GCC

Emirates of added taxation

by Executive Staff
written by Executive Staff

Recent history in the UAE has seen hundreds of thousands of expatriate workers, tourists and foreign businesses flock to cities like Dubai and Abu Dhabi, with the surging economy offering well-paying jobs and phenomenal business opportunities, while the absence of income or sales tax has made working and shopping in the Emirates exceptionally attractive.

The honeymoon of this “tax haven” is set to end soon though — as early as the beginning of 2009 — with the implementation of the government’s proposed value added tax, or VAT. Although Abu Dhabi has been conducting studies concerning this for several years, there was a recent announcement that Dubai Customs — the department responsible for instituting the VAT — is aiming to have all the necessary infrastructure in place by the end of 2008, ready for the government to implement the proposed levy of 3-5% soon after.

The stated aim of the tax is to begin the process of diversifying government revenues away from the current heavy dependence on energy resources. However, with 40% of the UAE’s GDP directly dependent on oil and gas output — some estimates put earnings-per-day at $225 million — it would seem the possible revenue gain through VAT would be relatively insignificant in comparison. This begs the question: how effective can this attempt at revenue diversification be?

“I think it [VAT,] will be very small compared to oil revenues, but nonetheless it is very important to introduce these taxes just so that you have increased revenue sources,” said Monica Malik, director of economics at EFG Hermes investment bank in Dubai.

Diversifying revenue

Mohsin Khan, director of the International Monetary Fund’s (IMF) Middle East and Central Asia Department agreed that, regardless of the amount of income government earns from VAT, simply having an alternative energy resources is essential. He remarked that, “The VAT revenue [will be] dwarfed by the oil revenue, but the important thing is to have a stream of revenue that is independent of oil and gas.”

Khan pointed out that the IMF has recommended the VAT be implemented in coordination with other governments in the Gulf Cooperation Council (GCC). “This is because the VAT should be seen in the context of establishing a single, unified market comprising all the GCC countries,” he explained. “The introduction of a tax that does not discriminate against trade in the context of removal of borders is an important element in the development of a single market.”

As it stands, however, the UAE looks to be well ahead of other GCC members in bringing in VAT, and in so doing is garnering much criticism from those who say the timing could not be more inopportune, with the Emirates having endured an average of 11% percent inflation through 2007 and as of yet no sign of relief in 2008.

Inflation paints a somewhat vexing problem for policy makers in the UAE though, as upward price pressures are being fuelled by roaring demand for housing and property, the global increase in food prices and the sinking value of the American dollar, to which the UAE’s dirham is pegged. The dollar peg

also strips monetary policy control from the UAE’s central bank and thus removes the standard option governments use to control inflation — raising interest rates. Price controls typically offer only temporary relief and can have damaging distortive effects on the economy, while fiscal restraint to curb inflation isn’t plausible given the massive infrastructure projects the UAE is undertaking. According to Khan, “The bottom line is that it may be necessary to tolerate a somewhat higher inflation rate in the short term, and focus on bringing inflation down in the medium term.”

In this context the new VAT would only be adding to these inflation woes, at least in the short term according to the IMF, which has stated that it expects VAT to cause a one-off jump in inflation of 1-2% during the first year, but that the tax would not cause permanently higher inflation.

VAT impact disputed

Dubai Customs has been quick to dismiss the IMF’s forecast however, claiming that any price increases resulting from the VAT will be offset by the planned cuts to customs duties on imported products — undertaken as part of the obligations the UAE has assumed for itself through signing on to international trade agreements, including with the US and European Union (EU).

“VAT is going to replace the current customs duties amounting to five percent,” said Abdulrahman al-Saleh, executive director of corporate support sector at Dubai Customs, in comments made in May. “Thereby it is expected to support the price level and mitigate the rise of the inflation rate.”

However Malik said it is too early to tell what the impacts might be, as it is yet to be determined which products will subjected to the new tax. “If there are a number of goods that are exempt from the customs [duties] and then would have VAT [imposed on them], then that would have a greater inflationary impact. But these all depend on which ones are going to have the VAT put on and which ones aren’t, so a lot of these questions will come out later on.”

She added that by international standards, the UAE’s proposed VAT rate is very low — internationally, for example, VAT rates are typically between 15-20%. Malik also pointed out that even though Dubai has been raising the cost of some government services — such as electricity, water and road tolls — “the fact that you don’t have income tax means you will still be very attractive for expatriates to come in and live here.”                        

141 nations currently collect some form of VAT, including almost all first world economies — bar the US — and as Mohsin Khan remarked, “The GCC is the only major region … that does not have a VAT. It is perfectly normal for an economy to have a tax based on turnover in the private sector. And it gives you a chance to get rid of elements that are negative for business, such as local fees and charges.”

Thus, while the timing of VAT implementation in the UAE could be open to criticism due to inflationary worries, if the Emirates are truly going to earn their place in the modern global economy, the government ought to have diversified revenue streams and a refined taxation system comparable to any of the world’s most advanced. Properly implementing VAT would go a long way in this regard.

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MENA

Virtual commerce

by Executive Staff
written by Executive Staff

Internet shopping has yet to take off in the Middle East, but online trading is another story, with banks and brokerages scrambling to set up platforms to tap into the surging demand for the service.

In the last few years, online trading (OT) has started to flourish in the region, with institutions in Egypt, Palestine, Saudi Arabia, the UAE, Kuwait and Lebanon getting in on the act where people can trade, at the click of a button, in stock markets, foreign currencies, securities, futures and options.

The sector is growing at such a rate that major OT players like Mubasher, which started in Saudi Arabia and expanded into Dubai and Abu Dhabi, then the rest of the Gulf, has plans to go global by entering the African, Indian, Indonesian, Iranian, US and European markets.

“We started with 300 subscribers in 1999, and went to half a million in 2008, so it’s a boom,” said Mohammad Jamal, business development manager of Mubasher. “We will maybe reach a million or more subscribers by the year end,” he added.

The attraction of OT as opposed to the traditional form of dealing directly with a broker is to cut out the middleman, save on transaction fees, and be able to immediately monitor and make transactions.

“Users save a lot, and know more about their investments. There also used to be a lot of misbehavior among brokers,” said Jamal.

Saving on Labor

The advantage for institutions is less staff and fewer brokers, as some 4,000 Merrill Lynch brokers in the USA found out recently when they were laid off due to the surging popularity of OT.

“In 1996 we had 50 financial brokers, and today just one or two brokers can do around the clock shifts,” said Walid Abou Sleiman, CEO of Aksys Capital, a Lebanon-based foreign currency brokerage.

For larger institutions, OT has allowed them to expand into other areas. Egyptian financial giant EFG-Hermes, for instance, has been able to enter the retail market by going online, as well as expand its footprint in the MENA region, initially with OT in Egypt, and now also in the Emirates.

“We’re going vertical and horizontal, trying to have an online team in every country that allows everyone to trade in different markets. We are also trying to get people in the UAE market into Egypt, and vice versa, as well as increasing percentage here,” said Mamdouh El Baz, regional director of online trading at EFG-Hermes.

Lebanon’s Arab Finance Corporation (AFC), which has developed the AFC BeirutTrader, the first OT platform that is providing for investors direct market access to the Beirut Stock Exchange (BSE), is also optimistic that their recently launched system will be a boon for Beirut.

