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Falling oil prices are unlikely to spur Gulf sovereign Sukuk issuance in 2015.

Summary: Standard & Poors believes that financing ability will likely remain strong, and there likely won't be a direct result of increased Sukuk in 2015

Upside for sovereign Sukuk issuance in countries in the Gulf Cooperation Council is limited in 2015, in Standard &Poor's Ratings Services' opinion.

"Although we expect that lower oil prices will lead to fiscal deficits in some countries in the GCC (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and United Arab Emirates), most governments' net asset positions will likely remain strong enough to enable their financing, says S&P. "Where this isn't the case, we see some potential for increased Sukuk issues, but the rationale behind choosing Sukuk over conventional capital market instruments remains a decision for each individual government. While keeping an eye on the likely financing mix for regional mega-projects, we continue to expect that most sovereign Sukuk issues will relate to essential infrastructure projects and refinancing needs, GCC governments, corporations, and project finance companies comprise the bulk of the second-largest Sukuk market in the world, after Malaysia. Most GCC countries are net hydrocarbon exporters. As a result, prevailing market sentiment suggests that overall Sukuk issuance goes hand in hand with oil prices, which, independent of seasonal factors, is why Sukuk issuance fromNovember2014hasbeensosubdued. However, in our opinion, the factors behind GCC sovereign Sukuk issuance are much more nuanced, and we believe that oil prices have had only little bearing."

Government-related entities' (GREs) financing activity, the availability of large government assets, and healthy liquidity in the banking sector all limit the linkage between changes in oil prices and the potential for sovereign Sukuk issuance, according to S&P.


-Market sentiment and broader capital market trends suggest that the recent drop in oil prices will go hand in hand with generally subdued Sukuk issuance from GCC sovereigns.

-S&P sees no meaningful correlation between oil price swings and trends in GCC sovereign Sukuk issuance.

- The strong fiscal positions of most GCC sovereigns curb the need for debt or Sukuk issuance to meet financing needs for infrastructure projects or deficits.

The extent and duration of the oil price fall will likely most affect the financing needs of those GCC sovereigns where expenditure side responses or liquid reserves are not available to cover fiscal deficits resulting from lower oil revenues.

However, GCC governments are not likely to tolerate a persistent annual reduction of state assets, in S&P's view. Bahrain and Oman have weaker fiscal positions, both in terms of projected fiscal deficits and net assets at their disposal. S&P believes that in these two countries, debt or Sukuk issuance are more likely as a source of deficit financing than for other GCC members. Bahrain has already issued Sukuk exceeding $1.1 billion in 2015, which is up more than 50 per cent on 2014 annual issuance. The tightening fiscal positions of regional governments may also spur GRE debt issuance that can facilitate off-balance sheet financing.


Governments that benefit from increased revenues during times of high oil prices often take the opportunity to initiate new projects, according to S&P. Among GCC members, such expenditure typically includes infrastructure development. Because of their size and duration, infrastructure projects often need a mix of public and private financing. Corporates and infrastructure financing companies have frequently obtained funding in local and international bank markets and also by accessing debt capital and Sukuk markets, albeit to a lesser extent. Large government backed infrastructure projects have become an increasingly popular investment opportunity for the large pool of regional liquidity, in part fed by oil-related revenues.

On the demand side, higher oil prices have, in the past, strengthened investment potential because they generated extra financial sector liquidity, says S&P. Similarly, on the supply side, periods of high commodity prices encouraged the development of hydrocarbon and infrastructure-related projects.

In addition, Islamic finance lends itself naturally to project finance because of the need under Shari'ah to have assets linked to a transaction. Project finance Sukuk are potentially attractive not just to investors in conventional project finance instruments, but also to those looking specifically at Islamic assets. With regard to project finance Sukuk, S&P sees a confidence affect at play that reinforces the relationship between oil prices and this type of issuance. If higher revenues reinforce a sovereign's fiscal and external position, then the sovereign's ability to continue financing complementary infrastructure expenditure should also strengthen, making related projects more attractive investment opportunities.


The largest sovereign Sukuk issuers are, for the most part, net hydrocarbon exporters. Still, S&P sees no meaningful link between oil price changes and GCC sovereign Sukuk issuance. As with conventional capital market issuance, the size and frequency of GCC sovereign Sukuk issuance grew alongside oil prices (from 2009 to 2014), albeit at a much more subdued rate. A simple correlation coefficient between Brent spot prices and monthly Sukuk issuance volume shows a relationship of just 0.16 for Middle East sovereign issuers. S&P notes that the development and depth of debt capital markets is also an important consideration when interpreting this data. For instance, Sukuk issuance has grown, but from a small and shallow base, which in part explains the volatility in this type of issuance.

In S&P's opinion, one of the principal reasons explaining the lack of linkages between oil prices and Sukuk issuance is the large stocks of fiscal assets that many GCC members have built up through years of fiscal and current account surpluses. Along with conventional debt issuance, governments tend to use these assets as the main sources of public-sector financing for infrastructure projects.

