Oil prices have plummeted sharply since mid-2014, putting an end to the commodities super cycle that started a decade ago. S&P Global Ratings expects oil prices will remain substantially below peak levels and stabilize at $50 per barrel by 2018 and beyond. When prices began to fall, several market commentators predicted a boom in Sukuk issuance in 2015 and thereafter, arguing that governments in oil-exporting countries would tap the Sukuk market to attract funding and maintain their current and capital spending. However, as we anticipated, the predicted windfall didn't materialize, with total issuance actually dropping compared with last year (see "The Global Sukuk Market: The Correction Is Here to Stay," published Jan. 6, 2016, on RatingsDirect). We continue to believe that Sukuk issuance will remain muted over the next 6-18 months for several reasons.
In our view, issuance in the second half of 2016 will continue to depend on monetary policy developments and volatility in developed markets as well as the policy actions of sovereigns in core markets--namely Gulf Cooperation Council (GCC) countries and Malaysia--in response to lower oil prices. While governments affected by the price drop are looking to spending cuts, taxation, and the privatization of state companies to adjust to the new reality, their financing needs remain significant. We think that part of these needs will be met by conventional debt markets and, to a much lesser extent, the Sukuk market, with the complexity of Sukuk issuance remaining a key deterrent to tapping the market.
• We assume Sukuk issuance will remain subdued, with total issuance of $50 billion-$55 billion in 2016.
• The complexity of Sukuk issuance, uncertainty regarding U.S. Federal Reserves' policy revisions, and government efforts to reduce financing needs in response to weak oil prices have and will continue to weigh on Sukuk market activity, in our view.
• At the same time, we believe the European Central Bank's quantitative easing program and the entrance of a few new issuers to the Sukuk market will continue to support issuance volumes.
Market Activity Remained Subdued In The First Half Of 2016
Despite the significant drop in oil price since mid-2014, total Sukuk issuance didn't pick up in 2015 or the first half of 2016, as was predicted by several market commentators. In fact, issuance actually dropped in the first half of 2016 by 12.5% compared with the same period in 2015 (see Chart 1).
S&P Global Ratings' base-case scenario assumes that Sukuk market activity will remain subdued for the remainder of 2016 with total issuance reaching around $50 billion-$55 billion for the full year 2016 compared with $63.5 billion in 2015. We expect this to be the case for several reasons: The negative correlation between oil prices and Sukuk issuance is a myth As with conventional capital market issuance, the size and frequency of sovereign Sukuk issuance increased alongside oil prices from 2009 to 2014, albeit at a much more subdued rate. A simple correlation coefficient between Brent spot prices and monthly Sukuk issuance volume shows a relationship of just 0.16 for Middle Eastern sovereign issuers. We note that the development and depth of debt capital markets is also an important consideration when interpreting this data. For instance, Sukuk issuance has risen, but from a small and shallow base, which in part explains the volatility in this type of issuance. In our opinion, one of the principal reasons explaining the lack of linkages between oil prices and Sukuk issuance is the large stocks of fiscal assets that many GCC countries have built up through years of fiscal and current account surpluses. Along with conventional debt issuance, governments are now using these assets as a source of public-sector deficit financing (or for infrastructure projects). Instead, the broader rationale behind GCC sovereign Sukuk issuance thus far, including that of central banks, has been for project financing, for benchmarking, or to offer liquidity-management instruments to local Islamic banks. Bahrain and Oman have been exceptions in the GCC as more active issuers of Sukuk and conventional bonds due to the smaller size of their reserves and the significantly higher fiscal breakeven oil price for their respective budgets.
Policy response impacts are starting to show
In response to sinking oil prices, GCC governments are introducing a mix of spending cuts and revenue-boosting initiatives to reduce their fiscal deficits and the speed of external asset burning. The reduction of energy subsidies, revaluation and reprioritization of current and capital spending, discontinuation of projects are among the strategies used by some GCC countries to adjust to the new oil price norm. Additional measures such as a tax introduction (VAT is likely to be introduced in the GCC by 2018-2019) or partial privatization of state companies (Aramco for example) are in the pipe.
A recent study by the International Monetary Fund (IMF) shows that some GCC countries will have to cut spending by significantly more than others to balance their budget with an oil price of $50 per barrel (see Chart 2). For Kuwait, this is less than 5%, while it would be more than 40% for Bahrain.
The exact deficit financing mix in our assumptions differs by sovereign, but on average, we expect GCC countries to finance their deficits using a mix of their assets and conventional debt/Sukuk issuance. We also think that sovereigns will rely more heavily on conventional issuance. In the first half of 2016, total conventional debt issuance (in the GCC) increased by 148.2% compared with the same period in 2015, while Sukuk issuance dropped by 15.2% over the same period. Most of the growth in conventional issuance is explained by Saudi Arabian and Abu Dhabi bond issuance
The complexity of Sukuk issuance deters market activity
One of the reasons why Sukuk issuance in the GCC is dropping while conventional issuance is booming is related to the difficulties inherent to Sukuk issuance (see Chart 4). While some commentators in the market believe that this debate belongs to the past, we continue to see this as an important issue. Today, it is still more time consuming and complex to tap the Sukuk market than issue a conventional bond. The time and cost gap has reduced but is still there.
On a positive note, several heavy weights in the financial industry are pushing the market toward more standardization, and preparing it for greater innovation and accelerated growth. The IMF advised GCC governments to integrate Sukuk issuance in their debt-management strategies. The Islamic Development Bank (IDB) and the Accounting and Auditing Organization for the Islamic Financial Institutions (AOIFI) are working separately on introducing more standardization to the legal documentation. The IDB is also working on a new structure that could, if implemented, simplify the Sukuk issuance process. In our opinion, standardization could help the market in two ways: On the one hand, it will restore the attractiveness of Sukuks for new and existing players. On the other hand, it will free up the capacity of market participants to develop new Islamic financing products that cater to the opportunities created by the regulatory changes in the global financial system (through higher profit and loss sharing) and the sustainable development agenda (through products for the financing of infrastructure).
Iran could be a game-changer but only in the medium term
Market participants are looking at Iran to turn up Sukuk market activity, because of the significant size of the country's investment needs. We think that the Iranian banking system and government resources alone cannot fulfill these needs. Therefore, we expect that some investment will find its way to the Sukuk market, assuming that Iran makes the necessary regulatory adjustments and, more importantly, all sanctions are lifted. However, we are of the view that this will take some time to materialize and translate into meaningful market activity. Besides Iran, we also expect to see some returning issuers (Indonesia, Hong Kong, Luxembourg, etc.) and a few new issuers, such as, Tunisia, which is currently going through the phase of market education as it tries to counter the perception that Sukuk issuance is the same as privatizing state assets.
Other important factors
We believe that the future direction of monetary policy and the recent episodes of volatility in advanced markets will also play a role in shaping future Sukuk market activity. Rate increases by the U.S. Federal Reserve will result in a drop in global liquidity that will ineluctably reduce global investor appetite for Sukuk and push up prices. Similarly, significant volatility in the international capital markets, such as the one we have seen following the U.K.' s referendum to leave the European Union (Brexit), could cause significant delays in issuances be it Islamic or conventional. Some market participants tend to forget that the Sukuk market is just a component of the global capital markets and that U.S. and European investors are still major Sukuk investors. At the same time, we are of the view that the market could benefit from the European Central Bank's (ECB) quantitative easing. Yields have been low or even negative for prolonged periods across Europe. As the ECB has opened widely liquidity taps to fight the deflationary pressures, we think that some investors are actively looking at emerging market instruments for better yields and believe that the Sukuk market will benefit from that.