S&P Global Ratings believes the global Islamic finance industry will return to slow growth in 2020-2021 after strong performance in 2019 underpinned by a more dynamic sukuk market. The significant slowdown of core Islamic finance economies in 2020, because of measures implemented by various governments to contain the COVID-19 pandemic, and the expected mild recovery in 2021, explain our expectations.

At the same time, we see an opportunity in the current environment for accelerating and unlocking the long term potential of the industry. Stakeholders are realizing the importance of standardization as government coffers are depleted and access to sukuk remains time consuming and more complicated than conventional instruments. Lockdown measures have also shown the importance of leveraging technology and creating a nimbler industry. Furthermore, industry players have been discussing the potential use of social instruments to help companies and individuals economically affected by the pandemic. With the right coordination between different Islamic finance stakeholders, we believe the industry could create new avenues of sustainable growth that serve the markets.

Recession and Mild Recovery Thereafter Will Hold Growth Through 2020-2021

After strong performance in 2019 explained by higher-than-expected sukuk issuance, we believe Islamic finance industry growth will slow in 2020-2021 due to lockdown measures and ensuing recessions in Islamic finance core countries (see charts 1 and 2).

Chart 1

Chart 2

We expect Islamic banking to show at best stable total assets or low-single-digit growth. This follows 6.6% growth in 2019 thanks to good performance in the Gulf Cooperation Council (GCC), Malaysia, and to a lesser extent Turkey and Indonesia, but a declining contribution from Iran amid the deep recession reported by the IMF. In 2020, we expect a slowdown spurred primarily by measures implemented by various governments to control the COVID-19 pandemic. This slowdown will be somewhat counterbalanced by strong liquidity injections from various central banks to help their banking systems navigate the difficult environment. However, this, together with complexity and lower investor appetite, will contribute to a sukuk market slowdown in 2020. We project the volume of issuance will reach $100 billion in 2020 compared with $162 billion in 2019--when Turkey, returning GCC issuers, Malaysia, and Indonesia supported the market (see Chart 3).

The market was, in fact, poised for good performance in 2020 but the pandemic and lower oil prices changed the outlook. Amid tougher conditions, we also don't see core Islamic finance countries using sukuk as a primary source of funding despite their higher financing needs. However, we think that Turkey might try to tap the market aggressively in 2020 to use all of its available funding options. More broadly, we continue to see the takaful sector expanding at mid-single-to-high-digit rates, while the funds industry might see some negative effects from market volatility. Overall, we believe low-to-mid-single-digit growth for the overall industry is a fair assumption over the next two years. However, in our view, COVID-19 offers an opportunity for more integrated and multifaceted growth with higher standardization, stronger focus on the industry's social role, and greater use of fintech. This can be achieved through higher coordination between the industry's different stakeholders.

Chart 3

Social Islamic Finance Instruments Can Make A Difference

COVID-19 is causing a significant slowdown in core Islamic finance markets and a spike in unemployment. Although the predominantly migrant population structure in the Gulf and governments' support packages could absorb some of the shock, several stakeholders will lose a portion of their income. We think four Islamic finance social instruments in particular can help core Islamic countries, banks, and corporations navigate the current situation (see Related Research).

These are:

• Qard Hassan--This instrument could provide cost-free breathing space until the environment stabilizes. One example is when some GCC central banks opened free liquidity lines for financial institutions to provide subsidized lending to their corporate and small and midsize enterprise clients.
• Social sukuk--These instruments could help support the education and health care systems amid the current slump and attract environmental, social, and governance (ESG) investors (those investing for social reasons) and/or Islamic investors (those looking for Sharia-compliant investments).
• Waqf--This could help provide affordable housing solutions or access to health care and education for people that might have lost a portion of their income.
• Zakat--Based on our conversations with market participants, we believe that Zakat could help compensate for lost household income because of COVID-19.

These instruments, together with green sukuk--which are taking a back seat this year--and the additional layer of governance Islamic banks and instruments are subject to could help put the industry more prominently on ESG investors' radar.

Streamlining Sukuk Issuance Will Restore Its Attractiveness

Sukuk instruments remain more complex and time consuming for issuers compared with conventional bonds (see chart 4). As with previous crises, for example when oil prices crashed in 2014, the pandemic has shown that when core Islamic finance issuers need faster access to capital markets they typically use conventional instruments. In the first five months of 2020, the total volume of sukuk issuance dropped 38% compared with the same period in 2019. Exceptions include issuers that have already established programs or can tap a recent issuance; issuers that are under stress and need to access all available funding sources; or issuers that are domiciled in jurisdictions where the sukuk process is streamlined.

