Global sukuk issuance falls by 15.3%

Muscat: The global sukuk market experienced a significant slowdown in issuance in the first half of 2018, as predicted by S&P Global Ratings in January. The total sukuk issuance dropped by 15.3 per cent compared with the same period last year, reaching $44.2 billion compared with $52.2 billion in the first half of 2017.
This drop was even more pronounced for foreign currency sukuk issuance at 45 per cent. S&P believes this is due to the absence of major issuances from the Gulf Cooperation Council (GCC) countries seen in 2017.
In the second half of 2018, S&P expects sukuk issuance volumes will continue to be slowed by the global tightening of liquidity conditions, as well as by lower financing needs of some GCC countries as a result of oil prices stabilising at higher levels. The sharp increase in geopolitical risks in the Middle East will also likely weigh in on investors' appetites.
Meanwhile, inherent challenges related to the sukuk market continue to drag on expansion of this market. That said, S&P believes that Malaysia will continue to support market growth, owning to its strong market foundations and government support for Islamic finance. Overall, S&P maintains its expectations for the volume of issuance at $70 billion-$80 billion in 2018.
Demand is dropping, but why?
The total sukuk issuance in the first half of 2018 dropped sharply compared with the same period in 2017. The absence of jumbo local and foreign currency issuance by some GCC countries explains this mediocre performance.
On a positive note, S&P understands that some of these countries are on the starting blocks with potential issuances in the second half of 2018. However, S&P expects the overall volume of issuance for 2018 to remain subdued, at around $70 billion-$80 billion, compared with $97.9 billion last year.
Global liquidity is tightening
S&P expects the tightening of global liquidity that started in the first half of 2018 to continue. Specifically, it expects the US Federal Reserve to hike its federal funds rate by another 50 basis points in the second half of 2018 after the two increases in the first half and that central banks of GCC countries will probably mirror such an increase due to the peg of their currencies with the US dollar.
In the same vein, after reducing the pace of asset purchasing (AP), the European Central Bank (ECB) will likely wind down its AP programme in December 2018 and start to raise interest rates in the third quarter of 2019. Overall, S&P believes that the liquidity channeled into the sukuk market from developed markets will reduce and become more expensive. Currently, European and US-based investors generally account for some one-quarter of sukuk investment in terms of volume.
At the same time, muted economic growth and declining lending activity in the GCC have shifted banks' focus to capital market activities in hopes of achieving higher yields than with cash and money market instruments.
Geopolitical risk is flashing red
The recent reinstatement of US sanctions on Iran and the continued animosity between Iran and some of its GCC neighbours are not helping investors' perceptions. Financing needs are declining in the GCC. S&P considers that GCC countries' need for financing is reducing as liquidity conditions improve.
This is thanks to higher oil prices, which S&P now expects to remain at some $65 per barrel in 2018, and continued expenditure reduction by GCC countries since 2015. Overall, the rating agency thinks that the gross commercial long-term debt issuance of GCC countries will decline by 15 per cent in 2018 from 2017.
In contrast, the repeal of the goods and services tax in Malaysia without sufficient offsetting measures could result in higher fiscal deficit and financing needs for the country. This could further boost its sukuk issuance. In the first half of 2018, the total sukuk issuance in Malaysia increased by around 50 per cent compared with the same period last year, underpinned by higher government and corporate issuance.
Standardisation is progressing slowly
Standard-setting bodies have made significant efforts to drive forward the standardisation of sukuk, but there is still work to be done. Some market participants still think that standardisation is unrealistic and that it would be better to aim for harmonisation—that is having standards, although these may vary across jurisdictions—and leave some flexibility for implementation.
S&P sees this as the status quo. Cases similar to Dana Gas — where the issuer reportedly defaulted on its $700 million sukuk on the basis that the instruments were no longer compliant with the Sharia law — will act as regular wake-up calls and bring the standardisation debate back on the table.
The rating agency continues to see standardisation as an important topic and notes that fixed-income investors tend to shy away from instruments with limited visibility on post-default resolution. Standardised Sharia requirements could prevent potential uncertainty on compliance after a transaction closes, and are therefore key in helping investors better understand the risks involved. Similarly, standard legal documentation provides clarity for investors on the recourse options available in the event of a default of a conventional bond. This is still lacking in Islamic finance.
S&P recognises, however, that the Islamic finance market has achieved a certain level of standardisation for the most common structures, while a few new instruments still need some refinement. In particular, investors are asking for additional clarity on the risks related to the Murabaha-Mudaraba structure that is widely used in some jurisdictions. S&P is of the view that standardisation for cross-border sukuk issuance is not only achievable, but will also boost the volume of issuance. It will improve the attractiveness of the instrument to issuers by making the issuance process smoother and faster and by providing more clarity on the underlying risks.