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Friday, 20 June 2008

Islamic finance is going from strength to strength

"High Finance"

Amid continuing turmoil in global credit markets, Islamic finance is going from strength to strength. Arabian Business examines the rise of Sharia investment, and analyses the challenges ahead.


With the credit crunch and markets in the West tightening their belts, more and more attention is becoming focused on the Middle East as a source of potential revenue and growth.

And with a host of Sharia-compliant products on offer, both local and international finance houses are scrambling to secure their slice of a lucrative market.

"Islamic finance is kind of like going fishing and having a net which is able to catch all kinds of fish - if you're going fishing in the Middle East and you have Sharia-compliant financing prospects, then a lot more people will likely be able to take advantage of your products," says Oliver Agha, head of Islamic Finance at DLA Piper, the world's largest law firm.

If you've only got conventional financing products then you're limiting your business. It's like appealing to a larger audience, and from a very simple commercial perspective, that's why it's becoming attractive.

Islamic finance has grown by between 15 and 20% in each of the past three years, and since the inception of modern Islamic banking, the number and reach of Islamic financial institutions worldwide has risen from one institution in one country in 1975, to more than 300 institutions operating in more than 75 countries today.

Although Islamic banks are concentrated in the Middle East and southeast Asia, they are also niche players in Europe and the US. Islamic banking assets and assets under management now exceed US$1.7 trillion, and the Islamic finance sector is expected to reach US$2.7 trillion by 2010.

"Project financings that previously were done purely conventionally are now beginning to be done on an Islamic basis, sometimes partially and sometimes wholly," says Agha.

Across the board you're seeing Islamic financing coming into the fray - insurance for instance has grown tremendously and the premiums now are at US$2bn to US$3bn, and we expect that to go up to US$10bn in a decade.

"So in all respects as the market develops and matures, we're seeing a growth that's pretty substantial."

While Islamic finance is still a nascent industry, with a small share of the global market - about 1% - the sector is benefiting from a number of favourable structural and cyclical drivers: strong growth in the GCC and emerging market economies of Asia, positive demographics of young and rapidly growing populations, and a shift of preferences of savers and investors towards Islamic finance in Muslim countries.

There are also handsome returns to be had.

"We have found that Sharia finance doesn't just help you pick good sectors from the broad universe, but it actually helps you move a step further and pick good companies from within those sectors," Jahangir Aka, senior executive officer for SEI in the Middle East, and author of a new report entitled Sharia Investing: Beating the Credit Crunch, tells Arabian Business.

In the report released last week, The New York-based investment operations solutions firm emphasises the consistent outperformance of the MSCI World Index by the Dow Jones Islamic Developed World Index.

"Sharia-compliant structures have many screens and requirements that should be recognised as contributing to this outperformance," the report reads. "The oft-quoted aversion to the financial services sector is only one of those."

"It is a much tighter, far more regulated market [than conventional finance]," says Aka. "There are so many screens and filters, and if you're applying your Sharia guidelines and principles then you have to be doing a very, very high level of due diligence."

In addition, the leverage component of Sharia finance has played an important role in assuring the security of investments. The broad Islamic screen on equities demands low-leveraged companies, with acceptable debt-to-revenue ratio levels below 33%.

"As a result, what we have ended up picking, in terms of stocks, have actually been far, far better performers," Aka continues. "We've been managing mandates for different religions for a while, and we have been pleasantly surprised by the performance of Sharia-compliant structures.

Despite the success stories, there are challenges ahead for the Sharia finance industry.

There is a dearth of large funds capable of investing in large project financings, and as a result some are calling into question the ability of Islamic institutions to be able to underwrite the massive projects with which the Middle East has become synonymous.

In addition, the issue of attracting and retaining staff to work in the Sharia sector requires education - and reeducation - at a number of levels.

"There is certainly a need for more professionals to get into the sector," says Agha at DLA Piper.

"We will have conventional bankers that make their way into Islamic finance, especially as it picks up while conventional banking goes into a downturn, but I think that the skills that they will bring will be conventional banking skills and not Islamic Sharia skills," he continues.

"The problem lies not in people failing to understand banking, but in people failing to understand the fundamentals of Islamic financing.

As Islamic finance booms and firms scramble to expand their capacity, so the movement of professionals schooled in conventional financing into the Sharia sphere appears inevitable.

However, it may also represent a threat to ‘pure' Islamic finance, as Sharia professionals and scholars are concerned that the market will witness the replication of conventional banking structures in an Islamic banking context - a shift that would be unlikely to benefit Sharia financing in the long-term.

"We are trying very hard to replicate the conventional world, and I think that in itself makes things a little bit difficult," says Aka at SEI.

