the role of sukuk in islamic capital markets 4.2.1 overview of malaysias capital markets 73 4.2.2...

The Role of Sukuk in Islamic Capital Markets

COMCEC COORDINATION OFFICE February 2018

This report has been commissioned by the COMCEC Coordination Office to the International Shari’ah Research Academy for Islamic Finance and RAM Rating Services Berhad. The report was prepared by Dr. Marjan Muhammad, Ruslena Ramli, Dr. Salma Sairally, Dr. Noor Suhaida Kasri and Irfan Afifah Mohd Zaki; while the advisors were Promod Dass, Rafe Haneef, Wan Abdul Rahim Kamil Wan Mohamed Ali and Assoc Prof Dr. Said Bouheraoua. The views and opinions expressed in the report are solely those of the author(s) and do not represent the official views of the COMCEC Coordination Office or the Member States of the Organization of Islamic Cooperation. The final version of the report is available at the COMCEC website.* Excerpts from the report can be made as long as references are provided. All intellectual and industrial property rights for the report belong to the COMCEC Coordination Office. This report is for individual use and shall not be used for commercial purposes. Except for purposes of individual use, this report shall not be reproduced in any form or by any means, electronic or mechanical, including printing, photocopying, CD recording, or by any physical or electronic reproduction system, or translated and provided to any subscriber through electronic means for commercial purposes without the permission of the COMCEC Coordination Office. For further information, please contact: The COMCEC Coordination Office Necatibey Caddesi No: 110/A 06100 Yücetepe Ankara, TURKEY Phone : 90 312 294 57 10

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TABLE OF CONTENTS

LIST OF TABLES v

LIST OF CHARTS vii

LIST OF FIGURES ix

LIST OF BOXES x

LIST OF ABBREVIATIONS xi

EXECUTIVE SUMMARY 1

1. INTRODUCTION 5

1.1 GLOBAL OUTLOOK OF THE SUKUK MARKET 5

1.2 AIMS, OBJECTIVES AND SCOPE OF THE STUDY 6

1.3 METHODOLOGY 6

1.4 OVERVIEW OF THE STUDY 7

2. DEVELOPING A SUKUK MARKET: KEY BUIDING BLOCKS 9

2.1 SUKUK AS AN ISLAMIC FINANCIAL INSTRUMENT 9

2.1.1 EVOLUTION OF SUKUK AS AN ISLAMIC FINANCIAL INSTRUMENT 9

2.1.2 GENERAL PRINCIPLES, MILESTONES AND KEY TRENDS 11

2.1.3 THEORETICAL AND LEGAL NATURE OF SUKUK 12

2.1.4 THE COMPATIBILITY OF CURRENT SUKUK PRACTICES WITH ISLAMIC LAW 14

2.2 IMPORTANCE OF SUKUK IN DEVELOPING THE ISLAMIC FINANCIAL MARKET 15

2.2.1 ASSET DISTRIBUTION IN VARIOUS SEGMENTS OF ISLAMIC FINANCE 15

2.2.2 THE ROLE OF SUKUK IN DEVELOPING THE ISLAMIC FINANCE INDUSTRY 16

2.2.3 PIONEERING COUNTRIES IN THE SUKUK MARKET 17

2.3 KEY DOMESTIC AND GLOBAL INSTITUTIONS IN THE SUKUK MARKET AND THEIR

ROLES 19

2.3.1 KEY ROLES OF DOMESTIC AND INTERNATIONAL INSTITUTIONS 19

2.3.2 EXISTING STANDARD-SETTING BODIES AND THEIR ROLES 21

2.4 PARTIES INVOLVED IN THE ISSUANCE OF SUKUK: ROLES AND RESPONSIBILITIES 22

2.5 THE IMPORTANCE OF ESTABLISHING SHARIAH ADVISORY BOARDS FOR SUKUK 24

2.5.1 SHARIAH GOVERNANCE FRAMEWORKS (SGFs) AND A CENTRALISED SGF 25

2.6 THE IMPORTANCE OF CREATING A CONDUCIVE ENVIRONMENT FOR SUKUK 26

2.6.1 LEGAL 26

2.6.2 REGULATORY 30

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2.6.3 SUPERVISORY 32

2.7 NEW FRONTIERS FOR THE DEVELOPMENT OF SUKUK IN THE ICM 33

2.7.1 CONVERGENCE OF SUKUK WITH SRI 33

2.7.2 PROPOSAL FOR A COMMON GLOBAL SUKUK AND TRADABILITY OF SUKUK

CERTIFICATES 34

3. SUKUK STRUCTURES, ISSUANCES AND INVESTMENT 35

3.1 CRITICAL SUCCESS FACTORS FOR A SUSTAINABLE SUKUK MARKET 36

3.2 KEY CHALLENGES IN THE DEVELOPMENT OF A SUKUK MARKET 39

3.2.1 LEGISLATIVE FRAMEWORK (COMMON LAW VS CIVIL LAW) 39

3.2.2 TAX FRAMEWORK 40

3.2.3 STANDARDISATION OF SHARIAH GOVERNANCE 40

3.2.4 DEVELOPMENT OF A SUSTAINABLE SUPPLY OF CORPORATE SUKUK 43

3.2.5 LEVEL OF FINANCIAL INTERMEDIATION AND DIVERSIFICATION OF INVESTOR BASE 44

3.3 COMPREHENSIVE ASSESSMENT OF SUKUK STRUCTURES 44

3.3.1 ARAB COUNTRIES 44

3.3.2 ASIAN COUNTRIES 46

3.3.3 AFRICAN COUNTRIES 49

3.3.4 NON-OIC COUNTRIES 50

3.3.5 ANALYSIS OF SUKUK STRUCTURES ISSUED BY OIC AND NON-OIC COUNTRIES 51

3.4 A COMPREHENSIVE ASSESSMENT OF SUKUK ISSUANCES – SUPPLY (SELL SIDE) 53

3.4.1 ARAB REGION 53

3.4.2 ASIAN REGION 57

3.4.3 AFRICAN REGION 59

3.4.4 SUKUK ISSUANCES IN NON-OIC COUNTRIES 61

3.4.5 ANALYSIS OF SUKUK ISSUANCES IN OIC AND NON-OIC COUNTRIES 62

3.5 COMPREHENSIVE ASSESSMENT OF SUKUK INVESTMENTS – DEMAND (BUY SIDE) 63

3.5.1 ARAB REGION 63

3.5.2 ASIAN REGION 65

3.5.3 AFRICAN REGION 68

3.5.4 ANALYSIS OF SUKUK INVESTMENTS IN OIC COUNTRIES 69

4. CASE STUDIES 70

4.1 INTRODUCTION: SELECTION CRITERIA AND METHODOLOGY 70

4.2 MALAYSIA 73

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4.2.1 OVERVIEW OF MALAYSIA’S CAPITAL MARKETS 73

4.2.2 GROWTH OF THE SUKUK MARKET IN MALAYSIA 77

4.2.3 ANALYSIS OF SUKUK STRUCTURES, ISSUANCE AND INVESTMENT 80

4.2.4 KEY FACTORS UNDERPINNING MALAYSIA’S SUKUK MARKET 91

4.2.5 COUNTRY-SPECIFIC RECOMMENDATIONS 93

4.3 UNITED ARAB EMIRATES (UAE) 95

4.3.1 OVERVIEW OF UAE’S CAPITAL MARKETS 95

4.3.2 GROWTH OF THE SUKUK MARKET IN THE UAE 99


4.3.4 KEY FACTORS UNDERPINNING THE UAE’S SUKUK MARKET 108


4.4 INDONESIA 114

4.4.1 OVERVIEW OF INDONESIA’S CAPITAL MARKETS 114

4.4.2 GROWTH OF THE SUKUK MARKET IN INDONESIA 121


4.4.4 KEY FACTORS UNDERPINNING INDONESIA’S SUKUK MARKET 133


4.5 TURKEY 137

4.5.1 OVERVIEW OF TURKEY’S CAPITAL MARKETS 137

4.5.2 GROWTH OF THE SUKUK MARKET IN TURKEY 140


4.5.4 KEY FACTORS UNDERPINNING TURKEY’S SUKUK MARKET 151


4.6 HONG KONG 156

4.6.1 OVERVIEW OF HONG KONG’S CAPITAL MARKETS 156

4.6.2 DEVELOPMENT OF THE SUKUK MARKET IN HONG KONG 160

4.6.3 ANALYSIS OF SUKUK STRUCTURES, ISSUANCES AND INVESTMENTS 161

4.6.4 KEY FACTORS UNDERPINNING HONG KONG’S SUKUK MARKET 164


4.7 NIGERIA 169

4.7.1 OVERVIEW OF NIGERIA’S CAPITAL MARKETS 169

4.7.2 DEVELOPMENT OF THE SUKUK MARKET IN NIGERIA 171


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4.7.4 KEY FACTORS UNDERPINNING NIGERIA’S SUKUK MARKET 178


5. POLICY RECOMMENDATIONS ON SUKUK MARKET DEVELOPMENT 182

5.1 STRATEGIC FRAMEWORK AND ROAD MAP TO DEVELOP SUKUK MARKETS 182

5.2 GENERAL RECOMMENDATIONS IN DEVELOPING A VIBRANT SUKUK MARKET 185

6. CONCLUSION 190

6.1 SUKUK STRUCTURES 190

6.2 SUKUK ISSUANCES (SUPPLY – SELL SIDE) 192

6.3 SUKUK INVESTMENTS (DEMAND – BUY SIDE) 193

REFERENCES 195

APPENDIX 1: ACKNOWLEDGEMENT 204

APPENDIX 2: SURVEY RESULTS 206

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LIST OF TABLES Table 1: Stage of Sukuk Market Development by Case-Study Countries 2

Table 1.1: Case-Study Countries by Category of Sukuk Market Development 7

Table 1.2: Case-Study Countries by Regional Location 7

Table 2.1: Comparison between Bonds, Sukuk and Shares 12

Table 2.2: Required Parties in Sukuk Issuances and Their Roles 23

Table 2.3: Optional Parties in Sukuk Issuances and Their Roles 24

Table 2.4: Asset-Based and Asset-Backed Sukuk 28

Table 2.5: Tax Changes to Promote Sukuk 31

Table 3.1: Facilitative Roles of Key Market Stakeholders 37

Table 3.2: Shariah Contracts under AAOIFI Shariah Standards on Investment Sukuk 41

Table 3.3: A Snapshot of Sovereign Ijarah Sukuk Issuances by Selected Non-OIC Countries 50

Table 3.4: GCC Countries’ Budget Deficits (2014-2017f/ USD billion) 54

Table 3.5: Arab Countries – Number of Domestic Sukuk Issuances by Country (2001-2016) 54

Table 3.6: Arab Countries – Number of International Issuances by Country (2001-2016) 55

Table 3.7: A Snapshot of Selected Sukuk Issuances by Arab Countries 55

Table 3.8: Asian Countries − Number of Domestic Sukuk Issuances by Country (2001-2016) 57

Table 3.9: Asian Countries – International Sukuk Issuances by Country (2001-2016) 57

Table 3.10: A Snapshot of Selected Sukuk Issuances by Asian Countries 58

Table 3.11: A Snapshot of Selected Sukuk Issuances by African Countries 60

Table 3.12: Number of Domestic Sukuk Issuances by Country (2001-2016) 61

Table 3.13: Number of International Sukuk Issuances by Country (2001-2016) 61

Table 3.14: Composition of Financial Markets by Country as a Percentage of GDP 63

Table 3.15: Key Indicators of Financial Intermediation by NBFIs as a Percentage of GDP 63

Table 3.16: Composition of Selected Asian Financial Markets as a Percentage of GDP 65


Table 3.18: Composition of Selected African Financial Markets as a Percentage of GDP 68


Table 4.1: Development-Stage Matrix for Sukuk 70

Table 4.2: Description of the Development-Stage Matrix 72

Table 4.3: Malaysia’s Budget Deficits (2014–2017f) 79

Table 4.4: A Snapshot of Benchmark Corporate Sukuk Issuances in Malaysia 84

Table 4.5: Malaysian Institutional Investors 87

Table 4.6: Recommendations to Improve Demand (Buy Side) – Medium-Term Solutions 94

Table 4.7: Recommendations to Improve Demand (Sell Side) – Medium-Term Solutions 94

Table 4.8: UAE’s Budget Deficits (2014–2017f) 102

Table 4.9: A Snapshot of Benchmark Corporate Sukuk Issuances in the UAE 105

Table 4.10: Key Laws for the Establishment of the DIFC 109


Table 4.12: Recommendations to Improve Supply (Sell Side) – Medium-Term Solutions 113

Table 4.13: Indonesia’s Budget Deficits (2014–2017f) 123

Table 4.14: Types of Sukuk Negara Shariah Structures Approved by DSN-MUI 127

Table 4.15: A Snapshot of Indonesian Corporate Sukuk Issuance 129


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Table 4.18: Turkey’s Participation Banks (as at end-June 2017) 138

Table 4.19: Timeline of the Development of Turkey’s Islamic Finance Industry 139

Table 4.20: Turkey’s Budget Deficits (2014-2017f) 142

Table 4.21: Turkey's Public Sector Sukuk Issuances 143

Table 4.22: Turkish Private Sector’s Sukuk Issuance by Type of Shariah Structure 144

Table 4.23: Number of Lease Certificates Issued by Corporates (2010-August 2017) 146

Table 4.24: A Snapshot of Benchmark Corporate Sukuk Issuances in Turkey 148



Table 4.27: Market Capitalization of the World’s Top Stock Exchanges 159

Table 4.28: Hong Kong’s Financial Position in Selected Areas 160

Table 4.29: Timeline of the Development of Hong Kong’s ICM/Sukuk Market 160

Table 4.30: Overview of Hong Kong Government’s Sukuk Issuances 162



Table 4.33: Overview of Nigeria’s Government Sukuk Issuances 172

Table 4.34: Timeline of the Development of Nigeria’s ICM/Sukuk Market 173

Table 4.35: Size and Composition of Nigeria’s Domestic Bond Market (2015-2016) 176

Table 4.36: Investors of FGN Bonds Allotted in 2016 178



Table 4.39: Recommendations to Improve Infrastructure – Medium-Term Solutions 181

Table 5.1: Components of a Comprehensive Framework for Developing Sukuk Markets 184

Table 5.2: Key Issues and Recommendations by Stage of Sukuk Market Development 186

Table 6.1: Key Components of a Comprehensive Framework to Develop a Sukuk Market 190

Table 6.2: Key Issues and Challenges of Sukuk Markets – Sukuk Structures 191

Table 6.3: Key Issues and Challenges of Sukuk Markets – Supply Side 192

Table 6.4: Key Issues and Challenges of Sukuk Markets – Demand Side 194

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LIST OF CHARTS Chart 2.1: Sectoral Distribution of the Islamic Finance Industry (2016) 15

Chart 2.2: Growth of Islamic Finance Assets (USD billion, 2012-2016) 15

Chart 2.3: Malaysia vs Global Sukuk Issuance 17

Chart 3.1: Selected Arab Sovereign Issuances by Shariah Contracts (2011-June 2017) 45

Chart 3.2: Quasi-Sovereign and Corporate Issuances by Shariah Contracts (2011-June 2017) 45

Chart 3.3: Selected Asian Sovereign Issuances by Contracts (2011-June 2017) 47

Chart 3.4: Quasi-Sovereign and Corporate Issuances by Shariah Contracts (2011-June 2017) 47

Chart 3.5: Selected African Sovereign Issuances by Shariah Contracts (2013-June 2017) 49

Chart 3.6: GCC’s and Jordan’s Sovereign and Corporate Sukuk Issuance (2013–June 2017) 53

Chart 3.7: Quasi-Government and Corporate Sukuk Issuances by Sector (2011-June 2017) 54

Chart 3.8: Quasi-Government and Corporate Sukuk Issuances by Sector (2011-June 2017) 57

Chart 4.1: Growth of Malaysia’s ICM over a 10-Year Period 73

Chart 4.2: Malaysia’s Outstanding Capital Markets vs Bank Financing Relative to GDP 75

Chart 4.3: Evolution of Malaysia’s Bond Market 76

Chart 4.4: Malaysia’s Sovereign Sukuk vs Conventional Issuance (2006-June 2017) 78

Chart 4.5: Malaysia’s Sovereign Sukuk vs Conventional Outstanding (2006-June 2017) 79

Chart 4.6: Malaysia’s Corporate Sukuk vs Conventional Issuance (2006-June 2017) 80

Chart 4.7: Malaysia’s Corporate Sukuk vs Conventional Outstanding (2006-June 2017) 80

Chart 4.8: Malaysian Corporate Sukuk Issuance by Type of Shariah Contract (2005-2016) 81

Chart 4.9: YTMs of Malaysian Corporate Bonds (AA-Rated) – Islamic vs Conventional 88

Chart 4.10: YTMs of Malaysian Corporate Bonds (AA-Rated) – Islamic vs Conventional 88

Chart 4.11: GII Issued Domestically – Classification by Holder (2008-2016) 89

Chart 4.12: MGS Issued Domestically – Classification by Holder (2008-2016) 90

Chart 4.13: Investor Profile of Malaysia’s LCY Corporate Bonds 90

Chart 4.14: Factors Influencing the Development of Malaysia’s Sukuk Market 94

Chart 4.15: UAE’s Islamic Finance Penetration − Assets to GDP Ratio (2012-2016) 97

Chart 4.16: UAE’s Islamic Banking Assets and Outstanding Sukuk (2012–2016) 98

Chart 4.17: UAE’s Outstanding Capital Markets vs Bank Financing Relative to GDP 98

Chart 4.18: Evolution of the UAE Bond Market (2000–2017) 99

Chart 4.19: UAE Sukuk vs Conventional Issuance (2006-June 2017) 100

Chart 4.20: UAE vs GCC Total Sukuk Issuance (2006-June 2017) 100

Chart 4.21: UAE vs GCC Total Outstanding Sukuk (2006-June 2017) 101

Chart 4.22: UAE Sovereign Sukuk vs Conventional Issuance (2006-June 2017) 102

Chart 4.23: UAE National Banks’ Non-Resident Funding to Total Funding 103

Chart 4.24: UAE Corporate Sukuk vs Conventional Issuance (2006-June 2017) 104

Chart 4.25: UAE Corporate Sukuk Issuance by Type of Shariah Contract (2006-June 2017) 105

Chart 4.26: UAE Corporate Sukuk Issuance by Sector (2007-June 2017) 106

Chart 4.27: UAE Sovereign vs Corporate Sukuk Issuance (2006-June 2017) 107

Chart 4.28: USD 10-Year Sovereign Bond Yield 108

Chart 4.29: Factors Influencing the Development of the UAE’s Sukuk Market 112

Chart 4.30: Size of Indonesia’s Outstanding LCY Bond Market in USD (1997-2016) 114

Chart 4.31: Outstanding Government Bonds (December 2004-June 2017) 116

Chart 4.32: Outstanding Indonesian Corporate Bonds (December 2004-June 2017) 116

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Chart 4.33: Indonesia’s Sovereign Sukuk vs Conventional Issuance (2006-June 2017) 122

Chart 4.34: Indonesian 10-Year Sovereign Bond Yield 122

Chart 4.35: Indonesia’s Sovereign Sukuk vs Conventional Outstanding (2006-June 2017) 123

Chart 4.36: Indonesia’s Corporate Sukuk vs Conventional Issuance (2006-June 2017) 124

Chart 4.37: Indonesia’s Corporate Sukuk vs Conventional Outstanding (2006-June 2017) 124

Chart 4.38: Indonesia’s Outstanding Capital Markets vs Bank Financing Relative to GDP 125

Chart 4.39: Indonesian Sovereign Sukuk Issuance – Type of Shariah Contract (2008-2016) 126

Chart 4.40: Indonesian Corporate Sukuk Issuance – Type of Shariah Contract (2008-2016) 126

Chart 4.41: Development of Indonesia’s Domestic Corporate Sukuk (2002-2016) 128

Chart 4.42: Investor Mix for LCY Government Bonds 132

Chart 4.43: Indonesian Retail Sukuk Issuance (2009-June 2017) 132

Chart 4.44: Factors Influencing the Development of Indonesia’s Domestic Sukuk Market 135

Chart 4.45: Turkey’s Outstanding Capital Markets vs Bank Financing Relative to GDP 140

Chart 4.46: Turkey’s Sukuk Issuance vs Global Sukuk Issuance (2011-June 2017) 141

Chart 4.47: Turkey’s Gross Public Sector Debt (2001-2016) 142

Chart 4.48: Turkish Private Sector’s Conventional vs Sukuk Issuance 143

Chart 4.49: Turkey 10-Year Sovereign Bond Yield 147

Chart 4.50: Turkey’s Historical Savings (as a Percentage of GDP) and Savings Rates 149

Chart 4.51: Domestic Government Debt – Classification by Holder (2006 To 2016) 151

Chart 4.52: Factors Influencing the Development of Turkey’s Sukuk Market 154

Chart 4.53: Bond Issuance in Hong Kong (2006-June 2017) 158

Chart 4.54: Factors Influencing the Development of Hong Kong’s Sukuk Market 167

Chart 4.55: Market Capitalization as a Percentage of GDP 169

Chart 4.56: Nigeria’s Sukuk Issuance vs Africa’s (2008-October 2017) 171

Chart 4.57: Nigeria’s Outstanding Public Debt (2012-2016) 174

Chart 4.58: Size of Capital Markets in Nigeria (2014-2016) 175

Chart 4.59: Nigeria’s Money-Market Indicators in August 2017 176

Chart 4.60: Nigerian 10-Year Sovereign Bond Yield 177

Chart 4.61: Factors Influencing the Development of Nigeria’s Sukuk Market 180

Chart 5.1: Key Building Blocks in Developing the Sukuk Markets in OIC Countries 182

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LIST OF FIGURES Figure 2.1: Main Phases of Sukuk Development 11

Figure 2.2: New Entrants in the Sukuk Market 18

Figure 2.3: Domestic Institutions in the Development of Sukuk Structures and Issuances 19

Figure 2.4: International Institutions in the Development of Sukuk Structures and Issuances 20

Figure 2.5: Major Standard-Setting Organizations 22

Figure 2.6: Shariah Governance Processes 25

Figure 2.7: Models of Shariah Governance 25

Figure 2.8: Types of Legal Systems and the Adopting Jurisdictions 27

Figure 2.9: Characteristics of SPVs 29

Figure 2.10: Types of Trustee 30

Figure 2.11: SRI Sukuk Issued in the Islamic Finance Industry 33

Figure 3.1: McKinsey’s Building Blocks to Sustain the Long-Term Growth of Capital Markets 36

Figure 3.2: IDB Trust Services Limited –Wakalah Bil Istithmar Sukuk Structure 46

Figure 3.3: Malaysia Sukuk Global Berhad –Wakalah Sukuk Structure 48

Figure 3.4: Perusahaan Penerbit SBSN Indonesia III –Ijarah Sukuk Structure 48

Figure 3.5: HM Treasury UK Sovereign Sukuk Plc –Ijarah Sukuk Structure 51

Figure 3.6: Arab Countries’ Infrastructure Spending 56

Figure 3.7: Selected GCC Credits’ Order Books, Pricing Dynamics and Investor Profiles 64

Figure 3.8: McKinsey Asian Capital Markets Development Index 67

Figure 3.9: Constituents of McKinsey Asian Capital Markets Development Index 67

Figure 4.1: Malaysia’s Shariah Governing Bodies 82

Figure 4.2: Malaysia’s Corporate Sukuk Issuance by Sector (2015-Sep 2017) 83

Figure 4.3: Tax Incentives Accorded to Islamic Finance Based on Budget 2018 85

Figure 4.4: Process Flow for Sukuk Issuance in Malaysia 86

Figure 4.5: Key Factors Underpinning the Growth of Malaysia’s Sukuk Market 92

Figure 4.6: Phases of Islamic Finance’s Inclusion into Malaysia’s Financial Landscape 93

Figure 4.7: Key Factors Underpinning the Growth of UAE’s Sukuk Market 111

Figure 4.8: Phases of Islamic Finance’s Inclusion into the UAE’s Financial Landscape 111

Figure 4.9: Four Important Roles of the KNKS 120

Figure 4.10: Regulatory and Fiscal Initiatives to Develop the ICM (1999-2016) 120

Figure 4.11: Key Factors Underpinning the Growth of Indonesia’s Sukuk Market 133

Figure 4.12: Phases of Islamic Finance’s Inclusion in Indonesia’s Financial Landscape 134

Figure 4.13: Timeline of Turkey’s Sukuk Regulation 141

Figure 4.14: Regulatory and Fiscal initiatives to Develop Corporate Bond Issuance 144

Figure 4.15: Types of Lease Certificates Approved by the Communiqué 145

Figure 4.16: Key Factors Underpinning the Growth of Turkey’s Sukuk Market 152

Figure 4.17: Phases of Islamic Finance’s Inclusion in Turkey’s Financial Landscape 153

Figure 4.18: Hong Kong’s Sovereign Sukuk Issuances (2014-2017) 161

Figure 4.19: Key Factors Underpinning the Growth of Hong Kong’s Sukuk Market 165

Figure 4.20: Phases of Islamic Finance’s Inclusion in Hong Kong’s Financial Landscape 166

Figure 4.21: Key Factors Underpinning the Growth of Nigeria’s Sukuk Market 179

Figure 4.22: Phases of Islamic Finance’s Inclusion in Nigeria’s Financial Landscape 179

Figure 5.1: A Comprehensive Framework for the Cohesive Development of a Sukuk Market 183

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LIST OF BOXES Box 2.1: AAOIFI’s Ruling on the Role of the Shariah Advisory Board in Sukuk Structures 24

Box 2.2: IOSCO’s Approach to Regulating ICMs 31

Box 3.1: Benefits of LCY Bond Markets 35

Box 3.2: Definition of NBFIs 39

Box 3.3: Turkey’s Asset-Leasing Companies and Trust Certificates 39

Box 3.4: AAOIFI’s Pronouncement on Revised Shariah Standards on Sukuk (2008) 42

Box 3.5: Crowding Out and Crowding In 43

Box 3.6: Depth of Malaysia’s NBFIs 66

Box 4.1: Malaysia’s Capital Market Plan 1 (CMP1) 74

Box 4.2: Malaysia’s Capital Market Plan 2 (CMP2) 74

Box 4.3: Size of Selected Asian Debt Markets as at end-2016 (USD billion) 77

Box 4.4: Malaysia’s GII 78

Box 4.5: DIEDC Strategies to Position Dubai as the Capital of the Islamic Economy 96


Box 4.7: Indonesian Capital Market Master Plan (2005-2009) 117

Box 4.8: Indonesia’s Capital Market and NBFI Master Plan (2010-2014) 118

Box 4.9: Indonesian Shariah Capital Market Roadmap (2015-2019) 119

Box 4.10: Indonesia’s National Medium-Term Development Plan (2015-5019) 130

Box 4.11: Turkey’s Tenth Development Plan (2014-2018) 137

Box 4.12: Turkey’s Medium-Term Programme (MTP) (2018-2020) 138

Box 4.13: Turkey’s Historical Inflation Rate 149

Box 4.14: Turkey’s Pension System 150

Box 4.15: Turkey’s Investment Funds 150

Box 4.16: Hong Kong Ranks among the Top 5 IFCs 156


Box 4.18: Nigeria’s 2015-2025 Capital Market Transformation Programme 170

Box 4.19: Nigeria’s NICMP Master Plan 2015 – 4 Key Strategies 171

Box 4.20: Nigeria’s National Savings Strategy 178

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LIST OF ABBREVIATIONS

AAOIFI Accounting and Auditing Organization for Islamic Financial Institutions ABCP Asset-backed commercial paper ABS Asset-backed securitization ADB African Development Bank ADBF African Domestic Bond Fund ADIA Abu Dhabi Investment Authority ADIB Abu Dhabi Islamic Bank ADX Abu Dhabi Securities Exchange AFDB African Development Bank ALC Asset-leasing company AT1 Additional tier 1 ATKM Available tone kilometers AUM Assets under management BAPEPAM Indonesian Capital Market Supervisory Agency BBA Bay’ bithaman ajil BCBS Basel Committee on Banking Supervision BEWG Beijing Enterprises Water Group BI Bank Indonesia BNM Bank Negara Malaysia BOFIA Banks and Other Financial Institutions Act BPA Bond pricing agency BPAM Bond Pricing Agency Malaysia BRSA Banking Regulation and Supervision Agency BSAS Bursa Suq Al Sila CAGR Compounded annual growth rate CBN Central Bank of Nigeria CBRT Central Bank of the Republic of Turkey CBUAE Central Bank of UAE CET1 Common equity tier 1 CIC Central Bank Ijara Certificate CMB Capital Markets Board of Turkey CMP1 Capital Market Plan 1 CMP2 Capital Market Plan 2 DCIBF Dubai Centre for Islamic Banking and Finance DFM Dubai Financial Market DFSA Dubai Financial Services Authority DIAC Dubai International Arbitration Centre DIB Dubai Islamic Bank DIEDC Dubai Islamic Economy Development Centre DIFC Dubai International Financial Centre DMO Debt Management Office DRA Dispute Resolution Authority DSN Dewan Syariah Nasional (National Shariah Board) ECDG Exports Credit Guarantee Department EMBI Emerging Market Bond Index EPC Engineering, procurement and construction EPF Employees Provident Fund

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ESG Environmental, social and governance ETF Exchange-traded fund ETP Economic Transformation Programme EURIBOR Euro Interbank Offered Rate FCY Foreign currency FDI Foreign direct investment FGN Federal Government of Nigeria FIRS Financial Inland Revenue Service FDQ Financial Dealers Quotation FPI Foreign portfolio investment FRACE Financial Regulation Advisory Council of Experts FSB Financial Sector Blueprint FTSE Financial Times Stock Exchange GCC Gulf Cooperation Council GDP Gross domestic product GFC Global financial crisis GIC Government investment certificate GII Government investment issue GLC Government-linked company GMC Government Musharakah Certificate GoM Government of Malaysia GRE Government-related entity HMVKS Hazine Müsteşarlığı Varlık Kiralama A.S. HNWI High-networth individual IAIS International Association of Insurance Supervisors IBI Islamic banking institution ICM Islamic capital market IDB Islamic Development Bank IFA-OIC International Islamic Fiqh Academy of the Organisation of Islamic Cooperation IFC International Financial Centre IFFIm International Finance Facility for Immunisation IFI Islamic financial institution IFR Islamic fixed rate IFSB Islamic Financial Services Board IIFM International Islamic Financial Market IIFS Institutions offering Islamic financial services IILM International Islamic Liquidity Management IMF International Monetary Fund IMLF Interim margin lending facility IOSCO International Organisation of Securities Commissions IOU I owe you IPO Initial public offering ISDA International Swaps and Derivatives Association ISRA International Shari’ah Research Academy for Islamic Finance IT Information technology JII Jakarta Islamic Index KNKS Komite Nasional Keuangan Syariah (National Committee for Islamic Finance) KWAP Kumpulan Wang Persaraan (Diperbadankan) LCIA London Court of International Arbitration

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LCR Liquidity coverage ratio LCY Local currency LIBOR London Interbank Offered Rate LOLA Lodge and launch LTH Lembaga Tabung Haji (Haj Fund Board) LUA Land Use Act MBSB Malaysia Building Society Berhad MDB Multi-development bank MENA Middle East and North Africa MGS Malaysian government securities MIFC Malaysia International Islamic Financial Centre MOF Ministry of Finance MTN Medium-term notes MTP Medium-term programme MUI Majlis Ulama Indonesia (Indonesian Ulama’ Council) NAICOM National Insurance Commission NBFIs Non-bank financial intermediaries NCEF National Christian Elders Forum NDMF National Debt Management Framework NICMP Non-interest capital market product NKEA National key economic area NMRC Nigerian Mortgage Refinance Company NSE Nigerian Stock Exchange OECD Organisation for Economic Co-operation and Development OIC Organisation of Islamic Cooperation OJK Indonesia Financial Services Authority OTC Over the counter PBS Project-based sukuk PDS Private debt securities PENCOM Pension Commission PFA Pension fund administrator PLN Perusahaan Listrik Negara PNB Permodalan Nasional Berhad PPP Private public partnership RAM RAM Rating Services Berhad REIT Real estate investment trust Repo Repurchase agreement S&P Standard and Poor’s SAC Shariah Advisory Council SBSN Surat berharga Syariah negara SC Securities Commission SCA Securities and Commodities Authority SDG Sustainable development goal SDHI Hajj fund sukuk SEC Securities and Exchange Commission SFC Sovereign finance corporation SFH Special finance house SGF Shariah governance framework SME Small and medium-sized enterprise

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SNI Sukuk Negara Indonesia SOE State-owned entity SPC Special-purpose company SPE Special-purpose entity SPV Special-purpose vehicle SR Sukuk ritel (Retail sukuk) SRI Sustainable and responsible investment SWF Sovereign wealth fund T2 Tier 2 UAE United Arab Emirates UK United Kingdom UKLA United Kingdom Listing Authority UN United Nations UNCTAD United Nations Conference on Trade and Development US VAT

United States Value-added tax

VBI Value-based intermediation WB World Bank YTM Yield to maturity


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EXECUTIVE SUMMARY

Since the advent of Islamic finance, Islamic capital markets (ICMs) have gained worldwide attention in financing the needs of the public and private sectors. Sukuk has been the financial tool used to propel the success of ICMs. Its importance as an intermediary in channeling funds towards building a country’s economy has brought Islamic finance to the fore of the international financial markets. So much so that global financial centres (e.g. the UK, Hong Kong and Luxembourg) have all included sukuk issuance as part of their value proposition.

This publication, The Role of Sukuk in Islamic Capital Markets, is a comprehensive analysis of the part played by sukuk in the development of a country’s economy. Comparative assessments have been made on matured and developing ICMs, as well as those in their infancy. Ultimately, the lessons gleaned from a country’s progress in nurturing its Islamic financial arena will be used as a benchmark to accelerate or jump-start another country’s developmental efforts.

Our analysis focuses on the issues and challenges related to structure, issuance (supply or sell side) and investment (demand or buy side) when comparing a domestic sukuk market’s state of development against its neighbouring peers or geographical groupings. Under these core headings, several yardsticks have been used to determine the level of the sukuk market’s inclusion in its domicile financial system, and the progress of sukuk as a financing tool for economic development. These yardsticks have then been deployed towards a Development Stage Matrix, in which the general findings are highlighted below:

1. Legal and Regulatory Framework

Whether a country adopts the common law or civil law system has a bearing on the initial stage of sukuk development. Countries that use the common law system require fewer legislative changes due to their acknowledgment of trust, beneficial interest or usufruct, which determines the essence of Shariah contracts. The adoption of a centralized Shariah governance framework by some countries further strengthens the argument that harmonization of Shariah opinions is important in building a stronger pillar to support the sustainability of sukuk issuance.

A comprehensive framework and guidelines to govern the operations of an ICM and the products it promotes to the financial industry facilitate the move towards international best practices, corporate governance and investor protection. Core sukuk markets consist of developing nations; as these countries move to align their domestic financial markets to the international standards adopted by leading financial centres, sukuk will gain firmer ground in attracting the wealth of global investors.

2. Market and Infrastructure Development

Market and infrastructure development refers to the diversification of sukuk structures and products, the establishment of trading platforms, the ease of listing and approval processes, the Islamic money market, and commercial elements (e.g. cost competitiveness, turnaround time). The diversity of sukuk structures and products that promote liquidity management and the efficiency of asset utilization to meet Shariah requirements are among the factors to be considered in promoting the growth of a sukuk market. Hence the combined efforts of the


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government, regulators and market practitioners to identify potential technical issues; their proposed solutions are pertinent to phasing the development of the sukuk industry. 3. Taxation – Tax Neutrality and Tax Incentives One of the first steps before introducing sukuk into a country’s financial system is the adoption of a tax-neutral regime to match the cost competitiveness of conventional bonds. Once a tax-neutral framework is in place, additional tax deductions and/or waivers can then be implemented to incentivise potential issuers and investors to choose sukuk. 4. Diversified Market Players on the Supply and Demand Sides Both supply (sell side) and demand (buy side) need to be collectively developed from inception, to promote the dynamic shift for the successful inclusion of sukuk as an instrument used by the public and private sectors in promoting a country’s economic health. Only by understanding the various stages of progress of the abovementioned parameters can countries be categorized into the matured, developing (advanced, intermediate and beginner) or infancy brackets. Practical policy recommendations will then be proposed to elevate a domestic sukuk market to its next phase of development. The yardsticks highlighted above are applicable to all phases of development and are key to elevating a nascent sukuk market to developing status, and from developing to matured. Based on the yardsticks above, the respective case countries had then been ranked according to sukuk market’s stages of development. Table 1 summarizes the country’s sukuk market growth and its contribution to the global sukuk market. Table 1: Stage of Sukuk Market Development by Case-Study Countries Country Stage of sukuk market

development Rationale

Malaysia Matured

Malaysia’s sukuk market has grown leaps and bound and remain as the world leader in terms of market share. As at end-2016, Malaysia recorded a 41.1% (USD29.9 billion) share of total global sukuk issued. Its classification under ‘matured’ is predicated by a healthy pipeline of sukuk issuance by the public sector (34.6%) and private sector (65.4%), vibrant ecosystem (e.g. tax incentives, intermediation by NBFIs) and a strong value proposition that puts sukuk at an advantage compared to conventional bonds.

UAE Developing (Advanced)

By market share, the UAE made up 10.7% (USD8.05 billion) of total global sukuk issuance as at end-2016, mainly from the private sector. On average, UAE ranked second after Saudi Arabia in contributing to the supply of GCC’s corporate sukuk issuance. Even though its ecosystem has room for further improvement, its healthy pipeline of corporate sukuk supports the market’s level of competitiveness.


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Country Stage of sukuk market development

Rationale

Indonesia Developing

(Intermediate)

The Indonesian government’s keenness to grow its ICM has been a boon to Indonesia’s sukuk market. As at end-2016, the country recorded 16.3% (USD11.9 billion) market share, supported by issuances from the public sector (97.2%) and private sector (2.8%). By comparison, the sukuk ecosystem favours the public sector with no real value proposition created for corporate issuers. Nevertheless, Indonesia is placed under ‘developing’ due to its growing influence and potential in capturing a slice of the global sukuk market.

Turkey Developing (Beginner)

The growth of Turkey’s sukuk market is driven by the development of its participation banks and sovereign issuances. From the release of regulator’s Communique for sukuk, the number of issuance has rapidly grown to garner more than 4.0% (USD3.0 billion) market share of total global sukuk as at end-2016. The country’s status under ‘developing’ evidenced key stakeholders’ supportive role to move the sukuk industry to its next phase of growth.

Hong Kong Developing Hong Kong is reputed as an established international financial centre. Its endeavour to include Islamic finance into its financial system is to support a complementary role to the Islamic finance community which it currently serves. As a non-OIC nation that has returned to tap the sukuk market three times, it underscores the government’s interest to expand its sources of financing and investor base. Its categorisation under ‘developing’ relate to this initiative by the government compared to other global financial centres such as London, New York and Singapore.

Nigeria Infancy Nigeria has proactively included Islamic finance into its master plan to facilitate its ICM progression. However, its underdeveloped financial system, currency fluctuation, etc. pose certain challenges to grow its domestic bond market. Hence, its placement under ‘infancy’ to depict the requirement to strengthen its market infrastructure and attainment of macroeconomic stability to facilitate the growth of its domestic bond market.

Sources: RAM, ISRA


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In conclusion, the critical success factors for the establishment of a sustainable sukuk market include the following:

Cohesive collaboration with key market stakeholders – the development of a country’seconomic growth is the responsibility of all market players. Specific roadmap andframework for the inclusion of ICM, interlinking sukuk as a core component is key to guideand measure the effectiveness of participation level.

Vibrant ecosystem – the amalgamation of a strong legal and regulatoryregime, coupled with a conducive tax environment is the basic buildingblocks for sustaining long-term capital market growth. Its evolution toestablish a compelling value proposition for sukuk will be the tippingpoint in creating a successful ICM landscape.

Sustainable supply of private sector – the best yardstick in tracking thepulse of a local sukuk market is the performance of the private sector (i.e.quasi-government and corporate issuance). There are many successfulprecedence of the role private sector plays in promoting economic growthand ensuring their support is a commercial balance which needs to be

developed on the onset.

Shariah governance framework – a seamless Shariah governance process build into thefinancial system will make it attractive for all market players. Harmonistion of Shariahprinciples and interpretations adds clarity to product development, builds marketconfidence and creates awareness of the benefits of Islamic finance.

Intermediation of domestic financial resources – core to building asustainable financial environment is the effective mobilisation ofdomestic financial resources. However, basic pillars to grow domesticwealth starts with the stability of a country’s macroeconomic factors thatpromotes value creation within the domicile financial system. Once this ispresent there will be a competitive financial system that mobilisesinternal savings (e.g. pension funds) for productive investment.


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1. INTRODUCTION

Sukuk, commonly known as Islamic certificates or securities, play an increasingly significant role in the ICM as it allows investors to share the profits derived from the asset or activity that has been financed. The growth of sukuk as a financial instrument has predominantly been driven by Muslim countries, such as Malaysia and those that make up the Gulf Cooperation Council (GCC). The combination of a large Muslim population and a well-structured Islamic banking system based on common principles among the Muslim community, notably Shariah or Islamic law, has enabled these countries to issue almost all the sukuk to date in a global market that is now worth more than USD100.0 billion a year.

Sukuk is becoming an important asset class for investors from both conventional and Islamic backgrounds. By the same token, it is also attracting the attention of sovereign, multilateral and corporate issuers worldwide, thus further increasing the numbers embracing the principles of Islamic finance. The following provides a brief outlook on the sukuk market and the objectives, methodology and overview of this publication, The Role of Sukuk in the Islamic Capital Markets.

1.1 GLOBAL OUTLOOK OF THE SUKUK MARKET

The sukuk market remained active in 2017, bustling with new announcements and promising indicators of progress. The industry delivered a strong performance in the first half of 2017 registering up to USD53.6 billion (Eikon-Thomson Reuters). Notably, the global sukuk market rebounded in 2016, providing renewed confidence to market participants and setting the stage for more sukuk issuance in 2017 and beyond.

Ground-breaking issues in 2017 include Saudi Arabia’s maiden domestic sukuk facility of SAR17 billion (USD4.53 billion) under its Saudi Arabian Government SAR-denominated sukuk programme, which was oversubscribed more than 3 times, with demand exceeding SAR51.0 billion. In Turkey, the government launched the sale of gold-denominated lease certificates on 2 October 2017, in an attempt to tap households’ gold holdings. The issuance utilized public assets held by the central government, state-own enterprises and local administrations as the underlying asset.

Africa has also made some waves in the sukuk market, with The Gambia’s issuance of a number of short-term sukuk and Nigeria finally making its debut with a sovereign sukuk valued at 100 billion Nigerian naira (about USD277.0 million), for road construction and rehabilitation. More countries in Africa are anticipated to join the sukuk bandwagon in the foreseeable future, such as Kenya and Morocco. Elsewhere, the Hong Kong government issued another sovereign sukuk in 2017, positioning itself as one of the favored emerging sukuk markets for issuers. Another noteworthy announcement was by the UK Treasury, which promised to return to the sovereign sukuk market in 2019 with the reissuance of its GBP200 million inaugural sukuk (issued in 2014). This underlines the UK government’s commitment to further developing its Islamic finance market.

Other issuances which generated much market hype include the pioneer RM250.0 million (about USD59.0 million) green SRI sukuk from Malaysia, issued by Tadau Energy Sdn Bhd in July 2017, followed by Quantum Solar Park Malaysia Sdn Bhd’s RM1.0 billion (about USD236.0 million) issuance in October. Given the increased emphasis on environmental protection, green


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sukuk is expected to play a more important role in the coming years and garner greater support from regulators, governments and the private sector in building a more sustainable and eco-friendly economy.

1.2 AIMS, OBJECTIVES AND SCOPE OF THE STUDY

The main objective of this study is to analyze the role of sukuk as an instrument for capital market development and resource mobilization and as an alternative financing tool for the economic development of the public and private sectors. The research showcases 6 countries in different stages of sukuk market development, including 5 OIC member countries and a selected non-OIC member country. Based on this analysis, the study provides policy recommendations to promote sukuk at both domestic and global levels. It also envisages to facilitate the building of a cohesive sukuk development roadmap that OIC member countries can adopt. The study specifically covers the following:

1. The key building blocks in developing a sukuk market, including examining the theoretical and legal natures of sukuk, the institutions involved in developing the sukuk market, the parties involved in sukuk issuance, and the requisite conducive environment.

2. Comprehensive assessment of sukuk structures, issuances and investments, including topics and challenges vis-a-vis operational aspects, such as legal and regulatory issues, Shariah governance, innovation in sukuk structuring, the nature and application of sukuk structuring techniques, risk analysis, rating and pricing.

3. Case studies of sukuk development in 6 OIC and non-OIC countries, including the growth of their sukuk markets, analysis of their sukuk issuances, structures and investments, the challenges and drivers affecting the development of the sukuk market, and policy recommendations to address the issues arising and spur the growth of the sukuk market.

1.3 METHODOLOGY

Based on the objectives and scope of the study, the following methodology has been adopted to investigate the various aspects of sukuk development in the OIC and selected non-OIC member countries:

1. Desktop Research: This involves the review of the written literature, information, documents, country experiences, practices and works of relevant international institutions, and open sources of relevant national institutions. To enrich the study, it also involves analysis of data from industry and economic reports, research publications, macroeconomic data, and surveys of OIC countries. Primary data from Bloomberg and Eikon-Thomson Reuters have been used to assess information on the market shares of various segments in the Islamic financial markets, including sukuk, to provide a comprehensive assessment of sukuk structures and issuances across jurisdictions by different entities―corporate, quasi-sovereign and sovereign.

2. Survey and Interview (Online Survey, Phone Calls, Face-to-Face Meetings and Field Visits): This involves the development of survey questions and semi-structured


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interview questions on the core scope of the study, i.e. the development of the sukuk market and its role in the ICMs, from various perspectives―issuances, structures, investments, enabling infrastructure, issues and challenges. A series of interviews have been conducted with various parties involved in the sukuk market, such as issuers, lead arrangers, investment bankers, investors, legal advisers and regulators. The results from the interviews provide some insights on the challenges faced and the necessary improvements required to further develop the sukuk market, particularly in countries in the infancy and developing stages.

The selection of subjects for case studies was based on the diversity of regions and the different development stages of their sukuk markets in terms of their legal and regulatory frameworks, size and segments. Looking at historical trends and the study’s proposal to create a development roadmap for sukuk markets, Table 1.1 lists the countries chosen as case studies. Five OIC member countries have been selected along with Hong Kong―a non-OIC member country, based on its developed capital markets and increasing importance as a sukuk issuer in South East Asia.

Table 1.1: Case-Study Countries by Category of Sukuk Market Development Infancy Developing Matured

Nigeria UAE Malaysia Indonesia

Turkey Hong Kong

In terms of regional location, the selected countries are classified as per Table 1.2.

