and other short-term financing.  However, a $2.875 billion syndicated financing is not a short-term money market, and there is a readily available structure that should provide a stable enough source of cashflows to (mostly) replicate the economics of conventional debt.

There are many nuances in how tawarruq work in individual cases, and the point is more about the rationale for using one structure over another.  It is mostly a question about whether Islamic finance should focus on bringing innovative versions of products that are similar to conventional debt or finding creative alternatives that may be less controversial.

Can Islamic finance in Indonesia reach 10% by 2020?

There were a few articles about Indonesia (ht Islamic Finance Indonesia) that demonstrate the rapid growth potential for Islamic finance in Indonesia.  The industry remains just a small part of the banking and finance marketplace in the country accounting for just 4% of total assets, but the growth rate has been astronomical (albeit, as is common in Islamic finance, from a small base).  The goal from Bank Indonesia, the central bank, is for Islamic finance to increase in Indonesia to grow to 5% in 2013 and to 10% of total assets by 2020.

While this seems like a remarkable growth rate to sustain (and it would be set back greatly if the country's recent economic success that has led the country to have its sovereign debt upgraded to investment grade), it might be possible.  The Islamic finance industry has become much more institutionalized and there are many more global heavyweights eying the Indonesian market (such as Al Rajhi Bank in Saudi Arabia and Standard Chartered Saadiq Islamic window), in addition to the interest from across the Strait of Malacca.

To get an idea of the required growth rates to hit these targets, I made a few very simplistic calculations, based on the historical growth rates in Islamic banking in Indonesia (36% per year 2005-2010 and 49% last year), as well as expectations for near-double digit growth rates for banking overall in Indonesia (according to a survey conducted by PwC [pdf]).  My assumptions used 25% growth 2011-2014 for Islamic banking, slowing to 18% for 2015-2020, with growth rates for banking overall in the country of between 8-10% annually for the entire period of 2011-2020.  Here's the evolution of the Islamic banking assets in the country under those (relatively unscientific, though probably lower for the next couple of years than Bank Indonesia's projections) assumptions:

Year	Low Estimate	High Estimate	Size ($bn)
2011	4.0%	4.0%	$16.1
2012	4.5%	4.6%	$20.1
2013	5.2%	5.4%	$25.2
2014	5.9%	6.2%	$31.5
2015	6.3%	6.8%	$37.1
2016	6.8%	7.4%	$43.8
2017	7.2%	8.1%	$51.7
2018	7.8%	8.8%	$61.0
2019	8.3%	9.7%	$71.9
2020	8.3%	10.6%	$84.9

While it is a bit presumptuous to project so far into the future on such flimsy evidence (I basically took the historical growth rate and subtracted 10% for the next few years and cut it in half for the out years).  However, consider the projected size of Islamic banking assets in 2020 against the size of the entire banking sector today (est. at ~$400 billion, if the 4% number is correct): it would be about 21% (which happens to be the share of Islamic bank assets in Malaysia).  That being said, while I don't have confidence in my numbers being at all accurate in predicting the future growth, I think the exercise points out the reasonableness of Bank Indonesia's targets, even if growth slows quite measurably in the next 8 years (and even total bank assets continue to grow rapidly). 

One area where growth has been slow, at least in the non-sovereign space, is sukuk issuance.  The sovereign sukuk could be boosted by plans from the government to use project-based sukuk to finance at least one of its development and infrastructure projects under its long-term economic development masterplan [pdf].

These articles further confirm my idea that Indonesia will be one of the primary growth areas in Islamic finance, something I mentioned in my newsletter at the beginning of 2012.   On a related note, I am starting to put up the back issues of my newsletter on my website.  It might take me a while to get them all up, but so far, I've put up the last 3 months of newsletters. It is still better to subscribe, which you can do on the right hand side of the blog, since going forward, there will be about a month lag in the newsletters up on my website.

GACA sukuk is repo-eligible and has a zero risk weighting

It sounds like the GACA sukuk (issued by the Saudi aviation authority and backed by the government) could indeed spark a more liquid sukuk secondary market in the country with the sukuk being able to be used in repo transactions (unclear whether these would be Shari'ah-compliant repo transactions or repos by conventional banks using the sovereign sukuk as collateral). 

