Zeti Akhtar Aziz: Towards gaining global growth potential of Islamic
finance
Speech by Dr Zeti Akhtar Aziz, Governor of the Central Bank of Malaysia, at the Seminar on
Islamic Finance "Towards Gaining Global Growth Potential of Islamic Finance", Hong Kong
Monetary Authority, Hong Kong, 15 January 2008.
* * *
It is my honour and great pleasure to be in Hong Kong today to speak at this seminar on
Islamic Finance jointly organised by the Hong Kong Monetary Authority and the Islamic
Financial Services Board. Islamic finance is now at the threshold of a new dimension in
which, it has now an increased potential to strengthen international financial linkages
between nations. And in so doing, it would contribute towards a more optimum allocation of
financial resources across borders. Hong Kong, with its sophisticated financial infrastructure
and high level of expertise in the financial sector, has strong potential to be an important
linkage and an engaging partner in the international Islamic financial activity.
It is exactly six years ago that we were here in Hong Kong as our first destination, to promote
the world's first sovereign sukuk issuance. The overwhelming response we received in Hong
Kong provided the momentum effect that resulted in the successful issuance of the
pioneering USD600 million Malaysian sovereign sukuk. It was more than two times over
subscribed with one-third of the investors from this region. Six years hence, the Islamic
financial landscape has been dramatically transformed into a vibrant, dynamic and
competitive global intermediation mechanism that is supported by more than 300 Islamic
financial institutions in more than 75 countries. It also has become among the fastest growing
segments in the financial services industry.
In the early phase of its development, Islamic finance was essentially domestic centric,
focussing on retail financing, trade financing and the financing of other commercial business
activities. Two recent developments have however, influenced the subsequent direction of
the development of Islamic finance. Firstly, the drive to diversify the domestic financial
infrastructure so as to avoid the over dependence on the banking sector and secondly, the
trend towards greater liberalisation of the financial system. These two trends have spurred
the development of the Islamic financial markets and its greater integration into the
international financial system, thereby raising the international dimension of Islamic finance.
This more dynamic environment, has fostered the generation of a wide spectrum of Islamic
financial instruments that has ranged from instruments to manage liquidity to structures for
the financing of that for financing mega investments. These developments have led to the
emergence of a new asset class. It has also drawn a higher level of foreign participation in
the Islamic financial markets which has resulted in increased cross-border flows. This has
not only contributed to enhancing international financial inter-linkages between economies
but it has also contributed towards the more efficient allocation of financial resources across
borders.
Islamic finance in 2008 and beyond remains positive despite the current challenging global
financial environment. The viability and competitiveness of Islamic finance is derived from
several factors. It is from its ability to meet the changing demands of the economy, from its
cost competitiveness and from being supported by a well developed legal, regulatory and
supervisory framework. But more importantly, are the fundamental Shariah requirements of
Islamic finance that support its viability and stability.
Shariah is the key pillar of Islamic finance from which Islamic finance derives its unique
characteristics. The Shariah injunctions require that Islamic financial transactions be
accompanied by an underlying productive activity. In Islamic finance, there is always a close
link between financial and productive flows. Moreover, under the risk sharing principle
required, Islamic financial institutions will share the profit or the loss incurred by the
entrepreneur. There is an explicit sharing of risk by the financier and the borrower. This
arrangement will thus entail the appropriate due diligence and the integrating of the risks
associated with the real investment activity into the financial transaction. In this arrangement,
the real activity is expected to generate sufficient wealth to compensate for the risks.
In contrast, conventional instruments generally separate such risks from the underlying
assets. As a result, risk management and wealth creation may, at times, move in different or
even opposite directions. Conventional financial instruments also allow for the
commoditisation of risks. This has led to its proliferation through multiple layers of leveraging
and disproportionate distribution, in turn, which could result in higher systemic risks, thus,
increasing the potential for instability in the financial system.
In addition, transparency represents a basic tenet underlying all Islamic financial
transactions. There is an inherent obligation on Islamic financial services providers to meet
the appropriate standards of transparency. It is from the profit-sharing feature of Islamic
financial transactions that imposes a high level of disclosure in the financial contract. The
accountabilities of the respective parties involved in the transaction are clearly defined in the
contract. This transparency also provides a strong incentive for Islamic financial institutions
to appropriately manage risks. This disclosure allows the market to assign the appropriate
risk premiums to the respective companies and thus the potential for the enhanced role of
market discipline to take effect. These inherent features as required by the Shariah
injunctions provides inbuilt checks and balances which serves to ensure financial stability in
the Islamic financial system.
