The budget showed that the government is continuing its work towards the issue of a UK government sukuk. This would clearly have an impact on the growth of the UK Islamic market, although it has to be pointed out that it is unlikely to have anything but an indirect impact on the range of Sharia’a compliant retail financial products.
It would, of course, widen and deepen parallel markets and lead to the creation of a greater variety of instruments, while providing the reference yield curve of choice to the market at large. This would be beneficial for all banks, finance and insurance companies offering Islamic finance products to retail clients.
The main benefit of such an instrument, however, is that it would provide a solid basis for product development and would further enhance London’s prime position as the pre-eminent centre for Islamic finance outside of the Muslim world.
This development is positive for wholesale and private banking, investment funds, pension funds and insurance operations in the growing Islamic finance market. A government sukuk would, for the first time, herald the availability of a marketable asset under Financial Services Authority regulations and provide a high quality hard currency instrument with “lender of last resort liquidity”, which to date has been missing from the market.
Since the government sukuk would be risk rated on a par with gilts, a higher yield would ensure sales success, as institutional investors would be eager to attain a better yield for the same issuer risk. However, a government sukuk with a higher yield than the equivalent gilt would be subject to market arbitrage, which would be undesirable from the government’s perspective.
With a projected issue size of £1bn, divided into three to four maturity bands to create a medium term yield curve, it would be large enough to provide much needed liquidity for the current UK Islamic banking market.
The fact that the sukuk would be eligible for discount at the Bank of England window also adds to its attraction.
Conversely it could be argued that the issue is unlikely to be attractive to Middle East investors, since the UK government sukuk yield would be lower than most sukuk in issue already. However, most of these existing corporate sukuk are rated BBB or lower, which represents an entirely different risk category than AAA UK sovereign risk.
The success of an issue would naturally be determined by investors’ reaction and appetite. In order to ensure it will reach a variety of investors and is not just bought up by a few large institutions, we have recommended to HM Treasury that the UK-based Islamic investment banks (BLME, European Islamic Investment Bank and European Finance House) are nominated as book runners with sale through auction. This will allow the Debt Management Office to allocate and scale down allocation in the sukuk issues and ensure a large variety of investors have the chance to buy the government sukuk.
An issue would also enable the government to access a new investor base, internationally as well as domestically. And demand for AAA assets from foreign investors would reduce the cost to government of servicing its debt.
A successful issue would need to be comparable to other UK government debt, in both price and maturity range. Provided that size and price criteria are met, the UK government sukuk has the potential to become the global benchmark for government sukuk, which would in turn emphasise the strength of the UK’s financial markets and its prime global position.
It would also be of significant importance in the development of the Islamic financial industry globally, most keenly felt in Europe, particularly the UK. Like gilts, some of the UK sukuk issuance is likely to be sold to foreign entities, although that would not be the primary aim of this landmark issue.
Retail products such as funds could be developed on the back of the UK government sukuk. This would have an impact on the growth potential of the market through the development of additional products. The lack of any significant range of instruments is one of the constraints on the market at the present time.
The actual growth that can be achieved is difficult to predict, and would be largely dependent on competitive pricing, and efficient marketing and distribution. Currently we are seeing an increased interest in Islamic finance, not only from a number of wholly Islamic institutions, but also from conventional financial institutions looking to offer Islamic products via subsidiaries or branches.
Potential growth is currently constrained by legal and tax issues, which are being addressed, the relative immaturity of the Islamic wholesale markets and the restricted range of comparable wholesale instruments.
In addition, limited but increasing awareness and understanding of the principles of Islamic finance still hinders growth and acceptability. For the retail offering in particular, standardisation of legal documentation is key in reducing cost, and hence facilitating growth.
Islamic finance is likely to remain a niche product as long as it merely mimics conventional financing products. However, significant growth will be achieved by the application of risk sharing principles, as evidenced in the shared ownership structures within the housing finance sector.
Finally, clear and open communication on both the structure and the aim of the issue would assist in its success and general acceptance both in Europe and internationally.