However, the zero percent risk weighting (from the Saudi Arabian Monetary Authority (SAMA)) could lead many financial institutions to hold onto the sukuk to maturity, or to not necessarily trade it actively.  However, I think that the size of the sukuk ($4 billion) should give the hold-to-maturity investors enough supply while leaving enough available for investors to buy and sell when they want to sell or buy corporate sukuk, giving the prospects for the Tadawul (where I would expect it to be listed) to become a much more liquid sukuk secondary market. 

As I have written earlier, I am not usually impressed by the "biggest" or "first" qualifier for sukuk, but I think this one ("it is also billed as the largest sovereign guaranteed issuance in emerging markets in the last ten years" and is also the first Saudi sovereign sukuk) is different because it could lead to follow-on offerings from other agencies in the Saudi government, as well as by corporate issuers who might be drawn in if the secondary market becomes sufficiently liquid to provide a reliable benchmark. 

Can the GACA sukuk spur a liquid secondary market or will it be held to maturity?

Moody's came out with a few comments on the GACA (Saudi Aviation Authority) sukuk, which is the first sovereign sukuk out of Saudi Arabia.  Moody's describes the sukuk as being a credit positive for Islamic banks in the Kingdom, as well as providing a pricing benchmark for banks and other issuers of sukuk. 

While the issuance of sovereign sukuk is definitely a positive around, if the banks take up the bulk of the issuance, it could hamper the benefit for secondary markets on Tadawul that a large, liquid sukuk would provide because many of the banks would hold the sukuk to maturity.  Some won't hold to maturity (and the 10-year maturity might help ensure that a greater portion eventually decide to sell), and there will hopefully be enough supply (SAR 15 billion or $4 billion) for investors who want to trade the sukuk. 

The development of a pricing benchmark is also a positive if it increases the supply of sukuk.  However, it will help more if the secondary market for the GACA sukuk is liquid because it will make the pricing benchmark more liquid.  It is especially notable that the GACA sukuk is 10-years, and not the more common tenor of 5 years because it will provide a pricing benchmark for longer-tenor sukuk, which have been relatively scarce in the GCC (10-year and longer are more common in Malaysia).

Could Tadawul become a regional sukuk trading center?

My earlier post on the expected $4 billion sukuk from the Saudi aviation authority GACA seems like it could be of even greater significance if the new rules allowing foreign investors to invest directly on the Tadawul exchange.  Currently the Tadawul sukuk and bond market has 7 listed sukuk from 4 issuers with a total size issued of SAR34.5 billion ($9.2 billion).

A sovereign sukuk (the GACA sukuk is guaranteed by the Ministry of Finance) with an issued size of SAR15 billion ($4 billion) would increase the total value of sukuk eligible for trading by nearly 50%.  If foreign investors were able to invest in sukuk directly through the Tadawul, and if foreign issuers were able to list their sukuk on Tadawul, it could create additional liquidity for sukuk, which is growing, but is still limited.

UPDATE: The activity on the Tadawul Sukuk and Bond Market for 2011 was very small (see Annual Report 2011, page 45 [pdf]).  On average, there was 1 transaction every 5 trading days (49 trades in 248 trading days) and the total volume was SAR1.8 billion ($480 million).

Largest sukuk ever - does it matter?

I am not usually impressed with most of the "first" or "biggest" news items relating to sukuk because there is usually more need for more plain vanilla sukuk and less need for overly complicated sukuk.  We all remember how the Nakheel sukuk worked out, and one of those was both a "biggest" and a "first".  However, the reports from Zawya that Saudi Civil Aviation Authority GACA is on the verge of issuing the first sovereign sukuk from Saudi Arabia, as well as the largest ever with a reported size of SAR 15 billion ($4 billion). 

This sukuk is significant because Saudi Arabia is the largest GCC economy and has been less active in both corporate and (of course) sovereign issuance of sukuk.  The $4 billion represents almost the entire total issuance for December ($5 billion) and a good portion of the average monthly issuance globally during 2011 ($85 billion total, or about $7.1 billion per month).  The sukuk is guaranteed by the Saudi Ministry of Finance, giving it a credit quality likely on par with the Saudi government's Aa3 rating from Moody's and AA- from S&P. 

The sovereign sukuk should provide a high quality for investors like takaful providers and pension funds, but not all of it is likely to end up being held-to-maturity and the sukuk, if it listed on the electronic market for sukuk with Tadawul, could provide a boost to the trading volumes in sukuk (e.g. an investor holding a corporate sukuk that wishes to remain invested in sukuk but not exposed to a corporate credit can sell the corporate sukuk and buy a sovereign sukuk, which they are not currently able to do). 

