Making a case for GDP-linked sukuk

Sukuk may be the most popular product in Islamic finance. It may also have international appeal and a global footprint.

Many governments, both of Islamic and non-Islamic countries, have issued sovereign sukuk denominated in US dollars or other major currencies to be listed and traded in the financial centres of the world.

The government-issued sukuk are in addition to corporate sukuk issued by corporations, Islamic banks and other private entities.

Given the strong growth in sukuk issuance in 2017, the total outstanding is now probably in the vicinity of US$500 billion (RM2.03 trillion). For a product that only came on stream barely 20 years ago, this is impressive growth by any measure.

Yet, where it really matters — the financing of development infrastructure — sukuk have thus far had insignificant contribution.

For Muslim countries, almost all of which are within the developing category and have pressing need for such infrastructure, this is quite a letdown.

Some studies noted that barely 10% of outstanding sukuk have been used for infrastructure financing. The majority of sukuk outstanding are of shortor medium-term maturity of five years, and are intended for working capital-type financing.

Moreover, they are mostly derived from debt-based contracts such as Ijarah and Murabaha that have fixed coupon and principal repayments.

If sukuk have not been instrumental in greenfield projects that expand productive capacity, but have merely been a Shariah-compliant substitute for debt, it then begs the question of how much value-added there has been for Muslim societies from its advent?

If sukuk and Islamic finance in general is to be more meaningful to the ummah, a reorientation may be needed. Sukuk design has to be recalibrated to be not just real asset-based, but also risk-sharing in nature.

When a developing government issues a fixed rate Ijarah sukuk, the cashflows, impact on leverage and debt servicing obligations are really no different from that of issuing a conventional sovereign bond.

Markets price and trade such sukuk exactly as it does conventional bonds.

 

Innovative Alternative

For developing Islamic nations that have pressing needs for development financing in the face of rapid population growth and budgetary pressures, such sukuk simply boosts the debt-to-GDP ratio, reduces policy flexibility and increases the country’s vulnerability to external shocks.

An innovative alternative for such countries would be the risk-sharing GDP-linked sukuk.

So, what is a GDP-linked sukuk? It is essentially a sukuk based on a standard contract like Ijarah, but with coupon/dividends linked to GDP growth.

When GDP growth is higher, dividends paid on the sukuk are higher — and vice versa if GDP growth is low.

In its simplest form, dividends are determined as a linear function of GDP growth. The principal portion, paid into a sinking fund, could also be designed to be repaid based on GDP growth.

Higher principal repayments in good years and lower (or none) in bad years. Here, an adjustment mechanism would be needed to settle the excess or shortfall of principal within the sinking fund at sukuk maturity.

Different permutations of the structure are possible. A perpetual version with only GDP-linked dividends would resemble pure equity, whereas one with guaranteed principal and a sinking fund would constitute a hybrid.

It would have the terminal and fixed principal feature of debt, but with the repayment flexibility of equity.

Investor returns which translate into funding costs to the issuer would obviously depend on the chosen structure. The more equity-like the structure is, the higher the potential variability in cashflows and hence, the higher the required returns or funding cost.

 

Flexible Design

Cost, however, is not an advantage of the GDP-linked sukuk, its true advantage is the inbuilt flexibility and automatic stabiliser that comes with the design. Macroeconomic stability is enhanced.

For example, when an economy goes into recession, repayment obligations for the sukuk fall, this ensures that countercyclical policies like social spending can not only continue, but be expanded.

The problem with debt is that the obligations are fixed and independent of economic conditions. Thus, during downturns, a government faced with a shrinking revenue, but fixed debt obligations that cannot be delayed, much less missed, have no choice but to cut expenditures.

The most common cut would be social welfare spending, hitting the lowest rung of society the hardest. When the cuts are large and the hurt deep, the poor take to the streets and political instability adds to the nation’s woes.

The GDP-linked sukuk helps avoid all these. Besides being congruent with the risk-sharing philosophy of Shariah, such sukuk reduces macroeconomic vulnerability to external shocks by linking repayment obligation to the ability to pay.

By not being interest rate sensitive, cross-border contagion is minimised — if not avoided altogether. For investors seeking diversification, such sukuk would constitute a new asset class.

 

By Prof. Dr. Obiyathulla Ismath Bacha

 

*This article first appeared in The Malaysian Reserve on 25 March 2019.

 

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