An arch between two government buildings frames a mosque in Putrajaya, Malaysia. The Malaysian government has been active in promoting Islamic finance.
Malaysia has cemented its status as the top issuer of Islamic finance, accounting for more than half of the total global sukuk issuance in 2009 and 2010, while the Middle East is struggling to recover from the financial reversal in Dubai and corporate defaults in Saudi Arabia. Besides Malaysia, other Asian countries - even those without an Islamic tradition - are strengthening their sukuk offerings too. Writer James Gavin
Three years ago, Middle Eastern issuers dominated the sharia-compliant debt capital market landscape. Gulf corporates and sovereigns alike had edged past Malaysia in the volume of debt being issued, as the appeal of sukuk pulled in regional investors eager to gain exposure to sharia-compliant debt instruments.
But over the past couple of years, Malaysia has re-emerged as the dominant debt issuer in the Islamic world, with Asian appetite for Islamic securities outpacing that of the Middle East.
In 2009, Asia was confirmed as the major engine of growth for the sukuk market, accounting for 63.9% of global issuance. Malaysia alone was the host country of 54.1% of issues, according to ratings agency Standard & Poor's (S&P). In contrast, the Gulf contributed 33.5% of new issuance. Even Indonesia, with a 16.89% share of sukuk issuance, exceeded the Middle East's largest issuer, Saudi Arabia.
That trend has been accentuated in 2010. First-half figures from S&P reveal that Asian issuers dominated, with 70% of total issuance, compared with the Middle East's 30%.
Cementing its position as the world's top sukuk market, Malaysia contributed 52.7% of total issuance, including a sovereign-sponsored Ijara transaction (a form of lease) involving the sale of 12 government-owned hospitals throughout Malaysia.
Asian companies and financial institutions have entered the sukuk market as a way of diversifying their investor base.
Kuala Lumpur has attracted some major-league issuers in recent months. In August, the Jeddah-based Islamic Development Bank listed a RM1bn ($320m) sukuk medium-term note (MTN) programme on Bursa Malaysia, the first multilateral development bank to list a ringgit sukuk MTN programme on the Malaysian exchange.
The Gulf has not been moribund: with three significant sukuk issued in the first half of 2010 by Saudi Electric Corporation for $1.8bn, the Qatari government for $1.3bn, and Dar al-Arkan, a Saudi real-estate group for $450m, large issuers have shown signs of renewed appetite.
But Gulf Co-operation Council countries are lagging behind in terms of sukuk and struggling to meet the needs of many of their relatively sizeable sharia-compliant issuer and investor bases. Kuwait's sukuk market is still valued at just 1.5% of its 2009 gross domestic product (GDP). Contrast that with Malaysia, where by the end of 2009 the country's sukuk issuances averaged about 38% of GDP.
Gulf issuance has been hit by Dubai's sharp economic reversal and the revelation of defaults at major regional corporates, including sukuk defaults. Malaysia has staged a quicker recovery from the 2008 downturn than Gulf countries, with sukuk issuances more than doubled in 2009 from 2008, exceeding $12.6bn last year.
Asian dominance
Asia's strong showing reflects a well-established Islamic banking system, a strong regulatory framework and government support that has rebuilt confidence levels.
The Malaysian government has actively promoted measures to encourage sukuk. "In Malaysia in particular, the government is really pushing for the development of Islamic finance and a large proportion of the issuance is coming from state- and government-related entities such as Malaysia's central bank, Bank Negara Malaysia, which issued a series of sukuk in the first half of the year," says Mohamed Damak, a credit analyst at S&P.
Malaysia has also been proactive in tackling some of the roadblocks hampering the development of the Islamic market. A new law in 2009 gave the central bank's sharia board the status of final arbiter in matters relating to sharia compliance, which has helped smooth out disputes over interpretation.