Table 1.2: Case-Study Countries by Regional Location

Region Asia Arab Africa

OIC Countries Malaysia UAE Nigeria Indonesia

Turkey Non-OIC Countries Hong Kong

1.4 OVERVIEW OF THE STUDY

The study comprises 6 chapters and is organized according to the following topics:

Chapter 1: Introduction

This chapter provides a brief outlook on the sukuk market, sets out the research objectives and explains the adopted research methodology.


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Chapter 2: Developing a Sukuk Market: Key Building Blocks

This chapter discusses sukuk as an Islamic financial instrument and delineates its role in developing the Islamic financial industry. It also deliberates on the prominent domestic and global institutions in the development of the sukuk market, as well as the roles and responsibilities of the parties involved in sukuk issuance. In addition, it touches on the importance of creating a conducive environment for sukuk, including the legal, regulatory and supervisory framework, and Shariah governance framework.

Chapter 3: Sukuk Structures, Issuances and Investment

This chapter assesses 3 main themes in sukuk: structures, issuances and investments. It first conducts a comprehensive assessment of the main sukuk structures used in OIC and non-OIC countries and adopted in sovereign, quasi-sovereign and corporate issuances. It highlights the key issues and challenges pertaining to disputed structures and the complexity of various structures. The chapter also assesses the sukuk issuances in domestic and international markets, new developments and trends, and issues and challenges. It then analyses sukuk investments, particularly focusing on factors influencing demand for sukuk, the different types of sukuk investors, the issues of credit rating as well as sukuk pricing, and the pursuit of the ESG agenda.

Chapter 4: Case Studies

This chapter examines the 6 selected case studies, classified as falling into either the matured, developing and or infancy stages of sukuk market development. Each case study provides an overview of the development of the sukuk market, an analysis of sukuk structures, issuances and investments, the challenges and factors shaping the development of the sukuk market, and policy recommendations to address the issues arising and to spur the growth of the sukuk market.

Chapter 5: Policy Recommendations on Sukuk Market Development

This chapter proposes a strategic framework and road map to develop the sukuk market. Based on the analyses in Chapters 2 and 3 as well as the case studies in Chapter 4, the recommendations seek to address structural, regulatory, technical and other main challenges that prevent the development of the sukuk market at the domestic and global levels. It also provides specific country- and international-level recommendations pertaining to sukuk market development.

Chapter 6: Conclusion

This chapter summarizes the research findings and concludes the discussion.


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2. DEVELOPING A SUKUK MARKET: KEY BUILDING BLOCKS

2.1 SUKUK AS AN ISLAMIC FINANCIAL INSTRUMENT

The idea of finding a Shariah-compliant alternative to interest-bearing bonds, with features and benefits similar to bonds, had led to the contemporary development of sukuk as an Islamic financial instrument. Islamic financial institutions had needed a Shariah-compliant tool that could be structured as a short-term instrument, to manage their excess liquidity. They also needed a Shariah-compliant instrument to raise medium- to long-term large-scale financing. Corporations and governments alike had sought a non-interest-based financing vehicle to raise funding for infrastructure projects, real estate development, asset acquisition, business expansion and other socio-economic projects. The early sukuk issuances had thus mimicked the features of fixed-income securities, providing regular returns to investors throughout the maturity period and repaying the capital upon redemption. The sukuk issuances had been backed by revenue from specific projects, instead of generating returns. Sukuk can also be issued in various denominations, currencies and tenures. Similar to conventional securities, they can be structured to target different types of investors, be rated and listed, be traded on the secondary market, be restructured and rescheduled, and be secured against different types of assets. All said Shariah compliance is vital in sukuk structuring, issuance and trading.

2.1.1 EVOLUTION OF SUKUK AS AN ISLAMIC FINANCIAL INSTRUMENT

The evolution of sukuk can be traced back from its classical use to its development in contemporary times. Early utilization of the term “sukuk” in classical literature can be traced back to the 1st Century AH, during the Umayyad Caliphate under the rule of Caliph Marwan ibn al-Hakam. A narration quoted in al-Muwattaʾ of Imam Malik (hadith no. 44) refers to sukuk as a certificate - more specifically, commodity or grain coupons - entitling its holders to the receipt of commodities/grains when the sukuk matured. The holders of these certificates used to sell the sukuk for cash before taking delivery of the commodities/grains upon maturity. This practice had led to the sale of the underlying assets that the sukuk represented before the holders took ownership of the commodities/grains. It was thus disapproved by scholars at the time.

According to Çizakça (2011), the Ottoman Empire (1299–1923) had been issuing similar financial certificates, known as esham, to finance public debt since 1775. These certificates had, as underlying assets, the right to collect taxes (a form of financial right); the tax revenue due to the state had been securitized to raise financing.

In more recent times, the International Islamic Fiqh Academy of the Organisation of Islamic Cooperation (IFA-OIC) discussed the issue of muqaradah bonds in 1986 and 1988. The deliberations established the conditions of issuing muqaradah certificates and thus legitimized the concept of sukuk. The idea approved was that of a muqaradah sukuk (a term used by the Maliki and Shafi’i schools of thought, which is similar to the term mudarabah sukuk), where the sukuk certificates represented:

... evidence of capital ownership, on the basis of shares of equal value, registered in the names of their owners, as joint owners of shares in the venture capital or whatever shape it may take in proportion to each one’s share therein (IFA-OIC, Resolution No. 30 (5/4), 1988).


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The IFA-OIC’s resolution on muqaradah sukuk had come after the Ministry of Awqaf, Islamic Affairs and Holy Places in Jordan initiated the process of issuing such sukuk in 1977. The Government of Jordan had been looking for Shariah-compliant financing for the renovation of waqf properties and had sought to use the revenue generated by specific projects to back the sukuk issuance. To initiate the process, it had promulgated the Muqaradah Bonds Act, which came into effect in 1981.

Besides Jordan, several attempts were made by other countries to issue sukuk before 1990, notably Pakistan, Malaysia and Turkey. These issuances were, however, short-lived (except for Malaysian government issuances) due to the prevailing conditions at that time in those countries.

The sukuk market underwent a nascent stage in 1990-2000. RAM (2013) identified this period as the awareness-building phase by stakeholders, including potential issuers and investors. In Malaysia, much attention had been given at that time to the introduction of the sukuk market, the players, the concepts, the mechanisms and the structures of sukuk.

The sukuk market marks its actual emergence from 2001. There has been an increased number of sukuk issues amid significant market growth. Sukuk has also evolved as a financial instrument in terms of the various types of Shariah contracts used in its structuring, the underlying assets backing the issuance, the types of sukuk issued and developments in terms of players, investors, markets and infrastructures, among others. Figure 2.1 summarizes these main phases of sukuk development.


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Figure 2.1: Main Phases of Sukuk Development

Source: ISRA (2017)

2.1.2 GENERAL PRINCIPLES, MILESTONES AND KEY TRENDS

Unlike conventional securities, sukuk must adhere to Shariah rules and principles, including its structuring, the underlying assets that back the sukuk issuance, the investment of sukuk proceeds, as well as its trading and rescheduling/restructuring.

A number of Shariah-compliant contracts are used to create financial obligationsbetween the sukuk issuers and sukuk holders, including sale, lease, partnership, agencyand a combination of contracts. Wakalah contracts have been increasingly used in recentyears.

The underlying assets of the sukuk structure must be Shariah-compliant and mayinclude tangible assets, usufructs, income-generating services, intangible assets,receivables from Shariah-compliant commodities, and the assets of particular projects orinvestment activities. The underlying assets of sukuk have further developed to include amix of both debts (e.g. receivables from Shariah-compliant sales of commodities) andnon-debt assets (e.g. tangible assets comprising lease assets and Shariah-compliantshares) to form a blended portfolio.


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The investment of sukuk proceeds should be for Shariah-compliant purposes and mostlyfund activities in real sectors.

The tradability of sukuk is guided by the relevant Shariah rules, e.g. sukuk holders mustown all the rights and obligations associated with the ownership of the sukuk assets, andsukuk must not represent receivables or debts (AAOIFI, 2015).

The rescheduling/restructuring of sukuk may be treated differently, depending on thetype of underlying assets involved and the underlying Shariah contracts used in theirstructuring.

2.1.3 THEORETICAL AND LEGAL NATURE OF SUKUK

In theory, all sukuk represent a form of equity as they epitomise certificates that confer to their holders’ ownership of an asset or a pool of assets, and/or a claim to its/their cashflows. In practice, sukuk are characterized according to their risk–reward structures and profiles; hence they are divided into sale-based, lease-based, partnership-based, agency-based and hybrid sukuk (which possess the characteristics of both debt and equity). This classification is also a reflection of the underlying Shariah contracts used in their structuring. Moreover, not all sukuk are asset-rooted: some are fully asset-backed, others have limited degrees of ownership while some merely refer to a pool of reference or collateral assets. The nature and type of assets used form the second category in sukuk classification. In addition, sukuk are known for their technical and commercial features, based on the nature of the issuer, the tenure of the certificates, the complexity of the structures and other features.

Sukuk, Bonds and Shares

Sukuk, bonds and shares are capital market instruments. They share some similarities and differences with each other. Table 2.1 provides a detailed comparison between the instruments.

Table 2.1: Comparison between Bonds, Sukuk and Shares Bonds Sukuk Shares

Nature

Represent IOUs or interest-bearing debt obligations of the issuer.

Represent proportionate ownership in Shariah-compliant assets, usufructs, services, intangible assets, commodities, or profit-sharing ventures, or financial assets, or any combination of these through a mixed portfolio of various assets.

Represent proportionate ownership in the corporation.

Issuers Issuers of conventional bonds are not limited in their business activities.

Any issuer that is engaged in business activities which are permissible under Shariah.

Any issuer.

Investors Only non-Islamic investors.

Islamic and non-Islamic investors. Islamic and non-Islamic investors.

Relationship Established Between Issuers and Investors

Lending relationship giving investors the status of creditors.

Relationships are based on Shariah contracts used in structuring the sukuk.

Investors are conferred ownership rights (become shareholders) in the corporations issuing the shares.


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Bonds Sukuk Shares

Underlying Assets

No asset is required for unsecured bonds, i.e. the bonds need not be backed by any collateral. For secured bonds, the underlying assets backing them may include non-Shariah-compliant assets.

Underlying assets must comply with Shariah requirements. Underlying assets can represent both debt (arising from Shariah-compliant activities) and non-debt assets. Asset backing has evolved from 100% of assets to minimum levels of 51%, 33% or 30%. In certain jurisdictions, it is acceptable to have 100% of debt receivables and no other asset.

Not required.

Asset-Related Expenses

Bond holders are not affected by asset-related expenses.

Sukuk holders may be affected by asset-related expenses.

None.

Status

Generally involves unsecured creditors, except if the bonds are backed by specific assets.

Sukuk holders in asset-backed sukuk have recourse to the assets in the event of default, or if the issuers have difficulty in repaying. They are ranked senior to unsecured creditors. Holders of asset-based sukuk are generally ranked pari passu with other unsecured creditors and have no recourse to the assets.

Shareholders represent the most junior in rank to other classes of securities with full or preferred voting rights. Equity can also be in the form of preference shares, which have near-senior claims to dividends and capital.

Returns to Investors

Coupon payments in the form of interest representing a percentage of the capital. They correspond to fixed interest, connoted as riba.

Periodic payments represent a percentage of actual profits (generated from sale and partnership contracts) and rental income (generated from lease contracts).

Shareholders receive dividend payments. These are not guaranteed by the corporation.

Principal Repayment by Issuers

Return of principal at maturity is an irrevocable obligation, irrespective of whether the funded project is profitable.

In principle, there is no ex-ante fixed obligation of capital repayment for equity-based contracts. There are usually repurchase undertakings or dissolution provisions to guarantee capital repayment under ijarah and other structures.

None, as shares represent perpetual instruments.

Utilization of Proceeds

No specific requirement. Bonds can be issued to meet any financing needs that are legal in the jurisdiction of the issuer.

Proceeds must be used to finance Shariah-compliant activities.

Equity can be issued to meet any financing need of the corporation.

Tradability in Secondary Market

Selling bonds represent a sale of debt.

Selling sukuk is basically the sale of a share in an asset or a project. Shariah standards at the global level (e.g. AAOIFI) only allow the sale of tangible assets, some intangible assets and interests in ventures, whereas Malaysia allows the sale of debt (for sale-based sukuk).

Represents a sale of shares in the company.

Pricing

Bond pricing is based on the credit rating of the issuer as well as terms and conditions, usually a spread over a reference interest rate.

Sukuk pricing depends on the structure of the sukuk. For non-recourse asset-backed sukuk, pricing is based on the asset backing the sukuk. For sukuk structured based on fixed-income and debt-creating contracts, their pricing is typically similar to bond pricing, but may be affected by factors that include market depth/breadth, liquidity and complexity.

Pricing is tied to the performance of the corporation.

Source: ISRA (2017: 31-33)


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Difference in Shariah Views on Selected Shariah Principles

There are differences in Shariah opinions among scholars on some of the Shariah principles applicable to sukuk structuring and trading, such as bay’ al-inah (sale and buy-back) and bay’ al-dayn (sale of debt). Bay’ al-inah is applied in ijarah and murabahah sukuk involving the sale and buy-back of the underlying assets or commodities. The majority of scholars prohibit inah. For example, the International Islamic Fiqh Academy (IFA) of the Organisation of Islamic Cooperation (OIC), in its 20th session (2012) issued a resolution prohibiting the current structure of asset-based ijarah sukuk because it is a form of sell-and-buy-back arrangement (bay’ al-inah). Nonetheless, based on its meeting held on 12 December 1998, the Shariah Advisory Council (SAC) of Bank Negara Malaysia (BNM) approves of bay’ al-inah as the mechanism is acceptable to the Shafi’i School. The Guidelines on Unlisted Capital Market Products under the Lodge and Launch Framework (2015) by Securities Commission Malaysia (SC) also allow the trading of sukuk representing only receivables at any price, subject to some conditions. Even so, there have been efforts in the Malaysian market to introduce some degree of Shariah harmonization by shifting away from bay’ al-inah practices. This is mainly the result of an attempt to align Malaysian market practices with Middle Eastern practices, to seek greater international acceptance of Islamic financial transactions.

Two main schools of thought prevail regarding the secondary market trading of sale-based sukuk, which faces the issue of bay’ al-dayn (sale of debt). These sukuk create indebtedness due to the sale of the underlying assets (e.g. in bay’ al-inah, tawarruq, murabahah, istisna’ transactions) or commodities to be received in the future (e.g. in salam sukuk). Global Shariah standards restrict the trading of these sukuk because receivables are viewed as money; thus, trading must be done at par, i.e. for the same amount with no discounting. On the contrary, the sale of debt at a discount is allowed by the SAC of the SC, which enables the trading of sale-based sukuk in the secondary market (ISRA, 2016).

2.1.4 THE COMPATIBILITY OF CURRENT SUKUK PRACTICES WITH ISLAMIC LAW

Sukuk structuring must, of course, comply with Shariah principles. However, Shariah issues arise in the structures of several sukuk. One of the strongest criticisms against partnership-based sukuk is by the prominent Shariah scholar, Mufti Taqi Usmani, in 2007. He stated that the use of purchase undertakings and liquidity facilities converts partnership-based sukuk to a debt-based transaction, whereby the sukuk is redeemed at par value and sukuk holders are paid a guaranteed periodic return on capital throughout the tenure of the sukuk. Pursuant to the Shariah concerns raised, the AAOIFI pronounced in February 2008 that partnership-based sukuk prohibit credit enhancements in the form of Shariah-compliant funding to smooth out periodic income distributions to sukuk holders and purchase undertakings to guarantee the return of the principal amount to sukuk holders at its par or nominal value. Shariah scholars constantly seek to address the concerns on Shariah issues.


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2.2 IMPORTANCE OF SUKUK IN DEVELOPING THE ISLAMIC FINANCIAL MARKET

Sukuk represents the second-largest component of the Islamic finance industry, after Islamic banking. Post-2000s, it has been championing the Islamic finance industry, capturing the attention and interest of a wide range of issuers and investors. It has expanded the Islamic financial market to far-off jurisdictions across the globe, with sukuk considered an important fund-raising tool by both Muslim-majority and non-Muslim-majority countries.

2.2.1 ASSET DISTRIBUTION IN VARIOUS SEGMENTS OF ISLAMIC FINANCE

According to RAM, the global Islamic finance industry’s assets across its 4 main sectors (i.e. Islamic banking, sukuk, Islamic funds and takaful) summed up to USD2.2 trillion as at end-December 2016. The industry has been charting a CAGR of 5% since 2012. The ICM, particularly sukuk, has been the fasting growing among all the asset classes in Islamic finance.

Islamic banking continues to dominate the industry, with USD1,657.0 billion of global assets as at end-December 2016, representing 75% of the Islamic finance market. It was followed by the sukuk market, with outstanding sukuk amounting to USD328.0 billion as at the same date, accounting for 15% of the entire market. However, Islamic fund assets and takaful contributions still only represent a small percentage of the Islamic finance industry, with a respective USD183.0 billion (8% market share) and USD40.0 billion (2% market share). Chart 2.1 shows the breakdown of Islamic finance assets by sector as at end-2016, while Chart 2.2 illustrates the growth of Islamic finance assets between 2012 and 2016.

Chart 2.1: Sectoral Distribution of the Islamic

Finance Industry (2016)

Chart 2.2: Growth of Islamic Finance

Assets (USD billion, 2012-2016)

Source: RAM


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2.2.2 THE ROLE OF SUKUK IN DEVELOPING THE ISLAMIC FINANCE INDUSTRY

Sukuk plays an important role in further developing and expanding the Islamic finance industry. It is the second fastest-growing asset class, with a CAGR of 5% since 2012, according to data from RAM. It provides issuers with an alternative to syndicated loan financing and bonds, to finance their capital expenditure and acquisitions. They can tap the ICM to raise alternative funding that is backed by strong investor demand. Similarly, it allows investors, who may have previously over-relied on bank deposits and equity, to access the ICM and non-equity-like instruments.

The following are some ways in which sukuk can further expand the Islamic finance market:

The issuance of sukuk adds to the diversity of ICM products, providing furtherdynamism to the Islamic financial system. Most international financial centres aim toinclude sukuk as one of their products to attract international issuers and investors.One such example is Hong Kong. To further consolidate its position as a globalfinancial centre, Hong Kong has been actively pursuing the development of a sukukmarket, with 3 issuances from the government to date, i.e. in 2014, 2015 and 2017.

Sukuk represents an alternative public and corporate debt instrument for fundingpurposes. For instance, Saudi Arabia’s reform plan, Vision 2030, which aims to reducethe country’s dependence on oil revenue, includes initiatives to develop the Saudicapital markets as a source of long-term funding for the financing of proposed projects.This provides opportunities for the further growth of sukuk.

For governments, sukuk represents an important tool to fund budget deficits,infrastructure and mega projects, and other economic development programmes. Forinstance, amid the GCC member countries’ dwindling oil revenues, they can capitalizeon the strong global appetite for sukuk to finance widening budget deficits.

Sukuk with shorter tenures can also be used as a tool in the Islamic money market,providing retail banks and other Islamic financial institutions with liquiditymanagement facilities. Such short-term sukuk for these purposes have been issued byBangladesh, Malaysia, Bahrain, The Gambia, Indonesia and Brunei Darussalam.Looking ahead, more of such shorter-tenured sukuk is expected to be issued injurisdictions that seek to promote their domestic Islamic finance industries.

The availability of short-term sukuk can support the launch of Islamic retailbanking/financing services in jurisdictions where such services are not available. Agovernment issuance of short-term sukuk, for instance, will provide a Shariah-compliant asset that banks could use to back the supply of Shariah-compliant retailproducts.

Similarly, the issuance of debut government sukuk can help create pricing benchmarksagainst which all other debt instruments in the same market can be priced. This is anessential starting point to encourage the development of corporate sukuk and othergovernment issues in markets where sukuk has yet to evolve.


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2.2.3 PIONEERING COUNTRIES IN THE SUKUK MARKET

Shell MDS Malaysia Sdn Bhd’s sukuk issuance in 1990 is widely recognized as the market’s pioneer sukuk. It was the first ringgit-denominated corporate sukuk and was issued by a non-Islamic company in a Muslim-majority country, i.e. Malaysia. Over the years, Malaysia has evolved into a leading centre for sukuk issuance accounting for a significant share global issuance, as reflected in Chart 2.3.

Chart 2.3: Malaysia vs Global Sukuk Issuance

Sources: Eikon-Thomson Reuters, RAM

Sudan was another pioneer of sukuk issuances in the 1990s. The Sudanese government developed sukuk as an alternative monetary policy instrument for open-market operations, such as:

Shahama Bonds or Government Musharakah Certificates (GMCs). These are short-termsecurities issued since 1999, to raise short-term government financing to cover suchcosts as civil service and defense expenses (Institute of Islamic Banking and Insurance,2009).

Government Investment Certificates (GICs). These are medium-term securities,whereby the Ministry of Finance is the originator and the money raised is invested inspecific projects financed by the government.

Central Bank Ijara Certificates (CICs), which are backed by the buildings owned by theCentral Bank of Sudan.

In recent years, some countries outside the key markets have launched some pioneering issues. These debut sukuk reflect the positive market momentum at present. Some of these ground-breaking issuances by the new entrants in the sukuk market are shown in Figure 2.2.


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Figure 2.2: New Entrants in the Sukuk Market

Source: sukuk.com

Although these issuances still represent a small percentage of the sukuk market, they reflect

the keen interest shown by sovereigns in tapping the ICM to generate funding. Efforts have

been made despite the existing challenges faced by the industry, such as the lack of a

standardized sukuk framework, which makes it difficult to set up legal structures and

legislation in the respective jurisdictions to facilitate sukuk issuance. This may mean a more

cumbersome issuance process, a longer time frame and higher costs compared to

conventional means of raising finance.


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2.3 KEY DOMESTIC AND GLOBAL INSTITUTIONS IN THE SUKUK MARKET AND THEIR ROLES

Domestic and international institutions are pre-requisites to the growth and development of sukuk markets, both local and global. While domestic institutions are pertinent to the promotion of a country’s domestic and international sukuk issuance, international institutions play their roles in fueling the growth and sustainability of the global sukuk market. 2.3.1 KEY ROLES OF DOMESTIC AND INTERNATIONAL INSTITUTIONS

Prominent Domestic Institutions Each country has its own domestic institutions that play key roles in different stages of sukuk market development. The most prominent domestic institutions are highlighted in Figure 2.3.

Figure 2.3: Domestic Institutions in the Development of Sukuk Structures and Issuances

Source: ISRA Section 3 of this publication will discuss in greater detail the roles of these domestic institutions and other key stakeholders in developing successful and sustainable sukuk markets.


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Prominent International Institutions

Many international institutions have played instrumental roles in the institutional

development of sukuk structures and issuances. Classic examples of these key institutions are

summarized in Figure 2.4.

Figure 2.4: International Institutions in the Development of Sukuk Structures and Issuances

Source: ISRA

The IDB is a regular issuer and the most prominent institution that has driven the global sukuk market to its current position. Its contribution is not limited to sukuk issuance but includes innovating new structures that fully comply with the tenets of Shariah. Besides funding its operational businesses, IDB sukuk issuances also aim to achieve the following objectives:

Expand the IDB sukuk yield curve. Enhance its profile in the international capital markets and reach out to new investors. Establish a benchmark in the supranational market. Undertake issuance in or linked to different currencies.

As of June 2017, the IDB had issued all its sukuk under an MTN programme, except for its debut sukuk in 2003, which was registered and approved by the Financial Services Authority/United Kingdom Listing Authority (UKLA). The IDB sukuk is currently listed on the London Stock Exchange, Bursa Malaysia (Exempt Regime), Nasdaq Dubai and Borsa Istanbul.


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The MTN programme was established in 2005, with an initial size of USD1.5 billion; it has since been upsized several times to USD10.0 billion. The MTN programme carries AAA ratings by international rating agencies. The IDB’s MTN programme is denominated in various currencies, with maturities of more than 1 year and take the form of both public issuances and private placements. In addition to its USD-denominated MTN programme, the IDB has also issued a LCY RM1.0 billion MTN programme in Malaysia, to finance projects in ringgit. To date, 3 tranches of RM sukuk have been issued, amounting to RM700 million. The 10-year MTN programme was established in August 2008 and will expire in August 2018. The programme is registered with the SC and is listed and tradable on Bursa Malaysia under the issuer/SPV name of Tadamun Services Berhad. Meanwhile, the World Bank is considered a new entrant in the sukuk market. Yet, given its mandate of alleviating extreme poverty and promoting shared prosperity, this institution will issue more sukuk in the future, particularly social and green sukuk. 2.3.2 EXISTING STANDARD-SETTING BODIES AND THEIR ROLES

Conventional standard-setting bodies such as the Organisation for Economic Co-operation and Development (OECD), the International Organisation of Securities Commissions (IOSCO) and the Basel Committee on Banking Supervision (BCBS) have issued different guidelines on economic development, governance, securities regulation, prudential regulation, risk management, and other topics. However, some of these guidelines do not cater to the unique nature, specificities and business propositions of the Islamic financial services industry. This has therefore led to the establishment of various international standard-setting bodies to support the growth and development of the global industry, as illustrated in Figure 2.5. These institutions have played pivotal roles in the development of the sukuk market. For example, the IFSB via its IFSB-15 (as indicated in Figure 2.5) provides guidance on the maintenance of high-quality regulatory capital components by IBIs that comply with Shariah rules and principles. It defines the relevant criteria for tier-1 (comprising common-equity tier-1 (CET1) and additional tier-1 (AT1)) and tier-2 (T2) capital to adapt to the regulatory changes under Basel III, and identifies the type of Shariah-compliant instruments that institutions offering Islamic financial services (IIFS) may issue to qualify for inclusion in AT1 and T2. These instruments include equity-based sukuk such as musharakah, mudarabah and wakalah sukuk. Following the implementation of Basel III and IFSB-15, the global sukuk market has seen the issuance of AT1 and T2 sukuk by Islamic banks to satisfy their regulatory capital requirements. While perpetual AT1 sukuk issues are mainly dominated by GCC-based Islamic banks (e.g. Abu Dhabi Islamic Bank (ADIB), Dubai Islamic Bank (DIB), Al-Hilal Bank, Qatar Islamic Bank and Boubyan Bank), other Islamic banks in various jurisdictions including Malaysia, Turkey, Pakistan and Saudi Arabia have issued T2 sukuk.


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Figure 2.5: Major Standard-Setting Organizations

Source: ISRA

These organizations have set various standards to facilitate the further growth of the sukuk market. Nonetheless, little success has been achieved thus far as their standards are only adopted by a few jurisdictions. Besides, more effort should be made, particularly in standardizing legal documentation for various sukuk structures that are available in the market. This standardization would go a long way towards providing simplified documents, thereby reducing sukuk issuance cost, which is regarded as the main deterrent pushing issuers and investors towards conventional bonds. Some argue that even sukuk structures and Shariah rulings on sukuk must also be standardized, especially with the recent Dana Gas episode (Ulusoy and Ela, 2017). Standardization would enhance transparency in understanding the complex requirements of sukuk structures, thus boosting market confidence.

2.4 PARTIES INVOLVED IN THE ISSUANCE OF SUKUK: ROLES AND RESPONSIBILITIES

Different sukuk structures involve different parties, depending on their underlying Shariah contracts. For instance, partnership-based sukuk (musharakah and mudarabah sukuk) require a manager to manage the venture; lease-based sukuk (ijarah sukuk) entails a lessor, a lessee and a servicing agent; and agency-based sukuk (wakalah bil istithmar sukuk) needs an investment agent to manage the investment assets.


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Nonetheless, any generic sukuk issuance would involve the parties listed in Tables 2.2 and 2.3. While Table 2.2 describes the essential or required parties and their roles, Table 2.3 delineates some optional parties involved in a sukuk issuance.

Table 2.2: Required Parties in Sukuk Issuances and Their Roles

Parties Roles and Responsibilities

Issuer An entity which offers and issues the sukuk; can either be the obligor or an SPV. Obligor An entity which needs the funding and is responsible for paying the sukuk holders –

coupon payments and principal amount at redemption. Originator An entity which sells the asset(s) to the SPV issuer and receives the proceeds from

the sale of the sukuk. Can also be the obligor or related to the obligor. Sukuk holder Owner of the sukuk; can either be the primary subscriber or a secondary investor. Primary subscriber

Entity or individual that subscribes to the sukuk offering and is the first holder.

Special-purpose vehicle

An entity incorporated in onshore or offshore jurisdictions; this corporate entity is used to nominally own assets and/or facilitate other aspects of the sukuk issuance and structure for various purposes, including tax efficiency and asset protection.

Shariah adviser

The formal authority which approves the sukuk structures in terms of Shariah compliance; it can be at the institutional level issuing the sukuk and/or at the central level (e.g. the SAC of the SC).

Regulator Sovereign approving body; all capital market offerings need to be approved or exempted by a regulator. Typically, there is a main regulator where the sukuk is primarily offered (in the country of the obligor), but international-currency issuances will need to be approved by the relevant regulators.

Credit enhancer

A third party (e.g. a government agency, bank or takaful company) or a related party (holding company) that provides a guarantee or some form of credit enhancement.

Investment bank

A single or small group of investment banks which primarily act the lead arranger (arranging the sukuk offering, advising the issuer/obligor on market conditions, and coordinating the offering, including marketing); a rating adviser (providing advice on how to achieve an optimal rating); a book runner (managing the fundraising, approaching potential investors, providing guidance on pricing, market conditions and appetite, and monitoring sukuk demand and orders); and a lead manager (a significant subscriber of the sukuk issuance that provides credibility).

Trustee A professional firm or unit of a bank or law firm which mechanically acts on pre-agreed instructions; acts and holds the sukuk assets on behalf of the holders.

Facility agent A professional firm or unit of a bank or law firm which manages the operational aspects of the sukuk structure, such as the disbursement of the issuance amount and profit payments to investor accounts. A facility agent can also act as a security agent/trustee.

Security agent/trustee

A professional firm or unit of a bank or law firm which manages the assets securitized/collateralized under the sukuk deal (e.g. holds specific security assets for the benefit of the holders, realizes/liquidates any mortgage or other collateral in the event of a default).

Credit rating agency

A pre-approved professional firm which provides opinions on credit risk and examines the parties in the transaction and the structure. Credit rating opinions are issued upon or soon after issuance, and updated throughout the life of the sukuk.

Legal adviser A law firm which advises on the legal and regulatory requirements (e.g. a legal opinion on structure and enforceability, and may cover legal due diligence, which may be a requirement, and guidance on commercial matters.

Source: ISRA (2017)


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Table 2.3: Optional Parties in Sukuk Issuances and Their Roles

Parties Roles and Responsibilities

Listing/registrar Listing means included in the official list of an exchange. Listing requires ongoing disclosure. The registrar records the names of the holders. However, not all sukuk are listed.

Market maker Investment banks which hold sukuk to facilitate ready buying and selling of small amounts.

Hedging provider

A bank or group of banks which hedge cash flows to enable the sukuk’s cash flow to be met (e.g. local currency to foreign, or floating rate to fixed).

Underwriter Investment banks which underwrite a sukuk offering, i.e. purchasing an amount of sukuk offered but not subscribed. Successful sukuk tend to be presold and oversubscribed, thus reducing underwriting risk.

Secondary investor

Entity or individual that becomes a holder and purchases the sukuk after it has been traded in the secondary market by the primary subscribers.

Source: ISRA (2017)

2.5 THE IMPORTANCE OF ESTABLISHING SHARIAH ADVISORY BOARDS FOR SUKUK

As an Islamic financial instrument, sukuk must adhere to the strict rules and requirements of Shariah at every stage: structuring, issuance and trading. Compliance with Shariah is essential in maintaining the distinguishing features of sukuk from conventional bonds and fixed-income securities. Any breach in meeting Shariah requirements would negatively affect the growth of the sukuk market. Consequently, it is imperative to establish a sound Shariah governance framework (SGF) that performs an oversight function during different stages of the sukuk’s development, from its inception and conceptualization until maturity. There is a role for Shariah advisory, Shariah supervision, and Shariah review and audit functions. Most importantly, a Shariah advisory board must be established to ensure effective, independent oversight of Shariah compliance. Box 2.1 explains the roles of the Shariah advisory board pertaining to sukuk, as outlined by the Shariah Committee of the AAOIFI.

Box 2.1: AAOIFI’s Ruling on the Role of the Shariah Advisory Board in Sukuk Structures

The Shariah Committee of the AAOIFI has issued the following rules for Shariah governance with regard to sukuk issuance, following its study of 3 sessions:

(i) Madinah on 27 June 2007 (ii) Makkah on 8 September 2007 (iii) Bahrain on 13–14 February 2008

Shariah supervisory boards should not limit their role to the issuance of fatwa on the permissibility of sukuk structures. All relevant contracts and documents related to the actual transaction must be carefully reviewed (by them), after which they should oversee the actual means of implementation, and make sure the operation complies, at every stage, with Shariah guidelines and requirements, as specified in the Shariah Standards. The investment of sukuk proceeds and the conversion of the proceeds into assets, using one of the Shariah-compliant methods of investment, must conform to Article (5/1/8/5) of the AAOIFI Shariah Standard No. 17 [Investment Sukuk]. Source: ISRA (2017)


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2.5.1 SHARIAH GOVERNANCE FRAMEWORKS (SGFs) AND A CENTRALISED SGF

The IFSB defines Shariah governance as “the set of institutional and organizational arrangements through which the IIFS ensures that there is effective independent oversight of Shariah governance” over each of the processes described in Figure 2.6.

Figure 2.6: Shariah Governance Processes

Source: IFSB (2009)

Shariah governance is regarded as the backbone of the Islamic finance regulatory and supervisory infrastructure since the industry’s adherence to Shariah largely depends on the effectiveness of Shariah governance itself. A vibrant and efficient Shariah governance system is central to guaranteeing the fair, competent and transparent operation of Islamic finance, as well as to support investors’ interests. Different countries adopt different organizational structures in Shariah governance. There are at least 3 models available across the various jurisdictions, as explained in Figure 2.7.

Figure 2.7: Models of Shariah Governance

Sources: BNM, ISRA


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For countries which have adopted the 2-tier centralized model, the SAC at the central regulatory authority must approve all sukuk structures prior to the issuance. In Malaysia, for instance, all matters pertaining to Shariah in ICM products and instruments, including sukuk, fall under the authority of the SAC of the SC. At the outset, sukuk issuances must be approved by registered Shariah advisers or the Shariah committees of the relevant Islamic banks and financial institutions. LCY sukuk that utilize the existing structures approved by the SC and issued in the market require the issuer to submit all the requisite documents to the SC for its SAC’s endorsement, at least 10 business days before the lodgment date. However, for issuances involving new structures or variations to existing structures, the SC must be consulted prior to submission to the SAC, to facilitate a detailed deliberation. For countries which adopt non-centralized Shariah governance, the commercial or investment banks appoint their own Shariah committees, which comprise eminent scholars, to provide their opinion on the Shariah compliance of the sukuk structures, without any specific national regulatory oversight. By contrast, the single centralized model only has a centralized SAC at the regulatory level. Nonetheless, this model remains unclear in terms of its practicality, considering the volume of sukuk structures that require Shariah approval. Based on our analysis, countries which have 2-tier centralized Shariah governance have facilitated the rapid growth of the sukuk market, and provided greater clarity and transparency to the industry in terms of the Shariah compliance of structures, thereby improving standardization. This is proven in the case of Malaysia, the sukuk market of which has reached maturity. This model has never interrupted the established regime of the country’s regulatory and supervisory frameworks.

2.6 THE IMPORTANCE OF CREATING A CONDUCIVE ENVIRONMENT FOR SUKUK

Most countries looking into the development of the sukuk market seek to establish a conducive environment that would support sukuk issuance and safeguard investor protection. In particular, they endeavour to set up a facilitative legal and regulatory framework in accordance with international standards and best practices. 2.6.1 LEGAL

Capital market transactions, including sukuk, are typically under the purview of the same laws and regulations that govern conventional finance, not Islamic law. Most of the contract clauses are usually compared against conventional practices and the sukuk documents generally reflect Shariah compliance and are not governed by Shariah. In general, there are 3 kinds of legal systems: common law, civil law and Islamic law. Most countries tend to adopt the common law or the civil law system or have legal systems that reflect aspects of both civil and common law. Many Muslim-majority countries tend to incorporate Islamic law within their conventional legal frameworks to some extent, especially on personal matters (e.g. marriage, divorce, family law, inheritance) and criminal law. Islamic law would not, in principle, govern commercial transactions. Figure 2.8 provides examples where these legal systems prevail.


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Figure 2.8: Types of Legal Systems and the Adopting Jurisdictions

Source: ISRA

Common Law vs Civil Law – Recognition of Trust Law One of the key factors that explains the level of financial development in a country is its legal system, and the adaptability of its laws in response to changing economic circumstances. Arguably, legal systems based on common law are usually more flexible vis-a-vis evolving and responding to changing conditions, as rules can be replaced based on the doctrine of stare decisis (i.e. previously decided cases or precedents). Such changes in law would be more difficult, time consuming and costly under the civil law system, which is based on statutes and codes promulgated by the legislature and can only be amended by the legislature, introduced by a formal procedure and considered binding on courts. The flexibility of the common law system in the face of new cases and its adaptability to new rules could facilitate the development of Islamic finance. A study by Grassa and Gazdar (2014) confirms that countries with mixed legal systems based on common law and Islamic law are favourable to the development of the Islamic finance industry. On the other hand, countries with mixed legal systems based on civil law and Islamic law are less flexible in making changes to their old laws, and inevitably hinder the development of Islamic finance. Another study by Said and Grassa (2013) reveals that countries with mixed common law and Islamic law systems have developed sukuk markets. A key legal issue with sukuk concerns the transfer of ownership of the underlying assets to sukuk holders. Common law jurisdictions recognize the concepts of trust and beneficial interest, unlike civil law systems, which only recognize ownership held by 1 party. For example, in GCC countries that apply civil and Islamic laws, the separation between legal and beneficial ownership is not recognized. This causes a problem in transferring beneficial title of the assets from the originator to the SPV ― without perfecting the legal transfer ― under an asset-based sukuk structure. The implication is that with a real asset transfer on a “true sale” basis (i.e. transfer of legal title), sukuk investors would have legal recourse over the underlying assets (asset-backed sukuk) under a default scenario. Otherwise, the investors would only have recourse against the obligor (asset-based sukuk). Under asset-based sukuk structures, sukuk ownership takes place through a trust which is widely used in common law systems. Under a trust arrangement, the SPV purchases the asset


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as a trustee and declares a trust over the sukuk assets in favour of the beneficiaries (sukuk holders/investors) that have beneficial rights over the assets, entitling them to receive cash flow from the assets, usufructs and/or investments. The trust assets hence comprise the underlying assets as well as the related rights and obligations. As a means of credit enhancement, these sukuk structures usually incorporate a purchase undertaking from the obligor to buy back the assets or the investors’ ownership in the usufruct, investment and/or partnership upon the redemption of the sukuk or in the event of a default. This purchase undertaking is akin to a contractual claim against the originator for non-payment of the sukuk’s financial obligations. As such, the level of protection afforded to investors depends on the type of contract adopted and the terms and conditions of the sukuk structure. Table 2.4 summarizes the key legal, financial and risk implications of asset-based and asset-backed sukuk structures. In civil law jurisdictions which do not easily allow the setting up of trusts, alternative structures have begun to emerge to allow sukuk transactions to be carried out in accordance with the local laws.

Table 2.4: Asset-Based and Asset-Backed Sukuk

Implication Asset-based Asset-backed

Legal - ownership of the assets

Originator/obligor transfers beneficial ownership of the assets to investors.

Legal ownership remains with originator/obligor.

In the event of a default, investors have recourse to originator/obligor.

Transfer of legal ownership of the assets from originator/obligor to a third party (typically, an SPV).

Financial - cashflow source

Based on originator/obligor’s principal activities, although structuring mechanism may elevate the creditworthiness of originator/obligor.

Based on cash flow generated by the assets.

Risk – default Investors have recourse to originator/obligor.

Investors have recourse to the assets and rights of disposal.

Sources: ISRA, RAM

SPV – Country-Level Differences between Sukuk Mechanisms/Structures, Acceptability from a Legal Perspective Sukuk structures typically involve a legal entity, known as an SPV (special-purpose vehicle) or SPC (special-purpose company) or SPE (special-purpose entity), which holds the sukuk assets as an agent or trustee on behalf of the sukuk holders. Trust laws tend to be the preferred mechanism when establishing such an entity. The characteristics of an SPV is described in Figure 2.9.


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Figure 2.9: Characteristics of SPVs

Source: ISRA (2017)

As mentioned in the earlier sub-section, the predominant structures of sukuk issued in common law jurisdictions have been based on a trust arrangement via the establishment of an SPV. Unlike the common law that recognizes the concepts of trust and beneficial ownership, thus allowing ownership to be held by more than 1 party (legal and beneficial), civil law only recognizes ownership by 1 party. In such jurisdictions, sukuk, therefore, tend to be issued through several alternative structures facilitated by the promulgation of local legislation. Turkey, for example, has passed specific laws that allow the formation of asset-leasing companies, which are a form of SPV regulated by the Capital Markets Board of Turkey. These asset-leasing companies are specifically incorporated to enable the issuance of certificates under the ijarah structure to investors which allows the asset-leasing companies to finance the purchase of the assets and lease them back to the obligor. Oman is another example, which introduced the concept of financial trust, which is akin to the common law concept of trust. Under this regulation, a financial trust, created through a trust instrument, transfers legal ownership of the trust property to the trustee, hence allowing the SPV to hold the property in trust for the benefit of the sukuk investors (Curtis, 2013). In other Gulf countries, mechanisms have been developed to replicate security via contractual arrangements with a ”local security agent”. These agents are usually reputable local financial institutions but do not have the fiduciary responsibilities required of trustees. Such agents are also important when purchasing local assets: in many jurisdictions, these assets cannot be sold to non-nationals (Howladar, 2006). The Role of the Trustee As mentioned earlier, the concept of trust has become an important element in sukuk structuring. The trust in sukuk structures is typically administered by a duly registered trustee body or corporation, although the sukuk issuer/SPV can appoint itself as the trustee in the sukuk structure. The trustee’s powers, rights and responsibilities are normally documented in a trust deed; hence it is the duty of a trustee to use a reasonable degree of skill and diligence in exercising such rights, powers and responsibilities. The trustee's main function is to protect


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the interests of the sukuk holders. Therefore, the trustee must always exercise reasonable diligence to ascertain whether the issuer has committed any breach of the terms and conditions of the sukuk, or the provisions of the trust deed, or whether an event of default has occurred. In such an event, proper notice should be given to the beneficiaries. The trustee may extensively cover the role of an intermediary or caretaker that manages the entire transaction of the sukuk until maturity, or may serve as an arbitrator when necessary (Hasan et. al, 2012). The trustee can be categorized into 3 types, depending on its function, as described in Figure 2.10.

Figure 2.10: Types of Trustee

Source: Hasan et al. (2012)

2.6.2 REGULATORY

In general, there are 3 broad approaches to a regulation adopted by different legal systems to various degrees. These are: (i) the fraud and abuse inhibition approach, which inhibits fraud and related abuses in the market; (ii) the merit approach, where the regulator intervenes to warn investors about the relative merits of an investment; and (iii) the fair dealing approach, which reflects fair dealing in market transactions (ISRA, 2015). Most jurisdictions seek to regulate ICM transactions premised on these principles-based approaches. These are in line with IOSCO’s core principles for securities regulation, i.e. the protection of investors; ensuring markets are fair, efficient and transparent; and the reduction of systemic risk - all of which are also applicable to the regulation of Islamic securities. The IOSCO’s (2004) Islamic Capital Market Fact Finding Report does not specify separate regulation for the development of an ICM, as delineated in Box 2.2. It does, however, recommend the establishment of an appropriate Shariah governance framework that would regulate the Islamic capital market.


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Box 2.2: IOSCO’s Approach to Regulating ICMs

…the conventional securities regulation framework and principles equally apply to the ICM, with the addition of some form of Shariah approval or certification process. This augurs well for the growth of the ICM as it implies that there is no need to formulate separate regulatory principles for the ICM. By extension, IOSCO’s objectives and principles of securities regulation can be applied to the ICM. Within this context, the ICM may be perceived as a class of products within the wider securities market [emphasis added]. Source: IOSCO (2004)

For this purpose, most jurisdictions have adapted their existing laws and regulations to comply with Shariah (Islamic law) by making the necessary amendments, instead of enacting new laws and regulations specifically for the ICM or sukuk transactions. Consequently, a 2-tier regulatory approach is applicable to sukuk in many jurisdictions:

A single legislation to govern the debt capital market and facilitate the issuance of both conventional bonds and sukuk.

Specific guidelines to regulate the issuance of sukuk. In Malaysia, e.g. the SC had issued Guidelines on Sukuk (August 2014), which were later superseded by Guidelines on Unlisted Capital Market Products under the Lodge and Launch (LOLA) Framework (June 2015) and Guidelines on Issuance of Private Debt Securities and Sukuk to Retail Investors (June 2015).

To further promote sukuk development, many jurisdictions have made changes to their tax regulations, to level the playing field for bonds and sukuk. Tax incentives have also been provided to further boost the sukuk market, attracting local and international issuers. Table 2.5 lists the various tax changes introduced by selected countries to facilitate sukuk issuance.

Table 2.5: Tax Changes to Promote Sukuk

Country Tax Changes

Malaysia Tax neutrality is provided in the Income Tax Act 1967 Stamp duty is exempted from Islamic securities issued under MIFC until 2020 Administrative tax procedures are exempted from special purpose vehicles

(SPVs) Expenses incurred during the issuance of sukuk is tax deductible Liberalization of withholding taxes to attract foreign entities to issue or invest

in sukuk Hong Kong Sukuk is treated as conventional bonds in terms of tax payment

Tax rebates are given to individual investors in retail sukuk Inland Revenue and Stamp Duty Legislation Ordinance 2013 have removed

the additional profit tax and stamp duty charges prior to sukuk issuance Nigeria All categories of sukuk issued are exempted from Companies Income Tax,

Personal Income Tax, Value Added Tax, Capital Gains Tax and Stamp Duties Sukuk holders are exempted from withholding, state and federal income, and

capital gains taxes. South Africa

The government introduced tax neutrality laws for diminishing musharakah, murabahah and mudarabah contracts in the Taxation Laws Amendment Act of 2010 which recognizes these contracts to be equivalent to other conventional contracts.

In 2011, government sukuk was also recognized under the Act.


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Country Tax Changes

United Kingdom

Alternate Finance Investment Bond (AFIB) introduced by Finance Act of 2007 deemed sukuk as 'securities' for tax purposes and eliminating VAT and stamp duty on transfer of certificates

Turkey In 2011, Turkish Law No.6111 was issued to provide tax exemption or favourable tax treatment for sukuk, reducing the withholding tax on sukuk and introduced tax neutrality on ijarah sukuk issuance

In 2016, the other sukuk structures namely wakalah, murabahah, mudarabah and istisna’ were granted tax neutrality with a law amending the Stamp Tax Law, VAT Law and Law on Charges.

