ISLAMIC FINANCE A SAFE HAVEN IN UNCERTAIN TIMES?

Transcription

1 ISLAMIC FINANCE A SAFE HAVEN IN UNCERTAIN TIMES? THE VIEWS EXPRESSED IN THE FOLLOWING ARTICLES ARE THOSE OF THE AUTHOR AND SHOULD NOT BE SEEN AS REPRESENTING THE VIEWS OF REUTERS NEWS.

2 AS THE GLOBAL ECONOMY WEAKENS AND INVESTORS SEEK SAFE HAVEN INVESTMENTS, WILL MORE MONEY GO INTO THE ASSETS THAT COMPLY WITH ISLAMIC LAW?

3 ISLAMIC FINANCE NEEDS ITS OWN PRICE INDICATORS Azrul Azwar Ahmad Tajudin, senior economist at Bank Islam BIMB. KL, the second-biggest Islamic bank in Malaysia by assets, considers the need for an efficient price indicator for Islamic finance instruments. (Editing by Tomasz Janowski) Sharia compliant assets have emerged as a viable alternative asset class as part of the strategy to diversify portfolios of investors. The outperformance of a number of global Islamic indexes in the medium-to-long term should encourage investors to consider allocating a portion of their portfolios to Islamic investment vehicles. To conform to sharia requirements, Islamic products will have to avoid elements of riba (usury), gharar (ambiguity/uncertainty/misinformation or deceit/fraud), maisir (gambling) and zulm (oppression), among others. Although the obligation to eliminate riba may result in complex structures for Islamic financial instruments, I believe the prohibition of other elements as mentioned above in Islamic contracts and in strict adherence to sharia rules and principles, should help assuage many investor concerns. Whatever it is, a product structuring or innovation exercise should comply with sharia requirements in substance and in spirit. In the absence of reference price indicators specific for Islamic finance, the Islamic financial services industry still relies heavily on interest rate-based benchmarks such as the London Interbank Offered Rates (LIBORs). Without a viable sharia compliant alternative, the industry will still have to use these quoted market rates as a basis to price Islamic financial instruments and securities. As such, it s a fallacy to think that movements in global interest rates will not have any implications for Islamic securities although the impact may be limited to those that are pegged to observed interest rates, especially LIBORs. On the other side of the coin, the use of common global benchmarks for both Islamic finance and conventional finance could help facilitate the integration of Islamic finance into the global financial system. Nonetheless, there is an urgent need to initiate the introduction of an alternative efficient price indicator for Islamic finance instruments to reduce reliance on the prevailing interest rate-based benchmarks. For a start, we may perhaps consider the actual rate of rental of Ijarah-based instruments with property as their underlying asset, which fluctuates according to the market supply and demand as a benchmark for pricing purposes. Market liquidity can be defined as the ability to transact over a relatively short period without exerting material impact on prices. Since market liquidity is closely related to investor confidence and investor creditworthiness, securities with high market liquidity generally command low risk premiums as investors are confident in their ability to perform market transactions quickly while risks are quantifiable. Rational investors would prefer securities with excellent market liquidity, which should enable them to exit the market easily, in particular during times of market turbulence. Market liquidity, or the lack of it, for Islamic financial markets in the majority of countries, remains one of the thorny issues dogging Islamic Finance as there appears to be more willing buyers than sellers. It reflects the tendency among investors to hold Islamic financial instruments or securities until maturity given their limited supply, especially of good-quality ones. Given the benefits of greater market liquidity for securities in general, such as more efficient price discovery process and effective market transactions, the Islamic finance industry will need to step up efforts to strengthen the depth and breadth of the secondary markets for Sukuk and Islamic Treasury products.

