Monday, March 21, 2011

Would an Islamic Sovereign Wealth Fund Be Workable?

Rushdi Siddiqui has a broad article about the role an "Islamic Sovereign Wealth Fund" could have in the Islamic finance industry and some of the obstacles it would face. He makes a strong case for why sovereign wealth funds overlap significantly with a fund that would select its investments within the constraints of Shari'ah-compliance. Nine of the ten top holdings of the Norwegian sovereign wealth fund pass through Shari'ah screens (with the exception being HSBC Holdings plc).

One thing that I notice right away is the concentration of these investments in the energy and natural resource sector: the fund holds three oil companies and a mining company along with a consumer products firm, a telecommunications firm and two pharmaceutical companies. Before returning to the issue of an Islamic sovereign wealth fund, it seems to me that the top ten holdings (if representative of the portfolio) has more exposure to energy and commodities than might be desirable given that the SWF gets its revenue from oil.

Returning to the issue of the Islamic SWF, the model for the sovereign wealth fund is based on the five characteristics of SWFs from Monitor Group/FEEM:
  • Owned by a sovereign government
  • Managed independently from government's other financial institutions
  • Not attached to explicit pension obligations
  • Invests in a diverse set of asset classes in pursuit of commercial returns
  • Invests a significant proportion of publicly-reported investments internationally
The Islamic SWF would need to overcome four major hurdles:
  • Source of funds/sovereign affiliation
  • Purpose of the SWF
  • Ability to diversify across all asset classes
  • Political sensitivities towards a Shari'ah-compliant SWF
Although these are not exactly how Rusdhi Siddiqui frames the problem, it is close and I think separates it into the different areas where there are major questions.

Source of Funds/Sovereign Affiliation
One of the biggest questions around an Islamic SWF in my opinion is how the funds will be mobilized and the resources (and investment opportunities) shared. There is of course a model for cooperation across Muslim-majority nations in the Islamic Development Bank, a multilateral development bank which is funded at different levels by Muslim-majority countries and which operates in all IDB member countries.

 However, the distinction between the Islamic Development Bank and an Islamic SWF is that the resources from the IDB are used primarily for development projects where an Islamic SWF would be focused much more on commercial concerns (i.e. generating the largest return). This would likely lead to even more of a concentrated ownership than the IDB (based on the relative wealth of the countries likely to support the Islamic SWF). Saudi Arabia alone is the largest investor in the IDB controlling more than 1/4 of the organization and combined with the next three largest member countries in terms of capital contribution (Libya, Egypt and Iran) represent more than half of the paid-up capital in an organization with 56 member states.

Tying into the point about political sensitivities, an ownership structure that was dominated by one or several countries would lead to allegations that some countries were trying to cloak their national ambitions (whether this allegation was based on the SWF's Islamic nature or not). This could complicate the international investments the SWF would try to make, particularly if it made a large acquisition a la the Dubai Ports World/P&O Ports controversy in the U.S.

One possible solution would be to alter the profit-sharing ratios within the SWF to reduce the share of profits accruing to any one large shareholder in the SWF (if it were set up like a musharaka vehicle, the losses would have to be shared in proportion to capital contributions). However, it would be naive, in my opinion, to assume that there would not be some form of tradeoff if the capital for the Islamic SWF were not exchanged for some other form of benefit. Whether this takes the form of selecting more asset managers from larger capital contributors or some other mechanism, it would create political problems within the organization.

Purpose of the Islamic SWF Rushdi Siddiqui suggests that an Islamic SWF would be set up as a way to either provide some form of support to asset management in Islamic finance (as opposed to the one-off product offering common now) or to possibly become a lender of last resort. I think both are noble goals for an Islamic SWF. However, both either duplicate the roles of organizations being set up today (like the International Islamic Liquidity Management Corporation and to some extent the Islamic Development Bank) or create opportunities for influence peddling or complicate the issues of ownership of the SWF.

On the latter issue, the tradeoff between providing more benefits to smaller or less resource rich countries greater than their ability to contribute to the capital of the Islamic SWF will always come at a price. It may be just the "status" of being a large owner of an Islamic SWF, but more likely the additional resources contributed to the Islamic SWF would lead to an implicit bargain that asset managers from that country would be selected disproportionately to reward that country for taking the lead by contributing more capital to the Islamic SWF.

