Turkey embraces Islamic finance with sovereign sukuk

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 İbrahim Öğüdücü, head of the financial institutions business at Bank Asya, the country's largest Islamic bank.

Market share

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.

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 Uğursel Önder, 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. Önder 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."

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.