While still without the usual risks faced in an unstable global economic environment, the principals of Islamic finance could help investors spread financial risks and therefore strengthen the stability of a region or country.
Governed by Islamic law or syariah law, Islamic finance adheres to virtuous principals such as the mutual risk and profit sharing between parties and prohibits activities such as gambling and speculative trading.
“Through the use of various Islamic finance concepts such as ijarah (leasing), mudharabah (profit sharing), musyarakah (partnership), financial institutions have a great deal of flexibility, creativity and choice in the creation of Islamic finance products.
“By emphasising the need for transactions to be supported by genuine trade or business related activities, Islamic banking sets a higher standard for investments and promotes greater accountability and risk mitigation,” Bank Negara Malaysia (BNM) said in its overview of the Islamic finance sector.
Asian Development Bank (ADB) assistant general and practice leader of Islamic Finance, Ashraf Mohammed, also said: “In keeping with syariah law, Islamic finance needs to be ethical.
“This means that it needs to be for the public good.
“For example, in Islamic finance it is not possible to invest in activities that harm society, such as the arms industry.” In recent years, he pointed out that the Islamic finance industry has grown 20 per cent per annum, most of which comes from Asia.
“We expect to see increased activity in Thailand, China, Bangladesh and India just as in the more traditional markets such as Malaysia, Indonesia and Pakistan,” he said.
The International Monetary Fund (IMF) has also endorsed the principles of Islamic finance, and pointed out that it could prove safer than conventional finance system.
In a report released by IMF, early April, it said the industry’s principles of risk-sharing and asset-based financing can help improve risk management by both financial institutions and their customers, as well as discourage credit booms.
“In the case of Islamic finance, a large portion of bank deposits are offered on a profit-sharing and loss-bearing basis (for example, 55 per cent in the Middle East and North African regions and so are explicitly “bail-inable” in the event of a banking sector facing distress,” it added.
The underlying ethical precepts of Islamic finance provide, in principle, an important basis for high levels of ethical conduct, governance, and consumer protection, the report explained.
Going mainstream
In the last few years, the global Islamic finance has been making headways across the world with more countries accepting this system in their markets.
Investments compliant with the syariah financial law are gaining popularity – with interest coming not only from the Muslim world.
BNM Governor Tan Sri Dr Zeti Akhtar Aziz in her keynote address during the Global Islamic Finance Forum 2014, highlighted that there is growing internalisation in Islamic finance which has resulted in greater cross-border financial flows that has in turn, facilitated greater, more diversified economic linkages between countries.
“With this increased pace of internationalisation of Islamic finance, the total global financial assets of the Islamic financial industry is now estimated to be more than US$2 trillion,” she said.
Leading the industry are its banks and sukuk markets, followed by other finance segments such as funds and the takaful market.
Ernst & Young (EY) in its World Islamic Banking Competitiveness Report 2014 to 2015, stated that Islamic banks’ total assets could reach US$1.8 trillion by 2019 across key markets Qatar, Indonesia, Saudi Arabia, Malaysia, United Arab Emirates (UAE) and Turkey (QISMUT).
It also expected a compounded annual growth rate (CAGR) of 19 per cent within this time frame.
“Key driving markets will continue to be Saudi Arabia and Malaysia, with Turkey and Indonesia also establishing themselves as populous participation Islamic banking centres,” it added.
On average, EY reported that Islamic banking growth in core markets from 2009 to 2013 has grown 1.9 times higher than conventional banking.
It estimated that by 2019, Islamic banking’s accumulated profit would reach US$36.9 billion, with US$35.1 billion stemming from the QISMUT markets.
“The industry is expected to strengthen with the emergence of several medium-sized players and with at least five additional banks crossing the US$10 billion mark in shareholders equity,” it added.
As for the sukuk market, the Islamic equivalent of the bonds market, IMF reported that the fast-growing segment with assets equivalent to about 15 per cent of the industry.
Franklin Templeton Global Sukuk and Middle East and North Africa (MENA) Fixed Income Strategies chief investment officer, Mohieddine (Dino) Kronfol, outlined that the sukuk market is becoming an integral component of the mainstream global financial system.
According to KFH Research Ltd (KFH Research), a decade ago, the sukuk market was valued at US$9.6 billion where issues were generally small in nature, and the market was concentrated amongst a handful of issuers.
However, in 2013, the market topped US$269.4 billion, representing a quarter of the global bond markets, IMF pointed out.