“The AFC BeirutTrader has been designed to cater to the needs of private and institutional investors as well as fund managers and gives a powerful tool to investors wishing to trade in the BSE,” said Tarek El-Ahdab, manager of AFC. “There is a general move towards OT globally and it is only natural that investors interested in the Lebanese market be given the possibility to trade online.”

For institutions like Aksys Capital, OT has enabled the firm to rise above the country’s political and economic instability through an online platform open to anyone worldwide for financial currency trading that has liquidity provided by major global players Citi Group, Deutsche Bank, the Royal Bank of Scotland, UBS, and Bank of America.

“Before OT the FX market was restricted to the big players but today, with technology, anyone can have access,” said Abou Sleiman, adding that out of the $3 trillion in foreign currency trading worldwide, OT accounts for over $60 billion.

Competitive systems

With OT platforms not necessarily restricted to one domestic market, but rather regional and increasingly global ones, competition between platform providers is tough and getting tougher. In Dubai, over 100 brokerages have opened up in the last four years, with some 60% having electronic capability. In Egypt, EFG-Hermes is competing with nine other players, although the company, along with Al Arabia Online, dominates 90% of the Egyptian market, according to El Baz.

In Saudi Arabia, the region’s biggest economy and where OT is at its most developed, 350,000 of Mubasher’s half million subscribers are from the country, and Mubasher handles more than 50% of all OT transactions and volume. “Last year, of all IPOs in Saudi 80% took place online, either through the website, via mobile phones, or at ATMs,” said Jamal.

The challenge for OT service providers is therefore to offer the best online platform that is easy for clients to use, offers multiple trading options and client specific tools, as well as being informative. Companies are consequently teaming up with international programmers, in the case of Aksys Capital with Ireland’s Squared Financial Services, while other OT platforms were developed in conjunction with, or actually for, local bourses, which was the case for Mubasher in Riyadh and AFC in Beirut.

And aside from buying and selling online, subscribers can also trade via their mobile phone, watch line prices and ticket rates. Nonetheless, improvements need to be made said Jamal. “At Mubasher we’ve done a lot of R&D, and will introduce advanced smart ordering features like algorithmic orders and, where orders take place according to your strategy, automatic trading and profit capabilities.”

OT providers are also scrambling to offer timely and informative analysis on financial markets to offset the region’s lackluster media coverage of financial markets.

“These are not established markets and there is a total lack of financial reports, information may be skewed, and not enough information for people to make wise decisions,” said Adam Kaye, center manager of the Online Trading Academy in Dubai. Indeed, millions of Saudis were stung when the Tadawul stock market plunged in 2006 — a fall which was blamed on, among other things, excessive speculation and insufficient knowledge of the risks associated with trading.

“The way people use OT could be dangerous,” said Sami Akhras, general manager of AFC. “You can get in and out within a few minutes, and they could be a catalyst for trading more than they should. People are under the impression it is an easy way to make money.”

As a result of such associated risks, Kaye said technical analysis and real-time charting is key.

“Everyone is trying to come up with a better mousetrap, but it’s not really working. The charting is the problem, and the greatest thing people are aware of is charting capabilities for markets — it’s still not developed to the point it is in the US. Reuters has MetaStock, and they are the leaders of global availability, but Mubasher is feeding to Reuters for the region, so Mubasher has a big edge over everybody else,” he pointed out.

Such an edge, said Kaye, could lead to the possibility of an oligopoly by a few online brokers, recounting how at a conference on OT Mubasher, the last company to address the audience, said that everything other OT companies had in the pipeline Mubasher had already done.

“Mubasher have created an amazing system and can replace 80% of small brokers in the region. The future is mega-brokers,” said Kaye.

Not all agree on such a future however. “I don’t think there can be a monopoly, as the backbone behind all this is IT, so you have to develop a good system. The feed is crucial and it comes from the banks,” said Abou Sleiman.

Market hindrances

With such rapid expansion, regulations in many countries are still not up to speed. Jamal said money transfers were an issue, with countries having different rules and regulations. Equally, settlement days differ, with Saudi Arabia doing so on the day, whereas in Egypt it is three days after.

“Egypt is doing this on purpose. It is a mature bourse and an investor market, not a trader market where people speculate. They want to lessen the effects by imposing day plus three to have only serious traders,” said Jamal.

In the Emirates, commissions are levied on OT transactions, a minimum of $20 one way.

“You have to make $40 first before counting your own money, and this can only be done if you have a very considerable amount. So if it’s less than 20,000 AED ($5,450), commissions will eat you, so you need 100,000 AED ($27,200) to make it,” said Kaye.

The solution to this, he added, is for universal standards that can be applied to all bourses and financial markets across the region.

The region’s dollar-pegged currencies are also hindering the growth of foreign currency OT, but if the GCC moves towards a common currency and de-links from the greenback, Abou Sleiman thinks there would be a surge in currency speculation.

Despite such obstacles and drawbacks in the mid-term, as Jamal put it, “online trading is the future.”

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By Invitation

A stitch for Turkey’s fraying ends

by Priyan P. Khakhar
written by Priyan P. Khakhar

After the decision of Turkey’s constitutional court to close down the Islamic AKP party due to allegations of promoting certain virtues in society, analysts and policy-makers have expressed concern about increasing tension in the already politically turbulent country. Political analysts may argue that the move, initiated by certain elements within influential circles of the Turkish state, is meant to maneuver the growth of the AKP.

Ever since the establishment of the Turkish Republic, secularism has been a red line in their politics, although today the secular establishment deemed it obligatory to allow the AKP greater representation, compared to thirty to forty years ago where any attempt by Islamists to capture power was foiled and deterred.

Due to the developments which have taken place in the past few decades in Turkey and the region, the military, which is the most influential source of the secular establishment, has not been at liberty to dictate the political culture of the country according to their visions. With the growth of Islamic movements, both philanthropic and political, along with leftist currents and Kurdish insurgency, the stance of Turkey’s military was forced to be moderated.

The question of which side in the political arena is following the just cause is a matter of deeper political analysis. What is meant to be addressed here, however, is whether the cohesion predicted could take shape through embracing pluralism in a society where many remain disillusioned or intolerant. The positive aspect of the AKP leading the government was that the main Islamic current moved closer to a line of moderation, meaning that the compatibility of Islam and democracy could have been demonstrated.

Furthermore, the presence of two main political trends, a secular and a religiously oriented one, gave the impression to many observers and politicians in the European Union that Turkey is moving closer to viable democracy and upping its chances of entering the EU, ignoring the French opinion on the matter.

It is evident that the secular republicans have acknowledged the importance of adopting a more pragmatic policy, provided that the AKP, once in power, assures the rest of the Turkish population that they will be free of schemes to gradually transform Turkey into a Islamic Republic.

The secular Kemalists, on the other hand, might have to use more progressive methods in promoting their culture. This may be achieved first through reforms within their circles, which would work to preserve the presence and importance of the military while being less reliant upon them; second, by acknowledging humanitarian issues like the Armenian genocide and the Kurdish question, without compromising Turkey’s core values and sovereignty.

