Malaysia - gateway to Islamic finance
By Hossein Askari and Noureddine Krichene
KUALA LUMPUR - Over the past decade or so, Malaysia has quietly become the
leading international player in Islamic finance and its gateway. The government
of Malaysia, through its two principal agencies, Bank Negara (the central bank)
and the Security Commission, has actively promoted Islamic finance. More
specifically, Islamic finance has been given formal prominence in the Financial
Sector Master Plan (FSMP) and the Capital Market Master Plan (CMP), which were
initiated in Malaysia in 2001.
Malaysia's achievements have been quite remarkable in developing market
institutions and Islamic financial products, in boosting capital flows, and in
establishing the country's dominant position in the world of Islamic finance;
it has become the leading player in the global sukuk (Islamic bond) market and
in developing
innovative products in money markets, derivatives, and in liquidity management.
The recent gathering of the Global Islamic Finance Forum 2010 (GIFF) in Kuala
Lumpur under the auspices of Bank Negara is a further confirmation of
Malaysia's continuing commitment to embracing and advancing Islamic finance.
The emergence of Malaysia at the top of the international Islamic finance
pyramid is by no means accidental. The country has one of the most advanced
financial systems among emerging market economies. Its financial system has
been liberalized and integrated into the global capital markets. Its advanced
financial infrastructure, relative to all other Muslim countries, was
supportive of Islamic financial innovation and development and establishing
Malaysia as the dominant country in Islamic finance.
Malaysia is an emerging market economy that has achieved sustained economic
growth over a number of years and reached a high level of development. Its
strong economic performance has been founded on efficient and relatively
democratic institutions. Strong institutions, modern infrastructure, growing
human capital and financial development, have all contributed to its emergence
as the present force Islamic finance.
In fact, two recent studies on the "Islamicity" of countries ranked Malaysia at
the top of all 56 Muslim countries in the world.
What is Islamic finance? What are its main foundations that make it supportive
of financial stability, economic prosperity and social justice?
Islamic finance draws its scaffolding from divine rules (the Quran and the life
of the Prophet Mohammad) that embrace risk-sharing (profit and loss sharing)
and ban risk shifting (debt that embodies interest), prohibit interest (riba),
gambling, speculation, and any unjust appropriation of wealth, and make zakat
(alms) a mandatory obligation for preserving an equitable distribution of
income and social justice. Although debt is not forbidden, it has to be
interest free, and hence debt plays a negligible role in Islamic finance.
In its pure form, Islamic financial finance can be defined as a two-tier
financial system, restricting commercial bank activities to (i) cash
safekeeping, and (ii) investing client money as in a mutual fund. Banks accept
deposits for safekeeping only (as for example in a system with 100% reserve
requirement) and charge a fee for providing this service and for check-writing
privileges.
In their intermediation capacity, banks identify and analyze investment
opportunities and offer them to clients; the bank charges a fee for this
service, much as with a traditional investment bank. The bank does not assume
any asset-liability risk on its balance sheet; instead, gains or losses accrue
directly to client investors.
However, the bank can at the same time invest its own equity capital in these
and in other investment projects, as can its client investors. In such cases,
the bank does not assume any asset-liability exposure, just a potential loss of
some (not all or its multiple) of its capital, which does not endanger the
bank's solvency.
In other words, in this example of a financial system, there is no debt
financing by institutions, only equity financing; and there is no risk
shifting, only risk sharing. Banks do not create money as under a fractional
reserve system. Financial institutions serve their traditional role as
intermediaries between savers and investors but with no debt on their balance
sheets, no leveraging and no predetermined interest rate payments as an
obligation.
Because of the structure of Islamic finance outlined above, it has received
increasing attention in the aftermath of the global financial crisis that broke
out in August 2007. It is considered as a more stable financial system, capable
of promoting sustained growth of income and employment. Prohibiting interest
and interest-debt contracts, Islamic finance eliminates money creation and
destruction by the banking system through the credit multiplier; it establishes
one-to-one mapping of financial and real sectors of the economy. That is, it is
based on real trade and production activities.
