Islamic Finance Sukuk - Case Study Example

Islamic finance Sukuk

Overview

Recently, the demand for Islamic financial instruments has increased in the global community. Since the financial crisis in the year 2008, most countries used the Islamic financial instruments as an alternative source of capital for various investment activities. The financial instruments are established according to the sharia rules that prohibit interests, speculation, collateral and preservation of property rights when issuing any financial instruments such as bonds. Despite the disregard of capitalist culture, the Islamic financial instruments offer competitive earnings. The issuance of bonds has been determined as the cheaper source of capital compared to other financial instruments that can be issued in the capital market. In addition, Sukuk is one of the alternative financial instruments commonly issued by the government and other organizations, and it pays profits and loss (Latham & Watkins, 2015). Recently, the capital market authority in Kuwait decided to use Sukuk as the main financial instrument in Kuwait. However, the conventional bonds still dominate the fixed income market in Kuwait. Therefore, this paper will analyze the regulatory measures and important market structures that must be developed by the capital market authority in Kuwait to make Sukuk the main Islamic financial instrument in Kuwait.

The analysis of the performance of both Sukuk and bonds in Kuwait financial market

In the year, 2014, the total debt market in Kuwait because of issuance of Sukuk was three billion Dollars, and the main issuers were the companies and other organizations that participated in the financial markets. Eighty-two percent of the total amount of issued Sukuk was from corporate organizations issued in Kuwait (Thomson Reuters, 2014). The bond and Sukuk market in Kuwait involve corporations and quasi-institutions and the debt market in Kuwait are still art an infant stage. Therefore, due to the current market conditions, most business and government entities use IPOs and bank loans as the major source of capital and funding of various investment opportunities.

The bonds and Sukuk market comprises of both corporate and sovereign issuance whose main aim is to achieve financing purposes. Over the years, the total number of bonds and Sukuk has increased indicating progressive investment activities in Kuwait. For example in the year 2011, the number of corporate issuance of both bonds and Sukuk rose by 42 percent because of an increase in the number of issuances. The Sukuk that was issued in 2012 dominated GCC bonds outdoing the performance in the previous year. The financial sector was the largest issuer of Sukuk with 134 total number of issuance. Another sector that followed was government sector whose major issuer was the central bank of Kuwait, which only issued bonds. Other areas like oil and gas industries played a major role in increasing the number of both Sukuk and bonds issuance in Kuwait over the years.

In the case of issuance of bonds, the central bank of Kuwait performs this function on behalf of the state and has total authority over the amounts and the number of bonds that can be issued in the capital market. Due to this condition, Sukuk has a small market share compared to the bonds in Kuwait in the year 2014. The comparison is indicated in the table below:

Source: (Trad, 2015)

From the table, the total number of Sukuk and bonds in Kuwait's capital market is over 89 million dollars. However, the number of bonds issued is high compared to those of Sukuk issued. A large number of bonds issued is as a result of CBK being the leading issuer. In the year 2006, the number of bonds issued in Kuwait increased by 13 percent since its implementation in the previous year (2005). This was due to its attributes that favored investment opportunities and was considered cheap compared to bonds that were being issued by the central bank in Kuwait. However, the year 2008, there was a tremendous decline in the issue of Sukuk due to the global financial crisis that affected the investors’ confidence. Despite the decline in issuance of both bonds and Sukuk, there were more bonds issued because of the central bank being the main issue of the bonds. The Arab spring greatly affected the performance of Sukuk in the capital markets until the year 2011 when it rose because of the reforms in the financial sector. The Arab spring affected the performance of both securities in the year 2013 where the decline increased from 32 percent to 45 percent (Hanieh, 2015).

The defaults in the issue of Sukuk also played a major role in the reduction in the number of Sukuk issued in Kuwait. For example, when AL Dar defaulted, investors shunned the use of Sukuk as it proved to be an unreliable source of capital. The fixed income market in Kuwait for both bonds and Sukuk include both the quasi-sovereign institutions and corporations. The sovereign issues dominate the fixed market by 83 percent of the total securities issued. Moreover, Sukuk issues comprise of very little market share in the Kuwait market. Due to the high presence of corporations in Kuwait, conventional bonds in Kuwait have been much larger that Sukuk since they have been issued by corporates for a long period (IMF, 2013). The representation of the total percentage of both Sukuk and bonds by the year 2015 is indicated in the figure below:

Source: (KAMCO Investment Company, 2015)

Comparison of the Sukuk in Kuwait and GCC (Bahrain, UAE, Kuwait, Oman, Qatar and Saudi Arabia)

For years, the GCC government have been issuing conventional bonds, however, due to the modification of various Islamic financial instruments like Sukuk; these countries have decided to move from issuing bonds to Sukuk. Therefore, the choice of issuing Sukuk is a major boost for the Sukuk market, which has been faced with a severe crisis that is constantly brought by emerging markets. However, Sukuk offerings allow issuers to offer investors both in GCC and Kuwait, unlike conventional bonds. Sukuk is currently viewed as the best option for investment as it is fast growing in other Arabian countries especially among the GCC member countries.

