With the single biggest Islamic financing signed, western banks jostling for position and even a secondary market on the horizon, the last six months have shown that sharia-compliant finance in the Middle East is more than a mirage, writes Simon Ellis.

The Islamic finance community’s International Islamic Finance Forum (IIFF) in Dubai buzzed this week with predictions about the role of Islamic finance in the Middle East that would have been unthinkable five years ago.

According to one speaker, 2020 would see an entirely Sharia-compliant Saudi market, a huge increase in sukuk (bond) issues and a widescale expansion of Islamic finance products into countries with large Islamic minorities such as Germany, France and India.

These remarks could have raised some eyebrows if they were not from Iqbal Khan, chief executive of HSBC's Amanah division which recently completed the biggest Islamic financing to date – the US$530m Islamic tranche in Qatargas II.

The trends for project finance are equally stark. A cursory glance over the last few months reveals a spate of Islamic finance deals impressive in their size and diversity [figure 1].

Figure 1: Recent deals in Middle East Islamic finance

The widening market

HSBC typifies the most eye-catching trend in Middle East Islamic project finance – the increasing enthusiam amongst western and far eastern banks to commit to what has been until recently viewed as a niche market.

The last year has seen BNP Paribas and ABN AMRO join the established players HSBC, Citibank (which operates through Citi Islamic) and UBS (Noriba) in setting up Islamic banking subsidiaries. Deutsche Bank too is rumoured to be poised to enter the market.

Duncan Smith, global head of Islamic products in Bahrain for ABC Islamic Bank subsidiary Islamic Asset Management explains that most international banks operating in the region now face a simple equation when it comes to Islamic financing:

‘Most recognise it as the entry point to a significant and growing pool of capital and a way of giving a certain slice of their current client bases what they want.' says Smith, 'The first of their motives is a recognition of an opportunity, the second a defensive measure to prevent losing clients.’

For banks active in the region, Islamic finance can offer more tangible returns than a public relations boost.

Javed Ahmad, a director of HSBC Amanah Finance states: ‘About five years ago the Islamic component of our businesses in Saudi Arabia was basically negligible, by offering a range of sophisticated Islamic products, today it accounts for about 40-50 per cent of the entire business by profitability as well as by turnover.’

The trend of western involvement transfers to Islamic sukuk issues. It is estimated that non-Islamic institutions had contributed 60 per cent of recent Islamic issues which totalled about US$6.7bn in 2004, a figure that compares favourably with the US$1.9bn offered in 2003.

The gaps between Islamic and traditional finance are narrowing as Nadim Khan - a senior associate at Norton Rose Dubai who acted for the Islamic banking syndicate on the BAPCO project and as Islamic council on Qatargas II - explains:

'The products themselves are evolving, and we are able to wrap two or even three instruments together to address the long-term financing concerns. People are now talking about the front-end istisn'a rolling into a lease and after five or so years having an issue of sukuk to diversify the financing base and further extend the tenor.'

Remaining Hurdles

Despite the unprecedented growth, bugbears remain. Experts agree that the lack of a consensus between scholars on what is permitted, an absence of education about sharia financing and a dubious recourse to liquidity can lead to time-consuming delays.

Michael Duncan, banking partner at Allen & Overy says: ‘One of the problems with it developing more in project finance is the shortage of banks that can participate in this market. Because really there are only Kuwait Finance House, Abu Dhabi Islamic Bank and Dubai Islamic Bank who are principal players so there is an issue with liquidity.’ 

Dr Habib Al Mulla, chairman of Dubai Financial Services Authority also recently claimed to be 'pessimistic' that the quality of service would also improve. 'There's a lack of skills for a proper, serious Islamic financial market and I don't see that changing for 15 years', he warns.

The final issue holding back Islamic finance is the lack of a credible secondary market. Islamic finance still lacks both the financing instruments and the volume of project-finance based sukuk issues for the market to take off.

However according to Norton Rose Islamic finance partner Neil Miller, who has led the drive to bridge the gap between Islamic and western finance, the former can be overcome.

‘On the derivatives front, watch this space,' he says. 'We are acting for institutions that are trying to create some plain vanilla instruments that will replicate profit rate or interest rate swaps, currency hedging instruments in a way that is accessible to Islamic institutions.’