"One reason why Malaysia has seen good supply is that it has developed a very healthy, effective and efficient local currency sukuk market. It is not just banks [issuing] - there are government-related entities, insurance companies, pension funds and mutual funds - as well as a diverse and deep base of investors in the market that we don't yet have in the Gulf," says Mohamed Dawood, head of debt capital markets at HSBC Amanah, the Islamic finance division of HSBC.
A strong secondary market has helped Malaysia too. "The vast majority of sukuk issued in Malaysia is listed in the local market, which improves liquidity compared with over-the-counter instruments," says Mr Damak.
Government issuance is helping to create a sukuk yield curve that will lead the way for private sector issuers. S&P argues that the dynamic short-term sukuk market currently in the making in Malaysia will help to enlarge sukuk issuance. By taking steps to address the need for short-term instruments, it could over time set a precedent for other countries aiming to develop more vibrant local Islamic finance activities.
"Bank Negara Malaysia is issuing a series of short-term sukuk, the yield on which could serve as a benchmark for the yield on private sector sukuk and improve the liquidity of the overall market," says Mr Damak.
Kuala Lumpur is also intent on providing a benchmark for local corporates to tap the US dollar market. HSBC was joint lead manager on a five-year Malaysian sovereign global sukuk worth $1.25bn launched in May - the first sovereign sukuk from Malaysia since 2002.
Expansion across Asia
Sukuk issuance is fanning out across Asia from its Malaysian base, with a stack of new borrowers approaching the market for Islamic securities - many of them outside the Muslim world. Nomura Holdings became the first major Japanese sukuk issuer in July 2010 with a $100m deal in July 2010. In coming months, a number of sukuk issues are expected from new players in Hong Kong, Singapore and Thailand.
Improved economic indicators may help inject momentum into Middle Eastern sukuk markets. The Gulf's sluggish economic performance in the past two years has translated into fewer projects that need financing and less debt issuance.
Gulf issuers have other problems to deal with, notably the messy aftermath of defaults by several major Saudi companies. "The Saad/Algosaibi corporate defaults in Saudi Arabia and issues surrounding the restructuring of Dubai World have made access to the market more costly for Gulf issuers," says Mr Damak. The region is still struggling with default concerns on some sukuk. This year has seen Kuwait-based International Investment Group default on its obligations to investors on a $200m sukuk.
With approval granted to Dubai World over restructuring of its exposures, confidence may return and more Gulf corporates will look to tap the market again. There is likely to be a flight to quality.
"If you are a sukuk buyer in the Gulf, your focus is going to be on better-rated, better credit-quality assets - sovereign-related assets as well as stronger, better-rated corporate credits. That's where the focus is. It's not that people are shying away due to questions about the structure of sukuk. Everyone understands it wasn't the underlying structure that was at fault, it was the credit cycle," says Mr Dawood.
The future's bright
The next few months should be more positive for issuers and the headwind going into 2011 is strong, as Islamic financial institutions with refinancing needs approach the market. "Gulf sukuk issuers may come back to the market now that the general economic environment is improving and new projects are being launched by both the public and private sectors, which will need financing - and the sukuk market is one of the best routes to fund these projects," says Mr Damak.
The next few issuances should see a good response from investors, given the recent dearth of activity. "The sluggish level of supply we've seen in the market over the past seven to eight months creates its own opportunities," says Mr Dawood. "There has been a build-up of liquidity in Islamic institutions and pressure is building up internally within banks and among Islamic investors to start booking assets and take on risk. As liquidity builds up, it creates a good environment for whoever comes to the market first."
Authorities will still have to think strategically about providing greater support for sukuk if revived interest is to translate into longer-term appetite for the asset class. One of the biggest challenges is redressing sukuk's short tenors.
"Historically, this has been a shorter market with typically five- to seven-year durations. We need to move the market gradually to longer durations, for example 10-year tenors, and we need Islamic institutions to become more comfortable with these longer tenors," says Mr Dawood.