Indonesia Withholding tax on interest payments for government securities, including sukuk, was removed

In 2016, the Financial Services Authority (Otoritas Jasa Keuangan (OJK)) provides lower registration fees for corporate sukuk issuances

Source: Compiled from various resources by ISRA and RAM.

2.6.3 SUPERVISORY

The role of an effective supervisory framework is to ensure discipline, control and minimum standards of prudential conduct, among others. The regulatory and supervisory framework encompasses the various frameworks put in place by the regulatory authorities in their respective jurisdictions to deal with specific areas: licensing of capital market intermediaries; requirements for acceptable market conduct; Shariah compliance requirements; registration of Shariah advisers; disclosure, corporate governance and transparency requirements; and establishment of robust infrastructure such as stock and commodity exchanges. These frameworks are usually established through the collaboration of different bodies and agencies, such as government authorities, regulators, exchange authorities, and industry associations. They can take the form of specific guidelines issued to fulfill certain purposes. For instance, the requirements set out under the LOLA Framework (June 2015) by the SC include the following:

Lodgement requirements. Requirements for the invitation, offering, subscription, purchase and issuance of

sukuk. Ringgit and FCY sukuk. SRI sukuk. Credit rating requirements and exemptions. Details of the approved Shariah primary and supplementary principles and concepts. Transferability and tradability, programme issuances, utilization of proceeds and

Shariah advisers.


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2.7 NEW FRONTIERS FOR THE DEVELOPMENT OF SUKUK IN THE ICM

As mentioned earlier, the growth of the sukuk market has been stimulated by a number of new entrants as well as innovative structures. A specific area that is gaining increasing interest relates to SRI and green sukuk. 2.7.1 CONVERGENCE OF SUKUK WITH SRI

There is an inevitable overlap of the rationale behind SRI and Islamic finance; both are trying to achieve a balance between ESG issues. Both sectors are now worth millions of dollars, with the SRI industry being at least 10 times larger than its Islamic counterpart. The SRI industry boasted USD21 trillion of assets under management as of 2016 (Responsible Finance Summit, 2016).1 The growing importance of ESG issues, particularly environmental concerns, has led to more concerted efforts in the Islamic finance industry to come up with more sustainable and greener initiatives. One such development is the issuance of SRI sukuk, which mobilises funds for sustainable development objectives. Malaysia, in particular, is a leader in this sphere; the framework for SRI sukuk was introduced by the SC in August 2014, to facilitate the financing of SRI initiatives. This framework has been integrated with the LOLA framework (June 2015).

Figure 2.11 provides details on prominent SRI sukuk issued in the market up to November 2017.

Figure 2.11: SRI Sukuk Issued in the Islamic Finance Industry

Source: ISRA

1 Responsible Finance Summit - Unlocking Finance, Expanding Impact (2016), RFS Concept Note, 30-31 March 2016, Kuala

Lumpur: Bank Negara Malaysia.


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2.7.2 PROPOSAL FOR A COMMON GLOBAL SUKUK AND TRADABILITY OF SUKUK CERTIFICATES

Taking the African Domestic Bond Fund (ADBF) project as an example, the African Development Bank recently approved USD25 million for the ADBF to develop its domestic debt markets. The fund is structured as an enhanced exchange-traded fund (ETF) listed on Mauritius and other stock exchanges to enlarge its investor base. The project has 3 components: the ADBF, the African Domestic Bond Index and Regional Multi-Disciplinary Working Groups. The OIC can take this project as a guidance in creating a Shariah-compliant project that can ensure common global sukuk issuance and tradability. Meanwhile, existing organizations that are highly rated and with innovative sukuk structures can assist with such sukuk projects. Examples of such organizations are: The Islamic Development Bank (IDB). The IDB Sukuk is offered in the Reg S format and

is open for subscription by investors in many countries. The current IDB Sukuk is based on the wakalah structure, under which the IDB plays 3 different roles:

(i) The Seller. On each sukuk issuance date, the IDB will sell assets to the SPV. The SPV acts

as the Issuer and Agent for the sukuk holders. The assets sold to the SPV will become the underlying sukuk assets, to be jointly owned by the sukuk holders.

(ii) The Wakeel and Guarantor. The IDB will be appointed as the wakeel to manage and administer the sukuk assets, as per the agreed terms and condition. On each periodic distribution date, the wakeel will collect and distribute the income generated by the sukuk assets for distribution to the sukuk investors. Any excess income will be retained by the wakeel as an incentive bonus.

(iii) The Obligor. On the maturity date, the IDB will buy back the sukuk certificates/assets from the SPV and redeem the sukuk certificates. The SPV will then distribute the cash proceeds to the sukuk holders.

The International Islamic Liquidity Management Corporation (IILM). The IILM has

adapted the asset-backed commercial paper (ABCP) model for its short-term sukuk. The programme includes 2 SPVs based on the wakalah contract, one for sukuk issuance and the other to hold assets. The programme has 3 main components:

(i) The Asset that is sold to a local SPV, which securitizes the assets and sells the resultant

sukuk to an asset-holding SPV set up by the IILM.

(ii) The Time Reserve amounting to 2% of the size of the issuance, to manage timing mismatches in cash flows.

(iii) The Primary Dealers Network that bids in an auction to set the price and quantity at which each primary dealer wishes to purchase the sukuk.


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3. SUKUK STRUCTURES, ISSUANCES AND INVESTMENT In determining the extent of sukuk’s inclusiveness in a country’s capital markets, a general review of its bond market has been undertaken in the respective case studies. Countries that have active LCY bond markets facilitate easier access vis-a-vis promoting sukuk as an alternative form of financing, as highlighted in Box 3.1.

Box 3.1: Benefits of LCY Bond Markets

LCY bond markets offer several benefits. Firstly, they eliminate the double-mismatch problem by aligning the currency and term of the credit with the currency and term of the credit providers. Secondly, LCY bond markets create competition against banks by providing large corporations and infrastructure projects an alternative source of funding in the event the terms and conditions of bank loans are deemed unattractive. Thirdly, bond markets are better able to provide long-term capital (with terms of over 10 years) compared to banks. Fourthly, LCY bonds provide alternative investment options that offer higher yields and/or a better match with the investment needs of individuals and institutions. Last but not least, bond markets convey important information about general credit conditions, as well as information on the creditworthiness of specific institutions, which is not readily available from the banking system. While the 2008–2009 global financial crisis has cast doubts on former US Federal Reserve Chairman Alan Greenspan’s contention that LCY bond markets can serve as a “spare tyre” by continuing to provide credit when the banking system is under stress, a well-functioning domestic bond market reduced the impact of bank liquidity problems (loans can be called while bonds generally cannot) and also conveys other significant benefits. Source: Asian Development Bank (2013) Central to the development of a sukuk market is the need for a clear roadmap that focuses on 4 key areas:

1. Promoting the issuance of LCY and FCY sukuk. 2. Fostering supply (sell side) and demand (buy side) for sukuk issuance. 3. Improving the existing legal, regulatory and tax frameworks to promote a level playing

field for sukuk issuance. 4. Enhancing market infrastructure (i.e. development of an Islamic money market to

support secondary trading, an electronic trading platform for transparency and monitoring of issuances and price guidance).

According to McKinsey (2017), 6 pillars or building blocks ensure the long-term growth of capital markets, as depicted in Figure 3.1.


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Figure 3.1: McKinsey’s Building Blocks to Sustain the Long-Term Growth of Capital Markets

Source: McKinsey & Company (2017)

3.1 CRITICAL SUCCESS FACTORS FOR A SUSTAINABLE SUKUK MARKET

Central to the development of a sustainable sukuk market is the provision of a level playing field vis-a-vis conventional bonds. Commercial reasoning will always be the tipping point for issuers, and creating a vibrant, thriving environment for sukuk is the key to success. Another critical component is to have a “top down” approach to promoting the Islamic finance agenda. The dynamic shift towards sukuk, instead of conventional bonds, is a balance driven by both supply (sell side) and demand (buy side). This can only be achieved through the collective efforts of governments and regulators, in collaboration with industry players. Based on our analysis, each jurisdiction has evolved in its own way to overcome inherent domestic risks. The concerted efforts of key market stakeholders listed in Table 3.1 can facilitate a supportive ecosystem in which sukuk issuance can thrive:


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Table 3.1: Facilitative Roles of Key Market Stakeholders

Market stakeholder Examples of development actions Impact on capital markets

Government “Top down” facilitator in promoting the Islamic finance agenda through measurable and transparent action plans.

Proactive commitment to include sukuk issuance as a debt-management tool in budgetary funding.

Leading issuer in building sovereign benchmark yield curves.

Stimulate growth of domestic savings through regulated pension schemes and the development of strong institutional investors (e.g. asset-management companies, takaful/insurance operators).

Fiscal stimulus (e.g. tax incentives) to promote the country as a point of origination and investment for sukuk.

Encourage savers to bring their wealth stored in physical assets such as real estate and gold, and bank deposits into the financial markets.

Identify suitable state-owned entities (SOEs) or government-linked companies (GLCs) to become sukuk champions in promoting innovative sukuk structures and creating benchmark yield curves.

Promote the efficient use of domestic wealth through financial intermediaries.

Create material sell and buy sides from the domestic and international communities.

Establish a robust and deep capital market.

Regulators Implement quantifiable master plans and roadmaps to guide market players in developing a strong ecosystem for the sukuk market.

Promote international best practices and standards for legal documentation, enforceability of security, bankruptcy or insolvency law, dispute resolutions, and investor protection, among others.

Encourage onshore issuance of LCY and FCY sukuk by domestic and international foreign entities with local set-ups.

Educate investors (both institutional and retail) and issuers on the value proposition of sukuk and related ICM products.

Provider of market/product courses in developing a pool of certified human talent for the ICM.

Attract foreign investors and strengthen the liquidity structure of the domestic capital markets.

Encourage participation from the sell and buy sides.


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Market stakeholder Examples of development actions Impact on capital markets

Exchanges Issuer-friendly listing requirements in terms of documentation and processes.

Provide incentives for sukuk compared to conventional bond issuance, in terms of listing fees and expenses.

Encourage good corporate governance.

Generate confidence among existing and potential investors.

Service providers (e.g. investment banks, securities companies, advisory houses, brokers, traders, rating agencies)

Collaborate with regulators in building market awareness of sukuk, issuance processes, tax-related issues and benefits, and timelines, among others.

Market maker to identify potential sell-side and buy-side clients for ICM products and provide liquidity through market participation.

Capacity building in human development to facilitate ICM talent management.

Diversify products to meet the various financing objectives of market players.

Stimulate product development in both the sell and buy sides.

Provide strong talent base to develop innovative products that appeal to the international community.

Non-bank financial intermediaries (NBFIs) (e.g. institutions, pension funds, asset and wealth managers, private bankers)

Develop strong market appetite for long-dated debt securities and encourage project-based funding.

Acceptance of lower-grade investment credits (high-risk, high-return mentality) to allow mid-cap companies to tap the capital markets.

Facilitate issuance of infrastructure-based sukuk with maturities exceeding 7 years.

Develop price guidance for corporates across the entire investment-grade rating spectrum.

Financial institutions and their holding companies

Encourage development of capital-market instruments as potential financing substitutes.

Create a sustainable supply of sukuk to finance capital-adequacy requirements.

Define a strategy and operational model that provides value-based guidance to clients between balance-sheet financing and capital markets.

Promote value creation through capital-market activities to enhance shareholder value.

Promote efficient use of capital between business lines.

Generate capital-market activity on both the sell and buy sides.

Source: RAM

As explained in Table 3.1, NBFIs are the cornerstone institutional investors, apart from financial institutions, that can elevate the growth of the sukuk market to the next level. Box 3.2 provides the World Bank’s definition of NBFIs.


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Box 3.2: Definition of NBFIs

NBFIs comprise a mix of institutions that include pension funds, insurance companies, mutual funds, leasing, factoring and venture capital companies. The common characteristic of these institutions is that they mobilise savings and facilitate the financing of different activities, but do not accept deposits from the public. NBFIs play an important dual role in the financial system. They complement the role of commercial banks by filling the gaps in their range of services. In addition, they compete with commercial banks and force them to be more efficient and responsive to the needs of their customers. Most NBFIs are also actively involved in the debt markets as well as the mobilization and allocation of long-term financial resources. The state of development of NBFIs is usually a good indicator of that of the financial system.

Source: World Bank Group (2015)

3.2 KEY CHALLENGES IN THE DEVELOPMENT OF A SUKUK MARKET

Although the sukuk market is developing at a significant pace, some countries still a slew of potential challenges, which could impede their growth and future development. These challenges include:

Legislative framework Tax framework Shariah standardization The development of a sustainable supply of corporate sukuk The level of financial intermediation provided by NBFIs and the diversification of

investor bases 3.2.1 LEGISLATIVE FRAMEWORK (COMMON LAW VS CIVIL LAW)

In a sukuk transaction, the creation of ”trust” and the recognition of ”beneficial interest” underscores the essence or validity of a contract to uphold the rights of sukuk investors over the underlying sukuk assets and the cash flows that are attached to the assets. As indicated in Section 2, the concept of trust and beneficial interest is recognized legislatively under common law but not civil law. As such, for countries that adopt the civil law code, the recognition of trust and beneficial interest must be incorporated into its legal framework to ensure the commercial viability of a successful sukuk issuance. To overcome this issue, some civil law jurisdictions such as Turkey (as explained in Box 3.3) have issued sukuk structured as a securitization instrument under a similar legislative framework as that for an asset-backed securitization (ABS).

Box 3.3: Turkey’s Asset-Leasing Companies and Trust Certificates

Turkey is a prime example of a country that has emulated the recognition of trust certificates. To facilitate the issuance of sukuk, the Turkish government in February 2011 passed vital legislation to allow the formation of asset-leasing companies (ACLs) or SPVs, including tax-neutrality measures. The ACLs are specifically incorporated to enable the issuance of certificates under a framework provided by the Capital Markets Board of Turkey’s Communiqué. The first approved Shariah principle had been the ijarah structure, which allows ALCs to purchase assets and lease them back to the obligor. Effectively, the ALCs finance the acquisition of such assets using funds raised by the issuance of certificates; the lease-rental payments from the obligor mirror the profit distributions due under the certificates. The cashflow from the lease rentals is used to service profit distributions to the sukuk investors. Source: Republic of Turkey Ministry of Finance, General Directorate of Revenue Policies


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3.2.2 TAX FRAMEWORK

In practice, a sukuk transaction necessitates multiple asset transfers from the SPV to the entity seeking to raise finance (i.e. the originator/obligor). Each transfer may result in a tax liability (e.g. stamp duty and capital gains tax) that will put sukuk at a disadvantage relative to conventional bonds. Due to the asset-backed or asset-based nature of sukuk, the necessary changes to tax legislation must be addressed to ensure greater outreach to market players. If the requisite changes to tax legislation are not in place, the considerable tax burden for sukuk issuers will rule it out as a credible funding source. Legislation changes are also needed for sukuk certificates to be considered securities and for investment returns on sukuk to be recognized in the same way interest would be treated for a conventional bond. Notably, Malaysia has exceeded all expectations in terms of the proactive measures adopted to facilitate sukuk issuance. The key reason the country continues to lay claim to the bulk of global sukuk issues is because of the changes enacted in favour of tax, land transfer and registration laws that do not penalize sukuk issues compared to conventional bonds. To further strengthen its Islamic finance appeal, Malaysia’s tax code provides substantial incentives which give sukuk an advantage over conventional bonds. Apart from being tax neutral, sukuk in Malaysia are also tax positive thanks to these incentives. As a result, the government and regulators have been successful in turning the country into a point of origination and investment for sukuk, reinforcing its reputation as a global centre for Islamic finance. For sukuk to be successful, it is important to create the necessary legal and tax frameworks as the basic building blocks for its ecosystem. As sukuk gains traction globally, more countries have started to integrate sukuk into their legal and tax codes. The UK, France, Luxembourg, Hong Kong, Japan, Singapore, Senegal, Morocco and Oman are some of the countries that have followed suit in creating the necessary tax-neutral framework which is central to the development of a vibrant Islamic finance market. The subsequent inaugural sovereign sukuk issuances by these nations represent the first step towards creating a benchmark yield curve that corporate issuers can follow. 3.2.3 STANDARDISATION OF SHARIAH GOVERNANCE

The approach to the type of sukuk structure used is defined by the accepted Shariah guidelines and framework in each jurisdiction. In principle, the standards that have been approved by the AAOIFI are the most widely adopted and preferred as the international benchmark by most Islamic countries. However, the AAOIFI’s standards are not binding on member countries. Despite the existence of international Shariah guidelines, differing views from Shariah advisers are a common challenge for market practitioners in countries that do not adopt any standardized or harmonized Shariah framework. Based on our analysis, each jurisdiction has evolved differently to accommodate the Shariah-related needs and requirements of its domicile country, with each having progressively developed its Islamic finance landscape. In our assessment of sukuk structures, reference is made to AAOIFI Shariah Standards No. 17 on Investment Sukuk, as summarized in Table 3.2.


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Table 3.2: Shariah Contracts under AAOIFI Shariah Standards on Investment Sukuk

Sale-based Leased-based Agency-based Partnership-based

Others

Murabahah – Mark-up sale

Ijarah – leasing of property or usufruct pursuant to a contract

Wakalah bil istithmar – investment agency

Mudarabah – profit-sharing and loss-bearing

Muzara’ah – share-cropping

Istisna’ – manufacturing sale

Musharakah – profit and loss sharing

Musaqah – irrigation

Salam – forward sale

Ijarah muntahiah bi al-tamlik – a leasing contract which includes a promise by the lessor to transfer ownership of the leased property to the lessee

Mugharasah – agriculture

Source: AAOIFI (2015)

As part of a sukuk transaction, a fatwa (or legal pronouncement) is usually procured from Shariah scholars, to provide issuers and investors with the comfort that a sukuk instrument is indeed Shariah-compliant. However, these endorsements are subject to different interpretations, and differences in opinion can create volatility. Since doubts about Shariah compliance are likely to affect marketability, a guiding set of principles which the majority of Shariah advisors can agree upon should be developed. On 7 February 2017, the AAOIFI announced a new exposure draft for a centralized Shariah board. With industry practitioners calling for greater standardization, this initiative marks another milestone in embracing a centralized model, which will further strengthen the Islamic finance ecosystem and increase consumer appetite for Shariah-compliant products. The Malaysian and Indonesian governments have progressed to address this problem at the national level, by establishing a centralized Shariah supervisory board to ensure that every sukuk issued fully complies with nationally accepted Shariah principles. In comparison, the GCC operates in an industry-driven environment, where each Islamic financial institution is guided by the views and opinions of its own Shariah advisory board. Based on market feedback, approval of a sukuk structure may not necessarily be viewed the same way by another Shariah scholar. Hence these differing interpretations and opinions have to some extent affected the progress of sukuk issuance in the GCC. In 2016, the UAE Cabinet approved the establishment of a Shariah authority to set the standards for Islamic finance products, as a means of providing a standardized approach to product development and setting the rules and principles for banking transactions.

https://www.islamicfinancenews.com/glossary/shariah-2


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An example that has defined the evolution of sukuk structures is the statement made by Sheikh Taqi Usmani (chairman of the AAOIFI Shariah Board) in late 2007. He commented that most of the sukuk in the market (specifically those under musharakah or mudarabah structures) were not in line with the principles of Shariah. As a result, the AAOIFI Shariah Board had convened a series of meetings in Bahrain, after which the revised AAOIFI sukuk guidelines were announced in 2008, as depicted in Box 3.4.

Box 3.4: AAOIFI’s Pronouncement on Revised Shariah Standards on Sukuk (2008)

First: Sukuk, to be tradable, must be owned by sukuk holders, with all the rights and obligations of ownership in real assets, whether tangible, usufructs or services, capable of being owned and sold legally as well as in accordance with the rules of Shariah. The manager issuing sukuk must certify the transfer of ownership of such assets in its (sukuk) books, and must not keep them as his own assets.

Second: Sukuk, to be tradable, must not represent receivables or debts, except in the case of a trading or

financial entity selling all its assets, or a portfolio with a standing financial obligation, in which some debts, incidental to physical assets or usufructs, have been unintentionally included.

Third: It is not permissible for the manager of sukuk, whether the manager acts as a mudarib

(investment manager), or sharik (partner), or wakeel (agent) for the investment, to undertake to offer loans to sukuk holders when the actual earnings fall short of the expected earnings. It is permissible, however, to establish a reserve account for the purpose of covering such shortfalls to the extent possible, provided the same is mentioned in the prospectus.

Fourth: It is not permissible for the mudarib (investment manager), sharik (partner), or wakeel (agent)

to undertake {now} to re-purchase the assets from sukuk holders or from one who holds them, for its nominal value, when the sukuk is extinguished at the end of its maturity. It is, however, permissible to undertake the purchase on the basis of the net value of the assets, their market value, fair value or a price to be agreed upon, at the time of their actual purchase. It is known that a sukuk manager is a guarantor of the capital, at its nominal value, in case of his negligent acts or omissions or non-compliance with the investors’ conditions, whether the manager is a mudarib (investment manager), sharik (partner) or wakeel (agent) for investments. In case the assets of sukuk of al-musharakah, mudharabah, or wakalah for investment are of less value than the leased assets of "lease to own" contracts (ijarah muntahia bi-tamleek), then it is permissible for the sukuk manager to undertake to purchase those assets - at the time the sukuk is extinguished - for the remaining rental value of the remaining assets, since it actually represents its net value. Fifth: It is permissible for a lessee in a sukuk al-ijarah to undertake to purchase the leased assets when the sukuk is extinguished for its nominal value, provided he (the lessee) is not also a partner, mudharib or investment agent.

Source: AAOIFI (2008)

Efforts to promote the streamlining of processes to shorten turnaround time and the adoption of a harmonized global approach to Shariah compliance will necessitate progression in building the next phase of growth for the sukuk market.


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3.2.4 DEVELOPMENT OF A SUSTAINABLE SUPPLY OF CORPORATE SUKUK

Several benefits accrue to an issuer (government and corporate sector) of sukuk, including the following:

1. Diversification of financing sources as a risk–mitigation measure. 2. The base of Shariah-compliant investors remains largely untapped, with significant

demand for products such as sukuk, which lacks in supply. 3. The potential to achieve competitive financing cost due to a larger investor base.

Sukuk can be purchased by both Islamic and conventional investors, but Islamic investors are restricted to only investing in Shariah-complaint instruments.

4. Capital-market instruments provide the necessary avenue to enter mainstream international markets and to access the liquidity of foreign investors.

Based on our analysis, the performance of the corporate sector (which includes quasi-government issuances) remains the best yardstick in tracking the pulse of a local sukuk market. Hence the key to building a sustainable supply of private sector sukuk is to create a sovereign benchmark yield curve for corporate issuers. The governments in core sukuk markets such as Malaysia, Bahrain, the UAE and Qatar have successfully tapped the ICM through LCY and FCY sukuk. This has helped set the necessary benchmark yield curve for corporate issuance. As a result, Malaysia, the UAE and Qatar have boosted the world’s most active corporate sector with sukuk issuances across various sectors (e.g. financial institutions, infrastructure and utilities, construction, property). Indonesia, despite being one of the largest sovereign sukuk issuers, has yet to create a sustainable supply of corporate sukuk. Macroeconomic factors (e.g. a volatile local currency and a high inflation rate) and the ”crowding-out effect” (as defined in Box 3.5) of public-sector issuance are the principal reasons local companies prefer conventional FCY bonds in meeting their financing needs. On the flip side, Saudi Arabia has a strong pipeline of corporate sukuk issuers despite lacking sovereign sukuk benchmarks. Saudi Arabia only raised its inaugural USD9.0 billion international sukuk in April 2017, followed by the debut of its SAR17.0 billion domestic sukuk in July 2017.

Box 3.5: Crowding Out and Crowding In

The neoclassical “crowding out” theory suggests that under certain conditions, an increase in government bond issuance will transfer a portion of investments away from private enterprises and towards financing public debt. This is because a surge in government issuance can inflate interest rates – increasing borrowing costs for the private sector and making sovereign debt more attractive than even corporate high-yield issues. This effect can be exacerbated by shallow financial markets and reduced reliance on bank lending for corporates. A high amount of external government debt could also deter foreign credit from the private sector in that country, due to a heightened vulnerability to a sovereign debt crisis. The Keynesian “crowding in” theory proposes instead that government debt, if incurred to stimulate the economy, will support investment in private enterprises, e.g. improving investor confidence. Specifically, regular and standardized issuance of government debt can play a key role in the development of corporate bond markets. In emerging economies, robust government bond markets can encourage and mobilise an investor base that can be tapped by corporate bond issuers. Source: Tendulkar & Hancock (2014)


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3.2.5 LEVEL OF FINANCIAL INTERMEDIATION AND DIVERSIFICATION OF INVESTOR BASE

The presence of strong NBFIs in an ICM is a key element in strengthening the liquidity of the primary and secondary markets. NBFIs play an important role in enabling the government to execute its funding strategy under a wide range of market conditions, thus minimising long-term execution and refinancing risks. Through intermediation by NBFIs, there will be increased funding efficiency, hence alleviating the negative economic and financial effects of heftier government debt, including the crowding out of banking credit to the private sector. In a mature market, the investor base should ideally include both domestic and foreign investors and all types of institutions — ranging from commercial and retail banks to corporate treasuries, insurance companies, mutual funds, pension funds and individual investors. Based on the World Bank’s sustainable development goals, there is a push for effective utilization of available resources and greater resource mobilization for private sector spending. The global financial crisis had highlighted the constraint on traditional banking vis-a-vis supporting long-term productive investments. BASEL III’s tighter regulatory requirements on financial institutions further dampen banks’ capabilities to sustainably provide long-term financing solutions. This opens the door for NBFIs as capital providers.

3.3 COMPREHENSIVE ASSESSMENT OF SUKUK STRUCTURES

Based on our assessment of sukuk structures, issuances and investments, each jurisdiction adopts Shariah standards and regulatory frameworks that have been approved or accepted by the local governing bodies (e.g. Shariah advisory boards and securities exchanges). To provide a better understanding of the differences between sukuk structures, issuances and investments, we have segregated our analysis according to the following geographical areas:

1. Arab countries 2. Asian countries 3. African countries 4. Non-OIC countries

3.3.1 ARAB COUNTRIES

The issuance of sukuk in Arab countries has predominantly been undertaken by the GCC countries (i.e. Saudi Arabia, the UAE, Bahrain, Qatar, Kuwait and Oman). Other Arab nations such as Jordan have also been successful in promoting sukuk issuance. Based on Chart 3.1, ijarah contracts constitute a large portion of sukuk issuances by sovereigns. Notably, the AAOIFI’s Shariah standards exert a significant influence on the type of Shariah principles used in the issuance of sukuk in this region. The AAOIFI’s requirement that any trading of sukuk must be backed by the ownership of tangible assets, usufructs/services or a mixture of tangible and intangible assets has resulted in a marked preference for ijarah. Nevertheless, the requirement of having to secure available unencumbered assets has pushed the commercial decision by governments and corporates to adopt wakalah contracts, which comprise a hybrid of murabahah receivables and ijarah assets or any other tangible assets. This trend is depicted in Chart 3.2.


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Chart 3.1: Selected Arab Sovereign Issuances by Shariah Contracts (2011-June 2017)

Sources: Bloomberg, Eikon Thomson Reuters* *Data extracted from Eikon Thomson Reuters is for Jordan only.

Chart 3.2: Quasi-Sovereign and Corporate Issuances by Shariah Contracts (2011-June 2017)

Sources: Bloomberg, Eikon Thomson Reuters* *Data extracted from Eikon Thomson Reuters represents Jordan only.


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Figure 3.2: IDB Trust Services Limited –Wakalah Bil Istithmar Sukuk Structure

Source: IDB Trust Services Limited Base Prospectus (17 October 2016) Note: Portfolio means a separate and independent portfolio of assets created by IDB, which includes: 1. At least 33% of the tangible assets must consist of leased assets, disbursing istisna’ assets, shares and/or

sukuk. 2. No more than 67% of the intangible assets must comprise istisna’ receivables and/or murabahah receivables.

A case in point is the Islamic Development Bank’s (IDB) first wakalah bil istithmar sukuk, issued in 2003. In the structure, ijarah assets constituted 65.8% of the entire portfolio while murabahah and istisna’ receivables made up the other 34.2% (Haneef, 2009). In IDB’s subsequent sukuk issuance, as illustrated in Figure 3.2, the proportion of tangible assets was reduced to 33% (i.e. the level set in the AAOIFI’s Shariah Standard). Because of this precedence, market practitioners in other countries have adopted similar benchmarks in the structuring of their wakalah structures. 3.3.2 ASIAN COUNTRIES

Within the Asian region, Malaysia and Indonesia boast the largest shares in terms of sukuk issuance. The key difference is Malaysia’s strong foothold underpinned by a sustainable supply of corporate sukuk issuers; Indonesia’s sovereign sukuk issuance is the key driver of its historical volume and number of sukuk issues. In September 2014, the Government of the Hong Kong Special Administrative Region of the People’s Republic of China became the first non-OIC country in Asia to issue a USD16.0 billion sukuk, following changes in tax legislation in July 2013. Japan and Singapore had followed suit in enacting similar reforms, in an attempt to eliminate asymmetries in the tax treatment of sukuk and traditional bonds. This is to level the playing field, so that sukuk can compete with conventional debt securities. Of the non-OIC


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countries in this grouping, only Hong Kong has returned to the debt market 3 times, to expand its Islamic finance reach in building its sukuk benchmark yield curves. In Malaysia, the resolutions by the SAC of the SC have become the overarching guide in the interpretation of Shariah principles, which have facilitated product development and the structuring of innovative financial instruments in its ICM. The top-down approach by the government and the regulators in implementing a centralized SAC within the SC had been a foresight that has turned Malaysia’s financial landscape into a successful dual-banking model. The resolutions and the Islamic Securities Guidelines are aimed at enabling and developing a more innovative and sophisticated ICM, as well as facilitating the introduction of a wider range of Islamic instruments. Chart 3.3 depicts sukuk issuance by sovereigns, with murabahah accounting for the largest share in Malaysia. Other sovereign sukuk issues in the Asian region predominantly use ijarah structures. This, we believe, is in line with the AAOIFI’s requirement on the trading of debt.

Chart 3.3: Selected Asian Sovereign Issuances by Contracts (2011-June 2017)

Source: Eikon-Thomson Reuters

Chart 3.4: Quasi-Sovereign and Corporate Issuances by Shariah Contracts (2011-June 2017)

Sources: Bloomberg*, Eikon Thomson Reuters *Data extracted from Bloomberg is for Indonesia only.


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Figure 3.3 describes the wakalah sukuk structure adopted in the Government of Malaysia’s (GoM) global sukuk issuance. From the GoM’s first global ijarah sukuk structure in 2002, the Shariah contracts have evolved to adopt a hybrid structure combining ijarah and wakalah. On the other hand, Figure 3.4 illustrates the ijarah sukuk structure used in Indonesia’s global sukuk issuance.

Figure 3.3: Malaysia Sukuk Global Berhad –Wakalah Sukuk Structure

Source: Malaysia Sukuk Global Berhad Offering Memorandum (20 April 2016)

Figure 3.4: Perusahaan Penerbit SBSN Indonesia III –Ijarah Sukuk Structure

Source: Ministry of Finance, Republic of Indonesia


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3.3.3 AFRICAN COUNTRIES

In the African region, The Gambia, Sudan, Nigeria, Senegal, South Africa, Togo and Ivory Coast have successfully issued sukuk. Sukuk as an alternative tool of financing is gaining traction and greater awareness in the African region, where requirements for infrastructure funding are high. According to the World Bank, the continent’s infrastructure gap needs a significant amount of investment to the tune of USD93.0 billion (International Financial Law Review, 2015). Governments all over the world generally finance their development and infrastructure budgets through tax and other revenue (including by borrowing from the capital markets through the issuance of various types of financial papers). Given the persistent commodity price slump affecting extractive industries, African governments are now receiving significantly less income from their traditional base of natural resources. As a result, alternative sources of finance are required to fund the capital projects necessary to spur economic growth and diversify their economies. The Gambia’s salam sukuk have predominantly been used by the Central Bank of Gambia for short-term liquidity management. For other selected African countries, since sukuk issuance proceeds have been used for infrastructure-related funding, the complementary sukuk principle has been ijarah. The reasons given by market players include the simplistic features in terms of flexibility, tradability and suitability in funding construction projects. Unlike the murabahah structure, the ijarah structure enables secondary trading of the sukuk instrument on an exchange, which in turn helps increase investors’ participation in the transaction. Additionally, the ijarah contract is inherently designed to produce periodic rental payments, which automatically act as coupon payments to sukuk investors. Chart 3.5 delineates the main Shariah contracts used by selected African countries in their sovereign sukuk structures.

Chart 3.5: Selected African Sovereign Issuances by Shariah Contracts (2013-June 2017)



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3.3.4 NON-OIC COUNTRIES

In 2014, the UK became the first government from the West to tap the sukuk market. Since then, other non-OIC countries (e.g. France and Luxembourg) have joined the ranks in making tax-related adjustments in support of sukuk issuance. The rationale behind these sukuk issuances is to provide financial intermediation and support to the Islamic financial services industry, as a complementary activity to their existing positions as international hubs in their respective jurisdictions. Table 3.3 gives a snapshot of sovereign ijarah sukuk issued by selected non-OIC countries. Meanwhile, Figure 3.5 illustrates the ijarah sukuk structure used in the UK’s sovereign sukuk issuance.

Table 3.3: A Snapshot of Sovereign Ijarah Sukuk Issuances by Selected Non-OIC Countries

United Kingdom Luxembourg Saxony Anhalt (Germany)

Sukuk issuer HM Treasury UK sovereign sukuk PLC

Luxembourg Treasury Securities SA

Stichting Sachsen-Anhalt Trust

Originator Government of United Kingdom

Grand Duchy of Luxembourg

Federal State of Saxony-Anhalt (through the Ministry of Finance)

Currency format

Pound Euro Euro

Structure Ijarah Ijarah Ijarah

Obligor/sukuk rating(s)

Unrated AAA (S&P), Aaa (Moodys)

AAA (Fitch), AA- (Standard & Poor’s)

Sukuk assets Government buildings and land

Government buildings and land

Specific buildings owned by the Ministry of Finance

Purpose Proceeds from the sukuk paid for the premium for the 99-year lease on the premises

To finance government spending

General budgetary purposes

Issuance date 2 July 2014 7 October 2014 August 2004

Tenure 5 years 5 years 5 years

Maturity 22 July 2019 7 October 2019 August 2009

Amount GBP200 million EUR200 million EUR100 million

Period distribution

2.036% 0.436% 6-month EURIBOR + 1 bps

Listing London Stock Exchange Luxembourg Stock Exchange

Luxembourg Stock Exchange

Geographical distribution of investors

Middle East, Asia and Britain

n/a n/a

Sources: Offering Circular of HM Treasury UK sovereign sukuk PLC, Prospectus of Luxembourg Treasury Securities SA, Structure Document of Stichting Sachsen-Anhalt Trust

https://www.sukuk.com/whos-who/luxembourg-stock-exchange-925

https://www.sukuk.com/whos-who/luxembourg-stock-exchange-925


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Figure 3.5: HM Treasury UK Sovereign Sukuk Plc –Ijarah Sukuk Structure

Source: HM Treasury UK Sovereign Sukuk Plc Offering Circular (30 June 2014)

3.3.5 ANALYSIS OF SUKUK STRUCTURES ISSUED BY OIC AND NON-OIC COUNTRIES

The difference in the types of Shariah contracts frequently adopted in Malaysia (predominantly murabahah) compared to other countries is due to the varying opinions of Shariah experts. For example, trading of debt or bay’ al-dayn is a common practice in Malaysia following the SAC of the SC’s acceptance of the principle of bay’ al-dayn as one of the concepts for the development of Malaysia’s ICM instruments in August 1996 (Securities Commission Malaysia, 2007). Unlike ijarah or equity-based Shariah contracts, which represent beneficial interests or rights over an asset or equity venture, sale-based sukuk denotes the sukuk holders’ rights to receive payments under the murabahah sale price, which is essentially a debt. The argument by the SAC of the SC on the permissibility of bay’ al-dayn is explained in the Resolutions of the SC’s SAC, which state that there is no general nas or consensus (ijma’) among Islamic jurists to forbid it. This proactive approach has facilitated Malaysia’s success in attracting corporate issuers that face problems in securing the requisite assets to meet the sukuk guidelines. Some Shariah scholars may view Malaysia’s approach as accommodative. However, market practitioners believe a balance between commercial reasoning and Shariah requirements is pertinent to building the necessary base for a strong ICM. The tightening of Shariah governance will always be an ongoing development as a domestic sukuk market grows in line with international best practices that satisfy globally accepted Shariah requirements. As described earlier in Box 3.4, the AAOIFI’s Shariah standards on sukuk, any trading of sukuk must be backed by tangible assets. Accordingly, almost all sovereign sukuk issues have opted


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for the contract of ijarah due to its wide acceptance by Islamic jurists. Nonetheless, securing eligible Shariah-compliant assets that are unencumbered has been identified as a limiting factor vis-a-vis meeting the expected asset-pricing guidelines. Hence over the years, more sukuk issues have adopted a hybrid structure (e.g. Figure 3.3 - Malaysia’s global wakalah sukuk issuance) – a combination of more than one Shariah contract to meet the commercial reasoning for the efficient use of assets. Based on historical sukuk issuance, wakalah or wakalah bil istithmar sukuk has a number of variations in the underlying assets, as explained below.

(i) Combination of ijarah and existing debts Figure 3.2 above depicts the IDB’s portfolio comprising 33% of tangible assets and 67% of intangible assets (istisna’ receivables and/or murabahah receivables). The percentage used in the portfolio sets the precedent for future ijarah sukuk structures adopted in other countries.

(ii) Combination of ijarah and newly created debt Cagamas’ sukuk al-amanah li al-istithmar used a combination of ijarah and newly created debt in its RM5.0 billion ICP and MTN programmes in 2010. Ijarah contracts represented 50% of the portfolio.

(iii) Combination of mudarabah and newly created debt Gulf Investment Corporation’s RM3.5 billion MTN sukuk programme in 2011 adopted a structure that incorporated mudarabah contracts and newly created debt.

(iv) Combination of ijarah, shares and newly created debt This structure was used in the GoM’s USD2.0 billion wakalah sukuk issuance in 2011. The sukuk created a new landmark as the largest ever USD sovereign sukuk, the largest issuance at that time by Malaysia in the international USD markets, and the first 10-year USD sovereign sukuk.

(v) Combination of intangible assets (e.g. vouchers representing the right to use a specific number of travel units), shares and lease assets

Figure 3.3 above illustrates Malaysia’s global sukuk issuance with this kind of assets combination.


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3.4 A COMPREHENSIVE ASSESSMENT OF SUKUK ISSUANCES – SUPPLY (SELL SIDE)

3.4.1 ARAB REGION

As at end-2016, corporate sukuk issuance accounted for 61.0% of total issuances by Arab nations; the other 39.0% originated from the public sector. In 1H 2017, there was a shift towards greater sukuk issuance by sovereigns due to Saudi Arabia’s inaugural international USD9.0 billion sukuk in April. This segment expanded further in line with Saudi Arabia’s 3-tranche domestic sukuk programme amounting to SAR17 billion in July 2017. Chart 3.6 illustrates the percentage of sovereign, quasi-government and corporate sukuk issuances by the GCC countries and Jordan between 2013 and June 2017.

Chart 3.6: GCC’s and Jordan’s Sovereign and Corporate Sukuk Issuance (2013–June 2017)

Sources: Bloomberg, Eikon Thomson Reuters* *Data extracted from Eikon Thomson Reuters is for Jordan

In the last 5 years following the plunge in oil prices, the sovereigns of Bahrain, the UAE and Qatar have been actively issuing LCY and FCY sukuk for budget financing purposes (refer to Table 3.4 on the GCC’s budget deficits). In 2017, Oman and Saudi Arabia made their debut in sukuk issuance, after having raised conventional bonds in recent years, due to the urgent need to plug their budget deficits amid the impact of weak oil prices. In April 2017, Kuwait followed its neighbours in raising debt, but chose an international conventional bond to build is first yield benchmark (Euromoney, 2017). Given the persistently low oil prices and the funding requirements to bridge budget deficits, we believe the GCC sovereigns will continue combining sukuk with conventional funding methods. In the GCC, the decision on whether sovereigns should issue bonds or sukuk is first determined by the targeted investor base, followed by the ease of the sukuk structure and Islamic finance strategy, since the structuring of sukuk is more complex and time-consuming compared to traditional bonds (Gulf News Banking, 2017).


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Table 3.4: GCC Countries’ Budget Deficits (2014-2017f/ USD billion) Country 2014 2015 2016 2017f Saudi Arabia (25.9) (102.9) (84.5) (56.4) Qatar 25.3 1.9 (11.9) (18.3) Kuwait 13.7 (19.6) (15.0) (9.6) United Arab Emirates 19.7 (7.7) (14.4) (7.8) Oman (2.7) (11.6) (12.5) (7.5) Bahrain (1.2) (4.0) (4.6) (4.2) Total 28.9 (143.9) (143.0) (103.8) Source: RAM (2017, March)

The GCC countries boast a healthy pipeline of corporate sukuk issuances, predominantly driven by Islamic financial institutions and government-related entities. Only Saudi Arabia has provided some diversification into other corporate sectors (i.e. aerospace, chemical, food processing, industrial, and O&G). Chart 3.7 shows corporate sukuk issuances based on a sector by the GCC countries and Jordan. Tables 3.5 and 3.6 indicate the number of domestic and international sukuk issuances by Arab countries from 2001 to 2006.

Chart 3.7: Quasi-Government and Corporate Sukuk Issuances by Sector (2011-June 2017)

Sources: Bloomberg, Eikon Thomson Reuters* *Data extracted from Eikon Thomson Reuters is for Jordan only

Table 3.5: Arab Countries – Number of Domestic Sukuk Issuances by Country (2001-2016)

Country Number of sukuk issues Amount (USD million) % of total value Bahrain 265 14,748 19.3 Jordan 3 272 0.4 Kuwait 1 332 0.4 Oman 3 825 1.2 Qatar 16 14,416 18.9 Saudi Arabia 52 37,179 48.7 UAE 14 8,251 10.8 Yemen 2 253 0.3 Total 356 76,276 100.0 Source: IIFM (2017, July)


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Table 3.6: Arab Countries – Number of International Issuances by Country (2001-2016)

Country Number of sukuk issues Amount (USD million) % of the total value Bahrain 101 9,310 8.5 Kuwait 15 2,577 2.4 Oman 2 582 0.5 Qatar 12 10,185 9.3 Saudi Arabia 43 26,305 24.1 UAE 90 60,244 55.2 Total 263 109,203 100.0 Source: IIFM (2017, July)

Table 3.7 gives a snapshot of some landmark issuances by selected Arab countries. Table 3.7: A Snapshot of Selected Sukuk Issuances by Arab Countries Name of issuance

Zam Zam Tower Sukuk 2003

SABIC 1 Sukuk 2006

Dubai Islamic Bank Sukuk

2015

Jordan Sovereign

Sukuk 2016

Saudi Sovereign

Sukuk 2017 Sukuk issuer Munshaat Real

Estate Projects KSC

Saudi Arabia Basic Industries Corporation (SABIC)

DIB Tier 1 Sukuk (2) Ltd

Jordan 2021 KSA Sukuk Limited

Originator/ obligor

Makkah Al-Mukarramah King Abdul Aziz Waqf Project

Saudi Arabia Basic Industries Corporation

DIB Tier 1 Sukuk (2) Ltd

Hashemite Kingdom of Jordan

Kingdom of Saudi Arabia Ministry of Finance

Currency format

USD Saudi Riyal USD Jordan Dinar USD

Structure Ijarah (Intifa’) Istithmar Mudarabah Ijarah Hybrid (Combination of mudarabah and murabahah)

Sukuk rating(s)

n/a Standard & Poor’s: A-

Not rated n/a Moody’s: A1(P) Fitch Ratings: A+

Sukuk asset(s)

The right to use the apartment complex (Zam Zam Tower) based on the time-sharing concept

Specified rights and obligations under the marketing agreements of SABIC’s marketing business for a period of 20 years

General corporate business of DIB

Shariah-compliant asset

Shariah-compliant asset

Purpose To build a high-quality service facility for pilgrims that met the specific goals of the waqf

To finance part of SABIC’s capex program and general corporate purposes

To enhance capital position of DIB

Completion of Ministry of Finance’s new offices

To finance its budget deficit

Issuance date

December 2003 29 July 2006 20 January 2015 17 October 2016

20 April 2017

Tenure 24 years 5-20 years Perpetual, callable after six years

5 years 5 years and 10 years


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Name of issuance

Zam Zam Tower Sukuk 2003

SABIC 1 Sukuk 2006

Dubai Islamic Bank Sukuk

2015

Jordan Sovereign

Sukuk 2016

Saudi Sovereign

Sukuk 2017 Maturity December 2027 First put option on

15 July 2011 n/a 17 October

2021 20 April 2022 and 20 April 2027

Amount USD 390 million SAR 3 billion USD 1 billion JOD 34 million USD 9 billion

Periodic distribution

An internal rate of return on the investment at 26%

3-month SIBOR + 40 bps

6.75% 3.01% 2.894% and 3.628% respectively

Listing n/a Saudi Stock Exchange

Irish Stock Exchange and NASDAQ Dubai

n/a Irish Stock Exchange


n/a n/a n/a n/a n/a

Sources: Bloomberg, Thomson Reuters, sukuk.com

In developing Arab countries’ sukuk markets, consideration should be given to the large infrastructure funding gap that has historically been funded by governments and commercial banks. As Arab governments look into economic reforms (i.e. cut-backs on subsidies and government spending) the silver lining amid the need to reduce dependency on oil revenue is the promotion of economic growth through public-private-sector relationships, which will lead to spill-over effects for the economy (e.g. increased construction activities, manufacturing, and job creation). As depicted in Figure 3.6, Arab countries face an annual USD60 billion funding gap. Research shows that the GCC governments are increasingly turning to public private partnerships (PPPs) to plug the budgetary gaps in public-transport infrastructure development amid fluctuating oil prices. The 2 key markets generally considered as the most promising in the near term are Kuwait and the UAE (i.e. Dubai), each of which recently adopted a legislative framework for PPPs. Saudi Arabia’s government has also decided to implement several transport infrastructure projects based on the PPP model (Gulf Traffic, 2017).

Figure 3.6: Arab Countries’ Infrastructure Spending

Water and Sanitation

Transport

Information and Communications Technology

5%

Electricity

9%

43%

43%

Annual funding gap of USD60.0 billion

Investment Requirements Current Spending

USD40.0 billion

USD100.0 billion

Infrastructure financing gaps Priority sectors for the next 5 years

Source: Arab Monetary Fund Calculation (2016)


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3.4.2 ASIAN REGION

By sector, financial institutions have been the core sector raising sukuk to meet capital adequacy requirements. Sectoral diversification can be observed in quasi-government and corporate sukuk issuances originated in Indonesia and Malaysia (refer to Chart 3.8). In terms of the number of issues and amount, however, Malaysia stands above its peers, as illustrated in Tables 3.8 and 3.9. Elsewhere, sukuk issuances from Bangladesh, Hong Kong and Brunei have all been by their governments and central banks.

