"Why Don't Islamic Countries Get Rich?"

I came across this paragraph a couple weeks ago, and finally remembered to post it to the blog. The paragraph is a small part from a review published in the July 23rd edition of The Economist on Alan Beattie's book, False Economy: A Surprising Economic History of the World. Beattie is the world-trade editor at the Financial Times and a former economist for the Bank of England.

Turning to religion, Mr Beattie asks: “Why don’t Islamic countries get rich?” Ah, he replies, some of them do. Islam is often held up as inimical to economic progress. That is nonsense, he says. The Muslim Hausa have provided some of Nigeria’s most successful traders for centuries. “Had Max Weber lived among the Hausa”, Mr Beattie sniffs, “he might well have concluded that Muslims were good for growth and constructed his convoluted psychological theories around the tenets of Islam.” The author picks his way through religious texts, history and modern commercial practice to argue that there is no reason to draw a firm causal connection between any faith and economic progress.

Here is another review for False Economy, from Business Week, that discuss the Islamic question:

Beattie, who studied history at Oxford University and economics at Cambridge, draws on both disciplines to overturn assumptions about the evolution of the global economy. For example, the data do not support the belief that Islamic societies inherently perform worse than other nations, or for that matter that there is any correlation between religion and growth. Malaysia has both a strong Islamic identity and a modern economy. Religion is an obstacle only when development is blocked in God's name, often in self-defense by those who hold power, Beattie argues.

In looking up information about this book, I came across an old blog post at Aqoul that discusses a Financial Times article Beattie wrote on the same subject, most likely becoming part of his research for the book now published. (Unfortunately, the FT article is no longer available on the FT website.) However, the Aqoul post refers to the original study Beattie was writing about, Religion, Culture and Economic Performance by Marcus Noland at the Institute for International Economics, which was published in August 2003. In that study, Noland found that:

The results with respect to Islam do not support the notion that it is inimical to growth. On the contrary, virtually every statistically significant coefficient on Muslim population shares reported in this paper—in both cross-country and within-country statistical analyses—is positive. If anything, Islam promotes growth.

(A similar paper by Noland and Howard Pack, Islam, Globalization, and Economic Performance in the Middle East (published June 2004), came to the same conclusion.)

So, the partial answer to the question, "Why don't Islamic countries get rich?" is, "It's not Islam's fault." To answer the question more thoroughly requires a more conventional economic analysis. (I hadn't originally planned a part two, but I feel one may be necessary at this point.)

Update (8 May 2011): I think the events of recent months (the "Arab Spring" and especially the examples of Tunisia and Egypt) have shown that the problem with respect to economic growth in Muslim countries is not Islam itself, but the authoritarian control by governments over economic activity, especially when that control is used to stifle the economic activity of the average Muslim in favor of cronyism. Don't forget that the Tunisian revolution, which started the Arab Spring, started when a young man, Mohamed Bouazizi, set himself on fire because local officials wouldn't allow him to support himself and his family by selling fruit and vegetables from a pushcart.

Mikhail Gorbachev: "We Had Our Perestroika. It's High Time for Yours."

There's a good essay by Mikhail Gorbachev, the former leader of the USSR, in The Washington Post. He argues, correctly, IMO, that America's political and economic systems are broken and in need of reform, although he offers no solutions.

I would offer several suggestions in all seriousness: look to Islam for guidance on economic and financial reform, and look to science fiction (and particularly Kim Stanley Robinson's Mars trilogy) for guidance on political and cultural reform. People might think I'm offering pie-in-the-sky suggestions, but many people have thought long and hard on all of these issues. For example, Robinson's work highlights some of the negatives and positives of both the current and future political and cultural systems. When Gorbachev writes, "But I am convinced that a new model will emerge...", everything that follows in Gorbachev's sentence has already been discussed in the Mars Trilogy.

I would not offer these suggestions as solutions ready made to be implemented directly, but I do believe that both can be used as the starting points for discussion on how to solve some of the world's problems.

Here are some of the highlights from the essay:

In the West, the breakup of the Soviet Union was viewed as a total victory that proved that the West did not need to change. Western leaders were convinced that they were at the helm of the right system and of a well-functioning, almost perfect economic model. Scholars opined that history had ended. The "Washington Consensus," the dogma of free markets, deregulation and balanced budgets at any cost, was force-fed to the rest of the world.

But then came the economic crisis of 2008 and 2009, and it became clear that the new Western model was an illusion that benefited chiefly the very rich. Statistics show that the poor and the middle class saw little or no benefit from the economic growth of the past decades.

The current global crisis demonstrates that the leaders of major powers, particularly the United States, had missed the signals that called for a perestroika. The result is a crisis that is not just financial and economic. It is political, too.

The model that emerged during the final decades of the 20th century has turned out to be unsustainable. It was based on a drive for super-profits and hyper-consumption for a few, on unrestrained exploitation of resources and on social and environmental irresponsibility.

But if all the proposed solutions and action now come down to a mere rebranding of the old system, we are bound to see another, perhaps even greater upheaval down the road. The current model does not need adjusting; it needs replacing. I have no ready-made prescriptions. But I am convinced that a new model will emerge, one that will emphasize public needs and public goods, such as a cleaner environment, well-functioning infrastructure and public transportation, sound education and health systems and affordable housing.

Elements of such a model already exist in some countries. Having rejected the tutorials of the International Monetary Fund, countries such as Malaysia and Brazil have achieved impressive rates of economic growth. China and India have pulled hundreds of millions of people out of poverty. By mobilizing state resources, France has built a system of high-speed railways, while Canada provides free health care. Among the new democracies, Slovenia and Slovakia have been able to mitigate the social consequences of market reforms.

The time has come for "creative construction," for striking the right balance between the government and the market, for integrating social and environmental factors and demilitarizing the economy.

What is Riba?

