A significant amount has been written and said about the sukuk, or Islamic bonds, market both globally and particularly in relation to sukuk originating from the Gulf Cooperation Council Countries (GCC). By Rizwan Kanji, senior debt capital markets lawyer, and Wiz Khayat, an associate, Norton Rose (Middle East) LLP Dubai.
The recent downturn in the global economy has had a negative impact in relation to the number and size of sukuk being issued both globally and from within the GCC. That said, the Kingdom of Saudi Arabia, in our opinion, may emerge as a key player in contributing to an increase in corporate sukuk issuance originating from the GCC.
The GCC and global sukuk market
Sukuk have gained great popularity over the past five to 10 years. During this period the volume of GCC sukuk issuance has risen in line with the overall increased activity in debt capital markets. Sukuk from the GCC region reached a five-year high at an estimated US$37.6bn in 2007, accounting for about 60% of the global sukuk market. As a result of the financial crisis and the subsequent downturn in the global economy, debt security issuance from the GCC fell to an estimated US$22.5bn last year, a reduction of almost 40% from 2007.
Historically, the UAE has been the main issuer of both sukuk and conventional bonds within the GCC, represented about half of total debt issuance in both 2007 and 2008 from the GCC. The UAE was followed by Saudi Arabia, which accounted for about 23% and 12% of total GCC debt issuance in 2007 and 2008, respectively.
Despite the ongoing financial crisis, sukuk issues roughly maintained their proportional levels relative to total debt issues within the GCC in 2008. Sukuk issuance represented about half of total debt issuance from the GCC in 2007, and about 40% of total debt issuance from the GCC in 2008. Issues from the UAE in 2008 represented around 60% of GCC corporate sukuk, followed by issues from Saudi Arabia, which accounted for about 24% of GCC corporate sukuk.
Based on announcements with respect to prospective issues, an estimated US$25bn of GCC sukuk are planned for 2009, with about half expected to continue to originate from the UAE.
Aside from the UAE, there are indications that a significant contribution to sukuk originating from the GCC will come from Saudi Arabia, which on the sovereign level has announced a number of key infrastructure and development projects in line with its policy of inward domestic investment. The sectors in which Saudi Arabia plans to deploy capital over the next five years include oil and gas infrastructure, general infrastructure, petrochemicals and electricity and water projects.
The current population demographics of Saudi Arabia are significant in supporting strong growth in the domestic consumer market. It is estimated that 79% of Saudi Arabia's population is under the age of 35, providing potential for greater demand for property mortgages, auto loans and general personal borrowing. It is expected that retail lenders will inevitably need to tap the international capital markets to meet potential increased demand for retail borrowing. The growth of the domestic market should also encourage the expansion of business interests that may require access to debt capital markets to help finance them.
An additional recent development in Saudi Arabia is a proposed law that would permit the granting of mortgages. With the lifting of limitations on mortgages, the true underlying value of real estate assets in Saudi Arabia could be tapped for the benefit of both retail and commercial sectors. The establishment of a mortgage industry would be significant for property developers and the financial sector in Saudi Arabia and would be likely to lead to the need for constant debt-raising to support such growth. The proposal to implement such a mortgage law is believed to be in advanced stages of consideration by Saudi authorities.
Recent key considerations in relation to structuring sukuk
Further to the discussion on trends in sukuk issuance from the GCC, it may be helpful to briefly discuss recent key issues in relation to structuring sukuk generally and in Saudi Arabia.
Returns and risk-sharing – By way of background, a fundamental principle of Sharia law is the prohibition of riba (ie, interest), which is essentially defined as a payment resulting from a return on money, as opposed to a payment from a return made on a Sharia-compliant asset. A starting point for architects of sukuk structures is typically to provide cashflows in the structure that would generate returns payable to sukuk holders.
These returns would then be attributed and traceable to Sharia-compliant assets. In these structures, sukuk holders own an undivided share in the underlying asset. This in turn meets the Sharia requirement of shared risk and reward in the underlying asset as opposed to the payment of money on money, as is the case in conventional bonds.
