May 2011

MAY 30, 2011

Mushtak Parker finished up the second installment of an interview with Rifaat Abdel Karim, the now-former head of the IFSB, the Malaysian based standards body.  The full interview is worth a read:

Part 1:
Part 2:

One interesting area that is covered  during the interview is the International Islamic Liquidity Management Corporation (IILM):

The challenge is that there are currently only two AAA rated members of the IFSB – Singapore and the Islamic Development Bank (IDB). So there are not enough AAA-rated issuers. The key aspect was rating arbitrage, and if you couple that with the chronic liquidity management problem within the Islamic finance industry you are solving dual issues – liquidity management on the one side and capital markets on the other side. (Rating arbitrage often refers to taking advantage of the difference between an asset’s risk level indicated by its credit rating and the actual amount of risk.) That is what the IILM is all about to issue AAA-rated papers for cross-border liquidity management and to develop an international Islamic capital market. To do that, any institution would have to have the credibility of the central banks because liquidity management is at the heart of central banks. But multilaterals and sovereign wealth funds can also play a bigger role. For instance the sukuk could be based against sovereign and corporate assets but they have to come through their respective central banks. The IILM will develop as the supply of requisite assets, come to the fore. The sukuk issued by the IILM could play a crucial role where capital and other reserves of Islamic banks can be parked especially in jurisdictions – both Muslim and non-Muslim – where the central banks do not have such Shariah-compliant liquidity management instruments.

This should be a good way for the sukuk markets to be deepened at the short end of the curve.  Combining the resources of the member central banks will strengthen the credit rating and perceived credit-worthiness of the IILM.  If one country runs into economic difficulties (e.g. the UAE with the Dubai debt crisis) or becomes politically unstable (e.g. recent protests in Bahrain), the institution’s credit rating should be relatively insulated because the resources it needs to service its outstanding sukuk can be replaced by other member central banks.

There has not been enough details of the mechanics around how the IILM works and part of this, I suspect, may be due to lack of agreement of how it will, in fact, work.  I don’t have any details about anything happening internally within the IILM, but one of the most difficult issue (given the structure included above) is what obligations will member central banks have for sukuk issued and backed by assets coming from other central banks.

If I understand it correctly, the IILM would provide a way for member countries to issue short-term debt “borrowing” the credit rating of the institution in exchange for providing the assets used to structure the sukuk.  This is beneficial for the countries involved (particularly those with lower sovereign credit ratings) because they would receive lower borrowing costs while the Islamic finance industry can benefit from the availability of highly-rated short-term instruments that likely would not raise the amount of capital they are required to have on hand (i.e. it would have a low or zero risk-weighting).

However, with the benefit given to the lower-rated member countries, there is a cost for the higher rated members.  These countries have lower borrowing costs and would benefit less from the AAA credit rating the IILM would presumably have.  However, they could be on the hook if sukuk backed by assets from a weaker member became distressed (because of economic or political problems, coupled with a fall in the value of the asset backing the sukuk).  These potential liabilities will have to be managed through negotiations between members and embedded in the institution’s legal structure.  That takes time–we are now about 8 months from the official announcement of the IILM–which probably explains the lack of information about the IILM structure.

Until we get more details about the IILM, about all we know is that it is headquartered in Malaysia, which passed a bill to make the IILM an international organization in the session ending in December 2010.

Now with 1 year in the books for the newsletter (and approaching 5 years for the blog), I want to thank everyone who reads the newsletter and the blog–and especially those who leave comments or drop me emails.  It has kept it interesting through the years and given me new perspectives on the topics I cover.

MAY 22, 2011

Wiliam Pesek, a reporter for Bloomberg wrote an opinion piece with a list of potential Asian candidates who he thinks should be considered for the recently vacated position running the International Monetary Fund.  One name on his list should be familiar to anyone with interest in the Islamic finance industry, Zeti Akhtar Aziz, the governor of Bank Negara Malaysia, the country’s central bank.  This is what he had to say about her qualifications for the position.

She is as internationally respected a central banker as any these days. The Bank Negara Malaysia governor played a key role in turning Kuala Lumpur into the global hub of the $1 trillion Islamic finance industry. Zeti also was part of the team that bet against the IMF and won. In the late 1990s, it seemed inevitable that Malaysia would join Thailand, Indonesia and South Korea in accepting multibillion-dollar IMF bailouts and stringent conditions like raising interest rates and cutting spending. Malaysia said no and Zeti helped it weather the turbulence. And then she watched the United States, in the height of hypocrisy, do all the things it told Asian officials not to do. Zeti would bring a different perspective to the IMF, one much-needed.

I think that he makes a good point on installing someone at the IMF who brings her diverse experience from the financial crises in 1998 as well as her role in adapting as things changed to ensure that the Malaysian Islamic finance industry developed as successfully as it has over the past decade in Malaysia.  That being said, I think for the Islamic finance industry, it is better if she remains just a candidate for the top job at the IMF.

