SPECIAL COMMENT: Does Islamic Finance have A.I.R. (Authenticity, Innovation & Reach)?

At the Joint High Level Conference on Islamic Finance in Jakarta, Indonesia, co- organized by Bank Negara Malaysia and Bank Indonesia, the question I wanted to address was:

Does Islamic Finance have A.I.R. (Authenticity, Innovation & Reach) or is it just hot air?

The question establishes the foundation for the follow-up question: How will Islamic finance contribute to financing a knowledge based economy in, say, Malaysia? Today, there is bias towards commodity Murabaha, real estate financing, all sort of retail consumer Islamic loans (Islamically overleveraged?), small paid it capital for banks and even smaller for Takaful operators, minimal reTakakful, Sukuk supply constraint and short/medium term tenors, etc!

My discussion was broken down to six parts: present situation on capital markets in Muslim countries; establishing country linkages with growth stories; de-linking from conventional finance; convergence of the $1T industry to its sister $640B Halal industry; building out the Islamic equity capital market, and, finally, has time arrived for an Islamic sovereign wealth fund (SWF)?

In Muslim countries, even those with stock exchanges, a debt culture has been the order of the day, but the need of the hour is a better balance in the development of the equity capital market. Banks and their customers are risk averse, hence, the bond and equity markets are, at one level, held ‘hostage’ to the continued pushing of loans by banks, Islamic and conventional. Banks finance what they know, real estate, and investors are short term oriented in cash (deposits), capital protected funds, and HNW focus is on wealth preservation and not creation due to confidence crisis and losses linked to credit and EU sovereign crisis combined with Arab spring.

De-Linking

For Islamic finance to achieve authenticity, it must de-link slowly from conventional finance. Our Islamic economists have been preaching the Islamic economy with its own currency for decades, but we need more applied research and less academic research.

QUERY: What country has followed the advice of Islamic economists to ‘Islamisize’ their economies, all or parts? Not Pakistan, not Iran, and not Sudan.

The first delink is from oil, as it will eventually run out or a viable alternative will be found. Islamic finance, generally, and Sukuk, specifically, rose as a global phenomenon on the backs oil prices, however, Malaysia is the sole exception. As the wait continues for delink from oil, we have examples of the delinking process commenced more than a decade ago with the launch of Dow Jones Islamic Market Index (1999), DJ Islamic Sustainability Index (2006), DJ-CitiGroup Sukuk Index (2006), and the SAMI Halal Food Index (2011).

These are performance benchmarks, and now we need to tackle the conventional pricing benchmark, LIBOR, that is referenced in Islamic financing contracts. It should be noted, performance benchmarks marks do not work for pricing ‘credit,’ hence, research based Islamic finance institutions (not to be named) will cause more damage to credibility of Islamic finance if they pursue, without understanding, the difference between the benchmark parameters.

Bottom-line, Islamic pricing benchmark is possible, but the industry will have to start with Murabaha contributions (viewed as Shariah screened companies or Islamic windows/subs) before migrating to wakala based contributions (viewed as Shariah based companies or dedicated Islamic banks).

Linkage

Much like BRIC (Brazil, Russia, India and China) linkage, Muslim countries also need to have a meaningful Muslim BRIC, well, its now called BRICS (S is for South Africa). The linkage must be linking growth stories that present investment and trade opportunities for conventional, Islamic finance and Halal industry. To date, Muslim linkages includes GCC, MENA, CIS, and OIC and they have not captured the imagination of BRICS as the former are too large grouping, not interesting to investors and has continued capital flight and brain drain, minimal growth, and/or politically charged places.

The acronym SAMI stands for Saudi Arabia, Ankara (Turkey), Malaysia and Indonesia. Here we have some interesting insights on these pre-RDEs (rapidly developing economies) that are anchors in their respective regions:

1. Three of the four are G20 countries (Saudi, Turkey and Indonesia)

2. One is the largest oil producer and largest importer of Halal foods (Saudi)

3. One is the global recognized hub for Islamic finance (Malaysia)

4. One is the gateway to CIS, EU and GCC and has been become a political power broker during the Arab Spring (Turkey)

5. One has the largest population of Muslims (Indonesia)

The SAMI countries present a clear and present opportunity to build a foundation that should be free from the politics and led by the private sector, much like the BRICS story.

