Malaysian Islamic Finance Sector Performs Well During the

UNCLAS SECTION 01 OF 02 KUALA LUMPUR 000781

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SIPDIS
E.O. 12958: N/A
TAGS: ECON EFIN EINV MY
SUBJECT: Malaysian Islamic Finance Sector Performs Well During the
Sub-Prime Crisis

REF A: 07 Kuala Lumpur 1462
REF B: 07 Kuala Lumpur 1429



1. (SBU) Summary: Malaysia continues to trumpet the virtues of
Islamic finance and its role as a key player in the issuance of
Islamic bonds. With no exposure to collateralized debt instruments,
the Islamic financial sector has held steady during the sub-prime
crisis. Secondary effects of the global financial downturn remain
muted largely because of a widespread perception that Islamic
financial products, which are required to be based on tangible
underlying assets, are safe. As issuers struggle to meet the demand
for Islamic investment products, Malaysia strives to be a global hub
for this niche industry. Challenges include a dearth of talent and
a lack of consensus by Shariah scholars on what is permissible under
Islamic law. The success of sukuk (Islamic bonds) illustrates much
potential for success when Shariah scholars agree. While Malaysia
offers an array of incentives to develop the country's Islamic
financial sector, the GOM's poor track record on the conventional
side of the financial industry could make it a hard sell in the
global marketplace. End Summary.

ISLAMIC BONDS (SUKUK) SEEN AS A SURE BET


2. (U) At a recent conference on Islamic Finance Dr. Zeti, Governor
of Malaysia's central bank, told participants that issuances of
global sukuk increased by 70 percent in 2007 and "held their
ground" in the first half of 2008. The outstanding global sukuk
market now surpasses USD 100 billion, she said, with more than 60
percent of those originating in Malaysia. While sukuk remain only a
small fraction of the global bond market, they represent more than
half the outstanding bond market in Malaysia. According to Moody's
Investor Services, sukuk represent the fastest-growing segment of
the Islamic finance market.


3. (U) Sukuk pay a fixed rate of return on certificates of ownership
backed by income-generating tangible assets. Often, the rate is
benchmarked to interest rates (usually LIBOR) in an effort to remain
competitive with conventional financial products. While some
Islamic scholars point out that this is simply interest by another
name, many Muslim investors still prefer sukuk to conventional
bonds, all other factors being equal. Most practitioners are
willing to tolerate some level of "impurity" in Islamic financial
practices in an effort to build the industry, with the hopes that
someday Islamic finance will command a large enough segment of the
market to be able to have its own benchmarks (ref A).


4. (U) Compared to the lack of consensus among Islamic scholars
regarding practices undergirding many other Islamic financial
products, sukuk enjoy widespread acceptance both in the Middle East
and in Southeast Asia. This near-consensus is largely responsible
for their success, particularly with large amounts of petrodollars
and sovereign wealth funds looking for safe, profit-bearing (and
preferably Shariah-compliant) investments. One Saudi banker told
Econoff that an added driver was that many Middle Eastern investors
wanted to diversify their holdings, particularly in a post-9/11,
post-Dubai Ports World environment of distrust.


ASSET-BACKED INVESTMENTS ARE PERCEIVED AS SAFER...


5. (U) Since Islam forbids the payment or collection of interest,
financial transactions must be based on tangible assets. This solid
basis provides investors with a sense of security. In addition,
Islamic investment vehicles such as mutual funds exclude debt-ridden
companies as well as those which rely heavily upon collecting debts
from others. Islamic jurists tolerate some level of interest,
invoking the Islamic "rule of necessity" in recognition that they
could not realistically exclude every company that had an
interest-bearing account or loan. The standards developed in the
1990s by the Dow Jones Islamic Indices have been adopted by
practitioners across the globe: companies are excluded if their
receivables are more than 45 percent of their assets, or if their
debt is more than 33 percent of their market capitalization (based
on a moving average). In some cases, companies with significant
interest income (more than five or ten percent of their total
income) also are excluded.

...BUT TRACKING WHO COMPLIES IS A CHALLENGE


6. (U) While in principle these cutoffs can result in a portfolio of

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safer investments, implementation can be a problem: there is no
effective mechanism to track the relative debts and assets of each
company. Debt to asset ratios can change from week to week. As the
sector grows, so does the challenge of keeping track of which
companies comply with these standards.


A BIGGER CHALLENGE: TALENT


7. (U) By far a bigger barrier to the development of the Islamic
finance industry is finding enough financial sector professionals
versed in Islamic law, or enough Islamic scholars with a background
in finance. Language is another challenge: the language of Islam
is Arabic, while the language of finance is generally English. In
the Middle East there is no limit to the number of Shariah boards a
scholar can sit on, so a single scholar might officially sit on
fifty boards but contribute little to each one. In Malaysia Shariah
scholars are limited to a single board, and there simply are not
enough scholars to go around. The differences in Islamic practices
between Southeast Asia and the Middle East add yet another layer of
complexity to training experts. In spite of the differences,
though, Middle Eastern countries routinely recruit Islamic finance
practitioners from Malaysia. Last year the GOM exempted Islamic
finance experts from paying income taxes in an effort to make local
jobs more competitive with the higher salaries being offered in
some oil-rich countries without income tax regimes.


GOVERNMENTS GETTING IN ON THE ACTION


8. (U) In an analysis for the RGE Monitor, Rachel Ziemba noted that
Gulf Cooperation Council (GCC) sovereign funds and government
investment vehicles were scaling up their investments in Islamic
finance. She speculates that this increased interest comes not only
from the surge of petrodollars and the outperformance of many
Islamic financial products during the credit crisis. It also is
intended to promote domestic financial centers in an effort to keep
money at home. Moody's suggests that government involvement lends
credibility to skeptics concerned about whether such practices are
truly compliant with Islamic law. Wider acceptance of Islamic
banking practices could also result in expanding financial services
to citizens, an important concern for countries where large segments
of the population remain unbanked.


9. (SBU) Rather than continue to hope Shariah scholars someday adopt
an agreed set of underlying principles, one analyst pointed out that
if Islamic finance reached critical mass in Malaysia, its national
set of principles could become the global standard by default. As
the sector grows, Hong Kong and Singapore are ramping up their
interest in Islamic finance. The benefit to Malaysia is that these
markets tend to lean toward the more lenient Malaysian model,
offering some legitimacy to its standards. The risk is that these
better-established financial centers could quickly surpass Malaysia
as a global hub, particularly in light of Malaysia's reputation for
heavy-handed, rather than even-handed, regulation of its
conventional financial sector. One international banker told
Econoff that Islamic finance was increasingly popular in Malaysia's
domestic market; however, whether its bid to become a global
financial center will be taken seriously in the global marketplace
remains an open question.

COMMENT:


10. (U) The fledgling Islamic financial sector has received
increased attention of late, largely due to its resilience during
the ongoing sub-prime crisis. Despite gentle cajoling by the GOM,
Islamic scholars are no closer to reaching consensus on what is
permissible and what is not. Nevertheless, the niche market
continues to grow in spite of the obstacles, and critical mass might
determine which set of principles will be adopted in the global
marketplace. In spite of Malaysia's best efforts to stay ahead of
the pack, it could easily be surpassed by better-established
financial sectors.

KEITH