Assessing major trends in the Sukuk and their developments in capital markets

Ernst & Young : Muhammad Khurshid, Manager Financial Services, Ernst & Young South Africa, talks about Sukuk trends in capital markets in his paper ''Assessing major trends in the Sukuk and developments in the primary and secondary capital markets'' 26th August 2008.

Assalam O Alaikum Wa-Rehmatullah-e-Wabarakatuhu.

By the Grace of Almighty, it’s been continues effort in the African region to arrange “Islamic Finance and Investment world – Africa”. We have been honoured by big names of industry who have been attending this conference over the years and this has enables us to develop foundations for strong Islamic Financial system in African region. This year the effort is extended by including more critical topics like, Insurance (Takaful) and Sukuk (Islamic Investment Bonds).

I feel honoured to present a paper on “Assessing major trends in Sukuk and their developments in Capital Market”. I will like to start my presentation with an overview of the global and the local capital markets.

Who are the Key players? Global vs Regional:

I would like to quote the words from Ernst & Young’s Managing partner of Bahrain practice, Mr. Noor-ur-Rahman Abid, who told Reuters in an interview that:

“We estimate that by 2009, $1.5 trillion of the world's high net worth individual wealth to come from the Middle East and 70 percent of this wealth could invest in Islamic financial products”

Sukuk comes as one of the most attractive Islamic financing tool, especially; they have been attractive for those financial institutions which are allowed by the central banks of their respective countries for Sukuk as eligible securities for their statutory and liquidity reserve requirements. This was not the end and in recent years we have seen a robust real estate development in Middle East, particularly in the state of Dubai. We have witnessed that most of the financing for developments of huge infrastructures came from Islamic Financing Institutions. These Islamic financing institutions, to meet their liquidity requirements for such big developments have called financing from general public and from the consortiums of other Financial institutions, including Islamic Mutual and Investment funds, conventional institutions were also attracted by Islamic financing products and high-worth individuals looking for investment portfolios with secure returns. Sukuk has played and will play a role of important vehicle for financing.

If we look into the global major players in the Sukuk market, following are the leaders:

° Abu Dhabi Islamic Bank (Musharakah Sukuk of USD 8 Bn)

° BMA International Sukuk Company (Ijarah Sukuk of USD 2.5 Bn)

° DAAR International Sukuk Company (Ijarah Sukuk of USD 6 Bn)

° Dubai Global Sukuk FZCO (Ijarah Sukuk of USD 10 Bn)

° Emaar Properties Sukuk (Ijarah Sukuk of USD 6.5 Bn)

° Emirates Airline Sukuk (Musharakah Sukuk of USD 5.5 Bn)

° Qatar Global Sukuk QSC (Ijarah Sukuk of USD 7 Bn)

° Pakistan – Dubai Islamic Bank and Government co-managed (Sukuk of USD 600 Mn were oversold)

° Malaysia – Sukuk offering started in 1990 by Shell Malaysia (offering USD 30 Mn) and now around 75% of all Malaysian Corporate financing covers under Shariah compliance, making it the lead player.

We can easily say that the issuance of Sukuk is big and growing. It has not only attracted Muslim investors but also been a good market for non-Muslim investors. In Middle Eastern region the main objective of the Sukuk issuance was targeted towards the infrastructure developments, but, in countries like Pakistan and Malaysia, Sukuk have served many purposes. Sukuk have been a good and attractive source of inviting liquidity, as well as, a new investment avenue for statutory reserves. This investment avenue comparatively provided better returns in relation to the government owned bonds issued by the respective central banks.

Locally, African region has not been that active in Sukuk market. Debt markets in African region are an integral part of the financial sector and effectively supplement the funds provided by the conventional banking sector, leaving a very little room for Islamic financing products.

We have seen some internal Sukuk issued by the financial institutions to their holding companies or to group companies for their financial and liquidity management, but none of them were available publicly for subscription. Recently, some of the Islamic financial institutions performed some feasibility studies for issuance of Sukuk in African economy, specifically in Southern Africa. Following are some latest initiative from global and African (regional markets):

° Recently Indonesia announced launch of Global Sukuk with a maturity of 5 to 10 years.

° In July 2008, First Community Bank (Kenya) announced plans to introduce Sukuk to the Kenyan market, subject to regulator approval.

Reviewing common Sukuk structures and benchmarking:

There are a very limited number of Sukuk structures available, due to the issues still being addressed of non-Shariah compliance and the factor of Riba. Shariah scholars have commented against some of the Sukuk structures, even after their issuance in the capital markets, as we have seen in Middle East. These comments came on the post issuance review of the Sukuk. These reviews helped Islamic Financial Institutions to correct the structures for the future issue of the Sukuk, as well as, standardisation of Sukuk market.

Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) has developed its standard on Investment Sukuk. This standard specifies following basic structures of Sukuk:

° Certificates of ownership in leased assets

° Certificates of ownership in usufruct

° Certificates of ownership of services

° Certificates of Murabaha / Salam / Mudaraba / Musharakah / Ijarah

° Certificates of Investment Agencies (Wakalah)

We can easily say that this has lead to the benchmarking of the basic Sukuk structures. The innovations in the Sukuk markets move around the basic structures as introduced and stated in AAOIFI standards.

What are new innovations in structuring Sukuk?

Using the basic structures, different types of innovated Sukuk have been floated in the market. The view behind such innovative Sukuk was to accommodate the risks of financial markets. The innovated structures have facilitated investors in evaluating the Sukuk for the portions of the fixed rental (Ijarah) income and also for the profit and loss (Musharakah / Mudarabah) shared portions within one Sukuk.