Kuwait is constrained by imperfect market conditions characterized by low development and unfavorable investment policies through IPOs. In addition, in Kuwait, the central government is the main issuer of securities making it the most dominant financial instrument in the Arabian countries. Apart from Kuwait’s market, the Sukuk market has continued to grow to allow both private and public limited companies to access the Sukuk market in GCC. The global Sukuk market is increasing in breadth and depth through long-term financing procedures. Countries like Saudi Arabia have the capability to fund long-term Sukuk. In the year 2013, the first long-term Sukuk was offered, and it lasted for thirty years. Such strategies are necessary as they are making Sukuk be the competitive financial instrument that investors can use.

The Muslim world has played a major role in supporting Sukuk market, and it has helped attract multinational investors the GCC have paved way for Sukuk. In the year 2014, the investors seeking sharia-compliant investment tools made Sukuk preferred security. The GCC has a huge liquidity pool supported by relevant institutions that support development process through the financial markets.

Sukuk has been very well by various investors in both Kuwait and GCC due to the increased demand for Islamic financial instruments especially for Sukuk. Both GCC and Kuwait market reacted positively in the past issuance of Sukuk. In addition, the increase in some financial institutions governed by the central bank and other companies has made Sukuk an attractive financial instrument. The converted conventional banks have made the Sukuk liquid and expanded their issuance to various investors. Established financial institutions in the GCC have made positive comments regarding the issuance of Sukuk.

In the UAE market, there has been rapid growth in both conventional bonds and Sukuk, particularly with the current issuance government bonds. This has made the United Arab Emirates a major hub for fixed income securities in the debt market (Oxford Business Group, 2013). However, the overall growth in the debt market has been slow because there is a rise in dependency on financial institutions by the private investors. Highly leveraged banks also increase the level of uncertainty due to the increase in debt equity ratio making issuance of Sukuk undesirable investment opportunity due to the increased level of risks.

The GCC regions had significant returns in various investments assets as a result of the issuance of new Sukuk and bonds in the fixed security market. Most economic activities in the GCC regions are powered by infrastructure improvement and processing of oil. In addition, the investment opportunities are well diversified by the governments. There is also the use of control measures that involve the use of institutions that will help in the future launch of Sukuk funds.

The constant interaction with foreign countries especially the Europeans, GCC member states can limit the impact of dormant trading activities in the financial markets. In Kuwait, the security markets are characterized by “buy and hold” concept where people buy bonds and Sukuk and wait for maturity period. This can limit the use of Sukuk as main investment tool compared to GCC regions that have well institutionalized financial markets that allow for trading of securities (KAMCO Investment Company, 2015).

In the recent financial reports from MENA daily fixed income report (2016), the Qatar Islamic banks wants to raise the issuance of Sukuk program by three billion dollars. Currently, the bank has a debt of 1.5 billion, however; the increase of loans through the issuance of Sukuk indicates that the popularity of Sukuk as an investment tool ha increased (Markaz, 2016).

Issuers of Sukuk in Kuwait

Sukuk is a fixed financial instrument that is used in Islamic regions to raise required capital, and it can be used as convectional bonds. Despite the similarity in functions, Sukuk has unique features that differentiate it from bonds. The first feature is the structure, which does not allow investors to earn interest after the issuance. Sukuk spreads the risk from the investor to the issuer according to the set terms and conditions (Thomson Reuters, 2014). Investors have the opportunity to earn a return according to the percentage invested in the business.

Through the analysis of the structure of Sukuk, there will be a determination of who issues Sukuk in the capital market. There is no official Sukuk structure compared to conventional bonds, but they are formulated according to the stipulated guidelines by the governing institutions in Kuwait. The organizations or individuals that are willing to acquire or invest in business using Sukuk are required to develop a suitable special purpose vehicle that can purchase more than one asset (Trad, 2015). In addition, the investors give money in exchange of Sukuk notes of which they will issue back to the issuer after the specified period has elapsed. The issuance of Sukuk is always accompanied by a service agreement that indicates the duties and responsibilities of the lesser.

According to the conditions above, Sukuk can be used to own a certain percentage or whole asset, which is an important aspect according to the sharia laws. There exist different types of Sukuk that are used differently according to the Accounting and Auditing Organization for Islamic Financial Institutions (Thomson Reuters, 2014). Issuance of Sukuk is only done according to the Sharia perspective, and it is mandatory that the investor and the seller deal with a tangible asset. This gives the investors some protection against the risks involved in the business transaction. Therefore, the securities traded in the when Sukuk is issued; determine the structure and functions of the Sukuk.

