Islamic Finance should have greater linkages to the real economy

The Chairmen of Islamic finance industry bodies need to put aside their egos for a bigger cause
July 29, 2011
Miracle of Ramadhan
August 2, 2011
The Chairmen of Islamic finance industry bodies need to put aside their egos for a bigger cause
July 29, 2011
Miracle of Ramadhan
August 2, 2011
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Islamic Finance should have greater linkages to the real economy

Can Islamic finance play key role in growth and prosperity?


In perhaps one of her more potentially important speeches in recent times, Zeti Akhtar Aziz, governor of Bank Negara Malaysia, the central bank, stressed that the increasing internationalization of Islamic finance and the burgeoning trade and economic linkages between the emerging countries present an important opportunity for the industry to make a meaningful and enhanced contribution toward economic growth and prosperity of these countries.

“The transition of Islamic finance into the mainstream of the global financial system is an opportunity for the Nusantara financial intermediaries, in particular in Indonesia and Malaysia, to open new frontiers and to participate in this trend and thereby strengthen further our economic and financial linkages. With our own respective comparative advantages, we can leverage on the complementarities between our respective economies that will bring forth synergistic effects which will in turn contribute toward expanding the markets, widen the spectrum of products and services, and enhance financial markets activities,” she added.

Zeti was addressing the Joint High Level Conference on Islamic Finance organized by Bank Negara Malaysia and the Bank of Indonesia which was held in Jakarta last week in the presence of the Indonesian President Boediono, Raja Nazrin Shah, the ambassador-at-large of the Malaysian International Islamic Financial Centre (MIFC) and Crown Prince of Perak, and Darmin Nasution, governor of the Bank of Indonesia, the central bank.

The theme of the conference, “Enhancing Financial Linkages toward Economic Prosperity,” and the location could not be more timely and symbolic. In the aftermath of the global financial crisis in 2008, there has rightly been a debate over the moral compass of market capitalism and conventional banking and how the excesses that nearly brought the global financial system to collapse could be pre-empted.

In parallel has been the debate about how banking should have greater linkages to the real economy and not merely concentrate on high risk and high reward speculative activities especially in gambling on derivatives.

These debates are not confined to conventional banking but are just as relevant to the Islamic finance industry, albeit it was largely unscathed by the underlying causes because of the Shariah proscription on investing in speculative interest-based derivatives but affected by the economic impact of the crisis.

But as the contemporary Islamic finance movement edges toward completing its fourth decade, it is increasingly pertinent to ask whether this “original concept of financial intermediation” from the south countries has started to make an impact on the real economy of the countries in which it is practiced and has contributed to wealth creation and distribution, or is it merely yet another way for Muslim high net worth individuals and shareholders to get richer under the label of ethical banking?

The answers are not easier given the nascency of the Islamic finance sector and the vexed question of how does one evaluate its impact on the real economy given the low base from which it has started effectively as a private sector initiative and given the very diverse nature of the Muslim markets and economies in which it is targeted.

Zeti alluded to three important global trends currently – the significant growth of emerging economies in the world; the greater international integration as economies and financial systems become increasingly more connected; and the fact that no longer is international trade solely between the emerging world and the developed world, but trade amongst the emerging world has increased immensely.

Trade flows between emerging countries has increased four-fold. Similarly, cross-border financial flows are no longer concentrating between the emerging world and the developed markets, but increasingly it is between emerging economies.

“As financial markets and financial systems in emerging economies become more developed, greater financial flows between our economies are taking place. These trends have supported and reinforced the recovery and growth that is currently experienced in the emerging world,” explained Zeti.

On the other hand, the internationalization of Islamic finance over the last decade or so has resulted in increased Shariah-compliant cross-border financial flows. With its internationalization, Islamic finance is therefore increasingly contributing to the more efficient mobilization and allocation of funds across regions, and strengthening the financial and economic linkages in particular in between our emerging nations.

