Dubai – Decypha: In the United Arab Emirates, it is not uncommon to see street-side vending machines selling crisps, chocolates, sodas and, since March 2015, Shariah-compliant bond certificates known as sukuk. The latter service is known as Sukuk Express, introduced and managed by the National Bonds Corporation (NBC), a subsidiary of Dubai’s investment arm The Investment Corporation of Dubai. During the first nine months, around 9800 transactions were performed, according to NBC figures. “We are very pleased with the excellent response from customers,” said Ahmed Bibars, the company’s Executive Director of Retail & Distribution at the time. There are currently around 1000 machines nationwide.
Of course it helps that the UAE is ranked third worldwide in outstanding sukuk issuances, accounting for 10% of actively traded sukuks according to the International Islamic Financial Market Sukuk Report in 2015. Also, the country was the fastest growing market for the Islamic bond in 2016, accounting for 28.5% of all new sukuk issuances worldwide. As of April 2017, Nasdaq Dubai, Dubai’s stock exchange, was by far the largest sukuk exchange market in the world by value with $53.3 billion in listed sukuk from local, regional and international issuers. Six months earlier, listed sukuk issuances were under $34 billion. Fueling this growth is UAE’s accomplished financial system, favorable sukuk legislations and conducive business environment. However, some have warned that too much exposure to foreign-currency denominated sukuk can put the country’s foreign currency reserves at risk if there is doubt over the UAE’s or global economic prospects.
A Global Sukuk Hub
Early 2013, Sheikh Mohammed bin Rashid, UAE’s vice president and ruler of Dubai, announced his vision to make the emirate the global hub for sukuk trading. The first step was to create the right legislative environment to attract issuers and investors alike. By 2014, an all-new sukuk law was issued by the Securities and Commodities Authority (SCA) aiming to make it faster and cheaper for companies to issue and trade conventional and Islamic bonds on the exchange. To ensure the legislation was investor-friendly, SCA adopted a hands-off approach. “Our policy is to stay away from issuing fatwas,” said Mounther Barakat, Senior Research Adviser at the SCA in 2014 to Reuters. In the new law, decisions on how to structure the sukuk and whether it would be asset-backed or asset-based are determined by the issuer. Though, Barakat noted that the Shariah Board in the Dubai Financial Markets will provide advice should the issuer request it.
Prior to the 2014 law modifications, companies mainly relied on conventional bank loans and retained earnings to finance themselves. Only large companies, with enough financial and technical resources, were able to use Islamic funding tools. To attract more companies to sukuk, the minimum issuance size dropped to AED 10 million from AED 50 million. The SCA also set a maximum of five days to review and approve issuance applications. Private placements of unlisted sukuk are allowed and don’t require SCA approval.
Reporting and trading requirements were also greatly simplified to attract SMEs. For example, financial reports would be filed annually instead of quarterly while issuers don’t have to be rated by a credit rating agency, reducing issuance costs. Meanwhile, to attract foreign investors, listed sukuk transactions can be executed outside the exchange and later settled at the clearing house. The new law also allows foreign sukuk investors to settle their local transactions aboard.
Foreign sukuk investors are also attracted to the UAE because of its currency peg to the dollar, which eliminates any exchange-rate risk. Also, the country has the most diversified economy in the GCC, allowing it to be the only one reporting a budget surplus during the first nine months of 2016, reaching AED 8 billion. This is confidence-boosting for investors, and opens the door to more diverse local sukuk issuers. Meanwhile, UAE’s already business-friendly environment continues to improve; ranked 28 in the Doing Business Report 2017 compared with 34th in the 2016 report.
This setup has made it attractive for local and foreign establishments to issue sukuk in the UAE. Dubai Islamic Bank (DIB) had three issuances in 2013, 2015 and 2017. In February 2017, DIB issued $1 billion worth of sukuk as part of its $5 billion sukuk program. This brought its total tally to $4.25 billion in sukuk issuances, all listed on Nasdaq Dubai. DIB is currently the biggest UAE-based issuer of sukuk in the country. The Emirate of Sharjah also issued sukuks worth $1 billion in September 2014 with a 10-year maturity. It was oversubscribed 10-fold. "From a financial perspective, the transaction has helped the government to diversify its investor base, access longer fixed-term tenors and optimize pricing,” said the emirate’s press release at the time. “From a wider economic perspective, the issuance will provide a benchmark for any transactions undertaken by Sharjah entities... It will also enhance the efforts of the UAE authorities to develop the local financial markets.” Sharjah’s issuance was rated A and A3 by Standard & Poor’s and Moody’s Investors Service respectively. Both are investment-grade ratings.