Since the implementation of Sukuk, there has been a serious economic impact in Kuwait because of the numerous benefits the investors can acquire from choosing them as an alternative investment strategy. In addition, the macro and micro-economic factors influence the structure and the issues. In that, the issuers find it easy to raise capital or funds from investors and another type of participants. Sukuk acts as a complementary investment tool to bonds and can be adopted by countries such as Kuwait that have adopted the Sharia law that governs and gives the required foundation for the Islamic fiancé. Therefore, based on the above analysis, Sukuk is normally issued by other government authorities like Islamic banks, individuals, and corporations but not by the main government (Hanieh, 2015).

The development barriers for Sukuk in Kuwait

Sukuk is an Islamic financial instrument that is rate free and has no fixed interest charge imposed on h principle amount invested. However, Sukuk has some asset backing that covers the investors from any risks that can occur when the contract is in progress. Since its implementation in 2005 in Kuwait, only 22 Sukuk have been issued, and they include different types of Sukuk instruments (Hanieh, 2015). Most Islamic investors believe that there is a low level of risks involved in investing in Sukuk hence limited chances of default.

Global incidences like economic crisis can result in an unexpected fluctuation in currency value and undesired pressure on the economy of a country (Trad, 2015). Developing countries like Kuwait can seriously suffer from global economic instability especially in the capital market. The organizations and Islamic financial institutions affected by economic instability can default on issued Sukuk because of financial distress. For example, I the year 2008, Investment Dar a Kuwait-based company defaulted on the issued Sukuk due to inability to pay the investors (Latham & Watkins, 2015).

Since most Sukuk are issued within a short period, the risk is normally increased in case a company is unable to pay the periodic payments. In addition, it is always important to determine the amount issued and the period that a company is expected to pay back the investors. That is, large investments require a longer period that can allow a company to issue periodic payments are stipulated in the contract. Therefore, time is an important aspect when issuing Sukuk. Therefore, incidences of default have greatly impacted the capital market I Kuwait forcing the investors to shun the fixed financial investment market in Kuwait (Markaz, 2016).

Due to the existence of poor market structure for Sukuk in Kuwait, there are serious concerns regarding the experience level of companies and financial institutions that offer different types of Sukuk (Hanieh, 2015). This increases the level of uncertainty among potential investors because most people worry that they must lose their investments. However, various institutions have established restructuring programs that can enable them to meet the Sukuk payments in time.

Also, companies such as All Dar investment sold some of their assets to pay off the investors. The default cases are important in learning how the issuers of Sukuk can handle default cases (Hanieh, 2015). Cases of default involving Sukuk that is registered outside the state of Kuwait can result in serious investment concerns about the Islamic laws. Investors are keen on developing protection measures on Sukuk that they have invested. Therefore, cases of default can greatly affect the investor expectations in Kuwait and can reduce the issuance of Sukuk.

Global financial crisis is another barrier that can greatly affect the performance of Sukuk in Kuwait. The economic depression has made the central bank of Kuwait issue only conventional bonds, and this can have a great impact on growth progress of Islamic financial products such as the Sukuk (Thomson Reuters, 2014). Besides, poor economic condition indicates that there are no quality infrastructure and suitable policies. This can help in the adoption of Sukuk as the main financial investment instrument by the capital authority of Kuwait. Sukuk is still in a developing stage and the existing economic condition in Kuwait is a major challenge. Therefore, major restructuring process is required (IMF, 2013).

Implementation strategies for Sukuk in Kuwait

The existing market statics have indicated a consistent growth in popularity of Sukuk in the Islamic countries. However, there still exist serious challenges that can limit the progress of Sukuk in a country like Kuwait that is still in the developing stage when compared to other GCC members (Hanieh, 2015).

The central government in Kuwait has to create some awareness of various Islamic financial instruments that can favor cheap and effective investment procedures. There is also the lack of knowledge regarding various institutions that offer relevant services that can help investors make appropriate choices when making investment decisions. Therefore, the government and the management in Islamic fiancé must create and implement strategies that can promote the use of Sukuk in Kuwait. This will help it to compete with other fixed securities such as the complementary bonds.

Sharia laws determine the outcome of various operations conducted by the Islamic financial institutions. This is a distinguishing feature from the traditional financial institutions. Sharia laws [prohibits imposing of interest and requires that the two parties entering a financial contract need to disclose all the relevant information that can assist in the prevention of unethical investment activity (IMF, 2013). Therefore, there is a need to promote Islamic institutions in the country to enforce secure issuance of Sukuk.

