Understanding Shariah Investment

RREEF Real Estate Research June 2008 Table of contents Understanding Shariah Investment........................2 Scale and Sources of Middle Eastern Capital...10 Capital Mobility and Allocation........................19 The Outlook for Shariah-Compliant Alternative Investment......................24 Authors: Henry Chin +44 207 545 6611 +852 2203 7908 henry.chin@rreef.com Peter Hobbs +44 207 547 4855 peter.hobbs@rreef.com Cameron Dowe +61 2 8258 2683 cameron.dowe@rreef.com Richard Hedley +61 2 8258 1477 richard.hedley@rreef.com Tae Kim +82 2724 4330 tae.kim@rreef.com Understanding Shariah Investment Introduction This paper introduces Shariah-compliant investment by reviewing its key terms and concepts, assessing its market size and potential, and outlining its opportunities and challenges for investors and financiers. Shariah-compliant investment represents a series of ethical financial transactions that are organised in accordance with Islamic law. The range of investment opportunities complying with Muslim religious beliefs has historically been fairly limited. Islamic banking is distinguished by a ban of interest-based transactions, an emphasis on equitable contracts, the linking of finance to productivity, the desirability of profit sharing, and the prohibition of speculation and uncertainty in business contracts. Saving and investing, however, are in line with Islamic religious principles so an increasing range of financial products are now emerging to meet Shariah rules. At the same time, the capital available for deployment into Shariah-compliant investments is vast and growing. At the heart of the Middle East, the countries of the Gulf Cooperation Council – Saudi Arabia, Kuwait, the UAE, Bahrain, Qatar, and Oman – form a market of 38 million residents (about the same population as California) with a combined annual GDP that grew 6.4% in 2007 to reach US$840 billion. Add to this another 430 million Muslims living outside the Middle East – many of whom reside in prosperous or growing economies such as India, Malaysia, or Turkey – and the market opportunities become quite clear. We conclude that strong economic growth, rising oil revenues, and healthy current account surpluses in many Muslim countries are among the factors supporting the growing potential of Shariah-compliant investment. But as with all good opportunities, we also caution that there are associated challenges, too. These include, among other things, a shortage of appropriately qualified Shariah scholars to serve on required review boards, the lack of a global consensus on Shariah interpretation with regard to financial products, and a lack of standardisation for transaction structuring and processing. Marcus Wignell +44 207 545 9833 marcus.wignell@rreef.com IMPORTANT: PLEASE SEE CONFLICT DISCLOSURES IMMEDIATELY AT THE END OF THE TEXT OF THIS REPORT RREEF Research 1 1. Understanding Shariah Investment Background and Market Opportunities The emergence of Islamic banking in recent years is one of the most important trends in the financial world. There has always been a demand among Muslims for financial products and services that conform to the Shariah (Islamic law). With the development of viable Islamic alternatives to conventional finance, Muslims are increasingly able to participate in the financial world without bearing an economic penalty. The Islamic banking industry today is valued at several hundred billion dollars with more than 300 financial institutions already participating. The Islamic banking industry today is valued at several hundred billion dollars (estimates vary)1, and consists of more than 300 financial institutions in and outside the Muslim world. This emerging industry is the product of the collective efforts of bankers, economists, and Islamic legal scholars over the past several decades to develop financial solutions that meet the religious requirements of Muslims. It is a young and fast-growing industry that continues to evolve and expand both financially and geographically. This industry’s vast market includes devout Muslims in indigenous Muslim societies as well as in Muslim minorities of non-Muslim countries. Furthermore, it offers a broad appeal beyond its traditional Muslim base: non-Muslim individuals and communities that seek ethical financial solutions have also been attracted to Islamic banking. The first modern Islamic financial institutions emerged in the 1960s and 1970s. Since then, Islamic banking has spread to a large number of Muslim countries, including the Gulf Cooperation Council (GCC)2, the Arab world at large, South and Southeast Asia, and even Muslim communities in the West and Africa. Bahrain is considered a hub for Islamic banking, with significant activity also taking place in Kuala Lumpur and London. Islamic financial institutions have taken the form of commercial banks, investment banks, investment and finance companies, insurance companies, and financial service companies. They follow different banking models: private institutions in a conventional economy (as in the GCC and the West), attempts at national Islamic banking systems (as in Sudan, Iran, and Pakistan), and dual banking models (as in Malaysia). They also take different forms: wholly Islamic institutions, Islamic subsidiaries of conventional banking groups, and Islamic banking ventures within conventional banks. This is an industry that is still evolving, developing, and growing. It has gone from commercial banking to syndicated transactions and equities, and more recently, into debt issuance and structured products. Its sophistication and product offerings have developed along with this change. At an earlier stage, industry growth was in part a reflection of economic growth in the Islamic world, fuelled primarily by oil wealth. This created a growing middle-wealth segment and hence made banking a necessary service to the larger segment of the population. In the past several years, increased awareness about Islamic banking has led to increased market share (from conventional banking) and continued high growth (15-20% in key markets). Middle Eastern investors hold US$2.4-2.8 trillion in traditional investment assets worldwide. RREEF Research The Middle East – especially the GCC – is an increasingly important source of capital for the global financial system3. Middle Eastern investors hold US$2.4-2.8 trillion in traditional investment assets worldwide, including treasuries, corporate bonds, equities, and funds. 1 According to the estimates from the UK Financial Services Authority in 2006, the Islamic banking and finance market is estimated to be worth between US$200 billion and US$500 billion. According to McKinsey’s (2006), “The world of Islamic Banking Competitiveness Report, the Islamic banking sector is worth between US$180 billion and US$250 billion. According to the estimates from Dubai International Financial Centre (DIFC), the global market for Islamic financial products is worth more than US$200 billion. 