Key Takeaways
- Total sukuk issuance stabilized at $147.4 billion last year compared with $148.4 billion in 2020 but foreign currency denominated issuance increased 10%.
- Shrinking global liquidity and increasing complexity related to regulatory standards are likely to hold back sukuk issuance in 2022, assuming any adverse COVID-19-related disruption in core Islamic finance countries remains in check.
- We also expect lower financing needs in some core Islamic finance countries.
- Therefore, we forecast total issuance of about $145 billion-$150 billion in 2022.
S&P Global Ratings believes that sukuk issuance volumes will be flat at best in 2022 amid lower and more expensive global and regional liquidity, increased complexity, and reduced financing needs for some core Islamic finance countries.
Notably, we assume a period of higher oil prices, together with higher production and tighter spending control, will result in lower financing needs for some core Islamic finance countries.
Amid a tight job market, accelerated inflation readings over the past few months, and increasingly hawkish forward guidance from the U.S. Federal Reserve, we now expect three rate hikes in 2022, with the first expected in May. This would trigger a similar increase in interest rates from Gulf Cooperation Council (GCC) central banks given their currency pegs to the U.S. dollar.
Outside of these broader trends, the sukuk market faced a period of dislocation in 2021 due to the implementation of Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) Standard 59. In the United Arab Emirates (UAE), for example, sukuk issuance volume dropped 64%, in part because of the additional complexity introduced by this standard. Although legal solutions were implemented, the change has negatively affected sukuk issuance appetite from issuers and investors. This, combined with the abovementioned factors, leads us to expect sukuk issuance volume will stabilize at about $145 billion-$150 billion in 2022.
However, on a positive note, we see opportunities created by the energy transition in core Islamic finance countries, higher environmental, social and governance (ESG) awareness from regional issuers, and stronger automation using fintech solutions as likely to support future sukuk market growth.
Sukuk Issuance Will Stabilize At Best In 2022
In 2021, total sukuk issuance reached $147.4 billion compared with $148.4 billion in 2020 (see chart 1). The increased volume in 2020 compared with our previous publication stems from the movement in exchange rates and higher issuance in Pakistan and Indonesia than previously reported. Last year, the market benefited from increased issuances by the Saudi Arabian public and the private sectors. Oman also returned to the market after conventional issuances in 2020 and Malaysia and Turkey saw higher sukuk volumes. In contrast, issuance volumes declined significantly in the UAE. We believe this was partly due to the implementation of AAOIFI Standard 59.
Chart 1
Chart 2
Foreign-currency denominated sukuk issuance increased 10% in 2021 (see chart 3). We attribute this growth to jumbo issuances in Saudi Arabia and continued issuance growth in Malaysia, Indonesia, and--to a lesser extent--Turkey, thanks to favorable market conditions and ample liquidity. The issuance of capital boosting instruments by some GCC banks seeking these same favorable conditions also provided a boost. In contrast, Qatar, Bahrain, and the UAE saw the steepest declines in foreign-currency-denominated issuance volumes.
Chart 3
In 2022, we believe that the following factors will result in stable issuance volumes at best:
Liquidity will be scarcer and more expensive. Amid a tight job market, accelerated inflation readings over the past few months, and increasingly hawkish forward guidance from the U.S. Federal Reserve, we now expect three rate hikes in 2022, with the first expected in May. GCC central banks are likely to follow such a move to preserve their currency pegs to the U.S. dollar. This will mean global and regional liquidity becomes more expensive.
Some core Islamic finance countries will have lower financing needs. We assume higher oil prices compared with the lows of the pandemic, which together with higher oil production and tighter spending control, will translate into lower or static financing needs for some core Islamic finance countries. That said, we still think that the implementation of economic transformation projects such as the Saudi Vision 2030 will result in some opportunities for sukuk issuance.
Chart 4
Increased complexity will deter issuer and investor appetites. The implementation of AAOIFI Standard 59 will continue to hit issuance volumes, although legal fixes have been implemented. Higher residual asset risks for investors and challenges related to the availability of unencumbered assets on the balance sheets of issuers will likely result in reduced appetite for the sukuk route. Standard 59 is applicable not only to issuers domiciled in jurisdictions that have adopted the AAOIFI standards but also to those targeting investors from these jurisdictions. So far, 20 jurisdictions have partially or fully adopted the AAOIFI Sharia standards, plus the Islamic Development Bank. Most of them are key players in the Islamic finance industry, although it is interesting to note that some large Islamic finance players are not part of the list. This could exacerbate differences in structures used in core Islamic finance countries and detract from the broader goal of a more integrated Islamic finance industry.
