Developments in Islamic Capital Markets

1. Introduction

The growth of Islamic capital markets is a direct effect of the growth of the Islamic banking industry. The need for liquidity management for Islamic banks and takaful operators drove a number of countries such as Malaysia, Kuwait and Bahrain to introduce sukuk to facilitate the management of assets by Islamic financial institutions. Growth is also attributed to growing awareness of, and demand for, investing in accordance with Shari’a principles. In more recent times, growth is attributed to the globally low-interest rates, the weakening US Dollar over the past 25 years, and the sub-prime mortgage crisis in the West prompting investors to seek alternative investments.

The importance of the Islamic capital markets within the conventional financial markets is becoming increasingly clear as evidenced by the move of regulators to establish standards and guidelines. In recent years, international Islamic bodies such as the Islamic Financial Services Board (IFSB) and the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) have formulated standards for the Islamic financial services industry. The Islamic capital markets star product is undeniably the sukuk. Most studies show that sukuk remains a major instrument within the suite of Islamic capital market products.

However, even with the impressive growth of the Islamic capital market, questions are being asked as to the inclusivity of the market. Are the products on offer simply to satisfy well-moneyed customers? If this is the case, then is the industry following the original intents and purposes of Islamic finance? This chapter looks into these issues. After assessing the state of the Islamic capital markets, attention will be given to the development of retail sukuk in Malaysia. This Special Focus section provides the potential of developing an Islamic capital market product that can benefit a wider section of the population. Following this, a proposal for an innovative instrument, Esham, which was used by the Ottoman government for well over a century to fund their current accounts, is made. This innovation can increase investment participation. While the industry is progressing, more needs to be done to spread the benefits and ensure stable and inclusive economic growth.

1. The sukuk market

Following Mufti Taqi Usmani’s criticism of sukuk in 2007 in which he opined that approximately 85% of sukuk are non-compliant, there resulted a significant drop of 50% in the primary sukuk market. After a series of developments and enhancements following his remarks, sukuk has become even more popular for both corporate and sovereign entities to raise funds and tap into the world’s wider investor base. This has certainly opened doors to the international markets, especially for the GCC where most HNWIs in this region are faith-based investors.

The development, in terms of structure and mechanism, has diversified issuer choices in raising funds based on the needs and nature of their businesses. From 1990 to 2012, there have been many exciting innovations made to the underlying sukuk structure. In 2004, Dawama was the first to issue a hybrid sukuk merging murabaha and ijara as the underlying contracts. This paved the way for the first international hybrid sukuk issued by Durrat Al Bahrain in 2005, which combined ijara and istisna. In quantifying the industry, Kuwait Finance House Research (KFHR) reports that whilst the Islamic finance industry grew at an average rate of 15% – 20% per annum over the past decade to reach approximately USD1.3 trillion in terms of assets, the sukuk industry grew at a compound annual growth rate (CAGR) of 67% to reach above USD230.0 billion outstanding sukuk papers as of 2012, and contributes approximately 14.3% of the global Islamic finance assets. In 2012, there was a total of USD131.2 billion worth of sukuk recorded in the primary market, representing 54% year-over-year growth. This surpasses and dwarfs that of the previous year and represents three times the size of the primary sukuk market pre-global financial crisis. (Figure 1).

The MENA region accounted for 15% of global sukuk issues in the fourth quarter of 2012, up from 2011 but below the previous quarter’s levels (Figure 2). In numbers, the MENA region was, in 2012, the domicile for approximately USD 24.5 billion worth of sukuk issues (2011: USD 19.8 billion). In 4Q12, sukuk worth about USD4.4 billion were issued throughout MENA as compared to the same quarter in 2011 of USD3.3 billion.  In 2012, sovereign entity issuances reached USD80 billion, representing 36% increase year-over-year (2011: USD59 billion). Although sovereign papers cover more than 50% of total issuance, they were overshadowed by significant growth in both corporate and government-linked entities which grew by about 92% and 103% to USD37 billion and USD15 billion respectively.

In terms of issuer type, despite the record amount of corporate sukuk placed during the year, sovereign-linked entities continue to dominate the market. New jurisdictions with debut sukuk issuances in 2012 include Kazakhstan and France. The Development Bank of Kazakhstan initiated the first debut sukuk through its5-year USD76.7 million sukuk murabaha having been issued in Malaysian ringgit. It marked the first paper from the CIS region which could act as a benchmark for subsequent issuances within that country and area. The French sukuk mudaraba was issued by Bibars SAS in Euro-denomination and was worth up to USD 7,000,000 in October 2012.

The future of the industry remains promising. According to estimates by Ernst & Young’s Global Islamic Banking Center of Excellence, the global demand for sukuk is forecasted to grow threefold from USD300 billion to USD900 billion by 2017.

 Developments in the Islamic capital markets

To uphold the integrity of the market and meet the demand of an increasingly sophisticated investor class, there is a need to strengthen the policy and market practices of Islamic capital markets. The development would need to balance the needs of both parties, where, in sukuk cases, issuers are seeking more options and flexibility to raise funds whereas investors are demanding more protection on their investments.