These features are also reinforced by the development of a comprehensive regulatory and
supervisory regime which has been strengthened considerably with the establishment of the
Islamic Financial Services Board in 2002. It's establishment has also contributed to the
harmonisation in the development of Islamic finance across different jurisdictions. Finally,
education institutions have been established to develop the supply of professional talent and
expertise in Islamic finance to support the growth and development of Islamic finance going
forward.
The evolution of sophisticated Islamic financial products that have been structured based on
multiple Islamic concepts have resulted in a new wave of innovation. These products have
become competitive and efficient both in terms of product structure and pricing. The more
recent innovations include the introduction of Islamic hedge funds and the creation of Islamic
benchmark indices. There has also been increased listing of Islamic financial instruments in
international exchanges. This has enhanced the depth of the Islamic financial markets has
increased its attractiveness of an asset class for investment. This has contributed to
increased sophistication of Islamic banking and takaful products evidenced by the recent
surge of structured products and investment-linked products.
The sukuk market is fast emerging as the most significant form of Islamic financing and
continues to receive strong interest as an avenue for fund raising and investment. The sukuk
market has been gaining growth momentum, increasing at an average annual rate of 40
percent. Significantly, 90 percent of the sukuk issuance are corporate issuances. In
Malaysia, the issuance of sukuk has surpassed the issuance of conventional bonds for three
consecutive years, with the annual turnover in sukuk trading in the secondary market at
about RM135 billion. Strong demand for sukuks have also been spurred by the high levels of
surplus savings and reserves in Asia and the Middle East.
The sukuk is also an attractive instrument to assist Islamic financial institutions in managing
their liquidity requirements. At the same time, it is also an effective instrument used by
corporations, institutions and sovereigns in tapping funds at competitive rates to finance long
term funding needs. At this juncture, the demand for sukuk is tremendous. The high demand
for the sukuk instrument is evidenced by the over subscription which has ranged from two to
thirteen times. This has pushed down the cost of issuance by at least 10 to 20 basis points.
This demand has originated from several different parts of the world, both from conventional
as well as Islamic financial investors. Due to the scarcity of sukuk issuance, the investors
have tended to hold the sukuk for investment thereby reducing the secondary activity in the
market. Thus, has resulted in a higher pricing in the sukuk secondary market thereby
generating good investment returns for investors. The sukuk thus offers a positive value
proposition for both issuers and investors.
Let me turn to Malaysia's experience in Islamic finance. Malaysia has had three decades of
experience in which we have developed a comprehensive Islamic financial system that
operates in parallel to the conventional system. The supporting legal framework includes a
dedicated legislation that takes into account the unique principles of Islamic contracts. The
legal infrastructure also includes the court system and arbitration mechanism to resolve
disputes to ensure that contracts relating to Islamic financial transactions are effectively
enforced. The Islamic financial system is also well supported by a significant number of
diverse players in the banking, takaful and capital market.
Finally, for a dual financial system, the tax reforms have been undertaken to accord neutrality
in treatment between conventional and Islamic financial products. The establishment of a
national central Shariah Council has been important to ensure harmonisation of Shariah
decisions in the Islamic financial services industry.
The Islamic financial industry in Malaysia has experienced rapid transformation in recent five
years. The product range has now expanded into broad array of innovative instruments.
Several new Islamic financial products were introduced which included residential mortgage
backed securities, commodity based financing, as well as investment and equity linked
product based on musyarakah, mudarabah and ijarah.
The Islamic financial system in Malaysia has evolved as a competitive component of the
overall financial system, complementing the conventional financial system as a driver of
economic growth and development. Malaysia continues to foster the expansion of the dual
banking system where both, the Islamic and conventional systems operate in parallel to
deliver innovative and competitive financial products and services. More recently, the
increased pace of liberalisation in the Islamic financial services industry has increased
foreign presence and participation in our domestic Islamic financial system. This has
increase the diversity of players in our system. The Malaysian bond market has also been
liberalised to enable foreign entities to raise ringgit and foreign denominated funds in our
domestic market. Following these developments we are now entering a new phase in the
development of Islamic financial system in Malaysia with the new initiatives to promote
Malaysia as an International Islamic Financial Centre. This aims at strengthening our
economic and financial inter-linkages and thus promoting greater trade and investment
across borders. We are therefore entering a new phase of development for Islamic finance in
Malaysia as it becomes more integrated with the international financial system.
