Tuesday, May 19, 2009

No magic in Islamic finance

There has been talk in some quarters in recent months that Islamic finance offers a safe harbor from the choppy waters of traditional financial markets.

For the uninitiated, "Islamic finance" is a branch of both theory and practice that grows out of Koranic prohibitions on riba, which means "interest" or "usury" depending on to whom you speak.

The need for a special branch of finance arises most pressingly when "riba' is understood broadly, to mean "interest" as such, the making of "money out of money." How does finance work without interest?

There are lots of ways to answer that question. In this post I'll just introduce one more Arabic term, "sukuk," (a plural term) which means literally "financial certificates" or perhaps just "checks." In contemporary parlance, "sukuk" is often used as the Islamic analog of "bonds." Bonds, of course, pay interest, which is bad. What do you get if you buy sukuk? You get a claim against the future profits from a particular asset. Sukuk, then, are akin in some respects to shares of equity (though they are bond-like in possessing a definite maturity date), and their equity-like aspects keep them legit in the eyes of the target market.

Another important point: sukuk bonds tend to be bought once and held to maturity. There is only a small secondary market. The more conservative scholars believe that this buy-and-hold aproach is required, otherwise one gets into a speculative secondary market and the line between Islamic and western finance blurs. Yet that view is not universal: there is a secondary market in sukuk.

Anyway, let me go back to my beginning: there has been some talk in recent months about how Islamic finance is a safe haven.

Alas, it is not the case. Last week, a $100 million sukuk bond by Investment Dar defaulted. Investment Dar is a Kuwait-based investment company which has been around since 1994 and owns half of Aston Martin, the UK car company whose products are featured in the movies about a spy called Sukuk, James Sukuk.

Anyway, if you are unfortunate enough to hold the affected sukuk, you'll have to awair court decisions that will determine whether you'll be treated as a holder of equity or debt. Unless religious convictions impel you powerfully against your monetary interests, you should hope that they find this to be debt.

According to today's Financial Times, the spread on HSBC's leading sukuk index is at four times the pre-crisis level.

So what? So this ... invest in instruments that use Arabic terms if you like, but it won't change the basic facts of supply and demand, or the fact (derived from those) that money has a time value. Europe broke itself out of a long stagnant era by deciding to ignore old bans on interest, and the Islamic world, much of which now needs to concern itself with the wise recycling of petro-wealth, since the days of living off long-dead dinosaur remains are themselves limited, would be well-advised to follow that example.

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