There has been a growing interest in Islamic finance among international investors, especially since at one point the industry was perceived as a possible hedge against the current financial meltdown. Islamic finance, or Shariah-compliant finance, is the practice of investing or lending money with the aim of earning a return on a real asset rather than interest on monies lent, and the associated structures that aim to comply with Islam’s ban on interest are numerous.
The industry emphasises social responsibility, and proscribes, for ethical considerations, investments in alcohol, pork, tobacco, arms, media and entertainment and conventional financial services firms.
The number and assets of Islamic financial institutions has grown considerably, with their number reaching more than 300, and assets estimated at between USD500bn and USD1tn, and growing at an average of 10-15% annually over the past few years.
For international investors, perhaps the most interesting Islamic product so far has been the sukuk, or Islamic bond. Sukuk replicate the access to capital markets that conventional bonds offer without using interest-based lending. They differ from conventional bonds in that there’s an underlying asset whose ownership changes hands, or the contract tying the sukuk-holder to the borrower entails joint ownership of an underlying asset. Therefore, the return on the sukuk is a profit resulting from holding or selling an asset, and not interest on a loan, even though sukuk have a similar risk-return profile to conventional bonds. The main centres of the industry have been South East Asia, specifically Malaysia, and the Gulf Cooperation Council (GCC).
Sukuk have received increasing attention from investors worldwide. A number of global banks have also entered the picture, with the likes of HSBC Amanah, JP Morgan, Calyon, Citigroup and Barclays competing against CIMB Islamic, Aseambankers and Dubai Islamic. Islamic bond issuance grew enormously between 2004 and 2007, with total issuance growing year on year by 49% in 2005, 53% in 2006 and 79% in 2007. 2007 sukuk issuance hit a record of USD46.65bn.
These results, though impressive, came at a time of easy access to credit benefited from oil prices that were at historical highs and rising. This led to ever increasing issuance, especially from the GCC. As the GCC bond market flourished, even after the initial impact of the subprime mortgage crisis in 2007, there were those who thought that Islamic finance can withstand this downturn intact due to the nature and features of Islamic banking and finance, and therefore of the sukuk market.
This led to some unreasonable expectations for the industry. Some industry observers thought that Islamic finance had successfully separated from global conventional credit markets, which was an Islamic variation on the now debunked decoupling theory. Others claimed that Islamic markets were now mature, independent markets, not related to the price of oil. A third view that was sometimes expressed was that lower leverage and emphasis on holding and selling real, tangible assets will save the industry from the full impact of the subprime crisis and subsequent credit crunch. Essentially, all of the above ideas centre around the notion that Islamic finance will succeed where conventional finance has failed, and emphasise the fundamentally different natures of Islamic finance and conventional finance.
But the evidence counters this. Sukuk have not done well in the past year. Total issuance in 2008 dropped by 66% compared to 2007, showing no immunity from the global downturn. The impact was felt across the board, with GCC issuance dropping by 50% and South East Asian issuance dropping by 75%. Financial institutions in the Gulf have been suffering a great deal, and both Islamic and non-Islamic institutions have run into trouble. All of Asia, including Malaysia, has been hit by the global economic downturn, and financial institutions have and will continue to suffer as a result.
The strength of Islamic finance is that it’s become a novel way to do business and has the potential to spread banking and finance to new markets and create more opportunities, even if it’s strongly correlated to the international market and to the local economies it serves. By virtue of its dependence on the GCC economies, Islamic finance is dependent on the price of oil to the degree that the underlying economy in the region is dependent on the price of oil. Islamic financiers would be the first to agree that the financial market cannot and should not be separated from the real markets. The weakness we see in the Malaysian Islamic bond market is the result of Malaysia’s real economy’s exposure to global markets.
Lower leverage has protected the industry, but not insulated it completely. However, the global problem is of proportions not seen in decades, and it’s only natural that it will have global consequences, especially for a region that has been seeking further integration in the world’s transport, energy and financial markets.
All this fails to discuss the true merits of Islamic banking and finance. First of all, Islamic finance allows for the provision of banking and insurance services to wide swathes of people who would be excluded from conventional systems, and who have been under-banked and under-insured for decades.
These services are being brought to the markets in a socially responsible manner that complies with Islam’s emphasis on charity and kindness to the needy. This combination of social responsibility and opening of new opportunities will continue to ensure that Islamic finance thrives in the coming years.
