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Long-run asymmetric effects of
financial risks on Sukuk market
development: empirical evidence
from Malaysia
Siti Nurhidayah Mohd Roslen, Mei-Shan Chua and
Rafiatul Adlin Hj Mohd Ruslan
Department of Economics and Financial Studies, Faculty of Business and
Management, Universiti Teknologi MARA, Puncak Alam, Malaysia
Financial risks
on Sukuk
market
development
Received 8 August 2022
Revised 28 February 2023
7 August 2023
11 November 2023
Accepted 21 December 2023
Abstract
Purpose – The purpose of this study is to empirically investigate the asymmetric effects of financial risk on
Sukuk market development for a sample of Malaysian countries over the period of 2010–2021.
Design/methodology/approach – This study refers to the International Country Risk Guide (ICRG) in
determining the financial risk factors to be studied in addition to the Malaysia financial stress index (FSI) to
capture changes in financial risk level. The authors use the nonlinear autoregressive distributed lag (NARDL)
model to tackle the nonlinear relationships between identified financial risk variables and Sukuk market
development.
Findings – The results suggest the existence of a long-run relationship between foreign debt service
stability, international liquidity stability (ILS), exchange rate stability (ERS) and financial stress level with the
Sukuk market development in Malaysia. Indeed, higher ILS and ERS will boost Sukuk market size, whereas
higher foreign debt services and financial stress are negatively related to Sukuk market development.
Findings also indicate that the long-run positive and negative impacts of identified financial risk components
on Sukuk market development are statistically different. Taking into account the role of the Sukuk market in
facilitating Malaysia’s economic growth, the country should aim to keep the foreign debt-to-GDP ratio at a
sustainable level.
Research limitations/implications – This study points to three possible directions for future research.
The first is the differential impact of financial risk components on Sukuk issuance for different Sukuk
structures. As more data becomes available in the future, this area could be further explored by conducting
the above analysis for different combinations of Sukuk structures and currency denominations. In addition,
future researchers could also consider exploring the variability of financial risk impacts through comparative
studies of the leading Sukuk-issuing countries to account for differences in regulatory frameworks and
supporting infrastructure.
Practical implications – This study provides valuable practical and policy implications for
strengthening the growth of the Sukuk market. While benefiting from the diversification benefits of funding
sources to finance private or government projects and developments, Malaysia should remain vigilant to
global economic conditions, foreign exchange markets and financial stress levels, as all of these factors may
significantly influence investor sentiment and the rate of return offered by Sukuk issuance.
Originality/value – The use of the NARDL approach, which investigates the long-run effects of financial
risk factors on Sukuk market development in Malaysia, makes this study a valuable addition to the literature,
The authors would like to express our sincere gratitude to the Faculty of Business and Management,
Universiti Teknologi Mara, for the research grant funding. This research was supported by the
faculty of Business and Management, Universiti Teknologi Mara. Grant Number: 600-TNCPI 5/3/
DDF (FPP) (011/2022).
Journal of Islamic Accounting and
Business Research
© Emerald Publishing Limited
1759-0817
DOI 10.1108/JIABR-08-2022-0200
JIABR
as there has been little research into the asymmetric effects of those variables on Sukuk market development
using samples from emerging Asian markets.
Keywords Financial risk, Sukuk, NARDL model, Malaysia, Financial stress index (FSI)
Paper type Research paper
1. Introduction
Sukuk have emerged as a critical financial instrument in the dynamic world of finance,
reshaping the global investment landscape. Sukuk have grown in popularity in recent years
because of their distinct characteristics and adherence to Islamic principles. Sukuk are
financial instruments designed to adhere to Shariah principles, which forbid the payment
and/or receipt of interest. The holders of Sukuk instruments have proportionate ownership
of the underlying assets of business activities financed by the Sukuk issuance. This one-of-akind structure allows Sukuk holders to participate in profit-sharing and risk-taking
arrangements, aligning financial transactions with ethical and moral concerns. The
popularity of Sukuk is evident from the growing size of Sukuk issuance globally, which
reached $152.6bn in 2020 (RAM Rating Services Berhad, 2021) as compared to only $336m
in 2000 (Bank Negara Malaysia, 2012).
In this study, we focus on the determinants of Sukuk market development, focusing on
the influence of financial risks on issuing countries. The development of the Sukuk market is
significant for some reasons. From investors’ perspectives, high Sukuk issuance will allow
for greater diversification. For institutional investors, they seek diversification (Ghaemi Asl
and Rashidi, 2021; Pirgaip et al., 2021) through alternative asset classes, be it from a
geographical aspect (Arfaoui et al., 2022; Le et al., 2022; Bhuiyan et al., 2019) or a sectoral
aspect of the issuers (Billah et al., 2022), the use of proceeds (Roslen et al., 2021), the tier of
Sukuk (Salhani and Mouselli, 2022), or a different investment horizon (Najeeb et al., 2017). A
broader range of asset classes and diversification in the Sukuk market can result in a market
that is less prone to market dips.
Secondly, a well-developed Sukuk market can also attract domestic and foreign
investments, contributing to economic growth and development (Yıldırım et al., 2020;
Ledhem, 2020; Smaoui and Nechi, 2017; Echchabi and Idriss, 2016). Sukuk funds can be
invested in productive sectors, promoting business development and job creation.
According to Selim (2015), Sukuk-based monetary policy is relatively more effective in
increasing output, increasing employment and maintaining low inflation rates without
creating any negative side effects in the economy as compared to conventional-based
monetary policy. Similarly, AbdulKareem et al. (2021) also show that Sukuk is a better
alternative and more reliable way of financing abandoned and new projects for the
development of the country. This evidence suggests that Sukuk issuance may result in more
equitable wealth distribution and economic development.
As the Sukuk market expands, it attracts foreign investors and strengthens global
financial integration (Wong and Bhatti, 2019; Asutay and Hakim, 2018; Bhuiyan et al., 2018).
The globalization of Islamic finance, especially in Sukuk, has the potential to open up new
cross-border investment opportunities with different objectives (Muhammad and Haruna,
2022; Miglietta, 2017; Bo et al., 2016; Alam et al., 2016), while also strengthening economic
ties between countries (Abd Majid et al., 2020). Ever since the Basel III rules were introduced
in 2009, bank financing has been considered a less attractive long-term financing source,
and issuers are moving from banks to bond and Sukuk markets to tap long-term
institutional investors to raise capital. Today, with Asian countries looking toward
developing policies and action plans in response to global policy developments and
initiatives aimed at the Sustainable Development Goals by 2030, Sukuk may be highly
adopted. As a result, it is critical to investigate the factors influencing the development of the
Asian Sukuk market.
The objective of this study is threefold. First, we attempt to provide insights into various
variables related to the Malaysian Sukuk market as the frontrunner in the Sukuk market.
Notably, Malaysia emerges as a market leader with a maximum Sukuk issuance of around
$21,654.08m, contributing significantly to global Sukuk issuances. By delving into specific
risk components contributing to Malaysia’s overall financial risk rating, as defined by the
ICRG methodology, this study aims to provide an understanding of the factors influencing
Malaysia’s leadership in Sukuk issuance and evaluate the financial risk levels associated
with its Sukuk market through a comprehensive analysis of specific risk components.
Secondly, this study also aims to investigate the asymmetric relationships, both in the longrun and short-run, among the cointegrated financial risk variables using the nonlinear
ARDL model. We propose that various forms of government debt could contribute to higher
financial risks. However, the extent of this risk appears to be contingent upon the level of
financial stress within the economy or market. To this end, our analysis sheds light on the
issue of the unclear impact of financial stress on government debt (Kasal, 2023) by
incorporating the financial stress index (FSI) factors into a nonlinear model. Thirdly, this
study extends its objectives to unravel the long-run relationships between various financial
risk components covering the issuer’s debt service ratio, current account stability (CAS),
international liquidity stability (ILS) and exchange rate stability (ERS) with Sukuk market
development, contributing to a nuanced understanding of their interconnected impacts.
In this regard, the financial system (including the Sukuk market) is influenced by
macroeconomic factors in terms of its stability, performance and overall health. Any
uncertainty and negative macroeconomic shocks may cause a spillover effect in financial
markets (Feng et al., 2023). Findings from past research also show that macroeconomic
factors such as GDP, economic size, trade openness and the percentage of Muslims in the
Sukuk-issuing countries have a positive effect on the growth of the Sukuk market (Said and
Grassa, 2013). While there is literature on Sukuk financing and market development,
academic literature on the determinants of Sukuk market development is both new and
limited (Boukhatem, 2022). Furthermore, even though Asia requires massive inflows of
foreign capital to support its budget and current account deficits as well as meet its
investment needs, research on the relationship between financial risk and Sukuk market
development is scarce. To fill this gap, this is the first study that covers the role of the
financial risk of the issuing countries in the development of the Sukuk market in Asia. Also,
the study takes into account the macroeconomic and financial factors in Malaysia, which is
one of the top three global Sukuk issuers as of 2020 with a market share of 39.2% of the total
global Sukuk issuance (The Star, 2021).
