The Islamic finance industry will continue to expand this year, but lose some momentum in 2018, said S&P Global Ratings in a new report.

The industry's assets reached $2 trillion at year-end 2016, slightly below our September forecast. “Even though sukuk issuance accelerated in the first half of this year and will likely stay strong in the second half, we don't believe this growth rate is sustainable. We think stronger growth is possible if, together, supervisory bodies and market participants achieve greater standardization, resulting in a truly global industry,” the ratings agency said.

Overview

•         The current economic situation in core Islamic finance markets and depreciation of local currencies have weighed on the industry's performance in 2016 and 2017.

•         The lack of product and market integration constrains growth, in our view, as does the absence of standardized Sharia interpretation and legal documentation.

•         Integration, standardization, and higher interest in responsible finance could be a game changer, but only in the medium term.
 
Economic conditions are not helping

Islamic finance remains concentrated primarily in oil-exporting countries, with the Gulf Cooperation Council (GCC), Malaysia, and Iran accounting for more than 80 per cent of the industry's assets. The drop in oil prices and governments' cuts to investment and current spending have reduced the industry's growth prospects, in our view. While Malaysia's economy continued to perform adequately, thanks to its diversification, the average growth rate in the GCC dropped significantly between 2012 and 2017. Iran, on the other hand, experienced a growth spurt in 2016 after certain sanctions were lifted and the oil sector picked up, but this growth is expected to moderate over the next three years. Meanwhile, Iran's economy will continue to suffer from the scarcity of financing options and the remaining sanctions.

“Another factor explaining the muted industry growth is depreciation/devaluation of currencies in some countries. In particular, we've observed a marked impact of this on Islamic finance activity in Iran, Malaysia, Turkey, and Egypt, where exchange rates have deteriorated. As the US dollar continues to strengthen in 2017 and 2018, we might see more of this effect. In this context, the Islamic finance industry was protected by the peg between the dollar and various GCC currencies.

“Overall, we think the industry's growth rate will stabilize at about 5 per cent in 2017 and 2018, which is lower than the average over the past decade. More recent industry entrants, such as Morocco and Oman, will likely show stronger growth, but their contribution to the overall Islamic finance industry will likely remain small,” S&P Ratings said.

Islamic banks in the GCC face a tough year

“We expect the slowdown at Islamic banks in the GCC will persist in 2017 after asset growth declined to 5.3 per cent in 2016 from 10.7 per cent in 2014. In our base-case scenario, we assume that asset growth will stabilize at about 5 per cent as governments' spending cuts and revenue-boosting initiatives, such as new taxes, reduce Islamic banks' growth opportunities in the corporate and retail sectors,” S&P said.

“We see banks becoming more cautious and selective in their lending activities, triggering stiffer competition. Yet we don't expect this will happen uniformly in all GCC countries. Although the economic slowdown will likely remain pronounced in Saudi Arabia, Islamic banks' growth accelerated there in 2016, thanks to their strategy of increasing business among corporates and small and midsize enterprises (SMEs).

“By contrast, the decline in economic activity was steeper in Qatar, where a mix of lower liquidity and government spending cuts prompted banks to curtail their expansion plans. Qatar's placement under sanction by some Arab countries could also further weaken prospects for its Islamic finance industry in 2017. Asset growth was about nil in Kuwait over the past year, hit by the depreciation of certain foreign currencies and the ensuing impact on the financials of some leading Kuwaiti Islamic banks. Despite the United Arab Emirates (UAE)'s tepid economic performance and the drop in real estate prices, Islamic banks continued to expand by high single digits,” it added.

“As the economic cycle turns, we think GCC Islamic banks' asset quality indicators will deteriorate in the second half of this year and in 2018. Such weakening was not noticeable in 2016 because--as is typical--banks had started to restructure their exposures to adapt to the shift in the economic environment. Therefore we saw an increase in restructured loans in the GCC last year, but not a marked increase in banks' nonperforming loans (NPLs) or cost of risk.

“We think the deterioration will be more visible in 2017 and 2018. Overall, we believe that subcontractors, SMEs, and expatriate retail exposures will bear the brunt of the turning economic cycle and contribute prominently to the formation of new NPLs over that period,” S&P said.

