February 2012

FEBRUARY 26, 2012 (PDF)

Islamic Microfinance for Renewable Electricity Generation

I have started thinking more about Islamic microfinance recently because I am speaking on the topic at an Islamic finance conference being held at the University of Maryland on March 11, 2012 and I was looking back at an idea that I first came across when I was researching for the paper I presented at the Harvard Islamic Finance Forum in 2008.  It occurs worldwide, but the example I saw was a microfinance institution SEEDS in Sri Lanka.  Their energy loan program was described in two reports that came out in 2007 [pdf] [pdf].  Their programs offer financing for three types of electricity provision across Sri Lanka: micro-solar financing, grid connection, and micro-hydro projects.

I think that all three could easily be used within an Islamic microfinance context with few changes in how they work.  Both the grid connection and solar panels (for a single house) are just as easy to provide using a murabaha, so I’m going to focus on the micro-hydro project (which would be expanded to be used for other forms of renewable energy like a small wind turbine or small biomass plant).

In the SEEDS micro-hydro projects, the community forms an electricity cooperative and contributes sweat equity, as well as some initial cash outlay, with the remainder coming in the form of grants or loans.  The cooperative collects payments for electricity use from the members of the cooperative, which pays for the operations & maintenance expenses, as well as repays the loan to SEEDS.

In an Islamic microfinance context, the basics of how the project works would not change, but the cooperative (owned either equally by members of the cooperative, or according to the share of initial capital each contributes) and the microfinance institution would form a musharaka with some cash contribution from the cooperative, as well as some sweat equity by the cooperative members (in the micro-hydro example, the community provides labor and in-kind contribution toward construction of the essential infrastructure, such as diversion channels and turbines).

After the project is constructed, the electricity usage charges would be collected and, after maintenance is covered, would be used to make profit-sharing payments according to the cooperative-MFI equity ownership ratio, with the cooperative’s share used to purchase equity from the MFI in the project.  At some point, the community would own the project entirely, and could decide whether to use the profits to either invest in additional projects, or to pay out to the members of the cooperative as profit payments.

This seems like the type of project which would both expand Islamic finance into projects that generate returns for investors, as well as contribute to helping lower-income communities and provide environmental and health benefits by reducing the reliance on gas or diesel generators.  It is also a microfinance initiative that would be easier to implement with a profit-sharing model rather than relying on murabaha, which is used commonly by Islamic microfinance institutions, but attracts the same criticism on the micro level as it does on the macro level.

New Format for Newsletter

I started writing this newsletter in response to a reader of my blog who wanted a way of receiving posts by email, and I have done it now for over a year and a half.  Through that time, I’ve wanted to make the newsletter look a bit nicer, and also make it easier to put up on my website (I have been slowly putting up back issues on my website, another thing I have been meaning to do for a long while, but finally got a few hours to work on this weekend).

I’m hoping to keep working on making the newsletter look good and we’ll see what time allows over the next few months.  I welcome feedback on the layout, as well as the content.  Please feel free to forward the newsletter and if you have received a forwarded copy, you can sign up by either emailing me or on my blog: http://investhalal.blogspot.com (enter your email in the box on the right hand side of the blog).

FEBRUARY 20, 2012

Due to the holiday, this is coming a day later than usual.  I want to add a few more thoughts to what I posted on the blog earlier today about the IMF’s Article IV report’s Appendix 4 which covers the impact of shutting down all the Islamic windows at conventional banks in the country.  There are two issues that the IMF points out motivated the Qatar Central Bank: liquidity management and monetary policy becomes more difficult when banks have both conventional and Islamic operations; conventional banks with large international operations on their conventional size have a significant advantage in their cost of funds, making Islamic banks less profitable.
1) Liquidity Management: The IMF says: “The segregation of Islamic and conventional activities is also aimed at improving the effectiveness of monetary policy, as it will enable the QCB to introduce different liquidity management instruments for the two types of activities.”  The effectiveness of monetary policy argument probably carries some weight because a bank that has conventional and Islamic operations would likely be tempted to arbitrage different conditions in the conventional and Islamic sides of monetary policy.  In order to effectively arbitrage the market, though, the bank would have to find a way to connect its operations in the conventional market and in the Islamic market.  This would lead to some commingling of funds, which the QCB pointed to in explaining its decision.
If the separation of conventional and Islamic banks leads to more options for Qatari Islamic banks to access liquidity from the central bank and allows the QCB to more effectively manage the transmission of monetary policy through Islamic banks (if necessary, with different policy than it has dealing with conventional banks).  We are currently at the beginning of widespread development of liquidity management tools like Islamic repos (excluding Malaysia which has had many more tools available than countries in the GCC).  Each country seems likely to do it slightly different, which will be good as a natural experiment to determine which structures are a) most effective; and, b) viewed as being the most “authentic”.
2) Cost of funds: The “level the playing field” argument is, in my opinion, both accurate and used as cover for favoring the domestic Islamic banks over foreign windows.  It is certainly accurate that a bank like HSBC or Citibank or Standard Chartered is more likely to be able to access cheap capital more readily than banks with only exposure to one country.  Their funding cost for sukuk is likely to be comparable, if not identical, to its conventional debt.  Their cost of deposits may or may not be cheaper than a conventional bank with an Islamic window that operates only or primarily in Qatar (this cost is likely to be relatively equal).  With a lower cost of funds than local banks, it will make them naturally more competitive than domestic Islamic banks with higher costs for its funds (and might also create an incentive for them to become more leverage if they have a wide cost advantage from sukuk issuance and little or no cost difference in raising deposits).
While I believe the level-the-playing-field argument has merit, I think in general it is a cover used for bolstering the domestic Islamic banking sector.  The obvious counter-point to this argument is that arguably the largest loser is Qatar National Bank, which is 50% owned by the Qatar Investment Authority.  However, it still seems to me that the directive was hastily constructed, announced and implemented (see my blog post below for a bit more on this).  The “level the playing field” argument comes across as reasonable and probably has some truth to it, but the director is likely to benefit domestic banks (wholly Islamic banks) at the expense of large international banks who were probably the target from the outset, even if QNB probably ended up losing more from the directive.

