Is Islamic finance at tipping point?

By Christopher Watts

Shari'a-compliant banking is fast moving from niche to mainstream, says Christopher Watts. But while continuing growth seems certain, challenges remain.

In January this year when the UAE's Sharjah Electricity and Water Authority (SEWA) needed cash to construct a power generation and desalination plant in the town of Hamriyah, it was Islamic finance that provided the answer: The utility raised USD 350 m by issuing its first ever sukuk – asset-backed bonds that comply with Shari'a, the Islamic legal code that prohibits interest.

By no means is SEWA alone in venturing into the Islamic capital markets. Corporate sukuk issuance leapt from USD 0.4 billion in 2000 to USD 24.5 billion in 2006, according to International Islamic Financial Market (IIFM), an industry association. Growth topped 122% in 2006 alone. "Islamic finance is no longer a niche market," says David Pace, CFO of Bahrain-based Unicorn Investment Bank (UIB), a Shari'a-compliant house. "It is increasingly a mainstream component of the global banking system."
To be sure, while the world's first Islamic bank was founded back in 1975, it is only in the last five years or so that Islamic finance has surged. Sniffing opportunity, conventional banks are now scrambling to set up Shari'a-compliant operations; and there has been a flurry of all-Islamic start-ups, from full-service investment banks to specialist advisory firms. Products have moved beyond lending, insurance and investment funds to include sukuk, hedge funds, currency swaps, and more.

Despite this boom – largely concentrated in the Middle East and South-East Asia – it's plain the Islamic finance industry still lacks global scale. Professor Rodney Wilson of the Institute for Middle Eastern and Islamic studies at Durham University in the UK estimates Islamic banking assets speak for less than 0.5% of the world's total. And worldwide sukuk debt outstanding amounts to perhaps USD 100 billion – just 0.1% of the global bond market.

Still, the signs point to a continuing surge in Islamic finance. Take economic growth: The Middle East and Asia are the two fastest-growing areas of the world. Kuwait Finance House expects 2007 GDP to rise 6.1% in the GCC and 6.2% in South-East Asia – in contrast to 2.4% in the EU and 2.2% in the US. Oil revenues lie behind the boom in the GCC; and in South-East Asia it is "the financial rigour adopted in the wake of the Asian currency crises," according to Douglas Clark Johnson, CEO of Calyx Financial, an alternative investment adviser based in New York.

Continuing growth in the GCC states and South-East Asia is fast creating a prosperous middle class among the regions' combined 410 m-strong Muslim population. As the ranks of the regions' newly well-off snap up credit to buy homes and cars, and invest in savings and retirement plans, demand for Shari'a-compliant retail financial services is set to accelerate. Behind such consumer products is a need for Islamic institutional finance too.

Consider, too, the vast cash-flows into the GCC region and South-East Asia: The IMF expects Indonesia and Malaysia alone to record a cumulative current account surplus of USD 132 billion for the five-year period to end-2008, in contrast to a deficit of USD 32 billion for the same period a decade earlier. And in the GCC, the surplus should reach USD 680 billion, versus a prior deficit of USD 8 billion.

Buoyed by this cash, regional governments are planning ambitious infrastructure programmes: Indonesia alone expects USD 110 billion of expenditure in the five years to end-2010; and consulting firm McKinsey estimates the GCC will invest USD 200 billion in the same period. Much of this spending is already being financed by sukuk – and the volume is set to balloon: Following its successful sukuk issue, SEWA hopes to raise another USD 2.7 billion. And in neighbouring Dubai, the electricity and water authority is eyeing a debut sukuk issue, with plans to raise USD 2.5 billion.

With ever-stronger foundations in the Middle East and Asia, Islamic finance is now starting to take hold in London, too. The UK's first standalone Shari'a-compliant bank opened its doors in 2004; two others have followed; another is on the way. (All are backed by Middle Eastern institutions.) And in April this year the London Stock Exchange listed its maiden sukuk, adding much-needed depth and liquidity to the market. Another milestone is in sight: the UK government is mulling its first sovereign sukuk issue, perhaps as soon as early-2008.

But challenges remain. If Islamic finance is to move deeper into mainstream global finance, the industry needs to improve transparency and foster credibility by harmonising standards and practices. Not least, Shari'a interpretation varies between regions and even institutions. Regulatory oversight need to be sharpened as well. These measures – and others – could be critical in broadening the appeal of Islamic finance and bridging the gap between Islamic and conventional financial systems.

The Islamic finance industry needs to work on innovation, too. Shari's-compliant products can be more complex than conventional ones because every transaction is backed a non-financial trade. Many instruments are still lacking, including corporate treasury and derivatives products. As UIB's Pace points out: "We [in the industry] need to change our perception of R&D, and view it as a core ingredient of success." But at the same time, innovation is hampered by the limited number of Islamic scholars able to vet financial products for Shari'a compliance.

For certain, industry practitioners are making progress. Earlier this year the International Capital Market Association and the IIFM agreed to develop standard contracts and common best practice for secondary trading of sukuk and other Islamic instruments. And it may help, too, that global banking giants are putting their weight behind Islamic finance. (Deutsche Bank, Barclays Capital and BNP Paribas are already among the world's top five issuers of sukuk.)

The question whether Islamic finance has reached critical mass remains open, of course. But Johnson of Calyx Financial is optimistic: "The tipping point may already have arrived," he ventures. Even if Johnson is wrong in his optimism, it seems unlikely history will prove him to have been very far wide of the mark.
Source : Economist.com