Green sukuk and oil exports

Bloomberg has an article about the prospects for a green sukuk coming out of the GCC (with suppport from Australia's National Australia Bank and Abu Dhabi-based Clean Energy Business Council).  One thing I noticed in the article that, while it makes sense if you step back, seems odd at first glance was the statement that: "Building a renewables industry allows more crude to be exported, said Indraj Mangat, a partner at Eversheds LLP". 

The idea that renewable energy development would be promoted in order to export more crude oil sounds contradictory, but it is not necessarily so.  In 2008, 4 of the top 10 countries in terms of carbon emissions per capita were located in the GCC (Qatar [1], UAE [3], Bahrain [5], Kuwait[7]) with Saudi Arabia [13] and Oman [14] not far behind.  Although some destinations for the oil and gas that would otherwise be exported (e.g. US and Canada) are not much better in terms of carbon emissions per capita, many destinations are (e.g. European nations, South Korea, Japan and China). 

The per capita carbon emission might not be the ideal measure (carbon emissions per unit of GDP is probably better, and comes up with slightly different results): Qatar [18], Bahrain [20], Kuwait [25], Saudi Arabia [26], UAE [36], Oman [39].  The real change here is whether the export markets are less carbon intensive than the GCC (which would make the shift away from domestic consumption of oil and gas towards renewable): USA [54], UK[115], Germany [92], France [144], Japan [96], South Korea [58], China [10].  Substituting oil that is sent to China will not reduce the overall carbon footprint because it will be used relatively inefficiently for creating GDP, and there will be marginal savings for oil sent to the US.  However, South Korea, Japan and European countries will convert the carbon emissions from the barrel of oil more effectively in creating GDP and there will be a net carbon savings relative to the GDP that is created. 

TAQA goes east with a sukuk

Abu Dhabi National Energy Company (TAQA) has issued a 10-year ringgit-denominated sukuk, which was met with strong demand, continuing a trend for GCC issuers to look east to Malaysia for capital to diversify funding sources.  In the past, I have suggested that some issuance in ringgit may be an effort to speculate on the direction of the Ringgit versus the US dollar (to which GCC currencies are pegged).  This has been speculation on my part (with the ringgit-dollar exchange rate at the highest point in at least 6 years, a fall in the value of the ringgit would reduce their obligations in principal and profit).  However, it appears that TAQA does not have this objective in mind since they swapped the exposure into US dollars at a rate of 5.3% (the ringgit rate on the sukuk was 4.65%).  The 10-year tenor of the sukuk is longer than most of the issuance out of the GCC (where 5 years is favored) so perhaps it was the ability to find demand for longer-dated sukuk (perhaps based on a more liquid secondary market) was the reason for looking to KL. 

Shared Risk & Reward (formerly known as the Sharing Risk Newsletter)

I have been writing the Sharing Risk Newsletter now since May 2010 (and the blog since September 2006).  It has been, and will continue to be, an email newsletter (which you can sign up for on the right hand side of my blog under "Weekly Newsletter"), although I have started to put the archives up on my website, www.sharingrisk.org.  The newsletter was originally created because I received an email from blog readers who wanted a way to receive the blog posts by email (which is now automated; you can also sign up on the right hand side of the blog under "Subscribe via email").  When I started it, I added an additional bit of commentary (an archive of which I am adding to my website). 

Despite having now sent out 87 issues of the newsletter, I have not yet had the time to come up with a name for the newsletter.  The 87th issue changes this.  I'm still working on formatting (please send me suggestions at blake@sharingrisk.org) but I have decided on a title: "Shared Risk & Reward". 

Shared Risk & Reward originated from the name of the blog and website (Sharing Risk), but added Reward because Islamic finance exists to make a profit, and recognizes that making a profit entails taking a risk.  The focus of the newsletter has been, and I hope will continue to be, finding ways where Islamic finance can continue to recognize the intimate connection between risk and reward in finance, and its connection with the underlying economic activity that finance is meant to support.  I also believe that the newsletter and the blog should call out Islamic finance when it emulates Icarus and flies too close to conventional finance's sun, melting the wax that holds its feathers together. 

For those readers who are not already subscribers, I have put the latest version of the newsletter up as a pdf.  I will continue to put up back issues on my website with about a month's lag, but if you want to get the latest updates on developments in Islamic finance you should subscribe to the newsletter.  It will also include the previous week's blog posts if you miss any.  It typically comes out Sunday evening US time, which gives me a little breathing room to take in the previous week's news as well as think more about the previous week's posts to give a refreshing complement to the blog.  And, it's free. 

