Hong Kong is considering finally passing a bill to make it easier for companies to issue dim sum sukuk (those denominated in Chinese yuan). One of the most interesting aspects is how muted the reaction is to a law which would come into effect in the first half of 2013, mostly due to the delay until the demand for dim sum bonds and sukuk had fallen. I found a post on my blog that the necessary legal changes were “almost done”…in February 2009.
Yet the underlying rationale for dim sum sukuk—the growth of China—may have slowed in the near-term, but unless the economy suffers a hard landing, there will be a return of demand for RMB sukuk. The Malaysian cellular company Axiata Group just issued its first (and the second ever) RMB-denominated sukuk for RMB1 billion ($160 million) which received strong demand (oversubscribed 3.5 times and priced at the bottom end of the expected range).
But the fall in demand is not just for dim sum sukuk; bonds are having a much slower year in 2012 due to slower Chinese economic growth. But should legislation be passed only when the market is pushing the hardest for it? I think that the appropriate time to put in place legislation for Islamic finance is when demand is slackest. This will provide an opportunity for the legislation to be thought through in a more thorough manner, and not be rushed into place.
It is also prudent to consider the factors that will keep RMB sukuk demand vibrant, allow longer tenor issuance and not require developing the ability for foreign issuers to use Shari’ah-compliant currency swaps to issue into the RMB market. In order to do so, there will have to be a pickup of growth for Chinese companies so that they have demand for sukuk issuance, and a source of funds to buy them.
This will be based on the trade flows between China and countries where Islamic finance is large (Malaysia and the GCC). According to Chinese customs data compiled by the US-China Business Council, Malaysia was the 7th largest supplier of imports to China while Saudi Arabia was the 10th with combined exports to China of $83.2 billion in 2010 and growth over 2009 of 55.9% and 39.2%, respectively.
China is trying to expand the international use of yuan in trade, and the currency is not freely convertible, so companies that export to China and get paid in yuan will seek investment opportunities in RMB, and some of those from countries like Malaysia and Saudi Arabia will seek sukuk rather than bonds, which should provide a stable and growing source of liquidity for the RMB sukuk market, which Hong Kong should be ready to pick up. If it fails to, it may lose the business to Malaysia, where the Axiata sukuk is listed.
Humayon Dar wrote a post on his blog recently that raised an important issue about the use of sukuk by companies. After pointing out the similarity between sukuk and conventional bonds in their risk-return profile, he cautioned: “An over-emphasis on asset-based Sukuk structures […] will increase [issuers’] indebtedness, thus magnifying the use of leverage in their capital structures. This will not only endanger operational sustainability of the borrowing corporates but will also contribute to the instability of the Islamic financial system as a whole. “
This is important to understand because much of the language used to describe sukuk focuses on the incorporation of an asset in the transaction makes it more stable, or secure than a conventional bond. However, most sukuk used an asset-based structure where only the legal right to benefit from an asset (the beneficial interest) is transferred, not full legal title.
As a result, the transaction amounts to an unsecured debt, and if the issuer defaults on the sukuk, the investors have only the right to line up with other unsecured creditors to seek recovery from the issuer. They do not have the ability to take the asset and sell it to recover their investment.
For the issuer, the disconnect between the performance of the underlying asset and the coupon and principal payments due to investors means it does not allow for losses to be shifted to sukuk holders (except in a liquidation, when the equity of the company is likely to be lost as well). There are slight differences in mudaraba sukuk (post-AAOIFI) where some of the principal may be decreased if the underlying assets do not generate enough income to pay the coupons.
As a result, the impact for the financial system of companies taking upon excessive debt by issuing sukuk will be identical to the situation where companies borrow too much with conventional debt. If too many companies become too leveraged (particularly in the financial sector), it sets up a possible debt-fuelled financial crisis.
Asset-backed sukuk may not be feasible in for many issuers, but the one protection they do provide is that investors can claim an asset (with caveats about whether they will be able to enforce on the asset in a default) while companies that issue asset-backed sukuk will potentially lose the assets backing the sukuk, but will not necessarily fail themselves if the asset fails to generate sufficient income to pay coupon and principal.
There have been some significant moves recently to introduce voluntary standards for Shari’ah scholar accreditation and managing potential conflicts of interest. There has been less progress getting these changes introduced in practice, and a lot of that has to do with their voluntary nature and lack of standardization of the proposals across borders in an increasingly global industry.
The focus recently on these issues is great, but it must have follow through to ensure it continues to progress towards implementation. When I was reviewing my past writing on the subject, I found a newsletter from 2010 about a proposal from ISRA that recommended creating a global Shari’ah adviser platform. I was supportive of that effort then, and I remain supportive, but it has not made measurable progress towards implementation in the 2+ years since it was proposed.
As far as actual proposals for the areas where regulations around Shari’ah scholars’ work, Murat Unal of Funds@Work wrote a short article (pdf) that proposes a few areas that I think are important (these are paraphrased):
- Central, transparent database of Shari’ah scholars’ assignments
- Separation of Shari’ah audit and other consulting/advisory roles
- Requirement for Shari’ah boards to have at least two younger Shari’ah scholars
- Rotation of chairmen and Shari’ah board members and clear rules on keeping minutes (including voting records) of the meetings and publication of fatawa
- Potential conflict caused by Shari’ah scholars serving on many boards and also on the boards of the standards-setting bodies
There has been a lot of focus on the governance aspects of these recommendations to ensure proper qualification of Shari’ah scholars (primarily assessing qualification in financial and contractual knowledge).
Less attention has focused on the areas where transparency can be introduced into the Shari’ah approval process, which I think is equally important. Understanding the process by which scholars decide the merits of a particular product are important for people not involved in the industry directly (e.g. potential consumers) to get a greater understanding about what makes different products Shari’ah-compliant.