globalization and islamic finance (convergence, prospects, and challenges) || empirical trends in...

121

CHAPTER 5 Empirical Trends in Conventional

and Islamic Financial Globalization

I n previous chapters, we have argued that a major embodiment of global ization is the enhanced fl ow of capital across borders. In this chapter, we

argue that the conventional debt - based fi nancial system has characteristics that make it susceptible to bubbles and is theoretically unstable. This insta-bility has, as in the case of the 2007 crisis, spread rapidly across national borders. Our reasoning behind the fi nancial crisis of 2007 would indicate that, in the future, more reliance may be placed on equity, compared to debt, in the conventional fi nancial system. This should encourage a conver-gence between Islamic and conventional fi nance.

We now turn to market capitalizations and capital fl ows to see whether actual market developments afford any insights as to the future course of Islamic and conventional fi nance.

5.1 Trends in Conventional Financial Globalization

Between 1991 and 2000, gross capital fl ows (the sum of the absolute value of capital infl ows and outfl ows) among industrialized countries expanded by 300 percent, the bulk of which was due to the rise in foreign direct investment and portfolio equity fl ows — both rising by 600 percent — while bond fl ows over the same period increased by 130 percent (Evans and Hnatkovska, 2005). Over the same period, both stocks and fl ows of capital movements increased substantially, especially in relation to the volume of domestic GDP and the size of fi nancing markets. More recent data (Table 5.1 and Figures 5.1 , 5.5 , and 5.8 ) show that, after the market turbulence in 2000 – 02, these trends resumed, with FDI and portfolio equity fl ows assum-ing a larger share of the total fl ow. The largest increase in FDI in 2006 was in the emerging European markets and the Middle East.

Globalization and Islamic Finance: Convergence, Prospects, and Challengesby Hossein Askari, Zamir Iqbal, and Abbas Mirakhor

Copyright © 2010 John Wiley & Sons (Asia) Pte. Ltd.

122 GLOBALIZATION AND ISLAMIC FINANCE

FIGURE 5.1 Total Global Cross - Border Infl ows, 1980 – 2005 Source: IMF (2007a).

Total flows(in percent of world GDP and in

billions of US dollars)

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

1980

1985

1990

1995

2000

2005

0

2

4

6

8

10

12

14

16

In percent of world GDP(right scale)

In billions of US dollars(left scale)

By type of flow(in percent of world GDP)

0

2

4

6

8

10

12

14

16

1980

1985

1990

1995

2000

2005

Foreign Direct Investment Portfolio Equity Flows

Portfolio Debt Flows Banking and Other Flows

0

20

40

60

80

100

120

140

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

All sample countries (54)Emerging markets (29)Mature markets (25)

FIGURE 5.2 Equity Market Capitalization, 1996–2005 (percent of GDP)Source: IMF (2007a).

Empirical Trends in Financial Globalization 123

0

20

40

60

80

100

120

20072006200520042003200220012000

Industrial Countries(MSCI)

DJ Euro Stoxx

Wilshire 5000

Topix

0

20

40

60

80

100

120

140

160

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

All sample countries (54)Emerging markets (29)Mature markets (25)

FIGURE 5.3 Bond Market Capitalization, 1996–2005 (percent of GDP)Source: IMF (2007a).

FIGURE 5.4 Equity Markets, 2000–06Source: IMF (2007b).


02002 2003 2004 2005 2006 2007

100

200

300

400

500

600Latin America

Asia

Eastern Europe

FIGURE 5.5 Portfolio Equity and FDI Emerging Equity Markets, 2002–07Source: IMF (2007b).

�10

0

10

20

30

40

50

60

70

2001 2002 2003 2004 2005 2006 2007

Equity funds

Debt funds

�10

0

10

20

30

40

50

60

70

FIGURE 5.6 Cumulative Net Flows to Emerging Market Funds, 2001–07 (US$ billion)Source: IMF (2007a).

TABL

E 5.1

E

mer

ging

Mar

ket

and

Dev

elop

ing

Cou

ntri

es: N

et C

apit

al F

low

s1

1996

–98

1999

2000

2001

2002

2003

2004

2005

2006

Tot

alPr

ivat

e ca

pita

l fl o

ws,

net

215

9.3

74.6

56.7

70.2

88.3

173.

323

8.6

257.

225

5.8

Pr

ivat

e di

rect

inve

stm

ent,

net

142.

317

7.4

168.

618

2.8

152.

216

5.3

190

266.

326

6.9

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ivat

e po

rtfo

lio fl

ows,

net

6060

.111

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80.5

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12.1

2529

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76.3

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ther

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vate

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ital fl

ow

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et�

43�

162.

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26.9

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ates

4

(Con

tinu

ed)

125

TABL

E 5.1

(C

onti

nued

)

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–98

1999

2000

2001

2002

2003

2004

2005

2006

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ate

capi

tal fl

ow

s, n

et2

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ate

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t, n

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95.

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ate

port

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l fl o

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t216

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(b).

