Dr. Mohamed Damak, Senior Director and Global Head of Islamic Finance, S&P Global Ratings rounds up the biggest developments in Islamic finance in 2017

Expectations of the growth of Islamic finance have outweighed the sector’s actual performance over the last couple of years. While the industry is, in our opinion, on course to reach $3 trillion in the next decade, [a 43 per cent increase on the current estimated size of $2.1 trillion], growth will remain muted at around five per cent in 2017. Is this growth rate the new normal for Islamic finance?

To answer this, we need to look at the growth drivers of Islamic finance: primarily the oil-exporting countries of the GCC, as well as Malaysia and Iran, which together account for more than 80 per cent of the industry’s assets. Given the dependence of these core Islamic finance markets on oil—and our expectations that oil price will stabilise around $50 per barrel in 2017—economic growth in these countries is expected to remain limited.

Malaysia and Iran could be considered as outliers in this environment. S&P Global Ratings expects GDP growth in Malaysia to reach 4.2 per cent in 2017/18, thanks to its diversified economy, of which the gas and oil sectors make up just 10 per cent of GDP. In addition, Malaysia has introduced various policies such as the removal of oil subsidies and a six per cent goods and service tax to counter the impact of oil price fluctuations. On the other hand, after some sanctions removal, Iran’s financing needs are reportedly high. Nevertheless, the country will only contribute effectively to the growth of the Islamic finance industry once the regulatory environment has matured and remaining sanctions/restrictions are lifted.

Policy responses to the drop in oil prices are being implemented in the GCC countries and while the magnitude and the efforts to diversify economies vary from country to country, the low oil price environment will continue to weigh negatively on economic growth in the GCC in the next two years.

There is little wonder then that Islamic finance will be negatively impacted as a result.

Islamic banks

Islamic banks’ asset growth started declining in 2015, falling to seven per cent from 12 per cent a year earlier. Growth rate remained muted in 2016 at around six per cent and we expect it to stabilise at around five per cent in 2017. Governments and their related entities make up between 20 per cent and 40 per cent of GCC banks deposit bases and the inflow largely depends on oil prices. With lower oil prices meaning lower liquidity, bank’s cost of funding has increased. Similarly, lower economic growth has exposed vulnerable borrowers, primarily sub-contractors and SMEs resulting in higher defaults and larger provisioning needs. This led to a decline in banks’ profitability, prompting some to limit or reduce their cost base. The debate around consolidation has also resurfaced. The merger between First Gulf Bank and National Bank of Abu Dhabi in the UAE that was finalised in March is a good illustration. However, we consider it as an exception rather than the new norm.

Sukuk

2016 has been an impressive year for conventional debt issuance in the GCC, which, spurred by the falling oil price, almost doubled in 2016 compared with 2015. However, contrary to market expectations, GCC Sukuk issuance actually dropped by six per cent in 2016, thus not living up to its countercyclical role in Islamic finance markets some had hoped for.

GCC countries governments tapped conventional sources of liquidity contributing to the decline in Sukuk in 2016 and we attribute that primarily to the complexity of the process of issuing Sukuk. In the first quarter of 2017, we have seen an increase in Sukuk volume issuance but we think this was primarily due to some issuers’ front loading their issuance plans ahead of the Federal Reserve rates increase. S&P Global Ratings still expects the volume of Sukuk issuance to remain subdued in 2017, with total Sukuk issuance around $60 billion-$65 billion. This comes down to two factors: complexity and market conditions.

The complexity of issuing Sukuk is a key factor in the muted performance of the market as issuers turned to conventional debt, which is generally regarded as more efficient from an issuance process perspective. Malaysia is, again, an exception here, where the process for issuing Sukuk is reportedly as efficient as it is for conventional bonds. Very little was achieved in 2016 to standardise Sukuk issuance despite commendable efforts by some of the market heavyweights and there is still a long way to go to achieve the market desired level of standardisation.

Secondly, the increase in Fed rate may squeeze liquidity and increase the cost of funding for issuers. Our base case scenario assumes that the Fed will increase the rates two to three times this year (including the increase that took place few weeks ago). This could dampen investors’ appetite for Sukuk as a component of global capital markets.

Conversely, the European Central Bank is likely to adopt a more dovish stance and the tapering of bond purchases by the ECB is not expected to occur in the next few months. Liquidity from developed markets is therefore expected to continue leaking to some emerging markets in general, and to the Sukuk market in particular, as investors search for higher yields.

Of the GCC countries, Bahrain is likely to remain a prominent player in the Sukuk industry while the other members are expected to tap the market this year. Malaysia and Indonesia will also play a significant role following their 2016 Sukuk issues of $28.4 billion and $7.3 billion respectively in 2016.

Similar to Hong Kong which returned to the market in the first quarter of 2017 raising $1 billion, Senegal and Cote d’Ivoire might also come back again in 2017.

Takaful

The trend is echoed in the takaful sector, where premiums growth rate has been declining. While this slowdown is likely to persist in 2017, potential growth could come from a regulatory push and development in Islamic finance more generally. For example, insurance penetration in core Islamic markets is still well below the global average premium to GDP, making up just one to two per cent in the six GCC countries. The introduction of compulsory health insurance in the Dubai and further regulatory environment revisions could create opportunities for the sector.

Outlook

While we expect growth to remain muted for the Islamic finance industry at five per cent in 2017, there is some potential for further growth with a few prerequisites.

Firstly, more involvement by multinational lending institutions in Islamic finance through Sukuk issuance and Islamic product offerings could revive stronger growth.

More standardisation in legal structure and Shari’ah interpretation is critical to put the industry back on a strong growth path. If standardisation is achieved, there will be more capacity to devote to innovation and creation of new Islamic finance instruments, which could foster growth.

Lastly, more integration of the industry will help its transformation from a collection of small industries to a truly globalised sector. Cross-border acquisitions may help the industry unite its Shari’ah interpretation while further progress could be achieved if regulators create a more supportive regulatory environment. Further integration between all of the sectors that form the Islamic economy would result in a more united industry, with universities providing the necessary training to foster the next generation of Islamic finance professionals.

United and more integrated the industry could achieve higher growth rate and increase its attraction to new players exploring the opportunities it offers.

© Islamic Business and Finance 2017