4 ISLAMIC INSTRUMENTS MADE COMPLEX BY LOCAL LAWS Badlisyah Abdul Ghani, chief executive of CIMB Islamic Bank, the world s top arranger of Islamic bonds, looks at some of the differences between the structure of Islamic financial instruments and conventional ones. (Editing by Tomasz Janowski) Islamic banking and finance activities are undertaken based on sharia, or Islamic law, which is applied based on the unique circumstances and parameters that exist in a particular jurisdiction. Since sharia is simple, it cannot be said to be the reason why some Islamic financial instruments are considered complex and opaque. The real reason for that is the need to comply with legal, regulatory and legislative frameworks that exist in a particular jurisdiction. In jurisdictions such as in Malaysia, where the market framework has been adjusted to conform with sharia, Islamic financial instruments are easily made to meet the sophisticated financial needs of clients in a very straightforward fashion. However, in other jurisdictions that don t have such an established legal, regulatory and legislative Islamic financial framework as Malaysia, it has proven tricky to structure even very basic Islamic financial instruments, such as an Islamic deposit. As a result, a certain degree of opaqueness arose from the structure of some Islamic financial instruments to investors. The complexities and opaqueness of some of these Islamic financial instruments are separate and different from the complexities and opaqueness that one would find under sophisticated conventional usurybased, or riba-based, financial products such as those found in the sub-prime market. Complexities and opaqueness for Islamic financial instruments result from the need to comply with various rules, while for conventional financial instruments the complexity is deliberate and forms the very nature of the financial product. As such, no matter how complex and opaque an Islamic financial instrument appears, investors can find comfort in the fact that what they buy is what they are told the product is. If it is a deposit product, then it is a deposit. If it is an investment in property, then it is an investment in property. If it is a sukuk (ie Islamic bond), then it is a sukuk. Their ownership and rights to the assets in the investment exist at all times as it is a requirement under sharia. Investors can feel and identify the assets in which they invested, unlike sub-prime products where investors found themselves no longer having the ability to sell their invested assets because they were no longer there. Furthermore, sub-prime type transactions (ie securitising the sub-prime asset over and over again) cannot occur under sharia because it is seen as unproductive and without value to society. Whether conducted in local or global markets, the Islamic financial industry exists in the same market as the conventional financial industry and chases after the same client base. Crises such as the sub-prime debacle cannot directly happen in the Islamic finance industry because of sharia rule. However, due to its relatively small size compared with the conventional financial industry it cannot escape any negative impact arising from the crises happening in the latter. The impact may be smaller and limited, but it will still be there for as long as the Islamic financial industry is smaller than the conventional finance industry. When the Islamic finance industry has achieved greater scale in relation to the conventional riba-based finance industry, it would definitely be better placed to escape any future ructions arising from the conventional industry. There is ample liquidity in primary sukuk markets globally. Secondary market liquidity is definitely a consideration when investors consider investing in sukuk but it is somewhat irrelevant to Islamic investors. Most Islamic investors adopt a buy and hold strategy due to limited supply of sukuk in the market anyway. The main concern of investors at times of turmoil is the pricing of the sukuk and not the secondary-market activity. They want to make sure that the risks that they take at time of turmoil are properly compensated in the pricing of the sukuk.

5 ISLAMIC ASSETS NOT IMMUNE TO GLOBAL DOWNTURN Mohamad Safri Shahul Hamid is Head of Islamic Structuring Asia and Manar Mahmassani is an analyst at German investment bank Deutsche Bank. They look at how Islamic financial investments and conventional ones compare in the global downturn. (Editing by Tomasz Janowski) In the context of the current persisting credit crisis and worsening global macroeconomy, it is essential that any misconceptions in the markets about Islamic finance be addressed. Unlike its conventional peer, Islamic finance is based on productive activities: trading, leasing, partnership/joint venture etc. All these activities involve the use of assets or businesses that comply with Islamic law or sharia. Islamic finance does not typically differentiate between good or bad performing assets - it does not claim that it offers safe(r) investment but rather, it provides investors with opportunities to put their monies into ethical investments. With regard to sharia compliant deposits and investment assets, though relative performance can naturally vary, sharia assets share a close correlation with their equivalent conventional assets. Money invested in Islamic financial markets is by no means insulated and we do not expect the global downtrend to be a trigger of demand for Islamic assets. Nevertheless, variables such as sharia structure, geographic/regional risk, and degree of business compliance with sharia can and do provide support and stability to Islamic financial instruments. Sharia compliant assets differ from their conventional counterparts primarily in terms of underlying structure (inputs, cash flow mechanisms, determinants, tests, legal documentation, etc.) in order to abide by sharia law. Yet ultimately, they function in just the same fashion as conventional assets and the related economics are identical. Indeed, as innovation and growth in the Islamic financial markets persist, almost all transactions that can be done conventionally can now be structured in Islamic format. For example, the sukuk market which started with plain vanilla issues has now seen complex trades structured in the form of exchangeable, convertible and hybrid sukuk. And, in the last couple of years, the market has also seen the emergence of Islamic risk management tools including profit and currency swaps, fx options, etc. We believe that these developments will benefit the market as a whole. At the same time, conventional investors from across the globe are also playing an increasingly active role in the Islamic financial markets. Their growing participation in Islamic issues and trade flows make Islamic assets more and more vulnerable to how non-islamic assets behave. Sharia compliant equities are only differentiable from the wider conventional pool subject to a series of qualitative and quantitative tests that need to be satisfied. Just like conventional equities, the Islamic equity world remains exposed to investor sentiment, news flow, dividend distribution, volatility pricing, etc. Indeed, the downturn in global equities in the wake of the subprime crisis has had a considerable impact on the global sharia compliant equity asset class. In the Islamic financing, structured products and risk management space, specific business activities would need to be undertaken to achieve the required economics. This is usually based on a purchase and sale of real assets or via a particular asset management/coinvestment agreement that comply with sharia. From a credit perspective, the latter dependency on real assets or finitely-sized business activities effectively reduces the risk of over-leveraging and it is this sort of fundamental differentiation that underpins the image of Islamic assets as a more stable asset type than conventional equivalent. However, since the economics are the same, these Islamic assets also behave in the same way as the conventionals. For sukuk, the impact of the global credit crisis is clearly visible. Sukuk credit spreads have widened substantially which resulted in marked reduction in the number of issues in the last 6 months. In short, the challenging environment we are in currently has had the same impact on the Islamic capital markets as it had on conventional ones - then again, should we be expecting otherwise?