2 The GCC bloc includes Saudi Arabia, Kuwait, UAE, Bahrain, Qatar, and Oman. 3 The UAE’s Abu Dhabi Investment Authority (ADIA) spent US$7.5 billion to buy a stake in Citigroup. 2 More specifically, Shariah-compliant products (which include banking assets and asset management) were valued at around US$450 billion (ex-Iran) in 20064. With growth of 23.5% p.a. over the past five years, Shariah compliant products are expected to grow at 17% p.a. to exceed US$1 trillion in value by 2010 (ex-Iran). The growth of international property investment has accelerated during this decade. The growth of international property investment has accelerated during this decade, due to (1) the maturity of real estate as an asset class, (2) increasing allocation to real estate by institutional investors, and (3) better returns in both absolute and relative terms, compared to other asset classes5. There are a growing number of infrastructure projects requiring Islamic-compliant finance, and this has created a considerable demand for professional services and products within the Middle East region. However, Shariah-compliant real estate and infrastructure investment are still relatively under-developed and fragmented. Given the growth of Middle East capital, it is essential to understand the requirement of Shariah-compliant investment, the scale of the investment markets, and the investors’ appetite for alternative investment. Chart 1 : Scale of Islamic Banking and Asset Management Islamic banking Asset*** 2006 USD billions 10 UK 250-270 320 9 Iran Turke 12 y24 Based on projected growth trends. Islamic assets are expected to exceed USD 1 trillion by 2010 (excluding Iran) Islamic assets 150-under 180 managment Bahrain Kuwai 90 t 100 KSA 4 Sudan 3 2 Pakista n 3 Brunei 33 38 Total Islamic Assets (excluding Iran UAE 400-450 Omar Malaysia 3 Indonesia Source: McKinsey (2007) Note: *including offshore assets **Estimate of Islamic share of Saudi market based on Islamic loans share out of total loans ***excluding Iran. Defining Shariah-Compliant Investment Shariah-compliant investment follows ethical principles that are in accordance with Islamic law. Shariah-compliant investment represents a series of ethical financial transactions that are organised in accordance with Islamic law. The range of investment opportunities complying with Muslim religious beliefs has historically been fairly limited. In order to offer new investment vehicles for those investors who are looking to develop a self-invested personal pension, or a small self-administered scheme, a new system of Shariah-compliant investment funds has emerged. These funds do not permit transactions that are eschewed by Islam, including option trading or interest-based transactions, such as margin trading and short selling. Islamic banking is an ethical and equitable mode of financial services that derives its principles from the Shariah (Islamic law). The Shariah is based on the Quran and the 4 McKinsey (2006), “The World Islamic Banking Competitiveness Report”. The sector outside Iran has reached $US400-500 billion and is on track to exceed US$1 trillion by 2010. 5 RREEF Research (2007), “Global Real Estate Insights”. RREEF Research 3 Sunnah of the Prophet Muhammad, and it governs all aspects of personal and collective life. Overall, Shariah investment must be carried out in accordance with the fundamental principles of Islamic law. A Shariah board of Islamic scholars advises the financial institution in the development of Shariah-compliant products. Islamic beliefs prohibit interest-based transactions… The most distinctive element of Islamic banking is the prohibition of interest, whether "nominal" or "excessive," simple or compound, fixed or floating. Other elements include the emphasis on equitable contracts, the linking of finance to productivity, the desirability of profit sharing, and the prohibition of gambling and certain types of uncertainty. These parameters define the nature and scope of Islamic banking, as interpreted by the Shariah scholars that work with financial institutions. …but encourage savings and investment. Saving and investing in line with religious principles is important for many Muslims, and an increasing range of financial products are now available to meet Shariah rules. Islam is very clear on a number of financial topics. While trade and investment are encouraged, Shariah rules prohibit involvement in alcohol, gambling, pornography, abortion, human cloning, defence, conventional banks or insurers, and most forms of entertainment. Industries associated with pork are prohibited. The most fundamental aspect of Shariah compliance is the prohibition of any form of usury, or riba6. Any amount in a contract of loan or debt – regardless of size – that exceeds the principal is riba. Such contracts are prohibited by the Quran, regardless of whether the loan is taken for the purpose of consumption or for some production activity. This indicates that any forms of receiving or paying interest are not allowed, because Islam defines all forms of interest as usury. The rationale behind the prohibition of interest in Islam suggests an economic system where all forms of exploitation are eliminated. In particular, Islam wishes to establish justice between the financier and the entrepreneur. The financier should not be assured of a positive return without doing any work or sharing in the risk, while the entrepreneur, in spite of his management and hard work, is not assured of such a positive return. In general, there are two forms of forbidden riba: 1. Riba al-fadl, where a particular good is exchanged for another hand-to-hand, but in different quantities; and 2. Riba al-nasiah, where money is exchanged for money with deferment. Key Principles of Shariah Finance The key principles of Shariah relevant to finance transactions include: 1. Interest (riba): Shariah regards money as simply a means of exchange, without intrinsic value and holds that money cannot be used to make money. Interest is the classic example of riba. Payment or receipt of interest is strictly prohibited, and any obligation to pay interest is considered void under Shariah. 2. Speculation (maisir): Shariah prohibits and treats as void transactions that rely on chance or speculation, rather than effort, to produce a return. This can create problems in relation to contracts that are seen as tantamount to gambling, which includes some conventional derivative transactions such as swaps, futures, and options. 6 Riba comes in the form of interest, unjustified rewards, and unlawful gains. RREEF Research 4 ... - tailieumienphi.vn