1 N

et c

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com

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t di

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t, a

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term

net

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stm

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s,

incl

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g of

fi cia

l and

pri

vate

bor

row

ing.

In

this

tab

le, H

ong

Kon

g SA

R, I

srae

l, K

orea

, Sin

gapo

re, a

nd T

aiw

an P

rovi

nce

of C

hina

ar

e in

clud

ed.

2 B

ecau

se o

f da

ta li

mit

atio

ns, fl

ow

s lis

ted

unde

r “p

riva

te c

apit

al fl

ows,

net

” m

ay in

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e so

me

offi c

ial fl

ow

s.3 E

xclu

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gran

ts a

nd in

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vers

eas

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stm

ents

of

offi c

ial i

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tmen

t ag

enci

es.

4 A

min

us s

ign

indi

cate

s an

incr

ease

.5 T

he s

um o

f th

e cu

rren

t ac

coun

t ba

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e, n

et p

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apit

al fl

ows,

net

offi

cia

l fl o

ws,

and

the

cha

nge

in r

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ves

equa

ls, w

ith

the

oppo

site

sig

n, t

he s

um o

f th

e ca

pita

l acc

ount

and

err

ors

and

omis

sion

s. F

or r

egio

nal c

urre

nt a

ccou

nt b

alan

ces,

see

Tab

le 2

5 of

th

e St

atis

tica

l App

endi

x.6 H

isto

rica

l dat

a ha

ve b

een

revi

sed,

refl

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cum

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data

rev

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ns f

or R

ussi

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tion

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7 C

onsi

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of d

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and

the

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127


Empirical evidence suggests that the composition of capital fl ows mat-ters a great deal. Equity fl ows (portfolio equity fl ows � FDI � venture capi-tal) promote better risk sharing, reduce volatility, and strengthen stability (Bekaert, 2000; Bekaert and Lundblad, 2006; Kose et. al., 2006; Albuquer-que, 2003; Alfaro et. al., 2005). There is a substantial body of evidence that these fl ows, especially FDI, are positively associated with economic growth (Levchenko and Mauro, 2006). FDI is considered an important channel for transfer of technology and organizational knowledge (Borensztein et. al., 1998; Ayyagari and Kosova, 2006). Over the past few decades, stock markets too have shown increasing vitality and rapid growth. The develop-ment of stock markets increases the rate of saving and leads to growth in investment, while enhancing its quality. Stock markets diversify the investor base while distributing risks across investors, which, in turn, increases the resilience of the economy to shocks (IMF, 2007a, 2007b). As mentioned earlier, the composition of capital fl ows has a signifi cant infl uence, with FDI and equity fl ows exerting a great stabilizing infl uence on the economy ’ s vulnerability to shocks and fi nancial crises. It has been demonstrated that greater reliance on debt fl ows exposes a country to a higher probability of sudden stops of international capital fl ows and to fi nancial crises (Frankel and Rose, 1996). A growing body of research has demonstrated the positive impact of stock market development on economic growth (Henry, 2000a; Stulz, 2005).

There is mounting evidence in the last decade that many developing countries have implemented reforms that promote legal and institutional development. They have improved governance, transparency, and account-ability, and have adopted regulatory and supervisory standards of best international practice in accounting and data reporting. They have also sta-bilized their economy with sound macro policies and debt management. Some have even borrowed or rented additional credibility by cross - listing their domestic corporate shares in more advanced markets (Doidge et. al., 2004; Edison and Warnock, 2006; Karolyi, 2004). As a result, they have received increased capital infl ows, with FDI and portfolio equity fl ows con-stituting a major portion of these fl ows (IMF, 2007a; Dehesa et. al., 2007; also see Table 5.1 and Figures 5.1 , 5.7 , and 5.8 ).

In addition to the evidence that many developing countries have improved their legal institutions and governance, there is some indication that the three paradoxes mentioned earlier — demonstrating the divergence between theory and empirics of fi nancial globalization — are beginning to lose strength. Lucas (2000) points out that the 21st century will witness a reversal of the widening inequality among nations. His assertion is based on an analysis of a Solow - type neoclassical model with global capital mobility, assuming that all countries have access to the same technology and institutions


0

200

400

600

800

1,000

1,200

1,400

1,600

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

TotalTo mature marketsTo emerging markets

�5

0

5

10

15

20

25

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Latin America/CaribbeanEmerging EuropeDeveloping Asia and PacificMiddle East and Africa

FIGURE 5.8 Global FDI Infl ows, 1996–2006 (US$ billion)Source: IMF (2007b).

FIGURE 5.7 Emerging Markets: FDI Outfl ows by Region, 1996–2006 (US$ billion)Source: IMF (2007b).


as well as to market - friendly economic policies. In this case, the “ Lucas paradox ” — that capital did not move from rich countries to poor ones — will no longer hold, and a “ catch - up ” process will rapidly narrow the income gap among countries. Lucas contends that more capital will move to devel-oping countries, which is reasonable as they adopt policies and institutional infrastructure that will reduce their risk premium on investment.

