Thursday, March 31, 2011

Berkeley Islamic Finance Forum

I will be speaking at the Berkeley Islamic Finance Forum next Saturday, April 9, 2011. Below is a poster for the forum.

Wednesday, March 30, 2011

Forward ijara and property speculation

Emirates 24/7 is reporting that Dubai Bank is waiving the rental payments it demanded for construction projects that were delayed. In an earlier post, I included quotes form a paper by Dr. Abdul Sattar Abu Ghuddah on the forward ijara contract. I am more convinced that this was the contract used in the disputed contracts and that the issue was that rent began accruing on what the bank referred to as the "expected date of delivery". For the people affected by the delays and facing large payments for the rent that the bank claimed as due despite the delays, it is surely a relief.

However, I think that the issue does not really end here. The bank realized it was at fault for the cost of the delays by virtue of the specific contract used (based on my reading of Dr. Abu Ghuddah's position on forward ijara). However, I think it raises some more fundamental questions about what potential misuse could come from the forward ijara contract in the future with this new precedent. There is not yet any form of consensus about what happens when a project that is the subject of a forward ijara is delayed so that delivery does not take place on the specified date.

However, for purchasers of future apartments where the contracts are forward ijara, it is pretty much assured that they will assume that the rents will be waived by the developer. This reduces the costs to speculating on these types of developments; in a way, it's back to 2007. Their possible gain by buying an apartment with a small amount made as a down payment gives them the upside if the development is built on schedule. If things go awry, then they always have the option of walking away and losing their deposit (there may be additional penalties depending on the country). Even if they do not do so, they will be stuck with an underwater property and rental payments into the future. However, they will not have the additional rental fees assessed in a lump sum for any delays in the project.

Contracts will vary on the conventional side, but I assume they would have some grace period from when the contract is signed for a specified number of months. After that period, the principal and interest would be due in monthly installments whether or not the property is completed. If this occurs, it will make the forward ijara economically preferable to a conventional loan.

While this is generally a preferable outcome--making Islamic finance products more desirable--in this case, it would create additional incentives to speculate on real estate projects. If there were a delay (caused, perhaps by financial crisis or real estate panic), the buyer could sit on the unfinished property until it were ready and then decide whether to take possession or renege on the financing. During the intervening period, they would be granted a free ride, (free of payments and accruing interest) which would alter their economic decision about whether to wait for markets to recover.

Viewed from the ex ante position, this would alter the decision about whether to speculate on an "apartment in the sky" because the cost of it being unsuccessful would be reduced and the downside risk would be pushed out into the future a few years. Most investors, particularly in situations where real estate speculation occur, are quite myopic (with high discount rates). This could have a substantial impact on decision-making and might even attract people who didn't choose Islamic finance for the ethics but for the economic outcome. While not a bad thing for a generic Islamic finance product, in some situations, this could lead banks to over-extend again and face a crash.

Tuesday, March 29, 2011

Where will sukuk markets gravitate?

The markets for Dubai's sukuk are giving the "all clear" with yields falling and the spread between Dubai's sukuk and Malaysia's sovereign sukuk falling to their lowest levels (the Malaysian sovereign sukuk was issued last summer). There are other articles giving warnings of the effect of the protests in many countries, with Bahrain causing the greatest effect on the Islamic finance industry.

The disruption caused by the protests is unfortunate for Bahrain which saw its financial industry grow to around one-quarter of the economy before the protests after capturing share from Beirut in the 1980s after the beginning of the Lebanese civil war. Now the protests in Bahrain could shift the center of finance--and Islamic finance in particular--elsewhere in the GCC if the disruption continues. The old saying about finance reminds that markets and financial firms, while taking risk, will avoid uncertainty. However, despite the disruption to business activity in Bahrain the Central Bank has continued its sukuk issuance with one sukuk al-salam recently that was heavily oversubscribed. However, the yield of 1.15% was sharply up from six months ago when the CBB issued a sukuk al-salam paying just 0.67%.

Even before the protests, the center of sukuk issuance was seen as shifting away from the GCC with Malaysia being the destination of choice for issuers with its much more liquid secondary markets. Although I still belive (as I predicted at the end of 2010) that this would slow and begin to shift back towards the GCC, it will probably take longer than I expected with the disruption in one of the financial capitals in the region. However, given that there has been limited spread in protests to Saudi Arabia, the UAE and Qatar, there should still be issuers looking to issue sukuk domestically (like, for example, Bank Al-Jazira, which just issued a SR1 billion ($267 million) sukuk).

