Adherents of Islamic Finance Mitigate Effects of Financial Crisis

Stephen DeAngelis

December 8, 2008

Resilience is often higher among conservative groups than others. The reason is simple — they take fewer risks. Most conservative cultures encourage thrift, hard work, and honesty. They live by the old adage “use it all; wear it out; make it do; or go without.” An article in BusinessWeek notes that “banks and mutual funds that comply with Islamic law have largely evaded the fallout from toxic debt” [“Islamic Finance May Be on to Something,” by Frederik Balfour, 24 November 2008 print edition]. Islamic financial laws are relatively conservative when compared with other international financial schemes. Hence, Balfour advises, “This might be a good time for investors to pick up a copy of the Koran.” He isn’t trying to get anybody to convert he just wants to point out how a conservative approach to finance can help mitigate market volatility.

“Stocks and other investments that adhere to sharia, or Islamic law—though hardly unscathed—have fared better than the broader market. That’s thanks largely to rules that forbid investing in collateralized debt obligations and other toxic assets that have caused the carnage in conventional financial circles. A big part of the appeal of Islamic finance is its simplicity. Speculation is taboo under sharia, and there’s a ban on assessing interest because the Prophet Mohammed said debts must be repaid in the amount that was loaned. Money proffered must be backed by collateral, and if financial instruments are traded, they generally have to sell for face value, which deters banks from repackaging debt. ‘This is one way to keep both feet on the ground,’ says Rozali bin Mohamed Ali, head of an Islamic finance university in Kuala Lumpur.”

Having a conservative approach to finance doesn’t mean you can’t make money. When oil prices surged past the $100/barrel mark, the airlines complained (as did many others) that it was the speculators who were driving up prices not market conditions. Although many Middle Easterners wouldn’t practice speculation themselves, they were certainly happy to reap the benefits of such speculation. They saw the combination of Islamic conservatism and Western speculation as a win-win situation.

“That doesn’t mean Islamic finance won’t suffer in an economic downturn. Because they must hold collateral, Islamic financial institutions tend to have more real estate assets than Western banks do. So far, sharia-compliant banks—mostly in the Gulf region—haven’t suffered because housing prices there have held up relatively well. But if those markets were to dive, there could be trouble, says Mohamed Damak, a credit analyst at Standard & Poor’s.”

For small, rich states like Kuwait, Bahrain, and the UAE, land is precious. That is why they are not only “making” more land, they are building taller buildings. But real estate holdings don’t make a balanced portfolio. Adherents of Islamic financial laws also hold bond-like instruments as well as equities like stocks.

“Evaluating the performance of sukuk—the rough equivalent of bonds—is more difficult. Banks have issued some $70 billion in sukuk, a drop in the bucket compared with the $36.8 trillion in bonds outstanding worldwide. And since many scholars say sukuk can be resold only at face value, there’s not much of a secondary market. It’s clear, though, that the global credit crunch has put the brakes on sukuk issuance. The market quadrupled, to $24 billion, from 2004 to 2007, but this year it has fallen by 31%, according to researcher Thomson Reuters. For investors in stocks, Islamic finance doesn’t differ dramatically from Western principles. To be sharia-compliant, companies can’t run casinos or sell tobacco, alcohol, pork, or pornography, and debt can’t exceed 30% of equity. Such rules leave more than half the companies in the Standard & Poor’s 500-stock index—including Microsoft, Southwest Airlines, and Nike—in compliance. ‘You can be an ethical investor without being Muslim,’ says Arne Lindman, CEO of Prudential Fund Management in Asia.”

Balfour points out that conservative stock investing has both its ups and downs — but the downside doesn’t go down as far.

“While sharia-compliant equities have performed in line with conventional stocks over the years, the prohibition on excessive debt has given Islamic mutual funds a lift in recent months. Two-thirds of new money now flowing into the sharia-compliant Amana Funds at Saturna Capital in Bellingham, Wash., comes from non-Muslims. The two funds have fallen by 27% and 33% this year, compared with the 41% decline for the S&P 500. ‘People are trying to hide from leverage by investing in our funds,’ says Monem Salam, Saturna’s director of Islamic investing. ‘But when leverage gets acceptable again, they will go somewhere else.'”

Although some investors and some companies will continue to pursue high risk, high reward strategies, most of the businesses that succeed in the developing world will take a more conservative approach. Short term investing opportunities that take advantage of volatile markets will still be exploited by some, but resilient organizations will look to the long term. Businesses offering good value in emerging market countries will do well in the long run because people in frontier economies understand resilient strategies and (if they don’t already) will come to appreciate ethical behavior. I repeatedly point out that corruption must be controlled in emerging market economies or they won’t be sustainable. As Balfour’s article highlights, Islamic investors will continue to seek out investment opportunities that adhere to sharia principles. That means that fiscally-sound businesses that operate ethically will be welcomed throughout much of the developed world.