Jan 22 The birth of three new sources of sovereign sukuk - Britain, Luxembourg and Hong Kong - will broaden the market in Islamic bonds, helping in a small way to ease a shortage of top-rated paper that hurts the ability of banks to manage their funds.
However, a full solution to the shortage probably depends on a decision by Gulf Arab governments to boost their regular, international issuance of sovereign sukuk - a policy which they show no sign of adopting.
Issuance of sukuk has been rising rapidly in recent years; global issues hit an all-time high of $134.3 billion in 2012, before falling to $114.3 billion in 2013 as jitters about U.S. monetary policy constrained sales of most kinds of debt.
Growth is expected to pick up again this year as the pool of Islamic funds in the Gulf and southeast Asia continues to expand. A Thomson Reuters study predicts issuance of $130 billion in 2014 and $237 billion in 2018.
But the international market still lacks a steady supply of top-rated sukuk, which are available only from a small number of sources such as the AAA-rated Islamic Development Bank and the International Islamic Liquidity Management Corp (IILM), rated a notch lower.
The IDB is expanding its London sukuk programme to $10 billion from $6.5 billion, has a 1 billion ringgit ($300 million) programme in Malaysia, and plans also to list sukuk in Dubai. The IILM has $1.35 billion of outstanding sukuk and aims to raise this as high as $2 billion.
The few other highly rated international issuers include Qatar, rated AA by Standard & Poor's, which issued $4 billion of sukuk in 2012 - the biggest U.S. dollar-denominated issue of Islamic bonds ever.
While conventional banks around the world can invest in the huge supplies of highly rated, interest-bearing sovereign bonds issued by the United States, Germany, Britain, Japan and other countries, Islamic banks cannot.
Governments in the Muslim world are often too rich to need to issue large amounts of sukuk, as in the case of the Gulf oil producers, or too financially constrained to be able to issue much, as in North Africa. This makes it difficult - and expensive - for Islamic banks to manage their balance sheets.
"There remains an acute shortage of high-quality sukuk in the market, and as such this constrains the liquidity management capabilities of Islamic banks," said Khalid Howladar, senior credit officer at Moody's Investors Service.
That is why the emergence of new sovereign issuers of sukuk is so important for Islamic finance. In October, Britain revealed plans to sell sukuk as early as this year, seeking to become the first sovereign outside the Muslim world to do so. It is still rated AAA by S&P.
AAA-rated Luxembourg, which competes with London as an Islamic financial centre, responded in early January by presenting a draft bill to parliament that would permit its own sovereign sukuk issuance.
A spokeswoman for Luxembourg's finance ministry said approval of the bill would ultimately depend on the legislative calendar, which was not yet known. But Luxembourg may be a step ahead of London as its bill identifies three real estate assets to back its sukuk; Britain has not yet released such details.
Luxembourg could come to market in a matter of months, a source there said; it has a tested legal structure, a law covering securitisation vehicles that was introduced in 2004 and has been used by the Luxembourg-domiciled sukuk from the IILM.
Legal structures are crucial in the design of sukuk, as the instruments can face heavy taxation because they involve multiple transfers of the assets backing them.
Also this month, Hong Kong's AAA-rated government said it hoped to raise funds with the territory's first sovereign Islamic bond after the introduction of new laws.
"We hope that the bill will be passed as early as possible to provide impetus to the development of a sukuk market in Hong Kong," a spokesperson for the territory's Treasury told Reuters, without giving a time frame.
Hong Kong would issue under an existing bond programme, and it accumulated experience several years ago studying a proposal for a sukuk issue by its airport authority which did not materialise. It introduced tax legislation last year to facilitate local issuance of sukuk.
All these factors would help speed up a Hong Kong deal, said Davide Barzilai, partner and Asia Pacific head of Islamic finance at law firm Norton Rose Fulbright in Hong Kong. He added that the bill could be passed as early as the first quarter, followed quickly by an issue.
"I don't think there is a new learning curve needed, they have already done that. This is not a race, but as it happens we (the three new sovereigns) are all moving at a similar pace."
Initial volumes from these centres will not be large, however. Britain has said its first sukuk would be about 200 million pounds ($330 million), and would probably be a "one-off" rather than the start of a regular programme. Luxembourg's bill envisages a size equivalent to 200 million euros ($270 million).
These amounts are dwarfed by the tens of billions of dollars worth of demand for highly rated sukuk expected from Islamic banks and other investors in coming years.
Unfortunately for these investors, this demand does not look likely to be satisfied by Gulf governments. Qatar now appears to be focusing on developing its domestic debt market, issuing 11 billion riyals ($3 billion) of local currency sukuk to local banks this month; its finance minister said in December that he had no plan for international debt issuance in 2014.
Saudi Arabia's General Authority for Civil Aviation, guaranteed by its AA minus-rated government, issued a massive 15.2 billion riyal ($4.05 billion) of sukuk last October, but that was in its domestic market. The government has been paying down its outstanding debt, which is very small, and has shown no sign of issuing sovereign sukuk internationally.
With its huge cash reserves, the Abu Dhabi sovereign has never issued sukuk and has not made public, international debt issues its debut deal in 2009. Dubai has been relatively active issuing sukuk, but has not sought a credit rating.
Nevertheless, the new sukuk issues from Britain, Luxembourg and Hong Kong should benefit Islamic finance at the margin. Barzilai said they would help some banks meet liquidity and capital requirements under Basel III rules which will be phased in around the world over the next few years.
"These issuances, depending on the currency, are a step in creating a level playing field for Islamic banks," said Nigel Denison, head of treasury and wealth management at Bank of London and the Middle East.
Another benefit is a potential widening of the range of currencies in which highly rated sukuk are denominated. The vast majority of international issues have been in U.S. dollars, but both Britain and Hong Kong plan local-currency deals, while Luxembourg could issue in either euros or dollars.
At present there is next to no cross-border trade in highly rated sukuk; primary dealers hold on to the IILM instruments after auctions and there has been little if any secondary market sales of them, said an official at one of the primary dealers.
An expanded flow of sovereign sukuk could move the industry closer to a tipping point where liquidity is high enough for secondary market trade to begin.
There is also the hope that sovereign issues from Britain, Luxembourg and Hong Kong will be imitated by other new issuers which want to attract funds from the Gulf and southeast Asia.
"Other European sovereigns may also follow the UK's lead," said Howladar.
Private corporations in the West may look more closely at sukuk, said Denison. "These transactions from the UK, Luxembourg and Hong Kong will help create a more liquid market by meeting the current demand, but will also raise awareness of sukuk and attract more conventional issuers."