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.

Conclusion
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.

Incorporating Islamic finance into a sovereign wealth fund

FT Tilt, an emerging markets blog (one I recommend), has a article about the Qatar sovereign wealth fund and the more aggressive posture it has taken compared with the Abu Dhabi Investment Authority. The article compares the track of the Qatar Investment Authority with that of the Dubai World private equity subsidiary Istithmar and quotes another blog:

"They did not want to own 20 million shares of Costco, they wanted to own Barneys. They didn't want to own six dozen holiday inns in the Midwest [US], they wanted to own the W Union Square in New York. They didn't want to own 3% of Federated Investors they wanted to own Perella Weinberg and GLG. For the powers that be in Dubai making levered investments into high profile companies was part of building 'Brand Dubai.'"

As they note, the Qatar Investment Authority has not taken nearly as aggressive an approach as the brand-driven Dubai fund, but if the global economy continues to recover, it may be tempted to take a similar approach (although probably with less leverage than Istithmar given the "New Normal").

An alternative "brand-driven" approach for the sovereign wealth fund would be one based (at least in part) on Islamic finance. While it is relatively small ($60 to $80 billion) compared to Abu Dhabi's sovereign wealth fund, it is still large enough to be selective in its investment decisions to avoid the types of investments that brought Dubai World to the brink of default. In the process, it could use its clout to force the investment banks bringing deals to strip out extra costs normally associated with Islamic financial products.

This would add value not only to the Qatar Investment Authority but also to the industry as a whole. While doing so, it should avoid the pitfalls of capturing "landmarks" but instead creating opportunities for others. For example, instead of subscribing to sukuk on its own, it could focus on taking a 'lead investor' position in sukuk from GCC companies as well as global companies interested in 'jumping the gap' into Islamic finance. More helpful (both to QIA in the long run and other investors), it could adopt the approach of creating liquidity in secondary markets by selling a portion of its allocation in secondary markets in sukuk with significant investor demand.

This would have the advantage of capturing some gains in sukuk that see high investor demand but would also spur secondary market development in sukuk generally (and free up capital to buy in other secondary market issues). More liquid secondary markets benefits sovereign wealth funds not only in assessing market values for sukuk they already hold, but also by providing opportunities to diversify their holdings and move between different sukuk. Most bond fund investors already do this with conventional bonds, but it is currently much more difficult to do with sukuk, particularly where investors are looking for larger volume trading opportunities.

In addition to sukuk, a move into Islamic finance could create an opportunity for the QIA to contribute to broader social goals within and outside of Qatar through Islamic microfinance. Many Istithmar investments (like the W Hotel) were "status" purchases. They may have been viewed as solid investments pre-crisis, but the acquisitions were done with secondary motives in mind (building Brand Dubai). If secondary motives are included in the investment decision, shouldn't they do more to contribute than just through the acquisition of landmarks? Qatar have been working in other areas to increase its global profile in arts, culture, media and diplomacy. Blending a poverty reduction strategy into a sovereign wealth fund that incorporates Islamic finance seems like a good way to build credibility for both Qatar and Islamic finance.

Malaysia sovereign sukuk, Dubai World debt settlement, WIEF

Malaysia sovereign sukuk
The basics of the coming Malaysian sovereign sukuk were officially released (although the total size has not been except that it will probably be larger than the $600 million issue in 2002). The proposed sukuk received an initial rating from S&P is A-. The dollar-denominated global sukuk, issued by the government's SPV 1Malaysia Sukuk Global Bhd, will be a 5-year ijara sukuk will involve the sale and leaseback of 12 hospitals according to the CEO of HSBC Amanah, Mukhtar Hussain. The government is meeting with prospective investors and will do so until May 27th and order-taking will begin a few days later.

One of the reasons for the issue, and the primary importance of the issue for Islamic finance, is that there are few sukuk issued (only one other by Malaysia) and they provide an important benchmark for corporate issuers. The five-year maturity is short, but it is in line with the most common maturity of sukuk, so near term it will be relevant to create a pricing benchmark for short-term sukuk. However, it does not establish a sovereign benchmark for longer-term sukuk, which would have been noteworthy. However, with the European debt crisis in full swing with the yield premium for new issues (e.g. Spain today) rising, the fact that the sukuk is likely to be issued blunts some criticism of its 5-year tenor. If Malaysia wanted to continue to help the global Islamic finance industry, it should follow this 5-year sukuk with a 10- or 15-year sukuk to establish a pricing benchmark.

One concern remaining is that the sukuk will be issued in a time of rising yields among sovereign borrowers as a result of the European debt crisis and this could establish a benchmark yield higher than what might have been received six months ago or six months from now. Therefore, the Malaysian government should make an effort to ensure that this sukuk is tradable in a liquid market (Malaysian sukuk secondary markets are less liquid than conventional bond markets but more liquid than most sukuk secondary markets). That would allow secondary market activity to price the changes in a 5-year sukuk sovereign yield that would provide more transparency for pricing future corporate issuers.

