While bankers might decry the slowdown in growth resulting from curtailed government spending and investor uncertainty, economists – who generally take a longer-term view – often see a silver lining in a sustained drop in the price of a barrel of oil.
Falling hydrocarbons revenues have compelled governments around the Gulf to embark on a process of fiscal reform many believe was overdue, and argue would not have been undertaken if prices had remained elevated. The new economic landscape has also encouraged governments to find alternative sources of capital to meet their spending obligations, resulting in a more diverse funding mix that is better able to withstand fluctuations in oil prices.
Debt issuance, which was not prominent on the agenda in the years leading up to the oil price decline that began in 2014, has become an area of interest for GCC governments, and the past two years have seen the emergence of clearly defined sovereign debt programmes, new debt ceilings and debt management institutions charged with coordinating sovereign offerings. This is good news for the region’s Islamic financial services (IFS) industry.
Governments looking to issue debt have noted the growing popularity of Islamic financing, and have shown increasing enthusiasm for sharia-compliant debt issuances. The past year has been especially fruitful for global sukuk (Islamic bonds), starting with a $9bn offering by Saudi Arabia in April 2017.
REGIONAL LEADER: This trend is not a new one. Since the first issuance of a modern sukuk in Malaysia in the 1990s the instrument has become an international staple, flourishing first in the GCC and more recently considered as an alternative route to funds in markets as diverse as Morocco, Nigeria and South Africa. In 2014 the UK became the first Western nation to issue a sovereign sukuk, offering a five-year instrument with a yield of 2.036%, which netted $3.9bn. The issuance was oversubscribed by 11 times, and this success in one of the world’s main financial centres represented an important acknowledgement of the concept by the global financial industry.
Bahrain has played a key part in the journey of sukuk from South Asian innovation to global standard, establishing itself as an important source of issuance and regulatory development. According to Thomson Reuters, between January 1996 and September 2013 the kingdom was the origin of 94 sukuk issuances, more than any other country in the region.
Bahrain has been at the centre of the institutional framework that has helped popularise sukuk globally. In 2001 it signed an agreement with Indonesia, Sudan, Saudi Arabia and Malaysia to establish the International Islamic Financial Market (IIFM), which was charged with creating a secondary market for the trading of sukuk and other Islamic financial instruments. The IIFM has played a key role in harmonising the standards applied to global sukuk, a task primarily carried out by a sharia supervisory committee made up of Islamic scholars from different regions and sharia schools within the member countries.
The Bahrain-based Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) has also been instrumental in the development of the modern sukuk market, setting standards which have resulted in course corrections as the instrument has evolved. A notable instance of the AAOIFI’s productive intervention came in 2007, when Taqi Usmani, chairman of its sharia board, published a paper stating that most sukuk in the market – those using a musharaka (partnership) or mudaraba (profit-sharing) structure – were not in line with sharia principles. The pronouncement led to the AAOIFI’s sharia board producing a comprehensive statement on sukuk frameworks in 2008, which established the direction of the instrument’s subsequent development.
APPETITE TEST: Despite Bahrain’s legacy of sukuk issuance and regulation, in 2017 questions were raised as to the kingdom’s ability to maintain its status as a leading originator, due to both internal and external developments. Bahrain’s weakened balance sheet, a result of the oil price drop, resulted in unfavourable ratings movements by all three major agencies (see Economy chapter). The sovereign rating has been lowered to non-investment grade with a negative outlook by Moody’s (“B1”), Standard & Poor’s (“BBregion, sovereign issuance spreads widened in 2017 as markets reacted to the new economic backdrop.
There have also been potentially damaging developments in the broader sukuk arena. Most notably, the vulnerability of sharia-compliant debt instruments to regulatory lacunae was demonstrated when UAE-based Dana Gas announced that it could not make payments to creditors as it had determined that its $700m sukuk was “unlawful”. Instead, the company proposed to replace the instrument with a four-year bond that would provide an interest payment equivalent to half that of the original.
This raised the possibility of a wider erosion of trust in Islamic debt offerings, and in 2017 it was reported in the global press that sukuk holders were seeking legal opinions regarding their investments. Adding to the sense of market uncertainty in 2017 was the diplomatic stand-off between Qatar and other GCC states that began in June, with its associated interruptions to transport and trade.
NEW OFFERING: These factors combined to make Bahrain’s September 2017 sovereign debt offering one of the most keenly observed in years. The kingdom widely trumpeted its first issuance since October 2016, holding investor roadshows in the UK, the US, the Middle East and Asia. The multi-tranche transaction was worth a combined $3bn, the largest in the kingdom’s history, and included a 7.5-year dollar-benchmark sukuk, which in the initial price talk of September 2017 was established in the 5.625% area.
Despite a reported block on bids by Qatari investors, strong demand from others drove books to over $15bn, an unequivocal demonstration of continued appetite for Bahraini government debt.
The $850m sukuk which was part of the deal was the biggest sharia-compliant bond to be offered in the region since the Dana Gas controversy, and has therefore been interpreted as an important vote of confidence in the principle of sukuk.
POSITIVE IMPLICATIONS: Bahrain’s sovereign issuance in the final quarter of 2017 has positive implications both for the kingdom’s ability to raise funds via sharia-compliant sovereign offerings, and for the longer-term future of sukuk in the global market. Once again Bahrain has played an important role in the instrument’s development, during a year in which it has been viewed with scepticism by some investors.
Nevertheless, the Dana Gas dispute has served as a reminder of how a young and evolving regulatory framework represents a potential vulnerability for the future expansion of sukuk. While the response to Bahrain’s sovereign issuance was encouraging, market conditions for future deals may not be so favourable. The kingdom’s government debt-to-GDP ratio has more than doubled since the onset of the Arab Spring, rising from 32.8% in 2011 to reach 82.1% in 2016.
While Bahrain’s strong links with regional allies help to explain why investors have shrugged off the verdict of international ratings agencies and continued to direct their capital to government paper, this enthusiasm is likely to decline as the debt burden increases. This is a concern for the wider region too, as debt programmes replace oil revenues in the funding mix.
Many in the GCC financial sector believe that regional sukuk issuances might grow more rapidly if jurisdictions around the Gulf improve the regulatory framework surrounding them. Bahrain’s recent tightening of the regulatory framework covering sharia finance in its jurisdiction is therefore a timely one.
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