When
Dubai World decided to suspend payments on its $26
billion debt, among the loans involved was a $4.05
billion repayment on a $3.52 billion sukuk or Islamic
bond issue. This presence of an instrument that has
gained some prominence in recent times has questioned
the credibility of the rapidly expanding field of
Islamic commercial and investment banking. The distinguishing
feature of this sector of finance is the generation
of assets which are structured to be Islamic law or
sharia-compliant. The sharia bans usury or the charging
of interest (riba) on money lent to others. The issue
then is to find alternative routes to ensuring a margin
between the cost of funds and the return they earn
to cover intermediation costs and make a profit.
One obvious way in which this can be done is for the
provider of funds to acquire an asset required by
a potential borrower and then to ''lease'' the asset
to her. Through periodic lease payments, the lessee
compensates the lessor for an amount equal to the
capital outlayed and an interest-margin equivalent.
At the end of the required period the asset is transferred
to the lessee. Another possibility is the sale of
an asset on a deferred payment basis by the lender
who then buys it back immediately for a discount.
That is, the client buys an asset from a financial
institution at a marked-up price that is to be paid
at a later date, and then sells the asset to the bank
at a lower price to raise finance. The transfer of
ownership of an asset in both transactions ostensibly
serves to establish that the arrangement does not
amount to lending money to earn interest.
Islamic bonds or sukuks are also structured along
these lines. As opposed to a normal bond which is
a promise to repay a loan, the sukuk confers partial
ownership in an asset or business. This kind of transaction
normally involves a real asset that backs the provision
of funds, and is therefore considered safer, even
if not completely safe. In fact, when the crisis of
2008 broke and the world was experiencing a credit
crunch, the small Islamic finance segment was seen
as having weathered the storm because of its very
different practices. That judgment, however, has been
questioned in the wake of the Dubai World payments
suspension.
Chart
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Methods
such as these to earn a return on money without formally
charging ''interest'' amount to circumventing the
sharia rather than adhering to it. This is easier
because of variations of interpretations of the law
between a more liberal Islamic country like Malaysia
and a more orthodox one like Saudi Arabia—a difference
that is not neutralised by the existence of industry
bodies like the Islamic Financial Services Board that
is expected to evolve and set standards for these
products. However, the process of identifying certain
products as sharia-compliant is rendered credible
by having a select group of scholars with the necessary
knowledge of Islamic law to vet the instruments created
as part of the burgeoning field of Islamic finance.
Assets cleared by this elite group can then be bought
by investors wanting to make sharia-compliant investments.
Islamic finance has a long history, but burgeoned
in the 1970s when the oil shocks increased surpluses
held by governments and corporations in the West Asian
region with religiously inclined states and investors.
Moreover, realizing that investors from this region
would prefer to invest in such religiously rated bonds,
the world's financial firms decided to enter this
field. And in periods when credit in normal markets
was stretched, even otherwise staid borrowers chose
to enter Islamic financial markets to raise funds.
In the process Islamic finance got integrated with
modern finance. According to The Banker's 2009 survey
of the top 500 Islamic financial institutions, ''The
volume of sharia-compliant assets of the Top 500 grew
by an extremely healthy 28.6%, rising to $822bn from
$639bn in 2008. At a time when asset growth in the
Top 1000 World Banks slumped to 6.8% from 21.6% the
previous year, Islamic institutions were able to maintain
the 28% annual compound growth achieved in the past
three years.'' Underlying this growth was a certain
distribution of the world's surpluses and an assessment
of the relative safety of instruments generated by
Islamic finance.
It is true that this sector is still a small segment
of current finance and is still substantially confined
to dominantly Muslim countries. Iran, Saudi Arabia
and Malaysia are the three leading countries in terms
of sharia-compliant banking assets and Bahrain, Kuwait
and Malaysia are the leaders in terms of Islamic finance
institutions. But the rapid growth in this sector
has seen the entry of unusual players both in terms
of financial engagement and in terms of borrowing.
Most banks and non-bank financial institutions have
Islamic banking divisions. These players from the
world of conventional finance come armed with the
ability to generate unusual (and risky) derivative
assets, which they then apply to generating sharia-compliant
instruments. In the event, even though West Asia remains
the centre of Islamic banking, investors and borrowers
from that region are increasingly turning to the City
of London to exploit its ability to develop opaque
products. Even the US is now host to a large number
of institutions involved in activities linked to Islamic
finance.
Once the metropolitan centres of finance also establish
themselves as centres of Islamic finance, borrowers
from the rest of the world who would normally abjure
these kinds of instruments and transactions choose
to both invest and borrow in these markets. The attraction
is strong for those seeking to tap the surplus funds
of oil-rich Muslim nations. But the opportunities
are not restricted to West Asia, since well-to-do
Muslims with investible surpluses are geographically
widely distributed. General Electric was the first
western conglomerate to exploit this opportunity by
issuing Islamic bonds. It has been followed by Tesco
of the UK and Toyota of Japan among others. Governments
too—such as those of Thailand and South Korea—have
expressed interest in mobilising money using such
instruments.