The Islamists, on their part, are being tested in this era like never before since even the president is from the AKP, which is a precedent. The AKP is in a position whereby they are responsible for the later developments, and may have to demonstrate their dedication of preserving the secular establishment, which has proven, regardless of its flaws, to be the most successful Muslim country to modernize its society and gain a strategic position in a region troubled by war and ethnic conflicts.

A cohesion would only be feasible if both sides compromised their positions on marginal issues, while guarding Turkey’s status as the only modern Muslim nation-state. It seems evident that the military, the constitutional court, and their proxy institutions are more concerned with protecting Turkey’s identity as a secular nation-state prior to potentially entering the EU, contrary to the view that they are not interested in the EU.

Moreover, the recognition of more minority rights may also enable Turkish immigrants in the West, particularly Germany, to be more accepted and vibrant in the cultural and commercial spheres. The AKP could leave a legacy behind if they succeed in entering the EU while consolidating Turkey’s various factions by endorsing national liberal reforms, ensuring the right for every party to participate rather than for each party to function in a revolutionary (AKP, Kurdish parties) and the other in a counter-revolutionary (Republican People’s Party) way and realize the crucial issues facing the country.

The core issue to be resolved at this stage is for both parties to realize the supreme interests of Turkey, both politically and economically, regardless of the difficulties the country has been facing.

The secular establishment should recognize the economic progress that the AKP-led government has been able to shape, while at the same time ensuring the rest of the Turkish population that it is concerned with preserving the secular values modern Turkey is based on. This could be achieved by proving the state institutions, including the military, to be competent in promoting a culture of liberality and tolerance where the AKP can be assimilated and brought closer to moderation, and to tone down the Jacobin rhetoric and practices upon which they have been reliant on for decades.

Having said the latter, the secular republicans could be seen as a credible force by the European Union and may eventually widen the umbrella of the Western powers (NATO, EU) over Turkey where culture and economics are interchanged freely and constructively.

By Dr. Priyan P. Khakhar is assistant Professor MME Track Olayan School of Business

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Editorial

The winds of change

by Yasser Akkaoui
written by Yasser Akkaoui

Summer is the period when the Middle East harvests the fruits of its hard labors. It is the time when families travel, head to the mountains, and hit the beach. It is a time when they might splash out on those luxury goods with which we reward ourselves: the watches, the cars, the clothes, even the holiday.

And yet even amid the conspicuous consumption of the oil rich statelets, the realities of life in the Middle East do not lie far beneath the surface of the polo clubs, the malls, the hotels, the racetracks and the beach resorts. On June 16, the MI6 branch of British intelligence picked up a coded warning of an imminent terror attack on Dubai. Yes Dubai, the third most popular holiday resort among British holidaymakers and currently coveted as the ideal location for emigration among westerners eager to escape the taxes, gloominess, mediocrity and urban crime of their own nations.

And yet on the cover — and inside — the May 26 issue of Time, the Middle East was portrayed in two distinct colors: the black of a Lebanon newly plunged into civil conflict and the white of a GCC — epitomized by Dubai’s iconic Burj al Arab —  as the affluent counterpoint to a Levant in turmoil with Beirut as the new epicenter.

But what may have been a marketable cover for Time ignores the reality. It is a reality that functions in shades rather than colour. Lebanon may be fragile: there is no government yet and the security situation as witnessed in the more remote areas of the country is uncertain. And yet in Beirut, full of post-Doha euphoria and a new president, the capital gears itself up for what it hopes will be a bumper summer.

In another corner of the spectrum, the GCC appears to go from strength to strength. Oil price margins fuel private equity funds, steel and glass rise out of the sand and the Gulf societies bask in unprecedented attention from western nations anxious to plant corporate, cultural and educational roots in countries they see as both allies and part of a strategic gateway to the eastern markets of the future. And yet we had that irritating warning from MI6.

What protects the whole Middle East is not only a commitment to economic prosperity but one that is underpinned with an equal commitment to security. In a region in which there are many players — let us not forget that the team sheet also includes the US, Israel, Syria and Iran — with many agendas, the winds of change can shift.

We must learn to trim our sails accordingly.

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Banking & Finance

Money Matters by BLOMINVEST Bank

by Executive Staff
written by Executive Staff

Regional stock market indices

Regional currency rates

Syria to collect $550 million from mobile operators in 2008

The Syrian government has forecasted $550 million in revenues from the country’s two mobile operators, MTN and Syriatel. The new figure represents a 31% increase over the 2007 collection due to the build, operate and transfer (BOT) nature of the project. This entitles the government to collect 50% of the revenues instead of 40% in 2007. The Syrian Telecommunication Establishment (STE), a state-owned monopoly fixed-line operator, collects the royalties on behalf of the government. STE, which is expected to have a $1.2 billion of revenues in 2008, is planning on investing $1.5 billion over the next five years in expanding its fixed-line network into remote parts of the country.

Citigroup inks $2.8 billion Yemeni gas project

Yemen’s $2.8 billion gas-liquefication plant, considered the country’s biggest financed project, has been finalized by Citigroup ahead of its June deadline. The project will be financed by a number of entities that include: $120 million loan from Japan Bank for International Development, $400 million loan from Export Import Bank of South Korea, an additional $1.1 billion loan from the French export credit agency Coface. The seven mandated lead mangers will also provide another $1.1 billion in loans. The lead managers are Tokyo-Mitsubishi Bank, BNP Paribas, Citigroup, ING, Royal Bank of Scotland, Société Générale and Sumitomo Mitsui Banking Corporation.

Egypt’s inflation at 15.5%

The Economist Intelligence Unit (EIU) has forecasted an average 15.5% inflation this year, from 9.7% in 2007. The surge in inflation comes at a time of increasing oil prices where the Egyptian government increased fuel prices by 57%, 32% and 35% for 95 octane, 92 and 90 octane fuels respectively. Diesel prices also rose by 47%. Tax on tobacco was increased by 10%. The hikes in fuel prices and cigarettes taxes were implemented to offset increases in public sector wages and subsidies.

The EIU is also forecasting inflation to peek to 22% this year and gradually decrease to 9.1% in 2009. The Egyptian Central Bank has made inflation targeting its main policy and is likely to use monetary measures to curb inflation. The Central Bank has already raised interest rates three times this year with overnight deposit and lending rates standing at 10% and 12% respectively. Rates are likely to be raised by no more than 100 basis points in the coming 18 months in the wake of balancing economic growth and inflation control.

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Financial Indicators

Global economic data

by Executive Staff
written by Executive Staff

Educational attainment of recent immigrants

Percentage of foreign-born labor force and of the native-born labor force aged 25-34 and 25-64 with a tertiary qualification (2005)

Source: OECD

In many emigration countries, emigrants tend to be of higher educational attainment than the general population. This is because emigration involves certain costs, which are more easily borne by persons with higher education and presumably higher incomes, and because highly educated persons are more “tuned in” to opportunities abroad. Whether or not emigrants are more highly educated than the native-born populations of the countries they are moving to, however, depends in part on the history of immigration in these countries, the needs of their labor markets and the returns to different levels of education in destination countries relative to those in the countries of origin.