One factor that could be slowing the return of issuers to the GCC besides the events in the region is the currency: the ringgit is the strongest it has been in 13 years against the dollar, to which the GCC currencies are pegged. Given the tendency of financial prices to revert to the mean in the longer term, this would benefit issuers from the GCC who issue sukuk at current levels because their repayment obligations is in ringgit and if the currency returns to the average level over the past five years, it would effectively reduce their local currency obligations. As the ringgit appreciates, it would be expected that this affect would be diminished and coupled with a return to calm in the GCC would encourage issuers to look more to the local GCC markets.

Within the GCC, the impact of the instability in Bahrain will probably lead to a shift of Islamic finance activities--particularly if the protests continue--to another country. While the resolution of some of the Dubai World troubles with cash payments being made to creditors will remove some uncertainty around the Dubai situation, it is unclear whether it will be the preferred destination for any financial institutions fleeing Bahrain. Perhaps Qatar, with its 2022 World Cup, or Abu Dhabi will become the destination. Or perhaps, Saudi Arabia, with its mortgage law expected to come into effect in 2012 will have its bid as a hub for Islamic finance become as significant as its economy's size within the GCC.

Monday, March 21, 2011

Would an Islamic Sovereign Wealth Fund Be Workable?

Rushdi Siddiqui has a broad article about the role an "Islamic Sovereign Wealth Fund" could have in the Islamic finance industry and some of the obstacles it would face. He makes a strong case for why sovereign wealth funds overlap significantly with a fund that would select its investments within the constraints of Shari'ah-compliance. Nine of the ten top holdings of the Norwegian sovereign wealth fund pass through Shari'ah screens (with the exception being HSBC Holdings plc).

One thing that I notice right away is the concentration of these investments in the energy and natural resource sector: the fund holds three oil companies and a mining company along with a consumer products firm, a telecommunications firm and two pharmaceutical companies. Before returning to the issue of an Islamic sovereign wealth fund, it seems to me that the top ten holdings (if representative of the portfolio) has more exposure to energy and commodities than might be desirable given that the SWF gets its revenue from oil.

Returning to the issue of the Islamic SWF, the model for the sovereign wealth fund is based on the five characteristics of SWFs from Monitor Group/FEEM:
  • Owned by a sovereign government
  • Managed independently from government's other financial institutions
  • Not attached to explicit pension obligations
  • Invests in a diverse set of asset classes in pursuit of commercial returns
  • Invests a significant proportion of publicly-reported investments internationally
The Islamic SWF would need to overcome four major hurdles:
  • Source of funds/sovereign affiliation
  • Purpose of the SWF
  • Ability to diversify across all asset classes
  • Political sensitivities towards a Shari'ah-compliant SWF
Although these are not exactly how Rusdhi Siddiqui frames the problem, it is close and I think separates it into the different areas where there are major questions.

Source of Funds/Sovereign Affiliation
One of the biggest questions around an Islamic SWF in my opinion is how the funds will be mobilized and the resources (and investment opportunities) shared. There is of course a model for cooperation across Muslim-majority nations in the Islamic Development Bank, a multilateral development bank which is funded at different levels by Muslim-majority countries and which operates in all IDB member countries.

 However, the distinction between the Islamic Development Bank and an Islamic SWF is that the resources from the IDB are used primarily for development projects where an Islamic SWF would be focused much more on commercial concerns (i.e. generating the largest return). This would likely lead to even more of a concentrated ownership than the IDB (based on the relative wealth of the countries likely to support the Islamic SWF). Saudi Arabia alone is the largest investor in the IDB controlling more than 1/4 of the organization and combined with the next three largest member countries in terms of capital contribution (Libya, Egypt and Iran) represent more than half of the paid-up capital in an organization with 56 member states.

Tying into the point about political sensitivities, an ownership structure that was dominated by one or several countries would lead to allegations that some countries were trying to cloak their national ambitions (whether this allegation was based on the SWF's Islamic nature or not). This could complicate the international investments the SWF would try to make, particularly if it made a large acquisition a la the Dubai Ports World/P&O Ports controversy in the U.S.