Can Islamic finance in Indonesia reach 10% by 2020?

There were a few articles about Indonesia (ht Islamic Finance Indonesia) that demonstrate the rapid growth potential for Islamic finance in Indonesia.  The industry remains just a small part of the banking and finance marketplace in the country accounting for just 4% of total assets, but the growth rate has been astronomical (albeit, as is common in Islamic finance, from a small base).  The goal from Bank Indonesia, the central bank, is for Islamic finance to increase in Indonesia to grow to 5% in 2013 and to 10% of total assets by 2020.

While this seems like a remarkable growth rate to sustain (and it would be set back greatly if the country's recent economic success that has led the country to have its sovereign debt upgraded to investment grade), it might be possible.  The Islamic finance industry has become much more institutionalized and there are many more global heavyweights eying the Indonesian market (such as Al Rajhi Bank in Saudi Arabia and Standard Chartered Saadiq Islamic window), in addition to the interest from across the Strait of Malacca.

To get an idea of the required growth rates to hit these targets, I made a few very simplistic calculations, based on the historical growth rates in Islamic banking in Indonesia (36% per year 2005-2010 and 49% last year), as well as expectations for near-double digit growth rates for banking overall in Indonesia (according to a survey conducted by PwC [pdf]).  My assumptions used 25% growth 2011-2014 for Islamic banking, slowing to 18% for 2015-2020, with growth rates for banking overall in the country of between 8-10% annually for the entire period of 2011-2020.  Here's the evolution of the Islamic banking assets in the country under those (relatively unscientific, though probably lower for the next couple of years than Bank Indonesia's projections) assumptions:

Year	Low Estimate	High Estimate	Size ($bn)
2011	4.0%	4.0%	$16.1
2012	4.5%	4.6%	$20.1
2013	5.2%	5.4%	$25.2
2014	5.9%	6.2%	$31.5
2015	6.3%	6.8%	$37.1
2016	6.8%	7.4%	$43.8
2017	7.2%	8.1%	$51.7
2018	7.8%	8.8%	$61.0
2019	8.3%	9.7%	$71.9
2020	8.3%	10.6%	$84.9

While it is a bit presumptuous to project so far into the future on such flimsy evidence (I basically took the historical growth rate and subtracted 10% for the next few years and cut it in half for the out years).  However, consider the projected size of Islamic banking assets in 2020 against the size of the entire banking sector today (est. at ~$400 billion, if the 4% number is correct): it would be about 21% (which happens to be the share of Islamic bank assets in Malaysia).  That being said, while I don't have confidence in my numbers being at all accurate in predicting the future growth, I think the exercise points out the reasonableness of Bank Indonesia's targets, even if growth slows quite measurably in the next 8 years (and even total bank assets continue to grow rapidly). 

One area where growth has been slow, at least in the non-sovereign space, is sukuk issuance.  The sovereign sukuk could be boosted by plans from the government to use project-based sukuk to finance at least one of its development and infrastructure projects under its long-term economic development masterplan [pdf].

These articles further confirm my idea that Indonesia will be one of the primary growth areas in Islamic finance, something I mentioned in my newsletter at the beginning of 2012.   On a related note, I am starting to put up the back issues of my newsletter on my website.  It might take me a while to get them all up, but so far, I've put up the last 3 months of newsletters. It is still better to subscribe, which you can do on the right hand side of the blog, since going forward, there will be about a month lag in the newsletters up on my website.

Should conventional banks be prohibited from issuing sukuk?

There are two developments in Islamic finance that motivate this post.  First, as I discussed on the blog (and in greater depth in my newsletter, which you can sign up for on the right side of the blog), the Qatar Central Bank's directive requiring conventional banks with Islamic windows went into effect, with the added stipulation that conventional banks are prohibited from investing in sukuk in the country.  Secondly, the controversy around Goldman Sachs' sukuk program has led to questions about whether sukuk issuance by conventional banks leads to the financing of non-Shari'ah-compliant activities. 

