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ISLAMIC FINANCE FINANCIAL TIMES SPECIAL REPORT | Thursday May 12 2011

www.ft.com/islamic­finance­2011 | twitter.com/ftreports

Inside The US Changes in tax law are being considered Page 3 Asia­Pacific Singapore’s first sharia­compliant Reit stimulates the sector Page 4 Middle East There is a divide between the Gulf and other Arab states Page 5 Construction Sharia­ based funding for landmark projects in London has broken new ground Page 6 Islamic bonds The market shakes off a series of financial setbacks Page 7 Hedge funds The speculative nature of investment tactics has hurt develop­ ment Page 7

Good omens amid turbulence The niche nature of the sector could be seen as a weakness but increasing populations and oil wealth offer the potential for substantial growth. David Oakley reports

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slamic finance has hit another storm. It has already weathered the global financial crisis, the Dubai debt standstill and disputes over what complies with strict religious rules. Now, there is poliitical turbulence in the Middle East and north Africa – among the main centres for this niche and emerging sector. So far, equities and products such as Islamic bonds, or sukuk, are holding up in spite of the instability. There is also continuing demand for financing for infrastructure projects.

On the high street, retail banking continues to grow too, as more Muslims in the Middle East and Asia, the two big markets, switch from conventional financial products to those that comply with their religion and ban the use of interest, or riba, which is outlawed because making money from money is considered sinful. Anzal Mohammed, head of Islamic finance at Allen & Overy, the law firm, says: “The Islamic finance market has been affected by events in the Middle East and Africa, but in spite of this we have seen a return of confidence.”

Razi Fakih, deputy chief executive of HSBC Amanah – the Islamic financial services division of the banking group – adds: “Islamic finance has continued to grow, although in the past six months or so, the sector has been affected. But I am confident that it can shrug off the problems in the Middle East.” It is significant that the Dubai debt standstill in November 2009, which rocked not just Islamic finance but global markets as well, has largely been forgotten by investors. It had the potential to stall the industry, because the success of Dubai in expanding

its service and tourist sectors was linked in many ways to the progress of Islamic finance in the Gulf. Global Islamic finance banking assets have grown to $900bn, according to research by The Banker magazine and Maris Strategies, the research and advisory group. This is a doubling in size since 2006 – impressive given the financial shocks, particularly the global market crisis of 2007 and 2008. Many investors say they have stuck with Islamic finance because it provides a stable Continued on Page 2


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Islamic Finance

Moves are under way to lower barriers

Omens are good in spite of turbulence Continued from Page 1

form of funding. This is thanks to the wealth of regions such as the Middle East, which continues to benefit from surging oil prices and its lack of exposure to the toxic assets that have been the downfall of some big banks. Nonetheless, worries remain. Although bankers say there are many deals in the pipeline for infrastructure projects and building work, some Islamic banks have taken a hit because of their exposure to the property market, which has seen a downturn in many parts of the world. The banks facing the biggest problems are mainly in the Middle East rather than Asia, which has more robust capital markets, partly because investors and bankers there have been determined to avoid repeating the mistakes that led to a crisis in the region in the 1990s. Gulf Finance House, once one of the strongest institutions in the Middle East, has run into problems, while Investment Dar, another stalwart, came up against difficulties on some of its loans. Malaysia, the biggest centre for Islamic finance in Asia, also saw some deals either dropped or delayed because of worries over the global economy. Another big debate centres on the standardisation of products and liquidity management. However, there are signs that regulators and bankers are now more determined to address these issues. For example, an International Islamic Liquidity Management Corporation has been established in Kuala Lumpur. It will issue short-dated debt that can be used by banks and other companies to manage liquidity in a sharia-compliant way. The Bahrain-based Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) and the Islamic Financial Services Board (IFSB) have also been forging plans to boost standardisation and harmonisation of sharia products to make them more attractive to investors. Analysts are mainly agreed that the potential for further growth in the Middle East is great – only a small percentage of Muslims, about 12 per cent of 1.6bn globally, use Islamic finance. The industry might also expand outside its core regions of the Middle East and Asia. London remains the main centre for Islamic finance outside the Muslim world. However, the shelving of plans for a sovereign sukuk, planned by the previous Labour government, has held back the market. Many non-Muslim investors in London see Islamic finance as a way to diversify portfolios, particularly as the financial troubles in the eurozone and the surging oil