Developing countries ’ adoption of the set of policies and institutions — sound macroeconomic policy, best - practice international standards of trans-parency, accountability, and good governance, as well as legal institutions that protect investors, creditors, and property rights, and enforce contracts — will reduce the risk premium (Ju and Wei, 2006). It is not unrealistic that, as their fi nancial sectors develop and international fi nancial integration proceeds, assets of identical risk will command the same expected return, irrespective of spatial or domicile differences. Moreover, data from 2000 show the increasing fl ow of capital to developing countries (Table 5.1 and Figure 5.7 ). In recent years, equity fl ows to emerging markets have been stronger than bond fl ows, and equity market capitalization stronger than bond market capitalization (Tables 5.2 to 5.5 , Figures 5.6 to 5.11 ). Micro data are also beginning to reveal a perceptible shift of household assets port-folio allocation toward greater risk - sharing instruments. The data on the composition of households ’ fi nancial assets in Europe, the United States, and Japan between 1995 and 2003 (Table 5.6 ) demonstrate that in the Euro area, the European Union, and the US, households allocated a larger portion of their portfolio to risk - sharing instruments. While comparable fi gures are not available in other areas, similar behavior could be expected as policy, institutional, legal, and fi nancial development progress in developing coun-tries. Considering the Lucas paradox, Alfaro et. al. (2005) concluded that “ institutional quality is the leading causal variable ” in explaining the para-dox based on their empirical study.

Recent empirical evidence also suggests that, since 2001, there has been a systematic decline in home bias, at least in US equity investments (IMF, 2007a; Ammer et. al., 2006; Aurelio, 2006; Kho et. al., 2006). There has also been some empirical evidence that social capital — especially trust, institutional and legal developments, as well as greater transparency and availability of information — may, at least tentatively, explain the equity pre-mium puzzle (O ’ Hara, 2004; Lorenz, 1999; Lopez - de - Silanes et. al., 1997; Helliwell and Putnam, 1995; Berg et. al., 1995; Ashraf et. al., 2005; Das-gupta and Serageldin, 1999). The last decade has witnessed a growing body of empirical research demonstrating that fi nance, particularly risk - sharing instruments such as equity, is trust - intensive; therefore, in societies where the level of trust was high, fi nancial sectors were deeper and more devel-oped. In particular, this literature indicates that there is a high correlation


FIGURE 5.9 Equity and Bond Market Capitalization Growth: All Sample Countries, 1996–2005 (percent)Source: IMF (2007a).

FIGURE 5.10 Equity and Bond Market Capitalization Growth: Mature Markets, 1996–2005 (percent)Source: IMF (2007a).

�20

�10

0

10

20

30

40

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Equity market capitalization growthBond market capitalization growth

�20

�10

0

10

20

30

40

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Equity market capitalization growth

Bond market capitalization growth


TABLE 5.2 Equity Market Indices, 2002–06

End of period Billions of US dollars

2002 2003 2004 2005 2006

World 792.2 1,036.3 1,169.3 1,257.8 1,483.6Emerging Markets 292.1 442.8 542.2 706.5 912.7 Latin America 658.9 1,100.9 1,483.6 2,150.0 2,995.7 Asia 140.4 206.4 231.6 286.2 371.5 Europe, Middle East and Africa 108.4 163.9 222.7 300.3 361.1

Period of ChangeWorld �21.1 30.8 12.8 7.6 18.0Emerging Markets �8.0 51.6 22.4 30.3 29.2 Latin America �24.8 67.1 34.8 44.9 39.3 Asia �6.2 47.1 12.2 23.5 29.8 Europe, Middle East and Africa 4.7 51.2 35.8 34.9 21.3

Source: IMF (2007a).

�30

�20

�10

0

10

20

30

40

50

60

70

Equity market capitalization growthBond market capitalization growth

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

FIGURE 5.11 Equity and Bond Market Capitalizaton Growth: Empirical Trends in Conventional and Islamic Financial Globalization, 1996–2005 (percent)Source: IMF (2007a).

TABL

E 5.3

E

quit

y an

d B

ond

Mar

ket

Cap

ital

izat

ion

in N

omin

al D

olla

rs, 1

996–

2005

(pe

rcen

t gr

owth

)

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

Equ

ity

mar

ket

capi

taliz

atio

n gr

owth

A

ll sa

mpl

e co

untr

ies

12.9

12.6

15.1

29.2

�6.

