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Sukuk, whether one likes it or not, has been
the flag bearer of the Islamic finance industry
and it has had a talismanic role in its growth
and expansion. Major conferences, entire
industry reports and multiple awards have been
devoted to this particular sector. Governments
and institutions from across the globe almost
exclusively contemplate their entry into Islamic
finance through the issuance of so-called
‘Islamic bonds’. New Islamic finance institutions
more often than not have a sukuk issuance at
the very top of their business plans, whereas
established IFIs have recently devoted time and
effort in launching sukuk funds to broaden
their appeal from an institutional to a retail
audience. However, if real estate is all about
location, location, location it seems that Islamic
finance has been simplified into sukuk, sukuk
,sukuk. The structure (albeit there’s more than
a dozen permutations) has been demonized as
the poison pill of the industry, so we must ask
is this the case of a jinn amongst us? We can
certainly choose to brand it as an evil spirit but
much harder it is to scrutinize Nakheel for what
might be in store for the industry. We foresee
the following trends:
Structural Reform:
Sukuk has exemplified one of the key areas
of discontent for industry participants.
Specifically, it has exhibited many shortcomings
in the way that some issuances have been
structured - this has been primarily due to the
predilection and popularization of structures
that are essentially asset-based debt products
rather than an asset-backed hybrid instruments.
Yet Nakheel has arrived at a point in time
when various Scholars, industry bodies and
practitioners at large have repeatedly voiced
their concerns over the former debt-like
structures. Nevertheless, these calls have been
fragmented and uncoordinated - making it
unlikely that any realistic change would be
enacted. This will see itself accelerated, with
the latest events giving stronger support to the
calls for industry reform (at least in the area
of product structuring) although even without
any official reform the shift away from certain
types of issuance (such as murabaha sukuk)
is already underway. There might be further
implications beyond sukuk, as there would be
spillover consequences onto other instruments
or practices. Whether change is proactive or
reactive is besides the point, as there will be
change nonetheless.
Allocator Mindset:
What begs a question is whether allocation
has been overly influenced by a preference
for certain types of returns (i.e. correlated
to interest rates). If sukuk aims to establish
itself as a distinct asset class (as it has been
suggested at conferences and forums) then it
will require an equally distinct risk management
framework and identify its proper place vis-avis
other asset classes in a portfolio. Allocation
decisions would have to be optimized in terms
of sukuk, equities, commodities, alternatives,
and so on. What is far from certain is whether
Islamic banks are ready to overhaul their
approach to allocation - this would require
a monumental shift. A detachment would
be required - by this we mean a financial,
structural and philosophical one - since the
economics of sukuk needs to move away from
interest-based returns (regardless of who
originates or underwrites such products). This
shift is required from scholars and structuring
teams but crucially it has to be driven by
investors at large. The usual over-subscription
to new sukuk issuance is evidence of their tacit
approval of current business practice and in this
respect the signs are not positive. Every single
type of service provider will have something to
say about sukuk, but the actual allocators are
mute in this respect. They are the ones that
can drive the necessary change - but are they
willing to do so?
Sector Diversification:
This is another area ripe for improvement - we have covered this aspect extensively as it pertains to Islamic investment funds (where we
have identified various issues such as a distinct geographical bias as well as multiple gaps in terms of asset classes). It is not surprising
this is the case for sukuk as well, where underlying assets have been focused on specific regions (say GCC) and sectors (say real estate).
Then again, there is absolutely nothing wrong with GCC exposure nor real estate exposure, except that such an exposure should be part
of an overall diversified portfolio - not the exclusive component of one. Another strong distinction in the industry has been between
Malaysian sukuk and GCC sukuk, with many Malaysian issuances deemed unacceptable to GCC scholars. It is rather ironic that the furore
is behind an issuance from the UAE, but one of the trends going forward will be a revisiting of how justified this distinction really is.
Many IFIs have been actively investing in issues from their counterparts on the other side of the Indian Ocean, and while this has typically
not been widely reported one will expect cross-border activity to be less of a taboo going forward.
Asset Origination:
A further line of inquiry relates to why products haven’t been developed for other regions/sectors? The un-elegant answer is sheer lack
of origination expertise. This relates to the ability of Islamic banks to identify assets and opportunities away from their home markets,
and the know-how to structure an issue in a timely and efficient manner in jurisdictions outside of their own. The concern here is that if
Islamic banks have been immune to the global financial crisis they will be equally immune to market rallies and the anticipated recovery
in the global economy (the simple fact that they are not present in a downward market does not validate their business model). Another
outcome of Nakheel will be a stronger impetus to build collaborative efforts with non-IFIs that can provide this sector expertise and/or
local know-how, so that IFIs move away from their comfort zones.
Asset Quality:
In the US, the default of East Cameron Gas sukuk has been highlighted as a positive development (the legal outcome has upheld the
sukukholder’s claim to the underlying assets). What is less evident is that this was a highly-engineered issuance that many in the
conventional world would not have touched with a stick. So we must ask whether Islamic finance is the dumping ground for suboptimal
investments? While distressed or special situation strategies have their merits it seems the project pipeline of Islamic finance tends to
attract rather unconventional offerings. The quality of the underlying assets has also been a highlight of Nakheel, and attract rather unconventional offerings. The quality of the underlying assets has also been a highlight of Nakheel, and this has often been
exemplified by the lack of rated sukuk and in that sense, sovereign sukuk has been highlighted as a pre-requisite for market development
(having a rated issue that in turn provides a benchmark for pricing corporate sukuk). Issuers might have to reduce their reliance on
government direction (or support) but most importantly the private sector will need to focus its attention on identifying a much broader
set of quality assets.
We expect plenty more headlines relating to Nakheel, but the real story will be on how the industry responds - either it falls back in denial
or it embraces this as an opportunity to reinvent itself. Oddly enough, a Jinn has the ability to appear in various forms (most references
point to a snake or other animals), so a financial instrument is not entirely out of the question. Then again, these spirits are not
exclusively evil and in fact are able to do as much good as they can do mischief. Most tellingly, the Jinn are said to have been created
from fire (and Nakheel is certainly fanning the flames of discontent in the industry). Nevertheless, human beings are superior to Jinns, so
it is not sukuk that should be demonized but instead the emphasis should be on the various stakeholders (scholars, IFIs, service providers,
and - most crucially - investors) as they have the ultimate responsibility to purge these problems away.
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