It is worth noting that, in Malaysia, debt is raised by the federal government through
conventional market instruments and Sukuk. The primary purpose of federal government
debt instruments is to provide funds for development expenditure needs and liquidity
management. As government debt grows, fiscal risk rises, and fiscal policy becomes more
uncertain, potentially leading to debt crises if not closely monitored (Liu, 2023). This is
because, with high debt, there will be higher interest payments associated with debt
accumulation, which consequently leads to limited financial flexibility in spending.
However, a high debt-to-GDP ratio by itself may not necessarily have a negative impact on
economic growth. The nonlinear relationship between debt level and economic growth could
be explained by the financial stress factor (Proaño et al., 2014). Many past findings
have shown that government debt in various forms can lead to higher financial risks
Financial risks
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market
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(Guo et al., 2022; Zhao et al., 2022; Croce et al., 2019), but the level of risk may vary depending
on the degree of financial stress in the economy or market. Despite vast research findings,
none to date have examined the relationship between financial stress and government debt
(especially related to Sukuk); hence, the impact of financial stress on government debt is not
yet clear (Kasal, 2023). Taking this importance into account, this study includes the FSI
factor together with other financial risk components in a nonlinear model to have a better
overview of how financial risk affects Sukuk market development in Malaysia.
Motivated by this previous study, which mostly focused on examining the
macroeconomic determinants of Sukuk market development, yield characteristics of Sukuk
issuance and empirical effects of Sukuk market development and economic growth, this
research is intended to re-investigate the determinants of Sukuk market development by
focusing on financial risk components and financial stress levels in the financial system as a
whole. This research examines the key components of a country’s financial risk that will
influence the Sukuk market’s development in Malaysia. Different from Boukhatem (2022),
this study uses the nonlinear autoregressive distributed lag (NARDL) model to detect
associated asymmetric effects between the identified financial risk components both in the
long run and the short run.
Given these arguments and objectives, this research contributes by first expanding
previously limited empirical evidence of the determinants of Sukuk market development.
Furthermore, understanding which component of financial risk is influencing Sukuk market
development is critical for gaining a better understanding of the appropriate regulatory
framework to be used in the specific Sukuk market to protect both investors and issuers.
Sukuk issued by high-risk issuers may require a better protection plan for all contracting
parties in the Sukuk agreement. Thus, the findings of this study can be used as a reference
to comprehend the need for proper modification in various aspects of conventional
regulations, improving the performance of Sukuk and meeting other challenges in
developing the Sukuk market for Asian countries. Finally, the study’s findings are expected
to provide some insight into the possibility of greater innovation and the development of
new Sukuk structures and contracts. Although there are numerous types of innovations and
Sukuk contracts available in global financial markets, not all of them are risk-compatible
enough to be offered in a specific market because of distinct financial risk characteristics.
The identification of significant financial risk components that may affect the development
of the Sukuk market may shed light on this. Therefore, this study attempts to fill in these
gaps by:
focusing on the impact of the financial risk associated with the issuing country’s
Sukuk market development;
the link between the issuance of Sukuk and the issuer’s financial stress level by
incorporating the FSI element in addition to the components of country financial
risk; and
identifying and analyzing any asymmetric impacts related to the financial risk
components, both in the long run and the short run.
The uniqueness of this study lies in the application of robust econometric techniques to
validate the adverse impact of financial risk factors on Sukuk market development while
controlling for the financial stress index factor in the context of Malaysia. The rest of the
paper is designed as follows. Section 2 discusses the overview of the Sukuk market in
Malaysia, relevant literature reviews and the theoretical relationship of the Sukuk market
with respect to financial risk components and financial stress levels. Section 3 delves into
the data source and methodology. The results and discussion are found in Section 4. Section
5 concludes the paper with insights on policy implications.
2. Literature review
2.1 General overview of Malaysia Sukuk market
It was reported by RAM Rating Services Berhad (2021) that the global Sukuk issuance in
2020 will reach $152.6bn, an incremental jump of approximately 16.8% over the previous
year’s (2019) issuance of $130.6bn. As of 2020, Malaysia had dominated the global Sukuk
market (The Star, 2021) with a market share of 39.2%, followed by Saudi Arabia (20.4%)
and Indonesia (17.5%). The Malaysian Sukuk market is set to continue its upward trajectory
in 2021 as the foundations supporting the issuance of Sukuk remain strong and
comprehensive. In many nations, including Malaysia, the construction of sustainable
infrastructure by both the public and private sectors has been made possible, thanks in large
part to the Sukuk market. In fact, as of the end of 2021, Malaysia is still one of the top five
driving forces in the global Islamic capital markets.
Additionally, one of the main goals of the Malaysia Financial Sector Blueprint (2022–2026),
which Bank Negara Malaysia (BNM) introduced with the intention of achieving value-based
finance through Islamic finance leadership, is to promote a wider selection of Islamic risk
management tools to investors. In the case of Islamic finance, transparency is crucial in
determining the price of assets being issued. This is to ensure there is no element of gharar
(extreme uncertainty) or maysir (gambling) to avoid injustice in wealth distributions. With
proper risk identification associated with Sukuk issuance, it may result in fair and accurate
pricing compatible with the levels of associated risk. Evidence on the unfair pricing of Islamic
financial assets in Southeast Asia reported by Salami (2021) may be an indicator that the
importance of risk identification in Islamic financial instruments is still underestimated.
2.2 Theoretical relationships and literature review
Globally, the Sukuk market has been receiving a lot of attention from industry and
academics as an important and attractive platform for government and corporate entities to
raise long-term finance for various economic, business and infrastructural needs. However,
relevant empirical literature on the Sukuk market is scarce (Aman et al., 2022). Some of the
earlier empirical works on Sukuk market development have been conducted by Said and
Grassa (2013), Smaoui and Khawaja (2017), Muharam et al. (2019), Aman et al. (2019),
Basyariah et al. (2021) and Ledhem (2022). The focus of these prior studies was on the effects
of institutional attributes, financial developmental factors, macroeconomic determinants,
stock market development effects and bank stability on Sukuk market development.
To summarize, Said and Grassa (2013) discover that economic growth, market size, trade
openness, Muslim percentage and the financial crisis all have a significant impact on the
development of the Sukuk market. Smaoui and Khawaja (2017) investigated the impact of
structural, financial and institutional factors on the Sukuk market and discovered a positive
relationship between economic size, the proportion of Muslims in the population, a better
investment profile and lower corruption on the development of the Sukuk market. Basyariah
et al. (2021) obtained similar results in their study in the same area, which was conducted
using samples of the top-five countries actively issuing Sukuk in the global Sukuk market
from 2002 to 2017. Muharam et al. (2019) discover a bi-directional causality between the
development of the Islamic stock market and the development of the Sukuk market in both
Indonesia and Malaysia. Muharam et al. (2019) found a positive relationship between trade
openness and Sukuk market development, similar to Said and Grassa (2013) and Smaoui
and Khawaja (2017). Aman et al. (2019) discussed the significance of the banking system,
Financial risks
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market
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money supply and current account balance in the development of the Sukuk market.
Furthermore, Ledhem (2022) adds to these findings by demonstrating that the development
of the Sukuk market can result in greater financial stability for the Islamic banking system.
In general, studies on the Malaysian Sukuk market have been concentrated on several
areas. Among those are the impact of Sukuk ratings on stock market reactions (Muhamad
Sori et al., 2019) and economic growth (Tan and Shafi, 2021), the differences and
connectedness between the Sukuk market and bond market (Asmuni and Tan, 2021;
Samitas et al., 2021; Ahmed and Elsayed, 2019), ecologies (Liu and Lai, 2021), the
performance and challenges of green Sukuk (Keshminder et al., 2022), the impact of
economic factors (Aman et al., 2022; Jaafar et al., 2021) on Sukuk market development and
the financial disclosure quality (Qizam and Fong, 2019) of green Sukuk. In the area of Sukuk
market development in Malaysia, studies by Aman et al. (2019) have focused on the impact
of the economic development stage, banking system, money supply and current account
balance on Sukuk market development. They have found that economic size and exports
appear to be negatively associated with Sukuk, whereas other studied variables show a
positive relationship with Sukuk market development. In another study conducted by Jaafar
et al. (2021), findings from the fixed-effect model have shown that GDP and control of
corruption both have a positive and significant relationship with Sukuk market
development. This could be explained by the conducive economic environment that will
stimulate participation in the Sukuk issuance. According to this evidence, the economic and
financial environment of the Sukuk issuing country is critical to attracting global investors
to invest in Malaysian Sukuk. As such, in this study, we look into other aspects that will
determine the stability of issuers’ financial environment in terms of financial risk level.
Next, we will discuss the theoretical underpinnings of Sukuk market development with
the selected independent variables. Notably, financial risk can have a significant effect on
the Sukuk market’s development in many ways. According to Schinasi (2006), one of the key
factors that will determine financial stability is the ability of the financial system to manage
financial risks. This risk increases with the great reliance on debt in financing structures
(Al-Sayed, 2013). Risk management is an essential component of the Sukuk structure. The
ability to manage and minimize Sukuk risk is highly correlated with the ability of the Sukuk
market to develop further. The first and most important step toward better risk
management is the identification of the risks associated with Sukuk. It is almost impossible
to think about effective hedging techniques unless the risk can be properly identified. There
are numerous risks associated with Sukuk, but in this study, we are going to concentrate on
financial risk.