7�

12.5

�14

.636

.418

.614

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mer

ging

mar

kets

10.7

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5�

20.1

65.2

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TABLE 5.6 Household Portfolio Allocation to Equity—International Comparisons, 1995 and 2003

Share and other equity

of which: mutual funds

sharesShare and

other equity

of which: mutual funds

shares

1995 2003

Portugal 25 7 27 9Belgium 29 9 29 16Denmark 23 7 17 9Germany 19 7 22 12Spain 31 11 39 13France 35 12 36 10Italy 20 4 35 17The Netherlands 20 5 11 4Austria 6 4 16 10Finland 5 1 41 5Sweden 30 7 40 12United Kingdom 20 4 16 5Euro area (9) 24 8 29 11European Union (12) 23 7 26 9United States 46 5 48 10Japan 14 2 11 2

Source: Cardoso and da Cunha (2005).

between trust and development of the fi nancial sector (Calderon et. al., 2002; Guiso et. al., 2004). Importantly, if the level of trust is high, more reliance is placed on risky assets, such as equity. People invest a larger por-tion of their wealth in stocks, use more checks, and have access to greater amounts of credit than in low - trust societies. Over the last decade, a number of researchers have demonstrated the impact of trust on economic perfor-mance (Knack and Keefer, 1997; Glaeser, 2000; Zak and Knack, 2001; Zak, 2003; Beugelsdijk et. al., 2004). In 1974, Arrow had suggested that trust “ is an important lubricant of a social system. It is extremely effi cient; it saves a lot of trouble to have a fair degree of reliance on other people ’ s word ” (Arrow, 1974). Fukuyama (1996) asserts that the general level of trust — an important component of social capital (Coleman, 1988, 1990; Glaeser et. al., 1999; Alesina and La Ferrara, 2002) — was a strong explanatory factor in the economic performance of industrial countries; the high level of trust was reinforced in these societies by strong institutions.


A recent empirical paper (Guiso et. al., 2005) demonstrates low trust as a crucial factor in explaining the low level of stock market participa-tion — that is, the equity premium puzzle. Based on the analysis of cross - country data, the paper suggests that where the level of trust is relatively high, investment in equity in general, and in the stock market in particular, is relatively high as well. Moreover, the paper asserts that in low - trust coun-tries, equity participation depends on observance of the rule of law and the existence of legal institutions that protect property, creditor, and investor rights, and those that enforce contracts. It suggests that in low - performing economies not only is the level of trust low, but property and investor rights are poorly protected, and legal contract enforcement is weak. The policy implication for these economies is to strengthen legal institutions, improve transparency, accountability, and governance — in both the private and pub-lic sectors — and to provide the public with a greater amount of information on risk sharing in general, and equity markets in particular. The growing body of empirical evidence over the last two decades has focused on the existence (or the lack) of strong institutions as a powerful factor explain-ing cross - country differences in economic performance. Recent research has underlined that the same legal and institutional factors are responsible for fi nancial sector development and its ability to integrate with global fi nance, which would strengthen economic performance.

In sum, the general indication is that there is globally a move in favor of equity participation in comparison to debt. This market development will be further reinforced by measures that increase the level of trust and by bet-ter and more transparent institutions.

5.2 Growth in Islamic Finance

Islamic fi nance has experienced rapid growth, 1 especially over the last decade, despite its analytic underpinnings, in modern economic and fi nancial terms, having been explained only a little over two decades ago (Khan, 1987). There is no accurate estimate of the size of the market at present, but it is certain that it is nowhere near its potential. Just as is the case with fi nancial globalization, Islamic fi nance has realized only an insignifi cant fraction of its risk - sharing capacity; of the 15 basic modes of available transactions, only a few have been used widely and even then only a few instruments have been innovated based on these transaction modes (Iqbal and Mirakhor, 2002).

In 2007, The Banker compiled a list of the 500 top Islamic institu-tions, including Islamic banks, Islamic windows, Islamic investment banks and insurance companies. 2 According to this report, the global total of Shari ’ ah - compliant assets grew at an impressive rate of 29.7 percent in 2007


compared to the previous year, to reach US $ 500.4 billion. Although this size is relatively small compared to the US $ 74,232.2 billion in total assets managed by the top 1,000 conventional banks worldwide, the rapid growth in Islamic institutions is almost double the growth rate of 16.3 percent for conventional banks.

Globally, the MENA (Middle East and North Africa) region accounts for the largest share (70.9 percent) of total Shari ’ ah - compliant assets, fol-lowed by Asia with a market share of 22.7 percent. Within MENA, market share is split almost evenly between the GCC (Gulf Cooperation Coun-cil, consisting of Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates) states with 35.6 percent and the non - GCC MENA states with 35.3 percent. Table 5.7 shows the size and growth rate of assets under management by the top 500 Islamic fi nancial institutions as com-piled by The Banker (2007). An interesting observation is that the top 15 countries by the size of Islamic assets include a non - Muslim country — the United Kingdom — at tenth place, with Shari ’ ah - compliant assets of US $ 10.4 billion, mainly due to successful operations by HSBC Amanah, with total assets of US $ 9.7 billion.