This post is primarily based upon a comment I wrote over at Jay Solomon's blog, The Zen of South Park:

This is one of the trickier questions in Islamic finance. As Jeffrey Harding pointed out in his recent article, The Money That Prays, the definition of riba is problematic, especially for non-Muslims:

After a long study of Islamic finance, the anthropologist Bill Maurer couldn’t settle on ‘interest’ as the perfect translation: it seemed clear at first but became streaky as he looked closer. ‘Usury’ is the obvious alternative, but are we to rely on the older sense of the term – any charge, however small, for the use of borrowed money – or on the way it’s understood today, as extortionate interest only? Wilson, a professor in the School of Government and International Affairs at Durham who is intrigued by ‘the influences of religious belief on economic behavior’, holds that riba is usury in the first sense. That’s the view of most practicing Muslims; it seems to echo the meaning of the word in Deuteronomy, where Moses instructs the people of Israel not to lend to their own kith and kin at a rate: ‘Unto a stranger thou mayest lend upon usury; but unto thy brother thou shalt not lend upon usury.’ Very close to ‘interest’ after all then. Yet if, like Melanie Phillips, you believe Islamic banking in the UK merely hastens the day when a green flag is raised over Westminster, it’s important to think of ‘usury’ in the later sense, in order to insist that Muslim law is either deluded or deceitful: ‘The whole issue of sharia finance,’ Phillips wrote last year, ‘is based on a fabrication . . . sharia does not proscribe interest. It proscribes usury.’

Phillips, a known Islamophobe, would obviously want riba to be "usury" in the modern sense, an excessive interest rate. However, Phillips is not an Islamic scholar by any stretch of the imagination. Riba, in my opinion, is any amount of interest, even one cent above the amount of principal. Consider the following ahadith:

Narrated Abu Salih Az-Zaiyat: I heard Abu Said Al-Khudri saying, "The selling of a Dinar for a Dinar [gold], and a Dirham for a Dirham [silver] (is permissible)." I said to him, "Ibn 'Abbas does not say the same." Abu Said replied, "I asked Ibn 'Abbas whether he had heard it from the Prophet s or seen it in the Holy Book. Ibn 'Abbas replied, "I do not claim that, and you know Allah's Apostle better than I, but Usama informed me that the Prophet had said, 'There is no riba (in money exchange) except when it is not done from hand to hand (i.e., when there is a delay in payment).' " (Bukhari: 3.34.386)

Abu Salih reported: I heard Abu Sa'id al-Khudri (Allah be pleased with him) said: Dinar (gold) for gold and dirham for dirham can be (exchanged) with equal for equal; but he who gives more or demands more in fact deals in interest. I sald to him: Ibn 'Abbas (Allah be pleased with them) says otherwise, whereupon he said: I met Ibn 'Abbas (Allah be pleased with them) and said: Do you see what you say; have you heard it from Allah's Messenger (may peace be upon him), or found it in the Book of Allah, the Glorious and Majestic? He said: I did not hear it from Allah's Messenger (may peace be upon him). and I did not find it in the Book of Allah (Glorious and Majestic), but Usama b. Zaid narrated it to me that Allah's Apostle (may peace be upon him) said: There can be an element of interest in credit. (Muslim: 10.3876)

Ubaidullah b. Abu Yazid heard Ibn 'Abbas (Allah be pleased with them) as saying: Usama b. Zaid reported Allah's Apostle (may peace be upon him) as saying: There can be an element of interest in credit (when the payment is not equal). (Muslim: 10.3877)

Ibn 'Abbas; (Allah be pleased with them) reported on the authority of Usama b. Zaid Allah's Messenger (may peace be upon him) as having said this: There is no element of interest when the money or commodity is exchanged hand to hand. (Muslim: 10.3878) [In other words, what is known as a spot transaction.]

What I find interesting is that riba applies even to material goods. Consider:

Abd Sa'id reported: Bilal (Allah be pleased with him) came with fine quality of dates. Allah's Messenger (may peace be upon him) said to him: From where (you have brought them)? Bilal said: We had inferior quality of dates and I exchanged two sa's (of inferior quality) with one sa (of fine quality) as food for Allah's Apostle (may peace be upon him), whereupon Allah's Messenger (may peace be upon him) said: Woe! it is in fact usury; therefore, don't do that. But when you intend to buy dates (of superior quality), sell (the inferior quality) in a separate bargain and then buy (the superior quality). And in the hadith transmitted by Ibn Sahl there is no mention of" whereupon". (Muslim: 10.3871)

Narrated Abu Burda: When I came to Medina. I met Abdullah bin Salam. He said, "Will you come to me so that I may serve you with sawiq (i.e. powdered barley) and dates, and let you enter a (blessed) house that in which the Prophet entered?" Then he added, "You are In a country where the practice of riba (i.e. usury) is prevalent; so if somebody owes you something and he sends you a present of a load of chopped straw or a load of barley or a load of provender then do not take it, as it is riba." (Bukhari: 5.58.159)

In the first hadith, the excess quantity of dates traded (the inferior quality dates) was riba and therefore haram; even an equal trade of inferior for superior dates would be haram as the quality of the two sets of dates would not have been equal. Thus, a halal transaction is two sided, the sale of the inferior dates for cash first, the purchase of the superior dates for cash second.

The second hadith is even more interesting for how commonplace this custom is. "I owe you, and I'm repaying my debt to you, but let me also give you this gift to make up for the fact that I owed you the repayment (and maybe I was late in making payment)." Sound familiar? That's riba, too.

Jeremy Harding: The Money That Prays

Moon of Alabama linked to a longish essay on Islamic finance at the London Review of Books (LRB). That's an odd place, I thought, for an essay on this topic, so I read the article with a little fear (you know, expecting the usual Islamophobe's-got-an-axe-to-grind-type rant). However, the essay turned out to be rather fair, although, to be honest, I'm still not sure what the author's purpose was in writing the essay to begin with.

Below are three excerpts from the essay; while it may look rather long, this is only a small portion of the entire article, which prints out at 11 pages.