A recent article quotes Badlisyah Abdul Ghani, the chief executive of CIMB Islamic, a large Malaysian Islamic bank (an Islamic window at CIMB Bank), who said: "A conventional bank, with the exception of multilateral development banks like the World Bank and the Asian Development Bank, should not be allowed to issue sukuk".  I have heard from other people in the industry, contrary explanations that the issuer's activities are not relevant for whether they can issue a sukuk, because investors are not investing in the equity of the company, and therefore they are not generating income from non-Shari'ah-compliant activities.  While I accept the premise of the latter argument, I find it a bit too cynical to be convincing to many people not involved in the day-to-day activities of the industry.

But, back to Mr. Ghani's comments, I think that limiting issuance to Islamic banks and other companies (would a company be allowed to issue sukuk if one of its subsidiaries provided conventional financial services) is counterproductive because it limits the potential for growth of the industry.  However, that is not the only consideration.  The main point of contention with the Goldman sukuk was that there was no separation between the proceeds from the sukuk and the rest of the bank, nor were there specific assets which would be financed by the sukuk proceeds.  Had there been a building that was owned by Goldman sold to an SPV and an ijara sukuk were issued (assuming Goldman has buildings it owns that house other businesses that are not conventional banking), there would probably be little in the way of criticism. 

However, this comparison raises another issue: how can it be Shari'ah-compliant to finance a conventional bank by buying one of it's buildings and renting that building back and not by selling a commodity to the bank, with repayment of principal plus profit deferred?  There is merit to this question because money is fungible (i.e. once the proceeds from the sukuk go into the company, they become indistinguishable from the other money held by the company).  However, the whole way that Islamic finance has developed--right or wrong--is by separating investor's money from non-Shari'ah-compliant activities (using an SPV, for example).  The criticism that Islamic finance is just adding layers (with added cost) is a criticism of the industry (for example, from Mahmoud El-Gamal).

The discussion at this point does not have a clean conclusion that I can point to and say X is ok, but Y is not.  It is, instead, a starting point for further discussion about what Islamic finance is meant to achieve and whether the idea of strict literalism in viewing the construction of sukuk and other Islamic finance products.  I think strict literalism is not useful, because it allows people to rely entirely on the form of a product and removes any grounds for intent to be considered by Shari'ah scholars (which, it has been pointed out widely, is an important consideration in terms of whether a product is Shari'ah-compliant or not).  Hopefully now, we can get beyond the mechanical arguments about whether a product like Goldman's sukuk is Shari'ah-compliant or not and look deeper into how Islamic finance should be developed. 

IMF report provides data on the impact of ending Islamic windows in Qatar

The IMF's recent Article IV report on Qatar (pdf) has an interesting discussion of the effect of the Qatart Central Bank decision to require conventional banks with Islamic windows to close these windows by the end of 2011.  As a beginning point, they discuss the share of total assets held by Islamic banks in Qatar, which for some reason is an uncommonly reported statistic.  In Qatar, 31% of bank assets were held in Islamic banks or windows as of the end of 2010 (i.e. right before the QCB directive).  The assets are further broken down, with conventional banks holding 12% of their assets coming from their Islamic windows.  Standalone Islamic banks accounted for 21% of total banking assets in the country. Before getting into the QCB directive, just a few more numbers about the market for Islamic banking (as of the end of 2010). 

• Islamic windows assets (% of total banking assets): QR54.7 billion (9.6%)
• Islamic bank assets (% of the total banking assets):  QR119.3 billion (21.0%) 
• Largest Islamic window (all other windows):Qatar National Bank, QR30.2 billion (QR24.5 billion)
• Largest Islamic bank (all other Islamic banks): Qatar Islamic Bank, QR51.8 billion (QR67.5 billion)
  [QR3.64 = $1]

The Islamic banking system in Qatar is relatively large, with more than 30% of total assets, higher than the roughly 21% of total assets in Malaysia, which has been viewed as having expanded the Islamic banking system.  Also, compared to markets like the UAE that are viewed as being "over-banked", the Qatari Islamic banking system is quite concentrated, especially the Islamic windows.  The Islamic banking market is relatively more competitive, though the market is dominated by 3 banks: QIB, Masraf al-Rayan and Qatar International Islamic Bank. 

The decision by the QCB to end Islamic windows for conventional banks (and also, it sounds like, prohibit them from investing in sukuk) was initially expected to boost Islamic banks at the expense of conventional banks, something which has not yet happened, according to the IMF.  IT would seem natural that Islamic banks would benefit from an inflow of assets, though only one conventional bank (the International Bank of Qatar) has sold off its conventional portfolio.  The remainder have held their assets and liabilities and allowed each to shrink through natural attrition. 