It was this asymmetry wherein conventional finance
cannot service the demand for sharia-compliant investments,
but conventional borrowers can issue sharia-compliant
bonds and conventional investors can choose to park
their money in such instruments that led to the belief
that Islamic finance had a great future. Moreover,
in terms of stock, Islamic finance accounts for less
than 1 per cent of all extant financial instruments.
Finally, the rapidly growing emerging markets are
the regions where a majority of the world's Muslim
population lives. Their demand for assets to invest
in is likely to increase if emerging market growth
returns to pre-crisis levels. The potential for growth
therefore seems immense. And recent rates of increase
in the volume of such instruments validate these expectations.
However, here were adequate grounds to be sceptical.
One factor that constrains the growth of this sector
is higher cost resulting from the multiple transactions
that typically have to be executed to make an arrangement
sharia-compliant. Instruments constituted on that
basis involve higher transaction costs and higher
interest rates, making them uncompetitive. Moreover,
if transactions have to be linked to assets to keep
them within the bounds of Islamic law, the proliferation
characteristic of derivative financial instruments
that feed on themselves is not possible. In addition
to this, there is the problem that sharia-compliant
investors are expected to avoid patronising institutions
that have borrowed too much, as is the case with most
highly leveraged modern financial firms. However,
the sheer need for an adequate volume of assets to
meet the investment needs of those wishing to be sharia-compliant
may have encouraged dilution of character to permit
expansion of the volume of these assets.
Such dilution may be facilitated by the shift of Islamic
banking at the margin away from more orthodox Muslim
countries to more liberal ones. According to a Standard
& Poor's estimate quoted by the Financial Times,
about 45 per cent of all Islamic bond issues between
January and July of 2009 took place in Kuala Lumpur,
way above Saudi Arabia's 22 per cent. They helped
raise $9.3bn and put Malaysia on top of the global
league table for issuance.
The ''capture'' of Islamic banking by the now-discredited
world of modern finance with its abstruse products,
speculative practices and unwarranted bonuses has
meant that Islamic finance merely mimics conventional
finance. Products existing in not-so-ordinary financial
markets are dressed up to be sharia-compliant. The
industry has in the process courted controversy. One
example quoted by the Financial Times (December 7,
2009) was a statement by Sheikh Taqi Usmani, a respected
member of the group of scholars accepted as certifiers
of sharia-compliant instruments that ''many Islamic
bonds went too far in mimicking conventional, interest-paying
bonds, which are banned by Islam.'' So influential
was this remark that it triggered a downturn in the
Islamic debt market, possibly because of fears about
redemption of investments that get identified as non-Islamic.
But it is not just the degree of adherence to Islamic
tenets that is a problem with these assets. An additional
problem is that with the industry mimicking conventional
finance it has imported all of the problems typical
of modern finance. This tendency has been aggravated
by the requirement that Islamic banking transaction
must be based on assets. Players with oil to sell
are unlikely to borrow on the basis of that commodity.
But accumulated capital assets are limited in many
countries where Islamic banking is popular. Thus often
the assets that commonly underlie Islamic financial
instruments are real estate and equity, which can
display volatile movements in value. This increases
the probability of default because of speculative
decisions. Dubai World would by no means be the first
instance of default, if that occurs. Others like US-based
East Cameron Partners, the Kuwaiti company Investment
Dar, and the Saudi Arabian Saad Group have defaulted
in the past, on debts which include those raised through
issues of sukuks. In fact, three among the largest
issues of Islamic bonds in countries belonging to
the Gulf Cooperation Council are in various stages
of default.
This implies that the presumption that these Islamic
bonds are safer because they have to be backed by
assets is not really true. One problem is that even
when assets are involved, they may have been just
accommodated to meet sharia requirements, in ways
that leave investors little recourse to the assets.
Another can be that the assets involved may prove
worthless when sought to be liquidated. This is what
seems to be happening in the case of Dubai World,
and its developer arm Nakheel, where the assets concerned
are reclaimed shorelines or strips of desert which
were to be transformed into some version of Paradise
on Earth to satisfy the whims of the wealthy. When
the crisis shrank the surpluses of the wealthy, there
were no takers for the part constructed real estate
assets, rendering them almost worthless. The resulting
losses forced Dubai World to declare that it was not
in a position to redeem its promises to pay. That
not only hurt investors. It also questioned the credibility
of the recent and rapidly growing versions of what
has been presented as Islamic finance.
