Saturday, December 12, 2009

Articles on Islamic finance and the Dubai effect

As the maturity date (December 14) looms for the Nakheel sukuk, there have been two avenues of media attention to the Islamic finance industry. One of these is trying to read the tea leaves and predict the outcome of the Nakheel situation. The other is to look at the overall impact of the recent Dubai debt crisis on the entire Islamic finance industry. Here is a sampling of some of what is being written along these two tracks, with a few comments along the way on what I think about the arguments.

Oxford Analytica wrote an article titled, "Islamic Finance Still Profitable", which goes to admirable length to differentiate between the areas of Islamic finance that are experiencing difficulties like property and those areas that are still growing.
"Although Islamic capital market activity was negatively affected by the global financial crisis, the impact on Islamic banks has been limited, largely because most are focused on retail business"

"Real estate has been the most troublesome, with mortgage lending reduced. In many instances, the value of property has fallen below the amount of credit outstanding. [...] As Islamic banks in the GCC had more conservative housing finance policies than their conventional competitors, they have been less affected by the fall in real estate prices."
The article concludes with a positive outlook for the Islamic finance industry:
"Most sukuk issuance is concentrated in Malaysia, which is not likely to be directly affected by the Dubai crisis. Moreover, if the Dubai case is tested in the courts, this could clarify the legal position of sukuk investors with regard to their rights to the underlying assets backing the issuance. Although this may be painful for Dubai World subsidiary Nakheel in the short run, a court ruling in favor of investors would increase confidence in sukuk in the longer term. Overall, the global Islamic finance industry seems well positioned for recovery in the longer term with further sukuk issuance, a widening of products to include takaful and the continuing buoyancy of Islamic retail banking."
I think this conclusion is right. There will be significant short-term pain for Nakheel, but it might also extend to other GCC-based Islamic financial institutions, but the resolution of Dubai World's subsidiaries' overindebtedness will clarify as of yet untested structured including sukuk. It should also remind issuers that they need to be mindful of the level of debt (whether conventional or Islamic) that they take on to finance their businesses.

The second article focusing on the future of the Islamic finance industry is a white paper released by the Dubai International Financial Centre Authority on the potential for Islamic finance to be involved in infrastructure finance in the GCC. While it is clear that the white paper was largely completed before the debt crisis hit, the white paper is still relevant. Most of the infrastructure projects would be long-term investments and the Dubai crisis should return the focus from building luxury or statement projects like the undersea hotel, Burj Al-Arab, Burj Dubai and return to the more needed projects like infrastructure across the region. There are only so many people who can afford and desire luxury apartments and hotels in Dubai, but there are far more--within the GCC and outside the region--with large infrastructure needs. A growing focus on infrastructure projects would be more beneficial to more people, although they may not seem as sexy as the luxury projects.

This leads into another article, which focuses on the lessons from Dubai written by Dr. Lin See-Yan. He argues that there is a light at the end of the tunnel, but not without significant changes in Dubai and across the GCC region:
"As it now stands, the Gulf markets are soft and under continuing pressure. To be fair, the structural underpinnings of these markets need to be viewed in perspective over the longer term."

"Lest it’s forgotten, Dubai’s hydrocarbon-rich neighbours – Saudi Arabia, Kuwait, Qatar and Abu Dhabi – command two thirds of the world’s oil and 45% of gas reserves."

"Debt levels are very low and high oil prices have enabled them to accumulate more than US$1 trillion in reserves. A few key elements set the stage."

"These Gulf nations need some US$2 trillion in infrastructure spending to diversify from oil."
"But these oil-rich nations are known to be basically conservative. No doubt the Dubai excesses present lessons to be learnt. Throughout history, nations have defaulted and live to fight again, and succeed, even prosper."

"To regain confidence, a number of things need fixing: call for fiscal transparency, opaque family business groups need to heed the lessons of Korean chaebols, and clarity on the road-map to government prudence over the longer term. This includes a credible plan on debt management once global recovery becomes sustainable."

