GCC Sovereign Wealth and Islamic Finance

In a recent report – Moodys suggested that GCC governments are taking a more active role in Islamic finance (via Reuters). This matches with a trend that has been developing for some time and which I noted in my report on GCC sovereign funds from some months back. On a side note, we recently released some new estimates of assets under management by sovereign wealth funds (RGE subscribers only).

At that time, I noted that GCC sovereign funds and government investment vehicles were scaling up their investments in Islamic finance, both by taking stakes in Islamic banks, promoting the development of such financial institutions at home, in the MENA region, Pakistan and outside and potentially purchasing the securities themselves.

Dubai holding announced that it was consolidating its various Islamic financial holdings into one unit under the oversight of Dubai financial group. Other sovereign investors already have stakes in Islamic banks or are exposed through the domestic banks that they own. Funds like the Kuwait investment Authority also suggested that they would increase exposure to Islamic products. KIA equity holdings may already be sharia compliant – they already avoid companies whose profits derive from alcohol, gambling etc. Now that a range of Shari’ah compliant equity indices and screening tools are available, this process may be easier, both for private and government investors and the asset managers who manage their money.

The market for Islamic finance products and investment strategies has been growing rapidly (see this recent Terrapinn survey for more on some of the products) helped by the surge of petrodollars, the development of mortgages in the Middle East. Furthermore, the outperformance of many Islamic finance products and equity indices during the credit crisis has attracted even some non-Muslim investors. It seems logical that GCC governments would want a part of this market.

Developing Islamic banks is a key part of the goals of all GCC governments to promote domestic financial centers – this involves both Islamic and conventional finance. In part this will keep money at home rather than it finding its way to the sukuks of Malaysia. Many Asian countries are seeking to follow Malaysia’s lead. And the U.K. has gone the farthest of any G10 country to level the playing field for Islamic finance – one of the reasons that London attracts so much GCC capital

GCC governments now may be stepping in in a new way, as consumers of Islamic financing. The $6 billion loan negotiated by Investment Corporation of Dubai, the umbrella investment vehicle for Dubai’s government includes two Islamic finance tranches of $1.5 billion and $2 billion as well as conventional components. With more arms of GCC governments seeking finance, it seems likely that at least some of them will seek out shariah compliant financing. Institutions like Aldar, the Abu Dhabi housing corporation already do. This would also have the side benefit of throwing business towards the very institutions in which they hold stakes. Noor Islamic Bank, the largest Islamic bank in a non-muslim country, is backed by Dubai’s government.

GCC governments are unlikely to shun conventional finance, but the demand of such public sector enterprises could further contribute to the development of Islamic finance, particularly as the market becomes large enough to raise such funds. Furthermore, even cash-rich GCC governments may be starting to feel the bite of credit shortages.

Moody’s suggests that there was another interest involved. Government involvement in Islamic financial institutions is seen as providing a guarantee. “The risk of consumers perceiving an Islamic Financial Institution as insufficiently compliant with sharia is somewhat mitigated” by a higher government ownership. One of the biggest bottlenecks or uncertainties is the relative shortage of trained Islamic jurisprudence experts, a gap which will ease over time and as new scholars are trained. As yet, there are no recognized global rules for Islamic finance – Malaysia has national regulations, though those are seen as somewhat lax by those in the gulf. And despite coordinating bodies, there are still gaps. Greater government involvement could lead to a critical mass in which certain structures start to become industry standard, something that GCC governments would like to encourage, particularly if it means that its financial centers and institutions which it owns abroad attract the capital. Furthermore it also serves the purpose of expanding credit to their citizens.

Speaking of extending credit to citizens - the IMF Article IV on Iran has long-awaited (at least by me) data on the Oil stabilization fund of Iran. Much of the savings in the fund have been spend, either to pay for Iran subsidies, or to offset the costs of sanctions. In the early years of the fund, lending costs were actually quite high in local currency terms, given the depreciation of the Iranian rial against the US dollar and relatively high interest rates on USD loans were higher than that charged on rial-denominated loans. This according to the IMF has now changed, with much of the OSF's capital loaned out to the private sector and used to finance Iran's government spending.