Recent arrivals to OECD countries who are in the labor force are in some countries more and in others less educated than the native-born labor force. Immigrants to southern Europe, Finland, the Netherlands and the United States in particular tend to show lower levels of tertiary attainment than both the native-born labor force and younger (25-34) native-born recent entrants to the labor force. In France, Belgium and Scandinavia, on the other hand, recent arrivals tend to have relatively more persons with tertiary education in the labor force than the native-born, but less than native-born persons 25-34. Finally, in Austria, Luxembourg, Switzerland, Central Europe and Ireland, the percentage of persons with tertiary education is higher among recent immigrants than among both the native-born labor force and native-born recent entrants to the labor force. Migration to these countries and in particular to Ireland, Luxembourg and Switzerland, is especially highly educated.

Producer Price Indices (PPI)

PPI: manufacturing (average annual growth in percentage)

Compared with consumer prices, producer prices have risen more slowly throughout the period 1993-2006, for OECD in total by 3%. More than half of OECD countries recorded average annual increases of under 2.5% and in two countries, Japan, and Switzerland, producer prices were actually lower at the end of the period than in 1993. All countries recorded unusually sharp rises in 1995, 2000 and 2005-2006 due to sharp movements in world commodity prices. For the Czech Republic, Hungary, Mexico, Poland and Turkey, very high growth rates in the first 3-year period have been replaced by moderate growth in 2003-2006.

Patents

Triadic patent families (number per million inhabitants, 2005)

Source: OECD

Growth during the second half of the 1990s was at a steady 7% a year on average until 2000. The beginning of the 21st century was marked by a slowdown, with patent families increasing by 2% a year on average. The United States, the European Union and Japan show a similar trend, with a stronger deceleration in Japan after 2000. About 53 000 triadic patent families were filed worldwide in 2005, a sharp increase from less than 35 000 in 1995. The United States accounts for 31% of patent families, a loss of around 3 percentage points from its level in 1995 (34.4%); the relative proportion of patent families originating from Europe has also tended to decrease, losing more than 4 percentage points between 1995 and 2005 (to 28.4% in 2005). In contrast, Japan’s share in triadic patent families gained almost 2 percentage points to reach nearly 29% in 2005. When triadic patent families are normalized using total population, Japan, Switzerland, Germany, the Netherlands and Sweden appear as the five most innovative countries in 2005. Ratios for Finland, Israel, Korea, Luxembourg and the United States are above the OECD average (44). Japan has the highest number of patent families per million population (119), followed by Switzerland (107). One of the largest increases between 1995 and 2005, from 7 to 65 patent families per million inhabitants, occurred in Korea. By size, China has less than 0.4 patent families per million population.

Contribution of key activities to aggregate productivity growth

Contributions of key activities to growth of value added per person employed (in percentage, 2000-2006 or latest available year)

Source: OECD

Over the period 2000-2006, “market services” accounted for the bulk of labor productivity growth in many OECD countries. Namely, in Greece, Luxembourg, New-Zealand, Norway, the United Kingdom and the United States, “market services” accounted for over 55% of aggregate labor productivity growth. However, the highest aggregate labor productivity growth performances can still be attributed to the manufacturing sector. This was the case in the Czech Republic, Finland, Korea, the Slovak Republic and Sweden. The contribution of “market services” to labor productivity growth has increased between 1995-2000 and 2000-2006 in Belgium, the Czech Republic, France, Luxembourg and New Zealand. This growing contribution of market services is sometimes linked to an increasing share in total value added, but in the Czech Republic, Japan and New Zealand, for example, it also reflects faster labor productivity growth in the market service sector. However, in several other countries, labor productivity growth in market services has slowed down in the most recent years.

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Financial Indicators

Regional equity markets

by Executive Staff
written by Executive Staff

Beirut SE: Shuaa  (1 month)

Current Year High: 3,423.90  Current Year Low: 1,761.53

The Beirut Stock Exchange was impacted by the latest act in the national political parody, titled approximately “how to form a cabinet.” Shares stayed resilient and Blom Bank’s BSI closed at 2031.83 points on June 26, a healthy improvement of 35.3% from the start of the year. Trading followed sideways trends for a number of stocks, Solidere closed the session above $36 per share, Blom and Audi GDRs closed at $103 and $99.30, respectively, and the common shares of banks Audi, BoB, and Byblos showed slight gains when compared with the end of May while BLC was unchanged and Blom listed shares appreciated by 13.8% between May 28 and June 26. 

Amman SE  (1 month)

Current Year High: 5,043.72  Current Year Low: 3,003.07

The Amman Stock Exchange moved up in early June as if Jordan were nowhere near Asia and immune to any contagion from Far Eastern or Western stock market tremors. The ASE market index crossed one of those famed psychological barriers by climbing beyond 5,000 points June 18 to a new year high of 5043.72 points the following day. Notably, this particular barrier is rather fresh for the Jordanian environment as it derives from the ASE’s new free float index which replaced the weighed index effective from June 8. In the last week of the review period, profit taking and selling moods ahead of the H1 results season erased 395 points from the index which closed at 4648.91 on June 26. Industry stocks led the market and climbed more than 29% between June 1 and 18. APC and JPMC were the focus of sellers after June 18, however, making the insurance sub-index the month’s best gainer, up 15.7%. For easier evaluation of the bourse’s movement in June, the index peak on June 18 was equal to 11,093.9 points in the weighed index.

Abu Dhabi SM  (1 month)

Current Year High: 5,148.49  Current Year Low: 3,327.86

The Abu Dhabi Securities Exchange fared better than the Dubai bourse in June but the largest UAE bourse couldn’t maintain mid-June price levels and the index dropped 1.6% in the course of the month. It closed at 4,957.21 points on June 26, receding below the 5,000 points line after trading above it between late May and June 22. The banking and consumer sub-indices outperformed the general index and ended the review period 3.1% and 1.8% up. Energy was the biggest loser, giving up almost 16% by market close on June 26. Dana Gas weakened to below $0.54 the share but the bigger energy loser was Taqa, which went through a dispute over trading rights for its convertible bonds and slid from $1.09 on June 10 to $0.78 on June 26. In structural terms, the UAE stock exchanges hope for increased listing by family-owned firms as the government announced that minimum flotation requirements for IPOs will be lowered to 25-30% from previously 55%.

Dubai FM  (1 month)

Current Year High: 6,291.87  Current Year Low: 3,968.09

The DFM index line had that downcast look in June that comes from dropping more than any other GCC market in this month. The first four sessions were alright but then things went south and the DFM general index closed at 5,432.43 points on June 26, down 4.3% from its reading at the end of May. With all sectors in the red, banking and insurance did better than other sub-indices whereas consumer staples severely underperformed and ended the period 22.2% down. The UAE, among whose main drawing points for business is the stable political and security environment had a fright minute from a warning by the British Foreign Office that terrorism is now a high danger for the British — and by implication all other — expatriates living in Dubai and other parts of the country. On the day after the terrorism alert was splashed across global media the DFM went down but only by a blip of three quarters of one index point, barely noticeable in the overall drag.