Other products

Other than sukuk, the Islamic capital markets include Islamic equity, Islamic funds, Islamic real estate investment trusts (REIT), and Islamic exchange-traded funds (ETF). Developments are relatively modest in comparison to sukuk. Focusing on Malaysia, Table 1 provides a useful microcosm of the overall Islamic capital markets. We see that the number of Shari’a-compliant securities that have been issued in 2011 and 2012 is significantly more than the number of unit trust funds, ETFs and REITs in the markets.

 Basel III-compliant sukuk Globally, the market is moving towards issuing Basel III-compliant sukuk which is seen as an exciting opportunity for banks to raise capital. Studies have shown that dealers find the new decree as an occasion for Asian banks to sell their own capital-compliant sukuk to attract more diverse investors. Already, Abu Dhabi Islamic Bank’s (ADIB) Basel III and Shari’a-compliant perpetual sukuk worth USD1 billion has been issued (November 2012) and achieved a relatively low yield due to the uniqueness of the deal. Malaysian banks are likely to follow given their familiarity and expertise, strong funding base, and good credit ratings.

Covered sukuk

A new type of sukuk, covered sukuk, is expected to offer investors greater security through a structure similar to conventional covered bonds. During the global financial crisis, by providing recourse to a pool of assets when the originator becomes insolvent, covered bonds found a new lease of life in Europe and the United States as investors sought a more liquid and safer haven to invest in.

The structure could be applied to Islamic capital markets in diversifying the product offering if tax and pricing issues could be resolved to the satisfaction of investors. The structure was used for the first time by London-based Gatehouse Bank via private placement in December 2012. The 5-year sukuk ijara issue, worth USD10.4 million, was backed by a property in Basingstoke which the bank acquired in 2011.

The covered sukuk operates in the following way: a purchase undertaking by the bank that gives primary security to sukuk holders, while in the case of default, they have secondary security on the property acquired. This replicates the structure of covered bonds, where investors are entitled to claim not only issuer assets but also the assets backing the structure, giving them two layers of security.

Retail sukuk

A recent development in the Islamic capital markets is the introduction of retail sukuk. The product has been offered in London, Indonesia, South Africa and a few other countries. Retail sukuk provides a promising avenue as it renders a stable income and is less volatile, but carries the same risks due to the product’s very nature. In Indonesia, investors are given direct access to a larger pool of capital by providing a platform to retail investors. Most retail sukuk was issued by the finance ministry of Indonesia. Indonesia started to issue retail sukuk in 2009 – Standard Chartered in its research noted that 57% out of Rp1.7 trillion were subscribed by the retail investors. Recently, the ministry announced that there will be another issue to be launched in early 2013 with indicative proceeds target of up to Rp15 trillion. Offering 6% profit per annum, the ministry has appointed 25 selling agents, consisting of 16 banks and 9 securities firms. Research shows that the proceeds raised from such issuance will be utilised to support the state budget.

On 1 February 2010, the London Stock Exchange launched an order book for retail bonds. Though the trading service offers access primarily to conventional bonds, it does not restrict the offering of retail-based and traded on the on-screen secondary market. The exchange claimed, other than transparency and a well-regulated framework, the platform is the first of its kind allowing private investors to trade fixed-income securities as easily as they would trade shares. Malaysia has taken a further step forward by offering the same to retail investors. Prior to implementation, Malaysia only opened the sukuk and bonds market to institutional and corporate clients with substantial investment for initial participation. The limited access to sukuk was indirect and only available through unit trust and exchange-traded funds. The framework for retail sukuk and bonds in Malaysia was developed pursuant to the SC’s Capital Market Masterplan 2 to facilitate greater retail participation in the bonds and sukuk market. Under this framework, potential issuers are able to issue retail sukuk or bonds either on the Malaysian exchange (Bursa Malaysia) via its newly developed platform, Exchange-traded Bonds and Sukuk (ETBS) – where the sukuk is available for trading on the exchange or over-the-counter via appointed banks. This would assist issuers in tapping into a larger pool of capital as well as gaining better pricing on their issuances. A recent example is Malaysia’s notable sukuk issuance by DanaInfra Nasional Berhad’s RM8 billion Islamic medium term notes programme (Figure 4). More information can be found later in the Special Focus section below.

Framework on agro-sukuk

Agro-sukuk is rather a new-fangled avenue for investors. Specifically, this type of sukuk is offered as an option to potential issuers with core businesses engaging in the agricultural-related sector. This indeed will stimulate further development in the Islamic capital and equity markets.

In Malaysia’s 2013 Budget, the Prime Minister announced the country’s intention to introduce an agro-sukuk framework to the market in the near future. The country’s regulator, the Securities Commission (SC), will provide such a framework in order to raise capital to finance agricultural companies and agro-related industries. As encouragement, the Malaysian government proposes that the expenses for the issuance of agro-sukuk be given a double tax deduction for a period of four years effective from 2012.

