Malaysia is struggling to maintain momentum amid political and economic chaos, while Middle East economies are surging forward and their capital markets are developing apace on the back of strong Sukuk demand. LAUREN MCAUGHTRY asks what we can expect from Islamic fixed income this year and, as the biggest contributor to the market, what impact the current Malaysian crisis could have on overall issuance…
A country in crisis
Malaysia is in the midst of a highly public political crisis involving the highest levels of government and extending to all corners of the administration including the central bank and ministry of finance — and the turmoil has had an inevitable effect on the market which, coupled with a plummeting currency, volatile oil prices and a substantial contraction in private consumption following the introduction of a goods and services tax (GST) in April, has seen GDP growth slow from 5.6% in the first quarter to 4.9% in the second quarter and led to perilous predictions of economic failure.
“The stock market has all but collapsed. Investors, especially foreign investors, are taking out their money to safer places abroad,” warned former Malaysian prime minister Dr Mahathir Mohamed in a recent blog post. “The government is short of funds. It has to cut budget allocations to all ministries. The introduction of the GST has only resulted in increasing the cost of living making the depreciation of the ringgit more acute.” The ringgit is currently at a 17-year low, down 23% year-to-date (according to Bloomberg figures) and sliding 3.8% against the US dollar just last week as foreign exchange reserves fell below US$100 billion for the first time since 2010 — leading to fears of capital controls or a currency peg (solutions that the country turned to during the 1998 crisis), although central bank governor Dr Zeti Akhtar Aziz has publicly ruled out these possibilities. “The government… will not be able to borrow. The country’s economy will collapse. And the people will suffer,” predicted Mahathir.
While this may seem like an ominous prediction, the figures do not look promising. The stock market closed at its lowest since 2012 this week, while funds are flooding out of the country. Overseas investors reduced their sovereign and corporate debt holdings by 2.4% in July according to central bank data — including a 16% reduction in sovereign Sukuk, the largest in 10 months. Funds have also pulled US$3 billion out of the country’s equity market in 2015 so far, the highest level since 2008, the FTSE Bursa Malaysia KLCI Index of equities has fallen 16% from a high of 1,862.58 in April to 1,572.54 (as of the 17th August, see Figure 1) and the FTSE Bursa Malaysia EMAS Shariah Index is down 16.41% for the year to 11,199.21 (as of the 18th August).
Faltering fixed income
But it is the debt capital market that is causing real concern, with borrowing costs rising to record highs as investors flee the market. The benchmark 10-year Sukuk yield has topped 4.2% and analysts say it could break the record high of 4.44% (seen in December 2013) to reach the 4.5% barrier this year; as falling commodity prices, continued oil price problems, a Federal Reserve rate raise and a falling ringgit compound the political issues and scare investors away.
Last month, rating agency Standard & Poor’s (S&P) issued a note warning of an impending correction in the global Sukuk market in 2015 after Bank Negara Malaysia (BNM), the central bank, stopped issuing short-term Sukuk this year. The agency subsequently revised its total Sukuk issuance forecast from US$100-115 billion to US$50-60 billion, half the original estimate. “In the first half of 2015, BNM’s pullback saw total Sukuk issuance drop by 42.5% compared with the same period a year earlier,” said Mohamed Damak, S&P’s global head of Islamic finance. Although the reason behind the reduction was concern from BNM that the Sukuk were being purchased by foreign banks rather than assisting domestic banks’ liquidity management, rather than any economic concern, the move has not helped the Sukuk situation given the current climate. “Excluding the BNM effect, the worldwide volume of Sukuk issuance performed in line with expectations, total issuance dropping by only 10.7%, confirming that the impact of falling oil prices on recurring government spending and investment projects in core markets (namely GCC countries and Malaysia) was limited in the first half of 2015,” noted S&P.
Even if the central bank was offering short-term Sukuk however, there is doubt as to whether the former demand would be there. Last month, Malaysia attracted its weakest sovereign demand of the year at a RM3.5 billion (US$851.68 million) auction of 10-year Sukuk on the 30th July, with a 1.85 bid-to-cover ratio (the lowest since December 2014) and a yield of 4.105%.
Middle East advantage?
So will these impediments translate into an advantage for the Middle East market? In stark contrast to the doom and gloom emanating from Asia, the GCC has seen a sustained success story in the Sukuk sector. While total issuance has fallen year-on-year (with total GCC Sukuk issuance declining by 26.45% to US$4.85 billion in the first half of 2015 from US$6.55 billion in the first half of 2014, according to the latest figures from the Kuwait Financial center (Markaz)), this was largely driven by a contraction in sovereign issuance, while the corporate market remains healthy. “There is an ever-growing demand for Sukuk products in the GCC, and this will continue to drive innovation in the Sukuk market to enable companies, from different sectors and with different assets available to underpin the Sukuk, to issue these products,” confirmed Jonathan Fried, a capital markets partner at Linklaters.
Despite the sovereign slowdown, oil price pressure and dwindling foreign reserves are driving governments to diversify their funding platforms, with the Islamic debt capital market one obvious avenue through which to do so. “Issuers who need funding and plan to tap the global Sukuk market are likely to continue finding support given the lack of primary supply for this asset class,” agreed Mohamed Safri Shahul Hamid, the senior managing director and deputy CEO of CIMB Islamic, speaking to IFN. “Given that Asian sovereign issuers which have previously shared their intent to tap the Sukuk market in 2015 have already done so (Hong Kong and Indonesia), we expect the rest of the year to see supply predominantly from Middle Eastern issuers which still have funding requirements.” One of these is likely to be the US$1 billion Oman issuance, which IFN understands is expected imminently; as well as an anticipated UAE deal. Sovereign issuances from the wider Middle East region including Tunisia, Jordan and Turkey are also expected; as well as a spurt in African issuance from nations such as the Ivory Coast, Kenya, South Africa, Senegal and Niger.