With respect to financial risk factors affecting Sukuk, this study used five variables in
measuring the financial components of risk to assess a country’s ability to pay its debt
obligations, guided by the ICRG methodology as in Boukhatem (2022). Despite the fact that
Sukuk are designed to be a risk diversification tool in investment, they are still heavily
influenced by financial uncertainties (Akhtar et al., 2017). Theoretically, financial market
development, such as in stock and bond markets, is subject to various economic factors. The
Sukuk market is also affected in the same way. The neoclassical theory of investment is an
economic theory that attempts to explain how firms and businesses make investment
decisions. As long as the expected return on investment exceeds the cost of capital,
investment will happen. The level of financial market development is dependent upon the
ability of the market to channel funds from net demanders of funds and net suppliers of
funds effectively and efficiently, and this can be achieved in a well-functioning financial
market. This theory is relevant to the objective of this study in identifying the most
significant financial risk component, which may have a more likely effect on investors’
confidence in the Sukuk market.
Within the framework of the neoclassical theory of investment, investment decisions are
contingent on the expected return on investment that surpasses the cost of capital. In the
context of Sukuk issuance, a Sukuk issuer’s foreign debt level and foreign debt service play
pivotal roles. A higher foreign debt level, coupled with efficient debt service mechanisms,
enhances a country’s ability to attract investment. The current account balance,
representing the difference between a nation’s savings and its investment, is crucial in this
scenario. Higher CAS signifies a higher propensity to invest, which aligns with neoclassical
theory. International liquidity, which denotes a country’s foreign currency reserves, adds
another layer to this relationship. Higher reserves enhance monetary autonomy and risk
management, which results in a conducive investment environment. Finally, a stable
exchange rate minimizes uncertainty, aligning with the neoclassical notion that investment
decisions are optimized when risks, including currency risk, are effectively managed. Hence,
within the neo-classical investment framework, the interplay of these factors shapes the
investment landscape for Sukuk issuers, which will influence their ability to attract foreign
investment and foster economic development.
In this study, the following hypotheses are tested with respect to Sukuk market development:
H1. Decrease (increase) in foreign debt stability decreases (increases) the Sukuk market
development.
Theoretical research has long argued for the existence of unfavorable effects of excessive
debt, such as debt overhang (Gan et al., 2022; Diamond and He, 2014; Hennessy, 2004; Mauer
and Ott, 2000); currency crises in the case of foreign debt usage (Jin et al., 2021); and negative
investment effects (Demirkılıç, 2021). All this evidence is aligned with the trade-off theory of
capital structure as suggested by Baxter (1967) and Kraus and Litzenberger (1973), which
stated that the employment of debt beyond the optimal point will lead to higher financial
distress costs (beyond the tax-shield benefit of debt), which are no longer beneficial to
the levered firms. Such effects can lead to fiscal insolvency, meaning overborrowing by the
government using foreign debt may result in a higher domestic burden and expose the
country to more global risk factors. The effect of foreign debt on fiscal insolvency is
supported by several studies revealing the difference in countries’ solvency levels based on
their accessibility to international financing sources. Park and Sung (2020), using data from
180 countries during the period of 1980–2015, find that non-OECD countries are more
fiscally solvent than OECD countries because of their limited access to international
financial markets (i.e. foreign debt). This could be attributable to the larger repayments that
are incurred on foreign debt than on local currency debt in bad states of nature (Korinek,
2011). Bordo et al. (2010) applied multivariate analysis to 49 countries and found that high
foreign currency debt is associated with increased currency and debt crises. In a related
study, Bordo and Meissner (2006) find that high exposure to foreign currency debt and the
currency crisis are more apparent in a country with a weak reserve position and low exports.
In mitigating the adverse effect of foreign debt, Sukuk can be used as a monitoring
mechanism because of the high government ownership and high level of corporate
governance in Sukuk issuing firms (Ashraf et al., 2021), besides providing a larger investment
universe to Islamic investors (Almaskati, 2022). For countries with high foreign debt, there is a
genuine reason to issue Sukuk in the subsequent capital raising activities because of its lighter
indebtedness and tax incentives (Uddin et al., 2020), especially for larger and longer tenor
issuances (Grassa and Miniaoui, 2018). Firms with high information asymmetry with their
foreign investors will be less likely to use foreign debt (Kedia and Mozumdar, 2003) and
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choose the Sukuk market instead (Nagano, 2017). Following the previous literature, this study
hypothesizes that when foreign debt stability increases (i.e. foreign debt as a percent of GDP
decreases), the Sukuk issuance size will be higher:
H2. Increase (decrease) in debt service stability causes an increase (decrease) in Sukuk
market development.
According to the ICRG methodology, debt service stability (DSS) is one of the components of
a financial risk rating. The DSS ratio reflects the issuer’s ability to service its foreign debt
using its export income. A high DSS ratio may signify a high level of foreign debt at a given
level of exports, which may be perceived as a riskier investment by the investors. The
deterioration in debt service ratio is not only going to increase the probability of default
(O’Toole and Slaymaker, 2021), but may also result in more constraints in future budget
allocations to the issuers (Khan and Shanks, 2020), which may hamper future Sukuk market
development. This could explain the results obtained by Said and Grassa (2013), which find
that issuers with a higher level of access to external funding will experience greater
development of the Sukuk market.
Numerous studies show that deteriorating debt repayment abilities have a negative
impact on the issuing of additional debt-like instruments. Azmat et al. (2014) find that the
debt service ratio is one of the significant factors that affect the bond spread. Liang and Li
(2022) investigate the impact of debt enforcement on bond yield in merger and acquisition
activities using samples from 28 countries and find that issued bonds will have lower yields
(i.e. less risk of default) only if there is strong enforcement that can improve a lender’s
chance of being paid back. Using external and domestic debt as percent of gross domestic
product (GDP) as a country’s indebtedness measure, Makun (2021) performs the linear and
nonlinear ARDL model of the symmetric and asymmetric effects of foreign debt on
economic growth and finds that external debt exerts a stronger negative effect on growth
compared to domestic debt. Phan (2017) develops a theory on the use of sovereign debt by
governments as a signaling tool in a high-information-asymmetry environment. The
findings reveal that additional sovereign debt issuance by a government will only send good
signals to investors if the government repays the debt. The role of the government in Islamic
bond issuance is also deemed important in signaling the probability of default by the
issuers. Using samples of 3,462 Islamic bond tranches issued in Malaysia, Halim et al. (2019)
find that the government’s presence as block holders through its privately held agencies
enhances debt monitoring and thus increases the creditworthiness of the bond issuers,
which will then result in a lower cost of capital. All this evidence suggests that issuers’ debt
repayment delinquencies and lower creditworthiness will somewhat negatively affect the
risk of the bond to be issued in the future and thus may discourage more bond issuance. In
keeping with most empirical findings, this study hypothesizes that a higher debt service
ratio will positively affect Sukuk market development:
H3. Increase (decrease) in current account stability leads to an increase (decrease) in
Sukuk market development.
The current account balance reflects a country’s ability to generate more foreign inflows
through net exports, income generation and trade activities. Because the current account
balance implies the issuers’ economic development state, it may be seen as a proxy for
investors’ expectations regarding future Sukuk issuance. High CAS may signify a developed
economy, which is attractive to investors (Eichengreen et al., 2008), and may cause the
Sukuk market to develop faster (Rajan and Zingales, 2003). Other researchers argue that the
relationship between current account balance and Sukuk market development exists
through currency value changes (Ekinci and Özcan, 2022) and market timing factors
(Nagano, 2016). The prior suggests that currency depreciation makes exports more
competitive and improves the current account balance, while the latter posits that firms tend
to issue Sukuk when they are undervalued. Despite the differences, all this empirical
evidence has one common conclusion: lower costs will encourage foreign investors to invest
more in local Sukuk. Given these findings, it is hypothesized that an increase in CAS (i.e. a
higher CAS ratio as a percentage of exports of goods and services) has a positive impact on
Sukuk market development:
H4. Increase (decrease) in exchange rate stability causes an increase (decrease) in Sukuk
market development.
Much of the empirical research on exchange rate variability concerns its adverse impact on
foreign investors’ participation in domestic financial instruments. There is substantial
empirical support for the idea that the depreciation of domestic currencies increases the
attractiveness of foreign-denominated Sukuk (i.e. global Sukuk). In a multivariate vector
error correction model analysis, Suriani et al. (2021) find that the depreciation of the
Indonesian Rupiah currency value leads to an increase in global Sukuk market investment.
Analysis of Malaysia’s bond and Sukuk markets demonstrates a positive unidirectional
causation relationship between the exchange rate and yield of short-term sovereign bonds
and long-term Sukuk, and the impact of exchange rate changes is not instantaneous and
drastic, as shown by the small value of the coefficient of error correction term (Arshad et al.,
2017). Despite the slow impact, exchange rate variability is still considered one of the types
of risks present in the Sukuk structure because greater volatility in exchange rates
contributes to greater uncertainty in the foreign exchange market, which will affect the
attractiveness of domestic bond and Sukuk markets among foreign investors. The
implications of exchange rate effects on securities pricing can be seen from the level of price
pass-through, which shows the impact on price inflation following exchange rate changes.
