ISLAMIC EQUITY MARKETS
ABDUL HALIM
Equity Markets from an Islamic Perspective
The financial system of any country or society evolves to meet the needs of its members for banking and financial services. By and large, the financial system usually consists of twin subsectors, the banking system and capital (or equity) markets.
In every community from the pre-Islamic era to the present day, the fulfilment of these financing needs has required equity financing and debt financing.
1. Equity-Financing and Debt-Financing in Pre-Islamic Arab Society
The relevant question to ask is, what is the stand of the Sharia with regard to equity-financing and debt-financing? To answer this question, we shall briefly trace the development of the Sharia on this subject just prior to and immediately after the advent of Islam.
In the Pre-Islamic period, the Arabs were affecting debt-financing through two main categories of contracts as follows:
(i) First Category: Deferred Contracts of Exchange (Al-Bai/Al-Tijarah/Al-Dayn)
a) Al-Bai Bithaman Ajil (Deferred Instalment Sale)
b) Bai Al-Murabaha (Deferred Lump-sum sale)
c) Al-Ijara (leasing)
d) Bai Al-Salam (Salam sale)
e) Bai Al-Istisna (Sale on Order)
f) Others
(ii) Second Category: Interest-Based Lending (Riba Al-Nasiah)
a) Interest-Based Lending
A contract of exchange takes place when a commodity or service is exchanged for another commodity or for money. In commercial dealings, contracts of exchange arise in sale-and-purchase contracts and leasing contracts. Th e contractual relationship is therefore of the category of seller-buyer or lessor-lessee. Contracts of exchange may be cash or deferred.
When the settlement from one side of the contract – such as payment in money – is deferred or delayed, the contract becomes a deferred contract of exchange. A deferred contract of exchange is therefore akin to credit sale-and-purchase. A deferred contract creates a debt. Hence its features as a debt-financing instrument.
Interest-based lending is not based on the contract of exchange; rather it is based on lending (in modern times, money-lending). The contractual relationship is of the category of debtor-creditor. At the point of lending, the lender lends the money to the borrower at the point of repayment, the borrower repays the lender the principal amount of money lent out, plus an ‘addition’ in the form of interest. Interest-based lending also creates a debt, and is naturally a debt-financing instrument.
2. Equity-Financing and Debt-Financing in Islam
With the advent of Islam, the Sharia laid down through its primary sources of the Qur’an and Sunnah various injunctions that would form the basis of the Islamic banking and financial system.
Islam allows both equity-financing and debt-financing. Equity-financing is to be affected through profit-sharing contracts while debt- financing is to be effected through deferred contracts of exchange. Interest-based lending is forbidden. This is indeed the foundation for establishing and developing the Islamic financial system.
Lending is still allowed in Islam, but is has to be without interest. In the Sharia, this type of lending is know as ‘Qard-al-Hasana’ (benevolent loan). This contract is therefore more relevant in the social-welfare sector of the economy, or where there is a social implication such as in government (public) debt, rather than in the private or commercial sector of the economy.
3. Major Differences in Equity-financing and Debt-financing in Islamic Finance and Conventional Finance
What are the major differences, then, in equity-financing and debt-financing in the Islamic financial system as compared with the conventional financial system?
In equity-financing, there are practically no major differences. The contract of Musharaka (joint-venture profit-sharing) is, in essence, similar to the conventional concept of a joint-stock company. Therefore – except for some minor details – to finance projects through equity participation, or to float a company on the stock exchange, or to organise a venture capital company, or to form an equity unit trust, would be generally the same under Islamic equity-financing as under conventional equity-financing.
The contract of Mudaraba (trustee profit-sharing) – whereby one party (the owner of capital) provides funds for the other party (the entrepreneur) to invest or trade and generate profit, and both share in the profit in pre-agreed proportions – while not widely practised is actually not totally unknown in the conventional financial system.
However, major differences between the Islamic financial system and the conventional financial system prevail in debt-financing. Debt-financing in the conventional financial system is almost totally based on interest-based lending, while this contract is forbidden in the Islamic financial system.
Nonetheless, there are some similarities, even in debt-financing. The contract of Ijara (leasing) is practised in the conventional system. Likewise, the contract of Murabaha (deferred lump-sum sale) is practised in credit sale-and-purchase, both in domestic and international trade.