Kronfol noted, “The Islamic finance industry is expected to continue growing at nearly 20 per cent per year, and the pool of investors interested in syariah-compliant securities is expected to rise along with it.
And while Islamic investors are natural buyers of sukuk, the appeal of sukuk now extends far beyond the Islamic world.” Overall, RAM Ratings expects new global sukuk issuance to remain fairly resilient at US$100 billion to US$120 billion in 2015, despite the challenging environment for Malaysia and Gulf Corporation Council (GCC).
“The stability of the sukuk market is also underpinned by sturdy demand from Islamic and conventional ringgit-mandated domestic institutional funds as well as Malaysian-domiciled Islamic banks that are less likely to be perturbed by external shocks,” it added.
As for the Islamic insurance industry, the takaful market, BNM had noted that the industry is expected to grow by 15 to 20 per cent annually, with contributions expected to reach US$7.4 billion by 2015.
Boosting Malaysia’s financial sector
For Malaysia, since the enactment of the Islamic Banking Act 1983 and the liberalisation of the Islamic financial system over 30 years ago, more Islamic financial institutions have been established and the industry has grown to be a vital part of the country’s overall financial sector.
“Malaysia’s long track record of building a successful domestic Islamic financial industry of over 30 years gives the country a solid foundation – financial bedrock of stability that adds to the richness, diversity and maturity of the financial system,” BNM said.
Over the last few years, with the introduction of the 10-year Financial Service Sector Blueprint 2011 to 2020 by BNM, Malaysia has made significant headways in developing itself as a major Islamic finance hub within the global sphere.
The Blueprint’s aim is to evolve the financial ecosystem in Malaysia that will serve a high value-added, high-income Malaysian economy while also increase the importance of Malaysia’s role in meeting the growing financial needs of emerging Asia.
Part of the Blueprint’s focus areas also revolve around the internationalisation of its Islamic finance so as to develop Malaysia into an international Islamic financial centre.
Over the past few years, Malaysia has also evolved its Islamic finance sector and overall finance sector with the introduction of the Islamic Financial Services Act and Financial Service Act in 2013 which aims to provide a stable regulatory framework for Malaysia’s financial institutions, offer a greater oversight on the Islamic money market and foreign exchange market as well as to promote consumer protection.
The IFSA 2013 in particular, according to BNM, provides the foundation for the shift towards a contract-based regulatory framework by providing legal recognition to the contractual requirements in accordance with the syariah.
To date, according to EY, Malaysia’s Islamic banking market penetration has reached 20.7 per cent while its share of the global market has reached 16.7 per cent.
Already a leader in the global sukuk market, thanks to its well-established capital market, Malaysia is expected to retain its leadership in this sector this year, says RAM Ratings.
The ratings agency pointed out that “Although ringgit-denominated sukuk issuance was rather slow off the block this year, issues from the infrastructure sector and financial institutions as well as some supply of Islamic securities from Bank Negara Malaysia are expected to keep Malaysia in the lead, with about 60 to 70 per cent of the global sukuk market’s issuances.” Promod Dass, deputy chief executive officer of RAM Ratings further highlighted, “Beyond leading the global sukuk market, innovation is also Malaysia’s forte.” As for Malaysia’s takaful market, RAM Ratings outlined that the liberalisation of the Malaysian financial sector in 2009 had allowed higher foreign equity in insurance/takaful companies.
It added that this had sparked a wave of mergers and equities in the industry, paving the way for greater competition, if not more challenging times ahead for the incumbents.
With all these turning points in Malaysia’s Islamic finance system, BizHive Weekly takes a look at several highlights in the Islamic finance industry.
MyETF-MSEAD: World’s first Islamic-based Asean exchange trade fund
The Islamic finance sector’s prospects has been viewed positively by analysts for its potential and stable mechanics.
For fund managers like i-VCAP Management Sdn Bhd (i-VCAP), the Islamic finance sector offers a vast untapped pool of Islamic funds.
Mahdzir Othman, CEO of i-VCAP
Chief executive officer (CEO) of i-VCAP, Mahdzir Othman shared, “For the issuer and manager, product innovativeness should be further developed as there is still lack of variety and supply of syariah compliant investment products.”
He also noted that investors in general are now more sensitive on ethical investments of which Islamic funds/finance are very much in line with such investment preference.