This was probably not what the QCB intended, but they also did not provide much incentive for the Islamic windows to transition away from the conventional banks. The process of segregating the Islamic and conventional assets could have been accomplished differently (and better, in my opinion) had they allowed conventional banks to spin the Islamic windows off as independent subsidiaries that would be required to apply for a separate Islamic banking license.  They would remain wholly-owned by the conventional banks, but have their capital, management, board oversight and assets segregated from the conventional side (which I thought was the intent). 

It would also facilitate the maximization of value for the conventional banks in exchange for losing a significant part of their business.  Instead of selling a portfolio in run-off, they would be selling operational subsidiaries, for which they could demand a premium to what actually happened.  While I understand some of the reasons for the move by the QCB, the way it was accomplished (and the suddenness of the decision) seems like a poorly thought out move to bolster Islamic banks.  The questions the IMF raises (how to address a mismatch between assets and liabilities as Islamic windows are wound down, managing the transition to an Islamic banking oligopoly, etc). 

There are a few more points from the report that interest me that I may hit on in my newsletter (pushed back to today by the long weekend).  Sign up on the left right side of the blog.

GACA sukuk is repo-eligible and has a zero risk weighting

It sounds like the GACA sukuk (issued by the Saudi aviation authority and backed by the government) could indeed spark a more liquid sukuk secondary market in the country with the sukuk being able to be used in repo transactions (unclear whether these would be Shari'ah-compliant repo transactions or repos by conventional banks using the sovereign sukuk as collateral). 

However, the zero percent risk weighting (from the Saudi Arabian Monetary Authority (SAMA)) could lead many financial institutions to hold onto the sukuk to maturity, or to not necessarily trade it actively.  However, I think that the size of the sukuk ($4 billion) should give the hold-to-maturity investors enough supply while leaving enough available for investors to buy and sell when they want to sell or buy corporate sukuk, giving the prospects for the Tadawul (where I would expect it to be listed) to become a much more liquid sukuk secondary market. 

As I have written earlier, I am not usually impressed by the "biggest" or "first" qualifier for sukuk, but I think this one ("it is also billed as the largest sovereign guaranteed issuance in emerging markets in the last ten years" and is also the first Saudi sovereign sukuk) is different because it could lead to follow-on offerings from other agencies in the Saudi government, as well as by corporate issuers who might be drawn in if the secondary market becomes sufficiently liquid to provide a reliable benchmark. 

When Islamic finance less fair than conventional finance

One of the things that Islamic finance touts when comparing it to conventional finance is an emphasis on fairness, yet the industry's practices do not always lead to outcomes that most people would consider fair.  One example is when the buyer in a murabaha defaults and the payment schedule for the principal plus profit is spread over a number of years.  An article describes how two brothers in Malaysia received RM200,000 in financing from an Islamic bank with repayment spread over 30 years.  After a year, they defaulted on the financing, and the bank claims that they owed RM642,263, amounting to the principal plus profit over the entire 30 year financing period. 

The reason that this could occur is that the property is being purchased and resold with a profit to the customer, with deferred repayment spread over 30 years.  The profit is determined so that the bank makes a similar profit as it would be paid in interest.  However, since the transaction is a sale with only the payments deferred and not a loan with interest, the customers have agreed to buy the asset for the full amount (principal plus profit).  When they default, the bank would say "you agreed to buy this from us for the full amount, even though we agreed to let you make monthly payments over a 30 year period.  Since you have defaulted, you owe us the difference between the purchase price and the amount you paid us."

While the structure of the contract most likely supports the bank's view (I am just guessing, I have not seen the contract), it puts the customer of the bank in a decidedly worse situation than if they had taken a conventional loan from a bank.  In a conventional loan, they would owe the bank the principal (less any amortized principal) plus the accrued interest for the time since they took the loan (less the portion of their payments that went to pay interest).  With the borrower defaulting a few years into a 30-year loan, they would owe far less than they do in a murabaha (probably a bai bithamin ajil, since it was in Malaysia where BBA is permitted). 

This issue has been heard in Malaysian courts before when a lower court ruled that BIMB could not force a customer in default to pay the entire amount of the purchase price (including future profit payments).  However, this decision was overturned by a Court of Appeal decision.

