S&P Global Ratings believes the Islamic finance industry will continue to expand this year, but lose some momentum in 2018. The industry’s assets reached $2 trillion at year-end 2016, slightly below our September forecast.
Even though sukuk issuance accelerated in the first half of this year and will likely stay strong in the second half, we don’t believe this growth rate is sustainable. We think stronger growth is possible if, together, supervisory bodies and market participants achieve greater standardisation, resulting in a truly global industry.
Economic conditions are not helping
Islamic finance remains concentrated primarily in oil-exporting countries, with the Gulf Cooperation Council (GCC), Malaysia, and Iran accounting for more than 80 per cent of the industry’s assets.
The drop in oil prices and governments’ cuts to investment and current spending have reduced the industry’s growth prospects, in our view.
While Malaysia’s economy continued to perform adequately, thanks to its diversification, the average growth rate in the GCC dropped significantly between 2012 and 2017.
Iran, on the other hand, experienced a growth spurt in 2016 after certain sanctions were lifted and the oil sector picked up, but this growth is expected to moderate over the next three years.
Meanwhile, Iran’s economy will continue to suffer from the scarcity of financing options and the remaining sanctions.
Another factor explaining the muted industry growth is depreciation/devaluation of currencies in some countries. In particular, we’ve observed a marked impact of this on Islamic finance activity in Iran, Malaysia, Turkey, and Egypt, where exchange rates have deteriorated.
As the US dollar continues to strengthen in 2017 and 2018, we might see more of this effect. In this context, the Islamic finance industry was protected by the peg between the dollar and various GCC currencies.
Overall, we think the industry’s growth rate will stabilise at about five per cent in 2017 and 2018, which is lower than the average over the past decade. More recent industry entrants, such as Morocco and Oman, will likely show stronger growth, but their contribution to the overall Islamic finance industry will likely remain small.
Islamic banks in the GCC face a tough year
We expect the slowdown at Islamic banks in the GCC will persist in 2017 after asset growth declined to 5.3 per cent in 2016 from 10.7 per cent in 2014. In our base-case scenario, we assume that asset growth will stabilise at about five per cent as governments’ spending cuts and revenue-boosting initiatives, such as new taxes, reduce Islamic banks’ growth opportunities in the corporate and retail sectors.
We see banks becoming more cautious and selective in their lending activities, triggering stiffer competition. Yet we don’t expect this will happen uniformly in all GCC countries.
Although the economic slowdown will likely remain pronounced in Saudi Arabia, Islamic banks’ growth accelerated there in 2016, thanks to their strategy of increasing business among corporate and small and midsize enterprises (SMEs).
By contrast, the decline in economic activity was steeper in Qatar, where a mix of lower liquidity and government spending cuts prompted banks to curtail their expansion plans. Qatar’s placement under sanction by some Arab countries could also further weaken prospects for its Islamic finance industry in 2017.
Asset growth was about nil in Kuwait over the past year, hit by the depreciation of certain foreign currencies and the ensuing impact on the financials of some leading Kuwaiti Islamic banks. Despite the UAE’s tepid economic performance and the drop in real estate prices, Islamic banks continued to expand by high single digits.
As the economic cycle turns, we think GCC Islamic banks’ asset quality indicators will deteriorate in the second half of this year and in 2018.
Such weakening was not noticeable in 2016 because–as is typical–banks had started to restructure their exposures to adapt to the shift in the economic environment. Therefore we saw an increase in restructured loans in the GCC last year, but not a marked increase in banks’ nonperforming loans (NPLs) or cost of risk.
We think the deterioration will be more visible in 2017 and 2018. Overall, we believe that subcontractors, SMEs, and expatriate retail exposures will bear the brunt of the turning economic cycle and contribute prominently to the formation of new NPLs over that period.
GCC Islamic banks’ profitability will therefore deteriorate again in 2017 and 2018, in our opinion; we foresee several factors coming into play:
1. The cost of funding has increased, and this squeezed banks’ intermediation margins in 2016. Although the pressure eased a bit after some governments issued international bonds and unlocked payments to contractors, we think the cost of funding will remain inflated in 2017-2018.
2. The US Federal Reserve (Fed)’s recent rate hike, which some GCC central banks have emulated, could result in deposits shifting to profit-sharing investment accounts (PSIAs) from unremunerated current accounts. If this happens, it would raise the cost of funding even further.
3. Very few Islamic banks have set aside significant amounts of profit-equalisation reserves, which they build in good years and use to smooth returns to PSIA holders if needed.
4. Cost of risk is on the rise. We also foresee higher credit losses in the coming two years, due to relatively weak economic conditions. Exposure to subcontractors, SMEs, and retail customers (especially expatriates) will likely fuel the upward trend for credit losses.
In general, we expect Islamic banks’ revenue growth will decelerate, and that they will focus on their cost bases to mitigate the impact (for example, by pruning branches). Like their conventional counterparts, GCC Islamic banks, through their relatively low cost bases, should be able to protect their profitability somewhat over the next two years.
Although consolidation might be a way forward in some GCC markets, we expect mergers will remain an exception in 2017-2018 rather than the norm.
Capitalisation is generally a positive factor for GCC Islamic banks. We note, however, that it has reduced because previous rapid financing growth was not matched by additional capital.
Few GCC banks have issued capital-boosting sukuk and those that have, are primarily in the UAE, Qatar, and Saudi Arabia.