The US Changes in tax law are being considered, says Aline van Duyn

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A wave of change: demonstrators in Egypt hold up flags in support of other uprisings in the region Getty

The opening of Islamic windows by conventional banks in Africa highlights another potential area of growth

price suggest to some that the Middle East will continue to see economic growth, in spite of the unrest on the streets of some states. The US has seen little growth, and in France the market has stalled over issues such as the banning of headscarves in public places, which has put off Muslim investors. Outside Europe, China looks like the place where there could be the most exciting opportunities, with some of its banks now offering Islamic financial services. India, too, may see expansion as it seeks to provide another form of banking for its Muslim community. And Australia has been considering ways to expand its involvement. However, the Muslim countries in the Middle East and Asia remain the places where the biggest hopes for growth lie. In the Gulf, the population is expected to increase by 30 per cent over the next decade to more than 50m, increasing demand for products, says HSBC Amanah. The opening of Islamic windows by conventional banks in Africa highlights another potential area of growth. The continent has a large Muslim population, many of whom do not use banks at all. Nigeria, Senegal and Kenya are seen as likely markets.

Indeed, Oliver Wyman, the consultancy, expects Africa to double its income from this kind of finance over the next few years. Overall, Islamic products remain one of the financial success stories of the decade. The industry has grown rapidly in a short time, having only emerged as a serious contender after Malaysia issued the first sovereign sukuk in 2002. Optimists insist it is likely to continue growing strongly. But sceptics warn that there will always be limitations on its growth because of strict religious rules that will deter non-Muslim investors. They say that Islamic hedge funds and derivative products are unlikely to grow or replicate the conventional markets because of the religious rules that ban speculation and earning interest. The term Islamic hedge fund is considered a contradiction by many scholars, who say that even the most innovative lawyers and financial engineers would be unable to create one. The strict religious rules explain in part why the industry makes up only 1.5 per cent of global financial assets. Despite the prospects for continuing growth, even the most optimistic supporter admits Islamic finance may always remain a niche sector.

Contributors David Oakley Capital Markets Correspondent Aline van Duyn US Markets Editor Kevin Brown Asia Regional Correspondent Ed Hammond Construction Reporter Sarah Mishkin FT Reporter Rohit Jaggi Commissioning Editor Steven Bird Designer David Bromley Illustrator Andy Mears Picture Editor For advertising details, contact: Ceri Williams on: +44 (0)20 7873 6321.; fax: +44 (0)20 7873 4296; e­mail: ceri.williams@ft.com or your usual representative All FT Reports are available on FT.com. Go to: www.ft.com/reports Follow us on twitter at www.twitter.com/ft.reports

nvestors have started to dip their toes into the US real estate market again. The plunge in the value of office blocks and other commercial properties following the 2008 recession has lured bargain hunters. Among those investors are some that shied away from buying US property for more than two years: banks and investment funds from the Gulf and other parts of the Middle East. “Gulf investors are returning to the US and the past six months has seen an increasingly strong pace of investment, particularly in real estate,” says Isam Salah, global head of the Middle East and Islamic finance practice at King & Spalding, a law firm. The importance of these investors for large property deals means US lenders active in the real estate market are used to including a “sharia addendum” to documents and contracts backing the transactions. According to lawyers, about 80 per cent of the Middle Eastern institutional investors that are interested in investing in the US market want deals to be structured to comply with Islamic law, which prohibits paying and receiving interest. Through the use of such documents, real estate deals can be structured so that the repayment of the investment comes from the value of the assets rather than explicit interest payments. “Islamic investors like investing in real estate, as income from tangible assets is not considered interest,” says Lewis Cohen, partner at Clifford Chance in New York. “It is also an asset class that tends to be well understood by Islamic investors – the high level of growth in