Sharia compliance – With conventional bonds, a termination event triggers, among other things, acceleration in the repayment of an investor's principal. In the Islamic context, a termination event accelerating the repayment of sukuk proceeds is typically managed through a purchase undertaking.
In a purchase undertaking, the transferor of the asset is required to repurchase the asset it initially transferred to a special purpose vehicle (SPV) at a predetermined price. As such, in terms of credit risk, sukuk investors are less concerned with the credit quality of the subject-asset, and more concerned with the transferor's ability to repurchase the assets at the predetermined price.
Certain market commentators are critical of a purchase undertaking purporting to guarantee capital while offering fixed profit payments. Some Islamic scholars argue that these types of purchase undertakings undermine certain fundamental Sharia principles, including the concept of risk-sharing.
The Accounting and Auditing Organization of Islamic Financial Institution (AAOIFI) has criticised structures utilising the purchase undertaking in sukuk other than in ijara (lease) structures. As noted above, purchase undertakings provide a mechanism at termination whereby the subject-asset reverts to the original owner at a predetermined price so that sukuk holders are repaid their initial capital outlay.
It is argued by AAOIFI that the purchase undertaking effectively provides a capital-guarantee feature and as a result the sukuk holder is not considered having a risk exposure to the value of the asset. By predetermining the repurchase price in the purchase undertaking, it is argued that the Sharia principle of risk sharing is undermined. That said, it should be noted that the sukuk holder is nonetheless exposed to risk because there is an assurance in a form of undertaking that the obligor will have to repurchase the asset at the predetermined price.
As a result, there has been a significant reduction in the number of sukuk utilising the musharaka, mudaraba and other similar structures. The ijara structure is currently the most prominent. Structures are being considered to address the concerns raised by AAOIFI.
Historically, the majority of debt issues from Saudi Arabia have been in the form of sukuk and it is expected that going forward this trend will continue. Accordingly, the above general structuring aspects will be applicable in addition to specific structuring factors in relation to Saudi Arabia.
Purchase undertaking and promissory notes – As set out above, under the ijara structure, the initial sukuk proceeds amount (which is analogous to the principal amount under a conventional bond) is essentially guaranteed by the requirement that the SPV sell back the underlying asset to the obligor at the original price.
One alternative that has been utilised previously in sukuk is the use of the promissory note, whereby the obligor issues a promissory note to the SPV in return for the initial capital outlay. This in turn provides sukuk holders with comfort that their initial investment will be repaid. In Saudi Arabia, the promissory note is evidence of debt owed by the promissor. As such, the enforcement of the promissory note does not require a court decision, as simple production of the promissory note is sufficient to invoke enforcement.
Tax implications (zakat and withholding tax) – In structuring sukuk originating from Saudi Arabia, one should be mindful of tax law implications. It should be noted that the initial one-off payment generated from the proceeds of the sale of sukuk (ie, the aggregate proceeds from the issue of sukuk) made to the obligor is subject to 2.5% zakat (a form of Islamic income tax). Second, the periodic payments made by the obligor to the issuer (ie, rental payments if an ijara structure is utilised) are subject to a 5% withholding tax.
The implication of zakat on the proceeds of the sale of sukuk is a cost that in most cases is borne by the obligor and is considered as a cost of borrowing. In relation to the withholding tax implications, most transactions have provided gross-up provisions that ensure that payments to sukuk holders are made at the amount due without any deductions.
Recently, there has been some reconsideration in relation to the applicable tax laws in Saudi Arabia in order to facilitate Sharia-compliant transactions, particularly in relation to zakat and withholding tax implications. Such reconsideration would naturally be welcomed by the obligor as there would be no requirement to gross up rental payments and therefore effectively allowing for lower profit rate premiums.
Conclusion
We have above briefly highlighted sukuk market trends in the GCC and the key indicators in relation to market trends going forward. The potential and opportunity that Saudi Arabia provides within the GCC and globally is widely acknowledged. Once certain key issues (some of which have been discussed above) are resolved, and with the passing of the proposed legislation, it is likely that Saudi Arabia will be a key contributor to the growth of sukuk issuance within the GCC.