Dubai World agreement
The Dubai World debt agreement surrounding $24 billion in debt has been reached in principle. The FT Alphaville blog posts the entire press release with the table describing the terms. The repayment will total $14.4 billion ($0.60 on the dollar), split into two tranches. Each tranche will be allocated pro rata to the debt claims. Tranche A will have a five-year maturity at 1% interest. Tranche B will have three options, the first two will be available for holders of USD denominated debt, while the third will be available for holders of AED denominated debt. Tranche B will have a longer maturity with shortfall guarantee for 1/2 of the $10 billion size. The interest rate will again be 1% except for AED-denominated debts when the 1% will have EIBOR-LIBOR up to 1% added in.

While it is not clear whether the debt covered will include Shari'ah-compliant debt, it does puts some firm numbers on the outcome for these lenders compared with holders of the 2010 and 2011 Nakheel sukuk, who have or will receive full repayment of all principal plus profit. Last weekend, I addressed my concern that this differential treatment could negatively affect the ability and willingness of conventional issuers to also issue sukuk and the numbers, I think, make this concern even more relevant.

World Islamic Economic Forum

• Speaking at the WIEF, Prince Andrew said that the UK, and London in particular, will continue to build on its status as the largest Western hub for Islamic finance.
  
• The new UK government may reconsider a sukuk if the value-for-money can be demonstrated; that is, will the additional source of demand and encouragement for the Islamic finance work within London offset the additional structuring costs. Assuming tax laws are changed, the UK's first corporate sukuk could be issued this year, according to Humphrey Percey, the CEO of BLME.
  
• The Malaysian central bank, Bank Negara, has established programs to educate other central banks on regulating Islamic finance.
  
• The executive vice chairman of Ithmaar Bank, Khaled Abdulla-Janahi, said that there is need for greater education among Muslims about Islamic finance and says that the history of Islamic finance in the future may regard Gordon Brown, for his work as finance minister of the UK, and Christine Lagarde, the current French finance minister, as the two biggest drivers of growth in the Islamic finance industry.
  
• Five memoranda of agreement worth $125.3 million were signed at the WIEF.
  
• The CEO of Maybank MEACP Pte Ltd, Mumtaz Khan, suggests a G3+3 group to work with the G20 to develop Islamic finance. The parties involved would be the three G20 members with Muslim majorities, Saudi Arabia, Indonesia and Turkey, in addition to Malaysia, the World Islamic Economic Forum and the Islamic Development Bank.
  

Other News

• Rushdi Siddiqui continues his excellent line of articles in Gulf News with one on the need for a global Islamic sovereign wealth fund.
  
• The head of the DFSA warns that forcing Islamic financial institutions to operate under the same regulatory rules as conventional financial institutions could hurt its growth prospects.
  
• The governor of the Reserve Bank of India says that Islamic banking cannot be licenses under current regulation, but it is still exploring whether Shari'ah-compliant non-banking financial institutions are possible.
  
• Qatar Islamic Bank is planning to sell as much as $750 million in its first sukuk issuance. The sales of sukuk so far have risen year on year at the fastest rate since 2007 (albeit from a low base) as yields have fallen more than emerging market debt.
  
• Lipper Research describes the performance of Islamic equity funds by investment area and geographical concentration. 45% of all funds are in Southeast Asia while 59% of total assets in Islamic funds are in the GCC.
  
• Dubai Islamic Bank has launched a new unsecured consumer lending product based on a salam contract with the commodity used being sugar. As I understand it, the bank would provide financing and the customer would be obligated to deliver a given amount of sugar (incorporating a markup) at the maturity. The transaction involves a sugar wholesaler that collects partial payments from the customer and at maturity will deliver the sugar to DIB.
  
• The Commercial Real Estate Sukuk (Kuwait) for $100 million was paid on its maturity date.
  
• Ireland hopes to attract Islamic financial institutions and Islamic funds to the International Services Centre in the country.
  
• The president of CIMA writes in an opinion article in The Australian newspaper that Islamic finance has significant growth potential but is still hampered by a lack of people skilled in understanding the requirements for Islamic financial products.
  

The New Normal in Dubai, Fallout from the Standstill Agreement

The recent news that Dubai World has asked for a standstill agreement with its debtholders, including the holders of the Nakheel sukuk which matures on December 14th, is undoubtedly bad news for those issuers. However, it is not necessarily the end of the world for the Dubai, Inc. entities or for their sukuk. The announcement about the standstill agreement has not yet been fully described, so it is unclear whether it will constitute a technical default on the debt of the Nakheel sukuk.

It has been clear for quite a while that Dubai's government related entities (GREs) like Nakheel have had more debt than they will be able to service out of the revenue they can generate with property prices down more than 50% since their peak. The Dubai World companies are legally distinct from the government of Dubai, one of the seven Emirates within the UAE. This has led to considerable uncertainty about what the eventual outcome of the debt when it matures. There was optimism in early November when Dubai's Department of Finance repaid the Dubai Civil Aviation Authority sukuk of $1 billion following the issuance of $1.93 billion in sukuk at the end of August.