Differences in sukuk markets within the GCC

As I mentioned in an earlier post, the sukuk market is not a unified market. It is made up of many different markets, each with their own characteristics. In that earlier post, I broke down the sukuk market into 4 separate regional markets for sukuk: GCC, South Asia, Malaysia and primarily non-Muslim countries. However, even within these regions there are stark differences in the factors which impact the sukuk market health and today I saw four different article that demonstrate the differences within half of the GCC countries: Qatar, Bahrain and the UAE.

In the UAE, the sukuk markets could be on the verge of coming back strongly with what is reported to be a heavily oversubscribed $400 million sukuk issued by Sharjah Islamic Bank. The sukuk, which is in the mid-range in terms of size from the expectation is rated BBB+ by S&P and Fitch, at the bottom end of the investment grade rating category. The order book is reported to have attracted $5 for every $1 in sukuk being issued ($2 billion reported order book). Given the overwhelming dominance of sovereign sukuk issuance in the years since the markets froze up, it is a positive development to see corporate issuers, particularly one with a low-investment-grade rating to see strong reception for its sukuk. In part, this could be due to the UAE being viewed as a safe haven having not seen the protests that spread across much of the region, including the financial hub of Bahrain.

In Bahrain, the government's harsh crackdown on protests and assistance from Saudi troops stationed in the country has restored some level of calm in the markets with the yield on the sovereign sukuk from the Central Bank of Bahrain at its lowest yields since the protests began in mid-February. However, there remains a lot of uncertainty about whether the grievances which led to the protests will be dealt with or whether the calm is just a lull created by the government crackdown on protesters. For example, the US government lifted its 'voluntary departure' status for US embassy staff also noted that "potential for spontaneous civil and political unrest continues" and "Clearly, fears have subsided to an extent but given current spreads and CDS levels the market is telling you things are not back to normal" according to a director, Akber Khan, of Al Rayan Investments as quoted by Bloomberg from Qatar. Bahrain, which had become a large hub for finance--including Islamic finance--in the region has lost its status as a stable country, at least for the time being. Still, it will remain at the center of a good deal of Islamic finance in the region due to its accommodative central bank and the presence of international organizations like the International Islamic Financial Market (IIFM) and the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI). However, the reputation for stability has not (and probably cannot entirely) return to the pre-protest levels, which will impact future sukuk issuance coming out of Bahrain.

Qatar is much closer to the UAE in terms of having seen continued stability but having some 'baggage' like the UAE does with Dubai World (although not nearly to the same impact). Its central bank surprised bankers in the country by requiring conventional banks to shut their Islamic 'windows' by the end of 2011 and thus handing that market over to banks that are fully Shari'ah-compliant. The conventional banks being forced to abandon their Islamic windows have asked the central bank to allow them to hold their Islamic assets through to maturity instead of being forced to divest them entirely by the end of 2011. Qatar Islamic Bank, one of the country's Islamic banks, is reported by Gulf Times to be planning a five-year sukuk in the third quarter. This is not surprising given the boost that Qatari Islamic banks are expected to receive by having the competition in the country dramatically reduced by the central bank's order, although there could end up being a way for the conventional banks to continue to compete in the Islamic banking by launching separately licensed Islamic subsidiaries that are regulated alongside the wholly Islamic banks and separately from the conventional parent banks. However, there remains a lot of uncertainty about what the central bank will (and will not) allow.

Just as there is significant differences between the markets for sukuk--and other areas of Islamic finance--between the regions in which it is growing, there is significant heterogeneity within the regions based on the different political, regulatory and financial climates for Islamic banks and for issuers of sukuk. The protests which spread across the region and the Qatari Central Bank order relating to Islamic windows both demonstrated the uncertainty of anticipating future developments, there is likely to be continued activity in the primary market for sukuk in the UAE as well as among Islamic banks in Qatar (and Islamic subsidiaries of conventional banks if the central bank allows that possibility). There will also likely to be stiff competition between Qatar, the UAE and Saudi Arabia for the financial firms that decide to relocate from Bahrain.

Where will sukuk markets gravitate?

The markets for Dubai's sukuk are giving the "all clear" with yields falling and the spread between Dubai's sukuk and Malaysia's sovereign sukuk falling to their lowest levels (the Malaysian sovereign sukuk was issued last summer). There are other articles giving warnings of the effect of the protests in many countries, with Bahrain causing the greatest effect on the Islamic finance industry.