FEBRUARY 12, 2012

An article I read recently (pdf) discusses the case for and against standardization, using as a case study the total return swap (wa’d based).  It is an interesting discussion and one that I think has no right answer because making a definitive case for why there should be blanket standardization (or should not) could provide an avenue for clever lawyers and bankers to exploit the setup to get a product approved that might be designed in Shari’ah-compliant form, but might be used as a way to circumvent the rules of Shari’ah-compliant (the discrepancy between form and intent).  Alternatively, the too much or too rapid standardization could freeze the Islamic finance industry in its current state, and limit the ability of Islamic financial institutions to adopt products that may be considered more ‘authentic’ than the products being used today because it will become more costly (even more costly than now) to develop and get approval for a new product (and the costs will be borne by one institution while the benefits under full standardization will accrue to the industry as a whole).
There is definitely a role for standardization in products that can improve the outcomes for both Islamic financial institutions as well as consumers.  There are two types of products, one that can and should be standardized and another that should remain judged by an individual financial institution’s Shari’ah board (and consumers of the product).  The former includes the most basic contracts: murabaha, wakala, ijara, qard (whether offered from one institution to one consumer or by one or many institutions (syndicated loans) to one or many investors (sukuk)).  In addition, there can be some standardization in more complex products whose uses are relatively homogenous (profit rate and exchange rate hedging tools).  These are products that nearly every Islamic bank will use to compose the bulk of its balance sheet and they are relatively homogenous (with perhaps some differences across countries based on regulatory requirements).
The standardization of the contracts does not (as the paper suggests at one point) remove the need for a Shari’ah board because there will be other products for the Shari’ah board to review, as well as the implementation of the standardized products.  However, it would reduce the need for Shari’ah scholars to review every aspect of the contracts, and focus their attention on the implementation of the products and the new types of products outside of the standardized products (hopefully better using their Shari’ah expertise).  Having a standardized product for basic products could also increase the legal predictability of the contract enforcement allowing for more precedent-setting cases when disputes arise (with still differences across the countries where the contracts are executed and using different choice of law (e.g. English, New York)).

There are already many developments that are doing just this (e.g. IIFM’s I’aadat al-Shira’a for Islamic repo, Taha’awut for hedging products, planned standardized contracts from IIFM for ijara sukuk).  It should be encouraged and every effort should be made to share the structure (if not the exact particulars of the contract) publicly to encourage public discussion.

FEBRUARY 5, 2012

There is more in the news about companies in the GCC moving away from bank loans to other forms of finance, with the European debt crisis leading these banks (which have a heavy presence in the GCC) from curtailing new loans.  As companies have to roll over their debt, they are pushed to consider more “unorthodox” strategies.  As I mentioned in an earlier newsletter, bank financing far outweighs equity and debt markets as sources of financing in the GCC and a shift away from bank debt could benefit sukuk markets, something that a large volume of refinancing of bank debt in a tough environment for banks would accentuate.
Another article highlights that a growing share of new issuance of sukuk is due to maturing sukuk with new issues being used to roll over outstanding sukuk.  The list compiled by Zawya contains just under $10 billion in sukuk coming due in 2012.  The reason for the glut of maturing sukuk is that most sukuk are issued for 5-year tenors and sukuk issuance hit a peak in 2007.  As you would expect, not all of the maturing sukuk (or scheduled maturity date; the list includes the $650 million defaulted Golden Belt 1 Sukuk issued by Saad Algosaibi) is of the highest quality.  There is also a concentration of the larger sukuk in the UAE (3 of the 4 largest and 6 of the 10 largest, including the recently troubled $1 billion Dana Gas sukuk), something also not unexpected given the large share of “mega-sukuk” from the UAE before the Dubai debt crisis.
These two factors present both a challenge and an opportunity for sukuk markets.  On the one hand, there should be strong issuance in 2012 and perhaps some new entrants among GCC-based companies who cannot roll over bank debt because the banks are holding back new lending as a result of the European debt crisis.  This new issuance will be supplemented by the large number of sukuk needing to be repaid or rolled over in 2012.  However, there is also a risk that a sukuk issuer is unable to roll over or repay its sukuk (at the moment, the one on the radar is Dana Gas, whose sukuk martures in October).  A more long-term challenge is for sukuk markets to separate out the quality issuers from the new issuers who decide to tap sukuk for the first time after losing access to (or seeing access curtailed) bank debt as a result of the European debt crisis.  It would be unfortunate if the sukuk market attracted more issuers who were denied bank financing because they are high risk or uncreditworthy borrowers.