Using a recursive vector autoregression (VAR) model, Ahmad and Muda (2013) suggested
that any Organization of Islamic Cooperation (OIC) countries planning on issuing local
currency-denominated Sukuk should first evaluate the strength of their currencies to
insulate themselves from external shocks because of the high degree of pass-through that
occurs in a nonlinear manner (Hagemejer et al., 2022) that may influence the attractiveness
of the local Sukuk as compared to foreign Sukuk.
Related studies that were conducted on the impact of exchange rate volatility on Sukuk
issuance have produced mixed results (e.g. Boukhatem, 2022; Basyariah et al., 2021; Asri
and Wulandari, 2021; Al-Raeai et al., 2019; Ahmad and Muda, 2013), while still being
scarcely investigated within the main Sukuk issuers’ countries. Boukhatem (2022), Asri and
Wulandari (2021) and Al-Raeai et al. (2019) unanimously affirmed that exchange rate
volatility creates uncertainty for the real value of Sukuk and thus hinders the growth of the
Sukuk market. In contrast, Basyariah et al. (2021), in their study on macroeconomic and
institutional determinants of Sukuk market development among the top five Sukuk issuers,
found no significant relationship between exchange rate and Sukuk market development.
As an extension of the previous studies, this study proposes a hypothesis that enables
researchers to visualize the nonlinear relationship between exchange rate changes and
Sukuk market development, with the objective of providing a more conclusive finding on
how ERS affects Sukuk market development. This study predicts that the depreciation of
local currency against US dollars will cause higher Sukuk market development:
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H5. Increase (decrease) in international liquidity stability leads to an increase (decrease)
in Sukuk market development.
Debates still exist on the importance of foreign exchange reserves for a country. Some
authors believe that an increase in foreign exchange reserves prepares a country for a
sudden reversal shock in the economy via a variable tax on foreign capital (Davis et al.,
2021) and attracts more foreign direct investment inflows (Matsumoto, 2022). However,
other researchers, such as Choi and Taylor (2022) and De Nicolo et al. (2003), document that
high foreign exchange reserves may result in negative consequences. De Nicolo et al. (2003)
show that the increase in foreign exchange reserves will result in growing shares of foreigndenominated deposits in the local banking system (dollarization of deposits), which may
expose the local financial intermediaries to higher risk. Furthermore, Choi and Taylor (2022)
indicate that the increase in foreign exchange reserves may lead to domestic currency
depreciation if it is combined with high capital controls.
In the area of Sukuk, there is limited empirical research being conducted in exploring and
understanding the relationship between foreign exchange reserves and Sukuk market
development although some research has been done on other related topics in the Islamic
finance literature, such as Tanjung and Windiarto (2021) who study the role of cash waqf
Sukuk in improving health related infrastructure and financing commodity exports to OIC
member countries and improving foreign currency reserves balance; Levy-Yeyati et al.
(2013) who investigated the impact of high foreign currency reserves on savings and capital
accumulation, and Korinek and Serven (2016) who find that there is an optimal foreign
reserves level that a country needs to consider. Another strand of literature on foreign
exchange reserves suggests that the government’s decisions to hold foreign exchange
reserves may reduce the probability of a debt crisis (Bianchi et al., 2018; Hernandez, 2017),
which is aligned with the benefit of exposure diversification received by Sukuk investors
because of the sovereign nature of Sukuk (Jobst et al., 2008). Because much of this literature
focuses on the impact of foreign exchange reserves on economic development, more research
is needed, particularly in the Sukuk area. This study complements this literature by
studying the asymmetric relationship between ILS (measured by the level of foreign
exchange reserves) and the development of the Sukuk market in Malaysia. Hypothetically,
researchers expect that there is a positive relationship between ILS and Sukuk issuance size:
H6. Increase (decrease) in the financial stress index will negatively (positively) affect the
Sukuk market’s development.
During times of financial stress, investors become more risk-averse and tend to seek safer
assets. At this time, investors are uncertain about the fundamental value of assets and the
behavior of other investors (Hakkio and Keeton, 2009). There are mixed findings on the risk
characteristics of Sukuk. Some past findings revealed that Sukuk are less risky (Nasir and
Farooq, 2017) and more stable in terms of sales growth (Mohamed et al., 2015) as compared
to conventional bonds, while others suggest that Sukuk tend to be issued by riskier firms
(Ahmed et al., 2018) and have smaller asset sizes (Majumdar and Puthiya, 2021). If investors
perceive Sukuk as a risky investment, there will be reduced demand for Sukuk (and thus
lower Sukuk market development) during periods of high financial stress. Consequently,
Sukuk issuers may face difficulties raising funds through Sukuk issuance. Therefore, we
hypothesize that an increase in financial stress will cause a decrease in Sukuk market
development.
Given the above literature and identified research gaps, this study contributes
valuable insights to the understanding of the relationship between financial risk and
Sukuk market development in Malaysia. Using the NARDL model, this study contends
that there are mixed long-run and short-run effects of financial risk components on
Sukuk market development. In addition, the findings obtained from this study not only
add to the existing body of knowledge on the relationship between financial risk and
Sukuk market development but also offer practical policy implications for fostering a
sustainable and resilient Sukuk market in Malaysia.
3. Data and methodology
3.1 Data for the analysis
We use the Refinitiv Eikon database to extract the list of active Sukuk issuances in
Malaysia between 2010 and 2021. These Sukuk cover all types of Sukuk issued in
Malaysia, which include those issued by the government, agencies, corporates and
Sukuk issued in local currency denominations and foreign currency denominated
Sukuk. As the objective of the study is to look at the impact of financial risk on the
overall Sukuk market development offered in Malaysia, and in reference to past studies
within the same area (Aman et al., 2022; Basyariah et al., 2021), no specific separation of
Sukuk types was made on the collected samples. The selection of the data timeline is
based on the availability of data to be used in this study until the fourth quarter of the
most recent years. In addition, we also gather related macroeconomic data from the
Bank Negara Malaysia Monthly Statistical Bulletin and the Department of Statistics
Malaysia database. Sukuk market development has been defined in many ways in
recent research. Some researchers use the size of global Sukuk issuance (Baita et al.,
2023; Boukhatem, 2022; Ledhem, 2022; Yıldırım et al., 2020), Sukuk market size as a
percent of GDP (Aman et al., 2022; Smaoui and Ghouma, 2020) and the total number of
Sukuk transactions per year (Smaoui and Nechi, 2017). Following Aman et al. (2022)
and Smaoui and Ghouma (2020), we use Sukuk issuance size as a percent of GDP to
measure Sukuk market development in Malaysia. Higher Sukuk issuance size denotes
an increase in Sukuk market development, and vice versa. The definitions of other
variables used in this study are provided in Table 1. Given the importance of a
country’s financial stress level to financial market development, as highlighted in
previous studies, this study uses the FSI as a control variable.
3.2 Stationarity test
Because this study uses macroeconomic time series to compute the financial risk
variables and Sukuk market development ratio, unit root tests need to be conducted.
The identification of unit roots will help us determine if the NARDL model is suitable
for use in generating the Sukuk market development model. No unit root (i.e. stationary)
implies that the series fluctuates around a constant long-run mean, which also means
that the variance is finite and does not depend on time. In contrast, non-stationary
series have no tendency to return to a long-run deterministic path, and at the same time,
the variance of the series also depends on the time factor. Non-stationary series will
cause the generated model to be affected by random shocks and not by the identified
independent variables used in the study. This will result in spurious results.
If the series is non-stationary at level and the first difference of the series is stationary,
the series contains a unit root. In this study, we use the augmented Dickey–Fuller (ADF) test
(Dickey and Fuller, 1979, 1981). The ADF model is primarily concerned with the estimate of
a in the following equation:
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Factors
Variable
Acronym Descriptions
Source
Sukuk market
development
Sukuk issuance
size per GDP
SUK
Refinitiv Eikon database
Financial risk
measures
Foreign debt
stability
FDS
Debt service
stability
DSS
Current account
stability
CAS
International
liquidity
stability
ILS
Exchange rate
stability
ERS
Financial stress
index
FSI
Financial
stress level
Table 1.
Variables definition
and data sources
Total amount of Sukuk issued
in Malaysia market, computed
as a percent of GDP
Gross foreign debt in a given
quarter, in US dollars as a
percent of GDP in US dollars,
quarterly data
Bank Negara Malaysia
Monthly Statistical
Bulletin, Refinitiv Eikon
database and the
Department of Statistics
Malaysia
Total external debt in US
Bank Negara Malaysia
dollars as a percent of total
Monthly Statistical
exports of goods and services in Bulletin, Refinitiv Eikon
US dollars, quarterly data
database and Department
of Statistics Malaysia
The balance of the current
Refinitiv Eikon database
account of the balance of
and Department of
payments for a given year, in
Statistics Malaysia
US dollars, computed as a
percentage of the sum of the
estimated total exports of goods
and services for that year in US
dollars, quarterly data
Official foreign currency
Bank Negara Malaysia
reserves in US dollars as a
Monthly Statistical
percent of total imports in US
Bulletin, Refinitiv Eikon
dollars, quarterly data
database and Department
of Statistics Malaysia
Appreciation or depreciation of Refinitiv Eikon database
the Ringgit against the US
dollar, quarterly data,
computed as a percentage
change
Percentage change in measure Asia Regional Integration
of stress in an economy
Center, Economic
covering four major financial
Research and Regional
markets (banking sector,
Cooperation Department
foreign exchange market,
(ERCD), Asian
equity market and debt
Development Bank
market), quarterly data
Note: Variables definitions were obtained from Refinitiv Eikon database, ICRG (www.prsgroup.com/wpcontent/uploads/2014/08/icrgmethodology.pdf), ERCD and Asian Development Bank
Source: Table by authors
Dyt ¼ u þ bt þ ayt1 þ
k
X
ci Dyt1 þ «t
i¼1
where D denotes the first difference, yt is the time series being tested, t is the time trend variable
and k is the number of lags that are added into the model to ensure that the residuals, «t has a
zero mean and constant variance that is uncorrelated with «s, for t = s. To determine the
optimal number of lag lengths (k), we use the Akaike information criterion (AIC).
