After a long period of relatively minimal bond market activity, the period of the global economic crisis has seen bonds and sukuk increasingly claim their place as the third pillar of the traditionally heavily bank-dominated GCC financial markets. While much of the issuance, especially in the financial services area, has been conventional, the regional sukuk markets have made particularly impressive progress as an alternative funding sources at a time when bank financing has been relatively scarce. And although the provisioning cycle in the region is largely over, the challenges of European banks in their home markets fuel uncertainty about the availability of syndicated loans.
A number of factors suggest that the sukuk market is likely to continue to see significant positive momentum in the Gulf. The wave of default-type situations appears to have passed, at least for now, and has left a legacy of a much better understanding of how to deal with them, as well as a pool of qualified professionals needed for such tasks. Consequently, risks are better understood and likely to be dealt with much more quickly. This has also contributed to the broader process of market clustering around certain widely accepted structures which are seen as more structurally robust and in keeping with Shariah law than some offerings before the crisis. Finally, there has been considerably innovation in the sukuk space, both in terms of tenors and structures. In particular, the emergence of project sukuk provides a potentially important instrument for financing the massive pipeline of infrastructure projects in the region. Such paper can serve as an important source of pooling capital from non-government sources, as well as offering an attractive investment opportunity into one of the most important growth stories of the coming decades. As far as concrete issuance prospects for project sukuk are concerned, we are increasingly moving from the stage of innovation to replication which is much faster and cheaper and should contribute to the positive market momentum.
While the ‘textbook fundamentals’ for the developing bond and sukuk markets are very strong the macroeconomically stable Gulf countries, the most compelling case comes from the region’s economic imperatives and resources. In the words of Chief Economist Jarmo T. Kotilaine of the National Commercial Bank, “The region faces an enormous economic diversification challenge linked to the ongoing efforts to employ its growing population and to create a basis for sustainable economic growth for the post-oil era. At the same time, the Gulf countries are home to exceptional pools of private and public wealth which could be much more effectively mobilized to support economic development locally. In both cases, bonds and sukuk provide an important bridge between the existing resources and these future economic opportunities.” Kotilaine was speaking at the “Strengthening the Debt Capital Markets in the Arab World” conference organized by the Arab Monetary Fund, the International Monetary Fund, the World Bank, and the European Bank for Reconstruction and Development in Abu Dhabi on May 23.
Project sukuk issuance in Saudi Arabia began with the $1 billion Saudi Aramco Total Refining and Petrochemical Co. (SATORP) offering in October, which will be used toward the company’s Jubail refinery. Highlighting intense interest, total subscriptions reached SR3.7 billion. An even more encouraging development was the landmark SR15 billion “Jeddah airport” sukuk issued by the General Authority for Civil Aviation (GACA) in January. The 10-year murabaha structure enjoyed a sovereign guarantee which allowed it to be priced at “only” 2.5 percent — only 50 bps above US Treasuries. In spite of this, the issue was 3.5 times oversubscribed. SAMA has approved the issue for repo arrangements with zero risk for capital adequacy calculations. Functionally, the GACA issue is therefore the closest thing Saudi Arabia has to a sovereign sukuk.
Similar issuance is likely to continue and the level of the recent oversubscriptions highlights the intense pent-up demand for quality long-term paper. Although some market practitioners resist the idea of government-guaranteed bonds/sukuk as more complex and expensive that direct government issuance, the GACA issue suggests that such considerations need not constitute a major obstacle. The Saudi authorities have repeatedly indicated that government bond/sukuk issuance should be based on a genuine fiscal need, which clearly does not exist in the current oil market environment. By the same token, however, the government recognizes that the absence of budgetary pressures does not have to prevent the emergence of sovereign benchmarks. Finance Minister Ibrahim Al-Assad recently noted that he would expect more sukuk issuance by government agencies that “can generate income and operate commercially.”
A number of such projects are planned with airport, seaport, and overland infrastructure ventures, not to mention the massive housing needs which would further benefit from the implementation of the eagerly awaited mortgage law.
The GACA precedent offers an attractive solution for government-sponsored sukuk market development with a direct government issuance program. While reducing the demands on the government budget by tapping other funding sources, such a model will clearly require well defined procedures and a high level of transparency about the use of government guarantees. The experiences of some of the Dubai government-related names highlight the need for caution and proper planning. On the other hand, success in this area promises to create virtual benchmarks, thereby facilitating the pricing of corporate issuance. The potential for relatively swift progress is considerable as recent developments point to growing interest by issuers and buyers alike. Better defined procedures should in turn reduce costs and increase the pool of potential market entrants beyond the largest, often government-owned blue chip companies.
The case for sukuk remains compelling