One possible solution would be to alter the profit-sharing ratios within the SWF to reduce the share of profits accruing to any one large shareholder in the SWF (if it were set up like a musharaka vehicle, the losses would have to be shared in proportion to capital contributions). However, it would be naive, in my opinion, to assume that there would not be some form of tradeoff if the capital for the Islamic SWF were not exchanged for some other form of benefit. Whether this takes the form of selecting more asset managers from larger capital contributors or some other mechanism, it would create political problems within the organization.

Purpose of the Islamic SWF Rushdi Siddiqui suggests that an Islamic SWF would be set up as a way to either provide some form of support to asset management in Islamic finance (as opposed to the one-off product offering common now) or to possibly become a lender of last resort. I think both are noble goals for an Islamic SWF. However, both either duplicate the roles of organizations being set up today (like the International Islamic Liquidity Management Corporation and to some extent the Islamic Development Bank) or create opportunities for influence peddling or complicate the issues of ownership of the SWF.

On the latter issue, the tradeoff between providing more benefits to smaller or less resource rich countries greater than their ability to contribute to the capital of the Islamic SWF will always come at a price. It may be just the "status" of being a large owner of an Islamic SWF, but more likely the additional resources contributed to the Islamic SWF would lead to an implicit bargain that asset managers from that country would be selected disproportionately to reward that country for taking the lead by contributing more capital to the Islamic SWF.

 On the former issue, I think that the IILM is creating a wide base of support from its member country governments and central banks for its sukuk program and this would provide a better base to become a multi-national Islamic lender of last resort. I don't know if it is better for a multi-lateral organization to be the lender of last resort, given the politics that will be involved in a crisis, but the International Monetary Fund, despite many valid complaints about how it operates, sets a model as the "global firefighters" that the IILM could become.

However, an Islamic SWF that has a large portfolio of assets--but not necessarily the same level of liquidity as the IILM--could get in the way or even become trapped by the illiquidity or decline in value of its assets that would make it less able to step in at the points of time when it is most needed.

Ablity to Diversify across Asset Classes 
Here I have few difference of opinion with Rushdi Siddiqui. He note that the Norwegian sovereign wealth fund is widely diversified across highly rated sovereign issuers and there are few if any sukuk available with that much diversification and size of issuance for an Islamic SWF to invest in. Other asset classes are available, but with equally spotty availability and diversification possibilities. With sovereign sukuk in particular, there is still enough of a shortage in sukuk issuance that an Islamic SWF may harm rather than help the supply and secondary market for sukuk. 

In general, sovereign wealth funds are long-term investors that do little trading (relative to some funds). Unless the Islamic SWF were to seed many different sukuk funds to invest in and trade sukuk, it would not support the development of liquid secondary markets for sukuk that are needed to induce greater supply by lowering the illiquidity premium attached to sukuk. The one thing that the seeding of sukuk funds could do would be to lower yields for issuers by raising the overall demand for sukuk (more demand = higher prices = lower yields). This would have some benefits because it would bring sukuk closer to on par with conventional bond issuers in terms of pricing (and could lead them to be priced more favorably than conventional bonds in some situations like sovereign and highly-rated issuers where demand would be greater).

However, this could lead to a negative feedback cycle by forcing takaful funds, for example, to reach for yield by investing in lower-rated sukuk with higher coupons but also greater risks. This would be the least desirable outcome for the Islamic finance industry because it would raise the risk to the takaful funds and also could lead to poorer-quality issuers flocking to sukuk markets to satiate the demand of fund managers for whatever sukuk are available, as long as they pay a good coupon.

Political Sensitivities There are few things that raise political tensions in the West (and especially the U.S.) than oil-rich countries in the Middle East buying "strategic assets" in domestic markets. The only thing that surpasses the level of paranoia that accompanies deals like the proposed Dubai Ports World acquisition of P&O Ports (which operated a few ports in the U.S.) is if it is done using something that has an "Islamic" label on it.

The most difficult logistical problem for any Islamic SWF of any size to deal with would be the hysterical reaction if it were to take a significant--even a non-controlling--interest in a Western company of any strategic interest. This would reduce the investment opportunities of an Islamic SWF greatly and make the SWF itself have to shift its own focus away from one of the stated goals of SWFs: finding the best commercial deals to invest in. Instead the Islamic SWF would be forced to look inward to its member countries for investment opportunities.

