Growth Begets Growth

Development in the Middle East, and the Gulf Cooperation Council countries in particular, is being fueled by the growth of Islamic finance. By Darren Stubing

The Islamic finance sector is set for further growth in 2015, with much of this expansion to take place in the Middle East-and the Gulf Cooperation Council (GCC) states are central players. The size of the Islamic finance market is now over $2 trillion, nearly all of it deriving from Islamic banking assets and the sukuk sector.

Growth in Islamic assets and activity in the Middle East over the past five years has come from both the retail and wholesale sectors, as households and companies are benefiting from new and innovative Islamic financing techniques. The first is for the purchase of homes and vehicles, the second to expand corporate growth.

Takaful services-Islamic insurance- continue to expand in the region, particularly in the large market of Saudi Arabia, with banks and insurance companies increasing their distribution channels. In the Middle East, the demand for shariah-compliant investment services is also growing, as both the breadth and sophistication of products increase.

The cost of sukuk financing is approaching that of conventional bond financing, but for many issuers the price is higher. Borrowers using sukuk need assets to underlie the debt. In addition, there is the cost of structuring the securities, which involves legal counsel and often requires significant input. Shariah scholars must also be hired to analyze the structure. Unfamiliarity with complex sukuk structures can translate into higher advisory fees for prospective issuers, while investors demand higher yields because of limited trading activity in secondary markets.

The Middle East, together with Malaysia, remains the epicenter of sukuk issuance. Sovereign and corporate funding needs continue to be serviced by Islamic finance, through both the banking industry and capital markets. GCC sovereigns and companies have been very active in sukuk issuance. Many large projects and economic developments are being supported by syndicated and bilateral Islamic financing, and this will continue to be the case in 2015. The Saudi-based Islamic Development Bank remains an important institution for financing and support. Infrastructure projects in the Middle East remain substantial and numerous, and the issuance of sukuk to fund these projects is growing.

Sovereign sukuk issuance is widening, with many non-Islamic countries seeking to tap this funding avenue to increase liquidity sources. With new countries issuing sukuk, benchmarks are being created, contributing to a growing appetite for further issues. A number of sovereigns, including the UK, South Africa and Luxembourg issued sukuk in 2014, and blue chip institutions such as Goldman Sachs also tapped the market. Middle East institutions have been actively involved in managing, arranging and placing sukuk deals, and many have also invested in sukuk assets.

The average yield on 10-year Malaysian sovereign sukuk tends to be around 20-30 basis points higher compared to nonIslamic notes of the same maturity. By comparison, Goldman Sachs' five-year notes wyield around 20 basis points more than similar maturity non-shariah compliant debt the firm issued.

The average gap between issuance costs for sukuk and conventional bonds in the GCC, however, is very small or nonexistent-and in some cases, it has proved to be cheaper to issue sukuk than conventional bonds. This is because sukuk have become mainstream in most Gulf countries, with demand from liquid institutional investors often exceeding supply.

INCREASING LIQUIDITY

Islamic banking assets in the GCC region now approach $600 billion and continue to grow at around 15% annually. The proportion of Islamic banking assets to all banking assets is above 50% in Saudi Arabia, 45% in Kuwait and 25% in Qatar. Islamic banking in the UAE and Bahrain is experiencing strong growth. The percentage is rising sharply, although from a small base, as it currently stands at just 17% and 13%, respectively, of Islamic banking assets in those countries. The push to develop local currency bond and sukuk markets in the region will help to increase liquidity while lowering borrowing costs. Regulators in the area are designing rules to make it faster and cheaper for companies to issue Islamic and conventional bonds.

Moreover, more international banks are underwriting sukuk as markets become more familiar with this type of financing. However, the large banks in the Gulf and wider Middle East region remain very important to the success of sukuk issuance. In Goldman's case, its success was very much due to the involvement of banks such as Abu Dhabi Islamic Bank, National Bank of Abu Dhabi, Emirates NBD and National Commercial Bank.

The financing focus varies among the GCC nations. In Saudi Arabia the corporate and commercial sectors dominate, while in Kuwait the key focus is household financing, particularly real estate.

RAISING NEW CAPITAL

In line with the Middle East's economic strides, regional Islamic banks are raising capital. In January 2015, for example, Dubai Islamic Bank (DIB) successfully priced a $1 billion, Tier 1 capital-eligible issuance with a perpetual maturity. Given the growth in its business, and the fact that this momentum is expected to continue for 2015, DIB wanted to tap the market for additional core capital, says Adnan Chilwan, chief executive officer of DIB.

The issue received 80 orders, amounting to more than $2.5 billion,reflecting strong investor demand. DIB's principal plan for 2015 and 2016 is to grow its core businesses of consumer, corporate, treasury and commercial real estate across the UAE. The bank also aims to expand its existing geographic footprint through a variety of options, including acquisitions, the establishment of new subsidiaries and branches and cooperation agreements with local partners in Asia, Africa and the Gulf.

In 2014, DIB completed the acquisition of a 24.9% stake in Bank Panin Syariah in Indonesia.

Abu Dhabi Islamic Bank is also positive about 2015, following a good year in 2014. With the growing acceptance of Islamic banking worldwide, AD IB is increasingly turning its attention to geographic expansion, notes Tirad Mahmoud, ADIB's CEO. This began in Egypt with the acquisition via a joint venture of National Bank of Development, followed by the establishment of Iraq, UK, and Saudi Arabia operations. New operations are now slated for Qatar and Sudan.

On the wholesale side, AD IB was very active in landmark sukuk deals in 2014, including transactions in Indonesia and Hong Kong. The offerings underscored ADIB's distribution strength in the Middle East and elsewhere.

Other regional Islamic banks are also witnessing strong growth. Qatar'sA1 Rayan Bank's financing facilities grew by 40% in 2014. The bank is also expanding its investment fund offerings, which now include an exchange-traded fund that will be the largest in the market.

National Commercial Bank, the biggest bank in Saudi Arabia, has decided to turn itself into a fully Islamic bank over the next five years. The state-run bank's decision came amid a $6 billion initial public offering-the largest-ever equity sale in the Arab financial world. NCB works along shariah-compliant Islamic banking guidelines but also follows certain Western banking conventions.

Kuwait Finance House maintains its prominent role in major development projects in the region and elsewhere. KFH succeeded in structuring a $500 million syndicated ijarah (rent-then-buy leasing) facility for Shaijah Electricity & Water Authority. KFH's $120 million participation in the transaction was the largest among the mandated lead arrangers, which included Gulf International Bank, ABC Islamic Bank, Sharjah Islamic Bank and Barwa Bank. SEWA will use the proceeds to finance its current and future projects, which include infrastructure expansion to meet the growth needs that Shaijah is witnessing. KFH's trading volume in the secondary sukuk market surpassed $3 billion in 2014.

PUBLIC- AND PRIVATE-SECTOR GROWTH

Such deals have contributed significantly to the increase of liquidity and support of Islamic financial markets, with sukuk issuance providing liquidity to infrastructure projects in Asia and Africa as well as GCC countries and playing a major role in both the public and private sectors.

The growth of the Islamic finance industry, particularly in banking and capital markets, also provides a strong platform for the financing of household spending on big-ticket items and public finances. As it does, key Islamic finance regions such as the Middle East will no doubt benefit, thanks to the increasing sophistication and product offering of Islamic finance institutions.

The push to develop local currency bond and sukuk markets in the region will help to increase liquidity and lower borrowing costs.