February 3, 2016    7 minute read

The Rise of Islamic Finance

   February 3, 2016    7 minute read

The Rise of Islamic Finance

A recurring theme in the media has been regarding the Islamisation of the world. With the rise of the self-proclaimed Islamic State (which isn’t Islamic at all based on readings from the Quran and Hadith), many believe that the Islamisation of the world has begun. However, an important aspect that most individuals ignore when considering the global impact of Islamisation is that it is not limited to promoting religion, building mosques and extending the boundaries of the Muslim diaspora. It is making in-roads into the financial services and capital markets as well.

Where it stands now?

  • Islamic finance (comprising banking, bond (sukuk) and insurance (takaful) markets) is growing at a phenomenal 17.6% annually, while conventional banking is registering a mere 5% annual growth. The global Islamic banking sector stands at more than US$2 trillion The Islamic bond market or sukuk is US$280 billion globally, while the market cap of the 2,387 shariah compliant component stocks of the Dow Jones Islamic World Index stands at a whopping US$18.8 trillion as of December 2015.
  • Today, Islamic finance is being operated in more than 75 countries, including both Muslim and non-Muslim dominated countries. Apart from ‘predictable’ countries such as Saudi Arabia, Pakistan, Indonesia, Turkey, Egypt and Malaysia, recent entrants include Britain, Luxembourg, Singapore, Hong Kong and France. Currently there are at least 12 institutions in Britain offering Islamic finance. Projects such as the London Olympic Village, Harrods and the Shard were reportedly financed wholly, or in part via Islamic finance.
  • Within the financial markets, Islamic or shariah compliant products are being developed to attract shariah compliant or shariah preferred customers and funds.

The above has raised many questions that are worthy of further research. However, since the subject matter for global Islamic finance is broad, for this particular article, I would like to focus on just the equity market, and, in particular, the Kuala Lumpur Stock Exchange (KLSE) in Malaysia.

Overview of KLSE

The KLSE dates back to 1930 when it was known as the Singapore Stockbrokers Association. With Singapore’s secession from Malaysia in 1965, the stock exchange activities came under the Stock Exchange of Malaysia. In 1976 it was corporatised as a company limited by guarantee and came to be known as the Kuala Lumpur Stock Exchange Berhad. Subsequently in 2004 it was renamed Bursa Malaysia Berhad.

Currently the KLSE supports the following listings:

  • Securities or stocks
  • Derivatives: offering ten derivatives products for equity futures, commodity futures, financial futures and equity options
  • Bonds
  • Islamic offerings including shariah compliant stocks and bonds (sukuk)

With over 1600 companies listed on the KLSE, it has a market capitalization of over US$190 billion.

The Introduction of Shariah Compliant Stocks into the KLSE

In 1997, the Shariah Advisory Council was established as the apex authority for Islamic finance in Malaysia. With this, all matters pertaining to Islamic equity, banking, bonds and insurance came under its purview. Subsequently in the same year, the Securities Commission of Malaysia appointed the Shariah Advisory Council as the sole body vested with the authority to designate counters in the KLSE as shariah compliant. For this purpose, the Council meets twice a year (in April and November) to determine the list of Shariah Compliant Stocks “based on their business and investment activities” which should comply with shariah principles.

What are Shariah Compliant Stocks?

The Shariah Council has its own set of criteria to determine whether a particular stock can be designated as shariah compliant or not. While some of these criteria and the operations of the Council can be vague, the following are the “official” criteria:

1. Companies whose activities are in the following lines of business will be excluded:

  • Gambling (e.g. Genting Berhad which operates the casino in Genting Highlands, and Sports Toto Malaysia, which operates a number forecasting business).
  • Tobacco (e.g. British American Tobacco which operates the largest cigarette retail network in Malaysia)
  • Alcohol (e.g. Guinness Anchor Berhad and Carlsberg Malaysia)
  • Military products (e.g. Sapura Defence Berhad)
  • Non-halal food products (e.g. companies in processing pork or porcine related food)

2. Companies with a cash-to-asset ratio of more than one-third have to ensure that any interest income should not exceed 5% of the company’s total revenue. If it does, it should move the excess into Islamic Deposit accounts.

3. Companies with a debt-to-asset ratio exceeding 33% need to convert some of these debts to Islamic debts.

As per the latest reviewed listing of November 2015 there are now 667 shariah compliant stocks in the KLSE, making up about 40% of all stocks listed.

The Significance of being designated as Shariah Compliant Stocks

There are now numerous investment funds including unit trust funds that invest only in shariah compliant stocks. As such, being designated as a shariah stock would mean that Islamic funds would be able to purchase these stocks as part of their portfolio, thereby contributing to greater demand and therefore higher stock price. With Islamic funds set to further grow in Malaysia, being chosen as a shariah stock would be a desirable state for the strategy of any public listed company. When a stock is re-designated from shariah compliant to non-shariah compliant, Islamic funds are given a 6 months grace to sell down these stocks from their portfolio.

The Impact of Stocks being Re-designated from Shariah Compliant to non-Shariah compliant

The Malaysian investing public and public listed companies have not been giving much attention to the designation of shariah compliant stocks in the past. Mainly the scenario was for non-compliant stocks applying to be designated as compliant stocks. The case of compliant stocks being re-designated as non-compliant was rather rare. This scenario took a drastic turn on 2nd December 2013, when the Securities Commission published its list of shariah compliant stocks. A shocking total of 158 counters were dropped from its list, and re-designated as non-shariah compliant.

The dropped counters included the following heavyweights:

  • Bumi Armada Berhad – controlled by Telco magnate Ananda Krishnan
  • Air Asia – controlled by Tony Fernandes
  • Dutch Lady Milk Industries Berhad
  • Panasonic Manufacturing Berhad
  • Oriental Holdings Berhad – the franchise holders for Hyundai cars in Malaysia

The impact of this re-designation was immediate and drastic. When the KLSE closed on the 2nd of December, all the above counters recorded losses; Dutch Lady shed 98 cents, while Oriental Holdings declined by 21 cents.

There was a buzz within the investment community, and chat forums came out with theories that the re-designation was politically and racially motivated, especially since most of these corporations were controlled by non-Muslims. The CEOs of the affected companies expressed shock and dismay and sought clarification. The Securities Commission stood firm on its decision and placated the public by stating that these companies can be re-listed as compliant in the next revision in April 2014, provided they took steps to rectify the ‘breaches’.

Interestingly enough Islamic fund managers were unhappy with the decision, for the following two reasons:

  1. They had to sell-down these stocks within six months and re-balance them with other compliant stocks
  2. These stocks were all ‘blue chips’ with high dividend earnings, and as such the fund managers will not be able to leverage off their profitability.

The message is clear. Shariah law has penetrated the investing community in Malaysia and across the world. Decisions made by a totally Muslim council (the Shariah Advisory Council) based on Muslim principles have impacted the entire investing and business community, regardless of their religious affiliation. No longer can entrepreneurs ignore Islamic finance by thinking that it only impacts Muslims. Public listed companies now have to make a strategic decision as to whether they want to be listed as a shariah compliant entity. If so, they need to put in place a structure and process within their organisation to monitor its compliance.

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