By Dr. Mohamed Damak, Senior Director & Global Head of Islamic Finance, S&P Global Ratings.
Though it has looked like last year’s recession scare was a false alarm, the global sukuk market is close to sending another signal about a slump. The noxious mix of the new coronavirus, low oil prices, and waning investor appetite is expected to hurt sukuk issuance in 2020 from core Islamic finance markets that include GCC countries.
The drop in oil prices and restrictions related to the COVID-19 pandemic is taking a toll on important sectors in core Islamic finance countries, including real estate, hospitality, and consumer-related businesses. We expect most government issuers may turn to conventional bond markets rather than issue sukuk as they grapple with the impact of weaker economic environment on their budgets.
Sukuk issuance is still more complex than conventional bonds. Added to this is investors’ increasing risk aversion in the uncertain environment and widening spreads, which imply that financing conditions will be extremely tight for issuers with weak credit quality.
Bearish markets make it a difficult year for sukuk
S&P Global Ratings acknowledges a high degree of uncertainty about the rate of spread and peak of the coronavirus outbreak. Some government authorities estimate the pandemic will peak about midyear, and we are using this assumption in assessing the economic and credit implications. We believe the measures adopted to contain COVID-19 have pushed the global economy into recession. As the situation evolves, we will update our assumptions and estimates accordingly.
Yet we don’t think issuance in the rest of 2020 will be enough to compensate for the first-half decline. Sukuk issuance volumes fell 32% in the first quarter of 2020 and we expect the decrease to be even steeper in the second quarter, since most core Islamic finance countries started implementing measures related to COVID-19 in March. Overall, we forecast around $100 billion of sukuk issuance this year, about 40% lower than in 2019. In the current environment, the number of defaults among sukuk issuers with low credit quality will likely increase. We now expect the economic performance of core Islamic finance markets to remain muted in 2020, with some of them recovering only in 2021.
Fresh liquidity in the market
In response to low oil prices and sluggish economic activity, several countries have implemented measures to unlock banking sector liquidity and help corporations cope with the adverse impact. We think most of their financing will come from the local banking systems, which have received incentives to provide funding from their respective governments or regulators.
We think most of their financing will come from the local banking systems, which have received incentives to provide funding from their respective governments or regulators. Central banks have few reasons to issue this year. Since they have opened liquidity taps through the banking sector, there is limited need for local currency liquidity management via sukuk. In 2019, central banks accounted for 17.5 per cent of total sukuk issuance.
Looking for alternatives
Market conditions have become very volatile. Over the past few months, we have observed large outflows of capital from some emerging economies, and therefore think sukuk issuers will probably wait for the best window of opportunity to tap the market in 2020 if they have no other alternative.
Another key factor is that sukuk issuance is still complex and the process of issuing them is not yet equivalent to that for issuing bonds. This means that, potentially, governments could turn to other instruments that are easier to bring to the market. These could take the form of bilateral/multilateral lending agreements, syndicated loans, or issuance on conventional capital markets. Intricacy in issuance also tends to push issuers to seek other avenues when they need to raise financing quickly. Standardizing legal documents and Sharia interpretation is a prerequisite to making sukuk a truly competitive instrument in terms of time and effort.
Increased risk of defaults
Given the shocks to the economic environment and rapid change in market conditions, we expect credit risk to increase sharply. The current situation will probably also result in a spike in default rates, especially for issuers with weak creditworthiness, which would test the robustness of sukuk legal documents. Among other things, we might see higher default rates among sukuk issuers, especially those with low credit quality or business plans that depend on supportive economies and market conditions.
Investors generally do not have access to the sukuk’s underlying assets in the event of a default, except when those assets were sold to the special purpose vehicle issuing the sukuk, which is an exception rather than the norm.
Innovation and green sukuk may take a back seat
The momentum in using blockchain for sukuk and issuing green sukuk will likely slow this year. These two areas we still expect will play a significant role in opening the sukuk market when conditions improve.
The crisis could even lead to developments such as “social sukuk or a new breed of instruments, for example, one on which the rate of return would decline if the issuer fulfils certain social objectives, such as supporting the healthcare system or helping companies affected by COVID-19 so they don’t need to lay off staff.
There might also be an opportunity for the re-emergence of certain strong Islamic instruments, such as Zakat and Waqf, which could again play a role in reducing the impact on the most vulnerable segments of the population or poor countries. This would not only be in line with the ultimate goals of Sharia but also create a new growth channel for the industry.