Chart 3.8: Quasi-Government and Corporate Sukuk Issuances by Sector (2011-June 2017)


Table 3.8: Asian Countries − Number of Domestic Sukuk Issuances by Country (2001-2016)

Country Number of sukuk issues Amount (USD million) % of the total value Bangladesh 4 37 0.0 Brunei Darussalam 137 8,829 1.6 Indonesia 195 31,822 5.6 Iran 1 144 0.0 Malaysia 5,106 515,662 90.6 Maldives 1 3 0.0 Pakistan 71 12,006 2.1 Singapore 12 788 0.1 Sri Lanka 1 3 0.0 Total 5,528 569,295 100.0 Source: IIFM (2017, July)

Table 3.9: Asian Countries – International Sukuk Issuances by Country (2001-2016)

Country Number of sukuk issues Amount (USD million) % of the total value China 1 97 0.2 Hong Kong 4 2,196 3.6 Indonesia 13 10,503 17.2 Japan 3 190 0.3 Malaysia 73 44,854 73.3 Pakistan 3 2,600 4.2 Singapore 4 711 1.2 Total 101 61,151 100.0 Source: IIFM (2017, July)


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The GoM’s concerted efforts to include Islamic banking and Islamic finance as policy tools in its economic agenda have been the driving force behind the country’s rise in the mainstream financial markets. The successful inclusion of Islamic finance lends considerable strength towards building a sustainable sukuk pipeline, not only in meeting the government’s budgetary requirements but also by quasi-government entities and corporates. Malaysia’s financial institutions and infrastructure sector are believed to remain the lynchpins for future large sukuk transactions due to their financing needs, which are better matched by domestic institutional investors’ appetite for long-term assets. Apart from Malaysia, other Asian countries particularly Indonesia and Pakistan are steadily increasing their volume of issuances. Table 3.10 gives an overview of selected sukuk issued by some Asian countries.

Table 3.10: A Snapshot of Selected Sukuk Issuances by Asian Countries Malaysia Indonesia Pakistan Brunei Japan

Sukuk issuer Axiata SPV2 Bhd

Tiga Pilar Sejahtera Food Tbk PT

Neelum Jhelum Hydropower Company (Private) Limited

Brunei Darussalam April 2017

Bank of Tokyo-Mitsubishi UFJ (Malaysia) Berhad (“BTMUM”)

Originator/ Obligor

Axiata Group Berhad

Tiga Pilar Sejahtera Food Tbk PT

Neelum-Jhelum Hydropower Company (NJHPC)

Government of Brunei

The Bank of Tokyo-Mitsubishi (UFJ)

Currency format

US Dollar Indonesian Rupiah

Pakistani Rupee Brunei Dollar Japanese Yen

Structure Wakalah Ijarah Musharakah Ijarah Wakalah

Sukuk ratings Baa2 (Moody’s), Baa2 (S&P) –International rating

idA (Pefindo)-Domestic rating

AAA (JCR-VIS) - Domestic rating

AAA (RAM2) AAA (RAM)

Sukuk assets Airtime vouchers

n.a n.a n.a Shariah-compliant asset

Purpose To improve its capital efficiency

To refinance its outstanding debt and finance its rice mill construction

Finance hydropower project

To diversify their portfolio

To diversify their funding sources

Issue date 13 November 2015

19 July 2016 21 April 2016 28 April 2016 25 September 2014

Tenure 5 years 5 years 10 years 1 year 10 years

Maturity 13 November 2020

19 July 2021 21 April 2026 13 April 2017 25 September 2024

Amount USD500 million IDR1.5 trillion PKR100 billion BND100 million JPY2.5 billion

Period distribution

3.466% 10.0-10.75% 0, 113 basis points over the 6-month KIBOR

1.03% n.a

2 RAM’s country rating for Brunei, as of 13 Dec 2016


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Malaysia Indonesia Pakistan Brunei Japan

Listing Bursa Malaysia, Singapore Exchange

n.a n.a n.a n.a


Asia (58%), Europe (22%), Middle East (20%)

n.a n.a n.a n.a

Sources: Islamic Finance News, Thomson Reuters, RAM

3.4.3 AFRICAN REGION

In the past, African governments had relied on traditional financiers such as export credit agencies, multilateral agencies, development financial institutions, commercial banks and private participants to cover their infrastructure costs. However, traditional sources of finance are finite and must fund other sectors besides infrastructure. Given the continent’s massive infrastructure gap, the need to actively seek alternative funding sources has become more urgent. As a result, several African countries have looked at the euro bond market, for infrastructure development and other purposes. In recognition of the continent’s significant Muslim population and the considerable financial strength of Asia and the Middle East, the number of African countries preparing legal frameworks for sukuk issuance is increasing amid a plethora of other Shariah-compliant instruments to attract investments from these economies. Despite the effects of the downward spiral in oil prices, many of the GCC states have sovereign wealth funds that, over the years, have amassed significant wealth, which may also be deployed through either conventional financial products or Shariah-compliant instruments. In light of this development, Osun State (in Nigeria), South Africa, Senegal and Nigeria have all issued sovereign sukuk backed by infrastructure assets. This highlights the growing influence of sukuk as a strategic debt-management instrument by African governments in meeting budgetary requirements. Table 3.11 provides a snapshot of these issuances.

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Table 3.11: A Snapshot of Selected Sukuk Issuances by African Countries Osun State of

Nigeria Nigeria Senegal South Africa Cote d-Ivoire

(Ivory Coast) Togo

Sukuk Issuer Osun Sukuk Company Plc

FGN Roads Sukuk Company 1 Plc

FCTC Sukuk Etat du Senegal

ZAR Sovereign Capital Fund Proprietary Ltd

FCTC FCTC

Originator/ Obligor

State Government of Osun, Nigeria

Federal Government of Nigeria

Government of Senegal

Government of South Africa

Government of Ivory Coast

Government of Togo

Currency Format Naira Naira CFA US dollar CFA US dollar

Structure Ijarah Ijarah Ijarah Ijarah Ijarah Ijarah

Sukuk Rating(s) Bb+ (Agusto & Co), A (Agusto & Co)

Not rated Not rated BBB- (S&P), Baa1 (Moody’s), BBB (Fitch)

n/a n/a

Sukuk Asset(s) Elementary, middle and high schools

Public road Usufruct of 3 buildings

Usufruct of government land

Usufruct of 2 building complexes in Abidjan

n/a

Purpose Construct schools Finance road projects

Finance economic and social development projects

Repay maturing debts

Finance development projects

Finance development projects

Issuance Date 10 October 2013 22 September 2017 18 July 2014 September 2014 21 December 2015 10 August 2016

Tenure 7 years 7 years 4 years 5 years 9 months 5 years 10 years

Maturity 10 October 2020 22 September 2024 18 July 2018 17 June 2020 21 December 2020 10 August 2026

Amount Naira11.4 billion Naira100.0 billion CFA100.0 billion USD500.0 million CFA150.0 billion CFA150.0 billion


14.75% 16.47% 6.25% 3.90% 5.75% 6.5%

Listing Nigerian Stock Exchange

Nigerian Stock Exchange, FMDQ OTC Securities Exchange

Regional Securities Stock Exchange

Luxembourg Stock Exchange

West Africa bourse Bourse Régionale des Valeurs Mobilières

Geographical Distribution of Investors

Domestic investors Domestic investors West Africa (74%), Middle East (24%), Central Africa (1%), Europe (1%), North Africa (0.1%)

Middle East and Asia (59%), Europe (25%), US (8%), Others (8%)

West Africa (56%), Middle East (38%), North Africa (8%)

n/a

Sources: Islamic Finance News (March 2016), Thomson Reuters (October 2016), Lexology (January 2017)

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3.4.4 SUKUK ISSUANCES IN NON-OIC COUNTRIES

To allow sovereigns to issue sukuk, changes have been made to the countries’ tax and legal frameworks. For example, the UK’s Finance Act 2009, which received royal assent on 21 July 2009, removed the tax barriers that had rendered Shariah-compliant financial products less tax-efficient than their conventional counterparts. The enactment of the legislation had been envisaged to promote the UK’s ambition of becoming a leading international centre for Islamic finance. A key component adopted by the UK in enabling Islamic finance is the embedding of the ability to allow future adjustments by way of statutory instruments (or other forms of guidance), without necessarily requiring primary legislation (SEDCO Capital, 2014). This approach demonstrates the government’s willingness to make any adjustment to facilitate other types of issues, showing that it has both the legislative authority and the tools available to do so. Unfortunately, there has been no further development to date in the UK’s sukuk market. France and Luxembourg have also enacted tax regulations that specifically show how Islamic financial products are treated according to their tax codes. Elsewhere, Singapore has made additional amendments to its income tax regulations to clarify in detail how Islamic banking is handled. Although there have been efforts by governments and regulators to develop the necessary infrastructure, the number of issues has been rather few. Table 3.12 indicates the total number of domestic sukuk issuances while Table 3.13 shows the number of international sukuk issuances by non-OIC countries (outside the Arab, Asian and African regions).

Table 3.12: Number of Domestic Sukuk Issuances by Country (2001-2016)

Europe Number of sukuk issues Amount (USD million) % of the total value France 1 1 0.0 Germany 2 83 2.8 Luxembourg 3 280 9.0 UK 9 1,368 44.1 US 5 1,367 44.1 Total 20 3,099 100.0 Source: IIFM (2017, July)

Table 3.13: Number of International Sukuk Issuances by Country (2001-2016)

Europe & Others Number of sukuk issues Amount (USD million) % of the total value Germany 1 123 100.0 Source: IIFM (2017, July)


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3.4.5 ANALYSIS OF SUKUK ISSUANCES IN OIC AND NON-OIC COUNTRIES

Absence of Islamic Pricing Benchmark One of the challenges of sukuk is that its returns usually rely on the conventional market’s benchmark rates such as the London Interbank Offered Rate (LIBOR) or the Euro Interbank Offered Rate (EURIBOR). The use of these interest-based benchmarks in pricing raises concern among scholars, who argue that the return is equivalent to riba (interest). From a practitioner’s perspective, sukuk―despite their unique characteristic of being Shariah-compliant―are commonly structured as debt-based instruments, with features similar to conventional securities. Given their bond-like features and that they operate in a conventional set-up where investors are familiar with the conventional pricing mechanism, this has influenced sukuk pricing to adopt the conventional pricing benchmark. In addition, the following are the key challenges faced when pricing sukuk: As a relatively new instrument, it has yet to develop its own pricing mechanism. There is a lack of consensus among issuers on what is a suitable Islamic benchmark rate. The sukuk market still faces low liquidity, lack of market depth, and lack of critical mass

for issuances. It is believed that as the sukuk market develops further, an Islamic benchmark rate will naturally develop.

The use of an alternative pricing benchmark is most pronounced in the case of ijarah sukuk, where sukuk holders receive their returns based on the rent of the underlying assets. Instead of using an interest-rate benchmark, it is often argued that the pricing of ijarah sukuk should be reflective of the rentals arising from the underlying assets. Economic Development Based on past sovereign sukuk issues, the core purpose of issuing sukuk has been to fund budget deficits or related budgetary requirements, including the construction of infrastructure projects. From the core sukuk markets (e.g. Malaysia, the GCC and Indonesia), the traction of sukuk issues by other OIC and non-OIC countries underlines the benefits of including sukuk as an alternative financing solution. Due to sukuk’s intrinsic value proposition to match long-term institutional funds with the capital expenditure for infrastructure projects, it has been a boon for countries such as Malaysia, which have identified the private sector as its engine of growth. Although other countries are emulating a similar trend, the inherent challenges in domestic sukuk markets have influenced the progress of development (e.g. lack of support from NBFIs in Indonesia and Turkey).

Regulatory and Shariah Standardization The lack of a standardized approach to regulatory and Shariah governance has influenced the development of sukuk markets. The international-standard benchmarks in the development of Islamic finance have been the AAOIFI and the IFSB. The standards adopted by each member country vary according to the policies and frameworks that have been established to govern local sukuk markets. Countries that have implemented a centralized approach have shown progression in terms of product development and market share of global sukuk issuance.

63

Value Proposition Key to the sustainability of a sukuk market’s development is the establishment of an LCY sukuk market where the private sector participates frequently. To attract the private sector is to build a strong value proposition for sukuk that is embedded in the country’s roadmap or financial masterplan. The stability of macroeconomic factors plays a significant role in determining the stage of the sukuk market’s progress. The amalgamation of all these factors is a prerequisite for the growth of a country’s ICM.

3.5 COMPREHENSIVE ASSESSMENT OF SUKUK INVESTMENTS – DEMAND (BUY SIDE)

3.5.1 ARAB REGION

According to the World Bank, the financial industry in the GCC is generally dominated by the banking sector. NBFIs have a limited presence in the GCC. Investment funds have been increasing rapidly in several countries, although largely focused on domestic equities and real estate. The insurance sector remains small and targets property/casualty risks. Contractual savings are underdeveloped and dominated by public pension systems, which are mainly defined as “pay as you go” schemes (World Bank Group, 2015). They contribute little to the accumulation of long-term resources for investment. Since most investment funds are owned by banks, it is not surprising that domestic investors of GCC sukuk largely comprise local financial institutions. Table 3.14 shows the compositions of financial markets as a percentage to GDP while Table 3.15 highlights the key indicators of financial intermediation by NBFIs as a percentage of GDP in the GCC countries.

Table 3.14: Composition of Financial Markets by Country as a Percentage of GDP

Historical data Data based on latest available date

Country Outstanding bond

Outstanding loan

Market Capitalization

Outstanding bond

Outstanding loan


Bahrain 25.7%(2012) 40.0%(1990) 77.2% (1996) 94.5%(2016) 91.1%(2014) 60.9% (2016) Kuwait 0.4% (2012) 96.5%(1995) 43.9% (1993) 6.2%(2016) 70.8%(2014) 105.4%(2006) Oman 0.8% (2012) 13.9%(1980) 12.9% (1993) 22.8%(2016) 49.0%(2014) 35.1%(2016) Qatar 23.3%(2012) 77.6%(1993) 119.8%(2007) 49.3%(2016) 67.7%(2014) 101.5%(2016) Saudi Arabia

1.7% (2012) 24.7%(1988) 74.2% (2009) 10.8%(2016) 55.8%(2014) 69.4% (2016)

UAE 9.7% (2012) 18.4%(1980) 20.4% (2003) 29.6%(2016) 90.3%(2014) 61.1% (2016)

Sources: World Bank, Bloomberg, The Global Economy Note: Outstanding loans is defined as bank credit to the public and private sectors.

Table 3.15: Key Indicators of Financial Intermediation by NBFIs as a Percentage of GDP Country NBFIs assets as % to GDP Pension fund assets as % to GDP Bahrain 31.5% (2014) 20.5% (2006) Kuwait 2.44% (2014) n/a Oman n/a n/a Qatar n/a n/a Saudi Arabia 14.4% (2014) 26.0% (2016) UAE n/a 2.7% (2007) Source: The Global Economy


64

A review of the investors of the GCC’s recent bond issuances (including sukuk) shows a high reliance on foreign investors. Amid negative or near-zero bond yields in the UK, euro zone and Japan, these investors have been attracted to the bond yields offered by the Gulf region. This is evident from the size of the order books of selected GCC bond issues in 2017 and pricing levels (refer to Figure 3.7).

Figure 3.7: Selected GCC Credits’ Order Books, Pricing Dynamics and Investor Profiles

65

Source: Bloomberg (2017, April)

3.5.2 ASIAN REGION

Hong Kong and Malaysia have undergone healthy developments in terms of the composition of their financial markets. Indonesia is still attempting to establish a higher ratio of its outstanding bond market against its GDP. The Indonesian government and regulators acknowledge the need to effectively diversify the country’s funding sources and have embarked on several measures to do so. Nonetheless, such efforts require persistence to ensure successful implementation. Table 3.16 shows the compositions of financial markets as a percentage of their GDP while Table 3.17 highlights the key indicators of financial intermediation by NBFIs as a percentage of GDP for some Asian countries. Meanwhile, Box 3.6 elucidates the depth of NBFIs in the Malaysian market.

Table 3.16: Composition of Selected Asian Financial Markets as a Percentage of GDP



Outstanding loan


Outstanding bond

Outstanding loan


Hong Kong 6.0% (1997) 163.5%(1990) 80.6% (1975) 66.5%(2016) 271.5%(2014) 995.1% (2016) Indonesia 17.0%(2008) 12.6% (1980) 32.9% (1995) 25.0%(2016) 36.2% (2014) 45.7% (2016) Malaysia 51%(1997) 75.9% (1980) 61.2% (1981) 102.0%(2016) 135.0%(2014) 121.4% (2016) Pakistan 4.2% (2012) 32.3% (1980) 24.6% (1993) 18.2% (2016) 36.0% (2014) 15.3% (2011)

Sources: The Global Economy, BNM, SC, Asia Bond Online

Table 3.17: Key Indicators of Financial Intermediation by NBFIs as a Percentage of GDP

Country NBFIs assets as % to GDP Pension fund assets as % to GDP Hong Kong n/a 37.4% (2014) Indonesia 3.3% (2014) 1.69% (2011) Malaysia n/a 57.9% (2014) Pakistan n/a 0.02% (2012) Source: The Global Economy


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Box 3.6: Depth of Malaysia’s NBFIs

Malaysia’s focus on the development of its NBFIs has had a multi-fold effect in building a stronger capital market. As at end-2016, the aggregate assets of NBFIs accounted for about 39.4% (2015: 38.8%) of the overall financial system’s assets. Provident and pension funds along with the fund-management industry accounted for the bulk (83%) of the NBFIs’ assets. The 7 largest NBFIs made 68% of their total assets. The financial-intermediation activities of NBFIs mostly take the form of financing and investment in “plain vanilla” debt and equity instruments. These comprised a smaller 98.6% of GDP in 2016 (2015: 101.9%), reflecting the slower growth of investment funds (2016: +4.3%; 2015: +6.0%) and a weaker equity market. Among the larger NBFIs, their share of investments in equity has remained mostly stable, constituting 29%-72% of their respective asset bases. Similarly, the share of investments in debt securities has been stable, ranging between 4% and 41% of their total assets. These entities continue to play an important role in supporting the liquidity of their domestic financial markets, including amid heightened selling pressure by non-resident investors. In recent years, NBFIs have been gradually increasing their investments in real estate, infrastructure projects and private equity, in a bid to improve yields and diversify investment risk. However, such investments remain relatively small at less than 10% of the total assets of individual NBFIs, although this is expected to trend higher following the announced intention of several large NBFIs to elevate investments in these asset classes over the next few years. The share of overseas assets has also remained broadly unchanged, ranging between 7.3% and 28.4% of the total assets of individual NBFIs. Source: BNM (2016)

In our analysis of the buy side of selected Asian countries, reference has been made to the McKinsey Asian Capital Markets Development Index to evaluate the level of intermediation, with a focus on countries that have raised sukuk in the past (refer to Figures 3.8 and 3.9). Malaysia is ranked the highest among its peers with a score of 3.25 (out of 5) in terms of: (i) funding at scale; (ii) investment opportunities; and (iii) pricing efficiency. Indonesia recorded a score of 2.20 and Pakistan 1.30. The key data points in the scores include the following: 1. Financial depth of the primary market - Malaysia is ranked as moderate compared to

Indonesia (shallow) and Pakistan (very shallow). 2. Availability of long-term debt – Malaysia is ranked as “deep” compared to Indonesia (very

shallow) and Pakistan (shallow). 3. Availability and stability of outstanding foreign portfolio investments (FPIs) against GDP –

Indonesia is ranked FPI > 25%, followed by Malaysia (FPI < 25%) and Pakistan (FPI < 10%).

4. Availability of investment opportunities across asset classes – Malaysia is considered “deep” (> 240%), with Pakistan and Indonesia deemed “very shallow” (< 80%).

67

Figure 3.8: McKinsey Asian Capital Markets Development Index

Source: McKinsey & Company (2017, April)

Figure 3.9: Constituents of McKinsey Asian Capital Markets Development Index

Source: McKinsey & Company (2017, April)


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3.5.3 AFRICAN REGION

In terms of financial market development, African countries liberalized their financial sectors in the late 1980s and 1990s, as part of the structural adjustment programmes promoted by the IMF and the World Bank. The reforms included the removal of credit ceilings, the liberalization of interest rates, the restructuring and privatization of state-owned banks, and the introduction of a variety of measures to promote the development of private banking systems and financial markets (Review of Development Finance, 2015). These measures had been accompanied by bank supervisory and regulatory schemes, including the introduction of deposit insurance in certain countries (Cull et al, 2005). South Africa’s financial market seems to be the most advanced compared to its peers, as depicted by an increase in its outstanding bonds and market capitalization as a percentage of GDP. Overall, despite the growth of Africa’s financial system, it remains relatively underdeveloped compared to other up-and-coming emerging markets. Table 3.18 shows the composition of financial markets as a percentage of GDP.

Table 3.18: Composition of Selected African Financial Markets as a Percentage of GDP



Outstanding loan


Outstanding bond

Outstanding loan


Gambia 0% (2012) 42.4%(1980) 17.0% (2003) 0.2% (2016) 40.4%(2014) n/a Nigeria 5.5% (2012) 18.2%(1980) 14.0% (2003) 12.4% (2016) 18.3%(2014) 7.4% (2016) Senegal 8.4% (2012) 38.4%(1980) n/a 30.0% (2016) 38.8%(2014) n/a Ivory Coast

50.9%(2012) 40.8%(1980) 12.0% (2003) 120.4%(2016) 26.3%(2014) 34.2% (2016)

South Africa

34.0%(2012) 49.6%(1980) 161.6%(2003) 82.7%(2016) 77.2%(2014) 322.7%(2016)

Sudan n/a 17.0%(1980) n/a n/a 9.8% (2014) n/a

Source: The Global Economy *n/a. – not available

Based on the composite mix of investors, Africa’s debt securities are mainly held by foreign holders. Although African governments have implemented measures to heighten the development of NBFIs, challenges such as financial inclusion and a low savings rate have been hampering progress, as depicted in Table 13.9.

Table 3.19: Key Indicators of Financial Intermediation by NBFIs as a Percentage of GDP

Country NBFIs assets as % to GDP Pension fund assets as % to GDP The Gambia n/a n/a Nigeria n/a 4.4% (2012) Senegal n/a n/a Ivory Coast n/a n/a South Africa 120.3% (2014) 40.8% (2014) Sudan n/a n/a Source: The Global Economy *n/a. – not available

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3.5.4 ANALYSIS OF SUKUK INVESTMENTS IN OIC COUNTRIES

Based on our observation of sukuk markets, the dearth of sukuk issuances has resulted in investors’ buy-and-hold behaviour, thereby causing the lack of a secondary market. For example, Malaysia’s secondary trading is more active than other sukuk markets due to its volume and number of sukuk issues. Nevertheless, the country’s Employees Provident Fund’s launch of a Shariah-compliant fund with an initial investment of RM100.0 billion in early 2017 has exerted pressure on the sukuk pipeline. Coupled with Islamic banks’ high liquidity requirements, this will further affect market conditions. In support of Islamic banks’ requirements for liquid assets, Islamic securities issued by the government, local central banks and selected highly rated sukuk have been used to fulfill market demand. The continued progress in product development and the identification of potential sukuk issuers in domicile sukuk markets will bode well for supporting the growing demand for Shariah-compliant assets. As highlighted earlier, sukuk has proven a useful tool in the funding of infrastructure projects. Continued development that supports both commercial needs and Shariah requirements, as well as the cooperation of all market participants, will strengthen the pillars holding up a country’s ICM.


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4. CASE STUDIES

4.1 INTRODUCTION: SELECTION CRITERIA AND METHODOLOGY

In determining the selection criteria and methodology, several factors have been analysed. The development-stage matrix (shown in Table 4.1) has been established to categorise the countries under review.

High

Moderate

Low

Table 4.1: Development-Stage Matrix for Sukuk Matured Developing Infancy

Malaysia UAE Indonesia Turkey Hong Kong Nigeria

Level of macroeconomic stability (ratings of the country based on various factors such as geopolitical tension, volatility of local currency, level of inflation rate)

A- (S&P), A3

(Moodys), A- (Fitch), A2 (RAM)

AA (S&P), Aa2

(Moodys), AA (Fitch) AA2 (RAM)

BBB- (S&P), Baa3 (Moodys),

BBB (Fitch),

BBB2 (RAM)

BB (S&P), Ba1

(Moodys), BB+ (Fitch) BBB3 (RAM)

AA+ (S&P), Aa2

(Moodys), AA+ (Fitch)

B (S&P), B2

(Moodys), B+ (Fitch)

Percentage of Muslim population to total population

61.3% 76% 87.2% 99.8% 1.4% 50%

Percentage of Islamic banking assets to total banking assets

> 20% > 20% < 5% < 5% < 1% < 1%

Market share of total global sukuk issuance

> 40% 10%-20% 10%-20% < 10% < 1% < 1%

Legal framework: - Common law or

civil law - Amendments to

local law - Clarity of dispute

resolution, bankruptcy act, arbitration

Common

law

Civil law, market driven

Civil law, market driven

Civil law, with clear processes

Common

law

Common

law

Regulatory framework: - Strong and single

regulation to govern bond market

- Specific guidelines on sukuk

- Regulatory protection for the bond market

- Ratings

Comprehensive

framework and

guidelines

Vulnerable

due to minimal

framework

Gaps between

sovereign and

corporates

Release of

Communique to govern

sukuk

Global financial

centre

Under- developed

71

Shariah governance framework: - Centralised

Shariah board - Resolutions on

sukuk structures - Key functions

such as advisory, review and audit

Tax neutrality: - Removal of taxes

related to transfer of assets

Tax incentives: - Waiver or

deduction of taxes and/or issuance costs

Product innovation: - Diversity in sukuk

structures and products

Infrastructure: - Trading platforms - Listing and

approval processes

- Activity level of Islamic money market

Diversification of investor base: - Intermediation by

NBFIs - Inclusion of retail

investors

Diversification and frequency of: - Sovereign

issuance - Corporate

issuance

Cost competitiveness: - All-in cost in terms

of legal, pricing, issuance timeline

Establishment of a sovereign sukuk yield benchmark

Establishment of a corporate sukuk yield benchmark

Sources: RAM, ISRA


72

Further details on the development-stage matrix are provided in Table 4.2 below.

Table 4.2: Description of the Development-Stage Matrix

Country Stage of Sukuk

Market Development

Rationale

Malaysia Matured Malaysia’s sukuk market has grown by leaps and bounds, and remains the world leader in terms of market share. As at end-2016, Malaysia accounted for 41.1% (USD29.9 billion) of total global sukuk issuance. Its classification as ”matured” is predicated by a healthy sukuk issuance pipeline for the public (34.6%) and private (65.4%) sectors, a vibrant ecosystem (e.g. tax incentives, intermediation by NBFIs) and a strong value proposition that puts sukuk at an advantage compared to conventional bonds.

UAE Developing (advanced)

By market share, the UAE made up 10.7% (USD8.05 billion) of total global sukuk issuance as at end-2016, mainly from the private sector. On average, the UAE ranks second after Saudi Arabia in contributions to the supply of GCC corporate sukuk issuance. Even though its ecosystem has room for further improvement, its healthy pipeline of corporate sukuk supports the market’s level of competitiveness.

Indonesia Developing (intermediate)

The Indonesian government’s keenness to expand its ICM has been a boon to its sukuk market. As at end-2016, the country recorded a 16.3% (USD11.9 billion) market share, supported by issuances from the public (97.2%) and private (2.8%) sectors. By comparison, the sukuk ecosystem favours the public sector, with no real value proposition created for corporate issuers. Nevertheless, Indonesia is placed under ”developing” due to its growing influence and potential in capturing a slice of the global sukuk market.

Turkey Developing (beginner)

The growth of Turkey’s sukuk market is driven by the development of its participation banks and sovereign issuances. Since the release of the regulator’s Communique on sukuk, the number of issues has rapidly increased, capturing 4.0% (USD3.0 billion) of the entire global sukuk market as at end-2016. The country’s ”developing” status is underpinned by its key stakeholders’ supportive role in propelling the sukuk industry to its next phase of growth.

Hong Kong

Developing Hong Kong is reputed as an established international financial centre. Its endeavour to incorporate Islamic finance into its financial system is to support a complementary role vis-a-vis the Islamic finance community which it currently serves. As a non-OIC nation that has returned to tap the sukuk market 3 times, it underscores the government’s interest in expanding its financing sources and investor base. Its categorisation under ”developing” relates to this initiative by the government compared to other global financial centres such as London, New York and Singapore.

Nigeria Infancy Nigeria has proactively included Islamic finance in its masterplan to facilitate its ICM progression. However, its underdeveloped financial system and currency fluctuations, among others, pose certain challenges against the development of its domestic bond market. Hence its placement under ”infancy” to depict the need to strengthen its market infrastructure and attain macroeconomic stability, to facilitate the growth of its domestic bond market.

Sources: RAM, ISRA

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4.2 MALAYSIA

4.2.1 OVERVIEW OF MALAYSIA’S CAPITAL MARKETS

The financial services industry has been a key driver of Malaysia’s economic development. It is one of the 12 national key economic areas (NKEAs) under the country’s Economic Transformation Programme (ETP), the national strategic initiative formulated by the GoM to elevate the country to developed-nation status by 2020.It is also the foundation of the Financial Sector Blueprint (FSB), the 10-year masterplan implemented by its central bank (BNM) for the management of Malaysia’s transition towards becoming a high-value-added, high-income economy. A key recommendation under the FSB is for Malaysia to consolidate its success and position itself as a leading international centre and global hub for Islamic finance. Under its financial services NKEA for Islamic finance, the GoM targets this segment to constitute 40% of total financing in Malaysia by 2020. As a result of the GoM’s and regulators’ (i.e. BNM and the SC) concerted efforts, Malaysia has evolved into one of the world’s most advanced and leading ICMs. Based on our methodology for this report, we have placed Malaysia under the “matured” category due to its comprehensive Islamic finance ecosystem, which underscores the country’s position the world’s largest market for sukuk issuance, with 48.0% (USD15.4 billion) of total global sukuk issues. Since Malaysia’s first sukuk issue in 1990, this financing tool has spurred its economic growth, channeling domestic financial resources towards infrastructure development and as a key component of the GoM’s budget management. Malaysia’s ICM commanded the lion’s share of 60% of the entire capital market as at end-2016, compared to 53% a decade earlier, as shown in Chart 4.1.

Chart 4.1: Growth of Malaysia’s ICM over a 10-Year Period

RM1.7 trillion

RM2.9 trillion

53%

60%

64%

0%

20%

40%

60%

80%

-

1,000.00

2,000.00

3,000.00

4,000.00

5,000.00

6,000.00

7,000.00

8,000.00

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2020e

RM billion

Total capital market Total size of ICM % ICM to total capital market

Sources: BNM, SC Note: Based on the SC’s definition, the size of the ICM is equivalent to the total market capitalization of Shariah-compliant securities and the amount of outstanding sukuk.

Malaysia’s capital markets have been developed through the recommendations mapped out in the SC’s Capital Market Masterplan 1 (2001-2010) and Capital Market Masterplan 2 (2010-


74

2020). The SC estimates that the overall ICM in Malaysia will swell to RM2.9 trillion (or USD670.4 billion) by 2020 (refer to Boxes 4.1 and 4.2 for details on these 2 Masterplans). Based on our analysis of historical data, the stimulus for Islamic finance in Malaysia and the attainment of global recognition have been predicated by the prominence of sukuk issuance by the private sector, following the GoM’s efforts to consolidate public-sector activities and promote the private sector as an engine of growth.

Box 4.1: Malaysia’s Capital Market Plan 1 (CMP1) A 10-year plan (2001-2010) outlining strategic focus and actions, with 152 recommendations to address 4 key Malaysian capital-market challenges. Objectives: 1. To be the preferred fund-raising centre for

Malaysian companies. 2. To promote an effective investment-management

industry and a more conducive environment for investors.

3. To enhance the competitive position and efficiency of market institutions.

4. To develop a strong and competitive environment for intermediation services.

5. To ensure a stronger and more facilitative regulatory regime.

6. To establish Malaysia as an international ICM.

Source: SC

Box 4.2: Malaysia’s Capital Market Plan 2 (CMP2) The roadmap to transform the competitive dynamics of Malaysia’s capital market over the next 10 years (2010-2020). Outlines growth strategies to address structural challenges and critical linkages to foster a more diverse and innovative intermediation environment, and to nurture new growth opportunities. A. Growth strategies: 1. To promote capital formation. 2. To expand intermediation efficiency and scope. 3. To deepen liquidity and risk intermediation. 4. To facilitate internalization. 5. To build capacity and strengthen information

infrastructure.

B. Governance strategies: 1. To enhance product regulation to

manage risks. 2. To expand accountabilities as

intermediation scope widens. 3. To develop a robust regulatory

framework for a changing market landscape.

4. To facilitate effective oversight of risks.

5. To strengthen corporate governance.

6. To broaden participation in governance.

Source: SC

Since the mid-1980s, the private sector has been playing an instrumental role in the strategic development of the Malaysian economy. Spurred by strong economic expansion and the concerted support and efforts of the GoM, regulators and market participants, the corporate bond market has charted an upward growth trajectory. The catalyst for this remarkable expansion was the Asian financial crisis in 1997, which highlighted the mismatches in funding maturities and the need for diversification from bank funding. The intermediation by the bond

Ph

ase

1

Ph

ase

2

Ph

ase

3

3 years (2001-2003)

Strengthen domestic capacity and develop strategic and

nascent sectors. 2 years (2004-2005)

Further strengthen key

sectors and gradually

liberalise market access.

5 years (2006-2010)

Further strengthen market

processes and infrastructure towards becoming a fully

developed capital market,

and enhance international

positioning in areas of

comparative and competitive advantage.

75

market has allowed the matching of long-term, capital-intensive spending with the long-term liquidity provided by institutions, pension funds and insurance companies, among others. As a result, the outstanding value of Malaysia’s LCY bonds has grown exponentially, from approximately RM143.7 billion as at end-December 1997 to RM1,251.6 billion as at end-June 2017. As depicted in Chart 4.2, Malaysia’s capital market and banking loans/financing position against GDP in 1997 shows an under-developed bond market and over-dependence on bank financing. Maturity mismatches and a sudden capital flight had pushed Malaysia into the thick of the Asian financial crisis in 1997. As at end-June 2017, the domestic financial system boasted a well-diversified mix of funding between the capital markets and the banking system, which has been tested during the global financial crisis. In comparison to major financial markets, Malaysia escaped relatively unscathed due to the strong foundation that was established through CMP1 and CMP2 following the Asian financial crisis. Chart 4.3 outlines the evolution of Malaysia’s bond market, which has expanded and developed steadily since 1987.

Chart 4.2: Malaysia’s Outstanding Capital Markets vs Bank Financing Relative to GDP

Sources: BNM, SC

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Chart 4.3: Evolution of Malaysia’s Bond Market

Source: Bond Info Hub, BNM ABS = asset-backed securities BPA = bond pricing agency

MIFC = Malaysia International Islamic Financial Centre PDS = private debt securities

CRA = credit rating agency

77

In comparison to other debt markets in Asia, Malaysia’s bond market remains competitive against the other big economies in the region, as explained in Box 4.3.

Box 4.3: Size of Selected Asian Debt Markets as at end-2016 (USD billion) Malaysia’s sizeable corporate bond market As a percentage of GDP, the size of Malaysia’s bond market ranked third after those of Japan and South Korea as at end-2016. In terms of absolute value, the USD260.2 billion Malaysian bond market was placed fifth after Japan, China, South Korea and Thailand as at end-2016. The GoM’s pragmatic approach to developing the domestic bond market is in line with its objective of attaining “developed nation” status by 2020.

Corporate bond

market

Government bond

market

Total

Japan 670.8 8,965.8 9,636.6 China 2,155.0 4,974.0 7,129.0 Korea 1,010.9 702.0 1,713.7 Thailand 81.5 221.5 303.0 Malaysia 119.0 141.2 260.2 Singapore 99.0 137.0 236.0 Hong Kong 97.0 133.0 230.0 Indonesia 23.0 139.0 163.0 Philippines 18.0 80.0 98.0 Vietnam 2.0 42.0 44.0

Size of Selected Debt Markets Relative to GDP (as at end-2016)

0.0%

50.0%

100.0%

150.0%

200.0%

250.0%

Japan Korea Malaysia Singapore Thailand Hong Kong China Philippines Vietnam Indonesia

% of GDP

Private Sector Public Sector

Balanced

Mix

46%

54%

Source: Asian Bonds Online

4.2.2 GROWTH OF THE SUKUK MARKET IN MALAYSIA

Spurred by the success of the corporate bond market, the GoM and regulators had the foresight to strengthen its Islamic finance ecosystem, which has propelled Malaysia into the international financial markets as a world leader in sukuk issuance. To incentivise an already active corporate bond market, additional fiscal and financial stimuli had been introduced, such as a tax-neutral framework and tax deductions for sukuk issuance expenses, which have honed sukuk’s competitive advantage against conventional bonds. As a result, the outstanding value of sukuk issued in Malaysia shows an average annual growth rate of 13% over the last decade, compared to 4% for conventional bonds. As at end-June 2017, the outstanding value of LCY sukuk amounted to RM718.4 billion, against RM534.0 billion for conventional bonds. Since 2014, outstanding sukuk has surpassed outstanding bonds by more than half, and the percentage has been rising steadily as the quasi-government and corporate sectors have been opting to issue sukuk instead of conventional bonds.

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Domestic Market – Public Sector Issuance Over the years, in support of its aspiration to turn Malaysia into an international ICM, the GoM has progressively increased the percentage of government investment issues (GII) compared to Malaysian government securities (MGS) (as described in Box 4.4). Chart 4.4 shows that as at end-June 2017, a total of RM67.0 billion of government securities had been issued, of which 46% constituted sukuk, compared to only 27% as at end-2006.

Chart 4.4: Malaysia’s Sovereign Sukuk vs Conventional Issuance (2006-June 2017)

0.00

20.00

40.00

60.00

80.00

100.00

120.00

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 June 2016 June 2017

RM billion

Sukuk issuance Conventional issuance

RM42.4billion

46%

RM67.0billion

RM94.0 billion

27%

Source: Bond Pricing Agency Malaysia (BPAM)

Box 4.4: Malaysia’s GII In 1983, the Malaysian Parliament passed the Government Investment Act to enable the GoM to raise funds through the issuance of non-interest-bearing certificates, known as GII. The first GII issuance took place in July 1983. The primary reason for the introduction of GII had been to enable Islamic banks to hold first-class liquid assets/instruments to meet the statutory liquidity requirements and also for investment. GII had first been issued based on the Shariah contract of qard hasan (benevolent loan). Since 22 July 2014, GII issuance has adopted the murabahah concept. As at end-2016, the percentage of GII relative to the GoM’s borrowings had increased to 39.6%, from only 10.0% a decade ago - indicating the GoM’s commitment to supporting the growth of Islamic finance.

GII (RM

billion)

MGS (RM

billion)

% of GII to total

issuance

2006 19.6 174.3 10.0 2007 28.0 191.7 12.7 2008 42.5 231.8 16.6 2009 66.0 242.3 21.4 2010 81.5 261.0 23.8 2011 110.0 277.7 28.4 2012 143.5 292.1 32.9 2013 172.5 305.1 36.1 2014 185.5 329.6 36.0 2015 214.0 340.1 38.6 2016 234.5 357.4 39.6

Source: BNM

Historically, a large portion of the GoM’s budget deficit has been funded by capital-market instruments. Hence given the larger budget deficit projected for 2017 (as depicted in Table 4.3), our analysis concludes that the GoM will remain committed to supporting the issuance of Islamic securities to finance its budget shortfall.

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Table 4.3: Malaysia’s Budget Deficits (2014–2017f)

RM billion 2014 2015 2016e 2017f

Government revenue 220.6 219.1 212.6 219.7 Government expenditure 259.1 257.8 252.1 260.8 Budget deficit (38.5) (38.7) (39.5) (41.1) Source: Ministry of Finance, Malaysia Due to the faster pace of issuance for Islamic government securities over the last decade, the total outstanding amount of Islamic government securities has augmented from 11% (RM21.6 billion) of total issuance as at end-2006 to 44% (RM291.4 billion) as at end-June 2017, as illustrated in Chart 4.5.

Chart 4.5: Malaysia’s Sovereign Sukuk vs Conventional Outstanding (2006-June 2017)

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300.00

400.00

500.00

600.00

700.00

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 June 2017

RM billion


44%

RM662.4 billion

RM198.1billion

11%

Source: BPAM

Domestic Market – Private Sector Issuance Malaysia’s economic pump-priming through infrastructure-led projects has been a boon to the sukuk market, especially for the quasi-government and corporate sectors. Total bond issuance by quasi-government entities and corporates swelled from RM79.3 billion as at end-2006 to a record of RM137.7 billion a decade later. The positive momentum carried through to 1H 2017, when total quasi-government and corporate bond issuance surged 17% y-o-y to RM78.9 billion, with sukuk accounting for 62% of the total, as illustrated by Chart 4.6.

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Chart 4.6: Malaysia’s Corporate Sukuk vs Conventional Issuance (2006-June 2017)

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80.00

100.00

120.00

140.00

160.00

180.00

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 June 2017

RM billion


RM79.3billion

RM137.7 billion

62%

RM78.9billion

58%

Source: BPAM

As at end-June 2017, sukuk issuance represented a hefty 73% of total outstanding quasi-government and corporate bond issuance (refer to Chart 4.7). Based on our analysis, the tipping point for the private sector to choose sukuk centres on its value proposition.

Chart 4.7: Malaysia’s Corporate Sukuk vs Conventional Outstanding (2006-June 2017)

0.00

100.00

200.00

300.00

400.00

500.00

600.00

700.00

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 June 2017

RM billion


73%

RM582.6 billion

RM232.5billion

49%

Source: BPAM

4.2.3 ANALYSIS OF SUKUK STRUCTURES, ISSUANCE AND INVESTMENT

Analysis of Sukuk Structures From predominantly debt-based Shariah contracts in 2005 (refer to Chart 4.8), the market has evolved through the last decade. Key developments include the establishment of Bursa Suq Al Sila (BSAS) in August 2009, and the publication of the AAOIFI’s Shariah Standards in 2010.

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BSAS is an international commodity platform that is able to facilitate commodity-based Islamic financing and investment transactions under the Shariah principles of murabahah, musawwamah and tawarruq. Following the establishment of BSAS, there was a spike in murabahah sukuk issuance in 2010; this has remained one of the preferred contracts for sukuk issuance. Our analysis indicates that the reasons for this increase point to ease of implementation and issuers’ choice to not utilise existing assets, or insufficient assets to comply with the SC’s asset-pricing guidelines. There are other platforms in the market that offer similar services such as AbleAce Raakin’s platform, which was established in 2006, and Sedania As Salam Capital Sdn Bhd’s As-Sidq in 2009 (collectively referred to as “approved platforms”). Nonetheless, BSAS is still the preferred platform for the issuance of commodity murabahah sukuk. Following the release of the AAOIFI’s Shariah Standards in 2010, several countries (including Malaysia) had aligned their operations and practices with the international standards. As a result, even though the types of Shariah contracts used are still diverse, murabahah, wakalah and hybrid contracts accounted for the bulk of Malaysia’s sukuk issuance as at end-2016, as shown in Chart 4.8.

Chart 4.8: Malaysian Corporate Sukuk Issuance by Type of Shariah Contract (2005-2016)

Sources: Eikon-Thomson Reuters, RAM

In the structuring of sukuk, the following SC guidelines are taken into consideration:

1. Shariah Resolutions for the ICM The initiatives by the regulators to solidify the foundation of Malaysia’s ICM include the establishment of a centralized SAC of the SC to govern all Shariah matters related to the ICM. Similarly, a separate SAC has been set up under BNM, to advice on all matters related to Islamic banking and takaful. The SACs have from time to time issued Shariah resolutions and decisions related to their relevant jurisdictions. The resolutions of the SACs are publicly available and are used as a reference point by the industry and academia around the world. The proactive approach of the SACs has allowed the ICM as well as the banking and takaful sectors to

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flourish, by cultivating a conducive environment for product innovation and flexibility while ensuring compliance with Shariah principles. Figure 4.1 summarizes the roles of these 2 Shariah authorities.

Figure 4.1: Malaysia’s Shariah Governing Bodies

MALAYSIA’S SHARIAHREGULATORY BODIES

Islamic Banking and Takaful Islamic Capital Market

Shariah Advisory Council of BNM

Shariah Advisory Council of SC

Objective: Established in May 1997, the committee is responsible to advise on matters relating to Islamic banking and takaful business or any other Islamic finance area that is supervised and regulated by BNM.

Objective: Established in May 1996, the committee is responsible to advise on matters pertaining to Islamic capital market.

Sources: BNM, SC

Based on our observation, several SAC resolutions differ from the opinions of Shariah experts in other countries. According to the Resolutions of the Securities Commission Shariah Advisory Council (Second Edition), these variations exist due to differences in time and place, and the divergence in the needs and background of a country. Regardless of the difference, each jurisdiction (e.g. Malaysia and GCC countries) has evolved to accommodate the requirements of its domicile country, with each having expanded rapidly over the years in the development of its Islamic finance landscape. 2. Requirement of Identified Assets, Ventures and/or Investments The Guidelines on Unlisted Capital Market Products under the Lodge and Launch Framework (2015) set out the asset requirements ― whether tangible or intangible ― for sukuk issuance related to the contracts of bay’ bithaman ajil (BBA), murabahah, istisna’ and ijarah:

a) The identified asset and its use must satisfy Shariah requirements. b) If the identified asset is subject to any encumbrance or is jointly owned with another party,

prior consent must be obtained from the charge or joint owner. c) Where the identified asset is in the form of a receivable, it must be mustaqir (established

and certain) and transacted on the spot, either in the form of cash or commodities. In relation to sukuk issuances based on musharakah, mudarabah and wakalah bil istithmar, the ventures and/or investments must also comply with the SC’s specific Shariah requirements.

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3. Asset-Pricing Guidelines on Sale and Purchase Sukuk Structures

The assets (tangible or intangible) used in a sukuk structure must also satisfy the asset-pricing guidelines. The purchase price for the sale and purchase of an identified asset under the sukuk structures of BBA, murabahah, istisna’ and ijarah must adhere to the following requirements:3

a) The purchase price must not exceed 1.51 times the market value of the asset. b) In cases where the market value of a particular asset cannot be ascertained, a fair value or

any other value must be applied.

