The market for Islamic bonds, or Sukuk, declined sharply in 2008 as a result of global market turmoil, drying up of liquidity, widening of credit spreads, and a wait-and-see attitude among investors. Although difficult to measure, part of this decline could also have been due to comments about the Shariah compliance of some Sukuk by the Accounting and Auditing Organization for Islamic Financial Institutions. Standard & Poor's considers that long-term prospects for the Sukuk market remain strong, however. Although volumes dropped dramatically in 2008 (down more than 56 percent), the market attracted about the same number of issuers as the year before. Conservative estimates of the pipeline of Sukuk that have been talked about or announced are in excess of $45 billion. Several factors support sustainable growth of this market, including the increasing popularity of Shariah-compliant products; government openness to Islamic finance; massive investment and financing needs in the Gulf; and issuers' desire to tap investors from the Middle East and Muslim Asia. Issuers from more than 20 countries have expressed interest in issuing, or announced their intention to issue sukuk, and Standard & Poor's anticipates that several new sovereigns will enter the market. To date, Standard & Poor's has rated 27 Sukuk (or Sukuk programs), the bulk of which are Ijara (lease financing), or Musharaka (venture capital financing). Credit spreads on Sukuk have followed the same trend as for conventional bonds, with a sharp widening in the past 12 months. Meanwhile, the average size of the Sukuk issued last year declined significantly, partly due to the lower appetite of investors. At the same time, the US dollar lost its place as the currency of choice for Sukuk, with only about 10 percent of issues raised in this currency. S&P expects the Sukuk market to continue being skewed toward issuances in local currencies, at least in the foreseeable future. The Sukuk market experienced a dreadful year in 2008, largely as a result of deteriorating global market conditions. For instance, the Gulf Cooperation Council (GCC) countries, one of the two key markets for Islamic finance, experienced a major shift in liquidity flows. The liquidity inflow into the Gulf - mainly into the United Arab Emirates (UAE) and Saudi Arabia - started to reverse from the second half of 2008 when investors betting on the revaluation of the domestic currencies left these markets. This led to a significant downturn in local and regional debt and equity markets, including the Sukuk market. Overall, total Sukuk issued globally dropped to $14.9 billion in 2008 from $34.3 billion in 2007. More than 45 percent of Sukuk issued in 2008 were Ijara, most probably as a direct consequence of the debate about Shariah compliance among some scholars. Appetite for Sukuk declined dramatically, along with that for international debt issuances, loan syndications, and other wholesale debt. We expect the Sukuk market to revive only in the second half of 2009 or early 2010 - if and when financial market conditions start to improve. This delay is despite the fact that the pipeline for Sukuk issuance remains healthy and the market is attracting interest from an increasing number of issuers in both Muslim and non-Muslim countries. Several structural factors indicate that growth in the longer term should be rapid: • On the demand side, investors from the Middle East and Muslim Asia are increasingly seeking to invest in products that are compliant with their religious beliefs. In addition, wealth accumulated when oil prices were high in the past few years means that their financial flexibility is still strong. • On the supply side, massive infrastructure projects in the Gulf require a huge amount of financing. Conventional borrowers are also seeking to diversify their investor base. They want to attract funding from investors as the crisis continues to widen and access to wholesale funding sources remains constrained. • The openness among governments and regulators to Islamic finance is increasing around the world. We observe this trend not only in Muslim countries but also in non-Muslim countries such as the United Kingdom, which is the European country most supportive of Islamic finance. • Financial institutions are seeking to better balance their funding, especially in the Gulf where short-term funding sources typically dominate and maturities are increasing on the asset side. __
