Conventional bills, bonds, and notes which pay interest are unacceptable from an Islamic perspective.
Tradable financial instruments using Islamic structures were introduced in Pakistan in 1980 and Malaysia in 1990.
The defining characteristic of sukuk is their asset backing.
There remains much controversy over sukuk structures, especially among shariah scholars.
There is growing worldwide interest in sukuk, including from the Treasury in the United Kingdom.
Incompatibility of Conventional Financial Market Instruments with Shariah Law
Islamic capital markets are made up of two components, stock markets and bond markets. This contribution is primarily concerned with the latter rather than shariah-compliant stock determination. In particular it is sukuk that have become the accepted Islamic alternative to conventional bills, bonds, and notes, and hence are the major focus here.
Conventional capital market instruments such as treasury bills, bonds, and notes are unacceptable from a shariah Islamic legal perspective as they involve interest payments and receipts. Interest is equated with riba, an unjust addition to the principal of a debt, and is seen as potentially exploitative. Islamic economists prefer equity to debt financing because of the risk-sharing characteristics of the former, which is viewed as fairer to all parties. They are also concerned about the injustices that often arise with excessive indebtedness, as in the case of developing country debt, or simply the higher interest charges often faced by those with no collateral to offer and the poor more generally.
Nevertheless, government and corporate borrowing is unavoidable, and can indeed be beneficial if the finance is used productively for investment that can contribute to employment and prosperity. Bank lending, however, commits assets on a long-term basis and reduces liquidity. The advantage of using capital market instruments to raise finance is that investors can exit at any time rather than wait for assets to mature. Furthermore, the investment banks that arrange the issuances earn fees and do not have to commit their own resources, unless the bill, bond, or note issue is not taken up, in which case, as underwriters, they will have to purchase the issuance.
The Introduction of Islamic Capital Market Instruments
There are no shariah objections to financial markets, only to the interest-based instruments which are traded in the markets. Therefore, the first attempt to develop shariah-compliant debt instruments involved securitizing traditional Islamic financing instruments, as with the mudaraba certificates issued in Pakistan from 1980 onward after a law was passed giving legal recognition to the certificates. Mudaraba involves the establishment of partnership companies with investors, and the company managers share in the profits, but the financiers alone bear any losses. In 2008 the original law was amended to bring the mudaraba companies under the regulatory supervision of the Securities and Exchange Commission of Pakistan, the aim being to ensure better investor protection.
In Malaysia, where Islamic banking started in 1983, a natural innovation was to securitize the debt instruments used, mainly murabaha financing, where a bank would purchase a commodity on behalf of a client and resell it to the client for a markup, with settlement through deferred payments. The first instrument was issued by the Shell oil company’s Sarawak subsidiary in 1990, with Bank Islam Malaysia as the arranger. By attracting third-party investors interested in benefiting from these deferred payments, the bank could use its capital for further financing rather than having it committed on a long-term basis. This debt trading, known as bai al-dayn, is permitted by the Malaysian interpretation of the Shafii School of Islamic jurisprudence which prevails in Malaysia and Indonesia, but is not permitted in Saudi Arabia or the Gulf. Scholars of Islamic jurisprudence in the Gulf believe that debtors should know who they are indebted to, rather than having their debt obligations traded in an impersonal market.
Given the concerns with bai al-dayn, it became clear that an alternative approach was needed to the securitization of debt instruments, and it was this that resulted in the emergence of sukuk. The defining characteristic of sukuk is that they are asset-backed, which implies that when they are traded the investors are buying and selling the rights to an underlying real asset, usually a piece of real estate or a movable asset such as equipment or vehicles. It is this that makes the transaction legitimate, as under sura 2.275 in the Qur’an, it states that “God hath permitted trade but forbidden riba.”
