Most Islamic Finance Markets Remain Untested for Sukuk Recovery

Fitch Ratings-Dubai reports that the majority of the Organisation of Islamic Cooperation (OIC) countries, as per Fitch Ratings’ updated Country-Specific Treatment of Recovery Ratings Criteria, fall into the lowest level of recovery. This highlights the underdeveloped and largely untested nature of sukuk recoveries in key Islamic finance markets. Despite the prevalence of sukuk issuance in these jurisdictions, there are minimal legal precedents for effective enforcement.

Out of the 57 OIC countries, 14 are covered by the updated criteria. These countries are divided into four groups (A to D), each with varying caps on instrument ratings and recovery ratings (RRs) based on country-specific factors. While none of the OIC countries are in Group A, over half are in Group D – the group with the lowest level of recovery.

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The United Arab Emirates (UAE) and Qatar are the only countries among the core Islamic finance markets classified in Group B, defined by a range of superior to poor recoveries. Saudi Arabia, Bahrain, Oman, and Malaysia fall into Group C, with recoveries ranging from good to poor. The remaining eight OIC countries – Azerbaijan, Indonesia, Jordan, Kazakhstan, Morocco, Nigeria, Turkey, and Uzbekistan – are classified in Group D, where recoveries range from average to poor.

Despite recent updates to bankruptcy laws in many countries where Islamic finance is prevalent, there is little precedent for how bankruptcy courts might handle sukuk defaults. This uncertainty extends to whether the treatment of sukuk defaults might differ from bond defaults and if sukuk certificate holders will be able to enforce their contractual rights in local courts. English law often governs internationally issued sukuk, but local law from the originator’s domicile may govern some of the documents. This could lead to local restrictions on enforceability.

Given the lack of legal precedents for sukuk default resolution and recovery in most key markets, the level and scope of investors’ ability to exercise their contractual rights remain uncertain. As of the end of 1Q23, only 0.24% of all issued sukuk had defaulted, with the first Fitch-rated sukuk defaulting in 2021. Additionally, in 1Q23, 78.5% of Fitch-rated outstanding sukuk were investment-grade. While Sharia (Islamic rulings) influences the sukuk rating process, a rating does not necessarily imply Sharia compliance.

The classification of countries is based on the assessment of each country’s governance environment, leveraging three indicators reported by the World Bank’s Worldwide Governance Indicators project. Qatar and the UAE, both Group B countries under Fitch’s assessment, had some of the highest rankings of the 55 covered OIC countries. The UAE recorded the highest rank (82.2) for Regulatory Quality, followed by Brunei and Qatar. Qatar scored 81.3 under the Rule of Law indicator, followed by Brunei and UAE, and Brunei ranked highest under the Control of Corruption indicator, at 86.1, followed by the UAE and Qatar.