Sukuk and the Real Economy: Exploring the Forgotten Link

Introduction

Sukuk has for years been considered as Islamic finance’s greatest innovation. It can be regarded as Pareto optimal in that both investors and the originators are equally benefited: the former receives a coupon rate and the later receive the needed liquidity. Moreover, Sukuk follow Islamic law making it palatable to the growing number of individuals that are concerned about the conduciveness of financial transactions with the Shari’a.

Sukuks are often regarded as Islamic bonds, and no amount of careful rhetorical wordplay can deny that there are similarities with bonds. But like bonds they provide a social function that is often forgotten to the investor searching for profits. Newspapers are replete with information about sukuk being oversubscribed, adumbrating the financial profile of sukuk often ignoring that sukuks can, and do, have tangible, real economy effects. This could be either through the generation of liquidity to help a bank or a country manage their cash flow or through the funding of infrastructural projects. The famous Qatar Global Sukuk is an example of the latter, issued to help fund the Hamad Medical City, an enclave which will have a women’s hospital, a physical medical and rehab facility, an ambulatory building, and a research institute. This is not to say that the generation of profits for the investor is not important. Investors have two main reasons for investing in financial assets: generating greater income and security for a rainy day. Sukuks can protect an investor’s income.

Thus, one cannot ignore the real benefits that sukuk can deliver. What follows is a discussion of the effects of sukuk and what it means for the investor and the invested. ISFIRE is fortunate to have practitioners who have worked on sukuk transactions to discuss their experience. We begin by describing the nexus between the real economy and sukuk. As sukuk can play an instrumental role in developing infrastructure, we will embark on a tour of three sukuk issued in Malaysia, Pakistan and Oman respectively. This sukuk have been used to generate funding for housing, transport and commercial ventures and are examples of how sukuk has the potential to propel an economy forward. Following the exposition, the discussion will move to the investor and how sukuk can make a noteworthy contribution to his portfolio. Finally, the discussion will conclude with predictions for the sukuk industry in 2014.

The importance of sukuk

Typically, reports on sukuk concentrate on the remarkable growth of security. Little attention is paid to the way sukuk investments are benefiting domestic economies and the inordinate focus on risk/return profiles ignores the simple reality that both corporate and sovereign sukuk raise funds that can help the originator to invest in the creation of tangible goods and services. We can see from Table 1 that government institutions have issued the most sukuk. The market share of government institutions issuing sukuk is substantially more than any other sector. After financial services, corporates from transport and the power and utilities sectors have issued the second and third highest number of sukuks to develop their projects. Transport includes the development of roads that typically have little monetary value unless a toll is charged. However, the creation of a network of roads, rail lines, airports, and the like help businesses transport goods and services. A strong infrastructure propels an economy forward. Similarly, power and utilities is a necessity to build a thriving economy. A constant problem for emerging markets like Bangladesh and Pakistan relates to power generation. Saudi Arabia is looking to expand its generation capacity to keep up with the kingdom’s rapidly growing power demand, which is climbing by around 9 percent per year. Saudi Electricity Co plans to issue sukuk in order to develop capacity in the near future.

The real estate sector has low market share. While sukuks, particularly ijara sukuks, generate coupons from the usufruct of property, raising funds for the purchase and development of real estate appears to be less popular. However, this is perhaps a mistaken way of looking at the figures. Purpose-developed real estate, for instance in health care, might be captured in another sector. At the same time, we can see that there have been 400 issues of sukuk for construction showing variances between what is considered real estate and developing property.

Thereafter, the shares plummet. Low market share in information technology, telecommunications, consumer goods, retail food and beverages imply that not enough is being done to encourage innovation and entrepreneurship. These are the sectors that are traditional sources of ingenuity and sukuk is an ideal instrument to facilitate the generation of funds. Much of the reason for this is to do with the high risk associated with entrepreneurial ventures. Investors will not be encouraged to invest in projects that could potentially offer little return. Moreover, sukuk tenors are generally quite low with investors clamouring for favourable returns. There is then a gap that needs to be filled in which sukuk can be used to generate the necessary funds for entrepreneurs to develop their ideas. To facilitate this governments and major entrepreneurship. These are the sectors that are traditional sources of ingenuity and sukuk is an ideal instrument to facilitate the generation of funds. Much of the reason for this is to do with the high risk associated with entrepreneurial ventures. Investors will not be encouraged to invest in projects that could potentially offer little return. Moreover, sukuk tenors are generally quite low with investors clamouring for favourable returns. There is then a gap that needs to be filled in which sukuk can be used to generate necessary funds for entrepreneurs to develop their ideas. To facilitate this governments and major corporations may wish to consider supporting entrepreneurs (just as Google, eBay, Microsoft and Facebook have) by offering a percentage of their revenue as coupon payments. If the idea and product is profitable, governments and corporations can recoup the revenue from the profits generated.

This is simply an idea and one that is unlikely to catch on! Nevertheless, there are ways in which sukuk can be used, given its multiple structures, to help develop an economy. Concentration has been on infrastructure, and for emerging markets, this is very important. Greater utilisation of sukuk offered internationally can be a means of pooling money from multiple sources. Building the infrastructure smoothens economic transactions and over time focus can be shifted. For the investor, a thriving economy will extenuate the returns. More emphasis needs to be put on innovation and ingenuity. Just as Japan, South Korea and even China have shown, it is in these areas, rather than infrastructure, that sustainable growth can be achieved. For these purposes, sukuk can be an effective tool.