The rise of the Sukuk

The financial crisis of 2008-09 once again proved that the structural flaws of conventional system result in its frequent collapse. Among the multiple quoted reasons, one of the most prominent ones is excessive leveraging and low transparency owing to the absence of the mandatory requirement of complete information. Hence, the focus in the post-financial crisis has shifted towards having greater accountability, enhancement in transparency, improvement in governance and a strict limit on leveraging.

This has persuaded the world to look towards Islamic finance as a viable financial alternate. The prohibition of debt and encouragement of risk-sharing forms a financial system that creates a direct link with the real sector. This demonstrates that there exists a strong link between the performance of the asset and return on the capital used to finance it. The asset-backed nature of Islamic financial transactions, in addition to the prohibition on speculative activities and the key pillars of equity, justice and transparency on which the Islamic financial system is based make it a more stable and prudent system than its conventional counterpart.

Sukuk, the most popular global instrument of Islamic finance, is being used by many developing countries as a tool of fiscal policy for economic development. Broadly there are two types of Sukuk: (i) Asset-based Sukuk – raising finance where the principal is covered by the capital value of the asset, and the returns and repayments to Sukuk-holders are not directly attached to those assets; and (ii) Asset-backed Sukuk – raising finance where the principal is covered by the capital value of the asset but the returns and repayments to Sukuk-holders are directly linked to the performance of these assets.

In terms of structure, 14 different types of Sukuk structures have been recognised by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), a Bahrain-based standard Setting organization. These structures are mainly based on the underlying modes of Islamic finance, namely murabahah, musharakah/mudharabah, wakala, istisna and ijarah among others, or combinations of these.

Since its inception, various structures of Sukuk have been successfully used by corporates and governments to raise funds. Projects like roads, railways, airports and hospitals etc, which generate revenues from tangible assets and are consistent with the Islamic rules of finance, are particularly appropriate for Sukuk financing. Given the importance of infrastructure development for sustainable economic growth, there is a large demand in emerging markets for Sukuk.

Sukuk enhance the stability of financial institutions by providing them with improved portfolio diversifications and liquidity. Sukuk also encourage genuine transactions as these are based on real, identifiable, existing assets. This results in the development of a stable and sound economy, founded on real assets and productive activities as opposed to artificial paper based transactions. Strict adherence to Shariah principles of ownership, transparency and risk-sharing ensure a relatively resilient position of Sukuk than conventional bonds.

According to research, it has been proven that Islamic securitisation  –particularly due to its ethical foundation and its reliance on real tangible assets if implemented – would have, arguably, reduced some of the unfavourable outcomes of the 2008 financial crisis, as real collateral limits the possibilities of speculative activities.

Pakistan joined the global Sukuk market with the issuance of its first international sovereign Sukuk of $600 million in 2005. In the domestic Sukuk market, the first Sukuk was issued in 2006. Since then more than 90 Sukuk (including corporate Sukuk and Government of Pakistan Sukuk) have been issued. However, in terms of volume, GoP Ijara Sukuk dominate the overall Sukuk market of the country.

Al-ijara Sukuk, the most popular structure, represent ownership of equal shares in a rented real estate or the usufruct of the real estate. For Sovereign Ijara Sukuk of the government of Pakistan,          a special purpose vehicle (SPV) known as the Pakistan Domestic Sukuk Company Limited (PDSCL) was established; the PDSCL issues Sukuk. The PDSCL raises funds from Sukuk-holders to acquire assets from the government and declare trust on these assets for the benefit of Sukuk-holders.

Each Sukuk certificate represents an undivided beneficial ownership interest in the trust assets. Subsequently, the trustee leases the assets for periodic payment of rentals for the life of the Sukuk. The rentals are received periodically by the trustee and distributed to the Sukuk-holders over the life of the Sukuk. On maturity of the Sukuk, the trustee sells the trust assets and the government purchases the assets while the proceeds are paid to the Sukuk-holders.         

Till now the government has issued total 18 domestic Sukuk and three international Sukuk. However, the share of Pakistan in the global market is still very low. According to the International Islamic Financial Market (IIFM), in the Sukuk database of December 2015 Pakistan’s share was below three percent (the issuance of two domestic Sukuk of Rs196.6 billion and one international Sukuk post-December 2015). Given that Pakistan has identified the country’s infrastructure needs in its Medium Term Development Framework, the financing for carrying out such developmental projects can be achieved through issuance of Sukuk.

Owing to its inherent strengths along with infrastructure requirements in the world, the global Sukuk market is expected to remain buoyant. The issuance of Sukuk is a complex process, and detailed documentation is required at each stage which ensures transparency. The expansion and progression of the Sukuk industry requires coordinated efforts from all stakeholders including issuers, regulators and investors.

The potential of Sukuk for economic growth, strengthening financial stability and catalysing inter-regional investment flows makes it an attractive asset class for issuers and investors. Going forward, it is hoped that the government will exploit the potential of Sukuk for broad-based development of the country.

 

The writer is a joint director at the
Islamic banking department of the SBP.