The year 2014 was an important one for the development of sukuk in Dubai, thanks to a series of sovereign sales from non-Muslim countries that have diversified sources, as well as proved the presence of global interest in this relatively young financial instrument. Sukuk are at the core of Dubai’s economic strategy, both as a method of raising capital and as a centre for trading. The emirate is likely to continue as a major source of issuance, in particular from the government-related entities (GREs) tasked with financing and developing signature projects, such as the infrastructure and real estate developments that will be required for Dubai to host Expo 2020. The emirate will also be a prime option for trading in the secondary market, as NASDAQ Dubai offers the third-largest volume of sukuk listings, in terms of aggregate market capitalisation.
Dubai has taken a leadership role in shaping the future of sukuk as a financial instrument. As a common set of rules, standards and expectations have not yet fully formed for the instrument, markets and practices worldwide differ. The global sukuk market as a whole is slowly converging, as sellers seek to appeal to the broadest possible group of investors, but Dubai is confident it can improve and accelerate that process by providing leadership. In 2014 the emirate sponsored discussions and roundtables, and plans to carry on with this role. The emirate’s vision is a globally integrated sukuk market with harmonised structures that are less risky, and easier for investors to understand.
Sources Of Growth
Regardless of how long this takes, it was clear in late 2014 that the size of the sukuk market is going to expand and that Dubai will be an important player in that process. In general this is because demand for sukuk far outweighs supply. Demand is fuelled by banks, which are keen to deploy capital to new sources. The growth in overall Islamic banking assets worldwide should, in general, be followed by growth in sukuk issuances. At present the UAE does not issue debt on a regular basis to help banks with this, but it may do so in the future. A law that would allow for it has been debated for years and as of late 2014 was being considered at the federal level, according to a country assessment published by the IMF.
Dubai, on its own, has to adjust its legal and regulatory environment, which is increasingly designed to encourage sukuk issuance to reduce reliance on bank financing. However, the UAE’s efforts to promote standardisation would encourage growth by simplifying processes and reducing the time spent on a per-issue basis by underwriters, lawyers and sharia scholars, who all come at a cost to issuers. Less expensive issuance is expected to lead to increased issuance.
The emirate’s growth plans, including new projects to prepare for Expo 2020, will require debt financing. The GREs that played important roles in building up Dubai in the 2000s used bank loans to finance their developments, and when contagion from the financial crisis spread to the emirate in 2009 and 2010, the banks suffered from this high degree of exposure to GREs. The Central Bank of the UAE (CBU) has subsequently introduced several macro-prudential regulations to avoid a repeat of this pattern. For example, banks are no longer allowed to lend more than 25% of their capital to any one customer, with the stipulation that GREs effectively count as one customer. That means the concentration risk to them as a group is limited to a one-fourth of capital. GREs will have to look for other financing options in addition to bank lending, and sukuk are expected to be a top choice.
There are two key exceptions to this rule, one of which is particularly relevant for the sukuk market. The first is that GREs with strong enough balance sheets do not have to be counted with the others in the 25% cap. Banks can treat them as a single entity, lending up to 25% of their capital in addition to the 25% allotment to this class of firms as a group. GREs can qualify for this exemption if they are profitable, able to service their debt loads without government assistance and are rated at least “BBB-” (or the equivalent) by any of the main ratings agencies: Standard & Poor’s, Fitch or Moody’s.
The second exception, and the most relevant for sukuk issuance, is that banks can invest in bonds and sukuk issued by GREs without that total counting towards the 25% cap, as long as the security is rated at least “AA-”, or the equivalent, from a ratings agencies. Enforcement of these rules would boost sukuk issuance and incentivise GREs to improve their operations (and thus their credit ratings), and benefits from that would filter through to the economy as a whole.
In the discussions hosted in Dubai as of end-2014 the idea of standardisation has been linked to several important benefits, but chief among them is improved sharia compliance. Sukuk that are agreed upon by all to be in accord with the religion would have the largest possible pool of investors and would provide a precedent to be copied in the future, making issuance faster and cheaper. Sharia scholars do not always agree on what makes for a sharia-compliant sukuk, and to some extent complete agreement is impossible – Islam has four schools of thought and no central authority, so differences have emerged over the centuries and will remain. Within Islamic finance, one disagreement stands out as historically relevant – in 2007, a prominent Pakistani scholar named Sheikh Taqi Usmani said that sukuk using the mudaraba ( cooperative investing) and musharaka (joint venture) structures, the dominant ones at the time, were not sharia compliant. Sukuk deals have moved on to newer methods and there is widespread agreement today that sukuk following the principles of ijara (leasing), wakala (an agency type of relationship), or a hybrid of both are an ideal form. Whenever circumstances allow for it, familiar structures are used to reduce the cost and time that existing precedents and documentation afford in the design of a new sukuk instruments.
Dubai aims to be widely considered the capital of the global Islamic economy, and this is a multi-pronged plan in which standardisation is an important element. Bodies to set rules for what is considered halal in food and consumer goods, in Islamic finance and other areas have all considered Dubai an ideal place to meet and discuss their issues. The emirate hosts conferences, trade shows and other events to help this process along. Ideas for how to bring standards to the sukuk market have focused thus far on the sharia scholars themselves. Currently every Islamic financial entity – banks, providers of takaful, securities issuers, investment houses and others – uses a board of sharia scholars to approve individual products and overall operations. The pool of scholars is small and these men are kept busy serving on multiple boards. In addition, some countries have their own sharia boards, as do some standards-development organisations.
No Single Board
The idea of one sharia board to oversee global matters has been ruled out, as interpretations of Islam vary, but alternatives include setting national standards, or establishing a single global entity to act as a trustee for the special-purpose vehicles (SPVs) sukuk require. SPVs allow holders a claim on revenue from an asset of the sukuk seller, and typically those assets are placed in SPVs until claims are met.