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Islamic Finance 2022-2023: Same Constraints, New Opportunities

This report does not constitute a rating action.

S&P Global Ratings believes the global Islamic finance industry will see double-digit expansion again in 2022-2023 after 10.2% growth in total assets in 2021 (excluding Iran). Growth last year was supported by Islamic banking assets in some Gulf Cooperation Council (GCC) countries and Malaysia, sukuk issuances exceeding maturities, and the solid performance of the Islamic funds industry.

This year, we think higher commodities prices will underpin a stronger recovery in many core Islamic finance markets. Moreover, most of these countries are relatively resilient to macroeconomic shocks resulting from the Russia-Ukraine conflict. This will support the industry's prospects for 2022-2023 but global headwinds could change the picture. We recently announced downward revisions to our global macroeconomic base-case forecasts the U.S., China, and the eurozone. We also expect high commodities prices and a changing global liquidity picture to result in lower sukuk issuance in 2022, after volumes declined 23.2% in the first quarter. Given discrepancies between various sources, we have focused our analysis on international sukuk issuances, which increased 12.3% in first-quarter 2022 after some riskier issuers tapped the market before the global liquidity retrenchment.

The Islamic finance industry is still held back by structural weaknesses, namely the complexity inherent to transactions and the correlation of performance with oil prices given concentration in commodities-exporting countries. The industry's geographical distribution has not materially changed over the past decade, suggesting that it may be struggling to attract interest beyond traditional markets. What's more, the clear preference of some Sharia scholars for a higher proportion of profit and loss sharing in sukuk is posing certain legal challenges. In our view, once sukuk become equity-like instruments, investor and issuer appetite will likely diminish significantly. Therefore, standardizing and satisfying the requirements of all stakeholders is a plausible way for the industry to maintain its attractiveness.

We also see opportunities in the alignment of certain Islamic financial products and environmental, social, and governance (ESG) factors. We expect to see a higher volume of green and sustainability sukuk (from a low base) as issuers look to broaden the investor base and include funds aligned with sustainability themes. Many Islamic banks have also made significant strides in digitalization, such as those in the GCC or Malaysia, but players in other core Islamic finance countries are yet to follow. Moreover, digital sukuk could generate significant investor interest in the future once the necessary prerequisites are implemented.

A Growth Rate Of About 10% in 2022-2023

The Islamic finance industry continued to expand in 2021 with assets up 10.2%, versus 11.4% in 2020, supported by banking asset growth (see chart 1).

Chart 1

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Thanks to higher commodity prices and the relative resilience of many core Islamic finance countries to the Russia-Ukraine conflict, we believe the industry will continue to expand about 10% annually, supported by:

Economic acceleration:   We expect economic growth to accelerate in most core markets, particularly the GCC and Malaysia, thanks to higher oil prices. Indonesia is also expected to see stronger economic growth, while we forecast a significant slowdown in Turkey following double-digit expansion in 2021 (see chart 2). Global headwinds are also clouding the outlook including:

  • The Russia-Ukraine conflict and heightened tensions with the North Atlantic Treaty Organization (NATO), which are more protracted than expected;
  • Continued stubbornly high inflation, fueled by food and commodity prices;
  • The Chinese authorities' lockdowns in major cities and regions to stem COVID-19; and
  • The U.S. Federal Reserve and other major central banks ramping up their fight to rein in inflation.

We recently announced downward revisions to our global macroeconomic base-case forecasts for the world's three major economic regions. We now forecast growth of 4.2% in China, 2.4% in the U.S., and 2.7% in the eurozone in 2022. This evolving global macroeconomic picture could affect core Islamic finance countries.

Chart 2

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Faster bank asset growth:   With the more supportive economic outlook for many Islamic finance countries, bank financing growth is expected to accelerate. In Saudi Arabia, continued mortgage demand and the implementation of Vision 2030 projects will create opportunities for industry expansion. In other GCC countries, more positive economic sentiment, government spending, and investments will help accelerate growth. In Southeast Asia, we expect the $290 billion Islamic banking market to expand at a compound annual growth rate of about 8% over the next three years. Meanwhile, in Turkey we still expect nominal lending activity to remain elevated, with growth estimated at 42% in 2022, but the global contribution will likely be affected by lira volatility.

Declining sukuk volume but increasing stock:  S&P Global Ratings forecasts total sukuk issuance will decline in 2022. This compares with a stabilization at $147.4 billion in 2021, versus $148.4 billion in 2020, and the 10% increase in foreign-currency-denominated issuance over the same period. Several factors are at play. Shrinking global liquidity and increasing complexity related to regulatory standards are likely to hold back sukuk issuance in 2022, assuming any adverse COVID-19-related disruption in core Islamic finance countries remains in check. We also expect lower financing needs for some core Islamic finance countries and some corporates to remain prudent with their growth capital expenditure after slowly recovering from the pandemic. At the same time, a more supportive economic environment and government spending are likely to create opportunities in commodity exporting countries. Moreover, local currency issuances by some governments are likely to continue as they seek to develop local capital markets and offer alternative financing avenues to their economies. We note the total volume of issuance was down 23.2% and foreign currency denominated issuance increased 12.3% in first-quarter 2022, after some issuers frontloaded their plans to benefit from market conditions prior to interest rate rises. Many of these issuances were either from low-rated counterparties or in the form of capital boosting instruments. Despite the decline in volumes, we expect sukuk issuance to still exceed sukuk maturing in 2022, which we estimate at about $96 billion.

