Economic woes, commodity slump could hit Islamic banks

SINGAPORE Mon Oct 13, 2008 4:46am EDT

SINGAPORE (Reuters) - Islamic banks have been barely bruised by the global credit crisis so far, but the worst is yet to come as falling property and commodity prices and slowing economies start to hit the sector.

As the global economy buckles, credit lines tighten and consumer confidence crumbles, Islamic institutions -- which manage an estimated $1 trillion worldwide -- will not escape the pain that is plaguing conventional lenders in the West.

Sliding commodity and property prices in predominantly Muslim countries in the Middle East and Southeast Asia are likely to have a particularly strong impact on the sharia market due to the industry's heavy reliance on those assets to support deals.

"Islamic banks are heavily exposed to real estate and private equity in many of these markets," said Abdulkader Thomas, chief executive of Kuwait-based sharia advisory firm Shape Financial.

"If these markets are overpriced -- which some of them are -- then Islamic banks could well be particularly exposed."

Strict lending requirements, insistence on transparency and requirements that physical assets underpin transactions helped the Islamic industry survive the first round of the U.S. subprime mortgage meltdown, which fueled a worldwide credit crunch.

But the global financial crisis has worsened dramatically in recent weeks, sparking heavy selling of stocks, commodities and oil and threatening to plunge developed and emerging economies alike into recession.

Many companies are freezing or slashing spending and cutting jobs, and consumers are reining in spending.

Prices for most commodities such as crude oil, metals and grains have fallen to multi-month lows as investors pulled billions of dollars from the sector. Bankers estimate that about $50 billion-$60 billion of value has been wiped off commodity markets in the last quarter.

The sharia bond market, one of the most popular segments of the industry, has been hit as companies from Japan to Kuwait and Malaysia cite tough market conditions and high borrowing costs as reasons for either aborting or delaying issue plans.

The launch of at least one sharia hedge fund has been shelved and even oil-rich Gulf economies, which are global hubs for Islamic finance, have not been spared.

The United Arab Emirates government agreed on Sunday to take measures to shield the economy, promising to protect banks from credit risks. Last month, the UAE central bank launched a $13.6 billion emergency facility to help keep interbank lending moving.

"The easing of oil and gas prices is unhelpful for the GCC (Gulf Cooperation Councils) economies where Islamic finance is most developed," said Rodney Wilson, an Islamic finance specialist at Durham University in the UK.

"Furthermore, governments have had to curtail capital spending due to inflationary pressures, and there are serious worries over the bubble in the property market in the GCC."

In Asia, where countries such as Malaysia and Singapore are vying to be Islamic finance hubs, once booming property sectors are slowing rapidly. CLSA estimates half the wealth of Malaysia, Singapore, South Korea and India are tied to property, making the region highly susceptible to a sharp brake in economic growth.

The higher costs of Islamic transactions are also expected to come under greater scrutiny at a time when investors are demanding a greater premium from banks for risking their money.

To satisfy the sharia's requirement that all transactions be based on assets, Islamic deals typically involve more paperwork and higher costs than conventional instruments.

"Sharia compliant funds have been adversely affected by global equity falls, and 2008 is likely to see more redemptions than new placements," said Wilson. "No further Islamic hedge funds are likely to be established, and alternative investments are now off the radar for most Islamic investors."

CONTAGION

Modern Islamic banking has been touted as the conservative substitute to the winner-takes-all approach of conventional finance, advocating instead a fair division of wealth and profit- and loss-sharing between the partners of a venture.

There are more than 300 Islamic financial institutions worldwide and the sector is valued at about $1 trillion, just a fraction of the conventional global banking industry. But the sector has been growing about 20 percent annually as it taps areas that conventional lenders have had a hard time reaching.

The growth of sharia banking has been fueled by an increasing focus on Islamic values and tons of cash from Middle East oil exporters hungry for assets that comply with Islamic principles.

With Muslims making up almost a fifth of the world's population, the Islamic industry is seen as offering plenty of room for longer-term growth.

Marcel Kreis, Credit Suisse's (CSGN.VX) head of private banking for Asia Pacific, thinks Islamic banks should survive the downturn better than conventional banks, as oil earnings will provide a buffer.

"With developments in energy prices, the Middle East has seen an absolute bonanza," Kreis told the Reuters Wealth Management Summit in Singapore on Monday.

Still, few parts of the global financial system appear completely safe in the near-term from the contagion effect of the current crisis and the fallout on economies.

"It is all about sentiment now," said Ahmad Zaini Othman, chief executive of Malaysian sharia bank AmIslamic.

"If Islamic banks also decide that they cannot support a line of credit to other Islamic banks because of the poor sentiment, then definitely there will be a ripple effect."

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