Turkey's issue of its first sovereign sukuk this week paves the way for Turkish companies to raise money through Islamic bonds, and may help the country become a major market for Islamic investors from the Gulf and southeast Asia.
After coming to power a decade ago, Prime Minister Tayyip Erdogan's government, which espouses Islamic values, largely shied away from Islamic finance for fear of opening itself to charges that it was trying to roll back state secularism.
This prevented the world's eighth most populous Muslim nation from participating fully in rapid growth of the industry. Islamic financial assets globally hit $1.3 trillion in 2011, a 150 percent increase over five years, according to an estimate by lobby group TheCityUK's UK Islamic Finance Secretariat.
The Turkish government's issue of a $1.5 billion Islamic bond this week, which drew heavy bids totalling about $7.5 billion from global investors, is a step towards bringing Turkey into the mainstream of Islamic finance, potentially giving it more access to tens of billions of dollars of Islamic investment funds from other Muslim nations.
The sukuk is expected to serve as a benchmark for the pricing of future Islamic bond issues in the Turkish private sector. Other Islamic financial practices, such as takaful or Islamic insurance, may also attract more demand in Turkey after the government's shift.
"This is a landmark for Islamic finance in Turkey. Sukuk would help to deepen capital markets in Turkey," said Ibrahim Oguducu, head of the financial institutions business at Bank Asya, the country's largest Islamic bank.
Islamic finance, which operates according to religious principles such as bans on interest and pure monetary speculation, has been growing during the global financial crisis partly because it can draw on a huge pool of religiously- oriented investment funds from the oil-rich Gulf.
But Turkey has only four Islamic banks, which held a combined 61 billion lira ($33.9 billion) of assets in June, only 4.8 percent of the country's banking assets, according to Turkish brokerage IS Investment. In the Gulf Arab states, Islamic institutions hold roughly a quarter of the market, according to an estimate by consultants Ernst & Young.
Because of political sensitivities in Turkey, and to adhere to local law, Islamic banks in the country do not describe themselves as such but use the label "participation banks". Sukuk are described as "participation certificates", a reference to the fact that instead of paying investors interest, they pay returns on a pool of assets.
This week's sukuk issue suggests Turkey is moving away from such squeamishness about Islamic finance. Another sign of this is the government's 2007-2013 economic development plan, which refers in general terms to "asset-based" and "interest-free" financial instruments as part of efforts to develop the country as a regional financial centre.
"We have strong expectation for the Turkish treasury to continue sukuk issuances in the following years," said Yavuz Yeter, group manager for investment banking, treasury product development and marketing at Kuveyt Turk, one of the Islamic banks.
One reason for the policy shift appears to be the growing confidence in power of Turkey's ruling AK Party, which in the last several years has succeeded in reducing the political power of the secularist military.
A bigger reason may be economic trends. The Middle East and North Africa are becoming increasingly important to Turkish companies as growth in Europe and the United States stagnates.
"In this year, 34 percent of Turkish exports went to the MENA, so we need a similar kind of story for financials, foreign direct investment and any kind of debt issuance," Melis Metiner, senior economist at HSBC Turkey, said at the bank's MENA-Turkey forum, held in Dubai this week.
"In terms of debt issuance I think that would be a very attractive market."
Turkey's Islamic banks have so far issued only two sukuk. Both were issued by Kuveyt Turk, 62 percent owned by Kuwait Finance House, which raised a total of $450 million in 2010 and 2011.
The sovereign sukuk is expected to stimulate more issuance by the banks, by giving investors a benchmark off which to calculate yields they will accept. Kuveyt Turk has said it plans to sell a lira-denominated sukuk this year.
Last November Bank Asya shelved a plan for a $300 million, five-year sukuk issue, citing "adverse developments in international markets", but it may eventually revive the plan. Al Baraka Turk, a unit of Bahraini lender Al Baraka, has been talking about a possible $200 million sukuk issue.
Current market conditions for Turkish sukuk issuance appear excellent. Because of a big overhang of unsatisfied investor demand for sukuk in the Gulf and elsewhere - Ernst & Young estimates outstanding demand globally is over twice this year's expected supply of sukuk - many borrowers have been able to issue Islamic bonds more cheaply than conventional bonds.
"In the current context, where Turkish banks have been able to obtain international financing via Eurobonds at relatively cheap rates, there is room for advantageous pricing," said Ugursel Onder, senior associate at IS Investment.
Turkey's Islamic banks have so far been depending largely on retail deposits and short-term syndicated loans for funding, and have had limited access to international markets. So borrowing longer-term money via sukuk could improve their funding structures, Yeter said.
Onder said sukuk might help Turkey's Islamic banks meet minimum capital adequacy ratios as regulators tighten standards around the world. Since sukuk are asset-based instruments, they may in some cases be treated as a form of capital on banks' balance sheets, unlike conventional bonds which are pure debt, she said.
"Participation banks can issue sukuk as capital-like loans. In that way, these can be considered as Tier 2 capital and be treated like equity, which will in return boost their capital adequacy ratios."
Once Islamic banks issue their own sukuk, they may shift their attention to underwriting sukuk for Turkish companies seeking to raise money.
"The first non-financial sukuk could come as early as 2013. I think corporates will closely watch the sovereign issuance first," Onder said.
"As the know-how improves in the market, big corporates, holding companies and commercial firms would be much more interested," said Oguducu. "A number of corporates are interested in issuing sukuk, especially in the domestic market."
Since many international investors would require companies to have investment-grade credit ratings before buying their sukuk, some companies will focus on attracting domestic investors with lira-denominated sukuk, analysts said.
Turkey's sovereign sukuk uses an ijara structure, a leasing contract in which investors acquire partial ownership of an underlying asset and share in returns on renting it out. Broadening the types of sukuk in the market to include structures such as musharaka and mudaraba, which resemble partnerships or asset management contracts, would encourage corporate issuance, Yeter said - though the necessary expertise would take time to develop in Turkey.
Another important issue is tax policy. Because sukuk can involve two or more transfers of their underlying assets - one at the time of issue, and a second when the sukuk matures - they can be taxed more than once, making them less attractive. The Turkish government currently exempts ijara sukuk from multiple taxation but not other structures, Yeter said.
In addition to demand for Turkish sukuk from international investors, significant interest is expected from Turkish pension funds, some of which offer Islamic products, and from other investment funds keen to diversify their fixed-income holdings, Oguducu said.
Sukuk could eventually hold a share of the lira corporate bond market that exceeds the roughly 5 percent share which Islamic lenders have in the banking sector, Ibrahim Turhan, chairman and chief executive of the Istanbul Stock Exchange, told Reuters. "In sukuk, I expect a better performance."
(Reuters / 19 Sep 2012)
Alfalah Consulting - Kuala Lumpur: www.alfalahconsulting.com
Islamic Investment Malaysia: www.islamic-invest-malaysia.com