IIRA's Role in Growth and Integration of Capital Markets "Developing Regional Sukuk Hubs" Table of Contents Foreword Global Domestic Debt Markets... 2 Trends in Sukuk Market... 4 Developing Regional Sukuk Hubs - A Road Map... 5 Step 1 - Sovereign Ratings by IIRA... 6 Step 2 - National Scale Ratings by IIRA and Development of Sukuk Hubs... 6 Development of Sukuk Hubs... 8 Malaysia... 8 Islamic Republic of Pakistan (Pakistan)... 8 Kingdom of Bahrain (Bahrain)... 9 Republic of Turkey (Turkey)... 9 Arab Republic of Egypt (Egypt)... 9 Republic of Kazakhstan (Kazakhstan)... 9 Sultanate of Oman (Oman)... 10 Kingdom of Saudi Arabia (KSA)... 10 Step 3 - Mapping of Ratings by IIRA and Cross Border Sukuk Trade... 10 Role of Islamic Development Bank in Facilitating Market Integration... 11
Foreword Information asymmetry between borrowers and lenders in a financial market leads to lack of confidence and hinders the establishment of an efficient financial market. Development of efficient Sukuk/debt markets is a function of maturity of capital markets, size and depth of the economy and availability of the necessary regulatory and legal infrastructure, of which ratings is an important pillar. There exists strong correlation between growth in the fixed income markets and the prevalence of ratings. From the platform of Islamic International Rating Agency (IIRA), our foremost objective is to increase penetration of national scale ratings in selected Islamic countries that represent the overall dynamics of Islamic countries. Initially, IIRA will be actively working in the Kingdom of Saudi Arabia, Kingdom of Bahrain, Sultanate of Oman, Arab Republic of Egypt, Republic of Kazakhstan, Republic of Turkey, Islamic Republic of Pakistan and Malaysia. With the spread of national scale ratings we aim to realize our ultimate objective of achieving market integration of Islamic countries and thereby facilitate cross-border transactions in the Sukuk market within the region. Our ultimate objective requires the deepening of Sukuk/ bond markets in Islamic countries and to develop Sukuk hubs. IIRA and its team has developed methodologies with specific focus on Islamic finance, appreciating its core precepts and its application to Islamic institutions, businesses and transactions. A dire need had long been felt by market participants for a ratings approach, tailored to the specificities of Islamic finance unlike rating frameworks that were previously being applied and more relevant to conventional business. At the same time, Global rating agencies have been at the receiving end of considerable negative attention, with the thoroughness and the quality of their ratings being widely questioned. The methodologies developed by IIRA highlight the role of the financial institution as a Modarib, Ameen or a Wakeel. We believe that with the right approach and processes, a lot of progress can be expected in the Islamic finance market. Islamic Development Bank (IDB) has also shown keen interest in developing regional Sukuk market. To achieve this objective, an enabling environment is required, particularly in countries which have been identified as being at the brink of substantial growth in capital markets. We believe that the most effective approach to ratings in emerging Islamic Capital Markets would be a top-down approach with IIRA first assessing Sovereign ratings. This sets the background for national scale ratings in that country and paves the way for regulatory acceptance and ratings of individual organizations and Sukuk issues within the state.