Instead, the broader rationale behind GCC sovereign Sukuk issuance, including that of central banks, has often been for project financing or benchmarking. For instance, in Qatar this includes issuing Sukuk as a monetary policy instrument to manage excess liquidity in the domestic financial system (including a $9 billion local currency Sukuk issue by the Qatar Central Bank in 2011) and partial financing of large infrastructure projects.


S&P estimates an average oil price of $55 per barrel in 2015, down from an average $99 per barrel in 2014. In our view, this drop will result in fiscal deficits for most GCC sovereigns in 2015. On the one hand, these likely deficits could incentivise sovereign issuance and provide an opportunity for governments to take advantage of what remains a relatively liquid financial system while maintaining their assets. On the other, the small size of these deficits relative to available fiscal assets--and GCC countries' limited culture of financing deficits through debt issuance--offset this potential, in our opinion. In general, S&P does not view the emergence of relatively small and potentially short- lived fiscal deficits alone as a precursor of increased debt issuance. Similarly, as lower oil prices feed through to lower corporate profitability, we expect that liquidity in the regional banking system will decrease--as will the need for central banks to mop up any excess, says S&P.

On the back of high hydrocarbon prices, Qatar and Saudi Arabia have run fiscal surpluses averaging 13.4 per cent of GDP and 6.7 per cent of GDP, respectively, over the past three years. Because GCC sovereigns in general have posted fiscal surpluses over the past decade, a culture of debt financing for fiscal deficits has not developed. GCC sovereigns have some of the strongest net asset positions among all sovereigns that we rate globally. S&P estimates Qatar's general government net asset position at 118 per cent of GDP in 2015, Saudi Arabia's at 135 per cent of GDP, and Abu Dhabi's at nearly 300 per cent of GDP. S&P expects that most oil exporting GCC sovereigns' liquid assets will remain available to assist with potential deficit financing. The c consequent impact on governments' net asset positions were central considerations in our recent sovereign reviews on oil exporting sovereigns.


S&P thinks that the size of fiscal deficits and their duration, which will be a function of both oil prices and policy response, will have a bearing on sovereigns' financing mix. The larger the deficits are or the longer they persist could increase the likelihood of financing through a range of instruments. GCC governments are not likely to tolerate a persistent annual reduction of state assets, in S&P's view. But S&P thinks that the dynamics underpinning Sukuk issuance will ref lect governments' willingness to maintain existing investment projects, rather than pure deficit financing, because issuing Sukuk necessitates an underlying asset under Shari'ah principles.

Bahrain differs from other GCC countries, as the only GCC government in a net debtor position and with consistent fiscal deficits over the past three years. It is one of the most frequent Sukuk issuers, and S&P thinks this will continue.

What's more, Bahrain's fiscal break- even oil price, at about $125 per barrel in 2014, is the highest among GCC sovereigns. S&P also considers that Oman, with a fiscal break-even oil price of $106 per barrel last year, could be more likely to enter capital markets or turn to Sukuk issuance to maintain its investment programme, rather than solely running down its more limited stock of assets.

Sizable infrastructure projects are underway in the GCC, including in Abu Dhabi ($90 billion in development projects),Qatar (capital investment program), and Dubai (Dubai Expo 2020). S&P expects that these projects, and essential infrastructure work, will underpin Sukuk issuance by sovereigns and government-related entities over the next few years.


In addition to the availability of liquid fiscal assets for deficit financing, the activity of government-related entities (GREs) as alternative or partial financers of infrastructure projects is an important consideration. GREs worldwide and multilateral lending institutions--predominantly the Islamic Development Bank--account for significant volumes of Sukuk issuance. However, as with GCC sovereigns, the correlation between regional GREs' Sukuk issuance and oil prices is weak. Still, Sukuk may appeal to the region's liquidity pool and provide an opportunity for diversification in an infrastructure project's financing mix.

Alongside organisational and efficiency gains, infrastructure financing through GREs--be it conventional or via Sukuk--allows governments to move a direct cost center off their balance sheet, while frequently maintaining ultimate control over the projects to be funded. Growth-boosting, counter-cyclical expenditures offer an additional incentive to continue with infrastructure projects, even during a period of subdued oil prices, particularly if the financing is on GREs' balance sheets, rather than on the governments'. However, S&P typically considers GREs as a contingent liability for a sovereign. GREs' issuance of either conventional debt or Sukuk could affect our rating on a sovereign if S&P deems the likelihood of extraordinary government support to the GREs is significant.

Credit Analyst: Benjamin J Young and Christian Esters

S&P estimates an average oil price of $55 per barrel in 2015, down from an average $99 per barrel in 2014

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Publication:Islamic Business & Finance
Geographic Code:7BAHR
Date:May 30, 2015
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