"The challenge is we are trying to run too fast - I think there's some element in people's view that we're trying to catch up with conventional and I don't think we are.

"I think the Islamic principles are different, and I think it's important that we design products that are true to those principles and not try and get too close [to conventional]," he continues.

The challenge is that there aren't enough people that are coming out of Sharia degrees and I think that as a result you're hiring people from conventional, and with them they transport practices - ‘this is how I do it in conventional, so let me find a loophole so I can do it in Sharia'.

"There is a risk of diluting the Sharia ‘brand' - with too fast an innovation, that we start cutting corners around what is ‘Sharia'," he adds. "I'd say that 90% of organisations are trying to stay true to it, but there are some with big marketing dollars that are definitely going the other way and potentially creating some risk to the Sharia ‘brand'."

Islamic boards have already launched the fightback. Sheikh Muhammad Taqi Usmani, president of the AAOIFI Sharia Council in Bahrain, warned last year that around 85% of Islamic bonds (Sukuk) do not truly comply with Islamic law.

"It was expected that Islamic banks would progress in time to genuine operations based on the objectives of an Islamic economic system and that they would distance themselves, even step by step, from what resembled interest-based enterprises," he said. "What is happening at the present time, however, is the opposite.

"Islamic financial institutions have now begun competing to present themselves with all of the same characteristics of the conventional, interest-based marketplace, and to offer new products that march backwards towards interest-based enterprises rather than away from these."

Sukuk are the fastest-growing segment of Islamic finance, and global volumes up to 2007 reached almost US$100bn. Sukuk issuance in Europe, the Middle East and Africa and Asia-Pacific increased by 71% in 2007 to US$33bn, and the average deal size increased to US$270m from US$175m.

It is expected that in 2008, overall Sukuk issuance will grow by some 35%.

Sheikh Usmani's comments shook the industry - some 160 institutions in more than 30 countries are members of AAOIFI, whose standards are mandatory in Bahrain, the Dubai International Financial Centre, Jordan, Qatar, Sudan and Syria, and are used as guidelines elsewhere.

AAOIFI has a board of 20 Sharia scholars, who are members of the Sharia boards of most of the world's largest financial institutions.

"I think already people are starting to get nervous about whether it's really "halal' (permissible) and are starting to question it more and more," notes Aka at SEI. "I think you're going to get more and more scholars who will start challenging this and contesting this.

"We don't want [the sector] to be over-regulated because we need some flexibility to be able to do our own thing, but there is a lot we can do," he continues. "There is haste in just wanting to do more for the sake of it - and that is somewhat inherent in the Middle East at the moment.

"I think it's a danger to the extent that all that you're doing is using a conventional banking deal and slicing it to appear Islamic," agrees Agha at DLA Piper.

The answer lies in part in consulting early on with the scholars and with the Sharia consultants that can help guide the structures along more Sharia-compliant forms. We need to get more Sharia scholars and consultants into the fray.

If the sector can address these concerns, then its growth potential is enormous. The GCC countries are innovating, with Islamic financing structures increasingly used to finance projects in the MENA region.

The prospective MENA dollar volume of project finance is estimated to be more than US$167bn, of which nearly half is in Saudi Arabia, followed by the UAE and Egypt.

Qatar alone has stated that US$70bn will be needed in the coming years to finance projects in the energy and telecoms sectors, of which US$15bn is expected to be financed by long-term fixed-income securities, both conventional and Islamic.

Given the planned expansion of many of the GCC economies and the commitment to invest in infrastructure, including transportation networks, public utilities, housing, health and educational systems, infrastructure funding through Sharia-compliant finance is clearly a highly attractive source for such investments.

The total cost of infrastructure projects planned or underway in the Gulf countries is currently estimated at around US$1.8 trillion. Given the ease with which capital market products transcend geographical borders, Sharia-compliant financing projects which originate in one country can source investors globally.

"I think it's going to take some time before you start getting larger muscle behind these funds to start underwriting the really big projects," insists Agha.

"But if Islamic finance grows properly, I think that will happen," he continues, noting that the Middle East is not alone in pursuing the Sharia dollar.

"London has really made a concerted move to become a Sharia finance capital, while Singapore and Kuala Lumpur have made real strides too," he says.

"Hong Kong has made a very big play for Islamic finance and is looking at a Sukuk, and they want to take a lot of the Islamic funds into China and structure them through Hong Kong."

The race is on for the next US$1 trillion - and beyond.

(Arabian Business)

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Alfalah Consulting - KL: www.alfalahconsulting.com 
Islamic finance consultant: www.ahmad-sanusi-husain.com 
Islamic Investment Malaysia: www.islamic-invest-malaysia.com

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