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* Designed to fill product gap in Islamic finance
* Saudi pull-out from IILM hints at tensions within body
* Exit blocks IILM's concept of "universal sukuk"
* But Saudi, other banks may still buy the issue
* Strong demand expected from mutual funds as well as banks
By Bernardo Vizcaino
DUBAI, April 18 (Reuters) - A surprise pull-out of Saudi Arabia from the International Islamic Liquidity Management Corp (IILM) may have deprived the body of a top credit rating, but its debut sukuk issue still looks set to be welcomed by a wide range of investors.
The Kuala Lumpur-based IILM, backed by central banks from the Middle East and Asia, said this month that it planned to issue as much as $500 million through its maiden sukuk programme in the second quarter of this year.
The long-awaited announcement was overshadowed by the unexpected news just three days earlier that the Saudi central bank had abruptly left the IILM's governing board, selling its shareholding to Qatar and Malaysia.
Saudi Arabia, the largest Arab economy, is home to some of the world's biggest Islamic banks, raising concern that the Saudi pull-out could remove a key source of demand for the sukuk.
But industry executives told Reuters that the pull-out would not necessarily deter Saudi commercial banks from buying the IILM sukuk - and that even if it did, demand in other countries would be more than ample.
"The IILM will be a milestone for the global integration of liquidity management in Islamic banking," said Ayhan Keser, an executive vice president at Albaraka Turk, one of the dealer banks which will be responsible for ensuring a secondary market in the IILM sukuk.
"Banks that have the IILM sukuk will have a chance to use them in open market operations. For this reason the secondary market is expected to be highly active, being an alternative investment source for both banks and their customers."
The IILM was founded in 2010 to address an obstacle to the growth of Islamic finance: a lack of highly rated, short-term financial instruments that banks and other firms could trade and hold to manage their short-term funds.
It has still not made its first sukuk issue because it has struggled since its birth with problems such as finding suitable assets to back the bonds. The IILM delayed its first issue several times and replaced its chief executive last October.
Such problems may have been behind the Saudi pull-out, though senior officials from the IILM and the central banks involved have not given a clear account of Riyadh's motives.
Some bankers say they believe Saudi Arabia's conservative central bank does not want to be involved in any way in the issuance or trading of the sukuk; issuing such multilateral instruments is not part of the normal role of a central bank.
Others said Saudi Arabia might have pulled out over the IILM's desire to have its sukuk rated as highly as possible. Standard & Poor's rated it A-1; to have obtained S&P's highest short-term rating of A-1+, the sukuk would probably have required assets from Saudi Arabia, which has that rating.
An A-1+ rating would have allowed the IILM to offer an ultra-safe, globally tradeable instrument known as a "universal sukuk", which the IILM originally envisaged.
"There was early in the IILM conception time an idea about universal sukuk. We were enthusiastic about the idea...but it seems it did not work, and probably that is why some stakeholders withdrew," said Tariqullah Khan, professor of Islamic finance at the Qatar Foundation.
But even without a top rating the IILM sukuk, which will have maturities of up to one year, may be popular enough to challenge current money market tools used by Islamic banks such as wakala and commodity murabaha contracts.
"These are fixed-term instruments and generally cannot be traded," Jason Kabel, head of fixed income at Bank of London and the Middle East (BLME), said of the current tools.
"The IILM sukuk will change this and bring Islamic finance even closer to competing on a level playing field with the conventional world."
Depending on the tenors, likely buyers of the IILM sukuk may include Islamic money market funds as well as the treasury departments of Islamic banks, said Doug Bitcon, Dubai-based head of fixed income funds and portfolios at Rasmala Investment Bank.
"A tenor of three to 12 months would be more attractive to Islamic liquidity funds, although should an active secondary market develop, I would expect Islamic treasury departments to also invest in the longer-dated (12-month) paper."
The IILM has still not revealed important details of its planned sukuk, including their structures and the assets on which they will be based. It has also not announced the full list of dealer banks, although Standard Chartered will be primary dealer, according to S&P.
The IILM has said, however, that it plans eventually to increase its issuance to as much as $3 billion. If it succeeds in creating a consistent stream of liquid sukuk, that could help break the buy-and-hold approach of many Islamic investors, an approach that has stifled secondary market activity.
"Regular repeat issuance would assist, as holders of the sukuk who required liquidity would be less concerned about selling if they knew that there will be another issuance in a week or two," Bitcon said.
Salman Al Sairafi, head of fixed income at NCB Capital, Saudi Arabia's largest asset manager, said Saudi commercial banks could welcome an additional liquidity management tool.
"The IILM sukuk will definitely help and I think we need more issuance of this type. It can be a useful tool as there is still a product gap that needs to be filled, similar to corporate paper."
Bahraini lenders may use it as well, even though Bahrain is not a member of the IILM, said Noor Abid Sharif, treasury and financial markets analyst at Bahrain's Al Salam Bank.
A key factor will be the yield that the IILM sukuk pays versus the cost of funds at individual banks.
With an A-1 rating from S&P, the IILM issuance could offer a return of 1.5 percent to 2 percent, said Sharif, who stressed that he was commenting in a personal capacity. "For banks in Saudi and Qatar, it makes a lot of sense," he said.
BLME's Kabel said such a safe asset might also attract institutions further afield. "If the yield is attractive, then conventional money market funds will also look at the issue." (Additional reporting by Al-Zaquan Amer Hamzah in Kuala Lumpur; Editing by Andrew Torchia)