The chaos of Nakheel’s unpaid bond may not signal the end of the world’s fascination with Islamic finance. Indeed, interest in the product may boom in the aftermath of the crisis, writes Helen Castell.

On December 14, Dubai secured an eleventh-hour bailout from neighbour Abu Dhabi, just weeks after the government announced a US$3.5bn Islamic bond issued by property giant Nakheel could fail to meet payment deadlines on that day and that its troubled parent Dubai World would be restructured.

The gesture ended weeks of media frenzy during which the Islamic banking market was forced under the microscope almost as much as the seemingly toppled goliath that is Dubai Inc. And although neither Nakheel nor its sukuk have any direct connection with trade finance, Dubai’s status as an export hub created concerns that there would be a knock-on effect.

Although the issue remains far from resolved – as GTR goes to press, banks are still in talks about how to get their money back amid Dubai World’s restructuring, and it remains to be seen what will happen to Nakheel’s bonds maturing in 2010 and 2011 – the crisis may ultimately have done more good than harm to Islamic finance, bankers and lawyers say.

Dubai is finally moving ahead with creating a modernised legal framework for dealing with insolvencies and restructuring, and to standardise the documentation of sukuks is expected to be fast-tracked.

Meanwhile, Islamic trade finance continues to grow – although from a low base – and market players are confident that 2010 will bring good things for the sector.

The Dubai World panic was a symptom of the global economic downturn, rather than a reflection on Islamic finance itself, argues Maninder Bhandari, managing director, head of treasury services – Middle East & Africa at Bank of New York Mellon.

Nakheel’s near-default was “significant, unprecedented and unexpected, given the very recent economic boom witnessed in Dubai”, says Muddassir Siddiqui, partner, head of Islamic finance – Middle East at Denton Wilde Sapte in Dubai. It was caused essentially by local conditions, and similar sukuk structures in other jurisdictions are either doing fine or not facing the same level of distress, he notes.

“Islamic finance is an integral part of the world economy,” Siddiqui says. As such it will be affected in general by the economic downturn, and particularly by local economic conditions.

It is also worth pointing out that the Nakheel bond was small in size compared to some of the bail-outs of some giant corporations over the past year, he adds.

Impact on trade finance
There is no reason why the problems with the Nakheel bond should affect Islamic trade finance, notes Mohamed El Shazly, an Islamic banking consultant in Dubai.

Firstly, Nakheel is a real estate company and the sukuk was not for trade purposes. Secondly, the bond was repaid and the market has regained confidence, he says.

“None of what we’re seeing in the Middle East should be construed as being something that has been caused by Islamic finance,” says Neil Miller, partner and global head of Islamic finance at Norton Rose in Dubai. “Dubai is just a symptom of the credit crisis globally.”

The Nakheel sukuks also have no relationship to trade finance, he stresses, meaning that any knock-on effect there should be very limited.

However, “Islamic finance … has got to find a way of managing some of the difficulties that have arisen because of the credit crisis,” he adds.

Islamic deals account for just 12 – 15% of the UAE’s total trade finance volume, largely because of the limited size of Islamic financial institutions, says Mufaddal Khumri, head of Islamic banking at Abu Dhabi Commercial Bank.

Trade deals work particularly well however within an Islamic finance context. This is because they readily satisfy the shariah requirements that a transaction should fund the purchase and sale of a real asset, and should be non-speculative, transparent and aid the wider economy and parties involved – for example through supporting manufacturers – Khumri says.

In a typical Islamic import financing, the bank actually buys the commodity and then sells it on, with the customer appointed as its agent. Many deals also have a foreign exchange component – for example an FX forward – although in contrast to the speculative nature of many conventional FX transactions, the purpose here is purely to hedge the currency risks faced by an importer when he pays for goods in the future.

Another key difference between Islamic trade finance deals and conventional letters of credit (LC) is that in an Islamic deal it is prohibited to charge a customer any interest or penalty in the event of a late payment.

The fact that Islamic finance is always built around a tangible asset and that “there is nothing speculative about transactions” makes it a fundamentally safer structure for financing trade than conventional trade finance, suggests Bank of New York Mellon’s Bhandari. This will aid its growth during a time when players remain more cautious following the global financial crisis, he adds.

There is clearly a big demand for Islamic finance in the Middle East and this is driving its growth, says Miller. However, the vast bulk of financings in the region are still done on a conventional basis, and the relatively small size of most Islamic financial institutions means that few big deals will contain more than one or two tranches of Islamic financing, he notes.

Out of around 40 active banks in the UAE, only seven of them are Islamic, and this is holding back the growth of Islamic finance in the region despite strong demand, says El Shazly.

Saying that, the volume of deals financed on a sharia’h-compliant basis has expanded six to seven times since 2000, he notes. Meanwhile, most of the major international banks have entered the Islamic finance sphere, opening dedicated departments or branches to meet their customers’ needs.