THE IMPORTANCE OF DEVELOPING ISLAMIC CAPITAL MARKETS
I. The Role of the Capital Market in Economic Development
During the last two decades, many Islamic countries and societies have striven to develop the Islamic banking system, with varying degrees of success. These efforts will no doubt continue. But the Islamic banking system, which dominates the debt market, is only one-half of the intended Islamic financial system. The other half is the Islamic capital market.
It is therefore timely now for the Islamic countries and societies to turn their attention towards developing an Islamic capital market in addition to the Islamic banking system. There are many compelling reasons for this suggestion. We shall only discuss briefly some of these reasons.
Many Islamic countries and societies are now moving along the economic development path – from the less-developed stage to newly emerging economies, and hopefully one day to being economically fully developed. It is, by and large, in the nature of the evolution of the financial system for any society that the debt market or the banking system is the first to develop.
However, as its economic growth gains momentum, disposable income gets higher, and savings increase, and the capital market begins to evolve. Indeed, the cause-and-effect relationship between the economic growth of a society and the development of its capital market is a two-way relationship.
Many developing countries consciously build up efficient capital markets in order to spur higher levels of savings, investments and economic growth. Thus, in a growing economy, both the banking system (or the debt market) and the capital market function side by side to mobilise savings and channel these into investments for higher economic growth.
2. Present Economic Order and Capital Market
In the modern economic order that has emerged in recent years, the view is quite pervasive that economic development and the growth of nations can be attained by countries embracing, among others, the following prescriptions:
• Private sector to be the engine of growth and creator of wealth
• Government to liberalise its economic policies
• Government to privatise its economic entities
The outcome of these prescriptions will be the emergence of the private sector as the economic power of nations, while the Government retains only the political and administrative power The private sector will thus hold power, among others, in:
• The nation’s wealth
• Creation of employment opportunities
• Economic knowledge, information and technology
• Economic international relations
Huge amounts of financing will be required by the private sector in order to carry out this task. Two types of financing are required: equity-financing and debt-financing. As we have discussed, the conduit for debt-financing is the debt market or banking system, whereas the conduit for equity-financing is the capital market. Both the banking system and the capital market thus acquire more significance under the post-cold war economic order.
3. Muslims and the Capital Market
Muslims cannot afford to ignore the capital market, for many reasons. The private sector, which is envisaged above as holding the nation’s power, is made up of entities. Usually, these entities are in the form of joint-stock companies, or Sharia-based on the contract of Musharaka in Islamic terminology. The control of these companies is naturally in the hands of their shareholders.
These are the providers or investors in the equity-financing of these companies through the capital market. To ignore the capital market is therefore to ignore the economic power of the private sector and its attendant power of wealth creation, employment and training opportunities, control of economic knowledge and technology, and global economic relations.
The wealth of nations is made up of tangible assets and financial assets. The financial assets may belong to the banking system in the form of bank deposits and the capital market in the form of stock and shares or equities. In societies where the private sector is pervasive, the country’s wealth in the form of capital market instruments is substantial. Muslims must not simply ignore this fact.
Muslims might also want to consider market instruments for investment of their savings. In terms of the risk-return profile, capital market instruments by nature belong to the high-risk-high-return category. However, the high risk can be reduced somewhat through portfolio management or unit trust (mutual fund) schemes.
As the disposable income of Muslims in developing countries increases over time, they would be in a position to channel a proportion of their savings into investment in capital market instruments through directly owning equities, or through portfolio management and unit trust schemes. This will serve to widen and diversify their household investments.
Developing the Islamic Capital Markets in Malaysia
The establishment of Bank Islam Malaysia Berhad (BIMB) in 1983 marked the beginning of the efforts of Muslims in Malaysia to develop an Islamic financial system in the country. Against the background of the country’s economic aspirations, policies and achievements, the Islamic financial system to be developed has to be modern, sophisticated and competitive, so as to be able to meet the country’s objectives.
Since its establishment in 1983, BIMB has been pioneering Islamic banking operations in the country’s banking system. The introduction of the Interest-Free Banking Scheme by the conventional financial institutions in 1993, based on its operations, clearly shows that the system is fast gaining acceptance.
Malaysia aspires to a dual system of banking and finance, one conventional and the other Islamic, both equally sophisticated and modern.
1. BIMB Securities Sdn Bhd
In 1994, BIMB shifted its attention to the capital market. The launching of BIMB Securities Sdn Bhd, being another subsidiary company of BIMB, marks yet another major step by the bank to extend its efforts to develop the Islamic financial system in the capital market.
