Islamic finance's growth story is only just beginning

The past 12 months have provided a watershed moment for the Islamic finance industry, as global sharia-compliant assets crossed the $1000bn mark. For an industry less than 40 years old, the global financial crisis represents the first major challenge that Islamic finance has faced but there is no doubt that its growth story remains in tact. The industry is expected to record a compound annual growth rate (CAGR) of 15% to 20% until 2015, according to a report published in November 2010 by professional services firm PricewaterhouseCoopers.  

With the eurozone debt crisis deepening and the US in financial turmoil, investors are increasingly looking to move away from a speculative and profit-based financial system. Within the new world order of austerity and caution, Islamic finance’s fundamental tenets of risk-sharing and a prohibition on interest have helped boost its image as a safe haven.

In particular, there has been a notable revival in 2011 in the global sukuk market, which recorded issuance of $44.6bn in September, up from $27.1bn in 2010. With their asset-backed/based structures, sukuk are an increasingly appealing asset class for investors because of the relative capital protection and predictable returns to investors that they provide.

Sukuk and DCM growth

“We are very optimistic about the future growth of debt capital markets [DCM],” says Razi Fakih, deputy chief executive of HSBC Amanah. “[This year] has been a great year for DCM and specifically for HSBC Amanah. We have been a market leader in this space for years now and we intend to retain this leadership position.”

The sizeable infrastructure development planned in both south-east Asia and the Middle East means that sovereign or semi-public issuers will rely, among other project finance sources, on sharia-compliant papers that are customised to meet different specific needs. Indeed, the Middle East’s project financing needs are estimated at $120bn for the next decade by professional services firm KPMG, and $150bn for south-east Asia over the next five years.

“The Islamic debt capital markets will have a significant role to play in these long-term projects,” says Mr Fakih. “The government and private sector developers can use conventional bank financing but the liquidity pool is shrinking by the day in light of tightening credit lines and strengthened regulatory requirements. There is a bigger pool of liquidity available for Islamic finance, making project finance sukuk a viable alternative.” 

Samad Sirohey, chief executive of Citi Islamic Investment Bank and head of global Islamic banking, believes that developing a deep buyside institutional market is critical as the project financing sector moves away from bank financing to capital markets in parallel.

Fund and asset management  

Furthermore, Mr Sirohey says that the growth of sharia-compliant fund and asset management and associated services will be important for the industry to take the next step forward. 

“To date, the main development in the industry has been the creation of Islamic banks,” he says. “Our key focus now is to facilitate the asset and fund management side of the business. The traditional array of products in the fixed-income world may not all be do-able and convertible, but there are plenty of products that are.” 

Global Islamic funds (excluding sukuk) are forecasted to achieve a CAGR of 25% from 2010-13, growing from a respective $83bn to $170bn. “With banking systems now under considerable stress, I think we should look to channel sharia-compliant capital directly into Islamic finance opportunities without intermediation,” says Mr Sirohey.  

The past few years have shown clearly that the model of short-term capital market liabilities and long-term assets poses risks in periods of market dislocation. As a result, there is now a growing focus on asset and liability matching.

“Transactional liquidity should be under a separate umbrella,” says Mr Sirohey. “I would like to see the development of Islamic fund management institutions seeded with capital that can be deployed in long-term projects.”

Asset management is an area that HSBC Amanah also has an eye on but with a particular focus on wealth. “A significant amount of wealth is generated in the Gulf so we consider this to be a very attractive opportunity in the coming years,” says Mr Fakih. “Gulf Co-operation Council countries are home to between $1000bn to $1200bn of wealth. Within that space, it’s not just high-net-worth individuals, but there is about $260bn of wealth distributed among the top-tier retail segment where customers typically have assets of between $200,000 and $1m. Some 85% of this wealth is concentrated in Saudi Arabia, the United Arab Emirates and Kuwait, so we view these as key markets.”

The Gulf has accumulated substantial liquidity over the past few years as investors seek to diversify away from a dependence on dollar-denominated instruments, and surging oil prices have further boosted liquidity. 

New and emerging geographies

In addition to expanding into new business lines, the key Islamic finance players are also looking to expand their global footprints. Notably, Standard Chartered Saadiq –  the Islamic finance division of Standard Chartered – is looking to expand into Africa in order to open up the continent to its Middle Eastern and Asian clients. Africa has a large Muslim population, a large proportion of which does not use banks at all.  

“Potential markets we are interested in are the majority Muslim-speaking countries,” says Afaq Khan, chief executive of Standard Chartered Saadiq. “This includes, but is not limited to, Nigeria, Kenya, Tanzania and Uganda. However, these are all subject to regulatory approval.”

Management consultancy firm Oliver Wyman expects Africa to double its income from Islamic finance over the next few years. As is the case with fellow emerging markets Asia and the Middle East, Africa has strong growth fundamentals. Seven out of 10 of the world’s fastest growing economies by country are in Africa, while the China-Africa trade corridor has seen a 175% increase in activity in the past five years.

Standard Chartered Saadiq currently has a presence in Bahrain, the UAE, Pakistan, Bangladesh, Malaysia and Indonesia. “In many of our markets, demand for sharia-compliant solutions is growing rapidly and spans retail, wholesale, capital markets [sukuk] and cash and trade,” says Mr Khan. “As long as we make sure that the service quality and price is comparable to traditional solutions, then the uptake could be massive.”

Western woes

Today, only a small percentage of Muslims, about 12% of 1.6 billion globally, use Islamic finance. But in light of the financial troubles in the West, many non-Muslim investors view it as a way to diversify portfolios.  

“The reason why Islamic finance is continuing to grow at double digits in most markets, in spite of the financial crisis, is because it’s a customer pull rather than a regulatory push,” says HSBC Amanah’s Mr Fakih. “From an industry perspective, there are emerging markets that are not currently open for Islamic finance but offer potential such as Egypt and India.

“As and when they become available, and if they have a matching customer demand for our products and services, then we will be interested in expanding our retail network to [these countries] as well. Islamic finance to us is an emerging markets’ play in both the Middle East and Asia. This has been the focus of HSBC Amanah since its inception in 1998 and our strategy has paid off.”  

Good to grow

The Middle East and Asian markets both exhibit strong economic growth, abundant liquidity, a strong government and regulatory push and high Muslim concentration. The Gulf’s population is expected to increase by 30% over the next decade to more than 50 million.

In the same vein, the heavyweight global Islamic banking players believe that it is the trade between the Middle East and Asia that will be the key driver of Islamic commercial banking over the next few years. Since 2000, trade between the Asia-Pacific region and the Middle East has increased noticeably – data from the International Monetary Fund shows that trade to the Middle East comprised 4.7% of Asia-Pacific’s trade worldwide in 2009, up from 3.2% in 2000.  

There is no doubt that the prospects for Islamic finance are bright. But while the Islamic finance industry continues to develop at a galloping pace – global Islamic banking assets have grown from $145bn in 2002 to $1,033bn in 2010 – it is important to remember that it is growing from a small base. Today it comprises only about 1.5% of global banking assets. 

The industry continues to be dogged by the familiar challenges of prohibitive taxation laws, a limited talent pool and a lack of standardisation. Its rapid growth has resulted in a lack of skilled sharia-trained talent – addressing this now is likely to be a key future differentiator for Islamic banks.

Meanwhile, it is clear that a one-size approach to standardisation will not fit all, but a better defined range of standards will benefit most concerns. These are challenges that need to be addressed if the industry wants to fully capitalise on its opportunities.