The rationale for the asset-pricing guidelines is to protect investors’ interests so that the market value of the underlying assets commensurate with the investors’ principal/investment value. Where there is an unavailability of assets (e.g. unencumbered, insufficient assets to meet the asset-pricing guidelines, commercial reasons), issuers have the option of utilising any of the approved platforms to purchase Shariah-compliant assets to facilitate the sale and purchase requirements under a murabahah (via a tawarruq arrangement) structure. Analysis of Sukuk Issuances – Supply (Sell Side) Since the early 2000s, the private sector has been identified as the country’s economic growth driver. The privatization of the country’s infrastructure has taken centre stage in building the base of the country’s capital markets. In 2003, fiscal stimuli were introduced via the annual budgets for Islamic finance. These have proven successful in incentivising the private sector to opt for sukuk instead of conventional bonds. As shown in Figure 4.2, the ICM has played host too many sectors, with financial institutions and infrastructure & utilities claiming a large slice of the pie due to their sizeable financing amounts.

Figure 4.2: Malaysia’s Corporate Sukuk Issuance by Sector (2015-Sep 2017)

Sources: BPAM, RAM

3 The guideline is not applicable to ijarah sukuk that does not involve the sale and purchase of identified assets.

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Table 4.4 provides a snapshot of benchmark corporate sukuk issued in Malaysia.

Table 4.4: A Snapshot of Benchmark Corporate Sukuk Issuances in Malaysia

Malaysia Building Society Berhad (First covered sukuk)

Ihsan Sukuk Berhad (First SRI sukuk)

Tadau Energy Sdn Bhd (First green sukuk)

Sukuk issuer Jana Kapital Sdn Bhd Ihsan Sukuk Berhad Tadau Energy Sdn Bhd

Obligor Malaysia Building Society Berhad

Khazanah Nasional Berhad

Tadau Energy Sdn Bhd

Currency format Ringgit Ringgit Ringgit

Structure Murabahah Wakalah Ijarah, Istisna’

Obligor/sukuk ratings

AA1 (RAM Ratings) AAA (RAM Ratings) AA3 (RAM Ratings)

Sukuk assets Portfolio of securitised assets

Tangible assets and the commodity murabahah investment

Solar PV Plants

Purpose To be used for working capital purposes,

To be used for the purpose of funding Shariah compliant Eligible SRI projects

To be used to finance the large-scale solar project

Issue date 24 December 2013 18 Jun 2015 27 Jul 2017


Maturity 22 December 2028 16 June 2040 27 July 2033

Amount RM3 billion RM1 billion RM250 million

Period distribution

4.4% 4.2% - 4.6% 5.0%

Listing Not listed Not listed Not listed


Domestic Domestic Domestic

Source: SC

Deduction of issuance costs for sukuk is one of the tax incentives provided under the Malaysian budget. Over time and in line with the market requirement of adopting Shariah contracts that are recognised internationally, the deduction of issuance costs moved from sale-based contracts (particularly BBA, bay’ al-inah) to partnership, lease, agency and selected sale-based contracts (i.e. ijarah, musharakah, mudarabah, murabahah based on tawarruq). Figure 4.3 elaborates on some tax incentives extended to Islamic financial transactions based on Malaysia’s Budget 2018.

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Figure 4.3: Tax Incentives Accorded to Islamic Finance Based on Budget 2018

Source: PwC 2017/2018 Malaysian Tax and Business Booklet

Other supporting tax-related initiatives that have facilitated the country’s transformation into a vibrant sukuk hub that has attracted not only domestic but also global issuers and investors are listed below. These fiscal measures have been introduced in line with Malaysia’s aspiration of becoming an international Islamic hub, known as the Malaysia International Islamic Financial Centre (MIFC):

1. Promoting Malaysia as a point of origination:

SPVs for the issuance of sukuk are not subject to the administrative tax procedures under the Income Tax Act 1967.

Companies that establish SPVs are given tax deductions on the cost incurred by the SPV for the issuance of sukuk.

The issuance cost for all Islamic securities approved by the SC is eligible for tax deductions.

Stamp duty is exempted for instruments relating to Islamic securities issued under the MIFC until 2020.

2. Promoting Malaysia as an investment destination:

No withholding tax is imposed on non-resident investors vis-à-vis the profit or income received from FCY sukuk originated in Malaysia and approved by the SC.

Foreign investors in Malaysia are allowed to hedge their positions with onshore banks in relation to committed flows of funds, such as the repatriation of investment proceeds, dividends and profits from Malaysia, and the purchase of ringgit assets in Malaysia.

Free inward and outward movement of funds relating to both foreign direct investments and portfolio capital investments.

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Another important element that has shaped the supply side is credit rating, which provides guidance on an issuer’s creditworthiness and facilitates price benchmarking. Credit ratings offer numerous benefits, predominantly investor-driven due to the requirement for continuous monitoring and surveillance of their investment portfolios. Since the release of the initial PDS guidelines by BNM in 1989, credit rating had been mandatory in Malaysia until end-2016. Effective 2017, the mandatory credit rating requirement has been withdrawn to allow market forces to determine the added advantage of independent credit opinions, a practice adopted by developed countries. Investors and issuers need to consider a multitude of risks, including inflation, interest rates, liquidity, credit, industry and market performance when evaluating their bond-/sukuk-related decisions. Supporters of rated bonds/sukuk argue that credit ratings improve market transparency through independent and comparable assessments of creditworthiness. Ultimately, investors will need to weigh the pros and cons in light of their responsibilities to monitor and assess risks on an ongoing basis. Figure 4.4, illustrates the process flow for sukuk issuance in Malaysia, of which credit rating or the credit process is a critical component.

Figure 4.4: Process Flow for Sukuk Issuance in Malaysia

Source: RAM

Analysis of Sukuk Investments – Demand (Buy Side) Malaysia has one of the largest and most liquid capital markets, characterised by a deep institutional investor base. The intermediation provided by its capital markets has allowed the matching of long-term, capital-intensive spending with the long-term liquidity provided by institutions, pension funds and insurance companies, among others.

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Malaysia’s broad investor base includes financial institutions, insurance companies, takaful operators and mutual funds. Leading institutions by the size of assets under management (AUM) include the Employees Provident Fund (EPF), Kumpulan Wang Persaraan (Diperbadankan) (KWAP), Permodalan Nasional Berhad (PNB) and Lembaga Tabung Haji (LTH) (refer to Table 4.5). These entities can be regarded as cornerstone investors for the sukuk market.

Table 4.5: Malaysian Institutional Investors

EPF (Malaysia’s largest retirement fund)

KWAP (Malaysia’s 2nd

largest retirement fund)

PNB (Malaysia’s largest fund-management

company)

LTH (Malaysia’s sole

pilgrimage fund)

AUM RM731.1 billion (end-2016)

RM126.8 billion (estimate, end-

2016)

RM266.5 billion (end-2016)

RM64 billion (estimate, end-

2016) Shariah-compliant investments out of total AUM

45% (end-2016)

49.7% (end-September

2016)

Not available 100%

Sources: Annual Reports

Given the enlarged investor base (inclusive of Shariah-compliant investors) for sukuk compared to conventional bonds and the growing appetite for Shariah-compliant assets, sukuk yields have been more competitive than those of conventional bonds, as depicted in Charts 4.9 and 4.10. Between August 2005 and 2006, the spreads between Islamic and conventional debt securities came up to double digits for tenures of 1 and 5 years. Since sukuk constitutes more than 60% of new issues now, however, the price differential has been reduced to 5 bps. This unique market-driven phenomenon adds to the conducive environment which, in combination with the various tax and regulatory incentives, provides that tipping point to become the preferred choice for issuers.

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Chart 4.9: YTMs of Malaysian Corporate Bonds (AA-Rated) – Islamic vs Conventional (Aug

2005-Aug 2006)

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1YR Conv-Corporate-AA1 1YR Islm-Corporate-AA1

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13bps

average

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average

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average

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average

Source: BPAM

Chart 4.10: YTMs of Malaysian Corporate Bonds (AA-Rated) – Islamic vs Conventional (June

2016-June 2017)

3.40

3.60

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%



3.80

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5bps

average5bps

average

5bps

average

5bps

average

Source: BPAM

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Since the GoM’s inaugural GII issuance in July 1983, the paper has been predominantly held by domestic investors. As at end-June 2017, approximately 43% of GII was held by banking and development financial institutions, 38% by institutional funds and another 9% by foreign investors (refer to Chart 4.11). As at end-2016, the bulk of MGS issues were held by foreign investors (47%), followed by institutional investors (22%) and banking and development financial institutions (17%) (refer to Chart 4.12). Since credit is agnostic as to whether it is Islamic or conventional, the disparity between holders of GII and MGS points to foreign investors’ familiarity with conventional documentation for MGS. In the last 2 years, the visibility arising from the incorporation of Malaysia’s GII into the Barclays Global Aggregate Index in March 2015 and the inclusion of the USD-denominated Malaysian sukuk in the EMBI Global Diversified Index in October 2016 have helped enhance the marketability of the GoM’s Islamic debt securities to foreign investors. In hindsight, the GoM should have included GII in recognised indexes much earlier, to promote its marketability among international investors.

Chart 4.11: GII Issued Domestically – Classification by Holder (2008-2016)

2015 – Incorporation of GII into Barclay’s Global Aggregate Index

43%

38%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2008 2009 2010 2011 2012 2013 2014 2015 2016

Other Insurance companies

Employees Provident Fund + KWAP Foreign holders

Banking institutions + Development financial institutions

2015 – Incorporation of GII into Barclay’s Global Aggregate Index

9%

Source: BNM

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Chart 4.12: MGS Issued Domestically – Classification by Holder (2008-2016)

17%

22%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2008 2009 2010 2011 2012 2013 2014 2015 2016

Other Insurance companies

Employees Provident Fund + KWAP Foreign holders

Banking institutions + Development financial institutions

47%

Source: BNM

As at end-2016, the investor base for LCY corporate bonds (i.e. Islamic and conventional bonds) is dominated by local investors, mainly domestic commercial banks, Islamic banks and investment banks (51%), insurance companies (33%) and the EPF (10%), with foreign investors making up another 6% (refer to Chart 4.13). Since the liquidity of Malaysia’s domestic corporate bond market is significantly derived from local institutions, this provides some cushion against external shocks and, in turn, accords some degree of stability to the performance of Malaysia’s bond market. Nevertheless, it remains susceptible to volatility stemming from global developments.

Chart 4.13: Investor Profile of Malaysia’s LCY Corporate Bonds

Sources: BNM, EPF

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Based on our analysis of Malaysia’s bond market, investors tend to “buy and hold” until maturity. The reasons given by local investors include the following:

(i) High demand for Shariah-compliant assets In January 2017, the EPF launched its Simpanan Shariah fund, with an initial investment of RM100.0 billion. According to the EPF’s statement, Shariah-compliant assets represented approximately 45% of its total portfolio as at end-2016. The EPF’s ongoing efforts to expand its Shariah-compliant investment portfolio is expected to boost its appetite for sukuk.

(ii) Limited supply of AA-rated debt instruments

Since the global financial crisis, investors have become more cautious in their investment strategies. Over the years, the issuance of single-A-rated papers in Malaysia has dwindled due to investors’ demand for at least AA-rated papers. Generally, AA-rated papers are issued by top-tier blue-chip companies or those that have secured concession or privatization contracts, with cash flows supported by strong paymasters (e.g. the GoM or government-related ministries or bodies). As such, the limited supply of AA-rated papers versus the large appetite for stable fixed-income assets has led to a lack of secondary trading.

4.2.4 KEY FACTORS UNDERPINNING MALAYSIA’S SUKUK MARKET Malaysia’s sukuk market has undeniably played a crucial role in propelling the country into the mainstream financial markets. Anchored by its unique value proposition and underscored by an ecosystem that has been developed progressively, Malaysia boasts a robust domestic ICM that looks set to become an international centre for Islamic finance. The key factors highlighted in Figure 4.5 have played an instrumental role in the success of Malaysia’s sukuk market.

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Figure 4.5: Key Factors Underpinning the Growth of Malaysia’s Sukuk Market

Sources: RAM, ISRA

In terms of financial engineering, Malaysia’s sukuk landscape has seen pioneering structures that have spearheaded the country’s leadership in terms of product and structure innovation. Examples include structural enhancements for tax efficiency, Shariah compliance and to support higher credit ratings. In 2016, Khazanah Nasional Berhad raised USD398.9 million of exchangeable sukuk that can be converted into shares of Beijing Enterprises Water Group Ltd (BEWG). The uniqueness of the structure allows Islamic investors to participate, as Khazanah will satisfy any exchange via a cash settlement if BEWG shares do not meet the financial ratios for Shariah compliance, as set by the Dow Jones Islamic Market Index and the FTSE Shariah Global Equity Index Series on the date of the exchange. Similarly, Malaysia Building Society Bhd’s (MBSB) USD931.3 million (or RM3.0 billion) covered sukuk was issued in 2013 – the world’s first such issuance. Sukuk investors are entitled to claims on the issuer and the assets backing the structure (i.e. dual-layer security). Malaysia’s advancement in Islamic finance has taken more than 30 years to achieve. Figure 4.6 encapsulates several developmental phases that Islamic finance has undergone since its formal inception in 1983, and its expected evolution in the coming years.

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Figure 4.6: Phases of Islamic Finance’s Inclusion into Malaysia’s Financial Landscape

Sources: MIFC, RAM

4.2.5 COUNTRY-SPECIFIC RECOMMENDATIONS

As a role model for other countries, the challenge for Malaysia now is to preserve its leadership in the development of Islamic finance. Based on the spider Chart 4.14, Malaysia is ranked the highest in all segments except the penetration of retail investors, which remains a heavily regulated industry. The subsequent Tables 4.6 and 4.7 highlight some of the key issues and challenges facing the Malaysian sukuk market, with some recommended solutions.

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Chart 4.14: Factors Influencing the Development of Malaysia’s Sukuk Market

Sources: RAM, ISRA

Table 4.6: Recommendations to Improve Demand (Buy Side) – Medium-Term Solutions

Issues and challenges Demand (buy side) opportunities Greater awareness of impact investing (e.g. achieving social objectives without compromising commercial returns) is required.

SRI is a USD60.0 trillion industry that is still expanding. The common shared values between sukuk and SRI can foster greater linkages between Islamic finance and conventional SRI investors. Ongoing efforts by the Islamic finance community to build awareness and promote a shift in mindset to consider social impact objectives.

Lack of participation by retail investors despite a few retail issues under GLCs.

Increase awareness among members of the public to invest in retail sukuk.

Shortage of liquidity-management instruments for Islamic banks.

Develop new products or promote innovation to enable Islamic banks to compete effectively against their conventional counterparts.

Sources: RAM, ISRA

Table 4.7: Recommendations to Improve Demand (Sell Side) – Medium-Term Solutions

Issues and challenges Supply (sell side) Opportunities Strengthen value-based intermediation (VBI) – In July 2017, BNM released guidelines on Value-based Intermediation: Strengthening the Roles and Impact of Islamic Finance

VBI has been identified as the next market mover for Islamic finance. Similar initiatives (e.g. peer-to-peer crowd funding) devoted to achieving social justice will heighten Malaysia’s appeal in light of the United Nations’ Sustainable Development Goals (SDGs).

Sources: RAM, ISRA

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4.3 UNITED ARAB EMIRATES (UAE)

4.3.1 OVERVIEW OF UAE’S CAPITAL MARKETS

The UAE is a constitutional federation of 7 emirates, i.e. Abu Dhabi, Dubai, Sharjah, Ajman, Fujairah, Umm al-Quwain and Ras al Khaimah, formed on 2 December 1971. Each emirate maintains autonomy over its oil resources, fiscal policies and debt issuance, and manages its own budget. Global Islamic banking and finance practices originated from the UAE when the world’s first commercial Islamic bank―Dubai Islamic Bank (DIB)―was founded in 1975. However, the UAE Islamic capital market only commenced in the early 2000s, with the establishment of the Securities and Commodities Authority (SCA) in 2000 (which plays a key role in organising and regulating the UAE capital markets) and the foundation of the Dubai International Financial Centre (DIFC) in 2004 (a financial free zone and full-fledged onshore financial centre to promote Dubai as an international financial hub similar to London, New York and Hong Kong). Securities exchanges had then been established to propel the growth of the financial markets in the UAE, notably the Abu Dhabi Securities Exchange (ADX) and the Dubai Financial Market (DFM), which operate under the SCA, and Nasdaq Dubai―the Middle East’s international financial exchange―located in the DIFC and regulated by the Dubai Financial Services Authority (DFSA). The UAE Islamic debt capital market expanded significantly in 2005, after the GCC economies’ efforts to reduce their overdependence on oil and hydrocarbon revenue and seek other investment strategies, including fixed-income instruments. The growth had been further spurred following the setting up of the Dubai Islamic Economy Development Centre (DIEDC) in 2013, to promote Dubai as the capital of the Islamic economy, whereby Islamic finance has been set as the first 7 key strategic pillars. In March 2017, the DIEDC launched its refreshed 5-year Islamic economy strategy (2017-2021), which focuses on the growth of 3 core Islamic economic sectors, including Islamic finance (refer to Box 4.5 for further details on both DIEDC strategies). In 2014, Dubai also launched its 7-year plan, known as Dubai Plan 2021, to reinforce and accelerate its position as a pivotal hub in the global economy.

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Box 4.5: DIEDC Strategies to Position Dubai as the Capital of the Islamic Economy

Strategic Objective of Dubai the Capital of Islamic Economy

Islamic Economy Strategy (2013-2016)

Key objectives: To develop an enabling and empowering environment, including the necessary infrastructure and legislative as well as regulatory framework to support the growth of the Islamic economy via 7 strategic pillars.

Key Strategies for Pillar 1: Work with both public and private sector partners to establish Dubai as one of

the international financial centres that will be a global reference and economic engine of Islamic finance.

Reach out within the Middle East and beyond to build the international bridges essential for the global success of Islamic finance.

Work with the Islamic finance industry to develop the regulatory framework that will enable the sector to flourish and become a global alternative to conventional finance.

Key Milestones for Pillar 1: Establishment of various institutions, including:

- Dubai Centre for Islamic Banking and Finance (DCIBF) - AWQAF International Organisation - Incubator for Islamic digital SMEs

Organising annual events dedicated to the Islamic economy and finance: - Global Islamic Economy Summit Islamic Economy Award

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Refreshed Islamic Economy Strategy (2017-2021) Key objectives: To set strategic directions to ensure long-term impact and support stakeholders in defining and executing initiatives to grow the global Islamic economy via 3 core sectors (Islamic finance, halal industry and Islamic lifestyle) and 3 enabling pillars (Islamic knowledge, Islamic standards and Islamic digital economy).

Key Strategies for Sector 1: To increase the contribution of Islamic finance products to Dubai’s/the UAE's

GDP and contribute to the resilience and diversification of the national economy.

To develop robust and transparent capital markets in Dubai/the UAE as a prime destination for investors and capital seekers.

To develop a global framework for Islamic finance and become globally recognised for Islamic finance educational programmes and philanthropic projects.

Sources: DIEDC (2013), DIEDC (2017)

As a result of these initiatives, Islamic finance assets in the UAE have been increasing since 2013 (as depicted in Chart 4.15). In 2016, the value reached USD203 billion, representing 55% of the UAE’s total GDP.

Chart 4.15: UAE’s Islamic Finance Penetration − Assets to GDP Ratio (2012-2016)

Source: DIEDC (2017a)

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Unfortunately, the percentage of the ICM, particularly sukuk (only USD30.12 billion), against total Islamic finance assets is rather low compared to Islamic banking assets, which contributed 44% (USD 163.12 billion) of the UAE’s GDP as at end-December 2016, as depicted in Chart 4.16.

Chart 4.16: UAE’s Islamic Banking Assets and Outstanding Sukuk (2012–2016)

Sources: DIEDC (2017a), Bloomberg

Nonetheless, Chart 4.17 shows that the overall UAE capital market (conventional and Islamic) grew from just USD31.39 billion (14%) in 2006 to USD153.07 billion (44%) in 2016, an increase of about 30%. Concerted efforts by the Dubai and Abu Dhabi governments have played significant roles in this development. Dubai, in particular, has undertaken major construction and infrastructure projects such as hotels, roads and parks in the lead-up to its role as the host of World Expo 2020.

Chart 4.17: UAE’s Outstanding Capital Markets vs Bank Financing Relative to GDP

Sources: World Bank, The Global Economy, Bloomberg, ISRA estimates

Despite the low penetration of the ICM relative to the Islamic banking industry in the UAE, numerous initiatives have been undertaken by the UAE government, particularly the Dubai government, to spearhead the growth of the ICM. Based on the methodology adopted for this

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study, it is clear that the UAE sukuk market is still at the developing stage, with some degree of advancement in certain aspects compared to other countries within the same category. Chart 4.18 summarises the evolution of the UAE bond market from 2000 to June 2017.

Chart 4.18: Evolution of the UAE Bond Market (2000–2017)

Source: DIEDC (2017a) 4.3.2 GROWTH OF THE SUKUK MARKET IN THE UAE

As noted earlier, the UAE sukuk market started in the early 2000s and charted phenomenal growth between 2005 and 2007. Nonetheless, it declined in 2008-2010 following the global financial crisis (GFC) and the resultant market conditions, and partly due to the pronouncement by the AAOIFI in 2008 on purchase undertakings in equity-based sukuk structures, as well as high-profile defaults by GCC sukuk issuers and the near-default on the Nakheel sukuk after the GFC in 2009. The market experienced a resurgence in 2011 and has been expanding steadily since, except in 2015. As at end-June 2017, total sukuk issuance in the UAE had reached USD3.23 billion, representing 26% of total bond issuance, as depicted in Chart 4.19.

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Chart 4.19: UAE Sukuk vs Conventional Issuance (2006-June 2017)

Source: Bloomberg

Among the GCC countries, the UAE ranks second after Saudi Arabia, with total sukuk issuance of USD3.23 billion as at end-June 2017, signifying 15% of total GCC sukuk issuance. Its outstanding amount of USD30.44 billion accounted for only 27% of total outstanding GCC sukuk as at end-June 2017. This was mainly due to Saudi Arabia’s USD9 billion dual-tranche debut sovereign sukuk in April 2017, which had raised the total issuance value and outstanding sukuk amount in the GCC market. As at end-June 2017, the total value of sukuk raised by GCC issuers summed up to USD21.52 billion while the total outstanding amount for the GCC market hit USD113.66 billion, an increase of USD14.34 billion over the previous corresponding period (refer to Charts 4.20 and 4.21, respectively).

Chart 4.20: UAE vs GCC Total Sukuk Issuance (2006-June 2017)

Source: Bloomberg

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Chart 4.21: UAE vs GCC Total Outstanding Sukuk (2006-June 2017)

Source: Bloomberg

The growth of the bond market in the UAE has been predominantly led by USD-denominated issues due to the pegging of the dirham (AED) against the USD, the influence of global investor sentiment, and the various benefits offered by the DIFC to firms and institutions, such as zero tax on profits, no restriction on foreign exchange, and double-taxation treaties. The advantages of issuing USD-denominated bonds and sukuk for UAE entities include the following:

No currency risk as the AED is pegged to the USD at 3.70. Low interest rates, hence reducing borrowing cost. Enhances the liquidity of bond markets.

Nonetheless, overdependence on external funding also poses some challenges, which will be discussed later. Domestic Market – Public Sector Issuance According to the IMF Report (2017), the UAE has very minimal domestic government debt because large fiscal surpluses during the oil price boom had weakened the incentive for the government to issue domestic debt. Emirati governments issue external debt (i.e. FCY bonds and sukuk) or tap sovereign wealth funds (SWFs) to finance budget deficits. Up to June 2017, only 3 emirates had issued sukuk, i.e. Dubai, Ras al Khaimah and Sharjah (only 2 issues had been in AED while the rest were in USD); the Abu Dhabi government had only raised conventional bonds. The peak of sovereign sukuk issuance occurred in 2009, with the Dubai government leading the UAE market. The high-profile sukuk defaults of Dubai’s GREs in 2009 triggered a slump in the UAE sukuk market in 2010. Investors’ perception of Dubai credit had, however, improved by 2012, leading the Dubai government to issue a 10-year benchmark-

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sized sukuk worth USD600 million (in 2012) and another valued at USD750 million (in 2013), yielding a respective 6.45% and 3.875%. Chart 4.22 indicates total UAE sovereign sukuk issuance in comparison to sovereign bonds as at end-June 2017.

Chart 4.22: UAE Sovereign Sukuk vs Conventional Issuance (2006-June 2017)

Source: Bloomberg

The plunge in global oil prices in 2015-2016 had slashed the UAE government’s revenue (refer to Table 4.8), leading to the diversification of its funding sources, including international bonds and sukuk, to finance its budget deficit.

Table 4.8: UAE’s Budget Deficits (2014–2017f)

AED billion 2012 2013 2014 2015 2016e* 2017f** Government revenue 550.032 582.839 550.439 391.542 358.419 388.863 Government expenditure

400.893 434.489 477.31 420.203 412.176 427.305

Budget deficit 149.14 148.35 73.13 (28.66) (53.76) (38.44) Source: IMF * IMF estimate **IMF forecast

Since each emirate is autonomous in terms of managing its individual budget and raising funds to finance budget deficits, the federal government has not issued any debt instrument. However, the UAE government’s proposed (in 2017) federal debt-management law will allow the federal government to tap the bond market; the latter is expected to issue sukuk in the future. This is in line with the SCA’s newly launched development strategy (in October 2017) for the UAE ICM, which includes the SCA’s role in updating regulations on sukuk and introducing a system of Shariah board governance. In addition, the UAE government, in collaboration with the Central Bank of the UAE (CBUAE) and the UAE Banks Federation, are working on the guidelines to set up a higher Shariah authority, as a national regulator to formulate guidelines, policies and regulations for Islamic financial products. Approval for the setting up of Shariah authority was secured in May 2016. The CBUAE’s establishment of an Interim Marginal Lending Facility (IMLF) ― similar to collateralised repo ― for both

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conventional and Islamic banks4 in April 2014, to strengthen liquidity management by domestic Islamic banks, would also help boost sukuk issuance. Since April 2015, the Shariah-compliant IMLF has recognised a borrower’s holdings of sovereign sukuk or sukuk issued by authorities in any of the emirates as collateral. Domestic Market – Private Sector Issuance Similar to public sector issuance, LCY domestic sukuk by corporates in the UAE is also very limited. Instead, the UAE sukuk market is very well known for its Eurobond market. Based on data from Blomberg (as at end-June 2017), only 10 LCY issues had been raised, mainly by companies involved in real estate. Most GREs, which have been a major source of growth and development for the UAE economy in Dubai and Abu Dhabi, tend to source their funding externally to supplement their domestic borrowing, which is highly dependent on bank loans/financing. The tendency to source external funding could be due to the absence of a long-term benchmark domestic yield curve. A similar trend can be observed for UAE national banks. According to the UAE Financial Stability Report (2016), the share of non-resident funding to total funding of UAE national banks increased from 17.6% in 2015 to 19.6% in 2016. Non-resident funding is split almost equally between capital market funding and non-resident deposits. External capital market funding of UAE national banks advanced 19.1% in 2016, from 16.2% in 2015, partly underpinned by the shallow domestic bond market (refer to chart 4.23).

Chart 4.23: UAE National Banks’ Non-Resident Funding to Total Funding

Source: CBUAE (2016)

Compared to conventional bonds, sukuk issuance by corporates and quasi-government entities in the UAE has declined significantly since 2009, partly due to major sukuk defaults by Dubai’s

4 The Shariah-compliant IMLF is based on collateralised murabahah. Refer to Guidelines for Collateral Management under the CBUAE’s Collateralized Murabaha Facility, published on 1 April 2015.

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GREs during and after the GFC in 2007-2009, as highlighted earlier. As at end-June 2017, private sector sukuk issuance only came up to USD3.23 billion (26% of total corporate bonds) compared to USD9.21 billion of conventional issuances, as shown in Chart 4.24.

Chart 4.24: UAE Corporate Sukuk vs Conventional Issuance (2006-June 2017)

Source: Bloomberg


Analysis of Sukuk Structures Since the UAE does not have any centralized Shariah authority (as at Dec-2017), sovereign and corporate issuers have the liberty to choose from an array of approved Shariah contracts outlined by the AAOIFI in its Shariah Standards No. 17 on Investment Sukuk to develop their sukuk structures. While governments have issued a combination of ijarah and wakalah bil istithmar sukuk, corporates have undertaken more diversified structures, as depicted in Chart 4.25.

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Chart 4.25: UAE Corporate Sukuk Issuance by Type of Shariah Contract (2006-June 2017)

Source: Bloomberg

UAE issuers stand among the global key players that have been actively issuing benchmark sukuk, with quite a few ”world’s first” innovative structures. Table 4.9 provides a snapshot of some benchmark corporate sukuk issuances in the UAE.

Table 4.9: A Snapshot of Benchmark Corporate Sukuk Issuances in the UAE

Abu Dhabi Islamic (ADIB) sukuk 2012

Medjool sukuk 2013 Khadrawy sukuk 2015

Sukuk issuer ADIB Capital Invest 1 Ltd

Medjool Limited Khadrawy Limited

Originator/ Obligor

Abu Dhabi Islamic Bank

Emirates airline Emirates airline

Currency format USD USD USD

Structure Mudarabah Wakalah Ijarah

Credit ratings A2/―/A+ n/a n/a Sukuk assets General business of

ADIB Rights to travel Rights to travel and all

services ordinarily provided by Emirates to passengers, except any service relating to the sale of alcohol, pork or tobacco-related products.

Purpose Raising Tier-1 capital.

General corporate purposes including, but not limited to, the financing of aircraft and working-capital requirements.

To purchase 4 new Airbus A380-800 aircraft.

Issuance date 19 November 2012 19 March 2013 31 March 2015


Maturity 16 October 2018 19 March 2023 31 March 2025

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Abu Dhabi Islamic (ADIB) sukuk 2012

Medjool sukuk 2013 Khadrawy sukuk 2015

Amount USD1 billion USD1 billion USD 913 million


6.375% 3.875% 2.471%

Listing London Stock Exchange

Nasdaq Dubai London Stock Exchange & Nasdaq Dubai


n/a n/a Middle East and Asia (49%), Europe (32%), US (29%).

Sources: ISRA (2017), ISRA (2016)

Analysis of Sukuk Issuances – Supply (Sell Side) The growth of the UAE’s sukuk market is predominantly driven by market players seeking to diversify their funding and investment portfolios. Private sector sukuk issuances, which include GREs and other corporates, account for the bulk of sukuk issuance in the UAE, with banks and real-estate companies dominating the market, as illustrated in Chart 4.26. The need to strengthen the capital structure of Islamic banks and comply with Basel III requirements as well as the more numerous infrastructure projects by the Dubai government have contributed to this trend. Chart 4.26: UAE Corporate Sukuk Issuance by Sector (2007-June 2017)

Source: Bloomberg

Sovereign sukuk constituted only a small number of issuances (or USD11.94 billion) between 2006 and end-June 2017. Chart 4.27 depicts the number of sovereign issuances in comparison to public sector issuances. It was only in 2009 that sovereign issuance surpassed corporate issuance. The Abu Dhabi government, in particular, has not issued any sovereign sukuk but instead has raised funding via a series of conventional bonds, to finance its budget deficit amid the oil price turmoil, as indicated earlier.

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Chart 4.27: UAE Sovereign vs Corporate Sukuk Issuance (2006-June 2017)

Source: Bloomberg

Both sovereign and corporate sukuk in the UAE have short tenures, with the majority with 5-year maturities. To date, the longest tenure is a 10-year sukuk, mostly issued by the Dubai government to fund its expansion as the global capital of the Islamic economy. For corporate issuance, Emirates airline offered 2 series of 10-year sukuk in 2013 (Medjol sukuk) and 2015 (Khadrawy sukuk), to finance the expansion of its headquarters and to purchase aircraft. The UAE debt market is dominated by international USD issues. As such, the LCY domestic bond market is very limited, causing overdependence on global investors. Foreign investors’ appetite for UAE papers can, however, dry up if they find more attractive investment opportunities elsewhere, or if there is a challenging macroeconomic situation in their home countries. The ICD-Thomson Reuters Islamic Finance Development Indicator (2012-2017) reported that only 21% of sukuk issuance was domestic while the remaining 79% was issued internationally. The scarcity of an active AED-based bond market in the UAE also leads to the absence of a yield curve for different maturities. This poses major challenges for banks in pricing long-term loan facilities. According to some commentators, the USD yield curve cannot be considered a proxy for the AED yield curve because of differences in economic factors in the US and the UAE (Baby, 2016). Chart 4.28 illustrates the USD yield curve for 10-year government bonds.

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Chart 4.28: USD 10-Year Sovereign Bond Yield

Source: Trading Economics

Analysis of Sukuk Investments – Demand (Buy Side) According to the DIEFC Report (2017a), Dubai is the world’s leading location for USD-denominated sukuk listings, which are offered by DFM and Nasdaq Dubai through a single trading platform. As at end-October 2017, both exchanges hosted about 75 listed sukuk. The DIEDC (2017a) stated that Nasdaq Dubai plans to set up a global sukuk centre, which is expected to further develop Dubai’s sukuk industry. With the institution of this centre, more new offerings will be introduced, including retail sukuk, while secondary sukuk market trading will be made available to SMEs. Due to the prevalence of USD-denominated debt securities in the UAE, demand for fixed-income instruments is mostly driven by financial institutions and fund-management companies. Sukuk investment by other key institutional investors such as pension funds or insurance/takaful companies is very limited, possibly due to the absence of long-term sukuk, the UAE’s tax-free regime which creates a level playing field between debt and equity products, and the dearth of LCY bonds. The UAE’s biggest sovereign wealth fund, i.e. the Abi Dhabi Investment Authority (ADIA), which could possibly be a catalyst for the growth of the ICM―like what Malaysia’s Khazanah Nasional does―has not tapped the domestic market. Rather, the ADIA manages a diversified global investment portfolio consisting of various asset classes. 4.3.4 KEY FACTORS UNDERPINNING THE UAE’S SUKUK MARKET

Leveraging the DIFC infrastructure as the leading Middle Eastern financial centre, the UAE―particularly the Dubai government―has been able to attract many foreign investors worldwide. Article 121 of the UAE Constitution enables the federation to establish financial free zones in the Emirates and to exclude the application of certain federal laws that are based on the civil law in the centre. A number of laws had created the DIFC, its own financial regulator (the DFSA) and other necessary bodies. The laws set out the objectives, powers and

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functions of the centre bodies. They also contain important exemptions and prohibitions in the DIFC. Table 4.10 summarises key laws that had been passed to create a conducive environment for the DIFC as a financial free zone.

Table 4.10: Key Laws for the Establishment of the DIFC

Laws Details Federal Law No. 8 of 2004 (Financial Free Zone Law)

Establishes the financial free zones in the UAE, hence: Allows the creation of a financial free zone in any emirate of the UAE. Exempts the financial free zones and financial activities from all

federal civil and commercial laws. Confirms the application of federal criminal laws in the financial free

zones, including the federal laws on anti-money laundering. Prohibits DIFC-authorised firms from dealing in “deposit taking from

the State’s markets […] [and] in the UAE dirham”. Federal Decree No. 35 of 2004

Creates the DIFC as a financial free zone in Dubai (the DIFC Law).

Dubai Law No. 9 of 2004

Acknowledges the establishment of the DIFC, hence: Recognises the financial administrative and independence of the DIFC. Creates the DIFC centre bodies, including the DFSA. Exempts the DIFC from Dubai laws and regulations and certain

conditions. DIFC Law No. 1 of 2004 (Regulatory Law 2004)

Sets out the DFSA’s regulatory powers, functions and objectives.

Sources: DIFC (2009), DIFC (2009a)

The DIFC’s exclusive legal and regulatory system based on common law has enabled the registration of SPCs/SPVs for sukuk issuers that prefer a domestic domicile, instead of traditional offshore centres such as the Cayman Islands. In addition, the DIFC has enacted laws related to dispute resolution, i.e. the Court Law (DIFC Law No. 10 of 2004) and the Arbitration DIFC Law No. 1 of 2008 (Amended in 2013 – DIFC Law No. 6 of 2013). This law had led to the setting up of the Dispute Resolution Authority (DRA) in 2014. The DRA has overall responsibility for the DIFC courts, an arbitration institute and other tribunals or ancillary bodies that may be required to perform the functions of the DRA. The creation of the DRA takes the DIFC a significant step towards offering a serious alternative to the traditional arbitration hubs of London, Paris and Singapore. Currently, there are 3 established arbitration centres within the UAE: the Dubai International Arbitration Centre (DIAC), the Abu Dhabi Commercial Arbitration Centre and the DIFC-LCIA Arbitration Centre, which is run by the Dubai International Financial Centre (DIFC) and the London Court of International Arbitration (LCIA). The DIFC has also established Nasdaq Dubai, which enables the public listing of sukuk issues. This has helped issuers maximise the number of potential foreign investors. Nonetheless, the exchange only facilitates institutional investors. As such, an accommodative infrastructure for retail investors should also be considered. In addition, the DIFC is home to many international and recognised rating agencies such as Standard & Poor’s (S&P), Moody’s and Fitch Ratings, which provide more transparency on the credit risks of sukuk issues and enhance their marketability.

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The hallmark of Dubai and the UAE economy is their “zero tax” regimes. The absence of corporate taxes indicates that corporate debt and leverage are not incentivised by tax breaks. As a result, corporates may source their funding for capital growth either through equity or debt. This therefore takes away an important instrument by which the government could incentivise and promote the development of the debt market in the UAE. With regard to Shariah governance, the UAE adopts a non-centralized model; approval for any Islamic financial product - including sukuk - is given by the appointed Shariah committee of the respective commercial or investment banks involved in the issuance. There is no national authority that performs the oversight function on the Shariah compliance of sukuk structures. Although the model works well in this jurisdiction, it is criticized for creating discrepancies in terms of Shariah rulings on sukuk structures, especially with the recent Dana Gas sukuk debacle. The issuer, Sharjah-based Dana Gas PJSC (the Middle East’s first and largest regional private natural gas company), declared Shariah non-compliance of its mudarabah sukuk structure in June 2017 - as a defense against not paying its sukuk holders. Although Islamic banking is well developed in the UAE, having contributed 44% (USD 163.12 billion) of its total GDP in 2016 and as illustrated earlier in Chart 4.16, the Islamic money market is still limited. Thus far, the CBUAE has not issued any short-term instrument such as treasury bills, notes, bonds or sukuk dominated in AED, thereby causing the total debt issuances of the UAE to be lower than those of the other GCC countries. Nevertheless, the CBUAE has already introduced Shariah-compliant IMLF since 2014 and accepted sukuk as a form of collateral. This effort is anticipated to aid in the growth of the Islamic money market, therefore enhancing the liquidity of the bond market. Figure 4.7 summarizes the key factors that have influenced the growth and development of UAE’s sukuk market. Meanwhile, Figure 4.8 highlights the phases of Islamic finance inclusion into the UAE’s financial landscape since the establishment of Dubai Islamic Bank in 1975 to what the market has currently achieved and what should be further improved to reach the status of a matured market.

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Figure 4.7: Key Factors Underpinning the Growth of UAE’s Sukuk Market

Sources: RAM, ISRA

Figure 4.8: Phases of Islamic Finance’s Inclusion into the UAE’s Financial Landscape

Sources: RAM, ISRA

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While the UAE has been an attractive jurisdiction for international sukuk issuances and a favourite domicile of foreign investors, the UAE ICM in general and the sukuk market in particular still face a number of challenges.5 In making the recommendations for the UAE, we have reviewed the issues and challenges faced by its sukuk market, as depicted in Chart 4.29. Tables 4.11 and 4.12 summarise some proposals to facilitate the depth and breadth of the UAE sukuk market in terms of supply and demand.

Chart 4.29: Factors Influencing the Development of the UAE’s Sukuk Market

Sources: RAM, ISRA

5 In 2015, Deloitte Corporate Finance - in collaboration with the Dubai Economic Council - published a report, Developing Dubai’s Debt Market to Promote Investment and Growth, to analyse the factors that stimulate the development of the debt market in Dubai.

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Issues and challenges Demand (buy side) opportunities Narrow investor base – Foreign-dominated investor base; lack of cornerstone institutional investors; no retail investors

Demand from institutional investors that need long-term investments, such as insurance companies and pension funds.

Demand from high-net-worth individuals who are now investing more in equities and real estate. A retail market would create depth for the ICM.

Unavailability of centralized Shariah authority

The standardisation of legal documentation, sukuk structures and Shariah rulings would create more certainty among investors, hence create more demand for sukuk. To improve clarity on investor protection, to avoid recurrence of Dana Gas-type events.

Sukuk issued have average maturities of 5-7 years

The capital market allows intermediation of long-term funds to match the funding of long-term financings, such as in project financing or infrastructure development projects. Federal governments and GREs to raise sukuk with different maturities and more frequently, to provide the necessary benchmark yield curves that would enable local corporations to raise longer-term issues.

Sources: RAM, ISRA

Table 4.12: Recommendations to Improve Supply (Sell Side) – Medium-Term Solutions

Issues and challenges Supply (sell side) opportunities Limited LCY domestic sukuk market

Federal government and Emirates’ governments to finance their budget deficits, especially when oil prices drop.

Limited Islamic money-market instruments such as short-term sukuk, Islamic treasury issues

The Islamic banking industry is growing in the UAE, but there is a lack of liquidity-management instruments, particularly high-quality and liquid financial assets to meet the liquidity coverage ratio under Basel III. The central bank is able to strengthen its monetary policy.

Sources: RAM, ISRA

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4.4 INDONESIA

4.4.1 OVERVIEW OF INDONESIA’S CAPITAL MARKETS

Since the early 1990s, through reformation led by the government of Indonesia, the country’s capital markets have developed tremendously, albeit with periods of significant volatility during the Asian financial crisis and the GFC. Nevertheless, the capital markets in Indonesia are smaller and less liquid relative to its ASEAN neighbours and other emerging markets. The government, Bank Indonesia (BI) and corporates have issued a variety of debt securities, both conventional and sukuk, as well as asset-backed securities in the domestic and international markets. Chart 4.30 depicts the Indonesia’s outstanding LCY bond market from 1997 to 2016.

Chart 4.30: Size of Indonesia’s Outstanding LCY Bond Market in USD (1997-2016)

Sources: Asian Bond Online, Bloomberg Note: Data indicates the LCY amount equivalent to USD billion.

As at end-June 2017, Indonesia’s outstanding bonds stood at USD250.0 billion, of which 90.6% comprised government debt securities while the balance originated from the corporate sector. The crowding out of sovereign issues in the local bond market has had some effect on the development of corporate bonds. Facilitative guidelines and tax incentives focused on the development of sovereign bond/sukuk transactions over the last decade (e.g. approval of the Islamic Shariah debt bill in April 2008 to allow sovereign sukuk issuance, and the removal of withholding tax on global sovereign bonds) have further constrained the growth of corporate debt securities. Box 4.6 explains the development of Indonesia’s domestic bond market vis-à-vis the size of other selected Asian debt markets as at end-2016.

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Box 4.6: Size of Selected Asian Debt Markets as at end-2016 (USD billion)

Development of Indonesia’s domestic bond market The government and regulators are working together to develop the domestic bond market, and have made it a key priority in their capital market masterplans. The ability to reduce the country’s reliance on foreign debt holders will reduce the impact of volatility arising from sentiment-driven foreign investors. The strategies that have been successfully implemented include the launch of government retail bonds in 2006 and the inclusion of Islamic finance products in 2008. Over the years, Indonesia’s bond market has grown steadily, recording USD163.0 billion of outstanding bonds as at end-2016, mainly comprising government issuances which accounted for 85% of total outstanding bonds; the remainder were held by the corporate sector.

Corporate bond

market

Government bond

market

Total


Size of Selected Debt Markets Relative to GDP (as at end-2016)

0.0%

50.0%

100.0%

150.0%

200.0%

250.0%

Japan Korea Malaysia Singapore Thailand Hong Kong China Philippines Vietnam Indonesia

% of GDP

Private Sector Public Sector

14%

85%


There is a significant difference in the currencies of debt issued by the government as opposed to corporates. The ratio of domestic debt relative to the government’s total debt has been trending downwards, from a high of 24% in 2015 to about 17% as at end-June 2017 (refer Chart 4.31). The government’s aim of refinancing maturing foreign debts by issuing bonds/sukuk in the domestic market supports the achievement of better pricing benchmarks in its own currency, a sound balance between foreign and domestic debts, and the strengthening of the domestic financial market. Meanwhile, Indonesian corporates have instead relied heavily on FCY bonds to meet their financing requirements (refer to Chart 4.32).

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The reasons include the following:

1. The government’s persistent budget deficits have relied on a significant portion of local liquidity to meet budgetary funding gaps. Limited participation by NBFIs has further reduced liquidity intermediation in funding corporate bonds.

2. The Indonesian rupiah’s history of hyperinflation and volatility has compelled companies to borrow and also bill in USD for many local goods and services (Reuters, 2015).

3. Access to lower-cost funding.

Chart 4.31: Outstanding Government Bonds (December 2004-June 2017)

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r-1

6

Ju

n-1

6

Se

p-1

6

De

c-1

6

Ma

r-1

7

Ju

n-1

7

USD billion

LCY Corporate (in USD billions) FCY Corporate (in USD billions)


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Indonesia’s ICM has been under development for the last 2 decades, due to the government’s concerted efforts to elevate the significance of Islamic finance and the ICM. Strategic action plans defined in the Capital Market Master Plan (2005-2009) and Capital Market Master Plan (2010-2014)―as highlighted in Boxes 4.7 and 4.8 respectively, had set in motion the establishment of the necessary infrastructure for the inclusive development of Islamic finance.

Box 4.7: Indonesian Capital Market Master Plan (2005-2009) This master plan is a continuation of the Indonesian Capital Market Blue Print (2000-2004) that had provided similar guidelines for the period of 2000 to 2004. The strategic planning in this roadmap had been envisaged to create a strong and globally competitive Indonesian capital market capable of spearheading the development of the national economy. Priority targets: 1. Strengthening capital market

supervision. 2. Strengthening legal certainty in the

capital markets. 3. Enhancing the roles and quality of capital

market participants. 4. Expanding alternative investments and

financing in the capital markets. 5. Developing the Shariah-based capital

markets.

Specific strategies and action plans to develop Indonesia’s Shariah-based capital markets: 1. Developing a legal framework to facilitate the

development of Shariah-based capital markets. Regulate the implementation of Shariah

principles. Set up accounting standards related to the

implementation of Shariah principles. Set empowerment programmes for market

participants (Shariah capital market experts) in relation to the development of Shariah-based capital markets.

2. Encouraging the development of Shariah-based products. Socialising the implementation of Shariah

principles in the capital markets to enhance market participants’ knowledge.

Developing existing Shariah-based products. Creating new Shariah-based products. Conducting joint research on the development

of Shariah-based products among the regulators, i.e. Nasional Shariah Board – Indonesian Ulemas Council (DSN-MUI in Indonesian acronym) and market participants.

Source: Indonesian Capital Market Supervisory Agency (Bapepam in Indonesian acronym), Ministry of Finance of the Republic of Indonesia (MOF) Note: In 2011, Badan Pengawas Pasar Modal (Bapepam) was changed to Otoritas Jasa Keuangan (OJK).