It operates within the same institutional and regulatory framework as the other member companies of the KLSE (Kuala Lumpur Stock Exchange), but modifies some parts of its operation to comply with the precepts of the Sharia.
The company carries the corporate mission of striving to offer facilities and services in the securities industry which are in compliance with Sharia to Muslims and the non-Muslims in Malaysia and elsewhere.
The Memorandum of Association of BIMB Securities specifies that: “All business of the Company will be transacted in accordance with Islamic principles, rules and practices.”
Subject to the compliance with Sharia principles, the services to be provided by the Company may deal only in securities which are on the List of Approved Securities issued by BIMB’s Religious Supervisory Council.
In general, the list excludes the securities of those companies whose major activities are involved with:
i) Interest-based banking and finance and conventional insurance
ii) Gambling
iii) Alcoholic beverages
iv) Non-halal products
It is imperative that BIMB Securities obtain its external financing needs, if and when required, on the basis of Islamic principles. There are two types of financing needs. One is long-term financing for the acquisition of immovable and movable assets to facilitate its operation. Th e other is the short-term working capital requirement for its operation.
The long-term financing may be obtained on the Islamic principles of Al-Bai Bithaman Ajil (Deferred Payment Sale) and Ijara. The short-term working capital financing may be obtained on the principles of Mudaraba and Murabaha.
The available sources for these financing requirements are the Company’s parent bank, BIMB, and the Islamic banking units in the conventional banking and financial institutions.
When BIMB Securities invests its funds in short-term investment, these will have to be in the form of Islamic money market instruments. Such instruments, which are presently available, include:
i. Deposits with BIMB and the Islamic banking units of the conventional banks and financial institutions
ii. Government Investment Certificates
iii. Islamically acceptable bills
iv. Cagamas Mudaraba Bonds
Margin financing for clients of the Company will also have to be obtained on Islamic principles. These include financing under Musharaka (joint venture profit-sharing) and Mudaraba (deferred lump-sum sale).
Depending on the policies, BIMB and the Islamic banking units of the conventional banks and financial institutions may provide these forms of financing.
2. Islamic Section in the Existing Securities (Stockbroking) Companies
What BIMB Securities Sdn Bhd has done has been followed by some of the existing stockbroking companies.
Now there are a few stockbroking companies that have set up a specialised section in their organisation offering similar Islamic stockbroking services to those offered by BIMB Sdn Bhd.
3. Islamic Unit Trust (Mutual Fund) Schemes
Islamic Unit Trust Schemes based on the securities in the Approved List have also made their appearance. The first was launched by Bank Islam Malaysia Berhad (BIMB). This was followed by state authorities and other unit trust management companies.
4. Islamic Fund Management
Even before the introduction of Islamic unit trust schemes, Islamic fund/portfolio management had been carried out based on the securities in the Approved List.
These funds were either set up and managed internally by the relevant institutions, or farmed out to specialised institutions such as merchant banks and securities companies for management.
Attaining Breadth and Depth in the Islamic Equity Markets
In order to be able to effectively service the needs of Muslims – as well as non-Muslims – in Malaysia, the Islamic equity market needs to expand its breadth and depth.
1. Attaining Breadth
By and large, the breadth of the Islamic equity market could be attained by expanding the number and variety of the participants. The development thus far, which saw continuously increasing numbers of retail and institutional investors in the markets, and an increasing variety of services – such as unit trusts and fund management – being offered should augur well for the market.
A promising potential for broadening the Malaysian Islamic equity market lies in attracting investors – in particular Muslim investors – from other countries to invest in the markets. This could presumably be done through straight Islamic asset management services, Malaysian Islamic country funds, and even Islamic regional funds managed by Malaysian financial institutions singly or in joint-ventures with foreign partners.
2. Deepening Islamic Capital Markets
The basic and initial instrument in the Islamic capital market is ordinary shares, based on the contract of Musharaka (joint-stock company).
Usually, as the economy grows and attains ever higher levels of development and sophistication, there arise new forms of financial needs from both the investors (sources of funds) and users of funds which cannot be effectively met by just the ordinary shares alone.
The size of the financial needs may keep increasing. The variety of the financial needs will also become more pronounced. There is the need to cater for the whole spectrum of the risk-management profile, of both the investors and users of funds, as well as to allow for their asset/liability diversification.
With the development of Malaysia as an industrialized nation, there will be new forms of financial needs.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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