ISLAMIC CAPITAL MARKETS
ADNAN AL BAHAR
Capital markets are the source for long-term funding, be it equity or debt, and as such they are very important tools for economic development especially in the later stages of that development.
Capital markets help route domestic savings to meet the important longer-term funding needs of an economy. They also act as a catalyst by attracting local savings from money markets by creating sufficient liquidity behind long-term investments, and thereby removing a key obstacle in directing local savings to longer-term uses.
They are also very critical to attracting foreign capital as the majority of foreign investors who invest in emerging markets are financial or portfolio investors. These investors need efficient capital markets to be able to trade their positions, that is to say, acquire and sell financial holdings in accordance with their investment strategies.
Capital markets also offer other advantages to their respective economies, such as:
• An increase in choice and terms to qualify issuers for a starter and the rest of the market at a later stage,
• Providing better tools to manage liquidity by the financial industry, and
• Providing the tools for efficient management of monetary policy by Central Banks.
Requirements for the Development of Capital Markets
For capital markets to develop we need more than just the desire to develop them. The respective economies need to advance to the stage where they cannot function efficiently without them.
Markets develop around buyers and sellers, who trade assets, commodities and other investments. When these exist in sufficient volume, a market develops. Once a market has developed, we can then look into ways to help it prosper and grow. Th e following are the three key players that enable a market to operate:
1. The buyers in a capital market are the large corporates and governments these seek to raise long-term debt or equity capital for the propose of funding their needs or as result of selling assets through their privatisation schemes.
2. The intermediaries: These are usually specialised financial institutions, primarily investment banks. Investment banks are usually key drivers in the development of a capital market, primarily because their well-being and growth depend on those markets, as they are their primary source of funding or raising money, as opposed to commercial banks, which raise money through deposits and lend on their balance sheet. This is why the growth of capital market instruments brought about the term dis-intermediation, meaning cutting out the intermediary function of banks.
3. Reasonably sophisticated investors: suppliers (of funds) or investors, including a large enough institutional base.
Once a market develops, a number of factors become important in helping that market grow and flourish. Key factors among them are:
• The legal infrastructure for these markets,
• A developed and competitive financial market and a market-based economic management approach, and
• A quality support services industry (legal, brokerage clearing, auditing etc.)
Where is the Islamic Capital Market Today?
Capital markets, both conventional and Islamic, are in their early stages in most Islamic countries, especially in the Arab world.
This is primarily a result of those economies either being in their very early stage of economic development, or because of centralised management of those economies and the associated restriction on movement of capital. It could also be because of the non-existence of demand for capital as a result of a cash-rich government providing for all the needs of the societies.
But lately things have changed, markets are being liberalised and controls lifted. Governments don’t have enough resources to cover all their needs, and are therefore privatising and shrinking their role in the economy, with the aim of controlling the growing budget deficits and increasing economic efficiency. This is creating the required “demand and supply” for the development of the capital markets.
The Islamic capital market’s development is following behind its conventional counterpart regionally. However, Islamic capital markets are exposed to some specific constraints that should be identified, namely:
1. Offers by quality names (i.e., investment-grade issuers) in this market are still not sufficient to meet the demand in those markets. In the Arab markets, the primary issuers of debt instruments have been banks (conventional) and Government, and the majority of IPOs have been for banks seeking to raise capital. Furthermore, the limited number of quality deals in the Islamic market are being kept on the books of the original investors or banks, thereby hampering the development of a secondary market in these papers.
2. In some markets the primary focus has been on tapping foreign capital and most of that comes conventionally.
3. There are very few Islamic investment banks, and the Islamic commercial banking industry is not competitive enough and therefore lacks the drive and the capacity to originate, structure and place transactions which are oriented towards the capital markets.
On a more positive note, the signs are that the above constraints are gradually being overcome. With the saturation of foreign capital flow, and increasing size and sophistication, the Islamic banking industry, with its local and regional funding base, is becoming increasingly seen as a competitive source of funding. This is attracting issuers to the market.
The industry does not lack structural solutions to bring product to this market. Some examples are:
1. The IDB Unit Trust An example of a development agency expanding its funding base through securitising its lease and Murabaha portfolio.
2. Kuwait Airways Lease Financing An example of a government-owned company raising funding by securitising leases and privately placing them.
3. Listed Islamic funds, of which there are a number, hut one that this author has experience with, is the “The TII Kuwait Real-State Development Fund”, which bought assets from the Kuwait government and was then sold to the public and listed on the Kuwait stock market.
To my knowledge, of all the above only the last was listed and its secondary market liquidity was totally supported by investor demand. Most of the rest were either not listed or liquidity was arranged by the issuer.
1. Increase the flow of quality assets (quality being where investors will buy the paper without doing any due diligence work).
2. Increase the knowledge of non-bank investors of these products, especially private investors and market traders, as these are the creators of liquidity in the market.
In conclusion, it should be remembered that the Islamic financial industry is only 15 years old. This market has developed from nothing to around US$80 billion (plus) in this time, and is growing at 10 to 15% per annum.
Islamic investors are getting more sophisticated, are seeking “higher value” products and shifting from short-term instruments to medium-term and equity-based investments.
When we couple this with the emerging realisation of corporates and Governments of the importance of the Islamic market, and how this market can help them improve their cost of funding and widen their sources, and the increasing number of Islamic investment banking outfits, we immediately see the basic ingredients of Islamic capital markets developing.
Countries that open themselves to this trend will benefit economically from the funding capacity and diversity that Islamic capital markets bring. I think our experience in Kuwait is a good example of such trends. Today in Kuwait the majority of investment banking outfits are Islamic.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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