Meanwhile, a major foreign sukuk issuer is the Hong Kong government which issued three sukuk issuances, each for $1 billion, in 2014, 2015 and March 2017. The Islamic Development Bank, a Saudi bank, has a $9.8 billion sukuk portfolio on Nasdaq Dubai with the latest one issued mid-April for $1.25 billion.
Challenges Ahead
Despite the rosy picture, the UAE will be facing some risks in the short and medium terms when issuing sukuk. One of which is the USA’s future economic and monetary policies given the UAE’s currency, and therefore interest rate, peg to the dollar. Since last November, U.S. interest rates increased from 0.4% to 1% for the first time since 2009. "This will inevitably dampen investors’ appetite for sukuk,” said Mohamed Damak, S&P Global Ratings’ Global Head of Islamic Finance, talking to The National early 2017, pointing out that higher interest rates will make sukuk more expensive for the issuer.
Another challenge facing the UAE is the complexity of issuing sukuk, which makes it a time-consuming process compared to conventional debt, according to Damak as reported by The National in 2017. Being so, government issuances of the Islamic bond have always been limited. “GCC governments shied away from tapping the sukuk market but relied largely on conventional debt which saw an increase of nearly 150% in the first half of the year,” wrote Debashis Dey, a Partner of White & Case in their Dubai office, to Gulf News in October 26, citing a Standard & Poor’s report. “The trend is not expected to reverse in the near-to-medium term.” This limits the investor base for sukuk, and recent issuances have been attracting more local than foreign investors.
The complexity of sukuk is mainly down to a lack of standardized documentation and issuance processes of the tool among sukuk-issuing nations, according to Dey. “It is often cited as one of the many reasons behind muted activity on the sukuk market over the past few years,” said Damak to Gulf News in April. “Although several heavyweights in the financial industry are pushing the market toward greater standardization, little was achieved in 2016 and we believe the level of standardization is still some way off."
Standardizing sukuk
To create a legal framework that would cater to almost every eventuality when issuing sukuk, the UAE have introduced several legislative reforms in April. A standout point is that sukuk can be reported as an on- or off-balance-sheet entry depending on the level of control the issuer and buyer have over the underlying asset. “This, coupled with... the recent proposal on centralized Sharia boards… could help the market move forward with standardizing the legal structure of sukuk and Shariah interpretation,” said Damak.
The modifications also classify on-balance-sheet sukuk as either liability, quasi equity or equity entries to determine the type of documentation required by the regulator. “The proposal not only recognizes that sukuk can be issued in the form of a liability of its sponsor, but also paves the way for strengthening the legal documentation for this type of sukuk,” said Damak to Gulf News in April. The legislation also prevents the assigning of a rating if contractual obligations are missing information. To achieve standardization, Nasdaq Dubai is working with foreign governments and companies to meet the UAE’s sukuk regulations. It is currently working with the Tunisian government to create a unified sukuk framework to help them increase their issuances.
A Changing Banking Sector
The use of sukuk is poised for an even brighter future in the UAE. A major factor in this positive outlook is that the loan-to-deposit ratio for UAE banks was over 100 percent between June 2015 and November 2016, dropping to 93.8% in December. Accordingly, increasing exposure to conventional loans will noticeably increase lending risk for banks. Sukuk, which are still underutilized by banks in the UAE according to observers, will provide these banks with sufficient diversification to bring down their risk levels while continuing to grow. It will also enable UAE’s central bank to bypass the dollar peg when it comes to changing the country’s monetary policy and liquidity management, according to Allen Baby, a lecturer at the Emirates Institute for Banking (EIBFS), Dubai Writing to Khaeelj times in July 2016. Thus creating a more dynamic monetary policy.
However, banks unconditionally increasing exposure to sukuk can prove risky. As it stands, the majority of the country’s sukuk issuances are denominated by dollars as either their issuers are foreign or the local ones are seeking foreign currency funding despite the currency peg. “This implies that the issuing country has no control over the currency in which the liabilities are raised,” said Baby. This will put the UAE central bank at risk if capital flees amid an economic shock in the UAE or abroad, and will have little ability to curb this drain as this capital is already in dollars, and doesn’t need repatriation. Too much dollar-denominated sukuk will also offset the benefit of using them to control monetary policy. “Any future possibility of de-pegging the currency can raise… challenges for these debts issued in USD as the value of debt in AED terms could [significantly increase] in case there is a major currency depreciation accompanying it,” said Baby.
The solution will lay in local banks focusing more on increasing local-currency denominated sukuk issuances that usually fund local enterprises, while restricting foreign currency listings for both local and international issuers. The latter shift in particular will require not just legislative reforms, but a complete change in the mindset of UAE rulers who have always welcomed foreign investors, offering them every possible convenience.
By Tamer Mahfouz
