Tuesday, March 01, 2011

The Gradual but Promising Expansion of Islamic Finance

Forbes: London Gets Jump on New York in Islamic Finance

Islamic finance is a relatively small industry, with Shariah-compliant assets (conforming to Islamic religious laws and principles) constituting only 2 to 3 percent of global financial assets. Bloomberg President, Dan Doctoroff, expects that Islamic finance will grow from $1.3 trillion to $2 trillion dollars in the next couple of years. Despite some downturn due to the global financial crisis, the industry is growing at an annual rate of 25% and offers tremendous opportunities for investors and beneficiaries of Islamic financial instruments alike.

Islamic finance differs from traditional finance in three principle ways: first, banks may not charge interest; second, there must be risk sharing among investors and the bank; and third, all transactions must be asset-based (must have as collateral some physical or commercial asset). This approach is a significant break with traditional methods of finance that focus on interest as a source of wealth creation for the lender. Because Islamic finance prohibits charging interest, financial instruments are altered in complex ways to satisfy Islamic law while also providing a revenue stream for the investor. Islamic financial institutions offer parallel products to traditional finance including Islamic hedge funds, home loans, derivatives, and insurance.

One common financial instrument, which western countries are also buying, is the Islamic bond—also called sukuk. When an Islamic government issues a sukuk, it may use land on which it plans to build its project as collateral. The government then sells the land to a special purpose vehicle or SPV (a company created for the purpose of the transaction and funded by the Muslim investors) that leases the land back to the government at a rate higher than what the SPV paid to purchase the land. The government’s lease payments, which take the place of traditional interest payments, are then channeled back to the investor. The land is eventually sold back to the government.

With Islamic finance poised for expansive growth, countries around the world are positioning themselves to be the beneficiaries of the developing industry. Last week London hosted its annual Islamic Finance Conference that attracted key industry participants, drawing London closer to becoming the second hub of Islamic finance, after Kuala Lumpur, Malaysia. France, which has a large Muslim population totaling 5 million people, is racing with Britain to be the first European country to issue a sovereign sukuk. The former Malaysian Prime Minister, Mahathir bin Mohamad spoke at an international forum in South Korea on February 24th, urging Seoul to follow through on its aims of launching an Islamic bond. Recognizing the tremendous growth potential, Bloomberg launched its Islamic finance services platform, including news and data compilation, in effect supporting future growth of Islamic finance. The reason for the rally toward creating Islamic financial products is that Muslim populations (particularly in the Middle East) have accrued enormous wealth in the oil-rich Gulf, and are looking to invest. Access to such wealth can provide governments and other capital-seekers opportunities to diversify and reach new sources of funding.

However, Islamic finance faces both internal and external pressures. Internally, there are many Muslims—including high-ranking clerics—who believe Islamic finance is just a cover for charging interest. Externally, governments issuing Islamic bonds have felt domestic pressures of “Islamaphobia” like in the United States and in South Korea, where people have argued that Islamic financing funds terrorists. While heads of government have tried to debunk such thinking, in the case of South Korea, the powerful Christian lobby has been successful in slowing the move towards a sovereign sukuk. Whether internal or external pressure will mount to a significant opposition is unclear, but it is clear that states and private entities see a strong future for Islamic finance.

Discussion Questions

Is there any credence to the Islamic clerics’ arguments that Islamic finance manipulates financial mechanisms to essentially charge an interest rate? Why or why not?

What might be the different risks and benefits of Islamic finance compared to traditional finance?

What difficulties might the growth of Islamic finance present to countries that issue a sovereign sukuk?

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