In this issue…
- Huge rise in GCC sovereign issuance to support Takaful stability
- Sustainalytics tracks the pulse of responsible finance
The Federal Reserve made waves, following the easing of policy in the European Union, by cutting its expected rate hikes for 2016 from four to two. The most significant impact from the move was a weakening of the dollar. The dollar’s strength has contributed to currency volatility in many emerging market currencies which threatens companies whose business has dropped as a result of falling commodity prices and who have dollar-denominated debt. The decline in the dollar gives these companies breathing room to adjust to the new reality of lower commodity prices.
One of the major challenges facing the GCC takaful market – excess allocation to real estate due to limited alternatives – may see an avenue for relief in the next few years. The region, home to two of the three leading markets globally (Saudi Arabia and the United Arab Emirates), will see $58 billion in bond and sukuk issuance in 2016 and $385 to $390 billion through 2020 according to Kuwait Finance Centre Markaz.
The stability of all insurance companies (including those operating takaful funds) has been put at risk by high allocations to equities and real estate. The high allocation to these asset classes can beneficial while times are good but leave the solvency of insurers and takaful operators more at risk when the economy slows. The excess allocation towards real estate (something which is common among insurers as well as takaful operators) has been exasperated by the shortage of Shariah compliant fixed income.
Going forward, the next few years may be challenging for the GCC and its takaful companies if energy prices stay low because the low penetration rate of insurance and takaful has led to an extremely competitive market. When Finance Forward surveyed insurance professionals in the region about the major challenges facing insurers, the top response (and the only one with more than 50% of responses) was pricing pressure driven by the over-competitive market.
With competitive pressures putting pressure specifically on underwriting margins, the investment side of the takaful business will be crucial for ensuring the long-term success for takaful operators. Many of them are relatively well capitalized and thus helping improve their resiliency of their investment allocations by including more of the (upcoming) sovereign sukuk.
A unique challenge facing takaful, even compared to conventional insurers with similar asset allocation problems, is the dearth of Shariah compliant fixed income, and particularly a shortage of sovereign sukuk. This shortage makes it challenging to implement the new rules being proposed or phased in that put a cap on real estate and equity exposure.
The new caps generally also limit foreign exposure making domestic, sovereign sukuk a highly desirable asset for takaful operators. The benefit from rising sovereign issuance is that it will have a chance of reaching such a volume that meets both banks’ (particularly Islamic banks which are highly liquid) need for high quality liquid assets and takaful operators need for domestic, Shariah compliant fixed income. A pipeline of around $60 billion per year for the next 5 years will support banks and takaful operators’ ability to manage their balance sheets and, thus, support growth.
The decision by Morningstar to team up with Sustainalytics to develop a scoring system for mutual funds on their application of sustainability criteria has been described as a “game-changer” because it brings more transparency to the responsible finance market. The approach to environmental, social and governance (ESG) integration has not been as well defined as in other areas of responsible finance which have more hard-and-fast rules, such as the approach used in Islamic finance.
The lack of definition in the ESG space has made it more difficult for the end-users of financial products, particularly the retail market where individual investors lack access to the asset managers that service the large asset owners. Providing these users and other stakeholders (including NGOs and the media) with more transparency about how financial institutions’ practices in regards to ESG integration match up with widely accepted uses of this data will certain facilitate greater clarity to an underserved group.
However, as much as standardized scoring systems are valuable in identifying where investment decisions align with common approaches (or not), they are not a be-all end-all. They should be used with a recognition that they embed, to some degree, an element of standardization in a market that does not always fit within standardized boundaries.
The approach of standardization works best where there is an established market practice that can be codified in simple form to define the baseline for expected behavior. Today’s ESG marketplace gives the appearance of having some baseline; however, a deeper look at the various approaches shows a very healthy divergence of approaches for a relatively new area of work.
Too some, the jumble of ESG may be a negative. Financial systems are particularly vulnerable to the herding instinct. By leaving open the possibilities for new and different approaches that incorporate Islamic finance, responsible finance can benefit from exposure to a wider audience without sacrificing creativity. It can also give an opening to new strategies that use ESG data in a way that better correlates what can be quantitatively measured with the values that responsible investors are trying to express through their investment behavior.
An unexpected benefit of the research conducted by Morningstar and Sustainalytics is to show how many unlabeled ESG funds there are. These funds invest in portfolios made up of companies that have high ESG scores despite not having a formal position on ESG integration or being signatories of the United Nations-supported Principles for Responsible Investment (PRI).
The transparency that the rankings demonstrate is the degree to which they are already close to appealing to responsible investors, and thus providing an entry into the responsible investment conversation that might be perceived as being difficult to join. In addition to evaluating the success of today’s responsible finance market, more transparent scoring against a transparent benchmark can help expand the market for the future.
Interested in Responsible Finance in the Islamic markets? Join the Responsible Finance Summit to hear from a diverse range of speakers spanning across the industry to see how responsible finance is developing and where Islamic finance fits within the global market. The Summit, which will be held from 30-31 March, is being organized by the RFI Foundation, co-organized by Middle East Global Advisors and hosted by Bank Negara Malaysia. For more information, or to register for the Summit, you can visit www.rf-summit.com.