The success of recent sukuk issuances show the Sharia-compliant sector is becoming a compelling alternative to conventional bonds.
Islamic finance sector is coming into its own
The recent growth of Islamic finance has proved revolutionary for two reasons: it has provided access to new sources of capital and liquidity and, equally important, it has shown the world an approach whereby ethical values can be reconciled with financial returns.
Some sources say Islamic assets worldwide total between about US$700 billion (Dh2.57 trillion) and $1tn, up from $150bn a decade ago. Some have argued that most Islamic banks, because they are new, have had neither the time nor the means to structure, in a Sharia-compliant manner, the sophisticated instruments that have caused the financial crisis. Others have argued that these sophisticated instruments go against the basic principles of Islamic finance altogether.
Immaturity, some say, may have prevented the Islamic finance industry from being affected by the crisis, meaning that it is now in a healthier shape and stronger position to rebound faster than its conventional peers and reap the benefits of the expected economic recovery. Unfortunately, such an interpretation does not bear much scrutiny. If we look at the recent evolution of the sukuk, or Islamic bond, market in the Gulf and compare it with the conventional bond market, we see that the Islamic market has not taken advantage of its positioning.
The volume of regional sukuk issuance in the first three quarters of this year has shrunk to $4.6bn from $8.7bn the year earlier, and from $11.4bn in 2007. In comparison, regional bond issuance has gone to $37bn this year from $15.7bn and $8.2bn in the first three quarters of 2007 and last year respectively. It is clear that issuers have resorted to standard means of financing rather than tapping into Islamic liquidity. The largest capital market deals this year have been conventional and the issuers have been sovereign or quasi-sovereign.
There have been only few GCC sukuk issuances in the first three quarters of this year, mainly from governments or sovereign entities such as the kingdom of Bahrain, the Government of Ras al Khaimah, the Saudi Electricity Company and Abu Dhabi's Tourism Development and Investment Company (TDIC). In 2007, the sukuk market accounted for almost 50 per cent of the total GCC capital market. In the first three quarters of this year, it decreased to a meagre 11 per cent.
How can we explain this reversal? The crisis has revealed a fragility which is characteristic of a young and inexperienced market, with little homogeneous regulation and few unanimously approved rules. Debates have been raging among scholars about what the right Sharia-compliant structures should be. Criticism of mudaraba and musharaka structures by prominent Sharia scholars in February last year has been well advertised. It has shown confusion across the market and reminded the industry that compliance with Sharia law is a matter of interpretation.
The crisis has also shown that Islamic finance is not a safe haven. For the first time in the short history of Islamic finance, GCC corporate sukuk have defaulted or are threatening to default. The Sharia-minded Saad Group in the hands of Maan al Sanea, who founded the Islamic investment bank, Awal Bank, is reported to have defaulted, inter alia, on its $650 million sukuk issued in 2007. The fate of the Saad Group exemplifies the hardships that a number of Sharia-compliant investment companies are going through, in particular in Kuwait where they have mushroomed on in an under-banked market.
It remains to be seen how local law systems deal with Sharia-compliant instruments in bankruptcy cases and whether Islamic creditors will be preferred over conventional ones in recourse to assets, given the asset-based nature of Islamic finance. The crisis will no doubt allow Islamic finance to strengthen and help it reach a certain level of maturity. The solution must lie in the themes that have been adopted by the conventional banking sector: better corporate governance and more homogeneous regulation.
The industry is ripe for consolidation and the recent announcements of mergers between Barwa and Alaqaria, two Qatari property developers that are Sharia compliant, and between Amlak and Tamweel, Islamic mortgage providers in the UAE, are testament to this. These mergers demonstrate that Islamic finance has entered into a new phase of its young history, which should be the prelude to the construction of a compelling and comprehensive alternative to the conventional financial system.
The recent success of the TDIC's $1bn sukuk issuance in Abu Dhabi (with an order book of $7bn and pricing within the spread of TDIC bond, issued in July this year, in the secondary market) testified to the deep appetite for Islamic assets. It showed that demand for solid, rated sukuk has now clearly outstripped supply. The shortage since the start of the year that has exacerbated the "hunger" for sukuk bodes well for the regional market, announcing a strong revival of sukuk next year.
Mr de Ricaud is head of Islamic finance, Middle East, and a director of Rothschild. These are the author's views and do not represent the views of Rothschild.