Economic Update

Published 09 Sep 2020

While Islamic banks emerged relatively unscathed from the 2008 global financial crisis, Covid-19 is having a deeper impact. Nevertheless, the disruption could provide opportunities to diversify the sector and accelerate its expansion once the pandemic subsides.  

Relative to conventional institutions, Islamic banks are more exposed to small and medium-sized enterprises (SMEs), microfinance and retail lending – particularly in Asia. The economic performance of core Islamic finance jurisdictions is likely to remain subdued for the rest of the year.

Consequently, although the industry had previously been on track for strong growth in 2020, ratings agency Standard & Poor’s (S&P) projected in June that it would record low- to mid-single-digit growth in 2020-21, due both to the pandemic and oil price uncertainty.

This is compared to 11.4% growth last year, which was underpinned by a more dynamic sukuk (Islamic bond) market and new growth opportunities.

Nevertheless, S&P believes that Covid-19 could unlock the long-term potential of the sector, arguing that the pandemic provides “an opportunity for more integrated and transformative growth with a higher degree of standardisation, stronger focus on the industry’s social role and meaningful adoption of financial technology”.

Sukuk amid the pandemic

Financial certificates similar to bonds in conventional banking, sukuk are a key element of the Islamic finance ecosystem.

However, the sukuk market is more concentrated, smaller and less liquid than its conventional counterpart. In addition, the process for issuance remains relatively complex and time-consuming, and involves higher transaction costs.

As such, it is expected that the overall volume of issuance will be muted this year, even if a slight recovery follows on from the steep decline seen in recent months. S&P anticipates that the volume of issuance will reach $10bn in 2020, against the $162bn seen in 2019.

Nevertheless, there have been signs that the pandemic could prompt an expansion in the role of sukuk.

In June, for example, the Islamic Development Bank (IsDB) raised $1.5bn with its first-ever Sustainability Sukuk, designed to aid the recovery from Covid-19 in its member countries.

Proceeds will go exclusively towards social projects under IsDB’s Sustainable Finance Framework, with a focus on “access to essential services” and “SME financing and employment generation”.

Following the success of the sukuk, Bandar Al Hajjar, president of the IsDB, called on the Islamic finance industry “to promote sustainable and social sukuk as alternate asset classes that have the potential to counter the multi-fold impact of the Covid-19 coronavirus”.

Several countries have begun exploring the potential of the vehicle in this context.

In June Indonesia issued a $2.5bn wakala (agency) global sukuk in three tranches, one of which was a $759m green sukuk, dedicated to sustainable development.

The principal aim of this sukuk, which was oversubscribed by nearly seven times, was to support the government’s coronavirus programme, as well as “to strengthen Indonesia’s position in the global Islamic financial market and support the development of Islamic finance in the Asian region”, Dwi Irianti, director of Islamic financing at the Ministry of Finance, told local media.

Despite being home to the world’s largest Muslim population, Indonesia has yet to fully leverage Islamic financing. This issuance is therefore an encouraging sign.

Meanwhile, it was recently announced that Malaysia’s Ministry of Finance will launch a RM500m ($120m) Sukuk Prihatin on September 22. Proceeds will go towards financing economic stimulus measures, as well as helping micro-enterprises, improving broadband coverage in schools and funding research in infectious diseases.

Post-pandemic future

While Covid-19 has given rise to industry-wide headwinds, these recent examples demonstrate how it has also prompted increased awareness of the potential of Islamic finance. How can this momentum be sustained and increased as we enter the post-pandemic world?

Digitalisation and the increased prominence of financial technology (fintech) are key.

“Covid-19 has led us to accelerate the digital transformation that was already under way prior to the pandemic,” Ayman Sejiny, CEO of ICD, told OBG.

This will expand access and increase the socially transformative role of the sector.

In addition, fintech can increase standardisation, streamline processes, reduce costs and boost transparency, making Islamic financial instruments more competitive relative to conventional forms.

With regards to sukuk, standardisation is particularly important, both in terms of the theory underpinning the vehicle, and the legal documentation associated with it.

Greater standardisation will also enable Islamic banks to move into new areas.

“Islamic finance should now explore new sectors such as health and sharia-compliant tourism. We should work hard to develop Islamic banking products suitable for these sectors,” Sejiny told OBG.  

There is also the potential for Islamic finance tools to play a greater role in trade, which could help to boost the economic recovery in emerging markets. 

“The Covid-19 outbreak has put in motion new opportunities for Islamic finance markets, such as the provision of sharia-compliant trade finance products, as well as trade development programmes to promote a stronger focus on social impact, sustainability, innovation and digitalisation,” Hani Salem Sonbol, CEO of International Islamic Trade Finance Corporation, told OBG. 

While Islamic banking continues to face significant headwinds related to Covid-19, the crisis could constitute an important watershed in the global growth of the industry.