The prohibitions for Muslims are puzzling to the modern commercial mind. The first obstacle for a pious Muslim trading and banking in conventional economies is interest, the term I’ve been using for the Arabic riba, though its literal sense is closer to ‘excess’ and it is sometimes translated as ‘usury’. Often, in the Hadith and even more in recent proselytising on the internet, riba is said to be ‘eaten’. One of the objections to riba is its propensity to up-end the social order. A person who consumes riba bungles the proper management of need – his own and his debtor’s – whereupon the grand plan of give and take, sufficiency for rich and poor alike, begins to come apart. This, as Charles Tripp explains in Islam and the Moral Economy, is also a challenge to ‘the balance and proportion of God’s ordering of the universe’, which must be reflected in ‘human relations’. Islamic tradition warns that riba is likely to lead to injustice and exploitation.

There’s a categorical objection, too: that money may not be conjured up from money to generate like from like. The goods that served (we’re told) as currency in Islamic tradition – gold, silver, salt, grain and dates – can only be exchanged ‘hand to hand’, i.e. in a spot transaction, without deferment; and only at parity, one quantity for its exact equivalent, no more, no less. It’s not clear why you’d want to swap something – a gold weight, say – for its identical other, but the point here is probably that units of currency, unlike the shirt or the saddle for which they’re exchanged, must be beyond any cavilling with regard to value for the system to hold up: an Islamic marker set down 14 centuries ago against arbitrage. In a story told by Abu Said al Khudri, one of Muhammad’s younger companions, the Prophet describes the transaction of a greater number of low-grade dates for a smaller number of quality dates as riba.

The most famous chapter and verse on riba is in sura 2 of the Koran. It warns that dealing in riba will bring on madness or ‘torment’ (via ‘Satan’s touch’), and that if you’re not prepared to waive a mark-up on a debt, war will be waged against you by God and the Prophet. One sharia-compliant banker I met last year told me that’s about as bad as it gets. There is also an injunction to forgive debt in a broader sense: ‘If the debtor is in difficulty, then delay things . . . Still, if you were to write it off as an act of charity, that would be better for you, if only you knew’ (the rules followed by HSBC Amanah try to catch something of this). The charging of riba, it follows, is always a missed opportunity to act generously, to give where a gift is in order, a gesture highly prized in Islamic tradition. In a faith embodied by a trader prophet and espoused by an impressive trading community for which, at its height, knowledge was a key commodity, believers are admonished not to confuse riba with trade. From the second sura, again: ‘God has allowed trade and forbidden usury.’

...

Riba catches many non-Muslims out. After a long study of Islamic finance, the anthropologist Bill Maurer couldn’t settle on ‘interest’ as the perfect translation: it seemed clear at first but became streaky as he looked closer. ‘Usury’ is the obvious alternative, but are we to rely on the older sense of the term – any charge, however small, for the use of borrowed money – or on the way it’s understood today, as extortionate interest only? Wilson, a professor in the School of Government and International Affairs at Durham who is intrigued by ‘the influences of religious belief on economic behaviour’, holds that riba is usury in the first sense. That’s the view of most practising Muslims; it seems to echo the meaning of the word in Deuteronomy, where Moses instructs the people of Israel not to lend to their own kith and kin at a rate: ‘Unto a stranger thou mayest lend upon usury; but unto thy brother thou shalt not lend upon usury.’ Very close to ‘interest’ after all then. Yet if, like Melanie Phillips, you believe Islamic banking in the UK merely hastens the day when a green flag is raised over Westminster, it’s important to think of ‘usury’ in the later sense, in order to insist that Muslim law is either deluded or deceitful: ‘The whole issue of sharia finance,’ Phillips wrote last year, ‘is based on a fabrication . . . sharia does not proscribe interest. It proscribes usury.’ Were riba just a term for exploitative lending, however, one or two countries might have shuffled nearer to a unitary sharia banking system. But the sharia has few attractions for exchequers and central banks in a modern economy, where the interest rate is a basic tool of monetary policy. The appeal of sharia-compliant banking and investing is in essence to the individual conscience.

The emphasis on risk-sharing in HSBC Amanah’s products – and all Islamic products – is related to the prohibition on interest: it’s obvious to the devout Muslim that collecting interest on a debt involves no risk worth the name; all that’s required, in this view, is for a creditor to sit back and wait. The exposure involved in the mere lending of money – self-evident to a non-Muslim – is an unticked box in Islamic tradition, while savings, for which non-Muslims see interest as a fair reward, give rise to worries about hoarding: money should be out there doing the work that enables trade to flourish. A Treasury expert would say Islamic tradition approves of narrow money; a historian would remember Bacon’s essay ‘Of Seditions and Troubles’ and his famous dictum that muck is ‘not good except it be spread’. (The essay goes on: ‘This is done chiefly by suppressing, or at the least keeping a strait hand upon the devouring trades of usury.’)

Risk-sharing, like generosity, puts human relations on an even keel in the Islamic view. A capitalist can weigh a risk but shouldn’t accept a promise from a partner to eliminate it: that would be ‘risk-transfer’, which denies the inherent truth of risk. (In the eyes of sharia scholars it also opens up a vista of potential exploitation, especially when risk is passed on in unknowable ways, say in the form of a mortgage-backed security with a dodgy rating.) No one must guarantee investors’ money, except against fraud.

...

Debt is a problem in its own right. Borrowing on a regular, matter-of-fact basis is open to question since sharia scholars are wary of conventional banking’s dependence on interbank borrowing. The ideal Islamic bank, Rodney Wilson told me, is financed entirely by its depositors’ money. In practice, there is plenty of imperfection, but a compliant bank will want to stay as close as possible to this model. Like riba, debt also raises fears about poverty and injustice (some Muslim NGOs are as evangelical about Third World debt as their Christian and secular counterparts). In the Hadith, debt presents a troubling face once the possibility of deferment arises, as it might with a debtor in difficulty. Is it a good thing or a bad thing to put off repayment? Does it matter whether the debtor is wealthy or poor? Bad faith is always threatening to break in on the relationship between a debtor and a creditor: a debtor says he can pay back a loan but how can he be sure? All this drags human relations into the realm of uncertainty – gharar – from which faith, the discourse of absolute certainty, was supposed to protect them. In commerce, gharar is best avoided. Whence the persistence of doubts about contracting for things that don’t (yet) exist: tradition might allow for a joiner taking orders on furniture he hadn’t yet made, but it disqualified the sale of a foal that was still in the body of the mare. Even the benign, textbook version of the forward contract – a farmer and a miller agreeing a grain price ahead of the harvest – brings a sense of uneasiness.

