Earlier this week, the South African Treasury made major news with the announcement that they intend to issue $500M USD worth of Islamic Sukuks. The growth of Islamic Finance has been huge over the last few years, with the total global assets under Islamic Finance growing to $1.7 trillion, suggesting a growth rate of 17.6% over the last four years. While South Africa is not the first non-Arab country to issue Islamic compliant sukuks, it highlights a changing dynamic in international finance and in financial instruments, as investors and countries are looking to capitalize on new financial strategies.
How Islamic Sukuks Work
Islamic sukuks, commonly referred to as Islamic bonds, are sharia-compliant investment instruments that have become one of the most common instruments of Islamic finance. Unlike other bonds, which repay the face value of the bond at the maturity plus some kind of interest (usually in some form of coupon payment), Islam forbids paying interest to investors. Under Islam, the practice of charging interest, or Riba, is considered unjust and is thus forbidden by sharia law. Until the widespread development of Islamic Finance in gulf countries, this posed a serious challenge to companies who needed to raise funds while adhering to Islamic religious beliefs. However, with Islamic sukuks, the Islamic Finance market has offered a unique alternative: the risk premium offered to investors is a claim on the asset of the entity issuing the sukuk, with the investors assuming a portion of the cash flows and risks associated with the income. Thus, by providing a share of the income, as opposed to a pre-designated interest rate, the transaction becomes sharia compliant. For a government-backed security, this income would be derived from the profits of government owned companies (which must be also sharia compliant with no dealings in alcohol, pork products, interest bearing, etc.) or from taxes paid. In recent years, the growth of the global market sukuks has increased tremendously, with an estimated global growth rate of sukuk issuing at 10 to 15% per year and a global market of roughly $137 billion. While the majority of issuers have come from gulf countries and Islamic countries in South Asia, the recent spread into European and African countries shows the global potential for such instruments.
The South African Sukuk
While the Treasury of South Africa has been debating the merits of issuing an Islamic sukuk since 2011, when the Treasury formed an exploratory committee to consider the merits, the announcement that occurred this week is a big step for both the South African Treasury and Islamic sukuks as investment instruments. The specific structuring of the South African sukuk has yet to be released, but it's reasonable to assume that the sukuk would use either cash flow from the numerous government owned companies or from taxes, with the government and Treasury having already amended its tax code accordingly. The South African Treasury is expected to travel and brief investors starting on September 8th of 2014 in Europe, the United States and the Middle East expecting to raise a "benchmark size sukuk". Estimates state that a "benchmark size" indicates that the South African Treasury is expecting to raise $500M with a 5-year maturity. This comes at a crucial time for South Africa, as the Treasury is forced to refinance $14.4 billion USD worth of debt over the next three years. With an expected peak in 2017, South African government debt is projected to be 48.3% of the country's GDP. At a time when investors are bracing for the end of the US Fed's QE stimulus program and emerging market central banks have been raising interest rates to combat inflation and protect their currencies, rising bond yields mean that to avoid higher borrowing costs and continued refinancing, the Treasury will have to look to other instruments to raise funds.
While South Africa is not the first African country to court the gulf and risk adverse investors with a government-backed sukuk, it is certainty looking to be the biggest. In July of 2012, Sudan raised $165 million USD in its first Islamic debt offering. In June, Senegal opened its offering on its first government-backed sukuk with half of the $208 million USD offering selling within a month. The United Kingdom, the first European country to issue government-backed sukuks, attracted 2.3 billion British Pounds in its offering for 200 million GBP sale. Hong Kong and Luxembourg have already passed legislation in preparation of sukuk offerings and Nigeria and Kenya's Treasury departments have released statements indicating their interest in issuing government-backed sukuks.
The issuing of a South African sukuk is not the first government-backed security on the African continent, but it certainty will be the largest to date. This announcement is the latest in a string of major announcements and sukuk offerings that highlight a growing trend within governmental debt offerings: central banks and treasuries looking to adapt to new, potentially less expensive, debt offerings. The rapid escalation of these offerings seems to have gone unnoticed by all but a few investors, making it the perfect trend for the smart investor to know about early.
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