Islamic banking — consisting of commercial and investment banking — is one of the oldest sectors of Islamic fi nance. Although Islamic banking has fi rm roots in the Middle East, it also has a presence in South and East Asia. Bahrain in the Middle East and Malaysia in East Asia are trying to estab-lish themselves as fi nancial centers for Islamic fi nance and thus offer special incentives for Islamic banks. Islamic banking assets in Bahrain grew from US $ 1.3 billion to US $ 8.0 billion at the compounded annual growth rate (CAGR) of 28.99 percent from 1998 to 2005. Similarly, Islamic banking assets in Malaysia grew from US $ 19.4 billion to US $ 31.5 billion at a CAGR of 17.48 percent from 2002 to 2005. 3

TABLE 5.7 Islamic Finance Assets, 2006–07 (US$ million)

Region 2007 2006 % Change

GCC 178,129.55 127,826.55 39.4%Non–GCC MENA 176,822.17 136,157.64 29.9%MENA total 354,951.72 263,984.19 34.5%Sub-Saharan 4,707.98 3,039.32 54.9%Asia 119,346.46 98,709.56 20.9%Australia/Europe/America 21,475.72 20,300.24 5.8%Global total 500,481.88 386,033.33 29.6%

Source: The Banker (2007).


Table 5.8 shows the percentage market share of total Islamic banking assets of various countries as of 2006.

Compared to Islamic banking, Shari ’ ah - compliant capital markets are relatively new. During the early stages of development, capital market activities were limited to syndicated fi nancing and Islamic funds. One main reason was the absence of a Shari ’ ah - approved structure that was tradable in the market. Therefore, the initial focus of capital market activities was on fund management, especially during the boom in the world equities mar-kets. Islamic funds were introduced in the late 1980s and early 1990s. These funds were a portfolio of different asset classes, such as funds specializing in commodities, equities, and Islamic instruments such as leases ( ijarah ). For equities, special screening fi lters were defi ned to satisfy the requirements of Shari ’ ah . For example, shares of those companies that dealt with interest - based income, or carried extensive debt in their capital structure, or engaged in activities that were not “ socially responsible ” — such as alcohol produc-tion or gambling — were excluded from the fund.

Islamic funds have enjoyed considerable success, but not all investors were willing to invest in the risky equities asset class. Typical investors in Islamic banks were looking for less - risky securities where the principal is protected and the security offered a steady stream of cash fl ow. In short,

TABLE 5.8 Islamic Banking Market Share by Country, 2006 (percent)

Saudi Arabia 19.54Bahrain 18.97Malaysia 16.30Kuwait 14.64UAE 14.39Qatar 3.79Egypt 2.83Iran 2.82Switzerland 1.86Jordan 1.73Bangladesh 1.24Indonesia 1.11Pakistan 0.35United Kingdom 0.25Palestine 0.09Yemen 0.06Rest 0.03

Source: ISI Analytics (2007). This list excludes Sudan, where the total banking system conforms to Shari’ah.


investors were looking for a security that is Shari ’ ah -compliant but has the risk/return characteristics of a conventional fi xed - income security — that is, a bond. Meanwhile, conventional fi nance witnessed an explosion of securitization of assets, ranging from accounts receivables to mortgages. Considering that Islamic fi nance promotes securities linked to an asset, and considering the success with securitization in conventional fi nance, it was inevitable that a security in the form of an Islamic bond — called sukuk — was designed, which became an immediate success. Within a short period of time, several different structures of sukuk had been introduced into the market.

Figure 5.12 shows the rapid growth of the market from approximately US $ 1 billion in 2002 to US $ 47 billion in 2007. The volume of new issuances almost doubled from 2006 to 2007, but did not grow signifi cantly in 2007. Only 207 sukuk were issued globally in 2007, compared to 199 in 2006 and 89 in 2005. 4 Some observers attribute this slow growth in issuance to turmoil in the fi nancial markets due to the sub - prime crisis. However, while the number of issues did not increase signifi cantly, the average issuance size of sukuk did increase. Of course, sukuk issuance was also hit by the global recession as a result of the fi nancial crisis in 2008.

A diverse range of structures was issued during 2007 and included structures based on Bai ’ Bithaman Ajil (BBA), istisna ’ , mudharabah , ijarah , musharakah , and wakala contracts. Table 5.9 lists sukuk issuances by vari-ous countries and sectors. It is interesting to note that whereas in conven-tional markets, sovereign bond issuance dominates the market, in the case of the sukuk market, 79.2 percent of issuances were by the corporate sector, with Malaysian corporations being the most active. This not only shows that sovereign entities have yet to exploit this market, but also is indicative of the fact that when it comes to structuring a sukuk , sovereign entities have

9805,717 7,211

12,034

27,166

47,099

15,823

0

10,000

20,000

30,000

40,000

50,000

60,000

2002 2003 2004 2005 2006 2007 2008

FIGURE 5.12 Global Sukuk Issuance, 2002–08 (US$ million)Source: IFIS.


fewer options compared to corporations, which have more tangible assets to securitize.

The global slowdown and fi nancial crisis in leading industrial econo-mies also impacted on the sukuk market, and a drastic downturn in issuance of sukuk was observed in 2008 (see Table 5.10 ). It is clear that total issuance dropped from US$47 billion in 2007 to US$16 billion in 2008. Although the global recession was the primary reason, the sukuk market also experi-enced a negative impact as a result of the statement issued by AAOIFI which raised questions about certain market practices and sukuk structures.

