Reuters Islamic finance summit

Reuters Islamic Finance Summit

There are a number of articles about sukuk from the Reuters Islamic finance summit. This is not terribly surprising because of the place of sukuk as the 'face' of Islamic finance, especially among Western investors. There are a few issues raised in these articles.

One article describes how the development of sukuk by French issuers, in particular, an $1.37 billion (1 billion euro) sukuk from an unnamed corporate issuer, has been delayed by the uncertainty about legal rules about sukuk in France. The French parliament passed a law recently clarifying the legal and regulatory treatment of sukuk, but it was thrown out by the courts on procedural grounds. France has said it wants to be a European hub for Islamic finance, but in the absence of a resolution of these issues, it is unlikely that it will be able to catch the U.K. quickly where regulatory and tax changes have already been made to put Islamic finance on a level playing field.

There are a few somewhat conflicting articles about Islamic finance in the Gulf that, despite the seeming contradictions, describe the situation facing Gulf issuers in the wake of Dubai World's request for a debt standstill (which investors were reminded of by recent news as well as other sovereign debt issues in Greece). The capital markets for new sukuk are relatively frozen right now, especially in the UAE and there have been few non-sovereign issues in the past year. However, there is significant latent demand by money market funds for high-grade corporate and sovereign issues.

An advisor to Morgan Stanley, Yavar Moini, does provide some background for what is needed to unlock this latent demand and bring new sukuk to market: domestic capital market development. However, in order for this development to occur, there needs to be greater legal certainty about how sukuk behave in different situations and for different structures. The advantage that many sovereign issuers have over corporate issuers in this environment is that many Gulf states (Dubai excepted) have signficant oil reserves that finance the government budgets and with oil prices having recovered, the revenue to repay debts on time is less uncertain than with corporate issuers whose ability to pay is less certain and more dependent on local economic conditions. This is, of course, accentuated for issuers looking to issue sukuk backed by real estate projects like Dar Al Arkan, which issued a smaller than expected high-yield sukuk (10.75% coupon) to raise $450 million compared to expectations of between $500 million and $750 million.

Worldwide, Mohd Daud Bakar, a Shari'ah scholar, expects that the leading country for new issues (ex-Malaysia) will be Saudi Arabia, based on its need for infrastructure projects and economic growth fueled by the rebound in oil prices. He expects 10 to 15 sukuk issues from Saudi issuers during the year. Bakar is also working for the South Korean Korea Investment & Security Company, which is structuring a sukuk for issue after the country passes a proposed bill to create a tax exemption for sukuk.

Apart from these new issues, there could be additional sukuk activity in the secondary markets with several Gulf-based banks launching sukuk funds. There have been a few sukuk funds launched since the onset of the financial crisis beginning with one launched by Algebra Capital in August of 2008. These funds will probably try to tap the desire for investors to invest in sukuk while taking advantage of depressed prices in some sukuk in the secondary markets. The growth in secondary markets will be aided by these funds who will provide a bid for distressed and other sales of sukuk holdings. The test for the markets will be whether these funds will then warehouse these sukuk until maturity or whether secondary markets will become liquid enough for them to sell holdings before maturity. If these funds become active players in the sukuk secondary markets, they could lower pricing for new sukuk by increasing the liquidity of sukuk (which would lower the liquidity premium attached to new sukuk issues).

An article with quotes from a lawyer in Islamic finance, Farmida Bi, and Toby Birch, the founder of Birch Assets Ltd., provides some interesting comments on the difference between sukuk and conventional bonds. Ms. Bi is quoted: "Investors have realized after Dubai World that what they are buying is not typically something that (gives) recourse to an asset". Mr. Birch described that "If bonds were properly Islamic there would be no guaranteed rate of return: the idea of a sukuk is you share the income flow because you are a co-owner of the real assets". This is, I think, the correct assessment of the situation of the sukuk market, but I am concerned that the selling of Islamic finance as asset-backed, while selling asset-based sukuk may reflect a flaw in how the industry markets itself and in particular, the difference between substance and rhetoric. If Islamic finance promotes itself as different because it is asset-backed, it should offer product that are secured by assets. In other cases, it should use investment structures that share risk between issuer and investors (like the Saudi Hollandi Bank sukuk). What is creating confusion is where structured of a sukuk based on an asset leaves investors without recourse to that asset. Islamic finance is not always asset-backed, but in the structures where an asset is involved, investors should have recourse to that asset.

In a related article, Mohd Daud Bakar, describes that the industry was developed to allow Muslims to buy houses and cars and has not yet moved beyond this area to involvement in the real economy. He is right to some degree; the Islamic finance industry is largely contained to offering products to others within the financial services industry with the exception of retail institutions which....offer financing for houses and cars for consumers. Another article describes the prospects for private equity in Islamic finance and real estate is now again in vogue in Islamic finance. The debate on the connection between the Islamic finance industry and the real economy is somewhat constant in the background, but the questioning of this connection (and the same discussion in conventional finance) somewhat loses the point that finance is by its nature somewhat disconnected from the real economy except that it is engaged in providing financing for everything else. If there were a concern about financial industry people becoming involved directly in the economy to directly benefit others, I think the best outlet would be Islamic microfinance. It is still relatively underdeveloped and could use the (volunteer) efforts of the top minds in Islamic finance.

Despite the growth touted for Indonesia in an article I linked to yesterday, there are a number of hurdles for Islamic finance in Indonesia, despite its large Muslim population. The primary obstacle is tax and regulatory difficulties for Islamic financial products (and I have seen other articles which cited endemic corruption as another obstacle. However, if the information in this article is correct, there may be a simple lack of demand from consumers, either through lack of understanding of Islamic finance or a belief that Islamic finance is not authentic or necessary in its current for, which replicates (or 'camouflaflaged' as it was described by the cheif economist at Bank Danamon, Anton Gunawan) conventional finance.

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