“We are unlikely to see similar levels of debut sovereign Sukuk issuance like we did in 2014, which in itself was a significant breakthough,” commented Anzal Mohammed, a partner with Allen & Overy in Dubai, to IFN. “Financial institutions will continue to dominate issuance volumes, including in the regulatory capital space, with more and more corporates and government-related entities considering Sukuk as a viable option to issuing conventional bonds.”
“Total global US dollar-denominated Sukuk issuance through to the 30th June 2015 was US$7.75 billion, indicating a growth of 28% compared against the same period in 2014,” pointed out Rizwan Kanji, a partner with King & Spalding, to IFN. “Looking forward, we are seeing continued strong activity around the private placement Sukuk, which is likely to continue. We are also seeing increased activity around regulatory capital by financial institutions, and I believe these trends will continue for the rest of 2015 with a few senior unsecured issuances and increased activity by sovereigns in the GCC to mitigate the budgetary pressures as a result of continued low oil prices.”
On the corporate side, the UAE put in an especially strong showing in the second quarter, emerging as a key player for corporate bond and Sukuk issuance with multiple maiden issuances from the likes of Bank of Sharjah and Noor Bank, along with a US$750 million Sukuk from Dubai Islamic Bank. Issuances by UAE entities raised the largest amount in the GCC bonds and Sukuk market in the first half of 2015, representing 75.6% of the total (US$14.99 billion), according to Markaz, and were also the most active with 99 issuances.
Saudi Arabia also made its presence felt in the Sukuk market this year with a significant US$1.07 billion issuance from Riyad Bank and a US$400 million Sukuk from Saudi British Bank. And the sector is on the up as activity is expected to increase after the summer lull. “Companies are still looking for new financing or refinancing of existing arrangements and therefore we should expect to see issuers going to market from September once investors return from the summer break” said Steve Drake, the head of PwC’s capital markets and accounting advisory services team in the Middle East region.
Cautious corporate optimism
Corporate activity is looking promising overall, and Malaysia is in fact no exception. Not everyone is as pessimistic as Mahathir, and players within the industry are keeping their heads high with hopes for the future as the market corrects and Malaysian strength in the market reasserts itself — especially on the corporate side. “While there is little doubt that the noise in the market surrounding Malaysia is likely to impact on sentiment for Malaysian issuers, we do expect demand to persist for sound corporate credits given the scarcity value for Malaysian-domiciled issuers,” confirmed Safri. “Islamic finance as a whole still observes a lack of high-quality assets given the growth in Islamic wealth, which should continue to provide good support for high-quality Sukuk issuances that are brought on to the market.”
Despite the current headwinds in the market there remains a stalwart pipeline that it is hoped will see Malaysia through the worst of the storm. “Despite the recent weaknesses in the Malaysian markets (currency, rates and equities), it is broadly believed that this is due to technicals rather than a fundamental shift in the macro landscape,” agreed Safri. “We expect and hope that things would normalize in the later part of the year, especially after the much-expected lift-off by the US Federal Reserve. On the domestic front, we continue to expect additional supply in the Sukuk pipeline and have several issuers already waiting on the sidelines while the market finds its feet.”
These include not only domestic firms such as West Coast Expressway (which announced plans for a RM1 billion (US$243.34 million) Sukuk Murabahah program last month) and state electricity company Tenaga Nasional (which has plans to raise up to RM9.5 billion (US$2.31 billion) through a Sukuk issuance), but also several foreign firms such as Japanese car manufacturer Toyota and financial services firm AEON, both of whom are planning sizeable issuances this year.
Other firms have been put off by the poor exchange rate and economic volatility however, and according to Bloomberg, sales in corporate Sukuk in Malaysia have fallen 34% in 2015 so far. Sarawak Energy, which had plans for a RM1 billion transaction in June, has delayed its issuance until the markets stabilize; and while state mortgage lender Cagamas still hopes to issue from its RM2.5 billion (US$608.35 million) program this year, foreign exchange volatility is impeding any US dollar issuance, its preferred option, the lender told Reuters this week.
With the potential interest rate rise already priced into the market and domestic funds still cash-rich, the outlook is nevertheless not as gloomy as it sounds; and observers remain cautiously optimistic. “The domestic Sukuk market in Malaysia will be the largest domestic Sukuk market (by volume) for years to come,” Anzal explained. “In the cross-border space, it has always lagged behind the Middle East region and that is unlikely to change in the short-to-medium term. I don’t envisage a dramatic change despite the recent events.” Rizwan agrees. “In 2015, we have seen strong US dollar-denominated international Sukuk issuances out of Malaysia including PETRONAS and the Malaysian government. If the geopolitical situation in Malaysia is going to impact its Islamic finance status, this has not reflected in the issuing trends, as yet.”
A fragile outlook
Whether Malaysia recovers its footing remains to be seen, but either way the global Sukuk markets will continue to be buffeted by economic challenges, and this is likely to result in an uncertain outlook for the coming year.
While the pipeline is positive as we emerge from the summer lull into the autumn’s activity, it is also likely that real activity will only return in the fourth quarter of the year, given the next Eid holidays landing in the third week of September. “It’s difficult to predict what 2016 will bring as the global capital markets are very much dependent on global economic and geopolitical events and decisions,” warned Anzal. “Foreign investors are conscious of the Greece situation and the more recent currency-related move by the Chinese government. The level of issuance in the fourth quarter of 2015 will be the litmus test in terms of impact.” For now, it really is simply a question of wait and see.