 This outcome would not be a bad thing on its face, but it would create significant institutional overlap with the Islamic Development Bank's Private Sector Development organization. This could also lead to competition over scarce large, quality investment opportunities which could create a bubble in one sector or country that would inevitably lead to an economic crash. This would be the worst case scenario for the Islamic SWF which was initially established to create stability creating economic volatility. If the political concerns within the Islamic SWFs member countries about its allocation of its resources didn't destroy an Islamic SWF, an economic crash that could be blamed (even if unjustly) on the Islamic SWF would do even greater great harm.

Conclusion
I don't think that an Islamic SWF is necessarily a bad idea and the title of Rusdhi Siddiqui's article, "Islamic sovereign wealth fund over mega bank?" may suggest that he had a different idea by suggesting it. However, there are always challenges when large proposals are put forward and column lengths give him significantly less flexibility in addressing the potential challenges than I have in my (no word limit) blog. The point of this post is not to shoot down the idea of an Islamic SWF, but to focus on some of the areas where I think it would have significant difficulties.

I don't think any of the potential problems are insurmountable and with the flood of sukuk from GCC being issued in Malaysia so far this year (and at the end of last year), there are clearly not enough long-term investors in Islamic finance to move beyond the day's newsflow to step in and buy when others are fearful (to paraphrase Warren Buffett). Perhaps an Islamic SWF with global representation could change that. Perhaps it could also do what I think was Rushdi's motivation: find a way to move Islamic finance from an industry that seems focused more on a product-by-product offering too busy to get to the boring areas of finance like asset management which create a more stable industry for the long run.

Thursday, March 17, 2011

Bahrain and Islamic finance: What progress has really been made?

I have not found the right way to approach the current protests and violence in Bahrain and throughout the Middle East and North Africa, mostly because I have not found a strong enough connection to the subject of the blog, Islamic finance. Bahrain presents an interesting example of the contradictions in Islamic finance and its stated goal of improving society, in part through providing inclusive and fair financial services.

Bahrain is a small economy and country with a disproportionately large footprint in Islamic finance, both in the number of Islamic financial institutions based in the country as well as by hosting some of the most important institutions to Islamic Finance (e.g., the International Islamic Financial Market and AAOIFI). However, much of the Islamic finance industry, both in Bahrain and globally is focused on the highest income people. Many of the people (40-50% or more) working in Bahrain (in Islamic finance and elsewhere) are not native Bahrainis. Many of the projects financed by Islamic finance in recent year are not generally made to benefit Bahrainis and the economy relies of finance (both conventional and Islamic) for over one-quarter of its GDP (based on data I could find from 2005). This is significantly higher than the US--the share in the US was 5.8% of GDP prior to the crisis--where critics allege the economy has become too 'financialized'.

That is not to say that the country would be better off by kicking out all the foreigners and banks and shifting towards another industry. That is not practical. However, it does explain part of the frustration coming into the headlines in the last week. Despite a thriving financial sector, Bahrain's youth unemployment rate is nearly 20%. The growth in Islamic finance does have a benefit and does provide some employment, but it is unlikely that the youth unemployment rate will drop significantly just based on financial services targeted at high-net worth individuals. Besides requiring specialized skills and education, it is not a career that is labor intensive and therefore growth in the financial industry leads to a much smaller reduction in the unemployment rate.

However, finance (including Islamic finance) does play a role in allocating financial resources into industries that can have a significant impact on the unemployment rate. Creating the newest bells and whistles for new sukuk or structured products is probably not the most productive use of resources in finance. Islamic finance is supposed to have a social goal and finance for the sake of the financial sector does not fit in well with that ethic. I lack enough knowledge about the specifics of the Bahraini economy (and it would not really be too useful if I went in and told them how to run their economy) but there are plenty of Bahrainis I am sure who are much better aware of business opportunities and needs that can be filled who may only need some finance and some assistance to create businesses that can employ others.

Perhaps it is naive to take this lesson from recent protests, but if they continue they will strangle the banking system which makes up such a large part of the economy. It is not enough for the government to try and buy off the current complaints; they will only reappear. If Islamic finance is not up to the task of assisting the creation of employment-creating businesses, than what has all the work really accomplished?

Sunday, March 13, 2011

Islamic banking in rural areas

An article describes the push by Islamic banks in Indonesia into rural areas. This is likely to be positive because in most areas of the world, rural areas do not have as much access to financial institutions because it is more difficult (i.e. costly) to serve areas with lower population densities. The article, citing the director of Islamic banking at the country's central bank Mulya Siregar who describes mudaraba as the "ideal" method for rural and agricultural finance.