We test the null hypothesis of a ¼ 0 against the alternative hypothesis of a < 0 as
follows:
Ho : a ¼ 0 against the H1 : a < 0
The acceptance and rejection of the above hypothesis are evaluated using the conventional tratio of a:
ta ¼ a
^ =ðseða
^ ÞÞ
^ Þ is the coefficient of standard error. Nonwhere a
^ is the estimated value of a, and seða
rejection of the null hypothesis implies that the series is non-stationary, whereas rejection of
the null indicates the time series is stationary. For robustness, we also report the Phillips–
Perron (PP) test for unit root results in this study. All these tests are conducted using Stata
software.
3.3 Cointegration analysis
The Engle–Granger two-step cointegration approach (Engle and Granger, 1987) is used to
look at how two non-stationary time series variables are related to each other in this study.
This approach has been a pioneering and influential method in the field of econometrics, as
it laid the foundation for cointegrating analysis and paved the way for more advanced
techniques. Specifically, this method is used to analyze whether there is a stable, long-term
relationship between the studied variables. With this method, first the variables are tested
for stationarity, and then cointegration is tested using a two-step procedure. In the first step,
we run normal OLS, and from there, we collect the residual from this regression:
Yt ¼ d0 þ dt Xt þ ut
Subsequently, this residual (ut) is tested for its stationarity. This can be done by using ADF
tests on the residuals, with the MacKinnon (1991) critical value adjusted for the number of
variables (n). If the cointegration holds, the OLS estimator is said to be super-consistent.
Secondly, the error correction model is estimated. The following model is tested using
variables at level:
DYt ¼ w0 þ
X
j¼1
wj DYtj þ
X
wh DXtj þ au^ t1 þ «1
h¼0
The standard hypothesis using t-ratios and diagnostic testing of the error term is used. The
adjustment coefficient a must be negative.
3.4 Nonlinear autoregressive distributed lag model
The objective of this study is to examine the asymmetric effects of financial risk components on
Malaysia’s Sukuk market development using the NARDL model as described in Shin et al.
(2014). The NARDL model is useful in studying the impact of explanatory variables on
dependent variables in the long and short runs. It also allows researchers to model cointegration
dynamics and identify the possibility of a non-symmetric relationship between the dependent
and independent variables. For example, an increase in the independent variable (positive
change) is said to have a stronger effect on a particular dependent variable than a decrease
Financial risks
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(negative change). A conventional regression model assumes that a change in the explanatory
variable has the same effect over time. Evidence from recent studies on the Sukuk market has
shown the existence of a long-run asymmetric relationship between Sukuk market development
and stock markets (Arfaoui et al., 2022; Joof, 2020; Naifar and Hammoudeh, 2016), green bonds
(Billah et al., 2023a) and geopolitical risks (Bouri et al., 2019). In addition, results in nonlinearity
tests, as shown in Section 4.1, further justify the use of the NARDL model in this study.
NARDL models have the ability to model cointegration dynamics and asymmetry
compared to traditional linear and nonlinear econometric methods. This model can be used
to explore the asymmetric effects of multiple independent variables on the Sukuk market’s
development over both the short- and long-run horizons. For empirical implementation, this
study adapted and adopted the NARDL model used in the study by Liang et al. (2020) and
Salami (2021). We consider asymmetric long-run regression of the form:
SUKt ¼ bþ FRVtþ þ b FRVt þ ut
(1)
where bþ and b are the associated asymmetric long-run parameters, ut is an independent
and identically distributed (i.i.d.) process with zero mean and finite variance and FRVt
stands for financial risk variable and is a decomposition of the form:
FRVt ¼ FRV0 þ FRVtþ þ FRVt
with FRV0 equal to the initial financial risk value, and FRVtþ and FRVt denoting the
partial sums of positive and negative changes in financial risk variables (CAS, ERS, FDS,
ILS, DSS and FSI), given by:
FRVtþ ¼
t
X
DFRVjþ ¼
j¼1
FRVt ¼
t
X
t
X
max DFRVj ; 0
j¼1
DFRVj ¼
j¼1
t
X
min DFRVj ; 0
j¼1
The NARDL (p, q) model derived from equation (1) can be rewritten as:
p
q X
X
þ
SUKt ¼
Uj SUKtj þ
uþ
FRV
þ
u
FRV
j
tj þ «t
j
tj
j¼1
(2)
j¼0
where Uj is the autoregressive parameter, uþ
j and uj are the asymmetric distributed lags
and «t is the zero-mean, homoscedastic i.i.d. process. The asymmetric error-correction
equation can be stated as:
þ
þ u FRVt1
DSUKt ¼ rSUKt1 þ uþ FRVt1
þ
p1
X
!j DSUKtj þ
j¼1
where:
q1
X
j¼0
þ
dþ
j DFRVtj þ dj DFRVtj þ «t
(3)
r¼
p
X
Uj¼1 1
and !j ¼ j¼1
p
X
Ui; for j ¼ 1; . . . ; p 1
i¼jþ1
and
dþ and d are positive and negative short-run adjustments to changes in the explanatory
variable, FRVt. Here, we point out that equations (1), (2) and (3) are connected as follows:
bþ ¼ uþ =r and b ¼ u =r
We generate the equation (3) NARDL model as in Shin et al. (2014) in four steps.
The first step involves the estimation of the error-correction model using standard OLS
procedures. Secondly, the F-test of Pesaran et al. (2001) is conducted to test for asymmetric
long-run relationships between the magnitudes of variables. The null hypothesis (no
cointegration) against the alternative hypothesis (cointegration) is tested. Specifically, we
test the following hypotheses:
H0 : r ¼ uþ ¼ u ¼ 0 versus H1 : r 6¼ uþ 6¼ u 6¼ 0
Thirdly, we test for long- and/or short-run asymmetries using the Wald test. The null hypothesis
(long-run symmetry) is tested against the alternative hypothesis (long-run asymmetry). Similarly,
the null hypothesis (short-run symmetry) is also tested against the alternative hypothesis (shortrun asymmetry). Mathematically, these tests can be described as follows:
H0 : bþ ¼ b versus H1 : bþ 6¼ b
H0 :
q1
X
dtj ¼
j¼0
q1
X
d
j versus H1 :
j¼0
q1
X
dtj 6¼
q1
X
j¼0
d
j
j¼0
Finally, the asymmetric cumulative dynamic multiplier effects of unit changes in FRVjþ and
FRVj on SUKj are computed as:
mþ
h
¼
h
X
@SUK
j¼0
tþj
@FRVtþ
; m
h
¼
h
X
@SUK
j¼0
tþj
@FRVt
; h ¼ 0; 1; 2; . . .
where:
þ
mþ
h ! b and mh ! b as h ! 1
Long-run symmetry is implied by equality between the long-run multipliers:
Lþ
FRV ¼ uþ
u
¼ bþ and L
¼ b ;
FRV ¼ r
r
they represent the equilibrium long-run Sukuk market development adjustments following
positive (negative) financial risk changes. H1 until H5 state that any increase in financial
risk variables will result in lower Sukuk market development. This happens only if both
Lþ
FRV and LFRV are negative and statistically significant.
Financial risks
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It is hypothesized that the impacts of higher financial risk levels outweigh those of a
decrease in financial risk levels. This can happen only when the Wald test indicates
significant long-run asymmetry. Or else, the observed difference in magnitude between the
long-run adjustments following the positive (increase) or negative (decrease) financial risk
changes may be because of chance. If the Wald test is significant, then we can classify the
long-run asymmetry as positive, which means that Sukuk market development exhibits a
stronger reaction to financial risk increase (jLþ
FRV j > jLFRV j) or negative, meaning that they
respond more strongly to financial risk decrease.
4. Results and analysis
4.1 Preliminary analysis
Preliminary data analysis was conducted by checking the descriptive statistics and stationarity
of the series. Table 2 provides a descriptive summary of the Sukuk market development,
financial risk components and FSI variables – SUK, FDS, DSS, CAS, ILS, ERS and FSI.