The disruption caused by the protests is unfortunate for Bahrain which saw its financial industry grow to around one-quarter of the economy before the protests after capturing share from Beirut in the 1980s after the beginning of the Lebanese civil war. Now the protests in Bahrain could shift the center of finance--and Islamic finance in particular--elsewhere in the GCC if the disruption continues. The old saying about finance reminds that markets and financial firms, while taking risk, will avoid uncertainty. However, despite the disruption to business activity in Bahrain the Central Bank has continued its sukuk issuance with one sukuk al-salam recently that was heavily oversubscribed. However, the yield of 1.15% was sharply up from six months ago when the CBB issued a sukuk al-salam paying just 0.67%.

Even before the protests, the center of sukuk issuance was seen as shifting away from the GCC with Malaysia being the destination of choice for issuers with its much more liquid secondary markets. Although I still belive (as I predicted at the end of 2010) that this would slow and begin to shift back towards the GCC, it will probably take longer than I expected with the disruption in one of the financial capitals in the region. However, given that there has been limited spread in protests to Saudi Arabia, the UAE and Qatar, there should still be issuers looking to issue sukuk domestically (like, for example, Bank Al-Jazira, which just issued a SR1 billion ($267 million) sukuk).

One factor that could be slowing the return of issuers to the GCC besides the events in the region is the currency: the ringgit is the strongest it has been in 13 years against the dollar, to which the GCC currencies are pegged. Given the tendency of financial prices to revert to the mean in the longer term, this would benefit issuers from the GCC who issue sukuk at current levels because their repayment obligations is in ringgit and if the currency returns to the average level over the past five years, it would effectively reduce their local currency obligations. As the ringgit appreciates, it would be expected that this affect would be diminished and coupled with a return to calm in the GCC would encourage issuers to look more to the local GCC markets.

Within the GCC, the impact of the instability in Bahrain will probably lead to a shift of Islamic finance activities--particularly if the protests continue--to another country. While the resolution of some of the Dubai World troubles with cash payments being made to creditors will remove some uncertainty around the Dubai situation, it is unclear whether it will be the preferred destination for any financial institutions fleeing Bahrain. Perhaps Qatar, with its 2022 World Cup, or Abu Dhabi will become the destination. Or perhaps, Saudi Arabia, with its mortgage law expected to come into effect in 2012 will have its bid as a hub for Islamic finance become as significant as its economy's size within the GCC.

Islamic finance lagging in private equity; sukuk for the Saudi mortgage market

An article cites Hussein Hassan, the head of Middle east structuring at Deutsche Bank pointing out that Islamic banks avoid private equity despite its similarity with the partnership approach in Islamic finance contracts like mudaraba. This is attributed to the use of high levels of debt in private equity, the financing of haram industries and the asset-liability mismatch in Islamic banks which limits their ability to invest in longer-term projects. Lahem Al-Nasser covers a similar topic when he chides Islamic banks for financing more "traditional" projects over projects which are new and untested. He says this bias is based on the management having experience in conventional banking who believe that "Islamic banking is nothing more than a marketing instrument to make profit" and they "lack the incentive to push for creativity and innovation".

The VP and MENA business manager for corporate trust at BNY Mellon Corporate Trust in Dubai suggests that "sukuk would be the best way to mortgage homes in a Shari'ah-compliant fashion" using an asset-backed structure. I would tend to agree because so long as most of the mortgages are tradable (i.e. not based on murabaha), they could be securitized in a way similar to the Islamic Development Bank's sukuk al-istithmar. In the istithmar sukuk, the underlying assets are other financing contracts (in the case of the IDB sukuk, they are murabaha, istisna'a and ijara). The sukuk is tradable so long as the proportion of ijara contracts (by value) is more than one-half of the total assets. The reason for this is that murabaha and istisna'a contracts create a debt obligation (the financier holds a receivable for future payment), whereas an ijara contract provides the financier with ownership of an asset.

Kazakhstan is planning to issue $500 million in sovereign sukuk, in part to try and make the country the "Islamic finance hub" for the former Soviet Union. The government of Abu Dhabi-owned Al Hilal Bank opened the first Islamic bank in the country earlier this year. The CEO of the Kazakhstan branch of Al Hilal Bank, Prasad Abraham, tempers the expectation saying that issuance could start at just $200 million this year but rising to as much as $3 billion per year by 2015. The sukuk is replacing a cancelled $750 million Eurobond, which Bruce Gaston, the CEO of Skybridge Finance, says will cost the government up to 150 basis points m more compared to the Eurobond.