the real estate sector in the Gulf means these investors have a history of analysing such assets and projects and they have taken that experience abroad to Europe and the US.” Yet even as growing numbers of such large deals are struck, the ability of individual Muslims to buy financial products in the US remains relatively limited. Plans are being discussed to set up an Islamic bank, for example. So far, however, none of the large banks based in the Gulf are pushing to break into the US retail market. Lawyers working with banks and investors in this field say it has been more difficult for the Middle Eastern banks to make money from their European operations in the post-crisis years, and this has dulled their appetite for further ventures abroad. There are other obstacles, too. Unlike in some European countries, there are still no rules that make it relatively easy to create financial products that are sharia-compliant.

‘Gulf investors are returning to the US and the past six months has seen an increasingly strong pace of investment’ For example, shariacompliant financial products are often subject to double taxation because of the way they are structured. Under current rules, each transaction has to gain exemption from double taxation from the US authorities. Efforts are under way to introduce legislation that would allow such exemptions to apply to all the deals done by one institution, streamlining the process of getting products off the ground. Kevin Parker, a senator whose Brooklyn constituency includes a large Pakistani community, is working on introducing new

High rise, low cost: the fall in the value of commercial property has brought Gulf investors back

rules. With the US municipal finance markets under strain and local-government budgets tight, as the effects of the recession continue to hit tax revenues, there are hopes that deals aimed at Muslim investors might bring money into projects such as schools, hospitals and community centres. Traditional US municipal bonds that are used to finance such projects are not sharia-compliant. Mr Parker has introduced a bill in the New York State senate in an effort to streamline the process needed to make projects attractive to local investors as well as investors in the Gulf or elsewhere seeking investments in the US. “In the past decade, nations from the Gulf, south-east Asia and other emerging markets have experienced tremendous growth,” says a memorandum supporting a bill introduced in February. “Investors from these countries are seeking opportunities abroad that comport with their religious beliefs as Muslims, namely a prohibition on interest.” Despite these efforts, there are broader obstacles in the way of people seeking to change US legislation to make it easier to structure sharia-compliant financial products. Andrew Metcalf, a partner at King & Spalding, says that 42 bills have been passed in 20 US states that seek to ban court use of sharia law or international law. Two states – Louisiana and Tennessee – have already adopted this legislation. Although the introduction of such bills was spurred by a case in New Jersey involving the rights

of women under Islamic law, the implications of such bills could feed through to the financial world. The result could be

to restrict changes in legislation aimed at making it easier to structure deals in such a way as to be shariacompliant.

AFP/Getty Images

“The fact that these bills have already passed in some places is a sign of growing anti-Muslim sentiment,” says Mr Salah.


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Islamic Finance

Singapore launch raises profile in the region Asia­Pacific Malaysia retains its leading role for now, says Kevin Brown