The concept of gharar doesn’t just apply to goods whose status is in doubt, but to bargains whose terms are ambiguous and contracting parties whose liability is vague. Though it’s often translated as ‘hazard’, it’s not the same as risk, which Muslim societies understand as well as anyone. Business risk is unavoidable and begins when a cargo plane taxis towards the runway. Gharar has more to do with the commercial imagination running ahead of itself: speculation still troubles Islamic scholars; many take a dim view not just of credit derivatives, the villains of the banking crisis, but of any instrument whose value is based on a contract for an underlying asset rather than the asset itself. This is changing, slowly, as a growing number of experts wrestle with intellectual tradition till they get to a place where derivatives, some in any case, appear acceptable. But no sharia adviser would approve of an Islamic financial institution bundling toxic mortgage debts into securities and packing them off to market, still less buying them up. To a conscientious Muslim, this is the perfect storm, in which opaque liabilities, the unknown nature of the underlying debt, fair-weather forecasts by ratings agencies, plus risk transfer and riba, conspire to wreck large parts of the fleet. Is there anyone clinging to the flotsam, post-9/15, who disagrees?

CNN: Islamic Finance Faring Well

I saw this video yesterday on CNN International, and was impressed by it. The story is a brief overview on Islamic banking and sukuk bonds, and suggests that the Islamic finance sector is doing better in the current economic climate than traditional financing. CNN even asks the question, Could Islamic banking be the answer to the current economic downturn? (Of course, this is not the first time I've suggested this on this blog.)

The video also expands a little bit further on the basic principles of Islamic banking, providing an answer to the recent odd story out of Bloomsberg. As I pointed out last week, there's more to Islamic banking than just no interest; we're not all going to become Islamic bankers anytime soon, insha'allah.

Islamic Banking - Basic Principles

Interest is prohibited

Any capital has to be invested

Lender has a stake in the business deal

Lender shares losses as well as profits

Capital used to buy assets can be held as collateral

No lending on speculation or promises

Business contract must be transparent

Sukuk:

Asset-backed Islamic bonds

Bond holders share the profits earned

Embedded video from CNN Video

"We Are All Islamic Bankers Now"

There's an odd article out of Bloomberg with the title We Are All Islamic Bankers Now. The premise is that as worldwide interest rates become closer and closer to zero, the global financial industry will become "Islamic."

By 2009, we may all be Islamic bankers, too.

It's an odd yet apt comparison. Islamic banking is more about the means by which a certain group of people obtains money. Zero interest rates are about getting as much money, in any way possible, to everyone.

There's still something to be said about the spreading appeal of scrapping interest rates. It's no longer a unique aspect of certain transactions or a banking novelty. Its becoming the norm, and its quite disorienting.

Japan's benchmark interest rate is 0.3% and headed to zero in the months ahead. The US federal funds rate is 1% and headed lower, too. The UK's rate is 2%, Canada's is 2.25% and the euro zone's is 2.5%. As the fallout from the global crisis worsens, these and many other benchmark rates will edge toward zero.

According to Islamic law, the charging of interest, or "riba" in Arabic, is unjust and exploitative. That concept bears little resemblance to Japan's zero-interest-rate policies, or ZIRP. The BOJ never argued it was seeking to foster brotherhood or socio-economic justice.

But that's exactly what the BOJ did. By eliminating borrowing costs, and going further in recent years with "quantitative easing," the BOJ was doing its bit for social fairness and stability. It was about protecting the Japanese way of doing business and maintaining the equalitarianism on which the nations 127 million people pride themselves.

Now the Fed is heading down a similar road for similar reasons. With an unprecedented array of emergency-loan programs aimed at easing the worst credit crisis in seven decades, the Fed is engaging in Japan-like quantitative easing. The level of rates is one thing. The more fascinating development is the Fed pushing waves of extra liquidity into the financial system.

What the author fails to understand is that there's a lot more to Islamic banking than having no interest rates. To be sure, interest-free financing is an important characteristic in Islamic finance; however, it's far from being the sole criterion. There are other aspects that must be considered before financing can be considered shari'ah-compliant, and there are very few people around the world who are qualified to make such a determination.

The final quarter of the article has the author slobbering over himself as greed for an untapped source of capital (in these days of tight credit) begins to take over:

The point here isn't to downplay a fast-rising asset class. Globally, Islamic banking assets are estimated at $US600 billion to $US650 billion and have registered annual growth of 10 to 15% over the last decade, according to Celent, a Boston- based financial research and consulting firm.

That kind of growth means Islamic assets will top $US1 trillion by 2010, Alexa Lam, deputy chief executive officer of the Hong Kong Securities and Futures Commission, said at a EuroMoney conference in Hong Kong last month.

The reason why data from Boston and perspectives from Hong Kong are being highlighted here is to show just how anxious the world is to get a piece of Islamic finance. The figures and growth rates speak for themselves.

Will we all become Islamic bankers now? The answer is "no" (insha'allah wa alhamdulillah).

VoxEU: Quo Vadis Islamic Finance?

A good article on Islamic finance (if you're interested in the subject) at VoxEU, the European economics blog. The three authors, all of whom work for the International Monetary Fund (IMF), give a brief analysis of the state of the Islamic finance market, a listing of significant challenges facing the industry, and some concluding remarks. Below are some excerpts, primarily from the introduction and the conclusion; the section on challenges is significant and noteworthy, but I'll let my readers go to the original post to read it if they're interested.

BTW, in case you're unfamiliar with the Latin phrase, "Quo Vadis?", it means, "Where are you going?"

Since the summer of 2007, the global financial system has undergone a period of dramatic turbulence, which has caused a widespread reassessment of risk in both developed and emerging economies. The global financial turbulence appears to have had a limited impact on the Islamic finance industry, which has been in an expansionary phase in recent years (Economist, 2008; Financial Times, 2008). This rapid growth has been fueled not only by surging demand for Sharia’ah compliant products from Muslim financiers but also by investors around the world, rendering the expansion of Islamic finance a global phenomenon. In fact, there is currently over $800 billion worth of deposits and investments lodged in Islamic banks, mutual funds, insurance schemes (known as takaful), and Islamic branches of conventional banks.

