Implications of Egypt’s Sukuk Law

Islamic Bank - Hamalawy.jpg

The Shura Council approved the Sukuk Law on March 19, 2013, sending it on its way to final approval by the presidency. As the first legislation to follow the FJP’s strong rhetoric on the subject of Islamic finance, the law seems to carry a dual-mandate: an addition to Egypt’s dwindling economic crisis-management tools that doubles as a cornerstone of a longer-term economic Islamization project.

Sukuk are the Islamic counterparts to bonds and are a key component of the Islamic finance industry, which forbids fixed interest under common interpretations of Shariah. Sukuk replace a bond’s periodic interest payments with pro-rata profit sharing agreements on an asset’s future cash flows. Another main difference is that sukuk are used to finance the underlying real assets on which the contract is built, i.e. the purpose of the funds is predetermined. In contrast, bond funding can be allocated more or less on the discretion of the borrower. Investors in sukuk have temporary ownership shares in the asset that terminate with the maturity of the security, which can range from a few months to 30 years. According to Ministry of Finance advisor Ahmed al-Naggar, the government has already compiled a list of at least 17 future public private partnerships (PPP) in road and rail infrastructure, utilities and the energy sector.

The global sukuk market is rapidly expanding, and 2012 was a bumper year. Malaysia still grabs around three fourths of the market and remains a growth driver, but MENA is essentially just getting started. Last year, Saudi Arabia and Turkey debuted in the sovereign sukuk market, and Jordan passed a long-debated sukuk law. Oman introduced Islamic banking in 2012 and has signaled plans for sovereign sukuk sales. It’s also sweeping North Africa as Tunisia, Morocco, Libya and now Egypt are looking to tap the markets. Even outside the region, non-Islamic G20 nations like France, Australia, and South Africa have expressed interest.

The cause for this strong growth in sukuk supply is basic: demand is much higher, making the current market a seller’s market. This was seen recently with the Dubai government’s 10-year sukuk being met with demand 12 times the size of the sale in January 2013, pushing borrowing costs significantly downwards, and also with the first-ever successful 30-year sukuk in March 2013, sold by the Saudi Electricity Company (SEC). Two causes of the high demand are the fast deposit growth in global Islamic banks, which have far less asset opportunities than conventional banks, and the increasing popularity with Western investors seeking to diversify across regions and investment vehicles. At a higher level, the high growth in demand is underpinned by the simple fact that the collective savings of 1.6 billion Muslims remain predominantly in cash – pointing to long-term growth in Shariah-compliant finance. The upshot is that the Egyptian government can potentially borrow at cheaper than what its outstanding conventional bonds indicate. Extrapolating on this, if sukuk become a staple source of sovereign funding, it would have a positive spillover effect on the state budget as 25% of annual spending is debt servicing. The accrued interest savings could then theoretically be allocated to higher-multiplier, job-creating capital expenditures like infrastructure and education.

Finance Minister Al-Mursi Al-Sayed Hegazy said up to $10 billion can be raised annually from sukuk to fund the country’s twin fiscal and balance of payment deficits. This guidance is aggressive, suggesting an overestimation of both domestic demand/capacity for sukuk as well as Egypt’s access to international financing. As it stands, more concrete and realistic plans are emerging on two sales summing to $1 billion by the end of June 2013, one in Egyptian pounds and one in US dollars. However, it is worth noting the bill is still a ways from translating into actual borrowing: it is now with the Council of Senior Scholars at Al-Azhar for review, after which it will be sent through the Islamic Research Academy in Cairo, the Supreme Constitutional Court, and finally the presidency. It is very likely to continue to catch more institutional and political flak on its way. Even Hegazy said three months in total were needed to iron out related regulations, implying sukuk sales by June are a best-case scenario.

Officials delicately add that the sukuk sales would be independent, but not in lieu of, the IMF deal. However, even if sukuk could potentially be cheaper than bonds, today would be the most expensive time to raise any type of debt since the president took office, with credit ratings tracing historic junk-level lows (lowest in at least 16 years) with still negative outlooks. This could invariably link even the sukuk to the IMF, on which rating upgrades depend, making sukuk no different than the other funds queued behind the IMF loan. It is improbable private investors will rush to make economic commitments at low rates before a multilateral development agency.

Having said that, June is a long ways away for a very fluid Egypt and its capital markets, and it’s possible that the sale is at least partly turned into a market-based aid mechanism. Besides Qatar, which pledged $2.5 billion in future debt purchases in January, other OPEC members (Saudi Arabia, Libya, Iraq), Turkey, and the Islamic Development Bank could subscribe. Furthermore, domestic bank liquidity is adequate to support a sale, never mind that the state effectively controls half the system through the ‘big three’ public banks. It may not be the free-market nod of confidence envisioned, but the sales could still prove to be relatively successful.

The law’s utility in the coming period remains to be seen, but in the medium to long-term it simply points to a rising proportion of Islamic finance in the economy. Despite Islamic finance being pioneered in Egypt in the 1970s, the banking status quo is still distinctly anti-Islamic and the law would mark a watershed moment in creating a more conducive operating climate for the 15 domestic banks with Islamic licenses. A 2011 IMF study unsurprisingly found the primary explainer of growth in Islamic markets was regulatory support. With the passage of the law, the government is signaling future economic goals to the marketplace – the now-dissolved lower house of parliament discussed introducing Islamic accounting rules and an Islamic interbank market. The longer term net effect of economic Islamicization is still uncertain, given the formative stage of the industry, but several studies suggest Islamic systems fared better in the global financial crisis due to jurisprudential restrictions. Regardless, in all likelihood the Sukuk Law is the first of a family of legislation that will attempt to drive growth in the segment.

David Mikhail is a MENA equity research analyst with a focus on the region’s banks.

Photo: Hossam al-Hamalawy

Image: Islamic%20Bank%20-%20Hamalawy.jpg