Global Domestic Debt Markets Snapshot of domestic debt markets of the world is presented in the following illustration: As depicted in the illustration, Emerging Asia comprises 9% of the global domestic debt market. This particular region has witnessed tremendous growth in the past 14 years with its share in the global domestic debt market increasing from 2.4% in 1996 to 9% in 2010. Of interest is the growth witnessed by various countries comprising 'Emerging Asia'. Republic of Korea and Malaysia, part of 'Emerging Asia', have experienced phenomenal growth in the past 14 years. The domestic debt market of Republic of Korea (South Korea) has grown from USD283b at end-1996 to more than a trillion USD by end-2010. Sovereign rating of South Korea has improved from 'BBB+' in 2000 to 'A+' in 2010. Similarly, growth has been witnessed in the Malaysian domestic debt market from USD71b in 1996 to USD247b in 2010. With a more efficient financial system, Malaysia has also been able to command a much higher sovereign rating, that has improved from 'BBB- ' in 1998 to 'A-' in 2010. During this time, there has also been a significant increase in penetration of ratings in the Malaysian financial system. ASEAN = Association of Southeast Asian Nations, LCY = local currency. Note: Emerging East Asia comprises People's Republic of China; Hong Kong, China; Indonesia: Republic of Korea; Malaysia; Philippines; Singapore; Thailand; and Vietnam. Source: Bank for International Settlements and Asian Bonds Online 2
Within Emerging Asia, explosive growth has been witnessed in the ASEAN+3 countries in the past five years as depicted in the following trend chart: 3
Trends in Sukuk Market While there has been growth in the global Sukuk market, it is still considered small and has the potential to grow exponentially. From less than 50 outstanding issues at end-2001, around 300 Sukuk issues were outstanding at end-2011. The aggregate Sukuk issue amount at end-august 2011 was around USD60b. Sukuks issued in Malaysia alone, represented more than 50% of this amount. Role of GCC countries in Sukuk markets has increased in recent years with some of the largest issues originating from the region. Distribution of Sukuks ($ mil) 4
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Step 1 - Sovereign Rating by IIRA Following a top-down approach, sovereign rating is assigned first by IIRA as it paves the way for National Scale Ratings. This approach has been successfully implemented in the case of Kingdom of Bahrain and Republic of Turkey and is similarly planned for other Islamic countries. Sovereign ratings position a country's risk profile vis-a-vis other global economies and thereby are of particular relevance to investors. Step 2 - National Scale Ratings by IIRA and Development of Sukuk Hubs Global rating agencies assign ratings based on international scale, wherein the rating ceiling is the sovereign rating. Countries with sovereign rating in the 'BBB' band or lower are at a disadvantage as a certain portion or the entire investment grade rating scale is compressed. In such countries, ratings on national scale, that recognize sovereign as the best credit (AAA) have the entire rating scale available and hence, provide meaningful distinction in quality of credits in the domestic context. Following figures depict the difference in national and international scale ratings. Let's say if sovereign rating of a country is 'BBB+', 70% of the ten notches in the investment grade scale are not available for ratings; this may serve as an impediment for domestic issuers to raise debt at feasible pricing as it eliminates meaningful distinction between the quality of credits. As evident in the graphs, Bank of Baroda (Republic of India) has a 'BBB-' rating on the international scale, while on the national scale it has a rating of 'AAA'. On the back of its international scale rating, the bank would not have been able to distinctly position itself in the local market or provide a true picture of the its credit worthiness relative to other Indian banks. The local scale rating provides 'Bank of Baroda' the means to distinguish itself in the domestic financial sector and thus, benefit in terms of pricing and also serve as a benchmark. On the same lines, 'Credit West Bank Limited' based in Turkey has a rating of 'AA' on the national scale and a 'BB' rating on the international scale. The bank has been able to attract confidence of the domestic investors through its local scale rating. 6
National scale ratings provide useful information to the local capital markets and help investors compare domestic issues and issuers in local currency. Many domestic investors in emerging markets feel more comfortable placing their funds in domestic financial markets and during times of global political tension, these local investors are wary of seeking investments in foreign markets. In addition, national scale ratings offer the same benefit to the growing number of non-residents investing in a country's local-currency paper. National scale ratings give domestic investors a clear picture of local credit distinctions permitting accurate pricing. This encourages local investment, which deepens and broadens financial markets and encourages the adoption of best practice standards. National scale ratings are particularly applicable as a nation's asset management and pension industries grow. For this reason, IIRA's focus is on national scale ratings, which play a more direct role in the development of local markets. IIRA's vision 'to foster growth in Islamic Capital markets, as a rating agency that stands for trust, transparency, fairness and independence, dovetails that of the Islamic Development Bank's, i.e. 'to foster economic development and social progress in Muslim countries in accordance with principles of Shariah'. As such, IIRA operates to further the developmental mission of IDB. The goal is not just to enhance foreign investors' confidence, but the facilitation of fund flow within local markets, the documentation of the national economy, and greater resilience stemming from within the system. 7
