Dubai Crisis Makes its Way to Asia

Malaysian and other Islamic bond issuers could suffer



The revelations of Dubai's monster debt problems have come at an unfortunate time for Malaysia's push to promote itself as both global centre and international mentor in thefield of Islamic finance.

Even if the there is eventually no default on Dubai's sukuk (Islamic bond) issues the image of sukuk as potentially safer than conventional instruments has suffered a blow. Malaysia itself may have little exposure to Dubai, or other over-extended Gulf borrowers, but as the world's leader in sukuk issues it could well see a marked slowdown in what has been a very rapidly expanding business.

The first test will come by December 14 when Nakheel, the property developer arm of state-owned Dubai World, has a big sukuk maturing. Despite a statement Sunday by the United Arab Emirates central bank that it stands behind domestic and foreign banks operating in Dubai, later tests will come if defaults arise and battles begin over how civil courts interpret legal rights under shariah law. There may also be battles if Nakheel or subsequent debtors favor sukuk over conventional bondholders or vice versa. A sukuk is supposed to have an element of risk lacking in secured bonds, but practice is another matter in an industry which is still young.

That is bad luck for a Malaysian industry which can reasonably claim to be bothinnovative and well-organized. Malaysia accounts for roughly 60 percent of total global sukuk issues totalling around US$100 billion. These are roughly divided between ringgit and US dollar issues, mostly by local entities but also by the World Bank and the Islamic Development Bank. Malaysia has been hoping to attract other big-name foreign institutions to its market.

But Dubai is unlikely to represent a permanent setback to Islamic finance, which has been growing in many parts of the world and establishing niches in developed Muslim-minority countries such as the UK.

Since the onset of the global crisis 18 months ago claims that Islamic finance was rooted in the real economy and avoided both derivatives and excessive leverage which devastated the western financial system seemed to be proven by events. At least that was the case until Dubai hit. Even that, so far, has not thus far imperilled any Islamic banks. So long as sukuk holders do not emerge any worse than conventional bond holders from the mess, sukuk's position in global finance should not be badly hurt.

Meanwhile investment funds which do not invest in banking, gambling and alcohol-related stocks have generally outperformed conventional ones since the crisis because of they avoid, among other stocks, conventional banking ones.

Islamic finance has already shown that it can compete on a nearly level playing field with conventional systems in Malaysia and has been able to attract non-Muslim investors. Countries such as Korea and Japan have changed their laws to end some tax disadvantages Islamic products faced because of their focus on profit instead of interest. Thailand also now enables sukuk issues.

Critics claim that the Malaysia sukuk market is being force-fed by the government. Most issues have been, not only by the government but its related enterprises such as national oil company Petronas, government holding company Khazanah Nasional and housing lender Cagamas, and companies with close connections to the government such as Plus and MISC.

Nonetheless, Malaysia can reasonably claim that it has developed a far more extensive range of Islamic products than anywhere else, backed them with a coherent body of regulations and given support both by lawyers and accountants able to operate easily in both Islamic and conventional systems. What began as very basic Islamic banking with only one institution back in the early 1980s has gradually involved to embrace all the significant financial players in Malaysia, even including such obviously non-Islamic ones as HSBC and OCBC, and to gradually grow its range of products to Islamic money market instruments, bonds, insurance (takaful), real estate investment trusts, ETFs and fund management. Now a whole range of big foreign names is present in one aspect or other of the system, the latest being re-insurance.

As of last week, the role of Bank Negara in operating a two-track financial system was officially embodied in new legislation. But in practice Bank Negara has long been responsible for the evolution of shariah-compliant finance by ensuring that first and foremost it was run by people with high levels of financial competence and was complementary to the conventional sector – which still compromises 80 percent of Malaysia's financial industry.

Indeed, the development of Islamic finance in Malaysia owes much to the deep penetration of all financial services throughout Malaysia – the best served of all developing countries according to the World Bank – and the presence of foreign bank and insurance companies willing and able to offer Islamic alongside conventional products.