Convergence

Islamic finance has been talking about convergence, be it between regions (GCC and Malaysia), standards, etc., and the parties are still sipping (now ice) tea and talking. The convergence concept must be expanded to include the Halal food sector, but Halal as an asset class and not the type of lunch Islamic bankers have. As this is food related, its presents food security issues that need to be addressed.

Islamic finance is $1T and halal is $640B, and it makes sense to start common based discussion, especially with the recent launch of the SAMI Halal food indexes in Malaysia. Obviously, halal food funds, like Shariah compliant equity funds, can be launched off of the SAMI Food Index, and the publicly listed halal companies, more than 200 with market capitalization of nearly US$15B, presents a demand based, non-cyclical economic sector play.

Its an easier sell, when the ‘man on street’ is already a consumer investor of the halal food company’s products, and now make them into a stock market investor of same company, but now with possible investment returns. In the emerging markets, its much easier to sell an investment when the consumer is already a user of the company’s product. For example, GCC based investors and real estate.

Obviously, the halal story can be scaled up to include Sukuk for balance sheet recapitalization, factory financing, trade finance, acquisitions, and so on.

Islamic ECM

The initial rise of Islamic debt capital market (DCM), over equity capital markets, is not unexpected as Muslim countries have had a debt based culture. But, one can also be Islamically over-leveraged and incur similar consequences as the conventionally heavily indebted, default and bankruptcy, where cash flows cannot support interest/profit rate payments. For example, Islamic institutions like The Investment Dar, known for its investment in Aston Martin, defaulted on their Sukuk obligations.

Shariah screened companies by index providers, like Thomson Reuters or MSCI, produce a bias towards (non-Muslim) G-20 countries and emphasize economic sectors not commonly found (with any depth) in Muslim countries like technology, energy and healthcare. These sectors are an important contributor to a knowledge based economy, but that’s a presentation article for another day.

Screen Shariah compliant companies are much like compliant product offerings of an Islamic window or subsidiary of conventional banks. But, the eventual objective is to move towards Shariah based publicly listed companies and dedicated Islamic banks to avoid leakage, promote inward investments in Muslim countries, and establish pulse of the health of Islamic finance at a country, regional and global level.

For example, Bank Islam and Al Rajhi may tell a better story of lslamic finance than compliant companies like Pfizer or Microsoft or even a conventional bank holding company with an Islamic subsidiary. Thus, Qatar’s central bank decree, mandating that Islamic windows/subs be closed by end of the year, may be an insight that deserves attention and careful monitoring.

Islamic SWF

An Islamic sovereign wealth fund (SWF) may well provide more impact to Islamic investing than an Islamic mega bank to Islamic financing. An Islamic SWF will build out the Islamic asset classes, hence, contributing to compliant investing and eventually Islamic ECM.

The $560B Norway SWF, the model fund for transparency, had nine out of the top ten companies as Shariah compliant without any intentions towards Shariah compliance (Sept 2010). Thus, for those critics that have bitterly complained that SWFs need not consider the restricted universe of shariah compliant investing, it may be time to revisit comments not well supported by data.

An Islamic mega bank, with paid up capital $1B-$5B, may well better compete with Islamic subsidiaries of HSBC and Citi for deal flow. But, it may still have real estate concentration risk, short term liquidity risk, counter-party credit and liquidity risk, etc.

May be a better question could be: should deposit taking Islamic banks undergo a customized stress test before a license for an Islamic mega bank is given by the central bank? An untested Islamic mega bank may provide systemic risk to an embryonic industry during external liquidity and confidence events?

In conclusion, Islamic finance must delink from oil and the conventional finance gradually. The Muslim countries need a champion linkage story, and convergence with Halal may be the lower hanging fruit that starts off inward investing and builds out the Islamic equity capital market culminating in an Islamic SWF.

But, Islamic finance must also become conventionally efficient to be deemed authentic and innovative, and reach will come naturally.

So, Islamic finance needs to be about AIR, otherwise hot air allegations may rise!