Other News

• Kuwait Finance House Research estimates that global sukuk issuance in 2010 will reach $30 billion. The first half issuance was $16.5 billion.
  
• Al Baraka Banking Group plans to raise $200 million through its first sukuk issuance by the end of 2010. Al Baraka also signed a non-exclusive memorandum of understanding with the Islamic Corporation for the Development of the Private Sector (ICD). ICD is part of the Islamic Development Bank group.
  
• Gulf Finance House is planning to increase its capital by $300 million but did not specify how it plans to raise that capital.
  
• Dubai may issue debt in 2010, but it is "not under pressure to do anything".
  
• Bahrain Financial Harbour raised $240 million through a 7-year ijara facility to repay debt.
  
• The Al Rajhi Bank-Cagamas cooperation may only be the first effort to bridge the divide--particularly in Shari'ah standards--between the GCC and Malaysia. While much of the news concerns the Shari'ah standards, there are other areas where harmonization of standards becomes difficult. Megat Hizaini Hassan, the head of Islamic banking & finance at Zaid Ibrahim, is quoted saying: "In the Middle East, in certain jurisdictions [Islamic finance] is not even regulated so how can you harmonise?".
  

DIFC Investments, Other News

JP Morgan said the government of Dubai may have to convert its $1 billion loan to DIFC Investments into equity, as well as make an equity investment in the company. The report also upgraded DIFC Investments' $1.2 billion mudaraba sukuk maturing in 2012 from "underweight" to "neutral" based on "improved asset coverage". Other analysts believe the rally--the sukuk rose in price to 79.15 (yielding more than 13%) --has gone to far in DIFC sukuk, as well as other Dubai-related sukuk.

Other News

• Gulf Finance House was able to roll over $100 million in debts for two years, with an option to extend it by another year.
  
• Standard Chartered is expanding its Islamic finance business. The bank recently launched a product that will allow for hedging against fluctuations in commodity prices.
  
• Bloomberg has a list of upcoming sukuk. Many new sukuk are coming from Asia including Hong Kong and Singapore, although regulatory challenges remain.
  
• The Houston Chronicle interviews Monem Salam on the Amana Funds.
  
• Moody's placed Dar Al-Arkan's credit rating (and the rating on its sukuk) on review for possible downgrade.
  
• Islamic finance has become as closely watched as celebrities, according to Lahem Al-Nasser.
  

GCC sukuk markets slow to recover, new AAOIFI rules on Shari'ah scholars may be coming

The headline is promising: "GCC bond and sukuk market bounce-back in Q2". The article--which reflects data from National Commercial Bank in Saudi Arabia--continues to show data that supports continued weakness in sukuk markets in the GCC (particularly compared to Asia). After a rosy headline of a bounce-back, the press release describes that "the primary sukuk market also picked up, lead by sovereign issuances, and reached a total value of $3.4bn, a significant rise over the same period last year." (emphasis added) This type of comparison--regardless of the data being reported--is relatively easy to make at the current time because one year ago, the global economy was just exiting a severe financial crisis. Reading further, "Sovereign sukuk issuance totaled $1.5bn during the quarter, whereas activity proved much more lackluster in the corporate sukuk space with the notable exception of a landmark issue by Saudi Electric Company". (emphasis added). The press release quantifies this weakness. There were eight sukuk issues from the GCC region in the second quarter of 2010, seven of which ($1.5 billion worth) were issued by sovereigns (Qatar and Bahrain), which leaves only the Saudi Electric Company sukuk from the corporate space (making up the $1.9 billion remainder). The details of the press release confirm that the market for sukuk--at least in the GCC--is still open primarily to governments. The corporate sector has not returned in the wake of the credit crisis, which saw defaults by Saad and Algosaibi, The Investment Dar, International Investment Group and the near-default of Nakheel increase uncertainty about sukuk. I would expect the third quarter sukuk issuance to be similarly slim, but it will be interesting to see what deals currently in the pipeline are brought to market after Ramadan.