The financial sector cannot expand beyond the real economy, and is immune to
un-backed credit expansion and speculation that are characteristics of
conventional finance and have destabilized even the most sophisticated and
complex financial systems.
Islamic finance operates with one rate of return, which is the rate of profit.
Conventional finance operates with two rates of return - the rate of interest
and the rate of profit. The distortion between these two rates and the
destabilizing effect on credit and prices were extensively analyzed by Thornton
(1802) and Wicksell (1898). Its modern form is known as the "equity premium",
namely the return on equities exceeds the rate of interest by about 6%-12%,
depending on markets and time-periods.
Proposals along these lines are not new. Financial systems in some such form or
other have been practiced throughout recorded history. Recently, such an
approach was recommended in the "Chicago Plan". This reform plan was formulated
in a memorandum written in 1933 by a group of renowned Chicago professors,
including Henry Simons, Frank Knight, Aaron Director, Garfield Cox, Lloyd
Mints, Henry Schultz, Paul Douglas and A G Hart, and was forcefully advocated
and supported by the noted Yale University professor Irving Fisher.
Fisher wrote: "I have come to believe that that plan is incomparably the best
proposal ever offered for speedily and permanently solving the problem of
depressions; for it would remove the chief cause of both booms and
depressions."
More recent than the Chicago Plan, James Henry and Laurence Kotlikoff have made
a proposal along similar lines, coining it as Limited Purpose Banking (LPB);
writing in Forbes (2010), they said:
Were we really serious about
fixing our financial system, there's a very simple alternative - Limited
Purpose Banking. LPB would transform all financial intermediaries with limited
liability into mutual fund companies. Under LPB a single regulatory agency -
the "Federal Financial Authority" - would organize the independent rating,
verification, custody and full disclosure of all securities held by the mutual
funds. Voila, by dint of competition and transparency, "liar loans",
off-balance sheet gimmickry, and toxic assets would all disappear. LPB would
let the financial sector do only what Main Street needs it to do - connect
lenders to borrowers and savers to investors. The financial sector's job is not
to take taxpayers to the casino and collect the winnings.
Recurrent
financial crises in recent and distant pasts have established the fact that
conventional finance needs support or is doomed to significant instability and
potential collapse. Conventional banking needs a central bank as lender of last
resort, deposit insurance and bailouts from government.
Conventional finance can be socially unjust; it creates money out of thin air,
called "counterfeiting" by Maurice Allais, and enables borrowers to acquire
free wealth. It is inflationary and it extols an inflation tax. The US Fed has
as one of its two main objectives price stability; yet the US dollar in 2010
has less than 5% of its real purchasing power of 1920.
Experiences of hyperinflation in Germany and Latin America demonstrate how
economies have been ruined by inflation. During the 19th and 20th centuries,
conventional finance caused increasing social inequities, resulting in the
emergence of powerful labor unions to defend real incomes against the rapid
erosion caused by inflation that is rooted in fiat-based conventional finance.
Over the last 40 years, some of the growing disparity in income and wealth in
the United States is attributable to finance.
Conventional finance has been accompanied by high uncertainty, exchange rates
instability, competitive devaluations and beggar-thy neighbor policies that are
detrimental to foreign trade. John Maynard Keynes (1936) likened asset and
commodity markets to a casino. In 2010, the price of gold hit $1,284/ounce; it
was $35/ounce in 1971. The price of oil hit $147/barrel in 2008; it was
$2/barrel in 1971.
Reserve currency countries have been trying to resolve the current financial
crisis using the same policies that led to the crisis in the first place;
namely, forcing interest rates to near-zero, printing money out of thin-air to
inflate their way out of the crisis, forcing more debt, and increasing fiscal
deficits.
Islamic finance is essentially immune to financial crises, inflation, and
factor price distortions. There is no wealth redistribution via debt and
inflation. Investment is based solely on equity financing. Zakat (alms) is
mandatory and helps to eliminate the need for borrowing by the poor.
Islamic finance does not orient resources to consumption, as one cannot finance
consumption by resorting to debt, and instead it orients them to investment and
accelerates the process of capital accumulation. Demand and supply grow in
harmony; namely, demand cannot be inflated through debt creation. There is no
credit expansion that triggers asset bubbles. The economic growth path is
sustainable, steady, and does not gyrate as in conventional finance.