Table 2 presents the descriptive scores for all the variables. The average size of the Sukuk
market accounts for $4,809.74m on average from 2010 until 2021. The maximum size of
Sukuk issuance is approximately $21,654.08m, which contributed around 33% to the global
Sukuk issuances in 2020, amounting to $65.6bn (Adilla, 2021). This figure puts Malaysia as
the market leader in this sector. In addition, Table 2 also exhibits the average scores for
financial risk component ratios for the Malaysian market. According to the ICRG
methodology, an overall financial risk rating of 0%–24.5% indicated a very high risk, 25%–
29.9% high risk, 30%–34.9% moderate risk, 35%–39.9% low risk and 40% or more very low
risk. To compute the overall financial risk rating, we first assign the risk points for each risk
component on a scale from zero up to a pre-set maximum as indicated in the ICRG
methodology guideline based on the five subcomponents:
(1) foreign debt as a percentage of GDP (maximum 10 points);
(2) foreign debt service as a percentage of exports of goods and services (maximum 10
points);
(3) current account as a percentage of exports in goods and services (maximum 15
points);
(4) net liquidity as months of import cover (maximum 5 points); and
(5) exchange rate stability (maximum 10 points).
The resulting overall financial risk rating is in the range of 50.67%–58%, indicating low risk.
During the study period, the FSI has on average been positive, with a mean value of 1.732. The
Variables
Table 2.
Descriptive statistics
of Sukuk market
development and
financial risk
components in
Malaysia
SUK ($ million)
FDS
DSS
CAS
ILS
ERS
FSI
Mean
SD
Minimum
Maximum
Skewness
Kurtosis
4,809.74
234.219
15.497
6.176
0.805
0.500
1.632
5,075.51
28.782
5.010
3.677
0.139
4.256
0.183
22.02
178.178
8.480
0.531
0.466
8.621
1.060
21,654.08
308.003
30.829
16.153
0.993
17.435
2.072
1.43
0.531
0.928
0.845
1.036
1.247
0.512
2.27
3.104
3.466
2.988
3.394
6.736
4.007
Source: Table by authors
highest FSI score is 2.072, while the lowest is 1.06. The variability in the FSI value is within
0.182% of the standard deviation.
4.2 Unit root tests
The analysis started with the determination of the stationarity level of the series to identify
the level at which the time series data are integrated. For this purpose, the ADF and the PP
tests were used. Table 3 presents the findings of these tests. The results show that the SUK,
DSS, CAS, ERS and FSI series are stationary at level, while the FDS and ILS become
stationary at first difference. This reveals that all FDS and ILS variables are I(1) data,
while other variables are I(0). Given these findings, the NARDL model is appropriate for
use in analysis because it can be used regardless of the order of integration (Katrakilidis and
Trachanas, 2012).
Financial risks
on Sukuk
market
development
4.3 Cointegration analysis
To test the cointegrating relationship between SUK, FDS, DSS, CAS, ILS, ERS and FSI, the
Engle and Granger two-step method (Engle and Granger, 1991) is used. Table 4 presents the
results of the Engle and Granger (1991) cointegration test. Based on the estimated value of
the test statistic, we confirm the long-run cointegrating relationship across Sukuk market
development (SUK), foreign debt services (DSS), ILS, ERS and FSI. The results based on the
ARDL model of cointegration (Table 5) confirm the earlier findings of the cointegrating
properties of variables in Models 1, 3, 5, 6 and 7. In Table 5, the F-test value falls within the
Level
Variables
SUK
FDS
DSS
CAS
ILS
ERS
FSI
First difference
ADF
PP
ADF
PP
6.006***
2.153
4.021***
4.795***
1.230
6.252***
7.843***
6.196***
1.687
3.882**
4.702***
0.853
6.246***
7.931***
11.024***
7.687***
9.794***
8.310***
7.539***
9.686***
11.470***
12.971***
8.250***
11.954***
10.260***
7.555***
12.083***
15.384***
Note: *** and ** indicate 1 and 5% significant levels, respectively
Source: Table by authors
Model
Model specification
1
2
3
4
5
6
7
SUKt ¼ f(FDSt, DSSt, CASt, ILSt, ERSt, FSIt)
FDSt ¼ f(SUKt, DSSt, CASt, ILSt, ERSt, FSIt)
DSSt ¼ f(SUKt, FDSt, CASt, ILSt, ERSt, FSIt)
CASt ¼ f(SUKt, FDSt, DSSt, ILSt, ERSt, FSIt)
ILSt ¼ f(SUKt, FDSt, DSSt, CASt, ERSt, FSIt)
ERSt ¼ f(SUKt, FDSt, DSSt, CASt, ILSt, FSIt)
FSIt ¼ f(SUKt, FDSt, DSSt, CASt, ILSt, ERSt)
Test statistic
Critical value at
the 5% level
7.529*
3.748
5.675*
5.429
7.983*
6.270*
8.590*
5.429
5.429
5.429
5.429
5.429
5.429
5.429
Note: * Shows rejection of null hypothesis of no cointegration at 5% level of significance
Source: Table by authors
Table 3.
Unit root test of
Sukuk market
development,
financial risk
components and
financial stress index
(FSI)
Inference
Cointegration
No cointegration
Cointegration
No cointegration
Cointegration
Cointegration
Cointegration
Table 4.
Engle and Granger
two-step method of
cointegration test
JIABR
Model Model specification
1
2
3
4
5
6
7
Table 5.
ARDL model
(robustness check)
SUKt ¼ f(FDSt, DSSt,
CASt, ILSt, ERSt, FSIt)
FDSt ¼ f(SUKt, DSSt,
CASt, ILSt, ERSt, FSIt)
DSSt ¼ f(SUKt, FDSt,
CASt, ILSt, ERSt, FSIt)
CASt ¼ f(SUKt, FDSt,
DSSt, ILSt, ERSt, FSIt)
ILSt ¼ f(SUKt, FDSt,
DSSt, CASt, ERSt, FSIt)
ERSt ¼ f(SUKt, FDSt,
DSSt, CASt, ILSt, FSIt)
FSIt ¼ f(SUKt, FDSt,
DSSt, CASt, ILSt, ERSt)
Optimal
lag
Lower bound Upper bound
critical value critical value
F-statistics at 5% level at 5% level Inference
(4,4,4,4,3,4,4)
17.798*
2.45
3.61
Cointegration
(1,2,3,4,4,4,4)
1.942
2.45
3.61
No cointegration
(4,4,4,4,3,4,4)
18.099*
2.45
3.61
Cointegration
(3,4,4,4,3,4,4)
3.061
2.45
3.61
Inconclusive
(3,4,4,4,3,4,4)
4.878*
2.45
3.61
Cointegration
(2,0,3,0,0,0,0)
24.501*
2.45
3.61
Cointegration
(4,0,2,0,0,0,1)
7.691*
2.45
3.61
Cointegration
Note: * Shows rejection of the null hypothesis of no cointegration at the 5% level of significance
Source: Table by authors
upper band I (1) for Models 1, 3, 5, 6 and 7, which indicates the existence of cointegration
between the variables. Moreover, the inconclusive decision obtained for Model 4 will be used
to justify the inexistence of a cointegrating relationship between CAS and Sukuk market
development (SUK), as reported in Table 4.
The cointegrating relationships among these economic variables carry several economic
implications. The cointegrating relationship between SUK and DSS suggests that changes
in foreign debt services can affect the growth and development of the Sukuk market. A
higher level of foreign debt services may put pressure on the government’s financial
resources, which may potentially affect its ability to support Sukuk market development.
Effective management of foreign debt services could result in a stable economic
environment, which may enhance investor perceptions of the stability of the Malaysian
Sukuk market. In addition, international liquidity conditions, as represented by the ILS
variable, can also influence the Sukuk market’s development in Malaysia. Positive liquidity
stability can encourage issuers to diversify their funding sources by tapping the Sukuk
market. This could explain the prominent size of Sukuk issuance by Malaysia among other
global Sukuk issuers. This highlights the importance of maintaining stable international
liquidity conditions to support Sukuk market development. Besides DSS and ILS, ERS also
shows a co-integrating relationship with SUK. This finding indicates that ERS is a crucial
factor for risk mitigation. Fluctuations in exchange rates may have a long-term impact on
Sukuk market development, as they can determine future capital flows and the value of
foreign reserves. Continuous monitoring of macroprudential policies and addressing factors
that could contribute to exchange rate volatility is pertinent to enhancing the attractiveness
of Malaysian Sukuk. All in all, the stable relationship between the aforementioned variables
underscores the importance of stable foreign debt management, foreign reserve levels and
exchange rate changes toward sustained growth of the Sukuk market. Moreover, the
cointegrated relationship between FSI and SUK also serves as an important indicator of the
Sukuk market’s ability to withstand economic shocks or financial stress. If Sukuk
instruments demonstrate resilience and stability during such times, they may be perceived
as an attractive avenue for investments among global investors, contributing to a favorable
trend in Sukuk issuance amid periods of economic turbulence.
The absence of a cointegrating relationship between the DSS variable and Sukuk market
development (as in Model 2 of Table 4) suggests that there is no long-term equilibrium or
stable relationship between these two variables. Several reasons could contribute to this
result. External factors such as global economic conditions, geopolitical events and changes
in investor preferences may contribute to fluctuations in both foreign debt levels and Sukuk
market development without establishing a stable long-term relationship. Besides that, the
availability of alternative funding sources may cause issuers to rely on other financial
instruments to raise funds, rendering the impact of foreign debt on Sukuk market
development less significant.
