How the landscape has changed for Islamic finance, a sector once viewed as an asset-rich haven for risk-averse investors. The global reverberations of Dubai World's decision to seek a "standstill" on its financial obligations have thrown the spotlight on the most imminent and pressing of those commitments: the US$4 billion (Dh14.69bn) bill on a sukuk payable by Dubai World's property company, Nakheel, in just seven days.
If, as many international investors now fear, Nakheel is unable to meet that deadline, it will raise doubts about the rest of the Islamic financial industry, which is worth about $720bn globally, the London Business School says. "This has been an extraordinary crisis, but it is the first for the embryonic sukuk industry," says Khalid Howladar of Moody's Investors Service. "The youth of the market has meant that such funding instruments are untested as various sectors of regional economies contract or even collapse."
The new doubts about the industry are in sharp contrast to the confident optimism it showed when the western financial system, or what might be called "secular" finance, was in the throes of the credit crisis last year. Then, advocates of Islamic finance were adamant that their system, with its built-in restrictions on risk and leverage, would escape the worst of the West. Even the Vatican praised Islamic finance for its "ethical principles".
But critics of Islamic finance pointed to significant difficulties still to be overcome before the industry could really be accepted as a viable alternative to western capitalism. Chief among these was the lack of uniformity of interpretation, with wide differences of opinion among Islamic scholars operating in different social and cultural environments, in Asia and the Middle East. Those worries have been aggravated significantly by the Nakheel situation.
Doubts began to surface before the shock of the Dubai World "standstill". Investment Dar of Kuwait, which owns half of the British car maker Aston Martin, defaulted on a $100 million sukuk last summer. Then the $650m Golden Belt Islamic bond, controlled by the debt-laden Saad Group run by the Saudi financier Maan al Sanea, also got into trouble. The lawyers and Islamic experts began pouring over the issue documents to evaluate investors' rights in distressed situations.
The issue goes to the heart of Islamic finance. Two basic principles of the industry are the avoidance of interest, for fear it may lead to the sin of usury; and avoidance of risk, which could be interpreted as gambling, which is also forbidden. So Islamic financial instruments have to be constructed on the foundations of real physical assets, such as land, machinery and equipment, in which the participants are profit-sharing partners. There is nothing wrong in Islam with profit, but it must be profit from the income from tangible assets. Money cannot come just from money.
In the Saudi and Kuwaiti cases, the continuing debate has focused on whether the sukuk were "asset-backed" or "asset-based". If the former, investors could expect priority in realising their investment when the sukuk got in trouble; if the latter, they would have to stand in line with the rest of the creditors, and maybe towards the end of the line. Those issues are now at the forefront of investors' thinking with regard to the Nakheel deadline. The sukuk gave investors security in the form of assets that could be realised in the case of non-payment, but it seems very few read the prospectus in detail.
The Nakheel sukuk is secured on vast swathes of development land south of Jebel Ali, outside Dubai, that Nakheel had set aside as a development "twice the size of Hong Kong Island". Little work has been done on the project. One American investor, who declined to be named because of his involvement in continuing negotiations ahead of the sukuk deadline of December 14, said: "Some of us just kind of assumed we had recourse to the Palm or some other real estate in the city, rather than just a big chunk of desert."
Enforceability of any claim to those assets is a further confusion but it is mainly a legal issue, rather than an Islamic one. To exacerbate things, the problems at Nakheel surfaced just as the sukuk industry was showing signs of recovering from the global crisis. New issues dropped to a three-year low last year as international demand dried up for all financial products, Islamic or not, but analysts had been expecting a boom in sukuk early next year.
Just before the Dubai World standstill request, the finance arm of the US conglomerate GE became the first major American corporation to launch a sukuk, in a $500m issue that was hailed as a sign that Islamic finance was firmly in the mainstream of world business. That recovery is now in doubt. "If some sukuk are not found to be equivalent to conventional bonds in a default or restructuring, it will have a significant effect on the shape of the sukuk market to come," Mr Howladar says.
Certainly, the medium-term ability of Dubai World entities to tap into the sukuk market looks impaired. The group had been one of the major players in the industry with four of the top 10 biggest issues made by one or another arm of the conglomerate. Moreover, the UAE dominates the sukuk industry, with three of the top five bonds issued by Emirati corporates. The Nakheel sukuk is the second-largest ever, behind a Malaysian issue.
The other potential knock-on effect is on the Islamic banking industry, where again the UAE has been at the forefront. HSBC Amanah, the Islamic arm of the global banking giant, has based its business in the country. Demand for Islamic retail banking products, regarded as a huge potential market, is likely to be comparatively unaffected by the Nakheel affair. The corporate banking business is more vulnerable. Big Islamic banks all have exposure both as investors in sukuk, and as creditors to Dubai World.
"Islamic banks - carry sukuk in their investment books and have funded as well as unfunded credit exposures to either Nakheel and/or Dubai World," says Anouar Hassoune, also of Moody's. "Therefore, they will suffer directly from the economic provision and impairment charges attached to such exposures, irrespective of any such accounting treatment." Dubai Islamic Bank, the region's oldest but also the most heavily exposed to Dubai World, is regarded as most vulnerable, and has been placed on review by Moody's because of the risk of non-payment and its exposure to the ailing property sector.
Dubai Bank, highly concentrated on the UAE's leading borrowers, is also likely to come under pressure, says Moody's. Underlying the potential gravity of the problem for the UAE's banks, the Central Bank has provided further liquidity facilities after the Dubai World standstill request. @Email:firstname.lastname@example.org