The financial policies need to be revaluated because they determine how financial institutions participate in the issuance of securities such as Sukuk and other financial investment instruments that are issued under the capital market authority. Due to the constant increase in the use of Sukuk in Kuwait, there is the need for effective management activities because other investors from various regions have begun appreciating the Islamic financial policies and systems. This will result in widening the scope of market securities forcing relevant authorities to deal with various types of Sukuk financial instruments.

The government must define the general objectives that can act as an effective guideline for investment activities. This is normally accompanied by the implementation of policies that help in overseeing investment activities that help in achieving the expected investment returns. Another important objective includes the provision of desirable liquidity level that meets the contingent needs of the investors without the issuer being forced to sell their assets to meet the costs of issuing Sukuk. The growing demand for Sukuk indicates its ability to grow and become one of the efficient sources of capital for the organizations in the fixed income market within Kuwait. Therefore, the government is required to determine the maturity structure of Sukuk despite the dominant five-year maturities.

It is important that the government should strive to minimize or remove investment risks that are always experienced as a result of uncertainties in the financial markets. Risk minimization can be achieved through diversification of security portfolio components depending on the types of investments made and setting up the maximum limits. In addition, the financial institutions should abide by the investment policies that act as regulators of various decisions that issuers and investors make. That is, there must be some rationalization where the rules governing the issuance of bonds can be used in issuing Sukuk. The rationalization process will assist in selling instruments that are not marketable and can help in evaluating the situation of both issuers and investors.

It is important that the government creates a proper balance between the policies governing the fiancé and banking sector. Creating and implementing a balanced investment policy helps in risk minimization and increasing the investor confidence as they are assured of income maximization (IMF, 2013). Additionally, it is important that the government setup a maximum limit for the participation of financial institutions and companies in the security market in Kuwait. For example, in the case of financial institutions, it is important that the ratio of securities owned by banks should not be above fifty percent of the total capital. This will assist in reducing the debt equity ratio and overreliance on the central bank for leveraging. Debt-financed bank institutions are risky and when they issue any form of Sukuk, investors might shun them hence limiting the growth of Sukuk in Kuwait (Hanieh, 2015).

Islamic banks are unique financial institutions because of their disregard of capitalism culture and extensive use of sharia law in implementation of financial policies and regulations. Therefore, taking into consideration the nature of uniqueness it is important that the banks must comply with the international accounting standards (Trad, 2015). However, the procedure and method of accounting normally differ because e of the type of investment activities carried out in the capital market. Therefore, it is important that each security must be classified when purchased by an investor. In addition, it is an import that consistency must be maintained according to the accounting policy that can be changed when the need arises. Changing the policies allows for flexibility in the management of the various types of securities that are traded under the capital market authority in Kuwait.

It is important that the central government sets up an appropriate system of a delegation that helps in the management of issuance processes (Markaz, 2016). The system must have a clear operational mechanism that defines the function of each person that involves administrative activities that help in the control of investment transactions. This will help in preventing poor performing financial institutions from issuing Sukuk hence limiting instances of risks in the capital market. The controls must be enforced to help banking institutions and companies define the type of financial instruments they are eligible to use in investment activities. The central bank must also be fully aware of various financial transactions that banks engage in to determine their progress and eligibility top issue any form of financial security to the public (Latham & Watkins, 2015).

The fixed income market in Kuwait is expected to grow in the twenty 2016 based on the performance of Sukuk and bonds in the previous year. According to the market predictions, the Sukuk is expected to outpace bonds because of their high liquidity rate compared to the bonds. Other factors that will enhance the performance of Sukuk in Kuwait are the increase in oil prices and the reduced deficit gap in the economy. In the year 2015, countries like Saudi Arabia led in the issuance of securities especially Sukuk despite the decline in performance in other GCC countries due to economic and policy challenges. Most GCC countries have unfavorable market structures that do not attract foreign investors in the global market.

Conclusion

The review of the capital market in Kuwait shows that the performance of Sukuk is affected by constant foreign influences on the Kuwait economy. That is, economic depression in the global community increased the breath of debt market that resulted in the creation of Sukuk, which considered an investment tool that favors organizations with the low level of capital and requires a cheap alternative source of investment capital. However, Sukuk is still at an infant stage since its introduction in Kuwait in the year 2005. The main issuers of Sukuk include companies and Islamic-based financial institutions that abide by the sharia laws. Due to the economic condition of Kuwait, the government decided to make Sukuk the main security that can be used by the capital market authority to replace the use of bonds and diversify sources of investment capital in the economy. However, there still exists several challenges that hinder the performance of the securities in Kuwait. This calls for various reforms that must be conducted to increase the performance of Sukuk in the financial market in Kuwait. In addition, Sukuk has been identified as a complementary investment source to bonds, which are only issued by the central bank of Kuwait. Regardless of the limitation, Sukuk is experiencing steady growth as investors from other regions have identified it as a suitable tool for investment compared to bonds, which require interest.