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Box 4.8: Indonesia’s Capital Market and NBFI Master Plan (2010-2014) This master plan is an integral part of previous ones. Rapid changes in the dynamic global financial systems that are affecting the Indonesian financial landscape have posed more complex challenges. To overcome these, the master plan’s strategies and work plans aim to promote a sophisticated state of development in information and communication technology, a bigger and more rapid flow of capital into Indonesia’s financial system, a conglomerate of financial services that is more widespread and integrated into a global network system, and advancement in financial innovation that will trigger various financial products with more complex risk profiles. Bapepam has set 5 objectives to address the various challenges faced by the capital markets and NBFIs, both domestic and international. These objectives are elaborated in a number of strategies and programmes that are contained within well-organised and measurable action plans. Objective 1: Easily accessible, efficient and competitive source of funds Strategy 1 - Reducing constraints faced by business

communities in accessing the capital markets for

funds.

Strategy 2 - Increasing public access to finance and

guarantee institutions.

Strategy 3 - Improving the role of professionals,

supporting institutions and underwriters in public

offerings.

Objective 2: A conducive and attractive investment climate as well as reliable risk management Strategy 1 – Increasing the distribution and quality of information disclosure. Strategy 2 – Encouraging the diversification of capital market instruments and NBFI service schemes. Strategy 3 – Developing Shariah-compliant capital

markets and NBFIs.

Strategy 4 – Improving the ease of transactions.

Strategy 5 – Developing schemes to protect

investors and customers.

Strategy 6 – Developing a secondary market for

bonds and sukuk as well as a supervisory

mechanism.

Objective 3: A stable, resilient and liquid industry Strategy 1 – Increasing market players’ quality. Strategy 2 – Encouraging good corporate governance practices. Strategy 3 – Improving the capabilities of the risk-management industry. Strategy 4 – Improving supervision over industry players. Strategy 5 – Improving the domestic investor base and long-term funds. Objective 4: Fair and transparent regulatory framework which guarantees legal certainty Strategy 1 – Improving quality of legal enforcement. Strategy 2 – Harmonising regulations among industries and meeting international standards. Strategy 3 – Drafting regulations based on the

needs and development of the industry.

Strategy 4 – Improving the quality and transparency of financial information of participants in the capital markets and NBFIs Objective 5: A credible, reliable international-standard infrastructure Strategy 1 – Developing an integrated securities trading system (straight-through processing). Strategy 2 – Developing a reliable information system.

Sources: Indonesian Capital Market Supervisory Agency (Bapepam in Indonesian acronym), MOF

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To further align the government’s Islamic finance agenda and boost the development of Islamic finance, the OJK launched a 5-year roadmap, i.e. the Indonesian Financial Services Sector Master Plan (2015-2019), which aims to provide an umbrella for the development of roadmaps in each respective sector of the financial services industry, including the Shariah Capital Market Roadmap (2015-2019)―as highlighted in Box 4.9.

Box 4.9: Indonesian Shariah Capital Market Roadmap (2015-2019) This roadmap is a subset of the Indonesian Financial Services Sector Master Plan (2015-2019), with a specific focus on the development of the country’s ICM. Objectives:

1. To promote the ICM as a source of funds for the public and private sectors, as well as investment choices for the public.

2. To promote an ICM that is growing, stable, sustainable and accountable.

3. To create qualified and trustworthy human resources in the ICM.

Target 1: Strengthening regulation

Regulations on the issuance of Islamic securities - Islamic REITs, mutual funds based on a portfolio of foreign Islamic securities.

Incentives for ICM products – discount on OJK levies, relaxation of Islamic mutual fund portfolio.

Regulation to support institutions and professions – regulation of Islamic experts and Islamic investment management.

Regulating Islamic securities trading – research on Islamic margin trading and Islamic repos.

Target 2: Promoting supply and demand

Product development – municipal sukuk, sukuk rating methodology.

Encouraging the issuance of Islamic securities – increasing sukuk issuance by financial institutions.

Broadening the investor base – matching potential local investors, facilitating investment access.

Developing a supporting infrastructure – enhancing the liquidity of the sukuk market, encouraging Shariah-compliant online trading system and Islamic index.

Target 3: Developing human resources and information technology (IT)

Improving the quality and quantity of ICM human resources – educating market players, facilitating the certification of Islamic experts.

Developing IT infrastructure – designing the application of Islamic stock screening, building risk-based supervision of the ICM.

Target 4: Promotion and education

Promoting the ICM – create branding via logos and taglines.

Socialisation and education – mass socialisation for the public and education institutions.

Cooperating with higher-education institutions – including ICM materials in the higher-education curriculum, training of trainers for lecturers.

Promoting the Indonesian ICM to the international market – promoting cooperation with overseas regulators, participating in international events.

Target 5: Coordinating with key market stakeholders

Coordinating with government and regulators – taxation policies, the liquidity of sukuk market.

Coordinating with Islamic banks and Islamic NBFIs.

Source: OJK (2015, November)

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To further elevate the development of the country’s Islamic finance landscape, the National Committee for Islamic Finance (Komite Nasional Keuangan Syariah (KNKS)), which has four important roles described in Figure 4.9, was established in July 2017. Chaired by the President, this high-level committee will review the current policies, regulations and roadmaps in strengthening the inclusion of Islamic finance, to promote the economic growth of Indonesia. This “top down” approach will necessitate the involvement of all market stakeholders, which is crucial in moving Indonesia’s Islamic finance industry to its next phase of development. The mandate given is to lead the country in creating an Islamic economic and financial system that will benefit all of society.

Figure 4.9: Four Important Roles of the KNKS

Source: Masterplan for Indonesian Islamic Finance Architecture (December 2014)

Figure 4.10 outlines key initiatives undertaken by the Indonesian’s government and authorities to develop a conducive landscape for ICM.

Figure 4.10: Regulatory and Fiscal Initiatives to Develop the ICM (1999-2016)

Source: Thomson Reuters & IRTI (2016)

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4.4.2 GROWTH OF THE SUKUK MARKET IN INDONESIA

In 2008, the government passed the enactment of Sovereign Sukuk Law No. 19, Shariah Banking and Government Regulation 56 Law No. 21 and Sovereign Sukuk Issuing Companies (as amended by Government Regulation 73), which laid the foundation for Indonesia’s Islamic finance industry. Since then, annual sukuk issuance (sovereign and corporate) has increased significantly, from USD0.02 billion in 2006 to USD13.8 billion as at end-December 2016, with a CAGR of approximately 90.9%.

Due to the pick-up in sovereign sukuk issuances since 2010, the size of the outstanding Indonesian sukuk market augmented from USD0.37 billion in 2008 to USD30.8 billion in 2016 and continued expanding to USD37.6 billion as at end-June 2017 (end-June 2016: USD28.6 billion). This translates into a 31% y-o-y increase, bringing the Indonesian sukuk market to 15.3% of all outstanding debts as at end-June 2017 (end-December 2008: 0.4%). Nonetheless, the conventional bond market still out-paced the sukuk market, with an 84.7% share as at the same date.

Domestic Market – Public Sector Issuance With the unveiling of Indonesia’s 10-year Islamic Finance Master Plan in August 2016, the government lent considerable support to elevating the issuance of sovereign sukuk, to 50% of its total debt issuance over the next decade (from 35.1% as at end-June 2017). As a result, sovereign sukuk issuance had surged to USD13.4 billion as at end-2016, from its debut issuance of USD0.35 billion in 2008 (refer to Chart 4.33). In line with the government’s push to develop the domestic ICM, initiatives and incentives have been provided to spur domestic activities. This includes the removal of withholding tax on interest payments on its global sovereign bonds (conventional and Islamic), which is aimed at lowering yields by 15%-20% (Indonesia Investments, 2016). Indonesia has one of the highest bond yields among Asian nations; its 10-year government bond yield hovered around 6.7% as at end-October 2017 (refer to Chart 4.34). The reasons cited for this include the following (Indonesia Investments, 2017):

1. Compared to its regional peers, Indonesia’s credit rating remains less competitive. Nevertheless, following S&P’s upgrade of Indonesia’s sovereign rating to BBB- (with a stable outlook) in May 2017, yields have been trending downwards.

2. Indonesia’s inflation rate has been creeping up since the start of the year due to administered price adjustments (higher electricity tariffs for specific households to contain costly energy subsidies).

3. The volatility of the Indonesian rupiah compared to other Asian currencies.

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Chart 4.33: Indonesia’s Sovereign Sukuk vs Conventional Issuance (2006-June 2017)

0.00

5.00

10.00

15.00

20.00

25.00

30.00

35.00

40.00

45.00

50.00

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 June 2017

USD billion


USD47.4 billion

USD26.0billion

USD14.7 billion

3.3%

35.1%

Sources: MOF, RAM

Chart 4.34: Indonesian 10-Year Sovereign Bond Yield

Sources: Indonesia Bond Pricing Agency, Trading Economics

In view of the government’s efforts to use sukuk in its national debt-management strategies, its huge appetite vis-a-vis funding budget gaps and having to meet the development requirements of infrastructure projects, the issuance of sovereign sukuk will increase rapidly in the immediate term. Table 4.13 presents Indonesia’s budget deficits from 2014 to 2017.

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Table 4.13: Indonesia’s Budget Deficits (2014–2017f)

IDR trillion 2014 2015 2016e 2017f Government revenue 1,550.50 1,508.00 1,555.90 1,750.30 Government expenditure 1,777.20 1,806.50 1,864.30 2,080.50 Budget deficit (226.70) (298.50) (308.40) (330.20) Source: MOF

Due to the government’s increasing support for the issuance of Shariah-compliant securities, the percentage of sovereign sukuk to total public debt had climbed up to 16.8% as at end-June 2017, from 0.4% when it was first launched, as shown in Chart 4.35. This ratio is anticipated to gradually rise in line with Indonesia’s push to develop its ICM.

Chart 4.35: Indonesia’s Sovereign Sukuk vs Conventional Outstanding (2006-June 2017)

0.00

50.00

100.00

150.00

200.00

250.00

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 June 2017

USD billion

Sukuk outstanding Conventional outstanding

USD82.3billion

USD223.7 billion

0.4%

16.8%

Sources: MOF, RAM

Based on our data and analysis, we can conclude that the government is earnestly committed to increasing sovereign sukuk issuance through the years to finance its medium- and long-term projects, which will eventually lead to the development of this niche market. Nevertheless, based on the amount of conventional bond issues by the government, the conventional bond segment is still far bigger than its sukuk counterpart, which indicates that more effort is required to ensure that sukuk can reach its full potential as a financing and monetary instrument in the Indonesian market. Domestic Market – Private Sector Issuance Based on historical issuances, the growth of the Indonesian LCY corporate bond market has lagged behind the LCY sovereign bond market, although there was a pick-up in corporate bond issuance in 2016. The common reasons cited include the following:

1. No major difference in terms of cost compared to bank financing, which is faster.

2. Requirement for issuers to carry investment-grade ratings limits the pool of Indonesian corporate issuers.

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3. Lack of understanding of ICM among corporates (i.e. unfamiliarity with Islamic structures and principles).

Given the aforementioned reasons, Indonesia’s corporate bond market has remained relatively small; total corporate bond issuance came up to USD8.7 billion as at end-2016, compared to USD47.4 billion for sovereign bonds. Of the total, corporate sukuk issuance only accounted for a mere 3.7% in 2016 (or USD0.32 billion), (end-2015: USD0.70 billion) (refer to Chart 4.36). The government and regulators are aware of the importance of growing the corporate bond market, and are taking the necessary measures to provide viable stimuli. Chart 4.36: Indonesia’s Corporate Sukuk vs Conventional Issuance (2006-June 2017)

Sources: Bloomberg, OJK, RAM

Due to the declining trend in LCY corporate sukuk issuance, outstanding corporate sukuk only

accounts for a miniscule 1% of total outstanding private debt securities, as depicted in Chart

4.37.

Chart 4.37: Indonesia’s Corporate Sukuk vs Conventional Outstanding (2006-June 2017)

0.00

5.00

10.00

15.00

20.00

25.00

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 June 2017

USD billion

Sukuk outstanding Conventional outstanding

RM4.5 billion

RM23.2 billion

0.3%

Sources: Bloomberg, OJK, RAM

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Accordingly, there is a plenty of room to expand total outstanding debts to GDP, which stood at 25% as at end-2016―a slight improvement over the 17% as at end-2008 (refer to Chart 4.38).

Chart 4.38: Indonesia’s Outstanding Capital Markets vs Bank Financing Relative to GDP

Sources: World Bank, Bloomberg, The Global Economy


Analysis of Sukuk Structures

In 2003, Bapepam (the regulator at that time) and the National Shariah Board of the Indonesian Council of Ulama (DSN-MUI) signed a memorandum of understanding to collaborate on the development of Shariah-compliant capital market products. The DSN-MUI remains the central Shariah body empowered to govern Indonesia’s Islamic finance landscape. As of mid-2015, the DSN-MUI had issued 96 fatwas that covered every aspect of Islamic financial services, including generic products such as wadiah, mudarabah and musharakah contracts, instruments for liquidity, hybrid products, the treatment of non-halal revenue, penalties, takaful and ICM operations, as well as hedging instruments. BI and the OJK regulation enforce the fatwas issued by the DSN-MUI; all Islamic financial services entities are required to comply with the rulings (Thomson Reuters & IRTI, 2016). As per the OJK’s sukuk guidelines, all sukuk issuances require the prior endorsement of a Shariah advisor licensed by the OJK. In general, Indonesia’s regulatory framework applies to both conventional and Shariah instruments. All securities to be issued via an offer to the public are subject to the submission of a Registration Statement and supporting documentation, and require the approval of the OJK. Issuers of Shariah instruments are required to observe BI regulations on foreign exchange and the stability of the Indonesian rupiah. Shariah instruments to be listed are subject to the same listing approval and disclosure requirements as conventional instruments, with certain additions prescribed under OJK Regulation Number 18/POJK.04/2015 concerning issuance and requirements for sukuk. Based on historical sukuk issuances, the ijarah contract is the preferred contract for sovereign sukuk (as depicted in Chart 4.39) because this structure utilises underlying assets in the form of fixed tangible assets and projects. Meanwhile, corporate sukuk issuers prefer a mix between ijarah and mudarabah as shown in Chart 4.40.

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Chart 4.39: Indonesian Sovereign Sukuk Issuance – Type of Shariah Contract (2008-2016)

Sources: Bloomberg, RAM

Chart 4.40: Indonesian Corporate Sukuk Issuance – Type of Shariah Contract (2008-2016)

Sources: Bloomberg, RAM

Table 4.14 highlights different sukuk structures approved by DSN-MUI for Indonesian sovereign sukuk issuance.

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Table 4.14: Types of Sukuk Negara Shariah Structures Approved by DSN-MUI Ijarah

(Sale and lease back)

Ijarah al-Khadamat

Ijarah (Asset to be

leased)

Wakalah

Description Sukuk issued based on the sale-and-leaseback mechanism (asset purchase transaction, whereby the purchaser then leases back the purchased assets to the seller).

Sukuk issued based on Islamic principles represents ownership of SBSN assets in the form of services.

Sukuk issued based on Islamic principles, represents ownership of SBSN assets, either already in existence or will exist.

Sukuk issued based on Islamic principles represents ownership of project or activities managed on the basis of an investment agency, by appointing an agent to manage the operation.

DSN-MUI fatwa Number 72/2008 Number 9/2000 Number 76/2010 Number 95/2014

Underlying assets

State-owned assets Hajj services Project and state-owned assets

Rent money/ margin/fixed fee

Tradability Tradable Non-tradable Tradable Tradable

Issuance documents

Akad bay’ Akad ijarah Sukuk asset-

management agreement

Sale undertaking and purchase undertaking

Akad wakalah Akad ijarah Handover

(BAST) services hajj

Booking letters Akad wakalah Akad ijarah asset

to be leased Sukuk asset-

management agreement

Sale undertaking and purchase undertaking

Declaration of trust

Purchase agreement

Procurement agreement

Lease agreement Servicing agency

agreement Substitution

undertaking Transfer

undertaking Purchase

undertaking Cost undertaking Agency

agreement Sukuk Negara series

Islamic Fixed Rate (IFR), Retail Sukuk (SR), Sukuk Negara Indonesia (SNI)

Hajj Fund Sukuk (SDHI)

Project based sukuk (PBS), SR

SNI

Source: MOF

Analysis of Sukuk Issuances – Supply (Sell Side)

The pace of growth of LCY corporate sukuk remains a challenge for the government and the regulators. Since the first sukuk issuance by PT Indosat in September 2002, there has been a limited number of corporate sukuk issues (refer to Chart 4.41).

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Chart 4.41: Development of Indonesia’s Domestic Corporate Sukuk (2002-2016)

Source: OJK

To address the challenges faced by the industry, the OJK (and its predecessor, Bapepam) has―through its capital market master plans and roadmaps―identified strategic initiatives to stimulate the market. These initiatives include the following: 1. Reducing the amount of documentation required by issuers. As a result, the timeframe

needed to launch a bond/sukuk has been reduced from 45 to 35 days (The Banker Asia, 2017).

2. Reducing the fees associated with the issuance of sukuk compared to conventional bonds (as highlighted in the Indonesian Financial Services Sector Master Plan).

An example is the reduction of the OJK’s registration fee:

Issuance value Registration fee

Sukuk Bond IDR 250 billion IDR 125 million IDR 125 million IDR 500 billion IDR 150 million IDR 250 million IDR 1 trillion IDR 150 million IDR 500 million IDR 1.5 trillion IDR 150 million IDR 750 million

3. Encouraging SOEs to fund government infrastructure projects via the sukuk market, and

amending the investment policies of domestic mutual funds to include investment in debt instruments issued by SOEs. Previously, pension and provident schemes had been restricted to channeling their funds towards: 1) bank time deposits and certificate-of-time deposits; 2) corporate shares and bonds, as listed on the Indonesia Stock Exchange; 3) promissory notes; 4) corporate equities; and 5) land and buildings (OCBC, 2017).

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The major reasons that have led to an underdeveloped corporate sukuk market in Indonesia are lack of understanding among corporates on ICM access and the viability of issuers’ credit ratings.6 Most corporates assume that the process of issuing sukuk is too complicated, thereby opting to issue conventional bonds instead. Additionally, the high returns expected by investors who demand a premium to offset the additional risks related to the illiquid secondary sukuk market have pushed up the overall cost of sukuk (IFAAS, 2014). Table 4.15 gives a snapshot of some Indonesia’s corporate sukuk deals.

Table 4.15: A Snapshot of Indonesian Corporate Sukuk Issuance

XL Axiata’s Ijarah Sukuk Programme (the largest corporate ijarah sukuk programme)

Subordinated Mudarabah Sukuk Bank BRI Syariah

Garuda Indonesia Global Sukuk Limited Wakalah Programme

Issuer XL Axiata (EXCL) Bank BRI Syariah Garuda Indonesia Global Sukuk Limited

Originator EXCL Bank BRI Syariah Garuda Indonesia

Currency format Rupiah Rupiah US Dollar 144A/Reg.S

Structure Ijarah Mudarabah Wakalah

Obligor/sukuk rating

AAA (Fitch Indonesia) A+ (Fitch Indonesia) Unrated

Sukuk assets Rights to benefits of telecommunication equipment owned by EXCL, such as base station controller, home location register and mobile switching centre

(BRI) Syariah financing assets

Rights to travel using an orphan-based SPV

Purpose To finance working capital To strengthen the capital structure for business expansion

To be used for Shariah-compliant general corporate purposes, including the repayment of certain existing Islamic financing arrangements

Issuance date 28 October 2015 9 November 2016 3 June 2015

Tenure 2-year shelf-registration programme

7 years 5 years

Maturity November 2017 16 November 2023 3 June 2020

Amount RP5 trillion RP1 trillion USD500 million


8.75% 9.5% - 10.25% 5.95%

Listing Indonesian Stock Exchange (IDX)

IDX Application has been made to Singapore Exchange

6 Under Bapepam Rule Number IX.C.11, it is mandatory for corporate bonds and sukuk to complete a re-rating exercise each year and publish the rating(s).

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XL Axiata’s Ijarah Sukuk Programme (the largest corporate ijarah sukuk programme)

Subordinated Mudarabah Sukuk Bank BRI Syariah

Garuda Indonesia Global Sukuk Limited Wakalah Programme

Securities Trading Limited (SGX-ST)


More than 95% of the sukuk had been offered to investors domiciled in Indonesia, comprising banks, pension funds, insurance companies, institutional investors, securities houses and retail investors

Indonesia (100%). By investor type: Insurance and pension funds: 65% Asset managers: 17% Individuals: 15% Banks: 3%

Middle East (56%), followed by Asia (32%), Europe (12%)

Sources: Islamic Finance News, Thomson Reuters, sukuk.com

Indonesia offers tremendous potential in building a healthy pipeline of corporates that issue project-financed sukuk. Based on the government’s current budget requirements, a large chunk of funding (via project-based sukuk) is already focused on infrastructure development. In view of privatization benefits via public-private partnership schemes, the government and the regulators are identifying potential SOEs and creditworthy corporates that can take the lead in financing government infrastructure projects through sukuk issuance. The government’s ambitious infrastructure plans are considered the biggest enabler in creating a pathway for Indonesia’s Islamic finance since sukuk issuance serves as a natural hedge in financing development projects (via project-based sukuk). Box 4.10 highlights the National Medium-Term Development Plan (2015– 2019) for infrastructure development.

Box 4.10: Indonesia’s National Medium-Term Development Plan (2015-5019)

Under the National Medium-Term Development Plan (2015– 2019), the infrastructure spending plan by the Indonesian central government summed up to IDR2,216 trillion (USD187.0 billion) over a 5-year period or 2.9% of nominal GDP on an annual basis. The government has set the overall investment target at IDR5,519 trillion (USD465.7 billion) for the same period, or 7.2% of annual GDP. State funding will contribute 50% of the total investment, including IDR545.0 trillion (USD46.0 billion) of sub-national government funding, with 19% coming from SOEs and 31% from the private sector. The role of government, SOEs and private sectors in developing infrastructure financing is summarized in the following table:

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Source: MOF

Analysis of Sukuk Investments – Demand (Buy Side)

Historical data shows strong interest from foreign investors since Indonesian government yields are the highest among its peers in emerging East Asia (Asian Development Bank, 2017). Banking institutions are also the main investors in government bonds while pension funds, mutual funds and insurance companies are the principal investors in corporate bonds. The high percentage of foreign participants is primarily due to the relative openness of Indonesia’s capital markets to non-resident portfolio investments, although there are notable restrictions and regulations on foreign investments in bonds and FCY transactions. Although foreign investors’ participation in the local bond market is subject to regulatory approval, such restrictions are not applicable to Indonesian government bonds. As at end-March 2017, foreign investors’ share of LCY government bonds stood at 38.2%. Locally, banking institutions were the largest investor group, accounting for 26.2% of the total stock of LCY central government bonds as at the same date. However, banks’ market share had, in fact, declined due to an increasing trend in holdings by pension funds, mutual funds and insurance companies (refer to Chart 4.42). The OJK has announced a slew of policy changes to allow greater investment opportunities for domestic mutual funds. These will review the percentage ruling on overseas investment and type of investment products. In August 2017, the OJK amended its rules governing investments by NBFIs; the options for required investment products were expanded to include debt instruments issued by SOEs (Reuters, 2017). This is aimed at encouraging SOEs to issue sukuk to fund public infrastructure projects.

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Chart 4.42: Investor Mix for LCY Government Bonds

Source: MOF To further deepen the domestic investor base, the government has optimised the use of retail sukuk as a source of financing since 2009. Retail sukuk, which remains significantly untapped in most countries, increases financial inclusion and can serve as a tool in spreading awareness on Islamic finance. As at end-June 2017, government retail sukuk accounted for approximately 11.5% of total sovereign sukuk issuance (as shown in Chart 4.43), and has been rising steadily. Furthermore, the government launched a savings sukuk in 2016, to reach out to lower-income investors; the sukuk was made available for sale for as low as IDR2.0 million-IDR5.0 million. This initiative underlines the government’s commitment to product innovation in Islamic finance and provides investment solutions to lower-income investors, a group which would otherwise remain largely untapped.

Chart 4.43: Indonesian Retail Sukuk Issuance (2009-June 2017)

0.41

1.05

-

2.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

18.00

2009 2010 2011 2012 2013 2014 2015 2016 June 2017

S

Retail Sukuk Issuance Sovereign Sukuk Issuance

Source: MOF

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4.4.4 KEY FACTORS UNDERPINNING INDONESIA’S SUKUK MARKET

The development and growth of Indonesia’s sukuk market have been mostly bolstered by sovereign issuances. On the other hand, the pace of LCY corporate sukuk issuance remains a challenge which the government and the regulators are trying to address. Therefore, the government and the regulators are aware of the significance of growing both the sovereign and corporate bond markets; they have expended the requisite efforts to provide viable stimuli, as depicted in Figure 4.11. To draw more attention to private sector issuers and boost demand for sukuk, however, more initiatives and incentives are required.

Figure 4.11: Key Factors Underpinning the Growth of Indonesia’s Sukuk Market

Sources: RAM, ISRA

Indonesia has made strides in developing its sukuk market since Indosat’s (a telecommunication company) corporate sukuk in 2002. However, Islamic finance in Indonesia commenced in 1991, with the establishment of Bank Muamalat Indonesia. Figure 4.12 highlights the development phases of Islamic finance in Indonesia, including some insights on the next stage of advancement.

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Figure 4.12: Phases of Islamic Finance’s Inclusion in Indonesia’s Financial Landscape

Sources: RAM, ISRA 4.4.5 COUNTRY-SPECIFIC RECOMMENDATIONS

The evolution and improvement of Indonesia’s sukuk market have been driven by several key factors, as depicted in Chart 4.44. Indonesia has a moderate score in most factors, indicating a requirement for the further enhancement of each factor in order to boost its sukuk market. In coming up with the recommendations for Indonesia, we have reviewed the challenges faced by its sukuk market. Tables 4.16 and 4.17 list the proposals to facilitate the supply of and demand for sukuk, with a specific focus on the corporate sector.

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Chart 4.44: Factors Influencing the Development of Indonesia’s Domestic Sukuk Market

Sources: RAM, ISRA


Issues and challenges Demand (buy side) opportunities The local ICM is very fragmented, with many market stakeholders that regulate the entire ecosystem.

KNKS’s strategic clout in synergising the efforts of all market stakeholders (e.g. MOF, BI, OJK, tax office) will help strengthen coordination efforts.

Low liquidity intermediation by NBFIs for corporate sukuk due to a preference for less risky sovereign papers

The OJK’s recommendation to expand NBFIs’ investment portfolios to include debt instruments issued by SOEs is a good start towards encouraging corporate issuance.

Investors’ lack of appetite to hold long-dated corporate debt securities

Tenures of corporate sukuk in Indonesia average between 3 and 5 years. The longest-dated corporate sukuk had been issued by Perusahaan Listrik Negara (PLN), with a maturity of 12 years (Asian Development Bank, 2014). Regulators and local rating agencies need to educate domestic investors on the effectiveness of matching their assets with long-term, project-based sukuk. The openness of NBFIs to hold long-dated papers (> 7 years) will spur the supply of infrastructure-based sukuk.

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Withholding tax Withholding-tax related to debt securities in Indonesia

Type of debt Type of investor or institution

Tax rate

Government securities

Domestic banks Approved pension funds Domestic mutual funds Other domestic investors Foreign investors

0% 5% 15% 20%

FCY government securities

Any investor Exempt

BI certificates Any investor 20% Corporate bonds Domestic banks

Approved pension funds Domestic mutual funds Other domestic investors

0% 5% 20%

Source: ASEAN+3 Bond Market Guide 2017

Different tax rate imposed on different groups of investors. To create a level playing field for all NBFIs is to consider full exemption/or reductions across the board. The sacrifice in foregoing tax revenue from withholding taxes will have a ripple effect on the fund flows into Indonesia’s capital markets.

Sources: RAM, ISRA


Issues and challenges Supply (sell side) opportunities Create a sustainable supply of corporate sukuk

Encourage SOEs and corporates to issue retail sukuk linked to infrastructure projects. Explore new sukuk programmes directed specifically at religious funds (hajj fund, zakat, waqf) that are linked to directly finance the government’s infrastructure projects.

Lack of understanding among corporates on ICM access (i.e. unfamiliarity with Islamic structures and principles)

There are ongoing efforts by the regulators to raise market awareness of ICM products. However, the level of awareness remains low. The government and the regulators can dedicate sections on their websites to share comprehensive information on sukuk and its processes, to increase knowledge and build market awareness.

Improve sukuk’s cost competitiveness to encourage corporates to issue sukuk

The OJK has initiated a reduction in registration fees for sukuk. Other applicable fees should be reviewed for waivers or exemptions. However, the tax authorities should also collaborate with the OJK to propose viable stimuli to encourage corporate issuance.

Promote activity in the Islamic money market

Following the release of the Islamic Repo guidelines in 2015, there has been market activity although this has yet to reach the regulators’ targeted volumes. Greater understanding of Islamic banks’ issues and challenges can facilitate better volumes of Islamic repo and look at alternative forms of liquidity-management tools offered in other countries, which can be adopted in Indonesia.

Expansion of ICM products Promote product innovation with social welfare benefits (i.e awqaf-linked sukuk).

Sources: RAM, ISRA

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4.5 TURKEY

4.5.1 OVERVIEW OF TURKEY’S CAPITAL MARKETS

In the last decade, the Republic of Turkey has made significant strides in developing its niche Islamic finance landscape. The strengthening of Turkey’s interest-free finance sector was announced by the government through its Tenth Development Plan (2014-2018) and Medium-Term Programme (2016-2018) (refer to Boxes 4.11 and 4.12 respectively). Efforts have been continuously expended to solidify the corporate and legal infrastructure as well as to foster a more diversified range of interest-free financial products. Priority has been given to establishing the Istanbul International Financial Centre Programme (IFC-Istanbul), which identifies interest-free finance as one of its core components.

Box 4.11: Turkey’s Tenth Development Plan (2014-2018)

The Tenth Development Plan 2014-2018 is a roadmap to advance Turkish society to high prosperity levels, in line with its 2023 targets. For efficient implementation of this plan, medium-term programmes, annual programmes, strategic plans, regional development and sectoral strategies will be prepared accordingly. 25 Priority Transformation Programmes have been identified towards achieving the 2023 targets and meet the objectives of this plan. Priority Transformation Programme: IFC-Istanbul The IFC-Istanbul was first initiated in 2009. Its development is envisaged to contribute to the formation of a financial sector that is integrated with the global markets, collect funds and effectively allocate resources, coupled with the exporting capabilities of international financial services.

Programme components: 1. Establishing an administrative

structure for IFC-Istanbul. 2. Increasing the diversity of financial

products and services, 3. Enhancing the legal infrastructure. 4. Improving the physical

infrastructure in the clustering areas.

5. Strengthening the technological infrastructure.

6. Increasing qualified human resources.

7. Strengthening interest-free finance and participation banking

Source: Ministry of Development, Turkey (2014)

Following the MTP (2016-2018), a comprehensive tax reform was introduced in August 2016, which significantly eliminated tax-related roadblocks and uncertainties vis-a-vis sukuk issuance and transactions. To further support the development of Turkey’s Islamic finance landscape, the Participation Banking Strategy Document (2015-2025) targets participation banks’ contribution to the country’s total banking assets to increase to 15% by 2025, from 5% as at end-June 2017. Looking back at its historical performance, the development of the Turkish sukuk market is directly linked to the growth of its participation banks. At present, 5 participation banks are in operation in Turkey. Based on the latest statistics shown in table 4.18, they have made commendable progress in expanding their deposits and asset bases since inception. Turkey’s first sukuk was issued by Kuveyt Turk via KT Sukuk Varlik Kiralama A.Ş. in 2011, valued at USD350.0 million. The ijarah sukuk had a tenure of 5 years and was successfully subscribed by investors in the Middle East (69%), Asia (19%) and Europe (12%).

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Box 4.12: Turkey’s Medium-Term Programme (MTP) (2018-2020)

The main objectives of the MTP are to maintain macroeconomic stability, to increase human capital and labor quality, to enhance high value-added production, to improve the business and investment environment and to increase the institutional capacity in the public sector, to increase employment and improve income distribution. In this framework; decreasing inflation, sustaining fiscal discipline and improving current balance, raising the quality of education, increasing the skills and productivity of the workforce, making the labor market more flexible, increasing the value-added production and exports based on innovation, facilitating business and investment processes, legal foresight in business and trade disputes and structural reforms aimed at strengthening institutional capacity in the public sector are quite important. Growth and employment priority policies and measures: A. With the purpose of achieving high growth rates

in the future, and increasing quality of growth: Sustaining low single-digit inflation. Keeping current account deficit at

sustainable levels. Increasing domestic savings and

investments further. Allocating resources to the manufacturing

industry. Increasing quality of exports.

Raising production infrastructure and technology level.

Improving the quality of labor force and increasing labor market flexibility are important issues.

B. For an economic structure that is growing at a high and stable rate during the Programme period: Sustaining macroeconomic stability. Qualified employment creation. Increasing high value-added

production. Improving the suitable environment

for private sector investments and further easing of doing business.

Increasing the institutional capacity of the public in order to support the private sector are aimed. Priority policy areas of the MTP: 1. Sustaining macroeconomic stability. 2. Improving the quality of the human capital

and labor force. 3. High value-added production. 4. Improving business and investment climate. 5. Strengthening institutional quality and

service delivery in public sector.

Source: Ministry of Development, Turkey (2017, October)

Table 4.18: Turkey’s Participation Banks (as at end-June 2017)

Full-fledged Islamic banks

Date of incorporation Total assets (USD million)

Total deposits (USD million)

AlBaraka Turk November 1984 9.6 6.2 Kuveyt Turk March 1989 15.1 10.5 Turkiye Finans December 2005 10.5 5.7 Ziraat Katilim May 2015 3.3 2.3 Vakif Katilim February 2016 2.7 2.1

Source: Participation Banks Association of Turkey

According to an empirical study by Jobarteh & Ergec (2017), the economic success of Turkey in recent years is attributable to the rise of its Islamic finance sector. Table 4.19 outlines the historical development of Islamic finance industry in Turkey since 1983 until 2016.

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Table 4.19: Timeline of the Development of Turkey’s Islamic Finance Industry

Year Timeline description 1983 A Cabinet Decree was passed on ”Special Finance Houses (SFHs)”

1999 SFHs were covered in the scope of the Banking Law

2005 The Banking Law officially replaced ”special finance houses” with ”participation banks”

2010 Guideline on Ijarah sukuk was established through the release of Communiqué Serial III no: 43 – principles regarding lease certificates and asset-leasing companies (ALCs). This regulated ijarah sukuk and the structures of a financial institution as well as SPVs and their principles of incorporation and activities.

2011 Kuveyt Turk issued Turkey’s first sukuk

Law no 6111 (known as the Tax Amnesty Law) - The Turkish National Assembly passed tax and other legislation to facilitate the issuance of ijarah sukuk, reducing the withholding tax on such sukukto 10% and exempting sales from value-added, stamp and corporate taxes. This facilitates the sale and transfer of the tangible real estate to an onshore SPV combined with asset-based ijarah characteristics. Further legislation includes tax exemption for revenue from sukuk certificates with a minimum tenor of 5 years. Certificates with shorter tenors would still be subject to tax ranging from 3% to 10%. However, since most corporate sukuk issues meet the shorter-tenor profile, further adjustment would be needed to open the market

2012 Law no 4749 The Public Finance and Debt Management Law was amended to enable the sovereign to access the sukuk markets

Undersecretariat of Treasury issued the first sovereign sukuk

Law no. 6362 (Article 61) – a new Capital Market Law (CML) was introduced, which included provisions for lease certificates and ALCs

2013 Amendments to the sukuk law via the release of Communiqué III-61.1 no: 28670 – introducing istisna’, murabahah, mudarabah, musharakah and wakalah sukuk

2016 Tax neutrality provided for all sukuk structures with a law amendment Sources: Thomson Reuters, IRTI & CIBAFI (2014), CMB

Turkey’s Islamic finance landscape progressed in tandem with the growth of the country’s economy. Chart 4.45 shows that GDP grew to USD857.0 billion end-2016 from USD732.2 billion recorded end-2010. As a percentage to GDP, representation of outstanding loans/financing increased to 67% in 2016 from 48% in 2010. However, intermediation of capital markets reduced denoting higher reliance on the banking system to fund the economic sectors.

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Chart 4.45: Turkey’s Outstanding Capital Markets vs Bank Financing Relative to GDP

2010Outstanding

amounts as a % of GDP at USD732.0

billion

Loans/Financing Outstanding

2016Outstanding

amounts as a % of GDP at USD857.0

billion

L

Bonds Outstanding

Source: CMB Annual Reports, Turkey IMF Country Report No. 17/35, The Banks Association of Turkey Report 2016

Based on our methodology, Turkey is placed under “developing” status due to sustained sukuk issuance by the public and private sectors, and the country’s concerted efforts in building a viable Islamic finance ecosystem. 4.5.2 GROWTH OF THE SUKUK MARKET IN TURKEY

The formal regulation of the development of sukuk began with the Capital Markets Board of Turkey (CMB) issuing the Communiqué on the principles regarding lease certificates and ALCs in April 2010. Through the issuance of the Communiqué, the CMB aims to facilitate the development of an alternative instrument for Islamic finance and has created a new era for the Turkish capital market. According to the Communiqué, only ALCs that function as SPVs are allowed to issue lease certificates. Subsequently, in 2012 the Law on Regulating Public Finance and Debt Management was amended to facilitate Turkey’s first sovereign sukuk issuances in international and domestic markets within the same year. The sovereign issuance was issued by Müsteşarlığı Varlık Kiralama AS (HMVKŞ), as ALC set-up by the Undersecretariat of Turkey. On June 2013, the CMB released a second Communiqué on lease certificates (which supersedes the first); this expands the principles governing lease certificates and originators of ALCs. Since trusts are not regulated under Turkey’s civil law, the ALCs can be incorporated as joint stock companies, as per the guideline in the second Communiqué. Figure 4.13 summarises the key phases that Turkey has undergone in strengthening its sukuk regulations.

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Figure 4.13: Timeline of Turkey’s Sukuk Regulation

Sources: Undersecretariat of Treasury, CMB

The revisions released in the second Communiqué allow varying sukuk structures. The domestic sukuk market has seen an unprecedented spike in lease certificates since then. As depicted in Chart 4.46, total Turkish sukuk issuance increased from USD350.0 million as at end-2011 to USD3.0 billion as at end-2016. The viable solution to diversify sukuk structures which are accorded tax neutrality were key in growing Turkey’s sukuk issuance. As at end-June 2017, a steady pipeline of sukuk issuance by the public and private sectors supported Turkey’s USD1.6 billion contribution to total global sukuk issuance.

Chart 4.46: Turkey’s Sukuk Issuance vs Global Sukuk Issuance (2011-June 2017)

Sources: CMB, Eikon-Thomson Reuters

Domestic Market – Public Sector Issuance In 2001, Turkey felt the brunt of the financial crisis when its public debt hit a peak of 77% of GDP while the inflation rate came in at a record 68.5%. The Turkish government had consequently implemented strategic economic reforms to combat its rising public debt and

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runaway inflation. As at end-2016, the gross public debt had more than halved to 32% while its inflation rate was brought down to only 8.5% (as depicted in Chart 4.47). Improved management of public debt through optimising borrowing costs, among other solutions, had extended the maturities of debt issues; fixed-rate LCY borrowings had been among the measures that had enabled Turkey to lighten its debt burden.

Chart 4.47: Turkey’s Gross Public Sector Debt (2001-2016)

Source: Undersecretariat of Treasury

Table 4.20: Turkey’s Budget Deficits (2014-2017f)

TL billion 2014 2015 2016e 2017* Government revenue 425.4 482.8 554.1 574.6 Government expenditure 448.8 506.3 584.1 601.1 Budget deficit (23.4) (23.5) (29.9) (26.5) Source: Ministry of Finance (MOF), Turkey * Based on figures as at end-November 2017.

Turkey has historically relied heavily on capital-market instruments through the issuance of domestic and external bonds to finance government budgets (refer to Table 4.20 on Turkey’s budget deficits from 2014 to 2017). With the amendment of the law for sukuk issuances in 2012, Turkey issued its first USD and LCY sukuk in 2012, which facilitated the setting up of sovereign benchmark yield curves for corporate sukuk issuance. To date, even though sovereign sukuk only accounts around 3% of its total sovereign debt issues, commitments under the MTP (2016-2018), MTP (2017-2019) and MTP (2018-2020) appear to have set the stage for interest-free instruments to potentially form part of future budgetary requirements. Hazine Müsteşarlığı Varlık Kiralama A.S. (HMVKS) has issued sukuk in the local market regularly since 2012 according to a calendar that has been announced at the beginning of the year. The maturity of the sukuk was 2 years between 2012-2015, however, since 2016, the HMVKŞ has issued both 2 and 5 years sukuk. Moreover, the HMVKŞ started to issue CPI indexed ijarah sukuk since 2016 in the the local market, as well as fixed lease rate sukuk. Also, to diversify sukuk instruments, in 2017 the HMVKŞ started to issue gold denominated ijarah sukuk in the local market to retail investors. In the international market, the HMVKŞ has issued USD denominated sukuks that have maturities between 5 and 10 years. Table 4.21 shows the number of domestic and international sukuk issuances by Turkish government from 2012 to October 2017.

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Table 4.21: Turkey's Public Sector Sukuk Issuances 2012 2013 2014 2015 2016 Oct-2017

Number of sukuk issuances in the local market

1 2 2 2 5 8

Issuances in local market (million TL) 1.624 3.333 3.173 3.390 6.262 4.462

Number of sukuk issuances in international market

1 1 1 - 1 1

Issuances in international market (million USD)

1.500 1.250 1.000 - 1.000 1.250

Share of sukuk issuances in total annual borrowing

3.7% 3.8% 3.7% 3.5% 8.5% 5.5%

Share of sukuk issuances in total debt stock *

0.8% 1.8% 2.3% 2.6% 2.7% 3.1%


Domestic Market – Private Sector Issuance The domestic corporate bond market in Turkey only picked up when the Banking Regulation and Supervision Agency (BRSA) issued guidelines relating to the issuance of TL bonds by Turkish banks in October 2010. Following the introduction of sukuk guidelines that same year, there was a spike in sukuk issuance by participation banks. As at end-2016, sukuk made up approximately 3% (or USD865.3 million) of the private sector’s bond issuance (refer to Chart 4.48).

Chart 4.48: Turkish Private Sector’s Conventional vs Sukuk Issuance

0.00

10.00

20.00

30.00

40.00

50.00

60.00

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 June 2017

USD billion


USD350million

USD973.9million

USD865.3million

Sources: CMB, Bloomberg, Eikon-Thomson Reuters In light of participation banks’ large appetite for Shariah-compliant investments to support liquidity management, the government and the regulators should encourage SOEs and blue-chip companies to issue sukuk. East Asian countries (Malaysia and Thailand) have used tax incentives to make it attractive for the corporate sector to issue bonds in their local markets. Similarly, the Turkish authorities have―over the last decade―taken regulatory and fiscal initiatives to build the necessary ecosystem for a corporate (e.g. utilities-backed companies) bond market to thrive in (as highlighted in Figure 4.14). Nonetheless, additional tax waivers (e.g. removal of withholding tax on investments in debt securities) and the relaxation of rules to allow FCY issuance in domestic markets may facilitate the build-up of a sukuk pipeline.

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Figure 4.14: Regulatory and Fiscal initiatives to Develop Corporate Bond Issuance

ax neutral ty ro ded or all su u structures t a la a end ent

o un ue on ortgage co ered bond er es III o

o un ue on asset bac ed secur t es er es III o

taxes on B and I reg strat on ees el nated

o un ue regard ng debt secur t es er es II o

o b n ng ar ous debt secur t es co un ue under s ngle rul ng er es III o

o un ue on r nc les regard ng asset co ered secur t es er es III o

o un ue on lease cert cates er es III o

t old ng taxes reduced to e u alent to go ern ent bonds

B A gu del ne to allo ur s ban s to ssue bonds

o un ue on t e r nc les regard ng ara cert cates and A s er es III o

ax A nesty a a o to allo tax neutral ty or lease cert cates

ett ng u a robust regulatory ra e or

A end ent to t e a on egulat ng ubl c nance and ebt anage ent a o

cut n ees by B to ncent se cor orate su u ssuance

anges t regards to taxat on and ees to lo er ssuance costs

Sources: CMB, BRSA *Note: In June 2016, CMB announced a 50% discount in registration fees which are charged from public offerings, sukuk issuances and issuances of real-estate certificates (Source: Growth Strategy Update 2016).


Analysis of Sukuk Structures Availability of eligible assets remains at the forefront in driving the choice of sukuk structures. For sovereign and private sector sukuk, issuances have been mostly structured based on the wakalah and ijarah concepts (refer Table 4.22). Figure 4.15 delineates the types of sukuk structures approved by the Communiqué.

Table 4.22: Turkish Private Sector’s Sukuk Issuance by Type of Shariah Structure Type of sukuk structure/ (USD million) 2013

2014

2015

2016

June 2017

Based on management contract (wakalah sukuk) 278.8 1,152.4 848.9 792.4 655.1 Based on ownership (covered ijarah sukuk)

565.4 672.2 175.5 56.7 14.2

Based on partnership contract (musharakah)

- - - - 118.0

Trading-based contract (murabahah/tawarruq sukuk)

- 250.0 226.3 124.8 78.0

Total 844.2 2,074.7 1,250.7 973.9 865.3 Source: Undersecretariat of Treasury

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Figure 4.15: Types of Lease Certificates Approved by the Communiqué

Source: Communiqué on lease certificates, CMB Note: Issuance under ownership-based lease certificates and partnership-based lease certificates require 90% of the fair value of the assets and rights to determine the issuance limit.

Based on historical lease certificate issuances, ALCs were established by banks and financial intermediaries. Some of the lease certificates issued by the ALCs are originated by corporates that use the ALCs as a funding conduit. This has raised solvency questions from investors where one ALC has several lease certificate issuances that have multiple originators. According to the Communiqué, ALCs are allowed to purchase assets from different source companies. A mandatory pre-emption right in favour of the source company is created in the land registry when the assets are transferred to the ALCs. To protect the interest of investors, a provision in the articles of association of the ALCs states if a commitment to the lease certificate holders is not fulfilled, then the assets behind the lease certificates shall be sold and the sale proceeds shall be distributed to lease certificate holders on a pro-rata basis according to their investments. There are other governing restrictions imposed on the operations and activities of the ALCs. Table 4.23 lists the number of lease certificates issued by corporates from 2010 to August 2017.

