Steady growth needed in sovereign issuances

Published in MEED, 7 December 2015

Islamic bonds are expected to play a greater role in propping up government finances and government-related issuers are expected to have the upper hand in the market.

There is no getting away from the fact that the sukuk (Islamic bond) market is going through a tough time. Globally, the value of issuances dropped sharply in 2015, according to data from US/Canada-based Thomson Reuters. In the first nine months of the year, sukuk issuance totalled about $48.8bn, compared with $79.5bn in the same period in 2014.

Part of that fall stems from the decision by the Central Bank of Malaysia to move away from using sukuk as a liquidity management tool for the country’s Islamic banks. Just as important, however, was the fact that no one else came to the market to pick up the slack. Uncertainty over US interest rates has been among the factors that seem to be holding some issuers back.

This trend is certainly visible in the Gulf. The GCC is the second-most important market for sukuk after Malaysia, with a total market share of between 20 and 30 per cent in recent years. However, issuance in the main Gulf markets has been on the slide.

In Saudi Arabia, the value of sukuk issuance has dropped from $15.2bn in 2013 to $12.1bn in 2014 and $5.4bn in the first nine months of this year. Issuance in the UAE fell from $7.1bn to $5.7bn and then $4.7bn over the same period.

However, there is some hope that sovereign issuance may start to turn things around. GCC governments need to raise finance to deal with their ballooning budget deficits and the bond market is an obvious place to turn, whether in terms of conventional or sharia-compliant finance.

“In the GCC and more generally as well, the funding requirements of sovereigns are lending a bit of a new lease of life to the sukuk market,” says Jarmo Kotilaine, chief economist at Bahrain’s Economic Development Board.

When making a decision on what type of bond to issue in the past, Gulf governments have more often than not opted for conventional bonds over sukuk. One consequence of this is that Islamic banks have plenty of liquidity available that could be used to invest in any sukuk that are launched.

“A lot of the Islamic institutions have more liquidity than the conventional institutions,” says Najla al-Shirawi, CEO of Securities & Investment Company (SICO), a Bahraini wholesale bank. “Most of the conventional institutions were buying the conventional issues from the government. So that sucked up a lot of their liquidity. The Islamic institutions have not seen the same pace of Islamic issues from the governments, so the liquidity remained intact.”

Given that banks are the dominant buyers of sukuk, that is a position that will be welcomed by many Gulf finance ministries as they try to put their fiscal house in order. Oil prices are expected to rise only slowly at best over the coming years, which means deficit management is likely to be one of the most important issues facing governments for some time to come.

“There is a pool of Islamic liquidity that is available and will play an important role in bridging these [fiscal] deficits,” says Nitish Bhojangarwala, assistant vice-president of the financial institutions group at Moody’s Investors Service, a US ratings agency.

The banks are, however, being adversely affected by other aspects of the current fiscal climate. Along with issuing more debt, governments have also been drawing down some of their savings to help cover their spending needs. In some cases they have done this by selling off assets held by their sovereign wealth funds, but they have also been drawing down their bank deposits.

Across the region, the authorities play a critical role in providing deposits for both conventional and sharia-compliant banks and, while their withdrawals have been relatively limited so far, the potential consequences of this are far-reaching. Even at the current rate of withdrawals, there has been an notable impact, with banks having less money to lend or to invest in bonds or sukuk.

“A lot of liquidity in the GCC environment is driven by the government deposits within the system,” says Bhojangarwala. “In 2015, we started seeing a sharp reduction in the deposit growth, which then means on the asset side banks will scale back as well. That is what we are seeing on the sukuk side. Credit appetite in general has come down, primarily driven by the reduction in deposit growth.”

All this creates a rather uncertain picture for the sovereign sukuk market in the region and there are mixed views on the likely extent of sovereign issues in the future. Bahrain is expected to concentrate on conventional issues in the short term, but others such as the UAE and Saudi Arabia could see a mix of both conventional and Islamic issues. The Kuwaiti government is also thought to be looking at a sukuk listing, possibly in 2016, according to Bhojangarwala.

In Oman, the recent sukuk issue by the government could lead to further activity, according to Hamood al-Zadjali, executive president of the Central Bank of Oman.

“The government of Oman has issued its first sovereign sukuk with a successful initial offering,” he said, speaking at the World Islamic Banking Conference in Bahrain in early December. “This is expected to help to some extent liquidity management issues in the Islamic banking sector and also to have a positive impact on Oman’s capital market in general and the sharia-compliant financial market in particular. The successful launch of this first sovereign issue will pave the way for future issuances.”

The best outcome is probably slow and steady growth in sovereign issues in the near term, so that other potential issuers are not crowded out of the market. If governments become too enthusiastic with sukuk issues, they could take up too much of the available liquidity, meaning the region’s large corporates might find it difficult to sell any sukuk issues of their own.

As it is, the tough market conditions look likely to continue for many issuers in the short term, but government-related issuers are expected to have the upper hand.

“There is liquidity there, but it is for specific players,” says Mohammad Farrukh Raza, managing director of IFAAS (Islamic Finance Advisory & Assurance Services), a consultancy specialising in Islamic finance and based in the UK.

“Not everyone will be able to tap the market in the near future. Historically we have seen a lot of players come to tap the market periodically; now we will see a few players tap the market regularly in the near future. I think the market at the moment is ‘wait and see’. [Investors] will only touch good, government-related entities that have issued in the past as well. That’s where the funding will go in the near future.”