Using the common structures of Sukuk, following classes of innovated Sukuk can be developed:

° Pure one structure Sukuk

° Hybrid / Pooled Sukuk

° Variable Rate Redeemable Sukuk

° Zero – Coupon Non-tradable Sukuk

° Embedded Sukuk

Pure one structure Sukuk: These certificates are issued on stand-alone assets / ventures. The assets / ventures can be parcels of assets like land to be leased or leased equipment such as aircrafts and ships or on the other hand could be ventures like development of such assets or long term businesses. So in-effect these could be based on any one of the common structures. These are the most commonly issued and subscribed Sukuk in the Islamic financial Markets.

Hybrid / Pooled Sukuk: The underlying pool of assets can comprise of Istisna or Salam, Murabaha receivables as well as Ijarah. Indeed, having a portfolio of assets and ventures comprising of different classes allows for a greater mobilization of funds as previously inaccessible.

Variable Rate Redeemable Sukuk: The above mentioned two types of Sukuk would partially represent the strength of the issuer’s balance sheet. Under some conditions, implementing Sukuk by representing the full strength of an issuer’s balance sheet can prove to be beneficial. Already, several corporate entities refer to these Sukuk as Musharakah Term Finance Certificates (MTFCs). This can be considered as an alternative to Sukuk because of its seniority to the issuer’s equity, its redeeming nature and its relatively stable rate as compared to dividend payouts. MTFCs have a few advantages. First, employing Musharakah returns is preferred from the viewpoint of jurists as such an arrangement would strengthen the paradigm of Islamic banking that considers partnership contracts as the embodiment of core ideals. Secondly, the floating rate of return on these certificates would not depend on benchmarking with market references such as LIBOR but would instead be contingent on the firm’s balance sheet actualities.


Zero – Coupon Non-tradable Sukuk: Another possible classification of Sukuk structures can be created where the assets to be mobilized do not exist yet. Consequently, the objective of the fund mobilization would be to create more assets on the balance sheet of company through Istisna. However, certificates of this nature would not readily be tradable because of Shariah restrictions. The primary asset pools to be generated would be of the nature warranted by Istisna and instalment purchase/sale contracts that would create debt obligations. The certificate on these debt arrangements can be termed as fixed rate zero-coupon Sukuk.

Embedded Sukuk: These could be Sukuk whether zero-coupon, pure-Ijarah or hybrid, with the embedded option to convert into other asset forms depending on specified conditions.

Meeting the demands for Sukuk among Non-Muslim Investors

Islamic financial institutions, just like conventional financial institutions, have provided avenues to investors and borrowers from all sectors of markets. We can see that Islamic financial institutions have been actively involved in following of the major market segments:

° Property Market

° Banking Sector

° Leasing Companies

° Mutual Funds (open and close end)

° Takaful (Islamic Insurance) Companies

° Manufacturing Sector

° Services Sector

If we look into the financial statements of Islamic financial institutions of those ventures which are involved in Shariah compliant financial services, the distributable profits on their balance sheet were huge and better than the conventional financial institutions. This has been a good attraction for non-Muslim investors. The basic question asked by the non-Muslim investors was about the security of the investments and regularity of the returns on their investment. This is well answered by the issuance of Sukuk. Most of the Sukuk are securitised over the tangible assets of the issuers or back by the government or by strong financial houses or a combination of these attributes.

Further to this, feasibility of such Sukuk were audited and ratified by the independent practitioners, making them more reliable for investment not only for the Muslim (or Islamic financial Institutions) but also for the non-Muslims.

Challenges and Solutions

There is a huge list of challenges which are being faced by the issuers, particularly for the prospective issuers of the Sukuk.

Laws and Regulations: There is a lack of laws and regulations governing Sukuk. Mostly issuers follow the issuance structures as approved by their respective regional laws. These laws, most of the times, are rigid and air-tight or based on terms which are not in compliance with the Shariah principles. This can be solved by the pro-active attitude from the regulators in understanding the needs of the financial markets.

Human Resource: Islamic finance from the very first day of its head to head launch in the commercial markets against conventional financial institutions is faced by the lack of relevant human resource. Sukuk are one of the most effected sectors of Islamic financing market. We have witnessed some of the Sukuk being categorized as non-Shariah compliant by Islamic Scholars, and I believe that lack of relevant human resource with adequate knowledge of Shariah structures have resulted in that mishap. The only solution to this is increased education among the users and particularly at the product development levels.

Education and Knowledge Sharing: We have seen that knowledge has been confined to some geographical region, here from knowledge I mean, literature and people. We can see that this has confined the complex and useful Islamic financing products to the geographical boundaries of these regions. The solution to this is very simple, and that is, lets share!

Shariah Compliance: Here I am talking about Shariah compliance structures, which are implemented, regulated and monitored. This will help in protecting the interest of the states / countries, where Islamic financial institutions are operative. This will also help in harmonization of Islamic financing products across the globe. This can be achieved by setting up Shariah Governance and Supervisory Boards as legislative bodies for Islamic financial institutions.

Product development: Product development is a difficult task for any of the financial institution, and specifically for an Islamic financial institution as, it has to go through different screening and approval processes. Due to the development in Sukuk structures, innovated Sukuk and high demand of Sukuk in capital markets, we can see that every Islamic financial institution wants to come up with a Sukuk structure which should be from its own distinctive class. The problem face by an Islamic financial institution in this process is of the knowledge of Shariah compliant product development. We have seen Sukuk structures being criticised by Islamic Scholars in Middle East, and I reason this criticism to the product structures.

I would like to conclude my words by saying, Islamic Financial industry has made remarkable progress and this progress has helped in uplifting of individual lives, unlike conventional financial institutions, which are trying to accumulate wealth in certain hands.

Jazak-Allah

Wassalam.

Note:

Global Islamic sukuk issued in USD so far...