Monday, October 13, 2008

Islamic finance at risk from commodity price volatility

Although Islamic finance has grown rapidly over the past 8 years, it still is not widely accepted by high net worth individuals in Asia, some of whom are concerned that it does not have a long enough track record. One of the concerns is whether Islamic finance will be able to endure after oil prices fall back to lower prices. After reaching nearly $150 per barrel, they are now trading around $80 per barrel. A Forbes article describes in further detail the risks of falling real estate and commodity prices for Islamic finance. In addition to falling commodity prices, which lowers wealth growth in the GCC compounded by slowing real estate price growth, there is another hazard: commodity price volatility. The reason that commodity price volatility is harmful is that, whether you agree with it or not, there is widespread use of products like commodity murabaha. In transactions like commodity murabaha transactions to synthesize conventional loans are structured using trades in commodities (e.g. metals). Greater volatility in the prices of these metals introduces trading risk if the prices at which these metals can be bought and sold (often on the London Metal Exchange).

The second soverign sukuk planned by the Malaysian government will reset the risk-free pricing benchmark for ringgit denominated issues and facilitate price discovery of ringgit-denominated sukuk during the current market turmoil. The last Malaysian sovereign sukuk was issued over six years ago.

Japan Bank for International Cooperation (JBIC) may be forced to delay its sukuk issue because of the credit crisis.

I disagree with the comments from Sheikh Qaradawi about the 'collapse' of the western financial system and the presumption that Islamic finance provides a unique alternative that can stand on its own right out of the gate. Islamic finance provides a good model for how to expand ethical finance beyond just screening investments, but there are still several products that are warts on the Islamic finance industry like commodity murabaha and tawarruq. In these two cases, products are structured to mimic conventional interest-based loans to meet financial demands of Islamic banks and consumers where alternatives that are unique from conventional products have not yet been developed. Islamic finance should not be focused on standing alone apart from other ethically-based financial systems. Other ethical systems share similar concerns as Islamic finance about interest-based finance, funding weapons and other products which have a socially detrimental effect like alcohol and tobacco. The similarities should be praised and used as a way to promote a more just financial system not just one for Muslims.

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