A PRIMER ON ISLAMIC FINANCE – Book Sample
Chapter 4. The Islamic Capital Market – A PRIMER ON ISLAMIC FINANCE
The Islamic capital market plays a pivotal role in the growth of Islamic financial institutions. Like any capital market, its primary function is to allow people, companies, and governments with surplus funds to transfer them to people, companies, or governments who need funds.
The Islamic capital market functions as a parallel market to the conventional capital market for capital seekers and providers.
The Islamic capital market attracts funds from outside as well as inside the market. The international sources might include high-net-worth (HNW) individuals, predominantly Muslims from the oil-rich countries, and others involved in the corporate and business sector
. The Islamic capital market does not prohibit participation by non- Muslims, which has increased the growth potential for Islamic products.
Little, if any, consensus exists about the size of the Islamic capital market. Cerulli Associates has estimated the market value of Shari’a-compliant assets at year-end 2008 to be US$65 billion, a figure much smaller than often estimated.10
This amount does not include the market capitalization of equities that are not specifically “Islamic” but in which Islamic financial institutions are permitted to invest (because the business activities of the companies are Shari’a compliant). Standard & Poor’s (S&P) estimated that as of the third quarter 2008, roughly US$5.2 trillion in market value of Shari’a-compliant equities was lost as a result of the global financial crisis that unfolded in 2008.11 If approximately 40 percent of market value disappeared during the crisis, by inference the current market value would be in the range of US$6 trillion to US$7 trillion.
In contrast, as noted, some analysts estimate Islamic banking assets to range between US$500 billion and US$700 billion and expect bank assets to rise to US$1 trillion in 2010 (“Morgan Stanley Says . . .” 2008). Banks have yet to move most of these deposits into managed investments. If the banks require Shari’a-compliant products for such investments, the implication is that the Islamic capital market has significant potential for continued growth.
Origin and Growth of the Islamic Capital Market
Although the origins of contemporary Islamic banking and finance may be traced to the early 1960s, the first wave of oil revenues did not wash over the Middle East
until the 1970s, when the idea of investing in products conforming to Islamic principles really gained momentum. Individuals in the region began to accumulate large amounts of wealth by the 1980s and began to seek Shari’a-compliant financial products in which to invest their savings. Western banks began servicing HNW
Muslim clients through their Islamic “windows” and were quickly joined in the marketplace by newly organized Islamic banks eager to participate in the growing faith-based demand for Shari’a-compliant financial products. As of the end of 2008, the Islamic capital market has largely resulted from retail, not institutional, demand (De Ramos 2009).
Institutional demand has developed, however, as Islamic banks and takaful (Islamic insurance) operators have sought to invest their surplus funds in Shari’a-compliant instruments that are liquid and have long-term maturities to match the long-term liabilities of these institutions.
Through the 1990s, Islamic banking deposits sufficed to provide the capital demanded by the Islamic financial markets, but demand for funds was quickly outstripping the supply of funds. New Islamic financial products that could compete with the flexibility and innovation of conventional financial products were needed, but two factors hindered the ability of the Islamic capital market to deliver such products. The first was that the conventional financial markets were developing with tremendous speed and in many different directions. Challenged to adapt these new products to Shari’a, the Islamic financial markets struggled to maintain a competitive pace. The second factor slowing the pace of Islamic capital market development was the conflict surrounding interpretation of what constitutes Shari’a compliance (Iqbal and Tsubota 2006; Khan 2006).
Yet, for the Islamic capital market to achieve sustainability, finding new and competitive products was imperative. Deregulation in several Muslim nations opened the door to the creation of two products largely responsible for the serious growth of the Islamic capital market—Shari’a-compliant equity funds and sukuk (Islamic bonds) (Iqbal and Tsubota 2006; Khan 2006).
Since 1999, the Islamic capital market has attracted non-Muslim as well as Muslim issuers and investors, and it now includes numerous products that can replicate the returns and characteristics of conventional financial products. In addition to equity and bond products, the market has expanded to include exchange- traded funds, derivatives, swaps, unit trusts, real estate investment trusts (REITs), commodity funds, and a range of Islamic indices and index products. The Islamic capital market comprises active primary and secondary markets that deal in the Islamic products described in this section.
Overview of the Islamic Capital Market
Not all the financial products discussed in this overview are acceptable to all Muslim investors. The controversy over what is and what is not Shari’a compliant is a byproduct of the existence of different schools of Islamic thought. No single body is currently in place to mediate these differences of opinion.
The Islamic Equity Market.
Islamic equities are shares of halal companies—that is, securities of companies operating in activities permissible under Shari’a principles and approved and periodically reviewed by Shari’a scholars through a process known as Islamic stock screening. For a company to be considered halal, the majority of its revenues must be primarily derived from activities other than the trading of alcohol, arms, tobacco, pork, pornography, or gambling or from profits associated with charging interest on loans.
The determination of Shari’a compliance rests with the judgment of Islamic scholars. In Malaysia, one of the most innovative providers of financial products, the body of Islamic scholars is the Malaysia Securities Commission Shari’a Advisory Council (SAC). Malaysia is one of only a few nations that has established a single governing body for this purpose. Other nations’ decision making regarding Shari’a screening procedures is much more fragmented. The SAC has enumerated detailed criteria to be used in screening companies for compliance with Islamic principles.
The SAC states that non-halal activities include manufacturing and trading of non- halal goods; banking and financing involving interest or usury; hotels and resorts involved in the sale of liquor or alcoholic beverages; gambling or related activities; and activities involving elements of uncertainty (gharar).