The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) has stated that for “sukuk, to be tradable, [they] must be owned by sukuk holders, with all the rights and obligations of ownership in real assets.”1
Again, it was Malaysia that took the lead in sukuk issuance, the first being for Malaysian Newsprint Industries in 2000, with an eight-year maturity. It was, however, the Malaysian government’s global sukuk in June 2002 that brought international attention, this being the first ever sovereign sukuk, with maturity after five years, the sum raised being $US 600 million. State-owned land provided the asset backing, and an ijara structure was used, with the government selling the land to a special purpose vehicle (SPV) and leasing it back, and the investors in the SPV receiving a rental income as indirect owners rather than interest payments. The returns were, however, benchmarked to the London Interbank OfferedRate (LIBOR), the return being LIBOR + 0.95%, which meant the sukuk had similar financial characteristics to a floating rate note. HSBC Amanah, the Islamic finance affiliate of HSBC, acted as arranger.
Since 2002 sukuk issuance has risen remarkably, with sukuk issuance peaking at $US 46.6 billion in 2007, representing 205 issuances. The subprime crisis in asset-backed securities had a negative impact on sukuk issuance from August 2007 onward, demonstrating that Islamic finance was not immune from global financial developments. However, it mainly affected dollar-denominated issuance, as issuers who were asked to pay much more for their financing decided to postpone or abandon planned sukuk. Hence, US dollar-denominated issuance fell to just over $US 1 billion over the September 2007 to September 2008 period. Sukuk issuance in other currencies was less affected, however, with the equivalent of $US 15.4 billion issued in Malaysian ringgit over the same period, and $US 6.6 billion in UAE dirhams, even though the latter currency is pegged to the dollar. The need for funds for project finance continues to propel sukuk issuance in the Gulf, with the Saudi Arabian Basic Industries Corporation, the region’s leading petrochemical producer, issuing sukuk worth $US 1.3 billion in May 2008, with the sukuk being riyal-denominated and paying SAIBOR (Saudi Arabia Interbank Offered Rate) plus 48 basis points over a 20-year period.
AAOIFI has identified 14 types of sukuk with different risk and return characteristics. Salam sukuk, for example, are a short-term substitute for conventional bills, as they yield a fixed return, usually over a 90-day period, and are regarded as very low-risk instruments, not least because the issuers are usually sovereign governments rather than corporate clients. The major limitation of salam sukuk, however, is that they cannot be traded, unlike treasury bills, as the investors are paying in advance for the delivery of an asset in 90 days. Under shariah investors can only trade assets that they own, and not those that they hope to own at a future date.
With the ijara sukuk cited above there is a return risk, as payments are usually linked to LIBOR which varies, and typically the issuance is for three to five years, which increases the possibility of default risk. Ijara sukuk can, however, be traded as the investors have a title to the underlying assets. This also applies in the case of mudaraba sukuk, which in some respects are less risky than their ijara equivalents as they pay a fixed return.
Unresolved Shariah Concerns with Sukuk
Despite the success of sukuk there remain fundamental questions about their legitimacy from a shariah perspective, as the current structures have been devised by lawyers and investment bankers and are not shariah-based, and as the contracts in traditional Islamic jurisprudence, fiqh, are significantly different. The sukuk are shariah-compliant in the sense that they have been approved by the shariah boards of the institutions undertaking their arrangement, but the shariah scholars serving on the boards have not been involved in the structuring of the financial instruments.
The first concern is overpricing, as although with mudaraba sukuk the returns are profit shares and with ijara sukuk they are rents, the benchmarks used, whether LIBOR or SAIBOR, are interest rate proxies. These are used so that the returns to sukuk investors are competitive with those on comparable conventional bonds and bills, but this is driven by market considerations and not by shariah. The second concern is that the returns to Islamic investors are supposed to be justified by risk-sharing, the notion of taking on each other’s burden. With sukuk, however, the main risk for the investors is of default, and in such circumstances the investors can be expected to instigate legal proceedings against the issuer to try to reclaim as much of their investment as possible. Most sukuk are rated, and the rating reflects the probability of default risk, which in turn is reflected in the pricing. For sovereign sukuk, for example, Pakistan has to pay a higher return than Qatar or Malaysia, reflecting country risk perceptions, yet it is the Government of Pakistan that can least afford the debt servicing.
