Luxembourg’s decision to issue its debut sukuk in euros seems to defy common sense, since it will be selling into a Gulf-dominated market where most investors are fixated on dollars. But the grand duchy is right to stick with the currency and sukuk market participants should welcome this unusual choice.
Ever since Luxembourg floated the idea of issuing up to €200m worth of sukuk in euros or dollars, there has been a chorus from the Gulf that one of those currencies is a much better plan than the other. Dollars are what they use, anything else would be illiquid and currency hedging an already very tight note would be, for many, a complication too far.
It’s true that there’s not really any form or precedent in the market for euro-denominated sukuk. The UK’s Gatehouse Bank put together a privately placed deal worth around €10m last year but you have to go back to 2004 and 2005 to find anything bigger than that (Arcapita’s €75m and €46m tranches, respectively). The largest euro sukuk – and an oft-cited precedent for Luxembourg’s musings on the currency – was the German State of Saxony’s one-off €100m five-year, also in 2004.
Unfortunately, the reason Saxony’s ijara sukuk was a one-off is because it wasn’t deemed a great success. Broad demand for the paper was found to be lacking and a big reason, say Gulf investors, is that it chose to issue the sukuk in euros. And as Luxembourg’s proposed sukuk will surely be, the deal was tightly priced, at just 1% over euribor.
But the Luxembourg debut should be different. For starters, back in 2004 there were no Islamic banks in the UK to buy sukuk – now there are six, all keen for highly rated Shariah compliant paper to put in their liquid asset buffers. Last month’s UK £200m debut, the first ever sukuk by a western sovereign, was a big step forward for them in that respect, but much more is needed to give the Islamic banks a level playing field with conventional counterparts. They will be strong supporters of the Luxembourg sukuk, regardless of any need for currency hedging.
And the wider market has changed. Demand is deeper and investors are more accepting. Luxembourg’s finance ministry is understood to have consulted on the issue of currency and found that there are enough players in the Gulf willing to buy in euros. The notes will not be bought up by fast money, but officials believe there will be enough buy-and-hold interest. Asia, where Luxembourg is sure to do some marketing, should provide even more euro demand. Bank regulation requiring institutions to hold highly rated paper should be enough to generate willing buyers.
Determined to do euros
Most important though is why Luxembourg is so adamant about doing its sukuk in euros.
The finance ministry points out this will distinguish its second place finish (in the race to issue a western sovereign sukuk) from the similar sized UK debut – along with the fact the smaller nation retains a triple A rating from all three rating agencies.
But it also suggests that Luxembourg sees its debut sukuk as a true test of the market rather than a one-off advertisement of its Islamic finance credentials. It prefers to fund in euros, and does not like currency risk, but if it wanted to issue a deal just to gain attention as an Islamic financial centre it would be easier to just issue dollars. The choice of the sovereign's real funding currency suggests the sukuk is a practical funding instrument.
The Luxembourg issue also anticipates planned arrival of Eurisbank later this year – the first fully-fledged Islamic bank headquartered in the Eurozone. And it suggests Luxembourg could become a regular issuer. £200m was a tiny issue for the UK, whose funding requirement is some £100bn a year, but €200m is not so insignificant for Luxembourg, which has budgeted for just €12bn in 2014. Larger-sized sukuk could plausibly form a useful part of its future funding efforts.
Luxembourg only passed its sukuk bill through parliament last week and it is not yet clear whether the treasury will be willing to pay an extra few basis points over regular bonds to get an Islamic deal done – and in euros. But it is reasonable to assume it will want to emulate the kind of success the UK had in pricing its sterling sukuk flat to the five year gilt.
All those who want the sukuk market to flourish in Europe and other new jurisdictions should recognise that individuality is exactly what the market needs and get behind Luxembourg’s decision. And all those in need of highly rated Islamic paper should take the time to look at the deal despite its currency.