Development of Sukuk Hubs For development of Sukuk hubs, IIRA has broadly identified Islamic regions such as the Middle East, North Africa, Central Asia, the Islamic states of South Asia and Far East. Specifically, in these regions, IIRA will focus on jurisdictions where regulatory environment is conducive to growth of capital markets and economic infrastructure is sufficient to facilitate rapid progress, such as the Kingdom of Saudi Arabia, Kingdom of Bahrain, Sultanate of Oman, Arab Republic of Egypt, Republic of Kazakhstan, Republic of Turkey, Islamic Republic of Pakistan and Malaysia. There are other Islamic countries that may also benefit from deepening of Sukuk markets and opportunities for cross-border trading. However, at the outset, we have selected few countries as a sample group, representing the dynamics of overall Islamic states, in terms of macroeconomic conditions, regulatory environment, and prevalence of ratings. While in the sample group, some countries serve as a benchmark for an efficient financial market, others stand to benefit from permeation of ratings owing to high market potential and some are expected to play the role of capital providers in the regional Sukuk/debt market. Brief overview of our sample group is discussed hereunder: Malaysia With Malaysian Rating Agency (MARC) on board with IIRA, as its technical partner, further insights can be gained into promoting Islamic Finance in the Malaysian market and the role of rating agencies. In turn, with the alliance of MARC and IIRA, local institutions operating out of Malaysia may have opportunities for engaging in crossborder transactions, the market for which IIRA aims to develop subsequent to the establishment of Sukuk hubs in various countries. MARC is recognized as an External Credit Assessment Agency by the Central Bank of Malaysia. The Malaysian Sukuk market is in the advanced stages of development with the Sukuk market in Malaysia alone representing more than 50% of aggregate amount of Sukuks outstanding (in terms of value). The country is poised to transition to the next level of engaging in cross-border transactions with other Sukuk hubs. Islamic Republic of Pakistan (Pakistan) Even though, issuance of first Sukuk took place several years ago; overall market has remained small in terms of number of issues outstanding. Of late, while a steady stream of sovereign Sukuk issuances has been witnessed, corporate Sukuk market has remained dull. National Scale Ratings are fairly entrenched in Pakistan, particularly in the financial sector on account of conducive regulatory framework. Given that JCR-VIS Credit Rating Company Limited - a leading credit rating company in Pakistan, is a technical partner of IIRA, we have access to the Pakistani market and believe that Islamic rating services should be promoted in the country, in addition to its establishment as a Sukuk hub in the region. JCR-VIS is also recognized as an ECAI by Central Bank of Pakistan. 8
Further regulatory initiative is required to rejuvenate the domestic debt market which currently represents a relatively smaller proportion of GDP in relation to other countries. Some regulatory initiatives are in the pipeline that may promote transformation of Pakistan into a Sukuk hub. Kingdom of Bahrain (Bahrain) As a home market and hub for Islamic Finance, Bahrain is also an area of concentration for IIRA. IIRA conducts ratings for the sovereign of Bahrain and plans to unroll the complete gamut of its rating services first in Bahrain as the largest hub of Islamic finance in the world. With over 400 financial institutions and a well regulated environment, IIRA believes that the country is ready in many ways, for a thriving Sukuk market. Sukuks issuances in Bahrain have primarily arisen from Central Bank of Bahrain. Corporate issuances have been few and can be encouraged through greater spread of national scale ratings. As IIRA is already recognized as an ECAI by Central Bank of Bahrain, this will support deepening of the market through National Scale Ratings. Republic of Turkey (Turkey) A reflection of burgeoning demand for Islamic finance in Turkey is the steady growth in market share of participation banks in the overall assets of the banking sector, with an independent set of regulatory framework introduced for facilitating the establishment of the same. However, issuance of Sukuks is fairly recent concept, with the first such issuance of Sukuk taking place in 2010 and less than USD500m worth of Sukuks outstanding at end-2011. There is potential for additional Sukuk