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alaysia has entrenched its position as the Asia-Pacific region’s dominant Islamic finance centre with a big rebound in local currency Islamic bond, or sukuk, issuance, which is up to M$11.4bn ($3.8bn) so far this year compared with M$6.7bn in the same period of 2010. The 70 per cent increase in issuance is nearly four times as big as the rise in global issuance of sharia-compliant bonds over the same period, which is up from $4.4bn to $5.2bn, according to data compiled by Bloomberg. However, the most significant development for the long-term prospects of Islamic finance in the region may turn out to be the creation of a sharia-compliant investment category in nonMuslim Singapore. The launch of the city state’s first sharia-compliant real estate investment trust (Reit) followed a change of tax law designed to facilitate the establishment of an Islamic segment of the Reit market, which has developed rapidly in Singapore as a conventional asset class. The Sabana Shari’ah Compliant Industrial Reit raised S$664m in a listing on the Singapore exchange in November and has generated substantial regional interest in Islamic Reits, despite trading at a discount to the offer price. With property prices rising fast in Singapore, analysts say the discount may be temporary. Daiwa Securities Research gave the stock an “outperform” rating in a report in March, arguing that the target yield of 8.3 per cent this year is in line with conventional competitors. In any case, the Sabana launch appears to have stimulated expectations of fresh Islamic Reit listings in Malaysia, which pioneered the sector with the launch of the Al-’Aqar KPJ Reit in 2006, the first publicly traded Islamic property trust in the Asia-Pacific region. At least three potential Islamic Reit offerings are thought to be in preparation, with Bursa Malaysia, the Malaysian exchange, saying that it expects two Gulf issuers to list in Kuala Lumpur later this year, and with a domestic listing

widely rumoured but as yet unconfirmed. The focus on the Islamic Reit sector reflects the increasing popularity of Islamic finance generally in the region, with both conventional and Islamic banks reporting a rise in interest in sharia-compliant products among non-Muslims as well as those whose faith compels them to use Islamic instruments. Afaq Khan, chief executive of Standard Chartered Saadiq, the international Islamic banking business of the UK-based emerging markets bank, says there is growing non-Muslim interest in a whole range of Islamic instruments. These include shariacompliant syndicated loans, mortgages and even credit cards, which charge a fixed fee on unpaid balances, rather than interest. “The beauty of using Islamic finance is that you do not lose any of your valued clients – you can have both conventional and Muslim participation, whereas if you have conventional [products] only, you cannot have Islamic participation,” he says. “People have to understand that Islamic banking is inclusive. It is not for a moment restricted to Muslims, either in terms of using the structures or in working in the industry.” Mr Khan says the growing interest in Islamic finance in the Asia-Pacific region is also being driven by Middle East investors, in spite of the conventional wisdom that holders of oil and gas wealth are generally reluctant to invest in sharia-compliant assets, because returns can be lower than from conventional counterparts. “It is true Middle East investors can get better returns, but they also want to diversify, and benefit from fast-growing Asian economies, and Islamic finance can be part of that,” he says. The biggest setback has come in South Korea, where legislation that would have created a more level playing field for Islamic investment products has been abandoned amid parliamentary claims that funds might be siphoned off to terrorists. More positively, however, Indonesia has moved to resolve tax problems that had discouraged sukuk issuance and is reforming the approval process for Islamic banking products. The government has also proposed halving income tax on some Islamic finance revenues. Many regional problems remain, including licensing issues in some

Market remains buoyant despite unrest Middle East There is a divide between the Gulf and other Arab states, writes Sarah Mishkin

Looking up: Singapore’s first sharia­compliant real estate investment trust followed a change in the law

‘The beauty of Islamic finance is that you do not lose any valued clients – you can have both conventional and Muslim participation’

countries, and a variety of issues related to legal problems in contracts, especially when they relate to the special requirements of Gulf-based investors. The lack of a standardised approach to sharia compliance, which results from differing interpretations of sharia law by scholars, also continues to hamper development. However, most experts think that continued

Dreamstime

growth is likely. Davide Barzilai, a Hong Kong-based Islamic finance expert at Norton Rose, the law firm, says Islamic finance is clearly gaining ground, although the process has not been easy. “Islamic finance is only about 15 years old in its modern form, so it is still in the very early stages. There is still a lot of wealth out there that could be channelled into this sector,” he says.