Some support from the takaful and fund industries:  Although their contribution to the industry remains small, we also expect the takaful and fund sectors to expand this year. We continue to see the takaful sector expanding at an annual rate of 5%-10%. Fund growth is less certain due to market dislocations since the beginning of 2022, with one-quarter of the industry equity funds and another 60% money market or sukuk funds that are likely to suffer from higher global interest rates.

Overall, we believe an Islamic finance industry growth rate of about 10% (excluding Iran) is achievable over the next two years. This comes in the context of traditional weaknesses in concentration and lack of uniformity but new growth avenues emerging.

Islamic Finance Is Struggling To Expand Beyond Its Traditional Borders

After 50 years, Islamic finance remains a collection of local industries rather than a truly globalized one. There was no major change in the distribution of Islamic finance banking assets over the past decade (see charts 3 and 4). Moreover, the industry is still concentrated in oil-exporting countries and seems unable to attract interest beyond its original territory. In our view, the lack of competitiveness for some Islamic finance products and complexity related to structuring sukuk are the main factors deterring noncore players and particularly non-Muslim jurisdictions.

Chart 3

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Chart 4

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One recent example is the implementation of Standard 59 of the Accounting And Auditing Organization for Islamic Financial Institutions (AAOIFI). The market for hybrid sukuk that combine a commodity murabaha with tangible assets almost froze in early 2021 when the standard came into force in the United Arab Emirates. The challenge issuers faced was how to implement AAOIFI standards without changing the credit characteristics of the transaction. Lawyers eventually came up with a solution that was acceptable to different stakeholders. However, this increased investor exposure to residual asset risks. As a result, some investors decided to focus on more traditional markets, leaving sukuk for now.

One recent example is the implementation of Standard 59 of the Accounting And Auditing Organization for Islamic Financial Institutions (AAOIFI). The market for hybrid sukuk that combine a commodity murabaha with tangible assets almost froze in early 2021 when the standard came into force in the United Arab Emirates. The challenge issuers faced was how to implement AAOIFI standards without changing the credit characteristics of the transaction. Lawyers eventually came up with a solution that was acceptable to different stakeholders. However, this increased investor exposure to residual asset risks. As a result, some investors decided to focus on more traditional markets, leaving sukuk for now.

In our view, the opposing forces of Sharia scholars advocating more equity-like characteristics and investors preferring more debt-like characteristics could disrupt the market. This could materialize if and when scholars question the valuation mechanisms for underlying assets, the setting of a purchase price at the time of issuance, or the payment of rent that is uncorrelated with the value of the underlying assets. In our view, if sukuk become equity-like instruments, investor and issuer appetite will likely diminish significantly. Therefore, standardizing and satisfying the requirements of all stakeholders is a plausible way for the industry to remain attractive. We believe there are sukuk structures for the full spectrum of instruments, from fixed income to equity like.

The Sustainability Angle Is Attracting Attention

Since the beginning of the year, a few sukuk transactions have held a sustainability tag (see chart 5). From green to social, we expect to see higher volumes as issuers meet investor demands.

Chart 5

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Many Islamic finance countries are exposed to climate transition risk and several are developing or implementing transition strategies, including significant investment in clean energy. These present real opportunities for sustainable sukuk in Islamic finance core countries. However, we expect the energy transition will take a long time to materialize in the GCC and Malaysia, and as such sporadic recourse to green sukuk.

The social angle of Islamic finance presents another opportunity for sustainable sukuk. As the economic effects of the pandemic continue to surface in the form of higher unemployment rates, especially in fiscally constrained countries, social sukuk can help amortize the shock. These and other Islamic finance instruments could have an even bigger effect if they are leveraged properly.

Digitalization And Fintech Could Unlock Growth Opportunities

The COVID-19 pandemic has demonstrated how the capacity of a company or a bank to shift its business online is critical for its continuity. For Islamic banks and sukuk, higher digitalization and fintech collaboration could help strengthen their resilience in more volatile environments and open new avenues for growth. The industry is slowly getting there, and digitalization is now prominent among decisionmakers' priorities. In the GCC, for example, banks shifted their activities to online platforms during pandemic lockdowns with minimal impact. Offering digital banking services, issuing sukuk on a digital platform using blockchain technology, and enhancing cyber security will be the three main factors for industry resilience.

However, the provision of adequate physical and nonphysical infrastructure and implementation of the necessary supervision and regulatory framework will be prerequisites for fintech to act as a catalyst for the Islamic finance industry. That is why several regulators and authorities in the GCC and elsewhere have launched incubators or specific regulatory sandboxes where fintech companies can test innovations. A regulatory environment for digital sukuk and a monetary bridge between the physical and digital worlds could help provide market access.

Related Research

Primary Credit Analyst:Mohamed Damak, Dubai + 97143727153;
mohamed.damak@spglobal.com
Secondary Contacts:Dhruv Roy, Dubai + 971(0)56 413 3480;
dhruv.roy@spglobal.com
Sapna Jagtiani, Dubai + 97143727122;
sapna.jagtiani@spglobal.com
Benjamin J Young, Dubai +971 4 372 7191;
benjamin.young@spglobal.com

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