...

...[P]erhaps the most striking has been the growth of sukuk, the most popular form of securitized credit finance within Islamic finance. sukuk commoditize capital gains from bilateral risk sharing between borrowers and lenders in shari’ah-compliant finance contracts into marketable securities without interest rate charges.

The sukuk market has held its own amid groundswell concern about the credit crunch and dysfunctional money markets. Although the current level of issuance remains a fraction of the global volumes of conventional bonds and ABS, the sukuk market had soared in response to growing demand for alternative investments before the first episode of severe market disruptions in 2007 showed first effects (Jobst et al, 2008). Gross issuance of sukuk has quadrupled over the past few years, rising from $7.2 billion in 2004 to close to $39 billion by the end of 2007, owing in large part to enabling capital market regulations, a favorable macroeconomic environment, and large infrastructure development plans in some Middle Eastern economies (see Figure 1).

By 2008, however, sukuk volumes dropped to $15.2 billion (about 50%) while the structured finance market dried up with just $387 billion issued (down by about 80%) during the same time. Factors contributing to this decline include the presentation of new rules on sukuk, the global financial crisis, and Gulf states’ currency risk. The slowdown in issuance was most pronounced in Malaysia, where fewer domestic transactions at smaller volume have balanced the market shares of Gulf Cooperation Council and Southeast Asian countries.

The rapid evolution of Islamic finance activities points to the available profit opportunities that beckon. This in turn has prompted a vetting process among a number of jurisdictions around the world to establish themselves as leading Islamic financial centres. In this regard, the case of London is perhaps the most remarkable insofar as it has managed to extend its leading position in world financial markets to become a center for Islamic finance. Similarly, Hong Kong, New York, and Singapore are also making important advances to accommodate Islamic finance within their jurisdictions and aspire to join the ranks of the more established Islamic centers such as Bahrain, Dubai, and Kuala Lumpur.

...

Islamic finance faces many challenges, including recent regulatory changes, illiquidity issues, liquidity risk management concerns, need for harmonized regulation, regulatory disparity amongst national supervisors, and a potentially unlevel playing field.

...

Despite the number of challenges outlined above, the long-term prospects look promising for Islamic finance. Financial institutions in countries such as Bahrain, the United Arab Emirates, and Malaysia have realized considerable demand for shari’ah-compliant assets and are gearing up for more shari’ah-compliant financial instruments and structured finance. In addition, financial innovation, driven by both domestic and foreign banks, will promote alternatives modes of intermediation and contribute to further development and refinement of shari’ah compliant derivative contracts.

As Islamic finance comes into its own, greater regulatory harmonization will be inevitable. Recent efforts have addressed legal uncertainty imposed by Islamic jurisprudence, discrepancies of national guidelines, and poorly developed uniformity of market practices. The Islamic Financial Services Board has moved ahead with its standardization efforts of the Islamic financial services industry that will foster the soundness and stability of the system. Globally accepted prudential standards have been adopted by the Islamic Financial Services Board that smoothly integrate Islamic finance with the conventional financial system.

Finally, despite the declining global sukuk issuance in 2008, emanating from both the Accounting and Auditing Organization of Islamic Financial Institutions decision and the impact of the financial crisis, the sukuk market will regain momentum, driven by demand from financial institutions, insurance companies, and pension funds across Islamic and non-Islamic countries. Many challenges still lie ahead, but the banks’ search for profitable opportunities and the ensuing financial innovation process in tandem with favorable regulatory developments at domestic and international levels will ensure that the Islamic finance industry will continue to develop at a steady pace in the long-run. The jury is still out how Islamic finance will be affected in the short-run by the repercussions of the global financial crisis.

HT: Economist's View

Muhammad Yunus: Casino Capitalism

The German magazine Der Spiegel has a short interview with Muhammad Yunus, founder of Grameen Bank and co-winner of the 2006 Nobel Peace Prize. Mr. Muhammad is asked about his take on the current financial crisis, but these two answers below are the real money quotes. You can read the entire interview here.

SPIEGEL ONLINE: Who do you think is guilty for the current financial meltdown?

Yunus: The market itself with its lack of adequate regulation. Today's capitalism has degenerated into a casino. The financial markets are propelled by greed. Speculation has reached catastrophic proportions. These are all things that have to end.

SPIEGEL ONLINE: The current financial crisis began as a credit crisis -- homeowners in the US could no longer pay down their mortgages. At Grameen Bank, which provides microloans, the repayment rate is close to 100 percent. Do you think your bank could be a model for the entire finance world?

Yunus: The fundamental difference is that our business is very connected to the real economy. When we provide a loan of $200, that money will go to buy a cow somewhere. If we lend $100, someone will maybe buy some chickens. In other words, the money goes to something with concrete value. Finance and the real economy have to be connected. In the US, the financial system has completely split off from the real economy. Castles were built in the sky, and suddenly people realized that these castles don't exist at all. That was the point at which the financial system collapsed.

The latter answer is also addressed in another recent blog post of mine; see I Hate to Say I Told You So...

HT: Economist's View

I Hate To Say I Told You So...

Metaphorically speaking, of course. One of the things I love about Islam is that it's a very practical religion. Non-Muslims may not like the various rules within the religion, but I have found, by and large, that Allah (swt) put them there for very good reasons. For example, "don't drink alcohol." How many benefits would there be to the individual, to society, if people didn't drink? How many lives would be saved, for example, if there were no drunk drivers? I used to read "Dear Abby." How many letter writers' lives would be changed for the better if they lived an Islamic lifestyle? "Dear Abby" would probably go out of business.

Likewise, the world is now in the midst of an economic crisis the likes of which no one has seen since my parents were toddlers. How much better would the economy be if it followed Islamic business principles? The following passage comes from one of the economics blogs I read, Angry Bear:

It was about an interview by Bill Moyers of John Bogle. He noted:

JOHN BOGLE: Well, it's gotten misshapen because the financial side of the economy is dominating the productive side of the economy...We've become a financial economy which has overwhelmed the productive economy to the detriment of investors and the detriment ultimately of our society.