Table 5.10 lists the top 10 investment banks that acted as lead managers for the issuance of sukuk in 2008. It is clear that the list is dominated by the leading conventional investment banks. Of the top 10, only four banks — Malaysian - based CIMB Islamic, Aseambankers Malaysia, Bank Negara, and Dubai Islamic Bank—are local as well as Islamic; the rest are Western banks. There are several reasons conventional banks play such a leading role. First, conventional banks are more experienced and knowledgeable about fi nancial engineering and structuring transactions. Second, conven-tional banks have more sophisticated sales channels to market the issues. There is a growing trend of conventional investors investing in sukuk , as they see better value. Third, conventional banks are working more aggres-sively to capture this growing fi eld, especially in GCC countries.

Growth in the sukuk market led to the development of the Sukuk Index by Dow Jones Indexes and Citigroup Corporation in 2006. An index plays a critical role in portfolio management as it serves as a proxy for the mar-

TABLE 5.9 Sukuk Issuance by Country and Sector, 2007

Country Sovereign Corporate Quasi-Sovereign Total

Bahrain 617 400 1,017Brunei Darussalam 222 222Cayman Islands 100 100Indonesia 81 113 193Kuwait 993 993Malaysia 3,777 22,752 26,529Pakistan 339 725 1,065Qatar 450 450Saudi Arabia 4,350 1,333 5,683Sudan 130 130United Arab Emirates 3,425 7,292 10,717Total 8,461 37,306 1,333 47,100Percentage 18.0% 79.2% 2.8%

Source: IFIS.


TABLE 5.10 Sukuk Issuance, 2008

By Country/Region

Amount in (US$ million)

Percent of Regional Market

Percent of Global Market

United Arab Emirates 5,995.91 66 38Saudi Arabia 1,873.74 21 12Bahrain 890.58 10 6Qatar 300.90 3 2

Total GCC Issuance, 2008 9,061.13 100 57

Malaysia 5,870.01 90 37Indonesia 678.1 10 4Brunei Darussalam 31 0 0

Total SEA Issuance, 2008 6,548.11 100 41

Pakistan 214.48 - 1Total Sukuk Issuance, 2008 15,823.72

Source: IFIS.

TABLE 5.11 Islamic Bonds Bookrunners/Lead Managers League Table, 2007

Ranking Bookrunner/Lead Manager Amount (US$ million) Issues

1 CIMB Islamic 1,716.87 302 HSBC Amanah 1,385.42 213 JP Morgan 1,077.00 24 Calyon 1,016.60 25 Aseambankers Malaysia 844.92 256 Dubai Islamic Bank 814.75 57 Citigroup 741.51 128 Barclays Capital 645.38 39 Bank Negara Malaysia 626.95 1

10 Standard Chartered Bank 497.36 9

Source: IFIS.

ket and is used as a benchmark by portfolio managers to measure their performance. The Dow Jones Citigroup Sukuk Index includes sukuk with a minimum issue size of US $ 250 million, minimum maturity of one year, and a minimum rating of BBB – /Baa3 by the leading rating agencies.

In the Islamic funds domain, property funds have recently gained popu-larity and interest among investors in the Middle East and Europe. In addi-tion, there are Islamic real estate investment trusts (REIT) which invest their portfolios in listed real estate securities — subject to Shari ’ ah compli-ance — that own and operate real estate such as residential, commercial, and


retail properties, storage facilities, warehouses, and car parks. 5 Although the number of Islamic funds available on the market has expanded in recent years (see Figure 5.13 ), most are relatively small in terms of size. For exam-ple, approximately 50 percent of the funds have less than US $ 50 million of assets under management. A signifi cant segment of Islamic funds is concen-trated in equity investment (see Figure 5.13 ), mainly because this is rela-tively easy to set up and a conventional equity mutual fund can apply the fi lter and construct such funds. However, there are gaps across other asset classes, including sector - specifi c funds and fi xed - income funds. 6

In 1998, the FTSE Group launched the fi rst series of Islamic equity indi-ces, the FTSE Global Islamic Index Series (GIIS). The GIIS are a subset of the FTSE All - World Index group, which includes stocks from 29 countries. The FTSE has 15 Islamic indices; classifi cation is based on industry (10 indices) and region (Global, Americas, Europe, Pacifi c Basin, South Africa). This was followed by the fi rst Dow Jones Islamic Market Index (DJIMI) in 1999, created to track the performance of companies whose activities are consistent with Shari ’ ah principles. More recently, Standard & Poor ’ s has also introduced similar indices. The performance of all these indices is regu-larly monitored and reported.

Whereas fi nancial engineering in conventional fi nance was driven by breakthroughs in fi nancial theory, fi nancial engineering in Islamic fi nance has been driven by the innovative application of Shari ’ ah rules. Shari ’ ah scholars have worked closely with the practitioners to develop products demanded by the market. In its early days, fi nancial engineering was limited to the development of a product for a fi nancial intermediary such as an Islamic bank; however, with the development of capital markets the focus of product development has shifted more toward marketable securities.