Middle Eastern demand for Islamic bonds and other financial instruments remains buoyant, even as regional unrest has pushed some companies to wait for prices to improve before coming to the market. In the first quarter of 2011, $32.4bn of Islamic bonds, or sukuk were issued, compared with $51.2bn raised in the entirety of 2010, according to data from Standard & Poor’s. The engine of the global market remains Malaysia, which accounted for 58 per cent of funds raised in the first quarter. In the Middle East, however, rising oil revenue and growing infrastructure spending in stable Gulf Cooperation Council countries such as Saudi Arabia and the United Arab Emirates should anchor the local sukuk market, says Samira Mensah, an analyst with Standard & Poor’s. The need of local investors and institutions for sharia-compliant returns is also growing relentlessly, pushing the market to continue to develop new types of Islamic instruments and deeper and more liquid secondary debt markets. “When we talk about the GCC, the fundamentals remain very strong, and what I mean by that is the oil prices especially,” says Ashar Nazim, Islamic finance services leader at Ernst & Young. Qatar accounted for the vast majority of funds raised last quarter, with a $9bn bond aimed at absorbing liquidity in the market as banks prepare to lend to companies bidding on football world cup projects. Yields have fallen back globally for sukuk and the spread between GCC sukuk and the London interbank offered rate has tightened since protesters took to Cairo’s Tahrir Square on January 25, according to HSBC/Nasdaq Dubai GCC US Dollar Sukuk Index. But trouble remains in the market, as investors demand higher yields to hold the debt of countries hit by unrest, in particular Bahrain. The kingdom has raised $200m so far this year, but is expected to delay a potential $1bn issuance as yields on its notes have risen. The country saw its credit rating downgraded after the

Dealing in dinar: Jordan issued its first domestic corporate sukuk at the end of April, raising JD85m ($120m)

start of the clashes between its Sunni government and majority Shia population. Corporate groups are also expected to continue to account for only a fraction of sukuk issuance, as they await better pricing and, in some cases, grapple with their own downgrades. “You’ve seen a few issuances, but you’ve seen it largely out of Abu Dhabi, and you’ve seen high quality issuances come out,” says Mohammad Dawood, head of Islamic Capital Markets at HSBC in Dubai. Mohammed Paracha, the director of Middle East Islamic finance for Norton Rose, the law firm, says one Gulf financial institution considering a medium-term note this year is likely to delay the transaction, after consideration of the group’s rating. In 2010, corporates accounted for 12 per cent of sukuk, according to S&P. They account for 8 per cent of this year’s pipeline of expected issues and were 6 per cent of the first quarter’s sukuk. Once the current unrest is past, bankers and analysts say Middle Eastern investors’ and institutions’ demand for Islamic products will force the market to expand and mature. Paul-Henri Pruvost, an S&P analyst, says: “There is a slow but steady base of creating a market that will mature at some point. “Maybe in two to three years, we will be able to say that the GCC or the Middle East in general has something that is akin to what we have in Malaysia, but it’s taking time.”

Almost $500bn globally is allocated for Islamic investments, but much of it is left in banks because of a dearth of products available, according to an estimate by Ernst & Young, says Mr Nazim. “Plain-vanilla equity funds can only do so much,” he says. Last November, the United Arab Emirates launched its first shariacompliant certificates of deposit, which the UAE central bank called the state’s “first Islamic liquidity management tools”. Most of the region’s Islamic financial activity

centres on the wealthier Gulf nations, but analysts also point out the potentially strong demand from Muslim retail customers in the rest of the Arab world.

Almost $500bn is allocated to Islamic investments but much is left in banks Other Arab countries also have a desire to offer sharia-compliant opportunities to attract increased investment from the Gulf.

In Egypt, the change in government delayed the country’s plans to introduce regulations governing sukuk and postponed some public-private partnerships there that had planned to offer Islamic tranches as part of their project financing, says Mr Paracha. Yet developments continue elsewhere. A royal degree from Oman this month approved the establishment of the sultanate’s first Islamic Bank. Outside the Gulf, Jordan recently saw its first domestic corporate sukuk issued at the end of April, raising JD85m ($120m) on a sevenyear note for Al Rajhi

Reuters

Cement Company, a Saudiowned Jordanian company. Because Jordan lacked regulations that accommodate the structure of sukuk, the bankers had to ask the government to exempt the deal from certain taxes normally levied on asset transfers. The government agreed to do this. “There is a lot of interest in the government for sukuk, even at the sovereign level rather than the just the corporate,” says Nasri Al-Ashkar, a banker with Capital Bank which arranged the deal. “I’m sure this is one of many more to come.”


