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.