The evolution of the pandemic could also be a source of risk for the sukuk market. S&P Global Ratings believes the omicron variant is a stark reminder that the COVID-19 pandemic is far from over. Uncertainty still surrounds its transmissibility, severity, and the effectiveness of existing vaccines against it. Early evidence points toward faster transmissibility, which has led many countries to reimpose social distancing measures and international travel restrictions. Over coming weeks, we expect additional evidence and testing will show the extent of the danger it poses to enable us to make a more informed assessment of the risks to credit. In our view, the emergence of the omicron variant shows once again that more coordinated and decisive efforts are needed to vaccinate the world's population to prevent the emergence of new, more dangerous variants.
What Are The New Risks Introduced By AAOIFI Standard 59?
Many hybrid sukuk are structured around a combination of tangible assets and commodities. Standard 59 altered the requirements for an important transaction feature necessary for Sharia compliance, the tangibility ratio. Before the adoption of the standard, an issuer was required to have a minimum ratio of 51% tangible assets and a maximum of 49% commodities at transaction inception. The maintenance of this ratio, throughout the lifetime of the transaction, was on a best-effort basis and remedial actions in case of a breach were unclear. With the adoption of Sharia Standard 59, the maintenance of a 51% tangibility ratio became a legal requirement throughout the transaction's lifetime and the remedies for a breach have been clarified.
In our view, compliance with Sharia Standard 59 creates or amplifies three primary risks.
Exposure to residual asset risk: For some structures, the risk is increasing as a partial loss event (in addition to total loss event) becomes relevant. Indeed, in a transaction with several assets, if one or more are destroyed, the tangibility ratio could be breached, and investors may not be fully reimbursed for their investment without recourse to the sponsor.
Changing investor ranking in a liquidation scenario: Standard 59 also affects the language related to the indemnity typically offered by the sukuk sponsor as an independent entity in case it fails any of its contractual obligations. This could make the sukuk creditors akin to subordinated creditors as contractual obligations might not be perceived as having the same ranking as financial obligations.
Increasing liquidity risk for issuers and investors: Standard 59 creates new potential scenarios for early sukuk dissolution. If the issuer has insufficient unencumbered assets on its balance sheet, there is prepayment risk for the underlying assets, or in a partial loss event, there could be sukuk acceleration and repayment before maturity. For some issuers, this could be problematic since it requires liquidity planning.
Higher ESG Awareness Could Drive A Gradual Increase In Issuance Volumes
Over the past year, we have observed a few sustainability sukuk issuances. The Islamic Development Bank issued a $2.5 billion sukuk and disclosed that the proceeds will be used to finance green (10%) and social development projects (90%). Malaysia also issued a $1.3 billion sukuk, including an $800 million sustainability tranche, which was 6.4x oversubscribed. The proceeds will reportedly be used to finance social and green projects aligned to the U.N.'s Sustainable Development Goals. Furthermore, Indonesia issued a $750 million green tranche as part of its $3 billion issue in 2021 and in Jan. 2022, Saudi National Bank issued a $750 million sustainable sukuk.
Green sukuk is another area where opportunities are reportedly high, given the energy transition in many core Islamic finance countries and ambitions of some in the electric vehicle space. These types of instruments may appeal to investors, given the increasing ESG awareness in the region. However, we think that green sukuk will only gradually contribute to market growth since it remains more complex and time consuming than conventional instruments.
Digital Sukuk Could Lead To A Smoother Issuance Process
Digital sukuk could provide a quicker and cheaper way to tap Islamic finance markets due to the limited number of intermediaries involved. The benefits may also include enhanced security, traceability, and integrity of the transaction, which could further strengthen compliance with Sharia. However, this assumes the availability of reliable technology and the readiness of legal frameworks to accommodate these instruments. It also assumes the presence of standard legal documents that can be used as a template for sukuk issuance. We note that the International Islamic Financial Market has already published standard legal documents for ijara and mudaraba Tier 1 sukuk. Reducing the time, cost, and minimum issuance volume requirement could open the sukuk market to a broader range of issuers. Investors in digital sukuk will continue to bear the traditional risks (including credit market and liquidity risk). They will also be exposed to higher operational risks stemming from technology stability and cyber risks.
Related Research
- Digitalization Of Markets: How Digital Bonds Can Disrupt A $120 Trillion Market, Oct. 4, 2021
- The Global Sukuk Market Is Returning To Traditional Risks, July 5, 2021
- Islamic Finance 2021-2022: Toward Sustainable Growth, May 3, 2021
This report does not constitute a rating action.
| Primary Credit Analyst: | Mohamed Damak, Dubai + 97143727153; mohamed.damak@spglobal.com |
| Secondary Contact: | Benjamin J Young, Dubai +971 4 372 7191; benjamin.young@spglobal.com |
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