It will highlight the growth in Malaysia’s Islamic finance industry without depriving the industry of one of its best spokespeople.  In addition to her role as governor of BNM, she is chairwoman of the new International Islamic Liquidity Management Corporation, which is developing short-term liquidity management tools for the Islamic finance industry, something which will be beneficial.  It would not be the end of the effort should she leave her current posts for the IMF, but she is one of the most recognizable central bank governors among the countries with large Islamic finance presences.

It is good to see the growth of Islamic finance recognized even tangentially, but it would probably be a net negative to have someone as involved with the Islamic finance industry as much as Ms. Zeti is depart to run the IMF.  And anyway, old habits die hard, so the next IMF head will most likely come from within Europe, just has it always has.

MAY 15, 2011

I was reading the World Takaful Report 2011 (the report is linked over at the Islamic Finance Resources blog).  It is an interesting report, but by far the most interesting data point in the entire report comes on page B32 where the asset class allocation of the takaful companies in the GCC and Malaysia are compared.  The charts are striking in their difference.  In the GCC, the equity component of the portfolios was 2/3rdbefore the crisis and then falling to lower levels in 2009 and 2010.  The sukuk component in much lower in the GCC takaful companies with a higher share of cash than Malaysian takaful companies.

This gives insight not only into the takaful companies themselves, but also the relative maturation of Islamic finance markets in each region.  First, the equity share of the takaful portfolios in the GCC was 66% in 2008 compared with 27% in Malaysia during the same year.  The less risky assets (sukuk and cash) made up 19% and 6.5% in the GCC compared with 40% and 28% in Malaysia.  Global equity markets in 2008 were terrible and the large performance difference between takaful funds’ investments in the GCC and Malaysia can largely be ascribed to this asset allocation discrepancy.

There is not enough data to know exactly the time horizons of GCC and Malaysian takaful companies (different product mix between the two regions could explain some of the difference in investment strategy), but the change in allocations on a year to year basis suggests there is more at work than just different investment needs.  In 2009, the equity share of the portfolio was 37% in the GCC compared with 28% in Malaysia while sukuk and cash represent 22% and 32% in the GCC and 40% and 28% in Malaysia.  From an investing perspective, one would expect to see a reallocation from cash into riskier assets like sukuk and equities after the type of crash that occurred in 2008 and that is what happened in Malaysia.  However, just the opposite happened in the GCC.  Takaful funds in the GCC withdrew from equity markets for the relative safety of cash and sukuk.

Another observation I have from the chart is what it says about the sukuk markets in the GCC and Malaysia.  In 2008, the cash + sukuk allocation in the GCC was 33% cash and 67% sukuk compared to levels of 43% cash and 57% sukuk in Malaysia.  In 2009, these numbers had changed dramatically and in opposite directions in the GCC (59% cash, 41% sukuk) and less so in Malaysia (30% cash, 70% sukuk).  One explanation I can think of is that in the pre-crisis day in the GCC, sukuk were available and were popular (one measure to use for this was how often pre-crisis sukuk were oversubscribed).

However, once the financial crisis began and spread from the US and the West to the rest of the world, the supply of sukuk dried up.  It has since returned and now exceeds pre-crisis levels, but more of the issuance is coming from Malaysia.  With fewer sukuk out there (and the glow around sukuk coming out of the GCC reduced), some of the money that would have pre-crisis gone into sukuk is either being held in cash for safety or for lack of investment opportunities.  In Malaysia, by contrast, the sukuk markets have returned to growth and issuers have been drawn into the market by investor interest (including by foreign investors who have directed money towards Malaysia leading to its currency strengthening).

There may be other explanations, but this explanation suggests that sukuk markets across the GCC as well as takaful firms have a lot of work to do to become as deep and well developed as those in Malaysia.  There are two areas where particular focus should be directed.  First, sukuk markets in the GCC remain unable to serve one of the primary source of investors in sukuk (takaful), particularly should issuers start to look to issue longer-term maturities.  Second, takaful companies should improve their investment management because it represents a large part of their business, nearly as large as their responsibility to adequately price the risks they are assuming through takaful policies.  There is no possibility for any investment allocation to time the markets perfectly, but professional investors should not have a huge exposure to one asset class immediately before it collapses and a far smaller allocation after the collapse occurs when the recovery is beginning.

Two final notes.  First, this is Issue 50 which means I have been writing this newsletter for nearly 1 year.  I think this is a good time to ask the readers for suggestions on things I can do in the second year to improve the usefulness of the newsletter.  Please reply to this message and share your thoughts.  Second, I recently added a new way for readers to read (most of) my blog posts.  Selected posts are being reproduced on the FT Tilt, the emerging markets blog that the Financial Times recently launched.  Some of their content is free (with registration) and I have found the content (written by people around the world, all focused on emerging markets) to be excellent.