146

Table 4.23: Number of Lease Certificates Issued by Corporates (2010-August 2017)

Issuer 2011 2013 2014 2015 2016 Aug 2017

Total

Aktif Bank Sukuk Varlik Kiralama AŞ - 2 2 2 3 9 18 Aktif Yatirim Bankasi IFM Istanbul Finans Merkezi Insaat Taahhut GAP Insaat Yatirim ve Dis Ticaret

- - -

- 2 -

1 1 -

2 - -

3 - -

8 -

1

14 3 1

Asya Varlik Kiralama AŞ - 5 4 - - - 9 Bankasya - 5 4 - - - 9

Bereket Varlik Kiralama AŞ - - 1 - 4 7 12 Albaraka Turk Katilim Bankasi - - 1 - 4 7 12

Halk Varlik Kiralama AŞ - - - - - 1 1 Halk Gayrimenkul Yatirim Ortakligi - - - - - 1 1

Kabtek Varlik Kiralama AŞ - 1 - - - - 1 Kablotek Kablo Sanayi Ve Ticaret - 1 - - - - 1

Katilim Varlik Kiralama AŞ - - - - - 2 2 Zorlu Enerji Elektrik Uretim - - - - - 2 2

KT Kira Sertifikalari Varlik Kiralama AŞ - 1 6 24 14 15 60 Kuveyt Turk Katilim Bankasi - 1 6 24 14 15 60

KT Sukuk Varlik Kiralama AŞ 1 - - - - 2 3 Derindere Turizm Otomotiv San Ve Tic Kuveyt Turk Katilim Bankasi Toprak Mahsulleri Ofisi

- 1 -

- - -

- - -

- - -

- - -

1 -

1

1 1 1

TF Varlik Kiralama AŞ - 1 7 12 10 14 44 Turkiye Finans Katilim Bankasi Turkiye Finans Katilim Bankasi (Fon Kullanicisi Cetin Civata)

- -

1 -

5 2

12 -

10 -

14 -

42 2

TFKB Varlik Kiralama AŞ - - 1 2 - - 3 Gama Guc Sistemleri Muhendislik Ve Taahhut Tirsan Treyler Sanayi Ve Ticaret Zorlu Holding

- - -

- - -

- 1 -

1 -

1

- - -

- - -

1 1 1

Vakif Varlik Kiralama AŞ - - - - - 7 7 Vakif Katilim Bankasi - - - - - 7 7

Ziraat Katilim Varlik Kiralama AŞ - - - - 3 9 12 Ziraat Katilim Bankasi - - - - 3 9 12

Grand Total 1 10 21 40 34 66 172 Source: CMB

Analysis of Sukuk Issuances – Supply (Sell Side) The basic building block of a robust domestic bond market is the development of a sustainable supply of domestic debt securities from both the public and private sectors. Key to this is the establishment of a sovereign benchmark yield curve. Benchmarks play a crucial role in the efficient functioning of the primary and secondary bond markets. The development of a liquid sovereign benchmark is essential towards improving the liquidity of the bond market and providing a risk-free yield curve. The Turkish government and regulators have done well in making available different maturities for sovereign conventional and sukuk issues, as depicted in Chart 4.49. Nonetheless, Turkey needs to diversify the funding sources for corporates and reduce their over-reliance on bank credit. A well-functioning corporate bond market will enable banks and

147

corporates to tap the capital markets and potentially optimise their financing costs. Direct funding via corporate bonds also reduces the need for foreign funding and renders the economy less vulnerable to external shocks. Bond markets contribute to financial stability by spreading credit risks across the economy while shielding the banking sector in times of stress. The average coupon rate on corporate debts issued since 2015 comes up to 12.1%, compared

to 11.1% for short-term deposits and 10.4% for 2-year government bonds.7

Chart 4.49: Turkey 10-Year Sovereign Bond Yield

Sources: Undersecretariat of Treasury, Trading Economics

In Turkey, the pioneers in the domestic corporate bond market are banks, factoring companies and financial intermediaries. Corporates that enter the bond market are priced above the sovereign benchmark, according to their risk premium. This risk premium can be measured based on the credit rating of the company. In Turkey, credit rating is not mandatory for the issuance of debt securities. Nevertheless, the majority of Turkish issuers have credit ratings. The bulk of sukuk has been originated by Turkish participation banks for liquidity management purposes, and some as funding conduits for leasing companies. To date, only the sukuk issued by Aktif Bank Sukuk Asset Leasing Company, a subsidiary of Aktif Bank in 2013 has been used for project financing―the development of the Istanbul International Financial Centre. The 1-year sukuk with a nominal amount of TL100.0 million had been 3 times over-subscribed. The government needs to make more concerted efforts to identify potential sukuk champions from among SOEs or GLCs to raise sukuk and provide the necessary benchmark yield curves to support other corporate issues. Table 4.24 gives a snapshot of benchmark corporate issuances in Turkey.

7 Turkey corporate bonds need a rescue plan, Bloomberg, 24 August 2017

%

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Table 4.24: A Snapshot of Benchmark Corporate Sukuk Issuances in Turkey

Sukuk issuer KT Kira Sertifikaları Varlık Kiralama A.Ş.

KT Sukuk Company Limited

TF Varlik Kiralama A. Ş.

Originator Kuveyt Turk Participation Bank

Kuveyt Turk Participation Bank

Türkiye Finans Participation Bank

Currency format Ringgit US Dollar Ringgit

Structure Wakalah Ijarah Murabahah

Obligor/sukuk ratings

AA3 (RAM) BBB- (Fitch) AA3 (RAM)

Sukuk assets Shariah-compliant commodities

Shariah-compliant commodities

Shariah-compliant commodities

Purpose To be used for general corporate and funding purposes

To boost the company’s capital

To be used for general corporate and funding purposes

Issue date 31 March 2015 17 February 2016 30 June 2014


Maturity 31 March 2025 17 February 2026 30 June 2034

Amount RM2 billion USD350 million RM3 billion


5.72% 7.90% 6.0%

Listing n.a Irish Stock Exchange n.a


Malaysia n.a Malaysia

Sources: RAM, Kuveyt Turk

Analysis of Sukuk Investments – Demand (Buy Side) High inflation (as described in Box 4.13) and an unstable macroeconomic environment have in the past limited the growth of domestic institutional investors. According to the IMF Report, as indicated in Chart 4.50, Turkey’s saving rate is considerably lower than the global average (IMF, 2016). Although the private sector’s savings rate had averaged 18% of GDP between 1998 and 2003, it has stayed below 13% since 2010. The public savings rate stands at around 3% while the investment rate has increased, from 17% in 2002 to 20% in 2014. Given this, domestic savings―both public and private―no longer cover investments, thereby opening a large gap between savings and investments and, in turn, a current-account deficit.

149

Chart 4.50: Turkey’s Historical Savings (as a Percentage of GDP) and Savings Rates

Sources: IMF calculations, Central Bank of the Republic of Turkey (CBRT), IMF World Economic Outlook (WEO)

In August 2016, the Turkish pension system underwent a change to automatically enroll the working population in a private pension scheme. As at end-2016, the base of contributors had increased to 6.6 million people, with a corresponding surge in participants’ funds to TL60.8 million (+26.7% from TL48.0 million a year earlier, including state contributions) (refer to Box 4.14). Given Turkey’s young population and rising income levels, the private pension system, investment funds and insurance/takaful market offer considerable potential. Box 4.15 gives an overview of investment funds industry in Turkey.

Box 4.13: Turkey’s Historical Inflation Rate The Turkish economy has had a long history of rampant inflation. Major reforms by the government in 2002 and responsible fiscal management have brought down its inflation levels. According to the latest forecast by the CBRT, however, the projected inflation rate for 2017 has been revised to 8.7%, driven up by higher food prices. Prices of food, which makes up a fifth of the inflation basket, rose more than 14% in June 2017. At month-end, the inflation rate stood at 10.9%, as depicted below.

Source: Turkish Statistical Institute

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Box 4.14: Turkey’s Pension System

The private pension system is regulated and supervised by the Undersecretariat of Treasury and CMB. The Turkish private pension system law was first approved in 2001 and started functioning in 2003. In August 2016, the Turkish Parliament approved an amendment to the law governing individual pension savings and the investment system. Based on the amended law, the pension system will incorporate an integrated automatic enrolment practice, commencing January 2017. Participating employees have the right to withdraw from the pension plan within 2 months from the date when the employer notifies the employee of its involvement in the pension plan. If the employee withdraws from the pension plan, contributions will be returned to them within 10 days, together with investment income, if any. To encourage the working population, the employee will receive a state subsidy in their pension accounts, at a rate of 25% of their paid contributions. Additional incentives have been provided to Turkish working individuals to remain in the system.

Fact sheet End-2016 Participants 6,627,025 Pension Mutual Funds (TL)

53,409,391,715

State Contribution Funds (TL)

7,438,179,620

Intermediaries 39,680 Pension companies 18

Notably, 7.8 million contracts were in force as at end-2016. The number of participants had grown to around 10% and exceeded 6.6 million when compared annually. Within the same period, the total net asset value of the funds surged 24% to TL53.4 billion.

Source: Pension Monitoring Centre (2017, July)

Box 4.15: Turkey’s Investment Funds Investment funds are the pool of asset which is established by portfolio management companies under the fund rules in conformity with the fiduciary ownership principles on the account of the savers, with money or other assets gathered from savers pursuant to the provisions of the CMB Law in return for fund units in order to operate the portfolio or portfolios consisting of assets and transactions specified by CMB Communique. Umbrella fund is the investment fund covering all funds the units of which are issued under a single fund rules. Investment funds are required to be founded in the form of an umbrella fund. Umbrella funds may be founded in ten types which are listed in Communique. According to portfolio sizes of investment funds looking at the distribution of fund types, “Debt Instruments Investment Funds” and “Money Market Funds” constitute 82% of investment funds total portfolio size at end-2016. Debt Instruments Funds are which at least 80% of the fund net asset value is permanently invested in public and/or private sector debt instruments. Money Market Funds wholly and permanently invest in highly liquid money and capital market instruments with maximum 184 days to the end of maturity, and the daily calculated weighted average maturity of portfolio of which is maximum 45 days.

Fact sheet End-2016 Investment Funds (TL billion)

43,755,33

Investment Funds (Number)

433

Investors 3,089,530

The total net asset value of the funds had grown to 12% to TL 43,75 billion when compared annually.

Source: CMB (2016)

Due to the small base of domestic institutional investors (insurance companies, pension funds, investment funds and other collective investment schemes), the funding of domestic government debt has largely been sourced from corporates, financial institutions and foreign

151

investors. As a result, short- to medium-term appetite has driven the maturity profiles (average tenures of less than 5 years) of debt securities issued in Turkey. Greater participation by NBFIs (e.g. pension funds, asset fund managers, insurance/takaful operators) that have long-term assets to match the long-term financing requirements of the government/corporates will facilitate the issuance of long-dated papers. Chart 4.51 illustrates the categories of investors for Turkey’s domestic government debt securities.

Chart 4.51: Domestic Government Debt – Classification by Holder (2006 To 2016)

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Foreign holders

CBRT

Securities mutual funds

Corporate investors

Retail investors

Development and investment banks

Foreign banks

Private banks

Public banks

18%

17%

26%

19%

10%


4.5.4 KEY FACTORS UNDERPINNING TURKEY’S SUKUK MARKET

The growth of Turkey’s sukuk market has been predominantly driven by sovereign issuances and participation banks. Concerted efforts in the areas, as shown in Figure 4.16, underpin Turkey’s progress in turning its sukuk market into viable financing solutions, to support the country’s budget deficits and participation banks’ funding requirements. However, additional measures need to be in place to heighten the appeal of sukuk in attracting more private sector issuers. Since the inception of the sukuk market in 2010, Turkey has made commendable progress in contributing to the growth of global sukuk issuance. Nonetheless, there is still room for improvement vis-a-vis accelerating the development of its sukuk industry. Figure 4.17 highlights the stages of progress made and its growth potential as a financing alternative in funding economic development.

152

Figure 4.16: Key Factors Underpinning the Growth of Turkey’s Sukuk Market

Through a law amendment, tax neutrality (i.e. removal of sales tax, value added tax, stamp tax, registry fee, etc) was provided for all sukuk structures.

Earnings from ijarahcertificates issued onshore (regardless of maturity) will not be taxed for a corporation but individuals incur 10% income tax.

A varying rate of 0% to 10% is applicable on income generated from the issuance of offshore sukuk.

Taxation

ue to ur ey’s c l la en ron ent a ded cated o un u on lease cert cates as ado ted along t t e establ s ent o A

ar a go ernance s currently on tored by t e art c at on ban s’ ar a co ttee

o re ens eness o t e o un u s related to su u ssuance broug t clar ty and gu dance on structur ng and roduct nno at on

tr ct o erat ons o t e A s bel e ed to ro de ade uate n estor rotect on and trans arency n ter s o d s ute resolut on or ban ru tcy rocesses

Issues of macroeconomic instability has brought ouse olds’ ealt creat on residing outside the financial market (e.g. gold, rest estate, etc).

B’s launc o a gold indexed ijara sukuk attempts to encourage the growth of savings within the financial system.

In support of developing a healthy corporate sukuk pipeline (from varying sectors), a clear value proposition must be created from the beginning.

Diversified market players in supply &

demand sides

reat on o A s l ted to certa n ent t es Barr ers to t e creat on and unct on o A s are re ent ng ot er cor orates ro ssu ng su u

e o un u does not ose a andatory cred t rat ng on ur s or do est c ssuances t so e exce t ons or nternat onal ssuances but n estor re erence ay nder so e ur s cor orates t at cannot secure a des rable rat ng

e ur s Go ern ent and regulators a e done ell n a ng a a lable d erent atur t es o so ere gn su u or y eld benc ar ng

art c at on ban s a e also been act e n creat ng t e r ate sectors’ benc ar y eld cur e

Market & Infrastructure Development

Legal & RegulatoryFramework

Sources: RAM, ISRA

153

Figure 4.17: Phases of Islamic Finance’s Inclusion in Turkey’s Financial Landscape

Sources: RAM, ISRA 4.5.5 COUNTRY-SPECIFIC RECOMMENDATIONS

In developing the recommendations for Turkey, we have reviewed the challenges faced by its sukuk market, as depicted in Chart 4.52. It ranks highest in tax neutrality while other factors require further development. Tables 4.25 and 4.26 propose key recommendations to support the progressive build-up in creating an ecosystem that is envisaged to drive the supply of and demand for sukuk.

154

Chart 4.52: Factors Influencing the Development of Turkey’s Sukuk Market

Sources: RAM, ISRA


Issues and challenges Demand (buy side) opportunities Capital market intermediation remains insignificant.

Macroeconomic instability (i.e. volatility of local currency, high inflation rate) have led to households investing their savings intangible assets (e.g. gold, real estate) and FCY. The Government plays a pertinent role in building institutional funds. Concerted efforts should be undertaken to develop wealth within the domestic financial system, which will take time considering the current market conditions.

Bonds issued have average maturities of between 3 and 5 years.

Capital markets allow intermediation of long-term funds to match the need for long-term financing. Identifying suitable candidates from among SOEs or GLCs to finance project-based sukuk can provide the necessary benchmark yield curves to support other corporate issues.

Retail investors prefer to invest in gold and real estate.

Encourage the government, SOEs and corporates to issue retail sukuk linked to infrastructure projects. Establish new products to tap Turkey’s religious funds (hajj fund, zakat, waqf) with financing linked to direct financing of the government’s infrastructure projects.

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Issues and challenges Demand (buy side) opportunities Withholding tax LCY issuance

Revenues that real person resident and non-resident taxpayers generate from lease certificate trading and coupon payments are subject to a withholding of 10% on income tax

FCY issuance

Earnings from offshore lease certificate issued with a maturity of one year

10%

Earnings from offshore lease certificate issued with a maturity of one and three years

7%

Earnings from offshore lease certificate issued with a maturity of three to five year

3%

Earnings from offshore lease certificate issued with a maturity of up to five year

0%

Under the Tax Amnesty Law 2011, ALCs are exempted from value-added tax on transfers of assets backing the lease certificates, stamp duty on the conveyancing of assets, duties/fees arising from title-deed transfers and corporate tax. This includes the waiver of withholding tax for longer-dated debt securities with maturities of not less than 5 years. Removal of withholding taxes on lease certificates will facilitate a greater flow of investments into Turkey’s capital markets and improve intermediation by NBFIs.

Sources: RAM, ISRA


Issues and challenges Supply (sell side) opportunities The dearth of investment instruments for participation banks’ liquidity management has resulted in an uneven playing field.

Growing demand from participation banks can be met by public and corporate issuances. Efforts should be made to promote SOEs, GLCs and blue-chip corporates. Specific focus on utilities-backed companies (e.g. telecommunication, electricity, water, power) or corporates with infrastructure projects (e.g. municipality company).

Limitations and/or restrictions on the capital markets.

Revision of regulations to allow: Multinationals operating in Turkey to issue TL bonds. Issuance of FCY bonds in the domestic bond market since Turkish financial institutions are allowed to lend in FCY.

Sources: RAM, ISRA

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4.6 HONG KONG

4.6.1 OVERVIEW OF HONG KONG’S CAPITAL MARKETS Hong Kong has robust capital markets that provide a platform to global investors from Asia, particularly China, as well as other parts of the world. Notably, Hong Kong is touted as: (i) a global financial centre, including a vibrant international bond market and as the world’s leader in equity funding; (ii) an international asset-management centre; and (iii) a global offshore renminbi (RMB) business hub (Hong Kong: China’s Global Financial Centre). Hong Kong is one of the world’s leading international financial centres (IFCs), with the highest Financial Development Index score. It prides itself as the world’s most competitive and freest economy. Box 4.16 describes the high ranking position held by Hong Kong in various international reports. Box 4.16: Hong Kong Ranks among the Top 5 IFCs

Hong Kong ranked third among well-established IFCs in 2017, after London and New York, and first in Asia ahead of Singapore. In the last 10 years (2007-2017), it has been competing with Singapore for the third and fourth positions, followed by Tokyo at the fifth position, as reported by various reports in the following table.

Rank

2017 Global

Financial Centres

Index 22

Financial Development

Index 2012

2017 Index of

Economic Freedom

Economic Freedom of the World:

2017 Annual Report

World Bank Doing

Business 2017

IMD World Competitiveness Yearbook 2017

1 London Hong Kong Hong Kong Hong Kong New Zealand Hong Kong 2 New York United States Singapore Singapore Singapore Switzerland 3 Hong Kong United Kingdom New Zealand New Zealand Denmark Singapore 4 Singapore Singapore Switzerland Switzerland Hong Kong United States 5 Tokyo Australia Australia Ireland Korea Netherlands

Sources: The Global Financial Centres Index 22 (2017), Financial Development Index (2012), Index of Economic Freedom (2017), Economic Freedom of the World: Annual Report (2017), World Bank Doing Business Report (2017), World Competitiveness Yearbook (2017) In the 2017 Global Financial Centres Index, Hong Kong was ranked the third most competitive financial centre in the world in the areas of business environment, human capital, infrastructure and financial development, and second in terms of reputation. It also stood among the top 5 IFCs in banking, investment management, insurance, professional services, and government and regulatory as highlighted in the below tables.

Area of Competitiveness Rank Business

Environment Human Capital Infrastructure Financial Sector

Department Reputation

1 London London London London London 2 New York New York New York New York Hong Kong 3 Hong Kong Hong Kong Hong Kong Hong Kong Singapore 4 Singapore Singapore Singapore Singapore New York 5 Shanghai Shanghai Shanghai Shanghai Tokyo

Source: The Global Financial Centres Index 22 (2017:8)

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Industry Sector Sub-Indices

Rank Banking Investment Management

Insurance Professional Services

Government and Regulatory

1 London London Shanghai London London

2 New York New York Hong Kong New York New York

3 Hong Kong Hong Kong New York Hong Kong Singapore

4 Singapore Singapore London Singapore Hong Kong

5 Shanghai Shanghai Singapore Shanghai Beijing

Source: The Global Financial Centres Index 22 (2017: 30) For more than a century, Hong Kong has served as a gateway for Mainland China. As a forerunner in international finance, Hong Kong can bank on its sophisticated financial infrastructure to provide investors with exposure to China’s different market segments and access to its expanding wealth. For instance, investors that wish to access China's property market can make use of the REITs listed in Hong Kong, with underlying exposures to properties in Mainland China. In turn, it serves as the wealth-management centre for the increasingly affluent residents of Mainland China and Asia. Hong Kong ranked third in investment management, after London and New York, in the 2017 Global Financial Centre Index. Hong Kong’s international bond market is characterised by vibrant activities and global issuers. It offers open access to both domestic and international issuers and investors, in domestic and foreign currencies. Offshore RMB bond issuance (also known as dim sum bonds) is becoming increasingly more significant, which renders Hong Kong one of the most frequented international bond markets in Asia (Financial CBonds Information). Besides, Hong Kong is the first venue outside China to have developed an RMB bond market, attracting issuers such as the government, enterprises and financial institutions from Hong Kong, Mainland China and different parts of the world. Relative to GDP, as shown in Box 4.17, Hong Kong’s bond market ranked seventh among the Asian bond markets as at end-2016, after Japan, South Korea, Malaysia, Singapore and Thailand. Chart 4.53 shows the increasing bond issues in Hong Kong by the government, quasi-government entities and corporates, from USD43.8 million in 2006 to USD414.7 million in 2016.

158

Box 4.17: Size of Selected Asian Debt Markets as at end-2016 (USD billion) Development of Hong Kong’s bond market The steady growth in bond issuances over the years demonstrates the healthy development of Hong Kong’s bond market. The broad investor base in Hong Kong has been attracting more issuers to expand their funding scale using the local debt market. The market offers open access to both domestic and international issuers and investors, in both domestic and foreign currencies. The Hong Kong Monetary Authority (HKMA) continues to support the sustainable development of the local bond market through the Government Bond programme involving institutional bond issuances as well as retail issuances such as the inflation-linked retail bond (iBond) and the inflation-linked Silver Bond which targets Hong Kong residents aged 65 and above. Apart from the Hong Kong dollar bonds, two US dollar sukuk issues were also outstanding as at 2016.

Corporate bond

market

Government bond

market

Total


Size of selected debt markets relative to GDP (as at end-2016)


Chart 4.53: Bond Issuance in Hong Kong (2006-June 2017)

Source: Bloomberg

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In July 2017, Bond Connect was launched to further promote the development of the bond markets between Hong Kong and Mainland China. Bond Connect is a new mutual market access scheme that allows investors from Mainland China and overseas to trade in each other's bond markets, through connections between the related Chinese and Hong Kong financial infrastructure institutions. Bond Connect is expected to strengthen Hong Kong’s position as the financial securities gateway to Mainland China, allowing overseas investors to trade onshore bonds from Hong Kong. Bond Connect may also be the gateway for Hong Kong to become the global Islamic finance centre, as it has been actively issuing sukuk since 2014; it introduced a 10-year sukuk in February 2017. The UNCTAD World Investment Report 2017 has labelled Hong Kong as a highly attractive market for FDI. Global FDI to Hong Kong amounted to USD108 billion in 2016, placing it in the fourth position globally, behind Mainland China (USD 134 billion). Hong Kong also ranks seventh among the world’s top stock exchanges, and third among Asia’s stock exchanges based on market capitalization as at end-June 2017, as shown in Table 4.27.

Table 4.27: Market Capitalization of the World’s Top Stock Exchanges Worldwide

Ranking Ranking in Asia

Market Capitalization (USD billion)

US (NYSE Euronext) 1 20,658.99 US (Nasdaq) 2 8,745.95 Japan (Japan Exchange Group) 3 1 5,501.98 China (Shanghai) 4 2 4,536.96 Europe (NYSE Euronext) 5 4,034.23 UK (London Stock Exchange Group) 6 4,004.81 Hong Kong 7 3 3,674.30 China (Shenzhen) 8 4 3,347.50 Canada (Toronto) 9 2,128.06 Germany (Deutsche Borse) 10 1,993.80 Source: Bloomberg, World Federation of Exchanges (WFE)

In December 2016, Hong Kong introduced its second Stock Connect with Mainland China. Since then, stocks have been recording higher turnovers. Stock Connect strengthens the Stock Exchange of Hong Kong as the number of IPOs in 1Q 2017 is the highest in more than 2 decades (KPMG, 2017), reflecting strong demand in the primary market. This scheme gives Hong Kong an opportunity to be the “super connector” between China and the world. Overall, Hong Kong features as a strong IFC, with a financial sector that is much larger relative to its size and population; it is also dominated by international companies. Hong Kong largely focuses on developing its capital markets to attract international issuers and investors, particularly serving as a prime regional centre that facilitates market access for Mainland China. Table 4.28 summarises Hong Kong’s global position and in Asia.

160

Table 4.28: Hong Kong’s Financial Position in Selected Areas Worldwide Ranking Ranking in Asia International financial centre* 3 1 Stock market** 7 3 Bond market*** n/a 7

* Source: Global Financial Centres Index (2017) ** Based on market capitalization as at end-June 2017 *** Source: Asian Bonds Online, RAM

4.6.2 DEVELOPMENT OF THE SUKUK MARKET IN HONG KONG

Hong Kong had the foresight to identify the booming potential that Islamic finance had in the mid-2000s. It had then sought to leverage its strengths as an IFC and world-class asset-management centre, to promote the development of the ICM. As Hong Kong has a relatively small Islamic community (only 0.1% of its total population, according to PEW Research Forum 2009), its strategy of venturing into wholesale Islamic financial activities was entirely deliberate. This was in line with its strategy of expanding its overall capital markets. On the one hand, as an IFC it wishes to consolidate its status by diversifying its financial products and services. On the other, as a forerunner in international finance that possesses key strengths in financial intermediation, it aims to bring together investors and fund raisers from China, the Middle East and other parts of the world through its sukuk platform, to match their fundraising and investment needs. Leveraging its connection with Mainland China, Hong Kong plays the role of a capital-raising centre to assist Chinese issuers to access the international markets and expand their Islamic investor bases. Concurrently, it aims to provide opportunities to Islamic investors from the Middle East and other regions to partake in the rapid economic growth of Mainland China and other Asian countries. As an IFC, it acts as a financial intermediary in the conventional market. With its endeavours to develop Islamic finance, Hong Kong will hone its competitive edge to serve the Islamic finance market. Table 4.29 provides a brief outline of the efforts made by the Hong Kong government in developing its ICM, particularly the sukuk market.

Table 4.29: Timeline of the Development of Hong Kong’s ICM/Sukuk Market Year Timeline description

2007

The Chief Executive of the Hong Kong Special Administrative Region identified the vast potential of Islamic finance in his 2007-2008 Policy Address and highlighted the government’s aim of leveraging this new trend of Islamic finance development to establish an Islamic financial platform in Hong Kong. This was to further consolidate Hong Kong’s position as a global financial centre. In particular, the following initiatives were noted: Promote Hong Kong’s financial services to major Islamic countries and regions. Develop an Islamic bond market.

To accomplish these goals, the Hong Kong Monetary Authority (HKMA) set up a dedicated team in collaboration with the financial sector, to study the relevant issues and make recommendations on the introduction of Islamic debt offerings in Hong Kong (The 2007-2008 Policy Address).

2008

Memorandum of Understanding (MOU) signed between the HKMA and the Dubai International Financial Centre Authority (DIFC Authority) on 20 May 2008, to foster co-operation in the development of Shariah-compliant financial products and the financial infrastructures in their respective jurisdictions (Press Release, HKMA, DIFC Authority, 2008).

161

Year Timeline description

2009 MOU signed between the HKMA and BNM in September 2009, to strengthen co-operation in

Islamic finance, particularly the development of human capital and financial infrastructure and the promotion of cross-border financial activities.

A mutual recognition agreement was inked by the Hong Kong Securities and Futures

Commission with the SC in November 2009, to facilitate the cross-border offering of Islamic funds.

2013

A previous study conducted by the Hong Kong government and the Treasury Management Authority had found that there was no major legal or regulatory obstacle against Islamic financial transactions in Hong Kong. However, to facilitate sukuk transactions and provide a level playing field between sukuk and conventional bonds, there was a need to refine the tax regime in Hong Kong.

In July 2013, the Inland Revenue and Stamp Duty Legislation (Alternative Bond Schemes) (Amendment) Ordinance 2013 was enacted by the Legislative Council, to establish a comparable taxation framework for sukuk and bonds.

2014 Enactment of the Loans (Amendment) Ordinance 2014 by the Legislative Council in March

2014, to enable the issuance of sukuk under the Government Bond Programme.

Source: Based on Speeches and Press Releases published by HKMA

Shortly after the 2007-2008 Policy Address that iterated Hong Kong’s aim of establishing an Islamic finance platform, the first Islamic fund was introduced by a local bank in Hong Kong in last 2007, to track the performance of the Dow Jones Islamic Market China/Hong Kong Titans Index. In May 2008, a new Dow Jones Islamic Market Index was launched, to track China-related equities listed on the Hong Kong Stock Exchange (Lau, 2008). To date, there has not been any significant activity in Hong Kong’s ICM, although the government has made efforts to kick-start its sukuk market. As of October 2017, the Government of Hong Kong had issued 3 sovereign sukuk, as noted in Figure 4.18. Figure 4.18: Hong Kong’s Sovereign Sukuk Issuances (2014-2017)

Source: ISRA

4.6.3 ANALYSIS OF SUKUK STRUCTURES, ISSUANCES AND INVESTMENTS

By entering the sukuk market, Hong Kong’s government is able to showcase its Islamic financial platform to local and international issuers and investors. Its second and third issuances have further built momentum in the sukuk market and demonstrated that Hong Kong has a viable and flexible sukuk platform, which can attract international issuers and investors. In 2014, it was among the sovereigns issuing their maiden sukuk, besides the UK

162

and Luxembourg. Since 2014, Hong Kong has issued 2 more international sukuk (in 2015 and 2017), both of which have proven successful, attracting AAA ratings by S&P, oversubscription in orders received, and a diverse range of investors. Details on the Government of Hong Kong’s sukuk issuances are provided in Table 4.30.

Table 4.30: Overview of Hong Kong Government’s Sukuk Issuances

SPV issuer Hong Kong Sukuk 2014 Limited

Hong Kong Sukuk 2015 Limited


Obligor Hong Kong SAR Government

Hong Kong SAR Government

Hong Kong SAR Government

Currency/format USD USD USD Structure Ijarah Wakalah Wakalah Sukuk ratings AAA (S&P)

Aa1 (Moody’s) AAA (S&P) Aa1 (Moody’s)

AAA (S&P) AA+ (Fitch)

Sukuk assets Selected units in 2 commercial properties in Hong Kong

A third of assets underpinned by selected units in an office building in Hong Kong; the other two-thirds underpinned by Shariah-compliant commodities

A third of assets underpinned by selected units in an office building in Hong Kong; the other two-thirds underpinned by Shariah-compliant commodities

Use of proceeds As purchase price for the assets pursuant to the purchase agreement. The proceeds received by the FSI will be credited to the Bond Fund (set up pursuant to resolution (Cap. 2S) passed on 8 July 2009 under section 29 of the Public Finance Ordinance (Cap. 2)) and then placed with the Exchange Fund.

No less than 34% as the purchase price for the Lease Assets pursuant to the Purchase Agreement; the remainder of not more than 66% for the acquisition of commodities to sell to the HKSAR Government pursuant to the Murabahah Agreement. The proceeds received by the FSI will be credited to the Bond Fund (set up pursuant to resolution (Cap. 2S) passed on 8 July 2009 under section 29 of the Public Finance Ordinance (Cap. 2)) and then placed with the Exchange Fund.

No less than 34% as the purchase price for the Lease Assets pursuant to the Purchase Agreement; the remainder of not more than 66% for the acquisition of commodities to sell to the HKSAR Government pursuant to the Murabahah Agreement. The proceeds received by the FSI will be credited to the Bond Fund (set up pursuant to resolution (Cap. 2S) passed on 8 July 2009 under section 29 of the Public Finance Ordinance (Cap. 2)) and then placed with the Exchange Fund.

Facility tenure 5 years 5 years 10 years Issuance date 11 September 2014 3 June 2015 28 February 2017 Maturity date 11 September 2019 3 June 2020 28 February 2020

https://www.sukuk.com/sukuk-new-profile/hong-kong-sukuk-2017-limited-5053


163

SPV issuer Hong Kong Sukuk 2014 Limited



Amount USD1 billion USD1 billion USD1 billion Profit rate 2.005% 1.894% 3.132% Order book Oversubscribed 4.7

times with USD4.7 billion of orders received.

Oversubscribed 2 times with USD2 billion of orders received.

Oversubscribed 1.72 times with USD1.72 billion of orders received

Listing Hong Kong Stock Exchange Bursa Malaysia Nasdaq Dubai/DFM

Hong Kong Stock Exchange Bursa Malaysia Nasdaq Dubai/DFM

Hong Kong Stock Exchange Bursa Malaysia (Exempt Regime) Nasdaq Dubai

Arrangers CIMB Islamic HSBC

National Bank of Abu Dhabi Standard Chartered

CIMB Islamic HSBC

National Bank of Abu Dhabi Standard Chartered

CIMB Islamic HSBC National Bank of Abu Dhabi Standard Chartered

Advisors Allen & Overy Norton Rose Fulbright

Linklaters n/a


Middle East (36%), Asia (47%), Europe (6%), US (11%),

Middle East (42%), Asia (43%), Europe (15%)

Middle East (25%), Asia (57%), Europe (18%)

Sources: Sukuk prospectuses for 2014, 2015 and 2017 sovereign issuances, sukuk.com

Analysis of Sukuk Structures As of 2017, Hong Kong had issued 3 sukuk with an issuance size of USD 1 billion each. The structure of the first sukuk is based on the concept of ijarah, which requires underlying tangible assets of at least 100% of the issuance amount. This had been a problem for Hong Kong as the funding cost was too high. It had consequently changed the structure of the second and third sukuk to wakalah, which uses less tangible assets, resulting in a lower funding cost, with a third of the assets underpinned by selected units in an office building in Hong Kong; the other two-thirds were underpinned by Shariah-compliant commodities. According to the Financial Secretary, the government hoped that by adopting a more “asset light” structure in the form of the wakalah structure, it could set a benchmark for potential issuers in the private sector (South China Morning Post, 2015). Analysis of Sukuk Issuances – Supply (Sell Side) The inaugural sukuk, which was issued on 11 September 2014, had a 5-year tenure and received USD4.7 billion of orders from 120 global institutional investors. Of these, 36% were from the Middle East, 47% from Asia, 6% from Europe and 11% from the US. According to investor type, 56% comprised banks and private banks, 30% wealth funds, central banks and supranationals, 11% fund managers and 3% insurance companies. The sukuk was listed in Hong Kong, Malaysia and Dubai. The profit rate came up to 2.005%, with an AAA rating by S&P. An SPV had been established for this particular sukuk, i.e. Hong Kong Sukuk 2014 Limited. The sukuk adopted an ijarah structure, underpinned by selected units in 2 commercial properties in Hong Kong.



https://www.sukuk.com/whos-who/cimb-islamic-165

https://www.sukuk.com/whos-who/hsbc-158

https://www.sukuk.com/whos-who/national-bank-of-abu-dhabi-328


https://www.sukuk.com/whos-who/standard-chartered-306











164

The second sukuk was issued on 3 June 2015. It also had a 5-year tenure with USD2 billion of orders received from 49 global institutional investors. Notably, 42% of this sukuk was distributed to the Middle East, 43% to Asia, and 15% to Europe. Based on investor type, 23% comprised supranationals, central banks or wealth funds while 77% constituted banks, private banks and fund managers. The sukuk was listed in Hong Kong, Malaysia and Dubai. The profit rate came up to 1.894%. Although the structure of this sukuk had been changed to wakalah, it was still rated AAA by S&P.

The third sukuk was issued on 28 February 2017, which made Hong Kong the first AAA-rated government issuing a 10-year sukuk. It received USD1.72 billion of orders from 88 global institutional investors. Of these, 57% hailed from Asia, 25% from the Middle East and 18% from Europe. According to investor type, 53% were banks, 36% fund managers, private banks and insurance companies, and 11% wealth funds, central banks and supranationals. This sukuk also attracted new investors, half of which had not participated in the earlier issuances. This sukuk was listed in Hong Kong, Malaysia and Dubai. It again received an AAA credit rating from S&P. An SPV named Hong Kong Sukuk 2017 Limited had also been established for this issuance. Its profit rate stood at 3.132%, i.e. higher than the 2 earlier sukuk. Compared to the 5-year tenure of the previous 2 sukuk, the third issuance of a 10-year duration extended the yield curve and served as a benchmark for potential issuers in the local market. Analysis of Sukuk Investments – Demand (Buy Side) Unlike other sovereign issuances that are commonly used to finance infrastructure projects or fund governments’ budget deficits, the proceeds from the 3 sukuk issuances by Hong Kong had been used to purchase the underlying assets in the sukuk structures, notably commercial buildings and Shariah-compliant commodities. This reflects Hong Kong’s motive of entering the sukuk market to promote its position as an IFC and broaden its product range, to attract international issuers and investors. The sukuk had been issued to set benchmarks for the industry, and not necessarily to raise financing to fund government projects. 4.6.4 KEY FACTORS UNDERPINNING HONG KONG’S SUKUK MARKET

Hong Kong has leveraged its reputation as an IFC to develop its sukuk market. As an IFC, Hong Kong offers a number of advantages to international investors and issuers, including a transparent, sound and internationally recognised legal and regulatory system, based on English common law; a simple tax system; deep and liquid capital markets; a strong bond market; a listing platform; a large number of international financial intermediaries offering their global expertise; a well-developed financial infrastructure; and a pool of highly trained professionals. With respect to sukuk, Hong Kong offers specific competitive advantages such as the government’s full support in promoting the sustainable development of the sukuk market, the AAA rating of the Hong Kong government, and its ability to leverage on the strong presence of international financial intermediaries and their Shariah experts to develop and structure a variety of Shariah-compliant products. Figure 4.19 describes the key factors underpinning Hong Kong’s sukuk market in terms of legal, regulatory, taxation and technical issues.

165

Figure 4.19: Key Factors Underpinning the Growth of Hong Kong’s Sukuk Market

Sources: RAM, ISRA

Still, Hong Kong is relatively a newcomer in the sukuk market. Its interest in developing a sukuk market only started from 2007. Since then, it has taken the necessary steps to facilitate sukuk issuance. Figure 4.20 briefly delineates the phases of Islamic finance’s inclusion in Hong Kong’s financial landscape. Undoubtedly, Hong Kong still has a long way to go in enhancing its integration in the Islamic finance arena. In the future, it should look at developing a more facilitative environment in the form of tax incentives to attract foreign issuers to utilise its sukuk platform, further improve its Shariah governance, achieve greater diversity in its issuer and investor bases, and examine the possibility of issuing more innovative sukuk, e.g. green and SRI sukuk.

166

Figure 4.20: Phases of Islamic Finance’s Inclusion in Hong Kong’s Financial Landscape

Sources: RAM, ISRA


Some key factors, as depicted in Chart 4.54, have contributed to the development of Hong Kong’s sukuk market. The Hong Kong government scores particularly highly in setting a benchmark yield curve, its existing infrastructure for bond/sukuk issuance, its strong regulatory framework, and its tax-neutrality policy for bonds and sukuk, over and above its favourable tax regime.

167

Chart 4.54: Factors Influencing the Development of Hong Kong’s Sukuk Market

Sources: RAM, ISRA

While Hong Kong’s sovereign issuances have been highly successful, underlining investors’ confidence in its credentials, there are a number of challenges that it still faces in further developing its sukuk market. Based on these challenges, the policy recommendations from the supply and demand sides are briefly outlined in Tables 4.31 and 4.32.


Issues and challenges Demand (buy side) opportunities Market awareness More promotional activities on Islamic finance and

sukuk among stakeholders. Establish collaborative platforms between the regulators and industry players, to settle arising issues and increase awareness on sukuk.

Limited domestic Muslim population Incentives provided through tax rebates for individuals to invest in retail sukuk.

Investor base As a leading global offshore RMB business hub, Hong Kong has the advantage in developing RMB-denominated sukuk products. Previous RMB-denominated sukuk issued in Malaysia had attracted a diverse group of investors, reflecting the strong demand for RMB-denominated sukuk. Hong Kong could take similar initiatives.

Sources: RAM, ISRA

168


Issues and challenges Supply (sell side) opportunities No corporate issuance so far Leverage the strong bond market infrastructure to promote the

sukuk market and attract corporate issuance, both foreign and domestic, in using Hong Kong’s sukuk platform. Provide additional incentives, in the form of tax, easy and flexible incorporation of SPVs, and competitive pricing, to attract corporate issuers.

No retail sukuk market Leveraging the high education levels that prevail in Hong Kong, the government can promote retail sukuk issuance to encourage participation in sukuk by its limited Muslim population and its general population.

Competition from other Islamic financial centres

To attract foreign corporate issuers, Hong Kong should examine the ecosystems in other Islamic financial centres, such as Malaysia, to improve its own sukuk infrastructure.

Competition from other IFCs Hong Kong should examine the infrastructure made available in other reputable IFCs such as the Cayman Islands, London, Luxembourg, Jersey, Bermuda and Labuan, which are deploying competitive strategies to attract Islamic finance business and sukuk structuring in their jurisdictions.

Shariah governance As a secular regulator, Hong Kong still does not have an established Shariah governance framework. Instead, issuers rely on the expertise of their own Shariah boards. This leads to additional structuring costs for issuers. The establishment of an improved Shariah governance structure could instill more confidence among issuers.

Sources: RAM, ISRA

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4.7 NIGERIA

4.7.1 OVERVIEW OF NIGERIA’S CAPITAL MARKETS

The Nigerian capital market has grown significantly since its inception, with a CAGR of 28.4% in 2015. Growth, however, weakened the following year amid policy uncertainties, a shortage of foreign currencies precipitated by the plunge in crude oil receipts, low power generation and weak investor confidence. The expansion of the sub-Saharan African economies also slowed down, from 3.4% in 2015 to 1.6% in 2016, following slow adjustments amid the impact from soft commodity prices, rising inflation and a less supportive global environment (DMO 2016 Annual Report). In 2016, Nigeria’s market capitalization as a percentage of GDP came up to 7% compared to the other developing sub-Saharan capital markets, i.e. 34% for Cote d’Ivoire, 62% for Mauritius, and 322% for South Africa, as noted in Chart 4.55.

Chart 4.55: Market Capitalization as a Percentage of GDP

Source: World Bank

The data in Chart 4.55 indicates that Nigeria’s capital markets are extremely small compared to its regional peers’. Nigeria aspires to become one of the world’s top 20 economies by 2020, through its Vision 20:2020 National Plan. It is a long-term plan that aims to stimulate Nigeria’s economic growth and launch the country onto a path of sustained and rapid socio-economic development. This requires robust capital markets that would effect intermediation and facilitate the meeting of the nation’s capital needs, including mobilising and channeling medium-to-long-term investment funds. To do so, Nigeria’s capital markets must be well positioned and structured. In 2013, a Capital Market Master Plan Committee was formed by Nigeria’s Securities and Exchange Commission (SEC), with the mandate of reviewing the state of its capital markets. The Committee had identified and classified issues under 4 transformation themes―contribution to the national economy, market structure, competitiveness and regulation and oversight―which have in turn led to the launch of Nigeria’s Capital Market Master Plan 2015-2025. The Capital Market Master Plan unveiled in 2015 by the SEC lays out strategic transformation themes, initiatives and recommendations for the growth of the niche market in amid the challenging economic environment (refer to Box 4.18).

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Box 4.18: Nigeria’s 2015-2025 Capital Market Transformation Programme

Nigeria’s capital markets vision:

“To be Africa’s most modern, efficient and internationally competitive market that catalyses Nigeria’s emergence as a top 20 global economy.”

To achieve this vision, 4 major strategic transformation themes have been identified, together with the key objectives under each theme and their recommendations. The 4 strategic transformation themes are:

1. To drive and facilitate capital raising for sustainable national development and transformation of Nigeria’s priority economic sectors, thereby effectively contributing to the national economy.

2. To align the market structure to the requirements of the economy as well as to increase the scale, size and professionalism of all stakeholders.

3. To ensure competitiveness by establishing practices to improve transparency, efficiency and liquidity, and to attract sustainable interest in the capital markets from domestic as well as foreign investors and participants.

4. To create an enabling and facilitative oversight and regulatory framework supportive of the deepening and development of the Nigerian capital markets.

A total of 101 initiatives have been proposed along the lines of the 4 strategic thrusts:

28 initiatives for contribution to the national economy

20 initiatives for market structure 29 initiatives for competitiveness 24 initiatives for regulation and

oversight

Source: SEC (2015a)

The Capital Market Master Plan 2015 identifies an important catalyst in driving the growth of the Nigerian capital market. It aims to make Nigeria the hub for ICM products in the region. To achieve this, 4 strategic initiatives have been ascertained for the SEC:

To work with the Central Bank of Nigeria (CBN), the National Insurance Commission (NAICOM) and the Pension Commission (PENCOM) to establish Islamic investment guidelines.

To develop Shariah-compliant products. To build capacity on Shariah-compliant products (SEC and operators). To develop awareness on Shariah-compliant products and their benefits.

The importance of the ICM is further reinforced by the issuance of a separate master plan for the development of non-interest capital market products (NICMPs)―refer Box 4.19 for details. The overall goal of the NICMP Master Plan 2015 is to contribute to at least 25% of the overall capitalization of the capital markets over the next 10 years (2015–2025). Within 2 years after the launch of the NICMP Master Plan, half of the stipulated recommendations have been implemented by the key regulators, i.e. the SEC, Debt Management Office Nigeria (DMO), the Central Bank of Nigeria (CBN), PENCOM, NAICOM, the Financial Inland Revenue Service (FIRS) and the Financial Dealers Quotation (FDQ).

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Box 4.19: Nigeria’s NICMP Master Plan 2015 – 4 Key Strategies

1. To build a strong regulatory foundation for the NICM

2. To encourage the development of NICM market stakeholders

Strategic Initiatives Strengthen the institutional capacity of the

SEC. Strengthen coordination among the

regulatory authorities within the financial sector.

Continuous review/creation of new rules on NICMPs.

Strategic Initiatives Regulatory authorities to continuously engage

stakeholders on issues relating to the NICM. Conduct robust public awareness and education

programmes on NICMPs. Build the capacity of stakeholders through tailored

courses/programmes/seminars/workshops. Ensure easy entry of market participants into the

NICM.

3. To encourage the development of

NICMPs 4. To create a regional NICM hub

Strategic Initiatives Ensure availability of NICMPs that meet the

regulatory requirements of banks, takaful companies, PFAs, assets managers and other fund/portfolio managers.

Ensure availability of NICMPs that attract retail investors, to achieve financial inclusion.

Regulatory authorities to engage stakeholders in addressing tax issues related to new products.

Strategic Initiatives

Promote and enhance cross-listing of NICMPs.

Promote and enhance multi-currency listing.

Rationalise cost of listing/issuance process of NICMP.

Ensure active promotion of the NICM in the sub-Saharan region.

Enhance the liquidity of NICMPs in the secondary market.

Source: SEC (2015b)

4.7.2 DEVELOPMENT OF THE SUKUK MARKET IN NIGERIA

The Nigerian sukuk market is still at a nascent stage. Africa only accounted for 0.46% of the global sukuk market, with only 619 sukuk issues valued at USD3.33 billion. Out of the 55 countries in the sub-Saharan region, only 7 countries had issued sukuk as at end-October 2017. Nigeria stands out as the third largest sukuk issuer in this region, behind South Africa and Ivory Coast, as shown in Chart 4.56.