While there are benefits to the mudaraba contract for farmers, it has not been used widely by many Islamic banks and I would be surprised if it were used widely in rural areas of Indonesia. Instead, I would expect murabaha and salam to be the most common financial instruments used. Murabaha is widely understood and is similar to a concentional loan in how it works. Salam, where the financier extends finance to a farmer in exchange for a certain volume of a homogenous commodity (e.g. bushels of corn), was historically used to finance agriculture.

However suited salam is to agriculture, it does not avoid the risk to the farmer that the product is still owed even if there is a crop failure (because the contract is for a generic bushel of corn, not the specific corn grown by that farmer). Murabaha also presents risks to farmers, but no more so than a conventional loan and could lead to improving the income of farmers if it can widely replace moneylenders that charge exorbitant interest and resort to violence if they are not repaid on time.

The advantage to a mudaraba for financing activities like farming which are dependent upon weather and other unpredictable events is that a portion of the loss can be shifted from the farmer to the bank. However, it also carries the disadvantage of depending on record-keeping that may not be possible in areas where education and literacy are limited. The requirements for mudaraba financing may lead the benefits to be reduced and it may be more beneficial to offer more simple products like murabaha and salam.

To mitigate the risks posed by unpredictable weather, particularly when climate change is making weather conditions more uncertain and extreme weather more common, is to introduce some sort of takaful alongside the financing. For example, banks could offer takaful covering drought, flood or pests. This would make it easier to determine events requiring payout and also limit the effect on incentives (i.e. lower incentives for the farmer to take measures to avoid a fall in yields of the crops if they receive payments based on crop yields). A covered event would happen widely across a particular region. This would also introduce risk to the bank, but based on its scale advantage, it can mitigate the risk by either operating across a broad geographic area or by reinsuring its risk using retakaful.

Wednesday, March 09, 2011

Considering the possible IILM liquidity tool structures

The International Islamic Liquidity Management Corporation (IILM) announced that it plans to issue the first short-term liquidity management instruments by the end of 2011. This is disappointing because the products are needed, the sooner the better. However, it is usually better to get it right than just to get it out there quickly. The size of the first issue will likely have a minimum size of $300 million, depending on demand, which is tiny compared to the volume of commodity murabaha contracts used for liquidity management which is estimated at $1.2 trillion.

No structure has been announced yet for the IILM, but it would likely not be commodity murabaha, which is not tradable. An article from Bernama describes (citing Mohd Razif Abudl Kadir, the deputy governor of Bank Negara Malaysia): "the main function of the IILM is to issue high quality papers as the shareholders are the central banks, which recognise it as eligible papers that can be traded among the players". Commodity murabaha (all murabaha) is not tradable on the secondary market outside of Malaysia except at par because it represents a debt receivable, subject to restrictions on trading in debt (bai al-dayn). He added that the maturity can be short-, medium- and long-term and gave the specific example that "it can be an avenue for the Malaysian government to tap global funds for the Mass Rail Transit mega-project". The Mass Rail Transit mega-project is a nearly 10 year project to put in 150km of rail in the Kuala Lumpur area by 2020 that is estimated to cost RM36.6 billion ($12.1 billion).

From this point, it is only speculation what the IILM product will look like, there are a few established and developing liquidity management tools (described well by Simmons & Simmons in a document from 2008 [PDF]; they are the basis of the descriptions I provide of the products):

Wakala/Mudaraba: In a wakala, two Islamic financial institutions (IFIs) enter into an agreement where one places funds with the other, who invests it on their behalf. The party placing funds (the lender) bears responsibility for losses. This could be a viable option for the IILM, but only on a short-term basis (unless a secondary market developed quickly). The IILM could provide an "indicative" rate of return, but is non-binding and is not a guarantee. However, the IILM would face a credibility problem if it did not meet the "indicative" rate of return. Central banks undoubtedly want to avoid losses, even if they are less concerned with generating a profit. Once the funds are placed with the IILM, they would have to be invested in something which generates a return that meets or exceeds the "indicative" return investors expect.

The advantage of this structure is that it could provide perpetual sukuk (or sukuk that were issued in equal amount as they matured), so long as the IILM is able to find things to invest in to generate a return sufficient to meet the "indicative" return (adjusted for changes in interest rates; the indicative return may even be calculated as a spread over a benchmark like LIBOR or KLIBOR). This would define the focus of the IILM. Instead of rotating assets from member banks to use as backing for, say, ijara sukuk, the IILM could focus on generating a return with the funds and on facilitating the secondary market.

