A year after Dubai's monster debt problems sent shockwaves though the sukuk (Islamic bond) world, sukuks are thriving again and with them Malaysia's role as the center of gravity of international Islamic finance.
Although Islamic banking, investment and insurance activity are again gaining global ground, is still relatively small and mainly concentrated not in the most populous Muslim countries but in those such as Malaysia and the United Arab Emirates, which are able to use local liquidity and government help to promote it outside their borders.
The Malaysian role is being further enhanced by the establishment of the International Islamic Liquidity Management Corp (IILM) being set up by a several central banks, mostly from Muslim-majority countries but including Luxembourg, location of many listed funds. The IILM will be based in Kuala Lumpur and is expect to be operational sometime in the first half of 2011, issuing short term AA paper to provide liquidity to enhance international trade in Islamic instruments.
The sukuk issue bounce-back has been the Dubai crisis and the preceding global financial meltdown has been characterized by a growing variety of instruments and sources, indicating an acceptance of them among investors such as sovereign wealth funds in non-Muslim countries as well as non-Muslim company seeking Muslim funds.
Thus the Japanese financial giant Nomura made a US$100 million issue while half of a US$500 million one by the Islamic Development Bank (IDB) was sold to European and East Asian investors. Meanwhile Malaysia's state holding company Khazanah created a first for the Singapore sukuk market with a S$1.5 billion issue. Total outstanding sukuk issues are now over US$100 billion from almost nothing five years ago.
Proponents of Islamic products claim that, notwithstanding the problems in Dubai and others in Kuwait in particular, they have proved more resilient than conventional ones during the crisis. They point to the fact that they avoid complex derivatives and all issue must be driven by an underlying economic and commercial purpose, not by pure speculation. Islamic equity funds also outperformed conventional ones over the crisis period, albeit only marginally.
However, skeptics suggest that other factors are at work. Although Islamic finance is supposed to be about sharing risk and reward, the Dubai bailout by its richer neighbor Abu Dhabi contradicted that principle. Others point out that in the case of Malaysia, the leader in sukuk issues, almost all were by state entities including the government itself, Cagamas the mortgage institution, Khazanah and state oil company Petronas, and that most of the buying was by local Islamic banks and the state-managed pension funds. Without the impetus provided by the huge current account surpluses of (mostly Muslim) oil exporters, international business could not have grown at anything like the pace of recent years. And local business could not have grown without tax breaks and official incentives.
Islamic banking is still a minority business in Islamic countries other than Iran and Saudi Arabia. Seven of the top 10 Islamic banks are Iranian – not a factor which enhances the global industry. In Malaysia Islamic banking continues to gain market share, but even with much official support is still only 20 percent of the system. In countries such as Indonesia and Turkey it is also growing but from a very low base.
Islamic micro-finance has recently been quite successful in Indonesia but the Muslim heartland of micro-finance, Bangladesh with its Grameen bank, has stuck with conventional forms. Nor is there much evidence, the IDB apart, that Islamic finance has become a way in which rich Islamic countries could help poorer ones such as by buying their sukuk issues.
Many in the Islamic as well as non-Islamic worlds continue to claim that there is scant practical difference between Islamic and conventional forms, the former merely mimicking the latter with similar rates of return but adding, at some administrative cost, a veneer of shariah risk/reward respectability.
Be that as it may, there has been a significant narrowing of gaps in interpretation of shariah. These had a particular impact on cross border trade with shariah scholars in the Gulf not accepting the legitimacy of some compliance decisions made in other jurisdictions. Disclosure standards are often weak, providing investors with inadequate knowledge of structures, or of the reasons for decisions on compliance made by shariah scholars.
Convergence and disclosure are however increasing and will probably continue to do so as Malaysia in particular forms a body of codes and practices, in English, which others can follow.
The global crisis also showed up some problems of dispute settlement and in both realizing ownership of security for sukuk issues. Gaps between civil law and its shariah counterpart also present potential dangers. For non-Muslim issuers there is also a problem of showing that funds raised are used in ways compatible with shariah.
But again, Malaysia itself has largely avoided such problems because of its orderly compliance system and the efforts made to align Islamic products both with civil law and with internationally accepted accounting standards. But not many Islamic countries are as organized as Malaysia where Bank Negara has been successful in developing Islamic finance mechanisms while running a tight ship for all forms of banking and finance.
In fact non-Islamic countries have sometimes paid more attention to making provision for it either to serve local Muslim communities or enable Islamic instruments to become part of their financial centre role – as in the case of the Britain. Other countries have or are moving in the same direction leading to suggestions in some quarters that Islamic finance should, at least in non-Muslim countries, be re-named "ethical" and make it more appealing to non-Muslims. Whether it is more ethical in practice as well as theory is another issue.
But at least for now Islamic finance will continue to grow, helped by its acceptance by non-Muslim central banks of its global role. The IILF itself stems from the creation of the Islamic Financial Services Board, which plays a role similar to the Basel committee of the Bank for International Settlements. The liquidity facility coupled with an increased number of issues will gradually enable the development of yield curves and other mechanisms which provide more benchmarks for comparisons with conventional yields.