I want to come back to the difference between the financial system and the productive system. The productive system adds to the value of our economy. And, by and large, the financial system subtracts. And, yet, it's growing and growing and growing. And this short term thing where short term orientation in which trading pieces of paper is regarded as a social value. It is not a social value.

Go listen to it. Then listen to Mr. Moyers latest interview with Kevin Philips.

But what's here that doesn't get the attention is the United States in the last 20 years undertook an enormous transformation of itself with no attention paid. And what it means is and what makes all this so frightening is the country is at risk because of the size of the financial sector that has never been graded on its competence and behavior in any serious way. They are the economy at this point. And we are now seeing what happens when a 20 to 21 percent of GDP financial sector starts to come unglued.

You had essentially a financial sector that, let's say, was sort of neck and neck with manufacturing back in the late 1980s. But they got control in a lot of ways in the agenda. Finance has been bailed out. I mean, everybody thinks this is horrible now what we're seeing in terms of bailouts. Even a lot of the people who do it think it's bad.

This has been going on since the beginning of the 1980s. Finance has been preferred as the sector that got government support. Manufacturing slides, nobody helps. Finance has a problem, Federal Reserve to the rescue. Treasury to the rescue. Subsidies this, that, and other.

I am certain we have to do something to help the money flow such that it does not take down the entire system. It would be cutting off our noses to spite our faces not to protect ourselves from what a few have done. We have to be adults, suck it up and clean up the alcohol aroma vomit all over our bathroom.

But, we do not have to let it happen again. There is only one solution to this and no one, not anyone is pointing it out: Put the financial sector of the economy back in alignment with the productive sector. What got us in this mess is our (well not all of us) belief that the financial sector can stand on it's own as a primary wealth/money creator. It can not. Never could. But, believing it put the impetus to the creation of “vehicles” for creating trades. You know all those securitized whatevers, and alphabet monikers, and insurance for insurance for insurance based on alphabet monikers of securitized whatevers. What did people expect would happen when you turn the part of your system that is dependent on activity in an other part for it's existence into a stand alone money creator. If you are going to keep generating money from money, then you are going to have to keep coming up with new “product.” New designs, new marketing to create an need and want, new packaging, BRANDING.

Again, Mr. Philip put's it this way:

But we've seen the central component of the rise of the financial sector is the rise of the debt industry. Mortgage, credit cards, all these gimmicks that Wall Street sells-- just all kinds of products. And, of course, the products are laying an egg all over the world right now.

Get it? We take an industry subservient to the needs of production and turn it into a competitor of production. I can polish and sell rocks without a bank to borrow from. I can accumulate wealth over time. My business may grow slowly and so may my wealth, but I can do it. But, remove all non-financial activities and what does financial do to survive? What does it do to survive with no one needing a loan, backing, no desire to produce in a way that increases our productivity such that we have more time to purse happiness (that constitution purpose)? We treat finance as if it is the chicken/egg question. It is not. Finance came second and is dependent.

This particular author, "Divorced one like Bush," isn't a Muslim as far as I know, but he actually advocates a principle of Islamic finance: Making money from money is not Islamically acceptable.

Money is only a medium of exchange, a way of defining the value of a thing; it has no value in itself, and therefore should not be allowed to give rise to more money, via fixed interest payments, simply by being put in a bank or lent to someone else. The human effort, initiative, and risk involved in a productive venture are more important than the money used to finance it. Muslim jurists consider money as potential capital rather than capital, meaning that money becomes capital only when it is invested in business. Accordingly, money advanced to a business as a loan is regarded as a debt of the business and not capital and, as such, it is not entitled to any return (i.e. interest). Muslims are encouraged to purchase and are discouraged from keeping money idle so that, for instance, hoarding money is regarded as being unacceptable. In Islam, money represents purchasing power which is considered to be the only proper use of money. This purchasing power (money) cannot be used to make more purchasing power (money) without undergoing the intermediate step of it being used for the purchase of goods and services.

Principles Of Islamic Banking

In Islam, we use money for productive purposes that are for the benefit of the community as a whole. Money is not to be used to make more money directly, such as through interest. We use money to make more money indirectly, by investing money into productive assets, such as businesses, that will (insha'allah) make profits. It's a slower process, but it's a much more stable and safer system than the highly leveraged economy that's now melting down.

Update: For some similar posts, read Islamic Finance Shows Banks the Way Forward and Islamic Banking Restrains Bankruptcy.

The Economist: Faith-Based Finance

This is the second of two articles in this week's (September 4th) Economist about Islamic finance. This article is much shorter, and also easier to digest (even for most Muslims ;) ) than the main article, being more of an introduction to the topic of Islamic financing.

The modern history of Islamic finance is often dated to the 1970s, with the launch of Islamic banks in Saudi Arabia and the United Arab Emirates. But its roots stretch back 14 centuries. Islamic finance rests on the application of Islamic law, or sharia, whose primary sources are the Qur'an and the sayings of the Prophet Muhammad. Sharia emphasizes justice and partnership. In the world of finance that translates into a ban on speculation (or gharar) and on the charging of interest (riba). The idea of a lender levying a straight interest charge, regardless of how the underlying assets fare in an uncertain world, offends against these principles—though some Muslims dispute this, arguing that the literature in sharia covering business practices is small and that terms such as “usury” and “speculation” are open to interpretation.

Companies that operate in immoral industries, such as gambling or pornography, are also out of bounds, as are companies that have too much borrowing (typically defined as having debt totaling more than 33% of the firm’s stock market value). Such criteria mean that sharia-compliant investors steer clear of highly leveraged conventional banks, a wise choice in recent months.

Despite these prohibitions, Islamic financiers are confident that they can create their own versions of the important bits of conventional finance. The judgment of what is and is not allowed under sharia is made by boards of scholars, many of whom act as a kind of spiritual rating agency, working closely with lawyers and bankers to create instruments and structure transactions that meet the needs of the market without offending the requirements of their faith.

