By Dr Mohamed Damak
The global Islamic finance industry is expected to grow by 10 percent – 12 percent in 2021-2022 and the growth of Islamic banking assets in some Gulf Cooperation Council (GCC) countries, Malaysia, and Turkey and sukuk issuances exceeding maturities explain this performance.
Islamic finance grew rapidly in 2020, albeit at a slower pace than in 2019, despite the double shock from the pandemic and the drop in the oil price. Although we expect a modest recovery for most core Islamic finance countries in 2021-2022, we think that the sector will expand against the backdrop of continued standardisation and integration.
Within the GCC countries, we expect financing growth in Saudi Arabia to remain strong, fueled by mortgages and by corporate lending as the country implements some of its Vision 2030 projects. We also expect some growth in Qatar supported by investments related to the upcoming World Cup, and to a lesser extent the United Arab Emirates where the Dubai Expo is likely to help boost economic activity.
On the sukuk front, we expect total sukuk issuance of about $140 billion – $155bn in 2021 as compared to $139.8bn in 2020. In the first-half of 2021, sukuk issuance volumes increased 5 percent (20 percent including primary issuances only) due to strong liquidity, low interest rates, and some issuers returning to the market.
Sustainable finance goes hand in hand with Islamic investing
The additional challenges related to compliance with Accounting and Auditing Organisation for Islamic Financial Institutions’ (AAOIFI) standards in the GCC has slowed some issuers, though.
The overall takaful sector and funds has a relatively small contribution to the overall industry, it is expected to grow this year. The takaful sector is expected to expand at 5 percent-10 percent, while the funds industry might see some growth as investors chase yields.
Potential risks
There remains high, albeit moderating, uncertainty about the evolution of the coronavirus pandemic and its economic effects. Some emerging markets may only be able to achieve widespread immunisation by year-end or later. Overall, we believe a 10 percent-12 percent growth rate for the industry (excluding Iran) over the next two years is achievable.
Will inclusive standardisation eventually happen?
Sukuk instruments remain more complex and time consuming for issuers than conventional bonds. What’s more, some jurisdictions’ adoption of AAOIFI standards has already caused some difficulties for sukuk issuers in early 2021, particularly those with hybrid structures that combine a commodity murabaha with tangible assets.
In the first half of 2021, the UAE particularly saw the steepest decline with a 50 percent drop in issuance volumes due to the adoption of AAOIFI Sharia Standard 59, which covers the sale of debt. The standard was finalised by AAOIFI in December 2018 and came into force in the UAE starting this year.
It has depressed hybrid sukuk issuance in part because it altered the requirements around an important transaction feature necessary for shariah compliance, the tangibility ratio.
In the past, the tangibility ratios of these structures were complied with on a best-efforts basis once the transactions were issued. With the adoption of the AAOIFI standard 59, compliance became an obligation throughout the lifetime of the transaction.
The challenge issuers are facing is how to implement AAOIFI standards without changing the credit characteristics of the transaction.
There are indeed several risks related to obligation of compliance with the tangibility ratio throughout the lifetime of the transaction. One of the risks pertains to the reasons for a potential noncompliance and if it is related to a partial loss, for example of the underlying assets. This returns investors’ exposure to the residual asset risks that were in the past mitigated by the restriction of the exposure to a total loss scenario.
The risk of having one asset destroyed is certainly higher than having several destroyed at the same time.
The second risk is related to prepayments on some assets and if the issuer does not have sufficient unencumbered assets. Another risk is related to dissolution of the transaction before its maturity if the tangibility ratio is not respected, which is one of the strategies implemented by issuers to comply with this requirement.
Overall, this could mean more difficulty in accessing the sukuk market and lower investor appetite for the instrument. This raises the necessity of a critical review of some of the existing standards, and the adoption of an inclusive approach taking on board the views of all the stakeholders.
The process would ultimately lead to the standardization of the full spectrum of sukuk, from fixed-income-like instruments to equity-like ones, factoring the requirements of regulators, sukuk issuers, and investors.
Some market participants believe that standardisation is not achievable. However, in our view, it is not only achievable but would unlock growth opportunities for the industry.
Standardisation here includes both aspects of sukuk: sharia interpretation and legal documentation. It is when sukuk issuance becomes comparable with conventional instruments from a cost and effort perspective that it will find a prominent place on the radar for issuers and investors.
Unified global legal and regulatory framework is being created
Over the next 12 months, we expect some progress on the unified global legal and regulatory framework for Islamic finance that Dubai and its partners are developing.
Dubai embarked on this project with the Islamic Development Bank, the United Arab Emirates Ministry of Finance, and several other advisors in 2020. The project’s stated objectives include providing a global legal benchmark for Islamic finance, reducing regional differences in product offerings and practices, providing legal protection to all parties involved, and developing an international dispute resolution framework.
Depending on the outcome of the project, issuers may benefit from a speedier and more streamlined process to tap the Islamic finance market. Investors may also gain greater clarity on sukuk resolution in the case of default.
While the pandemic offered the possibility of more broad-based and transformative growth, the industry has not yet fully unlocked the opportunities inclusive standardisation affords and increased its share of sustainable finance activity.
A unified global legal and regulatory framework could make the industry more attractive to new players.
Dr. Mohamed Damak,
Senior Director and Global Head of Islamic Finance, S&P Global Ratings