Kuwait SE  (1 month)

Current Year High: 15,654.80            Current Year Low: 12,039.00

The Kuwait Stock Exchange carried its uptrend to further highs, making it six months of consecutive index gains. With a 3.7% rise in the general index from the start of June until its close at 15,562.60 points on June 26, June was even more kind to Kuwaiti investors than each of the two previous months in terms of absolute point gains. The index scaled a new historic high at 15,654.80 on June 24 before dropping a bit ahead of the summer and the results season for the first half of 2008. The banking sector paced market gains early in the month but by the second half of June, industrial and real estate values were the star gainers, respectively adding 8.6% and 7.7% on the month. First Dubai Real Estate Development Co was late June’s top gainer on the KSE, climbing 29% on the week and 9.1% on the day to close June 26 at $4.53. The stock was already on the up when the board on June 25 adopted a proposal to increase the capital by about four-and-a-half times, to $378 million. The increase, if approved by shareholders, will include a 200% bonus shares issue.

Saudi Arabia SE  (1 month)

Current Year High: 11,895.47            Current Year Low: 6,900.50

The Tadawul Index traded sideways but managed a small gain in June and closed at 9581.34 points on June 26. The Saudi Stock Exchange is still down more than 14% since the start of the year but looks much better when one takes a glance to the east where stock market indices on the other side of Asia have been ravaged in the first half of 2008, losing up to 54% in the year to date. In the second half of June, the Saudi hotels, insurance, and banking sectors booked gains while the industrial and retail sub-indices trailed below the market trend. At the end of the review period, news from foiled terror plans for attacking oil facilities at Yanbu and in the Eastern Province caused some instinctive selling that added a downward nudge to the monthly picture. 

Muscat SM  (1 month)

Current Year High: 12,109.10            Current Year Low: 6,309.94

The Muscat Securities Market had a slight net loss of 0.6% when comparing its close of 11,484.23 points on June 26 to the start of the trading month. Intra-month, the MSM index touched a new record high of 12,109.1 points on June 11 before giving up those early June gains in the second part of the month. The MSM’s downward movement in those two weeks was on account of banking stocks while the services sector traded sideways and the industrial sector added further gains between June 11 and 26. Individual stocks showed volatility and by late June there were both limit-up and limit-down movements in the same session. Banking heavyweight Bank Muscat shed 15.2% of its share price from June 5 to 26.

Bahrain SE  (1 month)

Current Year High: 2,902.68  Current Year Low: 2,409.27

The index on the Bahrain Stock Exchange corrected downward by 61 points after recording a year high of 2,902.68 points on June 16. On the month, the index weakened by 1%. The insurance sector was the BSE’s best performing sub-index in June, showing intra-month gains of almost 4% and closing still in positive territory on June 25. Hotels and tourism was the only other sector to stay out of the red while banking slipped in the second half of the period and underperformed the general BSE index. Banking heavyweight Ahli United dropped 6.3%. In the longer-term view, the BSE is moderately up from the start of 2008 and in late June reported the lowest P/E ratio of all GCC bourses at 12.27x.

Doha SM: Qatar  (1 month)

Current Year High: 12,627.32            Current Year Low: 7,340.06

The Doha Securities Market starts June with positive sessions and the index climbs to a June 11 year high of 12,627.32 points. The DSM slides back below 12,000 points and closes at 11,875.09 points on June 26, marking a net loss of 0.1% in the review period. The banking sector led the market up and down through the month, letting the insurance sub-index come out on top as June’s best performer among DSM sub-indices. Industry and services under perform the general index in June. While opposing movements of DSM and KSE in June put the two exchanges on near identical footing in year-to-date share price gains of about 24%, the DSM is still the priciest in the GCC in terms of P/E ratios. In a development which participants hope will boost Doha’s future as regional financial hub, the NYSE Euronext exchanges make a deal with Qatari authorities for buying 25% in the DSM for $250 million; the contract’s completion is expected in the fourth quarter of 2008. 

Tunis SE  (1 month)

Current Year High: 3,059.63  Current Year Low: 2,436.94

The Tunindex conquered a new record high on June 26, closing at 3035.50 points. The closing price represents gains of 2.5% on the month and 17.05% from the start of 2008. During the second half of June, banks traded range bound with the general index while the financial services and consumer goods sub-indices outperformed the market; the industrial index trundled behind. In the year-to-date view, the two financial sub-indices — financial services and financial companies — rocked, with gains of 57.3% and 23.3%. Shares of Assad, a battery manufacturer, continued to gain in June and ended the review period at twice the price they traded at at the end of April. Assad and global manufacturer of industrial batteries, Enersys, announced a manufacturing joint venture.

Casablanca SE All Shares  (1 month)

Current Year High: 14,925.99            Current Year Low: 11,271.35

Perched on its hyper-valuation of 33.3 times price to earnings, the Casablanca Stock Exchange crept sideways and a bit downwards into the summer. The index closed at 14,188.96 on June 26, down by 328 points from the start of June. Market cap leaders Maroc Telecom and Attijariwafa Bank moved with the downward trend in June. While the Moroccan financial market’s relative isolationism as affecting local investors continues to distort the picture, the economy’s overall outlook of above 5% in 2008 and 5.5% in 2009 offers encouraging perspectives for the second half of this year.

Cairo SE: Hermes  (1 month)

Current Year High: 103,313.60          Current Year Low: 67,011.50

The Cairo and Alexandria Stock Exchanges in June didn’t make it out of the doldrums which the Egyptian had slipped into in May when the government announced an end to certain industrial subsidies and tax breaks. A 7,500 points fall in the EFG Hermes index in June to the close of 87,814.12 points on June 26 meant that the bourse dropped into the red on its year-to-date record and ended the review period 5.3% down when compared with the beginning of 2008. Market heavyweights Orascom Construction Holding and Orascom Telecom Holding shed 4.9% and 11.5%, respectively, between June 1 and June 26. At the end of the period, the market suffered another hit on the short-term confidence front when it was announced that the sale of Banque du Caire did not go through as planned because the government deemed the $2.025 billion valuation of BDC implied in the offer by top bidder National Bank of Greece as too low. 

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Economic diversification and the road to sustainable development

by Richard Shediac, Rabih AbouchakraChadi N.Moujaes & Mazen Ramsay
written by Richard Shediac, Rabih AbouchakraChadi N.Moujaes & Mazen Ramsay

A strong, sustainable economy enhances a nation’s standard of living, creates wealth and jobs, encourages the development of new knowledge and technology and helps ensure a stable political climate. Economic diversity across a wide range of profitable sectors and sustainability are intrinsically linked, and are key to a sustainable economy. Economic diversification can also reduce a nation’s economic volatility and increase its real activity performance.

Can diversification drive sustainability?
Many Gulf Cooperation Council (GCC) countries are “transforming” their economies from being based on a single commodity to being robust, diversified ones. Hydrocarbon rich GCC countries, with economies heavily dependent on oil and gas, face sizeable challenges in diversifying. It is therefore opportune to highlight the need to create sustainable economies.
As such, closely examining GCC economies, G7 economies, and transformation economies (Hong Kong, Ireland, New Zealand, Norway, Singapore, and South Korea) enabled the evaluation of trends in and potential relationships between economic diversification and subsequent sustainability.