6 ISLAMIC DEBT CARRIES RISK DESPITE SPECULATION BAN Razlan Mohamed, chief executive of credit rating agency Malaysian Rating Corp., notes a ban on speculation in Islamic debt reduces risk but does not eliminate it. (Editing by Dayan Candappa) IWith global markets in turmoil, investors may think they have good reason to favour Islamic assets because of the religion s ban on speculation, known as gharar, in sharia or Islamic law. It is true many of the complex transactions involving derivatives in conventional capital markets are excessively speculative and can be considered exploitative in Islam. But while the ban on speculation reduces risk, it does not eliminate it. Sound investment decisions depend on the credit quality of the entity or project that is raising finance. Industry, business and project fundamentals are bigger drivers of credit quality than the type of financial instrument and the concept on which it is designed. MARC s experience of corporate bond defaults suggests that the default incidence for Islamic bonds rated by us is no lower than for conventional bonds. Thus, shariacompliant financing instruments are no less vulnerable than conventional instruments at a given rating level to default risk. We are seeing a flight to quality that suggests there will be more money chasing after a limited supply of quality credits and projects, shariacompliant or otherwise. So sharia compliance would probably be a secondary consideration for most investors, except for Muslim investors. On the other hand, I don t believe that Islamic rules force financial institutions to create complex transactions and opaque structures that in themselves increase risk. Islamic rules are actually very straight forward. Islamic structured finance is certainly far less opaque than the complex derivative instruments and leveraged securitisation structures used to repackage sub-prime mortgage assets. GUARANTEE RETURNS But it is true that in authentic Islamic structures there is a greater uncertainty attached to returns. They are built around a profit-and-loss sharing concept that does not guarantee returns and may deter investment. This may actually work in favour of the stability of the Islamic financial system. For now most Islamic bonds, or sukuk, resemble conventional debt because they guarantee returns. I am hopeful that the next generation of Islamic debt instruments will look less like conventional bonds because pressure for real profit-sharing structures is growing. Scholars of the standards body, the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), have ruled that promoters of sukuk can no longer provide an undertaking to purchase the underlying asset from the sukuk holders at an agreed nominal value at the end of the tenor or on default if the sukuk is structured as a Mudaraba and Musharaka contract. The repurchase undertaking is tantamount to a guarantee in conventional financing. Now that is prohibited by a major standards-setting body, we expect only high credit quality projects or ventures with strong cashflows to sell Mudaraba and Musharaka sukuk. The new risk-reward breed of Islamic bonds will improve credit quality as a whole and make the Islamic financial system more resilient to the economic shocks that have assailed its conventional peer.

7 TRANSPARENCY, RULES KEY TO ISLAMIC FINANCE GROWTH Salman Younis is Asian chief executive of Kuwait Finance House, the Gulf state s biggest bank by market value. He argues the transparency and regulation of Islamic banking will play an important role in how quickly the sector can integrate with conventional banking systems. (Edited by Neil Fullick) In recent years, a genuine interest in Islamic banking products and services among Muslim and non-muslim communities alike has caused market forces to take over and steer growth. Access to the Islamic banking sector has opened up for individuals and companies as an alternative source of investment and funding, particularly at this juncture where the conventional banking sector is facing a serious credit crunch following investments in sub-prime U.S. housing mortgages. There is likely to be a bigger migration to Islamic financial services in certain markets due to the loss of faith in the conventional system. In general, sukuk still offers a more secure and resilient investment opportunity, given that sukuk investors are paid a profit rate stemming from revenue streams of tangible assets and are therefore inherently safer than securitised bonds or structured products. Innovation in terms of products and structures thus far has been driven by the need to ensure sharia compliance across different jurisdictions. However, as the sukuk market matures, we expect a broadening of product development and innovation more towards meeting the requirements of the issuers and the investors whilst still keeping within the confines of the sharia requirement. The speed and degree of success with which Islamic banking is integrated into conventional systems will, to a large extent, depend on whether the sector is perceived to be transparent and well regulated. As such, it is in the best interest of governments and industry regulators in each country to communicate to the public what types of Islamic institutions and products are supervised and encourage Islamic financial institutions to carry out their own awareness campaigns. The weaknesses in global credit markets stemming from the U.S. sub-prime woes has irked the sukuk market, where new issuances were either delayed or priced slightly higher to reflect rising debt market volatility as well as the slight drop in investors demand for sukuk. In the Gulf Cooperation Council, sukuk is still thinly traded or is held to maturity, given the scarcity of new issues for cash-rich Islamic financial institutions to buy. Although efforts have been made to increase sukuk trading in the region, more needs to be done in terms of the creation of a continuous supply of sukuk and instruments that would promote the secondary trading of instruments and add greater depth to the market. Republication or redistribution of Thomson Reuters content, including by framing or similar means, is prohibited without the prior written consent of Thomson Reuters. Thomson Reuters and the Thomson Reuters logo are registered trademarks and trademarks of Thomson Reuters and its affiliated companies.