At the banking and money market level, Bank Negara has emphasised the importance of liquidity management and provided the necessary access for market players to the central bank. Even more important, it has ensured that Malaysia has a single dominant authority on interpretation of shariah law, providing both consistency and security. Elsewhere conflicting interpretations by Muslim scholars about what is and is not acceptable have caused market confusion and continue to create problems for cross-border dealings.

Bank Negara's Shariah Advisory Council offers shariah compliance guidance to all sukuk, IPOs and insurance and other products and monitors them thereafter. Malaysia's civil courts are also bound by the Shariah Advisory Council when ruling on shariah related matters.

With extensive training programs and in-depth research at university levels, Malaysia has gone further than any country in creating a system which is coherent and relevant to today's needs and fits with existing accounting and other standards. Systems in Gulf countries are less developed. As for Saudi Arabia, it simply declares its system to be Islamic even if it hard to tell, say critics, what distinguishes it from conventional and is not exportable. Ditto Iran.

Malaysia's system on the other hand is detailed and it is in English and so more easily transportable to countries, Muslim and otherwise, who feel a need to create local shariah-compliant products.

Although Islamic finance is still only a small part of the system in big Muslim countries such as Turkey, Indonesia and Pakistan it looks set to continue growing both as the pious avoid conventional finance and others see little practical distinction between the two so they may be happy – as are many in Malaysia – to keep a foot in both systems.

If that is the case, Malaysia's mentor role should continue to grow. However, there are also several question marks over the future pace of expansion of Islamic finance, and of Malaysia's ability to capitalise on its expertise.

Firstly, the recent drivers of it – including Malaysia -- have been capital-surplus countries so it has been easy for them to persuade foreigners to create Islamic products which they will buy. Any sustained period of low energy prices will dry up this well, in which case a country like Indonesia, which has raised money through sukuks, will be looking more to countries like China, Korea or Europe for funds.
Secondly, non-Muslim financial centers such as Singapore and London, are developing their own Islamic products and international traders may ultimately prefer to do all their trading, Islamic and conventional, in one place, which is unlikely to be Kuala Lumpur.

Thirdly, it has yet to be shown that Islamic finance has much appeal in low-income Islamic countries such as Bangladesh – which pioneered conventional micro finance. It is barely known in Muslim Africa. India, with the world's second largest Muslim population, has refused to accommodate it. Though Indians t

Few Muslim majority countries are as keen as Malaysia on using the state to promote Islamic systems or have a centralised system of Islamic authority to impose a single set of rules compatible with the secular functions of government. Many Muslim countries, particularly in Africa and central Asia, take a relaxed attitude drinking alcohol, sexual matters and other activities which deviate from stricter interpretations of the Koran and so may be unenthusiastic about bringing piety and Islamic principles into banking.

Fourthly, many including Muslims find the Islamic finance business hypocritical. Most shariah products are, these critics claim, conventional products dressed up in Islamic clothing but in practice no different from interest-bearing and other conventional ones. Thus though they may be competitive, they are also unnecessary. In practice few Muslims actually refuse conventional banking interest, or decline to benefit indirectly from government spending financed by the profits of forbidden activities – gambling, alcohol etc. As a result, according to this argument Islamic finance will remain no more than a niche product for the pious in some countries while in other it is a fad which will fade.

On the negative side for Malaysia must also be reckoned the possibility that official promotion of Islamic finance is not well-received by many of the non-Muslim 40 percent of the population. They may buy some of the products but do not see why they should seem to be favored as are other aspects of Islam in Malaysia.
There is also scant evidence that sukuk have attracted capital to Malaysia. Although some foreign money has come into sukuk and other issues, it is small compared with the capital outflow from which Malaysia suffers. There may be no connection between these outflows and the Islamic agenda, but a current account surplus of 18 percent of gross domestic product in 2008 is evidence of lack of local investment opportunities. So although the progress of Islamic finance brings well-paying jobs and reflects positively badly needed innovation by Malaysians, it may not be a net attractor of capital. Indeed, local access to foreign sukuks may actually induce capital outflows.

But for now at least, Islamic finance is still a growing business. While it grows Malaysia deserves to profit from its many initiatives in expanding its scope and creating a system of rules and governance which complements the conventional one and incorporates liquidity and risk management systems in overall governance of the financial sector. Asia Sentinel by Philip Bowring