A brighter future

Once seen as an obscure backwater of banking, the Islamic finance sector has registered phenomenal growth in recent years.

While the concept of tailored services for devout Muslims has existed for decades, the oil-rich Gulf economies, hubs for Islamic finance, have catapulted the market into the mainstream. New entrants have flocked to capitalise on the trend, drawn by the region’s financial liquidity and the rising demand for Sharia-compliant products.

The sector’s boom, however, has run headlong into the global credit slump. Ebbing liquidity, risk aversion and weakening real estate and stock markets are all factors conspiring against banks around the world.

Islamic banks came late to the global downturn, but analysts are warning this resistance will not last. While long-term growth is still expected to remain strong, this year could prove challenging as the downturn in the Gulf’s property and equity markets takes its toll on bank assets.

“Islamic finance in the UAE has been good at avoiding international exposure, but a lot of it has been tied to the property market, which is not so good,” says Raj Madha, director of equity research at Egypt’s EFG-Hermes.

“When you look at their investment portfolios, they tend to be more equity-based and less debt-based. And if they’re more equity-based then of course they’ll have fallen more with the collapsing equity markets around the region.”

But Madha cautions against generalisations with regards to the Islamic banking sector, noting that some institutions have plenty of factors working in their favour.

“Some of the banks in some GCC countries have lower exposure to credit cards and tend to have lower exposure to personal unsecured lending, both of which are areas of possible high default rates. So that’s a positive,” he says.

They have also managed to dodge the crippling economic woes suffered by many US and European banks last year.

“An Islamic bank would have taken some writedowns on its equity investment portfolio but it wouldn’t have taken the kind of writedowns that any of the global banks have taken, or even some of the regional banks,” says Abdul Kadir Hussain, CEO of Mashreq Capital.

Furthermore, analysts are optimistic about the long-term prospects for Islamic finance, once the global economy rebounds. Worldwide, a large Islamic population and increasing wealth in Muslim nations has whetted the appetite of Western investment banks, which are now entering the field in increasing numbers.

Indeed, British prime minister Gordon Brown, in his former role as chancellor of the exchequer, pledged his support to boost the number of Sharia-compliant products on offer to Muslims in the UK.

The growing presence of Islamic finance has also been reflected in the launch of a undergraduate degree in the subject earlier this month at Strasbourg University’s School of Management in France.

The rise in interest in what is still an opaque industry, however, has highlighted the need for more regulation and better supervision. Islamic finance is still widely seen as an immature industry, a factor that may restrict its future growth.

“Basically it is one of the upcoming financial sectors that will depend heavily on regulatory progress and in times like this it is sectors that are upcoming that will take the first hit,” says Mandagolathur Raghu, senior vice president of research at Kuwait Financial Centre (Markaz).While the Bahrain-based Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) sets guidelines on Sharia compliance for Islamic financial institutions, it has no power of enforcement.

“These are asset-backed finances and asset-backed finances have really come under sharp focus in view of the deterioration in asset quality,” Raghu notes.

“With respect to recognition of values, with respect to risk management practices, I think there are a lot of grey areas with Islamic finance institutions, when compared to conventional banks.”

Research shows that regulatory issues had a negative impact on Islamic bond (sukuk) markets last year. The sector faced unprecedented challenges amid the ongoing global credit crisis in the latter half of 2008, but the debate over the Sharia compliance of some sukuk structures also had a significant role to play, Moody’s said in a recent note.

AAOIFI last year issued guidelines that questioned the compliance of certain sukuk structures. A number of structures fell out of favour as a result, including Mudarabah which was the dominant class in 2007. The comments caused confusion and may have contributed to a decline in issuance, suggests Hussain.

“Unfortunately we still don’t have a lot of clarity from them [AAOIFI] as to what structures they are okay with,” he says. “If structures were issued with their approval in the past, and now they’ve decided that they’ve changed their mind, what does that mean for the older structures?”

The number of sukuks issued last year slumped, taking analysts by surprise. For anyone hoping that the troubles in Western debt markets would bypass, or even benefit their Islamic counterparts, the second half of 2008 proved a turning point.