The Malaysian stock-screening criteria are similar to the criteria adopted by the Financial Times (FTSE) and Dow Jones Islamic Market Indexes series, the major indices that provide Islamic screening filters.12 An exception, however, is that the Malaysian criteria specifically prohibit companies involved in meat production or sale if the animals are not slaughtered according to Islamic rites. (The major Islamic equity indices are discussed in greater detail later in this chapter.)
Following the approach of these two indices, the SAC determines compliance on the basis of the core activities of a company; it does not exclude a company if a minor portion of its business is derived from involvement in haram (not permissible) activities.
The SAC has also adopted positive Shari’a screening criteria that require that the public perception or image of a company be good and that its core activities have importance to the Muslim ummah, the overarching global Muslim community. The company’s guiding principles should conform to maslahah, the beliefs of Muslims. Companies that serve the non-Muslim community, such as those oper- ated by the Chinese population in Malaysia, are regarded as legitimate for invest- ment purposes as long as their business activities are consistent with activities customarily accepted by Muslims.
The Shari’a stock-screening criteria used by Malaysia’s SAC, as well as other screening entities, are essentially qualitative, but some quantitative criteria are also used. Quantitative criteria include, for example, the calculation of certain financial ratios, such as the proportion of interest-bearing debt to assets or total debt to the average market capitalization of the company over a period of 12 months. (In Malaysia, screening by financial ratios is not used.)
The Islamic equity investment market is growing at a much faster rate than the overall Islamic sector as a whole because it started from a lower base. The total of funds under management in the Islamic finance sector is estimated at US$1 trillion. Only about an estimated US$20 billion of this is in equities, however, which is modest in comparison with the conventional equity sector with its market capital- ization of almost US$2 trillion. Global conventional equities are about US$20 trillion, even after the crash (Parker 2008a).
Malaysia is seen as aggressive in listing Islamic equities; more than 80 percent of the stocks listed on the Bursa Malaysia are classified as Shari’a-approved by the SAC. These securities have a total market capitalization of 426.4 billion Malaysian ringgits (RM), or US$129 billion, which is 64.2 percent of the total Malaysian stock market as of December 2008 (Ngadimon 2009). In Kuwait, Islamic and Shari’a– compliant companies make up 57 percent of the country’s total market capitalization (“Islamic, Sharia Firms . . .” 2009). Despite the recent huge decline in the financial markets, Islamic equity funds have been attracting global investors and more and more financial institutions are offering such funds to meet investor demand.
Islamic Bond (Sukuk) Market
One of the fastest growing sectors in the Islamic capital market is the sukuk, or Islamic asset-backed bond, market. The sukuk market grew at about an 84 percent per year compound rate between 2001 and 2007 and was estimated to have a market value of US$80 billion to US$90 billion before the 2008 market crisis (Cook 2008). Over the first eight months of 2008, global sukuk issuance totaled roughly US$14 billion, down from US$23 billion for the same period a year earlier, mainly because of the global credit crunch (“Sukuk Issuance . . .” 2008).
Sukuk are issued primarily by corporations, although sovereign issuers are becoming more common than in the past. About half of outstanding sukuk, mainly large U.S. dollar–based issues and Malaysian debt, are actively traded in the secondary market.
Sukuk are a relatively new financial instrument, first issued in the late 1990s. Sukuk were created in response to a need for Shari’a-compliant medium-term to long- term debt-like instruments that would have good liquidity in the marketplace (Iqbal and Tsubota 2006). The word “sukuk” is the plural of the Arabic word “sakk,” which means “certificate,” so sukuk may be described as certificates of trust for the ownership of an asset, or certificates of usufruct. Sukuk differ from conventional bonds in that they do not pay interest. Islam forbids the payment of interest, but a financial obligation or instrument that is linked to the performance of a real asset is acceptable.
Sukuk returns are tied to the cash streams generated by underlying assets held in special purpose vehicles (SPVs). The cash stream can be in the form of profit from a sale, profit from a rental, or a combination of the two. The conventional asset securitization process is used in structuring sukuk. An SPV is created to acquire the assets that will collateralize the sukuk and to issue financial claims on those assets
over the defined term of the sukuk. A trust financing, or mudharabah, contract is used to create the SPV, otherwise known as a special purpose mudharabah (SPM). The asset collateral must be Shari’a compliant (Iqbal and Tsubota 2006). Sukuk are, therefore, monetized real assets that enjoy significant liquidity and are easily transferred and traded in financial markets. A sukuk issue can be structured in a variety of ways and can offer fixed- and variable-income options.
Several classes of assets typically collateralize sukuk issues. The first class has financial claims arising from a spot sale (salam) or a deferred-payment (bai’ mu’ajjal) and/or deferred-delivery (bai’ salam) sale. These securities are typically short term in nature, ranging from three months to one year, and are used to finance commod- ity trading. Because the risk-and-return characteristics of the structure are some- what delinked from the risk-and-return characteristics of the underlying asset, the Gulf Cooperation Council (GCC) countries (see Exhibit 1.2) hold that trading these sukuk in the secondary market involves riba; hence, it is prohibited. Therefore, salam-based sukuk are typically held to maturity (Iqbal and Tsubota 2006).
A second class of assets that collateralize sukuk is leased, or ijarah-based, assets. The cash flows generated by the lease-and-buyback agreement, a combination of rental and principal payments, are passed through to investors. Ijarah-based sukuk have medium- to long-term maturities (Iqbal and Tsubota 2006), carry a put option, and can be traded in the secondary market. This type of sukuk has gained increasing acceptance by Shari’a scholars, particularly those from Middle Eastern countries. Recent successful issues include those by the Malaysian-based companies Al-’Aqar Capital (RM500 million, or US$153 million) and Menara ABS (RM1.1 billion, or US$337 million).
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