 On the former issue, I think that the IILM is creating a wide base of support from its member country governments and central banks for its sukuk program and this would provide a better base to become a multi-national Islamic lender of last resort. I don't know if it is better for a multi-lateral organization to be the lender of last resort, given the politics that will be involved in a crisis, but the International Monetary Fund, despite many valid complaints about how it operates, sets a model as the "global firefighters" that the IILM could become.

However, an Islamic SWF that has a large portfolio of assets--but not necessarily the same level of liquidity as the IILM--could get in the way or even become trapped by the illiquidity or decline in value of its assets that would make it less able to step in at the points of time when it is most needed.

Ablity to Diversify across Asset Classes 
Here I have few difference of opinion with Rushdi Siddiqui. He note that the Norwegian sovereign wealth fund is widely diversified across highly rated sovereign issuers and there are few if any sukuk available with that much diversification and size of issuance for an Islamic SWF to invest in. Other asset classes are available, but with equally spotty availability and diversification possibilities. With sovereign sukuk in particular, there is still enough of a shortage in sukuk issuance that an Islamic SWF may harm rather than help the supply and secondary market for sukuk. 

In general, sovereign wealth funds are long-term investors that do little trading (relative to some funds). Unless the Islamic SWF were to seed many different sukuk funds to invest in and trade sukuk, it would not support the development of liquid secondary markets for sukuk that are needed to induce greater supply by lowering the illiquidity premium attached to sukuk. The one thing that the seeding of sukuk funds could do would be to lower yields for issuers by raising the overall demand for sukuk (more demand = higher prices = lower yields). This would have some benefits because it would bring sukuk closer to on par with conventional bond issuers in terms of pricing (and could lead them to be priced more favorably than conventional bonds in some situations like sovereign and highly-rated issuers where demand would be greater).

However, this could lead to a negative feedback cycle by forcing takaful funds, for example, to reach for yield by investing in lower-rated sukuk with higher coupons but also greater risks. This would be the least desirable outcome for the Islamic finance industry because it would raise the risk to the takaful funds and also could lead to poorer-quality issuers flocking to sukuk markets to satiate the demand of fund managers for whatever sukuk are available, as long as they pay a good coupon.

Political Sensitivities There are few things that raise political tensions in the West (and especially the U.S.) than oil-rich countries in the Middle East buying "strategic assets" in domestic markets. The only thing that surpasses the level of paranoia that accompanies deals like the proposed Dubai Ports World acquisition of P&O Ports (which operated a few ports in the U.S.) is if it is done using something that has an "Islamic" label on it.

The most difficult logistical problem for any Islamic SWF of any size to deal with would be the hysterical reaction if it were to take a significant--even a non-controlling--interest in a Western company of any strategic interest. This would reduce the investment opportunities of an Islamic SWF greatly and make the SWF itself have to shift its own focus away from one of the stated goals of SWFs: finding the best commercial deals to invest in. Instead the Islamic SWF would be forced to look inward to its member countries for investment opportunities.

 This outcome would not be a bad thing on its face, but it would create significant institutional overlap with the Islamic Development Bank's Private Sector Development organization. This could also lead to competition over scarce large, quality investment opportunities which could create a bubble in one sector or country that would inevitably lead to an economic crash. This would be the worst case scenario for the Islamic SWF which was initially established to create stability creating economic volatility. If the political concerns within the Islamic SWFs member countries about its allocation of its resources didn't destroy an Islamic SWF, an economic crash that could be blamed (even if unjustly) on the Islamic SWF would do even greater great harm.

I don't think that an Islamic SWF is necessarily a bad idea and the title of Rusdhi Siddiqui's article, "Islamic sovereign wealth fund over mega bank?" may suggest that he had a different idea by suggesting it. However, there are always challenges when large proposals are put forward and column lengths give him significantly less flexibility in addressing the potential challenges than I have in my (no word limit) blog. The point of this post is not to shoot down the idea of an Islamic SWF, but to focus on some of the areas where I think it would have significant difficulties.

I don't think any of the potential problems are insurmountable and with the flood of sukuk from GCC being issued in Malaysia so far this year (and at the end of last year), there are clearly not enough long-term investors in Islamic finance to move beyond the day's newsflow to step in and buy when others are fearful (to paraphrase Warren Buffett). Perhaps an Islamic SWF with global representation could change that. Perhaps it could also do what I think was Rushdi's motivation: find a way to move Islamic finance from an industry that seems focused more on a product-by-product offering too busy to get to the boring areas of finance like asset management which create a more stable industry for the long run.

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