Chart 4.56: Nigeria’s Sukuk Issuance vs Africa’s (2008-October 2017)

Source: Bloomberg

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Nigeria has successfully issued 2 sovereign sukuk since 2013. The introduction of the Rules on Sukuk by the SEC had paved the way for its first sukuk―the State Government of Osun ₦11.4 billion ijarah sukuk (Osun State Sukuk). The Osun State Sukuk is part of the Osun State N60 billion Debt Issuance Programme, to fund the development of 20 high schools, 2 middle schools and 2 elementary schools in the state. The tax incentives under this sukuk are key to its oversubscription. The sukuk was taken up by local banks, fund managers, insurance companies and high-net-worth individuals. The tax incentives entitle the sukuk holders to payments that are free from withholding, state and federal income and capital gains taxes, with no deductions at source. In addition, proceeds from the disposal of the Sukuk and stamp duty on its sale or transfer are exempted from taxation. This tax benefit is due to the 10-year tax waiver approved by the federal government in March 2010, which exempts all categories of bonds (including sukuk) issued by all tiers of the government (sub-national and supra-national) and corporate bonds from company income tax, personal income tax, value-added tax, capital gains tax and stamp duties. The successful issuance of the Osun State Sukuk had paved the way for the issuance of Nigeria’s second sukuk. The Federal Government of Nigeria (FGN) ₦100.0 billion ijarah sukuk (FGN Sukuk) was issued in 2017. The proceeds will be used to construct and rehabilitate 25 roads in Nigeria’s 6 geopolitical zones selected by the Ministry of Power, Works and Housing due to their strategic economic importance. Similar tax incentives have been accorded to the FGN Sukuk, which had led to its over sub subscription by investors across a broad spectrum―pension funds, banks, fund managers, institutional and retail players. Further details on the Osun State Sukuk and the FGN Sukuk are described in Table 4.33. There is reportedly another sovereign sukuk in the pipeline; the Nigerian Mortgage Refinance Company (NMRC) plans to issue its first sukuk. The purpose is to source cheaper funding for mortgage refinancing and lighten the interest-rate burden of the ultimate mortgage beneficiaries.

Table 4.33: Overview of Nigeria’s Government Sukuk Issuances SPV issuer Osun Sukuk Company Plc FGN Roads Sukuk Company 1 Plc Obligor State Government of Osun Federal Government of Nigeria Currency/format Nigerian Naira Nigerian Naira Structure Ijarah Ijarah Sukuk/obligor ratings Bbb+ (Agusto & Co)

A (Agusto & Co) B- (Fitch)

Use of proceeds The net proceeds of Naira10.97 billion after deduction of the cost of the offer of Naira 0.43 billion (i.e. 3.77% of the amount) will be utilised for the following:

(i) Construction of 23 high schools (total cost of Naira 10.35 billion – 94.35% of sukuk value)

(ii) Construction of 2 middle schools (total cost of Naira 0.30 billion – 2.73% of sukuk value)

(iii) Construction of 2 elementary schools (total cost of Naira 0.32 billion – 2.92% of sukuk value)

To fund the construction and rehabilitation of roads across the country:

(i) North Central: 5 projects costing Naira16.67 billion: construction of Loko Oweta bridge, dualization of the Abuja-Lokoja road (sections 1 and 4), dualization of the Suleja-Minna road (Phase 2), dualization of the Lokoja-Benin road (Section 1)

(ii) North East: 5 projects costing Naira 16.67 billion: dualization of the Kano-Maiduguri road (Sections 2-5)

(iii) North West: 4 projects costing Naira 16.67 billion: dualization of the Kano-Maiduguri road (Section 1), dualization of the Kano-Katsina road (Phase 1), construction of Kano western bypass and the Kaduna eastern bypass

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SPV issuer Osun Sukuk Company Plc FGN Roads Sukuk Company 1 Plc (iv) South East: 4 projects costing Naira

16.67 billion: rehabilitation of the Onitsha-Enugu expressway and the Enugu-Port Harcourt road (Sections 1-3)

(v) South South: 5 projects costing Naira 16.67 billion: rehabilitation of the Enugu-Port Harcourt road (Section 4), dualization of the Yenegwe road junction-Kolo-Otuoke Bayelsa Palm, and dualization of the Lokoja-Benin road (Sections 2-4).

(vi) South West: 3 projects costing Naira 16.67 billion: reconstruction of the Benin-Ofosu-Ore-Ajebandele-Shagamu dual carriageway (Phases 3 and 4), and dualization of the Ibadan-Ilorin road (Section 2)

Facility tenure 7 years 7 years Issuance date 10 October 2013 22 September 2017 Maturity date 10 October 2020 22 September 2024 Amount Naira11.4 billion Naira100.0 billion Profit rate 14.75% 16.47% Order book Fully subscribed Oversubscribed more than 5.8% Listing NSE

FMDQ NSE FMDQ

Sources: Prospectus of Osun Sukuk Company Plc, Prospectus of FGN Roads Sukuk Company 1 Plc

The positive outcomes of these sukuk issues are underpinned by the reforms and infrastructure that have been incorporated into Nigeria’s regulatory framework and capital markets. Table 4.34 provides a brief description of the initiatives undertaken by the FGN in developing its ICM, particularly sukuk.

Table 4.34: Timeline of the Development of Nigeria’s ICM/Sukuk Market

Year Timeline description 2008 The first halal investment established by Lotus Capital Ltd. 2010 The SEC issued Rules on Islamic Fund Management 2011 The CBN issued Guidelines for the Regulation ad Supervision of NBFIs 2012 The Lotus Islamic Index was set up in the NSE to track selected Shariah-compliant equities

The SEC issued Rules on Sukuk 2013 The FIRS issued Guidelines on Tax Implications of Non-Interest Banking in Nigeria

The CBN inaugurated the Financial Regulation Advisory Council of Experts (FRACE) to provide advice on Shariah compliant matters

The issuance of Nigeria’s first sukuk: the State Government of Osun Naira 11.4 billion ijarah sukuk

2015 The SEC launched the NICMP Master Plan 2016 The CBN issued Guidelines for Granting Liquid Asset Status to Sukuk Instruments Issued by State

Governments 2017 PENCOM issued guidelines on investment by the Pension Fund Administrator

The issuance of Nigeria’s second sukuk, the FGN ₦100.0 billion ijarah sukuk Sources: SEC (2015b), CBN, SEC, PENCOM

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Domestic Market – Public Sector Issuance

Nigeria fell into an economic recession in 2016, with 2 consecutive quarters of negative GDP growth rate (-0.36% in 1Q 2016 and -2.06% in 2Q 2016). This was triggered by stagflation, shocks in crude oil production, and heightened vandalism of oil and gas pipelines, which had significantly affected output and earnings. The inflation rate shot up to 11.38% in February 2016 (end-2015: 9.55%), before escalating further to 18.55% in December. The rampant inflation is attributable to a shortage of foreign exchange and spiralling energy prices amid a weak power supply. Nigeria’s outstanding public debt stood at ₦17,360,009.57 million as at end-December 2016 (USD57,391.53 million), compared to ₦12,603,705.28 million (USD65,428.53 million) a year earlier, translating into an increase of ₦4,756,304.30 million or 37.74% (refer to Chart 4.57). The surge in public debt was due to additional issuances to fund the 2016 budget deficit, which had widened to 2.14% of GDP compared to 1.09% in 2015, and refinancing/redeeming matured securities, exacerbated by the depreciation of the naira against the USD following the liberalization of the exchange-rate regime (DMO 2016 Annual Report).

Chart 4.57: Nigeria’s Outstanding Public Debt (2012-2016)

Source: DMO

Based on available data, the country’s budget deficits have been funded by domestic borrowing, through monthly issues of FGN securities in the local debt market. This is in line with the objectives of Nigeria’s National Debt-Management Framework (NDMF), 2013-2017 and the DMO’s Strategic Plan (2013-2017), i.e. to efficiently meet government financing needs at minimum cost and risk; supporting the development of the domestic debt market; and sustaining capacity-building initiatives at the sub-national level for overall debt sustainability and the macroeconomic stability of the country. Undoubtedly, the successful launch of

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Nigeria’s 2 sovereign sukuk issues and potential future issuance will help the FGN meet its funding deficits and broaden the array of capital market instruments. 4.7.3 ANALYSIS OF SUKUK STRUCTURES, ISSUANCE AND INVESTMENT

Analysis of Sukuk Structures The Rules on Sukuk provide a list of sukuk structures that are based on Shariah contracts, including ijarah, istisna’, musharakah and murabahah. Despite the facilitating legal provisions, the 2 Nigerian sovereign sukuk structures are based on ijarah. Analysis of Sukuk Issuances – Supply (Sell Side) The size and liquidity of a debt market are important indicators of its vibrancy. A snapshot of the size of the Nigerian domestic bond market shows that it is still small compared to the equity market. The issuance of the FGN Sukuk and the Osun State Sukuk has slightly deepened the nascent Nigerian capital markets, by increasing the variety of instruments available to issuers and investors. Chart 4.58 depicts the size of the domestic bond market from 2014 to 2016. As at end-2016, the bond market was equivalent to 20% of the entire domestic bond market while the equity market dominated with a 70% share. Chart 4.58: Size of Capital Markets in Nigeria (2014-2016)

Source: NSE

Table 4.35 shows that within the domestic bond market, sovereign bond issues (FGN and state government bonds) outnumber corporate bonds. This highlights that debt securities have been a reliable and cost-effective source of financing for the government. Sovereign bonds are touted as safe, low-risk investments as they are direct obligations of the government, which is fully responsible for the payment of the coupon/rental income and the repayment of the principal at maturity. They are also backed by the full faith and credit of the federal government. However, the dominance of sovereign bonds in the debt market will crowd out or deter corporate issuers from entering the market.

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Table 4.35: Size and Composition of Nigeria’s Domestic Bond Market (2015-2016) 2015 2016 Issuer Amount outstanding

(Naira billion) % of total Amount outstanding

(Naira billion) % of total

FGN 5,808.14 89.14 6,663.36 93.33 State governments 457.38 7.00 324.20 4.54 Corporates 226.15 3.47 127.31 1.78 Supra-nationals 24.95 0.38 24.95 0.35 Total 6,515.62 100.0 7,139.82 100.00 Sources: SEC, DMO

The sovereign benchmark yield curve is key to developing an efficient and active debt market. The Osun State and FGN sukuk set the benchmark for the pricing of future sukuk with 7-year tenures that may be issued by other tiers of government, corporates and multilaterals. For investors, the 16.47% annual return offered by the FGN Sukuk is above Nigeria’s inflation rate of 15.98% (as of September 2017). The FGN Sukuk’s return is also favourable to investors as it is higher than the country’s official monetary policy rate (14%), Treasury Bill yield (13.35%), savings deposit rate (4.08%), and 1-, 3-, 6- and 12-month fixed deposit rates (8.86%, 10.14%, 11.51%, 11.40%). Chart 4.60 depicts the money-market rates published by the CBN in August 2017. For private issuers, however, high interest rates affect coupon rates and thus discourage private issuance. The Nigerian prime lending rate stands at 17.69%, as noted in Chart 4.59, and shows a wide spread of 6%-13%.

Chart 4.59: Nigeria’s Money-Market Indicators in August 2017

Source: CBN

Although there is no FGN bond with a 7-year tenure to compare with the FGN Sukuk, the range of coupon rates from the FGN benchmark bond issued in 2016 may be taken as a guidance. The FGN introduced a new 5-year benchmark bond and a 20-year benchmark bond in 2016, with the issuance of the 14.5% FGN JUL 2021 and 12.40% FGN MAR 2036 (refer to Chart 4.60 on Nigerian 10-year sovereign bond yield). The introduction of longer-tenure FGN benchmark bonds was due to the implementation of the nation’s second Debt-Management Strategy, 2016-2019. The strategy seeks to rebalance the country’s debt portfolio in favour of less expensive long-term external financing, to reduce the cost of debt and lengthen the maturity profile. It

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also seeks to lengthen the maturity profile of the domestic debt portfolio by reducing the issuance of short-dated debt instruments, in addition to the introduction of new debt instruments into the domestic debt market. The implementation of the debt strategy should help the FGN restructure its public debt, reduce its overall cost of debt, finance critical infrastructure at minimum cost, and help create room for private borrowing in the domestic debt market (DMO Annual Report 2016).

Chart 4.60: Nigerian 10-Year Sovereign Bond Yield

Sources: CBN, Trading Economics

Analysis of Sukuk Investments – Demand (Buy Side) The FGN bond market delivered an impressive performance in 2016, as underlined by the high level of subscriptions during the year. This indicates a diverse and expanding investor base driven by the growth of the pension sub-sector of the financial market, and increased awareness on bonds as an alternative investment vehicle. In spite of the economic recession, activities in the secondary market for FGN bonds picked up significantly during the year, as investors increasingly embraced fixed-income instruments to take advantage of their higher yields (DMO 2016 Annual Report). The total allotment, subscription and divergence of the type of investors for FGN bonds are shown in Table 4.36.

The widening of the investor base was also due to the recent regulatory revisions. In 2017, PENCOM revised its regulations on the investment of pension assets. As a result, the Pension Funds Administrators (PFAs) are allowed to invest in sukuk; prior to this legal amendment, PFAs had only been allowed to invest in bonds. The CBN’s guidelines on the liquidity status of NICMPs confer “liquid asset” status, i.e. the low risk of the FGN Sukuk and its “liquid asset” status make it relatively easy for investors to use these sukuk holdings as collateral. This is to promote the investment culture and mobilise savings. In addition, the liquidity of the FGN Sukuk in the secondary market is further enhanced as it is listed on the Nigerian Stock Exchange (NSE) and the FMDQ OTC Securities Exchange. Such listing provides alternative avenues for investors that may wish to sell part or all of their investment in the sukuk before

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maturity. Apart from that, Nigeria set up a technical committee to develop a road map for a national savings strategy in 2016, as delineated in Box 4.20.

Table 4.36: Investors of FGN Bonds Allotted in 2016 Description Amount Result Total amount offered 1,235,000.00 Total subscription 2,125,748.10 Range of bids (%) 8-19 Range of marginal rates (%) 11.3340-16.4348 Range of Coupons (%) 12.4000-15.5400 % of the total allotment Deposit money banks 325,296.81 24.86 Pension funds 285,437.75 21.82 Government agencies 240,603.33 18.39 Fund managers & NBFIs 408,362.88 31.21 Individuals 3,296.42 0.25 Insurance companies 20,880.39 1.60 Retail/other institutional investors 6,425.75 0.49 Foreign investors 18,000.00 1.38 Total allotment 1,308,303.33 100.00 Source: DMO

Box 4.20: Nigeria’s National Savings Strategy

The gap in Nigeria’s national savings is massive. At present, savings by the masses are still critically low. The table below depicts that in 2016, some 36% of the population had access to bank accounts, with 2% having insurance coverage and 5% enjoying the privilege of a pension scheme. The aggregate savings in the financial system do not include most of the wealth of the local population that either keep it as cash or invest it in land and cattle, among other things. Financial Inclusion in Nigeria for 2010, 2012, 2014 and 2016

Status as at

Focus areas Target by 2020

2010 2012 2014 2016 Variance to 2020 target

% of total adult population

Payments 70% 22% 20% 24% 38% -32%

Savings 60% 24% 25% 32% 36% -24%

Credit 40% 2% 2% 3% 3% -37%

Insurance 40% 1% 3% 1% 2% -38%

Pension 40% 5% 2% 5% 5% -35%

Financial exclusion 20% 46.3% 39.7% 39.5% 41.6% -21.6%

That said, the Pension Reform Act was reformed in 2014, making it mandatory for companies with 3 or more employees to join the pension scheme. Before the statutory amendment, the mandatory participation had applied to private entities that employed 15 or more workers. Under the current system, employees of state and local governments are excluded from participation. The total contribution rate will be 18% (i.e. 10% for employers and 8% for employees).

Source: EFInA

4.7.4 KEY FACTORS UNDERPINNING NIGERIA’S SUKUK MARKET

As a nascent industry, Nigeria requires more efforts to build a conducive sukuk market. Some of the basic pillars have been put in place, as illustrated in Figure 4.21.

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Figure 4.21: Key Factors Underpinning the Growth of Nigeria’s Sukuk Market

Sources: RAM, ISRA To support the progress of Nigeria’s sukuk market, the phases shown in Figure 4.22 will provide some insights on the next stage of development.

Figure 4.22: Phases of Islamic Finance’s Inclusion in Nigeria’s Financial Landscape

Sources: RAM, ISRA

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Nigeria shows a keen interest in developing its sukuk market. Nonetheless, it still faces a number of challenges in the process, as reflected in Chart 4.61. Tables 4.37 and 4.38 summarise some of the proposals to facilitate the depth and breadth of Nigeria’s sukuk market in terms of supply and demand. Table 4.39 provides some recommendations on improving the country’s infrastructure.

Chart 4.61: Factors Influencing the Development of Nigeria’s Sukuk Market

0

1

2

3

4

5

Legal framework &

dispute resolution

Regulatory

framework

Shariah governance

framework

Tax incentives

Tax neutrality

Product innovationInfrastructure

Diversification of

investor base

Diversification of

issuer

Cost

competitiveness

Benchmark yield

curve

Nigeria

Sources: RAM, ISRA


Issues and Challenges Recommendations Lack of short-term, non-interest liquidity instruments

Apart from its existing sovereign sukuk, the CBN plans to issue sovereign sukuk to Islamic banks for their liquidity management. The CBN will consider amending the Central Bank Act (CBA) and Banks and Other Financial Institutions Act (BOFIA) to accommodate the use of CBN assets to create non-interest liquidity instruments.

Shortage of state sukuk State governors should be encouraged to access the NICM through sukuk issuance.

No corporate sukuk GLCs must spearhead the issuance of corporate sukuk. This will set a benchmark for private issuers.

No supranational sukuk The SEC to engage the Islamic Development Bank (IDB), the AFDB and other multilateral institutions to issue supranational sukuk in Nigeria.

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Issues and Challenges Recommendations Lack of provision for the Shariah-compliant guarantee or credit enhancement

The SEC to engage with the IDB to work on provisions for Shariah-compliant guarantees.

Lack of NICMPs To promote and educate market stakeholders on how to structure more Shariah-compliant products.

Inadequate tax neutrality The SEC to collaborate with the tax authorities to accelerate the process of addressing tax provisions that may impede or discourage product development and innovation.

Inadequate tax incentives The SEC to work closely with the other regulators to initiate further measures to improve incentives, i.e. waiver of 50% on regulatory fees, reduction of tax rate and shorter turnaround time for the issuance of NICMPs. To also consider extending the current tax incentives to sukuk issued by non-sovereign bodies.

Sources: RAM, ISRA


Lack of awareness (including religious groups) on the domestic market for NICMPs

To effectively execute the awareness programmes on the NICMP, as detailed in the Report of Capital Market Literacy Master Plan Committee issued in 2015. The CBN and the SEC to engage with influential religious bodies, e.g. the National Christian Elders Forum (NCEF), to create mutual understanding on NICMPs.

Lack of external investors Operators to promote a wider range of NICMPs to create opportunities to tap external non-interest investment funds.

Sources: RAM, ISRA

Table 4.39: Recommendations to Improve Infrastructure – Medium-Term Solutions

Cumbersome registration process for mortgages

The Land Use Act (LUA) should be amended to facilitate the process for the perfection and transfer of title, to make the creation of mortgages less cumbersome. Thus, the SEC is to engage with the governors and relevant stakeholders in the land registry to create a level playing field for property acquisition using non-interest structures with conventional structures and dispense with the need to seek consent twice.

Lack of savings mobilisation policies and programmes

The Technical Committee on National Savings Strategy has to expedite the release and execution of the road map for a national savings strategy.

Low uptake of insurance services despite enormous exposure to risk for the low-income and mass-market population

NAICOM to work with the FGN to create incentives that will spur increased uptake of insurance services.

Social discontent. As a multi-ethnic society, minority interests or fears based on diversity are a source of discontent.

The government needs to take proactive measures to address social, political and economic challenges.

Sources: RAM, ISRA

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5. POLICY RECOMMENDATIONS ON SUKUK MARKET DEVELOPMENT After concluding the benchmarking exercise on the respective development stages of each case study based on 11 main criteria, we conclude that there is indeed no “one size fits all” framework and roadmap to develop the sukuk markets in different OIC countries. Each market has its own peculiarities, depending on the macroeconomic conditions that can be measured through its stability level. Spider Chart 5.1 summarises the position of each country, with Malaysia in the lead in all criteria, except diversification of investor base.

Chart 5.1: Key Building Blocks in Developing the Sukuk Markets in OIC Countries

Sources: RAM, ISRA

5.1 STRATEGIC FRAMEWORK AND ROAD MAP TO DEVELOP SUKUK MARKETS

Learning from Malaysia as a jurisdiction that has made strides in its sukuk market, we can conclude that a comprehensive framework―encompassing the building of both supply and demand―and the development of a robust regulatory and market infrastructure are pertinent towards achieving a state of maturity. Figure 5.1 can be used as a barometer to measure the state of development of each OIC country, and as a guide to building a cohesive roadmap that should be incorporated into a country’s capital market masterplan.

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Figure 5.1: A Comprehensive Framework for the Cohesive Development of a Sukuk Market

Sources: ISRA, RAM The framework comprises 3 key components:

1. A strong legal and regulatory framework, which includes Shariah governance, as the overarching principle in developing sukuk markets in any jurisdiction.

2. A robust market and strong infrastructure development, which are pertinent to facilitating sukuk issuance and investment.

3. A market with diversified players in both supply (sell side) and demand (buy side), to create a vibrant ecosystem.

Table 5.1 explains in detail each component of the framework.

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Table 5.1: Components of a Comprehensive Framework for Developing Sukuk Markets Key

components Requirements Functions

Legal and regulatory framework

1. Legal framework

To provide certainty to market players, especially in the event of disputes, by:

Amending the relevant local law(s) to accommodate the specificities of sukuk.

Ensuring clarity for dispute resolution, bankruptcy, and arbitration.

Dealing with the challenges posed by civil law, as opposed to common law in some jurisdictions.

To adopt supporting tax laws to level the playing field between sukuk and conventional bonds.

2. Regulations and guidelines

To ensure investors’ protection by:

Having a strong and single regulation to govern the debt capital market.

Issuing specific guidelines that impose the need for disclosure, transparency, governance, due diligence, representations.

Continuous liberalisation of policies through participation by foreign corporations, multinational agencies and multilateral institutions.

3. Shariah governance

To establish a centralized Shariah authority at country level and a robust Shariah governance framework comprising key functions, including review and audit, to periodically assess the Shariah compliance of any sukuk.

To ensure end-to-end Shariah compliance of sukuk at different development stages:

Inception and conceptualisation (structuring)

Issuance

Trading until maturity

Market and infrastructure development

1. Trading platform

To facilitate primary and secondary market trading for a more diverse investor base. including retail.

2. Registration and approval process

To expedite the issuance process by promoting process efficiency, shortening time to market and providing certainty of product offering.

3. Active Islamic money market

To issue more short-term sukuk for Islamic banks to manage their liquidity and to boost secondary trading.

4. Tax neutrality To create a level playing field between sukuk and conventional bonds, hence encouraging more sukuk issuance through the removal of taxes related to the transfer of assets and withholding tax on profits.

5. Tax incentives To motivate companies to raise funds via the debt market instead of the equity market, and to issue more sukuk instead of conventional bonds. This can be achieved via waivers or deductions of taxes and/or issuance costs.

6. Innovative structures

To cater for the needs of different market segments, i.e. government, corporate, retail. To expand the structures which include ESG and value-based elements.

7. Cost competitiveness

To increase the attractiveness of fund-raising via sukuk based on affordable legal fees, competitive pricing, efficient approval process.

8. Benchmark yield curves

To facilitate more corporate issuance with different maturities.

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Key components

Requirements Functions

Diversified market players on supply and demand sides

1. Diversified issuers and frequent issuances

To provide a sufficient supply, which includes both LCY and FCY issuances. To encourage issuance by different entities:

Government

Government-linked entities (or state-owned entities/government-related entities)

Corporates

2. Diversified investor base

To create demand and provide liquidity to the market from:

Banking institutions

Intermediation of NBFIs such as pension funds, takaful and insurance companies, fund management companies, sovereign wealth funds.

Inclusion of retail investors.

5.2 GENERAL RECOMMENDATIONS IN DEVELOPING A VIBRANT SUKUK MARKET

Based on the comprehensive framework above, Table 5.2 outlines general recommendations that OIC countries can adapt to develop their sukuk markets. These recommendations are proposed according to the developmental stages of the respective sukuk markets, which can be divided into 3 phases:

1. Matured 2. Developing, which is sub-divided into 3 stages:

Advanced Intermediate Beginner

3. Infancy The policy recommendations take into consideration the key issues and challenges faced by each market and its inherent macroeconomic conditions. Depending on the state of progress of each yardstick discussed earlier, practical solutions have been proposed to advance a domestic sukuk market to its next phase of development. The yardsticks are applicable to all the developmental phases and are vital towards elevating a nascent sukuk market to developing status, likewise from the developing to the matured stage.

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Table 5.2: Key Issues and Recommendations by Stage of Sukuk Market Development Stage of sukuk

market development

Issues and challenges Key recommendations Rationale

Matured (example of OIC countries includes Malaysia)

Market and infrastructure development To build a sukuk market that champions the UN’s SDGs, thereby heightening its appeal and positioning within the mainstream financial markets.

Shortage of short-term investments for the Islamic money market.

To deepen the Islamic money market and improve liquidity in secondary trading.

Lack of innovative sukuk structures that truly adhere to the spirit of maqasid al-Shariah, which emphasises substance and legal form.

To increase issues that embrace the VBI concept and SRI, which looks at elements of ESG.

Diversified market players on supply and demand sides Lack of investors that can

strike a balance between social responsibility and profit maximisation.

To create greater awareness among the Islamic finance community on impact investing, which emphasises social objectives without compromising commercial returns.

Lack of participation by retail investors.

To increase awareness among the public on investment in retail sukuk.

Developing (Advanced) (examples of OIC countries include the UAE and Saudi Arabia)

Legal and regulatory framework To provide greater certainty and protection to sukuk holders in the event of defaults and/or disputes.

Lack of a comprehensive legal framework and plagued by regulatory uncertainties, especially in civil law jurisdictions that do not have a separate trust law to facilitate sukuk structuring.

To improve clarity on investor protection and enforcement of charge over securities, to avoid defaults and/or disputes (e.g. Investment Dar and Dana Gas).

Decentralised Shariah governance has led to more uncertainties and ambiguities in Shariah compliance, which adds to complexity and negatively affects both primary issuance and secondary trading of broader Islamic capital-market instruments.

To establish a centralized Shariah authority to oversee the standardisation of legal documentation, sukuk structures and Shariah rulings. This will create more certainty among investors, hence lifting demand for sukuk.

Market and infrastructure development To offer more instruments so that Islamic banks can manage their liquidity.

Shallow Islamic money market and dearth of short-term instruments for liquidity management

To issue short-term sukuk or subscribe to IILM sukuk.

Diversified market players on supply and demand sides To provide a sustainable supply of government and corporate sukuk with different maturities, and

Lack of benchmark sovereign sukuk issues by federal and state governments

To increase more domestic issuance in addition to international issuance. Federal and state governments should

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Stage of sukuk market

development Issues and challenges Key recommendations Rationale

prioritise raising funds via sukuk instead of bonds to finance their budget deficits.

encourage ”crowding in” instead of ”crowding out”.

To increase funding efficiency and alleviate the negative economic and financial effects of heftier government debt, including the crowding out of banking credit to the private sector.

Shortage of long-term sukuk issues that cater to the needs of long-term investors such as pension funds as well as insurance and takaful companies.

To issue sukuk with longer maturities, especially by government, to fund infrastructure projects and provide the necessary benchmark yield curves that will enable local corporations to raise longer-term sukuk.

Lack of diversification in investor base – concentration on banking institutions with less intermediation from NBFIs.

To increase demand from various investors, including:

- Institutional investors that need long-term investments, such as insurance companies and pension funds.

- High–net-worth individuals who are currently investing more in equities and real estate.

- To encourage sovereign wealth funds to invest in their domestic bond markets.

- Retail investors.

Developing (Intermediate and Beginner) (examples of OIC countries include Indonesia and Turkey)

Legal and regulatory framework To provide a conducive environment for the ICM to prosper.

Local companies prefer to issue FCY conventional bonds to fulfil their financing needs due to the macroeconomic conditions of the market (i.e. high inflation rate and volatile local currency).

At the government and monetary policy levels, efforts should be made to improve/attain macroeconomic stability.

Limitations and/or restrictions within the capital markets.

To revise some regulations to allow multinationals to issue LCY and FCY sukuk in the domestic market.

Market and infrastructure development To create more efficient capital-market intermediation and encourage the issuance of more sukuk as a credible source of funding. To level the playing field between sukuk

Lack of awareness among key market stakeholders: service providers (e.g. investment banks, securities companies, advisory houses, brokers, traders, rating agencies), banking institutions and NBFIs.

To increase knowledge on the importance of sukuk as an alternative source of funding, and promote market awareness on the process of structuring, issuing and investing among different market segments.

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Lack of secondary market trading due to ineffective and inefficient platforms.

To develop an effective trading platform with efficient clearing settlement systems.

and conventional bond bonds, thereby ensuring greater outreach to market players.

Lack of tax incentives that motivate sukuk issuance and investors to invest in them, as opposed to conventional bonds.

To offer tax neutrality for sukuk and introduce more tax incentives (such as withholding taxes and deductions for issuance costs) to facilitate a greater flow of investments into the capital markets and level the playing field between sukuk and conventional bonds.

Shortage of attractive sukuk structures that cater to the distinct requirements of Shariah-based institutional investors.

To encourage innovation in sukuk structures (e.g. waqf-linked sukuk) to entice religious institutional investors (e.g. waqf and hajj funds) to tap the sukuk market.

Diversified market players on the supply and demand sides To provide more investment instruments to banks and NBFIs.

To strengthen the diversification of investor bases.

Non-existent/inadequate long-term issues that fund infrastructure projects to cater to the needs of long-term investors.

To encourage SOEs and blue-chip corporates, particularly utilities-backed companies (e.g. telecommunications, electricity, water, power) or corporates with infrastructure projects (e.g. municipality company) to issue sukuk.

Lack of cornerstone institutional investors.

To enforce a mandatory retirement/pension scheme or national savings strategy that will boost the setting up of pension funds.

Infancy (examples of OIC countries include Nigeria and most African countries that have newly tapped the sukuk market)

Legal and regulatory framework To facilitate a smoother and faster approval process for sukuk issuance.

To simplify the listing process for sukuk.

The need for a robust legal and regulatory framework.

Amendment of relevant laws (e.g. land law) to facilitate the process of perfecting and transfer of legal title, thus making the creation of mortgages less cumbersome.

Social discontent. As a multi-ethnic society with diverse religious beliefs, minority interests or fears based on diversity are a source of discontent.

Government needs to take proactive measures in addressing social, political and economic challenges.

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Market and infrastructure development To create more efficient capital-market intermediation and encourage the issuance of more sukuk as a credible source of funding.

Lack of awareness on the importance and benefits of sukuk as an effective financing tool to fund infrastructure projects.

Government, regulatory authorities and market players need to make concerted efforts to promote sukuk as an effective financing tool to fund the infrastructure gaps in underdeveloped economies.

Lack of awareness on ICM instruments among non-Muslim religious groups.

Promote understanding among the non-Muslim population on sukuk and other ICM instruments, by having more engagements with influential religious bodies.

Diversified market players on the supply and demand sides To diversify the investor base.

Issues of financial inclusion and a relatively small ratio in terms of the working population relative to the total population of the country.

To provide incentives to low-income groups and the mass market to encourage them to take up takaful or insurance services, thereby spurring the establishment of more takaful/insurance companies that subscribe for long-term sukuk.

Sources: RAM, ISRA

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6. CONCLUSION This final section summarises the key findings and recommendations of the study, which can be categorised into 3 main dimensions:

Sukuk structures Sukuk issuances (supply – sell side) Sukuk investments (demand – buy side)

These 3 dimensions have been used to measure the development of sukuk markets in the case studies and assess the main challenges faced by the particular country. Central to the development of a sukuk market is having a comprehensive framework that emphasizes 3 key components, as exemplified in Table 6.1.

Table 6.1: Key Components of a Comprehensive Framework to Develop a Sukuk Market Component Role Responsible Stakeholder

Legal and regulatory framework

To improve the existing legal, regulatory, Shariah governance and tax frameworks to level the playing field between sukuk and conventional bonds.

Ministry of Finance (or its equivalent) Capital-market authority Tax authority National Shariah authority

Market and infrastructure development

To develop an active Islamic money market to support secondary trading, an electronic trading platform for transparency and to monitor issuances and for price guidance.

Central bank Securities and commodities

exchanges

To promote the issuance of LCY and FCY sukuk that have different commercial features (i.e. tax neutrality and incentives, competitive costs, innovative structures catering to various needs, and benchmark yield curves) to attract market players to tap the sukuk market.

Ministry of Finance (or its equivalent) Tax authority Central bank Government-related entities

(GREs)or their equivalent (i.e. SOEs/GLCs)

Corporate Issuers

Diversified market players on the supply and demand sides

To foster supply (sell side) of and demand (buy side) for sukuk issuance.

Government Service providers (investment banks,

securities companies, advisory houses, brokers, traders, rating agencies)

Banking institutions and their holding companies

NBFIs

Sources: RAM, ISRA The study shows that countries with an active LCY bond market spearheaded by corporates make it easier to promote sukuk as an alternative form of financing. The following sub-sections summarise the current status of the different sukuk markets based on the abovementioned aspects.

6.1 SUKUK STRUCTURES

AAOIFI Shariah Standard No. 17 on Investment Sukuk has paved the way for the issuance of various sukuk structures, particularly in Arab countries. While ijarah contracts constitute a large portion of sukuk issuance in that region, recent trends indicate that wakalah/wakalah bil

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istithmar contracts, which combine tangible assets (such as ijarah assets and shares) and debt receivables (arising from murabahah or istisna’ transactions), are rapidly gaining ground. The benchmark issuances of wakalah bil istithmar sukuk by the IDB in 2003 and 2005 have influenced other market players (including Turkish private sector issuers) to adopt the same structure. A similar scenario can also be observed in Asia, with the exception of Malaysia; Brunei, Pakistan and Indonesia have adopted ijarah as the underlying Shariah contract for most of their issuances. Unlike other countries in the region, Malaysia has been issuing sukuk based on different Shariah contracts, predominantly murabahah. This is due to the varying opinions of Shariah experts. For example, the trading of debt or bay’ al-dayn is a common practice in Malaysia following the SAC of the SC’s acceptance of the principle of bay’ al-dayn as one of the concepts for the development of Malaysia’s ICM instruments in August 1996. Over the years, Malaysian practices have converged with international standards, hence the increased issuance of wakalah/wakalah bil istithmar sukuk, which comply with the AAOIFI requirements on secondary trading. For most African countries that have issued sukuk, the frequently used Shariah contract is ijarah. The reasons cited by market participants include the simplistic features in terms of flexibility, tradability and suitability in funding construction projects. Unlike the murabahah structure, the ijarah structure enables secondary trading of the sukuk instrument on an exchange, which in turn helps increase investors’ participation in the transaction. Moreover, the ijarah contract is innately designed to produce periodic rental payments, which automatically act as coupon payments to sukuk investors. On the other hand, The Gambia has issued short-term sukuk for liquidity management based on the salam contract. Based on case studies and field visits to the selected countries, several key issues and challenges confront the various sukuk markets in terms of structures, as explained in Table 6.2.

Table 6.2: Key Issues and Challenges of Sukuk Markets – Sukuk Structures Issues Affected countries Recommendations

Limited sukuk structures that have a balanced mix of social considerations and commercial values

Malaysia UAE Indonesia Turkey Hong Kong Nigeria

To increase green and social sukuk that embrace the VBI concept and SRI, which looks at ESG screening.

Shortage of attractive sukuk structures that cater to the distinct requirements of Shariah-based institutional investors

UAE Indonesia Nigeria Turkey Hong Kong

To expand the boundaries of innovation in sukuk structures (e.g. waqf-linked sukuk) to entice religious institutional investors (e.g. waqf and hajj funds) to tap the sukuk market.

Lack of understanding on ICM instruments (e.g. unfamiliarity with Islamic structures and principles)

Indonesia Turkey Hong Kong Nigeria

To increase market awareness on ICM products through conferences, training sessions and seminars.

Sources: RAM, ISRA

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6.2 SUKUK ISSUANCES (SUPPLY – SELL SIDE)

Due to persistently weak global oil prices, Arab countries―particularly the GCC nations―have been actively issuing both LCY and FCY sovereign sukuk to finance their budget deficits. While Bahrain, Qatar and the UAE (emirate governments) have been sourcing their government funding via sukuk for quite some time, the sovereigns of Oman and Saudi Arabia only started tapping the sukuk market in 2017. Kuwait followed its Gulf neighbours in raising debt in April 2017 but chose an international conventional bond to build its first yield benchmark. In the GCC, the decision on whether sovereigns issue bonds or sukuk is driven by the targeted investor base and the ease of the sukuk structure as well as Islamic finance strategy, given that the structuring of sukuk is more complex and time-consuming than for conventional bonds. In the GCC, corporate issuers are mainly Islamic financial institutions and GREs, except in Saudi Arabia, which provides some diversification into other corporate sectors (i.e. aerospace, chemical, food processing, industrial, and oil and gas). In Asia, Malaysia and Indonesia dominate the sukuk market. While Malaysia’s strong foothold is underpinned by the corporate issuance, Indonesia’s sovereign sukuk anchor its historical volume and number of sukuk issues. Notably, Hong Kong became the first non-OIC Asian country to issue sovereign sukuk in 2014, followed by 2 more issuances in 2015 and 2017. Other countries that have issued only government sukuk are Brunei and Bangladesh. Sectoral diversification can be observed in quasi-government and corporate sukuk originated in Indonesia and Malaysia. However, Malaysia stands above its peers in terms of the number of issues and issuance amount. Malaysia remains the world’s largest market for sukuk issuance, commanding 48.0% (USD15.4 billion) of total global sukuk issuance as at end-June 2017. In Africa, The Gambia, Sudan, Nigeria, Senegal, South Africa, Togo and Ivory Coast have issued sukuk, mostly to finance infrastructure projects. Notably, The Gambia’s issuances serve as liquidity-management instruments. All said, Africa’s sukuk market is still in its nascent stage and dominated by the sovereign and central bank issuances. With the establishment of sovereign benchmarks, the regulators are optimistic that corporate players will be attracted to tap the domestic ICMs. However, it is still early days yet and building the necessary value position for corporates to issue sukuk needs to be progressively developed. Based on case studies and field visits to the selected countries, the sukuk markets still face some key issues and challenges in terms of supply, as elaborated in Table 6.3.

Table 6.3: Key Issues and Challenges of Sukuk Markets – Supply Side Issues Affected countries Recommendations Limited/unavailability of LCY sukuk, particularly sovereign issuances

UAE Indonesia Turkey Hong Kong Nigeria

To create more awareness on the need for LCY issuance to deepen the domestic sukuk market.

Dearth of Islamic money-market activities and instruments

UAE Indonesia Turkey Hong Kong Nigeria

To increase the issuance of short-term sukuk and other Islamic money-market instruments.

To subscribe to IILM short-term sukuk.

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Issues Affected countries Recommendations Not cost competitive for corporate issuers

Indonesia

To amend the relevant tax laws to encourage corporate sukuk issuance.

Unavailability/limited retail sukuk

Malaysia UAE Turkey Hong Kong Nigeria

To make retail sukuk returns more attractive and competitive than fixed deposit rates.

Sources: RAM, ISRA

6.3 SUKUK INVESTMENTS (DEMAND – BUY SIDE)

The financial sector in Arab countries, particularly the GCC, is generally led by the banking sector. NBFIs have a limited presence in the GCC. Investment funds have been expanding rapidly in several countries, but focused largely on domestic equities and real estate. The insurance sector, meanwhile, remains small and targets property/casualty risks. Contractual savings are underdeveloped and dominated by public pension systems, which are mainly defined as benefit, “pay as you go” schemes. Since most investment funds are owned by banks, domestic investors of GCC sukuk are largely local financial institutions. A review of the investor profile for the GCC’s recent bond issues (including sukuk) shows a high reliance on foreign investors. Amid negative or near-zero bond yields in the UK, the euro zone and Japan, these investors have been attracted to the bond yields offered by the Gulf region. In Asia, Hong Kong and Malaysia have undergone healthy developments in their respective financial markets, with strong intermediation from NBFIs. Indonesia, on the other hand, is still working towards augmenting the ratio of its outstanding bond market against GDP. Based on McKinsey Asian Capital Markets Development, Malaysia takes pole position among its Asian peers, with a score of 3.25 (out of 5) in terms of funding scale, investment opportunities and pricing efficiency; Indonesia recorded a score of 2.20. Elsewhere, African countries liberalized their financial sectors in the late 1980s and 1990s, as part of the structural adjustment programmes promoted by the IMF and the World Bank. The reforms included the removal of credit ceilings, the liberalization of interest rates, the restructuring and privatization of state-owned banks, and the introduction of a variety of measures to promote the development of private banking systems as well as financial markets. South Africa’s financial market appears to be the most advanced, as evinced by the increase in its outstanding bonds and market capitalization as a percentage of GDP. Nonetheless, Africa’s financial system remains relatively underdeveloped compared to other emerging markets. Based on its investor profile, Africa’s debt securities are mainly held by foreigners. Although African governments have implemented measures to hasten the development of NBFIs, they are still hampered by challenges such as financial inclusion and low savings rates. The main issues and challenges facing the sukuk market in terms of demand are briefly presented in Table 6.4.

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Table 6.4: Key Issues and Challenges of Sukuk Markets – Demand Side Issues Affected countries Recommendations

Lack of participation by retail investors

Malaysia UAE Turkey Hong Kong Nigeria

To increase public awareness on investment in retail sukuk.

Insignificant or low level of intermediation in capital markets

Indonesia Turkey Nigeria

More efforts on improving the macroeconomic conditions of the country (e.g. volatile local currency, high inflation rate).

Lack of long-term sukuk UAE Turkey Nigeria Hong Kong

Government and GREs/SOEs to raise sukuk with different maturities and more frequently, to provide the necessary benchmark yield curves that will enable local corporations to raise long-term financing.

To finance infrastructure projects via sukuk instead of conventional bonds, bilateral agreements on syndicated financing.

Non-competitive issuance cost

UAE Indonesia Turkey Nigeria

Removal of withholding taxes, taxes on asset transfers, stamp duty on the conveyance of assets, duties/fees on transfers of title deeds and corporate tax.

Narrow investor base – lack of cornerstone institutional investors

UAE Indonesia Turkey Nigeria Hong Kong

To create more demand from NBFIs, which need long-term investment vehicles.

Sources: RAM, ISRA In conclusion, the mobilisation of financial resources towards building a country’s economy forms the bedrock of self-sustainable development. Specific government strategies―including disciplined macroeconomic policies and fiscal policies, clear objectives for the mobilisation of tax and non-tax revenues, and responsible public spending―are vital to attaining organic growth. The primary responsibility lies with the government vis-a-vis promoting a conducive environment that makes it possible to secure the requisite financial resources for investment. Domestic policy makers determine the state of governance, macroeconomic and microeconomic policies, the condition of the financial system, and other basic elements of a country’s economic environment. Through proactive measures to encourage participation by the private sector in building the financial ecosystem, a country will be able to realise its long-term vision of becoming a contender for the status of a “power house”.

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APPENDIX 1: ACKNOWLEDGEMENT

Researchers would like to record their utmost appreciation to parties who were involved in interviews and discussions during the field visits and answered survey questionnaires from different institutions listed below. Malaysia AmInvestment Bank Berhad CIMB Islamic Maybank Islamic Berhad Securities Commission Malaysia United Arab Emirates HSBC Bank Middle East Limited First Abu Dhabi Bank Indonesia Indonesia Financial Services Authority (OJK) Bank Indonesia Indonesia Port Corporation Ministry of Finance of the Republic of Indonesia Dewan Shariah Nasional (DSN) CIMB Niaga Syariah PT Perusahaan Pengelola Aset (PERSERO) Islamic Development Bank (IDB) ZICO Law BNI Syariah PT. Angkasa Pura I (Persero) Directorate General Of Budget Financing and Risk Management PT Adira Dinamika Multi Finance Tbk Indo Premier Sekuritas PT Aneka Gas Industri Tbk PT Indosat Tbk PT Bank Maybank Indonesia Tbk PT Bank Muamalat Indonesia Bank BRI Syariah PT DBS Vickers Sekuritas Indonesia PT Mandiri Sekuritas Marsinih Martoatmodjo Iskandar Law Office PT. Bank Pembangunan Daerah Sumatera Barat KAP Purwantono, Sungkoro & Surja PT Bank Sulselbar Assegaf Hamzah & Partners Banwo & Ighodalo World Bank Global Islamic Finance Development Center KT Portfoy Yonetimi A.S. (asset mgmt)

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Turkey Albaraka Turk Katilim Bankasi Banking Regulation and Supervision Agency Capital Markets Board of Turkey Central Bank of Republic of Turkey Iller Bank Investment Support Promotion Agency of Turkey Istanbul Metropolitan Kuveyt Turk Mukafat Portfolio Parksoy Lay Office Turkish Capital Market Association Turkiye Ekonomi Bankasi Turkiye Wealth Fund Undersecretariat of Treasury World Bank Ziraat Katilim Bank Hong Kong Hong Kong Monetary Authority Nigeria Banwo & Ighodalo Law Firm Buraq Capital Limited Dr. Bashir Aliyu, Shariah scholar Jaiz Bank Plc Legacy Pension Managers Ltd Lotus Capital National Insurance Commission National Pension Commission Nigeria Securities Exchange Noor Takaful Securities and Exchange Commission Sterling Bank Plc The Metropolitan Law Firm

206

APPENDIX 2: SURVEY RESULTS

Part 1: Market Overview Question 1

Question 1(a)

207

Question 1(b)

Question 2

208

Question 2(a)

Question 3

209

Question 4(a)

Question 4(b)

210

Question 5

Part 2: Sukuk Structures, Issuance and Investments Question 1

211

Question 2

Question 3

212

Question 4

Question 5

213

Question 5(a)

Question 6

214

Question 7

Question 8

Question 9

How do you rate the importance of the following variables in relation to sukuk investment/trading in your country?

218

Part 3: Legal, Tax and Regulatory Framework Question 1

Question 2

219

Question 3

Question 4

220

Question 4(a)

Part 4: Challenges and Drivers Affecting a Sukuk Market Question 1

221

Question 2

Question 3

222

Question 4

Question 5

223

Question 6

Question 7

224

Question 8

Question 9

225

Question 10