Evaluating economic diversification
Three key findings were established during the analysis of economic diversification.
1. Gross Domestic Product (GDP) should be distributed across sectors
Economic concentration and diversification was assessed by analyzing whether GDP was distributed across a wide variety of economic sectors — or across a few. This evaluation determines a “concentration ratio” and a “diversification quotient”. The concentration ratio measures a nation’s concentration in a given sector, while the diversification quotient is the inverse of the concentration ratio — providing an innovative metric that policymakers can use to gauge economic diversity. The lower the concentration ratio and the higher the diversification quotient, the more diversified is a nation’s economy. Results showed that GCC countries have the highest concentrations in terms of sector contribution to GDP and thus the lowest diversification quotients due to the historic dominance by the oil and gas sector.
Growth in non-oil sectors reflects spillover effects from increased oil receipts and subsequent record-high inflows of capital. These cannot be considered inherently sustainable because of dependency on the dominant sector’s fortunes in the marketplace. GCC countries’ non-oil sectors have not fully matured and still have pervasive structural gaps. This suggests revenues from oil and gas are not being reinvested effectively in GCC countries, but instead are being used to fund nations’ internal (i.e. local) economies, rather than external ones.
Therefore an economy with a strong foundation in export helps insulate against unexpected changes in the domestic economy, and insulates against volatility of oil and gas prices and the subsequent knock-on effects.

2. Concentration is not inevitable in hydrocarbon-rich economies
Many GCC economies, especially larger ones, have been susceptible to such changes in oil prices. In the KSA, GDP growth has been driven by the oil and gas sector, but has varied over the years due to oil price changes and shocks. Growth in non-oil sectors has also varied due to fluctuations in oil prices. This suggests “contagion effects” — the tendency of failure in one economic or financial arena to spill over into other arenas.
The UAE’s GDP growth has been driven mainly by the oil and gas sector. Nonetheless, the UAE has recently experienced relative improvement in non-oil sectors as a result of Dubai’s efforts toward economic diversification. Only 5% of Dubai’s GDP came from the oil and gas sector in 2005. In neighboring Abu Dhabi, the Emirate drew 59% of its 2005 GDP from oil and gas, and growth in non-oil sectors continues to lag.
Being hydrocarbon-rich does not predestine economic concentration. Sustained, robust policies focused on diversification can make large differences in an economy, and nations rich in any single commodity must be particularly attentive to the issue of diversification to avoid a natural tendency toward economic concentration. Beyond the need of building a solid economic base that would endure after natural resources expire, economic diversification is key to shielding domestic economies from underpinning and relatively uncontrollable risk factors related to global demand and supply shocks.

3. Labor distribution should support growth
Employment distribution generally reflects and shapes GDP distribution across sectors. In the GCC, employment is distributed unevenly, compared to G7 and transformation economies with employment balanced across a variety of profitable sectors. The oil and gas sector, producing 47% of GCC countries’ GDP, provides work for only 1% of the employed population, with the majority of the workforce employed in sectors relatively less economically productive and of secondary strategic importance. In reality, government services constitute around 20% of total GCC employment, while a majority of workers are laboring for the support of other economic sectors, rather than being the key drivers of growth themselves.

Evaluating economic sustainability
Measuring the relationship between economic diversification and sustainability highlighted a statistically significant relationship between the two. A collection of analyses measuring productivity and competitiveness and the relation of economic volatility to concentration, employment, and economic performance, resulted in a number of key findings:

Poor economic diversity is linked to low productivity and competitiveness
Productivity is directly related to competitiveness; the more people and/or capital it takes to do a job or create a product, the lower productivity is, which in turn raises the product’s price and lowers its potential for competition in the marketplace. GDP labor productivity in GCC countries in 2005 was $1.6 million per employee for the oil and gas sector but only $9,300 per employee for construction. GDP-to-credit capital productivity was $121 million per unit of credit for the oil and gas sector but only $1.2 million for construction.
Labor and capital productivity are key measures of sustainable economic development. As such, poor economic diversification — the over reliance on a single dominant economic sector — has an unfavorable effect on the productivity and competitiveness of other lagging sectors.
Underperformance is persistent across GCC economies and productive sectors. Even in the oil and gas sector, GCC output per employee remains low, suggesting inefficiencies or less-than-ideal production processes. The achieved gains in labor and capital productivities have mostly been visible in the oil and gas sectors and limited in others.

High economic concentration leads to volatile growth and fluctuating economic cycles
High economic concentration makes an economy vulnerable to events like price changes in the dominant commodity. Price shocks have resulted in fluctuating business cycles, as economies respond to rises and dips in the price of oil and the spillover of volatility from oil to non-oil sectors. This sensitivity is manifest in all sectors that contribute to the bulk of economic output and employment. A high level of volatility hinders sustainable economic growth, because periods of prosperity generally do not fully offset the negative structural effects of bad times. Economic shocks have a long-lasting negative effect.

Volatility in concentrated economies may spawn structural unemployment issues and engenders systemic risks
Elevated volatility in GCC countries is highest in economic sectors that employ most of those nations’ populations. High volatility causes frequent unemployment, resulting in high structural unemployment rates — i.e. unemployment because available laborers do not have the skills or knowledge for the available jobs. Workers with particular knowledge and skill sets cannot easily be moved to different sectors of the economy.
Volatility in non-oil sectors in the GCC region has relatively been on a downward trend over time. Nevertheless, this reduction could be more the result of there being fewer total shocks, rather than the result of effective diversification.

External trade helps reduce economic volatility
Pervasive volatility can be decreased with the development and diversification of high value-added exports of goods and services, especially for economies based on a single commodity. When non-oil exports are mapped against real activity volatility, an inverse relationship is revealed between external trade diversification and economic uncertainty — the higher and more diversified a country’s exports, the lower its volatility. High but concentrated economic growth will be outweighed by excessive volatility leading to low risk-adjusted performance if diversity is not effectively implemented. This phenomenon can be captured by a revisited version of the Sharpe ratio, which measures an economy’s risk-adjusted performance.
On average, transformation economies increase volatility by 1% with growth of 2.52%; in comparison, GCC economies increase volatility by 1% with growth of just 0.69%. For GCC economies, any increase in growth inherently increases economic risk rather than economic reward.

Diversification is a critical component of a sustainable economy
How can economies that have relied on the export of a single commodity reduce volatility and achieve sustainability? Is economic diversification a key part of accomplishing this?
The study compared GDP growth volatility against economic concentration and GDP reward-to-volatility ratio (i.e. the Sharpe ratio) against the diversification quotient. The results revealed a clear link between economic diversification and sustainable development.
Nations, like those in the GCC, with a high concentration ratio suffer from higher growth volatility than G7 or transformation nations. Nations with a high diversification quotient like Norway, South Korea, and Ireland enjoy a high Sharpe ratio — a high economic return per unit of volatility.
Regression estimators in the analysis are significant. About 30% of variation in GDP growth volatility and reward- to-volatility ratio is captured by single independent variables — economic concentration and diversification. The remaining 70% of the variation not explained by the regression can be explained by other factors — oil prices, inflation, exchange rates, investor and consumer confidence, general asset price shocks, and so forth. Many of these are difficult for policymakers to directly influence, while economic diversification is measurable, monitorable, and a critical component of a sustainable economy.

