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Sukuk Your Dreams

Essays on Islamic Banking, July 2008

sukukrs At a time when the global oil industry, celebrates 100 years of existence, basking in record oil prices, it is interesting to note the realisation of another milestone, Islamic bond (sukuk) market, which has an even greater potential of transforming the economic landscape of the Middle East and North Africa (MENA) region.

The impact of record breaking energy prices is currently being felt from the poorest farmer in Haiti to the sumptuous settings on Wall Street. There is no doubt that over the last century, oil has transformed the fortunes of many countries in the Middle East. However, the jury is still out on the economic and social benefits. Indeed, writing for the prestigious Oxford Institute of Energy Studies, Kevin Rosser implies that the oil wealth has been at the expense of regional development:

“No one denies it has brought needed revenue for producing nations and a better quality of life for citizens. But in the eyes of some, a century of oil has yielded more affluence than development, more stability than freedom, more conflict than peace, more interference than independence.”

This point is supported by a recent World Bank report where it is highlighted that education in the Arab world is falling behind other regions. So, given this unforgiving history it is tempting to conclude that the recent oil price hike will do little to usher in new economic development in the Middle East. However, there is something different in the air this time: the phenomenal rise of the sukuk industry.

Capital markets and economic development.

Economic growth is dependent on efficient capital markets which bring together domestic savings and foreign capital and allocate these resources to those areas that will prove to be most beneficial for the economy. From the internet search giant Google to the British rail infrastructure group, Network Rail, the role played by the capital markets in raising capital has proved to be instrumental in the economic success story. Efficient capital markets can lead to economic growth in the following ways:

* Better management of risk, with diverse products
* Efficient at identifying productive projects and firms
* Advocating good corporate governance
* Mobilising savings and capital

With average economic growth hovering at 0.5% (3% excluding population growth) for the last 25 years, compared to 2% seen by developing countries, we must examine the link between capital markets and economic growth. More pertinently, can capital market structure explain these disappointing growth figures in the MENA region? Certainly, the below diagrams shows that there is a marked difference in the capital structure of faster growing regions of the world, compared to the MENA. Indeed, one really significant inequality is the debt market, with the MENA debt market accounting for just 3% of overall capital structure, compared to 42% at the global level. It can be argued that it is this reason why the MENA region has lagged in development and it is this reason why there is so much excitement on the potential of the Sukuk industry.

Sukuk: Filling the Gap....

Before defining a sukuk, it will be useful to look at why there is a need for such an instrument. In conventional finance, one of the most popular methods of financing are bonds. These are debt investments, in which an organisation borrows money and in return pays a fixed interest (coupon) rate to the investor. This is something that is explicitly prohibited in Islamic finance, two of the main reasons being: during difficult times the investor is still obligated to receive the coupon from the company (even if the company makes a loss); and the underlying project could be unethical. Due to these reasons, the debt market has never taken off in countries with majority Muslim populations. This is one of the key drivers of the sukuk industry.

A sukuk, generally referred to as an Islamic bond, is better defined as an investment certificate, where the investor has a share of an asset, which generates profits or revenue. The type of certificate or sukuk can vary from lease based (Ijara sukuk) to project finance related (Istisna).

The industry has traveled a long way in a relatively short time. From humble beginnings in 1990, when Shell issued the world’s first sukuk in Malaysia, many records have been registered - with the world’s first sovereign five year sukuk valued at $600mln in 2002 to the $2.5bln issuance by the Nakheel Group. It is these projects that are turning around the gap in the debt market in the MENA and adding financial depth which can change the economic landscape.

Dubai Electricity and Water Authority (DEWA): Ijara Sukuk

DEWA, state owned utility, recently announced $1bln Ijara sukuk issue. With a monopolistic market position, good growth prospects, better regulatory framework and water tariffs, DEWA has received a warm response to the sukuk issue.

In such a transaction there are three main parties: the Islamic bank; investors; and special purpose vehicle (SPV) – this is denoted by the below diagram. The SPV's main objective is to act as an administrator for the payments (generated from the revenue for the Ijara sukuk) and it is used as a tool to acquire the asset on behalf of the investors. It is domiciled in a tax-efficient jurisdiction such as Cayman Islands, Jersey, Bahrain and Lebanon. In the event of bankruptcy, there is no impact on the rights of sukuk holders with regards to the underlying asset.

In terms of the below diagram, the investors provide cash to the SPV and in return receive certificate of participation. The sum of the cash provided by the investors is used by the SPV to acquire title of the asset from the issuer (in this case, the issuer is DEWA). This cash is used by the issuer to finance the project. Why does the issuer pay rentals to the SPV (which in turn pays rentals to investors)? This is because the issuer, DEWA, will continue to use the asset after the ownership has been transferred to the SPV.

To summarise, there are three main parts to this agreement. Firstly, the investors pay cash to SPV and receive a certificate in return. Secondly, the SPV uses this cash to buy the asset from the issuer and at the same time enters into a lease agreement (where DEWA agrees to pay rentals). Finally, at maturity (generally five years), the issuer will buy back the asset from the SPV and pay back the initial sum, which it had received from the SPV.

The DEWA sukuk issue is a typical example of a new way of financing, gripping the MENA region. Certainly, with the levels of liquidity increasing and investor confidence remaining strong, the U.K. government is also considering to join the global race in Islamic finance. The below table, shows some of the strong performers in the sukuk space globally.

It is interesting to note some surprise showings. For example, generally the United States has shown a lukewarm response to Islamic finance. Having said this, there is strong effort at a private level to engage with the government in creating a conducive environment for the industry. At the same time, it is promising to see supportive developments at government levels in countries such as Saudi Arabia and Indonesia which have historically been not so keen on developing the industry. The example of Malaysia has been an inspiration for many countries.

This increased activity certainly bodes well for overall economic story in the MENA region. As noted in this article, previous oil booms have not led to long term economic success in MENA due to little financial depth in the region. However, the development of the sukuk industry shows that the market is becoming more sophisticated. More importantly, this increased sophistication is being achieved with an eye on the religious and moral understanding of the Muslim world.

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