On the trade finance side, shariah-compliant funds are starting to plug a gap in the market and “invest in an activity that frankly, for the last 10 years, has largely been ignored”, says Norton Rose’s Miller. Norton Rose is currently talking to clients who are putting together trade finance funds to go into that space, which until recently did not offer good enough yields.

Islamic trade finance funds are increasingly in vogue in the Middle East and are boosting the supply of Islamic finance to the region, says Khumri at ADCB. “If you don’t want to participate in financing the trade directly, then you put your money into the fund and the fund then goes out and partially funds the requirement of a customer to do trade.”

Watching Dubai
Islamic financiers will be closely following Dubai’s efforts in the coming months to introduce insolvency reforms. The new laws, set out on December 14, should reduce conglomerates’ dependency on state bail-outs, analysts have said. Market participants also believe an overhaul of how sukuks are documented is likely. But just how lacking is the current system and what would players like to see changed?

“It would be a mistake for people to think that systemically Islamic finance as a tool is more damaged than any other type of instrument used in the region,” says Miller at Norton Rose. “The enforceability of rights is a distinctive but also an inextricably linked issue. But those issues usually arise regardless of the type of finance used.”

Where complexity can arise is in the structure of the transaction. For example, a sukuk contains two components – the asset underlying the documentation and the prospectus of the offer document – making it legally more complicated to restructure than a conventional bond, Miller says. However, “they are capable of being restructured”, he notes. “You just have to think about it a bit more deeply and work out how to do it.”

Denton Wilde Sapte’s Siddiqui comments: “Generally speaking, sukuk defaults would be dealt with like any other default.”

“The difference between the sukuk and conventional bonds is primarily in form and structuring, but not in function.”

“To the extent that parties to a sukuk have agreed to abide by shariah principles, they would be subject to their agreements,” he continues.

“In the Middle East, many legal systems have incorporated and integrated shariah principles and procedures in local civil codes. If there is legislation on the subject, then the legislation would generally control the legal process.”

As a relatively new investment tool – and one that is used in a region where a variety of legal systems are at play – sukuks do however require that investors pay close attention to the specific prospectus, terms and conditions written into each one, says Siddiqui.

“Each country in the Middle East has its own legal system and varying level of competence and capacity to handle complex legal controversies,” he says. “There are some common features related to sukuk defaults but not one single solution would fit all circumstances.”

“As such, there is no single standard on which one can rely to predict the rights and obligations of the parties. Investors must read the prospectus and terms and conditions of each issue carefully to know what their rights and obligations are.”

The Nakheel issue could actually boost the Islamic bond market long-term, primarily by speeding up work to make sukuk documentation more uniform, and to clarify the legal position regarding repossession of assets in a restructuring or default, says Bhandari at Bank of New York Mellon. “This will actually bring forward the discussion that might have occurred later.”

The Dubai World panic will ultimately produce “lots of positive outcomes” for Islamic finance and the region in general, says Norton Rose’s Miller. “It’s a wake-up call to financiers and generally emerging markets that they need to understand risk,” he says. “They need to look at projects, at transactions, and at propositions based on fundamentals. It’s about getting back to proper basic relationship banking.”

“I hope we’ll see more of the things that the Dubai government announced mid-December – a modern updated regime for bankruptcies, insolvencies and restructurings. Although this is only applicable to Dubai World and its subsidiaries at present,” he says, “if it works, one could envisage it being rolled out on a wider basis”.

The Islamic banking market – and the sukuk structure especially – has “yet to mature – it’s still quite new”, ADCB’s Khumri notes.
Therefore, “it needs to be measured over a period of time” before enforceability issues are fully stress-tested.

The Nakheel issue should however speed that process up and make parties in future sukuks look more closely at the documentation of deals before they go ahead.

“They will look into the possibility of default happening and check whether the underlying documentation which has been executed can be enforceable in a court of law,” Khumri notes. “In a gung ho market people generally don’t look into these matters.”

Ultimately, while the Islamic banking market certainly needs a shake-up, the problems with documentation, over-stretched corporates and lenders, and a legal environment that has proved insufficient in the event of a crisis could as easily be applied to conventional finance over the past two years.

And while recovery is anticipated, Islamic finance and the geographic areas in which it is most commonly practiced are now so interlinked with the global economic machine that much depends on what happens in other economies. At the same time, local conditions in each of the UAE’s territories will have a big effect on the success of individual Islamic finance deals.

The future growth of Islamic trade finance will depend on the local economic conditions of each country in which it is practiced. “What can be said of Dubai would not necessarily apply to Abu Dhabi, Qatar or Saudi Arabia,” observes Siddiqui.

However, due to economic uncertainties, non-essential projects will probably continue to be postponed and all kinds of financing activities – both Islamic and conventional – will not grow as rapidly as in the past, he predicts.

BNY Mellon’s Bhandari is more upbeat, predicting that Islamic finance could be back on track as early as Q2 as the world economy recovers more quickly than first expected.