Beyond willpower

Islamic finance is slowly becoming a force in Turkey – but it needs more supply to match the clearly rising demand. Elsewhere, we’re seeing a host of products rise in popularity, from CoCos to project finance to SME covered bonds.

Man is not truly one, but two, said Robert Louis Stevenson. The same might be said to be true of most countries, not least Turkey, a nation with diametrically opposed faces: one commercial, one political.

First-time visitors see an increasingly modern country whose economy is driven quietly from within by an “intelligent and capable business elite and a strong entrepreneurial spirit”, said Timothy Ash, head of emerging market research in London at Standard Bank.

The country’s political mien is rather different. This may be an ostensibly secular nation that still cleaves to Mustafa Kemal Ataturk’s 1924 Constitution, which excised Islam as the national religion.

Yet at heart it remains a deeply conservative and pious nation, embodied in the modern era by President Recep Tayyip Erdogan, whose efforts to reinsert faith into the country’s bloodstream is affecting society at all levels, and quietly shaking up the nation’s capital markets.

A key moment occurred in late 2012, when the government raised US$1.5bn from its first Islamic bond issue. The debut sukuk offering, which attracted heavy bidding, was widely seen as a landmark for the industry.

Many expected it to usher in a new era of Islamic finance and Islamic bond issuance in a country seen as a bridgehead between the West and the Middle East. Islamic financial assets globally reached US$2.1trn in 2014, up from US$1.3trn in 2011, according to the Dubai-based AlHuda Centre of Islamic Banking and Economics.

And while the industry has struggled for momentum since that blockbuster debut sukuk issue, this year, for all of the economic turbulence and political uncertainty surrounding Turkey’s future, may finally prove its making.

In October, two domestic commercial lenders, Ziraat Bank and Halkbank, were handed licences allowing them to set up their own Islamic banking units. The former is set to launch its Islamic business in May; the latter, by the end of the year.

In March, the country’s banking regulator granted an operating licence to state-run lender VakifBank, taking the number of institutions allowed to package and sell Islamic financing products to six.

Ziraat, the country’s largest unlisted lender, boasts a strong branch network in rural regions. Halkbank, Turkey’s biggest publicly traded state bank, is notably strong in urban areas. Together the two should add further impetus to a quietly growing market, by tapping a far wider and deeper institutional and retail investor base.

“[T]heir ability to issue Islamic products to a wider market, and to add volume and drive to that section of the capital markets, is very significant,” said Kaan Basaran, Nomura’s head of origination and sales in Turkey.

The decision to allow more commercial banks to sell Islamic bonds and products is both timely and much needed, and could prove the making of the sukuk market. Issuance has risen steadily but quietly in recent years.

“Given limited growth expectations for 2015, corporate issuers will probably be less keen to tap the capital markets for the rest of the year. Turkish banks will likely continue issuing, albeit at a slower pace”

“We saw reasonable activity in the Islamic bond market in 2013 and 2014,” said Basaran. “Sukuk issuance increased in each of the past two years, and in 2014 accounted for around 15% of total bond issuance in Turkey.”

Selim Kervanci, head of capital financing, MENA and Turkey, at HSBC, said he expected “another buoyant year for sukuk issuance in Turkey, from new and existing issuers, as the market evolves and new structures are allowed by the Turkish Capital Markets Board”.

Most Turkish corporates are still restricted to issuing specific sukuk structures such as ijara and murabaha, but HSBC’s Kervanci pointed to a “renewed interest from the Middle East and Asia” for Turkish risk. The decision by two domestic financial services firms, Turkiye Finans and Kuveyt Turk, to issue debut sukuk denominated in Malaysian ringgit last year offers further cause for cheer.

Deals continue to sprinkle the market. The Turkish government returned to the market for a third time in November, launching a US$1bn, 10-year sukuk issue at mid-swaps plus 205bp. Domestic conglomerate Dogus Group was granted approval to issue the country’s first US dollar-denominated corporate sukuk offering in September. In April, Islamic asset manager Alkhair Capital announced plans to launch an investment service to educate and advise clients about Islamic bonds.