Effecting sustainable development: summary of key findings
and recommendations for policymakers
• GCC economies are the most concentrated and inadequately diversified. Hydrocarbon-rich nations are not necessarily doomed to poor economic diversification, as shown by the paragon economies of Norway and to a certain extent Canada.
• Employment distribution is balanced in G7 and transformation economies, but skewed toward low-value- added sectors in the GCC economies.
• High economic concentration exposes economies to external or exogenous events like changes in oil prices, which creates economic volatility.
• Overall volatility and subsequent spillover effects can be mitigated with the effective development and diversification of high-value-added exports.
• Volatility minimization and risk-adjusted real activity performance improvement can be achieved with increased economic diversification.
Policymakers must focus on economic diversification when creating development agendas, and must rigorously measure and monitor economic diversity in evaluating the success of their policies. Specifically, policymakers should pursue the following courses:
• Diversify economic bases in terms of output and input distributions. Stakeholders should incentivize injection of labor and capital into productive economic sectors, as well as the development of new knowledge and technology.
• Foster the growth of the external sector by exporting a wide range of high value-added goods and services internationally.
• Enhance productivity and competitive levels of the economic base, through resources and strategic investments, including enhancing human and financial capital, technology and knowledge to entrench innovation. Innovation allows economies to create high economic value from almost nothing as a starting point. This said, although preparing the ground and establishing the prerequisites and underpinnings of an innovation economy should be initiated at early transformation stages, the effective generation of economic output out of innovation sectors should come as a natural phase in an economy’s transformation path. A premature reliance on innovation sectors is likely to minimize chances of success and expose a not-yet-immunized economy to harmful and disruptive competition.
• Use the metrics of economic concentration and diversification, as well as economic sustainability and uncertainty, as targets when determining policy.
• Monitor and devise clear diversification strategies and mechanisms to mitigate economic volatility and spillover effects, uncertainty, and perturbed business cycle transitions.
These steps will help policymakers create long-term, sustainable growth in their economies to help ensure stability and a high standard of living for their nations.

RICHARD SHEDIAC is a partner at Booz Allen Hamilton who leads the firm’s public sector and health businesses throughout the Middle East

RABIH ABOUCHAKRA and CHADI N. MOUJAES are principals at Booz Allen Hamilton

MAZEN RAMSAY NAJJAR is an associate at Booz Allen Hamilton

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Wealth begets more wealth for luxury brands and stocks

by Fadi Eid
written by Fadi Eid

Luxury goods are in vogue like never before. In fact, 2007 was a record year for many manufacturers of luxury items. The share prices of these companies have also benefited, with luxury stocks having easily outperformed the Morgan Stanley Global Equity Index over the last six years. Many structural indicators suggest that this trend is set to continue.

The luxury goods industry continues to benefit from the fact that the rich continue to get richer. As a result, more and more money is spent on luxury goods. This phenomenon manifests itself strongly in the US, where the top 20% of earners account for 60% of total US income. Where assets are concerned the picture is even more extreme, with the wealthiest 1% owning 40% of total US assets. In the first three months of 2008, sales of high- end luxury goods in the US continued to display double- digit growth for most companies. At least, where high-end consumer goods are concerned, the anticipated slowdown in consumption has not been felt.

Not only is the luxury goods industry growing fast, it is also a very profitable business. This is hardly surprising given that luxury products tend to beautiful, of very high quality, but also very expensive. Consumers are evidently willing to pay a disproportionately high amount for the products of renowned luxury brands, not least because they are perceived to confer prestige and social distinction. Strong brands can thus dictate their prices. In historical terms, the prices of luxury goods have even risen faster than inflation, something that is only possible in very few industry sectors. As a result of the price-setting power enjoyed by luxury brands, the luxury goods business can be very lucrative, but here too, there are winners and losers.

Branding Is Key
What makes for a successful luxury brand? What luxury goods manufacturers represent good investment bets? For every company in the luxury goods industry, branding is the be-all and end-all. But owning a brand is just the beginning. There are countless examples of brands that have either been sold too expensively — and therefore never really made money — or successful brands that were not properly looked after, and even diluted. A successfully managed brand will display at least the following four characteristics.

First, a luxury brand must brook no compromises when it comes to product quality. Luxury consumers are prepared to spend large sums of money on brands, but in return they expect top quality when it comes to material, production processes and service. For example, the Kelly or Birkin handbags from Hermès will set the purchaser back more than 5,000 Swiss francs ($4,800). Despite these hefty price tags, these products have waiting lists. In return, the purchaser is assured of exclusive leather, painstaking hand-stitching and the right to have the bag repaired, even after many years.

Second, the brand needs to be clearly positioned. Every brand sends out a message that differentiates its products from those of other brands. Competition in the motorbike industry is strong. There are many manufacturers of motorbikes competing for the favor of bikers. But those who buy a Harley-Davidson acquire not just a motorbike, but also the Harley-Davidson lifestyle: freedom, independence and America. In this respect, Harley-Davidson has virtually no competition.

Third, successful brands are famous for their continuity. Consumers have expectations of the brands they buy. The Four Seasons hotel chain is renowned for its good service. All staff is subjected to a harsh training process designed to ensure that guests are satisfied in return. The hotel’s internal guidelines are very strict and highly client-focused. This is the only way the hotel’s high prices can be justified. The hotel’s guests can have high expectations, and will not be disappointed.

Innovation as sales argument
Finally, perhaps the most important of all the features of a successful brand is its ability to innovate. Consumers of luxury goods are quite sophisticated, and need to be continually seduced by new and attractive products to buy. After all, how many women nowadays actually need another new handbag? How many affluent men do not already own a watch? The proportion of new products in overall sales volumes is often considerable, depending on the brand and the product. The Porsche Cayenne, for example, launched just a few years ago, today accounts for more than a third of all Porsche models sold.

Hence the appeal of investing in luxury stocks. What are the opportunities and risks? The fundamentals appear outstanding. In Asia and the emerging markets, the number of consumers wanting to buy Western luxury brands is rising every day. The luxury product business generates so much cash flow that most companies have healthy balance sheets with very little indebtedness. The operating margin is often over 15%. Though among other things, this will depend on how much is spent on brand maintenance and marketing.

Luxury goods firms are currently spending large sums of money. Tapping into new markets requires great marketing expenditure, and this can often account for up to 40% of sales revenues. The smaller the brand, the proportionally greater the marketing investment. This is where large companies, which enjoy economies of scale, can benefit most.

The same is true of the opening of luxury boutiques, for which only the most expensive and most coveted locations can be considered. These investments in the future of brands are both necessary and good business. However, unexpected events such as the outbreak of bird flu or other unforeseeable crises can lead to short-term collapses in sales in the luxury goods industry, with consequences for profit margins.

Another risk — albeit more for the much more volatile luxury stocks than the luxury goods industry itself — is a further strengthening of European currencies against the dollar and the Asian currencies. The fact is that most luxury goods companies continue to manufacture the majority of their products in Europe, yet export them around the world. Exchange rate fluctuations can be compensated for through price adjustments over the long term, however. In recent years, investors in luxury goods stocks have made handsome profits. Given the healthy fundamentals of the luxury goods industry, it is only fair to assume that this will continue to be the case in future.