Given the surge in demand for Islamic financial products and services, several countries and
financial centres are increasingly participating in the industry. The global front-runners will be
those with combined strengths of having the capabilities and resources, as well as the ability
to secure the confidence of the international Islamic financial community. It is against this
backdrop of rising competitive environment that the potential of cumulative bilateral and
multilateral strengths will become important in managing the complexities and constraints
found in the Islamic financial services industry.
This increasing interest by several financial centres together with their international linkages
will contribute towards creating a more integrated international Islamic financial system. Such
centres, such as Hong Kong, have the potential infrastructure and the ability to facilitate
product offerings that will bridge the regional and international financial linkages. Strategic
alliances among Islamic finance players would be a catalyst unleashing the regional and
global potential of Islamic finance.
In South East Asia alone there is an immense potential market to be tapped. This market not
only comprises the 217 million Muslim population but extends to the non-Muslim community
and the foreign national community that operates in the region. The region is increasingly
becoming an investment destination, including from the Middle Eastern investors. In 2006,
Asia Pacific region has surpassed Europe as second largest region for investment from GCC
with USD460 billion investment.
The recent specific initiative to enhance the securitisation market by Cagamas Berhad, the
Malaysian Mortgage Corporation and Hong Kong Mortgage Corporation by establishing a
joint venture company to provide a mortgage guarantee programme for both Islamic and
conventional mortgages in Malaysia is an example of a collaboration. This could be a
catalyst for more similar initiatives in the future.
Conventional financial institutions may also enter into alliances with Islamic financial
institutions to be co-arrangers, to structure sukuk or other Islamic products based on Shariah
compliant assets in this region. The wide ranging availability of such assets and the massive
financing needs of the new growth areas in the region such as in China, Indonesia and
Vietnam will be attracting funds from surplus economies such as from the Gulf economies.
Efforts can also focus on facilitating cross listing of sukuk in multiple jurisdictions.
Additionally, the viability of setting up of Asian Sukuk Fund as an extension of Asian Bond
Fund can also be explored.
Potential issuers may leverage on Malaysia's sukuk platform and the strengths as the world's
largest sukuk issuance centre with over US$56b or 62% of world's sukuk issues. Malaysia
has one of the most active primary sukuk market with an average annual growth of 17%
during the period 2001-2006. It also has one of the most active secondary market with the
turnover of the sukuk trading registered more than USD40 billion annually. International
issuers with good rating will benefit from the simplified issuance procedures. This is in
addition to the ability to issue multi-currency sukuk and the flexibility to swap RM funding into
other currencies to enable foreign issuers to capitalize on the price premium of issuing RM
denominated sukuks.
A further area of collaboration is outsourcing, in-sourcing or white labelling. These
mechanisms will not only serve as a means to drive down cost of doing business, achieving
economies of scale and the avoidance of duplication of resources, but also gives optimum
focus by players to develop the newly ventured Islamic finance business. Malaysia's
experience in Islamic financial operations and product design can be leveraged upon to
systematically structure a complete solution to be offered to other players.
Going forward, Islamic finance as a new industry requires more initiatives to expand the
horizon of business parameters and innovative products offerings. There is a need to
conduct further in-depth research on Shariah issues relating to risk mitigation, liquidity
management and hedging. The combined market knowledge and insights from education
and training institutions such as INCEIF, the International Centre for Education in Islamic
Finance in Malaysia can make meaningful contributions to the global Islamic finance industry
that addressed both market needs and Shariah compliance. In addition, INCEIF's flagship
programme, the Chartered Islamic Finance Professional (CIFP) offers the world's first
professional certification programme in Islamic finance aims to nurture skilled talent pool for
Islamic finance.
Let me conclude my remarks. The global Islamic finance industry has evolved from a
faithbased to a business driven industry for all communities. With total global Islamic financial
assets amounting to only 40% of the largest conventional bank and with only 300 players
compared to 23,000 conventional players globally, competitive pressure moving forward are
likely to be intense. But with the underlying strength inherent in Islamic finance and its
potential role in bringing together different parts of the world with surplus funds in search of
investment opportunities to those with financing requirements accords tremendous
opportunities to be drawn from Islamic finance. The combined efforts and collaborative
alliances will pave the way for mutually reinforcing developments that will contribute to the
overall international finance system and global economic prosperity.