There are probably good reasons why the bank cannot specify in the contract that they will agree to waive the future profit payments in the case of a default, but it does end up making Islamic look unfair to customers who default (compared with conventional banks), which is in contrast to the principles at the root of Islamic finance of fairness and compassion towards people who cannot pay their debts.   This should be an issue at the forefront of Shari'ah scholars minds because this contract is used widely in Malaysia, and similar murabaha contracts are used in other countries where BBA is not permissible. 

Unintended consequences in Qatar

When the Qatar Central Bank announced that Islamic windows would have to be closed by the end of 2011, the initial reaction in the markets was that it represented a positive for Islamic banks and a negative for conventional banks with Islamic windows.  Recently HSBC, which had an Islamic window through its HSBC Amanah operations, announced that it had converted its Islamic branches to conventional branches with customers given the choice of converting their accounts or closing them.

While many of the customers of HSBC Amanah likely closed their accounts and moved to an Islamic bank, there are likely some who didn't want to go through the trouble and converted to conventional bank accounts.  When an industry like Islamic finance is trying to attract customers--particularly those who consider price and quality when deciding whether to bank with an Islamic bank or a conventional one--pushing some back to conventional banking is probably not the best strategy.  Perhaps this will turn out to be one of the unintended consequences of the Qatar Central Bank's decision. 

Can the GACA sukuk spur a liquid secondary market or will it be held to maturity?

Moody's came out with a few comments on the GACA (Saudi Aviation Authority) sukuk, which is the first sovereign sukuk out of Saudi Arabia.  Moody's describes the sukuk as being a credit positive for Islamic banks in the Kingdom, as well as providing a pricing benchmark for banks and other issuers of sukuk. 

While the issuance of sovereign sukuk is definitely a positive around, if the banks take up the bulk of the issuance, it could hamper the benefit for secondary markets on Tadawul that a large, liquid sukuk would provide because many of the banks would hold the sukuk to maturity.  Some won't hold to maturity (and the 10-year maturity might help ensure that a greater portion eventually decide to sell), and there will hopefully be enough supply (SAR 15 billion or $4 billion) for investors who want to trade the sukuk. 

The development of a pricing benchmark is also a positive if it increases the supply of sukuk.  However, it will help more if the secondary market for the GACA sukuk is liquid because it will make the pricing benchmark more liquid.  It is especially notable that the GACA sukuk is 10-years, and not the more common tenor of 5 years because it will provide a pricing benchmark for longer-tenor sukuk, which have been relatively scarce in the GCC (10-year and longer are more common in Malaysia).

Do Islamic financial institutions care about Islamic microfinance?

The CGAP microfinance blog highlights the lack of progress in developing laws to facilitate microfinance since the Arab Spring. One point the post makes is that "The irony in all this is that only in Syria and Yemen, two countries still heavily affected by the uprisings, did the governments sanction savings mobilization by MFIs meeting minimum standards." 

It is interesting to me that in both these countries where microfinance was sanctioned by the governments there have been Islamic microfinance institutions, in Jabal al-Hoss in Syria and Hodeidah in Yemen.  There is still much to do in both countries, and in both countries there are more pressing needs with the departure of Ali Abdallah Saleh from Yemen and the continued fighting in Syria against Bashar al-Assad. 

However, despite the continued unrest in both countries, there have been examples of demand for Islamic microfinance which suggests that there is probably demand in other countries where the Arab Spring has run its course.  These countries should move forward on both conventional and Islamic microfinance development as a top priority.  Some may point out that there are more weighty concerns in the forefront today, but I would argue that the development of programs to provide economic opportunities should be at the forefront because the Arab Spring largely arose out of one man, Mohammed Bouazizi, very publicly died after setting himself on fire due to having his livelihood snuffed out by the police when they confiscated his fruit crates and electronic scale. 

It is fair to question whether Islamic microfinance is well developed enough to be moved to the top of the agenda alongside conventional microfinance.  However, with so many resources being devoted to developing the (macro) Islamic finance industry, there should be an equivalent commitment to developing Islamic microfinance.  Today, two of the biggest Islamic microfinance programs are being facilitated with funding for technical support from the US international aid agency USAID in Afghanistan and Iraq.  Where are the Islamic finance institutions who claim to embrace corporate social responsibility, ethical finance and a concern for the poor in laying the groundwork for Islamic microfinance to develop across the MENA region after the Arab Spring?