"Dubai teaches an important lesson. Unpredictable, unsustainable, unclear and uncertain policies are a no-no."
Dr. Lin's analysis is correct and looks to whether the future growth will come from. However, to paraphrase J.M. Keynes, "In the long run, we're all dead". A blog post from The National highlights the impact in the short term from the ripples that the Nakheel and Dubai World debt crisis sends through the UAE via credit ratings agencies. The post focuses on how the impact of Dubai World is transmitted to other companies through reviews by the ratings agencies who have downgraded other companies across the UAE and in some cases, this may produce financial difficulties for those companies that would not have existed had Nakheel's sukuk been paid on time without a standstill request. The author, Wayne Arnold, does describe a way for the government to help clear up some of the uncertainty that has affected the ratings of other (mostly) state-owned or government-related companies:
"Last month's announcement, therefore, has prompted all three agencies to scale back their assumptions once again, this time eliminating from their ratings any assumption that Government-owned companies enjoy implicit guarantees of any kind. Obviously, the Government could still move to back some companies considered too big to fail, and not all companies may ever need such a bailout."

"But the onus is now on the Government to do what the US Government did with Fannie and Freddie -- make the implicit explicit and clear up just which companies enjoy guarantees and which will have to stand on their own."
Until now, the Dubai Department of Finance has refused request to meet with the credit ratings agencies and so the uncertainty continues, which casts a long shadow over many other companies in the UAE, some of whom would be judged to be fine if the ratings agencies were given clarity about their status vis-a-vis the government (or they would be downgraded based on the information provided). Either way, it could speed up the necessary process of separating good companies from bad and as long as the uncertainty persists, the good will be dragged down by the bad.

Returning to the specifics of sukuk rather than the entire Dubai debt crisis, Oliver Agha and Claire Grainger write a thought-provoking article about whether the inclusion of clauses to provide bond-like protections for sukuk holders in sukuk can or should be enforceable. They criticize the structures created, rather than than Islamic finance itself, because the documentation does not involve risk-sharing but instead incorporates risk transfer:
"Blaming Islamic finance for sukuk defaults is both simplistic and misinformed. The ‘defaults’ occurring in instruments today would not necessarily qualify as genuine Islamic defaults because such provisions effect the kind of risk-transfer that is inimical to Islamic finance."
They then review the difficulty of structuring sukuk to include legally enforceable requirements that the sukuk not violate Shari'ah and point to the Beximo Pharmaceuticals case in the U.K. which English law was ruled to be the only governing law because "Shari'ah was not a governing body of law but merely embodied the religious principles to which Shamil Bank held itself as doing business".

They conclude by suggesting that:
"In short, purchasers of sukuk and other Islamic instruments need to be aware these products may be subjected to scrutiny at enforcement and certain non-conforming provisions may be excised or disregarded. While sukuk holders share in the rewards, they would take the risk of a depreciation of their capital in adverse business circumstances provided there was no negligence on the issuer’s or manager’s part."

"Islamic finance is a permissive field and, apart from the fundamental prohibitions, a multitude of structures can be developed to serve varying commercial needs. However, referring to sukuk as Islamic bonds is like jamming a square peg into a round hole and then wondering why it does not fit."
While this article highlights much of what the Islamic finance industry should focus on in the future, it does not provide much help to the sukuk holders trying to enforce their claims on Dubai World. An article in the Times speaks with several lawyers involved in Islamic finance who reiterate the point that should have been clear to investors. The Nakheel sukuk and any other debt issued by or guaranteed by Dubai World or its subsidiaries is not sovereign debt. Investors had no explicit guarantee of that debt by the government of Dubai, the UAE or any other Emirate. This misunderstanding and the equally important misunderstanding that all sukuk are backed by and give investors recourse to a tangible asset should make the article by Agha and Grainger even more important to consider as the Islamic finance industry tries to move on from the Dubai World debt crisis.

Finally, the National provides an update on the range of possible outcomes of the Nakheel maturity and suggest that the most likely outcome is a restructuring that pays 70 percent in cash and the remaining 30 percent in new debt (nothing mentioned about the Shari'ah-complaince of such a restructuring). A top Dubai government official told Gulf News that there will not be a Dubai default, which doesn't necessarily apply to Nakheel's maturing sukuk which is not government-backed, but may be another signal that Dubai will pay in full the DEWA bond, which may be facing accelerated payment. An article from Bloomberg provides other updates on the Nakheel sukuk maturity.

Finally, John Foster provides another article critical of the Islamic finance industry which includes accusations (supported by quotes from an anonymous investment banker in Dubai working for a "major Western financial organization") of fatwa shopping.

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