However, this strength would also create a weakness. It would force the IILM to compete with the Islamic Development Bank and would also limit the size of the tradable market to the amount of funds the IILM could invest in quality projects to generate a return sufficient enough to make profit payments to the holders of the certificates. This is less of a hurdle than it appears at first. If the figure above were only for overnight liquidity management (i.e. the same amount was created and redeemed each day), it would represent just under $5 billion in certificates (i.e. $1.2 trillion divided by 250, the rough approximation of business days in a year). Assuming that the demand for these certificates increase 20% per year for the next 10 years and only 1/2 of the outstanding certificates trade in a given day, that would allow $60 billion in certificates in ten years to replace the equivalent of $7.5 trillion in commodity murabaha contracts. [Note: my assumptions for this calculation is by no means realistic, but used as an exercise to put the $1.2 trillion of commodity murabaha into context]

While the wakala/mudaraba structure seems like it is viable as a structure (there are many asset managers with more than $60 billion in assets), it would be difficult to create the liquid market for the certificates. Pricing would be relatively easy if the IILM is able to garner a credit rating at least as good as its member states (for comparison, the Islamic Development Bank has a AAA rating).

Wadiah: The two IFIs agree that one will place funds with the other and the one receiving the placement invests the funds like in the wakala. However, the placing institution does not have the right (although the receiving institution can voluntarily make profit-sharing payments) to any profits, but is entitled to a return of capital in the full amount, regardless of the performance of the investments made with the funds placed. This has the benefit that the IILM could use it as a way to get certificates into the market. However, it would be more likely to incur losses in adverse market environments. This is unlikely because although the IILM would be forced to pay out deposits in full (in contrast with the mudaraba/wakala), in both situations it would be expected to incur these costs to keep its credibility.

The benefit of the wadiah for the IFIs would be that even though they give up the legal right to a share of profits, they are entitled to their deposit back in full. Given the way markets and institutions operate, the IILM is likely to pay out profit-sharing payments in the good times and make good on deposits in bad times. However, this introduces a new risk to IILM member central banks. Under wadiah, they are obligated to make full payment of deposits on request even if the investments turn out to be unprofitable. It is definitely a "tail risk", but it is worth considering with the hindsight of the experience in the US with Fannie Mae and Freddie Mac, which operated under implicit government guarantees from the US government that were called upon following the US financial crisis. In wadiah, the guarantee would be explicit, while under mudaraba/wakala it would remain implicit.

Accrued Notes: An accrued note works like the wakala product but allows the IFI to either reinvest the profits or take them out in specified intervals. This would allow the IILM to underake longer-term projects with its capital because instead of paying out profits every period (month or quarter), it would issue new certificates to investors who reinvest the profits. Depending on the percentage of certificates held for a longer term (e.g. cash held by money market funds), this would both require less capital to be held in liquid form (i.e. cash) if new certificates could be issued for the same par value as the outstanding certificates. Longer-term investments have the potential to generate higher yield but are also have more risks, which would introduce a greater likelihood of a 'tail event'.

Capital Protected Products (including multi-currency products): In a capital protected note, there is a combination of a commodity murabaha and a wa'd-based swap of returns from a specified index. This is an unlikely structure for the IILM because trading would be difficult because of the commodity murabaha to create the capital protection. It would also be relatively unnecessary if the IILM were able to get a high rating that I would expect (i.e. similar to the Islamic Development Bank). If the IILM is operating on a global scale, it would be able to issue multi-currency certificates and the wa'd-based multi-currency feature would be better served by the Islamic window at a conventional bank, which could limit its currency risk by using conventional hedging tools.

Tradable Sukuk: Besides the wakala/mudaraba and wadiah, this is the most likely product. In fact, it might be more likely because of the relative familiarity that the market has for sukuk. The biggest problem in sukuk markets besides lack of supply is liquidity. Where the wakala/mudaraba product needs both a new market for the certificates and sufficient liquidity, an IILM sukuk issuance needs only a liquid marketplace. The central bank members of the IILM might not have the assets needed to issue a large volume of sukuk, but the comment in the Bernama article that the IILM would consider short-, medium- and long-term products and could use the funds for domestic projects suggest that other assets that are not directly owned by the central banks could be used to back sukuk.