Sheikh Taqi Usmani, a leading shariah scholar who specializes in Islamic finance, alleged in a speech in November 2007 that most sukuk were not shariah-compliant, as the investors expected to get the nominal value of their capital returned on maturity, avoiding exposure to market risk. In the case of mudaraba and musharaka sukuk, he believed that the amount the investor gets returned on maturity should reflect the terminal market value of the asset backing the sukuk and not simply its initial nominal value. The asset used as backing for the sukuk should have real financial significance and not simply be used as a legal proxy to justify sukuk trading.
Unlike equity investors, sukuk investors do not want market exposure. There may be justifiable reasons for this. First, investors may want a balanced portfolio and may be willing to risk a proportion of their capital for a potentially higher return, but they may not be willing to take excessive risk. Second, Islamic takaful insurance operators hold significant amounts of sukuk in their asset portfolios in the same way as conventional insurance companies hold bonds and notes. If their capital diminished, they would be unable to meet the claims of their members. If asset values are at risk this may also distort the type of sukuk which can be offered. The first Saudi Arabian sukuk was by HANCO, a car rental company, with the vehicles used as the underlying asset. If the original vehicles had been revalued on maturity after three years, they would have been worth less, and the investors would have lost some of their capital. Where real estate is used investors may gain, but those wanting exposure to the real estate market will invest directly, rather than through sukuk.
The Globalization of Sukuk
Despite controversies over the structuring and characteristics of sukuk, they have become an established asset class of interest to conventional as well as Islamic financial institutions. In the United Kingdom, HM Treasury published a consultation document on sukuk in November 2007 declaring that such an issuance could “deliver greater opportunities to British Muslims—and also entrench London as a leading centre for Islamic finance.”2 Following responses to the consultation, another document was published in June 2008 indicating that the Treasury was planning a series of sukuk bills issues, probably starting in 2009, which would provide a benchmark against which sterling corporate sukuk could be priced.
There have been sukuk issues already in other Western countries, with the German state of Saxony–Anhalt issuing a Euro-denominated ijara sukuk in July 2004 and the East Cameron Gas Company issuing a sukuk in the United States in June 2006. The major potential is in the Islamic world, however, and it is notable that in the most populous Muslim country, Indonesia, interest in sukuk is increasing, with Metrodata Electronics issuing an ijara sukuk in April 2008 to fund its expansion in telecommunications. Qatar has been particularly active in sukuk issuances, with major sovereign sukuk issued in September 2003 and January 2008, and 12 corporate sukuk, including by leading Doha-based real estate and transportation companies. In the years ahead the Qatar Financial Centre may well become a major center for sukuk trading, contributing to the country’s diversification into financial services.
The temporary pause in dollar-denominated sukuk issuance provides an opportunity for reviewing sukuk structures, and in this context the debate that followed Sheikh Taqi Usmani’s remarks is timely. There can be no doubt that once the market in conventional asset-backed securities revives internationally, dollar-denominated sukuk issuance will revive. The weakness over the 2000–07 period, however, was that although there was much new sukuk issuance, trading was limited, apart from in Kuala Lumpur in ringgit-denominated sukuk. The investment banks and regulators of financial centers in the Gulf, and indeed London, will have to consider how more active trading can be facilitated, as until this occurs sukuk will not fulfill their potential in providing long-term financing while maintaining investor liquidity.
1 Accounting and Auditing Organization for Islamic Financial Institutions shari’ah board statement. Bahrain, February 13 and 14, 2008; p. 1. Online at: www.aaoifi.com/aaoifi_sb_sukuk_Feb2008_Eng.pdf