With that, i-VCAP had recently launched the world’s first Islamic Southeast Asia underlying Exchange Traded Fund (ETF), MyETF MSCI SEA Islamic Dividend (MyETF-MSEAD) which is set to list on Bursa Malaysia this coming May 7.
MyETF-MSEAD’s main objective is to closely track the performance of the MSCI Southeast Asia IMI Islamic High Dividend Yield 10/40 Index (Benchmark Index) which objectively and passively represents the dividend yield opportunity within Southeast Asia’s syariah equity markets.
With access to up to 30 syariah-compliant companies listed on five Southeast Asian countries stock exchanges, MyETF-MSEAD offers a cost effective and easy access for investors to regional dividend yielding stocks that can provide income and potentially, capital growth over medium to long term period.
With MyETF-MSEAD being the first Islamic-based ETF in the Asean region, Mahdzir Othman viewed, “In my opinion, the listing of the first syariah compliant ETF with Asean underlying securities may help to strengthen Malaysia’s position as the world’s hub for Islamic finance.
“Coupled with other investment products and services available, this may help investment capital flows into Malaysia.
“Malaysia’s economy may gain in the sense that capital flows can help increased business activities within domestic capital market.”
While MyETF-MSEAD’s geographical exposure is similar to CIMB FTSE Asean 40 ETF in terms of its stocks which comprises from five Asean countries, Mahdzir noted that, MyETF-MSEAD is a syariah-compliant fund which tracks an index with dividend yield feature (style investment) as opposed CIMB A40 that tracks a market capitalisation weighted index.
“Hence, the performance of both funds may be different due to the different investment screening methodologies,” he told BizHive Weekly in an email interview.
Of note, ETF is similar to a mutual fund except that it can be traded like stocks in real time.
Like a unit trust, ETF provides exposure to a pool of securities but charges much lower fees as they are passively managed.
When asked what i-VCAP hopes to achieve with the listing of MyEFT-MSEAD, Mahdzir said, “The listing can help to further develop and create more awareness about ETFs in Malaysia.
MyETF-MSEAD provides additional option and variety in the range of ETF products offered that can meet the investment objective based on the different risk profile of investors.
“Given that investors are increasingly in search for low cost investment products, the listing could help investors to be aware about ETFs and its various benefits.” The launch of the fund is also in line with Malaysia’s effort, being the current chairman to the caucus, in promoting Asean’s growth prospect and financial integration framework.
Of note, i-VCAP’s principal business activity is to provide syariah-compliant investment management services through ETFs, wholesale funds and private mandates.
As at end of March 2015, i-VCAP’s total asset under management (AUM) stood at approximately RM1.1 billion.
“i-VCAP shall continue with the investors’ educational activities on ETF.
“In addition, i-VCAP also plans to engage and collaborate with other key participants in order to further boost the development of ETF products and its eco-system domestically.
“Besides the promotion of the existing funds under management, i-VCAP also plans to launch more investment products in the market in order to increase its asset size under management,” Mahdzir disclosed.
Meanwhile, on the challenges of the overall Islamic finance sector, the CEO believed that one of the key challenges is the harmonisation of syariah investment principals, especially in the global space.
“The different views can result in the inability to market syariah compliant investment product in other parts of the world despite it being acceptable domestically.
“On the other hand and in line with increased product offerings, Islamic fund/asset owners will also need to be more acceptable to new innovative products that are structured in accordance with syariah principals,” he commented.
RM1 billion international sukuk
Investments compliant with Islamic principles (syariah) are gaining popularity, and Malaysia has become a global hub for issuance of Islamic bonds, known as sukuk, Hanifah Hashim, Franklin Templeton’s head of fixed income – Malaysia, said.
In a bid to boost Malaysia’s sukuk market to meet the increasing global demand for sukuk, Malaysia’s Ministry of Finance (MoF) had recently announced the issuance of a global sukuk for a total of RM5.4 billion (US$1.5 billion) by special purpose entity, Malaysia Sovereign Sukuk .
It has priced its latest global sukuk at RM3.65 billion (US$1 billion) of 10-year and RM1.8 billion (US$500 million) of 30-year benchmark Trust Cerficates (sukuk), and according to the ministry, the 30-year tranch was the government’s inaugural sukuk issuance which is the longest tenured sukuk ever offered by a sovereign.
MoF added, the offering is Malaysia’s fourth US dollar-denominated sovereign global sukuk issuance, following the global issuance in 2002, 2010, and 2012.
