Pakistan: Sukuk offeres enormous potential

In countries like Pakistan the governments facing shortage of revenue, indulge in borrowing to meet their developmental expenditures. While the conventional banks have been the key beneficiaries of such borrowing, Islamic financial institutions (IFIs) face serious liquidity management problems as these can’t invest in Riba-based instruments like Treasury Bills and Pakistan Investment Bonds. Issue of Sovereign Ijara Sukuk and corporate Sukuk on one hand offers an opportunity to invest in Riba-free instruments and on the other hand opens a venue for IFIs to manage their liquidity in a more prudent manner. Over the years the Government of Pakistan (GoP) has successfully mobilized funds for the infrastructure project and the latest being mobilization of over Rs49 billion equivalent to US$495 million though another Ijarah Sukuk.

Through this Sukuk the State Bank of Pakistan (SBP) has mobilized funds against M-3 Motorway for a period of three years. This is the first Sukuk that has been issued during the current fiscal year (2014-15). M-3 is a 52 kilometer long strip of motorway situated in Punjab that connects Faisalabad with M-2 near Pindi Bhattian.

This Sukuk has been issued in accordance with the provisions of the Ijara Sukuk Rules 2008. As per transaction mechanism, profit on the GOP Ijara Sukuk will be based on the rental rate benchmarked against the latest weighted average yield of the 6 month Market Treasury Bills or 6-month PKRV (as per FSCD circular 13 dated September 06, 2008). In addition, the rental rate as mentioned may be adjusted based on the difference between estimated supplementary rental and actual maintenance expenses of the underlying asset.

Further, it was also decided that for this particular issue of Sukuk (M-3), the total auction participation of a single Primary Dealer (PD) would be capped at Rs 25 billion or 20 per cent (whichever is the lower) of Total Demand and Time Liabilities-Islamic (excluding FE-25 deposits) of the respective PD Islamic bank / Islamic window of that particular PD. For this purpose, Total Demand and Time Liabilities-Islamic as of 28th March, 2014 were used. The central bank also reserved the right that in case any PD breached the aforesaid limit, it could cancel all or some of the bids of the bank concerned.

The Islamic Banking Department of SBP shall be responsible for monitoring: 1) proper execution and 2) the legal documentation as per approved Shariah structure, to ensure Shariah compliance and seamless management throughout the tenor of the Sukuk and at the time of maturity of the Sukuk. The SBP has advised all the designated PDs for the Sukuk to ensure meticulous compliance with the instructions issued.

Sukuk is an alternative Islamic finance instrument for conventional bonds. This is a certificate that represents ownership in underlying real asset(s). Islamic law does not permit interest and hence conventional coupon paying bonds are impermissible as per Islamic law. However, Islamic law allows sale and lease of real assets and the resulting income in the form of profit on sale or rental income stream on lease of assets. Holders of Sukuk share the lease or profit income generated from the ownership of real assets that the Sukuk certificate represents.

Sukuk has emerged as an instrument of choice after 2008 financial crisis. Not only Muslim countries, but non-Muslim majority countries are also taking interest in it. UK treasury has issued a Sukuk worth £200 million. It became the first sovereign state outside the Muslim world to issue an Islamic bond.

In Pakistan, capital markets are not as developed and most of the formal sector financing takes place through banks. Due to political instability and policy inconsistency, usually, the long term investments are not very popular among the investors. In the last few years, only a handful of IPOs had been made. The bond market is also very small and dominated by sovereign issues than corporate bonds.

While investors had found comfort with bank investments even though these do not offer inflation beating returns, most savers with adequate risk apatite look to invest in secondary market for equities. Karachi Stock Exchange has been offering immaculate that encourages investors to invest in liquid stocks for parking their surplus money.

There are many reasons why corporate bond market did not develop as per expectations in Pakistan. The national savings scheme instruments issued by the GoP offer very attractive yields and these are almost risk free. Some national saving scheme instruments are also tax-free and hence after-tax yield on such instruments are even higher as compared to the corporate bonds.

In Pakistan, prior to the latest issue, 78 Sukuk had been issued amounting to Rs 637.43 billion. Out of these 32 Sukuk issues of Rs 100.10 billion have been fully redeemed. The GoP had issued Ijarah Sukuk in the past to meet its escalating borrowing requirements. Entities like Water & Power Development Authority (WAPDA) and Sui Southern Gas Company Limited (SSGC) had also issued Sukuk in past. Karachi Shipyard and Engineering Works also issued an Ijarah Sukuk in 2007.

Sovereign Ijarah Sukuk issued by the GoP have been structured in such a way that it allows the government to utilize surplus liquidity of IFIs. The Sukuk holders are also able to earn Shariah compliant income. It also facilitates Islamic banks to manage their liquidity as well as meet statutory liquidity requirement stipulated by the central bank of Pakistan.

Within the corporate sector, Sitara Chemical Industries Limited, Wateen Telecom, Engro Chemicals, Dawood Hercules, Century Papers & Boards, Attock Generation, Arzoo Textile, Liberty Power, Amreli Steels, Eden Builders, Quetta Textile, Pakistan American Fertilizers, PEL and Kohat Cement are some of the companies that had issued Sukuk in past. Out of these, only one private sector entity Maple Leaf Cement defaulted on Rs8 billion Sukuk in 2009.

Recently, K-electric (formerly KESC) issued Rs6 billion Sukuk that were to be listed Karachi and Lahore stock exchanges. There was no Pre-IPO placement and the entire amount of Sukuk issue was offered to retail investors and it was fully subscribed in a matter of few hours.

Through issue of more Sukuk, the investment class assets universe will expand and it will also enable those seeking Riba-free return to effectively diversify their portfolios. Treasuries of Islamic banks will also have an expanded set of investment avenues. It will increase liquidity of these Sukuk and generate wider interest among all investors in the economy to consider investing in these investment vehicles.

Moody’s improves Pakistan outlook

Moody's has revised the outlook on Pakistan's foreign currency rating to Stable from Negative, with the move occurring post a "stabilization in the country's external liquidity position." This does not come as completely unexpected. Pakistan's total foreign exchange reserves have risen to a 2-year high of US$14.6 billion and exchange rate parity also improved by 6.7 percent CYTD against US Dollar.

With the outlook change having the potential to act as a self-fulfilling prophecy, analysts expect further improvement in rating. This should facilitate the valuation rerating process where the KSE-100 Index still trades at a forward P/E of 8.0x, at a discount of 18% to its average 7-year P/E multiple of 9.4x.  Pakistan’s leading brokerage house AKD Securities forecast June'15 Index target at 35,000 points.
The rationale to revise the outlook is "primarily based on stabilization in the country's external liquidity position supported by the GoP's strong commitment to reforms under an ongoing program with the IMF."

In the near-term, this vote of confidence from Moody's may encourage State Bank of Pakistan (SBP) to lower discount rate, although analysts still maintain that the central bank may choose to follow a cautious approach keeping in view geopolitical risks to international crude oil prices.

After offering a muted 0.18% return, the KSE-100 Index gained 1.32% on Monday after news came that Moody's has raised the outlook for Pakistan's foreign currency rating. This underpins the view that the valuation rerating process has room for further improvement and prospects for medium-term triggers such as a credit ratings upgrade and upgrade to MSCI Emerging Markets have improved.