RIYADH, 1 October 2007 — The sukuk market is currently valued at over $50 billion and it is projected to reach $150 billion by 2010. In 2006, 80 sukuk issues raised $18.15 billion globally, with a large share of this issuance occurring in the Gulf region.
So far this year, 58 sukuk issues have raised over $20 billion. In the GCC alone, the sukuk market has accounted for $16.50 billion or 33 percent of the total global sukuk issuance. Increasingly, the takeovers of foreign firms by Gulf-based corporations are being financed with sukuk. For instance, last year’s takeover of P&O by Dubai Ports was financed with the issuance of a $3.5 billion convertible sukuk.
What is driving this massive issuance of sukuk? Plainly, it is a combination of the economic boom being witnessed in the GCC coupled with an increasing acceptance of sukuk as a mode of financing this growth.
High oil prices have resulted in large surpluses for Gulf countries and created opportunities for strong economic growth. Thanks to the oil windfall, oil exporting countries’ cumulative current account surplus increased from 5.4 percent of GDP in 2002 to 20 percent last year.
The focus of domestic economic policy on the private sector has made the current oil-induced economic boom different from the previous ones that the GCC has experienced. Across the GCC, the non-oil sector is currently growing at almost double the rate of the oil sector and, within the non-oil sector, the private sector has taken the lead.
Saudi Arabia’s performance is particularly remarkable as the largest economy in the region, representing more than 50 percent of the GCC, has successfully embarked on a program of economic diversification and reforms. Given the size of proposed projects, equity and government budgets alone cannot be the only source of financing for the next phase of the Kingdom’s economic growth and industrialization. Increasingly, reliance will be on debt capital markets for raising funds through sukuk and other instruments.
According to estimates, during the period 2007-11, over $200 billion of debt will have to be raised across the GCC region to finance infrastructure, petrochemicals and other projects. In the past, syndicated loans have dominated the funding of domestic investment projects. But this is now changing with capital markets gradually increasing in importance and replacing banking as the major source of funding. As a result, sukuk financing is witnessing strong growth.
Last year, the Middle East project finance market was the largest in the world with debt capital raised in the first half of 2006 amounting to $33 billion, compared to $24 billion raised in 2005 and only $7 billion in 2001. The issuance of sukuk on domestic and international capital markets is now often part of the funding package of major investment projects. In 2006, SABIC issued its first sukuk; a few weeks back, the petrochemicals giant issued another sukuk to finance its $11.60 billion acquisition of GE’s plastics business.
The growth of the sukuk market can be traced back to 1988 when the Islamic Jurisprudence Council released a decision stating that “any combination of assets (or the usufruct of such assets) can be represented in the form of written financial instruments which can be sold at a market price, provided that the composition of the group of assets represented by the sukuk consists of a majority of tangible assets”. In 2001, the earliest sukuk program was introduced to the market with the Bahrain Monetary Agency issuing domestic sovereign fixed-rate Ijara and Salam sukuk. And in 2003, the Accounting and Auditing Organization for Islamic Financial Institutions pronounced a Shariah standard on Sukuk, which became effective in early 2004.
Although issuance growth has been impressive, there are three major areas that need development to allow the secondary market for sukuk to flourish. Firstly, in the absence of a five- or 10-year benchmark yield curve in Saudi Arabia, a synthetic yield curve needs to be developed that provides comparative pricing for sukuk.
Secondly, Saudi Arabia can consider issuing a sovereign sukuk. The first and foremost objective of a sovereign sukuk is to put Saudi Arabia’s name on the map of the international capital market by making a strategic entry; borrowing from the capital market is not the goal. The second objective is to establish a pricing benchmark that serves as a gauge of economic and financial health of the Kingdom for a range of investors.
The favorable dynamics generated by the strong economic growth of the past few years have provided an ideal opportunity to greatly expand international awareness of the Kingdom’s economic progress and its continually improving policy fundamentals. In July, Standard & Poor’s affirmed this belief and raised its foreign and local currency long-term sovereign credit ratings on Saudi Arabia to “AA-” from “A+”.
Thirdly, sukuk liquidity needs to be increased in the secondary market to encourage trading and over time, increased supply of sukuk issues should achieve this. Tadawul and market makers can play a constructive role in improving liquidity over the short to medium term.
Over the past several years, the MENA region has become more integrated with the global economy, especially the US business cycle. According to Morgan Stanley, the growth correlation coefficient of Saudi Arabia vis-à-vis the US economy increased from -0.66 in the 1990s to 0.68 in the last six years. Although greater openness and integration with the rest of the world has played a role, a very important factor has been oil dependency.
Consequently, the recent US subprime-related turmoil in financial markets has had its fallout on regional GCC debt markets. As credit spreads have widened, this has affected the issuance of new sukuk. However, as long as economic growth in Saudi Arabia is not adversely impacted, demand for capital will continue to keep pace with growth, and once credit markets stabilize in the next few months, borrowers will again return to tap the sukuk market.
(Farhan Mahmood, CFA, is head of Asset Management at FALCOM Financial Services in Riyadh).