The successful sukuk issuance of US$1.5 billion after a lapse of almost four years, has drawn positive response from international investors who have reaffirmed their confidence in the country’s long-term economic fundamentals, analysts were quoted as saying.
Malaysia’s US$1.5 billion (RM5.4 billion) sukuk was oversubscribed, attracting an aggregate interest of over US$9 billion (RM32.8 billion) from a combined investor base of over 450 accounts, of which market experts viewed that this shows foreign appetite for Malaysian bonds remained strong.
Meanwhile, Moody’s Investors Service issued a definitive A3 senior unsecured ratings to the US-dollar sukuk.
“The A3 rating assigned to the sukuk is at the same level as the long-term local-currency and foreign-currency issuer ratings of the Government of Malaysia, as the sukuk certificate holders will effectively be exposed to the Government of Malaysia’s senior unsecured credit risk; not be exposed to the risk of performance of the Portfolio Assets relating to the Certificates; will not have any preferential claim or recourse over the Trust Assets, or rights to cause any sale or disposition of the Trust Assets except as expressly provided under the Transaction Documents; and only have rights against the Government of Malaysia, ranking pari passu with other senior unsecured obligations as provided in the Transaction Documents,” it explained.
Largest syariah-compliant pension fund
Late last month, Prime Minister Datuk Seri Najib Tun Razak had announced that Malaysia’s state pension fund, Employees Provident Fund (EPF), will offer a syariah-compliant investment option for its members by 2017.
This, according to Najib, is expected to create the largest syariah fund of its kind in the world.
Maybank Investment Bank Bhd’s research arm (Maybank IB Research) in a recent report, viewed this development as supportive to its view that syariah stocks will continue to re-rate over the longer term as syariah investing starts gaining better prominence.
“We have highlighted this re-rating potential since 2013, during the run up to the Securities Commision’s new syariah screening methodology to better reflect international practices.
“In Malaysia, Islamic assets under management (AUM) have grown by a strong 23.3 per cent, compounded annual growth rate (CAGR), over 2010 to 2014, versus the industry AUM’s 13.7 per cent CAGR,” it said.
The research house further pointed out that the growth potential for Islamic AUMs remains high as the current RM110.6 billion Islamic AUMs as at end of 2014 makes up only 17.6 per cent of the total industry AUMs of RM630 billion.
It added, Islamic AUMs as a percentage of the Malaysian bourse market capitalisation was also still a small 6.7 per cent as at end of 2014, compared to the industry AUM’s 38.2 per cent.
“We think that EPF’s proposal for syariah-compliant retirement savings will be well taken up with the Muslim population in this country, making up a sizeable 61 per cent of the total population (in 2010),” Maybank IB Research opined.
As at end of 2014, EPF has a total of 6.66 million active members and a total savings of RM440.3 billion.
“The pace of re-rating for syariah stocks in this context will depend on the “migration” phase of EPF members electing to switch to syariah-compliant retirement savings, and the number of members opting for this,” it said, noting that the latter would, in turn, determine the base size for this new syariah-compliant fund under EPF.
Global challenges in implementing Islamic finance
In a recent report released by IMF titled: ‘Islamic Finance: Opportunities, Challenges, and Policy Options’, the authors highlighted that while the popularity of Islamic finance is growing across the globe, there are still be many obstacles in implementing the system.
The report said the principles of risk-sharing and asset-based financing can help promote better risk management by both financial institutions and their customers, as well as discourage credit booms, however, the industry could fail to achieve its promise if it does not design its rules more carefully and implement them more consistently.
It highlighted that some of the key challenges in the Islamic finance industry worldwide, include regulatory and supervisory frameworks that have yet to cater to unique risks in the Islamic banking industry.
“An important regulatory challenge is to ensure that profit-sharing investment accounts (PSIA) at Islamic banks are treated in a manner that is consistent with financial stability,” it added.
Additionally, it said, although Islamic banks appear well-capitalised, there will be challenges with the implementation of the Basel III Accord.
The report also outlined problems in the monetary policy formulation and implementation in the presence of Islamic finance due to the scarcity of syariah-compliant monetary policy instruments and a lack of understanding of the monetary transmission mechanism.
Nevertheless, Reuters reported that some of these issues are now being tackled by standard-setting bodies such as the Bahrain-based Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) and the Malaysia-based Islamic Financial Services Board (IFSB).
It also noted that last month, the IFSB said it had finalised a standard on “core principles” for use by regulators as well as a guidance note on liquidity management.