With the UK, Luxembourg, Hong Kong and South Africa all preparing to issue, the popularity of sukuk is going global. And though each is likely to be limited in size, they will bring with them greater international awareness of sharia-compliant financing options.

The global sukuk market is evolving swiftly. Total issuances have exceeded $100bn annually since 2011, while complex hybrid deals and the diversification of asset underliers point to the growing sophistication of these transactions. As a result, a number of first-time issuers from non-Islamic jurisdictions are being drawn to the sukuk market. These deals will be among the first to be executed by countries outside of the Organisation of Islamic Co-operation, with the potential to increase the global appeal of sukuk as a mainstream debt instrument.

At present, the UK, Luxembourg, Hong Kong and South Africa are all readying themselves for a first issuance. The UK government is leading this charge, and is set to issue a £200m ($340.7m) sukuk with a five-year maturity by the end of June or early July. If executed, this would make it the first sukuk issuance by a Western sovereign. The UK in particular is well prepared, having readied itself to issue as early as 2008, before postponing the transaction due to the challenging economic climate.  

Hong Kong is expected to follow the UK, with a sukuk issuance scheduled towards August or September. The total issuance is likely to be between $500m and $1bn with a tenor of five years. Both the UK and Hong Kong will adopt an ijara (lease-based) structure, which has traditionally been popular among sovereign issuers due to its ease of implementation. Details surrounding the issuances from South Africa and Luxembourg are more opaque; however, both are likely to issue in the short to medium term. In the case of Luxembourg, a draft bill is currently under consideration by the country’s parliament for the securitisation of $275m in assets to support an issuance.

The motivations driving these transactions differ, though there is a strong dynamic of financial centre competition underlying the activity in the UK, Hong Kong and Luxembourg. “These jurisdictions are looking to establish their leadership status within the Islamic financial industry and in a sense they are all aiming for a share of this growing market,” says Ahsan Ali, head of Islamic origination at Standard Chartered.

Tapping new pools

Competition aside, the common thread uniting all of these prospective transactions is a desire to tap into new liquidity pools, as well as a new investor base. Similarly, these jurisdictions are hoping to improve cross-border trade and investment flows with capital surplus regions, particularly in the Middle East. Attracting Islamic financial products and services is seen as an effective way of achieving this.  

“We hope to attract more international investors to our financial market. Given the shortage of high-quality sukuk in the global market, the strong credit rating of the [Hong Kong] government is well positioned to fill the gap by providing high-quality sukuk to meet the strong demand from investors,” says a spokesperson from the Hong Kong Monetary Authority. “Hopefully, it would help widen the range of financial products and broaden the types of market players here, adding to the breadth, depth and diversity of our financial market. This would in turn consolidate our role as an international financial centre and asset management centre.”

For South Africa, the prospects of diversifying its debt portfolio to mitigate refinancing risks are an additional incentive. “Unlike the established financial centres, South Africa is seeking to attract a new class of investors and diversify away from the conventional bond markets,” says Noel Lourdes, executive director of Amanie Advisors, an independent sharia global advisory firm.

Yet, the limited size of these expected transactions means much of this impact will likely be indirect, coming from greater market awareness of sharia-compliant financing options, as well as the prospect of follow-up corporate transactions. “Each new issue improves the depth of the Islamic finance market and transactions from highly rated sovereigns increase general market awareness and sentiment of Islamic finance,” says Richard Williams, chief financial officer at the Bank of London and the Middle East, Europe’s largest Islamic bank.

One time only?

For now, it appears that each of these sovereigns will be issuing on a one-off basis, with the possible exception of South Africa. Given that the UK, Luxembourg and Hong Kong either run budget surpluses or are capable of securing attractive funding rates from the conventional markets, there appears to be little incentive for additional issuances over the medium term.

“These sovereign issuances themselves would not add much to the overall size of the sukuk market. However, they are likely to act as a catalyst for other quasi-sovereign entities, corporates or institutions to issue a sukuk in their respective markets, once a yield curve has been established. That is where we see the real opportunities for the growth of the global sharia-compliant capital market,” says Mr Ali at Standard Chartered.

Mr Lourdes from Amanie Advisors supports this view, arguing that the creation of risk-free benchmark rates in Hong Kong dollars, sterling and euro will make it easier for constituent corporate entities to engage with Islamic financing options. In turn, this will mitigate the systemic risk of reliance on the Eurobond market.

Perhaps more significantly, the issuances will go some way to address the shortage of highly rated Islamic paper in the global market. This deficiency has created challenges for the growth of the broader Islamic finance industry, and the banking sector specifically, in terms of liquidity management. At present, demand for highly rated sukuk massively outstrips total supply. As a result, most sukuk are held to maturity, which has hampered the development of a vibrant secondary market.

Sharia-compliant banks in the UK are expected to be the primary beneficiaries of this trend. “These issuances will improve the availability of highly rated paper, particularly for the UK’s Islamic banks, which have historically had problems holding UK government paper because it hasn’t been structured in a sharia-compliant manner. But what is really needed is larger and more frequent issuances to address this problem over the longer term,” says Atif Hanif, head of European Islamic finance for law firm Allen & Overy.

Igniting interest

In tandem with more frequent issuances, the global sukuk market will require a greater spread of long- and short-term instruments, as well as a more diversified investor base, in order to mature. The Gulf Co-operation Council countries, in particular, lacks the strong presence of institutional investors which could provide requisite levels of liquidity and stability to the market.

In this sense, Mr Lourdes from Amanie Advisors sees scope for these non-Islamic sovereign issuances to ignite greater interest from conventional institutional investors in the sukuk market. “You could see the large conventional institutional investors searching for yield, tapping into sukuk opportunities, which from a purely commercial point of view are merely another type of credit investment instrument. This will make the sukuk market a truly global affair.”

However, a number of challenges remain. The abundance of cheap credit, made available through various central bank quantitative easing programmes, has in some cases discouraged corporate entities from diversifying their funding profiles even when the regulatory environment has been supportive. This has led to a situation in which corporate entities in particular can enjoy attractive financing options from the conventional markets. “In the Western market, these highly rated entities don’t have a problem raising funds from their traditional sources,” says Mr Hanif.

The prospect of follow-up issuances in these jurisdictions will be subject to broader market conditions over the short term. But the decision to execute these sovereign transactions points to a new phase in the growth of the global sukuk market. In turn, greater acceptance by these sovereigns has the potential to further integrate trade and investment flows between capital surplus regions, particularly the Middle East, and non-Islamic jurisdictions. With total Islamic finance volumes set to reach $2000bn by the end of 2014, the prize may be too big to ignore. 

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