Non-Muslims may find the distinctions between conventional finance and Islamic finance a trifle contrived. An options contract to buy a security at a set price at a date three months hence is frowned upon as speculation. A contract to buy the same security at the same price, with 5% of the payment taken upfront and the balance taken in three months upon delivery, is sharia-compliant. Then again, winning over non-Muslims is not really the point.

There is no ultimate authority for sharia compliance. Some worry that this may hold the industry back. Malaysia has tackled this by creating a national sharia board. Some industry bodies, notably the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) in Bahrain, are working towards common standards. That a few scholars dominate the boards of the big international institutions also helps create consistency. But differences between national jurisdictions — between pious Saudi Arabia and more liberal Malaysia, say, are likely to remain.

Both of these countries feature in the top three markets for Islamic finance, measured by the quantity of sharia-compliant assets (see table). Top is Iran, although international sanctions keep its industry isolated. The Gulf states, awash with liquidity and with a roster of huge infrastructure projects to finance, are the most dynamic markets. Britain is the most developed Western center, although France, with a much larger Muslim population, wants to close the gap.

The Economist: Savings and Souls

The Economist has come out with two articles this week (September 4th) on Islamic finance. Below is the main article, Savings and Souls; I've posted the second article, Faith-Based Finance, separately.

The basic premise of this article is to give a primer about the state of Islamic finance in the world today, focusing on various problems and challenges facing the industry.

To see Islamic finance in action, visit the mutating coastline of the Gulf. Diggers claw sand out of the sea off Manama, Bahrain’s capital, for a series of waterfront developments that are part-funded by Islamic instruments. To the east, Nakheel, a developer that issued the world’s largest Islamic bond (or sukuk) in 2006, is using the money to reorganize the shoreline of Dubai into a mosaic of man-made islands.

Finance is undertaking some Islamic construction of its own. Islamic banks are opening their doors across the Gulf and a new platform for sharia-compliant hedge funds has attracted names such as BlackRock. Western law firms and banks, always quick to sniff out new business, are beefing up their Islamic-finance teams.

Governments are taking notice too. In July Indonesia, the most populous Muslim country, said it would issue the nation’s first sukuk. The British government, which covets a position as the West’s leading center for Islamic finance, is also edging towards issuing a short-term sovereign sukuk. France has begun its own charm offensive aimed at Islamic investors.

Set against ailing Western markets such vigor looks impressive. The oil-fueled liquidity that has pumped up Middle Eastern sovereign-wealth funds is also buoying demand for Islamic finance. Compared with the ethics of some American subprime lending, Islamic finance seems virtuous as well as vigorous. It frowns on speculation and applauds risk-sharing, even if some wonder whether the industry is really doing anything more than mimicking conventional finance and, more profoundly, if it is strictly necessary under Islam (see article).


Sukuks in the souk

As the buzz around the industry grows, so do expectations. The amount of Islamic assets under management stands at around $700 billion, according to the Islamic Financial Services Board, an industry body. Standard & Poor’s, a rating agency, thinks that the industry could control $4 trillion of assets. Others go further, pointing out that Muslims account for 20% of the world’s population, but Islamic finance for less than 1% of its financial instruments—that gap, they say, represents a big opportunity. With tongue partly in cheek, some say that Islamic finance should by rights displace conventional finance altogether. Western finance cannot service capital that wants to find a sharia-compliant home; but Islamic finance can satisfy everyone.

Confidence is one thing, hyperbole another. The industry remains minute on many measures: its total assets roughly match those of Lloyds TSB, Britain’s fifth-largest bank (though some firms that meet sharia-compliant criteria may attract Islamic investors without realizing it). The assets managed by Islamic rules are growing at 10-15% annually—not to be sniffed at, but underwhelming for an industry that attracts so much attention. Most of all, the industry’s expansion is tempered by its need to address the tensions between its two purposes: to serve God and to make as much money as it can.

That is a stiff test. A few devout Muslims, many of them in Saudi Arabia, will pay what Paul Homsy of Crescent Asset Management calls a “piety premium” to satisfy sharia. But research into the investment preferences of Muslims shows that most of them want products that benefit their savings, as well as their souls—rather as ethical investors in the West want funds that do no harm, but are also at least as profitable as other investments.

A combination of ingenuity and persistence has enabled Islamic finance to conquer some of the main obstacles. Take transaction costs which tend to be higher in complex Islamic instruments than in more straightforward conventional ones. Sharia-compliant mortgages are typically structured so that the lender itself buys the property and then leases it out to the borrower at a price that combines a rental charge and a capital payment. At the end of the mortgage term, when the price of the property has been fully repaid, the house is transferred to the borrower. That additional complexity does not just add to the direct costs of the transaction, but can also fall foul of legal hurdles. Since the property changes hands twice in the transaction, an Islamic mortgage is theoretically liable to double stamp duty. Britain ironed out this kink in 2003 but it remains one of the few countries to have done so.

However, just as in conventional finance, as more transactions take place the economies of scale mean that the cost of each one rapidly falls. Financiers can recycle documentation rather than drawing it up from scratch. The contracts they now use for sharia-compliant mortgages in America draw on templates originally drafted at great cost for aircraft leases.

Islamic financiers can also streamline their processes. When Barclays Capital and Shariah Capital, a consultancy, developed the new hedge-fund platform, they had to screen the funds’ portfolios to make sure that the shares they pick are sharia-compliant. That sounds as if it should be an additional cost, but prime brokers already screen hedge funds to make sure that risk concentrations do not build up. The checks they make for their Islamic hedge funds can piggyback on the checks they make for their conventional hedge funds.

Mohammed Amin of PricewaterhouseCoopers, a consulting firm, says the extra transaction costs for a commonly used Islamic financing instrument, called commodity murabaha, total about $50 for every $1m of business. That is small enough to be recouped through efficiencies in other areas, or to be absorbed in lenders’ profit margins. In addition, bankers privately admit that less competition helps keep margins higher than in conventional finance. “Conceptually, Islamic finance should cost more, as it involves more transactions,” says Mr Amin. “The actual cost is tiny and can be lost in the wash.”

