The use of Sukuk is now in vogue. The term itself is a plural for sakk, which in Arabic refers to a note, and is believed to be the origin of the English word cheque. The financial instrument is used in contemporary capital market practices as an investment certificate, note or simply a bond-like instrument, which replicates the economic characteristics of an interest-bearing bond.
A number of governments in the block of countries represented in the Organisation of Islamic Conference are using innovative Sukuk structures to raise money for a variety of purposes, including financing budget deficits. Since the government of Pakistan’s dollar-denominated Sukuk issue of $600 million in 2005 (which involved selling its M2 motorway to a special purpose vehicle (SPV), and then leasing it back from the SPV), a number of sovereign and corporate Sukuk have been issued in the country. The government raised Rs163.3 billion last year by issuing three sovereign Sukuk. The government of Turkey has also recently issued two landmark Sukuk (one $1.5 billion sakk and another Lira-denominated $1.62 billion sakk).
While supporters of Islamic finance have reasons to be joyous over the impressive growth of Sukuk, caution must be exercised when advising investors and issuers on matters related to the use of the instrument. The current trend in Sukuk structuring tends towards debt-based structures, which renders most of the issued Sukuk very similar to conventional bonds in their risk-return profile. This is a significant concern, given the increasing share of Sukuk in the total assets under management of institutions offering Islamic financial services. At present, assets under Sukuk are estimated to be about a fifth of the total global Islamic financial assets of $1.35 trillion, according to the Global Islamic Finance Report 2012.
An over-emphasis on asset-based Sukuk structures means corporations and sovereigns borrowing from the Islamic capital markets will increase their indebtedness, thus magnifying the use of leverage in their capital structures. This will not only endanger the operational sustainability of the borrowing corporations, but also contribute to the instability of the Islamic financial system as a whole. Government borrowing through debt-based Sukuk structures, like commodity Murabaha, will result in governments using Islamic structures to finance their budget deficits (as is very much the case in Pakistan).
Although sovereign Sukuk in Pakistan have allowed Islamic banks in the country to have access to Sharia compliant securities for liquidity management and other treasury operations, the government must exercise caution in raising funds through Sukuk, as it crowds out private investment in the country.
Asset-based Sukuk are all but conventional bonds in their economic effects. In the event of a default, investors may end up losing significantly and will not have any recourse to an underlying asset. Sukuk defaults have just started. For instance, there are problems on the horizon for those who invested in Dana Sukuk, which was a nearly $1bn Sukuk maturing on October 31, 2012. But as the obligor has run out of cash, investors will find it difficult to receive their paybacks.
Now that new rules for Sukuk have been issued in Pakistan, one should hope that Pakistan will provide an example of developing an Islamic capital market based on true asset-backed Sukuk rather than Sukuk based on commodity Murabaha, which are only slightly different from conventional bonds.
THE WRITER IS AN ECONOMIST AND A PHD FROM CAMBRIDGE UNIVERSITY
Published in The Express Tribune, November 19th, 2012.