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Islamic Finance

Scholars remain wary of speculative instruments

Sukuk Market shows resilience

Hedge funds Attempts to make some strategies acceptable have made little headway, says David Oakley

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The Shard skyscraper is a potent symbol of the growing significance of the sector, which can help make real estate transactions viable in a complicated tax environment such as the UK

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Investors transform UK horizon Construction Sharia­based funding for landmark projects in the UK capital has broken new ground, writes Ed Hammond

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he lights twinkling from the 35 completed storeys of the Shard near London Bridge already dwarf the tower blocks that punctuate the night sky along the south bank of the river Thames. The Shard is a potent symbol of the growing significance of Islamic finance, which was partly behind the funding of the project. That, though, is only half the story of this new London landmark. Illuminated sporadically by the red flashes of aircraft warning beacons, the concrete spine of the half-built skyscraper climbs another 40 storeys into the translucent gloom above London. At 280 metres the Shard is already the tallest building in the UK and by early next year, when it is crowned with another 15 storeys of steel spire, will be the

highest anywhere in the European Union. It is a landmark on the London cityscape and has been the subject of almost constant media attention. However, the audacious project very nearly did not happen. In late 2007, the gathering uncertainty in the global financial markets sparked concerns about getting the construction started. Then, with some fearing the tower would have to be abandoned, a consortium of Qatari investors paid £150m to secure an 80 per cent stake in the project. The new owners quickly stumped up the cash to start construction and the foundations were built. In the three years since, the Shard, which at its fastest rose at 30cm an hour, has typified the role played by Islamic finance in not only supporting, but defining a new era in the UK construction and property industry. “It is all about owning a chunky trophy asset in one of the world’s big global cities and London is seen as the safest place to put large amounts of cash – it is very stable politically,” says one person involved in the Shard project. “They want to create the biggest, fastest-built and most sought-after properties on the skyline,” the person added.

As well as the change in scale and speed of some of the building projects being financed by shariacompliant investment – which forbids earning money through interest payments – there are certain conditions on which kinds of businesses are permitted to become tenants of the finished building. Casinos, most banks and companies connected to the alcoholic drinks industry would be very

‘They want to create the biggest, fastest­built and most sought­after properties on the skyline’ unlikely to get permission to occupy space in a building backed by Islamic finance. A few miles upstream from the Shard, near Chelsea Bridge and opposite Christopher Wren’s Royal Hospital for the Chelsea military pensioners, Islamic finance was at the core of Clifford Chance’s work on the £1.25bn acquisition and funding of the Chelsea Barracks site.

The £959m deal – the highestvalue UK land acquisition in history – was carried out by Qatari Diar Real Estate Investment alongside the CPC, the Guernseybased developers, in order to build a big upmarket residential complex. The deal showed that Islamic financing of real estate transactions can be made to work in a complicated tax environment such as the UK. Neil Miller, global head of Islamic finance at KPMG, believes the UK is some way ahead of other European countries in attracting money from buyers wishing to work within a shariacompliant framework. “There have been high-street banks offering sharia-compliant products to retail buyers in the UK since about 2003, so the foundations were there. The legal and tax frameworks are also much more friendly to foreign investors in residential and commercial property,” says Mr Miller. However, Mr Miller says that France and Germany are looking closely at how they can adjust their tax regimes to appeal better to Islamic investment. It is not just funding the latest rash of skyscrapers that appeals to Islamic investors. At a time