After establishing the cointegrating properties, we explore the long-run and short-run
asymmetric relationships between the cointegrated variables using the nonlinear ARDL
model as expressed in equations (2) and (3), respectively. Variables with no cointegrating
relationship with SUK will be dropped from subsequent NARDL models.
4.4 Nonlinear autoregressive distributed lag empirical results
The estimated NARDL model shows mixed results of positive and negative long-run and shortrun effects, as shown in Panel A of Table 6. In Panel E of Table 6, the results of the model
diagnostic tests presented using the Portmanteau test, Breusch/Pagan heteroskedasticity test,
Breusch/Pagan heteroskedasticity test and Jarque–Bera test on normality are presented.
Findings show positive and negative long-run cointegration effects between DSS-SUK, ILSSUK, ERS-SUK and FSI-SUK.
Panel B of Table 6 shows the results for the asymmetric relationship between financial
risk components and the Sukuk market’s development. Findings from the Malaysian Sukuk
market elucidate that a 1% increase (decrease) in the foreign debt service (DSS) ratio will
result in a 4.779% decrease (5.771% increase) in Sukuk issuance size (SUK) in the long run.
This implies that Sukuk market developments are adjusting differently to positive and
negative changes in foreign debt service levels, with a greater effect observed in negative
changes in DSS. The foreign debt service ratio provides an indication of a country’s foreign
debt repayment ability using its total export earnings. A higher foreign debt service ratio
infers that a significant portion of a country’s export earnings are channeled toward
servicing the outstanding foreign debt. If the debt service profile is not consistent with the
country’s debt repayment capacity (Jonasson et al., 2019), this may result in fiscal
unsustainability and financial stress. Deteriorations in debt servicing capacity may increase
the effect of default (O’Toole and Slaymaker, 2021), especially if the country tries to service
most of its debt during high credit spread conditions (Roubini, 2001). This matter is
becoming more critical if a country has high debt denominated in foreign currencies because
foreign debt must be serviced by inflows of foreign currencies (Samsu et al., 2016). The
country’s inability to match its foreign debt service decisions with its current repayment
capacity will raise concerns among investors about the country’s debt sustainability and
ability to manage its debt obligations, thus deterring Sukuk issuance in the future. Findings
on the DSS ratio suggest that policymakers should carefully manage foreign debt service to
align the country’s repayment capacity to avoid fiscal unsustainability and financial
distress, to uphold investor trust and to foster the growth of the Sukuk market. This
involves assessing the fiscal sustainability of the debt service profile and adjusting
repayment strategies accordingly.
Furthermore, results in Panel C also indicate that there is a long-run positive or
negative relationship between higher or lower ILS and Sukuk market development.
Financial risks
on Sukuk
market
development
JIABR
Variables
Coefficient
t-Ratio
Panel A: Long-run and short-run impacts of financial risks on Sukuk market development
SUK(1)
1.498***
7.30
7.158***
4.99
DSSþ(1)
DSS (1)
8.645***
6.57
15.181***
6.04
ILSþ(1)
8.859***
4.00
ILS(1)
þ
4.921***
3.51
ERS (1)
ERS (1)
6.209***
4.52
18.973***
5.75
FSIþ(1)
15.525***
5.73
FSI(1)
DSUK(1)
0.175
1.28
þ
1.468*
1.98
DDSS
4.405***
3.36
DDSSþ(1)
4.712***
4.93
DDSS
0.229
0.30
DDSS (1)
8.511***
3.17
DILSþ
0.040
0.02
DILSþ(1)
2.194
0.68
DILS
4.193
1.22
DILS(1)
þ
3.341***
3.10
DERS
0.892
1.34
DERSþ(1)
1.568*
1.81
DERS
4.129***
3.43
DERS(1)
þ
DFSI
5.097**
2.72
9.200***
5.04
DFSIþ(1)
5.002**
2.92
DFSI
0.314
0.17
DFSI (1)
Constant
26.438***
6.60
F (stat)
7.47***
RMSE
0.40679
2
0.8001
Adj. R
Panel B: Long-run effect
Positive
4.779***
10.134***
3.285***
12.666***
Negative
5.771***
5.914***
4.145***
10.364***
Long-run asymmetry (F-stat)
5.541**
4.231*
4.795**
3.873*
Short-run asymmetry (F-stat)
16.22***
1.93
14.4***
10.79***
DSS
ILS
ERS
FSI
Panel C: Asymmetric relationship
DSS
ILS
ERS
FSI
Panel D: Asymmetric cointegration test
F
pps
Table 6.
tBDM
Dynamic asymmetric
estimation of Sukuk
market development
8.8966***
7.2993***
(continued)
Variables
Panel E: Model diagnostic
Portmanteau test
Breusch/Pagan heteroskedasticity test
Ramsey RESET test
Jarque–Bera test on normality
t-Stat
p-Value
15.13
0.4776
1.57
1.929
0.7142
0.4895
0.2441
0.3811
Notes: (1) indicates lag 1 of the tested variable. D implies the variable at first differed. *, ** and ***
represent 10, 5 and 1% significance levels, respectively. FPSS indicates the Paseran–Shin–Smith F-test, and
following Pesaran et al. (2001), the conservative of critical values is adopted, k ¼ 5, and the upper bound test
statistics at 10, 5 and 1% are 2.93, 3.34 and 4.21, respectively; tBDM indicates the BDM test. Based on Shin
et al. (2014), the conservative of critical values is adopted, k ¼ 5, and the upper bound test statistics at 10, 5
and 1% are 3.49, 3.83 and 4.44. The diagnostic tests results indicate that the residuals follow the white
noise process, are homoscedastic and are normally distributed. The non-rejection of the null hypothesis for
the Ramsey RESET test also suggests that the model is not suffering from an omitted variable problem
Source: Table by authors
Foreign currency or exchange reserves, otherwise known as forex reserves, encompass
cash and other assets that are held by central banks. Higher foreign reserves denote a
country’s higher holding of foreign currencies and other assets. The accumulation of
foreign reserves has a positive impact on the monetary autonomy of a country (Law,
2023; Taguchi, 2011), which will allow the country to respond more effectively to
domestic economic challenges. Holding sufficient levels of foreign reserves can lead to
better risk management strategy formation (Silva, 2019) and signal a country’s ability
to meet its debt obligations. Increased creditworthiness will influence investors’
confidence in the country’s sovereign investment cost and financial stability (Brooks
et al., 2015) of its offered financial products, including Sukuk. In times where there are
high uncertainties surrounding the financial market, investors are more likely to invest
in a market that is perceived as less risky. Accumulating foreign reserves is viewed
positively for risk management purposes because it may signal the country’s ability to
meet its debt obligations and improve its creditworthiness. Hence, higher ILS will result
in higher Sukuk market development because it will enhance investor confidence and
drive increased demand for Sukuk.
Similarly, findings obtained for the FSI variable also indicate that, in the long run, a
market with higher financial stress will negatively affect the Sukuk market’s development.
In addition, an increase in financial stress has a more significant impact on Sukuk market
development than a decrease in financial stress. Financial stress can cause a significant
economic slowdown (Cevik et al., 2016), which dampens trade and growth in capital inflows
(Stamm and Vorisek, 2023) and adversely affects the investment profile of the Sukuk issuing
country. Without a good investment profile, it may be challenging to increase the size of the
Sukuk market (Smaoui and Khawaja, 2017). This finding is aligned with Naifar and
Hammoudeh (2016), who suggest that financial distress conditions and uncertainty factors
have negative impacts on Sukuk returns, which may have adverse implications for the
return profiles of Sukuk holders’ portfolios. In short, evidence on the FSI variable suggests
that mitigating financial stress is crucial in maintaining economic stability, stimulating
trade and building up investors’ confidence to promote Sukuk market development and
financial stability.
A careful interpretation needs to be made of the ERS variable findings. ERS represents
the value of the Ringgit against US dollars. A higher ERS indicates Ringgit depreciation,
Financial risks
on Sukuk
market
development
Table 6.
JIABR
while a lower ERS signifies Ringgit appreciation. Long-run asymmetric relationship results
obtained for the ERS variable presented in Table 6 show that a 1% decrease in Malaysian
currencies will subsequently lead to a 3.285% increase in Sukuk market development,
whereas a 1% increase in Ringgit will result in a 4.145% drop in Sukuk market
development. These results could be supported by the higher issuance of Ringgitdenominated Sukuk than foreign currency-denominated Sukuk offered by Malaysia during
the study period. A depreciation in Ringgit currency against foreign currency can make the
cost of servicing Sukuk denominated in Ringgit lower, and this will incentivize more issuers
to tap the Malaysian Sukuk market to raise funds for financing their projects, resulting in
higher Sukuk issuance size and increasing Sukuk market development. The results obtained
confirm the works of Billah et al. (2023b), Boukhatem (2022) and Suriani et al. (2018), who
show a significant role for ERS in Sukuk market development. Policy measures that manage
the stability of the ringgit can impact Sukuk market development by influencing the cost of
servicing Sukuk denominated in foreign currency. A lower cost of servicing Sukuk can
incentivize issuers to opt for the Malaysian Sukuk market in raising capital, supporting
higher Sukuk issuance and market development. To lessen the effects of unstable exchange
rates, policymakers may want to consider hedging against currency risks, negotiating better
payment terms with Sukuk holders and diversifying the composition of currencies used in
Sukuk payments.
