S&P Global Ratings is maintaining its global sukuk issuance forecast at about $160 billion-$170 billion following the market's good performance over the first half of 2024. Total issuance reached $91.9 billion over the first six months of this year, up slightly from last year's $91.3 billion. But a notable difference is the 23.8% increase in foreign currency issuances, which reached $32.7 billion by June 30, 2024, up from $26.4 billion a year earlier. The main contributors to this increase were issuers from Saudi Arabia, United Arab Emirates (UAE), Oman, Malaysia, and Kuwait.

Improved visibility on the medium-term trajectory of interest rates has benefited foreign currency-denominated sukuk issuance--we expect the U.S. Federal Reserve to start cutting rates in December 2024. Simultaneously, high financing needs in core Islamic finance countries explain the increased issuance, which is notably funding an ongoing economic transformation program in Saudi Arabia and strong growth in the UAE's non-oil economy.

Adopting AAOIFI's Standard 62 guidelines--as they have been presented--could disrupt the market. This will not affect 2024 issuance but will likely be a consideration from next year. The standard will transition the industry toward asset-backed sukuk by requiring the real transfer of underlying assets to investors.

However, it is difficult to anticipate the appetite for such instruments from both investors and issuers, as well as the legality of moving assets off their balance sheets, given the current market structure. This could either lead to further market fragmentation, or worse, issuance could be put on hold until sukuk structurers figure out a middle ground. A more conservative interpretation of Sharia is already affecting some market structures. But, even if Standard 62 is adopted, it is unlikely to disrupt existing sukuk, since we understand that any changes in contractual obligations are subject to investors' consent.

Financing Needs And Money Policy Visibility Boosted Sukuk Issuance

Global sukuk issuance stabilized in the first half of 2024 (see chart 1). We expect it will reach about $160 billion-$170 billion by the end of the year thanks to higher financing needs in some core Islamic finance countries and improved visibility on rate trajectory. Geopolitical risk has not yet dragged on issuance but could pose some downside risk, though under our base-case scenario we do not expect significant disruption.

Chart 1

The volume of local currency-denominated sukuk issuance continues to fall.   Local currency-denominated sukuk issuance has dropped by 8.8% year-on-year, primarily due to lower issuances in Türkiye, Pakistan, UAE, and Malaysia (see chart 2). The largest drop of local currency issuances was in Türkiye, where monetary tightening combined with better fiscal policy coordination continues to help rebalance the economy. Since June 2023, the Central Bank of the Republic of Türkiye (CBRT) has adopted a host of measures to tighten credit conditions. Among them, the CBRT increased its policy rate to 50% from 8.5% in just 11 months. We expect additional tightening of credit conditions and policies in a bid to tame inflation, which we project will remain elevated in 2024, at an average 55.8%, up from 54% in 2023, before falling to 27.3% in 2025. In the UAE, the decline can be explained by lower local-currency denominated issuance by the Federal Government and other authorities. For Pakistan, the issue might be related to a lack of data on issuances in the first half of 2024. In addition, the fall in local currency issuance in Malaysia was marginal due to the country's strong sukuk issuance footprint. We have observed that local currency issuance in Saudi Arabia has resumed its growing trend. The government has tapped the market with jumbo issuances and has also started to issue retail sukuk.

Chart 2

Foreign currency-denominated sukuk continued to increase.   High financing needs in core Islamic finance countries, stable rates, and improved clarity on the future path of rate cuts explain the continued increase in foreign currency-denominated issuances. We have seen a high issuance volume in Saudi where the government and banks continue to tap into the market to finance various projects related to the economic transformation plan (see chart 3). We now expect the Saudi banking system to shift to a moderate net external debt position in the next few months. We have also observed UAE real estate developers and banks accessing the sukuk market. The real estate sector has sustained its strong performance, prompting developers to rush into launching new projects while real estate prices remain high. We have noted that other countries are also contributing to higher foreign currency issuances. In fact, three transactions settling in July total an additional $3.6 billion. We did not see issuers outside core Islamic finance countries coming into the market in the first half of 2024.