MAY 8, 2011

One of the major themes of the form versus substance arguments in Islamic finance is the desire by some people to move the Islamic finance industry more towards equity-based methods of finance.  Looking at the conventional markets, the areas where the equity-based, profit-and-loss sharing methods used in Islamic finance have the greatest overlap are in venture capital and the equity markets.  The reason to look to the conventional markets for areas of overlap is that to the chagrin of those who say that Islamic finance has to be totally different from conventional finance, is that the way the industry works is in finding ways to replicate conventional products that serve a valid economic need.  If one is to make a shift towards the PLS-type products, it will have to begin with the areas of finance that are familiar to the market already.  It is difficult, if not impossible, to expect investors and financial institutions to set off on a totally new course.

With that in mind, the recent National Takaful Company (Watania) IPO in Abu Dhabi is step forward on both counts (I recognize that most of this discussion will be GCC-centric, but there is a tremendous wealth of opportunity there and it has not been as well developed as, for example, Malaysia).  The easy area to recognize is that it is a (public) equity offering of shares in a company that is entirely Shari’ah-compliant, something that is relatively rare in the larger scheme of things.

The other significant thing that this IPO is only the third of the year on GCC bourses.  Insurance House completed an IPO earlier in the second quarter and Eshaq Properties is currently conducting its IPO.  The IPO market in the GCC grew from $2.1 billion in 2009 to $2.9 billion in 2010, although the number of IPOs fell from 12 to 10.  The significance of this is that the IPO market provides one exit for venture capital investments (the other primary exit being a sale to another company).  Venture capital is a close approximation to a mudaraba or musharaka structure, but it will not develop if the path to exit from the investment is not clear.  The development of a domestic IPO market in the GCC will determine whether domestic venture capital develops (in addition to the omnipresent concerns about the development of  a legal system that respects property rights and the rights of investors in particular).

However, as much as the VC structure mirrors mudaraba/musharaka, there are differences (and some of the solutions to the issues that the differences create will be controversial in some circles).  For example, it is common for VC funds to invest in companies and take preference shares to avoid some of the problems that could occur if they were making a straight equity investment.  However, these issues are not insurmountable and the solutions–while they could attract some critics–should not undermine the perception of VC as offering a more profit-and-loss sharing structure than many of the products used in Islamic finance today.  Therefore, the development of an IPO market (even if the 2nd quarter of 2011 is in some ways making up for the absence of any IPOs in the 1st quarter) is something that should be viewed as constructive for the Islamic venture capital possibilities down the road.

MAY 1, 2011

Ok, after that week off last week, I’m back.  With all of the turmoil around the GCC region–which is after all one of the largest regions for Islamic finance in the world–there are questions about whether the industry will continue growing despite the violence and disruptions.  It is also currently a toss-up whether Bahrain can avoid sustaining major damage to its reputation and retain its status as one of the hubs of Islamic finance in the GCC.

However, with the forced departure of Hosni Mubarak in Egypt, there is potentially some good news amidst the concern for Islamic finance.  I am not an expert on the Islamic finance industry in Egypt, so apologies if my explanation misses factors (in fact, you should hit “Reply” and tell me where I am wrong).  However, there are generally two explanations for why the Islamic finance industry in Egypt is relatively small compared to other countries in the region.

The first is that Mr. Mubarak, when in power, used the Muslim Brotherhood (rightly or wrongly) as a straw man to generate fear of instability if he ever lost power.  As a part of this narrative, he tried to limit the growth of Islamic finance.  Mr. Mubarak is not the only person to (wrongly) suggest that the Muslim Brotherhood is behind the Islamic finance industry.  It is a common theme among the anti-Islamic finance groups in the West as well and has been more consistently repeated than perhaps any other fallacy about the industry.  So, with his departure, Islamic finance should be able to grow (estimates from Bankscope and ThomsonReuters put the industry at $6 billion as of 2007 in Egypt and project $10 billion by 2013).

Now, that is the easy explanation, but alongside this, there is questions about how much the public will trust Islamic finance institutions after many small investors lost their money in the 1980s in scandal-plagued banking crisis.  So, there are two ways to look at the future.  First, Mubarak’s departure removes one big impediment and opens the door for Islamic finance presaging rapid growth.  The second is that Islamic financial institutions will be more free to operate, but will struggle until they are able to demonstrate their prudent management and protection of investors and depositors.

I think the latter is far more likely.  Trust is at the core of finance in all forms and rebuilding broken trust is a long and arduous process.  I hope the Islamic financial institutions are up to the task, but if things play out the way I think they could, it should serve as a reminder to the rest of the industry to focus on prudent actions to avoid causing massive losses to investors that will dent the image of the industry as a whole.  This should be self-evident after the financial crisis with several Islamic finance institutions struggling to adjust to the new post-crisis environment.  Based on the frequency of claims that Islamic finance avoided the crisis, however, I don’t know if everyone is on the same page.  If Islamic finance struggles to get rapid growth in Egypt, it should serve as a reminder of the difficulty of rebuilding trust.