Author: Gordon Platt
Rapidly growing liquidity is fueling a surge in interest in Islamic financing in the GCC countries.

The Middle East—and particularly the Gulf Cooperation Council (GCC) countries—is awash with liquidity, which is being invested in traditional industries such as oil and gas but also nascent industry sectors such as real estate, construction, tourism, financial services and telecommunications. Alongside the investment renaissance that is occurring in the region is the development of financial products to sustain investors’ appetites. “As demand for financial products in the region increases, so too does demand for Islamic financing,” observes Arshad Ismail, head of sukuk, HSBC Amanah, the global Islamic banking division of the HSBC Group, which recently concluded several Islamic financing transactions worth a total of $1.45 billion in the GCC region, which includes Bahrain, Kuwait, Qatar, Oman, Saudi Arabia and the United Arab Emirates.

Islamic banking is the fastest-growing sector in Middle Eastern financial services. It first emerged 30 years ago, but its growth has accelerated sharply in the past decade. Arcapita, an Islamic investment bank, estimates that Islamic bank deposits within the GCC region stood at $60 billion in 2003, which it expects to rise to $110 billion by 2010. The exact size of the Islamic financing market is unknown because there is no official body that collects data. However, Khaled Yousaf, head of business development in the Islamic finance sector for Dubai International Financial Center (DIFC), says the overall industry balance sheet is approximately $300 billion and includes 282 institutions, most of which are relatively small. The two largest Islamic financial institutions, with capital of more than $1 billion each, are Dubai Islamic Bank and Al-Rajhi Bank in Saudi Arabia.


Khaled Yousaf,
growth for sukuk

The recent wave of IPOs throughout the region has also resulted in a number of new Islamic banks entering the market, including Saudi Arabia’s Al-Bilad Bank, whose IPO last year was oversubscribed, and Boubyan Bank in Kuwait which has paid up capital of 100 million Kuwaiti dinars ($346 million). Similarly, in Bahrain there has been a string of IPOs of Islamic banks, including the $111 million IPO of Al Salam Bank and Al Baraka Bank’s $450 million IPO. Even well-established banks such as Saudi Arabia’s National Commercial Bank, which is eager to be seen as Shariah compliant, is re-branding its retail operations accordingly. “Islamic banks are experiencing phenomenal growth rates compared to conventional banks,” says Ismail. “This is an indication of where the market is headed.”

Although Islamic financing is growing at a rate of 15% to 20% per annum, it is not about to challenge the dominance of conventional financing any time soon, even in the GCC countries. The volume of Islamic bank deposits, for example, is a mere drop in the ocean when compared with the $13 trillion held by conventional banks. Islamic banks are also relatively undercapitalized compared to their Western rivals. More than 80% of Islamic financial institutions have a market capitalization under $25 million but would need to become institutions of considerable size in order to compete with Western banks.Bahrain is attempting to resolve this problem by creating a “mega-Islamic bank” with a market capitalization of $1 billion, which will provide liquidity to other Islamic banks. Dubai Islamic Bank (DIB) is also pursuing international expansion, focusing on acquisitions in Sudan, Pakistan, Turkey, Iran and Western Europe, to help boost its balance sheet.

Big Deals, Bigger Hurdles
Despite the growing popularity of Islamic financing, conventional financing still forms the bulk of the debt market in the GCC. Ismail says Islamic financing has gained in prominence in the GCC only over the past 10 years or so, but he says that the industry will certainly continue to grow at a rapid pace and eventually become a significant and crucial component of the wider financial industry.

While it may not be sizable, Islamic financing is certainly significant. Some customers may be indifferent to whether a transaction is financed conventionally or according to Shariah law, but Ismail says more and more customers are making a conscious decision to raise money in a Shariah-compliant manner. And with a flourishing IPO market, a number of companies are seeking to make their businesses Shariah compliant by establishing a board of Shariah scholars.

Aref Kooheji, executive vice president for investment and corporate banking at Dubai Islamic Bank, believes that the gap between Islamic and conventional financing is closing. “Many have the perception that Islamic financing is so limited, but innovation will continue,” he says, adding that an increasing number of projects are now 100% financed according to Shariah principles.