Chart 3

Change Could Be Around The Corner

In late 2023, the AAOIFI published its exposure draft of Sharia Standard 62 on sukuk. It subsequently delayed the deadline for industry feedback twice, ultimately extending it to July 31, 2024, from March 31, 2024. If it is adopted as proposed, Sharia Standard 62 could change the nature of the sukuk market and increase fragmentation.

A key requirement of the standard is that the ownership and risks related to the underlying assets are to be transferred to sukuk holders. As such, the market will shift from structures where the contractual obligations of sukuk sponsors underpin the repayment to structures where the underlying assets have a more prominent role. In our view, this could affect the market in several possible ways, among them:

• Sukuk may become more expensive than conventional issuances. In some jurisdictions, issuers or investors will have to incur the cost of asset registration in the name of sukuk holders. This could make some transactions uneconomical, for example, if they use properties in countries where property registration taxes are high.
• Investors may be exposed to asset-related risks. Confiscation or asset nationalization could become more relevant, posing risks that sponsors may no longer be able to bear. Investors could also be exposed to the market value of the assets, and sponsors may use that to escape their remaining payment obligations if the value of the underlying assets drops materially.
• Potential legal issues: In some countries, sukuk may become difficult to structure if foreign investors cannot own the assets. Also, the proposed Standard 62 stipulates that Sharia should be the governing law of sukuk while the market norm is to use English law. If English law continues to be used, the standard specifies that the application of the law should not contradict the principles of Sharia as determined by the AAOIFI Sharia standards.

This indicates that if the standard is adopted as is, the market for AAOIFI adopters could be put on hold until sukuk structurers find ways to restore the fixed income characteristics of the instrument and make it more appealing to fixed income investors. This could lead to a situation where the complexity of the instrument increases further or where issuers become obliged to breach contractual obligations or Sharia requirements. Another possibility is a more prominent market fragmentation where it would be divided between AAOIFI adopters and non-adopters. This could encourage some adopters to transition away from the standards if they see a significant effect on their ability to tap capital markets. In any case, some fixed income investors may decide to disinvest temporarily, or permanently, which we observed when previous Sharia requirements were changed.

The market has until July 31, 2024, to comment on Standard 62, and the publication and effective date of the standard is not yet known. Assuming the standard is approved later this year, the adaptation will likely begin next year. We note that a change in standards is unlikely to affect existing sukuk since we understand that any changes in the contractual obligations of these instruments is subject investor consent.

Sustainable And Digital Sukuks Are On The Backburner, For Now

The total volume of sustainable sukuk issuance reached $5.2 billion during the first half of 2024, down from $5.7 billion during the same period last year, though a large transaction from a frequent sustainable sukuk issuer was settled over the past few days. We expect the issuance volume of sustainable sukuk to hover at approximately $10 billion-$12 billion in the absence of any major acceleration in the implementation of net zero policies by core Islamic finance countries or regulatory action. It is also worth noting that 80% of sustainability issuance in the first six months of 2024 came from Gulf Cooperation Council banks as they begin their climate transition journey.

Chart 4

In June 2024, the Central Bank of the UAE (CBUAE) approved a regulatory framework for licensing and overseeing stablecoins. This move is likely to encourage the wider adoption of stablecoins and help to resolve one of the impediments for the development of a digital sukuk market, namely how to bring money onto the blockchain. HAQQ-–an Islamic blockchain network--is reportedly working toward obtaining a license to create a stablecoin and issue a sukuk. Given the slow adoption in the conventional world, we believe that digital sukuk will take long time to materialize, especially in the absence of standard legal documents and Sharia interpretation. The Standard 62 adoption could also delay the creation of digital sukuk, so for now it remains a future avenue of growth.

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