GCC Islamic banks' profitability will therefore deteriorate again in 2017 and 2018, while several factors are seen coming into play:

“The cost of funding has increased, and this squeezed banks' intermediation margins in 2016. Although the pressure eased a bit after some governments issued international bonds and unlocked payments to contractors, we think the cost of funding will remain inflated in 2017-2018. The U.S. Federal Reserve (Fed)'s recent rate hike, which some GCC central banks have emulated, could result in deposits shifting to profit-sharing investment accounts (PSIAs) from unremunerated current accounts. If this happens, it would raise the cost of funding even further. Very few Islamic banks have set aside significant amounts of profit-equalization reserves, which they build in good years and use to smooth returns to PSIA holders if needed.

“Cost of risk is on the rise. We also foresee higher credit losses in the coming two years, due to relatively weak economic conditions. Exposure to subcontractors, SMEs, and retail customers (especially expatriates) will likely fuel the upward trend for credit losses.

“In general therefore, we expect Islamic banks' revenue growth will decelerate, and that they will focus on their cost bases to mitigate the impact (for example, by pruning branches). Like their conventional counterparts, GCC Islamic banks, through their relatively low cost bases, should be able to protect their profitability somewhat over the next two years, however. Although consolidation might be a way forward in some GCC markets, we expect mergers will remain an exception in 2017-2018 rather than the norm.

“Capitalization is generally a positive factor for GCC Islamic banks. We note, however, that it has reduced because previous rapid financing growth was not matched by additional capital. Few GCC banks have issued capital-boosting sukuk and those that have, are primarily in the UAE, Qatar, and Saudi Arabia,” S&P said.

Sukuk activity recovered this year, but 2018 is less certain

“The sukuk market gave a strong showing in the first half of 2017 compared with the same period in 2016, thanks primarily to the jumbo issuances of GCC governments. We believe this performance stemmed mainly from the good liquidity conditions in the GCC and more generally in the global financial market. Although we expect issuance numbers will stay solid for the rest of 2017, we consider it unlikely that some of the large transactions seen in the first half of the year will be repeated in 2018. We also continue to believe that the process for issuing sukuk is deterring some issuers from tapping the market. However, we note that the Islamic finance industry's standard-setting bodies have made some progress on that front this year,” S&P report said.

“Most of the investors in sukuk are in the GCC. Within this universe, we understand that banks are playing the biggest role. Over the past two years, we have observed a reduction of liquidity in GCC banking systems, due to reduced deposit inflows as a result of low oil prices and high dependence on deposits from governments and their related entities. This situation started to reverse in the first half of 2017 after oil prices stabilized and governments issued large bonds and injected liquidity locally. Moreover, in our view, GCC banks tend to keep sizable amounts of cash and money market instruments on their balance sheets. In the currently difficult operating environment, marked by few opportunities for lending growth, we think some banks might invest a portion of their liquidity in assets that generate higher income than cash and money market instruments. In this context, bonds and sukuk appear more attractive than interbank or central bank deposits.

“On another note, global liquidity remained abundant in the first half of 2017 and we expect this will continue until the year's end. The European Central Bank (ECB)'s Quantitative Easing (QE) program, the slow increase in the Fed's interest rates, and good liquidity in some Asian countries will continue to support demand for both bonds and sukuk. The cost of funding might start rising, however, as the Fed increases its rates and the ECB tapers its QE program. We expect an additional 25 basis-point rise in the Fed's rates by the end of 2017, after the recent increase in June. However, we see the ECB's QE program coming to a close only by the end of 2018, or in 2019 if external conditions (such as commodity prices and exchange rates) become more deflationary. We also see interest rates starting to move in 2019.”

“Given the currently low interest rates in developed markets, emerging-market issuers with good credit stories might still be on investors' radar, as shown by the significant oversubscription of some recent transactions. Consequently, we believe liquidity will continue to leak into the sukuk industry from developed markets, although at a slower pace because of recent developments in the GCC. There has been some progress on reducing the complexity of issuance, but it is not sufficient, in our view. It is still more time-consuming and complex to tap the sukuk market than to issue a conventional bond, even though this situation has improved over the years,” the report said.

“Positively, in the first half of 2017, we saw the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and other financial industry heavyweights pushing the market toward greater standardization. The AAOIFI has issued exposure drafts on central Sharia boards and sukuk accounting that aim to address the complexity related to Sharia compliance and legal structuring of sukuk. But the process for issuing sukuk is still not as smooth as that for a conventional bond. Until we reach that point, we think issuers will continue to show a preference for bonds.”