Fady Eid is General Manager for Credit Suisse (Lebanon Finance) S.A.L

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What is so Islamic about Islamic Banking?

by Nada Abdelsater-Abusamra
written by Nada Abdelsater-Abusamra

The Islamic banking industry has grown impressively during a short period of time. In the early 1960s, the Islamic finance sector witnessed a steady growth in different aspects such as size, complexity of the transactions, and internal processes. It has been estimated that the sector is witnessing a 15% to 20 % annual growth rate (10% of which is in the Gulf region). One of the reasons pertaining to this growth — but certainly not the only reason — is the huge amount of petro-dollars following the rapid increase in oil prices.

Islamic finance now exists in more than 75 countries with more than 300 Islamic financial institutions and Islamic windows operating globally. According to McKinsey & Co, it is estimated that this sector will attain $1 trillion in assets by 2010. Currently, this sector is estimated at more than $500 billion in assets. The success of Islamic banking prompted many multinational conventional banks to offer Islamic financial services. For instance, HSBC, Citibank, and Deutsche Bank are already providing such services worldwide. So what is so different about Islamic banking and what is so “Islamic” about it? Is conventional banking non-Islamic? And is Islamic banking non-conventional?

Answering these questions warrants an in-depth analysis of Islamic Finance which is clearly beyond the scope of this article. This article aims at introducing, from a legal perspective, basic concepts of Islamic finance.

Some have questioned the rationale of distinguishing between Islamic and conventional finance with a skeptical approach advocating that there were no real differences between the two systems. However, the Islamic banking industry is different from conventional banking in several aspects of its core legal features even though some Islamic banking operations may ultimately lead to the same results as conventional banking operations.

The fact that the same result may be reached in both systems does not mean that both systems are identical. An expressive example was used by Professor Mahmoud Amin El- Gamal from Rice University when comparing an “Islamic finance contract” to a “marriage contract”. Whether the “marriage contract” is held under Islamic or civil law, this will lead in both cases to two persons being married and forming a family. In certain respects, “a marriage is a marriage” and “a “financial contract is a financial contract.”

Does this mean that Islamic marriage is identical to civil marriage only because both lead to the same result? The answer is “of course not.” In Islamic marriage (and similarly in Islamic leases), the contract must comply with additional requirements warranted by the sharia. As with marriage, the outer form of an Islamic lease (for example) may seem to a casual observer to be identical to a regular lease. However, recognizing the differences requires alertness to the legal requirements of sharia.

Fundamental principles
We shall now turn to some fundamental principles of Islamic banking including the prohibition of riba, the requirement to structure transactions according to Islamic compliant vehicles and invest in halal activities, the concept of Profit and Loss Sharing schemes, and the prohibition of gharar (uncertainty).

In Islamic banking, no interest (riba) is paid or charged for any transaction or service. In other terms, one cannot make “money from money.” According to Islam, prohibition of riba ensures justice, welfare and non-exploitation of the other party’s weaknesses.

However, an increase in business activity derived from invested money is not riba. Taken as a “trade” activity, investment is not only permitted by sharia, but it is also encouraged. This is taken from the hadith whereby “a man’s labor and every legitimate sale” are the best forms of income generation. This shows the necessity to clearly define what constitutes a “prohibited” interest (i.e. riba). In addition, the prohibition of interest is not the only “Islamic finance rule”. In fact the Islamic financial system is supported by other key principles consecrated by sharia such as risk sharing, trade, property of rights and the “sanctity of contracts”.

Second, investments of an Islamic bank must be channeled to approved (halal) sectors, and such by using Islamic structures of finance such as mudaraba, musharaka, bai- muajjal, bai-salam, and ajar among others.

Third, Islamic banking deals with the Profit and Loss Sharing (PLS) scheme. In fact, the financer or investor usually shares in the profits or losses arising out of the enterprise’s business where the money is invested with other contributing parties. This concept is derived from sharia, where Islamic finance is based on the belief that the provider and the user of capital should share the risk of business.

Fourth, gharar (uncertainty, risk or speculation) is prohibited under sharia. Consequently, the contracting parties should have perfect knowledge of the counter values intended to be exchanged as a result of their transactions. For instance, maysar (gambling) is prohibited by sharia law since it involves speculation and uncertainty. At this level, a distinction should be made between gharar and “risk” as such. In fact, according to Islamic principles not only is risk permitted but risk must be inherent to any profit. In other terms, reward must be accompanied by risk. For example, this is why investment in stock is permissible (market risk) while investment in bonds is not (credit risk).

In addition to the above, several points are worth noting when addressing the particularities of Islamic banks such as the principle of non-guaranteed investments as well as the most common Islamic vehicles.

Value of investment not guaranteed
Islamic banks neither guarantee the capital value of investment nor the return on investment except in the case of mismanagement or negligence. These banks mainly pool funds provided by the “depositors” (account holders) and therefore provide them with professional investment management (whilst conventional banks guarantee the depositors’ fund and provide them with a fixed interest rate). From this perspective and due to the application of the PLS scheme, Islamic banks may viewed as being in a better position than conventional banks in absorbing external shocks. This is because they have the ability to reduce the capital value of investment deposits in the case of loss, thus transferring part of the loss to the investment accounts of the investors.

As for Islamic legal vehicles, these include murabaha or mark-up financing, accounting for 75% of Islamic financial activities, where the seller adds a cost plus to the initial price of the acquired product. Another well-known instrument is mudaraba or profit sharing where the rabb al- mal (capital owner) provides the total amount needed to finance a project while the entrepreneur offers his labor and expertise. Another instrument is musharaka or equity participation where the bank enters into an equity partnership agreement with one or more partners to jointly finance an investment project. Profits and losses are shared strictly in relation to the respective capital contributions. Other tools include ijara (lease), salam (deferred payment), and sukuk (Islamic bonds).

The use of the above described Islamic legal vehicles is not limited to Islamic banking, nor should Islamic banking be viewed as the only component of Islamic finance. Islamic finance is much broader and forms part of a comprehensive financial and legal system. As such this system also encompasses financial intermediation, financial markets, funds, insurance, and other financial and non-financial transactions.

However, the legal and technical framework of these systems needs further elaboration and development. The implications of corporate governance, risks, systemic risks as well as other considerations need to be addressed by regulators and appropriate best practice Islamic standards have started to be developed.

In addition, capital market players (as well as regulators) need to take cognizance of the importance of Islamic finance compliance notably in the context of an IPO. In this respect Islamic Investment criteria (also referred to as sharia “filters” or “screens”) have been developed by Islamic law scholars as well as international financial institutions. The most widespread sharia “filters” or “screens” are the ones adopted by the Dow Jones Islamic Market Indices, Standard & Poor’s Islamic Indices, the Bahrain-based Accounting and Auditing Organization for Islamic Banks and Organizations (AAOIFI), FTSE’s indices, the Malaysian Securities and Exchange Commission, Meezan Bank of Pakistan and many other private and public institutions in Saudi Arabia, Kuwait, the United Arab Emirates and other Arab and Muslim countries including also Iran.

 

Nada Abdelsater-Abusamra is a corporate and finance attorney admitted to the courts of Beirut and courts of New York. She is a lecturer of law at the American University of Beirut and speaker on Islamic Finance in international conferences. She advises regulators as well as private and public financial institutions on Islamic Finance. Bassem Dagher is a legal counsel and holds an MBA from the American University of Beirut.

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