Once limited to mortgages and retail bank deposits, the range of Islamic financial products is also expanding to include sukuk (fixed income) and asset financing based on ijarah (a Shariah-compliant leasing arrangement where a bank earns its profit by charging rentals on an asset leased to a customer). The sukuk market, in particular, is forging ahead. The Dubai Department of Civil Aviation broke the $1 billion barrier when it issued the world’s biggest sukuk, but that blockbuster deal has since been usurped by Dubai Ports, Customs & Free Zone Corporation’s (PCFC) $2.8 billion sukuk, the largest so far in the history of Islamic banking. It was lead managed by Dubai Islamic Bank, which also developed the first airline sukuk for Emirates and the first gold-linked sukuk.

Product Range Grows
The market for sovereign Islamic bonds is growing rapidly as Gulf governments begin introducing a series of debt issues to create a benchmark. There is no secondary market in the region for Islamic bonds, but Bahrain is working to develop a yield curve for Islamic debt. The United Arab Emirates is expected to launch Shariah-compliant treasury bills soon and eventually to offer a longer-term bond.

There are approximately $500 billion of Islamic finance funds under management, while the international sukuk market, which is almost entirely sovereign debt, totals $13 billion, according to Yousaf. “The market for sukuk is growing at a phenomenal pace,” he says, “from about $2 billion three years ago. However, the demand continues to far outstrip the supply.”

Other Shariah-compliant financial products are also emerging. The development of takaful, or insurance, is being led by financial centers such as Bahrain and the DIFC’s insurance and re-insurance division, which hopes to work with leading insurers such as Lloyds of London. However, takaful currently comprises only 20% of the conventional insurance market. The DIFC also hopes to provide short-term Islamic finance, or murabahah.

HSBC Amanah recently acted as lead arranger on the $850 million five-year revolving murabahah for Kuwait Finance House. It has also been active in the area of project financing as financial adviser on a $600 million Islamic facility involving the procurement of project assets, which are then leased back to the project company on the Rabigh Refinery & Petrochemical Project.“Project finance in the Middle East is growing at a great pace, which is an indication of the booming local economies,” says Azad Zafar, managing director, HSBC Amanah’s Asset Finance Advisory Group, adding that an increasing number of the related funding requirements are being structured according to Shariah law.

Yousaf of the DIFC says the next step in Islamic financing is to focus on derivatives, hybrids, hedge funds and exchange-traded products. But it is still doubtful that supply can keep up with increasing demand for more complex and innovative Islamic financial instruments. Ismail says that derivatives products are a natural progression, but developing them in a Shariah-compliant manner is a little challenging.

A Shortage of Scholars
When it comes to introducing new products, Yousaf says the market is not moving as fast as some would like. He believes it will pick up pace, though, as bankers and Shariah scholars become more familiar with the offerings. Yet the lack of qualified Shariah scholars is putting the industry at a competitive disadvantage, Yousaf adds. “There is a shortage of skilled Shariah scholars,” he explains. “Most of them are repeated on the boards of Islamic financial institutions, which we feel is not helping the industry. To get Shariah fatwa approval can take up to six months, which is not acceptable.” Ismail says there is definitely a need for more scholars, not only those who appreciate Shariah law but who also understand banking and finance.
Another key challenge the industry faces is the need for liquidity and risk management tools. Most conventional liquidity management instruments are interest-based, and the earning of interest or ribah is not permitted under Shariah law. Commodity murabahah can be used for short-term investment and liquidity management, but they provide low returns.

Alternatives being considered include applications of the sukuk structure, but what is really needed is the development of an Islamic secondary market, with liquidity management as its main focus. The International Islamic Financial Market (IIFM) has been assigned the task of developing an active secondary market in Shariah-compatible instruments.

One of the biggest obstacles the IIFM and the industry as a whole face is the lack of standards. For instance, a financial product approved by Shariah scholars in Malaysia might not receive the same level of approval in the GCC countries. As Yousaf explains, there are no standardized rules that apply to Islamic financing in various countries. He says countries such as Malaysia, Pakistan, Sudan and Iran have Shariah boards at the central-bank level that approve standards. In other countries the finance industry appoints its own Shariah board. Among Sunni Muslims, there are also four separate schools of thought on Shariah law, he adds. “Egypt and Malaysia have very liberal interpretations of Shariah law, while Saudi Arabia and Kuwait are quite strict. Dubai is somewhere in the middle.”

On the other hand, Ismail believes that the focus should not be so much on standardization, as he says Shariah scholars will always have different interpretations of the law. “The point is that it depends very much on your target investor. If you want to sell your products to investors in a particular market, you have to understand what those investors expect from a Shariah perspective so you can ensure your product complies with Shariah standards those investors are comfortable with.”

—Additional reporting
Gordon Platt