TCS Daily

Shariah-Grade Investing

By Ganesh Sahathevan - June 9, 2006 12:00 AM

It is said that man finds religion in times of trouble. In the aftermath of the Asian financial crisis of 1997-98, demand for Islamic financial facilities -- those that prohibit interest - spiked, particularly in Malaysia. That spike gives the adage a new verity. Recent events, however, suggest the market may soon be looking to Christianity's principle of forgiveness.

According to Malaysia's deputy minister for finance Nor Mohamed Yakcop, in 2005, a total of 126 bond issues were approved valued at $16.3 billion, of which 77 were Islamic bonds valued at $11.5 billion, or more than 70 percent of new bonds issued. In Yackop's words, "it is ...evident that Islamic bonds have become increasingly a preferred choice among investors and issuers, with the number and size of Islamic bonds approved exceeding those of conventional private debt securities."

Hence, major events in Malaysia could have consequences for the global Islamic finance market, and these consequences could well flow on into the conventional banking system given that most of the major banks now have Islamic financing windows through which they actively participate in the international market for shariah-compliant funds.

Some recent events in Malaysia are cause for concern:

  • In January this year the Malaysian Government, which has encouraged the development of the local bond market -- and especially the Islamic bond market -- suddenly announced that it was tightening regulations for the bond market.
  • A few days later, the country's two rating agencies, Rating Agency Malaysia Bhd (RAM) and Malaysian Rating Corp Bhd (MARC) issued what a local financial paper described as "a slew of credit rating downgrades."
  • The same paper reported that the corporate regulator, the Securities Commission (SC) was "sifting through bond sale applications more carefully now following the recent defaults that rocked the private debt securities market." A local finance executive was quoted saying "they (the SC) are scrutinizing more closely now while rating agencies also have to be more stringent."

Among the companies whose debt RAM downgraded in January this year was a technology company which has a monopoly over the supply of mandatory electronic identification cards and passports. In total, about $80 million in commercial paper was downgraded, but still rated as investment grade even though the downgrade was due to concerns about future cash flow from operations.

The other rating agency, MARC, downgraded to below investment grade the credit ratings of three property developers who had issued bonds worth about $210 million in total.

In another case, a toll road operator is re-negotiating an Islamic bond issue of some $533 million as a result of actual traffic flows falling below forecast. Negotiations are being held up by the refusal of the original owners of the toll road company to provide any recompense to the lenders.

These current problems appear to be an extension of issues that were not resolved in 1997.

Malaysia, like Thailand and Indonesia saw financial markets practically collapse in 1997, together with the value of their currencies.

Many Asian corporations suffered a liquidity crisis brought on by having to repay US and other foreign dollar loans with significantly depreciated local currencies. The fact that many of these companies were highly leveraged was, of course, a large part of the problem.

It was against this backdrop that the demand for Islamic financial facilities grew. The reasons for this growth in demand -- especially from non-Muslim borrowers -- may lie in the way shariah compliant facilities are structured. In essence they are either structured as zero-coupon bonds, or the coupon is linked to the earnings of some underlying asset that the funds borrowed are used to purchase or construct.

However, regardless of the structure, all facilities provide for a pre-determined rate of return.

According to Deloitte Touche Tohmatsu Malaysia, "the primary value proposition that attracts non-Muslims (in Malaysia) to Islamic Banking is the certainty and fixed profit rate element, especially since the 1997 Asian financial crises."

Some observers of the Malaysian corporate scene take a slightly more cynical view; that cash-strapped companies are drawn to the proposition that they do not have to worry about repaying interest on a loan until maturity, and that even then refinancing or rescheduling of loans might well provide them more room to maneuver. Meanwhile, the funds borrowed would have been exhausted for any number of reasons, not necessarily in compliance with the loan agreement.

Data provided by the Malaysian Central Bank may support the more cynical view. The same data suggests that the global market for Islamic debt issues sits on a rather steep slope.

The Malaysian Central Bank provides details of Islamic financial facilities denominated in Malaysian Ringgit.

Issuers include both Government owned entities as well as privately held corporations. Generally, only local corporations are allowed to raise funds in Malaysia.

The list of corporate issuers shows just one facility issued in 1996, two in 1997, five in 1999; but in 2000 the number of Islamic facilities issued rose more that 20 times to about 120. This sudden explosion of demand for Islamic facilities in 2000 coincides with the period in which Malaysian corporations began to re-schedule their debts and restructure their assets under the watchful eye of the Government. However, very few of these were actually recapitalized. Even listed companies remained largely in the hands of their controlling shareholders, who often held between 30-75 percent of the stock.

In other words, much of this explosion in demand for Islamic finance appears to have gone into propping-up poorly capitalized, highly leveraged companies.

Today, the amount issued by privately owned Malaysian corporations stands at $18 billion, or just under half of the world market as estimated by Moody's.

It is unclear what the sources of these funds are. The cash rich oil fiefdoms of the Middle East are thought to be a major source; indeed some commentators have suggested that a massive inflow of funds from the Middle East is what helped Malaysia weather the Asian Crisis with minimal restructuring of its banks and other corporations.

This inflow of Middle Eastern funds into Malaysia was especially apparent after 9-11. Financial Times has reported that in 2003 the Saudis alone pulled some $200 billion out of the US markets, and reallocated those funds into Bahrain and Malaysia.

Given such, is another financial meltdown -- this time in the Islamic bond market -- imminent? The answer probably lies with the sheiks of the aforementioned Middle Eastern fiefdoms. It could well be that with crude oil prices having risen to $70 (and rising) in just under a year they might be willing to extend some charity. On the other hand, the sheiks are known to be shrewd, tough negotiators. If they decide to pull their funds out of shariah-compliant bonds and return them to investments in more conventional instruments they have always invested in (regardless of religious prohibitions), the Islamic bond market could well dry up overnight. Bankers and other promoters of Islamic financing facilities, and certainly Malaysian corporations, might well be expected to make good the losses suffered by those who have purchased these bonds.

Ganesh Sahathevan is a Sydney-based journalist focusing on Southeast Asian business, economic and politics.


1 Comment

maybe junk bond grade
Mostly muslims will only call something properly muslim when it suits them. If they can't rationalize things, perhaps by calling 'interest', or 'profit', by another name, they will just plain ignore their own religious injunctions. After all, they don't mind being hypocritical on all other issues.

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