issues, given the positive response of investors for earlier issuances. Moreover, Turkey has demonstrated greater resilience in the face of global economic challenges. It has been our assessment that ratings are fairly prevalent in the country; however, there is untapped market potential with respect to the Sukuk market. Arab Republic of Egypt (Egypt) There is increased focus in the area of Islamic Finance in Egypt. Regulations for issuance of Sukuks are expected to be finalized by the end of first half of 2012. Issuance of sovereign Sukuk has also been recently announced. Such positive developments will ease the way for the country to evolve into a Sukuk hub. Currently, penetration of national scale ratings is low in Egypt. IIRA may pursue the possibility of facilitating an enabling environment for Sukuk transactions in the country backed by wider spread of National Scale Ratings. Republic of Kazakhstan (Kazakhstan) At present, the size of Kazakhstan's domestic debt market is small in relation to GDP. Moreover, penetration of ratings in the market is low. We believe that prevalence of national scale ratings in the market is essential to develop the local debt/sukuk market. Again, the most effective way to go about it is through a top-down approach with IIRA first assessing Sovereign ratings. This sets the background for national scale 9
ratings which is expected to facilitate the development of Sukuk/debt market. Subsequently, Kazakhstan could transition to the next step of tapping funding channels in the regional debt/sukuk market. Sultanate of Oman (Oman) Several initiatives have been taken in recent months to promote Islamic finance in the country. In 2011, Central Bank of Oman allowed establishment of Islamic banks and conventional financial institutions to offer Shariah compliant operations; thus, facilitating access to a wider set of investors/ capital providers. We view these developments positively as there is considerable latent demand for Islamic finance products and services in Oman. At the outset, when Islamic finance is in the origination stage in Oman, there is a clean slate for marketing Islamic rating services and receptiveness to the same may be higher. Kingdom of Saudi Arabia (KSA) KSA is the largest economy in terms of GDP in the Gulf Cooperation Council; it also has the highest foreign exchange and gold reserves in the region. Subsequent to the issuance of Sukuks by some blue chip companies operating in KSA, first sovereign Sukuk has been issued in 2012. The first sovereign Sukuk issued by KSA is the largest outstanding Sukuk with a staggering size of USD4b. This will pave the way for establishment of pricing benchmark. An impediment to marketability and development of Sukuk market is the absence of national scale ratings. A few US dollar denominated issues have been rated by global rating agencies. We believe that as an economy where Shariah is well entrenched as a way of doing business, there is potential demand for ratings by IIRA that offer a rating approach specifically catering to Islamic finance. With greater depth in the Sukuk market, greater access to diverse funding channels will be possible for the KSA market. Step 3 - Mapping of Ratings by IIRA and Cross Border Sukuk Trade Lessons can be learnt from the Global Financial Crisis of 2008 that had lesser impact on the Asian and Arab World economies. In a research paper 1, low level of financial openness (particularly to USA) and lesser degree of dependence on USA for shortterm funding have been highlighted as two of the reasons amongst others as to why some economies weathered the financial crisis better than the others. While access to foreign sources of funding is considered important, diversification in the same is equally important. Thus, at IIRA our vision is incomplete if our efforts do not lead to development of regional Sukuk markets allowing issuers domiciled in a region to engage in cross-border transactions and thus, have access to multiple sources of 10
funding. Currently, the major impediment for these issuers is marketing their securities as a viable investment option in other Islamic countries as there is no common language for translation of risk, given the differences in sovereign ratings. Following graph presents the differences in sovereign ratings across various countries in the sample group (sovereign ratings in foreign currency terms, assigned by Standard & Poor's): As IIRA is planning to assign ratings on a national scale in Kingdom of Saudi Arabia, Kingdom of Bahrain, Sultanate of Oman, Arab Republic of Egypt, Republic of Kazakhstan, Republic of Turkey, Islamic Republic of Pakistan and Malaysia; rating benchmarks for institutions within Islamic countries will be developed, which may be distinct from conventional benchmarks and thus, allow assessment of entities/issues incorporating the essence of Islamic Finance. Role of Islamic Development Bank in facilitating market integration Recently, multilateral agencies have begun to play a greater role in promoting cross border trading of bonds; particularly, in emerging economies. Similarly, to facilitate fund flow across Islamic states, IDB can play an important part, given the considerable resources at its disposal and its financial influence on Islamic states. 11
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