There have also been substantial cross-border deals between the points where the discrepancies are greatest. At least three murabaha debt transactions are known to have have taken place between south east Asian and the Middle East.

Outlook

Dr Mulla has predicted that the Islamic banking and finance industry, which is already believed to be worth US$100 billion, would continue its steady growth rate of 20 per cent per year. In project finance terms the long-view also bodes well for Islamic finance.

There are a number of LNG projects in Qatar still awaiting bank finance, a vast potential for LNG shipping and if the much-vaunted Saudi transport and water boom follows the model established by the kingdom’s real estate boom, the region’s largest kingdom will also provide a further outlet for Islamic project finance.

The key to market growth is the growth of sukuk, according to  Neil Miller: ‘I actually think sukuks could benefit project finance because I think projects could underpin the critical mass that needs to be built up in the Islamic capital market to create secondary instruments.’

Whether or not the secondary market can play catch-up, the primary market for Islamic finace is set for a bumper year. Sources cite a range of impressive deals ahead including another wholly Islamic project in Saudi Arabia and a large corporate sukuk for a power project.

Duncan Smith of Islamic Asset Management sees the growth as sustainable: ‘I would be surprised if within five years every major project financing in the Middle East didn’t have an Islamic finance component. At present I believe this is considered for every project in the region outside Oman.’

John Inglis, head of Norton Rose’s Islamic finance team warns that the breakthrough into the mainstream will come sooner rather than later: ‘I think that will take a year or two and then we will be in a situation where we can see some very significant projects, probably funded purely by Islamic finance.

'I will not be surprised seeing Islamic project finance compete with conventional debt project finance. I think that is inevitable.’

Figure 2 – Glossary of Islamic Financial Terms

Gharar (uncertainty)

The existence of uncertainty in a contract is prohibited as it requires the occurrence of an event which may not occur. When entering into a contractual relationship, there must be ‘full disclosure’.

Ijara (leasing)

A contract under which a bank buys, and leases out for a rental fee, equipment required by its client. The duration of the lease and rental fees are agreed in advance. Ownership of the equipment remains in the hands of the bank.

Ijara wa-iqtina (lease/hire purchase)

Very similar to ijara, except that there is a commitment from the client to buy the equipment at the end of the rental period. It is pre-agreed that at the end of the lease period the client will buy the equipment at an agreed price frorm the bank, with rental fees previously paid constituting part of the price.

Istisna’a (construction financing)

A contract of acquisition of assets by specification or order, where the Islamic financial institution funds the manufacturer during the construction of the asset, acquires title to that asset on completion and either immediately passes title to the developer on agreed deferred payment terms, or, possibly, leases the asset to the developer under Ijara wa Iqtina.

Murabaha (cost plus financing)

This is a contract sale between the bank and its client for the sale of goods at a price which includes a profit margin agreed by both parties. As a financing technique it involves the purchase of goods by the bank as requested by its client. The goods are sold to the client with a mark-up. Repayment, usually in instalments, is specified in the contract.

Mudaraba (trust financing)

This is an agreement made between two parties: one which provides 100 per cent of the capital for the project and another party, known as a mudarib, who manages the project. Profits arising from the project are distributed according to a pre-determined ratio. Any losses accruing are borne by the provider of the capital. The provider of the capital has no control over the management of the project.

Riba (charging of interest)

Riba is strictly prohibited. Any return on money should be linked with the profits of an entrerprise. The conceptextends beyond interest and usury and can also means prohibition of exploitation by one party who owns a product that includes money or capital and which another party wishes to acquire.

Sharia

Islamic canon law derived from three principal sources - the Qur’an, the Hadith (sayings of the Prophet Mohammed), and the Sunnah (practices and traditions of the Prophet Mohammed).

Sukuk (bond issue)

A sukuk amounts to commercial paper that provides the subscriber with ownership or part ownership in the underlying asset. Typically, an SPV will purchase the asset in question and lease it to the ultimate purchaser under back-to-back arrangements. The special-purpose company will issue sukuk certificates under a note issuance facility entitling the holders of the sukuk to a pro rata ownership of the asset and a right to receive a proportion of the rental payments. The sukuk may be issued in a tradeable form.