020406080

100120140160180200

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2007

FIGURE 5.13 Growth of Islamic Equity Funds, 1996–2007 (US$ billion)Source: ISI, Falaika.


A relevant example is the introduction of sukuk , which have become an overnight success. There are more than 10 different structures of sukuk , and the instrument has been welcomed by both Islamic and conventional market players. Following the success of sukuk , there has been more fi nancial engi-neering activity in customized and structured products.

Despite the above - mentioned obstacles, Islamic fi nancial engineering is taking place in several Western institutions that have extensive market and fi nancial engineering knowledge and experience in order to capture market share. Most such activities are taking place through “ wrapping ” in the form of structured deposits, funds, or bilateral contracts. While these products are labeled as Shari ’ ah compliant, details of the structures are often not available publicly. Below are some examples of recent applications of fi nan-cial engineering:

Deutsche Bank (DB) has offered a structure that enables DB to issue Shari ’ ah - compliant securities linked to a wide range of asset classes, such as commodities, fi xed-income, and money market funds with a range of different payoffs, such as capped and leveraged returns. These securities are also transferable at market value, which enhances market liquidity. Through this instrument, investors deposit funds with DB which are invested in Shari ’ ah - compliant securities, such as shares selected from a Dow Jones Islamic benchmark, and both investors and DB exchange promises ( wa ’ d ) to sell the securities at predetermined levels. The net effect is that, from an economic aspect, the wa ’ d arrangement amounts to an outperformance put or call option, even though such options are not normally considered to be Shari ’ ah compliant. 7 Standard Chartered Bank, Malaysia has introduced several hedging instruments that are Shari ’ ah compliant. For example, the Islamic Profi t Rate Swap (IPRS) was introduced to assist in the management of profi t rate risks. A profi t rate swap is a mechanism structured to allow bilateral exchange of profi t streams using two parallel and back - to - back Islamic marked - up sale ( murabahah ) transactions. In simple IPRS, a series of murabahah sale and purchases are conducted, allowing parties to swap or exchange profi t rates from fi xed to fl oating rates, or vice versa. In another version, called Islamic Cross - Currency Swap (ICCS), the same mechanism is applied for the purpose of cross - currency swaps. The pric-ing of all these Islamic hedging solutions depends on the expected rate of profi t, which is agreed upon by the bank and the client. The period of the swap ranges from one to fi ve years. 8 Deutsche Bank executed the fi rst Islamic Collar Profi t Rate Swap with Dubai Islamic Bank (DIB) in October 2007. The transaction was over

■

■

■


US $ 500 million in notional size, and is the largest such structure executed in the Islamic markets. The transaction was customized to the needs of DIB, which had specifi c hedging requirements that could not be achieved through plain - vanilla Islamic profi t rate swaps. DB worked with DIB and their Shari ’ ah teams to design an off - balance - sheet profi t rate swap with caps and fl oors to provide the desirable protection for DIB. 9

An insurance conforming to Shari ’ ah is known as takaful , literally meaning “ mutual guarantee, ” and is designed based on solidarity and coop-eration among members. Unlike Islamic fi nance, the takaful business did not spread rapidly. The primary reason was a division of opinion among Shari ’ ah scholars with respect to the legitimacy of underwriting an event in the future, which was considered similar to speculation and thus gambling. Such an objection was particularly applicable to underwriting life insur-ance, which was considered totally unacceptable as it involves gambling and uncertainty, and goes against the Islamic concept of predestination ( qadar ). 10 Due to this internal debate, the takaful industry did not take off smoothly; however, over time, some of the internal Shari ’ ah issues have been resolved and a consensus has emerged on the permissibility of including business losses and — to a lesser extent — loss of life.

Even after one convincingly argues that insurance does not amount to gambling, the issue is raised of how to invest premium funds in a man-ner that is compliant with Shari ’ ah — that is, investments without involv-ing riba . Unlike conventional insurance underwriters, takaful companies did not have access to liquid money and capital markets to construct effi -cient portfolios of fi xed - income securities with desirable risk/return profi les. Therefore, during the early stages of development of Islamic fi nance, takaful companies had diffi culty in placing funds in liquid securities. As the market for Shari ’ ah - compliant products is expanding, this constraint has become a lesser issue.