At times, though, the development of this market has been jarringly slow, particularly for a government determined to become a world leader. Erdogan has publicly stated his desire to see the sum total of the country’s Islamic finance assets reach US$100bn by 2023.

Fadi Hakura, a Turkey expert at Chatham House, a London-based think-tank, said the build-out of the market was central to Erdogan’s attempts to turn “Istanbul into a financial hub, and also [his] aversion to interest rates”, which are prohibited under Islamic laws.

But as many found before, and will discover again, a market cannot be created by willpower alone. Just look at the failed attempts by Russian corporates and lenders to circumvent Western sanctions by tapping Asian institutions for capital. Or the recent slowdown in debt issued offshore by foreign corporates in renminbi, despite concerted Chinese efforts to encourage the use of its currency.

The key challenge facing Ankara involves fostering an environment in which sukuk can thrive, along with a range of parallel Islamic finance products, such as Sharia-compliant insurance.

That may be easier said than done but all the potential in the world is clearly there. The market is being driven “not only by the traditional buyers but also an increasingly global and diversified investor base”, said John Wright, a member of Barclays’ European syndicate team.

In April, Mohamed Damak, global head of Islamic Finance at Standard & Poor’s, noted that Turkey’s share of the total global sukuk market last year was just 3%. Yet he tipped the country to become the leading global player in Islamic finance within a decade.

Supply and demand

For that to happen, volumes need to rise, and corporate and financial issuers need to be given reason to believe that a foray into the market is going to be met with open arms, not indifference.

“This is a market driven by both demand and supply, and if you look around you can see that the demand for international Islamic finance assets is huge, but that there is a simultaneous lack of supply,” said Nomura’s Basaran.

Abdeslam Alaoui, head of DCM, MENA, at Barclays, points to the relatively high cost of Islamic debt. “Sukuk are still more expensive than conventional bonds,” he said, adding that until costs come down, the market “cannot expect to see a surge of issuance in the sukuk space”.

In the more conventional world of debt financing, the past year has offered reasons for both cheer and gloom. On the downside, the country’s largest firms have been infrequent visitors to the debt markets.

“There aren’t a lot of corporates out there in serious need of capital funding right at the moment,” said Kathleen Middlemiss, head of emerging EMEA and Latin America credit research at UBS.

Said HSBC’s Kervanci: “Given limited growth expectations for 2015, corporate issuers will probably be less keen to tap the capital markets for the rest of the year. Turkish banks will likely continue issuing, albeit at a slower pace. We could expect more activity following the [June 7 general] election, once political uncertainty is removed from the equation.”

On the plus side, deal-flow has been punctuated by the roll-out of products new or relatively rare to this sprawling economy. Issuers are looking to package project bonds, having been encouraged by Mersin International Port’s US$450m issue in June 2013, the first Eurobond issue by a domestic infrastructure project company in June 2013.

In February 2015, VakifBank completed the country’s first Basel III-compliant, 10-year, non-call issuance: a US$150m, Tier 2 print.

HSBC’s Kervanci said he expected to see “more activity in the form of Tier 1 or Tier 2 capital” issued by Turkish lenders in the year ahead.

UBS’s Middlemiss said that while it was difficult to foresee a surge in Tier 2 issuance, “the near-term window is open and if the need arises, you can see more banks issuing senior paper”.

Last year also saw a spate of credit-based covered bonds, printed by small and medium-sized enterprises, a theme that has continued into 2015, with local lenders lining up to issue mortgage-backed covered bonds in the first quarter of the year.

Then there is the metamorphosis of the investor base, which now includes an increasingly heavy weight of Asian and Middle Eastern funds and institutions.

Said Barclays’ Alaoui: “Over the past year, you’ve seen a major inflow of Middle Eastern money into the region, with institutions looking to snap up Turkish Eurobonds, both in primary and secondary markets.”

Order books on Turkish Eurobonds from Middle Eastern now typically account for about 15% of debt capital market transactions, up from 5% a few years ago. Not bad for a market and a country with two faces.