World finance Islamic finance goes mainstream

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World finance: Islamic finance goes mainstreamEIU ViewsWire. New York: Dec 8, 2006.

Abstract (Summary)(c) 2006 The Economist Intelligence Unit Ltd. All rights reserved. Reproducedwith permission of the copyright owner. No further reproduction is permitted.

World finance: Islamic finance goes mainstream

Western investors tap an emerging market in sharia-compliant products

IT was one of the year's big political flash points: the takeover of Britain's P&O,an international ports operator, by DP World of Dubai caused a rumpus fromWestminster to Washington, DC. Politicians may have shunned the bid butinvestors did not--even though it was financed with a sukuk, a bond-like productcompliant with the principles of sharia, or Islamic law. Demand was so strong thatthe initial $2.8 billion issue was raised to $3.5 billion, and ultimately drew $11.4billion in subscriptions, about half of them from international investors.

No wonder investment bankers--who needed terms like riba (interest) translatedonly a year ago--no longer scratch their heads at the wonders of Islamic finance.Next week a new $2.5 billion sukuk offered by Nakheel, a big Dubai developer,closes. It will be the world's second-largest such note--and could even surpassthe one from Dubai Ports, Customs and Free-Zone Corporation (PCFC), theparent of DP World. In the most recent such issue (an $800m sukuk from AbuDhabi Investment Bank that closed on December 4th) nearly 40% of theinvestors came from Europe.

Islamic finance, long considered in the West as more of an oddity than anopportunity, is going mainstream. Standard & Poor's, a rating agency, puts the

market for Islamic financial products--banking, mortgages, equity funds, fixedincome, insurance, project finance, private equity and even derivatives--at about$400 billion. It is estimated to have grown at some 15% annually in the past threeyears, and looks set to expand further as the petro-economies of the Gulf boomand Western investors become more comfortable with some of its culturaldifferences.

Once available only in mostly Muslim places like Malaysia and the Gulf (Bahrainwas a pioneer), Islamic finance now appeals to some of the world's biggestfinancial institutions seeking to tap into emerging markets. Investment banks,hedge funds and even pension-fund managers are getting keener. "This is anew, parallel financial system," says Sameer Abdi of Ernst & Young, aconsultancy. "It's not something that can be ignored."

No improprieties, no interest

To get the stamp of approval from Islamic scholars as sharia-compliant, aproduct should adhere to two principles: it must not pay interest, and wealthshould not be generated from means considered improper; alcohol, gamblingand tobacco, for example, are off-limits.
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Although sharia-compliant products have been around for decades, there areseveral reasons why the market has taken off in the past few years. First is thesheer wealth in parts of the Middle East where oil--and petrodollars--gush. RichMuslims have long parked much of their money abroad, and continue to do so.Mr Abdi says about one-third of investors in countries where there is a Muslim

majority are seeking sharia-compliant products; another 50-60% will use them ifthey are "commercially competitive".

At the company level, Middle Eastern institutions no longer rely exclusively onprivate financing (if they need to borrow at all). They are now shifting to publicvehicles that offer access to international markets. As they become moreconspicuous, such companies are seeking to comply with the Islamic traditions intheir countries. So, for instance, Islamic finance has been used in biginfrastructure projects.

Meanwhile, foreign investors want to diversify across countries and asset types."As a global investor, you need exposure to this region of the world," says ArulKandasamy, head of Islamic banking at Barclays Capital, which helped arrangeboth the PCFC and Nakheel sukuks. In the Middle East more than 80% of fixed-income products are Islamic. Malaysia also has a big concentration: about 60%of the $40 billion global sukuk market is there.

Investors who used to hang back from these notes due to worries about the lackof liquidity--there is virtually no secondary market for most of them--areemboldened by the recent, bigger offerings. Mr Kandasamy says the averagevolume of trading in the PCFC sukuk has been $10m a day since its launch.

Finally, for foreign institutions raising funds, "this is another pool of money" totap, says Matthew Sapte, a London-based lawyer working on Islamic-financedeals. "A number of European corporates are looking at this very closely."

No wonder then that international banks are offering sharia-compliant products oftheir own. Some have long experience. Citibank, for instance, has offered Islamicproducts since the 1990s. ABN AMRO, BNP Paribas, Standard Chartered, andGoldman Sachs are also involved.

As the market for Islamic products has become more crowded, yields have fallen.Today the returns on Islamic products in the Gulf are similar to those ofcomparable conventional instruments in the region, says Abdulkader Thomas, afinancial consultant and founder of the American Journal of Islamic Finance. InMalaysia, he adds, sharia-compliant products have lower yields thanconventional products, but they are also taxed at a lower rate.

For all the excitement being generated, Islamic finance is still just a sliver of theglobal financial market. And international investors still find aspects of itimmature. For example, there is a dearth of credit ratings for Islamic productsand institutions (which is also true of many conventional instruments in theMiddle East).

If the industry is to avoid being "ghettoised", argues Anouar Hassoune, ananalyst at Standard & Poor's, it needs to shape up in several ways. First, it mustbecome more standardised. Products considered sharia-compliant in relatively


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liberal Malaysia are off-limits in more conservative Saudi Arabia. Second,accounting standards and financial reporting must be better aligned. Third, hesays, more innovation is needed, particularly in areas such as derivatives andstructured finance. Fourth, there is a skills shortage, which is driving up salariesfor anyone working in Islamic finance. Lastly, the industry needs to create new

tools for assessing risk.None of these challenges is insurmountable. This is an era of financial innovationwhere investors delight in exploring new areas of risk. Cultural barriers are thereto be crossed.

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EIU ViewsWire. New York: Dec 8, 2006.

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