As late as September, Standard & Poor’s (S&P) analysts were predicting issuance would reach $20bn to $25bn given the good pipeline. At the time, the ratings agency said that based on the appetite it was seeing from issuers; it expected the sukuk market to continue to grow into a mainstream product with global reach.

Four months later, S&P data showed the value of sukuk issued in 2008 had dropped by more than 56 percent on the previous year to $14.9bn. “We do not expect the market to revive before the second half of 2009 or early 2010,” says S&P analyst Mohamed Damak.

According to Moody’s business development manager for Islamic finance, Faisal Hijazi, sukuks worth over $45bn were announced in 2007 and 2008 but only $15bn have been issued. Some of those sukuks will come back into the market this year, but much of it will be dependant on market conditions, he says.”These are things that are in the pipeline and companies will be keen to issue those sukuks once the cost of borrowing comes down.”

The need for project financing in the region remains, Hussain notes.

“The problem is that the investor base in this market is very concentrated. Traditionally the only real buyers were Islamic banks. And now those banks’ balance sheets are stretched and they are doing everything they can to fund their loan base,” he says.

“They don’t have a lot of excess liquidity to go out and buy sukuks with, and if an Islamic bank isn’t going out and aggressively buying sukuks, there isn’t any other natural investor of size in this market.”

The sukuk market got a dramatic boost in the first half of 2008, amid speculation that the dirham was going to be revalued against the dollar. “You had a situation where banks were very liquid so they could buy sukuks, and a situation where speculators wanted dirham assets. The performance you have seen since then is another indication that that is exactly what happened,” Hussain says.

Once market talk of revaluing the dirham subsided, the price of many issues fell sharply.

“It’s just difficult to find positive linings in 2009 that would make risk appetite rebound and that would make investors come back and invest in these asset classes,” he says.Mashreq Capital is banking that last year’s sukuk sell-off was overdone, and that it will provide investors in its new $50m sukuk fund with returns of between 12 and 20 percent over the next 12 months.

“The yields that you are getting now in a lot of these securities are extremely attractive. You are getting equity type returns at current prices,” Hussain says.

“The risk for the investor is obviously that some of these sukuks are not able to be repaid at the time that they mature. That’s where we add value. Before we invest in any one of these things we undertake a pretty stringent risk assessment.”

Hussain’s top picks include Abu Dhabi property giant Aldar, the Dubai government’s dirham-denominated sukuk, and Saudi real estate company Dar Al Arkan.

“We think that repayment risk is extremely small. The chance of an outright default, or a restructuring or an extension of a maturity is very, very small,” he says.

Hussain is more cautious on Nakheel’s sukuk that matures on Dec 14 this year and currently carries a yield of 37 percent.

“I think there is a place for Nakheel in a portfolio of these and that’s why a fund is probably a more efficient way to do this than trying to go and buy the sukuk yourself,” he says.

“Clearly the market is pricing in the fact that there is repayment risk. I can see why that is because if you actually do the numbers, and look at where its sources and uses of funds are and will be over the next 12 months, you cannot deny the requirement that Nakheel is going to need external funding to repay it.”

The Palm developer may be unable to raise the money through an IPO if stock markets continue to languish.

“Given where debt markets are, it’s clear that Nakheel is going to have to pay more than it has previously if it wants to refinance. And given where the real estate assets markets are it will extract a heavy price from Nakheel if they have to sell assets into this market,” Hussain says.

He believes Nakheel will use a combination of instruments to pay the maturity.

“I think there’s potentially going to be some deal with private investors along with a refinancing package from the banks, and potentially, towards the end of the year, a public market debt issue, once markets start to stabilise.”

On the upside, 2009 could be the year when Islamic investors diversify away from the volatile equity markets, which Hussain believes will benefit the sukuk fund he is launching. Few equity investors will be able to recover the losses they incurred last year even with an uptick in equity markets.

“From that perspective I think they are going to have a difficult time of it, which is why we’re hoping that a sukuk fund is something that’s attractive to them,” he says.

“On a year to date basis you will get outperformance of a sukuk fund versus any equity class.”