The risk from IILM sukuk being used to fund national projects (like the Malaysian rail project mentioned in the article) is political. How will the assets be selected to back IILM certificates? Even with an IILM guarantee, the certificates would not be identical. You could buy a sukuk that was backed by the transit system in Malaysia (which has Ringgit exposure) or the one in Luxembourg (which has Euro exposure) and your sukuk might be denominated in dollars. It would be preferable to reduce external factors by having the certificates backed by a large number of diversified assets.

This could be accomplished either by the use of wakala or murabaha contracts or by the IILM issuing sukuk using mudaraba or wakala as the underlying contract. Reflecting on the description of what is created with mudaraba or wakala certificates, I think I was essentially describing sukuk certificates. In my opinion, an IILM wakala or mudaraba sukuk is the most likely structure.

Sukuk repos: This is an unlikely product for the IILM because it would duplicate the efforts of the IIFM (which is on the first stages of a difficult road towards a repo master agreement) and would step on the member central banks' toes because one of the primary uses of repos is for monetary policy. It also requires a larger supply of sukuk than exists today (particularly higher-quality sukuk) for it to become feasible.

I would hope that more details are released as we see the IILM develop and the next opportunity for further announcement is coming up when the IFSB holds a seminar on liquidity management in Islamic finance in Istanbul, Turkey on April 6th and 7th.

Thursday, March 03, 2011

Incorporating Islamic finance into a sovereign wealth fund

FT Tilt, an emerging markets blog (one I recommend), has a article about the Qatar sovereign wealth fund and the more aggressive posture it has taken compared with the Abu Dhabi Investment Authority. The article compares the track of the Qatar Investment Authority with that of the Dubai World private equity subsidiary Istithmar and quotes another blog:
"They did not want to own 20 million shares of Costco, they wanted to own Barneys. They didn't want to own six dozen holiday inns in the Midwest [US], they wanted to own the W Union Square in New York. They didn't want to own 3% of Federated Investors they wanted to own Perella Weinberg and GLG. For the powers that be in Dubai making levered investments into high profile companies was part of building 'Brand Dubai.'"
As they note, the Qatar Investment Authority has not taken nearly as aggressive an approach as the brand-driven Dubai fund, but if the global economy continues to recover, it may be tempted to take a similar approach (although probably with less leverage than Istithmar given the "New Normal").

An alternative "brand-driven" approach for the sovereign wealth fund would be one based (at least in part) on Islamic finance. While it is relatively small ($60 to $80 billion) compared to Abu Dhabi's sovereign wealth fund, it is still large enough to be selective in its investment decisions to avoid the types of investments that brought Dubai World to the brink of default. In the process, it could use its clout to force the investment banks bringing deals to strip out extra costs normally associated with Islamic financial products.

This would add value not only to the Qatar Investment Authority but also to the industry as a whole. While doing so, it should avoid the pitfalls of capturing "landmarks" but instead creating opportunities for others. For example, instead of subscribing to sukuk on its own, it could focus on taking a 'lead investor' position in sukuk from GCC companies as well as global companies interested in 'jumping the gap' into Islamic finance. More helpful (both to QIA in the long run and other investors), it could adopt the approach of creating liquidity in secondary markets by selling a portion of its allocation in secondary markets in sukuk with significant investor demand.

This would have the advantage of capturing some gains in sukuk that see high investor demand but would also spur secondary market development in sukuk generally (and free up capital to buy in other secondary market issues). More liquid secondary markets benefits sovereign wealth funds not only in assessing market values for sukuk they already hold, but also by providing opportunities to diversify their holdings and move between different sukuk. Most bond fund investors already do this with conventional bonds, but it is currently much more difficult to do with sukuk, particularly where investors are looking for larger volume trading opportunities.

In addition to sukuk, a move into Islamic finance could create an opportunity for the QIA to contribute to broader social goals within and outside of Qatar through Islamic microfinance. Many Istithmar investments (like the W Hotel) were "status" purchases. They may have been viewed as solid investments pre-crisis, but the acquisitions were done with secondary motives in mind (building Brand Dubai). If secondary motives are included in the investment decision, shouldn't they do more to contribute than just through the acquisition of landmarks? Qatar have been working in other areas to increase its global profile in arts, culture, media and diplomacy. Blending a poverty reduction strategy into a sovereign wealth fund that incorporates Islamic finance seems like a good way to build credibility for both Qatar and Islamic finance.