Bloomberg is reporting that the Secretary General of AAOIFI, Mohamad Nedal Alchaar, said that the body is considering placing rules on Shari'ah scholars to minimize potential conflicts of interest. The rules may limit the number of boards on which a scholar may sit and may also limit the scholar's ability to have investments in those institutions as well. It will be interesting to see whether there is push back, both from scholars, but especially from Islamic financial institutions. My expectation is that the financial institutions--particularly the mid-size ones--will complain (in some cases validly) that the limitation on Shari'ah scholar's participation on multiple boards will harm them because there is a shortage of well known scholars and the multi-national financial institutions will be able to draw the most recognizable scholars. This is probably a valid concern (depending on how low the bar is set as far as the maximum number of boards each scholar can sit on). In the longer-term, it will be beneficial by helping younger scholars become more well recognized, but there will be a cost in the interim where the mid-sized institutions that have thus far been able to have well regarded Shari'ah boards may get priced out of their services by multinational banks. But until there is a firm proposal on the table from AAOIFI, this is just speculation.

Other News

• Falling yields on sukuk issued by Malaysia and Indonesia may be the result of their rising currencies against the US dollar which has attracted foreign investors, reports Bloomberg.
  
• Cagamas issued RM230 million ($72.8 million) in three-year, variable rate commodity murabaha sukuk.
  
• There is a good article in Arab News about a conference held at the George Washington Law School. The conference featured Frank Vogel, Yusuf DeLorenzo, Umar Moghul, Aamir Rehman and Ibrahim Warde.
  
• Deutsche Bank's Saudi-joint-venture Deutsche Gulf Finance launched its Islamic mortgage product that offers home financing for up to 30 years, according to a press release.
  
• A Malaysian expressway company is planning to issue new sukuk to redeem their outstanding sukuk because the tolls will be insufficient to cover the first repayments later this year.
  
• Indonesia sold 2.855 trillion rupiah($319 million) in 4-year sukuk to the government's Islamic Haj Fund. The planned global sukuk sale was cancelled because the deficit is smaller than expected and the government had trouble attracting investors at yields it would accept. The illiquidity of the sukuk were cited as the reason for higher yields.
  
• Qatar Islamic Bank (which owns Asian Finance Bank in Malaysia) is reportedly searching for a partner to expand into Indonesia. There have been quite a few Malaysian Islamic banks that recently announced interest in or completed acquisitions to enter the Indonesian market.
  

Thursday bullets

• The head of Shari'ah and CEO of IIMF believe that greater transaction document standardization, like the Master Agreement on Treasury Placement released by IIFM, will benefit the industry.
  
• There are a number of articles on Khazanah's S$1.5 billion ($1.1 billion) sukuk, including from Bloomberg, AsiaOne News and and Reuters.
  
• The Deputy Governor of the Central Bank of Malaysia gave a speech at the 21st Conference of Presidents of Law Associations of Asia on Islamic finance. The full text is available as a pdf.
  
• Al Rajhi Investment and Banking Corporation Malaysia Bhd, a subsidiary of the Saudi Islamic bank Al Rajhi Bank joined the Bursa Suq Al-Sila', the commodity murabaha/tawarruq platform in Malaysia.
  
• An article offers a few details about the Family Bank Bahrain, an Islamic microfinance institution that is working with the Grameen Trust.
  
• An article published by Zawya, written by three lawyers at King & Spalding, covers the different trends in how Islamic financial products are taxed.
  
• BMB Islamic released its Global Islamic Finance Report 2010, which in addition to describing the industry's growth also acknowledges that there is a shortage of authentic data on the size, growth and performance of the institutions making up the industry.
  
• The Maldive's Monetary Authority issued the first Islamic banking license to Maldives Islamic Bank Pvt. Ltd.
  
• Bloomberg has another article about the potential for growth in sukuk issuance from Asia while the GCC primary markets are at their slowest pace since 2005.
  
• A commenter for the Guardian Michael Tomasky takes a look at Islamic finance and realizes that the hyperbolic charges leveled against it are ridiculous on further examination.
  
• An Islamic brokerage, Makaseb Islamic Financial Services, in Abu Dhabi is closing.
  
• Malaysian companies Axiata Group Bhd and Malaysia Airports Holding Bhd are planning RM4.2 billion ($1.3 billion) in 7-10 year sukuk and RM3.1 billion ($981 million) in sukuk of unspecified tenor, respectively. The bulk of the Axiata sukuk will be sold to the Employees Provident Fund.