Originally published in Islamic Finance News on April 5th, 2017
The US Federal Reserve’s 25 basis point (1/4%) interest rate hike on 15 March was very much anticipated by the market. However, what should have been a wake-up call for the market was simply met with a yawn. This was the third rate hike by the Federal Reserve in 15 months. It was a clear signal that rates were headed higher after being held down close to zero for seven years, a first in the central bank’s more than 100-year history.
In Europe, the European Central Bank (ECB) decided a week later to keep its rates at zero for a while longer given the fact that Eurozone countries are still suffering from below average growth despite the fact the inflation, a key determinant for the direction of interest rates, has been rising across the continent. In the UK, for example, the latest inflation data was recently released showing inflation ticking up higher than expected at an annual rate of 2.3% versus and expected 2.1%. Eurozone inflation is currently at 1.9%, which is close to the target rate of 2% by when the market expects the ECB to put the brakes on its quantitative easing program and start hiking rates. The UK, however, is under pressure today to start hiking rates and may do so before summer.
What does this have to do with the sukuk market? On the surface, they may seem like unrelated events, but rising interest rates directly affect the sukuk market. The sukuk market, especially US dollar denominated sukuk, are benchmarked to LIBOR, which is the London Interbank Offered Rate, or floating interest rate charged by banks. A majority of interest rate products around the world are directly or indirectly linked to LIBOR. According to the Intercontinental Exchange (ICE), in 2014 there were over $350 trillion worth of debt instruments linked to LIBOR and sukuk are among them. Therefore, rising LIBOR rates mean rising sukuk rates.
While many of us have been watching the US Federal Reserve and ECB for interest rate directions, we have been blindsided to what has been going on in the LIBOR market, which is more relevant to us in the Islamic financial market. LIBOR, as you can see from the chart below, has been steadily rising since the summer of 2015 and has now reached a high not seen since 2009. Issuers and investors in the sukuk market should take notice of this.
The recent surge in sukuk issuance from oil producing countries has been well-received by the market. The drop in the price of oil, which began in June 2014, has forced many of these countries to cut back their spending and look for creative solutions to finance their budget deficits. Sukuk have been one of these solutions. Now that the price of oil has stabilizing over the past year, it still remains over 50% below the highs of 2014. Nevertheless, oil producing countries are still keen on tapping capital markets on both the conventional and Islamic fronts to finance their deficits.
Sovereign issuance, regardless whether conventional or Islamic, has been good for the sukuk market. Saudi Arabia issued a $17.5 billion bond in 2016 and is looking to repeat it again soon. Kuwait issued its first sovereign bond in recent memory last month that was 8 times oversubscribed. These sovereign issuances are good for the overall sukuk market because they set the benchmark rates for the rest of the market and test international investor demand for such instruments. Islamic banks have been at the forefront of sukuk issuance in recent years, but this is expected to change as both governments and corporates look to tap the Islamic market. What has happened since LIBOR began rising in 2015 is a rush by both governments and corporates to issue sukuk at fixed rates to lock in lower rates as rates rise. As a result, rising rates will be good for sukuk issuance this year.
On the flipside, rising rates also mean that governments and corporates needing to constantly tap capital markets for debt financing will be squeezed and could face repayment challenges going forward. Rising rates mean rising debt payments at a time when revenues and tax receipts are flat or falling.
Emerging markets such as China and Turkey are especially vulnerable to rising interest rates as they have taken on a record amount of debt over the past 8 years. In a recent report issued by the Bank for International Settlements (BIS) titled “BIS Quarterly Review, March 2017,” China and Turkey are at the top the BIS list of emerging countries most likely to suffer the most as a result of rising interest rates.