Chart 4

We acknowledge that the market has developed a certain way of doing transactions. However, a global set of standards that would be acceptable to all stakeholders is still lacking. The different standard setters of the industry--the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), the Islamic Financial Service Board (IFSB), and the International Islamic Financial Market (IIFM)--are working together to drive this agenda. More recently, the United Arab Emirates Ministry of Finance, the Islamic Development Bank, and the Dubai Islamic Economy Development Centre (DIEDC) established a partnership to develop an international legislative framework for Islamic finance, with the goal of accelerating growth and reducing discrepancies around the globe.

We view this as a step in the right direction as differences persist. For example, countries that adopted the AAOIFI standards might deem some sukuk structures commonly used in core Islamic finance countries noncompliant. This emphasizes the necessity for a critical review of some of the existing standards and the adoption of an inclusive approach taking on board the views of all stakeholders. The process would ultimately lead to standardization of the full spectrum of sukuk (from fixed-income-like instruments to equity-like) factoring the requirements of regulators, sukuk issuers, and investors. Standardization includes both aspects of sukuk: sharia interpretation and legal documentation. When sukuk issuance become comparable with conventional instruments from a cost and effort perspective they will find a more prominent place on issuers' and investors' books.

Fintech Will Enhance The Industry's Resilience

Lockdown measures have demonstrated how the capacity of a company or a bank to shift its business online is critical for its continuity. For Islamic banks and sukuk, higher digitalization and fintech collaboration could help strengthen their resilience in a more volatile environment and open new avenues for growth.

However, recent months have demonstrated that there is still room for improvement. For example, because of the lack of financial inclusion and dedicated digital solutions, workers' remittances were delayed in some countries as exchange and money transfer outlets were closed. Sukuk structuring and issuance were also delayed because of a lack of fintech, despite the creation of a new platform where the issuance process is reportedly fairly streamlined. Last year, a new platform for sukuk issuance and management using data technology blockchain was launched. This platform, if adopted by the market, could boost GCC issuance volumes over time, since it significantly simplifies sukuk processes. It relies on a set of standardized legal documentation for sukuk structure. The issuer can just plug in its underlying assets and start building its investor book with a few clicks. The overall transaction is managed using blockchain, which helps improve transparency and traceability. This platform can also open the market to a new class of issuers that were until now excluded because of costs or complexity. More importantly, this shows that standardization of legal documents and Sharia rulings is actually achievable. Additionally, security of transactions and resisting cyberattacks while remaining in compliance with existing regulations has proven to be a prominent source of risk and could be remedied using regulatory technology.

A prerequisite for fintech enriching the Islamic finance industry is the provision of adequate physical infrastructure and implementation of the necessary supervision and regulatory framework. This is why several regulators/authorities in the GCC and elsewhere have launched incubators or specific regulatory sandboxes where fintech companies can test innovations.

How Are Islamic Finance Ratings Affected?

In our view, fintech and social instruments will have a limited bearing on Islamic finance ratings in the next two years. So long as the use of social products or a more lenient approach to cost reduction is not significantly affecting banks' profitability, the impact on their creditworthiness would be limited. Similarly, we would not expect the social nature of a sukuk to affect the instrument's creditworthiness as long as we don't see any changes in the sponsor's financial obligations to pay sufficient amounts for the periodic distribution and principal reimbursement. We also forecast only a marginal influence from fintech on our Islamic bank and sukuk ratings over the next two years. We consider that Islamic banks will be able to adapt to their changing operating environment through a combination of collaboration with fintech companies and cost-reduction measures. We also believe that regulators across the wider Islamic finance landscape will continue to protect the financial stability of their banking systems. Moreover, although we think that blockchain could help the operational management of sukuk, we believe it will not induce any changes in the legal substance of transactions.

Related Research

• Islamic Finance And ESG: Sharia-Compliant Instruments Can Put The S In ESG, May 27, 2020
• How Resistant Are Gulf Banks To The COVID-19 Pandemic And Oil Price Shock?, April 22, 2020
• Credit FAQ: Will COVID-19 And Cheap Oil Reset The Market For GCC Tier 1 Instruments?, April 22, 2020
• Virus, Oil, And Volatility Will Put Sukuk Issuance Into Reverse, April 13, 2020
• GCC Banks Face An Earnings Shock From The Oil Price Drop And COVID-19 Pandemic, April 6, 2020
• AAOIFI's Proposal May Result In Different Interpretations On The Treatment Of Unrestricted Investment Accounts, Jan. 29, 2020