Optimism was the first reaction a couple days ago when Dubai raised an additional $5 billion in debt from two government-owned banks, National Bank of Abu Dhabi and Al Hilal Islamic bank, in Abu Dhabi. The optimism soon turned to pessimism after Dubai World, the ultimate guarantor of the sukuk, said they would need a 6 month standstill agreement from creditors, including the Nakheel sukuk. The result was a fall in the price of Nakheel's sukuk (story includes graphic of the price chart for the sukuk) from 110 prior to the announcement to close to 50. At the same time, the credit default swaps on Dubai's debt (the cost of insurance) rose from around 300 basis points to 541.2 basis points on Friday. ThomsonReuters had a chart showing the increase (not including the rise on Friday):


This summary of the latest events seems to confirm the negativity surrounding the Nakheel sukuk and the other debts owed by Dubai World and its related companies. However, it could be the start of a much needed restructuring and a realization that things have changed, the much mentioned "New Normal" (originally coined, I believe, by PIMCO's Mohamed El-Erian).

The new normal for Dubai is a recognition that it cannot continue the breakneck speed of development that it had embarked upon, fuelled in large part by debts like that of Nakheel. It has recognized that the world today is a more risk averse, less leveraged place. In order for Dubai to realign itself within the New Normal will probably include some form of bail-out from its wealthy neighbor of Abu Dhabi, which has far more oil revenue that continues to flow in, as well as the sovereign wealth fund, Abu Dhabi Investment Authority, which has assets estimated at $627 billion.

This will be a profoundly humbling experience for Dubai, which has been able to raise debt on its own and on behalf of the companies located there. However, with a much longer timetable for the development of sufficient resources to repay the bonds and sukuk issued, it may be the best alternative, especially prepared to a straight default by Nakheel or Dubai World. The announcement that a chief restructuring officer has been appointed to work with the Dubai Financial Support Fund which is managing the so-far-raised $15 billion may signal that the Emirate has started on the road to the New Normal. Only time will tell whether a default (which would likely be followed by others) can be avoided.

The turmoil created by the Nakheel sukuk being the first shoe to drop, however, may have spillover effects in the Islamic finance indsutry, particularly the sukuk markets. Until this point in what had been a recovery in the sukuk markets, only high-grade corporate and sovereign issuers had tapped the markets. Dubai's Department of Finance was one of these issuers and it will be telling how the prices of these new issues fares in the market with the developments in the Nakheel sukuk resolution. The spillover will probably be mitigated the better the resolution goes, but there will still be fallout. Investors bid up the Nakheel sukuk from the low 60s earlier to 110 and they have seen the value of these sukuk fall precipitously. This could make investors hesitant in the future to invest in sukuk. We shall see.

Islamic finance could appeal to investors damaged in the credit crisis; new sovereign sukuk

Continued woes in the conventional financial system may make Islamic finance attractive as the industry has not been significantly affected by the credit crisis. A few issuers have delayed sukuk issues, but there have been no writedowns since Islamic financial institutions do not participate in any of the markets for products that were at the center of the credit crisis. Islamic financial institutions had no exposure to toxic products like CDOs and Auction Rate Securities because they do not pass the relatively conservative Shari'ah screens adopted by the industry. The Reuters article linked to did note one way where Islamic finance may be more risky than conventional finance—Shari'ah screens exclude several asset classes, reducing the possibility for diversification. One asset class that is heavily overweighted in the GCC region is real estate. Mohamed Damak at Standard & Poors comments: "A correction of the real estate sector would impact Islamic banks involved in this business line. Islamic finance is not immune from risk"

The Indonesian sukuk could spur greater development in the Indonesian sukuk market. As of July 31, there were 4.18 trillion Indoonesian Rupiah ($488 million) in sukuk outstanding, comprising about 5% of the total corporate debt market. In Malaysia, by contrast, sukuk account for nearly 1/3rd of total outstanding corporate debt.

Islamic finance practitioners in the UK expect the number of Islamic investment banks based there to double to 10 in the next five years as part of the international growth of Islamic finance, growing by an estimated 15 percent per year.

Malaysian bank Hong Leong is the first to receive a license to offer Islamic banking services in Hong Kong. Two other banks, Standard Chartered Bank and Royal Bank of Scotland, announced plans to begin offering Islamic banking through subsidiaries in Malaysia. Standard Chartered has received a license and RBS plans to apply for a license.

RGE Monitor analyst Rachel Ziemba provides an analysis of the recent Moody's report on Islamic finance, particularly relating to the influence of GCC sovereign wealth funds in the Islamic finance industry.

An Israeli lawyer working in London suggests that cooperation between Israelis and Palestinians could be helped if Israeli banks began offering Islamic finance or even a sukuk.