Full-employment is preserved.
The only possible shortcoming of Islamic finance is the unproven contention
that conventional finance is more supportive of economic growth. This, however,
is an empirical point that must be assessed over a long period, assessing
growth over cycles of booms and busts.
Because of the attractive features of Islamic finance, Malaysia has positioned
itself as an Islamic investment gateway to the world, with a niche in Islamic
fund and wealth management. The comprehensive Islamic financial system
developed by Malaysia operates in parallel with the conventional financial
system and includes banking and takaful (Islamic insurance) components, and
Islamic money and capital markets.
Following the development of a robust and vibrant domestic market, there are
now initiatives under way to raise the international profile of the Malaysian
Islamic financial system. These include a wide range of liberalization measures
that include attracting foreign entities in the field of Islamic finance to
Malaysia system by issuing new licenses - including to Islamic fund management
companies - and allowing for greater percentage of foreign ownership in
Malaysian domestic financial institutions.
Liberalization has also involved the potential for greater foreign
participation in Malaysia's conventional domestic financial markets.
Islamic banking has also spurred efforts by non-bank financial intermediaries,
such as the development financial institutions, savings institutions, and
housing credit institutions, to introduce Islamic schemes and instruments to
meet their customer demands. In addition, the capital market has seen the rapid
growth of sukuks and equity markets.
To complement these developments, the Labuan Offshore Financial Center has
embarked on a serious effort to establish an International Islamic Financial
Market to stimulate the creation of liquidity and financial instruments as well
as to enhance investment opportunities aimed at greater mobilization of Islamic
funds.
The number of Shariah-compliant securities on Bursa Malaysia was 847 in May
2010, representing 88% of the total listed securities and 63.8% of the total
market capitalization. The FTSE Hijrah Shariah index and the FTSE Bursa
Malaysia EMAS Shariah index provide a broad benchmark for Shariah-compliant
investments. These indices are designed for investors who wish to invest in
Shariah-compliant stocks.
Islamic funds include unit trust funds (UTF), which are Islamic equity funds,
and mutual funds (sukuks and other Sharia-compliant securities), real estate
investment trusts (REITs), venture capital funds, and exchange traded funds
(ETFs).
As of June 2010, there were 156 approved Islamic funds. Sukuks are structured
securities and most financing deals have been structured along the concepts of
Murabahah (where the seller informs the buyer of a commodity the cost that has
been incurred on the commodity and adds that as a known mark-up in the sale);
Ijarah (lease or rent) and Bai' Bithaman Ajil (sale of goods on a deferred
payment basis).
To sustain the tax competitiveness of Malaysia's Islamic capital market, the
government has extended tax deductions on sukuk issuance expenses. It has also
established a financial guarantee institution to provide credit enhancements
for sukuks, which would increase the creditworthiness of these and reduce the
time required to place new issues.
Malaysia's position as a center of innovation was reinforced with the launching
of the world's first Shariah-based commodity trading platform, Bursa Suq
Al-Sila, in 2009. This was a collaborative effort of the Security Commission,
Bank Negara Malaysia, and Bursa Malaysia and was supported by the Malaysian
Palm Oil Board, the Malaysian Palm Oil Association and the Malaysian Palm Oil
Council.
Malaysia has made Islamic finance a priority and placed it at the center of its
financial and capital market development plans. The decision to accelerate the
development of Islamic finance was a reasoned one to promote future financial
stability and sustained growth, in contrast to the financial crisis that the
country experienced under the conventional financial in 1997-98.
Moreover, as Islamic finance is growing rapidly the world over and can be
expected to do so in the foreseable future in part because of rising oil
revenues, Malaysia is well positioned to become the combined New York and
London of Islamic finance, a position that it should maintain and solidify for
years to come.
Hossein Askari is professor of international business and international
affairs at George Washington University and Noureddine Krichene, who has
a PhD from UCLA, is professor of finance at INCEIF in Kuala Lumpur.
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