when house sales in the UK are running at historically low levels, buyers from across the Arab world are propping up demand in London and the south-east. The demand is expected to facilitate the construction of 10,000 homes in the capital and the expected £5bn of investment from overseas buyers – which is likely to target high-end residential developments – has pumped up competition for land to levels last experienced before the recession. Indeed, as the political upheaval in Egypt, Tunisia and Libya spreads to other parts of the region, housebuilders and property agents in the UK capital are expecting another round of buying from cash-rich investors seeking a safe place to lock up their wealth. Simon Brown, a housebuilding analyst at Northland Capital, comments: “What we are seeing at the moment is a flight to security, as many investors are looking at London as the best place to put their money. “Spending by buyers from the Middle East is one of the main factors which has protected sales of new-build housing in London compared to other parts of the country,” he explains.

t is a much debated question among religious scholars and financial experts. Will Islamic finance, which bans speculation because of religious objections, ever see Islamic hedge funds? Opinions are divided. Hedge funds as they exist now are in essence money making machines and speculation is fundamental to their operation. Scholars are the arbiters of what constitutes a sharia-compliant product and some of them say an Islamic hedge fund is a contradiction in terms. The notion of “short selling”, a common strategy of hedge funds that involves betting that a market will fall, is un-Islamic, according to sharia orthodoxy. However, this has not stopped lawyers and investors from attempting to construct Islamic hedge funds. They insist that hedging can be used, claiming it is the ultimate goal of a sector that attempts to replicate conventional markets. Islamic finance has, for example, successfully created products equivalent to those used in conventional finance, such as Islamic bonds, or sukuk. Middle East investors In particular recognise the attraction of sharia-compliant hedge funds. Yet, since the financial crisis in 2007, progress on the creation of Islamic hedge funds has been slow. One of the biggest problems is finding an acceptable equivalent to the key tactic of short selling: investors typically borrow assets and sell them, hoping the price will have fallen by the time they have to buy the assets to return them to their original owner. They can then pocket the difference. The practice aims to take advantage of a falling market. Other bread-and-butter hedge fund strategies, such as equity long-short and bond arbitrage, also face fundamental problems with sharia-compliance. A further hindrance is the fact that many Islamic investors are happy to

A clear view: many hedging strategies face problems with sharia­compliance

invest in non-Islamic products, which reduces the need for a religiously acceptable alternative. So far, therefore, the development of an alternative hedge fund industry has been slow. Many Islamic investors are unwilling to risk their money in these funds when they can use conventional funds or stick with Islamic products that are universally accepted as compliant with the rules. On the other hand, many

The dynamic nature of portfolios would require constant checking by sharia boards scholars have begun to regard investment in hedge funds as acceptable, if the intention is to hedge against risk instead of gambling. One banker says: “There is demand for Islamic hedge funds, mainly from [wealthy] individuals who at the very least want to hedge risk rather than speculate.” Using the concept of maslahah (the public good), hedging could be seen as a justifiable way of avoiding

risks for investors, but the dynamic nature of most hedge fund portfolios means they would require constant checking by sharia boards. Such specialist services are expensive. The cost of operating a sharia-compliant hedge fund is, therefore, one of the greatest hindrances to development. In spite of their reputations, hedge fund management companies are lean businesses that can ill afford high cost bases without market-beating performance to back them up. Attempts to recreate tactics such as short selling have been most successful where the underlying assets are commodities – tangible products lend themselves more easily to compliance with sharia, which frowns on the accumulation of money in the form of interest payments as well as speculation. It is no coincidence that the most prominent shariacompliant funds are commodity specialists, but there are not many of these and they are limited in how they trade, compared with conventional hedge funds. Many strategists say it is hard to separate speculation from the hedging of risk. One senior strategist says: “I would propose it is

