3 July 2009

Sukuk, the way forward in emerging markets

Recent innovations in Islamic finance have changed the dynamics of the Islamic finance industry, resulting in tremendous growth in Shari'ah (Islamic law) compliant, structured financial instruments such as Sukuk.

Shari'ah regards money as a measuring tool for value and not an asset. It prescribes that one should not be able to receive or generate income from money. This receipt or generation of money from money (i.e. interest) is defined as Riba. Shari'ah strictly forbids Riba.

Sukuk is defined by the Accounting and Auditing Organisation of Islamic Finance Institutions (AAOIFI) as "certificates of equal value representing undivided shares in tangible assets, usufruct and services or the assets of particular projects or special investment activity". Essentially, Sukuk is the Shari'ah-compliant equivalent of a bond.

A Sukuk structure operates on the principle that Sukuk holders each hold an undivided ownership stake in an underlying asset. Sukuk holders are entitled to a share in the revenues generated by such underlying assets, as well as being entitled to a share of the proceeds from the realisation of these assets. It is important that suitable assets are identified for purposes of investment (e.g. assets unrelated to industries involving alcohol, gambling or pork).

Types of Sukuk

Sukuk can take many forms depending on the type of Islamic modes of financing used in its structuring. The AAOIFI recognises 14 types of Sukuk, the most common of which are summarised below.

Al-ijarah Sukuk

Al-ijarah Sukuk (leasing notes) are issued where assets are sold by the issuer into a special purpose vehicle, then leased back for the duration of the leasing period. When the notes mature (i.e. when the lease period expires) the issuer has the right to buy back the assets.

Istisna'a Sukuk

Istisna'a Sukuk is used for the advance of funds in respect of real estate development, major industrial projects or heavy equipment such as turbines, power plants, ships or aircrafts.

An Islamic financial institution (the investor) funds the manufacturer or contractor during the construction or manufacturing of the asset, acquires title to that asset and upon completion, either immediately passes title to the developer on agreed deferred payment terms, or leases the asset to the developer under an Al-ijarah Sukuk.

Murabaha Sukuk

Murabaha Sukuk is based on a 'cost-plus' financing model whereby a mark-up is added to the selling price of an item with a deferred payment structure. In practical terms, the financial institution concerned would take ownership of the goods or assets for onward sale to its client at a price. The price would include a profit margin on the goods or assets. The financial institution will therefore amortise its cost and return over the period of instalments.

Salam Sukuk

Salam Sukuk refers to a sale where the seller undertakes to supply a specific commodity to a purchaser at a future date, which is paid for in cash and in advance. As a form of financing, the purchaser is able to acquire the asset at a discounted price and subsequently sells the asset upon delivery.

Although this type of 'forward contract' would in principle be forbidden under Shari'ah, Salam Sukuk attaches certain strict conditions aimed at eliminating uncertainty, thereby establishing Shari'ah compliance.

The way forward

Sukuk has proved viable as an alternative to mobilise medium- to long-term savings and investments from a huge investor base. It is expected that the development of various Shari'ah-compliant financial structures, such as Sukuk, will encourage Muslims to participate in financial markets, and will be instrumental in expanding these markets, particularly in emerging countries.

Nathisha Maharaj

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