The fi rst takaful entity was established in 1979 — the Islamic Insurance Company of Sudan — followed by Malaysia in 1984, before spreading to Saudi Arabia and other Middle East countries. The takaful industry has been growing at a rate of 10 – 20 percent per annum, compared to the global average growth of the conventional insurance industry of 5 percent per annum. A large number of takaful companies exist in the Middle East, the Far East, and even in some non - Islamic countries. Re - takaful business has also been developed in Malaysia, Bahrain, Saudi Arabia, and the United Arab Emirates. 11

The takaful industry has witnessed high growth in recent years (see Table 5.12 ). The total gross premiums underwritten by takaful companies were


worth US $ 530 million in 2000; this rose close to US $ 3 billion by the end of 2006. 12 As of 2005, there were 82 companies engaged in takaful business. Of these, 77 were dedicated takaful companies and fi ve were offering taka-ful products through Islamic windows. There were also eight companies engaged in re - takaful business. 13 In terms of market share, as of 2005, South and East Asia held 56 percent of the market, followed by the Middle East with 36 percent, Africa with 7 percent, and Europe, the United States, and others with a 1 percent share. Industry growth is forecast to be maintained at approximately 15 percent until 2015. 14

Islamic fi nance is gradually being introduced in countries that are not Muslim. Although Western fi nancial centers and fi nancial intermediaries have always played an important part in executing and innovating Islamic transactions, such activities have been mostly carried out in the private sec-tor and in a discreet fashion. By early 2000, this trend began to change, and several non - Muslim countries began to take an interest in the emerging market. This can be attributed to several factors, such as booming oil rev-enues leading to the accumulation of investible funds looking for attractive investment opportunities, increased awareness of regulatory issues relating to Islamic fi nancial intermediaries, the desire to tap into alternative fund-ing resources by sovereign and corporate entities, an increasing Muslim population in Western countries interested in Shari ’ ah - compliant fi nancial products, and Western fi nancial institutions seeing profi table opportunities in Islamic fi nance. These developments have motivated Western countries, most notably the UK, to adopt regulations that afford Islamic fi nance and Islamic fi nancial products an equal footing with conventional fi nance. Islamic fi nance going global is evidenced by the wide distribution of subscribers investing in sukuk , as shown in Table 5.13 . Sukuk issued by institutions based in Malaysia, Saudi Arabia, and the United Arab Emirates are held in signifi cant portions by investors in Asia, Europe, and the United States.

TABLE 5.12 Islamic Insurance (Takaful) Market, 2002–06

Year Size (US$ million) General Takaful Family Takaful

2002 1,396 98% 2%2003 1,648 98% 2%2004 1,749 98% 2%2005 1,980 98% 2%2006 3,000 98% 2%

Source: ISI Analytics (2007).


5.3 Convergence or Divergence?

There are numerous developments and factors that point to a future conver-gence of the two fi nancial systems. These include the present unprecedented turmoil in the conventional fi nancial markets resulting in a more careful examination of fi nancial stability, the theoretical and observed instability features of the conventional fi nancial system, the increasing recognition that equity capital fl ows are more stable and supportive of stable fi nancial development and growth, the growth of Islamic fi nance beyond the borders of Muslim countries, relatively higher fl ows of equity capital across bor-ders, and signifi cant surplus capital in several oil - rich Islamic countries who may be increasingly demanding Islamic fi nancial products. Opportunities in developed economies due to depressed asset prices, and extra liquidity in Islamic fi nancial markets, will also play a role in further globalization of Islamic fi nance.

In the next chapter, we look at the issues involved in designing and developing an Islamic fi nancial system, before taking up the issue of fi nan-cial convergence in more detail in Chapter 7 .

Endnotes

1 See Financial Times report, “ Islamic Finance, ” May 24, 2007, for estimates of the growth, size, and potential of Islamic fi nance.

2 The list of 500 Islamic institutions includes 292 commercial banks (both fully Islamic and those offering Islamic windows or selling Islamic products), 115 Islamic investment banks and fi nance companies, and 118 insurance compa-nies, adding to a total of 525 institutions from which the top 500 list was drawn.

3 ISI Analytics (2007). 4 Islamic Financial Information Services (ISI Analytics, 2007). 5 ISI Analytics (2007). 6 Ernst & Young (2007).

TABLE 5.13 Global Investor Base for Sukuk (percent)

Middle East Asia EuropeUnited States

Malaysia sukuk—2002 51.0 30.0 15.0 4.0State of Qatar sukuk—2003 72.0 11.0 14.0 3.0IDB sukuk—2004 32.0 35.0 26.0 7.0Emirate Airlines sukuk—2005 59.6 8.4 32.0

Source: Ismael (2007).


7 Deutsche Bank. 8 Aziz (2007). Please note that many structures that are acceptable in the Malay-

sian market may not be acceptable in the Middle Eastern market. 9 www.db.com/presse/en/content/press_releases_2007_3654.htm?month=3 . 10 According to Saleh (1992), the proponents of the contract of insurance argue

that gambling and insurance have distinct features. In the case of the former, a gambler pursues, through unlawful means such as betting and wagering, risks that could be easily avoided if he so wanted. As for insurance, the insured per-son seeks protection from danger over which he has no control. Moreover, gambling has very detrimental social effects, whereas insurance is very desirable and sometimes vital for trade and commerce.

11 Ayub (2007). 12 Ernst & Young (2007); IRTI and IFSB (2006). 13 ISI Analytics (2007). 14 Ibid.

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