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Monday, 19 May 2008

The rise of Islamic finance

The notion of ethical investing goes back at least to 1758, when the Quakers banned profiting from the slave trade. But the market for ethical investments has always remained a niche. The goals of maximizing profit and fulfilling a moral agenda conflict more often than they complement one another, and investors who want to put ethics first have turned out to be relatively few.

Finance that complies with Shariah, or Islamic law, is still a niche within the ethical investing niche. In all, there are at least $500bn worth of Islamic finance assets worldwide. That's not much in terms of global banking - US banks alone hold about $12.7 trillion in assets.

But the industry's growth is eye-catching: Islamic banking has expanded by more than 10% annually over the past decade, according to Standard & Poor's. It's grabbing the attention of some of the biggest banks in the world and changing how they do business.

In the 1990s, HSBC and Citigroup established global Islamic finance divisions. Far beyond just offering a few mutual funds to suit religious investors, they and stand-alone Muslim banks are creating instruments that parallel many of the Western world's financial products, from consumer loans to insurance to bonds.

Central banks and corporations in other industries are likewise feeling the demand. The governments of Japan and the UK - whether in an attempt to lure Muslim investors or impress Muslim voters - have announced plans to issue sukuk, which behave like bonds but conform to Islamic law.

Ford Motor's $848m sale of Aston Martin to Investment Dar, a Kuwait-based Islamic bank, required Shariah-compliant financing, and Caribou Coffee, America's second-largest speciality coffee chain after Starbucks, is owned by a Shariah-compliant private equity firm based in Bahrain.

So just what does Shariah-compliant banking entail? Some of it is simply prohibiting things seen as immoral. Investing in casinos, pornography and weapons of mass destruction is out.

The animating religious goal behind other restrictions is to achieve greater social justice by sharing risk and reward. Islamic finance bans people from selling what they don't own, which rules out short selling, and from engaging in contracts deemed to have excessive uncertainty on either side. That rules out traditional insurance, so Islamic banks have instead developed takaful, in which a group of people pool risk.

The Shariah stipulation banning interest, though, is the one that poses the most problems for modern finance.

To be sure, from the Bible to Buddhism, most of the world's faiths have issued warnings against usury, and theologians through the ages have debated the line between permissible and excessive interest rates. But ultimately, in the West, governments and religious authorities deemed some amount of interest permissible.

Not so in Islam, in which most scholars deem fixed-interest payments forbidden. So, for example, the sukuk issuer does not sell a debt, as a traditional bond issuer would, but rather sells a portion of an asset, on which the buyer is then entitled to receive rent. Likewise, rather than take out an interest-bearing loan, a business in need of financing might enter a musharaka, a partnership with profit-and-loss sharing.

Why the growth in Islamic finance now? After all, Islam's rules have been around since the seventh century, and some Muslim countries have been rich since the discovery of oil.

One important factor has been the recent rise in religiosity in Muslim countries, says Ibrahim Warde, author of Islamic Finance in the Global Economy and an adjunct professor of international business at Tufts University. He dates the rise to shortly after the terrorist attacks of September 11, 2001. With the US-led invasions of Afghanistan and Iraq, 'there was a feeling in many countries that Islam was a religion under siege,' he says.

Some observers date the rise in religious observance back even further, to the 1980s, when guest workers in Saudi Arabia from across the Muslim world began returning to their own countries, re-importing with them the strict Wahhabi subsect of Islam for which the desert kingdom is known.

Whenever this burgeoning religious observance began there is now an increasing appetite for Shariah finance. In some cases, Warde says, Middle Eastern governments have embraced Islamic banking to advertise their religious chops.

There are, of course, glaring exceptions to this growing demand. Saudi billionaire (and member of the ruling sect) Alwaleed Bin Talal owns big stakes in Citigroup, the Walt Disney Co. and Planet Hollywood. But Saudi Arabia, where the ruling family is trapped delicately between reform and radical extremism, may prove Warde's point.

'The government did not encourage Islamic finance there at all. It was a grassroots movement,' says Warde. Now, many banks and financial products there are Shariah-compliant. 'Once there was nothing they could do about it, they accepted it,' he says.

Some of the growth in Islamic finance has also been due to clever marketing by Malaysia. After September 11, US authorities froze the bank accounts of several prominent Saudis, which triggered other wealthy Arabs to withdraw their funds from the United States.

Ultimately, some $200bn left the US. Many of the investors were from tiny Gulf states whose economies were too small to absorb their funds, and so they looked to Malaysia, a Muslim country with a relatively sophisticated financial system. It issued the first sovereign sukuk in 2002, and made a point of appointing Shariah scholars from the Gulf to monitor compliance.

'They marketed it all over the world, and especially in the Arab world,' Warde says. Today, Kuala Lumpur rivals traditional hubs like Dubai and Bahrain as a global centre of Islamic finance.

In the end, the maths behind the growth of Islamic banking may be pretty simple: There are 1.3 billion Muslims in the world - roughly a fifth of the world's population. Some live in quickly developing economies, some sit on vast oil wealth and some are newly middle-class Americans and Europeans.

No one can say for sure how many will seek out banking that complies with Islamic law, or even pay a premium for it. But even a small fraction of 1.3 billion is a market no one wants to ignore.

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