The possibility of CSR sukuk

A corporate social responsibility sukuk (CSR sukuk), where proceeds are raised to create funding for priority social sector initiatives and decent causes, is seen as a new opportunity for investors who are in search for a different asset class of sukuk. The CSR sukuk was suggested by Iqbal Khan, the 2012 recipient of the prestigious Royal Award for Islamic Finance.

It can be issued by any endowment, institution or government that has long-term commitment budgeted for CSR activities for the next five to ten years. Due to its budgeted annual commitment, the sukuk will be repaid accordingly and therefore will initiate a good credit rating.

One of the first CSR bonds was introduced by the World Bank in 2008. In its efforts to cater to climate change, the development bank issued a bond where the proceeds were directly invested in climate change-related projects. As for a CSR sukuk, there is a long way to go as costs and benefits require evaluation.

Other developments

Islamic finance, in general, has gained popularity due to its competitiveness. Jurisdictions are keen to establish their own Islamic financial activities via the introduction of Islamic capital market instruments where sukuk will be the most prominent instrument to start with. Many countries are exploring opportunities in Islamic finance, and the organisation of forums and seminars throughout the world suggests there is a lot of interest.

ASEAN

ASEAN regulators in January 2013 discussed the possibilities of regional cooperation in the Islamic capital market as part of the ASEAN Capital Market Forum’s effort to better integrate the regions’ capital market activities. This is expected to boost cross-regional transactions and activities in the Islamic capital market so as to enhance the ASEAN’s competitiveness and to achieve greater economies of scale utilizing numerous resources across the ASEAN region.

Japan

The Japanese Securitisation Law has been amended to facilitate the issuance of the J-Sukuk. The tax law allows both local and foreign investors to be exempted from tax when it comes to issuing sukuk. Though the market in Japan is new, it is believed that the J-Sukuk may soon become popular among Japanese entities. Although no local entities have made their mark in the J-Sukuk market, Nomura Bank has issued one sukuk overseas, proving that local players are taking part in Islamic finance even if the J-Sukuk market itself has proven slow to take off. On the positive side, amending the tax law has levelled the sukuk playing field with conventional bonds in the Japanese capital market.

Maldives

The Maldives Capital Market Development Authority (CDMA) has signed a memorandum of understanding with the Ministry of Islamic Affairs to develop Islamic capital markets activities within the country. In order to promote Islamic financial services within the jurisdiction under one organization, the country proposes to establish the Maldives Centre for Islamic Capital Market and Finance. In addition, the government has issued MVR150 million (USD9.75 million) sukuk wakala bi al-Istithmar papers to facilitate the Shari’a-compliant liquidity management for the country’s only Islamic bank, Maldives Islamic Bank. Proceeds raised from the issuance will be used for oil trading activities of Fuel Supplies Maldives, a subsidiary of the government-owned State Trading Organization. The issuance was divided into three tranches with a maturity of 6 months per tranche.

Challenges ahead

Lack of liquidity in the secondary market has been a concern since the inception of the Islamic capital markets. The behaviour of investors, known for their predilection for buy-to-hold papers to maturity, and the lack of investor diversity are perhaps some of the main reasons for the current deadlock in the secondary market. Notwithstanding the efforts from the central banks, such as the Central Bank of Bahrain and Bank Negara Malaysia, to stimulate the growth of this market through the issuance of short-term papers and the establishment of Islamic International Liquidity Management (IILM), the market has yet to truly yield the results of these efforts. The lack of product supply, especially sukuk papers, and with issuances from highly-rated issuers and sovereigns remaining sparse, sukuk holders are holding onto securities until maturity. Investors are then unable to purchase enough papers. These supply and demand imbalances have inhibited trading on the secondary market for fear of not finding other papers of similar credentials and good ratings to invest in. Sime Darby’s recent USD1.5 billion sukuk issue can be seen as a result of a lack of quality papers in the market as it was oversubscribed by 10 times

Conversely, based on the issuance momentum seen at the end of 2012, the global sukuk market is expected to illustrate strong but moderated growth between 20% and 30%, underpinned mainly by weaker-than-expected global economic growth. The weaker forecast will absolutely shift the appetite of investors, regardless of whether they are corporates or HNWIs, to fixed income-based instruments which would render safer investment returns. Sovereign issuances are expected to dominate the market in 2013, similar to 2012. The sukuk market in 2013 will be spurred further by the new jurisdictions that have shown interest in applying Islamic finance and using sukuk. Egypt, Libya, Tunisia, Senegal, and Nigeria are expected to make the necessary regulatory amendments for future issuances.

Last but not least, Malaysia, given the recent growth forecast of above 6% for 2013, has produced a good breadth of the country’s investment prospects. More investments are expected to flow into the country and this will increase the number of projects that could indirectly boost the Islamic capital markets through its diverse fund-raising tools, particularly sukuk. Given its current position as the home of the world’s largest sukuk market with various incentives offered, Malaysia will continue to be an Islamic finance hub in years to come.