This may be true in a limited number of countries, albeit the supportive cost-benefit analysis has yet to be presented both intellectually and statistically. But if one considers the state of intra-Islamic trade, for instance, both at a multilateral and private trade finance level, then the stark reality and challenge of this connectivity (or lack of it) between Islamic finance and the ultimate real economy activity such as financing exports and imports and small and medium-term enterprises (SMEs) becomes apparent.

The establishment of the Islamic Trade Finance Corporation (ITFC) as a stand alone trade finance fund of the Islamic Development Bank Group was supposed to herald a new era for intra-Islamic trade. In 2009, ITFC’s trade funding allocations totaled $2.16 billion, of which 82 percent was directed to intra-Islamic trade. The ITFC says that its target for trade funding in 2011 is $3 billion. But put this against the total trade of the 56 IDB member countries of $3.374 trillion in 2009, then the sheer scale of the challenge is much starker.

This is exacerbated by the lack of connectivity between multilaterals such as the ITFC, ICD (Islamic Corporation for the Development of the Private Sector) and other IDB Group entities, with the commercial Islamic banks. The IDB’s bureaucracy in dealing with syndication enquiries is legendary and many have been put off also by the perceivedly uncompetitive pricing, mark-up policy and maturity flexibility of the facilities extended by the ITFC, ICD et al.

Massoud Janaekeh, director of Islamic capital markets at Bank of London & Middle East (BLME), for instance, would like to see the ITFC expand its product base to include more Murabaha syndications and structured trade finance solutions, and perhaps more importantly act more as a catalyst to develop and expand the international Islamic trade finance market by providing the platform for Islamic banks to participate in trade. “I think they genuinely can be a market maker, and a truly significant one. They can ease the flow of transactions rather than underwrite all of them by bringing in participation from banks, As such they don’t need the capital for underwriting. What they need is other Islamic banks committed to the cause,” he adds.

There are similar challenges in other key areas of policy making, regulation, legislation, development finance, affordable housing and so on – may be a little less in Malaysia than in other markets.

That is why the location of Zeti’s speech could not be more poignant. Indonesia is the world’s most populous Muslim country. Although it is blessed with many natural resources, it is also a relatively very poor country with many of the structural economic deficiencies usually associated with developing countries. The fact that it has only relatively recently emerged from the shadows of decades of military rule and endemic corruption has not helped, although Indonesians have shown that that they have a resilient capability to build workable democratic institutions on the back of almost nothing.

If there is one country that ought to be the laboratory and the showcase for the successful merger of Islamic finance and the real economy then it ought to be Indonesia. With its 220 million population, Indonesia is a banker potential paradise. Think of those retail accounts and consumer finance; the infrastructure and corporate finance opportunities; the asset management and investment mobilization potential; the possibility of project and retail sukuk; and the virgin market for Islamic insurance and pension products.

True Malaysia is engaging with Indonesia on several fronts, whether between the policy makers and regulators, and the private sector investing in Indonesian Islamic financial institutions. This has to a certain extent, as Zeti has suggested, helped create the enabling environment for effective and efficient cross-border financial business. There has also been a greater sharing of technical expertise and experiences on financial markets and infrastructure development including the harmonization of regulatory arrangements.

But to put it bluntly, Indonesia needs to go much further to even come near to Malaysia’s Islamic banking model whether in terms of enabling legislation, regulation, Shariah governance framework, product innovation and human capital development. The recent delay in Indonesia’s follow-up sovereign sukuk was officially put down to the failure to identify an appropriate pool of assets for the securitization and hence the passing of the required legislation.

Even Indonesia’s flagship Bank Muamalat, one of the first Islamic banks in the country, has been plagued by operational issues over the years, only to be saved by an injection of capital by the Islamic Development Bank at the time, which now is reportedly keen to exit the investment.

Best Regards

With my best entertainer, Ameen and Iffah

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