Reuters

difficult to distance hedge funds from speculation, and while many scholars accept the need for risk management, the financial tools applied are often the same. “For the scholar, the tough element will be assessing the compliance of strategy – is hedge fund investing in order to compensate for risk or is it pure speculation – gambling?” It is also significant that the appetite for an Islamic hedge fund industry has waned since the financial crisis of 2007. Many fund managers no longer have the money or the desire to hunt for returns in a new market that provides little advantages, compared with conventional finance. Indeed, one of the biggest problems for the overwhelmingly western, nonMuslim promoters of shariacompliant hedge funds is that each large institutional investor has its own board of Islamic scholars. There is no central authority and these boards of scholars often disagree on questions at the cutting edge of financial theology. There is a large body of opinion in the market that is sceptical that hedge funds can ever truly develop in Islamic finance. And it is a debate that may never fully be resolved.

The Islamic bond, or sukuk, market at last appears to have shaken off the series of financial setbacks that stalled its growth in the past four years, writes David Oakley. Sukuk issuance is once again growing, with many bankers, lawyers and investors forecasting that this can be maintained in spite of global uncertainty and turmoil in the Middle East and north Africa. Farmida Bi, partner at law firm Norton Rose, says: “The sukuk market can see strong growth again, particularly as the global recovery seems to be taking hold and there is more confidence in general.” Sukuk issuance this year, which has risen above $30bn in the first quarter, according to Standard & Poor’s, looks set to surge comfortably past the total issuance of $51.2bn in 2010. Other data providers, such as Dealogic – whose narrower definition of what represents sukuk does not include bonds that can convert into equity – show issuance so far this year is the highest since 2007, when the market was growing at record rate in the buoyant period before the financial crisis. Even if the market cannot match the pace of expansion from 2002, when it started to take off, to 2007, it looks more likely that it can build on its past success of attracting non­ Muslim investors. However, there are risks, primarily from outside factors such as political instability in the Middle East, which is one of the main centres, and the health of the global economy. The chances of it repeating its earlier success may be restricted by the fact that small markets tend to see rapid growth in the early years and slow as they mature. The world is also a very different place now, compared with the pre­ financial crisis era – and this may not benefit the sukuk market. This is because investors in sukuk, predominantly Muslim from Asia and the Middle East, are typically cautious. This caution was offset by the general and widespread confidence in markets everywhere before 2007. These

investors have in the past year often been deterred from buying sukuk on the slightest hint of uncertainty, often in regions outside the main Muslim centres of the Middle East and Asia. The eurozone crisis, for example, has been bad news for sukuk, as many investors have used the deepening crisis there in the past year as a reason for shunning any asset that looked remotely risky, such as sukuk. However, other Islamic experts say the fact the market has shown resilience and grown strongly this year augurs well for the future. They argue that a market that can shrug off violence and turmoil in Libya, Egypt and Gulf states such as Bahrain, and at the same time record the highest issuance in four years, has shown it is maturing and able to cope with further financial shocks. “The market is unlikely to suffer again the shocks of the past few years,” says one senior fund manager. “If it can weather the storms of recent years, such as the financial crisis and arguments over how an Islamic bond should be structured, it can weather anything.” Crucially, bankers say there are strong signs that investors are generally happier to buy more exotic instruments, such as Islamic bonds, as the global recovery starts to take hold. At the height of the financial crisis in 2008 in the wake of the collapse of Lehman Brothers, investors refused to buy anything but the safest instruments such as US and German government bonds. This was primarily because investors were only willing to purchase bonds that were liquid, or could be easily bought and sold – typically US Treasuries and German bunds. This is because investors wanted the comfort of knowing they could exit the market and preserve their capital in cash if the crisis intensified further. There are still risks, particularly in Gulf states such as Bahrain, which has seen issuance of sukuk stall because of its internal and political problems. But most analysts say that most of the Gulf and the big Asian sukuk markets of Malaysia and Indonesia are unlikely to be affected by instability in the Middle East and north Africa.


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FINANCIAL TIMES THURSDAY MAY 12 2011

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