The other area of substantive development has been in redefining sharia-compliance. New products require scholars to cast sharia in fresh, and occasionally uncomfortable, directions. Some investors express surprise at the very idea of Islamic hedge funds, for example, because of prohibitions in sharia on selling something that an investor does not actually own.

“You encounter a wall of skepticism whenever you do something new,” says Eric Meyer of Shariah Capital. “It is no different in Islamic finance.” He says that it took eight long years to bring his idea of an Islamic hedge-fund platform to fruition, applying a technique called arboon to ensure that investors, in effect, take an equity position in shares before they sell them short. Industry insiders describe an iterative process, in which scholars, lawyers and bankers work together to understand new instruments and adapt them to the requirements of sharia.

Differences in interpretation of sharia between countries can still hinder the economies of scale. Moreover, the scholars can sometimes push back. Earlier this year, the chairman of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), an industry body, excited controversy by criticizing a common form of sukuk issuance that guarantees the price at which the issuer will buy back the asset underpinning the transaction, thereby enabling investors’ capital to be repaid. Such behavior contravened an AAOIFI standard demanding that assets be bought back at market prices, in line with the sharia principle of risk-sharing. The sukuk market has enjoyed years of rapid growth (see chart), but early signs are that the AAOIFI judgment has dented demand.

Although Islamic finance has done well to reduce its costs and broaden its product range, it has yet to clear plenty of other hurdles. Scholars are the industry’s central figures, but recognized ones are in short supply. A small cadre of 15-20 scholars repeatedly crops up on the boards of Islamic banks that do international business. That partly reflects the role, which demands a knowledge of Islamic law and Western finance, as well as fluency in Arabic and English. It also reflects the comfort that this handful of recognized names brings to investors and customers.

There are plenty of initiatives to nurture more scholars but for the moment, the stars are pressed for time. That can be a problem when banks are chasing their verdict on bespoke transactions. It takes a scholar about a day to wade through the documentation connected with a sukuk issue, for example. But scholars are not always immediately available. “You’ve got to have the scholar’s number programmed into your mobile phone and be able to get hold of them,” says a banker in the Gulf. “That is real competitive advantage.”

Assets are another bottleneck. The ban on speculation means that Islamic transactions must be based on tangible assets, such as commodities, buildings or land. Observers say that exotic derivatives in intangibles such as weather or terrorism risk could not have an Islamic equivalent. But in the Middle East, at least, the supply of assets is limited. “Lots of companies in the Gulf are young and don’t have assets such as buildings to use in transactions,” says Geert Bossuyt of Deutsche Bank. This limits the scope for securitization, a modern financing technique that is backed by assets and is thus seen by sharia scholars as authentically Islamic. There are not enough properties to bundle into securities.

Governments have more assets to play with. The Indonesians have approved the use of up to $2 billion of property owned by the finance ministry in their planned sukuk issuance later this year. But oil-rich governments in the Gulf have little need to issue debt when they are flush with cash. That is a problem. Sovereign debt would establish benchmarks off which other issues can be priced. It would also add to the depth of the market, which would help solve another difficulty: liquidity.

It may seem odd to worry about liquidity when lots of Muslim countries are flush with cash, but many in Islamic finance put liquidity at the top of their watchlist. The chief concern is the mismatch between the duration of banks’ liabilities and their assets. The banks struggle to raise long-term debt. In a youthful industry, their credit histories are often limited; they also lack the sort of inventory of assets that corporate sukuk issuers have.


Desert liquidity

As a result, Islamic banks depend on short-term deposit funding, which, as Western banks know all too well, can disappear very rapidly. “Lots of assets are generally of longer term than most deposits,” says Khairul Nizam of AAOIFI. “Banks have to manage this funding gap carefully.” If there were a liquidity freeze like the one that struck Western banks a year ago, insiders say that the damage among Islamic banks would be greater.

There are initiatives to develop a sharia-compliant repo market but for the time being the banks have only limited scope for getting hold of money fast. Loans and investments roll over slowly. The lack of sharia-compliant assets and a tendency for Islamic investors to buy and hold their investments have stunted the secondary market. The shortest-term money-management instruments available today are inflexible. Cash reserves are high, but inefficient. Western banks with Islamic finance units, or “windows”, are just as troubled by tight liquidity as purely Islamic institutions are: their sharia-compliant status requires them to hold assets and raise funds separately from their parent banks.

There are other sources of danger, too. Because Islamic banks face constraints on the availability and type of instruments they can invest in, their balance-sheets may concentrate risk more than those of conventional banks do. The industry’s ability to steer its way through stormy waters is largely untested, although Malaysian banks do have memories of the Asian financial crisis in the 1990s to draw on.

None of these tensions need derail the growth of Islamic finance just yet. There is plenty of demand, whether from oil-rich investors, the faithful Muslim minorities in Western countries or the emerging middle classes in Muslim ones. There is lots of supply, in the form of infrastructure projects that need to be financed, Western borrowers looking for capital and ambitious rulers eager to set up their own Islamic-finance hubs. The industry is innovative; new products keep expanding the range of sharia-compliant instruments. And as in conventional finance, the economics of the Islamic kind improve as it gains scale.

But further growth itself contains a threat. The AAOIFI ruling on sukuk earlier this year neatly captured the contradictory pressures on the industry. On the one hand, bankers are worried that the narrow enforcement of sharia standards is liable to stifle growth; on the other some observers fear that Islamic finance is becoming so keen to drum up business that its products, with all their ingenuity, are designed to evade strict sharia standards. This presents a dilemma. If the industry introduces too many new products, cynics will argue that sharia is being twisted for economic ends—the scholars are being paid for their services, after all. But if it fails to innovate, the industry may look too medieval to play a full part in modern finance.

Balancing these imperatives will become even harder as competition grows fiercer. Anouar Hassoune of Moody’s, a credit-rating agency, believes that unscrupulous newcomers could harm the reputation of the entire industry, “like the space shuttle undone by something the size of a 50 cent coin”. Islamic finance serves two masters: faith and economics. The success of the industry depends on satisfying both, even if the price of that is a bit more inefficiency and a bit less growth.