In Search of Shariah Funds

Liquidity deficit and financial turbulence spurred on by the bankruptcy of Lehman Bros. has highlighted the end of highly leveraged transactions at cheap funding levels. Though regulators have been injecting money since the onset of the credit crunch, attracting funds for longer terms and at lower rates is still the order of the day.

Traditional sources of capital are definitely not enough to satisfy the increasing demands of emerging and developed economies. Thus, the borrowers are in search of alternative liquidity sources. One interesting avenue of finance is Shariah-compliant funding from Islamic investors.

The rise in oil prices in 2007-2008 gave investors major headaches — cash flow grew quicker than the volume of invested funds. In 2006, more than 500 Islamic financial institutions managed Islamic investments exceeding $750 billion. This figure is expected to grow to $1 trillion in the next 2 years.

European countries have been persistently taking steps to develop Islamic finance and now American companies are no longer newcomers to the Islamic bond (sukuk) market. GE, for instance, this year sold $500 million in a sukuk issue, while IFC placed a $100 million Islamic bond issue. But the sukuk market has only just started the road to growth — its volume is under $100 billion, or about 0.1 percent of the global bond market. Although minor, this sum is enough to satisfy the Russian local corporate bond market’s appetite for four to five years.

Islamic investment has been mobilized by a number of international issuers including sovereigns and corporates. The issuers have been both investment grade as well as subinvestment grade. On the subinvestment grade side, there has been a sukuk issue from the government of Pakistan. Likewise, the government of Indonesia also launched a successful sukuk issue in 2009 — both issuers have credit ratings below Russia.

So, the question now remains, which spheres of the Russian economy can spark Islamic investors’ appetite and what kind of framework is required to structure these transactions? That being said, I would like to highlight a few critical points.

First and foremost, Islamic investors take a pragmatic stance and focus on investing in transactions and industries that are Shariah-compliant (alcohol, gambling, pork and interest are strictly prohibited). It is essential to have a legislative, accounting and tax framework that allows for such transactions to be structured efficiently and for the financing-related elements of a transaction not to be treated as capital-gains tax.

Generally, most Islamic financing products require assets to be the underlying transactions, giving rise to special tax issues that do not affect conventional banks, like:

• Musharaka or a “partnership” agreement between the Islamic bank and the customer that requires a tax return to be filed. This adds to the administrative burden and financing cost;

• In conventional transactions, the primary document to be stamped is the loan document. While in Islamic funding (murabaha) two additional agreements like asset-purchase and asset-sale are also to be stamped. This might bring on dual stamp duty charges;

• In countries like Malaysia, Islamic banks also deal with “Real Property Gains Tax”;

• Installments paid by customers of Islamic banking are technically payments for the acquisition of assets, a capital expenditure and as such may not be tax-deductible;

• As VAT is a transactional tax, the VAT treatment of Islamic products may differ from conventional banking transactions.

In the context of where Islamic finance can be applied in Russia and the CIS, one cannot ignore project finance and infrastructure investments among various other sectors. In June 2009, VTB Capital, Inter RAO and Fouad Alghanim & Sons Co. for General Trading & Contracting signed a memorandum of understanding, aimed at creating value through the development and construction of electricity generation and related infrastructure projects in Russia, CIS and in Arabian Gulf countries. The Russian Federation needs more than $1 trillion in infrastructure investments over the next 10 years. In this respect, an investor-friendly framework that facilitates ease in attracting international capital flows including Shariah-compliant funding is critical.

Gulf investors — conventional and Islamic — have made investments in the real estate sector in various manners — through Shariah-compliant funds, co-investments, sale and lease back transactions, Islamic mortgages etc. In September 2009, VTB Capital signed a memorandum of understanding with the State General Reserve Fund of the Sultanate of Oman to facilitate investments in Russia’s real estate sector. Earlier, VTB Capital had signed a memorandum of understanding with Liquidity Management House (a wholly owned subsidiary of Kuwait Finance House — one of the largest Islamic Banks) to develop sukuk and other Islamic products for Russian corporates.

Islamic investors have interest in a wide range of asset classes such as commodities, agriculture, oil and gas, natural resources, retail banking, equity funds and asset leasing, etc.

Corporate sukuk issuances jumped from $400 million in 2000 to more than $16.8 billion in 2009, crossing the $27 billion threshold in 2007. While Islamic sukuk investors are currently cautious over the recent Dubai world debt standstill announcement, there remains strong interest in high-growth markets and economies, quality assets and business lines.