The takaful sector is vulnerable to the less-supportive environment

“Growth of gross takaful (insurance) contributions was flat in 2016 compared with 2015, and we expect this will be the case in 2017-2018, all other factors unchanged. Yet we believe the takaful industry has ample room for growth if aided by regulatory incentives and further development in other Islamic finance segments,” &P Ratings said in the report.

“Insurance penetration in core Islamic finance markets is still low, with premiums in the six GCC countries averaging 1 per cent-2 per cent of GDP, compared with over 6 per cent in more developed markets. Some recent regulatory actions, such as the introduction of a compulsory health insurance scheme in Dubai, for example, have created growth opportunities for participating companies. In our opinion, rising demand for life and savings products, or the introduction of further compulsory coverage, could further stimulate growth. At the same time, we believe tightening risk-based regulations in some markets will help create stronger takaful players but could increase operating costs, particularly for some smaller companies.”

What's next for Islamic finance

Standardization can support expansion

Numerous institutions have looked at Islamic finance and the sukuk market and eventually walked away, rather than go through all the steps required for issuance. Having standardized Sharia compliance and legal documentation, as well as more information for prospective issuers, could help the market move forward. Sharia is still interpreted in different ways across the various Islamic finance markets. However, the industry appears to be going in the right direction with the proposal for central Sharia boards.

“Also, in our view standardization could go one step further, through establishing globally accepted guidelines and adopting a post-transaction audit rather than pre-transaction approval. We believe a suite of standard products, ranging from debt-like to equity-like instruments, could help the industry regain its appeal. The risk-and-reward equation for investors should also be clarified. Some sukuk are sold as fixed-income instruments although they are not. Such an approach could destabilize the market if investors were to face a sukuk default. Issuances in Saudi Arabia, instruments with residual asset risks or structures that are based on a number of assumptions, should be well explained and understood by investors,” S&P said.

Responsible finance, sustainable development goals, and impact investing

“We see a natural connection between Islamic finance principles, responsible finance, sustainable development goals, and impact investing. All aim to create financial systems that are more equitable and have a positive tangible impact on the economy and population. Greater involvement of multilateral institutions (MLIs) in Islamic finance--through sukuk issuance and Islamic products, as well as stricter application of the principle of profit and loss sharing--could create growth opportunities for the industry. The contribution of Islamic finance has so far been limited by the industry's relatively small size and by its structure, consisting of a collection of diverse markets. Beyond Islamic finance instruments, zakat (alms giving) and waqf (charity) could prove particularly useful in the future in financing social infrastructure, such as affordable housing, health care, or education,” S&P said.

Resolution regime or profit and loss sharing?

In the aftermath of the global financial crisis, regulators have created resolution regimes to deal with failing systemically important banks without injecting taxpayers' money or destabilizing the financial system. For conventional banks, this involves building a buffer of loss-absorbing liabilities that protect senior creditors in case of major stress. Regulators in core Islamic finance markets have not yet implemented resolution regimes, but could do so over the next few years.

“In our view, a resolution regime could fit in with Islamic finance because profit and loss sharing is one of the industry's key principles. Possible prerequisites for such a regime could be that issuers make it clear to investors that instruments might be used to offset losses (similar to what the Malaysian Central Bank did when it created loss-sharing deposits) and clarify the conditions under which this might happen. In addition, creditors should receive adequate compensation for the additional risk,” said S&P.

A united industry is a stronger industry

“In our opinion, Islamic finance markets need amalgamation to transform them into a truly global industry. But there are already several success stories, and these could entice new players into the market. For instance, some issuers could benefit from observing Islamic finance in Malaysia, where we understand the process of issuing sukuk is as smooth as that for conventional bonds. Another example could be found in cross-border acquisitions, which might result in more cohesive Sharia interpretation. Closer integration may also lead to increasing sukuk issuance, which could reduce takaful operators' exposure to riskier real estate and equities investments or help banks manage their liquidity. Sukuk could also provide investment funds with additional fixed-income revenue, and encourage a shift toward more profit-and-loss sharing instruments. In addition, Islamic banks could start offering takaful products more systematically if the relevant regulation were in place.

“We believe progress would be aided if regulators acted to create a more supportive regulatory environment, while scholars, MLIs, and lawyers worked together to achieve standardization. What's more, universities could provide the necessary training and knowledge to create the next generation of Islamic finance professionals. Overall, we believe that, united and more integrated, the industry will become stronger,” S&P Ratings noted. – TradeArabia News Service