4.5 Findings on the asymmetric relationship
As reported in Panel C, Table 6, three of the financial risk components included in the model
reveal an asymmetric relationship with Malaysian Sukuk market development (SUK) in
either the long-run or short-run, at least at the 10% significance level. DSS, ERS and FSI
variables exhibit short-run and long-run asymmetric effects on Sukuk market development,
while ILS demonstrates only long-run asymmetric relationships with SUK. The effect of
foreign reserves on Sukuk market development may not be immediately evident because
changes in foreign reserves can take time to influence market dynamics. For example, a
sudden drop in foreign reserves in the current year may not explicitly indicate that the
economic condition of the country in the current year is also falling. There are various other
macroeconomic factors, such as interest rates, inflation and credit ratings, that will respond
to changes in foreign reserve levels before economic conditions and financial markets can
actually be affected.
Figure 1 displays the cumulative effect of previously identified asymmetric relationships.
In Figure 1-1 and 1–4, a decrease in DSS and FSI has a temporary positive effect on SUK.
While increasing DSS and FSI has a temporary negative effect on SUK, there is no trend in
the asymmetry effect with time. On the other hand, a negative asymmetric relationship
between ILS-SUK and ERS-SUK was detected, as shown in Figure 1-2 and 1–3. Figures 1–2
show that a decrease in ILS has a temporary negative effect on SUK. While increasing ERS
has a temporary positive effect on SUK, similar reactions were observed for the ERS
variable in Figures 1–3.
Findings from Panel C (Table 6) and Figure 1 provide insight into investor behavior and
market dynamics in the context of the Malaysian Sukuk market. The presence of
asymmetric effects suggests that investors in the Malaysian Sukuk market respond
differently to positive and negative changes in certain financial risk components. For
instance, a temporary positive effect of a decrease in DSS and FSI on SUK indicates that, in
the short run, investors may find SUK more attractive during periods of reduced foreign
debt service and financial stress. Conversely, an increase in DSS and FSI has a temporary
negative effect on SUK, implying that adverse changes in these factors may result in a
Financial risks
on Sukuk
market
development
Figure 1.
Cumulative effect of
asymmetric
relationships
decline in Sukuk market development. Investors may be responsive to fluctuations in a
country’s ability to service its foreign debt and the overall financial stress in the market.
Hence, policymakers and market players should monitor and manage these factors to
maintain investor confidence and Sukuk market development. For the ILS variable, the
identified long-run asymmetric relationship with SUK suggests that changes in ILS may
have a sustained impact on SUK market development. This indicates that investors consider
the stability of a country’s foreign currency reserves over the long term when making
investment decisions in the Sukuk market. Similarly, the asymmetric relationships observed
for ERS-SUK variables imply that changes in exchange rates can also influence Sukuk
market dynamics.
The findings on the asymmetric relationships depicted in Figure 1 may not align
perfectly with the neoclassical theory of investment. The neoclassical theory of investment
is rooted in classical economic principles, emphasizing rational decision-making by
individuals and firms based on factors such as interest rates, expected returns and costs of
capital, which in this study are linked to the financial risk level of the issuers. While the
findings in Figure 1 highlight asymmetric relationships between various financial risk
components and Sukuk market development, the nuances of these relationships may not be
fully captured by neoclassical investment theory. For instance, the temporary positive effect
during a decrease in foreign debt service and financial stress index could be influenced by
factors beyond neoclassical investment theory considerations, such as market sentiment,
JIABR
investor perception and short-term market dynamics. In addition, the observed negative
asymmetric relationship during a decrease in ILS and the temporary positive effect on
Sukuk market development during an increase in ERS might be less intuitive from a purely
neoclassical standpoint. Apart from market sentiment and investor perception, other factors
that could contribute to these observed asymmetric effects include specific institutional
characteristics and behavioral factors that shape market dynamics. The recognition of time
lags in the effects of foreign reserves on Sukuk market dynamics introduces a temporal
aspect that may not be fully in line with neoclassical expectations. In summary, while some
aspects of the findings may align with neoclassical theory, the observed asymmetries and
short-term effects might be better explained by behavioral, institutional and market-specific
factors with consideration of time lags that contribute to the complexities in the relationship
between financial risk components and Sukuk market development.
5. Conclusion, policy implications and future directions
This paper is motivated by the insubstantial evidence on the asymmetric impact of financial
risk on Sukuk market development. Using the NARDL model proposed by Shin et al. (2014),
we seek to investigate the dynamic impacts of financial risk on Sukuk market development.
The key objective of this paper is to examine the nexus between a country’s ability to pay its
debt obligations and Sukuk market development in Malaysia.
Our primary arguments are that foreign debt levels significantly affect the financial risk
of the Sukuk issuing country. However, there is no evidence of significant negative
relationships between foreign debt stability and Sukuk market development. This indicates
that the increase in foreign debt level does not significantly cause the country to issue fewer
Sukuk. Diverse investor bases with strong appetites for Sukuk may explain why Malaysian
Sukuk issuance is still increasing, irrespective of the foreign debt situation. Furthermore,
this study also finds inconclusive results with regards to the co-integrating relationship
between CAS and Sukuk market development. A possible explanation for this result is the
high market demand and favorable investors’ appetite for Sukuk, especially from the
leading Sukuk issuing country, Malaysia.
The empirical results of both Engle and Granger’s (1991) cointegration test and ARDL
methods for cointegration demonstrated that Malaysia’s foreign debt service ability, ILS,
Malaysian Ringgit stability, financial stress level and Sukuk market development are
cointegrated. A 1% rise in the foreign debt service and the financial stress index will lead to
a lowering of Sukuk issuance by 4.8% and 12.7%, respectively. This evidence illuminates
the limited borrowing capacity of a country with high foreign debt service obligations,
which can lead to higher borrowing costs for the country. In terms of Sukuk, the high
borrowing cost is reflected in the project’s economics and budgetary constraints. As a result,
this country may also face higher financial stress if it struggles to meet its debt service
obligations.
Our findings also indicate that high ILS and currency stability have a positive effect on
Sukuk market development in Malaysia. With an adequate international liquidity level, it
may encourage higher market demand for Malaysian Sukuk as a result of higher investor
confidence in the country’s financial stability in meeting its external obligations.
Additionally, the strength of local currencies against foreign currencies may also play a
crucial role in stimulating the demand for local currency-denominated Sukuk among
international investors. Given all this evidence, this study reveals the important association
between financial risk and Sukuk market development, especially during periods of high
economic uncertainty.
Our empirical analysis enables us to draw conclusions about a number of policy
implications. The foremost among them is that Malaysia should cautiously monitor its
foreign debt level to ensure that it is within manageable limits. The country should aim to
keep the foreign debt-to-GDP ratio at a sustainable level, taking into account the role of the
Sukuk market in facilitating Malaysia’s economic growth. There is also an urgent need for
the country to realize that it is continuously building investor trust, be it in the domestic or
international financial markets, as this may positively affect the country’s future borrowing
costs. While taking advantage of the diversification benefits of funding sources to finance a
country’s projects and developments, Malaysia should stay attentive to global economic
conditions, foreign exchange markets and financial stress levels because all these factors
may significantly influence the investors sentiment and rate of return to be offered from the
Sukuk issuance. Excessive reliance on foreign currency Sukuk may pose particular risks
because it can lead to exchange rate and/or monetary pressure if foreign investors become
reluctant to refinance the issuer’s Sukuk obligations. All these effects are not only having an
impact on the Sukuk issued by the government or agencies but also on corporate Sukuk.
Corporations are more likely to issue Sukuk when all the aforementioned factors are
properly managed because the group of targeted investors is somewhat the same regardless
of whether the issuers are coming from corporates, agencies, institutions or the government.
Any factors that lead to greater financial uncertainties will deter investors’ confidence and,
thus, the demand and development of the Sukuk market itself.
Before drawing a conclusion, one must consider the limitations of the study. First, this study
focuses specifically on Malaysia, and as such, the findings may not be directly applicable to
other countries with different economic structures, financial market dynamics and investor
behaviors. Second, this study uses the NARDL model, which, while offering valuable insights,
introduces a level of complexity. The interpretation of results may be sensitive to the
assumptions and specifications of the model, which may also explain slight deviations in
asymmetric relationship findings from the theoretical framework of the study. Third, this study
considers specific financial variables, such as foreign debt service, ILS and currency stability.
The exclusion of other potentially relevant variables may limit the comprehensiveness of the
analysis. This study points to three possible directions for future research. The first is the
differential impact of financial risk components on Sukuk issuance for different Sukuk
structures. As more data becomes available in the future, this area could be further explored by
conducting the above analysis for different combinations of Sukuk structures and currency
denominations. In addition, future researchers could also consider exploring the variability of
financial risk impacts through comparative studies of the leading Sukuk-issuing countries to
account for differences in regulatory frameworks and supporting infrastructure.
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Naifar, N. and Hammoudeh, S. (2016), “Do global financial distress and uncertainties impact GCC and
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Phillips, P.C. and Perron, P. (1988), “Testing for a unit root in time series regression”, Biometrika,
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Corresponding author
Siti Nurhidayah Mohd Roslen can be contacted at: sitihidayah@uitm.edu.my
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