Government-issued Sukuk: Challenges, innovations, and the path forward

In-Depth Analysis

While sovereign Sukuk have grown significantly, several structural challenges continue to constrain the market's development. Understanding these challenges — and the innovations being developed to address them — is essential for assessing the future trajectory of sovereign Islamic capital markets. The asset availability challenge is perhaps the most fundamental. Sovereign Sukuk, particularly Ijarah structures, require the government to identify state-owned tangible assets to sell to the SPV. For countries with large portfolios of government-owned real estate and infrastructure, this is manageable. But repeated issuances gradually deplete the pool of available assets, and some governments may be reluctant to transfer legal title to strategic assets (even to a trust structure that will ultimately return them). This has led to creative solutions including using future revenues (tolls, fees) as the underlying asset, using usufruct rights rather than full ownership, and adopting Wakalah structures that can accommodate a diversified pool of assets. Tax neutrality is another significant challenge. In many jurisdictions, the multi-step transaction structure required for Sukuk — involving the sale, lease, and repurchase of assets — triggers multiple layers of taxation (stamp duty, transfer taxes, capital gains taxes) that are not incurred in a conventional bond issuance (which involves only a single loan transaction). Without specific tax legislation to provide neutrality, Sukuk issuance becomes prohibitively expensive. The UK, Luxembourg, and Hong Kong all enacted specific legislation to ensure tax neutrality for Sukuk before their respective sovereign issuances. Many other countries, particularly in Africa and Central Asia, lack such legislation, which inhibits sovereign Sukuk development. Legal framework compatibility presents related challenges. Common law jurisdictions (UK, Malaysia, Hong Kong) have found it relatively straightforward to accommodate Sukuk trust structures, as the trust concept is well-established. Civil law jurisdictions (many European and Latin American countries) may lack an equivalent trust concept, requiring alternative legal arrangements or specific legislation to enable SPV structures. Innovation in sovereign Sukuk has focused on several areas. Retail Sukuk — small-denomination certificates sold directly to individuals — have been pioneered by Indonesia and expanded to Turkey and other markets, promoting financial inclusion and public participation in Islamic capital markets. Social Sukuk, funding healthcare, education, or poverty alleviation, represent another frontier. The digitization of Sukuk issuance and distribution through blockchain technology is being explored, with early pilot projects in several markets aimed at reducing costs and increasing accessibility.